The term trade balance is somewhat of a misnomer. When any trade or exchange takes place with any party, foreign or domestic, it is assumed that the transaction is “balanced”. In the case of voluntary exchange, it tends to occur that an equivalent amount of wealth is being exchanged by both parties. If this is not the case, why would the party on the losing end of the deal voluntarily enter the transaction?

It is important to remember, nations don’t trade with each other, people do.

In the case where wealth is exchanged directly, for instance an apple for an orange, this balance occurs instantaneously. In other words, one apple will leave the country for every orange coming in. This would then be a balance of trade assuming that the orange and apple are of equivalent economic value. However, where money is involved, there may be periods, where countries become net importers where goods and services flow into the country and money is flowing out. This will then be followed necessarily by periods of net exports, where goods and services will flow out of the country. The country receiving the exported goods will pay for them with the money they received for their previous imports. This then balances the trade.

If a country is importing more than they export, many tend to think this is “bad” for the importing economy and that the nation must be losing wealth, while the exporting nation is gaining it. However, this is not the case. Again, if these transactions are voluntary, it is assumed that they are exchanging the equivalent amounts in terms of wealth. If the country is exporting goods and services in return for money, the exporting nation assumes that the value of that money is equal to the goods and services it is exporting. This is one reason the faith in a nation’s currency is vitally important.

The misunderstandings dealing with trade deficits tends to lead people toward the absolute conclusion that exports are good and imports are bad. This then leads to the belief in economic protectionism, such as “Buy American” campaigns and even protective tariffs. These practices actually tend to harm domestic economies by restricting free trade, which reduces options for exchange. This reduces the efficiency of wealth exchanges and artificially promotes domestic products including some that are of poor quality or low value for the sole reason they are made in the USA. Think, Ford Pinto. Was there any reason to purchase that vehicle versus another of better quality at a comparable price, regardless of where it was made? The bottom line dealing with purchases or exchanges is that both parties should look to maximize the value of the wealth they have created by purchasing the highest quality or valued product for the lowest price, regardless of where it is made.

Why should a nation be concerned with their trade balance with a particular nation on the basis of prosperity, anymore than I should be concerned with my trade balance with my local grocery store? It is assumed that each transaction with the grocery store is balanced. If we looked at the trade balance between myself and the grocery store the same way some people see the trade balance among nations, I am getting a really bad deal! However, this is not the case. My concern should be that I am producing enough of my own wealth to exchange with the grocery store for items that I need or want (their wealth). It is assumed that the grocery store will use that money to buy other goods and services, which will in turn “balance the trade” since it will be spending money in the same system from which I will be producing wealth and exchanging it for cash. This same principle applies to nation’s economies and their own wealth and relative exchanges. If all parties involved are producing enough wealth to pay for their exchanges, a balance will eventually occur.

America’s Cause for Concern

What should give the US cause for concern is its true capacity to produce wealth. Much of our importing capacity comes by way of debt. We are either borrowing from other countries or the Federal Reserve. Just as the case with the grocery store, it should not be of much concern that I am exchanging money for their goods. As long as I am producing wealth and can continue to pay them with the money I have exchanged in return for my production, I am on a sustainable course. However, if I am financing my purchases with credit cards and IOU’s. I should be greatly concerned. Instead of borrowing more money, I should immediately figure out a way to begin producing enough wealth in order to pay for my “trade deficit” with the store.

Artificial Demand for Foreign Goods

With regard to trade, we should call into question the issue of self sustainability and related economic vulnerability in times of crisis. If we are on a desert island which is next to a very large population of clams producing high quality pearls, but the island has very little ability otherwise to produce all the things that we need for survival, we will need to rely more heavily on imports of crucial resources in order to sustain a certain level of economic well being. We may be able to produce a lot of wealth in pearls, but we will need to import much of our food, raw materials and goods. Notice, our net export of pearls balances the goods we import. However, if a war breaks out and we can no longer receive some crucial resources, we may find ourselves in a very difficult situation. We may have a lot of pearls, but little food. One thing comes to mind for the US in this example and that is energy.

This then calls into question a situation where the domestic government is artificially preventing domestic wealth production by regulation or other restrictions artificially forcing a higher level of importation of certain goods and services. For example, the US has enough energy supplies within its borders for its own needs in the form of oil, oil sands, oil shale, coal and natural gas; but there are heavy restrictions from accessing and using them. This is artificially decreasing the wealth generation capacity of the US economy by placing extremely onerous restrictions on domestic energy production, this forces the US to import as much as 70% of its daily petroleum needs in order to meet its energy demands. Whether the US is producing enough wealth in order to make up for this artificial loss in energy production does not remedy the risks of the artificial dependency on foreign oil.

The Trade Balance on its own is not sufficient to determine the productivity and related prosperity of an economy. In a true free market where the government maximizes economic freedoms such as economic development and trade, there should be much less concern regarding the trade balance, especially for the US since it has many diverse resources and therefore, the ability to produce a variety of products, goods and services. What we should really begin to examine however; are the artificial restrictions to wealth creation by the central government and its unnecessary effect on the balance.

Question: Is it better to “buy American”, than from a foreign producer?

To answer this question, we have to look at the basics of economics and it starts with the concepts of wealth and money.

What is the basis of wealth? Production, which is a result of time, resources and energy/labor.

What is money? A universal medium of exchange, a wealth storage mechanism.

If a person buys something from a foreign producer for $100, is that person and the  related domestic economy losing their wealth? Only if that person is foolish enough to exchange $100 in cash for a product or service worth less than what that $100 can otherwise purchase.

If I buy $100 worth of wheat from a domestic producer or foreign producer, that transaction doesn’t change the net wealth of the nation with which I reside, nor the wealth of the nation from where it is purchased. It does not even change my personal wealth. Keep in mind however; If that wheat is in my possession, any consumption or destruction (theft, fire, degradation) of that wheat does reduce my wealth. Taxation of that wheat also reduces my wealth, but that deals with the price of government as another topic.

Note: This is assuming prices include all necessary transportation costs.

Let’s take a look at the two possibilities and respective balance sheets of a domestic and foreign purchase.

1. I buy $100 worth of wheat from the foreign producer:

Before the transaction:

Domestic producer has $100 worth of wheat, I have $100 in cash.

— US balance sheet = $200

Foreign producer has $200 in wheat.

— Foreign balance sheet = $200

After transaction:

Domestic producer has $100 worth of wheat, I now have $100 in wheat.

— US balance sheet = $200

Foreign producer has $100 in cash and $100 in wheat.

— Foreign balance sheet = $200

2. I buy $100 worth of wheat from the domestic producer:

Before the transaction:

Domestic producer has $100 worth of wheat, I have $100 in cash.

— US balance sheet = $200

Foreign producer has $200 in wheat.

— Foreign balance sheet = $200

After transaction:

Domestic producer has $100 worth of cash, I now have $100 in wheat.

— US balance sheet = $200

Foreign producer has $200 in wheat.

— Foreign balance sheet = $200

There is no difference in wealth. In both cases the beginning and ending result was $200 for both the US and foreign balance sheets. If simply selling your product (converting it to cash) doesn’t make you rich, what then makes you more wealthy? Wealth production!

How can both countries become more wealthy? They can increase their production of wheat or other forms of wealth. Money isn’t wealth itself. It is only a wealth storage mechanism. This is the most common misconception regarding money. Money only has value because of the goods and services it can be exchanged for. If nothing is being produced, that money is worthless. What good is money if there is no bread to buy?

Production, which is the combination of time, resources and energy/labor is the basis of real wealth.

Buying Less for More

Take the dogma of nationalism out of it. Let’s change the geographic boundaries, since they are only relative in this debate. Is it somehow more prudent for you to buy a product that is made in your State or even local community regardless of quality or value? Does this make your community better off? No, it makes your preferred economy poorer by subsidizing the producer of low quality/value goods or services and deprives you and the community of either more value or higher quality, in other words, the ability to maximize the return on your own wealth production.

Notice, the question above is under the premise that we are buying locally regardless of quality or value. If the local producer happened to provide the highest quality or value, it would be by accident that your local economy is not suffering a loss.

Let’s put this in terms of wheat again for consistency. If I buy a certain product from my preferred economy as a matter of geographical bias, but I happen to be buying that product which is of lesser quality/value. Can we agree that it is the same as buying a lesser amount of wheat for the same $100 as before?

So, let’s say that outside of my preferred economy I could receive 10 bushels of wheat for $100. But, my neighbor is offering me only 5 bushels of wheat of otherwise comparable quality for $100. Why would it make me or my community better off if I were to implement a geographical bias toward my neighbor’s wheat?

My neighbor would be better of because he could then take that $100 and buy other products and services truly worth $100, but as for me and the rest of the community. We’d be the poorer for it, because it would require us to produce twice as much in wealth in order to overpay for our neighbor’s crummy deal. We would have produced $100 in wealth, only to receive $50 in return or produce $200 in wealth, only to receive $100 in return.

Let’s look at this in terms of the balance sheet:

I buy $50 worth of wheat from a local producer for $100

Local producer has $50 worth of wheat, I have $100 in cash.

— Local balance sheet = $150

Foreign producer has $200 in wheat.

— Foreign balance sheet = $200

Regardless of whether I buy from the foreign or local producer does not change either community’s balance sheet. While I personally will be better off if I buy from the foreign producer, the single transaction itself is not what makes the local community poorer. The lack of production is making it poorer.

Notice that in the 1st set of examples the “local/US” balance sheet was $200. With the latest example, it is $150. Why? Because the local producer is producing $50 less in wheat (wealth). If the local community subsidizes this lack of value by over paying for their product or service, versus promoting producers that produce at full value, the community will be the poorer for it. The rest of the community will have to produce more wealth in order to subsidize the lack of production quality/value of the local producer, or simply go without that additional wealth and be the poorer for it. However, if the community is going to increase its wealth production, it is best if they buy from the better supplier outside of town or only buy from the local producer if he lowers his price to reflect the actual quality/value they are creating. The extra wealth that was produced can then be used to buy from the foreign supplier, which will maximize the value of that extra wealth generated.

If the local/domestic producers provide the highest quality product/service at the least cost, there is no reason to buy elsewhere, but biased protectionism that argues that we should buy local/domestic products and services for no other reason than geographic preferences, destroys the wealth of that economy, even if it is a value loss of $1, there is no gain for the community, there is a net loss in wealth relative to buying from the another producer that is either providing the same product or service for less money, or a higher quality/value product for the same amount of money.

For further consideration, what if the foreign producer moved to your local community, who would you buy from now? Why would it change? It is always to your advantage and to that of your relative economy to make the highest use of your wealth and that necessarily involves maximizing the value of your wealth in exchanges (purchases).

A Perverted Conclusion

Keep in mind, in the example that the local producer was not producing to their maximum potential, some Statists come to the conclusion that we should force that producer to increase their production. Not only would this violate the Liberty of that individual or company (property of the individual[s]). It has been shown that force does not increase economic productivity. To the contrary, the promotion of economic freedoms provides for the most productive environment to maximize prosperity.

Question: What got America out of the Great Depression, The New Deal or WWII?

Truly, it was neither.

Each gave some appearances of a recovery, but it wasn’t until our men returned home from WWII, capital was given some time to reset and wealth production resumed, that America saw an actual recovery. However, the effects of the New Deal continue with us to this day, where our Federal government continues to induce artificial prosperity with a perpetual spending dive that is taking us closer to the bottom.

Neither WWII nor The New Deal created prosperity. WWII was arguably necessary, depending on your study of history, but we will save that for another debate. The New Deal however, was a massive waste of money that began America on it’s perpetual debt binge.

WWII

Some say WWII got us out of the Great Depression because it created jobs and reduced unemployment. They also say it was because it created demand for tanks, ammunition, guns and so on. Yes, this is all true. However, regarding unemployment in the US. When most of your men are overseas fighting a war, what do you expect to happen to unemployment? Further, where did all of this money to pay for the troops, necessary equipment and armament come from? It was borrowed or came directly out of the real production of the economy through taxes!

War is sometimes a necessary expense, but to argue that it somehow produces prosperity is a complete fallacy. To illustrate this, let’s use an example given by Thomas Woods from his book “Meltdown”. If War Time Prosperity is true, then Japan and the US should agree to duke it out in the Pacific Ocean. Only, to avoid the loss of human life, let’s build the most sophisticated, advanced and expensive remote controlled navies the world has every known. Let’s agree to meet in the middle of the Pacific and watch the remote controlled fireworks begin. Win or Lose…we both lose economically.

Consider all of the time, resources and energy involved (capital), all of which are paid for using “money”. After the end of this battle, all of that capital invested in the destroyed navies will be at the bottom of the Pacific Ocean. If War Time Prosperity were true, Japan and America would be economic superpowers overnight and our recession would be over!

What is unseen here is all of the wealth that could have been produced with the same capital now resting at the bottom of the ocean. How many cars, tools, TV’s, computers, could be made with that capital?

WWII did not make America prosperous. War is an expense, sometimes a necessary expense, but the economic destruction that it causes because of the destruction of wealth that occurs is devastating.

THE NEW DEAL

The New Deal was simply a modern day “Stimulus Package”. It was birthed from the ideas of John Maynard Keynes who suggested that a central government could induce economic prosperity by “priming the pump”. He suggested that if the government simply spends money, that will create demand for products and services and it will jump start the economy. He famously boiled his theory down to this simple example. You can pay a man to dig a hole and another person to fill it. The fact that nothing productive is taking place doesn’t matter, the spending alone will stimulate the economy. He argued that debt spending was the best way to go, because taxes can damage an economic recovery by taking real capital out of the economy, thus defeating the purpose.

In some ways Keynes was right, but that is a complicated argument to make and filled with caveats that in the end, actually debunk his theory. One particular caveat is “time” itself. When Keynes introduced his theories there were other prominent economists, including F.A. Hayek, who would offer one damning criticism in the form of a question. “What about the long run?” To which Keynes famously replied, “in the long run, we are all dead”. As if this is some sort of joke. John Maynard Keynes knew that what he was theorizing was not sustainable, but he obviously felt that the long term negative effects were so far off in the future that they were irrelevant. The problem for us today is that you and I have reached the long run. We are paying for his misguided economic theories. Our economy is not based on the only sustainable path to prosperity, which is wealth creation, but instead, it is a marriage of capitalism and a massive amount of subsidization and central planning which is administered by the Federal Government and Federal Reserve which are ultimately funded by the US taxpayer, now and in the future.

Subsidies Include:
Direct Farm Subsidies
Welfare for the poor
Corporate Welfare
Loan subsidies and guarantees – (homes [FNMA, FMAC HUD], education, business loans)
Direct government spending, “stimulus”
Tax “Credits” – Cash for Clunkers, Home Buyer Tax Credits
etc.

Central Capital Planning:
Interest Rates (FED)
Money Supply (FED)

What we saw during the New Deal Era was a fake recovery, much like we are seeing now. It wasn’t until capital was allowed to reset, in spite of the New Deal, that real investment and subsequent production of real wealth returned. The problem is that we have been left with this legacy of economic manipulation that is ultimately making us poorer. When government intervenes and acts outside of its Constitutionally limited role, it takes wealth, whether from the present through taxes or the future through debt and diverts it as a central planning agent. This diversion of capital causes bubbles and busts, like the one we saw which resulted with the current credit crisis.

Furthermore, many point to increases in GDP under the New Deal and other economic indicators to say that it worked, much like we are seeing today. The misleading thing about GDP is that it is only a good indicator if it is solely a result of free market activity. As soon as intervention is introduced, there is no way to compare GDP or use it or any other economic indicator as a measure of real economic productivity. Under the New Deal, there were prices floors which were implemented. This temporarily caused an increase in GDP for more inelastic goods such as food and vital raw materials. Furthermore, when much of the spending is debt based and coming from the government in the first place, the GDP is inflated beyond its true level.

Keynesian economics is a sort of pyramid scheme. It can work or give the appearance of working until either a.) the government can no longer borrow (see Greece) or b.) capital has been so miss-allocated that a massive economic collapse occurs as a result. Yet, we continue down the same road building new bubbles and subsequent busts, each successive bust is worse than the one before it.

The most common misconception dealing with wealth is that money = wealth. This is not true. Wealth can be measured in money, but that does not mean that the unit of measurement is wealth itself. If money equals wealth, countries could simply print wealth and their citizens would just sit around all day drinking beer. One problem, where is that beer going to come from? The only way to true and sustainable prosperity is through wealth creation (production). We know this by this simple example: Which country is more wealthy? The one who is producing bread, shoes, clothes, tools, cars, etc. Or the one who produces “bank notes”?

What good is money if there is no bread to buy? The one temporary exception to this is an economy based upon debt, like ours. 70% of the US economy is based upon consumer spending. That is why following the 9/11 attacks President Bush told everyone to go shopping. Why didn’t he tell us to go produce wealth? Because that is not how our economy has been constructed. America has been producing some wealth, but not nearly enough to justify its rate of consumption. We could be as wealthy, if not more wealthy than we currently appear. But we have allowed the Federal government to squander and destroy our wealth and that of future generations through the justification of Keynesian economics.

Government spending does not create prosperity. Government is an expense to any nation, it is a necessary expense when it is confined to its legitimate role of simply protecting natural rights from legitimate foreign enemies and domestic criminals, but when it ventures beyond this role and takes on the powers of economic manipulation, it destroys wealth which is the basis of prosperity. Instead of making us richer, it actually makes us poorer for it.

In both cases, whether dealing with the New Deal or WWII, a point should be made clear. Most of the money that was used to pay for these activities came from debt spending. It was from this era that perpetual debt was no longer something to be avoided, it was something to be embraced. Not only is perpetual debt unsustainable, it is immoral. Thomas Jefferson felt that it was immoral for one generation to create debt which it was unable to pay off itself.

Prosperity doesn’t come from government spending, even when it comes from the illusion that is created by debt spending. One day, someone will have to pay up. This is the generational version of a ponzi scheme, it really is a scam and irresponsible. We are not leaving posterity with a better life, we are leaving them poorer.

“I sincerely believe… that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.” –Thomas Jefferson to John Taylor, 1816. ME 15:23

“[Using], for instance, the table of M. de Buffon, [it can be determined that] the half of those of 21 years and upwards living at any one instant of time will be dead in 18 years, 8 months, or say 19 years as the nearest integral number. Then 19 years is the term beyond which neither the representatives of a nation nor even the whole nation itself assembled can validly extend a debt… With respect to future debts, would it not be wise and just for [a] nation to declare in [its] constitution that neither the legislature nor the nation itself can validly contract more debt than they may pay within their own age, or within the term of 19 years? And that all future contracts shall be deemed void as to what shall remain unpaid at the end of 19 years from their date?” –Thomas Jefferson to James Madison, 1789. Papers 15:394

This series is based on the book “Economics in One Lesson” by Henry Hazlitt.

Related Chapters:

Broken Window: http://jim.com/econ/chap02p1.html

Blessings of Destruction: http://jim.com/econ/chap03p1.html

Public Works Mean Taxes: http://jim.com/econ/chap04p1.html

Disbanding the Troops: http://jim.com/econ/chap09p1.html

The Mirage of Inflation: http://jim.com/econ/chap23p6.html

Thomas Sowell is an American economist and author who holds to a laissez-faire, free market and individual liberty perspective. In this special, he gives a brief summary of his analysis regarding the recent housing boom and subsequent bust, which he outlines in his highly recommended book: Housing Boom and Bust.

Find more videos of Thomas Sowell at LibertyPen.com