Following is my response to the Commerce Department’s request for public comments on the “Causes of Significant Trade Deficits.”
In a globalized economy, where the value embedded in most manufactured goods originates in multiple countries and two-thirds of trade flows are intermediate goods, bilateral trade accounting is meaningless. In a world where statistical agencies attribute the entire $180 cost of producing an Apple iPhone to China, where it is merely assembled for a cost of about $6, what do trade statistics and trade balances mean? By assigning 100 percent of the value of an import to the final country on the assembly line, trade statistics have lost most of their meaning.
The misguided belief that the trade account is a scoreboard measuring the success or failure of trade policy explains much of the public’s skepticism about trade and trade agreements, lends plausibility to claims that the United States is routinely outsmarted by shrewder foreign trade negotiators, and provides cover for the same, recycled mercantilist and protectionist arguments that have persisted without merit for centuries.
If the trade deficit reduces economic activity and destroys jobs, why are there positive relationships between these variables? The overall trade deficit, by and large, is also a meaningless statistic. It is neither a barometer of economic health nor a running tally of debt with which we are burdening future generations.
For 42 straight years, the United States has registered an annual trade deficit with the rest of the world. That means that year after year, Americans spend more on foreign-produced goods and services than foreigners spend on U.S.-produced goods and services or, put simply, the dollar value of U.S. imports exceeds the dollar value of U.S. exports.
For almost as long, some economists have been arguing that trade deficits are unsustainable – they sap economic growth, bleed jobs, and saddle our descendants with debt. Perhaps if one fixates on the trade deficit (or the slightly broader current account deficit, which includes interest on foreign assets and remittances) in isolation, these concerns might seem to have merit. But looking at the U.S. trade or current account deficits without considering the capital account surplus is a meaningless, misleading exercise.
The trade deficit is not a problem because the associated capital surplus (the excess of inward investment over outward investment), which includes high-quality foreign direct investment, bestows huge advantages on the U.S. economy.
After all, one of the reasons that trade is so maligned is that the public has been led to believe that the trade account is a scoreboard, with the deficit indicating that Team America is losing – and it’s losing on account of poorly negotiated trade deals and foreign cheating. The United States runs a trade deficit with the rest of the world because Americans spend more dollars on foreign-produced goods and services than foreigners spend on U.S.-produced goods and services. The dollar value of U.S. imports exceeds the dollar value of U.S. exports, so our trade account is negative. It’s in deficit. That’s straightforward.
A slightly broader measure of international transactions than the trade account is the current account. The current account includes the trade account plus net proceeds on investment (income earned on U.S. assets abroad minus income earned on foreign-held assets in the United States) plus net transfers (remittances and aid, primarily, flowing into the United States minus remittances and aid, primarily, flowing out of the United States). Those two components (net proceeds and net transfers) are much smaller than the value of exports and imports, so the U.S. current account typically isn’t much larger or much smaller than the trade account. In 2016, the trade deficit amounted to $503 billion and the current account deficit was $481 billion.
So, how is it even possible to run a trade deficit in the first place? How can Americans send $503 billion more abroad for goods and services than foreigners send to the United States for goods and services?
Americans are able to purchase more goods and services from foreigners than they sell to them because foreigners buy more assets from Americans than Americans buy from foreigners. There is a positive inflow of dollars on the capital account. Foreigners don’t only buy goods and services from Americans. They buy U.S. assets (equities, property, factories, service centers, shopping malls, machines, other physical assets, corporate debt, and government debt) from Americans. Likewise, Americans don’t only buy goods and services from foreigners. We buy the same kinds of assets from foreigners, as well.
The proper way to account for international transactions is to note that the value of the goods, services, and assets that Americans purchase from foreigners is approximately identical to the value of the goods, services, and assets that foreigners purchase from Americans. If there is a difference between the current account deficit and the net capital inflow, it is accounted for by the change in foreign reserves.
The United States ran a $481 billion current account deficit with the rest of the world in 2016, and it ran a $481 billion capital account surplus. The capital account consists of three broad components: U.S. purchases of foreign assets; foreign purchases of U.S. assets; and, the change in foreign reserves. And it is a mathematical certainty that the current account plus the capital account equals zero. Put another way, the value of the current account deficit is identical to the value of the capital account surplus.
So, the U.S. trade deficit is financed by inflows of foreign capital used to purchase U.S. assets. Most of the assets purchased are equities and physical assets (direct investment). Some of the assets purchased are corporate debt and government debt. As of the end of 2014, Americans held a total of $24.6 trillion of foreign assets. Foreigners held a total of $31.6 trillion of U.S. assets. Of that $31.6 trillion foreign asset portfolio, treasury bills and bonds accounted for about $6 trillion — just under 20 percent of the total. It is only this portion — government debt owned by foreigners — that the American public (of this generation or the next) is on the hook to pay back. Corporate debt has to be repaid, but only by the shareholders and employees of the companies issuing the debt — not by you or me or our children, generally. Equity purchases don’t have to be paid back at all — they’re not loans! When European, Japanese, Korean, Chinese or any foreign investors purchase U.S. companies or make “greenfield” investments to build new production or research facilities or hotels or shopping centers, there is no debt to be repaid. Americans are not on the hook to repay Honda for its investment in production facilities in Marysville, Ohio, for example. Americans simply benefit from Honda’s success, earning wages and profits they would not have enjoyed without Honda’s presence.
Selling equity or property or even entire U.S. companies to foreigners does not constitute debt and it is not akin to subsidizing our consumption by draining down our assets, as some suggest. It’s not a reverse mortgage. By the simple logic of supply and demand, the presence of foreigners in U.S. asset markets is good for U.S. asset holders. Foreign participation constitutes greater demand in the market, which increases the price of the assets in question. And, there are some real knock-on benefits associated with foreign-headquartered companies operating in the United States. These “insourcing” companies tend to perform well above the average U.S. company in terms of value creation, capital investments, research and development spending, compensation, employment, and many other metrics, as this paper documents.
In fact, there is a compelling argument that a trade deficit is actually good for the U.S. economy because the quality, experience, and successes of the foreign companies that actually come and operate in the United States are better, deeper, and more numerous, respectively, than the average U.S. company. Foreign direct investment in the United States is a conduit for bringing world class companies that have succeeded and thrived in other markets to share their expertise with Americans.
Let me conclude this one by reiterating that only a portion of our trade deficit needs to be repaid by the American public to foreigners, and it is that portion used to finance government budget deficits — roughly one-fifth of the annual trade deficit. The trade deficit is not an argument for trade barriers, but rather one for reducing profligate government spending.