In light of President Donald Trump’s current trade policy, it is perhaps worthwhile to review some common-sense principles about international trade.
The most basic and important principle is that countries do not trade, only individuals trade. The U.S. does not trade with China. Rather, some individuals residing in America buy valuable goods and services from individuals residing in China. These are imports from China. At the same time other individuals resident in America sell valuable goods and services to other individuals who reside in China. These are exports to China.
There is absolutely no reason why the total dollar value of the first set of transactions (American imports from China) should exactly match the dollar value of the second set of transactions (American exports to China). Such a zero trade balance would be a very strange coincidence. We expect to import more from some places in the world (for example, where manufactured goods are cheapest) than from others, and those places are likely not the places where the demand for our exports is highest.
The matter is no different from what happens when people in Texas trade with people in New York. No one expects the balance of trade between Texas and New York to be zero. In fact, almost no one knows or cares what that balance is. Residents of Texas would not be surprised to learn that the trade balance between Texas and other U.S. states varies considerably.
Negative trade balances are paid for by capital inflows — investments or trade credit. If people in New York as a whole sell more to people in Texas than vice versa, then it must be true that funds to pay for those sales flow from Texas to New York. These private transactions automatically ensure that payments always balance. Any aggregate negative (or positive) trade balance is equaled by an aggregate positive (or negative) capital account balance.
By the same token, the balance of trade with China should be of no concern. Logically it should be balanced by a favorable aggregate capital account balance with our trading partners including China. And, yes, it is.
And that would be the end of the matter but for one important fact: government involvement. In cases involving trade across national borders, often involving the conversion of currencies, governments are involved. For this reason, trade balances have become intimately involved in domestic government spending. Government budget deficits are financed in large part by foreign capital inflows.
For example, when Chinese exporters receive dollars from American buyers, the Chinese government takes those dollars in return for local yuan currency. For many years these accumulated dollars have been invested in U.S. Treasury bonds. In effect, the U.S. has borrowed from the trade surplus earned by Chinese sellers. The same is true for our other large trading partners.
In October 2018, the Chinese government held $1.14 trillion in U.S. debt. It’s the largest foreign holder of U.S. Treasury securities. The Chinese government fears that if it did not buy the dollars flowing in to the country with an increasing supply of domestic currency, the price of dollars (the exchange value in terms of yuan) would fall. This would mean Chinese exports to the U.S. would become more expensive and imports from the U.S. to China less expensive. Each country wants to limit imports and boost exports, not only by imposing tariffs, but also by countering natural flows of goods and finance with monetary and fiscal policy. Despite the Chinese government’s occasional threats to sell its U.S. Treasury bond holdings, it apparently continues to be happy to be America’s biggest foreign banker.
At the same time, the U.S. government has become dependent on these foreign sources of finance. And the debt keeps mounting up.
Is that a legitimate reason to be concerned about the large trade deficit with China? No, not really. It is not the trade deficit that is the real problem. It is the U.S. government budget deficit that should receive our attention. The best way to fix this is to reduce government spending, not to increase taxes. It is the overall size of the federal government that is the overarching problem of both foreign and domestic economic policy.
If the Treasury borrowed less, or if China decided to lend less (buy fewer U.S. bonds, or no bonds), what would happen? The dollar exchange rate would fall, imports would become more expensive, and exports would become cheaper and more attractive. That is what Trump says he wants. But it would happen automatically and it would mean downsizing the government, so don’t hold your breath.
Peter Lewin is a clinical professor of finance and managerial economics and Director of the Colloquium for the Advancement of Free-Enterprise Education at the University of Texas at Dallas.