At this point I have to wonder if Don Boudreaux is baiting me.

In a post entitled “Ptolemaic Economics” he writes

C. Fred Bergsten claims that eliminating America’s trade deficit is a costless way to boost employment in America (“An Overlooked Way to Create Jobs,” Sept. 29).  He’s mistaken.  Among his several errors is his illegitimate assumption that all dollars that foreigners don’t spend on American exports remain idle, effectively withdrawn from circulation.

Consider two cases.  First, Americans buy $1 million worth of textile imports from the Chinese who then buy $1 million worth of pharmaceutical exports from Americans.  The result: balanced trade.

Second case: Americans buy $1 million worth of textile imports from the Chinese who then buy $1 million worth of land in Texas.  The American seller of the land immediately spends this $1 million on American-made pharmaceuticals.  (Perhaps the Texan is opening a pharmacy.)  The result: a $1 million U.S. trade deficit.

In both cases, Americans producers sell an additional $1 million worth of output as a consequence of Americans importing $1 million worth of goods.  So – although America runs a trade deficit only in the second case – the employment effects in both cases are identical.

Such an example, being entirely plausible, is sufficient to prove the absence of any necessary negative connection between trade deficits and employment.

In general its not necessary that dollars foreigners don’t spend on exports is removed from circulation but practically speaking this is exactly what is happening.


Because most of those dollars end up being invested in T-Bills.

The Federal Reserve essentially targets the T-Bill rate and creates or destroys money to set the T-Bill rate where it wants.

In more detail what happens is this:

The Federal Reserve targets the overnight interbank lending rate, known in the US as the Fed Funds rate. The Fed Funds rate washes with the T-Bill rate. That is, to say the two rates move in lock-step.

If foreigners push more money into T-Bills that will tend to drive down the T-Bill rate. Money will move out of the T-Bill market and into the overnight lending market. That will tend to drive down the overnight lending rate. In normal times the Fed would then shrink the money supply in order to increase the overnight lending rate back to its target.

Now, to get even more into the weeds, currently the Fed is paying interest on reserves. That bounds the overnight lending rate and so the dollars may end up piling up as excess reserves on bank balance sheets.

But, in either case the dollars don’t get back out because the Fed controls the T-Bill rate. Businesses and consumers respond to prices. If the price of T-Bills aren’t moving then neither banks, nor businesses, nor consumers have any incentive to change their holdings of T-Bills. So money that flows into the T-Bill market is effectively destroyed.

Now does this mean that trade deficits always leads to a destruction of currency and if so how can they ever be okay? Well, what can and often does happen is that the trade deficit lowers prices.

The reason people are buying more goods from foreigners than foreigners are buying from the US is because foreign goods are cheaper. Again people respond to prices.

This means that as the US increases its consumption of low cost foreign goods the cost of consumption goes down. This puts downward pressure on inflation. As inflation goes down the Fed should intervene to push it back up again. It does this by creating money.

This money lowers the cost of borrowing and encourages businesses and consumers to take on more debt. This could be consumer debt and you could see an economy where people are simply buying foreign goods with borrowed money. However, it could also be debt used to finance investment.

In that case you are seeing trade finance increases in the amount of capital in the US. This is how we usually think of trade – that it finances real investment – but this need not always be the case.

In either case, however, trade deficits and increased debt are duals of one another. You can close the circle by thinking of the whole thing in real terms. The Chinese sent us more goods than we sent them because we promised to send them something else later. This promise is what we call debt.

However, unless someone in the US economy is taking on more debt as a result of the trade deficit then increasing debt to China or whomever is simply going to wind up decreasing the US money supply.