Statistical Illusions

by Don Boudreaux on February 25, 2006

in Trade

The argument – or, at least, my argument, and I dare say Arnold Kling’s argument – that the trade deficit is a red herring is not an argument that an individual, a family, or a firm that consistently spends more than it earns need not worry. Nor is it an argument that the level of savings and investment doesn’t matter. Nor is it an argument against the proposition that Uncle Sam’s profligate spending is wasteful and harmful.

Instead, the argument is that any nation that is reasonably free and open is not a salient economic unit.

Suppose that South Dakota and North Dakota each cede from the U.S.  Each of these former states is now an independent country. One is the Republic of South Dakota; the other is the Republic of North Dakota. Happily for the citizens of each of these countries, their respective governments leave them free to trade domestically and internationally – but, for whatever reason, the people of each country of Dakota choose voluntarily not to trade with citizens of the other Dakota. (This last assumption is made only to keep the arithmetic of this example clean, as I hope will become clear below; it is not at all necessary for the validity of my point.)

Further suppose that for each of the past several years citizens of the Republic of South Dakota export $150 worth of goods and services and import $110. Statisticians working for the government of the Republic of South Dakota find that this country runs an annual current-account surplus of $40.

But the citizens of the Republic of North Dakota, for each of the past several years, export $100 and import $160. Statisticians for the Republic of North Dakota find that this country runs an annual current-account deficit of $60.

Conventional wisdom says that South Dakotans’ trade is “sustainable,” while North Dakotans’ trade is “unsustainable.” This wisdom praises South Dakotans for their thriftiness and enterprise, and warns North Dakotans of their profligacy.

Now let the two countries merge politically to form the independent Republic of the Dakotas. Let each person’s, each family’s, each firm’s – as well as the now-unified-government’s – income-earning activities, spending, saving, and investment practices remain unchanged in light of this political unification.

Statisticians for the newly formed Republic of the Dakotas will find that this country runs an annual current-account deficit of $20. The reason is that total exports are $250 (made up of $150 worth of exports from the southern part of the country and $100 of exports from the northern part) and total imports are $270 (made up of $110 imports into the southern part of the country and $160 imports into the northern part).

Is the welfare of any citizen of the Republic of the Dakotas materially changed because each now lives in a country that officially runs a current-account deficit? Were Dakotans in the southern part of the country in sound economic health before the political unification but now in economic distress after unification? Are people in the northern part of the country better off after unification because now their country’s current-account deficit is only $20 (rather than the $60 that is was before unification)?

Answers: no, and no.

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{ 7 comments }

spencer February 25, 2006 at 3:22 pm

You need to build more assumptions into your model. For example, do they have separate monetary and fiscal policies, is one or both running massive government deficits, or is the currency of one country massively overvalued? You are not providing enough information to answer the questions you raise.

tarran February 25, 2006 at 8:47 pm

The implication was that everything is the same except people's preferences. The southerners taken as a whole produce more either because they work harder and the northerners as a whole produce less becasue maybe they take long siesta's or use less efficient equipment.

The point is that borders are, economically speaking arbitrary. West Virginia is not poorer than California because of a trade deficit, it is poorer because for various cultural, geographical and political reasons, West Virginans as a whole are less productive. It is the productivity that determines wealth, not the "trade" deficit.

Put another way, there is no trade deficit. If you and I echange items in trade, let us say I sell you 4 lbs of apples in exchange for a piece of paper with $20.00 written on it, we both have benefitted; you value the apples more than that piece of paper, and I value the piece of paper more than the apples. Now, I have this piece of paper that I can either , consume, trade for something else, stockpile, or invest.

If I consume the paper, perhaps by burning it, then you are not any worse off, since you have your apples.

If I trade it back to you for something else, again you benefit because presumambly the thing I buy is worth less to you than that piece of paper.

If I invest it, then the capital goods it purchases will make somebody somewhere more productive, allowing them to ptroduce more goods that eventually will result in more wealth being available to consume, which will be more or less to your benefit.

If I take the piece of paper and stockpile it, it just means I do one of the earlier three things later.

The pieces of paper we are trading to the Chinese should be a concern, not because they are stockpiling these pieces of paper, but rather because the Federal reserve is producing pieces of paper that are not actualy backed by any wealth.

Since we are forced at gunpoint to use those pieces of paper in trade (The phrase 'This note is legal tender for all debts public and private' is one of the most destructive threats aimed at people in the U.S.), in effect we are being robbed of our purchasing power by the Federal Reserve. Who ends up holding the newly printed bills is irrelevant. Even if China was still behind the bamboo curtain, and the goods we purchase from China were instead made in Alabama, the fact that someone was piling up pieces of paper that were not backed by actual wealth that would be the danger.

FBAC February 25, 2006 at 9:09 pm

If a family makes 80K/year and spends 100K/year, then they will soon find themselves drowning in debt. That basic fact is probably why people think a trade deficit matters. Of course, a country is not a family. Countries can print money out of thin air and can't get arrested. :)

Note: If family A has a deficit of 20k/year, family B saves 10k/year, and they join together ala the Brady Bunch, then family AB will have a deficit of 10k/year. And they will be in debt. You can increase the number of people involved, and they can be considered neighbors or states instead of families, but the basic math works the same – although in large groups it is quite possible to be personally fiscally sound.

Don Lloyd February 26, 2006 at 1:18 am

Tarran,

"…The pieces of paper we are trading to the Chinese should be a concern, not because they are stockpiling these pieces of paper, but rather because the Federal reserve is producing pieces of paper that are not actualy backed by any wealth…."

This is a misconception, although probably mostly of technical interest. The key point about the supply of money of any type is the broadly defined profitability of its production. If anyone or any entity can produce money with a perceived marginal benefit that exceeds its perceived marginal costs, both financial and political, then it is a good bet
that new money will be incrementally produced.

The backing of money with wealth is at least irrelevant, if it's even possible.

There is no essential difference between China holding stockpiled dollars in a dollar standard world and holding stockpiled gold in a gold standard world. Once the gold has been mined and stored, all of its costs are sunk costs. If China, or the US, for that matter, uses part of its stockpile to bid up the prices of the labor and components used in the building of an aircraft carrier, for example, the question of gold or dollars doesn't come up.

China must continue to stockpile dollars if it wants to continue to have Chinese-made products appear on the shelves of Walmart stores. One effect of this is that the Fed is not required to immediately pay the price that would otherwise be involved with its highly inflationist monetary policy.

Regards, Don

tarran February 26, 2006 at 9:19 am

Don,

I don't completely agree with you, although being I tyro I could be misunderstanding the terminology.

In indirect exchange, when someone trades X for Y, intending then to trade Y for Z, and they, and the vast majority of the actors in the economy have no other use for Y, Y becomes the currency, the money used.

If someone produces a large quantity of Y and introduces it into circulation, it can cause price inflation. This happened with gold in the Mediterranian when the king of Mali went on a Hajj several centuries ago and spent huge quantities of gold in the Egyptian markets.

The danger I alluded to was in the threat on every dollar bill which requires you to accept it in trade if offered. If I were to show up at your store offering to pay you in Continentals, you would laugh in my face and refuse to accept them. Thus, it does not matter if someone prints lots of new ones.

Similarly, let us assume that there was a free-market for money, in that people could choose what they use for it. Then, perhaps one day everyone but the silver-cranks use gold. Then someone discovers how to pump gold out of the earth's mantle* rendering it much more plentiful, and then people switch to using some other scarce commodity like platinum.

The chief weapon against inflation is the ability of economic actors to abandon the inflated currency.

It is the political systems that deny us this freedom that I rail against.

*I made this idea up. I'm sure it is geologically impossible.

Don Lloyd February 26, 2006 at 10:20 am

Tarran,

Most of what you say is true, but the market value of money is the result of a demand to hold money, and is not directly related to its involvement in actual transactions.

The supply of money is important because every bit of money is always owned by someone. This is what gives money its economic scarcity value. The supply of money will tend to increase when anyone or any organization has both the capability to produce new money and the expectation that doing so will leave them better off in their own judgment. The increase will likely have occurred even if the expectation is proven to be false in the event.

Paper dollars would be better than gold, from a restraint of supply POV, if the Fed and the Treasury knew that if the supply of dollars increased by more than 0.05% in any year, then the top Fed and Treasury officials would be summarily executed. This is one reason why China at least has the potential to pursue a possibly superior monetary policy.

Regards, Don

Helen's_kid February 26, 2006 at 10:41 am

If I invest in something, I, generally, have no say in how that capital is used. The share of my interest is out weighed by the share of other investors. I am only interested in a profitable return of my investment. That is to say, the return of my investment plus a profit. If I am a major investor, then I can attach conditions to how my capital is used, since my share outweighs the share of others. The same holds true for foreign investors…like China. As China increases it's share of investment it also increases it's voice in how things run.

Evidence of Chinese influence in our affairs can be found as far back as the Tianamen Square episode, when congress granted China Most Favored Nation Status. Microsoft bent to the Chinese will and now Google is submitting to Chinese will. A light bulb should turn on in your head. You buy Chinese products long enough and they'll tell you what flavor of toothpaste you like. Let them reform their political system befor you enter into trade with them.

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