Democrats and deficits

Earlier today, I wrote an entire blog entry concluding my Portland trip, and then I somehow managed to delete the whole thing while attempting to upload pictures. So I got frustrated and moved on to other things. I'm back now, but I'm in an econ-y kind of mood, so it's time for a trade deficit lecture! Yay!

Let's start with the basics (and I apologize in advance if any of this is too basic--I assume many of you already know some of this, but I want to be certain that we're entirely clear on what we're discussing). The US interacts financially with the rest of the world (RoW) through two basic flows: the current account and the financial account. The current account (CA) is primarily the balance of trade (i.e. the value of what we export minus the value of what we import), but it also includes interest payments on debt that we pay to the RoW and remittances that people working in the US send to their families in the RoW. The financial account (FA) is primarily the balance of trade in assets: the value of financial assets purchased from the US by the RoW minus the value of the assets purchased from the RoW by the US. An asset is generally anything that stores value, so it includes, among other things, stocks, bonds, precious metals, treasury bills, and currency itself.

CA + FA = 0. This is a mere accounting identity, and in the long run it must hold. If the current account is in deficit (as the US's is), the financial account must be in surplus (as the US's also is, of course). The reason is fairly straightforward: if we buy more stuff (in value terms) from the RoW than they buy from us, how are we going to pay for it?

The obvious answer is that we borrow the money, and that's essentially correct. We sell assets to the RoW, and the money that we get is enough to cover all of our purchases from abroad. Again, in the long run, it has to be. But remember that "borrow" is a non-exact term for everything that goes on in the FA. If a foreigner buys a share of stock in an American company, we aren't in debt to that foreigner. Furthermore, it's not like when I borrow money from my mom. We don't have to call China and ask for the money; they lend it because they want to. And I don't mean that they want to lend us money in an evil loan-shark way; they want to because of their own economic objectives (more on that later).

There is also a straightforward algebraic relationship between the CA and net private and government savings in the US. Specifically, CA = private savings + government savings (this has to do with the fact that domestic expenditures have to equal domestic income, and the trade balance is part of the expenditure function--I can explain it if you want, but you may as well take my word for it). Private savings includes both household and business savings: the former is slightly negative, the latter positive, but small. Government savings, as you know, is significantly negative (as in they have been running a huge deficit every year for the past few years). So it's no coincidence that we're running a trade deficit and a budget deficit at the same time.

This idea is a familiar one, and it is expressed most often in the popular media through our trade and financial relationship with China. It goes like this: we buy lots of cheap crap from China, and we pay for it with the money that we borrow from China when we sell them US treasury bonds. China buys the bonds because they're trying to keep their currency, the yuan, artificially low (although by how much the yuan is really undervalued is a matter of considerble debate). By continuing to buy US treasury bonds, the Chinese central bank is enabling the US to run these huge trade deficits. By running these huge trade deficits, the US is allowing China to continue to manipulate their currency for the purposes of export-led growth.

And now, before you fall asleep, let me get to the part where I get annoyed with the Democrats. They understand the link between the budget deficit and the trade deficit, and that's a good thing. But they generally mischaracterize the nature of this relationship. I refer you to a passage from "A New Direction for America", a bit of Democratic propaganda released in June and written about recently in Slate:

Nearly half of our nation’s record debt is owned
by foreign countries including China and Japan.
Without a return to fiscal discipline, the foreign
countries that make our computers, our clothing
and our toys will soon be making our foreign
policy. Deficit spending is not just a fiscal
problem - it’s a national security issue as well.

I would love to hear a cogent explanation of how China having nearly $700 billion in dollar-denominated assets, the majority of them US treasury bonds (i.e. US government debt) is a national security issue. The Democrats make it sound like China and Japan own us. They don't. They own a bunch of treasury bonds. The worst thing they can do to us is sell those treasury bonds, or at least stop buying them. But what will happen if they do that? If the demand for dollar-denominated assets falls, then the value of the dollar falls. This is bad for the US in some ways--imports become more expensive, and inflation is likely. On the other hand, it would make US exports more competitive, it would improve the CA deficit, and it would force the government deficit to shrink, at least in the long run. Meanwhile, it sucks for China, because their $700 billion isn't worth as much as it used to be, because the dollar isn't worth as much as it used to be. Furthermore, their exports aren't as cheap for Americans to buy as they used to be, because the yuan has risen relative to the dollar.

Economists have been debating for several years now about the sustainability of the current global imbalances (US spends, RoW saves). My semi-informed opinion is that the dollar will have to depreciate at some point, growth in China will have to slow a bit, Americans will have to stop spending so much (partly because the housing-equity free-for-all is basically over), and depending on how it all shakes out, there could be a recession here, in the RoW, or in both places (or neither, if we manage to increase our savings while the RoW decreases theirs). But we're not going to have an Asian- or Latin American-style currency crisis, and China and Japan are not going to take us over. They have as much to lose as we do, if not more.

So I guess my complaint about the Democrats is that they use the government and trade deficits as an excuse for economic nationalism and protectionism, neither of which are likely to do much good. I'm not saying, of course, that globalization and free trade are universal positives. Although technically speaking, international trade doesn't cause unemployment in the long run, it does cause significant displacement and changes in the employment and wage structure of this and other countries. In the short run, it does cause unemployment, and it contributes to income inequality (as do changes in technology). Trade hurts people. But it also helps people, both in the US and in countries where way more people are way more poor. I understand that American politicians are elected to represent Americans' interests, and that unions exert a great deal of protectionist pressure on the Democratic party. But every American worker is also an American consumer, and cheap imports raise our standard of living, while simultaneously helping to bring millions of non-Americans out of poverty. It bothers me when politicians blame US corporations for abandoning American workers and developing nations for stealing our jobs, as if poor Chinese peasants don't deserve to have jobs. Furthermore, if the Democrats are concerned about national security, they should want China as a powerful, hopefully democratic ally in Asia, and the bigger China's middle class gets, the more likely they are (in my opinion, anyway) to successfully demand more democratic freedoms.

Obviously this is a very complex topic, and I could go off on a lot of other issues, but that's more or less the gist of what bugs me about the Democrats' attitudes toward trade and the budget deficit. There's also another interesting article in Slate that discusses protectionism in the Democratic party and is generally more articulate than I am. I'm interested to hear what other people think about this stuff as well.