The Real Reason for the Trade Deficit

The performance of the U.S. economy in the 20th century owes much to the predominant role of the U.S. dollar in the international monetary system. A large factor behind attaining this role was the political and military supremacy the United States gained after World War I. The position of the dollar in the world today represents a major underpinning of prosperity at home and provides the basis for the expansion of America’s military presence around the globe.

Post–World War II Monetary Systems

Like the earlier Bretton Woods system, the current system is characterized by the fixing of foreign currencies to the dollar at an undervalued rate. Yet this time, unlike under the original Bretton Woods system, the pegging is informal and unsystematic, and practiced mainly by Southeast Asian countries, particularly by China. Through this arrangement, the economies in Southeast Asia receive a similar advantage to that which was once enjoyed by the Western European countries in the 1950s and 1960s, when undervalued currencies gave them a competitive advantage that helped them to rebuild their industrial base.

Once this reconstruction stage was completed, the Bretton Woods system fell apart, and the Europeans began to build their own currency system. The decoupling of the European currencies from the dollar progressed step by step and finally led to the introduction of the euro in 1999. Since then, the need for the euro-area countries to hold dollars as reserves has greatly diminished. Yet as an international reserve currency beyond Europe, the dollar dominates and still holds a share of over 60 percent of the worldwide stock of international reserves.

Trade Deficits and External Debt

The status of global reserve currency brings with it that the American economy suffers persistent trade deficits and a growing external debt. Because the rest of the world wants to accumulate dollars as reserves and use the leading currency in international trade, the U.S currency a foreign country gains through its exports to the United States does not flow back as demand for American goods but returns as financial capital. More specifically, foreign countries use the excess of dollars to buy U.S. Treasury notes and bonds. By the end of 2017, the amount of federal debt held by foreign and international investors amounted to over $6 trillion (figure 1).

With the dollar overvalued, American exports necessarily become less competitive. Consequently, the United States suffers from persistent current-account deficits (figure 2).

 

Over time, the current-account deficits accumulate and lead to a negative international investment position, which represents foreign debt for the deficit country and foreign assets for the country that enjoys trade surpluses. By the end of 2017, the U.S. net international investment position stood at around -$8 trillion (figure 3).

 

The United States has a persistent trade deficit not because of “unfair trade” but because the dollar serves as the global reserve currency. While, for example, the purchasing power parity of the dollar would otherwise be 3.5 yuan per dollar, the actual exchange rate at the beginning of August 2018 stood at 6.8 yuan per dollar. Yet China is only one of the more extreme cases. With few exceptions (particularly Norway and Switzerland), the dollar is overvalued relative to almost any other currency in terms of purchasing power parity. 

False and True Culprits

By making international trade the culprit behind the American deficits, the U.S. government commits the error of blaming something extremely beneficial for a malaise that has different roots. The causal logic is the opposite of what the government claims. The position of the dollar as the main international reserve currency is the source of the financial inflows. These inflows, in turn, make it possible for the American economy to afford to have a low national savings rate because the inflow of foreign savings closes the gaps between domestic savings, on the one hand, and private investment and public spending, on the other.  It is by this mechanism that the American trade deficit emerges.

The cure for the deficit problem is not to hamper free trade but to replace the dollar as the international reserve currency with a private currency and to reduce America’s budget deficit, which absorbs the financial inflows from abroad.

Believing that the balance of trade determines the capital account and ignoring the fact that the arrow of causation can also work in the opposite direction is a very common and old fallacy. It lives on, although it was already refuted a long time ago, most succinctly by Eugen von Böhm-Bawerk in 1914. Then as now, this ignorance becomes dangerous when it serves as the motive to attack international trade and thus to damage a vital pillar of prosperity. 

Source for charts: Federal Reserve Bank of St. Louis

Sign up here to be notified of new articles from Antony Mueller and AIER.

Antony Mueller

Antony P. Mueller is a professor of economics at the Federal University UFS in Brazil where he is also a researcher at the Center of Applied Economics, and Senior Fellow of the American Institute for Economic Research. Antony Mueller earned his doctorate in economics summa cum laude from the University of Erlangen-Nuremberg, Germany. He was a Fulbright Scholar in the United States and a visiting professor at the Universidad Francisco Marroquin (UFM) in Guatemala as well as a member of the German academic exchange program DAAD. Antony Mueller has recently published the book “Beyond the State and Politics. Capitalism for the New Millennium”.