By No notion in economics is responsible for more misunderstanding and misguided government policies than that of the “balance of trade” (or “balance of payments”).
Rightly ridiculed in 1776 by Adam Smith as “absurd,” the so-called “trade balance” supplies protectionists with cheap yet convenient cover for their destructive interventions. The main reason is language: Saying that a country’s trade is “imbalanced” – especially if that country has a “trade deficit” – suggests to the economically uninformed that something is amiss. Who, pray tell, is comfortable with being out of balance?! All talk of “trade deficits” conveys the impression that the home economy is malfunctioning, or that foreigners are cheating at trade, or both.
But as I and others have explained repeatedly, this impression is not only false, it’s backwards. While hypothetical examples can be conjured in which a country’s trade deficit is a signal of domestic economic trouble, in reality U.S. trade deficits are overwhelmingly evidence of America’s economic vigor, at least relative to other economies. The reason is that U.S. trade deficits – or, more precisely, current-account deficits – arise whenever foreigners, during some period (say, some month), invest more in America than Americans invest abroad. Not only does this net inflow of global capital add to America’s capital stock, it’s also solid evidence that global investors are especially keen on the U.S. economy. Why Americans should be bothered by these realities is mysterious.
Nevertheless, if someone is intent on making the best case possible for being concerned about U.S. trade deficits, that case would point to the connection between U.S. trade deficits and U.S. government budget deficits – the so-called “twin deficits.”
Unlike trade deficits, which do not necessarily increase Americans’ indebtedness, U.S. government budget deficits do necessarily push American citizens further into debt: When the government borrows money to cover its current spending, future Americans are put on the hook to repay this debt. They’ll do so by paying higher taxes, by taking government-spending cuts, or by losing wealth through inflation.
So what’s the connection between U.S. trade deficits and U.S. government budget deficits? It’s the following: One of the countless ways for foreigners to invest dollars that they don’t spend on American exports is to lend those dollars to the U.S. government. These foreign investments in the U.S. both raise U.S. trade deficits and represent increased American indebtedness.
Is this a problem? Yes and no.
It’s a problem for what it signals, namely, government’s fiscal irresponsibility. It’s not a problem for what it does, namely, bringing more capital to the U.S. to help Americans shoulder the burden of Washington’s unsavory mix of gluttony (for spending) and cowardice (to raise taxes).
The U.S. Government’s Fiscal Incontinence
To the extent that U.S. trade deficits rise because the government sells more U.S. Treasuries – that is, borrows more dollars by issuing bonds – that part of the increase in U.S. trade deficits does in fact reflect a real problem in the U.S. That problem, again, is irresponsible government spending. But it’s vital to note that irresponsible government spending is caused exclusively by the fiscal recklessness of Congress and the White House; it’s not caused by foreigners making attractive offers of imported goods to Americans, or by Americans choosing to accept these offers. Regardless of how many or few imports Americans buy from foreigners, if the U.S. government lived within its means, there would be no new U.S. Treasuries for foreigners (or for Americans) to buy.
Someone might respond that foreigners’ eagerness to invest in safe U.S. Treasuries encourages Congress and the White House to spend irresponsibly. Such a causal connection between foreigners’ investment preferences and U.S. government budget deficits is logically possible, but it’s practically implausible, and highly so.
First, more than 60 percent of all federal spending today is non-discretionary; it’s on entitlements and debt service. These expenditures are obligatory. They are at today’s levels because of irresponsible commitments made by the government in the past.
It’s farfetched to think that Congress through the years arranged for entitlement spending and debt-service expenses to increase as much as they have (without being covered by increased taxes) because members of Congress were convinced that foreigners would eagerly lend to the government to cover these outlays. What happened instead is that politicians bought votes in the upcoming elections while giving little or no thought to just how these promises would be paid for. “Vote for me! I arranged for grandma today, and you tomorrow, to have more Social Security and government-funded medical care. And I didn’t raise your taxes to do it!”
Because the benefits to politicians of making such fiscal deals are reaped by those office holders immediately (in the form of greater electoral support), while the costs of these deals come due only in the future (when many of those same officials will be long gone from office), politicians who vote for increased entitlement and debt-service spending that isn’t covered by corresponding increases in taxes simply give no thought to how this spending will be paid for.
Second, discretionary government spending is driven overwhelmingly by similar political considerations. Politicians who vote for, say, agricultural subsidies without corresponding tax increases don’t do so because foreigners’ willingness to buy U.S. Treasuries keeps the government’s borrowing costs lower than otherwise. No. Even if the Almighty announced to Congress just before such a vote was to take place that only Americans and not foreigners can purchase U.S. Treasuries, the politicians who support these boondoggles wouldn’t in the least be deterred from voting for them. All that matters to these politicians is that the costs of today’s promises will be paid for tomorrow, largely by people who aren’t among today’s voters. And today’s politicians give absolutely no thought to the nationalities of the creditors to whom those future U.S. taxpayers will be obliged to pay.
Third, foreigners today own only about 23 percent of U.S. government debt. The bulk of this debt, in other words, is owned by Americans. If, therefore (and contrary to fact), the U.S. government’s fiscal incontinence is rightly to be blamed on people’s willingness to buy U.S. Treasuries, most of this blame would fall on Americans. Yet I’ve never heard any protectionist demand that the government obstruct Americans’ commerce with each other in order to reduce the profitability of that commerce and, in turn, diminish Americans’ willingness to lend to the U.S. government.
Before moving on, it’s worthwhile to make one further observation about protectionists who point to foreign purchases of U.S. Treasuries as evidence that U.S. trade deficits are a problem. In doing so, these protectionists portray the U.S. government as mindlessly borrowing money from foreigners that it shouldn’t borrow and spend. Yet to prevent this reckless borrowing and spending, protectionists propose giving that very same government more power to obstruct Americans’ freedom to trade. What miracle do protectionists have in mind that would transform a government that can’t be trusted to make sound decisions about how to spend its citizens’ tax dollars into a government that can be trusted to make sound decisions about how to obstruct those citizens’ decisions about how to spend their own dollars?
Foreigners Help Americans Share that Burden
Foreigners’ purchases of U.S. Treasuries push real interest rates in the U.S. lower than these rates would be absent such purchases. These purchases, therefore, help to encourage more productive investment in the private economy even if the projects on which the government spends the borrowed funds are wasteful or destructive. If foreigners were to stop lending money to the U.S. government, interest rates would rise and that part of the budget deficit once financed with funds borrowed from abroad would be financed instead with funds borrowed from Americans. In turn, Americans would devote fewer funds to private investment projects. The growth rate of the American economy would be made slower.
There’s no question that the government’s grotesque fiscal irresponsibility and resulting budget deficits pose a real threat to America’s economy. It’s a threat that should be taken much more seriously. If saner heads somehow manage to prevail and restore a measure of fiscal restraint, U.S. trade deficits might indeed fall, as foreigners buy fewer U.S. Treasuries. But, perhaps counterintuitively, U.S. trade deficits might instead rise. Greater fiscal responsibility in the U.S. would improve the future prospects of America’s economy. Attracted by these improved future prospects, foreigners might well increase their investments in the U.S. private sector by more than they decrease their lending to the government.
Either way, however, pointing to U.S. trade deficits as an excuse to have politicians – who are today incapable of fiscal responsibility – restrain Americans’ freedom to trade is, to use the most scientifically precise term, totally bonkers.