≡ Menu

Not All Facts of Reality Are Relevant for Drawing Policy Conclusions

Below the fold are slightly revised versions of two comments that I left at EconLog on this recent post by David Henderson.  Both comments are sparked by the error – as common as it is careless – to assume that international economic transactions differ fundamentally from domestic economic transactions.  (I note that this error is not committed by David Henderson.)


Great post, David.

Commenter Benjamin Cole is correct to suggest that foreign lending to Uncle Sam is not itself a cause of U.S. government budget deficits. But Mr. Cole is mistaken when he writes that

When a regional economy imports more than it sells, then it must borrow or sell assets, or shrink population, to maintain per capita income.

Although often-made, this claim rests on the false assumption that the world’s stock of capital is fixed. But it is not fixed. Because capital can grow – and often does grow – when people specialize more deeply and trade more, when people in a region (or nation) import during some period more than they export during that same period, per-capita income there need not fall. It can, and often does, grow as a result even with no increase in net borrowing domestically, no net decline in domestic-citizens’ net asset holdings, and no reduction in population.

Here’s an example. Suppose, for simplicity, that America’s current account is now in balance (or, even more simply, that over the past year, the dollar value of Americans’ exports equalled the dollar value of Americans’ imports). Then today, American Jones, discovering that a Chinese steel producer has perfected a means of making better structural steel and selling it at lower prices, buys $10M worth of this steel from the Chinese producer.

Jones uses this steel to expand his factory in Wisconsin in a way that he would not have done had he not had access to this lower-priced, higher-quality steel. Jones is thereby able to profitably expand his production: Jones himself produces more output and sells it at lower prices to all of customers, most of whom are Americans.

Meanwhile, the $10M received from Jones by the Chinese steel producer is used by this steel producer to buy a $10M condo in Manhattan from the American Smith. (This condo was Smith’s second home.) Smith uses the proceeds from the sale of this condo to start a restaurant in Brooklyn, which is hugely successful. Smith turned his $10M investment into a restaurant now worth $15M – and diners in Brooklyn get more and better dining options.

This transaction – American Jones’s purchase of $10M in steel from a Chinese producer and the Chinese producer then spending this $10M to buy a condo in New York City – caused America’s current-account deficit to increase by $10M. Yet not only did it not result in an increase in any American’s indebtedness or in a fall in the value of any American’s net asset holdings, it also resulted in an increase, not a decrease, in per-capita income in America.

Although obviously stylized, an example such as this one clearly describes transactions of a sort that frequently occur in reality. And such plausible examples can be multiplied easily.


Now on to a different point.

Another way to describe the flaw in Conard’s argument is to note that it rests on the mistaken assumption that there’s something unique about domestic citizens (whether individually or as organizations) borrowing from foreigners rather than from each other.

Suppose that consumers throughout America buy $1M worth of corn from Farmer Williams in Kansas, and that Farmer Williams uses all of these sales proceeds to buy U.S. Government bonds (rather than to invest in, say, a Silicon Valley start-up or even in improving his own agricultural operation in the American heartland). Would Conard conclude from observing this perfectly plausible series of transactions that freedom of trade in agricultural products is worthwhile only when the investments made by sellers of agricultural products are in the entrepreneurial private sector – and that, whenever such investments are made in ways that he, Conard, judges (let’s grant correctly) to be unproductive, then the problem is with free domestic trade in agricultural products? Would Conard believe it to be an error for someone to insist that we should never worry about American-consumers’ trade deficit with American corn farmers? Would Conard argue that American-consumers’ trade deficit with American corn farmers is a cause for no concern only if American corn farmers invest their sales proceeds in ways that expand the economy rather than not?

To be clear: I believe that government spending almost always destroys economic value, and that – because it makes such destructive spending less costly for politicians – deficit financing is an evil (both economic and ethical). But the problem with such wasteful or destructive spending, and with deficit financing of it, is with itself; it’s not with the voluntary economic transactions through which those who finance such spending acquire the funds to supply the financing or with the artifactual accounting relationships that such transactions generate. (And, again, even if I am mistaken in this last claim, there’s still no reason to single out foreign transactions that have this result from domestic transactions that have this result.)

I add, along with David, that I’ve read only Tyler’s post on Conard and not Conard directly. So, like David, I assume that Tyler’s interpretation is correct. This assumption is likely sound, although it’s possible that it is in this case mistaken.


Next post:

Previous post: