Warren Buffett Was Wrong - Trade Deficits Don't Matter

Summary

• It's a common enough theme, that the American trade deficit tells us something important about the American economy. This is false.
• Both Warren Buffett and Robert Lighthizer - who is the current Trade Representative - insist that this deficit does matter. They are both wrong.
• We can show this by looking at the household accounts for the US as just published. Disregard the deficit as a useful indicator of the economy or investment patterns.

It's a common complaint

That we buy more from foreigners than they buy from us isn't actually something true. Nor even possibly true. However, we do divide the trade accounts into two parts, the current account and the capital account. It's entirely possible for us to buy more on the current, they to do more on the capital, account. This is often worried about under the general rubric of the balance of trade. Adam Smith told us there was little more ridiculous than worrying about this and this has become ever more true since his day as we have floating, not fixed, exchange rates today.

That this is all something not to worry about means we should pay little to no attention to market movements caused by people worrying about it. Even, trade against the movements caused by those worries. True, this is rather more a long term point than an immediate trading opportunity but it is still one worth understanding.

The trade deficit

We can see in the current politics that many do worry about the trade deficit. The President for example. It's also true that unions are rather against it, their power being concentrated in manufacturing - in the private sector at least - and it's manufacturing where the deficit bites hardest upon domestic employment.

The problem with the formulation is that it simply doesn't matter. So, we buy more goods and services from foreigners than they buy from us. And?

Some then say that we must borrow to pay that bill and that means that in the end disaster will strike. For at some point we've got to repay the borrowings. This is not true, we do not borrow to cover the trade deficit. Instead, the balance of payments always balances - that's why it's called the balance. If there's a deficit on the current account (almost all, but not entirely, that trade in goods and services) then this will be balanced by a surplus on the capital account (almost all, but not entirely, selling assets to foreigners).

If you like, we if buy more short term stuff from foreigners then foreigners must buy more long term stuff from us.

Squanderville

Back nearly two decades Warren Buffett took this argument a step further. He said sure, this is what happens. But eventually the foreigners will end up owning more and more of the capital of the country. So, they'll be getting not just the labour return from their own labour but also the capital return from the American economy. The article in which he explained this idea is here.

This idea has the merit of being something worth worrying about in that if it did happen it wouldn't be a good idea. The question is therefore is it something that is happening, or even close to doing so, that we should?

The idea is repeated in this by Robert Lighthizer just recently:

To carry the analogy further, the trade deficit I run with providers of goods and services I consume is benign if it is offset by the surplus I run with my employer through the sale of my labor. But the situation may prove unsustainable if I’m funding my consumption by taking out a second mortgage on my home. And that is essentially what the United States has been doing over the past three decades by running a trade deficit year after year. These persistent deficits are financed by net inflows of capital—which means that every year, the country must sell U.S. assets to foreign investors in order to sustain the gap between exports and imports.

A slight correction, it's not the country doing the selling - we've not got to sell the Washington Monument because I buy a Chinese screwdriver set. Rather, someone has to sell some asset located in America to a foreigner so as to balance those payments if I do buy that Chinese screwdriver set.

But other than that, yes, this is true. But there's an awful lot in an economy that is true and yet is not important.

Household accounts

Which brings us to the household accounts for the most recent period. Where we are told this:

Household wealth collapsed in the first quarter as the stock market plunged in the face of the COVID-19 pandemic and start of the economic recession. Wealth fell by $6.5 trillion to $110.8 trillion following a revised $3.1 trillion increase in the fourth quarter.

And:

(Household accounts from Moody's Analytics)

The trade deficit

The trade deficit runs along at some half trillion a year or os in current money. It was $616 billion in 2019 for example.

So, we can compare that to $100 trillion and change, $120 trillion minus change, in household wealth and think that we've got perhaps two centuries before this becomes a problem. Because we can keep selling assets to finance that deficit for about that long.

Except that's not in fact the way to do it. Instead, look at the quarterly generation of that wealth. Sure, this last reported quarter is a bit of a downer but then we are in the middle of the worst economic contraction on record.

Look instead at our more usual numbers. The generation of one and three trillion a quarter in new wealth. Or, given a bit of rounding, $5 to $10 trillion a year of new wealth. Of which we've got to sell $616 billion to foreigners in order to finance our trade deficit.

This isn't a problem, is it? In fact, we can keep doing this forever and foreigners will be owning an ever smaller portion of the American economy. Yes, smaller.

That is, Warren Buffett's wrong because he's not including the new wealth created. So too is Lighthizer because the sums are, compared to the wealth that exists, simply too trivial.

So, why do people worry?

Clearly, some people worry about this because they think there's political mileage in being seen to do so. Not that I'd be so rude as to point out who. Others simply don't know it.

But the real reason is that it did used to be important and now it isn't. For we used to have fixed exchange rates. So many $ were worth so many DM and that was just that. Before that, gold was the determinant. At which point the balance of payments doesn't necessarily balance. Because as with supply and demand itself it has to be possible for price to vary to make it so. And if we've fixed the price then we've not got the flexibility in the system.

So, it became ingrained in people that the balance of trade was important. We had a duty to export and also to limit our consumption of imports. This is now outdated as we've those floating exchange rates. Thus, whatever we do, that balance is going to balance. And as the asset sales to make it do so are trivial compared to the size, growth and strength of the economy it just doesn't matter how it's balanced across current and capital accounts.

My view

Yes, it does annoy that people get these basics of trade wrong. Even more so that the error persists among people as important as Lighthizer and Buffett. Trade deficits just aren't important anyway and even if they are the current sort of level - half a trillion a year or so - in the US still doesn't matter.

The investor view

Trade deficits simply do not matter economically. An increase in it is simply more Americans gaining more of what they want by getting it from foreigners who make it better, cheaper or faster. And that's it.

There are people who worry about it though and there are enough such worriers that the deficit numbers can move markets at times. Even more weirdly the reports can move markets the wrong way. An expanding economy, one doing better than foreign ones, usually has a rising trade deficit. A falling deficit is usually - not always but often enough to count - a signal that the domestic economy is doing worse than those foreign ones. But when reports of the deficit do move markets they move them the other way. A rising deficit is seen as something bad which then hits stock market indices.

Which is what provides us with a trading opportunity. If prices are moving away from reality then that is an opportunity of course.

True, this is rather a long term piece of information rather than something we can trade upon today but it's still relevant. If markets fall because of reports of a rising trade deficit then that is our signal to buy. Often enough, although unfortunately not always, a falling deficit is a sign to sell.

If you'd like the entirely opposite view of this then that's explained here at Seeking Alpha. Clearly, I think that other explanation is wrong, not taking account of new wealth creation and its size in relation to the trade deficit but there it is for you to see it.

A rising trade deficit is normally to usually a sign of outperformance by the US economy, not as it's often taken to be, a problem.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.