The Balance-of-Payments Deficit: Not to Worry

By Henderson, David R. | Freeman, January/February 2010 | Go to article overview

The Balance-of-Payments Deficit: Not to Worry


Henderson, David R., Freeman


Quick. What's the trade deficit between California and the rest of the world? Don't try Googling it because you won't find an answer. No government agency - or private entity - computes the dollar value of goods that people in the rest of the world sell to or buy from Californians. Why not? Because it doesn't matter.

Yet governments do that computation for countries. Do trade deficits between countries matter? They do, but a lot less than most people think. A high trade deficit is not a definite sign of an economy's weakness, and a low trade deficit or high trade surplus is not a definite sign of an economy's strength.

First, let's define our terms. By the most comprehensive measure, there can never be a balance-of-payments deficit. If we import a higher dollar value of goods and services than we export, then the extra dollars we spend on imports balance that difference, and the net balance is zero.

Of course, when people refer to a balance-of-payments deficit they are not thinking about this comprehensive measure; they're thinking about a narrower measure - the merchandise trade deficit. This is the difference between the dollar value of what we spend on imports and what we are paid for exports. In 2008, the latest year for which these data are available, Americans spent $840 billion more on imports than foreigners spent on U.S. exports. Offsetting this was a U.S. surplus on services of $144 billion. The net balance of trade on goods and services, therefore, was $696 billion. To put this into perspective, this was about 4.8 percent of the total U.S. gross domestic product.

Where did this $696 billion go? It went to other countries, of course, but most of it came back in one of three forms: 1) foreign purchases of American bonds, mainly government bonds; 2) foreign purchases of other assets such as stocks, land, and property; and (3) so-called direct investment whereby foreigners build plants and equipment in the United States.

Is this bad? Consider each in turn.

1) If foreigners refused to buy government bonds, the U.S. government would need to offer higher interest rates to make holding the bonds attractive to Americans. That would drive up the cost of financing the U.S. budget deficit. We can decry this deficit - and I do - but given that it exists, which is better: having the irresponsible federal government paying a higher or lower interest rate? I vote for the latter.

2) One reason foreigners invest in U.S. stocks, land, and property is that the United States is still a relatively safe haven for investment. Granted, it's probably less safe than it was before the U.S. government changed the rules with its bailout, the so-called Troubled Asset Relief Program (TARP), and with the so-called stimulus package. But it's still safer than investing in much of the rest of the world. So rather than being bad, the size of this investment is actually good.

3) The same reasoning applies here. It's good, not bad, that foreigners find it attractive to invest directly in the United States. It's especially good for U.S. workers. The more capital there is per worker, the higher worker productivity is and, therefore, the higher are real wages.

Dollars on the Penny

What if the money doesn't come back in any of the above three forms of investment but, instead, is held in U.S. dollars? That's even better for Americans. Instead of giving up capital in return for merchandise, we are giving up paper money. According to the Bureau of Engraving and Printing, the average cost of a unit of paper money is 6.4 cents. Because of the production process, the cost is probably higher for a one-hundred-dollar bill, and presumably a disproportionately high number of such bills is held abroad. …

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