An article by Frank Shostak about the trade deficit, and a refutation of his arguments.

Smiling Dave posted on Sun, Jan 16 2011 4:28 AM

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http://mises.org/daily/2029

He argues that a trade deficit is no problem.

1. Argument the first:

"Let us take an American individual who earns his money by exchanging something useful for it — he produces consumer goods. He then decides to exchange the money for some other consumer goods that are manufactured in China. A Chinese producer who has received the American dollars uses them to buy consumer goods from the above American producer; i.e., he is importing from the United States. So what we have here is a situation in which the American producer has paid for the Chinese consumer goods with his saved consumer goods. Likewise the Chinese producer has paid with his saved consumer goods to secure American consumer goods. The American and Chinese trade balances are in balance.

Now let us assume that instead of using the dollars to buy American consumer goods the Chinese producer decides to invest his dollars in US corporate bonds. The US trade account in this case will move into a deficit whilst China's trade account will show a surplus. From the trade deficit perspective, as espoused by the popular way of thinking, this will be seen as bad news since American foreign debt has risen by the size of the deficit."

In other words, the American consumer has done his fair share of work, doing something productive, and that's how he has the money in the first place to buy that Chinese TV set. Just because the Chinese do what they please with the dollars they earn, like investing it in corporate bonds, does not mean the US is in any trouble whatsoever.

To illustrate why I think there is a problem, let us examine the situation of the [imaginary] Banana Republic. This country produce only one thing, and very efficiently at that, bananas. They get all their other needs, like TV sets and everything sold in WalMart, from abroad.

Oddly enough, only the citizens of Banana Republic eat bananas. Everyone else in the world dislikes bananas.

The citizens of BR do productive work, growing the bananas they love, and for which there is a huge domestic market. They get paid in dollars, and buy Chinese TV sets with the dollars. The Chinese buy corporate bonds with the dollars, and everyone is happy.

What's wrong with this picture? Quite simply, why do the Chinese accept those dollars in the first place? Corporate bonds or no corporate bonds, ultimately there is only one thing to with those dollars, buy bananas. And the Chinese hate bananas.

We have a trade deficit of close to a trillion dollars a year, year after year. Meaning we are making bananas nobody else wants to buy. Sooner or later they will wise up to this, realize there is no point owning dollars that can only buy bananas. And they will stop accepting dollars in exchange for all the stuff we are used to seeing on the WalMart shelves. Those shelves will empty, and we will be stuck.

The trade deficit is not neccesarily a problem, but it is a symptom of a bad situation that will one day fall apart.

2. His second argument:

Now, if the national balance of payments is an important indicator of economic health, as various economists are saying, one is then tempted to suggest that it would be a sensible idea to have balances of payments of cities and regions. After all, if we could detect the economic malaise in a particular city or a region, the treatment of the national malaise could be made much easier. Imagine that economists in New York City have discovered that their city has a massive trade deficit with Los Angeles. Does this mean that the New York City authorities must step in to enforce the reduction of the deficit? Luckily we do not have balances of payments between cities and it seems that no one is concerned with this issue. Why then be concerned with the so-called international trade account?

This is of course not a proof, but a riddle. Why do people care about deficits between two countries, but not between two cities in the same country? Fleshing out the riddle into an argument would go something like this: For whatever reason, people don't worry about intra city deficits. We are not saying why they are right, but we assume they are right about this. And whatever mysterious reason makes them right about cities also applies to countries.

But the above parable of the Banana Republic solves the riddle. The people of Los Angeles are [obviously] never going to say to the people of New York, "We don't want your dollars. There is nothing we can buy with them that we like". But the Chinese will say exactly that one day.