Friday, May 27, 2005

Walter Williams: the trade deficit is nothing to worry about

Note, March 23, 2006: I've noticed quite a few people coming to this page in search of Walter J. Williams. My reference is to Walter E. Williams, professor of economics at George Mason University and syndicated columnist.

Walter Williams' latest column, "Our Trade Deficit", is brilliant as usual. And I seem to be in good company, because his initial analogy of buying groceries is one that I've used:
I buy more from my grocer than he buys from me, and I bet it's the same with you and your grocer. That means we have a trade deficit with our grocers. Does our perpetual grocer trade deficit portend doom? If we heeded some pundits and politicians who are talking about our national trade deficit, we might think so. But do we have a trade deficit in the first place? Let's look at it.
This is basically what I've said to my oldest friend, who I'm glad to say is starting to view international trade as not a bad thing.

If you spend $100 at the grocery store, do you worry if the employees there buy $100 worth of goods and services from you (or the business where you work)? Of course not. All that matters is that you can afford to buy the goods you want. Everything balances out in the end, because only your overall trade is important: your trade deficits will be balanced by surpluses.

The U.S. has an overall trade deficit, but it's balanced out by a form of foreign lending. Here's how it works. Americans consumers buy more from China, Japan, et al, than we buy from them. The foreigners stuff some of the dollars in their central banks as reserve holdings. Other dollars they use to buy petroleum, and others they invest right back here. The U.S. continues to attract a great deal of foreign investment because of two decades of nearly constant economic growth (especially the 1990s), while most of the other major economies have had stagnant growth since the start of the century. Since foreigners take our dollars and invest them right back into our businesses, we Americans don't have to save as much to invest in our own companies. That means we wind up with extra money for consumption spending, which often involves cheap foreign goods.

Foreigners meanwhile increase their ownership of our stocks, corporate bonds and real estate. Basically we're trading long-term ownership for a higher standard of living today, which isn't bad per se, just not sustainable at this rate of growth. Eventually the trade deficit will correct itself, probably not to a perfect balance, but certainly not through government trade restrictions. The free market will do it just fine. Update: and remember that foreigners will increase their ownership in terms of absolute dollars, but not as a percentage of total assets. As they contribute to our domestic growth, we'll create even more stocks, corporate bonds and real estate for them to buy. There's no danger of foreigners will "crowd out" domestic ownership.

My personal belief is that as long as the U.S. has sustained economic growth, and Japan and Europe remain in trouble, foreigners will have no problem continuing to invest in the U.S. (whether in business, which sustains the trade deficit, or in Treasury bonds, which sustains the budget deficit). I think the limit is not when foreigners lose confidence in the U.S. -- I doubt that will happen anytime soon. The limit is when the U.S. economy could absorb more foreign savings, but foreigners have already invested all they can.

A depreciating dollar can't really fix the trade gap. It would have to weaken massively to bring net U.S. trade to zero, which, even if that were desirable, isn't going to happen. Dr. Williams brought up a point which, if I may say so in all modesty, I myself have stated before:
What about the possibility of foreigners dumping our debt? Foreigners aren't stupid. Dumping large amounts of Treasury bonds would drive down their value. Foreigners as well as we would take a hit.
Such a massive weakening of the dollar isn't in our interest at all. The macroeconomic effects would be surging interest rates (from reduced demand for the dollar) and a spike in the Consumer Price Index. The CPI is, loosely, "inflation." I've explained before what it really is, and what real inflation is. The CPI is a "basket" of goods and services, includes foreign products. A weaker dollar cannot buy as much foreign goods, so if the dollar goes down, our overall buying power goes down.

There's a macroeconomic theory called the J-curve, which says that when a country's currency weakens, its trade gap will suddenly widen before it shrinks; when plotted on a graph, it looks like a J. The idea is that import prices suddenly rise, and consumers continue to pay those prices at first. But I don't think that applies to the U.S., at least not now. I personally think Larry Kudlow is right about the dollar, that it will regain ground by the end of 2005. The trade deficit is on track to grow faster in 2005 than ever before, which will throw the idea that "the J-curve did it" right out the window.

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