Bryan Caplan  

Trade Deficit? What Trade Deficit?

Old-time Macro Religion... Strictly Preferred to the AEA ...

According to standard government statistics, the U.S. has accumulated a massive debt to the rest of the world during the last three decades - over 5 trillion dollars. No statistical tricks, however clever, are going to erase that debt. Or so I would have thought.

But today the brilliant Ilia Rainer plugged me into the most shocking macroeconomic debating point I've heard in years. Decades of trade deficits notwithstanding, Americans' net return on foreign assets (the income we earn from our foreign assets minus the income foreigners earn from U.S. assets) has been roughly constant at positive $30 B per year! Harvard's Ricardo Hausmann and Federico Sturzenegger's have a fascinating research agenda which uses this raw fact to topple the conventional wisdom on trade deficits. Here's a very readable intro:

The Bureau of Economic Analysis (BEA) indicates that in 1980 the US had about 365 billion dollars of net foreign assets (that is the difference between the foreign assets owned abroad and the local assets owned by foreigners). These assets rendered a net return of about 30 billion dollars. Between 1980 and 2004, the US accumulated a current account deficit of 4.5 trillion dollars. You would expect the net foreign assets of the US to fall by that amount, to say, minus 4.1 trillion. If it paid 5 percent on that debt, the net return on its financial position should have moved from a surplus of 30 billion in 1982 to minus 210 billion dollars a year in 2004. Right? After all, debtors need to service their debt.

So let’s look at how much is the actual return on the US net financial position. The number for 2004 is, yes, you’ve guessed it, still a positive 30 billion, just like in 1982! The US has spent 4.5 trillion dollars more than it has earned (which is what the cumulative current account deficit implies) for free!

The upshot: The dollar is not going to collapse. In fact, it looks like we should expect the dollar to slightly appreciate. As Neo says, "Woh."

How is it possible for the U.S. to sell assets like crazy but keep the net income flow positive? In a nutshell:

Part of the answer is that the US benefited from about 1.6 trillion dollars of net capital gains so that instead of owing 4.1 trillion, it owes “only” 2.5 trillion (which, at best, cuts the puzzle in half, leaving a whole other half to be explained). The other part of the official answer is that the US earns a higher return on its holdings of foreign assets than it pays to foreigners on its liabilities.

It's easy to miss the latter effect in a simple macro model that has just one "rate of interest." In reality, of course, there are many interest rates. The basic pattern in world investment seems to be that Americans invest abroad in risky high-return assets, and foreigners invest here in low-risk, low-return assets.

Hausmann and Sturzenegger go so far as to propose a new accounting system to help make these economic realities more transparent:

We start by assuming that if an asset consistently pays more than another asset, then it is worth more, even if they both have the same historical cost or “book value”. We choose to value the assets on the basis of their returns. This is just like valuing a company by calculating its earnings and multiplying by some price-earnings ratio, or valuing a property based on its rental value.

If we take their approach, you will probably initially feel like you've entered Bizarro World:

First and foremost, the US does not appear as a net debtor but as a net creditor and, as mentioned above, its net foreign asset position has remained stable over the last 20 years. Japan, consistent with official data, is a growing creditor, while the European Union and the rest of world are net debtors.

But on reflection, it's the conventional story - that the United States' three decades of apparent financial tranquility are just about to end in disaster - that's bizarre.

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The author at amcgltd in a related article titled Trading in Darkness writes:
    Like the guys over there say, trade deficit? What trade deficit? I read through it and, economic expert that I am, what the originating authors seem to have done is proposed a method to account for what everyone sees... [Tracked on August 3, 2006 10:48 AM]
The author at in a related article titled Trade Deficit? What Trade Deficit? writes:
    [Source: EconLog: Library of Economics and Liberty] quoted: So Bryan, in the spirit of your public finance lecture I must ask how much you have tied up in currency markets betting on the dollar increasing? I can't imagine how awkward THAT conversation ... [Tracked on August 5, 2006 12:01 AM]
The author at Caveat Bettor in a related article titled Today's myth-busting post ... i.e. free the bears writes:
    Another nice take from Bryan Caplan, here, who says "The upshot: The dollar is not going to collapse. In fact, it looks like we should expect the dollar to slightly appreciate. As Neo says, "Woh." If only Warren Buffett and Bill Gates had read that H... [Tracked on August 9, 2006 7:47 AM]
COMMENTS (9 to date)
Daniel writes:

So Bryan, in the spirit of your public finance lecture I must ask how much you have tied up in currency markets betting on the dollar increasing? I can't imagine how awkward THAT conversation must have been, given how things went when you moved into mostly international assets. :)

John Hall writes:

Very good post.

quadrupole writes:

Congratulations, you have finally discovered the dark materialists :)

I would venture to suggest that part of the reason for this disparity is that the rest of the world is sending us their money for wealth storage. We then turn around and invest that money both at home and abroad.

Tim Worstall writes:

I’m surprised that people are surprised at this. I thought it was well known that much of the overseas investment by both the US and the UK earned better returns than much of the inward investment into the two countries? I take it to be a function of risk personally.

Roger M writes:

There has been a lot of criticism of this "dark matter" theory. For examples, check out Martin Wolf's blog at

I think the theory has a lot to offer, but I wonder how much of the effect is from foreigners reinvesting their earnings in the US rather than taking them home. Also, there's the issue of changing exchange rates. When the dollar dives, foreign assets become worth more in dollar terms.

Frank Jones writes:

I share the feelings of Tim about this matter. Even tough it's not completely accepted by everyone, for how long the current trend can go on etc, the deficit is generally regarded as a non-issue by most analytics in the business.

Like quadrupole and Tim says, the western world is functioning like an insurance company for the developing world and at the same time it's our companies that are reaping the profits in
exchange for jobs in Kina etc.

Now if you look at the deficit as a part of US assets (what the US can sell to keep financing the deficit) and taking into account the asset growth, the future becomes even brighter and the deficit truly turns into a non-issue.

Dezakin writes:

Great news; But when do we get to stop worrying about US government debt?

quadrupole writes:

Don't worry about government debt. Worry about government *spending*. Borrowing is just one of many techniques for extracting the money the government is going to spend. Or in other words, borrowing is just another form of taxation. All forms of taxation have costs. When does it make sense to be worried about government borrowing? When the cost of borrowing exceeds the cost of the fund raising means you seek to substitute for it.

For example, if your choices are borrowing or a capital gains increase, you have to be pretty dim not to choose borrowing. Borrowing is much cheaper than discouraging capital formation through captial gains taxes.

Given that most of the tax increases that are politically viable (ie at least somewhat progressive) also strongly discourage capital formation, I have to say I'm quite a fan of government borrowing right now.

DS writes:

I have always thought there was something wrong with the whole concept of the "trade deficit", I've thought for a long time that it didn't measure the right thing.

To listen to the doomsayers, over the past 25 years the economy was continually about to collapse due to the "trade deficit" and yet, those 25 years have possibly been the most prosperous in U.S. history. The common complaint was always that we were simply borrowing against the future and that it all had to come due because it was unsustainable.

But how many years must a theory produce incorrect predictions before you figure out that maybe the theory is just incorrect? 25 years? Paul Samualson predicted for 30 years that the Soviet economy would overtake the U.S. in 10 years. We're still waiting.

This paper seems to confirm the biggest flaw I see in trade balance calculations: it doesn't measure profit. If every business in America would simply sell all of its exports at a loss the "trade deficit" would disappear tomorrow. Would anybody be better off? No (except foreigners who would get goods and services below cost). Is this what I think a lot of countries that run "trade surpluses" do? Yes.

I once read a quote where somebody called Japan the largest non-profit organization in the world. Its no coincidence that they run a big "trade surplus" with the rest of the world.

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