The Trade Deficit: Worth Worrying About

A response to Don Boudreaux's "Stop Worrying About the Trade Deficit"
(http://www.tcsdaily.com/article.aspx?id=021006G)

By Aaron Krowne

2006-02-13

The famous political economist Maynard Keynes, whose ideas form the basis of
modern Western government fiscal policy, taught us that deficits are OK.
They're even good, in measured amounts, for short times.

What he didn't say is that deficits are good when they are run indefinitely, in
ever-increasing amounts, creating a mounting debt that becomes an increasing
burden on a nation.

And of course he wouldn't say this: any fool can see it would result in an
unsustainable situation.

The trade deficit is in many ways similar.  

As Don Boudreaux (GMU economist) has pointed out, there is nothing about a trade
deficit that is inherently "bad"---it may even be a sign of investment by
foreigners in the country which is running the deficit.

But what he ignores is the fact that this kind of deficit also should not go on
indefinitely, not take on the character of ever-increasing scale, and that there
*is* such a thing as having a trade deficit that is "too big".

Let's begin with a sane axiom of international finance: dollars are useless to
foreigners unless they can be spent on dollar-denominated (American) goods and
services.  This is trivial, right?  A currency isn't useful unless you can buy
something from someone who wants that currency.

So even if massive quantities of excess US dollars---held by foreigners because
of Americans buying their exports---were being invested in the US, this would
not change the underlying dynamic, because investments are useless unless they
can be redeemed!

That is, if every single trade deficit dollar were being re-invested in the US,
it would still someday need to be redeemed.  And at this point, we'd be
back to the original problem: foreigners would be holding vast quantities
of excess dollars, and have nothing to spend them on.  In fact, the problem
would be worse, since now they'd have *more* dollars through capital gains.

Perhaps Don would say that US investments were *so* attractive that foreigners
were passing up perfectly good US exports in order to invest in the US.   Thus,
when they redeem their capital gains in dollars, they will immediately go
back to buying the foregone US goods with them, restoring balance.

I am not so confident about this thesis.  Given that we've already lost 3
million manufacturing jobs since 2000, and that most contractable technology
service jobs have been moved overseas, I'm not sure what will be left for
foreigners to buy from the US en masse when they redeem their investments.
Maybe Chinese tourism will pick up the slack?

The preceding points only address the unlikely case where every single deficit
dollar held by foreigners is being productively re-invested in the US, just
like any domestic citizen investing in the stock market.  In reality, we know
this is not the case: over the past few years, foreigners (at least half of
which consists of foreign central banks) have been buying public debt
at a historically unheard-of rate.  

This is half of the reason the net public debt has grown four trillion dollars
in the past four years---the budget deficit is only enough to account for about
half of this increase!  This has taken our debt burden from 30% to 60% of GDP,
and that alone should be cause for concern (most countries with a debt
burden this high or above are not what you'd call "economically
healthy").   So, in contrast to what Don Boudreaux says, the budget
deficit and wily congressmen are only half responsible for what he is
admonishing them for.  The other half originates with the phenomenon he
wants to you believe is not a problem: the trade deficit.

The trade deficit results in an accumulation of debt back in the US, public or
private, which is itself a problem because of the massive scale of the
phenomenon.   Having nothing particularly attractive to do with all their
excess dollars acquired through trade with the US, foreigners are basically
forced to "park" them in US treasury bonds and notes.  That is about all they
can do with them, as most of their investment expertise is domestic.

Well, buying an asset class automatically and mindlessly is not a recipe for
prudent investment.  In fact, there is a term for this kind of
investing-unwisely: malinvestment.  

Malinvestment hurts everyone---both the party investing and the party receiving
the investment.  The former will be disappointed by a poor return, because he
placed his money without regards to any sort of moral hazard (in this case, he
also drives down interest rates, guaranteeing a poor return even from
the US government).  The receiving party will run out and waste the
money, having acquired it too easily, but at the end still be liable for its
repayment.  

If this sounds familiar, you've been paying attention.  The influx of
re-patriated dollars has led to an orgy of debt and spending in the US, which
everyone has been participating in, and so virtually no one has thought to stop.

This orgy has manifested in a real estate and consumer credit bubble, the evils
of which I'm sure you've heard about elsewhere (and probably ignored).  It has
manifested in the inflation of public debt, which is of course eagerly spent by
the government---its like getting free money without having to raise taxes!
These phenomenon have tricked both consumers and government into mass
irresponsibility.

But all of this debt is ultimately not free.  The government will have to pay
the interest on all of these bonds, out of what money I know not.  After years
of free money in the form of bond purchases, it is questionable the government
will remember how to do anything except print more of the stuff.  Currently
interest on the debt amounts to 11% of federal outlays, and rising (that is
about $250 billion dollars completely thrown away every year), and this
will have to increase.

The consumer side of debt faces looming peril as well.   As bond purchases slow
and the Fed raises interest rates, suddenly $1.3 trillion dollars of
variable-rate mortgages will be exposed to dramatically rising mortgage
payments (this is about 17% of the housing market).  Consumer credit will face
a similar problem as credit card rates rise.

Finally, portfolio holders of even fixed-rate mortgage investments will be
exposed: in an environment of rising interest rates and inflation, their
returns will be squeezed to nearly nothing.  Inasmuch as large financial
institutions hold these investments, they may be exposed to failure, and
inasmuch as individuals hold them in their retirement portfolios, they may have
to work a few extra years.

Far from being innocuous, the trade deficit has been fuel on the fire of our
spendthrift, irresponsible government, and bubble-prone economy.  The situation
has been allowed to grow out of control merely because, for most people, the
consequences will be time-delayed.  

But manifest they will.