In light of current Trump trade policy, it is perhaps worthwhile to review some common sense principles about international trade.
The first, most basic and most important principle is that countries do not trade, only individuals trade. The U.S. does not trade with China. Such a statement is meaningless. Rather, some individuals residing in America buy valuable things (goods and services) from individuals residing in China. These are imports from China. At the same time other individuals resident in America sell valuable goods and services to other individuals resident in China. These are exports to China. (Often these individual actions are expressed through the legal fiction of companies, but the essential units of trade are individual people). There is absolutely no reason why the total dollar value of the first set of transactions (American imports from China) should exactly match the dollar value of the second set of transactions (American exports to China). Such a zero trade balance would be a very strange coincidence indeed, and not a very satisfactory one. In the normal course of trade we expect to import more from some places in the world (for example where manufactured goods are cheapest) than from others, and those places are likely not the places where the demand for our exports highest.
The matter is no different from what happens when people in Texas trade with people in New York. No one expects the balance of trade between Texas and New York to be zero. In fact, almost no one knows or cares what that balance is. Residents in Texas would not be surprised to learn that the trade balance between Texas and other US states varies considerably, some being negative and some being positive and probably none being zero. Negative trade balances are paid for by capital inflows – investments or trade credit. If people in New York as a whole sell more to people in Texas than people in Texas as a whole buy from people in New York, then it must be true that funds to pay for those sales must be flowing from New York and other places to Texas in the form of investments or extensions of credit. These financial transactions are private transactions that automatically ensure that payments always balance. Any aggregate negative (or positive) trade balance is equaled by an aggregate positive (or negative) capital account balance. It happens automatically through the market process. People work it out voluntarily in the routine actions of purchase and sale, investing and granting credit. Prices and quantities adjust to achieve the balance.
By the same token, the balance of trade with China should be of no concern. Logically it should be balanced by a favorable aggregate capital account balance with our trading partners including China. And, yes, it is. And that would be the end of the matter but for one important fact, namely, government involvement. In cases involving trade across national borders, often involving the conversion of currencies, governments are involved. One might say that governments have polluted the situation by insinuating themselves into what would otherwise be self-adjusting private trade in goods and finance. For this reason, trade balances have become intimately involved in domestic government spending. Government budget deficits are financed in large part by foreign capital inflows.
For example, when Chinese exporters receive dollars from American buyers the Chinese government takes those dollars in return for local yuan currency. For many years these accumulated dollars have been invested in U.S. treasuries. In other words, the U.S. has borrowed from the trade surplus earned by Chinese sellers, to finance its spending in the U.S. This is facilitated by the Chinese government in effect appropriating that surplus. Essentially the U.S. government has obligated its citizens to pay the extent of the debt owed to Chinese citizens who have been obligated by their government to lend money to the U.S. government. The same is true for our other large trading partners.
In October 2018, the Chinese government held $1.14 trillion of U.S. debt. It's the largest foreign holder of U.S. Treasury securities. The second largest holder is Japan at $1.023 trillion. The impetus for this policy has been a Chinese government fear that if it did not ‘neutralize’ the inflow of dollars by buying them, thus increasing the supply of domestic currency, the price of dollars (the exchange value in terms of yuan) would fall. This would mean Chinese exports to the U.S. would become more expensive and imports from the U.S. to China less expensive. In other words, the Chinese government has for many years been motivated by the same disastrous export-led, protectionist goals as the Trump administration now is. Each country wants to limit imports and boost exports by not only imposing tariffs, but also by countering natural flows of goods and finance with inhibiting monetary and fiscal policy. Despite the Chinese government's occasional threats to sell its holdings, it apparently continues to be happy to be America's biggest foreign banker.
At the same time, the U.S. government has become dependent on these foreign sources of finance. And as the debt keeps mounting up, the interest on the debt increases with it. With each passing day babies born in America inherit an increasing debt to our foreign bankers.
Is that a legitimate reason to be concerned about the large trade deficit with China (and other nations) that is fueling the current Trump protectionist trade strategy? No, not really. It is not the trade deficit that is the real problem. It is the U.S. government budget deficit that should receive our attention. Quite simply our government should not be borrowing so much money. The best way to fix this is to reduce government expenditure, not to increase taxes. The latter will hurt the economy and may not even result in a significant increase in revenue; in fact, it may reduce revenue. It is the overall size of the federal government that is the overarching problem of both foreign and domestic economic policy.
If the Treasury borrowed less, and/or if China decided to lend less (buy fewer U.S. bonds, or no bonds), what would happen? The dollar exchange rate would fall, imports would become more expensive, and exports would become cheaper and more attractive. Ironically that is what Trump says he wants. But it would happen automatically and it would mean downsizing the government, so don’t hold your breath.
A shorter version of this was published on January 2, 2018 in the Dallas Morning News.