Beware of Mistaking Artifacts for Economic Realities

America runs a trade deficit during some period – say, a month – whenever the dollar value of that period’s imports exceeds the dollar value of that period’s exports. Unfortunately, the name given to this situation – “trade deficit” – is a never-ending source of deep confusion, sometimes even among economists. A few years ago, Scott Sumner appropriately scolded some prominent economists for their shallow thinking about the so-called trade deficit. Specifically, Sumner noted that these economists mistake human-constructed accounting categories for real and essential economic phenomena.

We can clarify Sumner’s concern by elaborating on one of his astute examples. He writes: “In terms of pure economic theory, the US sale of a LA house to a Chinese investor is just as much an ‘export’ as the sale of a mobile home that is actually shipped overseas. But one is counted as an export and one is not.” By choosing to classify all purchases of real estate as investments, the accountants who long ago created the rules and categories of international commercial accounting ensured that many transactions that are economically identical to each other will be recorded in international accounts in ways that create the false impression that these transactions differ from each other in economically relevant ways. It follows that these international commercial accounts convey misleading information.

Suppose Mr. Peng in China sells $2 million worth of steel to Ms. Jones in Texas. This transaction is recorded as $2M worth of American imports. If Mr. Peng then immediately spends his $2M buying lumber grown in Alabama and shipped to Shanghai, this latter expenditure is recorded as $2M of American exports. In this case, Mr. Peng’s commercial engagement with Americans neither raises nor lowers the US trade deficit: the $2M of American steel imports is exactly offset by the $2M of American lumber exports.

“Whew!” many Americans sigh with relief. “Our trade is balanced, so there’s no need for the government to restrict trade further.”

But suppose instead that Mr. Peng, after exporting steel to the US, used his sales proceeds of $2M not to buy lumber grown and harvested in Alabama but to buy Mr. Smith’s condominium in Manhattan. According to long-established international-accounting conventions, this real-estate purchase will be recorded as a foreign investment in the US rather than as a US export. As a result, the measured US trade deficit will be higher by $2M: We Americans bought an additional $2M of items classified as “imports” but did not sell any additional amount of items classified as “exports.”

“Oh no!” many Americans cry with concern. “Our trade deficit is rising! This untenable situation must be corrected by government intervention!”

Yet what if the individuals who long ago created the accounting rules had instead – as they easily and reasonably could have done – arranged for purchases of residential real estate to be classified, not as investments, but as purchases of, say, consumer durables. Under this alternative rule, Mr. Peng’s spending of his $2M on a New York City condominium would be classified as a $2M American export, in much the same way that foreign visitors’ purchases of hotel stays in Manhattan or in Los Angeles are counted as American exports. In this latter case, America’s measured trade deficit would not be higher by $2M. The same Americans who cry with concern when this purchase is classified as an investment sigh with relief when it’s classified as an export. But nothing has changed except the accounting convention. In both cases, Americans send $2M out as payment for imports, and then the $2M returns to America as demand for something Americans sell.

Simply by changing their conventions for classifying various transactions, accountants could raise or lower the US trade deficit by billions. Yet any such changes in accounting conventions would change nothing in economic reality. Regardless of how it’s classified, Mr. Peng’s purchase of the Manhattan condominium puts $2M into the pockets of the American seller.

If the American seller is a developer building new units, Mr. Peng’s purchase of a Manhattan condo increases the demand for this American developer’s outputs and, hence, for construction workers employed in New York. If instead the American seller is a previous owner-occupant of the condo, this American now has an additional $2M of liquidity that he or she will spend or invest, possibly on another condo to be newly constructed in New York using lumber from Alabama. This spending or investing will contribute to the creation or maintenance of particular jobs in the US. Importantly, the effects of this spending or investment on American employment – and on other economic variables – are the same if the foreigner’s purchase of the condo is classified as foreign investment in America (in which case the measured US trade deficit is higher by $2M) or if, instead, it’s classified as an American export (in which case it has no effect on the measured US trade deficit).

Recognition that the size, or possibly even the very existence, of any measured US trade deficit depends heavily on the accounting conventions used to record international commercial transactions should be sufficient to calm the fears that arise whenever this accounting artifact shows a deficit. This recognition also reveals the folly of proposals – of which there are many – for the government to restrict trade with the goal of drastically shrinking measured US trade deficits. More fundamentally, international commercial accounts are best ignored altogether. The value of what little useful information these accounts might convey to informed policymakers and business people is swamped by the Niagara of nonsensical conclusions regularly drawn from these accounts – nonsensical conclusions drawn innocently by poorly informed pundits (such as, for example, those at American Compass), and drawn disingenuously by rent-seeking producers grasping for excuses to justify their pleas for protection from competition.

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