Gwen's Pub
Re: Trade Deficit

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By sonofed
June 15, 2006

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Why do we have to have balanced trade and how does us borrowing money (them buying T-bonds) balance trade?

Okay, You are selling a couch for $100. I have a bike to trade with you worth $70, leaving me $30 short. You aren't going to make the trade, because it isn't a reasonable trade for you. So I say, give me the couch, I'll give you the bike, and I'll owe you the $30 plus interest.

Now the trade is balanced. I gave you $70 worth of merchandise and $30 worth of debt security to pay for the $100 couch.

In the larger scale economy, the mechanism is roughly the same, but the operation is somewhat different.

Let's consider what would happen if the Chinese couldn't buy US assets or US debt to balance out the trade:

If the Chinese (To continue using them as an example) trade $1B worth of hard goods to us, and we sell them $700M in return, we have to give them the balance in dollars. The Chinese only have a use for a limited number of dollars because dollars have a limited utility.

Where can they spend those dollars? Well, in essence, the only place dollars have actual value is in the US (Which is a bit oversimplified given global currency trading, but is reasonably accurate). That means that the Chinese, in accepting the dollars, accept a claim on future production in the US. But wait, there was already a trade imbalance. Next year, the Chinese already have $300M in paper currency, so when they sell us $1B and we sell them $700M again, now they have a $600B stockpile of dollars. How long are they going to let that continue? Not all that long, if they don't have a place to invest those dollars. When their desire for dollars dries up, they effectively stop trading with us...well, what would actually happen is that the Yuan would rise dramatically with respect to the dollar (if it was allowed to float) and eventually would rebalance the trade, but that's tricky when one side doesn't float their currency and it also can wreak havoc on the economy since the process is fairly disruptive to the market.

Anyway, to avoid that disruption and to keep the whole thing working, we give them a place to invest the surplus from our trade.

Now they give us $1B worth of stuff and we give them $700M worth of stuff and either $300M worth of treasury debt or $300M worth of ownership positions in our corporations. Viola...the trade is balanced.

They trade $1B worth of stuff for $1B worth of stuff and everyone is happy.

Long term, that relationship isn't wise because over time we essentially give all of our assets to our foreign investors, which will have a dramatic impact on our ability to sustain our living standard, but that's how it works in the short term.

The thing is, just asking China to let their currency float won't do that much to change things. The US treasury is addicted to foreign savings. Currency adjustments to balance trade are just going to reduce the amount of foreign capital available to finance our budget deficit, which could have significant impacts on our economy.

The real answer, as I identified in my original post, is twofold:

1) Get Americans to consume less (and that means the government primarily)
2) Get them to change their preference for foreign goods.

#1 is far and away more important than #2. Americans have sustained an almost zero national savings rate - in fact it recently dipped into the negative. The means that every dollar we earn as a nation is getting consumed and we are relying on foreign direct investment to fund our growth. That isn't sustainable if we also try to eradicate the very "trade deficit" we are using to create the pool of funds to support foreign direct investment.

Okay, so this is a very long-winded post. Here it is in a nutshell:

1) Investment is required to drive economic growth and increase living standards.

2) The US government runs a massive budget deficit and the US people save almost nothing.

3) The investment capital needed to drive the US economy has to come from somewhere: Either trade imbalances or a very attractive investment environment (read "higher interest rates")

4) It comes primarily from the US "trade deficit".

If you want to eliminate the "trade deficit", you first need to eliminate the need for foreign investment capital by eliminating the government budget deficit and by encouraging Americans to save. Austerity doesn't sell that well to the American people, but that's the route we're going to need to take.

You could also eliminate the "trade deficit" by allowing the currency to devalue, but if you do that while the country is still hooked on borrowing, you have the potential for significant economic disruption.

Man...that will teach you to ask me a 1 line question, huh?


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