A Thought Experiment on the Balance of Trade: Part the First

A few years ago, I came up with a thought experiment to demonstrate that a trade deficit or surplus is not, in and of itself, particularly meaningful. Not yet having been inducted into the cow-cult formerly known as Catallarchy, and being too lazy to set up my own blog, I just sat on it. But it's kind of lumpy and I'm getting tired of sitting on it, so here we are:

Consider first a country "A" existing in autarky--that is, not engaging in any sort of foreign trade. Each year, the only goods available for use are the goods produced that year, or goods produced in prior years but not yet consumed.

Next we add trade with a second country "B" into the mix. First, the case of balanced trade. There will be gains from trade on both sides due to comparative advantage, so both countries will now have access to more goods than they would under autarky. But there is no net trade surplus or deficit.

Now consider a perpetual trade imbalance. Each year country A imports goods from country B, but sends back only money in return. Rather than using the money to buy goods from country A, the citizens of country B hold on to the money, and this imbalance persists indefinitely. For country A, this arrangement is clearly preferable to balanced trade. Not only do they have access to goods imported from country B, but they are able to keep the goods they otherwise would have exported.

Of course, this is an unlikely scenario (albeit not a completely absurd one; if country A's currency is very stable and country B's is not, the citizens of country B may wish to use country A's currency for domestic trade rather than sending it back in exchange for country A's exports). But it's important to understand that a perpetual trade deficit is actually quite desirable. This runs contrary to the intuitions most people have on the topic.

Let's stop here for today. Next week we'll see what happens when the trade imbalance evens back out.

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Brandon, ...if country A's

Brandon,

...if country A's currency is very stable and country B's is not, the citizens of country B may wish to use country A's currency for domestic trade rather than sending it back in exchange for country A's exports...

The demand for money is best considered as a demand to hold rather than concentrating on its movement. Additionally, the inferior currency is the one that will be preferentially traded away.

Emphasizing the circulation of money is like saying that gravity is all about falling objects. Every mass is impacted by gravity and most of them are balanced between the forces of gravity and mechanical support.
A falling mass is a transition to a new equilibrium and a different level of potential energy. So it is with money. Money is completely functional even while it is immobile and only representing potential and a balance of forces.

Regards, Don

A perpetual trade deficit

A perpetual trade deficit would be great for Country A... something for nothing! Who can beat that?

Show me greater consumption than production over an extended period of time in a country, and I'll show you a country that is becoming poorer. Period. To not be heading to the poor house, domestic production must exceed the trade deficit. Again, the critical factor isn't the trade deficit per se, but where is the money coming from to fund that deficit? If it's from savings from prior production, expected future production or other legitimate means, there's probably not going to be a problem. If you're funding the deficit through monetary inflation, you're looking at price inflation, the devaluing of your currency and eventually lower standards of living as the exporting country demands something of greater value than your increasingly worthless currency.

At least that's how I see it though I don't claim to be an economist. Am I wrong? You can't have consumption without production, unless you are running some kind of scam. In which case, you're depending on the other guy not to find you out.

Joe K, I'm not sure that you

Joe K,

I'm not sure that you realize that it is the country with the trade surplus that is suffering monetary inflation and that it is the country with the trade deficit that is experiencing monetary anti-inflation.

You are correct that importing only is likely to become more and more limited as the monetary unit becomes more valuable to you and becomes less valuable to the country exporting to you.

Regards, Don

inflation

At the moment the trade is made, I agree that if Country A were exporting dollars, then Country A would experience monetary deflation and Country B monetary inflation. I disagree that Country B would allow this to go on forever, and that is why large, continual trade deficits can be potentially harmful. At some point the bill becomes due.

You are correct that importing only is likely to become more and more limited as the monetary unit becomes more valuable to you and becomes less valuable to the country exporting to you.

Exactly! If Country B holds on to Country A's money, their supply of Country A dollars will obviously increase. In Country B we have monetary inflation because of all the Country A dough rolling around. Wouldn't Country A now have to pay us more for our exports as their currency has decreased in value in Country B. Country A can either cease trading with us because they think their currency is so strong, or they can hold on to their currency and ship us other items in exchange. But if Country A's currency is so valuable, the people in Country B would use it to buy stuff in Country A. Why pay $100 for a loaf of bread in Country B when you can get a loaf of bread for 59 cents in Country B?

And, in the real world, this is what happens. If Country A imports but doesn't export, and the rest of the world becomes awash in their currency, either the trade imbalance straightens itself out, or the currency of the importing nation gets severely devalued. If running trade deficits were inherently good, why wouldn't all nations just print money and import goods from sucker nations? That's obviously ridiculous. The money sent overseas doesn't just disappear. You can't have trade without faith in the currency you're dealing with. To get something of value, you have to give something of value.

Something is not right if you are constantly running large trade deficits.
People can only give without receiving for so long...

All in good time

Show me greater consumption than production over an extended period of time in a country, and I'll show you a country that is becoming poorer. Period.

Not if they're being subsidized, as is the case in the model I described. I'll discuss more realistic models next week.

But the money is still out there.

The problem is that the country running a trade deficit is *not* being subsidized, they are getting a loan. The money is out there and represents a claim on future goods and services.

You can also keep getting more and more credit and using it to consume, but unless you've got assets that are growing faster than your debt balance, that may not be such a good idea.

So country A is getting an influx of cash to spend, but it's not essentially different (when considering the total financial welfare of just that country, which is of debatable worth) from running up spending on a credit card. Sure, as long as you have good credit, you may be able to keep flitting the balance around or getting your credit limit higher and adding more new purchases than you pay off in payments. While this is happening, things feel fine if you aren't looking at the balance sheet.

The point about complaining about trade deficits is to note that they are larger than the amount our GDP has grown for the last few years. So basically, our entire economic growth is coming from foreign savers failing to demand goods for their money. If we had not had a trade deficit for the last 6 years, we'd have been in recession.

Why isn't that significant? The only reason I can come up with is that the nation state is an artificial financial boundary that we shouldn't care much about. What matters is how individual people are doing.

Not if they never spend it.

If you don't believe that they'll hold it and never spend it (which you pretty much have to, because it's a given in the model), assume they burn it.

Holding != burning

Even if someone never spends the money, nevertheless as with any good, his demand for more of it would typically go down the more of it that he accumulates. But if he burns it (e.g. accidentally), then he may have a strong demand for new money to replace what he burned. So holding forever, and burning, are not necessarily the same thing, in terms of their effect on the holder's/burner's economic behavior.

Even money that is held and never again spent, is not necessarily un-felt by the economy. It can be felt indirectly by its effect on the behavior of the person holding it. Since he has so much, he may be less eager for more of it than he would have been otherwise.

Now, this difference may have no impact on your current discussion. I am only responding because your comment taken in isolation reminded me of something interesting, which is that a specific quantity of money doesn't actually need to be changing hands to have an effect.

In which models are useful for, well... modeling.

I would like to point out that if, in your model, they hold the money and are absolutely bound *never* to spend it, then reasoning about your model is unlikely to have much interesting to say about actual trade deficits, where presumably the people who are holding the money value it as something other than a conversation piece -- namely its value as a proxy for future goods/services or its ability to purchase US land and capital.

Michael, The money is out

Michael,

The money is out there and represents a claim on future goods and services.

Not really. The vast majority of dollars exported (and not immediately balanced in trade) has never returned and never will. There is unlikely to be more than a handful of countries, if that, whose overall ownership of US dollars and US dollar denominated accounts has not continuously increased for decades.

As individuals become better off and no longer live hand to mouth, they will start to build up cash balances, part of which may be in the form of dollars. As the governments of developing countries expand in size and scope, their demand for dollar reserves will increase.

As a trade imbalance of either polarity continues, an opposing force due to monetary value changes will build up, but by no means will all dollars come back.

Regards, Don

As long as the dollar

As long as the dollar remains valuable as a reserve currency, this is true, many (even most) of the dollars will either stay out or come back only as FDI.

Just as if I make a high income and pay all my bills on time, it's very possible for me to run up ridiculous amounts of debt and die before it needs to be paid back.

But if the reserve value of the dollar for that country drops, as it assuredly will in the long run under a scenario where the country maintaining the imbalance is getting much richer relative to the US, things may change.

Note, I do not believe that the trade deficit is a "big deal" in the sense that something should be done to narrow or close it. I agree that it's very much like getting a big interest free loan. Not only that, it's a loan that will never be in the creditor's interest to call all at once, which means the likelihood of an abrupt transition (where we have to make up decade's worth of trade deficits with surpluses over just a few years) is very small. So clearly we should thank the people giving us the loan rather than put up tariffs in an attempt to make them stop.

What I don't buy is the idea that it doesn't matter at all. An interest free loan is still a loan, and we need to recognize that a large portion of our economic growth over the last 5 years is essentially the free stuff we've been loaned by foreigners. Ok, great, but it was a loan, not a gift. You're assuming it's a gift. But it only looks and works like a gift as long as we're the world's economic leader.