The US Balance of Payment Deficit

 

Does it really Matter?

 

By: Dan Fraser

 

Updated: Sunday, February 8, 2004

 

Against most conventional wisdom, this writer maintains that the balance of payments deficit of the United States does not matter. Neither the deficit in goods trade or the current account deficit. That curing it may be worst than the disease.

 

Scale of the problem:

 

In 2002 the US was the world’s biggest exporter with exports of $774 billion[1]. A huge amount. However, the country also imported $1.224 billion. Almost 1¼ trillion dollars of goods for a net difference of $449 billion. However, there are invisible inflows and outflows to contend with, like money wired in for services and money wired out to families in Mexico.  These pretty well balance out giving the USA a current account deficit of $444.7 billion in 2002.

 

How can a country cope with that much money being removed from its domestic money supply in one year and leaving foreigners with that much ofof a call on the USA’s goods and services? The US did have foreigners invest $444.1 billion in the country, bringing things so close into balance that there is no net effect. What did these foreigners buy? Largely government bonds but this also includes all foreign investments in the stock market as well. It is estimated that perhaps ½ of this amount was to purchase government debt.

 

Why did foreigners buy all these bonds anyway? Certainly not to do the USA any favors. Not even because they were a good investment with a great rate of return. The interest rate on all that government, to tell you the truth, pretty well stinks considering the risk in lending to a country that appears to be incapable of living within its means. OK, granted they are considered a safe investment in spite of the overspending. You will get your capital back, no matter what, even though there is an exchange rate risk to worry about..

 

Important point. – Foreign governments, mostly Asian, bought most of the bonds. They did not do it to do us any favors. They bought these bonds to prevent their currencies from appreciating too much against the dollar. Japan spent over $80 billion doing this. By early 2004 Japan had over $800,000,000,000 in US dollar reserves.

 

They are terrified that if they let their currencies appreciate against the dollar, we will no longer buy their stuff and there will be mass unemployment in their country.

Is this a great racket or what? The US imports stuff from all these countries and they turn around and lend the money right back to the US so the government can overspend while keeping down taxes for the American people. They are as hooked on selling stuff to Americans as much as Americans are hooked on cheap imports.

 

 

Important concept: It would not have mattered if that investment did not come back to finance a good part of the deficit. We did not need the money. There is enough money awash in the USA to have bought all those bonds.

 

Let’s examine how international trade works.

 

The USA makes something and sells it to foreigners. How do the foreigners pay for it?

 

They go to their bank and convert their local currency to US dollars to make the payment, often through a letter of credit. This is because most international transactions are priced in US dollars. The transaction tends to strengthen the US dollar by increasing the demand for it. The transaction tends to weaken the local currency by making more of it available on the world market. The effect of any one transaction is miniscule considering over a trillion dollars a day is traded worldwide in the currency speculation market. Actual trade is such a small part of currency speculation that it has little effect.

 

Now a imagine that a US buyer wants to import something. The US buyer just sends US dollars straight to the seller because international transactions generally occur in dollars. The seller then deposits US dollars in their bank and takes out only enough local currency to pay domestic expenses. The balance is used to buy raw materials imported from the USA or other countries and are purchased in transactions prices in US dollars. Profits are usually held in US dollars as well and most of these find their way through the banking system to the national reserves of the selling country.

 

Note that only the portion for the exporters domestic costs are converted to local currency. This makes the pressure on the US dollar a much smaller amount than if the entire amount was converted into local currency. Laws vary from country to country but in most free countries, every business has a US dollar bank account as well as their domestic account. In many cases, all the companies local currency expenses are paid with earnings from the domestic market while the US dollar sales pay for the company’s dollar priced raw materials with the profits put in a dollar account someplace, not necessarily the company’s home country, but seldom the USA either.

 

Now what happens when goods flow between countries other than the USA and somewhere else. The importer goes to their bank and uses US dollars they already have or convert their local currency into US dollars and sends US dollars to the exporter. Local currencies seldom ever change hands outside their own countries.

 

The US dollars used for this used to be called Euro dollars but are now what the writer calls “World Reference Currency”. As much as the Europeans would love for international transactions to be priced in Euros, most world trade still flows in US dollars.

 

Important concept - For trade volume between countries to grow requires a steady growth in this flow of US dollars into the world economy. If the dollars available did not grow every year, international trade would not be able to grow. If the US did not pay out more than in took in every year, international trade would suffer. Besides, every year a major amount of these dollars get siphoned off.

 

Foreign currency reserves held by countries outside the USA increased by $127 billion dollars in 2002. This had to come from the US balance of payments[2] deficit. It could not have happened without the US importing at least the same amount over what it exported. This is critical for these countries as many currencies now base their value almost completely on the value of the US dollars they hold. Many only issue currency according to the amount of foreign reserves, mainly US dollars their central banks possess.

 

If the US balanced its trade and current accounts, as many economists suggest, this would choke off the ability of these countries to grow their own domestic money supplies. With a balanced US balance of payments, central bankers, to increase reserves in order to continue growing their country’s economies will suck dollars away from the funds used for international trade, quickly drying them up. This would make international trade harder to accomplish and it would certainly stop any growth in non US trade. This choking off trade because of a limited supply of money is one reason Nixon took us off the Gold standard.

 

After the US$127 billion used to increase foreign countries central bank reserves, this leaves about $320 billion to cover the growth in international trade in 2002 and the increase in the amount of money stuffed away under mattresses in say, Russia and Columbia.

 

Important concept - If it is important that the US keeps the international trading system as well as the currencies of all the other countries afloat, how can the USA afford it. Where does all the money come from. Think about it? What is the one product the USA can manufacture that no one else can?

 

US dollars of course.

 

The broad money supply grew at 9% in 2002.

 

You ask: Won’t such a fast growth in money supply cause inflation? Yes, it would, in a classical economy, the kind that exists in an economics classroom. Where the amount of goods available are fixed or defined by a slow growing “capacity”. After all, more money chasing the same number of goods will make those goods cost more. However, with a huge hole draining $444 billion from the money supply, over a billion dollars a day, the money available domestically rises a lot slower, greatly reducing inflationary pressures. Think of it as a leech, reducing the economy’s blood pressure. In the mean time, all these foreigners send the US all this desirable stuff and the US gives them nothing in return except the right to print more of their own money and to trade with each other better.

 

You may have noticed a real estate bubble going on in 2003. Land cannot be imported and houses are a bit hard to import as well. The supply of these is limited and indeed the price of these are rising at a fast clip. However, manufactured goods, of which an unlimited supply is available from Asia, have not risen in price. If anything they are falling as the foreign suppliers fall all over themselves to lower prices and get a competitive edge. Even if currencies elsewhere are rising.

 

Remember that most classical economics assume a closed system, not one with a bottomless supply of cheap labor in China, one kept artificially cheap by the Chinese government by fixing the exchange rate between the yuan and the US dollar. In fact this fixed rate essentially makes the Chinese labor pool part of the domestic US economy and giving the USA unlimited capacity.

 

Remember, we can only do this trick because the US dollar is the World Reference Currency, because it is the currency of international trade and is the main component  most foreign central bank reserves.

 

Important Concept – The US dollar does not fall in value. It does not rise in value. Since the US dollar is the world reference currency, a US dollar is always worth exactly 1.000000000000 US dollars. All the other currencies rise or fall against it. If foreigner’s don’t want to take US dollars for their goods, their currencies will rise against it. That is what would happen if those countries central banks did not intervene.

 

When you go to Asia, like I have, every person there seems obsessed with exporting to the US market. Most will do anything not totally illegal or immoral get those US dollars. The US dollar is highly prized around the world and they are only made in the USA. Think of the dollar as our most valuable export. As a commodity we export, that other people find useful for their own needs. Thought this way, the US has a neutral balance of payments. If the foreigners did not want US dollars, the demand would fall and so would the value to them, that is their currency would rise, their exports would go down and they would have higher unemployment. And if the dollar does fall compared to their currency, it just means that their reserves are worth less and they will have to reduce the amount of their currency in circulation which would cause them to have a recession. That’s their problem, not America’s.

 

Another View

Look at it this way. When the US buys something from another country, they send us stuff, made through the sweat of their brows. We send them dollars. Sure some dollars are then used to buy stuff from the USA but a lot isn’t. Over $400 billion a year. Now what are those dollars?

 

Gold? Heck no. Nixon took us off the gold standard in the 70s. Why? Because, like the author, Nixon believed that there was no point in limiting the growth rate of world commerce to the amount of a particular metal removed from holes in the ground (gold mines) and placed into other holes in the ground (Fort Knox, etc.)

 

Dollars are not even paper. Big money is transmitted electronically. World trade involves increasing the numbers on one bank’s hard drives while decreasing them on another. It is all just data and that data merely represents potential wealth. That is, promises of the US Federal Reserve that these numbers represent legal tender that can be exchanged for real goods and services.

 

If they can’t find things in the USA to buy, this not the US’s problem. They got our dollars and they can have our stuff if they want it. That they don’t, too bad. It is only the US’s problem if they decide to not keep taking these “promises to pay” called US dollars.

What would  they take instead?

 

Euros? Maybe. Some do. However, the entire Euro area’s deficit is only $54 billion. Not enough to finance the increase in foreign reserves, let alone any increase in international trade. Japan alone sucked in more than that just in increasing their reserves let alone for anything else.

 

Yen? Japan sucked in $116 billion dollars overall in their balance of payments. The Yen is in short enough supply in Japan that they are in a deflationary spiral yet alone to have enough to finance world trade. But then the Bank of Japan has been desperately making more Yen for years to try to pump up their economy then spending it on US dollars.

 

The Franc or the Mark. Don’t exist any more. Sorry.

 

Sterling? This used to be the world reference currency. However, the $25 billion a year outflow from Britain just counteracts the goods surplus from China giving no net effect to world trade.

 

The Peso. Lets be real here. The US dollar is the 800 pound gorilla of world currencies and that fact is not going to change any time soon.

 

Actually, the USA has the rest of the world over the proverbial barrel. Lets just say that the exporting countries decide they won’t sell to the USA unless the US sells more to them. As if this will happen but lets say it did. The exporting country involved would find mass unemployment on their hands. They need those dollars to keep their people employed. Next, someone else would break ranks and a competing country would take their business.

 

After this, if they all ganged up on the USA, what would happen is that their currencies would go up in value quite a bit compared to the US dollar. This means that the US dollar reserves they held would be worth less in terms of the local currency. From the perspective of that country, it would appear that the US dollar had fallen, making their reserves all that less valuable ultimately making their wealth effectively lower. They would have to reduce the amount of local currency circulating in their country. Either that of manufacture more money not based on foreign reserves which would drive their currency back down until their exports were again competitive on the US market.

 

Low, let’s imagine what if they ganged up on us and in spite of massive unemployment at home, they refused to sell the US anything that was not matched with a sale from the US to their country. To tell you the truth, what we import is generally stuff we don’t really need, just stuff that is nice to have. The USA is perfectly capable of making all the cars the domestic market needs. The 100,000+ Mercedes sold each year can be replaced by Cadillacs. The 5 for $10.00 Chinese T-Shirts can be replaced by $4.99 T-Shirts from South Carolina. China builds DVD players that sell here for $50.00. The USA can build its own for to sell for $100.00. All that would happen is that these countries would be exporting their jobs back to the USA where they took them from in the first place.  SO what if things cost a little more. Were we really that bad off when VCRs cost $500.00 and when a T-Shirt did cost $5.00? Before there was a cheap “C-class” Mercedes? Before there was a Lexus. Sure American cars then were crap but they’re far better now than the Japanese cars were then.

 

Besides, would anyone think that Mexico would not still be a cheap labor source for us? That the people in Central America would not take US dollars.

 

In the 2004 we are seeing the Japanese dump huge piles of yen on the market trying to buy US dollars to drive the value up. The Yen has risen quite a bit against the dollar, making Japanese exports too expensive. The Japanese are actively conspiring to prevent the US dollar from falling too much against the Yen.  As long as foreigners are actively trying to prevent the US dollar from falling against their currencies, what’s the problem? And if they stop, the foreign governments have an even bigger problem.

 

Even if the US government wants to weaken the US dollar against other currencies, there are those who will work against it. The foreigners need the flow of US dollars to keep coming to keep their workers employed. The foreign central bankers, even though they know that money in large amounts is mere numbers on hard drives, they know they cannot do much to weaken the US dollar because all they will do is merely make their currency rise in value, pricing their exports out of the US market while countries like China who have pegged their currency to the US dollar takes away their business.

 

The bottom line is that the rest of the world needs a steady stream of US dollars and the US should be willing to shoulder the burden of supplying them to the rest of the world. Yes it can be tough on US workers when you buy a German car but the rest of the world is counting on the US consumer.

 

That world growth is so dependent on the US market is another problem but one that will be dealt with in another essay.