Academics like me are often accused of being out of touch with the real world, relying on unrealistic theories of an idealized world of free trade. So let’s imagine a discussion between me and a “trade realist” (TR).

TR: Let’s face it; a high wage country like the US can’t possible compete with low wage countries in Latin America and Asia. We need trade barriers.

Me: What exactly do you mean by “can’t compete”?

TR:  I mean we’ll end up with big trade deficits, and a loss of jobs.

Me: OK, so does this inability to compete apply to other high wage economies?

TR: I assume so.

Me: But the Eurozone is currently running a $465 billion current account (CA) surplus, seven times larger than China’s surplus, and they have high wages. Indeed the really big surpluses occur throughout northern Europe, where the wages are highest.

TR: Well the Europeans use clever tricks to favor their industries; the US tries to play fair. The bottom line is that the US has a $443 billion CA deficit, and it’s costing jobs.

Me: Yes, I forgot about those devious Nordics.  But the unemployment rate in the Eurozone is currently 8.2%, while the US has a 3.7% unemployment rate, despite huge CA deficits.

TR: Europe has lots of socialist policies; you can’t compare their unemployment rate to ours. In any case, you can’t deny that persistent CA deficits are a drain on our economy, a ticking debt bomb.

Me: Can you be more specific?

TR:  These current account deficits mean that we are borrowing money from the rest of the world to pay for imported goods.  This can’t go on forever.

Me:  Why not?

TR:  Because eventually the interest burden on that debt would become too large to handle.

Me:  So you are saying that huge current account surpluses result in a net indebtedness position, which leads to a net outflow of interest income?

TR:  That’s right.

Me:  But when I check the international accounts, I see our net international investment position has plunged to a balance of negative $7.7 trillion (as you say), but the net flow of investment income is a positive $221 billion/year (red line), and rising.

TR:  How is that possible?

Me:  Imagine you borrowed $15 trillion from your neighbor, at 2% interest, and simultaneously loaned him $7.5 trillion at 7% interest.  Then you’d receive $225 billion more in interest each year than you had to pay him for your much bigger loan.

TR:  But why would he do this?

Me:  Search me.  The point is that the US basically took $15 trillion in Treasury and corporate debt, and used it to buy roughly $7.7 trillion in goods and services from the rest of the world, and also $7.3 trillion in high earning assets.  Those high earning assets spin off more than enough investment income each year to service our much larger foreign debt.

TR:  This seems much too good to be true.

Me:  There is a potential risk here.  At some point in the future, foreigners my not be willing to lend us money at much lower rates than what we earn on our investments in their countries.  At that point, the net investment imbalance could become a big problem for the US.  Something very bad might happen.

TR:  I though so!  What is the specific bad thing that you are worried about?

Me:  If that day of reckoning ever came (and I won’t live to see it, so it’s hard to know for sure), then the US would have to sharply boost its exports of goods and services to the rest of the world, to service our debts.

TR:  More exports?  Umm, why would that be so bad?

Me:  It’s obvious; producing more exports requires labor, it means more jobs.

TR:  Having more jobs is bad?

Me:  Of course it’s bad!  Work is hard, that’s why they call it work.  Work is so undesirable that you have to pay people to work. Visiting Disney World or going to a movie is fun; people must pay money to do fun things.  Work is just the opposite; you must pay people to work. We’d have to work harder without getting to consume more.

TR:  But you said the US already has a very low unemployment rate, so is it really likely that it can go much lower?

Me:  Perhaps not, but in that case we’ll need to tighten our belt.  It won’t be so much that we are having to work hard (we already work harder that the Europeans), rather a share of our income will be “garnished” by consumers in East Asia and Northern Europe.  They will get to consume a part of our labor.  They’ll be paid for our hard work.

TR:  Is there any way to reduce the risk of this happening?

Me:  Let’s begin by stop running $1 trillion budget deficits, which just add fuel to the fire.  We’d have to slightly tighten our belts today, but it would impose less of a debt burden on future generations.  In addition, it will make the future tax system less oppressive.  Other Singapore-style, pro-saving tax reforms would also help.

PS.  I have another piece on trade over at MoneyIllusion.