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A dangerous myth about trade deficits

Summary:
In the long run trade must balance, in the sense that imports must ultimately be paid for with exports---plus interest. Thus if we buy a billion dollars in laptops from China, we might pay for those goods by exporting .5 billion in Boeing jets in the year 2030. But this true fact leads many economists to falsely assume that a country cannot run measured trade deficits forever. In previous posts I like to cite the case of Australia, which sells condos and vacations to Asians in payment for cars and TVs. The Australian government will report a trade deficit year after year, which never seems to go away. But that's misleading. Overall trade in goods, services and assets may be balanced; it's just that those condos are not counted as exports of "goods". Tyler Cowen recently quoted Jason Furman and Olivier Blanchard: Net revenues from border adjustment taxes and subsidies will be positive so long as the United States runs a trade deficit. But if foreign debt is not to explode, trade deficits must eventually be offset by trade surpluses in the future. Net revenues that are positive today will eventually have to turn negative. Indeed, any positive net revenues today must be offset by an equal discounted value of negative net revenues in the future. This is flat out wrong, and it's not even debatable.

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In the long run trade must balance, in the sense that imports must ultimately be paid for with exports---plus interest. Thus if we buy a billion dollars in laptops from China, we might pay for those goods by exporting $1.5 billion in Boeing jets in the year 2030.

But this true fact leads many economists to falsely assume that a country cannot run measured trade deficits forever. In previous posts I like to cite the case of Australia, which sells condos and vacations to Asians in payment for cars and TVs. The Australian government will report a trade deficit year after year, which never seems to go away. But that's misleading. Overall trade in goods, services and assets may be balanced; it's just that those condos are not counted as exports of "goods".

Tyler Cowen recently quoted Jason Furman and Olivier Blanchard:

Net revenues from border adjustment taxes and subsidies will be positive so long as the United States runs a trade deficit. But if foreign debt is not to explode, trade deficits must eventually be offset by trade surpluses in the future. Net revenues that are positive today will eventually have to turn negative. Indeed, any positive net revenues today must be offset by an equal discounted value of negative net revenues in the future.
This is flat out wrong, and it's not even debatable. The official trade deficit does not measure the increase in net indebtedness; as a result the measured U.S. trade deficit can (and likely will) go on indefinitely.

A common mistake made by famous economists is to confuse statistical measures such as "the trade deficit" or "CPI inflation" with the theoretical concept that economists use in their models. 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.

You might think that this is mere semantics---who cares how these terms are defined? But this confusion leads to important errors in policy evaluation, such as the incorrect assumption that the proposed border tax/subsidy would be neutral towards trade. That might be true if all imports were taxed and all exports were subsidized. But that's not what's being proposed. When a British tourist visits Disney World in Orlando, the spending is a US service export. But that service export will not be subsidized. When a Chinese buyer purchases a home in California the "export" of the home will not be subsidized. The real strength of the US economy is in the export of services and assets, which are largely ignored under this system.

It is one of the most profound consequences of China's growing wealth: Chinese investment in U.S. real estate has exploded, particularly in California and New York. Chinese nationals are now the biggest foreign buyers of American homes, purchasing at least $93 billion worth of home in the past five years, including $28.6 billion in 2015 alone. Commercial property purchases have surged as well, to $8.5 billion last year, a 15-fold increase from 2010. And, at nearly $208 billion, China is the biggest foreign holder of U.S.-government-backed residential mortgage bonds.
A dangerous myth about trade deficits

This error leads some economists to confuse a theoretically neutral border tax that applies to all imports and exports, with the one actually being proposed, which would tax imports far more than it subsidized exports, and hence would end up being at least somewhat protectionist.

This does not mean that the tax reform proposal that the GOP is putting together is necessarily a bad idea---the proposal does have a number of good features, such as expensing investment and equal treatment of debt and equity. But we need to be aware of what is being proposed. As far as I can tell the plan is at least slightly protectionist.

Scott Sumner

Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better “induce the correct level of business investment”. In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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