The Trade Deficit

For over three decades, the U.S. has consistently imported more than it has exported.  That automatically increases foreign ownership of U.S. assets, both financial and real.  Many view the trade deficit with alarm, and see it as diminishing the wealth of America.  They also fear that some day the U.S. will be unable to pay off its indebtedness to foreign interests, or that the exchange value of the dollar will collapse.  A closer look will show that these fears are unrealistic.

Investing in America

One nation invests in another by selling to it more than it buys.  When an American buys a Japanese-made auto and pays in dollars, the Japanese auto company acquires a dollar balance in a U.S. bank.  In so doing, it has invested in the America.  If the auto company wanted payment in yen rather than dollars, the buyer would first have to trade his dollars for yen.  Then the seller of yen rather than the Japanese auto company would have invested in the America.

Trade Policies

Contrary to conventional wisdom, the U.S. does not seek to borrow from its trading partners to support its trade deficit.  Rather the trade deficit reflects the desire of foreigners in the aggregate to increase their holdings of U.S. dollar assets.  They willingly offer their goods and services in exchange for dollar credits.  They vigorously compete in the U.S. market, selling at the lowest possible prices, while attempting to hold down their domestic wages to increase their competitiveness.  When foreign goods are offered at attractive prices in an open economy like that of the U.S., they will be bought in preference to higher-priced U.S. goods of the same quality. 

Another reason for the U.S. trade deficit is that its trading partners depend on exports to help support their own domestic employment.  As long as other countries promote trade surpluses with tariffs, import restrictions, and interventions in the financial markets to support the U.S. dollar, they are helping foster the U.S. trade deficit.  In a truly floating exchange rate system, free of trade restrictions, the U.S. trade deficit would tend towards zero over time.

How Foreigners Can Use Their Dollar Holdings

Foreigners can use their dollar holdings in several ways: 

(1)  They can buy U.S. goods and ship them home for their own use or resale, which will reduce the trade deficit and help support U.S. employment. 

(2)  They can invest them in dollar-denominated assets including new enterprise, which will help support U.S. employment and economic growth. 

(3)  They can trade them for their own or another currency in the forex market, in which case the dollars will simply change hands without affecting net investment in the U.S. 

(4)  They can sell the dollars to their central banks, which will invest them in U.S. Treasury securities and thereby help to hold down long term interest rates.

A Broader View

The U.S. economy comprises not only its domestic base but also the many foreigners who invest in the U.S. one way or another.  The greater the fraction of their assets that foreigners hold in dollars, the more their financial well-being depends on a strong dollar.  Ultimately they will become full members of the U.S. economy.  That they may live overseas is no longer relevant.

Suppose an Italian decides to produce wine for sale in America.  He hires workers, develops a vineyard, bottles the wine, and exports it to the U.S. for sale.  If his wine sells, the U.S. trade deficit will have increased by the amount of dollars he acquires.  Like any American citizen, he must pay U.S. taxes on the net income from his sales in America.  One can think of him as an American who happens to work abroad.  The wine is produced in Italy, but his earnings are in dollars and they remain a part of the dollar economy.   

If his sales do well enough, he will become an integral part of the U.S. economy.  His own financial well-being will depend on the strength of the dollar relative to the euro.  The stronger the dollar, the more euros he can acquire to cover his employee costs, and therefore the greater his profits in euros.  Because of the large market the U.S. presents and the status of  the U.S. dollar as world’s primary reserve currency, in effect the U.S. trade deficit expands the dollar economy beyond America's geographic borders.

Why a Collapse of the Dollar is Unlikely

As long as foreigners run a net trade surplus. with the U.S, their dollar-denominated assets will increase.  They can repatriate their dollar holdings individually, but not collectively.  A wave of selling dollars could leave the same quantity of dollars in foreign hands, but at a lower value in terms of the foreign currencies.  The trade deficit would be largely self-correcting if foreigners collectively tried to repatriate their dollars. 

The time will come when some nations have acquired more dollar-denominated assets than they wish to hold.  However they cannot arbitrarily cut their exports to the U.S. without increasing their unemployment levels, unless their domestic market can take up the slack.  Nations that have accumulated large dollar reserves must also be careful in diversifying into other currencies lest they hurt the dollar's exchange value and shoot themselves in the foot.  A collapse of the dollar is highly unlikely short of an environmental catastrophe or runaway inflation that ruins the U.S. economy.

The U.S. trade deficit will likely diminish in relative terms as the economies of its major trading partners grow.   But the deficit will continue until they are capable of buying most of their own production.  Until then, foreign investment in the U.S. will grow, and further expand the dollar economy and dollar's role as the world's primary reserve currency, a role once played by the British pound sterling.