As I noted in my previous column, foreign holdings of U.S. dollars are classified as foreign holdings of U.S. assets and, therefore, contribute to the U.S. trade deficit. However, as I argued, it would be perfectly reasonable to classify foreign holdings of US dollars not as holdings of US assets, but as foreign purchases of a US export: purchases, specifically, of the services of a currency especially useful for holding or for global trade.
Because of the high global demand for U.S. dollars or their use for international trade, this alternative classification would dramatically reduce the magnitude of reported U.S. trade deficits. These "deficits" represent the excess of U.S. imports over U.S. exports, so this alternative classification would reduce U.S. trade deficits by increasing the reported amount of U.S. exports relative to U.S. imports. (Since trade, or "current account" deficits are precisely offset by capital account surpluses, another consequence of such a reclassification would be to decrease the reported size of U.S. capital account surpluses.)
Measured trade balances would change significantly without any change whatsoever in the underlying economic forces and facts that give rise to international trade and investment flows. Understanding this reality helps to understand how absurd it is for Americans to worry about the accounting artifice called the "U.S. trade deficit."
"But," someone might object, "since foreigners who hold U.S. dollars eventually intend to use them to purchase U.S. goods, services, or assets, those dollars represent debts owed by Americans to foreigners. After all, dollars are claims on goods, services and assets denominated in dollars. Therefore, when foreigners hold U.S. dollars, they have claims on U.S. assets; that is, for every U.S. dollar currently held by foreigners, Americans owe a dollar debt to foreigners."
While this objection is understandable - I often find it even from intelligent people committed to free trade - it is wrong. The holding of U.S. dollars by foreigners does not obligate Americans to pay debts to foreigners.
To understand why foreign holdings of U.S. dollars do not constitute U.S. debt, consider the following simple example. In March, the only international trade that occurs is when Joe in Jacksonville buys $1 million worth of tomatoes from Mia in Mexico, and then Mia immediately uses that $1 million to buy $1 million worth of oil from Dave in Dallas. In this case, the U.S. in March has neither a trade deficit nor a trade surplus; the value of U.S. exports equals the value of U.S. imports. Protectionists breathe a sigh of relief.
However, in April, although Joe in Jacksonville buys back $1 million worth of tomatoes from Mia in Mexico, Mia now keeps all of her newly acquired U.S. Federal Reserve bills. As a result, the U.S. posts a $1 million trade deficit in April. Protectionists are expressing concern. In fact, they will insist that, as a result of this trade deficit, Americans have become $1 million in debt to foreign countries.
However, this claim of increased indebtedness is erroneous. If Mia had lent the $1 million to Americans - for example, if she had bought $1 million worth of U.S. Treasury bonds - this $1 million U.S. trade deficit would, in fact, represent an additional $1 million of U.S. debt to foreigners. But Mia doesn't lend the dollars to anyone; she keeps them (imagine keeping them in her subway safe in Mexico City).
No U.S. person is obligated, as a result of Mia's holding her U.S. dollars, to pay her anything, whether money or goods and services. If Mia's dollar holdings do not obligate any U.S. person to pay her (or anyone else) anything, it cannot be reasonably asserted that her dollar holdings constitute U.S. debt to foreigners. It follows that the $1 million trade deficit caused by Mia's decision to keep her $1 million does not increase the indebtedness of Americans.
This conclusion could be challenged by two possible objections. One is that U.S. dollars, being Federal Reserve-issued bills, are redeemable at the Fed. That is, the Fed is obligated to redeem Mia's dollars if Mia presents them. And since the Fed is the central bank of the United States, Americans are effectively indebted to foreigners to the tune of $1 million as long as Mia holds that $1 million.
If the United States still followed the gold standard, this challenge would have some merit. Under the gold standard, when someone presented the one million Federal Reserve bills to the Fed, the Fed was obligated to deliver one million dollars in gold in return. But the U.S. abandoned the gold standard in 1934. (Well, practically abandoned it; the U.S. abandonment of the gold standard was not completed until August 15, 1971, a story for another time.) If Mia presents her one million Federal Reserve bills to the Fed in 2025, she will receive one million Federal Reserve bills in return. In effect, the Fed owes Mia nothing.
The second and more substantial possible challenge to the above conclusion is the following: because Mia can use her dollars to purchase $1 million worth of goods, services or assets from Americans, her dollar holdings represent $1 million worth of goods, services or assets that Americans will deliver to a foreigner and therefore not retain for themselves.
The key phrase in the preceding sentence is "shall deliver to a foreigner". If Mia's dollar holdings were actual debt, the sentence would have been "must deliver to a foreigner." The difference between "shall deliver" and "must" is crucial.
The simple fact that no American is obligated to give Mia anything in exchange for her dollars means that no American can rightly be said to be beholden to foreigners. No legal or ethical duty would be breached if all Americans refused to give Mia anything in exchange for her dollars. If everyone did so, Mia would find herself with a large amount of worthless paper money and would have no legal or ethical recourse to recover what she once believed to be the purchasing power of her dollars.
However, in reality, Mia can spend her U.S. dollars to purchase goods, services or assets. Many Americans will be eager to acquire Mia's dollars by giving up their goods, services or assets. Crucially, however, precisely because no American is legally (or ethically) obligated to sell her anything, no American owes her money. When Mia spends her dollars in the United States, every American she deals with benefits, and not as a debtor by repaying a debt.
Americans who sell goods, services or assets to Mia are not canceling any debts they have incurred in the past. Unlike a genuine debtor, who would benefit if his creditor said, "Don't bother paying me. Don't give me anything," Americans selling to Mia would be harmed if, just before the sale was finalized, Mia said, "Never mind, I don't want to buy what you're selling." No American who sells to Mia is obligated to sell to her and, therefore, benefits as a result of selling to her.
"Wait a minute!" someone might object, "Mia's dollar holdings give her the practical power to acquire $1 million worth of American goods, services, or assets; things that, if Mia did not have those dollars, would be available for purchase by Americans. The result is a loss to Americans."
So it would seem. But since any goods, services or assets that Mia buys from Americans with her dollars were produced by Americans in the hope of selling them at a higher price, if Mia were to lose her dollars - or if the government were to prevent her from spending or investing them in the United States - some Americans, in their role as producers, would suffer. The losses suffered by U.S. consumers as a result of Mia spending their dollars in the United States are more than offset by the gains of those who sell their goods, services or assets to her.
How do I know that U.S. sellers' profits are greater than U.S. consumers' alleged losses? (I say "alleged U.S. consumers' losses" because Mia's spending of dollars does not cause any American to lose anything to which he or she is legally entitled.) Easy. No U.S. buyer was willing to pay as much as Mia paid for the goods, services or assets it acquired from the United States. The value of what U.S. sellers sell to Mia is obviously greater than what any American was willing to pay for those goods, services or assets. Perhaps, for example, no American was willing to accept less than 160,000 bushels of wheat in exchange for $1 million, while Mia was willing to accept 159,900 bushels. The American sellers got more in return for selling to Mia than any American buyer was willing to give.
Language is important and influential. By calling foreign holdings of U.S. dollars "U.S. debt," the impression is given that such holdings represent a burden on Americans. And from this impression, it is a short, albeit unwise, step to the conclusion that the U.S. government should restrict the trade of Americans to protect them from creating such a burden on themselves. However, this impression is false: foreign holdings of U.S. dollars do not constitute U.S. debt at all.
Donald J. Boudreaux, The Daily Economy