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Foreign aid

| Wednesday, Dec. 15, 2010

Suppose Toyota sells a $20,000 car to an American and then immediately uses that $20,000 to buy software from Microsoft. Because the value of additional U.S. imports (a car) equals the value of additional U.S. exports (software), there's no change in the U.S. trade deficit.

Now tweak the example just a bit. Toyota sells a $20,000 car to an American, then uses that $20,000 to buy stock in AT&T from another American. The American who sold the AT&T stock, in turn, spends the $20,000 on software from Microsoft as part of his effort to launch a new business. Because Toyota spent none of the $20,000 on U.S. exports, the U.S. trade deficit rises by $20,000.

Is the second situation worse than the first?

If the pronouncements of the mainstream media and of most politicians are to be believed, the answer is a resounding yes. A rising trade deficit is bad!

But look more closely. In both cases, Americans get an additional car worth $20,000, and Microsoft produces and sells additional software worth $20,000. In both cases, the amount of extra American-made output produced and sold as a consequence of Toyota selling that car to an American is the same: $20,000 worth of Microsoft products. If you're a Microsoft employee, shareholder or creditor, it matters not a whit to you whether that company's increased sales are made to foreigners or to Americans.

Clearly, a rising U.S. trade deficit does not necessarily mean less demand for American-made goods and services.

And as the above examples show, nor does a rising U.S. trade deficit necessarily mean that Americans are losing assets. While an American did sell $20,000 worth of stock to a foreigner, that American used the proceeds from the sale to invest in -- to "grow" -- his own company. If his company succeeds, that American's net worth increases.

That American is richer, no American is poorer, and the American economy has more capital in it -- all as a result of a transaction that raised the U.S. trade deficit.

To better understand why anxiety over the U.S. trade deficit is misplaced, it's important to distinguish a country's capital stock from that country's capital ownership .

The stock of capital in a country is the amount of productive assets its economy possesses -- the quantity of lathes, computers, assembly lines, research labs and other equipment (and knowledge) that enables workers in that country to produce more output per hour worked.

A country's capital ownership is the amount of assets owned by citizens of that country.

What enables an economy to create possibilities for its workers to earn high and growing incomes is not its capital ownership but the size of its capital stock.

In principle, America's capital stock can be high even if none of it is owned by Americans. What matters is not the nationality of the owners of the capital but, instead, how much capital is in an economy and how effectively that capital is used. A factory in Fort Wayne is no less (and no more) productive if it is owned by an Indonesian than if it is owned by an Indianan.

Because America's prosperity depends upon a large and growing capital stock, we should all welcome increases in the U.S. trade deficit because such increases mean more capital than otherwise is invested in America.

But what about foreigners lending money to Uncle Sam by buying U.S. Treasuries• Surely these foreign investments in America don't make Americans richer, do they• Answer: Yes they do.

By purchasing U.S. Treasuries, foreigners shoulder some of the burden of Uncle Sam's deficit spending. This fact means that foreign savings -- resources owned by foreigners -- come to America to help fund government spending. If foreigners bought no U.S. Treasuries, Uncle Sam's deficit spending would consume more American-owned resources.

It's true that this debt must be repaid, but it would have to be repaid, regardless of who owns it.

The burden of government deficit spending today is measured by the resources it soaks up. So the more that foreigners lend to the U.S. government, the fewer are the American-owned resources that are soaked up by this spending.

The burden of government deficit spending in the future is best seen in the taxes that government must impose to repay its debts. Those taxes must be paid by Americans in the future, regardless of who owns the U.S. Treasuries submitted to Uncle Sam for redemption.

The problem with government deficit spending is never the nationalities of government's creditors but the excessive spending itself. Such spending makes us Americans poorer -- but not as poor as we would be if foreigners did not help us to shoulder the burden of this profligate spending.

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