2017-09-13 / Opinions & Letters

Trade deficits and the dollar safe haven

By Michael Hicks

Probably the single most misunderstood facet of the economy involves trade and foreign investment. At least a dozen times a year I hear some version of the following claim: “Our nation needs to rebalance trade while attracting more foreign investment.” This statement sounds sophisticated, sober and well-reasoned, the words of a thoughtful statesman with exposure to commerce. In fact, it is raw baloney, or, in the jargon of economics, Taurus Excretum.

Underlying any understand of economics is something known as National Income Accounts. These are the accounting equations that describe the flow of money, goods and services among nations, business and households. These equations are not theories or abstract notions, but are simple accounting facts that must hold at all times.

Among the most basic of these is that net exports plus net foreign investments must equal zero. For the purist, that means that (X - M) + (FI - DI) = O, where the difference between exports (X) and imports (M) must be equal to the difference between foreign investment in the US (FI) and American investment abroad (DI). Here I use the US only as an example, for the math applies equally across the globe.

The equation free explanation for this is simple. If a country buys more goods than it produces (X - M is negative) it runs a trade deficit. But, the accounting ledger must balance. In order to pay for this trade deficit, a nation must attract more foreign investment. So, what does this look like?

In reality, trade consists of tens of billions of small transactions between businesses and households. There are huge amounts of exports, imports, foreign investment and American investment abroad. This can be as complex as an American firm expanding operations overseas or as mundane as a Spaniard buying a bottle of Coca-Cola.

Nations don’t really trade with one another, people and businesses do, but in this process the cash flows between nations must balance. Thus, it becomes an arithmetic necessity that if a nation runs a trade deficit of say $502.3 billion, it must in turn attract $502.3 billion in net foreign investment. A declining trade deficit means declining foreign investment. Period. Thus reducing the trade deficit and attracting more foreign investment is not possible. The list of political figures who misunderstand this fact is lengthy and bipartisan.

As it turns out, the U.S. trade deficit in 2016 was $502.3 billion, and net foreign investment was $502.3 billion. Most of that foreign investment came in the form of treasury bonds, or the purchase of US government debt rather than direct investment in property. These purchases are made by individuals and governments. So how is it that foreigners would be willing to buy U.S. treasury debt, and thus accommodate our consuming a half trillion more goods than we produce each year?

The answer is simple. The dollar is the most secure currency in the world. It is a ‘safe haven’ in the jargon of finance. For that reason foreigners who may be most untrusting of their own national currency crave the American greenback. The shear impossibility of a U.S. default and the improbability of a major devaluation of the dollar make it a low risk asset as well as a medium of exchange. This international trust in the dollar makes holding dollars valuable, but how big is the effect?

The U.S. trade deficit is 2.7 percent of our Gross Domestic Product (the total value of all the goods and services we produce). The status of the dollar as a nearly zero risk “safe haven” means that the typical American consumer consumes $102.70 worth of goods for every $100 worth of goods they produce. Sadly, what we’ve mostly bought is ineffective federal government spending, but that is another story.

The real implication of this little factoid is that the trade deficit isn’t something that can be erased by an improved trade deal, buy American campaigns or other magical thinking. Every dollar reduction in the trade deficit means a dollar less of foreign investment. The arithmetic is ineluctable, no matter how earnest or seemingly sophisticated claims to the contrary may be.

Michael Hicks is the George and Frances Ball Distinguished Professor of Economics and the director of the Center for Business and Economic Research at Ball State University.

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