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Beware Being Confused By Accounting Conventions

In my latest column for AIER I explain that the so-called “trade deficit” is not as objective as it appears. A slice:

America runs a trade deficit during some period – say, a month – whenever the dollar value of that period’s imports exceeds the dollar value of that period’s exports. Unfortunately, the name given to this situation – “trade deficit” – is a never-ending source of deep confusion, sometimes even among economists. A few years ago, Scott Sumner appropriately scolded some prominent economists for their shallow thinking about the so-called trade deficit. Specifically, Sumner noted that these economists mistake human-constructed accounting categories for real and essential economic phenomena.

We can clarify Sumner’s concern by elaborating on one of his astute examples. He writes: “In terms of pure economic theory, the US sale of a LA house to a Chinese investor is just as much an ‘export’ as the sale of a mobile home that is actually shipped overseas. But one is counted as an export and one is not.” By choosing to classify all purchases of real estate as investments, the accountants who long ago created the rules and categories of international commercial accounting ensured that many transactions that are economically identical to each other will be recorded in international accounts in ways that create the false impression that these transactions differ from each other in economically relevant ways. It follows that these international commercial accounts convey misleading information.

Suppose Mr. Peng in China sells $2 million worth of steel to Ms. Jones in Texas. This transaction is recorded as $2M worth of American imports. If Mr. Peng then immediately spends his $2M buying lumber grown in Alabama and shipped to Shanghai, this latter expenditure is recorded as $2M of American exports. In this case, Mr. Peng’s commercial engagement with Americans neither raises nor lowers the US trade deficit: the $2M of American steel imports is exactly offset by the $2M of American lumber exports.

Whew!” many Americans sigh with relief. “Our trade is balanced, so there’s no need for the government to restrict trade further.

But suppose instead that Mr. Peng, after exporting steel to the US, used his sales proceeds of $2M not to buy lumber grown and harvested in Alabama but to buy Mr. Smith’s condominium in Manhattan. According to long-established international-accounting conventions, this real-estate purchase will be recorded as a foreign investment in the US rather than as a US export. As a result, the measured US trade deficit will be higher by $2M: We Americans bought an additional $2M of items classified as “imports” but did not sell any additional amount of items classified as “exports.”

Oh no!” many Americans cry with concern. “Our trade deficit is rising! This untenable situation must be corrected by government intervention!

Yet what if the individuals who long ago created the accounting rules had instead – as they easily and reasonably could have done – arranged for purchases of residential real estate to be classified, not as investments, but as purchases of, say, consumer durables. Under this alternative rule, Mr. Peng’s spending of his $2M on a New York City condominium would be classified as a $2M American export, in much the same way that foreign visitors’ purchases of hotel stays in Manhattan or in Los Angeles are counted as American exports. In this latter case, America’s measured trade deficit would not be higher by $2M. The same Americans who cry with concern when this purchase is classified as an investment sigh with relief when it’s classified as an export. But nothing has changed except the accounting convention. In both cases, Americans send $2M out as payment for imports, and then the $2M returns to America as demand for something Americans sell.

Simply by changing their conventions for classifying various transactions, accountants could raise or lower the US trade deficit by billions. Yet any such changes in accounting conventions would change nothing in economic reality. Regardless of how it’s classified, Mr. Peng’s purchase of the Manhattan condominium puts $2M into the pockets of the American seller.