Why is a trade deficit considered a Bad Thing?

Factual Questions
1

I’ve wanted to ask this question on the Dope forever, this thread just spurred me to. Books/articles on the subject seem to assume a level of money-understanding that I just don’t have.

Budget deficit --If I spend more than I earn, I’m in trouble. A company or a government who spends more than they earn will also be in trouble. This, I understand.

Trade deficit --If I (in the U.S.) buy a bunch of books from someone in France, but I don’t sell him anything, so what? I’ve now got a bunch of books, and he’s got a bunch of money, we’re both happy.

This is where I get lost. Americans “buy too many Chinese goods, but don’t sell them anything, so there’s too many dollars out there, and the dollar falls.” But in exchange for these goods, we don’t air-mail them suitcases full of dollar bills. We transfer the money by wire, no?

If I (in the U.S.) buy books from a French seller on Amazon.com, I don’t ship him dollar bills. He wants 50 Euros, my bank debits me 72 dollars (or so), a wire transfer happens, and his bank credits him 50 Euros. No dollars have actually “gone anywhere”, have they?

When American retailers buy masses of Chinese goods, don’t they pay in a similar fashon? We’re not actually “sending dollars” into China, are we? Aren’t we sending bips and beeps over a telephone wire that leave as dollars and arrive as yuan?

This is where I’m lost. To people who grasp this stuff intuitively, I know the question sounds ridiculous. Can someone in the know with a knack for explaining things help me understand? Why, in terms of money in circulation, is a trade deficit a Bad Thing?

(Mods, I hope this is OK in GQ rather than IMHO…)

2

I’m with you. Trade is based on each party thinking they got a reasonable deal.
The only real problems are not trade per se.
They are when one goverment has an agenda against the other.
Like the OPEC cartl to restrict production to drive up prices.
Or when certain crops are state-supported and then ‘dumped’ to kill off another country’s farm economy, allowing jacked up prices in future years.

3

But how do you pay for those imported goods? With dollars, obviously. You use your dollars to buy, say, Euros, and you give the money to the French guy, and he gives you the books.

So somewhere there’s a French guy with dollars. For those dollars to be worth anything, he has to be able to exchange them for goods and services produced in America. If no such goods and services are forthcoming, that means that his dollars are worthless.

And if dollars are worthless, that’s bad. It means Americans can’t import anything anymore. Which we like to do, because that’s how this guy ended up with dollars in the first place.

So, we want foreign goods services, but giving foreigners little pieces of paper just means that someday we promise to give them goods and services in exchange for that money. It’s like running up a tab at a store. Eventually the store has to get paid, somehow, and if they can’t get paid they won’t let you run a tab any more.

4

Well, a trade deficit isn’t always a bad thing, but I think you’re confusing money with currency. Currency, like the dollar bills you have in your wallet, is a kind of money, but there’s a lot of money that isn’t currency. Money is a lot harder to define, but basically, it’s purchasing power, it’s a standard of value.

When you pay the French guy you’ve gotten your books from, and the money goes from your account to his account, no actual currency has changed hands, but your money has. That’s $72 that you can’t spend on food or clothes or whatever else, and that’s 50 euros that the guy who sold you the books can. So money has changed hands from you to him.

5

The primal concept that you have to grasp is that money is always imaginary. Whether it’s in the form of gold or paper dollars or photons in a database is irrelevant. It’s the amount of buying power that has symbolically transferred from one side to the other that counts.

The fact that we mostly don’t ship tons of dollar bills from country to country is therefore a non-issue.

Lots of people stumble over this concept - look at any goldbug - and our everyday experience conditions us to thinking that a pocketful of bills is more meaningful than a line of credit.

Once you get past the notion that money has a form, take another look at the situation.

In our trade deficit scenario, China now has an extra $100 billion of buying power and the U.S. has things. We both have presumably equal value in the current transaction. But what happens next time when the U.S. wants to buy something - anything, from anybody? That buyer won’t accept used Chinese things in exchange for what it’s selling. We have to come up with a new set of buying power equivalents to make the purchase.

Where does that new set come from? Other sales? They aren’t as high as our purchases. From savings? Savings run out. From promissory notes concerning our future wealth? Call them t-notes or the equivalent and that’s what we use to fund our purchases. China take the flood of U.S. dollars, buys U.S. securities (and real estate and businesses and other things) and makes a profit from its investments.

How long can this situation continue? Don’t we eventually run out of value if we keep sending our buying power to other countries? In the long run, certainly yes. In the short run, the dollar loses value to other currencies, as it has to the Euro, the Canadian dollar, and practically every other currency on earth. We’re still astoundingly wealthy so this depreciation of our currency is a mild irritant, but in the long run it could become fatal.

The economy is far more complex than this and includes more facets than just the trade deficit. We can go on for a long time like this and presumably we still produce many things that other countries want. The danger that one day the dollar loses its value and countries decide to stop buying U.S. securities and real estate and businesses and stuff - not only stops buying but cashes out and says give us all the money you’ve promised right now - has people is what gives bankers nightmares.

6

Who is the French guy with dollars? My bank debits me 72 dollars, sends a wire transfer to French guy’s bank, who credits him 50 Euros. The French guy has Euros now, not dollars. He can withdraw them from his bank and hop down to the épicerie and buy 50 Euros worth of cheese the same afternoon.

7

The transaction will still have a devaluating effect on the dollar. Your bank debits you $72; the French bank will credit the seller €50; but the French bank will charge your American bank the equivalent of that sum. Suppose the two banks have an open account to settle their mutual transactions. Your book purchase means that the American bank will owe the French one $50 more than without the transaction (or, if the account balance is in favor of the American bank, its credits with the French one will decrease by $50). This means that European credits with U.S. banks will increase. America’s economy will owe Europe’s economy $50 more than without your book purchase. This increased balance is something the European economy can avail itself of: It can be used to balance the purchase of American goods, or U.S. treasury bonds, or European investments in America, or whatever. The transaction, although no physical currency was shipped, means that the supply of dollar funds available internationally will increase, and the dollar value decreases.

8

Does this mean, then, that every bank in the world has reserves in several different currencies at any given moment? (Even if the “reserves” are just marks on a ledger sheet?)

Is this then the crux of the matter, that Chinese banks have shored up enormous “reserves” of dollars (even if they don’t have physical dollar bills on hand)? I know banks create money in lending, does this mean then that Chinese banks cannot “create” yuan out of dollars they have in reserve? They must lend these virtual dollars as dollars?

This is making more sense now. Dollars do not magically become yuan during a wire transfer. They stay dollars, and the receiving bank is stuck with them, as it were?

9

Your bank has a pile of dollars. The french guy’s bank has a pile of euros. In order to make this purchase, your bank has to buy euros from the french bank, and pay in dollars. Your bank buys euros and sells dollars, his bank buys dollars and sells euros.

So you take your 72 dollars to your bank, your bank hands you 50 euros, you send the 50 euros to France, the French guys sends you your books.

You now have books, the French guy has 50 euros. But to get those 50 euros, your bank has to send 72 dollars to the French bank. So what has also happened is that the French bank has 72 dollars.

But what good is that 72 dollars? It’s only good if it can be used for the reverse. If it can’t be used for the reverse, then it’s worthless. And if it’s worthless, then you couldn’t use it to buy French goods because no one in France would want it.

Now, in real life, people in France buy lots of American goods, so the dollar isn’t worthless. But if Americans want to buy more European goods and the Europeans want to buy fewer American goods, the value of the dollar will fall relative to the euro. In order to buy that 50 euros worth of books you’ll have to part with 87 dollars instead of 72, then 123 dollars, then 168 dollars, then 1,000,000 dollars.

Of course, it probably won’t fall to that million to one ratio, unless the US economy is reduced to literal rubble. But things like that have been known to happen with disasterous hyperinflation. For instance, once upon a time the Italian Lira was about equal to the British Pound, because both were supposed to represent a pound of silver. Except by the 80s the lira was less that 1/1000th the value of the pound, to buy a nice dinner in Rome would cost 10,000 lira.

Hyperinflation and currency devaluation are runious because it makes all sorts of normal financial transactions a problem. You can’t lend your buddy $20 for a week if by next week that $20 has half the purchasing power. But what rate of interest should you charge him? There’s no way to match the interest rate to the future rate of inflation. And so loaning and borrowing become highly speculative, and eventually disappear.

10

The increased balance in the hands of foreign investors means that you wake up some morning, and discover that you’re working for the French, a French firm having bought your employer. And the new landlord of your apartment building is Chinese. Guess whose tax base that increases?

Note that a devaluing dollar helps to REMEDY this situation, as American exports then become bargains. American manufacturing companies like Caterpillar have experienced a jump in exports recently. Some European construction company interested in buying a bulldozer may now choose buy a cheaper Caterpillar model in US dollars, rather than a European competitor in Euros. Of course, when Caterpillar employees want to buy imported French goods, or take a vacation to Europe, they are in for an unpleasant surprise.

11

Thank you for the many excellent responses, my ignorance has been fought.

12

Large banks usually have permanent cooperations with banks in other countries (especially if the foreign bank is a subsidiary of it, or if both are the subsidiaries of the same parent corporation). But even if the bank does not have reserves in a particular foreign currency, this does not fundamentally change the situation. In most countries, commercial banks are legally obliged to maintain a certain amount of reserves with their national bank (even where they are not obliged to do so, they usually hold such reserves in order to maintain liquidity); and most national banks will maintain reserves in foreign currencies. They do not necessarily hold these reserves in the form of cash; they hold them in the form of credits with the bank (or the central bank) in the debtor nation.
In fact, cash is of secondary importance in this respect. In 2000, there were $571 billion in cash circulating worldwide (cite; I didn’t find more recent numbers), but China alone holds over $900 billion in U.S. bonds (cite).

That’s about it. What the receiving bank gets is an IOU from an American bank saying that the American bank owes the receiving bank a given amount in dollars. But as long as the American bank remains solvent, this is just as good as having dollar cash for the recipient, because the recipient’s creditors in America will accept these dollar balances with a U.S. bank just as they would accept dollar cash.

The recipient bank (in your example the French one) can use this dollar credit with an American bank to pay off debts with American creditors. These debts could be the result of, for example, a French client of said bank buying stuff in America or investing in American businesses.