December 20, 2005, 8:42 am

After you finish this post, I have an updated post on the same topic here.

Well, the US trade deficit is up again, and you can be sure the news was accompanied by a lot of moaning and groaning and soul-searching. The main reason that all the media and the majority of Americans freak out over large trade deficit numbers is that they look at the American economy as a large bank vault with a fixed supply of money on the shelves. They reason that if more money is going out of the vault to buy things than is going back in from sales, then eventually the vault will go empty and we will be bankrupt. Either implicitly or explicitly, those who fear trade deficits perceive the trade imbalance to be red ink, something bleeding out of a fixed supply.

This view of the trade deficit as a being a growing and unsustainable debt is wrong. I will try to explain in a couple of ways.

The micro view

Lets first look at it from the perspective on one individual. Lets say Fred made $50,000 this year, and lives in a US where, before he makes his spending decisions, trade is exactly in balance with China. Fred spends some of his income on rent, and invests some in some nice US equities. And he takes $1000 of what he just made that he might have saved and buys himself a nice Chinese-made plasma TV so he can really enjoy the Superbowl next year.

So, where's the debt? One can argue that net savings is lower (perhaps - we haven't gotten yet to where the Chinese are spending their extra US dollars), but Fred seems to have increased the trade deficit without incurring any debt. In fact, Fred is actually better off, since in a free society no one engages in a transaction that doesn't return more value than one spends. In this case, the plasma TV provides more than $1000 of value back to Fred, or else he would not have engaged in the transaction.

Yes, many people are buying Chinese TV's with consumer debt, but these same people are buying much more American stuff with consumer debt as well. To the extent that there is or is not a "problem" with people taking on too much consumer debt, this problem is absolutely unrelated to the country of origin of the goods they are buying. You can max out your Visa card on American stuff just as easily as on Chinese stuff.

But wait, you say. The reason the debt is not obvious is from the way I structured the problem. I assumed the rest of the economy was static while Fred was making his decision. But if Fred had bought American, somewhere in the US economy there must have been less debt. So we will tackle this next.

The Economy is Not Zero Sum

Repeat please: The economy is not zero-sum. Never has it been so hard to convince people of a concept that should be so obvious. I used up bushels of electrons explaining why the economy is not zero sum here, but the short proof is easy: Look at the world in 1900. Look at it today. The world as a whole and most every individual is far richer. The fact is that economies create wealth every day, and free economies create a LOT of wealth.

At the heart of every argument that the trade deficit is bad is the mercantilist notion that the US economy is a bank vault leaking funds. But this analogy that seems to be in everyone's head is flawed. The supply of money or wealth in the US, in the vault, is constantly growing. If you really have to think of it as a vault, then think of what's inside as rabbits rather than gold bars. Does anyone doubt that if you start with a hundred rabbits and every year sent a few to China that you might still have more rabbits than you started with in the vault? A free economy is like a group of rabbits on Viagra. Even if the Chinese took billions of dollars they got from selling goods to the US each year and burned the money in a big bonfire, the US still would be growing in wealth.

Of course, the vault analogy sucks for a larger reason, that the US economy is deeply integrated with that of the rest of the world. In fact, much of the wealth creation comes from this very integration, providing a more robust division of labor and a deeper well of creativity and entrepreneurship than any one country could achieve on its own. And the dollars we send overseas don't stay there, they come back. But we will address this next.

So What do the Chinese do with Those Dollars?

OK, so we are all short-sitedly (at least according the the "progressive" intelligentsia) sending dollars to China to satisfy our consumerism. So what do those Chinese do with those dollars? They can't spend them domestically, because stores and vendors in China don't accept dollars any more than the Wal-mart down the street from me accepts Yuan.

Most all the dollars have to come back to the US, or the person in China holding them gets no value. You could say, well that person can take them to the bank and exchange them for Yuan, and that is true. But that bank would not accept the dollars for exchange unless it knew it could get them back to the US, or had another client that needed them to make a purchase in the US. So, the dollars will have to come back to the US to purchase something.

Some of the dollars come back to purchase US goods and raw materials, but of course this is less than the total dollars the Chinese have to spend, or else there would be no trade deficit. In fact, this all that the words "trade deficit" really means. It means that of the dollars the Chinese receive from sales to the US, only a portion is used to buy American goods that are shipped back to China. The rest goes to buy American .. something else.

What?

Well, some of it goes to purchase American goods that stay in the US. Lets shamelessly steal an analogy from Don Beadreaux and Jack Wenders. If Chinese companies buy American steel and lumber and ship it to China, it shows up in the trade balance. If they buy the same products and build a factory in the US, it does not. The Chinese use a lot of their dollars to invest in buildings, real estate, capital assets, factories, production facilities, etc. in the US. And this is bad, how? I know that since the Japanese investment boom of the eighties, there are lots of folks who call themselves "liberal" who suddenly got very upset about foreigners owning US-based assets. It is impossible for me to see this concern as anything but xenophobia and racism, since hundreds of years of Dutch, Canadian, and British investment never worried a soul but Japanese and Chinese investment has everyone in a lather.

By the way, if you worry about China as a security threat, wouldn't you rather see them invested in the US economy, and therefore have a strong interest in our continued prosperity? One could easily wonder why Saudi Arabia does not use their power over oil reserves to screw with the US like they tried to do in the early 70's. The reason is that all of their wealth is invested in dollar and euro-denomitated assets. People worry about the power the Saudis may have to mess with our economy, but their reinvestment of dollars back in our economy has made this a game of mutual assured destruction. The same thing is occuring with China.

The other thing the Chinese do with the money is invest in dollar-denominated financial assets, which in many ways is just an indirect way of investing in the same capital assets listed above. They will invest dollars in equities and, yes, debt securities. But the fact that the Chinese choose to spend their dollars on debt securities does not mean that the trade deficit is causing the debt. If the Chinese had a predilection for debt securities, more so than say an American holder of dollars, one might argue that this predilection drives down interest rates a bit and therefore might increase total debt, but this is a fairly tenuous chain of causation and not, I think, what seems to be bothering folks who panic over the trade deficit. In fact, one can argue that the causation runs more strongly the other direction, that the large US budget deficit keeps the dollar higher than it might otherwise be, increasing the trade deficit.

So when people lament that "we now consume much more than we produce", they are making a meaningless statement because the we in the first part are not the same as the we in the second part. The US and the Chinese are sending equal amounts of money back and forth - its has to be, over the medium to long term, or exchange rates would crash. All the trade deficit means is that there is a difference in WHERE Chinese and Americans consume the goods. Americans consume Chinese goods in the US. The Chinese consume some of the US goods it buys in China, and then consumes the rest in the US. The trade deficit represents the net amount of American goods and services the Chinese buy in the US and choose not to haul back to China. Instead, they take ownership of the American goods here, in the form of capital assets or financial securities that represent ownership or calls on the cash flow of these capital assets.

Anyway, you can find more here at Cafe Hayek.

Postscript: By the way, the US has run a trade deficit of a magnitude that panics people for over two decades. If this is bad, surely we would be able to find the damage somewhere. But the US over the last two decades has had the strongest economy in the world. I suspect that a lot of people would answer "we have run up a huge debt". But any increase in total debt in the US is not relevant to the trade deficit, or only tangentially related as discussed above. The Federal debt is run up because the politicians are all spending whores who support their reelection with "good works" paid for with our money. Consumer debt, which may or may not be "too high", is based on individual spending and saving choices, and is unaffected by whether a person buys an American or Chinese TV.