The Facts on Trade Deficits…

A common refrain this political season from both sides of the political spectrum is concern with American trade deficits.  This is especially true with our alleged trade deficit with China.

Using the American and Chinese trade imbalance as an example, a trade deficit occurs when the people of the United States buy more goods from China than the Chinese buy from us.  But is this really a deficit?

If you were to ask each of the current candidates for president if a deficit existed in our trade with China, they would unhesitatingly answer in the affirmative.  Unfortunately, they’d all be wrong!

There can be no trade deficit in a true economic sense.  It’s nothing more than an accounting fiction.

So let’s take a closer look at so-called trade imbalances…

I live in a small coastal town in Florida where we have a single grocery store.  I buy most of my groceries from this store, and since I buy more from my grocer than he buys from me, I have a trade imbalance with my grocer. Truth be told, my grocer buys nothing from me, so our trade imbalance is completely skewed to the grocer.

But here’s the point…

Despite the appearance of a huge trade imbalance with my grocer, none actually exists.

You see, when I buy $100 worth of groceries, my goods account (groceries) rises by $100, while my capital account (bank account) falls by $100.  For the grocery store, it is the reverse: his goods account falls by $100 and his capital account rises by $100.

Now if I’m a candidate for political office trying to score points with a special interest group, I would turn everyone’s attention to the goods accounts, which on the surface look imbalanced by $100.

But that’s like looking at one side of your check register to see how much money you have in the bank.  You have to reconcile the income against outflows to determine the actual balance.  And this is true in my relationship with my grocer.  If we include both sides of the register (goods account and capital account), we’re perfectly balanced.  And everyone’s happy… except the politicians and those who believe their nonsense.

These folks harp on the idea that trade deficits are bad and trade surpluses are good.   But that’s contradicted by the large trade surpluses the United States held in the 1930s, which did nothing to keep us from the Great Depression.  During this time, the U.S. had a current account trade surplus in nine of the 10 years of the Great Depression, with 1936 being the lone exception.

It’s also true that the United States has had current account deficits from 1790 right up to the present time.   Need you be reminded that we grew from a relatively poor country to the richest and most powerful nation in the history of mankind?  How is this possible in light of the fear that trade imbalances engender in our political classes?

Perhaps, economies are far more complex than politicians or central bankers care to admit.  They’re certainly too complex to draw causal relationships between trade deficits and economic growth.

Now, before you let someone say that foreign trade differs materially from domestic trade, don’t fall for the lie.  Foreign trade operates under the same general principles as domestic trade.

So when someone decries the $366 billion trade deficit we had with China at the end of 2015, a closer look at both sides of the register will show that the Chinese used their surplus capital account to purchase our capital goods, such as corporate stocks, bonds and U.S. Treasury debt instruments.

In other words, the deficit on our current account was exactly matched by the surplus in our capital account, which consists of U.S. Treasury debt held by foreigners. In the end, our trade was balanced.

Ironically, if we didn’t have a goods deficit with China, they wouldn’t have had the capital to buy our treasuries.  Just think for a moment.  The government wouldn’t have had the resources to bail out bankers, car makers, and union thugs during the Great Recession if it weren’t for our trade deficits.  In a way, we should thank the Chinese for allowing us to continue operating while effectively bankrupt!


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