Rule Breaker Portfolio Our Friend, the Trade Deficit

Carrying a trade deficit is not necessarily a bad thing, since that figure doesn't accurately reflect a country's contribution to the world economy. Foreign investment is counted as a "debt" in international trade accounting, putting a negative spin on investments in America. Trade deficits demonstrate an openness to foreign cultures and a favorable atmosphere for the consumer.

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By David Gardner
May 30, 2001

Last Friday I wrote a column about innumeracy, the lack of understanding and appreciation of numbers. Innumeracy is broadly evident, even among the educated lawmakers of our fair country (perhaps yours too, if you're following the Fool from overseas). While innumeracy is a general problem, my column laid it particularly thickly over our government's seemingly constant inability to adjust its metrics and decision-making to account for inflation. Whether we're talking hard money political donation limits or IRA contributions, inflation adjustment bedevils and eludes Congress. And at the heart of this is either poor planning or innumeracy. Or both.

I got a bunch of supportive emails on this column, inspiring me to launch into a new sometime series that I'm going to call Rule Breaker Iconoclasm. In it, we'll target (as did those Iconoclasts of old) statuary. In this case, it's the statuary that results from thinking that is so ossified it qualifies as statuary! Chalk up "lack of inflation adjustment" as the first entry in our occasional series, and count this one the second. Below, I hope to help you understand a nebulous concept that nevertheless directly affects our standard of living, how we see the world, and how we vote. And as is the secondary aim of everything we do here in RuleBreakerLand, I hope with the material below to make you a star at cocktail parties. You ready?

Let's talk trade deficits.

"Trade deficits?! International trade balances?! Here? In this otherwise colorful Rule Breaker space devoted to pungent thinking about business and stocks?! BORING!" And complicated, right? Not really. And not boring, either. Highly relevant! Let's start with the skinny:

The country you live in sells stuff to other countries. Likewise, those countries sell stuff to your country. When you as a consumer buy, say, a foreign automobile, you get the wheels, they get your (foreign to them) currency. You've each benefited pretty equally, right? Ay, but here's the rub: Using the standards of international trade accounting, they are at a "surplus" and you are at a "deficit." Your money "flowed" out of your country. Shame on you.

The United States runs a "trade deficit." That means that here we buy more foreign stuff than foreigners buy from us. This is popularly thought to be a bad thing, a sign of weakness, something worthy of journalistic jeremiads and immediate political remedies. "Save this or that industry!" some will cry (generally, those in that particular industry), and their cries are directed toward politicians expected to solve "problems." That's why we elected them in the first place, right?

Perhaps you're getting the sense by now that in this issue of Rule Breaker Iconoclasm, we're going after the popular fallacy of "harmful trade deficits." Trade deficits are in fact a pretty healthy sign in America, and we need not tinker to reduce them.

OK, back to you. U.S. citizens are a lot like you in the foreign car example given above. They like to buy foreign stuff, too. In some cases, foreign stuff is cheaper; in others, of better quality; in others, more exotic or not otherwise attainable. Because the U.S. has generally low barriers to international trade (for which its citizens should be extremely grateful), you as a U.S. citizen have an opportunity to buy lots of foreign stuff. You benefit from doing so. Otherwise, why buy?

As a country that for most of the past century has run a trade deficit, America is termed a "debtor nation." Headlines have proclaimed it, pundits have decried it. Loaded terms like "debtor nation" tend to make people emotional, and in this case, tend to make us think we're making a big mistake... until you read The Motley Fool, that is (or Thomas Sowell's excellent 2001 book Basic Economics, for example) and learn three basic truths you need to know before forming an opinion on the subject:

1. International trade balance accounting does not count services rendered. Yep, shocking but true, international trade balances only track the movement of goods across borders. America may be the biggest and best software services provider in the world, but this doesn't get counted. The trade balance turns a blind eye to much of the profitable service-based economy of the United States, which for beneficial reasons will likely run as a "debtor nation" more often than not well into the future. Please note that "debtor nation" status has been the standard U.S. status over the past century, right alongside unprecedented broad gains in America's standard of living and prosperity.

2. In international trade accounting, foreign investment in a country is counted as a "debt." We turn over our dollars to foreigners when we purchase their goods. Guess what they usually do with them? Reinvest those dollars back into the U.S. of A. (BlackDane made this point really well in this post on our Economy & Markets discussion board, opining that foreigners who purchased our stocks the past few years at overinflated prices essentially gave us their goods for free.)

But just think of it, again: Foreign investment in a country is counted as a "debt"! In his book, Thomas Sowell writes, "The 'debts' generated by such activities are more like what happens when you deposit money in a bank, rather than like what happens when you simply charge things on a credit card.... Some people might become alarmed if they were told that the bank in which they keep their life's savings was going deeper and deeper into debt every year. But such worries would be completely uncalled for, since the bank's growing [so-called] debt means only that many other people are also depositing money in that same bank."

Ask yourself, then, how much do you wish to concern yourself with trade deficits, when not only do they ignore services but they also fail to credit a strong and constant foreign influx of capital? Let me ask the investor in you: Are the best companies on the stock market those that lure larger and larger amounts of invested capital? Of course. But in the bizarro world of applied trade accounting, those would be "debtor" companies and would have the popular media (and some politicians) criticizing them, saying "things must change." By contrast, "creditor" companies would be those whose own capital investment (into plants and infrastructure) outnumbered the amount that outside investors were willing to risk. Et cetera.

Again, it's a great situation to have the world's investors all injecting capital in increasing amounts over the long term into your economy. This compliment means you're perceived as a great investment, not a "debt" that must be "corrected" with trade surpluses.

3. Finally, trade deficits generally demonstrate a healthy openness to, and appreciation of, the culture and assets of other nations... and demonstrate as well as a trade policy that favors the consumer. The loudest voices in support of trade protectionism -- protecting a domestic industry being overrun by those naughty foreign infidels with their lower prices and more desirable products -- come of course from our fellow citizens who happen to be working in the doomed domestic industry. Their voices can be quite loud. And in politics, often the loudest voices are heard.

Further, some of us do tend to respond to "victims" who have been personified for us by a journalist or a politician. (The fallacy of composition, but that's another essay.) When a presidential candidate begins, "Let me tell you about a woman named Sally Tucker. Sally is 49 years old, from Gastonia, North Carolina, and has worked in textiles most of her life, just like her father and mother before her"... this is a sure emotional appeal designed to get you and me upset about our trade deficit and our poor textile industry. What -- who -- is being forgotten is all the rest of us -- y'know, the consumer... the nearly 300 million consumers who may not have a single voice as passionate as the special interests of the threatened domestic industry, but would all end up having to pay more money for the same or lower quality product if legislation aiming to restrict the importation of foreign goods were passed.

The fallacy of protectionism here is that it "saves" industries, in the same way I guess that throwing good money after bad in a loser investment may "save" that investment. Feels good at the time, perhaps, but doesn't provide you the ultimate consequences you sought.

For the three reasons listed above, I hope you now have enough cerebral ammo to be a star at your next cocktail party. Whether you mix in a crowd that loves talking domestic policy, or are surrounded by friends harmed by or benefiting from protectionism, you'll find many Americans are affected by direct hits to their pocketbooks based on the policies pursued by Uncle Sam. The ideas are therefore extremely important, and must be shared in a world that, in my experience, lacks an understanding of basic economics every bit as much as or more than it lacks numeracy! In a democracy!

I hope I've earned your interest and attention, throughout. Perhaps you didn't come here today thinking, "I hope he writes about trade deficits!" But if you're interested, I encourage you to join us on our Economy & Markets discussion board here in Fooldom (after clicking the link, you can make that board a "Favorite Place" by clicking its red heart) and come to learn with us and teach us lots more about the world in which we live.

Thus much for Rule Breaker Iconoclasm, for now. Fool on!

David Gardner, May 30, 2001

David Gardner is co-founder of The Motley Fool -- investors writing for investors.

Rule Breaker Portfolio


5/30/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AMGNAMGEN INC(1.48)(2.20%)65.82
AMZNAMAZON.COM(1.56)(9.06%)15.66
AOLAOL TIME WARNER INC0.100.20%51.10
CRAAPPLERA CORP - CELERA GENOMICS(2.23)(5.10%)41.47
EBAYEBAY INC0.130.22%59.88
HGSIHUMAN GENOME SCIENCES(3.31)(4.83%)65.20
SBUXSTARBUCKS CORP0.221.11%20.09

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(8/5/1994)
Annualized
Rule Breaker(1.58%)(4.33%)4.35%26.25%486.27%29.61%
S&P 500(1.57%)(2.33%)(0.11%)(5.47%)172.27%15.82%
S&P 500 (DA)(1.49%)(2.22%)(0.10%)(5.21%)186.53%16.69%
NASDAQ(4.18%)(7.40%)(1.50%)(15.63%)189.44%16.86%

Our overall return stats understate the portfolio's actual returns; here's why. See the internal rate of return below for an accurate statement of our annualized returns.

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (8/5/1994)
Rule Breaker35.00%
vs. S&P 50015.14%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4551.105618.21%
9/9/971320AMZN3.1815.66505.04%
12/16/981160AMGN21.4465.82206.93%
7/2/98940SBUX13.9820.0943.73%
2/26/991145EBAY46.5559.8828.65%
12/17/991260CRA39.7641.474.31%
9/22/00560HGSI80.0565.20(18.56%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain *
8/5/944020AOL$1,816.44$205,422.00$276,198.00
9/9/971320AMZN$4,204.20$20,671.20$55,978.10
12/16/981160AMGN$24,875.50$76,351.20$51,475.70
2/26/991145EBAY$53,294.44$68,562.60$15,268.16
7/2/98940SBUX$13,138.62$18,884.60$5,745.98
12/17/991260CRA$50,093.00$52,252.20$2,159.20
9/22/00560HGSI$44,830.50$36,512.00($8,318.50)
 
Cash: 
Total: 
$18.42
$478,674.22
 

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.



Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.