Reply To: US Balance of Payments and Current Crisis Outcomes

#17718
jmherbener
Participant

If foreign demand to hold dollars collapses, then the foreign exchange value of the dollar will fall, which will prompt a repatriation of the dollar resulting in price inflation in America. But this scenario has nothing to do, per se, with U.S. trade deficits, foreign Treasury holdings, and so on. Accounts such as these result from people acting on their preferences. If their preferences change, then the patterns of exchange and production change, which then change the accounts. If their preferences do not change, then the pattern of exchange and production do not change and the accounts do not change.

Foreigners prefer to sell us more goods than we sell them and to buy from us dollars. They want to hold additional dollars and until that preference changes, the dollar’s exchange value will not collapse, no matter what the size of our trade deficit. If our trade deficit grows it means that foreigners want to hold additional dollars. Here is a story about the significant increase in foreign holding of dollars since the crisis:

http://www.federalreserve.gov/pubs/ifdp/2012/1058/ifdp1058.pdf

What checked profligate monetary inflation and deficit spending under the classical gold standard was the redemption of each currency at a fixed rate for gold. When people called into question the fixed rate of redemption of a currency for gold (e.g., after a government inflated its currency), this led to adverse trade flows, devaluations, and so on.

When the U.S. runs a trade deficit with China, the dollars the Chinese do not desire to hold they use to make financial investments in the U.S. Markets bring people with different preferences into mutually advantageous relationships. Americans save little and consume lots. Chinese save lots and consume little. When we come together in a market economy, the Chinese will produce more goods for us than we do for them and they will invest more in America than we invest in China. That’s what both groups of people want to happen. Our trade deficit is balanced by our capital inflow and China’s trade surplus is balanced by their capital outflow. These trade accounts are sustainable because they reflect people’s preferences. There is no problem here until the government crowds out Chinese investment in American private enterprise with Treasuries. That’s where the problems originate, not in imbalances in trade accounts.