Stop Worrying About the Trade Deficit

by Don Boudreaux on February 10, 2006

in Trade

Today at Tech Central Station you can read this new essay of mine explaining why Americans shouldn’t worry about the U.S. trade deficit.

What we — indeed, what people everywhere — should instead worry about is the fact that misunderstanding of the trade deficit fuels the fires of protectionism.

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Kevin February 10, 2006 at 9:11 am

**** [DB:] But doesn't a higher trade deficit mean that Americans are sinking more deeply into debt? Not at all. A trade deficit isn't debt. My young son, for example, received for Christmas several Chinese-made toys. These were bought with cash. *****

One thing I'd love to see an economist comment on is where wealth-creation fits into this. People seem to accept it as an accounting identity that the trade/current account deficit must be financed by debt or by foreign investment.

But isn't new wealth created? Can't that wealth be instantiated as "money"? Can't that money be used to pay for imports? Am I missing something here?

Chairman Don no doubt creates wealth in his activities, and some of that wealth flows through to his paycheck, part of which was used to buy his kid's Chinese toys. Don didn't necessarily go into debt or sell an asset to buy toys. Am I understanding this right?

Charlie February 10, 2006 at 11:31 am

I think the problem is the US does export a lot of debt. Not just the US gov't. There's a lot of corporate debt and mortgage backed securities being exported too. The interest payments on debt in the past has been net positive for the US, but it's about to go net negative and once it does, it will rapidly go more and more negative unless we can somehow balance our current account deficit. I think the only long term solution is for the US gov't to print a lot of money to pay off the debt since it's doubtful the US will be able to increse exports enough to bring the CAD back to neutral or a stable pct of GDP.

I see a future of high inflation, a greatly devalued dollar and high interest rates. It may not occur for a few years, but occur it will.

spencer February 10, 2006 at 12:07 pm

The trade deficit is just the way the old original concept of "crowding out" works in an open economy. At its heart it is driven by the federal deficit. The original crowding out scenario assumed the US was a closed economy and that large structural govt deficit would force up rates and crowd out economic sectors sensitive to higher rates. But because of foreign capital inflows it did not work this way. Rather, the crowding out was of sectors subject to international competition.

John Dewey February 10, 2006 at 12:18 pm


I think you're saying that exported debt, government and corporate, is an impending problem, right? Are you including foreign purchases of corporate bonds and mortagage securities as part of that problem? What's the problem?

My investment advisors consistently recommend that I invest in Asia and Europe. Why shouldn't we expect Europeans and Asians to also diversify by investing in the U.S.? Doesn't that indicate they believe in the long term strength of the U.S. economy? Why do they have more confidence than the U.S. doomsayers?

Steve Podraza February 10, 2006 at 2:12 pm

I'm really trying to understand this issue. Help me make sense of two things I read today in a USA today story about this.

First, it said that the trade deficit "had to be financed" through public debt. This sounds misleading to the point of being an outright lie, if what you are saying is correct.

Second, it said that if foreigners are holding dollars or US stocks, they could decide they don't want them anymore and dump them, making the value of the dollar and US stocks "plummet".

Why are these statements wrong?

Aaron Krowne February 10, 2006 at 2:16 pm


I think you're conflating the abstract fact that a trade deficit is not /necessarily/ bad with concrete reality that it can be lead to "bad" behavior; i.e., malinvestment, distortion of the labor market, and so forth.

I think a trade deficit is much like Keynesian budget deficit-running: a little bit for localized periods of time is fine and even beneficial, but a lot over long periods of time is cause for concern.

Moderation in all things is important. I have yet to find a counter-example of this maxim, even in economics. The idea seems to not be popular in the West. But to ignore the extremes that have been attained in the present global imbalance by latching onto theoretical benefits which are likely in the minority is truly to place one's head firmly in the sand.

By the way, anyone who thinks that inflated equity values in real estate are "OK" because the majority of the financing is fixed is wrong. Someone holds those low-yield mortgage portfolios, and they may soon find themselves in a more inflationary environment. Suddenly these investments won't look so sweet for investors–the institutional side which will clamour for state bail-out, and the individual side (in retirement portfolios and so forth) which will just be the little guy getting screwed again.

Max Born February 10, 2006 at 2:55 pm

Here is a thought experiment that can help clarify things. Imagine tomorrow we discover 10 trillion tons of gold in America owned by various American citizens. And as the news spreads Indians (who love gold) and Chinese feel the desire to own some of it. Suddenly, the Indians and Chinese will start using the dollars they earn from selling us stuff (software, pens, cars) to buy some gold assets (not as exports but as a stake in our gold assets as investment).

In today's method of looking at things, our trade deficit would shoot to $1 trillion. And many would cry that America is in trouble when in reality our national net worth just went up by $9 trillion in gold assets and $1 trillion in cash.

How does this analogy relate to today's world?

Well, America has been creating 'gold' assets by inventing chips, software, designing cars, new processes for chemicals, new drugs etc. Our national 'net worth' has gone up by trillions of dollars over the last 50 years. And some foreigners are eager to own some of that gold assets in exchange for cash that they earn by providing us valuable services.

I guess the key metric I would be interested in (if I were a nationalist)is what is the Net Worth of the planet earth and what %-age of that net worth is owned by Americans. Just the value of land owned by Americans is worth more than the entire major economies of the world.

Max Born February 10, 2006 at 3:03 pm

The statements are wrong as follows.

Trade deficit does not have to be financed through public debt. In fact, trade deficit does not need any financing. If you buy a 10% interest in my taxicab (invest in my taxicab business) and in exchange you pay me $5000 not in cash but by giving me $5000 worth of a used car. In trade deficit terms, since I imported $5000 worth of a used car I have a $5000 trade deficit. But it does not have to be financed as it is 'paid for' by me selling you a small fraction of my taxicab business. I bought a car and in exchange gave you a 10% interest in my business- deal done. Nothing to do with the government whether or not we live in the same country.

Yes foreigners can dump stocks i.e., sell them. But so can Americans. What if all Americans with blonde hair dumped stocks- it would hurt the value of the stocks. All humans (and companies) that own stocks can potentially sell them- it happens everyday on the stock market. Foreigners are no different.

the Radical February 10, 2006 at 3:06 pm

"Moderation in all things is important. I have yet to find a counter-example of this maxim"–Aaron

So a moderate amount of theft, murder, rape and child molestation is OK?

the Radical February 10, 2006 at 3:14 pm

Correct me if I am wrong, but don't we necessarily import capital when we export debt? This capital is used to create additional wealth. In this way, even if debt did have to be "financed", it would finance itself through capital wealth creation. This follows a simple rule of capital: no one is going to take on a debt liability at 10% if the capital is only going to yield an 8% profit. The only reason we would borrow from foreigners is if we believed that we would make a profit from the additional (borrowed) capital that was higher than the cost of borrowing that capital.

Don Boudreaux February 10, 2006 at 3:20 pm

In response to Steve's second question, here's a letter that I sent on Wednesday to the Washington Times:

8 February 2006

The Editor, The Washington Times

To the Editor:

Mark Skousen worries about the amount of dollars and U.S. debt held by foreigners. "If foreign investors decide to place their funds elsewhere, we could face a sharply declining dollar, a stock market crash, or worse," Skousen says ("American Dream Putting Homeowners in Deep Debt," Feb. 8).

Perhaps. But this problem has nothing to do with the nationality of people holding dollar-denominated assets. Even if every cent of U.S. cash and debt were owned exclusively by Americans, the dollar would fall, the stock market would crash, and interest rates would skyrocket if Americans decided "to place their funds elsewhere." Investors' nationality is a red herring.

Donald J. Boudreaux

spencer February 10, 2006 at 3:59 pm

Radical — if we were using the imported debt to finance investment you would be right, but we are using the imported capital largely to finance current consumption. so we are not creating the means to repay the debt.

Steve –the trade deficit has to be financed, but not through public debt.
They are two different things, although they are closely related.

And to my mind this is the problem with your analysis Don, it is based on the assumption that the foreign borrowing is used to finance investment when most of it is used to finance current consumption.

Steve Podraza February 10, 2006 at 4:10 pm


Imagine the government balanced the budget and stopped buying debt abroad or at home.

In this alternate universe, the US is still running a trade deficit, only know it is for the reasons Boudreaux describes. Any reason to worry now?

Steve Podraza February 10, 2006 at 4:12 pm

that should read "only now it is for the reasons…" sorry.

Kevin February 10, 2006 at 4:17 pm

Steve, a similar incorrect statement (or maybe same one) in the AP article currently on the wires:

"The rising trade deficits must be financed by increased borrowing from foreigners…"

A matter of fact statement, flatly incorrect. The AP writer also quotes 2 people, a union leader and Democrat Senator — both quite breathless in their doomsaying — but choses not to quote any Republican, or Economist, or anyone who possesses any knowledge of economics.

John Pertz February 10, 2006 at 4:46 pm

"Radical — if we were using the imported debt to finance investment you would be right, but we are using the imported capital largely to finance current consumption. so we are not creating the means to repay the debt."Spencer

Dont know about that one. There was a recent piece in a business weekly that talked about how the current acount deficit in this country probably isnt something to be worried about. They used the ipod as an example and said that there were millions of dollars that went into its creation however none of those r and d dollars are counted in the investment ledger for the US under the current acounting system. However, China received the tally in their investment column because they are produced in China. This idea of the U.S facing certain crisis due to lack of investment seems like a nonstarter to me because of I think the Macro acounting methods pioneered by Simon Kuznets in the thirties are antiquated. This is extremely problematic because its lending credence to doomsayers and the political class who want nothing more than to be able to describe a problematic situation so that they can have amunition for their plans. I think the information age is proving that we need to reevaluate our accounting procedures as it pertains to current investment.

Tom February 10, 2006 at 6:00 pm

I think the R&D dollars are accounted for. Ipods are manufactured in China for $20, sold here for $100. Value of R&D = 80- marketing – profit.

If they couldn't make money on the R&D, then it was valueless.

R&D is not reflected as an investment because it's value is 0 until a profit is made on it. At that point it is counted under profit.

the Radical February 10, 2006 at 9:20 pm

Apologies in advance for the lengnth of this post.

Politicians, labor leaders and members of the MSM who whine about trade deficits are, I believe, are implying three things: 1) we should buy more products and services from Americans and less from foreigners, e.g. more Fords and less Toyotas (the 2 Toyotas we own were built in the US); 2) we should keep our capital at home and reject foreign capital; and 3) any negative effects of the borrowing necessitated by the fiscal irresponsibility on the part of politicians and bureaucats should be blamed on big business and forigners. A further implication is that to believe otherwise is nonsensical, unpatriotic or, the cardinal sin, "anti-worker". This is evidenced by the constant effort to tie Chinese made products sold at Wal-Mart to supposed trade woes as well as the mention in every MSM story about the decline of Ford and GM of these companies inability to compete with "foreign" auto makers.

As usual, protectionist politicians and the labor leaders who own them are wrong. We do not need to "buy American", restrict capital mobility or blame government spending on foreigners (except maybe foreign aid, but that's another thread for another day). What we do need to do is reign in government spending.

Deficits are not the same as debt; only part of the deficit figures represent debt. The amount of the trade deficit that is debt can be divided into two columns; borrowing for government spending and private borrowing for reinvestment. The former column is consumption borrowing, the latter investment borrowing. Even though some government spending is investment (in roads, dams etc.) that does create wealth, most of that column represents money that is essentially blown. The debt in the second column represents invested capital which creates wealth and "finances" itself. It is true that the debt in the first column is entirely unsustainable: this is not, however, because foreign deficits or debt are unsustainible. Foreign debt incurred by the government is a unsustainable because excessive government spending is unsustainable no matter how it is financed.

I believe that Don is arguing against those politicians and labor leaders who cry foul trade deficits and foreign debt incurred by private foreign trade and borrowing. Those who whine about foreign debt are talking about debts and deficits in the business investment column which I mentioned above. As such, they are wrong. The debt part of foreign deficits used for investment is acceptable and sustainable, that used for government consumption spending is not. If foreign deficits are a problem it is for the sole reason that the government spent too much and dug itself into a hole, the nationality of the creditor in this situation makes no diference. Far from needing more protetionism, what we need is less government.

Russell Nelson February 11, 2006 at 2:38 am

Spencer: be more careful about what you call capital consumption. What if some amount of the increased productivity of the American worker is imputable to the money spent by workers on leisure activities? What looks like consumption would then be investment.

quadrupole February 11, 2006 at 3:44 am

There is also a *lot* of corporate debt that is sold as a means to avoid repatriating assets. If a company repatriates the earnings of their foreign subsidiary, they must pay 35% tax on it. If they sell bonds to their foreign subsidiary, they owe no tax, and are effectively paying interest to themselves. There are a lot of other games played there. If you really want to eliminate the trade deficit, allow companies to repatriate foreign earnings tax free.

WMCW February 11, 2006 at 8:29 am

Assuming that we think that economics is a scientific disciplinne I would like to make the following non-nationalistic questions:
How do we know if an economic policy is right or wrong from economics science point of view? Would you involve national interest as an important matter in this criteria? How can it be possible to believe in economic freedom and to let prevail national interest over systemic (international) interest to assess economic policy? Would you change your ideas if you were chinese?
Actually I believe that David Ricardo was not only interested in England but in free trade (England plus Portugal)


spencer February 11, 2006 at 9:39 am

The driving force behind the trade deficit is the idenity that the current account deficit has to equal the domestic savings –investment gap. We have a very large domestic saving-investment gap for two reasons. One is the structural federal deficit. The second is the sharp drop in personal savings rates. So the foreign capital inflow or the current account defict == two sides of the same coin that have to equal === is a function of these two things. So if we increase personal savings or cut the federal deficit our need for foreign capital to finance the gap will drop. The exchange rate, relative growth rates, and/or the spread between domestic and foreign interest rates will adjust to assure that the new balance is achieved. This is basic fundamental international economics, If you think this is something weird I suggest that you look
at the spread between US and foreign interest rates and the dollar over the last 25 years.

The trade deficit is just the way that crowding out works in an open economy.

spencer February 11, 2006 at 9:52 am

I completely agree with Don's conclusion
about protectionism but disagree with the cause of the problem. Politicians caused the problem to begin with by creating the structural federal deficit and protectionism is just the natural outcome of the original problem.

spencer February 11, 2006 at 12:34 pm

Steve asked –Imagine the government balanced the budget and stopped buying debt abroad or at home.

I do not have to imagine it, it happened in the late 1990s. So what happened. We had an investment boom where nonresidencial fixed investment rose to a record share of gdp. When you look at how it was financed almost half of the financing came from the government surplus and foreign capital inflows. Normally in the US economy virtually all of nonresidential fixed investment is financed by corporate savings.

Stefan Karlsson February 11, 2006 at 12:52 pm

Don, your article would have been right on the mark hadn't it been based on the implicit assumption ( that you made explicit elsewhere ) that the United States have a sound monetary system which don't distort prices and thus economic behavior. But unfortunately, this assumption is false as Alan Greenspan have pushed down interest rates below their free market level which in turn have created a housing price bubble something which in turn have contributed to increasing the trade deficit.

The trade deficit is not the basic problem here, but it is a symptom of the distortions created by the Fed's inflationary policies.

Don Boudreaux February 11, 2006 at 1:04 pm


I concede that no monetary policy will ever be as good as the results of free banking.

But I don't believe that the U.S. trade deficit is a symptom of the Fed's inflationary policies. Such policies — to the extent that they exist — would make dollar-denominated assets less desirable to hold, not more desirable. That is, an inflationary dollar policy would reduce rather than increase the U.S. trade deficit.

Don Boudreaux February 11, 2006 at 1:09 pm

P.S. to my last post:

Being no great adherent of rational-expectations theory, I concede that people can be fooled by inflationary monetary policies for a time — that they might invest in dollar-denominated assets (whose nominal values are rising because of inflation) because these investors are duped into believing that these assets are truly more highly valued in real terms.

But the U.S. has run a trade deficit for thirty straight years. It's implausible to suppose that the bulk of this trade deficit is the result of people being misled so deeply for so long by inflationary monetary policy.

Stefan Karlsson February 11, 2006 at 5:28 pm

Don, A inflationary monetary policy will increase the trade deficit because of the simple fact that if you lower interest rates this will discourage savings and encourage investments. A increase in investments combined with a decrease in savings means a increase in the trade deficit (or decrease in trade surplus or shift from trade surplus to trade deficit, depending on what the original situation was, but for simplicity I simply say "increased trade deficit"). It is true that this effect will to some extent be mitigated by the fact that such a policy will put strong downward pressure on the local currency in foreign exchange markets, and a lower real exchange rate will of course reduce the trade deficit.

But there is theoretical reasons for believing that the net effect will still be
a increased trade deficit, since a depreciation of the real exchange rate will
make foreign investors accept lower yields since the lower real exchange rate creates expectations of a future real appreciation of the currency.

We can also see empirically that there is a
strong correlation between asset price bubbles and trade balance changes. Apart from a brief peak in the mid-1980s driven by Reagan's budget deficits, the U.S. trade deficit were quite modest until the tech stock bubble of the late 1990s . While that bubble have been deflated it have been replaced by a housing bubble.

And it's just not the U.S. Britain, Australia, France, Spain and Italy have seen similar increases in trade deficits correlated with sharp asset price increases. We can from that conclude that the domestic demand increasing effects of inflationary monetary policy overwhelmes the effects of a lower exchange rate- at least as long as the newly created money is used to bid up asset prices.

Charlie February 13, 2006 at 8:51 am

John Dewey,

Maybe If I gave you an anology to what is happening it will be easier to understand…

Imagine one of our creditor countries is like Wal-Mart. I'll choose China as an example. China = Wal-Mart. The US is a Wal-mart customer and we have a Wal-Mart credit card that we use to buy goods from Wal-Mart. We also own Wal-mart stock that pays us dividends.

Over time, our Wal-Mart credit card debt has grown and we continue to pay interest on it, but don't pay off the principal. It's not a big problem because the dividends we get from Wal-Mart cover our interest expenses.

Whenever we reach our credit card limit, Wal-Mart increases our limit because they need us to continue to buy things from them. They send us a nice letter saying they have confidence is our ability to pay off our debt and that's why they keep increasing the limit.

We've hit a critical point in our debt. We are now paying more interest than we are receiving in dividends. This is going to become a big problem because now, for the first time, we will have to start paying to Wal-Mart, monies generated outside of Wal-Mart, which will mean we have less money to spend on non Wal-Mart items. To compound the problem, the interest will start to accumulate and we will have to pay interest on the interest in addition to the principal and this has the potential to grow out of control. In addition, our spending habits have forced us to buy more and more stuff for Wal-mart every year. What's strange is my interest rates have remained low. I would have expected my interest rates to go up as my debt piled up due to increased risk. I wonder what's going on.

I spoke to a Wal-mart representative. Wal-Mart is going to extend our credit even more because they have so much confidence in us and we shouldn't worry because they wouldn't do this unless they thought giving us credit was a good business move for them.

Upon furthur research, I found out that Wal-Mart isn't trying to make a profit off me in the short term. They need me to keep their staff employed. They're willing to lose money off me for a time so that they can use my payments to pay for more and more salaries. Plus, Wal-mart has tons of cash. More cash than they know what to do with, so they are eager to loan it out so they can get something for it. Whatever they make off me is better than just letting the money sit and get nothing. This explains the low interest rates.

John Dewey February 13, 2006 at 12:23 pm


I don't think your simple explanation is relevant to what I asked about. It was the third sentence in your first post that I didn't understand:

"I think the problem is the US does export a lot of debt. Not just the US gov't. There's a lot of corporate debt and mortgage backed securities being exported too."

To me, your first three sentences imply that exporting corporate debt and mortgage backed securities is part of the problem. But your simple explanation doesn't apply to them. Almost all corporations and homeowners do meet their debt obligations.

If you are arguing that the federal government shouldn't be spending more than it takes in, then I will agree with you. But I'm not sure that it makes any difference who buys the government debt. The problem that I see isn't exporting of government debt. The problem is the uncontrolled growth in U.S. government spending.

Charlie February 15, 2006 at 4:30 pm

Sorry I didn't answer your question.

The problem with borrowing from overseas is the interest goes overseas instead of staying in the US. Up until recently, we got at least as much interest as we paid out, but recently our interest payments have started to exceed what we collect in interest. In addition to this, the gap is increasing year after year and will be made much worse as our interest rates go up. It's kind of like an increasing tax that we have to pay to foreigners for financing our deficits.

Up until now, we didn't feel much pain from our deficits but from now on we'll begin to feel pain and it will get worse each year.

Chad August 8, 2007 at 6:17 pm

“Stop worrying about the trade deficit”

Sounds like naivety bordering on ignorance to me.

Forcing a level playing field in world wide trade will ensure that the average US worker is paid 15 to 50 cents per hour for their work.
You might be worth 15 cents an hour but I and most other educated workers will move to another smarter brighter country that will reward work with pay instead of a life of slavery in all but name.

Any USA based manufacturer trying to export to China faces very discriminatory rules on imports, language issues, and overwhelming red tape.
You say that if these barriers are removed all is good.
You overlook the critical factor that the majority of the Chinese population earns a fraction of what U.S. wage earners make, hence they have a fraction of the buying power of a USA consumer. They cannot afford American made products.

Just in case you don't read the news, China is now saying that if the USA tries to level the playing field by introducing similar protections to that which China currently employs against the USA, that they could dump their enormous surplus of USA cash resulting in a crash of the US dollar. (Doesn’t look like they were investing back in the USA does it?)

Your naive utopian outlook on free trade is fine in fairytale land but in the land of reality with corporate greed reaching historical proportions, free trade is only a guarantee of cheap slave labor for multinational companies. One only has to look at the average multinational company to see that the interests of the USA are not in their game plan, rather they are bent on filling their ever-bulging pockets with even more.
You might as a amoral economist think this is wonderful, but for the majority of the world it will mean endless slavery and no hope of escape.

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