Most economists are extremely alarmed about the effect of the expanding deficit on the current account. In 2004 the deficit stood at $668 billion, or 5.7% of the gross domestic product (GDP). For 2005 we have estimated that the deficit was around $788 billion, or 6.3% of GDP. As a result of the ballooning deficit, the value of US net external liabilities, expressed at historical cost, jumped to $5.1 trillion in 2005 from $4.3 trillion in 2004. As a percentage of GDP, net external liabilities climbed to 41% in 2005 from 37% in the previous year and 4.9% in 1980.
It is held that this increase in foreign debt cannot go on forever. If the Americans do not begin reducing their trade deficit, there will come a time when foreigners will become less willing to hold dollar denominated assets. This in turn will weaken the US dollar. Consequently, once this happens the United States will be forced to increase interest rates (maybe sharply) to continue to attract foreign investments. Higher interest rates in turn will plunge the economy into recession. In short, given the size of the current account deficit it is held that the US dollar has to plunge in a big way against most currencies, and it is not possible to avoid a painful adjustment as a result of this. It would appear that the trade deficit is a major economic problem that must be urgently addressed in order to avoid serious economic disaster.
What information does the trade account provide?
Let us take an American individual who earns his money by exchanging something useful for it — he produces consumer goods. He then decides to exchange the money for some other consumer goods that are manufactured in China. A Chinese producer who has received the American dollars uses them to buy consumer goods from the above American producer; i.e., he is importing from the United States. So what we have here is a situation in which the American producer has paid for the Chinese consumer goods with his saved consumer goods. Likewise the Chinese producer has paid with his saved consumer goods to secure American consumer goods. The American and Chinese trade balances are in balance.
Now let us assume that instead of using the dollars to buy American consumer goods the Chinese producer decides to invest his dollars in US corporate bonds. The US trade account in this case will move into a deficit whilst China's trade account will show a surplus. From the trade deficit perspective, as espoused by the popular way of thinking, this will be seen as bad news since American foreign debt has risen by the size of the deficit.
By its design the national balances of payments do not disclose the transactions that occurred within the economy. The balances of payments only deal with transactions that are external to the economy. In other words, a balance of payments describes how much money a particular country spent on goods from other countries and how much money it received for the goods it sold to other countries. Now, the larger the economy is the less information, as far as economic activity is concerned, can be derived from the balance of payments statement.
On this Mises wrote,
While an individual's balance of payments conveys exhaustive information about his social position, a group's balance discloses much less. It says nothing about the mutual relations between the members of the group. The greater the group is and the less homogeneous its members are, the more defective is the information vouchsafed by the balance of payments. The balance of payments of Denmark tells more about the conditions of the Danes than the United States balance of payments about the conditions of the Americans.1
In the above example one is tempted to conclude that as a result of the trade deficit America's economic fundamentals have deteriorated, or at least there are signs that this may be the case. A closer inspection of what has really happened would show that an American importer has paid for Chinese goods with money that he has earned by producing useful consumer goods.
The fact that the Chinese producer has invested the dollars in American corporate bonds doesn't pose any threat to American economic fundamentals. What we have here is a situation where claims on real savings have been channeled to America Inc. Once these claims are exercised and real savings are employed efficiently it only promotes a further expansion in US real wealth. Is anything wrong with this? All we have here is that instead of buying final American consumer goods, the Chinese producer buys future US goods.
According to Rothbard,
More nonsense has been written about balances of payments than about virtually any other aspect of economics. This has been caused by the failure of economists to ground and build their analysis on individual balances of payments. Instead they have employed such cloudy, holistic concepts as the "national" balance of payment without basing them on individual actions and balances.2
Also, contrary to the popular way of thinking, an emerging trade deficit doesn't mean here that American's are now saving less. We have seen that an American individual has exchanged unconsumed final goods, i.e., saved goods for money — claims on real savings. Now if the Chinese producer transfers the received claims in return for his goods to an American corporation this will lift the pool of real savings at the disposal of Americans. Because real savings were obtained from China — via the import of Chinese consumer goods — in addition to the real savings generated by the American producer.
What matters as far as real economic growth is concerned is real savings. The balance of payments statements, which deal with monetary flows, cannot tell us much about the flow of real savings. For instance, Americans are importing tools and machinery from Japan and exporting consumer goods to Japan. In terms of the net flow of money it turns out that the value of American imports from Japan exceeds exports to Japan — i.e., a trade deficit emerges. The conventional wisdom would argue here that Americans are now saving less and are in fact funded by the Japanese. In reality the exact opposite takes place. Americans are in fact supplying real savings — final consumer goods — to Japanese producers of tools and machinery. In other words, it is the American real savings that in fact support (i.e., fund here) the Japanese producers of capital goods. Observe that Japanese tools and machinery do not as yet produce any real wealth, they are just potential future wealth. Also, note that it is not money that funds economic activity but real savings. Money is just the medium of exchange; it is not however the means of payment, and it never funds anything.
Let us now consider an American individual who borrows money from a bank and uses the dollars to buy goods from China. The bank has transferred money — claims on real savings — to the borrower of money. The bank has obtained the money from some other American producer who instead of exchanging the money for goods has decided to lend them out. Again, if the Chinese producer uses the dollars to buy US corporate bonds or stocks, this will lead to a US trade deficit and to a so-called increase in the US foreign debt, which in turn will be seen as bad news. But all this is just a misguided story. Every transaction here is fully backed up by real wealth or expectations of real wealth. Also, transactions are not enforced and are done willingly by the individuals involved.
Now, if the national balance of payments is an important indicator of economic health, as various economists are saying, one is then tempted to suggest that it would be a sensible idea to have balances of payments of cities and regions. After all, if we could detect the economic malaise in a particular city or a region, the treatment of the national malaise could be made much easier. Imagine that economists in New York City have discovered that their city has a massive trade deficit with Los Angeles. Does this mean that the New York City authorities must step in to enforce the reduction of the deficit? Luckily we do not have balances of payments between cities and it seems that no one is concerned with this issue. Why then be concerned with the so-called international trade account?
According to Rothbard,
It should be clear that the principles applying to the balance of payment of the United States are the same for one region of the country, for one state, for one city, for one block, one house, or one person. Obviously no person or group can suffer only because of an "unfavorable" balance; he or the group can suffer only because of a low level of income or assets.3
Trade account deficits and monetary pumping
Consider an American counterfeiter who uses counterfeit money to buy goods from Japan. The money that he has exchanged is not supported by anything useful. The counterfeiter has produced nothing useful and is not expected to produce anything useful in the future. He is exchanging nothing for money and then he exchanges money for useful Japanese goods. The Japanese producer who gets the fraudulent dollars — unbacked by real-wealth dollars — will have difficulties realizing them for real wealth. The emerging US trade deficit is just an indication that Japanese producers were ripped off.
Obviously, if the Japanese happened to be the earlier recipients of the newly printed dollars, then they could secure American goods at the expense of some other American wealth producers. In this case the US trade account will be well balanced — because the Japanese have managed to import goods from America by exercising their dollar claims on real US goods. Consequently, some economists may even conclude that the net flow of savings is also in healthy shape. However, the story of the trade account here will be false and incomplete because the monetary pumping has been overlooked. American wealth producers are being hurt — prices of inputs are now rising faster than the prices of their products — their ability to produce and to export has weakened. As a result, the flow of real savings, all other things being equal, now comes under pressure. Consequently, as time goes by the trade balance moves into deficit.
Note that the trade deficit here is the result of printing dollars out of "thin air." It mirrors the weakening of the process of real wealth generation. What is then required is not the fixing of the trade deficit but the cessation of the activities of the money counterfeiter. (The economic effect of the central bank's loose monetary policies is exactly the same as that of the private counterfeiter). It must be stressed here that it is not trade deficits that undermine the process of wealth formation but rather the loose monetary policy of the central bank.
While the widening trade deficit is not the cause of the economic illness, it also doesn't lead to a fall in the currency rate of exchange as popular thinking has it. The fundamental determinant of the currency rate of exchange is its relative purchasing power, which in turn mirrors the relative average price in an economy. Here is why.
Price is the amount of money per unit of a good. The average price then will be the amount of money per unit of real stuff in an economy. (We are aware that such an average cannot be computed so we are using this term for illustrative purposes only).
Now, let us assume that there are ten units of real stuff that are traded between the United States and Europe. There are also ten dollars and ten euros — implying that the average price of the real stuff in dollar terms is $1 whilst the average price in euro terms is €1. Consequently, the rate of exchange between the dollar and the euro must gravitate to 1:1. Any deviation from this rate of exchange will give rise to arbitrage actions, which will bring the rate of exchange into accord with the average buying power of money in the respective countries.
If the amount of dollars doubles, and all else remains unchanged, then the average price in dollar terms is going to be $2. This in turn must lead to a rate of exchange of $2 per euro. Note that the state of the US and European trade accounts have no effect on the amount of the real stuff that is traded and it has no effect on the supply of dollars and euros. The trade account statement just records transactions; it doesn't produce or generate anything else.
So if the dollar falls as most economists are suggesting, it would have to happen not on account of the trade deficit but on account of the fact that the rate of dollar printing is going to be much faster than the rate of printing of other country's monies — all other things remaining equal. So far, however, this is not the case. According to the charts below the yearly rate of growth of American money AMS has been trending down since 2005. In contrast the growth momentum of Japanese and the Euro-zone, money AMS has been trending upwards since 2005. Thus in January 2005 the yearly rate of growth of money AMS stood at 7% in the United States, 10.8% in the Euro-zone and 4% in Japan. In December 2005 the yearly rate of growth stood at 2.1% in the United States, 12.2% in the Euro-zone, and 5.4% in Japan.
Our analysis doesn't imply that the US economy is in healthy shape - far from it. However, what we maintain is that the key factor behind the erosion of US fundamentals is not the widening in the trade account as such, but rather the policies of the Fed. During the reign of Alan Greenspan between August 1987 and December 2005, money AMS has increased by 173%. Greenspan's strong monetary pumping was accompanied by a massive artificial lowering of interest rates. The federal funds rate was lowered from 6.5% in 2000 to 1% in 2003. Obviously then such reckless policies must have severely undermined the process of real wealth formation. However, focusing on the trade account statements only diverts the focus of attention from the true culprit behind the erosion of US economic fundamentals.
The habit of pursuing economic analysis in terms of the so-called foreign debt adds another confusion. If an American, Mr. Jones, borrows money from an Australian, Mr. Smith, the entire transaction is their own private affair and is not of concern to any other. Both the American and the Australian are expecting to benefit from this transaction. Lumping individuals' foreign debt into the national foreign debt statistics doesn't make any sense. What is this total supposed to mean? Who owns this debt? What about all the individuals who do not have foreign debt, should they also be responsible for the national foreign debt? The only situation that Americans should be concerned with is if the government incurs a foreign debt. The government is not a wealth creating entity and as such derives its livelihood from the private sector. Consequently, every foreign debt the government incurs means that the private sector will have to foot the bill some time in the future.
Conclusions
Most economists are of the view that the ever-growing US trade deficit and the subsequent expanding foreign debt pose a threat to the well-being of Americans. What is then required, so it is held, is to set in motion policies that will help curtail the widening trade imbalances between the United States and the rest of the world. Focusing on the trade deficit as the supposedly major problem of the US economy only diverts the attention from the real culprit, which is the US central bank.
What matters for the process of wealth formation is the flow of real savings. The balance of payments statement doesn't provide such information. Consequently, it is not possible to determine the implications of a given state of the current account on the well-being of Americans without information regarding the state of the flow of real savings. Therefore various pessimistic assessments regarding the US economy, which are based on the state of the balance of payments, are likely to be without much foundation.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He maintains weekly data on the AMS for subscribers through Man Financial, Australia. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Comment on the Blog.
- 1Ludwig von Mises, Human Action (3rd revised edition, Contemporary Books), p. 451.
- 2Murray N. Rothbard, Man, Economy, and State(Nash Publishing), p. 720.
- 3Ibid., p. 722.
