Back in September 2007 Robert Murphy posted an article concerning one of the analogies that Peter Schiff makes in his book Crash Proof. Schiff’s argument is essentially that persistent trade deficits are unsustainable and Murphy’s article attempts to refute this.
Since I appear to have fallen into the same trap as Schiff in one of my recent posts, Murphy’s article got me thinking and the following is an attempt to clarify the objections to Schiff’s argument and my previous post, both for myself and the reader. With a bit of luck I can also add a bit to the discussion that was not covered in either Schiff’s book or Murphy’s post.
I’m going to do this by telling a story similar to the one in my somewhat naive Feasts to cure famine post, but where the previous story described farmers who both raised sheep and grew tomatoes, in this story I’m going to dispense with the tomatoes.
American Farm Inc.
Initially our farmers start out with enough sheep to eat a couple of lamb chops a day, as well as keep aside enough breeding sheep to maintain the same level of consumption year after year. In the second year of production the farmers decide to go it rough for a bit and save. Instead of eating two lamb chops per day they only eat one. Their savings (and their short term hardship) mean that at the end of the year they then have enough sheep left for breading that in the following year they have way more lambs and can now eat 3 lamb chops per day (and have enough sheep left over to maintain the same population of sheep the next year).
Basically the point here is to illustrate that savings (and thus delaying immediate consumption) are required in order to provide the capital to invest in improved productive output and thus provide long term gains. Essentially the same process happens in the real economy when savings are invested in factories and other round about production methods but it’s much easier to see in the case of lambs and sheep. In either case, the investment of capital and the decision to delay immediate consumption is made for what is hoped to be even greater profits (and eventual consumption) at some stage in the future.
Now in the fourth year, rather than keeping enough spring lambs and tomatoes aside to sustain their current consumption (long term) they do the opposite of what they did in year two and they consume 4 lamb chops per day. However in order to do this they had to eat into their capital reserves (lambs that were to become breeding sheep for the following year). As such in year 5 they only have enough lambs to provide a dismal 2 lamb chops per day. The farmers thus find themselves in the same situation in which they started. This point is just as important as the point in the previous paragraph. For if delayed consumption and positive savings can provide the necessary capital to increase the productive output of an economy then it is also true that negative savings can have the opposite effect.
Now let’s imagine that in year 6 the farmers decide that they’d like to be back where they were before (eating 3 or even 4 lamb chops per day). However they don’t really feel like saving and going through the whole 1 lamb chop a day thing for another year in order to be able to save the capital required to get their production back up to previous levels. So this time round they decide to borrow some sheep from the Chinese down the road.
The story can now go one of two different directions. If Peter Schiff were telling it then the farmers would, in year 6, eat ALL the sheep that they borrow from the Chinese. If Murphy was telling it then they would invest at least some of the sheep that they borrow in future production (i.e. keep them aside for breeding)… and this is where the analysis of Murphy differs from Schiff . For Schiff assumes that the US trade deficit is currently used entirely to sustain over consumption.
So let’s run with a Bob Murphy version of the tale. Let’s imagine the farmers do not consume all the goods that they import but instead choose to invest a certain portion of them with a mind to boost their future production. What are our possible outcomes? Effectively the farmers are borrowing savings and can choose what portion of those savings they want to use for immediate consumption and what portion they want to invest in future production.
- If too much is invested in short term consumption then they will not be able to improve their productive output enough to pay back even all the interest on the loan (much less the principal). In this case the farmers are in a worse position than they were before having taken the loan out… this kind of borrowing is clearly unsustainable and consumption must be curbed in order to bring the economy back within sustainable limits (if this is still possible).
- If just enough is invested, their productive output will be increased enough that they can continue to pay the interest on their loan (and thus they don’t go any further into debt). There is no real point in this outcome from the farmers’ point of view although it works out OK for the Chinese lenders.
- If they get it right then they can improve their productive output enough to both pay back the interest and have some left over (which could be used either to enjoy higher levels of consumption or to pay down the principle on their loan).
- If they invest too much in long term production then they might even run into shortages and insufficient lamb chops to sustain immediate consumption. In the case of our lambs and sheep this isn’t such a problem, since you can go out and cannibalise your capital (i.e. your breeding sheep) and turn them into consumer goods (mutton, if not lamb chops) reasonably easy. In the real world economy it isn’t always so easy to convert factories into cherry pies though and so this is a very real possibility.
Let’s imagine that what played out was scenario number 3. This turned out to be profitable for both the Chinese and the US farmers. Now if borrowing from the Chinese in scenario number 3 turned out to be so profitable in year 6, why wouldn’t the farmers do it again in year 7 for an even larger quantity of sheep? Suppose this is what occurs and suppose the Chinese economy is also growing. In year 6 the famers borrow 10,000 spring lambs and in year 7 they pay back 6,000 of these (so they still have 4,000 outstanding) but they strike a new deal with the Chinese for a further loan of 20,000 lambs. Essentially they now have a net import of 14,000 lambs where in the previous year they had imported only 10,000. Clearly their trade deficit has increased, but so have the revenues that the Chinese are earning from their loans to the US farmers and (the important bit) the productivity of the US farmers has increased by enough to pay for all of this.
What is important then is not the trade deficit, but that the economy which is borrowing is able to improve its productive output, as a result of the loans, by enough to both pay back the interest and to reap some gains (which could be used either for consumption or to pay back the principal). If this is not the case then the lending does not make sense and will only detract from the profitability of the economy doing the borrowing… eventually perhaps to the point where they start to make a loss.
If the productive output of the US farmers were to shrink for any significant amount of time then no doubt both lender and borrower would do well to re-evaluate the wisdom of further borrowing. For the purpose of borrowing should not be to sustain unprofitable economic activity but to enable profitable activity. Just as companies that consistently make losses eventually find it difficult to obtain loans, so too do countries.
Therefore as long as the US (real world US) is able to continue to pay sufficient yeild on their bonds to entice people to buy them and as long as the US economy continues to grow, a persistent trade deficit in and of itself is not necessarily cause for concern.
There is one further complication in the real world, which is not reflected in the simple story above, which is that in the real world international investors in US Inc. are implicitly making a currency play. Anyone purchasing US denominated assets and investing in the United States is taking a risk on the exchange rate. If I live in Japan and buy US bonds that pay a yeild of 2% over 12 months but the USD drops against the Yen over the same period by 10% then it’s clear that I’ve made a real loss, in terms of my buying power. Similarly the USD could shift in the opposite direction and increase my profits. As such, the spectre of inflation is ever looming over the Federal Reserve that runs the printing press over at US Inc. For if they should ever let this cat out of the bag then they will have to pay a hefty yield on their bonds in order to entice ever more wary investors to buy their bonds… and an increased yeild on bonds would perhaps turn an otherwise profitable economy into one that was instead making a loss. On this, at least it seems that both Murphy and Schiff agree that the early signs aren’t good.
 Note that Murphy also discusses, at some length, the distinction between service and manufacturing but I figured this was probably because Schiff placed so much emphasis on the recent trend towards service industries in the US. To my mind this wasn’t really relevant. There is no difference between the profits that banks make and the profits that manufacturers make. In both cases what goes into the entity is a set of goods/capital that is considered (by the markets) to be inferior in value to what comes out of them. So a profitable company is a profitable company, regardless of the origin of its profits (service or manufacturing)… similarly a country can export services or manufacturing goods to the world. What is important is not the nature of the goods but their relative values in the free market.
It may be that the conventional statistics measuring imports/exports fail to take account of certain profits but that wasn’t really what interested me. I was interested in discovering, assuming that perfect statistics could be maintained, whether a consistent trade deficit was sustainable and whether continued investment by outside parties count be considered reasonable. I think the analogy we’re using above takes care of this since the only good involved is sheep – thus all profits are measurable and nothing can slip through the cracks.