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Where Do Trade Deficits Come From?

November 29, 2011

The impression that you get from the press is that the reason for the US trade deficit is low wages in foreign countries – or, conversely, Americans who get paid too much. The general idea is that Americans are in competition with foreigners who make $0.10 per hour, and that unless they can compete at that level, they’re expendable.

But I wonder if the press has got it exactly backward.

Suppose, hypothetically, there was a foreign country (“China”) with a central bank. That bank, like all central banks, could purchase assets “for free”. If those assets were the currency of another country, say, the US dollar, and if the central bank 1.) kept the dollars, and 2.) purchased them on the open market, what result would there be?

One result would be a depreciation of the currency (“the yuan”) of the buyer – since the dollars are removed from the market, but the yuan is not. Another would be an increased demand for Chinese products from abroad (what else, ultimately, is the yuan good for, but for buying things from China?) A third would be an increase in the ownership of dollars by China (or, better yet, US Treasuries, which at least draw interest). A fourth would (likely) be a current account surplus – assuming at least some of the yuan made its way back to China (and China can always sell more yuan, if needs to, to ensure that happens). Finally, as long as not all the returning yuan is used to purchase Chinese investments, China has more or less guaranteed itself a trade surplus.

What if, in other words, the trade deficit is simply a product of Chinese purchases of US dollars?

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