A lesson on trade deficits and current accounts balances.

There is some amount of interest in trade deficits and the proper role of governments in regulating the flow of trade.   When people speak of import subsidies, export subsidies, tariffs and quotas they are talking about regulating trade.  Interfering is a better term.  As you can see each of the tools governments use interferes with trade patterns.  Regulation through these tools interferes with the trade patterns that would otherwise occur.  Why would a government want to interfere with trade?  After all trade is a mutually agreed upon exchange between parties.

In order to understand we must ask, what is trade?  Trade is merely an exchange between interested parties.  An exchange is made when the involved parties give something they have for something they want.  Some trade is in the form of a barter arrangement; you give me some of your stuff and I will give you some of mine.  At other times the exchange is goods and services for a claim against future goods and services.  You have some stuff I want, do you want to trade for what I have to offer?  No? Well then I have these chits you can use as a claim against other goods and services at a later date, or if you do not want what I can offer this other guy has stuff you can get in exchange for the chits I have.  If the chit is widely held and used then I need not explain who has what and how many chits they require in exchange.  The other party in my exchange has an idea what they can get and in what quantities.  What is this magical chit?  Well around the world there are several variations on this chit.  Most around the planet recognize and accept chits with pictures of dead US presidents on them.  US dollars.  But if you want to use bits of shiny metal, or cool looking crystals, you are free to use them, however; the parties you wish to do business with may not like bits of shiny metal or cool looking crystals as much as they like pictures of dead presidents so they may discount your perceived value of shiny metal objects.  You may end up having to part with more shiny metal objects than you thought you would in order to get the stuff you want.   However, and this is the important point, the eventual trade agreement will result in both parties getting something they want, that to them is of at least equal value to the thing they give up.  What they get is equal to, or greater in value, to them, to what they give up.  Of course caveat emptor applies, make sure you know what you are going to be getting.

So if freely chosen exchanges benefit both parties why do governments get asked to interfere?  Well if I want a quality vehicle that I know will last for a while I look around and see what is available.  I have several choices.  Let’s just assume I have settled on two options, a Toyota Tundra and a Ford F150.  A quick comparison reveals the Tundra is less expensive with more choices for color and more horsepower and torque (4.7 and 4.6 liter motors).   I think to myself I just might like to have that Tundra, it seems a better buy.  I think I will see if they will take my pictures of dead presidents as a down payment and a promise to give them more over time in exchange for that cool truck.

Now the guy down the street who happens to run a factory that produces F150’s sees all these Toyotas parked in driveways on his way home from running the factory, he is constantly getting passed by them on the highways, sees them at the mall and the country club and he thinks to himself,

“I could change the way we make our pick-ups so they are a better buy or I could call my congressman to see if he can help me out here.  Which would be easier and less expensive?  Traficant seems pretty cheap, but he is going to jail, someone else might cost me a bit more.  I have voters in my factory and all along the supply chain; they could probably be persuaded to save my ass if I tell them their jobs are on the line; well, except for that damn dealer who could just switch to selling Toyota.  And god forbid Toyota opening a factory near here, where they would hire my workers, but not me.  So rather than give my employees training and institute production improvements I will ask for, no demand, political interference to get people to buy my trucks.”

In order to convince the politician to help the factory owner facts must be found to distort in order to provide a leg to stand on when he gets called for interfering in the free flow of goods and services.  As the saying goes, there are lies, damn lies and statistics.  Who better to tell damn lies and distort statistics than an economist?  The factory owner asks the economist “how do I get people to choose my truck instead of theirs?”  The economist says “simple, make yours relatively cheaper.”  Relatively means that one ratio of cost/utility must be lower than the other.  The economist correctly states increase your utility or decrease your cost, unless you can affect their ratio, then decrease his utility or increase his cost.  A correct assessment, “how” is not the same question as “should.”

The factory owner then summons an accountant and the economist in his quest for the facts to distort so that he can provide some argument for the politician to use. He will then hang his name as a businessman along with two professionals and the union behind whatever proposal they come up with so he can call it a consensus agreement between business, academia and labor.  The economist and the accountant sequester themselves in some deep dark paper filled room full of computers with links to search engines, MissusDe and a super duper secret password for the trilateralists provided by dharkangell and some insight into the murky world of accounting by Chickencounter.  They discover this commonly used accounting tool, the T account, and an economic term called the Current Accounts Balance which could be used.

How does a T account work?  It is simple double entry bookkeeping.  The first two T accounts are the cash flows based upon capital or consumption selling and spending.  Behind theses cash flow T accounts are the actual goods and services T account.  As you can see the individual T accounts, Capital and Current Accounts are not in balance by themselves.  The Current accounts are the consumption goods and services sold in the economy.  The Trilateralists have prevented me from posting the actual numbers, but allowed me to post fictitious ones that reflect reality.  The Current Accounts table, by itself, has a credit balance, a trade deficit.  And the Capital Account is a debit balance.  But by themselves they do not balance.  Aha we have data to distort and call evil!

If you notice the Current Account has a credit balance of $150, which balances with the Capital Account debit balance of $150.  Add the two together and you get zero.  In the micro accounts I haven’t filled in the numbers rather I have just set up the basic structure so you can get a picture of how it works.  Total the cash side and make the appropriate entry in the Macro account.  Now the economist and the accountant look through these T accounts, and the current account balance and they discover that the Trucks T account shows a large credit dollar balance helping to create the current accounts deficit.  Since a deficit has a bad connotation, as does the term trade deficit they now have the facts to distort so that the politician can propose protectionist legislation all to coerce me to buy a Ford rather than a Toyota.  Of course this is an accounting fiction, if there is a large credit dollar number in the trucks account that means there is an equal debit dollar value of trucks in the trucks T account.  It balances.  We sent away pictures of dead presidents, they sent us trucks. 

But the story doesn’t end there, although as far as most protectionists are concerned it does.  Toyota doesn’t wallpaper their corporate offices with pictures of dead US presidents.  They use them, remember they are a claim against future goods and services and capital from whomever will accept them.  So if you look through the other T accounts you will see those dollars returning here.  They can be an entry in the chickens table, the legal services table or any number of other tables.  If they all show up in the current accounts section then there is no ‘trade deficit.’  The current accounts table balances by itself.  Those few protectionists who will admit that the story goes beyond current accounts, and over to the capital accounts table, will claim that a zero balance on the current accounts is desirable.  We don’t want them buying our factories and other capital.  Well a zero balance on the current accounts does not say anything about the structure of the capital accounts.  All it says is that we sell them the same amount of stuff that they sell us, and that we buy as much of their capital as they buy of ours.  They could buy 100% of our capital and we could still have a zero current accounts balance.  As it happens the current trade pattern is one where we send them pictures of dead presidents for stuff.  They choose to buy some stuff, some services and some capital with that cash.  We do in fact have, have had for a long time, a negative current accounts balance.  Is it a bad thing to run a trade deficit for the long term?  How long is the long term?

We can answer those questions by looking around and asking where do current accounts ‘imbalances’ exist?  And are they detrimental?

I have a negative current accounts balance with the grocer down the streets.  I buy more from him than he does me, should the government step in and require him to buy more from me?  Or should the government prohibit me from buying more from him than he does from me?  It would be silly to answer yes to either question.  And on further analysis I, in all likelihood, will never have a positive current accounts balance with the grocer.  Therefore; on this scale, a negative current accounts balance for my lifetime is a good thing.  I get to buy all the food I desire and the grocer never has to worry about buying anything from me.

Stepping the scale up a bit larger let’s look a group of people.  Washington Apple farmers have a POSITIVE current accounts balance with Japan; they buy more apples from the farmers than the farmers buy Japanese anime and computers and habu whiskey  etc.  Should the government step in and require Washington apple farmers to buy more stuff from Japan?  Should the Japanese government step in and control the amount of apples their citizens buy?  Will the Japanese ever sell more stuff to the Washington apple farmers?  I don’t know, apple farmers need tractors, they may eventually decide they like Komatsu more than they like John Deere.  John Deere better listen to their customers or they will find Komatsu’s all across the Washington apple farms.  Is it a bad thing that Washington Apple farmers sell more to Japan than they buy from them?  Would it be a bad thing if that situation never reversed itself?  I can’t see why, if the transactions remained voluntary.

How about a slightly larger pool of people?  The citizens of Idaho, in aggregate, have a negative current accounts balance with Ford.  We buy more trucks from them than they do potatoes.  Should the government step in and require Ford to buy more stuff from Idaho?  Should the government prohibit Idahoans from buying Fords?

In each of these three cases current accounts balances do not equal zero and in none of these cases is it preferable for the government to step in and enforce a zero current accounts balance.  Why then would it make sense for it to be a goal at the national level?  The answer is it doesn’t make sense.  People send their pictures of dead presidents to other people because they want Toyotas or JVC TV’s or little plastic toys in McDonalds Happy Meals.  The people who have those things want something else that they could use pictures of dead presidents to obtain.  The old saying “what comes around goes around” is especially applicable here.  It dollars get sent out under the current accounts balance, they eventually come back around, sometimes under the current accounts tables, sometimes under the capital accounts tables, and quite often under both.  When the dollars come back under the current accounts tables we send them consumables, apples, chickens, legal services, entertainment and so on.  When the dollars come back under the capital accounts tables we send them titles, or certificates indicating ownership.  It is a proven fact that capital investment is the route to increased labor wage rates.  Should we be upset that they, whoever they are, provide the capital to make our wage earners more productive, and therefore more capable of earning higher wage rates?  As I have pointed out before the time period between 1995 and 2000 saw 2% wage growth, a 2.5% improvement over the 1978 to 1995 period.  And that improvement is directly related to capital investment in technology that makes workers more productive.  Is it a bad thing that our capital accounts are positive?  Hardly, quite the opposite in fact.

Back to our story; the accountant, the economist, and the factory owner now have the damn lies and statistics to present to the politician, and the votes to deliver in exchange for championing the cause.  They cannot reasonably reduce the utility of the imported trucks, so they are going to raise the price.  Remember the factory owner only needs to sell a relatively better buy.  If possible he will raise the price of the import to the point where he can raise his price too.  The economist and the factory owner present a tariff plan, 25% on imports, that the accountant and the economist and the business owner all assure the politician will result in 10% more jobs in his home district, and 30% more votes assuring the politician re-election and the resultant seniority so he can get those coveted appropriations committee and the conference committee seats which he intends to use in rent seeking from interested parties all across the land.  You know how that works; see Robert Byrd, Ted Stephens et al as prime examples.

What is wrong with that you ask?  The policy creates more jobs for Americans, lowers our reliance on the Japanese for trucks and the factory owner earns more profit for expansion.  And the politician who lobbied for the policy retains his seat and can be counted on to pass even more legislation in that style. Well that is only part of the picture.  You see, the tariff is really a tax levied on the buyers of trucks, not just Toyotas, but all trucks, and even on some passenger vehicles whose market segment overlaps.  When the price of Toyota rises all the overlapping market segment vehicles raise their price.  And the vehicles, whose market segment doesn’t overlap the Toyota directly, but overlap the vehicles related to the Tundra, get higher prices.  So in order to get people like me to choose a F150 instead of a Tundra virtually all passenger vehicles see a ripple effect, the closer they are to a Tundra the larger the effect.  Again many will say “so what?”  If the higher prices go to American companies, or even foreign companies operating in America who cares?  It is just a larger paycheck for American workers.  Don’t be so sure about that.  If the price goes up the quantity of cars purchased will fall.  There are alternatives to a new car.  Fix the old one, buy a used one, ride the bus, walk, ride a bike… the list is only bounded by individual imagination and situations.  I certainly won’t buy a Yugo to go four wheeling in, but I could fix my old jalopy.  So now we have a situation where, with price increases and lower quantities purchased, less labor is employed and total revenue falls.

How again did the protectionist legislation help?  Oh yeah our hero’s, the accountant, the economist and the politician were paid.  The Politician retained his seat and is now on the appropriations committee and the conference committee.  The factory owner is doing just fine, no need to worry about him; his inability to run a factory such that it produced a superior product didn’t cost him a job.  The volume of production may be down, but times are tough all across the auto industry and he has a friend in high places.  Plus his ROI is higher now that they get to charge higher prices for basically the same inferior product, although in smaller numbers.

Who is harmed?  The factory workers who have been downsized because the auto industry contracted, thanks to the corrupt politician they support and the lazy factory owner.  They get hurt twice, they are also potential consumers of automobiles, and all automobile consumers have been hit by higher prices, and a lack of improvement thanks to corrupt politicians and lazy factory owners.  And don’t forget the factory workers in Japan that used to sell trucks to us, they used to buy our chickens, apples and entertainment.  They don’t buy near as much now that they have been downsized too.  So their suppliers are harmed too.  The apple farmers, the chicken plants, the entertainers that used to ply their wares overseas find a contracted market, just because the factory owner down the street wanted me to buy a F150 instead of Tundra and he was too damn lazy to just design a process for his competent workers to build me a better truck.  That, friends and neighbors is how protectionism works.