Trade deficits and fiat currencies

By Robert P. Murphy

There is a connection between fiat currencies and trade deficits, and many cynics have argued that the US dollar's status as global reserve currency allowed Americans to consume more than they produced for decades. However, this "deficit without tears" argument is sometimes overstated. To gain a deeper understanding of both monetary theory and international trade, it is useful to probe the issue more carefully.

Does fiat money cause trade deficits?

In his book, The Creature from Jekyll Island, G. Edward Griffin explains, “When the dollar was separated entirely from gold in 1971, it ceased being the official IMF world currency and finally had to compete with other currencies. From that point forward, its value increasingly became discounted. Nevertheless, it was still the preferred medium of exchange. Also, the US was one of the safest places in the world to invest one's money. But, to do so, one first had to convert his native currency into dollars. These facts gave the US dollar greater value in international markets than it otherwise would have merited. So, in spite of the fact that the Federal Reserve was creating huge amounts of money during this time, the demand for it by foreigners was seemingly limitless. The result is that America has continued to finance its trade deficit with fiat money — counterfeit, if you will — a feat which no other nation in the world could hope to accomplish.”

Griffin then further explains, “There is a dark side to the exchange, however. As long as the dollar remains in high esteem as a trade currency, America can continue to spend more than it earns.

But when the day arrives — as it certainly will — when the dollar tumbles and foreigners no longer want it, the free ride will be over. When that happens, hundreds of billions of dollars that are now resting in foreign countries will quickly come back to our shores as people everywhere in the world attempt to convert them into yet more real estate, factories, and tangible products. As this flood of dollars bids up prices, we will finally experience the [price] inflation that should have been caused in years past.”

Regardless of Griffin's particular stance, there are definitely some members of the sound-money community who believe that trade deficits would literally be impossible if all countries were on a gold standard. That is incorrect, as I will argue in the next section.

Gold does not prevent trade deficits

One quick way to see a puzzle in Griffin's analysis above is that the reasons for the appeal of the US dollar would only be enhanced by a return to gold. Griffin says that foreigners still believe the US was the safest place to invest money. If the Treasury or Fed credibly announced that henceforth the dollar would once again be redeemable for a fixed weight of gold, surely investors would flock to it even more so. It would be much safer to buy a government or even corporate bond issued in the US knowing that the gold standard would restrain further dollar creation.

When economists compute the trade balance, they do not include the sale of financial assets. So if foreign investors want to spend more (once we convert to a common denominator) on American assets than US investors want to spend on foreign assets, the trade balance is negative. The capital-account surplus is counterbalanced by a current-account deficit.

Tying the dollar to gold, or, better yet, abolishing the government's involvement in money and banking completely, would make the US an even stronger magnet for foreign investment. It is possible that the absolute size of the trade deficit would fall, but it would not disappear.

In fact, if the US government not only returned the dollar to gold, but also eliminated the Internal Revenue Service (IRS) and slashed its budget, it is possible that the US trade deficit would mushroom. This would make perfect sense, as capital from around the world would flow to the new haven where its (after-tax) returns would be much higher.

Unfortunately, there is another possibility. If the Federal Reserve creates hundreds of billions in new dollars out of thin air, and the foreign investors are other central banks that gobble up the dollars because their own rules treat them as reserves, then this increase in the foreign demand for "American assets" is of a much-different character.

In particular, the low US interest rates that accompany such a gusher of new dollars will encourage domestic consumption and will discourage foreigners in the private sector from investing in the US. The rest of the world will acquire American assets all right, but they will be more heavily tilted toward debt (rather than equity in growing companies). The physical goods flowing into the US will be consumer goods such as TVs and iPods.

Griffin is perfectly correct that this type of mushrooming trade deficit is indeed unsustainable as the influx of consumer electronics does not allow the US economy to produce more in the future.

The increase in foreign claims on US income streams therefore is not a constant or shrinking portion of the growing American pie, but rather is a growing portion of a constant pie. It can be sustainable for the absolute dollar amount of US corporations' outstanding bonds to increase over time, so long as earnings and profits increase proportionately. But it is not sustainable if households and the government experience a rising debt-to-income level.

Conclusion

There is a definite connection between fiat currencies and trade deficits. Critics of the Federal Reserve are right to blame it for distorting trade flows and setting the US economy up for an inflationary crash. However, a trade deficit per se is not a sign of a bad economy. Indeed the trade deficit might blossom if the US ever returned to the gold standard, though it would be due to a productive net inflow of producer goods.

— [Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog, Free Advice, and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. This article is submitted in Pakistan by Alternate Solutions Institute Syndication Service, Lahore.  http://asinstitute.org