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Ashish's Niti

Niti in Sanskrit means policy/strategy/vision. This blog hosts my political views, along with news and commentary. This blog has moved here.

Wednesday, March 30, 2005

Is Trade Deficit harmful?

Karlsson answers the question on Trade Deficit in a very clear and illuminating way.

Also, see John Tammy's other articles, More Current-Account Confusion and Trade Charade. He also addresses Buffetts worries about trade deficits. According to me, Buffett was more worried about impact of trade deficit on US dollar than on the US economy.

I had a good discussion with Mr. Tammy on this. He convinced me that the value of US dollar is largely determined by the Federal Reserve as they have monopoly on its issuance. The Fed can always absorb dollars by selling the bonds from its portfolio to neutralize selling of dollars by Asian central banks. Also, he thinks that increasing or decreasing money supply by the Fed will not always result in inflation or deflation:

As for Fed money creation, remember that the demand for money shifts back and forth all the time. Simple money creation is decidely not inflationary if the economy is growing such that it needs lots of
That's what happened in the late '90s: the capital gains cut in '97 put the economy into high gear and while monetary aggregates suggested the Fed was loose, gold, treasuries and the dollar's value vs. foreign currencies suggested the Fed was way too tight.
Conversely, the Fed extinguishing dollars is not per se deflationary if the economy is growing so slowly that extinguishment by the Fed should be even greater.
That's why we can inflate in a slowing economy (see Irrational Exuberance Is Not Inflationary), and we can deflate even if money creation seems high. I'm for a gold exchange or gold standard for that reason - let the gold price be the indicator for how much or how little money the Fed should be creating.

Mr. Tammy also made an simple but interesting point:
Consider Gillette. It’s top-of-the-line M3Power
Razor sells for $13.99 in the U.S. In England, the same product sells for $17.78. The 27 percent markup is without a doubt a positive for Gillette and its shareholders, but for those who calculate trade imbalances, the $3.79 gained overseas would add to the U.S. trade deficit.
remember that exports are counted in terms of their value when they
leave our shores. The $13.99 is the value exported, the $17.79 is what returns to us; thus whether we buy Rolls Royces from England or whether we convert Pounds to dollars and buy Nissan cars, positive trades will always increase the value of imports we bring in in
exchange for our exports.

This makes sense. We always export what is less valuable to us and in return import what is more valuable to us. Thus even in case of "balanced" trade each trading partner will have a trade deficit.

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