We need to talk about the trade deficit. President Donald Trump is desperate to reduce it and regards every splash of red in the charts as money owed to the United States as a nation. Others in the free trade camp say this is ridiculous and that there is nothing at all wrong with perpetual trade deficits. We should reduce tariffs to zero and forget about it.
Who is correct? Let’s reflect on this topic, the understanding of which requires some historical reflection.
My philosophical tribe is essentially libertarian in politics, although I resist the word because it can mean everything and nothing. My teachers on politics and economics are Murray Rothbard and, historically, Albert Jay Nock, Frank Chodorov, Garet Garrett, and others, but never mind if you don’t know the names. They are the successors of the old liberals of the 17th to 19th centuries.
They loved and defended free trade (Garrett favored some tariffs) back when all the money in the world consisted of different names for interchangeable things like gold and silver. The names of coinage celebrated the nation, but the underlying value of the coinage was rooted in something else. That was true for hard money and also for paper money, which was always convertible unless the government was corrupt.
Many great old liberals rallied around free trade. These included David Hume, Adam Smith, David Ricardo, and, in the 20th century, Gottfried Haberler (also my teacher). They said trade barriers make no more sense internationally than they do domestically. Arbitrary lines on a map should not prevent deals from being made.
They further said that no nation has anything to fear from competition with its business sectors. It will only make them competitive and efficient. Money flows out as goods flow in, while money flows in while goods flow out. It’s just part of the market mechanism.
David Hume drilled down deeply into this system and its workings. He came up with a good descriptor of the monetary angle to all of this: the price-specie flow mechanism.
When nations import goods, they send money out. If you understand the relationship between money and prices, you know what happens next. Domestic prices fall and foreign prices rise. That includes wages. Crucially. The costs of production RISE in the exporting country.
What happens in the importing country? They experience an equal and opposite effect. Their prices fall. That includes wages. Crucially. The costs of production FALL in the importing country.
You see how this works? No one country has a permanent advantage over any other country. They only have comparative advantages that last only so long as markets have not yet settled back toward a conceptual equilibrium.
To be sure, this simple model presumes just two countries, bilateral trade. In real life, many nations participate at all stages of production. The central insight remains the same: Accounts settle and production is rivalrous based on factors other than a permanent cost advantage (except natural resources, of course).
Lest you think this is purely speculative, this is, in fact, how things worked for hundreds of years. And this is precisely the basis on which the free traders preached their doctrine. And they were right. They further said that barriers lead to war and impoverishment because they end up only taxing the people.
I agree with all of this. But here is where the story gets complicated. The specie-flow mechanism stopped working in 1971 and following, when the United States went off the gold standard and all other countries in the world followed.
That meant that the United States would gradually become an importing nation while the market for dollars abroad became essentially infinite without any consequences on their domestic prices. As for the expected fall in prices for any net importing nature, that did not happen. Why? Because the Federal Reserve just kept inflating and inflating forever.
The free trade system of international settlement broke down with the fiat dollar system in which the United States would provide liquidity for the entire world forever.
This also guaranteed that the United States would eventually lose the whole of its comparative advantage in manufacturing. Foreign central banks would sock away dollars forever while expanding their own domestic manufacturing to compete directly with the United States, sector by sector.
Dear reader, I sincerely hope that you have followed me so far, because this is extremely important to understand. I say this to my free-trade friends too: There is nothing to be gained by pretending to be ignorant of these points. They must be addressed.
Now to the trade deficit: It is only a measurement of settlement. If it is in the red, prices are not falling to match foreign competitors, and foreign competitors’ prices and wages are not rising to match those in the United States, then there is a major problem. The problem is not the chart, it is the complete loss of the ability to compete on anything but natural resources and debt.
That is where we are today. The trade deficits began and only got worse.
Japan was the first country to figure out the racket after 1973. Our piano industry vanished. Then watches and clocks. Then household electronics. Then they came for audio equipment. Then cars, which were eventually better than anything made in the world capital of cars. In all these areas, the United States led the world. We had the technology, the markets, the infrastructure, the workers, the materials, and the long tradition.
In something like 10 years, they all went away. Meanwhile, the Japanese central bank was sitting on U.S. dollars that were deployed as collateral to expand their own manufacturing. There was no clearing. There were no adjustments in prices and costs. They simply cleaned our clock, so to speak.
U.S. prices never fell. Japanese prices never rose.
International markets stopped clearing.
A bit too late, James Baker, under the Reagan administration, tried to fix the problem with an exchange-rate agreement (Plaza Accord, 1985). It simply could not hold. There was no gold to flow. It was a paper-money world and the United States had the dominant currency, which simply meant an infinite demand for dollars and forever unsettled accounts. There was no mechanism available to enforce any particular exchange rate for anything.
After China opened up, they figured out the trick, too. See what the United States does. Invest in that and do it better, cheaper, and forever, until that industry dies there and comes to China. Textiles left, then toys, then shipbuilding, then apparel, then tools, then essentially everything.
Biden tried a new scheme to invest in green energy. Oh, the bad Chinese will never figure that out! Except that it took about five minutes. China with its low wages and affordable resources made the same at a fraction of the price. Next thing you know, the Chinese were selling solar panels and wind turbines to the United States.
The joke’s on us!
Do you see what is happening here? It is a simple math problem. So long as the U.S. fiat dollar is the world reserve currency, U.S. producers will forever be outcompeted.
Under these conditions, neither Hume nor Smith nor Ricardo could ever have made a case for free trade. Their whole paradigm hinges on the crucial reality of settlement systems that completely broke down in the early 1970s.
(A good friend and economist wrote to me that the industrial production index in the United States just hit an all-time high, so therefore there is no problem. That index includes oil and gas production, and on that export, the United States is in fine shape. The index doesn’t actually tell anything real and certainly does measure manufacturing as traditionally understood. As I say, my analysis above does not pertain to mineral resources, which are necessarily localized.)
Will it work? It’s possible. I’m not optimistic, however, simply because nothing like this has ever been tried. That is because the world has never faced an international trading system that is completely broken in all its essential functioning.
My point is this. The scheme may not work. But let’s please stop pretending like there is no problem. Every free trade theorist of the past knew for sure that this would be a problem. Trump is trying to address it using very blunt tools that could end up breaking down supply chains and imposing new costs on American businesses and consumers.
What is my solution? It is an international gold standard. Sadly, that is a slogan and not a plan. I have no way of knowing how to get from here to there. But I do know this much. If we stop with the money printing and debt creation, we can at least plug some of the holes. That is within our power, and it is a good start.
This problem will not be solved until the U.S. dollar is no longer tagged and unfairly burdened with the impossible job of being the world reserve currency. So long as that is true, U.S. manufacturing and production in general will be at an unwinnable disadvantage. It’s just math.
