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Balance Trade Fallacy

Imbalance doesn't mean there's a problem...

TRADE, fundamentally, is a simple thing, but people like to make it complicated, writes Nathan Lewis of New World Economics in this article first posted at Forbes.

In part, this arises because if you make it complicated, you might be able to fool someone into giving you an advantage that you don't deserve.

I've been addressing some common trade-related fallacies, in part because I want to eventually get to some discussions of real trade-related issues without having these fallacies popping into the discussion all the time.

Among these fallacies is the idea that trade should be "balanced" and that the mechanism to achieve this balancing is foreign exchange rates. This is not just a layman's fallacy, it is common among serious economists as well. Here's an example from Wikipedia:

"One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances.

"Broadly speaking, there are three possible methods to correct [Balance of Payments] imbalances, though in practice a mixture including some degree of at least the first two methods tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based adjustment."

This is howling nonsense. The first premise is that a "fundamental function" of an international monetary system is to "provide mechanisms to correct balance of payments imbalances."

A monetary system should do no such thing; nor is "correcting imbalances" something that needs to be done. Trade is always in balance, by definition. The Balance of Payments actually shows this, by definition.

We already saw that "trade imbalances" can be seen as a form of capital flows. Capital flows from where it is in relative surplus (places with more savings than attractive domestic investment opportunities) to relative deficit (places with more attractive investment opportunities than domestic savings).

Strangely enough, foreign exchange changes can affect this: for example, when a country's currency is on a decline – let's take Turkey today – who would want to invest there? Thus, net capital imports shrink.

From these notions, we get the general idea that a country that has a current-account surplus should have a rising currency; and a country that has a current-account deficit should have a falling currency.

Supposedly, the effect of this would be to eliminate "balance of payments imbalances." This argument is much loved by all those parties that would benefit from such a change in foreign exchange rates. A proper approach is for countries to effectively share the same currency.

This is the principle of the United States – all the States can trade with each other, using a uniform currency (the Dollar), and there are no problems. The same is true of the Eurozone. It used to be true of the entire world, when all the major currencies were based on gold, and thus had fixed exchange rates.

"Balance of payments imbalances" were very large, representing the international flow of capital, but nothing bad came of it, over a period of many decades.

China subscribes to the idea of fixed exchange rates. The Chinese Yuan has been linked to the Dollar since 1994. This used to be an unchanging, fixed exchange rate. Since 2005 – in large part due to US pressure – the exchange rate has been allowed to vary somewhat.

The US argued that China was a "currency manipulator" because it maintained a fixed exchange rate – that, in other words, China effectively had the same monetary policy as California.

This was a popular idea among those who wanted to suppress Chinese competition with changes in exchange rates. And this strategy had already proven successful against Japan, where the Yen/Dollar exchange rate went from a fixed 360 Yen/Dollar during the 1950s and 1960s, eventually to 80 Yen/Dollar in 1995, in part because of US pressure

But that move did little for Japan's current account surplus, which was basically a reflection of high savings rates in Japan. Japan's current account surplus was $50 billion in 1985, when the Yen averaged 238/Dollar, and $110 billion in 1995, when the Yen averaged 94/Dollar.

The move did however make things difficult for Japanese exporters, to the glee of US domestic producers who got their money's worth from their political contributions.

The only "fair" or "level playing field" for trade is one in which foreign exchange values are fixed – for example, in the Eurozone. Because changes in exchange rates inevitably create "unfair" advantages and disadvantages.

If the Mexican Peso is devalued by half, then Mexican workers' wages are also effectively devalued by half. This creates an artificial and "unfair" disadvantage for US domestic producers.

Mexican workers probably think it is pretty "unfair" also to have their effective wages slashed. The owners of Mexican export industries, however, love it.

This contention, created by changes in exchange rates, has always been one reason people have favored Stable Money systems, whether the "Dollar bloc" and "Euro bloc" of fixed exchange rates today, or the international gold standard systems of the Bretton Woods period or the pre-1914 era.

When floating exchange rates have appeared, such as during the 1930s, the reaction of many governments was to isolate themselves somewhat from their trade effects by imposing tariffs.

Usually, the "free trader" types stop here, but I think there is a remaining issue, which is the real issue:

Is it "fair", or in any case desirable, to have free trade with a country like China or Mexico, which has relatively low wages, and thus a large natural advantage compared to domestic producers?

Do we Make America Great(er) with more free trade, or less?

This is an interesting question with too many aspects to address here. For now, let's dispose of the idea that "trade imbalances" should somehow be resolved with changes in exchange rates.

Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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