Thank Goodness for Trade Deficits

After hitting a 4-½ year low against the Yen last week, and an all-time low versus the Euro, the media reaction to the dollar's fall was mostly positive. The Wall Street Journal said a weakening dollar would "correct the U.S.'s huge trade deficit." The Journal's view was the consensus view despite voluminous historical evidence that perceived trade imbalances are not corrected by devaluations.

To begin with, the dollar has been falling for the last two years, yet the trade deficit has continued to rise, hitting a record $51 billion in October. In a 1977 study, economist Arthur Laffer researched fifteen currency devaluations, and found that the trade balance of the devaluing country tended to worsen on average.

Dartmouth professor Douglas A. Irwin explains why devaluations don't necessarily work in his book, Free Trade Under Fire. In describing the manufacturing process of a U.S. carmaker, he noted that:

"30 percent of the car's value is due to assembly in Korea, 17.5 percent due to components from Japan, 7.5 percent due to design from Germany, 4 percent due to parts from Taiwan and Singapore, 2.5 percent due to advertising and marketing services from Britain, and 1.5% due to date processing in Ireland. In the end, 37 percent of the production value of this American car comes from the United States."

Irwin's passage shows what the media often miss when commenting on the dollar. Imported inputs are a big factor in the production of any exportable item, and as long as they are, the country that chooses to debase its currency will gain no advantage. If a cheap currency were the path to prosperity, Turkey, Brazil, and Argentina would be world economic powers, while the U.S., England, and China would be basket cases. The opposite is true.

In truth, the problem with trade deficits has nothing to do with the deficits themselves, but instead with the media and political class that continue to misunderstand what they are. The very idea of a trade deficit is a misnomer in that as Irwin points out, "If a country is buying more goods and services from the rest of the world than it is selling, the country must also be selling more assets to the world than it is buying."

The Cato Institute's David Boaz explained the above concept best in his 1997 book, Libertarianism: A Primer. Boaz noted that he ran up trade deficits with his grocer, dentist, and department store, all of which bought nothing from him. On the other hand, Boaz had a trade surplus with his employer, along with the publisher of his book. His point was that all trade must in the end balance, that we produce in order to consume, and that buyers of goods and services must have produced something of value in order to be buyers.

Taking the David Boaz example and applying it to the U.S. as a country, if our citizens are buying more TVs and DVDs from Japan and China, it can only mean that someone, somewhere is buying something of value possessed by U.S. citizens; giving them the means such that they can afford to be such aggressive consumers.

The above-mentioned "means" is foreign investment. If I own a car company and sell a car to a German, the sale is booked as an export. On the other hand, if I sell shares in that same car company to another German, or for that matter an investor in Canada or Japan, the sale is booked as foreign investment, and will not factor into the trade deficit/surplus calculation that has so many so worried.

Given that foreign investment is not counted in the import/export equation, is it any surprise that the Unites States runs a trade deficit? Realistically, it would be extremely scary if we did not. Once again, all trade must balance, and the ability of the United States to consume so much of what the world produces has to do with the world showing enormous investment interest in U.S. based assets.

Because of this, and because of the mostly impressive economic growth of the United States since its founding, the U.S. has almost continuously had a trade deficit. Thank goodness it has, in that the flipside of excessive U.S. consumption of foreign goods is heavy foreign investment in U.S. assets. This is nothing to be ashamed of, or worried about for that matter.

The United States most recently had a trade surplus in 1991. Unsurprisingly we were in a recession in 1991. The U.S. also ran surpluses during the Great Depression.

In short, the U.S. trade deficit is self-correcting in that a reduction of foreign investment will necessarily lead to a reduction of U.S. consumption around the world. The problem is not with trade deficits, but with the negative connotation of the term itself. Arthur Laffer calls trade deficits "capital surpluses" for a reason, in that they're certain evidence that world investors see the United States in an attractive light. We can rid ourselves of trade "deficits," but in doing so we'll also be ridding ourselves of jobs and the investment that creates them.

John Tamny lives in Washington, DC and can be reached at jtamny@yahoo.com