Do trade deficits harm the US economy?

No

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by Iroquois

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On the Trade Deficit

These days professional economists, the Executive Department, the Congress, and our media commentators are continually discoursing on the subject of the trade deficit. While we might expect that the debate would have produced some consensus by now, we know that the issue remains embedded in controversy. The reason for this lies primarily in a misunderstanding of the cause of the trade deficit and of its consequences.

Those who advocate free trade subscribe to the tenets of the "Theory of Comparative Advantage," which holds that, if all nations dedicate their resources to the production of those economic goods in which they are most efficient and trade their surpluses for the other goods they require, there will be a larger availability of economic goods at lower costs for all nations

Unfortunately , in the real world the differential costs of production among nations are not determined on the simple basis of productivity alone, but rather on a complex of considerations in which productivity may be a subordinate constituent. Moreover, the theory ignores altogether other important aspects of international trade. The business transactions among nations involve not only the sale of merchandise and services but also transfers of the ownership of physical and financial assets, as well as the extension of credit, and the activities of central banks in international financial markets.

The so-called trade deficit arises from the fact that the dollar value of our nation's imports of merchandise and services exceeds the value of our exports of them. Conventional wisdom tells us that this deficit is largely the consequence of our producers not being competitive with foreign ones, of artificial barriers erected by other governments against imports of our merchandise, and of their subsidization of their domestic producers. While there is a measure of truth in these conclusions, the fact is that there really is no trade deficit when we include what has become our number one "export"-the sale of U.S. financial assets to foreign interests.

In the 19-year period 1980-98 the cumulative U.S. merchandise trade deficit was $2,326 billion while the cumulative increase in foreign holdings of U.S. assets was $4,046 billion. Take note of the fact that the increase in foreign holdings of U.S. assets exceeded the increase in the trade deficit by $1,720 billion. Clearly this evidences that foreign investments in U.S financial assets occur not as some passive consequence of our trade deficit nor as a default phenomenon. There are two reasons for the high level of foreign investment in U.S. assets. The first is that the U.S. leads the rest of the world in supplying high quality financial assets for investors in a free, transparent, and regulated market. The second reason is that the U.S. dollar has replaced gold and much of the hard currencies of the world as principal reserve assets of foreign central banks.

The funds that have been accruing to foreign interests as a result of the trade deficit have occasioned a diversion of the purchasing power flowing into our commercial markets to our financial markets. This relative shift in the employment of purchasing power is the reason that consumer prices have experienced only modest inflation, that interest rates have declined, and that stock prices have dramatically inflated-all at the same time that the M3 money supply increased by $3,417 billion. While the movement of these prices has been beneficial to our consumers, producers, borrowers, and investors, the employment opportunities in our commercial markets have suffered as a consequence of this reallocation of purchasing power.

Many U.S. manufacturers have closed their plants at home and shifted to foreign based ones or been driven out of business by foreign producers. The resulting loss of domestic production was not necessarily because foreign resources were more productive in any physical sense but rather because the end product could be delivered in our market for a lower cost in U.S. dollars than if it had been manufactured here. One of the primary reasons for this differential has been the low wages and benefits paid to foreign workers in the lesser developed nations. Because of these circumstances, it can be anticipated that the U.S. will continue to experience a shift to foreign sources for those products that are most labor intensive. Other equally important factors in determining the costs of production are taxes and environmental regulations.

The Theory of Comparative Advantage holds that a trade deficit will be only temporary because foreign markets will in time turn to us to supply them with economic goods that they produce least efficiently. Therefore, even though some workers may lose their jobs because the fruits of their labor are purchased abroad, they will in time be re-employed in other industries supplying the foreign markets with our economic goods. Regrettably, these results are not being realized. The fundamental reason for the failure of the Theory to deliver its predicted results is that it does not anticipate the impact of what is purchased with the U.S. dollars earned by countries from their export surpluses with us. The implicit assumption is that in time this money will be used to buy U.S. goods and services that will require alternative U.S. production and replacement employment. But this is not what has happened.

In effect we are trading the jobs of millions of our workers that have been employed in the manufacture of textiles, shoes, electronics, automobiles, and the production of farm products for the sale of our financial assets to foreign investors. While this tradeoff has contributed to a booming stock market, kept interest rates low, and lowered the prices of imported products, it has also contributed to the contraction of employment in domestic manufacturing and farming. There is reason to believe that much of the savings that have been realized from cheaper foreign made goods has been offset by the higher social costs associated with the loss of jobs.

The U.S. dollars earned by other nations from their trade surpluses with us have in fact been used principally to acquire U.S. financial assets. As foreign interests have accumulated savings, their demand for investment opportunities has grown proportionately; and the United States provides the most rewarding and safest haven for investments.

We often hear that we cannot expect the rest of the world to continue to provide us with large amounts of their "capital" to make up for our lack of savings. Here it should be noted that our external debt is denominated in U.S. dollars. So, if foreigners ceased investing in U.S. assets, foreign central banks could avoid accumulating increasing dollar balances only by letting the dollar decline in value relative to their currency. If such a dollar depreciation occurred, foreign countries would import more U.S. goods and services and their exports to the U.S. would decline, either of which would decrease our merchandise trade deficit.

In the end the U.S. dollar has to be spent in the U.S. market-the only place where it is legal tender. Foreign owners of U.S. dollars have only four legitimate choices for their use: they can buy U.S. goods and services, invest them in U.S. based wealth (stocks, bonds, real estate, certificates of deposits, etc.), lend them to others to use for the first two purposes, or hoard them.

If we really want to make our financial and physical assets less attractive to foreigners for investment, we can do so by applying the same taxes on the earnings they produce as U.S. citizens must pay. We could also make foreign goods less competitive with domestic ones by restructuring our tax system so that imported goods will carry much the same tax burden that domestically produced goods must bear. This could be accomplished by substituting a value-added tax for the corporate income tax and the payroll tax, applying it 100% to imports, and exempting our exports-just as other nations do. This change in our tax structure would also do much to reduce the shift of our domestic production abroad.

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