Monday, August 15, 2011

Confusion About Trade Deficits

The blogger Cynicus Economicus has a new post here:
“A Ramble towards a Conclusion,” Cynicus Economicus, August 13, 2011.
In this post one finds a curious statement about the nature of trade deficits:
“And then there is the West. We have the infrastructure. We have opportunities and systems that have allowed us to have lifestyles that this emerging labour could only dream about. However, it was not enough for us. We wanted more, and more and more. We voted in governments that told us that we could have more and who borrowed in our names, and we borrowed to support our lifestyles, all the time thinking that it was our ‘right’ to enjoy our huge share of the world’s resources. Well, it is time for the West to wake up, and accept that the game has changed. What excuse was there for countries with fully developed infrastructure to borrow money, or why did so many individuals borrow so much when their wages might allow for a reasonably good life? It was borrowed because we wanted to consume more than we can produce.”
The post, and in particular this passage, demonstrates fundamental confusion about trade deficits: the author conflates a government budget deficit with a trade deficit.

Governments with monetary independence borrow in their own currency: they do not require foreigners to finance their deficits. When foreigners in fact purchase the newly issued bonds of another country it is because they have freely chosen to convert their foreign exchange for the local currency and purchase the bond. A great deal of government spending goes to purchasing domestic output, and even when money in a government deficit is used to buy an import, the financing of that purchase of a foreign good is a completely separate matter.

The blogger Cynicus Economicus complains that Western nations “consume more than we can produce,” a state of affairs that is allegedly an example of the West “living beyond its means.” What is conveniently ignored is the fact that the Eurozone* is the second largest Western economy (as well as the second largest in the world) and generally has trade surpluses:
Euro Area Trade Balance 2008–2011,
Moreover, any country that successfully runs a trade deficit is not “living beyond its means.” Such a nation paid for its imports because it attracted a capital account surplus to fund its current account deficit.

Foreigners freely and voluntarily bought the nation’s real and financial assets, and gave it the foreign exchange necessary to pay for imports. Even an individual is not “living beyond his means” if he sells, say, four of his 100 luxury cars to pay for additional consumption in one year, over and above his salary: he had the money to pay for his additional consumption by selling his assets. And, if he has a very large stock of many assets (both real and financial) which is constantly growing, he might be able to live like this for his whole life. Some nations (like Australia) have had virtually perpetual trade deficits through their history, but have no difficulty running them, precisely because they have a very large stock of real and financial assets, which is constantly growing, and these assets are bought by foreigners every year to fund trade deficits, even though the actual percentage of financial assets owned by foreigners each year might only fluctuate within the 15–30% range.

In short, the only time that a country is actually “living beyond its means” is when it has a balance of payments crisis, and the whole central argument of Cynicus Economicus collapses like a house of cards.

* The Eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.


  1. Irrelevant, but heads up -

    Paul Krugman has made a post countering MMTers, saying that deficits financed by printing of money will lead to hyperinflation.

    Yes, he used the H-word, hyperinflation.

  2. @Prateek Sanjay
    And Bill Mitchell has made a post answering Krugman's fears.