David R. Henderson  

The Conard Line on the Trade Deficit

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Tyler Cowen writes:

This framework makes Conard a revisionist on the U.S. trade deficit. The traditional story is that Americans buy goods from, say, East Asia, and the sellers respond by investing those dollars back in the U.S., a win-win situation. Conard believes that analysis would hold only if people who accumulate cash from foreign transactions invest their funds into risky, innovative enterprises.

But too often they buy government securities, and so Conard views the U.S. trade deficit as something that makes the government bigger without making the economy more dynamic. This confounds the traditional libertarian defense of free trade by indicating that we are not really getting market-oriented investments when the funds return.


This is part of his article discussing Edward Conard's new book, The Upside of Inequality.

I'll assume that Tyler is stating Conard's view accurately. If so, Conard is wrong. The trade deficit per se does not make the government bigger or smaller. What makes the government bigger is more government spending, more regulation, etc.

There's another problem. First, let's recognize that when people use the term "trade deficit," they mean "current account deficit." When there's a current account deficit of magnitude x, there's a capital account surplus of magnitude x. This is a mathematical necessity. Second, let's recognize that there is likely to be, for the next few years, a large U.S. government federal budget deficit.

Now to the analysis. For a given size trade deficit, there's a same-size capital account surplus. Let's say there's also a large U.S. federal budget deficit. Whether foreigners buy bonds to finance the budget deficit or Americans buy bonds to finance the budget deficit, the budget deficit is financed. If foreigners buy more bonds, then Americans buy fewer bonds and invest in those "risky, innovative enterprises." So it's hard to see why foreigners buying bonds means that there's less investment in those enterprises.

Now it's quite possible that the higher U.S. federal budget deficit crowds out investment in those enterprises. But then it's the U.S. budget deficit doing that, not the foreigners' choice of U.S. assets to invest in.


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CATEGORIES: International Trade




COMMENTS (26 to date)
Khodge writes:

Is that not the point (or at least the obvious outcome) of QE?

Toby writes:

Hi David,

I thought about this line that Tyler posted as well and the way that I interpreted the claim, was that the demand for government securities shifts out when Americans import goods from East Asia compared to the situation when Americans purchase goods at home.

Now whether this is true or false, I don't know. However, it seems to me that the rational response to this, is to increase the deficit to finance more government spending. At least that's how I read Conard's argument as represented by Tyler.

The difference between you and Tyler's version of Conard is, I think, that he looks at the medium / long run and you look at the short run. In the short run, this:

Second, let's recognize that there is likely to be, for the next few years, a large U.S. government federal budget deficit.

seems like a plausible assumption to make. In the medium to long run, it might not be.

I don't know the empirics, but it seems like an interesting question for research. Conard seems to posit that an exogenous increase in the demand for government securities will increase government spending and the deficit. This is a hypothesis that can conceivably be refuted. It seems like the kind of question that a journal like Public Choice could be interested in.

Toby writes:

To add to that if Conard is right, then:

1. more stringent capital requirements for banks and other financial institutions will grow the size of government, in addition to the regulations themselves;

2. diminishing investment opportunities around the world, perhaps due to government regulations, will increase the size of government above and beyond the regulations themselves;

3. ageing of the population will grow the size of government as pension funds / individuals switch from stocks to bonds (above and beyond the demands from interest groups representing older individuals.).

That's how I read him in any case.

John Goodman writes:

When I first read this, I thought Tyler and Conard were making a freshman economic mistake. It's so obviously wrong, I couldn't believe what I was reading. Am I missing something?

When foreigners buy assets, it doesn't matter what assets they buy. They are injecting new funds into the capital market. Those extra funds are available for new investment -- which will be made by the previous holders of the assets the foreigners purchased.

Josh writes:

Wouldn't the higher demand for government bonds from foreign dollars lead to lower rates paid on those bonds? Which then prompts people like Paul Krugman to say we should be running even bigger deficits because rates are so low. Maybe that's what he's talking about.

Toby writes:

@John: there is not one capital market. There is a market for AAPL, there is a market for GOOG, etc. Saying that it doesn't matter which assets are bought because there is one capital market is akin to saying that it doesn't matter what consumption goods are bought because there is one market for goods.

@Josh: that's more or less how I understand it as well. Not just from Krugman mind you, but also from libertarians. It seems that a little bit more government spending has just become a little bit cheaper.

Jon Murphy writes:

@Josh Wouldn't the higher demand for government bonds from foreign dollars lead to lower rates paid on those bonds?

Well, it depends on the direction things are going. If there is increased demand for gov't bonds (at the expense of corporate bonds and stocks), then yes, rates would be lower and the increased government deficit would be in response to that since borrowing is now cheaper.

However, if the government is deficit spending, increasing its demand for funding, then interest rates would be rising.

I suspect that there is demand for US government bonds, which results in interest rates being relatively low, but it does not come from trade deficits but rather the fact the US is a "safe haven." The British, European Union, Japanese, and even Chinese bond markets look relatively unstable. So, people are flocking to US gov't bonds.

khodge writes:

@John Goodman
"It doesn't matter what assets they buy." That seems to be exactly Conard's point and it strikes as a valid question that needs to be expanded to Fed policy (not just trade).

Over the last decade, the Fed has flooded the markets with cash (by buying bonds) in an effort to "increase aggregate demand." Why would the banks push this cash out to non-safe loans when they can make a ton of revenue with low interest Fed bonds in a non-inflating economy? It is not exactly an accident that we do not hear of bank failures in this environment.

We have malinvestment caused by: the Fed trying to fix the economy; cash rich companies unwilling to invest; banks making money by not lending to medium and high risk clients. Does the current business environment show that the Fed is now working (has cured the problem!) or not is open to question. I think that Conard's explanation is likely; I doubt that there is a workable solution.

David R. Henderson writes:

@khodge,
@John Goodman
"It doesn't matter what assets they buy." That seems to be exactly Conard's point

No. Conrad’s point, assuming Cowen has characterized it correctly, is that it does matter what assets they buy.

khodge writes:

David, thanks. I ought to said that when I selected that quote.

Scott Sumner writes:

Very good post.

Benjamin Cole writes:

When a regional economy imports more than it sells, then it must borrow or sell assets, or shrink population, to maintain per capita income. There is no free lunch. The US economy is not different. (Include tourism and net taxes as part of "imports").

Not sure how foreign lending to the U.S, or offshore buying of US assets encourages government borrowing. I prefer balanced federal budgets.

It is true, the continued encumbrance of a regional economy by lenders and investors outside the regional economy may lead to more government welfare, as living standards drop.

Don Boudreaux writes:

Great post, David.

Commenter Benjamin Cole is correct to suggest that foreign lending to Uncle Sam is not itself a cause of U.S. government budget deficits. But Mr. Cole is mistaken when he writes that

When a regional economy imports more than it sells, then it must borrow or sell assets, or shrink population, to maintain per capita income.

Although often-made, this claim rests on the false assumption that the world's stock of capital is fixed. But it is not fixed. Because capital can grow - and often does grow - when people specialize more deeply and trade more, when people in a region (or nation) import during some period more than they export during that same period, per-capita income need not fall. It can, and often does, grow as a result.

Here's an example. Suppose, for simplicity, that America's current account is now in balance (even more simply, that over the past year, the dollar value of Americans' exports equalled the dollar value of Americans' imports). Then today, American Jones, discovering that a Chinese steel producer has perfected a means of making better structural steel and selling it at lower prices, buys $10M worth of this steel from the Chinese producer.

Jones uses this steel to expand his factory in a way that he would not have done had he not had access to this lower-priced, higher-quality steel. Jones is thereby able to profitably expand his production: Jones himself produces more output and sells it at lower prices to all of customers, most of whom are Americans.

Meanwhile, the $10M received from Jones by the Chinese steel producer is used to buy a $10M condo in Manhattan from the American Smith. (This condo was Smith's second home.) Smith uses the proceeds from the sale of this condo to start a restaurant in Brooklyn, which is hugely successful. Smith turned his $10M investment into a restaurant now worth $15M - and diners in Brooklyn get more and better dining options.

This transaction - American Jones's purchase of $10M in steel from a Chinese producer and the Chinese producer then spending this $10M to buy a condo in New York City - caused America's current-account deficit to increase by $10M. Yet it also resulted in an increase, not a decrease, in per-capita income in America.

Although obviously stylized, an example such as this one clearly describes transactions of a sort that frequently occur in reality. And such plausible examples can be multiplied easily.

Don Boudreaux writes:

Another way to describe the flaw in Conard's argument is to note that it rests on the mistaken assumption that there's something unique about domestic citizens (whether individually or as organizations) borrowing from foreigners rather than from each other.

Suppose that consumers throughout America buy $1M worth of corn from Farmer Williams in Kansas, and that Farmer Williams uses all of these sales proceeds to buy U.S. Government bonds (rather than to invest in, say, a Silicon Valley start-up or even in improving his own agricultural operation in the American heartland). Would Conard conclude from observing this perfectly plausible series of transactions that freedom of trade in agricultural products is worthwhile only when the investments made by sellers of agricultural products are in the entrepreneurial private sector - and that, whenever such investments are made in ways that he (Conard) judges (let's grant correctly) to be unproductive, then the problem is with free domestic trade in agricultural products? Would Conard believe it to be an error for someone to insist that we should never worry about American-consumers' trade deficit with American corn farmers? Would Conard argue that American-consumers' trade deficit with American corn farmers is a cause for no concern only if American corn farmers invest their sales proceeds in ways that expand the economy rather than not?

To be clear: I believe that government spending almost always destroys economic value, and that - because it makes such destructive spending less costly for politicians - deficit financing is an evil (both economic and ethical). But the problem with such wasteful or destructive spending, and with deficit financing of it, is with itself; it's not with the voluntary economic transactions through which those who finance such spending acquire the funds to supply the financing or with the artifactual accounting relationships that such transactions generate. (And, again, even if I am mistaken in this last claim, there's still no reason to single out foreign transactions that have this result from domestic transactions that have this result.)

I add, along with David, that I've read only Tyler's essay on Conard and not Conard directly. So, like David, I assume that Tyler's interpretation is correct. This assumption is likely sound, although it's possible that it is in this case mistaken.

Glen Smith writes:

Don't see anything the quoted article suggesting that Conrad is saying trade deficits directly drive government size. What I see is that the availability of money is A driver to government spending which is A driver to government size relative to the total. While availability of money may not be as significant as Conrad thinks, intuitively, increased availability of funds (whether driven by greater deficits or greater revenues) will ALWAYS increase government spending and regulation.

pyroseed13 writes:

"The trade deficit per se does not make the government bigger or smaller. What makes the government bigger is more government spending, more regulation, etc."

I'm confused here. Couldn't one argue that the availability of foreign savings from the trade deficit makes it more easy to finance government spending here, and therefore we would expect government spending to increase?

Jon Murphy writes:

@pyroseed13:

Well, sort of. Bonds go to auction to finance planned spending. In that case, the legislation needs to be passed first. The legislators may take into account interest rates (the "price of money," so to speak, which can convey information about the relative scarcity of funds available), but the ultimate action still needs to be, as Prof. Henderson said, regulatory or via legislation.

Think of it like this: if the price of beef suddenly fell to $0.01/lb, my incentive to consume beef vs other meats would rise. However, the relative abundance of beef (as signaled by the fall in price) does not guarantee my consumption habits will change. I may still consume the same amount of beef regardless of the now relatively lower price. It'd still require action on my part.

Capt. J Parker writes:

I believe Dr. Henderson's critique of Conrad is wrong because Dr. Henderson is relying on a hidden assumption. Namely, that the quantity of financing that government demands is fixed as opposed to there being increasing quantity demanded when the cost of financing is lower.

Imagine that there is a market for government bonds and a separate market for private enterprise bonds. Government bonds give low returns to savers and also lower risk. Also imagine that savers allocate their investment decisions between one or the other market based on their risk/return preferences. Now suppose something happens that causes savers to have a much greater preference for lower risk government bonds. (this something could be a change in trade arrangements that create a capital account surplus where the owners of the surplus favor government bonds) It shouldn't be hard to imagine that this change in preferences causes the demand curve for private bonds to shift to the left decreasing the quantity demanded and decreasing the price and thereby decreasing the total amount of investment in private enterprises. At the same time the demand curve for government bonds shifts to the right increasing quantity demanded and increasing the price and hence increasing the total number of dollars going into financing the government.

Now, you might argue that government borrowing isn't market driven, deficits are political decisions, the Fed sets government bond rates etc. But, Dr. Krugman has been arguing for years that government should be spending more on infrastructure since the cost to government of borrowing is so low now so, I don't think it's not too much of stretch to say there is some price elasticity to government borrowing and there is some elasticity in the reach of government based on the cost of financing deficits. Price elasticity of private investment is macro 101 stuff.

It's also possible that whatever caused the shift in savers preferences (money coming form a capital surplus with foreign trading partners preferring government bonds say) also caused the total quantity of money spent on government and private bonds to increase. But, this doesn't refute Conrad, it just means his argument doesn't hold in all cases. It's just as easy to imaging that the shift in preferences was accompanied by no change in total investment or by a decrease.

Benjamin Cole writes:

Reply to Don Boudreaux above:

If your new restaurant example, you are hitting upon an interesting point.

Yes, a region can raise its living standard by taking in each other's laundry more efficiently. Imagine an island nation without trade (1960s USA was close). Living standards exploded on the upside, due to rapid increases in labor productivity and increases in the size of the labor force. International trade was a small footnote, negative or positive.

Your example of a Brooklyn eatery is puzzling but anecdotal. We can assume the new Brooklyn eatery is better value for the money. It is a variation of taking in each other's laundry more efficiently. So living standards could be said to be higher, However, in a no-growth economy the new Brooklyn eatery may have also creatively destroyed someone else's eatery and capital invested etc.

In this part of your example, I think you are missing something:

"American Jones, discovering that a Chinese steel producer has perfected a means of making better structural steel and selling it at lower prices, buys $10M worth of this steel from the Chinese producer."

That also means an American steel producer lost $10 million in business. So perhaps that loser-steel factory went out of business, sucking down capital with it.

The examples you have provided are anecdotal in nature, not comprehensive in outlook.

Anyway, my point is not that global trade is bad per se, or that every trade deal is bad.

It is that chronic and large USA trade deficits, in a world of nation-state regional economies, must be financed by borrowing or selling assets. There is no free lunch. This is indisputable.

Within this global structure (with limits of labor mobility) chronic trade deficits can only be financed by a nation growing deeper in debt, or selling off increasing amounts of assets.

There are some wiggles in this.

If rich mainland Chinese want to escape President Xi and come here and be Americans and bring their money with them, we become unencumbered, get the money back without working for it or selling assets (if the new American buy assets, that's okay, they are now Americans living here)

All in all, the arguments in favor of chronic and large national trade deficits run against the rules of regional developmental economics. A nation-region with large and chronic trade deficits--like Detroit--will inevitably suffer economic consequences. Free trade arguments are glib on this point.

If the world can become stateless, with perfect labor mobility, perhaps trades issues would not matter much.

Also, of much greater importance to the US economy today is the straitjacket known as property zoning,

Pundits who wish for a boom in American prosperity should devise plans to end property zoning.

Property zoning is a much bigger issue than free trade or the minimum wage.

Jon Murphy writes:

@Benjamin Cole

It is that chronic and large USA trade deficits, in a world of nation-state regional economies, must be financed by borrowing or selling assets. There is no free lunch. This is indisputable.

No, as Don point out, this is incorrect. It'd be true if, as you assumed earlier, trade is a zero-sum game ("in a no-growth economy"), but that is not a realistic or helpful assumption to make given that the exact opposite is true (economies tend to grow over time).

Further, your "indisputable" claim is readily disproved simply by looking at the economic historical evidence: the US has run chronic trade deficits for decades, and yet our stock of assets has grown, not shrunk.

Additionally, you make a mistake here:

"So perhaps that loser-steel factory went out of business, sucking down capital with it."

No reason to think the steel factory's capital is destroyed. It's not eliminated, never to be seen again. In fact, it is freed up for other uses. The capital, building, labor force, etc can be retooled for other, more productive, purposes leading to growth that would not have occurred otherwise (remember your broken windows!)

Jon Murphy writes:

@Captain J Parker

Namely, that the quantity of financing that government demands is fixed as opposed to there being increasing quantity demanded when the cost of financing is lower.

No, that assumption is not made anywhere in the post. Prof. Henderson is well aware of downward-sloping demand curves. See my response to pyroseed13 (immediately before your post) for a more detailed answer.

Capt. J Parker writes:

@ Jon Murphy

Dr. Henderson said:

Whether foreigners buy bonds to finance the budget deficit or Americans buy bonds to finance the budget deficit, the budget deficit is financed.

In the above quote there is no acknowledgement of movement in either the price or quantity of government bonds sold as a consequence of different consumer preferences. This is where the hidden assumption comes in.

If foreigners demand curve for government bonds lies to the right of Americans demand curve for bonds then the equilibrium price and quantity demanded of government bonds will be higher if foreigners are buying them than if Americans are buying them. This leaves less money for private enterprise bonds. Even if the supply of government bonds is fixed (vertical supply curve) a stronger preference for government bonds (rightward shifted demand curve) raises the price of government bonds and leaves less savings available for private bond purchases.

You said:

However, the relative abundance of beef (as signaled by the fall in price) does not guarantee my consumption habits will change. I may still consume the same amount of beef regardless of the now relatively lower price. It'd still require action on my part.

So, is market demand for beef downward sloped or not? I'll admit that Dr. Hendersons analysis is correct if the supply curve for government bonds is vertical and the demand for government bonds is horizontal but that is a very peculiar analysis.

Jon Murphy writes:

@Capt. J Parker:

Even if the supply of government bonds is fixed (vertical supply curve) a stronger preference for government bonds (rightward shifted demand curve) raises the price of government bonds and leaves less savings available for private bond purchases.

Well, no. If foreigners purchase more bonds, then domestic investors would have more to invest domestically since they are buying relatively fewer bonds (in fact, might even encourage it. If foreigners do indeed have a greater demand for US government bonds than domestic investors, then they would bid the interest rate down in order to secure those purchases. Since that would mean that domestic investors would want a higher rate, they'd direct their interests to areas that provide a higher return (say, corporate bonds). Either way, the effect is the same as Professor Henderson said.

So, is market demand for beef downward sloped or not?

Of course it is. Remember your marginal analysis! A lower price may not necessarily induce me to purchase more if the marginal benefit of consuming that extra good is below the marginal cost (for example, if I've already eaten my fill of beef, and i know even just one more bite will make me sick, no matter the price I will not consume. Remember than the supply and demand curve doesn't start at infinity. It starts at a fixed number).

I'll admit that Dr. Hendersons analysis is correct if the supply curve for government bonds is vertical and the demand for government bonds is horizontal

I'm sorry, I just don't get where you are seeing this.

Capt. J Parker writes:

@ Jon Murphy you said:

If foreigners do indeed have a greater demand for US government bonds than domestic investors, then they would bid the interest rate down in order to secure those purchases.

Quite true. Foreigners bid the interest rate of government bonds down. That means they bid the Price of the bonds up. What will that look like in an econ 101 supply and demand graph? It looks like the investor demand curve for government bonds has shifted right. Price is up. Quantity demanded is up and TOTAL dollars spent on government bonds is up.

You also said:

If foreigners purchase more bonds, then domestic investors would have more to invest domestically since they are buying relatively fewer bonds

Domestic investors will increase the ratio of private bond holdings relative to government bonds in response to the government bond price increase but it doesn't follow that that increase will counteracts foreign investor aversion to private bonds. From the first statement of yours that I quoted we both agree that foreigners have bid the price of government bonds up (interest rate down) and thereby increased the TOTAL dollars spent on government bonds. So, it follows there are FEWER dollars left over from the total investment budget for anyone to spend on private bonds, not more dollars. The only way the total amount of money spent by anyone on private bonds will remain unchanged is if the TOTAL dollars available for investment increases. This might happen (e.g. higher income because of benefits of trade) but it can't be assumed to happen. Even if you assume total investment is more in the case of a trade deficit you still need to then assume total investment increases enough to counteract foreigners preference for government bonds. That's a lot of assumptions to leave out of an argument claiming that Conrad argument is flat out wrong.

Mabuse writes:

I don't want to step on anybody's toes but; while David is absolutely correct in his criticism of Conard's argument as presented by Tyler, I think Tyler may have misrepresented Conard's argument a little bit by not emphasising the right point. Having read a little of Conard's book it is readily apparent that his problem is not with foreigners buying government bonds per se, but rather the fact that foreigners (and domestic investors) are so eager to buy them is a symptom of a global rise in risk-averse investing behaviour that he believes is the root cause of the slowdown in productivity and long-run economic growth (he also heavily criticises companies holding on to large cash reserves for the same reason).

His prescription for this problem is that taxation and financial regulation policy must be designed to ensure that investors in risky-yet-potentially-innovative enterprises receive outsized returns for their investments compared to investors in low-risk assets even if that leads to greater concentration of wealth; because those investments will ensure higher productivity and therefore income growth, hence the title of the book.

Capt. J Parker writes:

@ Mabuse,

I take the "Conrad as presented by Taylor" argument to be: foreign investors have a stronger preference for low risk government bonds over investment in the private sector than domestic investors have. A consequence of this is that a globalized US economy with a big US trade deficit, which means a bigger percentage of investment dollars are being directed by risk averse entities than would otherwise be the case, makes it easier for government to finance nonproductive government growth and harder for the private sector to finance productive private sector growth.

If I am correct that "Conrad as presented by Taylor" is arguing that trade deficits cause a shift in investor preferences then it seems likely wrong for one to argue, as I believe Dr. Henderson does, that this shift in preferences will not cause a change in how investment dollars are allocated between government bonds and private investment. This would only be true in the very narrow case where the total of dollars invested in government bonds is insensitive to shifts in the demand for those bonds.

If Conrad is really arguing that the increased preference for government bonds is universal to both foreign and domestic investors then yes, "it's hard to see why foreigners buying bonds means that there's less investment in those (private) enterprises." but that is not "Conrad as presented by Taylor" as I understand it.

I fully agree with Dr. Henderson that the root cause of bigger government is all the political decisions to make government bigger. But easy financing for government can still be a proximate cause of bigger government that is worth dealing with.


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