Deficient Economic Analysis

by Don Boudreaux on November 11, 2013

in Balance of Payments, Myths and Fallacies, Seen and Unseen, Trade

Here’s a letter that I sent a few days ago to the New York Times:

Despite writing confidently about the trade deficit, Jared Bernstein and Dean Baker do not understand what they’re writing about (“Taking Aim at the Wrong Deficit,” Nov. 7).  For example, it is simply wrong to assert that “Running a trade deficit means that income generated in the United States is being spent elsewhere” and not in America.

In fact, nearly every dollar in America’s trade deficit is, after going abroad briefly, spent in America.  Why would it be otherwise? Foreigners, like Americans, accept dollars in exchange for what they sell to Americans only because they wish to spend or invest those dollars in America.  Dollars not destined to return as demand to America are as worthless to their holders as is Monopoly money – and foreigners are quite unwilling sell their exports for Monopoly money.

When, say, foreigners buy U.S. government bonds, these purchases raise America’s trade deficit.  The dollars used to buy these bonds, however, obviously return to America and are spent here (in this case by Uncle Sam).  So Messrs. Bernstein’s and Baker’s claim that a U.S. trade deficit creates a “gap in demand” is incorrect.  This error is so fundamental that those who commit it have no business offering advice about economic policy.

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA  22030

Anticipating one likely response: It is indeed possible that foreigners will simply hoard U.S. dollars indefinitely and thus drive up America’s current-account deficit in a way that doesn’t feature a return to America – on the capital account or (because of sticky prices) through the operation of the real-cash-balance effect – of the demand represented by the hoarded dollars.  But there’s nothing here unique about a current-account deficit.  Dollars earned exclusively through domestic trade – $$s earned by Americans from trade with Americans – can be hoarded by Americans just as easily as can dollars earned through foreign trade be hoarded by foreigners.  Obviously, domestic hoarding will cause the same problems that foreign hoarding causes or is imagined to cause.  And there’s no reason to suppose that foreigners are more likely to hoard U.S. dollars than are Americans to hoard such dollars.

Also on trade: last week the Mercatus Center published my brief paper “The Benefits of Free Trade: Addressing Key Myths.”  (I thank my Mercatus Center colleagues Nita Ghei and Angela Kuck for expert and patient assistance on this paper way above and beyond the call of duty.)

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