The persistence of the U.S. trade deficit has led economists and politicians alike to revise some old beggar-thy-neighbor policies. One such update is that fixed-exchange-rate countries are unfair. Fixed exchange rates, it is being argued, are protectionist. But this is an old-school mercantilist view, even though it’s sadly bipartisan — both Senator Kerry and at least Treasury Secretary Snow share this view.
The new mercantilists are also concerned with our dependency on foreign financing, and worry that foreign-debt holders could someday blackmail U.S. policy makers. The Wall Street Journal’s Greg Ip recently characterized this sentiment:
“There is surely something odd about the world’s greatest power being the world’s greatest debtor,” Lawrence Summers, Harvard University president and former U.S. Treasury Secretary, said in a recent speech. He calls it “troubling” that the U.S. depends so much on “inevitably political” entities to finance its foreign debts.
The U.S. has run such deficits for years, but most of the time they were financed by private investors and their purchases were seen as a sign of confidence in the U.S. economy. But in recent years, private inflows haven’t kept pace with the growth in the current-account deficit and foreign central banks have stepped into the breach, buying more than $200 billion of U.S. assets, mostly Treasury bonds and bills, last year. They do this to hold the dollar’s value up against their own currencies, which makes their exports more competitive.
Foreign central banks, led by China’s and Japan’s, now hold close to $1 trillion of Treasury bonds and bills, almost a quarter of publicly held U.S. debt.
In simple textbook macroeconomic analysis, a trade deficit is viewed as a leakage. It represents a net export of domestic aggregate demand and as such a net export of jobs. But that’s not the whole story.
Double-entry bookkeeping tells us that the only way foreigners can have a net export position with the U.S. is if they accumulate U.S. paper. The trade balance has to be matched with another entry — capital inflows. That in turn represents an increase in domestic aggregate demand.
The accounting identity tells us that one way to finance a trade deficit is for a country to become a net borrower. This is one of the arguments against a trade deficit. But the merits of a trade deficit can be cast in terms of whether it is good or not to be a borrower.
Borrowing to finance conspicuous consumption is more than likely an undesirable outcome for a country. If a country’s markets are reasonably efficient, under this scenario a stock market will likely decline as a trade balance worsens (i.e., net borrowing increases). On the other hand, borrowing to increase productive capacity — which in the future will produce higher income, high enough to repay the debt with some change left over — is a desirable outcome.
In this second case, borrowing should affect the relative market valuation of the debtor country vis a vis the rest of the world. Observe, for instance, an increase in the U.S. stock market relative to the rest of the world as we borrow (or as the trade balance worsens). Looking at the data, the verdict is fairly clear: Contrary to the assertions of the mercantilists, periods of U.S. trade balance deterioration have been accompanied by a rising U.S. stock market relative to the rest of the world.
Some people seem to forget that since the 1980s the U.S. has been the engine of world growth, even though our trade balance has been in deficit. The reason, simply stated, is that the U.S. has been the location where higher returns can be realized.
The story is always the same. Look at the U.S. during the 19th century: We had had trade deficits for almost 100 years, and we emerged as the preeminent economic power of the 20th century. The rest of the world financed our growth because we had the higher rates of return, and as capital flew in, the trade deficit worsened.
More often than not a trade deficit is a sign of prosperity. This logic applies not only to the U.S. but also to emerging economies, such as China. Its current trade deficit is a sign of prosperity and growth. By absorbing world goods and services, China and the U.S. are keeping their respective economies going.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.