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On Balance, This Reality Is Easy To Grasp – But It Is Too-Often Missed

David Henderson, over at EconLog, rightly calls out Dean Baker for Baker’s poor grasp of balance-of-payments matters.  Here’s a comment that I left at David’s post (link and small corrections added):


Dean Baker simply doesn’t understand what a trade deficit (or current-account deficit) really is. His interpretation of it is the standard one shared by uninformed ‘men-in-the-street.’ (Peter Morici, by the way, suffers from the same misunderstanding.) You should recommend that Baker read Herbert Stein’s entry, “Balance of Payments,” in your wonderful Concise Encyclopedia.

Each semester I share with my class the following example:

SCENARIO 1: Suppose that Mr. Honda in Japan earns $1,000,000 by selling goods to Americans. He then spends that $1,000,000 buying lumber from Alabama in order to build his dream house in Tokyo. This purchase neither adds to, nor subtracts from, America’s trade deficit; $$exports = $$imports. Whew! No increased trade deficit!

SCENARIO 2: But now suppose that Mr. Honda uses the $1,000,000 to buy, not lumber from Alabama, but a restaurant in Alabama from its American owner. The American seller of the restaurant then immediately spends the $1,000,000 proceeds from the sale of her restaurant to buy lumber from Alabama to build her dream house in Montgomery.

In the second scenario (and only in that one) the U.S. trade deficit rises by $1,000,000. Yet clearly the amount of American employment that is supported by the transactions in this second scenario does not differ from the amount that is supported by the transactions in the first scenario. In each scenario, a restaurant in Alabama is operated, and an extra $1,000,000 of demand flows to the Alabama lumber industry.

That Baker doesn’t see that funds in the U.S. trade deficit flow back to the U.S. on the U.S. capital account – and that the flow of such funds back to the U.S. on the capital account are no less likely to spur or support employment in the U.S. than are funds that flow back to the U.S. on the current account – reveals his poor grasp of balance-of-payments economics.


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