We need to talk about exchange rates and the trade deficit because this is a topic that receives a fairly large amount of attention in the media, but almost all of this discussion demonstrates absolutely no understanding of what is actually at issue. I don’t know who’s to blame for this. Perhaps it’s economists who have done a bad job articulating the core concepts; perhaps it’s the news media for not having the wherewithal to put anyone on air who can actually explain what the issue is. But whoever’s to blame, there seems to be a need for a simple explainer on what economists call “the balance of accounts.” So that’s what I’m going to try to provide here.
The common idea that I see repeated on the news is that there is this competitive enterprise, trade, and the goal is to do the most of it. Exports are great. Whoever is exporting things the most wins, because that means that they are producing the most, which means that their economy is the strongest. If you are winning at trade, you have so much trade you don’t know what to do with it: it’s a trade surplus. If, on the other hand, you are losing at trade, you have so little trade that your citizens are suffering: it’s a trade deficit. The goal, therefore, is to win at trade by accumulating a trade surplus.
That narrative makes emotional sense; it’s been fully embraced by President Trump, who is preternaturally skilled at fostering emotionally resonant narratives. And from a military perspective (more about this at the end of the post), this is a sensible way to think about some aspects of the American economy. But if you’re a typical American consumer who just wants the best for yourself, your family, and your fellow citizens, this is not how you should think about foreign trade. At all. It is, in fact, probably the worst way to think about trade. Long story short: if you want the best for yourself, your family, and your fellow citizens, that means you want a massive trade deficit, not a trade surplus. We are, if anything counts as “winning at trade,” winning about as badly as the Falcons were at Super Bowl halftime. And I’m worried that, like the Falcons, we’re about to throw our lead away.
To understand the significance of a trade deficit, it’s best to think in terms of general economic principles. What is money, and why do we have it? The standard story from Adam Smith, still accepted today, is that having money is vastly superior to a system of barter. If we have to trade with one another by exchanging consumer goods for one another, the economy will be massively inefficient. If I only have apples, and I need some socks, I need to look all over to find someone who has extra socks and needs apples, so I can make the trade. Much better to have a common unit of account – money – to facilitate these trades. I could sell my apples to whoever needs them for money, then use my money to buy all the things I need. This makes me much more productive: I can focus on growing apples, rather than scouring the countryside for useful apple trades.
So imagine that there is a village that has never discovered the wonderful economic benefits of money, and which operates on a barter system. Suppose that a young woman, Ursula, enters this village and has an idea: everyone can switch to using money. The villagers are initially skeptical, but Ursula is eventually able to convince everyone that using money is a good idea. But the villagers have a problem; they don’t have any money! That is, they have all agreed to use paper currency, but no paper currency exists to use. Ursula solves this problem: She prints her own money. The villagers, who currently have no money but want it very badly (since they see the benefits to using it), are willing to trade their goods and services to Ursula in exchange for her money. And at the end of the day, the village finds itself with a working money-based economy, and Ursula finds herself with a huge number of goods that she received from the other villagers. Urusla is immediately tempted to print more and more money, in order to get more and more goods from the villagers. But she realizes that, if she does this, the money she prints will quickly become worthless. So she controls how much money she prints very carefully, making sure only to print enough to replace worn out bills and keep pace with the needs of the village’s expanding economy. The money maintains its value, the villagers are happy to continue using it, and Ursula is able to make a living for herself simply by judiciously operating the printing press without ever having to make anything for herself.
The parable of Ursula is key to understanding the trade deficit. The village economy in this story runs on two kinds of assets: consumer goods and financial assets. Consumer goods are what people ultimately consume, and financial assets are used to help facilitate the production and exchange of consumer goods in a variety of ways. Although financial assets and consumer goods play fundamentally different roles in the economy, you can still trade financial assets for consumer goods. Also, someone needs to produce the financial assets. These two facts mean that, in any economy that contains both consumer goods and financial assets (i.e. any non-barter economy; i.e. every actual economy), someone gets to be the person who produces the financial assets for the economy as a whole, and that person basically gets consumer goods for free.
In the village in our parable, the person who gets consumer goods for free is UrSulA. In the world economy, the nation that gets consumer goods for free is the USA. (Cute, right?) In exchange for these consumer goods, the US trades away financial assets: the US Dollar, US treasury bills, and other stocks and bonds denominated in US Dollars. Many of these financial assets are created by the US Government. Many others are created on Wall Street.
There is incredibly high demand for US financial assets because the US has the strongest economy in the world. US financial assets are all (in one way or another) backed by the strength of the US economy. If you own a government bond – basically a promise, by a government, to pay you some money at some later date – which government would you like to hold that promise from? The government of Venezuela? Greece? Russia? Or the USA? There’s no real choice here. When it comes to financial assets, the rule of thumb really is Buy American. Not only does the US have the money to pay you back, they have to do it. The US government can’t ever just walk away from its debt – that’s actually in the Constitution! Because the US economy is so strong, and because its financial assets enjoy strong legal and Constitutional protections, US financial assets are particularly valuable. Because those assets are particularly valuable, everyone wants them. And because everyone wants US financial assets, we can trade our financial assets to the rest of the world in exchange for their consumer goods. We get Urusla’s job; we get to turn on the printing press and take a nap, so long as we don’t print too much money by the end of the day. That’s an awesome place to be in.
What does this have to do with a trade deficit, you might wonder? The answer is: this is the definition of a trade deficit. Urusla runs a massive trade deficit with her village. She exports money, but that doesn’t count for the economic measure that we label “Exports.” “Exports” are exports of goods. Thus, according to the practices of economic record-keeping, Ursula is exporting nothing to the village, but the village is exporting many things to her. This means that Ursula is running a massive trade deficit. By the common wisdom, Ursula is losing at trade. But if anything, it looks to me like Ursula is winning; she’s getting more than she’s giving. That kind of deal – where the US gets more from trade than it has to give – is precisely the kind of deal we should want for our country. I think President Trump would agree!
The point is that, in terms of trade, having a trade deficit means getting something for nothing. (Specifically, it means receiving consumer goods in exchange for financial assets). It’s really good to have a trade deficit.
So why is the trade deficit so often portrayed as bad? When I was first writing this, I wrote “Honestly, I’d just have to guess here. The trade deficit is portrayed in the media as being so self-evidently bad that the only question is what to do about it; no case is really made that we should think of the trade deficit as bad to begin with. But here are my two guesses for why we do think of the trade deficit as bad.” Then, mere hours later, the Wall Street Journal ran an op/ed by Peter Navarro, director of the White House National Trade Council, where Navarro gave the two arguments I guessed he would.
I would like to personally thank Mr. Navarro. Without his article, I would probably never have taken the step of starting this blog. But his arguments are so bad that they need to be refuted.
So here are the two reasons that we think the trade deficit is bad. First, we are addicted to a certain number in economic statistics: Gross Domestic Product, or GDP. When people talk about “the economy,” this is what they are talking about. When you read in the news that “the economy grew 1.7% last quarter,” what is being reported is that GDP increased at a rate of 1.7% last quarter. By common agreement, GDP is “The Economy.”
GDP is, by definition, the sum of consumption spending, investment spending, government spending (minus taxes), and net exports. It’s the last item, Net Exports (i.e. exports minus imports), that’s important to us. Because GDP is defined as the sum of Net Exports and a few other things, when Net Exports increases, GDP increases, by definition. But having positive Net Exports – exports greater than imports – is just another name for a trade surplus.
Thus, losing at trade – running a trade surplus – raises GDP while winning at trade – running a trade deficit – lowers GDP. And so, perversely, policies that constitute winning at trade are described as “weakening The Economy.”
Why focus on GDP at all? The answer is that GDP is an incredibly important number if you are a Pentagon official planning for a wartime economy. The amount of actual physical stuff that your nation can produce is really important if you need to convert all of the industrial capacity of your economy into producing tanks, planes, and ships, and if the winner of the war will depend on who is able to produce the most tanks, planes, and ships. This is not an abstract concern at all. World War II was exactly this kind of total war, and the US won that war precisely because it had the largest industrial capacity (if not at the beginning of the war, certainly by its end). For national security reasons, then, it is best not to let our industrial capacity atrophy completely. But we’re very far off from that actually happening. We run a trade deficit that is very large compared to the rest of the world (lucky us!), but the trade deficit is small compared to the total size of the domestic economy.
If we care about the domestic economy, consisting of the consumption of goods and services, by citizens, for their material improvement, then we ought not focus on the GDP number as the relevant measure of “The Economy.” And the main reason for this is that trade scenarios that boost the domestic economy weaken the GDP number. Focusing on GDP makes us stupid about trade.
The second reason that people think a trade surplus is good is that China has run massive trade surpluses for the last several decades, and their economy has been growing like crazy. It seems to follow that, should the US copy China’s policies, the US will end up with similar growth. But this analogy overlooks the fact that the American and Chinese economies are coming from completely different places.
Quick world history review: China missed out on Europe’s industrial revolution and fell badly behind the West, technologically, in the late 19th and early 20th centuries. By the time the world wars ended and the Chinese Communist revolution was over, China was still basically a pre-industrial or early-industrial society. Mao knew that China would have to rapidly industrialize in order to regain a place of prominence in the world. So Mao implemented his rapid industrialization plan, The Great Leap Forward. Subsistence farmers would melt their tools down to make the great factories that would power China into the future! Or at least that was the plan. Millions died in the ensuing famines.
After Mao’s death, the Deng Xiaoping realized that the Chinese would have to open themselves up to foreign investment and technology, to learn from the rest of the world instead of trying to jump to the cutting edge of the industrial age in one fell swoop. China’s currency policy was part of this: they would encourage a massive trade surplus, volunteering themselves to be “the world’s factory,” shipping iPhones and other valuable consumer goods around the world in exchange for pieces of paper with pictures of dead presidents on them. But they really weren’t in it for the worthless pieces of paper. By volunteering themselves as the world’s factory, the Chinese would receive foreign investment and technology, integrate themselves into the world economy, and complete the economic development that had eluded them in the Great Leap Forward.
In essence, the last 40 years or so has been the story of China’s completing an apprenticeship in having an industrialized economy. Like a medieval apprentice, a substantial portion of the benefits of the apprentice’s labor have gone to the master (the US, and the post-industrial West, generally), rather than the apprentice. But in doing the work, the apprentice gains the skills and experience necessary to one day become a master himself. The Chinese have a deep cultural respect for the way that diligence and hard study can lead to excellence.
This explains China’s current precarious economic position. China would like to transition to being in the US’s position: living off their economy’s dividends while running a trade deficit. (China is eagerly looking to recruit apprentices of its own in Asia and Africa.) But that means carefully unwinding a lot of the financial and industrial institutions that got China to where it is today. Whether China can accomplish this without incurring a major recession or political upheaval is the subject of much debate. I’m not sure whether to be a China optimist or a China pessimist in the current scenario. But the important point is that the US can’t do what China is doing in order to accelerate economic growth. China is growing rapidly from a low baseline: it’s completing its apprenticeship, and beginning to assume a position where it can directly compete with the US. Attempting to eliminate the US trade deficit and the Chinese trade surplus is viewed by many in the US as a way of undercutting China and halting its economic surge. But as far as I can see, this is at least as likely to aid China in its difficult transition to a post-industrial economy. If we declare that we will no longer allow China to produce goods for our benefit, that might leave Chinese businesses without markets to sell into. But look for unintended consequences: the rebalancing of exchange rates that would result from an elimination of the Chinese trade surplus would make Chinese consumers much more wealthy. The value of the RMB goes up; it becomes cheaper for Chinese citizens to buy imported goods; Chinese consumers then have extra money to buy domestically-produced Chinese goods. Thus, Chinese businesses will likely just produce their goods for the benefit of Chinese citizens, not American citizens. That’s exactly what China wants, and it may be, in some sense, more fair. But why would anyone view this outcome as being in the US’s best interest, either economically or geopolitically?
There are many worthwhile debates to be had over US trade policy, and there are certainly improvements that could be made. But to have these debates rationally, we need to first have a reliable idea of what is, and what is not, an improvement to US trade policy. Unfortunately, too many people are talking as though our greatest strength is in fact our greatest failure.