4.e. Dollar outflows, Trade Deficits, and Bank Runs
Many Americans see a US trade deficit as a bad thing. The following statement reflects a typical attitude:
I know we were screaming in 1992 when the trade deficit was $50 billion a year. We are now at over $650 billion a year, headed north of $700 billion. This is a transfer of $700 billion of American wealth out of the country on an annual basis. We are not paying for our imports with our exports. We are paying for it with American wealth. And that is a dangerous trend. (Terrence Straub, Senior VP of US Steel, 2005)
One would never guess it from listening to statements like the one above, but a trade deficit is not a bad thing. Trade between countries is voluntary, and people will not trade unless they gain from that trade. The fallacy of ‘dangerous’ trade deficits is widespread, but easily refuted. When the VP of US Steel says that the US trade deficit amounts to a transfer of $700 billion of American wealth out of the country, he neglects to mention that the US receives $700 billion of foreign goods in exchange. When he says that we pay for imports, not with exports but with our wealth, he says only that foreigners have used $700 billion of their export earnings to buy $700 billion worth of US stocks, bonds, real estate, and cash (all of it from Americans who were willing, even eager, to sell).
Figure 4.e.1 shows trade between New Zealand and Japan. Japan is exporting $100 worth of cars to New Zealand, while New Zealand exports $80 worth of wool to Japan. As shown,New Zealand is running a $20 trade deficit, while Japan has a $20 trade surplus. Many people would think that Japan, with its trade surplus, is getting the better end of the deal, while New Zealand is on the losing end. This is not the case. Trade between two countries must always balance. Japanese exporters would never send $100 worth of goods to New Zealand unless they received $100 worth of items in return. Since the $80 worth of wool does not quite cover the $100 worth of cars, there must be another $20 worth of something flowing from New Zealand to Japan. That something might be $20 worth of bonds, stocks, real estate deeds, cash, etc. For our purposes, it is easiest to suppose that it is 20 US dollars.
The Fundamental Theorem of Exchange says that all voluntary trade must benefit both traders, else the trade would not have happened. In this case, Japanese people must have wanted the wool and the $20 cash more than they wanted the $100 worth of cars. New Zealanders must have wanted the cars more than they wanted the wool and the cash. Neither country is injured by this trade.
The $20 in cash that was paid from New Zealand to Japan would be considered a ‘dollar outflow’ by New Zealanders and a ‘dollar inflow’ by Japanese. In the days of the gold standard, such payments would have been gold outflows or gold inflows. In Adam Smith’s time, mercantilists believed that a nation should try to accumulate gold. Trade deficits were thought to be bad because they produced gold outflows, while trade surpluses were thought to be good because they produced gold inflows. While mercantilism has been discredited, many still believe the fallacy that dollar outflows or gold outflows are bad, while dollar inflows or gold inflows are good. In fact, both outflows and inflows are harmless. A nation is not injured by a dollar outflow any more than you are injured when you get $100 worth of groceries in exchange for a ‘dollar outflow’ of $100.
Bad theories lead to bad policies. The theory that trade deficits and cash outflows are dangerous has led many countries to impose tariffs, in the misguided hope that tariffs on imports would reduce imports and thereby reduce cash outflows. We saw earlier in this chapter that a small country like New Zealand will be hurt by a tariff, while gaining nothing from reduced cash outflows and smallertrade deficits.
Bank Runs
There is, however, a type of cash outflow that is anything but harmless. That is the kind of cash outflow that occurs during a bank run.Consider the bank in table 1 below. The banker accepts 100 ounces of silver on deposit and issues 100 paper receipts (dollars) in exchange. This is shown in line (1) of table 1. The paper dollars can be used as money, and assuming the banker always stands ready to pay one ounce per dollar, each dollar will have a market value of one ounce of silver. It is clear that as long as every dollar issued is backed by an ounce of silver, any amount of dollars can be issued without causing inflation. It should also be clear that it is immaterial whether the dollars are issued as printed pieces of paper or as bookkeeping entries transferable by check or other means.
In line (2), the bank lends $200 to a farmer. Assuming a market interest rate of 10%, the farmer might promise to repay 220 ounces of silver after one year. The banker could make the loan by printing and lending 200 paper dollars to the farmer. For his part, the farmer gives the banker his 1-year, 220 ounce IOU, which is worth200 ounces (or $200) today. The banker would normally place a lien on the farm, so that if the farmer fails to repay the loan, the banker could take the farm.
Table 1
AssetsLiabilities
(1)100 oz. silver$100 paper
(2)Farmer’s IOU worth 200 oz.$200 paper
The banker’s loan triples the supply of paper dollars. Anyone familiar with standard macroeconomic theory would expect the value of the dollar to fall—perhaps to one-third of an ounce of silver. This is incorrect. The value of paper dollars is correctly described by an economic theory known as the real bills doctrine, which says that the value of money is equal to the value of the assets backing that money. In this case, the real bills doctrine tells us that the 300 paper dollars are backed by assets worth 300 ounces, so each dollar must be worth 1 ounce, even though the quantity of dollars has tripled. This can be demonstrated by assuming that the contrary is true. Suppose, for example, that the tripling of the supply of dollars caused their market value to fall to something less than one ounce of silver. The bank has promised to redeem each dollar for one ounce of silver, so holders of dollars will present them at the bank and demand one ounce of silver for each dollar. Since there are 300 dollars outstanding and just 100 ounces of silver in the bank, it might seem that the bank is unable to redeem all of the dollars ithas issued. But in fact the 300 dollars are fully backed by the silver plus the 200 ounce IOU, and the bank is capable of redeeming every dollar at par. For example, the bank could sell the 200 ounce IOU for 200 of its own paper dollars. It could then burn the 200 paper dollars, and be left with 100 outstanding paper dollars laying claim to 100 ounces of silver in the bank. The bank could then redeem each of the remaining 100 dollars for 1 ounce of silver. At no point in this process would the value of the dollar fall below 1 ounce of silver.
Now suppose that the farmer defaults on his loan. The banker will then seize the farm, hoping that the farm can be sold for at least 200 ounces. But suppose that the farming business has fallen on hard times, and the farm is only worth 100 ounces. At this point the bank has assets worth 200 ounces, but there are 300 paper dollars laying claim to those assets, so the exchange value E of each dollar is E=200 oz./$300, or E=.67oz./$. The dollar will have fallen in value. Put another way, there has been inflation, because the dollars have lost backing.
The bank is now insolvent, as it does not have enough assets to buy back all of its dollars at 1 ounce each. When faced with this situation, bankers will often make the mistake of acting as if nothing has happened and continuing to maintain convertibility of the dollar at 1 ounce per dollar. This might work for awhile if the bank’s customers do not know that the bank is insolvent, but customers normally won’t put their money in a bank unless they have some way to tell if the bank is solvent. If the customers know about the insolvency, they will realize that the bank is paying out 1 ounce of silver for a paper dollar that is really worth only .67 ounces. The result is a bank run, as customers rush to the bank to try to get their silver before the bank runs out of silver.
Suppose that as the run progresses, the bank takes in 100 dollars and pays out 100 ounces. At this point there are still 200 paper dollars outstanding, while the bank’s remaining asset (the IOU) is worth 100 ounces. The new exchange rate E will now be E=100 oz./$200, or E=.5 oz./$. There has been further inflation, and the bank has experienced a silver outflow. This is not the harmless kind of outflow that happens during a trade deficit. This outflow hurts the bank, since the bank is losing .33 ounces on every dollar it redeems. If the bank continues on this course, it will sell the farmer’s IOU for 100 ounces, and pay out the 100 ounces for another 100 of its paper dollars. Now the bank has no assets left, but there are still 100 paper dollars in the hands of the public. The exchange value of the dollar is now E=0 oz./$100, or E=0. The dollar has lost all value, the bank has collapsed, and the economy will be experiencing a credit crunch, meaning that its supply of currency has been drastically reduced. We would expect this economy to suffer a recession.
There is a clear difference between the harmless kind of cash outflows that result from a trade deficit, and the bad kind of cash outflows that result from a bank run, but a careless observer might not distinguish between the two. Over a period of many years, a country might experience both kinds of outflows at various times. Sometimes the cash outflows will result from a trade deficit, and there will be no ill effects, but other times the cash outflows will be the result of a bank run, and the country will sink into a recession. It would be understandable if government officials came to fear all cash outflows, especially if the officials do not know the difference between the two kinds. They will then grasp at any proposal that might reduce cash outflows. Tariffs will seem attractive, since they can potentially reduce imports and thus reduce cash outflows. The trouble is that a tariff would only act to reduce the harmless kind of cash outflow, while doing nothing to prevent the bad kind of cash outflows that result from bank runs. Meanwhile the tariff still has the harmful effect of reducing mutually beneficial trade between countries