Unsound economic ideas, like cats, seem to have several
lives. Errors which have been laid to rest in past decades and even
centuries are often resurrected, and once dusted off and dressed in new
apparel, they haunt humanity yet again.
One such spurious idea is the national "balance of
trade" notion which was articulated by the mercantilist writers of the
sixteenth, seventeenth, and eighteenth centuries. Although soundly
refuted by Adam Smith and following classical economists, the concept
has reemerged and is today the focus of national attention.
The U.S. trade deficit, which has increased
dramatically since 1983 and was a record $170 billion in 1986, is a
leading concern of our nation's politicians, labor leaders, businessmen,
and media. We are solemnly warned that jobs are being lost as we are
invaded with "cheap" foreign goods, American industry is losing a "trade
war" and is threatened with extinction, and America is becoming a debtor
nation. To sit by and do nothing about the trade deficit, according to a
growing opinion, is tantamount to national suicide.
It is most often suggested that the solution to this
"trade gap" is a policy of increased protectionism. To those who value
liberty this is a serious threat on at least two accounts. First, import
restrictions directly lessen the individual's freedom to exchange, and
correspondingly increase the government's power over the affairs of its
citizens. Second, and perhaps more importantly, individual freedom may
be further attenuated because the impoverishment accompanying trade
restrictions will likely cause people to invest more power in the civil
authority. Such was the experience of America during the 1930s when the
economic havoc created by the Smoot-Hawley tariff was instrumental in an
unprecedented expansion of government power.
The balance of trade notion owes its modem existence to
mercantilist writers. Prominent in the thinking of these early
economists was the desirability of the natural acquisition of gold and
the concomitant (or so they thought) increase in national power. A
nation could best accrue specie, they reasoned, by exporting more goods
than it imported. This was called "a favorable balance of trade." The
payment for the excess of exports over imports would take the form of a
gold flow into the nation and this new money (which mercantilists
confused with wealth) would stimulate the nation's production and add to
its power.
Two erroneous ideas pervaded mercantilist thought.
First, trade was mistakenly seen as a contest in which one party
inevitably bested the other. In each exchange there was a winner and a
loser, and a nation "won" at trade if it exported more goods than it
imported.
A second fundamental flaw in mercantilist thinking was
its holistic approach to economic analysis. The nation was considered to
be an entity in and of itself, separate from and more important than its
individual citizens. Thus international trade was not analyzed from the
perspective of the individual participants, but rather from the
perspective of the nation, or more accurately, the state.
Mercantilism Refuted
Beginning with the publication of David
Hume's essay "Of the Balance of Trade" in 1752, the mercantilist
arguments for the pursuit of a favorable balance of trade were soundly
refuted. Hume pointed out that no nation could have a continuously
"favorable" balance of trade because gold inflows would serve to
increase domestic prices and consequently discourage exports while at
the same time encouraging imports. The result would be an outflow of
gold, and a nation's balance of trade would tend toward equilibrium in
the long run.
Adam Smith and following classical economists, notably
David Ricardo, refined the case for free trade and exploded other
mercantilistic myths. The holistic approach to economic analysis was
soundly rejected since, as Smith wrote, "What is prudence in the conduct
of every private family, can scarce be folly in that of a great
kingdom." 1 The nation was seen as the sum of its citizens
and thus "national gain" was simply the total of all individual gains.
Furthermore each trade did not have a winner and a loser, but rather was
a mutually advantageous exchange, undertaken only because each
individual believed himself to be gaining. And if each individual gained
in each trade, how could the nation suffer from a trade deficit?
The holistic thinking of the mercantilists has been
readopted and modified by much of modern economic thought, and today's
emphasis on "national trade" has confused many people. To understand
what a trade deficit is, we must start with the individual. After all,
it is individuals and not nations who actually trade goods and services.
When an individual agrees to exchange one commodity for
another, he does so only because he believes it to be to his advantage.
This is true for both parties in any trade; it matters not whether the
exchange takes place across the street, or across national boundaries.
Consider an American trading with a Japanese citizen
(we could just as well take a New Yorker trading with a Californian).
Suppose that the American values a Japanese television set more than a
particular piece of machinery which he has produced, and at the same
time, the Japanese values the piece of machinery more than the
television. If such is the case, they will exchange. This, of course, is
simple barter-goods are exchanged directly for goods-and there is no
monetary intermediary. But notice that no one has a "deficit" in this
transaction -both parties are satisfied that they have gained more than
they have given up.
Of course, very few barter exchanges actually take
place. It would be difficult for the person desiring the TV set to find
a person in need of the particular machine tool which he had to offer in
exchange. Rather, the exchange is facilitated by the use of money, which
allows the machine tool manufacturer to sell his product to anyone who
wants it and then use the money to purchase the specific good (in this
case a TV) from the Japanese producer. The Japanese producer can convert
these dollars into the American product (in this case a machine tool)
which he desires.
Although these individuals do not exchange directly,
but through several intermediary buyers and sellers, the exchange is in
principle the same as if they did. Ultimately the good produced by the
American "pays" for the good received from the Japanese, and the
Japanese good "pays" for the good received from the American. In other
words, exports pay for imports.
But how then is a trade deficit possible? If in each
exchange both parties are paying via goods and services, how can there
ever be a national imbalance of trade? Why would foreigners agree to
give up their products to us if they are not receiving American goods
and services in exchange?
The answer is that they do not. Since each party trades
only to gain, the difference between the value of the tangible or real
goods which are given up by the "surplus" country and the value of the
real goods which are received must be made up of other types of valuable
goods. Each trade must balance; the deficit of real goods must be
countervailed by a surplus of another type of exports.
And it is. The difference is made up of a net transfer
of dollar claims from American individuals to foreign individuals. The
trade deficit, which is more accurately called the merchandise trade
deficit because it includes only the real goods traded, is possible only
because on a net basis foreigners are willing to accept dollars in
exchange for their goods and services, and temporarily hold these
dollars. In other words, the U.S. currently is running a "surplus" of
dollar exports with the rest of the world.
Why Value the Dollar?
Why are foreign individuals willing to
accept paper assets in exchange for their real goods? The obvious answer
is that they value the American dollar highly. This is true for a number
of reasons.
First, the dollar has become, since the demise of the
Bretton Woods agreement, the reserve currency of the world. It serves
the function previously served by gold, allowing foreign central banks
liquidity and the ability to inflate their currency.
Second, until recently, the real return on U.S.
securities has been very attractive to foreign investors. Relatively
high interest rates combined with the relatively low inflation of the
dollar during the first several years of this decade (in comparison to
other major currencies) has made dollar investments popular with
foreigners. Foreign holdings in the U.S. are now over one trillion
dollars and are growing at an annual rate of $100 billion.2
Third, the U.S. and thus the dollar, has become an
international haven for "capital flight" from the less stable and less
free countries of the world. Morgan Guaranty estimates that during the
past ten years $188 billion has come into the U.S. from eighteen
developing countries .3
Fourth, because of massive foreign loans during the
1970s, there is a substantial demand for dollars to service these debts.
Countries such as Brazil and Mexico can only repay their
dollar-denominated loans by running trade "surpluses" with the U.S. They
obtain the necessary dollars the only way they can-by trading real goods
for dollars on a net basis.
And fifth, because of widespread currency debauchment
among foreign countries, the American dollar serves as a parallel money
throughout Latin America, Southeast Asia and even parts of southern
Europe.
These factors explain why on a net basis, foreigners
are willing to "buy" our dollars with their goods. But the high demand
for the dollar does not by itself explain the continuing U.S. trade
deficits.
The other major factor enabling America's consumption
to exceed its production is the Federal Reserve's policy of monetary
inflation. In any inflation, the individuals who initially possess the
newly created money gain the maximum benefit. This has been the case in
the international arena where, because of dollar inflation, individual
Americans have found themselves the initial recipients of new money.
Having increased nominal incomes, but not wishing to
increase their individual "cash balances," Americans have spent this new
money for real goods, either domestic or foreign. New dollars spent on
domestic goods tend to bid up domestic prices, and foreign goods (which
have not yet been bid up) become more attractive to American consumers.
Eventually dollars pour abroad in exchange for foreign goods. Inflation
of this "world currency" has allowed Americans to bid goods and services
away from other international buyers.
On net, Americans have been trading dollars for real
goods because, for a number of reasons, they value the foreign goods
more highly than their dollars. At the same time, on a net basis,
foreigners are valuing the dollars they receive more highly than the
real goods they are giving up. Can we say which party is getting the
better deal? To do so would suggest that one is either irrational in its
dealings or does not know its own best interests.
The questionable validity of seeing a trade deficit as
"bad" and a trade surplus as "good" becomes apparent. If we can say that
the U.S. is experiencing a trade deficit because it is losing dollars,
we can just as accurately say that the Japanese are experiencing a trade
deficit, as they are losing automobiles and television sets. Which are
more valuable, dollars or real goods" This is purely subjective
decision. While one person values dollars or dollar-denominated
investments more highly, another person places a higher value on real
goods.4
If an individual is not harmed by running a "trade
deficit," can a nation be? The answer is no. The economic gain or loss
of a nation, as the classical economists recognized, is the gain or loss
of its individual citizens. But what about charges that the trade
deficit has led to unemployment and declining wage rates, the
uncompetitiveness of American industry, and the debtor nation status of
America?
The Effect on Labor
It is popular to speak of the trade deficit
as "exporting" American jobs. It is thought that when American consumers
buy foreign goods produced with "cheap" labor they are disemploying or
at least reducing the wages of American workers. The assumptions
underlying this argument are specious.
The first erroneous assumption is that there is a fixed
number of jobs in the world, and that the employment of a foreigner
means the corresponding disemployment of an American. This is
reminiscent of the mercantilist thought of past centuries which assumed
a fixed amount of wealth in the world. The number of jobs, or more
accurately the demand for labor, is not some quantity mysteriously
mandated from above, but rather is completely dependent upon the price
(wage rate and benefits) that workers demand for their labor. If the
price of labor is held above the marginal productivity of labor,
employers cannot profitably hire, and unemployment is the result.
Unemployment has everything to do with the price of labor and nothing to
do with the foreign goods we purchase.
Second, this argument overlooks the factors that
determine wage rates. Wage rates in America are not comparatively high
because we have more humane employers or a more benevolent government.
They are higher because the marginal productivity of American workers is
higher, and this is due primarily to capital investment. Nothing, aside
from declining marginal productivity, threatens the level of wages.
Therefore, the low level of foreign wages does not threaten the wage
rates of Americans.
This does not deny that the wage rates in specific
American industries may be affected by imports. If American consumers
begin to purchase less expensive foreign steel instead of domestic
steel, the wage rates within the American steel industry will tend to
fall as producers cut costs to compete. But at the same time, unseen
benefits are also occurring. The real wage rates of all Americans will
rise since the less expensive imports allow them to either buy more
products containing steel, or buy the same amount of steel-related goods
and more of other goods. Furthermore, since the division of labor is
enhanced, both the productivity of labor and wage rates are generally
improved.
The third faulty assumption in this argument is that
when dollars are spent on foreign products (as opposed to domestic
products) wealth and employment are lost forever to American industry.
But the dollars received by foreigners do in fact return to demand
American goods and services in one of two ways. They either will be
invested in American capital and equities markets, or spent on American
real goods and services. If the former, they serve to lower capital
costs for American entrepreneurs and contribute to American employment
by lifting the marginal productivity of some workers over institutional
barriers. To the degree that dollars are redeemed for real American
goods and services, they are "votes" for efficient American industries
and contribute directly to employment. In either case, net jobs are not
lost because of imports, but rather are diverted from less efficient
industries to industries at which America has relatively lower
production costs.
Does the trade deficit indicate that American industry
is losing a "trade war" and is becoming uncompetitive? First of all, we
must bear in mind that trade is never comparable to a war. In war the
stronger triumphs at the weaker's expense, but in trade the weaker gains
as does the stronger. In war armies cross borders to harm and destroy
people; in trade goods cross borders to please and enrich people. While
losing a war denotes national weakness, imports signify no such thing
but instead are a sign of a country's relative inefficiency in the
production of a particular good. It is certainly true that each time a
consumer buys an imported good it reveals that a particular domestic
industry is inefficient relative to a for sign producer. But this only
means that America is the same as every other nation and has relative
strengths and weaknesses of production.
Furthermore, imports only reveal the areas at which
American industry is relatively inefficient; they are not the source of
this inefficiency. The competitiveness of any industry depends on the
costs it must pay for capital, labor, government, and resources. It is
true that some traditionally competitive American industries may, for
any number of reasons, become uncompetitive in relation to imports. But
contrary to the beliefs of many politicians, trade restrictions do not
improve an industry's competitiveness and only end up punishing all
consumers by forcing them to pay higher prices. In the long run, trade
barriers only lower the real wages and living standards of all people.
Why is the U.S. a "Debtor Nation"?
Another evil attributed to
the trade deficit is America's debtor status. It is true that the U.S.
has been a "debtor nation" since 1985. This sounds ominous. But the word
"debtor" is misleading in this case since there is no outstanding debt
which must be paid by Americans to foreigners. The debtor status of the
U.S. simply means that the dollar value of foreign investments in the
U.S. surpasses the dollar value of assets owned by American individuals
abroad.
This has come about because during the past several
years Americans have freely chosen to relinquish ownership of dollars
(and dollar assets) in return for real foreign goods.5 This
influx of foreign capital poses no threat to the well-being of the
nation, and is actually beneficial. In 1986, while American individuals
and corporations saved some $680 billion, the various levels of
government borrowed $143 billion to finance deficits.6 The
foreign capital inflow of $144 billion (made possible by the trade
deficit) in effect cancelled the capital consumption of government. It
has temporarily allowed private investment to proceed as if there were
no budget deficit.
While the trade deficit probably has been beneficial to
the American economy, a major cause of the trade deficit, the inflation
of the U.S. dollar, will have adverse effects. As the exchange markets
respond to the increased quantity of dollars in circulation, the dollar
depreciates in value. In the past, foreign dollar holders-both
individuals and governments have invested many of their dollar holdings
in fixed-return securities. Their capital investments have kept U.S.
interest rates below what they otherwise would have been.7
But the depreciation of the dollar has punished these holders of
fixed-return securities. Becoming less willing to bear this loss,
foreign investors are seeking other uses for their dollars. Such is
happening today as foreign held dollars are flowing into U.S. equity
markets. Foreign holdings of U.S. equities increased by $5 billion in
1985, $23-$25 billion in 1986, and will increase by an estimated $35
billion in 1987.8 The recent stock market boom is partially
fueled by this foreign buying.
When the speculative boom in the stock market comes to
an end, foreign dollar holders will likely use their dollars to buy real
American goods and services. This will cause domestic prices to be bid
up. Because a shrinking amount of foreign-held dollars will be available
to finance U.S. capital demand, domestic interest rates also will rise.
Interest rates will increase further as savers become aware of rising
prices and take into account the future depreciation of their dollars.
As the dollar depreciation continues, American goods and services will
become more attractive to foreign consumers. And at the same time,
because of the depreciating dollar, imported goods will become more
expensive for American consumers. The trade balance will once again tend
toward equilibrium.
Thus, the end of the trade deficit will likely be
accompanied by high interest rates and inflated prices, and followed by
a recession. But these undesirable consequences arc not the result of
the trade deficit per se, but of monetary inflation-the consequences of
which have been forestalled for a time because of the unique position of
the American dollar. The fruits of past monetary sins are at last
revealed as the economic distortion becomes apparent. As foreigners
convert their dollars into real goods and the inflow of foreign capital
subsides, interest rates will rise and entrepreneurial "malinvestments"
wilt be exposed.
If the trade deficit is a national problem, it is for
two reasons. First, its eventual end will exact a price for the Federal
Reserve's past excesses, and individual Americans no longer will be able
to consume more than they produce. And second, because of special
interest groups and the mercantilist perspective of many politicians,
the trade deficit threatens to lead to protectionist legislation. This
is despite the fact that the actual threat posed by a trade deficit is
minimal or non-existent. In the words of economist Herbert Stein, "There
must be something more serious to worry about." 9
While the trade deficit itself is not threatening,
government interference with international trade is. Any political
efforts to rectify what is seen as "the trade problem" are certain to
harm the economic interests of the vast majority of Americans. As far as
the trade deficit is concerned, there is little doubt that any
government cure will be worse than the imagined disease.
Mr. Ewert was a recent graduate of Grove City College
at the time of the original publication, and was working on a master's
degree in public policy at CBN University.
1. Robert L. Heilbroner, The Essential Adam Smith (New
York: W. W. Norton & Company, 1986), p. 266.
2. Jaclyn Fierman, "The Selling Off of America,"
Fortune, December 22, 1986. pp. 44-56.
3. "Foreign Money Finds Haven in U.S.," The Wall Street
Journal, May 27, 1986, p. 2.
4. In retrospect we see that foreign individuals who
have chosen to accept and hold American dollars have been harmed by the
subsequent inflation and depreciation of their dollar assets. But the
fact that people sometimes misjudge the future and take actions contrary
to their best interests does not suggest that the individual's freedom
should be lessened for his own good. Who could be a better judge of
someone's interests than the person himself?
5. Americans can buy foreign goods or invest in
American business, but they can not do both at the same time. To the
degree that Americans are exchanging dollars for foreign consumer goods
(obviously not all imports are goods for consumption). the trade deficit
is an indication of our "present orientation." It indicates a preference
for consumption over investment, or in other words, present enjoyment
over future enjoyment. The trade deficit, however, does not cause this
high time-preference, but is a symptom of it. Protectionist legislation
would not change the time-preference of American consumers (i.e., stop
people from consuming instead of investing), but only changes how
time-preference is manifested (forcing consumer spending to shift from
foreign to domestic goods). As Gary North writes: "Americans are
increasingly willing to exchange their economic futures for present
delights . . . What should the Federal government do about the
short-sighted vision of American consumers? Is it the responsibility of
the Federal government to pass legislation controlling people's time
perspective? . . . Those who want to invest in American business should
be allowed to invest." (Gary North, "Should American Business Give Up
Smoking?" Biblical Economics Today, April/May 1987, p. 3)
6. Herbert Stein, "Leave the Trade Deficit Alone," The
Wall Street Journal. March 11, 1987, p. 29.
7. Lewis E. Lehrman, "Trade War or Monetary Reform,"
The Wall Street Journal, January 28, 1987, p. 26.
8. Michael R. Sesit, "Overseas Holdings of U.S. Stocks
Grow," The Wall Street Journal, February 27, 1987, p. 13.
9. Stein, p. 29.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.
, November, 1987, Vol. 37, No. 11.
Yourname@libertyhaven.com
