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The Whole Doctrine of the Balance of Trade Is Absurd and Misleading

Here’s a letter to a reader of my blog:

Mr. A__:

Thanks for your e-mail.

Prompted by my Law & Liberty response today to Oren Cass, you ask if I’m “too nonchalant toward chronic U.S. trade deficits.” Specifically, you wonder why I “don’t realize long standing trade deficits cause the dollar’s value to fall against other currencies.”

I don’t believe that I’m mistaken.

U.S. trade deficits would never be long-lived if international economic activities were limited to importing and exporting. The reason is that a trade deficit (more precisely, a current-account deficit) today would – as you recognize – increase the supply of dollars on foreign-exchange markets relative to the demand for dollars. The resulting fall in the dollar’s exchange rate would increase exports and decrease imports until U.S. exports and U.S. imports equal each other.

But international economic activities are not limited to importing and exporting. People also invest across international borders. Foreigners demand dollars, therefore, not only to buy U.S. exports but also to invest in America. It’s thus untrue that U.S. trade deficits inevitably cause the dollar’s value on foreign-exchange markets to fall. The dollar amount of a U.S. trade deficit in any period might well equal the dollar amount that foreigners during that period wish, at current exchange rates, to invest in America.

Suppose that in the first quarter of 2024 the U.S. runs a trade deficit of $200 billion. If at current exchange rates foreigners during that quarter want to invest $200 billion in America, this trade deficit doesn’t increase the supply of dollars on foreign-exchange markets relative to the demand for dollars. And so the dollar’s value against other currencies does not fall. The problem that you fret about doesn’t arise.

I close by expressing agreement with Adam Smith when he wrote that “nothing, however, can be more absurd than this whole doctrine of the balance of trade.” Economic policy would today be far better had this foolish mercantilist notion been completely discarded in the 18th century and ever since utterly forgotten. Unfortunately, obsession with this doctrine continues to sow confusion that fuels bad policy.

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