The fallacy of the balance of trade

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The rhetoric by the U.S. to pressure China into strengthening the Yuan is more than a tad interesting. They are saying it is undervalued and is causing harmful imbalances to world trade, adversely affecting the global economy given China’s role as the world’s largest exporter. Arguably, this was the main financial story for 2010. If you knew your history well you may well conclude that this accusation lacks any basis in reality.

Adam Smith, the great eighteenth century economist, was a keen observer of contemporary events with a historical perspective and of its causes and effects on the economies of nations. In his grand work, ‘The Wealth of Nations’, he states that “Nothing, however, can be more absurd than this whole doctrine of the balance of trade.” (Book IV, chp III, part II). If trade were perfectly balanced, there would be no progress, as the advantage of one nation that creates prosperity in that nation can only come at the expense of another. His profound statement of the invisible hand also works at the national level as all exchange is motivated by self interest.

In today’s world, this basically means that China is selling goods on the market cheaper and other nations are not able to compete. Since the U.S. is the main importer of Chinese made products and the American dollar is the reserve currency through which most international trade is denominated, China has accumulated a huge amount of dollar reserves (2.5 trillion) that it then recycles back to the U.S. by purchasing U.S. Treasury Bonds effectively lending the money back so that the American consumer can continue purchasing more goods. This summarises the commercial relationship between these two nations and it has been going on for more than a decade.

Just like most other things in life, trade is a zero sum game where if one nation is getting richer by selling goods and getting money in return, another by definition is poorer, buying and consuming giving up money in exchange. This was how England in the nineteenth century and America in the twentieth became the wealthiest nations in the world. They simply were the manufacturing powerhouses of the world and provided goods the people of other nations world wanted at the most competitive rates.

The moral in this is that all nations have and will continue to act in their own self interest and any talk of a group of nations co-operating in a kind of idealistic utopian world for the benefit of everybody is completely unrealistic and unsupported in history. The only motivating force that has ever bound nations, industries, groups or individuals to co-operate with each other was that of self interest.

Penalising Peter to give to Paul was the mantle of communism which led to its collapse in Russia and Eastern Europe a couple of decades ago. People also remember what led to Tiananmen Square. Profit motive or individualism was taken away by force. At the national level this cannot be enforced by one nation upon another except by force of arms.

In this latest battle of words the U.S. has used an old trick of blaming currencies for its ills. Instead of looking at decades of failed policies and tax regimes that has driven capital and jobs offshore seeking a lower cost to make goods and services, the U.S. politician has sought to point the finger at an easy target, in this case supposed currency manipulations by China.

In the U.S., it now takes a husband and wife to provide the same quality of life that a generation ago only required one. The government has subsidized the public sector at a cost of half the national private income for the last three decades. Since the average American consumer can now no longer afford to buy more expensive locally made products, it is China that has benefitted by filling the gap.

Just recently, the U.S. congress, to back up its accusations, passed a bill through the House but is still pending Senate approval that will impose duties on imports deemed given unfair subsidies by foreign governments. If the bill becomes law this will effectively make goods even more expensive for the average American rendering their condition all the more intolerable with real un-employment above 15% and over 40 million people on food stamps.

It is not a wise strategy for America to antagonize the Chinese, with its huge spending and lending power and ability to produce cheap goods, given the fragile state of the U.S. economy. In retaliation and possibly as a prudent investment strategy China can sell its holdings of U.S. Treasuries, given the policies coming out of Washington and the Federal Reserve, to further weaken the dollar, and to align China’s long term strategy of evolving to a consumption based economy relying on regional and other emerging market economies for trade that is surely to decline from the U.S. and other developed economies. Asia is already exporting within itself and this will only increase. For the Americans to take the strategy they are pursuing is probably about as sensible as sensible as Napoleon invading Russia.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]