Right about many things but not about trade deficits

A not uncommon complaint is that it’s not possible for a country to run a trade deficit forever. At some point that debt has to be repaid. Warren Buffett is fond of explaining this with a construction of “Squanderville” and this is one of the things that Buffett gets wrong in reality. Firstly, for good theoretical reasons, second for good reasons of just counting, basic arithmetic.

Warren Buffett’s explanation:

But as head of Berkshire Hathaway, I am in charge of investing its money in ways that make sense. And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country’s “net worth,” so to speak, is now being transferred abroad at an alarming rate.

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time that’s how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there’s a quid pro quo–but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which at their core represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off–or simply service–the debt they’re piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat–they have nothing left to trade–but must also work additional hours to service their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

Well, OK, that all looks reasonable. Except it never does work out that way for a theoretical reason. The return to land – rent – even the return to capital is a small fraction of a modern economy. After such things as depreciation, something that is always going to remain domestic, that capital share of the economy is about and around the return to capital. Not all that surprisingly really. So, somewhere in the 5 to 10% range. Meaning that if foreigners did own all the capital, all the land, everything, they’d still only be getting 5 to 10% of GDP, of everything being produced.

That’s distinctly less scary.

Note what Buffett does get right though, as Don Boudreaux points out to a correspondent here:

You’re the second person in as many days to e-mail me to say that the U.S. trade deficit “can’t go on forever.”

Yet it can.

The main reason why people believe that the U.S. trade deficit cannot go on forever, or indefinitely, is the erroneous notion that every increase in the trade deficit is an increase in Americans’ indebtedness to foreigners. If this notion were true, then proclaiming that the U.S. trade deficit can’t go on forever would have merit. But despite its name, a trade deficit is not synonymous with increased debt. While some of the U.S. trade deficit can, and does, become debt, much of it never does – and none of it must.

We Americans ‘run’ a so-called “trade deficit” whenever, in some period – say, the month of March 2018 – the amount that foreigners invest in America (including investments in dollar holdings) is greater than the amount that Americans invest abroad.

The trade deficit doesn’t, by definition, increase debt. It might but it usually doesn’t, usually the increase is in capital ownership of the US economy. As I say, Buffett got that right but it’s still not as scary as generally thought.

Which brings us to the arithmetic point. How large is the trade deficit and how large is US wealth?

The trade deficit is some $500 billion a year. OK, that’s not accurate, but we’ve at least the right number of digits there. That’s not the goods trade deficit, which is larger, but the US runs a services trade surplus, the two netting off to about that half trillion. Is that a large or small number? Sure, it’s large compared to my or your wallet but compared to America?

It’s small. US wealth is about $95 trillion. So we could run a 500 billion trade deficit for 190 years before we sold the country. Except even that’s not true:

The total net worth of U.S. households climbed by $2.3 trillion in the first quarter of 2017, reaching a record $94.8 trillion as the stock market soared and home prices climbed in many parts of the country.

We’ve a $2 trillion rise – and recall this isn’t the wealth of the US, this is just households, without government holdings of anything – in a quarter, or perhaps $8 trillion in a year. We’ll have noted that 8 is larger than 0.5. That is, even with the trade deficit we’re creating wealth faster than foreigners are buying it. So, we’re running a trade deficit, the foreigners are buying the country, and even at that rate of half a trillion dollars a year the foreigners are ending up with an ever smaller percentage of ownership of the US.

That is, Buffett’s Squanderville never actually does become owned by Thriftville, simply because Squanderville is creating wealth faster than it’s selling it.

The US trade deficit can go on forever, there’s just no problem here at all.

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5 COMMENTS

  1. It may be that even the horrible business-as-usual Omnibus Spending Bill that Trump disparaged – and then signed! – combined with the slashing of corporate tax rates, will mean that borrowing a million million dollars every year will represent a declining share of an exploding US economy, and Trump will add it to his list of “wins,” though as interest rates rise, it will cost ever more to issue bonds to pay off the maturing ones.

    However, 7 months from the general election, I have heard no candidate bemoan the federal debt except in generic terms such as a desire to live in Thriftville. Nor especially do anything about it, if it would result in the sacking of any unionized federal employee. The official Republican position is that the GOP will balance the budget, over x decades, by “reducing the rate of growth,” which is why 100% of Calculus students vote Republican. This process will start in some future year, not this one. Deficit spending is the perfect stealth way to steal people’s production, as the resulting inflation is always the shopkeeper’s fault. Yes, it will continue.

    PS – The US has vast land holdings, including a majority of the land in most Western states, not included in the tally because it’s not doing anything. America’s wealth would be much greater if this were made productive.

  2. The US is a special case because its currency is that global currency, the dollar. Most international transactions today are denominated in dollars. The US also has vast financial markets and investors will carry on moving dollars into and out of the US regardless of the deficit, because those are world markets and the other side of your transaction is very often not an American but a world citizen.

    Take the sh*thole where I live. Nobody wants to park their money here even overnight because by tomorrow morning some politician may have uttered some pronouncement that makes the Trump Twitter Machine look like an oracle of wisdom by comparison. If our balance of trade runs at a deficit for long enough we run out of foreign currency and we simply have to stop importing, servicing our foreign debt, etc. This has happened before, so it’s not conjectural: it will happen again.

    The rule that deficits can indeed go on forever applies only to certain large nations. It is not a universal principle, written on Page Three of Samuelson’s Economics.

    • That the dollar is the global currency is not a universal principle either. The US is prosperous enough to patch over a lot of fiscal damage, but allow the notion that the US government does not value its use as a store of value, and the world’s other nations have several alternatives and can invent others. This is the risk (not serious, yet) of using access to US banking as a political tool.

      Fortunately, whatever Larry Kudlow manages to convince Trump of, he will convince him to defend the value of the dollar, versus pursue a weak dollar as a political favor to the nation’s exporters, which Kudlow faults Bush for.

      PS – Trump tweets never seize anyone’s wealth. Even the ones that threaten to.