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 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 unfounded.
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 America. If the auto company prefers
payment in yen rather than dollars, the American would first have to trade his
dollars for yen. Then the seller of yen rather than the Japanese auto
company would have invested in America.
The U.S. trade deficit reflects the successful efforts of foreign
exporters 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 market like that of the U.S., they will be bought
in preference to higher-priced U.S. goods of the same quality.
Foreign governments actively promote trade surpluses with the
U.S. to help support their own domestic employment. They do so with
tariffs, various import restrictions, and interventions in the currency markets to
support the forex value of the U.S. dollar. In a truly floating exchange
rate system, free of trade restrictions, the U.S. trade deficit would tend
towards zero over time.
Financing the Trade Deficit
The U.S. trade deficit is directly funded from
private savings and/or bank loans, including credit card loans. Public
money is seldom used. The Treasury securities acquired by foreign
interests are not issued to cover the trade deficit. They simply represent
one option that foreigners have of investing the dollars they acquire from
their trade surpluses. When foreigners prefer the option of Treasury
securities over other dollar-denominated investments, their holding of public debt
increases along with the trade deficit. The so-called twin deficits
-- budget deficit and trade deficit – are not functionally related, but they may at times respond to the same stimuli.
How Foreigners Can Use
Their Dollar Holdings
Foreigners can use their dollar holdings in several
(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.
(2) They can invest them in dollar-denominated assets
including new enterprise, which will help support U.S. employment and economic
(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
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 would 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
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.
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 the dollar's position as the world's primary
reserve currency, a role once played by the British pound sterling.