Earlier today I heard Washington Post columnist Robert Samuelson interviewed on WTOP radio (a local all-news/sports/weather channel in DC). Samuelson is usually pretty good, but he — like so many others — fails to understand the trade deficit. He said in this interview (as he says sometimes in his columns) that the trade deficit "must be financed."
That's simply not so.
If Mr. Toyota sells $1 million worth of cars to Americans in 2009, spends $600,000 buying ("current") goods and services — exports — from Americans, and stuffs the remaining $400,000 into his mattress, the U.S. trade deficit rises by $400,000 but there's no more "financing" of this amount going on than if Americans had spent that $1 million buying, not Mr. Toyota's product, but Mr. Chrysler's and Mr. Chrysler had used the proceeds exactly as Mr. Toyota did. The only difference between these two scenarios is that, in the first, the U.S. trade deficit rises while in the second it does not rise.
Ditto if, say, Mr. Toyota used the $400,000 to buy shares of General Electric and 3M — or if he used the $400,000 to buy real-estate in Ohio.
Only if Mr. Toyota lends the $400,000 to Americans is there any financing going on, but even here there isn't necessarily a problem. Is it worse for Entrepreneur Jones in Jacksonville to launch his firm with money borrowed from Mr. Toyota than with money borrowed from, say, Bill Gates? In both cases there's debt. But economically it matters not one whit which government issues the creditor's passport. If the borrowed funds are used wisely, they serve a useful purpose. Period. End of story.
If the borrowed funds do represent a problem, it must be because the debtor went into debt unwisely — say, he borrowed the $400,000 not to launch a new firm but to throw a gigantic party. (Yes, yes. I know that even gigantic parties are not unambiguously wasteful or unwise, but please don't be pedantic with me on this point.) But the problem here, again, is not the nationality of the creditor but the status of the debt — how it was used.
There is a great deficiency in the way even otherwise well-informed pundits think and write about the so-called "trade deficit."
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I believe this is the most beautifully titled blog post in history…
The problem with this scenario is that it assumes an open market and a free flow of capital, which no nation has with Japan.
During the Cold War we shut out one communist country from the marketplace (Soviet Union) while we embraced another (China). How these nations fit into our national security, had a big impact on the economic trajectory of these countries (and certainly Japan's outcome as well). You could go back and come up with a similar comment on Mr. Breshnev, but you probably wouldn't and for good reason.
Likewise, the Japanese view their economic model as first and foremost a function of national security. We might be able to cram Japan into free market economic narrative too, but we wouldn't have a reliable predictor of future outcomes.
Don,
Thank you for that clear explanation. My brother-in-law just completed his macro class at NSEAD, where he was taught that the trade deficit itself is a problem. I forwarded your post to him.
MnM,
Yea, it gave me the most amazing visual of Don's basement…
"Thank you for that clear explanation. My brother-in-law just completed his macro class at NSEAD, where he was taught that the trade deficit itself is a problem."
As I recall, the great depression was a period of trade surpluses. I wonder how they reconcile that …
Right on. Imports are paid for in real money, cash on the barrelhead, more or less.
True, this results in dollars begging for a return, which are only good in the U.S. And it's also true that these tend to be loaned back to the U.S. at whatever rate they'll fetch.
So trade deficits are associated with the creation of debt, but only through the mechanism of "fire sale" interest rates.
It's closer to the mark to say that a trade deficit depends on the availability of a market for debt than to say that it creates debt.
Keep beating this horse, Dr. Boudreaux. I have found this to be one subject that is sorely misunderstood on both the left and the right.
When Mr. Toyota holds U.S. currency, he is "financing" the Federal Reserve. Up until last year, we could say that he was financing the U.S. government, since the Federal Reserve was invested more or less entirely in U.S. government bonds. Today, he would be financing various elements of the Shadow banking system.
It is true, however, that if Mr. Chrysler holds the currency instead, it is the exactly same.
In either case, U.S. consumers get the cars now, and later will have to provide something in exchange to Mr. Toyota or Mr. Chrysler.
In either case, U.S. consumers get the cars now, and later will have to provide something in exchange to Mr. Toyota or Mr. Chrysler. – Bill Woolsey
Bill,
I don't understand your point. The only trade I've made with Mr Toyota or Mr Chrysler is my dollars for their car. Their possession of dollars that used to be mine does not obligate me to them.
Why do you call debt financing "financing," but not equity financing "financing"? Maybe the problem you are having with this dead horse is that your definition of financing isn't the same as everyone else's. M-W dictionary says "finance – to raise or provide funds or capital."
If Mr. Toyota buys a mortgage or a t-bill, he provides money today for interest later. If he buys stock, he provides money today for an expected return. Either way the deficit is financed. The question you really want addressed is whether it's bad that we are consuming now and promising people consumption later.
The question you really want addressed is whether it's bad that we are consuming now and promising people consumption later.
So the question boils down to: are we making positive NPV investments? Good question, Charlie.
One nitpick with regard to creating promises of consumption in the future. Debt financing creates an obligation that equity financing does not because equity holders are residual owners.
When Mr. Toyota sells to Mr. Usa, there is an exchange of currency which affects the supply/demand relationship between the USD and the Yen. When Mr. Chrysler sells to Mr. Usa, the exchange rate is not affected.
A low dollar exchange value indicates relatively more dollars used by foreigners which affects import and export industries in both countries. This can result in a large influx of foreign investment due to the relative strength of the foreign currency.
This influx of currency (if you believe Bernanke and Greenspan) take US monetary policy out of the hands of the Federal Reserve (by keeping interest rates low regardless of the Fed's efforts). This then creates an asset bubble and financial crisis for which the Fed can deny any responsibility.
Bill Woolsey —
"Today, he would be financing various elements of the Shadow banking system.
Exactly. And how much confidence should he have?
What if the U.S. Government borrows money to throw a gigantic party?
U.S. dollars go overseas in exchange for goods and services. When those dollars come back to fund real investment, everything is fine. No problem . (A trade deficit may even be a good thing for a particular country, because anywhere with a trade deficit must be a relatively attractive place to invest).
But it must be real investment. If foreign holders of dollars buy U.S. Government debt, then that portion of the trade deficit (or investment surplus) is good for nobody but politicians.
In the future, when it comes time to pay off the debt, those who borrowed keep producing but spend less. This frees up goods and services (i.e. pushes down prices), and allows investors to enjoy real purchasing power with their returns. But the government never spends less, and doesn't produce viable returns. When the dollars come back to the U.S. there is no reduction in spending by the government, and no real investment with borrowed funds. The money was malinvested, debt payments were merely consficated from the bank balances of taxpayers.
The government actually defaults on all of its debts. The losses are simply papered over and thereby socialised.
And we sold Rockefeller Center for a billion and bought it back for 250 millionâwho got the better of the deal? If you read the papers , then it was 200 hundred years ago that we were becoming slaves of the bankers in London, then it was Berlin, then it was Tokyo, then Peking, etc., etc. I cannot wait to see who the next boogeyman will beâjust watch out for the deceitful Dutch, they are almost as those unscrupulous Luxembourgers.
Don,
I agree. It makes no difference to entrepreneur Jones in Jacksonville if the financing comes from Bill Gates in Seattle, Washington or Mr. Toyota in Nagoya, Japan. After all, capital is capital.
But a few observations: If Mr. Toyota uses that $400,000 to buy shares in GE or 3M, this must be in the secondary market for it not to be classified as financing. If these funds are used to buy shares in the primary market, it is in fact financing, as defined by financial economists.
Now, given developed capital markets, no taxes and no agency costs (that is, ignore Jensen and Meckling, 1976) then this proportion of Company X's equity is irrelevant relative to the proportion financed by its issuance of new debt (Modigliani-Miller), but make no mistake about it, it is indeed financing.
In other words, if Mr. Toyota bought already-issued equity or debt, it is not financing, because presumably they bought it from others who already did the initial financing when the firm needed capital. However, if Mr. Toyota buys equity in the primary market, or newly issued debt, that is indeed financing.
While probably not rigorous, one could think of it, as a thought exercise, as indirectly financing if buying securities from someone else (Americans or other foreigners like Mr. Nissan or Mr. Volkswagon) as they already did the initial financing, so that the buying in the secondary market (irrespective of country origin) displaces someone else's purchase of these securities.
Their saving is then allocated to the next best alternative, and somewhere within the incredibly sophisticated economy, new financing does occur, but it's not exactly (direct) financing at the margin if Mr. Toyota directs some else's saving to the next best alternative.
Either way, everyone is better off.
Most discussion of trade deficits unwittingly parrots mercantilistic ideas that are 400 years old.
"When Mr. Toyota sells to Mr. Usa, there is an exchange of currency which affects the supply/demand relationship between the USD and the Yen. When Mr. Chrysler sells to Mr. Usa, the exchange rate is not affected."
I have thought Mr Toyota and Mr Usa would share the same currency presuming that Mr Toyota is Japanese since Usa is a town in Japan. After all, U.S.A. is an abbreviation not a word.
http://en.wikipedia.org/wiki/Usa,_%C5%8Cita
"Usa is a town in Japan"
There's a WWII anecdote about packages stamped "USA" being sent to the wrong place. I can't recall the details.
After all the "S" in thw word in U.S.A. was, at one time, a plural word [insert non-winking, angry-faced emoticon].
The preferred anecdote is that the Japanese capitalised on the town by creating the misleading label 'MADE IN USA'.
[insert non-winking, angry-faced emoticon] – >:( ?
Pingry wrote:
However, if Mr. Toyota buys equity in the primary market, or newly issued debt, that is indeed financing.
Pingry, I agree with your entire comment, but for the sake of clarity, let's make clear that in the case you refer to above, what is being financed is not the "trade deficit" — what is being financed is the activity (whatever it may be) of the firm whose securities Mr. Toyota buys.
Pingry,
I like your post, but you bring up a new point that bears some exploration. The very act of buying securities on the secondary market provides liquidity. Liquidity reduces the risk of investment, lowers transactions costs, aids in price discovery and lowers the cost of capital for companies looking for capital in the public markets. These are also benefits to the primary market because a very liquid secondary market reduces the risk for those who provide initial financing. So, beyond just freeing up the capital of the initial financiers, the liquidity provision is a net gain to the economy.
We can see the negative effects of very illiquid markets in CDOs and Real Estate, as just two examples.
Is anyone able to forward this to Mr. Obvious? (Lou Dobbs.)
.
Yes, it may provide some immeasurably small amount of liquidity, but I am reasonably assuming here that Mr. Toyota is a pricetaker, and therefore has no influence over the market.
And yes, real estate is illiquid, and if Mr. Toyota would use his $400,000 to buy some real estate, he would still be a pricetaker and would fail to increase the market price of real estate.
Real estate is getting crushed right now because there are millions and millions of pricetakers who have taken mortgages on homes which they simply cannot afford.
So, rather than incomes increasing proportionally to match the previously increasing home values (there are other variables too), home prices have declined, bringing down incomes at a lesser, although very significant rate.
Most people are pricetakers, including Mr. Toyota. If I go to the bank, withdraw money from my demand deposit account, and then proceed to burn it, shred it in the blender or flush it down the toilet, then the reduction in the money supply does have some effect on the economy. But will it be measurable?
No, because I'm a pricetaker. I'm sure that the Fed could care less about what I do to my checking account balance.
Now if all of us do the same thing, well Ben Bernanke might need to buy some new underwear!
Pingry,
That's very interesting, but being a price taker has absolutely nothing to do with providing liquidity.
If Mr. Toyota buys stock XYZ with some of the money that he acquired by selling his cars to U.S. consumers, he provides liquidity by providing a bid (and, at some point, an offer) for the security. It is the number of ready bids and offers that determines liquidity, not the ability of the market participants to influence price.
My intention was not to contradict but to add to your post on secondary markets. To the extent that Mr. Toyota uses some of his profit from the sale of cars to the U.S. consumer to purchase U.S. securities from the holders of those securities, he provides liquidity and liquidity is often undervalued because it is poorly understood by many people. It doesn't matter if the amount of liquidity provided by these trades is small or large as liquidity provision is a secondary and beneficial effect.
I seriously doubt if Mr. Toyota can change the elasticities in an otherwise sufficient manner. A market, like the stock market, is considered liquid if bid-asked spreads are narrow.
These narrow bid-asked spreads (marketmakers are a textbook example of perfect competition) will occur if the expected volume of transactions is quite large and the expected risk of large equilibrium price change is low.
Large volume (much larger than Mr. Toyota's orders) ensures that an inventory of securities can turn over easily from frequent orders to buy and sell. And low price volatility means the risk exposure to a given inventory is small.
If say, Mr. Toyota were trying to buy in a thin market (a market without depth, breadth and resiliency) then in fact, he ceases to be a pricetaker and could change the equilibrium price. Bid-asked spreads would be quite wide and the market could not be classified as liquid.
Remember, these securities markets are not determined like some Walrasian auction settling at a point where the demand and supply curves cross. Rather, people wish to deal with each other immediately to reduce uncertainty, and the dealers/marketmakers provide this service for a profit.
Their profit, of course, comes from the bid-asked spread. A new dealer could enter the market and simply quote the same bid asked spread which currently prevails. Otherwise, it is inventory changes which provide the crucial signal that some exogenous event has occurred causing the equilibrium to change.
Pingry,
You missed the point entirely. One need not change elasticity to change liquidity. Smaller bid/ask spreads result from more market participants, therefore an additional market participant adds to liquidity – even in very liquid securities. Large volume does not have to result from individual large orders, it can also result from lots of individuals executing small orders. In fact, the latter is better as it's harder to lean on small orders.
As a market maker, allow me to assure you that market makers are not a textbook example of perfect competition because market makers have advantages other market participants do not. You can thank the regulators for that. But, that's outside the scope of this discussion.
The trade deficit is only an emotional problem for the America-first crowd. Usually a bunch of racists.
Yes, I understand that large volume can, and does result from many small orders.
I have invoked the ceterus paribus clause numerous times because we're assuming nothing else changes other than Mr. Toyota's decisions.
Now, If there are no exogenous shifts in the supply and demand curve of any appreciable amount, we can safely assume (ceterus paribus again) that changing elasticities can change the bid-asked spread, and hence liquidity.
Marketmakers, as you know, absent the presence of other information, can determine the equilibrium which would occur in the Walrasian auction by ensuring appropriate inventory adjustments.
That is, the bid price is on the supply curve and the asked price is on the demand curve, aligned vertically over quantity, such that these spreads cluster near the true equilibrium price.
Now, assuming no change in price variability, changes in elasticites, do in fact change liquidity, all things being equal.
All else aside (I'm getting tired of saying ceterus paribus), typically we assume that supply and demand curves usually become more elastic in the long-run, and with smaller bid-asked spreads and more liquidity, this would tend to put pressure on dealer profitability and some may leave the market as they are earning economic losses.
But anyhow, while we're assuming constant variability in these thought exercises, it seems as though we have all deviated substantially from talking about trade issues.
I see your point, Pingry. Mine was a small point that you've fleshed out quite a bit. I haven't thought about the elasticity of, say, stocks, but my initial assumption would be that elasticity does not change liquidity and liquidity does not change elasticity because the elasticity is perfect or almost perfect anyway. We also can't talk merely about price because all price is relative to fair value assumptions.
Incidentally, small market makers in extremely liquid securities have been largely pushed out. That's good news as it means the market is extremely efficient and transaction costs are minimal. The new thing is for large market makers (SIG, for example) to provide locked markets for commission. More risky, but worth it for both customer and market maker.
Yes, we're off topic now, but at least it's related.
forgot to add: I've never thought about the relationship of elasticity and liquidity, so I'm going to go think about that for a while.
On another related subject, it's worth noting that the UAW has regularly cited the lack of American cars being sold in Japan(and recently, South Korea) as evidence that those countries have trade barriers and argument that therefore, so should the US impose penalties on foreign cars.
I think it'd be great to ask the next person who advances that argument if they think that a) the lack of sales is in fact due to trade barriers or b) the Japanese and Korean buyers, correctly or not, don't think much of American cars?
If a) then aren't those countries the real losers, needlessly making a good product more costly?
If b) then haven't you just pointed out the real problem, which isn't going to be changed by any protectionism but only better advertising or manufacturing?
I don’t want to pretend to understand any of this stuff, but I do try. I followed your link here from your recent Peter Schiff post.
In the case of Japan and China, isn’t there something political as well as economic going on?
I don’t think Peter Schiff regards the trade deficit as a problem in and of itself. I think he is only asking the question, why is there a *chronic* and ever increasing trade deficit when in a free market one wouldn’t expect this (except under really special conditions.)
I think Schiff is arguing that via America’s dominant position in the world and the dollar reserve currency status, America is able to run trade deficits that would not be possible if there were a free market. And further that as this runs against the natural direction the free market would be probably be taking, there will be eventual consequences.
That is, he seems to be suggesting US policy has been to rig the system in its own perceived favor, but that in the long run this won’t pan out. Instead it’ll have really negative consequences.