Don Boudreaux at Cafe Hayek has another great post on trade imbalances and protectionism. I don’t always agree with him but on this topic, he is pretty consistently spot-on and he has helped me significantly develop my own thinking and arguments when it comes to trade “imbalances.” I recently have been thinking about the different ways exporters can use dollars.
Consider anybody who exports to the US. That person is dealing with American consumers who are well-known around the world for getting paid in, holding and therefore paying in US dollars. Therefore, exporting to the United States means having an outflow of widgets and an inflow of US currency. In order to see what happens next, one must carefully consider what the exporter (or some intermediary) does with those US dollars. There are roughly 5 different things they can do: buy US goods and services, invest in US dollar-denominated assets, lend money to the US government, hoard dollar bills temporarily or participate in foreign dollar-denominated markets.
The first three can’t be that worrisome to our job-conscious policy-makers. Purchasing creates jobs, so does investment and if they didn’t think they could do something good for the US with that money they borrow as the US government, they shouldn’t be borrowing it whether from foreigners or locals. That leads me to the conclusion that their problem is with the money that leaves and never comes back. It is proper to worry, but protectionism is the wrong answer.
Let’s consider what happens when that money leaves. That means that that money is no-longer available in the US to mediate transactions. In other words, the money supply has shrunk. A glance at the equation of exchange MV=PY=NGDP tells you that when M falls and V remains the same, NGDP falls.
NGDP unexpectedly falling below trend disturbs nominal contracts which implies a recession. [Update: It has been pointed out to me in the comments that I am overstating my case here especially without more argument/data. I agree. NGDP falling below its expected growth path is likely to disrupt nominal contracts which may under certain assumptions result in a recession. I will make a more cogent/thorough argument in favor of that in a later post.]
Of course, upon reading this, you could say: “See! Trade can be bad! That’s why we need protectionist policies.” No. We don’t need protectionist policies as long as the central bank is doing its job and stabilizing the NGDP growth path. If the central bank responds by printing more money to counter the drop in the money supply, NGDP remains on its predicted growth path and everything goes well.
Now I understand that printing money to solve a problem may be anathema to some of my readers. But think of it this way: Chinese exporters are sending us a clear market signal: they currently value pieces of paper with pictures of dead presidents more than widgets. That’s why they don’t send the money back in exchange for different widgets stamped made in the USA. As a producer, the central bank should respond to this market signal and send them more of that which they seem to crave until the market clears.