Let us take an American individual who earns his money by exchanging something useful for it — he produces consumer goods. He then decides to exchange the money for some other consumer goods that are manufactured in China i.e. he is importing from China. A Chinese producer who has received the American dollars uses them to buy consumer goods from the above American producer; i.e., he is importing from the United States. So what we have here is a situation in which the American producer has paid for the Chinese consumer goods with his saved consumer goods. Likewise the Chinese producer has paid with his saved consumer goods to secure American consumer goods. The American and Chinese trade balances are in balance.
Now let us assume that instead of using the dollars to buy American consumer goods the Chinese producer decides to invest his dollars in US corporate bonds. The US trade account in this case will move into a deficit whilst China’s trade account will show a surplus. From the trade deficit perspective, as espoused by the popular way of thinking, this will be seen as bad news since American foreign debt has risen by the size of the deficit.
In the above example one is tempted to conclude that as a result of the trade deficit America’s economic fundamentals have deteriorated, or at least there are signs that this may be the case. A closer inspection of what has really happened would show that an American importer has paid for Chinese goods with money that he has earned by producing useful consumer goods. The fact that the Chinese producer has invested the dollars in American corporate bonds doesn’t pose any threat to American economic fundamentals. What we have here is a situation where claims on real savings have been channelled to America Inc. Once these claims are exercised and real savings are employed efficiently it only promotes a further expansion in US real wealth. Is anything wrong with this? All we have here is a situation where instead of buying final American consumer goods, the Chinese producer buys future US goods.
According to Rothbard,
More nonsense has been written about balances of payments than about virtually any other aspect of economics. This has been caused by the failure of economists to ground and build their analysis on individual balances of payments. Instead they have employed such cloudy, holistic concepts as the ‘national’ balance of payment without basing them on individual actions and balances.
Contrary to the popular way of thinking, an emerging trade deficit doesn’t mean that Americans are now saving less. We have seen that an American producer has exchanged unconsumed final consumer goods that he produced, i.e., saved consumer goods for money — claims on real savings. This means that we have an increase in real savings.
Additionally if the Chinese producer transfers the received claims i.e. US dollars, in return for his goods, to an American corporation (the Chinese producer bought corporate bonds) this will further lift the pool of real savings at the disposal of Americans. This is because real savings were obtained from China — via the import of Chinese consumer goods — in addition to the real savings generated by the American producer.
What matters as far as real economic growth is concerned is real savings. The balance of payments statements, which deal with monetary flows, cannot tell us much about the flow of real savings. For instance, Americans are importing tools and machinery from Japan and exporting consumer goods to Japan. In terms of the net flow of money it turns out that the value of American imports from Japan exceeds exports to Japan — i.e., a trade deficit emerges.
The conventional wisdom would argue here that Americans are now saving less and are in fact funded by the Japanese. In reality the exact opposite takes place. Americans are in fact supplying real savings — final consumer goods — to Japanese producers of tools and machinery. In other words, it is the American real savings that in fact support (i.e., fund) the Japanese producers of capital goods. Observe that Japanese tools and machinery do not as yet produce any real wealth, they are just potential future wealth. Also, note that it is not money that funds economic activity but real savings. Money is just the medium of exchange; it is not however the means of payment, and it never funds anything.
Let us now consider an American individual who borrows money from a bank and uses the dollars to buy goods from China. The bank has transferred money — claims on real savings — to the borrower of money. The bank has obtained the money from some other American producer who instead of exchanging the money for goods has decided to lend them out. Again, if the Chinese producer uses the dollars to buy US corporate bonds or stocks, this will lead to a US trade deficit and to a so-called increase in US foreign debt, which in turn will be seen as bad news. But all this is just a misguided perspective. Every transaction here is fully backed up by real wealth or expectations of real wealth.
The trade account and monetary pumping
Consider an American counterfeiter who uses counterfeit money to buy goods from Japan. The money that he has exchanged is not supported by anything useful. The counterfeiter has produced nothing useful and is not expected to produce anything useful in the future. He is exchanging nothing for money and then he exchanges money for useful Japanese goods. The Japanese producer who gets the fraudulent dollars — unbacked by real-wealth dollars — will have difficulties realizing them for real wealth. (The Japanese producer will have to bid US prices higher to secure some US goods. This however, will undermine the purchasing power of dollars held by the Japanese producer). As far as the US dollar flow is concerned the trade account is actually in balance. The counterfeit dollars spent on Japanese goods are matched by the same counterfeit dollars spent by Japanese on goods in the US. Since the trade account is in balance, some economists may even conclude that the state of savings is also in healthy shape. However, the story of the trade account here will be false and incomplete because the monetary pumping has been overlooked. American wealth producers are being hurt because Japanese, by exercising the counterfeit dollars, are now diverting real wealth from wealth producers. As a result American wealth producers’ ability to produce has weakened. Consequently, the flow of real savings, all other things being equal, is going to come under pressure.
What matters for the process of wealth formation is the flow of real savings. The balance of payments statement doesn’t provide such information. Consequently, it is not possible to determine the implications of a given state of the current account on the well being of Americans without information regarding the state of the flow of real savings. Therefore various assessments regarding the US economy, which are based on the state of the balance of payments, are likely to be without much foundation.
This article is based on one previously published at Mises.org in February 2006