Balance of Trade

If there’s one term I really wish people would drop into a deep, dark hole and bury it that would be “favorable” or “unfavorable” balance of trade.  And right alongside it they can bury “strong” and “weak” with respect to currencies.  Thee terms imply things about what is good or bad economically that simply do not match economic realities.

The idea of favorable/unfavorable balance of trade dates back to 18th century and earlier Merchantilist ideas of economics.  According to them, the wealth of a nation was defined by the amount of gold, and to a lesser extent silver, it had in its treasury.  Thus if it imported more (in terms of gold value) than it exported, its gold reserves would decrease and it would be poorer.  One effect of this measure of wealth was that it really only affected the upper classes.  The great unwashed masses and their standard of living was not something the Merchantilists worried about.

One of Adam Smith’s great insights was his defining the wealth of a nation not in the amount of specie that it retained, but in terms of the goods and services it obtained.  One effect of this measure is that it applies to everyone, not just the upper classes.  A nation wealthy by this measure will, generally speaking, have more goods and services available to everyone.

Once one realizes that, then one immediately sees that importing goods and services makes a nation richer.

Let me repeat that:  Importing goods and services makes a nation richer.

And, thus, it sees that if anything, the “favorable” and “unfavorable” balances of trade swap places.

“But we’ve got the money going out and what about domestic businesses and…” Or so the complaints go.

Let’s look at that.

Let’s take a simple case,  Two countries:  A and B.  Country A uses the Dollar.  Country B uses, let’s call it a Credit (a common science fiction term for future currencies).  One dollar equals 100 Credits.  Okay?  Now, Country B is able to produce everything Country A does, but cheaper so that anything that in Country A costs a dollar, they can get it from Country B for 90 credits (90 cents at the exchange rate).

Looks pretty bad for Country A’s merchants and manufacturers doesn’t it?  They can’t compete with Country B selling everything cheaper.  If we stop there, we seem to have vindicated the concept of “unfavorable balance of trade”with the extreme case.  If we stop there.

But we don’t stop there.  The result of this is that Country B has a bunch of dollars.  Country A has goods and services.  What is Country B going to do with those dollars?  They can’t eat them.  They can’t drive them around.  They make poor building material.  And, Scrooge McDuck to the contrary, they make a poor medium for swimming in.  I suppose they could burn them for heat, but that would mean they’re trading an awful lot of goods and services for what amounts to firewood.

Those dollars are only good to Country B if they can trade them, or invest them.  And in the end, they have to trade or invest them in Country A, where they are legal currency.

Let’s dismiss invest at this time–a subject for another day although I’ll make a further brief mention later in this post–and just look at the “trade” side.  How are they going to trade them when everything they want to buy in Country A is more expensive than the locally produced stuff at the current rate of exchange?

And there’s the secret:  at the current rate of exchange.  If the Dollar, instead of being traded at 100 Credits per dollar, were traded at 90 Credits per dollar, They would be able to buy from Country A at the same price as from their own Country B.  That would also mean that people in Country A would be able to buy from their own Country A at the same price as from Country B.  This “weakening” of the dollar compared to the Credit, means that Country A’s manufacturers and merchants are better able to sell their product both domestically and internationally although at the same time it’s making goods and services available to the buyers more expensive.  It’s not exactly obvious whether this is a good or bad thing on balance.   This despite the tendency of many to automatically consider a “weak currency” to be bad and a “strong currency” to be good.  Both have their good and bad aspects and great care must be exercised in looking at why a currency is weak or strong in making that determination.  And even so, “reasonable men may justifiably disagree.”

Voluntary exchange, both in goods and services, and in the currencies involved, would tend to quickly correct mismatches.  Going past the simplistic model of everything being cheaper in one country than the other by the same amount, the same principal still applies  The exchange rate (again, assuming voluntary exchange in the market) will tend toward an average and one country will produce some goods and services more efficiently with different goods and services produces more efficiently in the other.  Country A might import more steel (perhaps to the consternation of steelworkers) but export more grain (to the joy of farmers).

And, of course, we cannot completely ignore investment.  Instead of buying a country might choose to invest.  They have the same amount of currency:  Country B received some number of dollars from its sale of goods and services to Country A.  But instead of using those dollars to buy goods and services in turn, they might use it to invest in enterprises in Country A.  They might buy property in the hopes of reaping rents and appreciation in value (which will tend, through competition, to increase other properties values).  They might invest in factories, putting people to work producing more goods and services.  Sales outlets, again putting people to work providing their goods and services to others.  These things are beneficial when done by domestic investors.  They do not change their nature when done by foreign investors.

So people need to stop thinking in terms of “favorable” or “unfavorable” balance of trade.  A balance of trade is not favorable or unfavorable by itself.  It is only in the context of the larger economic picture that the benefits or detriments of the details of that particular balance can become known.  The catch is that the detailed effects are often not obvious, which can lead to heated disagreements even among those who do try to look at that big picture.

The one thing that history has shown us, though, is that interference with the system of voluntary exchanges rarely if ever works out better than allowing it to freely operate.

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