Here’s a letter to a long-time, friendly patron of Café Hayek.
Pete:
Thanks for sending along Noah Smith’s Christmas-eve post titled “Why Europe should resist the Second China Shock.” Like you, I disagree with much that’s in this post. Especially disappointing is Smith writing this: “That’s what a trade deficit is – the writing of IOUs in exchange for imports.”
He’s deeply mistaken.
Some part of a country’s trade deficit is debt – namely, the part (and only the part) that’s borrowed from foreigners. An example is U.S. government borrowing from Europeans. This borrowing both raises the U.S. trade deficit and creates debt that Americans must repay to foreigners.
But other parts of a country’s trade deficit aren’t debt. When foreigners use their export earnings to buy American real estate, the U.S. trade deficit rises but there’s no increase in Americans’ indebtedness. Ditto when foreigners hold U.S. dollars, and when foreigners make equity investments in the U.S. If, for example, a Spaniard living in Madrid uses her export earnings to open a restaurant in Cleveland, the U.S. trade deficit is made higher than it would otherwise be without putting any American further into debt.
I know from experience that many people will push back, pointing out that foreigners expect returns on their investments – returns that, when foreigners invest in America, will come from America.
Well, of course foreign investors, like all investors, expect returns. But when no American is contractually bound to pay returns on some foreign investment in America, no Americans are indebted to foreigners as a result of that investment. When, for example, foreigners make successful equity investments in America, those investments create new wealth in America, and it’s from this newly created wealth that foreign equity investors receive their returns. To look, as many protectionists do, on such returns as payments from Americans to foreigners is to fail to recognize that the wealth out of which those returns are paid would not have existed without those investments by foreigners. These returns come not from the pockets and purses of Americans but, instead, from the ingenuity and risk-taking of the foreigners who receive these returns.
It’s distressing that so many non-economists misunderstand so-called “trade deficits.” It’s doubly – indeed, quadruply – distressing to encounter prominent economists who share that same misunderstanding.
Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030
