Tuesday, December 20, 2016

Lesson 1. International Trade Ignorance

Those of you who can count will recognize that my last lesson was Lesson 16 and therefore you were expecting Lesson 17 this time. Unfortunately I checked the records and I never had a Lesson 1. I started with 2. Sheesh. So I am naming today’s main plate Lesson 1.

This lesson is about international trade. International trade is a lot like pho, the Vietnamese soup. A lot of people really like it but almost no one knows how to prepare it. Otherwise Campbell’s would have canned it already. We're similarly ignorant about international trade. When my fifth grade teacher called me ignorant, I was very hurt. But later I realized it did not mean I was terminally stupid – only that I didn’t know very much. I was willing to go with that.

I fear that our President-Elect is a bit ignorant about international trade. I also fear that he will read this post and ask me to be Secretary of Doggie Bags, but the truth is that most of us are ignorant about international trade. So no insult is intended.

One of my professors once talked about international trade in terms of the tail that wagged the dog. Unless you have a really small dog with an unusually large tail, you expect the dog to wag its tail. So saying international trade is like the the tail wagging the dog ought to have your ears perked and your tail wagging.

What my professor meant is that there used to be a day when trade pretty much meant one thing – countries selling goods to each other. "Goods" implies a tangible, e.g. a manufactured product or an agricultural product. You can imagine a time when much of world trade was coal or corn or clothing or cars. Countries loved to export goods because it expanded their ability to sell. The more they sold, the more incomes and employment grew.

So exporting goods was really cool. It was the big dog. You were the coolest kid on the continent if you could export your goods to other countries. That’s what many people think is what international trade is all about. Exports of goods! In 2015, the US exported $1.5 trillion of goods. Go team.

The interesting thing about an export of goods is that a bunch of foreign currency comes into world markets to pay for your goods. What do we do with all those foreign currencies? They are pretty but papering your walls with it can only go so far. Then some bright bulb thought, "Hey, with all this foreign money, maybe I could buy things from other countries!" So export countries would use the foreign currency to buy goods from other countries. Imports go hand in hand with exports. And more important, imported goods can really help your country – especially if you import things that help you to be happier and more productive.

So exports of goods imply imports. While exports have an important role for national goals, imports of goods are also part of that equation. If a country imported only Twinkies, then maybe you might want to rethink the value of the imports. But countries often import vital things they can’t get at home.

Nowadays most of the world has discovered services. Services are intangibles which essentially disappear once they are consumed. A float down the Rhine might cost you $20k but on your way home all you have left are some nice memories and the JD bottle you stole from your room fridge. Travel, tourism, entertainment, communications, utilities, healthcare, etc. are services. In the US today, about 70% of what we spend goes for services. So whatever I wrote above about goods adheres equally to services. Services exports augment a nation’s output and employment; services imports fill in what we don’t or shouldn’t make ourselves. In 2015, US services exports were $743 billion.

When people subtract national imports from exports, they are doing a legitimate operation. For example, if exports are less than imports of goods and services, we call that negative number a trade deficit. That causes frowns. We don’t like deficits. But in reality the negative number is telling you only one thing directly – currency going out exceeded currency coming in. What this negative number tells you – for example, a deficit of goods and services of $500 billion in 2015 – is that $500 billion did not return to the US via imports of goods and services. So what? It does NOT tell you that the US is in a half-billion dollar hole. In fact, what we know is that the nation got benefits from the exports AND it got benefits from the imports. Adding them together, we got about $5 trillion of benefits to the country in 2015.

I see you are tiring. Give me 10 burpees. The best part is coming.

What we have left out of all this is a huge part of trade call financial stuff. Okay, there is a more technical term but for now remember that the trade deficit left $500 billion of dollars around the world that people did not want to use for US goods and services. 

Notwithstanding wallpaper, foreigners who hold all those dollars can use that money and more if they want to buy financial stuff in the USA. They can open up an account  at the IU Credit Union. They can buy corporate or government bonds. They can buy shares of Apple or shares of an index fund. They can also acquire or merge with Apple or the Crosstown Barber Shop.

Wow. And they are not limited by that $500 billion left over from the trade deficit. They can invest all they want. And I don’t have to convince you that when foreigners buy US assets, it is a good thing. It is good because US firms find it easier and less costly to raise capital for investment. It is good because it lowers US interest rates. It is good because it can infuse the latest technology and innovations into American companies.

In 2015, foreigners increased their ownership of US companies (what we call foreign direct investment or FDI) by around $350 billion dollars. That’s not how much they owned – that’s how much they INCREASED their ownership in that one year. They increased FDI by around the same amount in 2014. In those two years, foreigners increased their ownership of portfolios in America by about $736 billion. Money is gushing into the USA. Between this portfolio investment and the FDI, we are talking about an increase of dollars buying US assets of more than $1.4 trillion.

Here’s the point: Trade includes cross border transactions of goods, services, foreign direct investment, portfolio investment, and more. Anyone who focuses on one of these to the exclusion of the rest is not telling you the full story. International trade is great for the USA. Yes, we have a trade deficit. But we also have a pile of very valuable imports of goods and services flowing in and a waterfall of the world’s savings wanting to invest here. Anyone who suggests that we should jeopardize the latter so as to remediate the trade deficit in goods is not understanding the meaning of international trade.  


  1. A tariff on imports (Trump wants 45% on Mexican exports to the US) raises the dollar price to US consumers but lowers the price received by Mexican exporters. This is the likely benefit from a welfare view point: the United States is able to improve its terms of trade, that is the ratio of US export prices to US tariff-excluded imports prices. Any big country can do that because of the size effect. Small countries can't do it. It assumes that other countries, big ones, do not retaliate. If they do, the welfare benefit for the US would peter out or disappear altogether.

    Now quantities. Clearly, import quantities fall for the US unless the demand is totally inelastic. The trade account improves, again assuming no retaliation. With retaliation, both US exports and imports decline and their difference in ambiguous. Employment at home can go either way depending on relative price elasticities and labor intensity of import-competing industry and export industry. The employment effect for the US may be positive but it is not a sure thing.

    The big stuff is capital repatriation. With trillions of dollars brought back home by US multinationals, the capital account would swing to a big plus. Under flexible exchange rates, the current account must match with the opposite sign the net inflow of capital. In sum, the prediction of Trump is a bigger current-account deficit. Of course, Trump may blame other countries for this deficit unless someone in his entourage explains to him the basic macro identity.


    Michele Fratianni
    Professor Emeritus, Indiana University, Kelley School of Business, Bloomington, Indiana 47405 (USA) and Economics Department, Università Politecnica delle Marche

  2. Dear Larry,

    I find your lessons are very useful, as always! Reading this post reminds me why macroeconomics was one of my favorite subjects in my MBA time, and you were of course among my favorite teachers.

    I like it that you bring phở in as an example, and feel flattered for our traditional food. I know how to make it, by the way!!

    By the way, even if the POTUS is ignorant about international trade, doesn't he have a whole supporting team of experts that can explain him how to deal with this? I'm so confused about his policies now...

    1. Hello Nhien,

      Thanks for your kind words. I hope all is going well for you. I think we are all a bit confused by President Trump's policies. Let's hope some of those advisers help him produce something that works. Only time will tell.