May 24, 2017

Deficits in Trade and Deficits in Understanding

Omar Ahmad Al-Ubaydli

Senior Affiliated Scholar
Summary

America’s trade deficit represents foreigners letting Americans buy more goods than they sell, in exchange for the right to invest in America more than Americans invest abroad—that’s a sign of a thriving economy.

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Donald Trump has asserted the need to cut the $500 billion U.S. trade deficit, yet support for his proposal is based on misconceptions about what this deficit means. During the 1970s, importing more than you exported was problematic, as was the breakup of the Beatles. Today, neither matters.

To see why the current trade deficit is benign, we need to understand the relationship between trade and the dollar’s value. Greenbacks are like any commodity in that the more people want to possess them, the higher their price. People acquire dollars primarily for two reasons: buying American goods and investing within the United States.

Let’s momentarily ignore the investment-based demand and focus on the trade-derived need for dollars. If the United States is importing more than it exports, then American consumers are exchanging dollars for foreign currencies to buy foreign goods more than foreigners are doing the reverse, meaning that foreigners are accumulating lots of dollars that they’re not using to buy American goods.

The glut of dollars circulating among people who don’t need them will push down the value of the dollar, just like the value of Christmas trees declines after December 25th. A falling dollar makes U.S. exports cheaper, and foreign imports into the United States become more expensive. Cheaper U.S. exports will entice foreigners to buy more American products—including manufactured goods—while more expensive foreign imports will make Americans buy less foreign products, reversing the original trade deficit. So a deficit changes the value of the dollar, which in turn brings the deficit back into balance.

The Netherlands offers a further illustration of the link between the exchange rate, trade balance, and manufacturing jobs. The discovery of a gas reserve in 1959 led to a large trade surplus, creating upwards pressure on the Dutch Guilder (just as a trade deficit creates downward pressure on a currency). As its currency appreciated, the Netherlands’ manufacturing exports became less competitive, and during the period between 1970-1977, unemployment increased from 1.1% to 5.1%, and private sector investment shrunk. Therefore, the surprise surplus caused manufacturing unemployment, just as a surprise deficit can in principle boost manufacturing exports. This conventional and well-studied phenomenon is known as Dutch Disease.

Artificially devaluing a currency is a historically-deployed tactic for boosting manufacturing and the trade balance, which many accuse China of exploiting. However, the U.S. deficit, with numerous non-manipulators such as Germany and Russia, confirms that the imbalance is not the result of foul play.

The automatic trade-dollar adjustment becomes a problem when the United States is operating a fixed exchange rate, as it did under the postwar Bretton Woods system. The government guaranteed a fixed price for the dollar that didn’t balance the trade account: America was importing a lot more than it was exporting.

Foreigners became unwilling to accumulate dollars that they had no intention of using at the prevailing price, and were feverishly exchanging them for gold at the price the U.S. government was guaranteeing. The precipitous decline in U.S. gold reserves forced President Nixon to abandon dollar-gold convertibility in 1971. This is why policymakers used to be such trade deficit hawks—trade imbalances threatened America’s ability to maintain its international obligations.

And therein lies the first major difference between the 1960s and today: The dollar is fully flexible, with markets determining the exchange rate, rendering trade imbalances self-correcting.

So why has America been recording a large, persistent trade deficit, and why isn’t the dollar devaluing? It’s due to the second major difference: The investment-based demand for foreign currencies—which we momentarily set aside—has ballooned. People no longer exchange currencies just to buy foreign goods.

International financial markets are extraordinarily integrated, as capitalists invest globally to seek higher returns and safer portfolios. Australians still want dollars to buy F-18 fighters—but also Treasury bills and Microsoft shares. In 1970, global foreign direct investment (FDI) was $10 billion, equal to 3% of global merchandise exports. In 2007, FDI has grown three hundredfold to $3 trillion, or 22% of global merchandise exports.

Consequently, the dollar no longer corrects trade imbalances. Some of the $500 billion deficit reenters the United States as foreign investment in the U.S. economy, while some of the rest is retained by foreign central banks in case of a rainy day.

America’s trade deficit represents foreigners letting Americans buy more goods than they sell, in exchange for the right to invest in America more than Americans invest abroad—that’s a sign of a thriving economy. In contrast, a struggling economy combined with a trade deficit would send the dollar tumbling, balancing the flow of capital and goods.

The dollar’s fortitude despite the trade deficit, therefore, confirms that the United States is a good investment—and that policymakers need not worry about Americans importing more than they export.

Nixon once complained to the American public about the “all-out war on the American dollar” waged by speculators. In 2017, there is no campaign against the American dollar, there is no fixed exchange rate, the U.S. economy is thriving, and Ringo Starr has reached out to Paul McCartney about a reunion tour.