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Americans presumably realize by now that living in a bubble economy, while exhilarating as long as the champagne lasts, is not a good move.

Therefore it is worth understanding why the biggest bubble of all may be yet to pop. I refer to America's trade imbalance with the rest of the world.

As I explained in a previous post, our trade deficit with the rest of the world means that we must a) borrow money and b) sell existing assets in order to cover the yawning gap between our imports and our exports.

And while a rich nation can indeed borrow a huge amount of money and has a lot of assets to sell off, this doesn't mean Santa has installed an ATM on every street corner. Which is what a lot of people seem to think.

Now it used to be that American liberals were the ones traditionally accused of "money-grows-on-trees" thinking. But I've noticed something: when it's convenient to them (i.e., not a matter of cutting social programs they don't like), American conservatives are now even worse.

Let's take as a case-in-point this recent assertion by Don Boudreaux of the libertarian Cato Institute:

Second and most importantly, Mr. Fletcher doesn't understand what a trade deficit is. An increase in the U.S. trade deficit does not necessarily mean that Americans are borrowing more or are selling off assets. The volume of productive capital assets is not fixed. Foreigners who invest dollars in creating and expanding businesses in America increase America's capital stock without either putting Americans further in debt or decreasing Americans' ownership of assets. Given that America is the world's leading destination for foreign direct investment, it hardly seems plausible that the U.S. trade deficit is evidence of American impoverishment or of inadequate production.

Now the key phrase here is, "The volume of productive capital assets is not fixed." The idea appears to be that because we can always make more assets, there's nothing wrong with selling them off to foreigners. Sounds logical enough.

The problem, though, is that even if you can bake more cookies, selling off the cookies you already have results in your ending up with fewer than you would otherwise have. Maybe you don't end up with nothing, but your still have fewer cookies than if you hadn't sold any.

The meaning of this analogy is that even if America can increase its stock of capital assets over time (as we obviously can), selling off some of those assets to foreigners still means we own fewer assets. Our net worth is still lower. We are poorer, by basic accounting. We own less.

Debt works the same way. Even if America's capacity to service debt goes up over time (as it does with a growing GDP), assuming debts to foreigners still means that we owe more than we otherwise would. Again, our net worth is lower. Our debit column went up.

Now let's look at the next tenet of bubble-think expressed above, the idea that "foreigners who invest dollars in creating and expanding businesses in America increase America's capital stock without either putting Americans further in debt or decreasing Americans' ownership of assets."

There are two problems with this idea.

First is that most foreign investment into the United States simply doesn't fall into this category. For example, of the $260.4 billion invested in 2008, 93 percent went to buying up existing companies, according to the Bureau of Economic Analysis. (Thomas Anderson, "Foreign Direct Investment in the United States," BEA, June 2009, p. 55.) Worse, a huge chunk of foreign investment in the U.S. just goes for Treasury securities, which get recycled, by way of deficit spending, into consumption, not even investment in existing assets.

Second, it's a baseline trick. It is indeed true that if we take our low savings rate as a given and ask whether we would be better off with foreign-financed investment or no investment at all, then foreign-financed investment is better. But our savings rate isn't a given, it's a choice, which means that the real choice is between foreign- and domestically-financed investment. Once one frames the problem this way, domestically-financed investment is obviously better because then Americans, rather than foreigners, will own the investments and receive the returns they generate.

Developing nations face this problem all the time (and more honestly than we do right now): While it's certainly nice to have foreigners come and invest in your country, because this creates jobs et cetera, what's even better is if you have the capacity to invest for yourself. Being able to develop your own country with your own investments, rather than depending upon others, is part of what distinguishes the serious players from the also-rans.

The last time America was importing huge amounts of capital was in the 19th century, when we were still a developing nation dependent upon European bankers to pay for building our railroads and the like; as we matured into a major industrial power in our own right, the tide reversed and we exported capital back to Europe to rebuild it, for example, after two world wars. In the 19th century, we borrowed to invest in projects that made us more productive, improved our capital stock, thus we could (and did) pay back the borrowing. Borrowing to consume is quite the opposite. Today, we are selling off our capital stock and damaging our future productivity.

The free trade crowd also assumes that the economics of trade takes place in a vacuum. This is where the golden rule applies: He who has the gold makes the rules and controls the key decisions. There are important economic and political consequences. If Washington is under the influence of Wall Street and so-called "American" multinationals, what will our policies look like, what freedom of action will we have as a nation? How does one possess national security when the economic sinews thereof belong to someone else?

At some point, all this will come out in the wash. Don't say I didn't warn you.

Source: America's Trade Imbalance: The Biggest Bubble of All Has Yet to Pop