A thought experiment, dear reader, on how to think about international trade and its impact on the wealth of a nation.
Suppose one day, every country in the world suddenly said, in unison, “Hey America! We’ve decided we think you’re just the best and to show how much we love you, we’ve decided that from now on we’re going to send you 10% of everything we produce, free of charge. And in return, you don’t need to send us anything at all! Everything you produce, you can keep for yourselves. Plus, you also get the benefit of everything we send you!” Suddenly Americans are receiving cars, books, electronics, food, and so on, all free of charge. If other countries decided to send us lots of valuable stuff for free, wouldn’t that be great? (Great for Americans, anyway – not so great for the citizens of those countries.)
Now, imagine the opposite scenario unfolding. Every country on earth decides to say “Hey America! We think you’re absolutely awful and we’ve decided that from now on, you must send us a tithe consisting of 10% of everything you produce, for which we will send nothing in return. Everything we produce, we will keep for ourselves.” Now, many goods and services that are produced by Americans no longer are able to be consumed by Americans, nor do any Americans consume goods or services produced elsewhere in the world. If we were sending lots of valuable stuff out to the rest of the world but not getting any stuff in return, wouldn’t that be lousy? (Lousy for Americans, anyway – but pretty great for the citizens of those other countries.)
New scenario time. It’s the same as the first scenario, only instead of sending us stuff for free, every country in the world decides to send American all this stuff in exchange for 1% as much stuff from us as we are being sent. Getting lots of stuff in exchange for giving up very little stuff isn’t quite as nice a deal as getting lots of stuff for free, but it’s still really good.
Last scenario – same as the second, but instead of forcing Americans to send 10% of what we produce in exchange for nothing, all the other countries in the world agree to send Americans 1% as much stuff as Americans send them. Sending away lots of stuff and getting only a tiny amount of stuff in exchange isn’t quite as bad as sending away lots of stuff while getting nothing at all – but it’s still a lousy arrangement.
But what if I told you that in the first and third scenarios above, America would actually be running a trade deficit with the rest of the world, while in the second and fourth scenarios, America would be running a trade surplus. Does that suddenly change which scenarios are good or lousy? Clearly not. The trade deficit situations are still much better to be in if you’re an American citizen, and the trade surplus situations are still pretty awful. In the trade deficit scenarios, Americans can consume all (or nearly all) the goods and services they produce plus even more on top, while in the second scenario Americans consume fewer goods and services than they produce, and lack (or barely gain) an offsetting benefit of goods or services produced elsewhere.
In international trade, imports are benefits and exports are costs. Paul Krugman put it well when he said “imports, not exports, are the purpose of trade. That is, what a country gains from trade is the ability to import what it wants. Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to demand payment.” A country that is running a trade deficit (or, put another way, a country running an investment surplus) is a country where citizens get more goods and services from foreigners than those citizens send away for foreigners to consume.
Those who claim Americans would benefit if only we exported more goods and services while importing fewer would have to conclude the second and fourth scenarios actually enrich Americans while the first and third impoverish us. Too many people think a trade deficit is in some way analogous to a household running a budget deficit. If I’m consistently spending more than I’m making, my household budget is in a deficit and if that goes on too long, things will end very badly for me. People hear “America is running a trade deficit” and think it means America is like a household that is spending more than it is making, but that’s simply a category error. Trade deficits and budget deficits describe things that are categorically unlike each other. The idea that a country running a current account deficit in trade is in any way analogous to a household spending beyond its means, and the populist movements inspired by such muddled thinking, has to be among the most damaging of all the common economic myths out there.
READER COMMENTS
steve
Dec 6 2024 at 11:10am
A very good explanation. Unfortunately I dont think most people understand this and as I noted with Pierre I think this has been conflated with he jobs issue. People seem to think that all of the good jobs got sent to China which is why they currently dont have great jobs. They need someone to blame. (I think Pierre has been writing some good stuff on populism but I dont think he has emphasized that enough. Populism (fascism too) needs specific, identifiable groups to blame for their problems. The “people” are absolved of all agency for their difficulties.)
Steve
Jon Murphy
Dec 6 2024 at 11:55am
The most internally consistent answer I had to your question (which is not to say a correct answer) came from a rando on Twitter. They argued that imports (indeed all consumption) makes people worse off because you are exchanging a stable asset (the dollar) for a depreciating asset (whatever you buy). Therefore, this person argued, imports make a nation worse off.
David Henderson
Dec 6 2024 at 3:39pm
You write:
Yikes! Notice that this argument could just as easily be applied to any purchase of a consumable produced in America. Do these people buy food?
Jon Murphy
Dec 7 2024 at 12:22am
I asked exactly your question. They did argue buying food was making the purchaser worse off because food is a rapidly depreciating asset.
They were consistent.
David Seltzer
Dec 7 2024 at 4:24pm
Of course if they don’t buy food…THEY will depreciate and die.
TMC
Dec 7 2024 at 9:25am
The whole point of production is consumption. Investment, if it didn’t lead to eventual consumption, would be useless.
Thomas L Hutcheson
Dec 6 2024 at 11:01pm
And the odd thing is that many of the people who think trade deficits are bad think that fiscal deficits are OK if they are the result of cutting taxes (c.f. the “Tax Cuts for the Rich and Deficits Act of 2017.”)
David Seltzer
Dec 7 2024 at 4:54pm
Kevin: I’m wandering into macroeconomics where my grasp of this subject is tenuous. It seems imports exceeding exports indicates strong domestic demand and a strong economy. If domestic consumers import, it’s probably because the exporting country enjoys a comparative advantage for certain productive assets. If that’s the case, domestic consumers would have a surplus as well. A little help here from some of the commenters would be appreciated.
Ahmed Fares
Dec 8 2024 at 9:16pm
No, comparative advantage should not produce a surplus. As Michael Pettis explains, it’s because those countries that have a trade surplus force households to subsidize businesses, leaving households with a low consumption share of GDP. As Don Boudreaux consistently points out, doing more of something means doing less of something else. More Chinese workers in their EV industry means less Chinese workers in other industries, which forces them to import in those latter industries. The following is a Twitter/X thread from Michael Pettis:
Twitter thread
Ahmed Fares
Dec 8 2024 at 8:10pm
Tyler Cowen writes:
Don Boudreaux weighs in at Cafe Hayek and agrees with Cowen. And now we have this article by Kevin Corcoran.
As a longtime follower of Michael Pettis, I can say that Pettis is right, and these economists are wrong. Let’s start with some selected Pettis quotes:
Do read the whole article:
America Cannot Continue to Absorb Global Imbalances
Jon Murphy
Dec 8 2024 at 8:25pm
As a published trade economist and PhD economist, I can say Pettis doesn’t even get rudimentary theory and facts correct.
Ahmed Fares
Dec 8 2024 at 11:15pm
With all due respect, Jon, credentials mean nothing to me. All that matters is that you make a reasoned argument. As for length of time spent studying, I have more than you there. A little bit about myself.
I was raised in poverty, so I could only afford 2 years of formal education (electronics trade). I then became a self-trained securities analyst, a job which I did full-time for 30 years, working for my own account while my wife paid the bills. My informal education is 4 years of accounting, 6 years of finance, and 8 years of economics. In addition, I also have 10 years in the study of comparative religion. That’s reading books cover to cover. (I read 16 hours a day, and I’ve been doing so for over thirty years.)
As for earnings, my peak earnings were $400k a year. That’s in Canadian dollars, which incidentally is what the Prime Minister of Canada makes. So I must have been doing something right.
So no, I don’t follow Michael Pettis because it’s a fad. I’ve actually worked through the accounting identities to confirm that what he says is true.
Jim Glass
Dec 8 2024 at 11:41pm
That’s the problem with Pettis, he does economics by accounting identities. Much as MMTers do. But accounting identities do not an economic model make. Making his international trade analysis as screwy as MMTers’ domestic fiscal and monetary analysis, IMHO.
OTOH, much of his commentary about what is going on within the Chinese political economy is spot on, IMHO. (His international economic opinions strike me as a projection of his view of the domestic Chinese economy onto the international order, which is not a sound methodology. After all, his intellectual training is as a trader and a finance guy, not in economics, and his strengths and weaknesses seem to correspond, IMHO.)
Ahmed Fares
Dec 9 2024 at 12:06am
I’m also an MMTer which I came to through Post-Keynesian Economics. I applied the same rigor to studying MMT as I did to everything else I study.
You tell people that you follow MMT, and they think that you read a Reddit post or something, which is what brought you to MMT. In fact, I was one of the early adopters of MMT and I recall reading articles with hundreds of comments into the wee hours of the night to understand this stuff. I then went on Bill Mitchell’s website and wrote his Saturday exams to test my knowledge. (I typically flunked 2 out of 3 questions, and I kept at it until I could understand the accounting identities forwards and backward, which is why I get this stuff.)
Incidentally, it was a guy named “Winterspeak” who used to write on Megan McArdle’s website which was my first introduction to MMT. Steve Randy Waldman who blogs as “interfluidity” and is no lightweight in the intellectual department writes the following about him:
Winterspeak wonderland & miraculous Mencius
Jon Murphy
Dec 10 2024 at 6:52am
Agreed. Theory is required to understand the models and accounting identities (as well as understand their limitations!). A model becomes a dangerous thing in the hands of one who does not understand the theory. The model gives them an air of respectability when one is not due.
Don Boudreaux
Dec 9 2024 at 8:48pm
One can tell much about someone by his or her friends.
Knut P. Heen
Dec 10 2024 at 11:11am
Suppose two areas, USA and Europe. Suppose Europeans on average is older than Americans. Suppose the Europeans understand that they should export more than they import now to do the reverse when most of them retire in the future. The result will be that the Europeans exchange goods for paper now (American trade deficit now) and paper for goods later (American trade surplus later). This is how we save for retirement.
Ahmed Fares
Dec 10 2024 at 10:04pm
The story we are told is that for the US, a trade deficit with China is a good thing because it means more investment in the US which creates jobs for US workers in the investment sector and that the investment increases US worker productivity, making the US richer.
There is however a problem with this story in that it happens to not be true.
What the accounting identity actually tells us is that Chinese saving leads to a widening of the gap between US saving and US investment, which can happen in one of two ways, either by a rise in US investment or by a decline in US saving. Because the US does not need investment, after all, US corporations are doing share buybacks for lack of investment opportunities, the flow of Chinese saving lowers US saving instead. It is not because Americans save too little that they need Chinese saving, but rather it is Chinese saving which forces US saving to fall. This happens in various ways, which I won’t go into.
Here, the sectoral balances equation:
Private Domestic Financial Saving + Government Financial Saving + Foreign Financial Saving = 0
(S – I) + (T – G) + (M – X) = 0
When Chinese saving rises, which is an increase in the third term, and assuming US government fiscal policy does not change, then to maintain the identity at zero, the term (S – I) must get larger in the other direction. Either I has to increase, or S has to fall.
So what actually happens is not that US investment increases because of Chinese saving, but rather that China grabs a larger portion of existing US investment, which shows up as a surplus on the US capital account. Because there is no increase in US investment to offset the purchases of imports, this leads to a rise in US unemployment, a rise in US public debt, a rise in US private debt, or some combination of the three.
For a better explanation from Michael Pettis, watch a few minutes of the following YouTube video, should open up at roughly at the 27:30 mark:
Trade Intervention for Freer Trade: A Conversation with Michael Pettis
Jon Murphy
Dec 10 2024 at 11:21pm
Again, an accounting identity does not a theory make. How on earth does Chinese saving crowd out American savings? That makes no sense.
Further, as a factual matter, the Chinese are indeed investing. A quick Google search shows it to be the case. Even Trump knows it. He frequently complains that the Chinese invest too much!
Even furthermore, it’s odd to claim there are lack of investment opportunities in the US as the stock market, bond market, and investment spending continue to grow.
This is what I meant earlier when I said Pettis fails to grasp even basic facts. He’s not a reliable source. I, like Tyler Cowen, wonder why people take him seriously.
Jon Murphy
Dec 11 2024 at 5:51am
This is a chart of real US investment spending. You’ll note that, generally speaking, real US investment spending is rising to new record levels pretty much every quarter. In fact, just eyeballing the numbers, investment spending is roughly $2 trillion higher now than in 2000 when trade with China opened up. It’s difficult to see how one can draw the conclusion there is a “lack of investment opportunities” here.
Ahmed Fares
Dec 11 2024 at 4:04pm
It’s important to make a distinction between a rise in US investment versus a rise in US investment caused by an inflow of Chinese saving, the latter being the argument that Don Boudreaux and others are making.
Ahmed Fares
Dec 11 2024 at 4:34pm
The laws of physics say that when I wave my arm, Jupiter quakes, ever so slightly.
The best way to understand an idea in economics is to use a very simple example. Imagine there are only two countries in the world, the US and China, and there is zero trade between them. Trade now opens up, and a single transaction takes place for the whole year. In this example, a US consumer buys a Chinese widget for $100. The US records a deficit on its current account of $100 and surplus on its capital account of $100. China does the opposite.
Now, despite this ridiculously small transaction that barely moves the needle, Don Boudreaux and others will claim that this will cause US investment to rise by $100. I claim that will cause US saving to fall by $100. Note that one of the two assertions must hold true to satisfy the accounting identity that I posted earlier. I prove my case using another accounting identity, this time the Kalecki Profit Equation.
Profits = Investment – Household Saving – Foreign Saving – Government Saving + Dividends
Now before trade opened up with China, and assuming workers spend all their wages, the US paid a wage bill of $1,000 to each of its workers and received back $1,000 in spending from each of its workers. This is why the wage bill drops out of the profit equation. But in this new example, one worker spent $1,000 of which $900 was spent in the US economy and $100 was spent on that Chinese widget. Thus, business profits, a component of US saving, drops by $100. Note that “Foreign Saving” in the Kalecki Profit Equation is the same as the term “(M – X)” in the sectoral balances equation in my earlier post, which satisfies both accounting identities.
So, a rise in Chinese saving of $100 was exactly matched by a fall in US saving of $100.
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