All Who Squander Are Lost

Once upon a time, trade meant a trade. “Since all trade is in reality barter, money being a mere instrument for exchanging things against one another,” wrote John Stuart Mill, elaborating on David Ricardo’s theory of comparative advantage, “we will, for simplicity, begin by supposing the international trade to be in form, what it always is in reality, an actual trucking of one commodity against another.”

Lest that sound archaic, Nobel laureate Robert Solow made the same assumption selling free trade with China to the American people more than 150 years later. “China will compete for some low-wage jobs with Americans,” he lectured from the White House briefing lectern. “And their market will provide jobs for higher wage, more skilled people. And that’s a bargain for us.” Trade generally benefits both parties, the thinking goes, and trade that allows each of two countries to focus on those areas where it has a “comparative advantage” can create opportunities for increased productivity and consumption on both sides.

But while the list of industries offshored to China is a long one, which were the industries “offshored” from China, or anywhere else in the world, to the United States? The top American exports to China are oilseeds and grains. Globally, the $60 billion surplus run by the United States in advanced technology products at the Cold War’s end has collapsed to a $200 billion deficit. And the deficit in areas where the United States would in theory have excelled is but a small element of the nation’s overall trade deficit, which has steadily ballooned and now exceeds $1 trillion annually.

Therein lies the fundamental problem of globalization for the United States: not too much trade, but rather too much imbalance. Yes, Nobel laureate Friedrich Hayek expected that “the self-regulating forces of the market will somehow bring about the required adjustments to new conditions,” including “necessary balance … between exports and imports.” Sure, Nobel laureate Paul Krugman assured students that “trade deficits are self-correcting.” But apparently no one told the global trading system, which settled gladly into an equilibrium where the United States buys much more from producers abroad than it produces to sell back.

How could this happen? Mill, Solow, Hayek, and Krugman were all wrong. Rather than facilitate the exchange of goods for goods, creating productive prosperity for all, international trade can also yield a flow of goods into a country and assets back out. Much of what Americans once bought from each other, and much else that they could buy from each other, they now receive from abroad instead. But rather than Mill’s “actual trucking of one commodity against another,” the foreign producers acquire American real estate, corporate equity, and debt in return.

In effect, Americans are living high today by selling off the real estate and corporate equity whose value accrued over past generations of hard work, and by running up an enormous credit card bill that future generations will be left to pay. Selling off the existing assets will only make repaying debts harder. One can see why so many people enjoy this status quo, of course. What is much harder to see is how one might defend it, on either economic or moral grounds. Conservatives rightly condemn the easy politics of borrowing and spending when it appears as a budget deficit and a growing national debt. The dynamics here, and the consequences, are the same.

In 2003, when the problem was just emerging, Warren Buffett issued a blunt warning:

Our trade deficit has greatly worsened, to the point that our country’s “net worth,” so to speak, is now being transferred abroad at an alarming rate.

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time that’s how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there’s a quid pro quo–but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which at their core represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off–or simply service–the debt they’re piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat–they have nothing left to trade–but must also work additional hours to service their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

It can be argued, of course, that the present value of the future production that Squanderville must forever ship to Thriftville only equates to the production Thriftville initially gave up and that therefore both have received a fair deal. But since one generation of Squanders gets the free ride and future generations pay in perpetuity for it, there are—in economist talk—some pretty dramatic “intergenerational inequities.”

The United States is Squanderville. The rest of the world is Thriftville. “In effect,” Buffett concluded, “our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4% more than we produce—that’s the trade deficit—we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.”

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While the ecstatic squanderers of Squanderville may seem cartoonishly short-sighted, they are well represented amongst economists and other commentators who see the trade deficit as at least unconcerning and in some cases downright beneficial. Scott Winship, a sociologist at the American Enterprise Institute, provides a good illustration. He observed recently: “Our ‘terrible’ trade deficits let us fund a public retirement system that would require more fertility, higher taxes, or higher interest rates in its [sic] absence.”

On one hand, this is entirely correct. In economic conditions where the United States consumes far more than it produces, we can have a generous public retirement system that would otherwise be unaffordable at current rates of family formation and taxation. Put colloquially, we can give a lot of stuff to seniors without having to work for it. What’s not to love?

The difficulty emerges in the phrase “let us fund,” which sounds benign but in fact means “fund by exchanging future claims for consumption today.” We citizens of Squanderville are working our eight hours a day to meet our own needs and then, rather than allocate a share of our output to supporting the elderly, we are relying on Thriftville to send those resources. In return we send back real estate, equity, and debt—especially U.S. Treasury debt. As a nation, we get to live beyond our means, and we send IOUs to those who fill the gap.

Could we accomplish this trick without massive government borrowing? Sort of, sure. Americans could pay sufficient taxes to fully fund the government and its entitlement programs, then turn around and trade their own assets and take on debt to fill their own gaps between their remaining resources and what they wish to consume. But the politics of that are hard to envision. Which perhaps is why Winship anticipated that, without our trade deficit, we would need higher taxes. If the idea is to maintain the high government spending and the low tax revenue, and thus the large budget deficit, the excess consumption enabled by the trade deficit is what makes up the difference. In effect, the government debt issued to “let us fund” the budget deficit fulfills its purpose by getting traded for the resources that the government wishes to deploy. We’ll pay someday.

None of this should be counterintuitive, it is merely a corollary of the principle that there is no free lunch. Of course, if the United States relies on foreigners to cure the mismatch between what its citizens will expend effort to produce and what its citizens wish to consume, it will have to commit future production in return. And unless it raises taxes so that the gap appears in household budgets rather than the federal budget, the future commitment will take the form of debt.

“Imagine that I, Warren Buffett, can get the suppliers of all that I consume in my lifetime to take Buffett family IOUs that are payable, in goods and services and with interest added, by my descendants,” as the Oracle of Omaha put it. “This scenario may be viewed as effecting an even trade between the Buffett family unit and its creditors. But the generations of Buffetts following me are not likely to applaud the deal (and, heaven forbid, may even attempt to welsh on it).”

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At least in the American context, then, the unwise embrace of massive trade deficits as a means to enable easy consumption suffers from many of the same flaws as the unwise embrace of massive budget deficits for the same purpose. No one would say, “our ‘terrible’ budget deficits let us fund a public retirement system that would require more fertility, higher taxes, or higher interest rates in their absence.” Yes, budget deficits allow the nation to do just that, in the short-run anyway. No, that’s not a responsible or sustainable plan.

Concerningly, people seem to have great difficulty grasping this point. One mistake, made most clearly by Josh Dean, an economics professor at the University of Chicago’s Booth School of Business, is to confuse the bilateral trade deficit that the United States might run with one country for the overall trade deficit it runs with the rest of the world. Distinguishing the case of the trade deficit from that of the budget deficit, Professor Dean remarked, “my large household trade deficit with the grocery store is not a problem. A large household budget deficit would be.”

If the debate were over a U.S. trade deficit with one country, the professor would be on point. A U.S. deficit with Norway has no particular implications for the wellbeing of the United States, if offset by a surplus with Belgium, just as Professor Dean’s deficit with Whole Foods is offset by his surplus with the university where he teaches. But the analogy for the U.S. deficit with the world is, well, the large household budget deficit that would likewise be a problem. If a household or a country buys and consumes more than it can produce and sell, it must sell off assets or take on debt. Buffett understood this, without having attended a single class at Booth.

(This is as good a time as any to briefly address one important aside: What about foreigners “investing in America”? A common refrain from economists is that the flipside of a trade deficit is greater incoming investment, or even that the irresistible desire of so many foreigners to invest in America is what drives the trade deficit to begin with. “Investing in America” conjures images of Japanese auto companies building new factories in the American South, so it is important to emphasize that such “Greenfield Foreign Direct Investment” accounts for only a few percentage points of the foreign “investment” that occurs each year. In almost all cases, “investing in America” refers not to building new productive assets in America, but acquiring those already built or government and corporate debt.)

Another mistake, stranger than conflating bilateral and global trade deficits, is general confusion over the relationship between trade and budget deficits. Obviously, they are not the same thing. The question is, at least as they operate in the United States, are they concerning for the same reasons? One difference might be foreign versus domestic debt: As the Squanderville example illustrates, a trade deficit that leaves a nation indebted to foreigners might have dangerous implications beyond the unsustainability and inequity of domestically funded budget deficit in which the indebtedness is only to the nation’s own citizens. But that’s an argument for the trade deficit being worse.

Likewise, the imbalanced exchanges that generate a trade deficit lead to decreased demand for domestic productive capacity, simultaneously eroding the economic foundations of future prosperity from within while also selling off the claims to its bounty. At least a domestically financed budget deficit—that is, one in which the government acquires domestic output in exchange for IOUs—maintains or even expands the industrial base. Short-run consumption is higher with a large trade deficit, true. But the economy’s long-run trajectory is lower.

Conservatives argue for closing budget deficits, ideally by expanding productive capacity and, when necessary, by reallocating existing resources and accepting cuts in various categories of consumption. We should bring a similar moral seriousness to the similar problems that our trade deficit creates. If there is wisdom in trading away future prosperity to foreigners in return for them providing to us a domestic standard of living beyond what our own productive capacity can sustain, it remains to be explained. The common good demands living within our means and investing to grow, no matter how much easier it may be to cash in our inheritance for a few more years of fun.