The following blog post is prompted by a brief e-mail conversation that I just had with my great colleague Walter Williams (who, I add, I believe does not disagree with anything that I write below).
One common way of describing a current-account deficit (or, more colloquially, a trade deficit) is captured by this passage in Wikipedia’s entry entitled “Current account” :
If an economy is running a current account deficit, it is absorbing (absorption = domestic consumption + investment + government spending) more than that it is producing. This can only happen if some other economies are lending their savings to it (in the form of debt to or direct/ portfolio investment in the economy) or the economy is running down its foreign assets such as official foreign currency reserve.
Although it conforms fully to the standard manner of discussing and analyzing current-account deficits and surpluses, this passage is wrong in one way and highly misleading in another.
Why the Passage is Wrong. The way in which this passage is wrong should by now be no surprise to regular readers of this blog: funds that foreigners invest in the domestic economy can be lent to citizens of the domestic economy, but they need not be lent. Equity investments and purchases of real estate that foreigners make in the domestic economy (as well as holdings by foreigners of the domestic-economy’s currency) increase the domestic-country’s current-account deficit but involve no lending. Likewise, such investments need not (although, of course, they can) involve the domestic country “running down its foreign assets” or citizens of the domestic country reducing their net asset holdings.
I offer yet again my go-to real-world example of the validity of my point: If the U.S. current-account deficit is increased (as it likely is) when Ikea spends dollars building a store in the United States, this equity investment by Ikea involves no increased American indebtedness. And even if the Americans who sell to the Swedes the land and materials simply hold on to the dollars they receive on their sales of this land and these materials, there is no net decrease in the value of Americans’ asset holdings. (Dollars, remember, are financial assets. Dollars are counted as such when non-Americans hold them, and such foreign holding of U.S. dollars is one of the actions of foreigners that raise the U.S. current-account deficit.)
This language of “lending,” “debt,” and “repayment” casts a completely misleading impression of increases in current-account deficits given that not all such increases involve debt.
Why the Passage is Highly Misleading. The passage is additionally misleading because of its use of the term “absorption.” This term is commonly used by economists to describe the financial flows associated with current-account deficits. I believe this term to be wholly inaccurate, for it mistakenly implies a passivity of economic decision-making that very often is simply not there.
If the United States, for whatever reason, is an especially attractive place, relative to many other countries, for entrepreneurs to create firms or to otherwise undertake risky investments, the result will be U.S. current-account deficits (or, alternatively, U.S. capital-account surpluses). But to describe these ‘deficits’ as the result of global funds being “absorbed” by the U.S. from abroad is to miss what is in many cases non-Americans’ active decision-making not only to take advantage of ‘given’ investment opportunities here (say, to buy 1,000 shares of stock in Apple, Inc .), but very often actually to create in the United States investment opportunities that would otherwise not exist.
The term “absorption” here suggests that domestic investment opportunities somehow exist and, not being completely filled by the savings of domestic citizens, absorb savings from abroad to the extent that foreigners are willing to allow their savings to be “absorbed” into the U.S. economy.
We don’t describe western PA and Cleveland, OH, as having “absorbed” John D. Rockefeller’s funds, or River Rouge, MI, as having “absorbed” Henry Ford’s funds, or Cupertino, CA, as having “absorbed” Steve Jobs’s funds. Standard Oil, the Ford Motor Co., and Apple are enterprises that were actively created by these American entrepreneurs, and the investments that they and others made to launch and to expand and improve these enterprises were the results of active, entrepreneurial decisions. Yet had one of them – say, Ford – been instead a Canadian living in Windsor, Canada, then the U.S. dollars that he’d have invested to launch the Ford Motor Co. in Michigan would have increased the U.S. trade deficit and have been described as funds “absorbed” from abroad to “fund” the U.S. trade deficit.
Such language is utterly economically misleading, even if it is conventional and acceptable from the point of view of strict accounting.