This EconLog post from Scott Sumner, and the accompanying post from Don Boudreaux, provide much useful pushback against typical worries about trade deficits. However, Sumner in particular makes some strong claims that are misleading, and the two posts together could understandably make critics think that free traders are naive and distracting people from a genuine danger.
To be sure, I am not doubting the case for free trade. Rather, I’m saying that when Scott and Don write posts with such confidence (bordering on smugness), if they actually overstep, then it really makes it hard to convince critics who start out suspicious.
The easiest way for me to illustrate is through a simplistic fable. Because I’m still sick of apples from the Great Debt Debate, I’ll use bananas.
Originally all of the real estate in the USA is owned by Americans. The only output good is bananas. There are 100 units of land, and each produces one banana per period. Real GDP is 100 bananas. In the beginning, Americans consume all the bananas. GDP = C + I + G + Nx = 100 + 0 + 0 + 0. There is no trade deficit (or surplus). Let’s denote this original situation as Period 0.
Then at some point a US firm wants to fertilize some of the land to make it more productive, but it can’t raise any domestic capital because American savings is zero. So Chinese savers lend the US firm the money. Specifically they lend the market equivalent of 20 bananas worth of fertilizer.
So we now have the following:
Period 1: GDP=100; C=100, I=20, G=0, Nx=-20.
Specifically, the Americans still eat all 100 bananas that are grown domestically, and the Chinese send over 20 units of fertilizer (measured in bananas’ of market value). GDP is still 100 bananas, while domestic investment is now 20 bananas and we have a trade deficit of 20 bananas. Because there were no earnings on foreign investments either way, the current account deficit is also 20 bananas, while the capital account surplus is 20 bananas. Americans imported more goods (fertilizer) than they exported, while foreigners invested more in American assets than vice versa.
Now the interest rate on this debt is 5 percent. Further assume that the increase in physical yield is 5 percent. (I’m assuming the relative prices of bananas, land, and fertilizer all stay the same, just to keep it simple.) Just to isolate the effect of the original bout of Chinese saving/investment, suppose there is no new investment. Then we have:
Period 2: GDP=101; C=100, I=0, G=0, Nx=1.
Specifically, the application of 20 units’ worth of fertilizer in Period 1 has caused a permanent increase in real output from the land, to the tune of 1 extra banana per period. Americans still consume the 100 bananas they always had, while 1 banana is exported to the Chinese who consume it as interest on their debt. The US has a trade surplus of 1 banana, but a current account deficit/surplus of 0 (and of course a capital account surplus/deficit of 0).
Now, however, suppose that the Chinese keep rolling over their interest earnings on the US debt. That is, instead of consuming their interest income, instead they acquire more US assets. Yet for whatever reason, the Americans do not match this influx of additional Chinese savings with increased domestic investment, but rather with increased domestic consumption.
The simplest way to think of it is to start by studying the numbers in Period 2. When that 1 banana in interest income flows to China, they redirect it to lend to an American who eats it today. Now how does that American convince the Chinese owner to do that? He can either issue debt (i.e. a promise to pay bananas over the course of the future), or he can sell some of his land.
Let’s assume he sells the land, which is capitalized at 5 percent. That is, to receive 1 banana today, an American sells the Chinese person 1/20th of a unit of land.
At some point the Chinese own half of the real estate in the US. They again reinvest all of their earnings rather than consume any bananas. Let’s look at the numbers for that period:
Period n: GDP=101; C=101, I=0, G=0, Nx=0.
All 101 bananas physically produced on US soil are eaten by Americans. But what the GDP figures don’t show is that only 50 of the bananas were produced on land owned by Americans. The other 51 were grown on land owned by the Chinese. Yet rather than eat them, the Chinese sold these bananas to Americans, in exchange for about 2.5 units of US soil. Thus, an the end of period n, the Chinese now own about 52.5 units of US soil, while Americans only own about 47.5 units.
[UPDATE: In this period, the current account deficit is 51 bananas and the capital account surplus is 51 bananas. The Chinese earn 51 bananas’ worth more of real income from US assets than Americans earn from their Chinese assets–which are $0 in this exercise–and this is matched by the Chinese acquiring on net 51 bananas’ worth of additional US assets this period. But note that there is no trade deficit in this period. The fact that Americans are “living beyond their means” is reflected in the net sale of assets [financial claims on future US banana output] to the Chinese, not in the physical importation of goods made in China.)
In the long run, the Chinese eventually acquire ownership of just about the entire real estate in the US. Because the Americans now have no assets to sell, the Chinese revert to consuming the annual yield of their assets. The long run numbers look like this:
Period LR: GDP=101; C=0, I=0, G=0, Nx=101.
The US trade surplus is 101 bananas, while the current account deficit/surplus is 0, and the capital account surplus/deficit is 0. No American eats anything. All US output is shipped to Chinese for their consumption.
Now here’s what’s really interesting. At every single point along the way, free market economists were blogging that there was nothing to worry about, and that the critics were simply racists who hated the Chinese. For example, one economist pointed out that the Americans couldn’t possibly be living beyond their means, because in no period did C ever exceed GDP.
Another economist pointed to the example of Period 1, when the trade deficit fueled an increase in domestic investment, paving the way for permanently higher GDP. This was obviously benign, and a reflection of the superior investment opportunities in the US vis-a-vis China.
These free market economists were particularly amused when the critics engaged in silly rhetoric by claiming that “Americans were selling their birthright for a mess of pottage,” etc. The free market economists argued that selling US real estate was the same thing as shipping a banana plant overseas, and yet the former was counted as an import while the latter was counted as an export. For some arbitrary reason, the people at the BEA thought selling real estate was somehow different from exporting bananas. What mercantilist idiots!
P.S. It should go without saying that I am not saying a tariff or other government restriction on trade would help things. I’m just trying to get you guys to see why people like Vox Day think libertarian economists are fools.
P.P.S. Don Boudreaux was being much more careful than Scott Sumner was. Don was arguing that trade deficits might not be a problem, etc. But after you’ve digested my fable above, go re-read Scott’s post. He is way too sweeping in some of his statements. And look at how he dismisses the quite serious objection by Phil in the comments, like it’s a real chore to have to answer somebody who gives a counterexample to his sweeping (and unqualified) statements in the original post.
P.P.P.S. I am particularly sensitive to this because I did a very similar thing with Peter Schiff back before the financial crisis. (In this piece I was pretty careful, but not so much in this piece, forcing me to write a mea culpa.) I’m not saying I’m better than Scott or Don, I’m saying I’m wiser since I got burned before. In particular, neither Scott nor Don even mentions the fact that the Chinese hold $1.2 trillion worth of Treasuries. What reason do we have to think that this has gone hand in hand with wise domestic investments that boost US output?