Isn't the Capital Surplus a Good Thing?
One of the strongest arguments in defense of large US trade deficits1 is to point out that they are the accounting flip side of a net capital inflow to the United States. This is quite effective rhetorically. Although the man on the street passionately believes that we ought to sell more stuff to foreigners than we buy from them, he also believes quite strongly that it's good if foreign companies build factories here, rather than Americans exporting capital abroad. So when we free market economists point out that the two positions are mutually exclusive, that at least causes the protectionist to scratch his head.
In this context, Peter Schiff's recent piece, "Wall Street's Spin-Meisters Are At It Again," is quite delectable. Schiff tackles this pro-deficit argument head on, and sets out a very clear (though clearly wrong) case. Refuting his points will provide an excellent primer on international trade.
Current Account Deficit = Capital Account Surplus
Schiff first positions himself to be sticking up for common sense against the Wall Street fat cats:
To rationalize why trade deficits can be a good thing, Wall Street is pointing to the seemingly positive benefits of the "capital account surplus" that mirrors the deficit. On the surface this seems to make some sense, as most people have positive associations with "surpluses." The thinking goes that our trade "deficit" is O.K. because it is balanced by a "surplus" somewhere else.
Because this is such an important point, let's first make sure we believe and understand it. If Americans spend more on current goods and services sold by foreigners, than foreigners spend on current goods and services sold by Americans, this necessarily means that foreigners must be investing more capital in American assets than vice versa. This isn't an economic theory, but rather an accounting tautology.
There are two easy ways to see this. First think about it in terms of money. Remember that all of these transactions have to be reduced to a common denominator, namely market prices measured in some currency. So to say that the United States is running a trade deficit with the rest of the world means that we are spending more dollars on foreigners' stuff, than the dollar value these foreigners are willing to spend on American output. Hence, the rest-of-the-world gets a growing stockpile of dollar bills.
Now whatever the rest-of-the-world does with this net growth in dollar bills, it constitutes an investment in dollar-denominated assets. If they simply hold them as cash, that counts because the dollar is, well, a dollar-denominated asset. Or (the more likely scenario) the foreigners will use their gain in dollars to buy US assets, such as bonds from Uncle Sam or shares of American corporations.
Note that if the foreigners use the dollars to buy American products, such as a Ford pickup, then that will reduce the US trade deficit. So it is clear that a positive trade deficit must yield a positive capital account surplus, i.e., a net inflow of foreign investment in US assets.
This is such a crucial point, let's forget about money and think in terms of physical goods. To avoid all the complications of comparing apples and oranges (a difficulty that can only be solved by recourse to money prices), suppose that shovels are the only type of good in the world. In this (absurd yet instructive) scenario, a capital account surplus would mean that foreigners send more shovels into the United States than Americans send out; i.e., there would be a net immigration of shovels into the country in a given period of time.
Now what would constitute a trade deficit in this outlandish world? Well, it would mean that Americans bought more shovels from foreign producers, than the number of shovels the rest of the world bought from Americans producers. I.e., a trade deficit would entail a net immigration of shovels into the country in a given period of time.
Notice that this description of a trade deficit was the same thing as our description of a net inflow of capital. This wasn't a coincidence, for they are just different ways of thinking about the same situation. Of course, in the real world there are millions or billions of different types of goods and services. But the relationship between current account deficits and capital account surpluses is the same.
Are Liabilities Always Bad?
Now that we're settled on the tautology, let's see how Schiff derives a catastrophe from it:
However, having a surplus of bad things, such as poverty, hunger, crime, etc., is not a good thing. A capital account surplus is really a surplus of liabilities. This is not a good thing.
It is true that a net inflow of capital represents growing liabilities to foreigners. But is this necessarily bad? After all, there should be a presumption of benignity to each individual transaction, since it is voluntary.
Consider an illustration that I've used elsewhere: Suppose an American entrepreneur wants to start a new firm. He wants to rent out office space, hire a bunch of workers, and buy copiers, computers, fax machines, and other equipment. Unfortunately he doesn't have enough capital saved up to finance his plans, and so he seeks outside investors.
To the rescue come a few Japanese businessmen who give him the money, in exchange for partial ownership of the new firm. To make the tautology stand out, we can suppose that the Japanese literally ship over copiers, faxes, etc., in exchange for the intangible shares of stock that the American sends back over the ocean. Once again, a deficit on the manufactured goods side is counterbalanced by a surplus on the investment side.
Now, is this increase in liabilities to foreigners—after all, the Japanese investors now have a legal claim to future income flows earned by an American firm—a bad thing? The American entrepreneur didn't seem to mind. Yes, he would've preferred to get the capital with no strings, but those wily foreigners usually insist on getting something for their investment.
Before moving on, my typical disclaimer: I don't claim that my hypothetical scenario is representative of our current situation. But it does show that the standard handwringing over the trade deficit is quite simplistic.
Are the Trade Deficits Unsustainable?
I've come to love Schiff's articles, because he often comes up with neat analogies to make his point. (It just so happens that I always consider his analogies to be very bad ones.) True to form, Schiff explains the massive US trade deficits in this way:
If our capital account surplus is good then by extension Japan's capital account deficit must be bad. The difference between creditor and debtor nations is that debtor nations derive their status by running capital account surpluses while creditor nations achieved theirs by running capital account deficits. Does Wall Street really expect us to believe that a nation is better off being a debtor than a creditor?
The situation is analogous to a consumer justifying his purchase of a big screen TV on credit because it is offset by his rising debit balance. The bill the consumer eventually gets is in effect a statement of his capital account surplus. By running a trade deficit with the electronics store, the consumer simultaneously runs a capital account surplus with the retailer as well. He gets their big screen without paying for it (his trade deficit) and the retailer gets his IOU in exchange (his offsetting capital account surplus.)
First, let's deal with Schiff's claim that those of us defending the trade deficits for the United States, must (to be consistent) condemn foreigners for their foolish trade surpluses. No, that's not true, because the situations are different between the United States and those countries with a trade surplus. Really what we apologists are defending is the spontaneous outcome on a free market.
Schiff's argument sounds reasonable at first, but it commits the classic mistake of believing economic value is objective. Consider this: In addition to the US trade deficit, I also defend Joe Blow's decision to spend $25 on a particular DVD. That is, I say that it is entirely defensible that Joe Blow gave up $25 in order to acquire that particular item. Now, does consistency require me to say that the merchant in question was wrong in giving up the DVD in order to acquire the $25?
But back to the main point: Is it really helpful to view the annual trade deficits as a necessary sign of growing indebtedness? In the common parlance, are these massive deficits unsustainable?
Generally speaking, the answer is no. That is, a country could experience trade deficits indefinitely. So long as foreigners wanted to invest more in the country than its people wanted to invest abroad, the trade balance would remain negative.
The problem is that Schiff is viewing the causality in one direction only. He thinks prodigal Americans decide how many TVs, cars, etc. to import from Japan on net, and then issue bonds to make up the difference.
But we can reach the opposite conclusion by going the other way. Suppose prudent Japanese decide how many shares of IBM, Ford, etc. to buy from Americans on net, and then send us TVs, cars, and other goodies to make up the difference. From this perspective, it's clear that Americans are reaping the rewards of having a relatively attractive business climate.
USA: Investor's Haven?
Schiff actually considers this view but rejects it:
[Another Wall Street] argument is that America's capital account surplus exists because returns on American assets are superior to those available elsewhere. This difference supposedly induces foreigners to sell us their products so they can earn the money necessary to invest in our assets. This ignores the fact that for the past seven years U.S. markets have underperformed just about every other market in the world.
Now we've finally hit the point where I've lost patience with Mr. Schiff. Does he really mean to say that these silly foreigners know less about their billions in investments than he does?
The lower rate of return on American assets is a consequence of their superiority (on other grounds). Suppose I said that investors tend to prefer US Treasuries to corporate bonds, because the latter are riskier. Would Schiff refute my claim by pointing to the lower yield on the former?
This isn't a mere pedantic quibble. Surely even Schiff would concede that New York is a better financial center than, say, anywhere in Malaysia. Now how would this superiority manifest itself? Why, it would mean that foreigners would be willing to lend New York financiers money at a certain rate, even though those financiers could earn a higher rate abroad. The differential would show up as a yearly net flow of manufactured goods into the United States as payment for our comparative advantage in financial activity.2
Once again, it's easier to see at the individual level. Suppose a stock speculator spies a company that is undervalued. He invests $100,000 in the company, waits one week, then sells the shares for $105,000. Then he uses the profit to buy his wife a necklace.
His wife, a subscriber to Peter Schiff's newsletter, is quite furious. "How much did you earn selling your labor or merchandise last week?!" she demands. He thinks for a moment and realizes the answer is "None."
The speculator's wife continues with the interrogation: "And how much did you spend on assets this week?" The husband replies that he spent $100,000 on stock shares.
She then demands, "And how much did outsiders spend on assets that you owned during this same time frame?" After a pause—for he's not used to thinking in these terms—the husband informs her that outsiders invested a total of $105,000 in assets that he owned.
The wife starts to tremble with rage. "Do you mean to tell me that you financed this $5,000 bauble purely by increasing your liabilities to people outside of this household??"
I hope my analogies have been at least as amusing as Peter Schiff's. But the ultimate question is, which of our analogies better fits reality? Schiff proudly informs us that he has been warning of the "dangers of America's trade deficit" since at least March of 2005. On the face of it, this is a bit odd; generally speaking, people don't take credit for predictions until they come true.
So let me offer some predictions of my own. In 2007, there won't be a US recession as defined by the NBER. The dollar will be stronger against the euro on December 31 than it was at the beginning of the year. Finally, the spot price of a barrel of oil will be $50 or less.3
For those readers who subscribe to Schiff and other doomsayers, I encourage you to prod them for comparable specificity. Anyone can predict recession if he's not held to a timetable. So does Schiff truly think the "unsustainable" deficit will break this year, or does he really just want you to buy his book on the coming crash?
- 1. For this article, I will use the terms trade deficit and current account deficit interchangeably. This isn't quite accurate, though the differences don't affect the substance of my arguments. For an excellent treatment of these subtleties see Herbert Stein's encyclopedia entry.
- 2. For a fascinating scholarly article on this topic, see the famous "Dark Matter" piece (PDF).
- 3. The one escape hatch I allow myself is a major terrorist attack. In that case, yes, there could very well be a recession and the price of oil might skyrocket. But those effects would have nothing to do with the trade deficit per se. Beyond this caveat, though, my prediction stands. So if oil next Christmas is above $50 because of OPEC, then I'm wrong.