What's So Favorable About a Favorable Balance of Trade?

Wednesday, July 30, 1997

The notion of a "favorable" balance of trade has its roots in mercantilistic practices of governments. The mercantilists identified a nation's wealth or well-being with its stock of precious metals. Accordingly, a country was encouraged to export more than it imported since the net outflow of goods would be matched by an inflow of gold. To stimulate a trade surplus, mercantilists counseled tariffs and export subsidies. The tariff discouraged imports, whereas the export subsidy encouraged exports.

The thrust of the classical attack on mercantilism--particularly by Adam Smith in his great work The Wealth of Nations--was that the mercantilists incorrectly specified the wealth of nations by identifying it with the government's stock of precious metals rather than with the consumption alternatives available to the nation's citizens--that is, the nation's standard of living. Although tariffs and export subsidies could increase the government's stock of precious metals, they could also reduce the economy's consumption alternatives by comparison with a policy of free trade. The classical economists argued that free trade constituted a decrease in the real wealth of the nation, even though the government's gold stock would be increased by trade interventions. Free trade is a better policy if the intent is to maximize a country's consumption opportunities.

Notwithstanding this argument, the mercantilistic fallacy--that an export surplus is inherently a good thing for the nation--is so ingrained in the public's mind that even today it is routinely referred to as a favorable balance of trade. Why should this be? Why should it be considered favorable to the nation if the value of the goods and services it sends to foreigners is greater than the value of the goods and services they send the nation in return?

Japanese investors recently bought the Essex House Hotel in New York City. Do the guests really care who owns the hotel so long as they are pleased with their room?

The reason modern mercantilists give is that the trade surplus generates funds that can be invested abroad in foreign stocks, bonds, real estate, companies, and so on. This accumulation of foreign assets is alleged to expand the influence and power of the surplus country and decrease that of the deficit country, just as two hundred years ago the inflow of gold was considered to expand the influence and power of the prince at the expense of his foreign rivals.

The current fear of and hostility to Japan in the United States, for example, is based in part on the fact that Japan's export surplus has allowed that country to build up substantial holdings of U.S. assets in what neomercantilists believe to be Japan's latest attempt to take over the world. "In recent years," writes Karen Elliott House in the Wall Street Journal, "all too many Americans have come to see Japan as an invincible economic machine destined to roll over the world, leaving America a second-rate global power. The sight of Japanese investors buying Rockefeller Center and Columbia Pictures, coupled with a ballooning surplus in Japan's trade with the United States, has frightened and angered many Americans. The current best-selling novel, Rising Sun, panders to their fears and resentments. 'At the rate things are going, we are all going to wind up working for the Japanese,' predicted Lester Thurow a few years ago."

But what does it matter who owns Rockefeller Center, Columbia Pictures, or whatever so long as these assets are properly managed? Japanese investors recently bought the Essex House in New York City. Do the hotel's guests really care if Japanese, Chinese, or Americans own the hotel so long as they are pleased with their rooms, service, and prices? And what reasonable objection could an American worker have to working for a Japanese boss so long as he or she paid decent wages for a decent day's work? Or would Mr. Thurow prefer working for an American who paid substandard wages? From the point of view of maximizing the U.S. living standard, what counts is how well or poorly the assets are managed, not the nationality of asset ownership.

Notwithstanding these questions, neomercantilistic warnings of an imminent Japanese takeover of the global economy at best look downright silly today given Japan's prolonged recession and the enormous amounts of money Japan has lost on the foreign investments neomercantilists have most fretted about. As David Sanger writes in a piece titled "Asian Money, American Fears" (New York Times, January 5, 1997):

In the 1980s, the Asian money that fueled scores of conspiracy theories in America was all Japanese. The sale of the giant American icons--Rockefeller Center and Columbia Pictures, the Seattle Mariners and much of downtown Los Angeles--gave rise to dark warnings that decisions about the country's economic future would be made in Tokyo, not New York or Washington. Exactly how this power would be exercised was always left a bit vague. Would executives at Sony kill movie scripts about the Emperor's role in World War II or about the dark side of corporate life in Japan? In the short retrospect of seven years, the questions now sound even more paranoid than they did then. The Japanese took a multibillion-dollar bath on most of their investments. . . . It seems almost laughable these days to think of the United States as an imminent "techno-colony" of Tokyo, a phrase slung around with great abandon in Silicon Valley until Japan plunged into recession.

To underline the point that there is nothing inherently favorable about a "favorable" trade balance, the recent example of Romania is instructive. Like eighteenth-century mercantilists who wanted gold to increase their power and in-fluence in world affairs, Romania's former dictator, Nicolae Ceausescu, thought his influence on the world stage would grow in the 1980s if Romania accelerated the paydown of its substantial foreign debt. To the delight of its foreign bankers and the consternation of its citizens, Romania generated export surpluses by barring imports and forcing exports to finance the required capital outflow. The mandated increase in domestic savings put intolerable pressure on Romania's already meager living standard and was a prime factor behind the eventual overthrow of the Ceausescu regime and the assassination of both Ceausescu and his wife. Is it unreasonable to argue that the Romanian export surplus had disastrous consequences for both its citizens and its rulers?

A corollary of the principle that a trade surplus is not inherently good is that a trade deficit is not inherently bad. To demonstrate this point, consider the case of a country that imports capital and runs a trade deficit. The nation gains from importing capital if the rate of return from the use of

Defense spending was high during the 1980's because of President Reagan's desire to face down the Soviet Union. The results have been more than gratifying. Yet the defense buildup was financed in part by imports of foreign savings.

the imported capital exceeds its cost. Then, while present consumption remains the same, future consumption--net of interest payments to foreigners--will be greater than what would have been the case had capital not been imported. This was precisely the case of the United States for much of the nineteenth century, when we experienced persistent trade deficits with the rest of the world because we had to import much of our investment capital from overseas. These trade deficits laid the basis for the highly productive American industrial economy of the twentieth century. They clearly were worthwhile.

The trade deficits of the 1980s, during the Reagan years, provide an interesting special case of the principle that trade deficits can work for the general good. U.S. defense spending was high during this period because of President Reagan's desire to face down--and close down--the Soviet empire. The results have been more than gratifying--yet in part, at least, the U.S. defense buildup was financed by imports of foreign savings. Clearly, the trade deficits that financed the U.S. military buildups constituted a worthwhile use of borrowed funds even if the U.S. defense buildup was not the sole cause of the demise of the Soviet state.

Imported savings, of course, can be used to finance present consumption, in which case the trade deficits can be viewed as less benign. When savings are imported solely to increase present consumption, society passes on interest payments to future generations without a sufficient income stream from investments to support or finance them. Present consumption increases at the expense of future consumption. This probably is the case of present U.S. trade deficits and explains why many U.S. citizens are opposed to them. Note, however, that what troubles here are considerations of intergenerational equity--shifting the burden of increased present consumption onto future generations--not vague and misleading notions of flagging U.S. power and influence, as modern mercantilists misguidedly allege. The U.S. trade deficit may be unfair to future generations, but it is not a sign of American decline.