In a Forbes article Saturday ("Donald Trump's Trade Policies: Blessing Or Curse?") Forbes contributor Stuart Anderson features comments from Mercatus Center Senior Fellow Dan Griswold and me as he tries to answer the question "What do economists think of Donald Trump's proposed trade policies?"
Here's an excerpt, supplemented with the chart above and some additional comments of mine that weren't included in the Forbes article due to space limitations:
Anderson: As economists can you explain what most economists think about trade deficits.
Griswold: Foreigners like American exports, but they love American assets. In a typical year, foreigners take about $500 billion of what they earn selling us imported goods and services and use those dollars to acquire U.S. assets. That's another way of saying our $500 billion current account deficit is exactly offset by a $500 billion investment surplus. The net inflow of foreign capital allows our level of domestic investment to exceed our level of national savings, fueling productivity and growth. If politicians try to "fix" the trade deficit, they will only succeed in cutting off the net inflow of foreign investment, leading to higher interest rates and less investment in foreign-owned factories.
Perry: One very important, but almost always overlooked point is that there really is no overall deficit (or surplus) for international transactions once we account for both: a) cash flows for goods and services (current account) and b) cash flows for financial assets (capital account). A full accounting for all cash inflows and cash outflows over a certain period for all international trade in goods, services and financial assets in known as a country's "balance of payments." And just like a corporate balance sheet for a company, our balance of payments as a country always has to balance once we consider our "current account" (which has been in deficit for many decades) and our "capital account" (which has been in surplus for many decades).
Therefore, any trade deficit for our current account has to be exactly offset with an equal dollar amount of surplus on our capital account. Another way to think about it is to say that our trade deficits for merchandise are always accompanied by a "foreign investment surplus." In terms of numbers, our recent current account trade deficits of about $450 billion per year are offset by $450 billion in annual capital inflows used to purchase America's financial assets like corporate stock and bonds, real estate, bank deposits and Treasury securities, and as foreign direct investment in America's factories and businesses. (see chart above). Therefore, in reality, the trade deficit as most people (mis)understand it doesn't even really exist, because America's total trade with the rest of the world is always perfectly balanced once we account for all international transactions for goods, services, investment income, and financial assets.
Beyond the fact that the discussion on the trade deficit is typically incomplete by focusing only on trade flows for goods and services while ignoring trade flows for financial assets, there is a larger issue with the obsession with America's trade deficit. And that's the fact that the trade deficit is almost always reported in the media as a sign of America's economic weakness, when that is not the case at all. After all, the flip-side of the "trade deficit" is an inflow of foreign capital that provides a vital source of financing that fuels capital creation and business expansion in America, which leads to increased future output and employment in the U.S., and a more dynamic and vibrant economy. George Mason University economist Don Boudreaux expressed it this way: "To lament America's trade deficit is to lament the fact that foreigners are investing in America. And that seems very odd."
To think more clearly about international trade and trade balances, every time in the future that you hear the term "trade deficit" in the media or from a politician, especially when it used negatively to imply America's economic weakness, just replace "trade deficit" with the term "vital capital-creating, job-generating foreign investment surpluses for a better America."
In a related op-ed in Friday's New York Times ("Want to Rev Up the Economy? Don't Worry About the Trade Deficit"), Harvard economist Greg Mankiw makes some similar points about trade and trade deficits (emphasis mine):
The most important lesson about trade deficits is that they have a flip side. When the United States buys goods and services from other nations, the money Americans send abroad generally comes back in one way or another. One possibility is that foreigners use it to buy things we produce, and we have balanced trade. The other possibility, which is relevant when we have trade deficits, is that foreigners spend on capital assets in the United States, such as stocks, bonds and direct investments in plants, equipment and real estate.
In practice, these capital inflows from abroad have been large. Net foreign ownership of American capital assets has risen to about $8 trillion from $2.5 trillion at the end of 2010. American companies moving production overseas get a lot of attention, but this data shows that capital has, over all, moved in the opposite direction.
It is easy to understand why foreigners are eager to buy American assets. Despite the meager recovery from the financial crisis and recession of 2008-9, the United States remains one of the more vibrant economies of the developed world. And if you want a safe place to park your wealth, United States Treasuries are your best bet.
The trade deficit is inextricably linked to this capital inflow. When foreigners decide to move their assets into the United States, they have to convert their local currencies into American dollars. As they supply foreign currency and demand dollars in the markets for currency exchange, they cause the dollar to appreciate. A stronger dollar makes American exports more expensive and imports cheaper, which in turn pushes the trade balance toward deficit.
From this perspective, many of the policies proposed by Mr. Trump will increase the trade deficit rather than reduce it. He has proposed scaling back both burdensome business regulations and taxes on corporate and other business income. His tax cuts and infrastructure spending will most likely increase the government's budget deficit, which tends to increase interest rates. These changes should attract even more international capital into the United States, leading to an even stronger dollar and larger trade deficits.
Rather than reflecting the failure of American economic policy, the trade deficit may be better viewed as a sign of success. The relative vibrancy and safety of the American economy is why so many investors around the world want to move their assets here. (And similarly, it is why so many workers want to immigrate here.)
Mr. Trump says he wants to restore more rapid economic growth. That is a sensible goal. But focusing on the trade deficit is not the best way to achieve it.
Bonus: George Mason University economist explains in the video below why there's no need to fear the U.S. trade deficit, and why trade deficits always improve the economy because trade deficits = foreign investment in America.