As I pointed out in my previous column, foreign holdings of US dollars are classified as foreign holdings of US assets and therefore contribute to the US 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: specifically, purchases of the services of a currency that is particularly useful for maintaining or conducting global trade.

Due to the high global demand for US dollars or their use for international trade, this alternative classification would drastically reduce the magnitude of the trade deficits reported by the United States. These “deficits” represent the excess of US imports over US exports, so this alternative classification would reduce US trade deficits by increasing the reported amount of US exports relative to US imports. (Since trade deficits, or “current account” deficits, are precisely offset by capital account surpluses, another consequence of such reclassification would be a decrease in the reported magnitude of US capital account surpluses).

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 “US trade deficit.”

“But,” someone might object, ”since foreigners who hold US dollars eventually intend to use them to buy US goods, services, or assets, those dollars represent debts that Americans owe to foreigners. After all, dollars are claims on dollar-denominated goods, services, and assets. Therefore, when foreigners hold US dollars, they have claims on US goods; that is, for every US dollar currently held by foreigners, Americans owe a dollar to foreigners."

Although this objection is understandable—I often encounter it even from intelligent people committed to free trade—it is mistaken. Foreigners' holdings of US dollars do not obligate Americans to pay debts to foreigners.

To understand why foreign holdings of US dollars do not constitute US 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 Mia then immediately uses that $1 million to buy $1 million worth of oil from Dave in Dallas. In this case, the US has neither a trade deficit nor a trade surplus in March; the value of US exports equals the value of US imports. Protectionists breathe a sigh of relief.

However, in April, although Joe in Jacksonville again buys $1 million worth of tomatoes from Mia in Mexico, Mia now keeps all of her newly acquired US Federal Reserve notes. As a result, the United States records a trade deficit of $1 million in April. Protectionists express 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 million dollars to Americans—for example, if she had purchased a million dollars worth of US Treasury bonds—this US trade deficit of a million dollars would indeed represent an additional million dollars of US debt to foreigners. But Mia does not lend the dollars to anyone; she keeps them. (Imagine she keeps them in her underground vault in Mexico City.)

No American is obligated, as a result of Mia keeping her US dollars, to pay her anything, whether money or goods and services. If Mia's dollar holdings do not oblige any American to pay her anything (or anyone else), it cannot reasonably be claimed that her dollar holdings constitute US debt to foreigners. It follows that the US trade deficit of one million US dollars caused by Mia's decision to keep her one million US dollars does not increase the indebtedness of Americans.

This conclusion could be challenged by two possible objections. One is that US dollars, being banknotes issued by the Federal Reserve, are redeemable at the Fed. In other words, the Fed is obliged to redeem Mia's dollars if she presents them. And since the Fed is the central bank of the United States, Americans are effectively indebted to foreigners for $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 million Federal Reserve notes to the Fed, the Fed was obliged to deliver $1 million in gold in exchange. But the United States abandoned the gold standard in 1934. (Well, it practically abandoned it; the US abandonment of the gold standard was not complete until August 15, 1971, a story for another time.) If Mia presents her million Federal Reserve notes to the Fed in 2025, she will receive a million Federal Reserve notes in return. In effect, the Fed owes Mia nothing.

The second and more substantial possible challenge to the above conclusion is as follows: because Mia can use her dollars to purchase goods, services, or assets worth $1 million from Americans, her dollar holdings represent goods, services, or assets worth $1 million that Americans will deliver to a foreigner and therefore not retain for themselves.

The key phrase in the previous sentence is “will deliver to a foreigner.” If Mia's dollar holdings were real debt, the phrase would have been “must deliver to a foreigner.” The difference between “will” and “must” is crucial.

The simple fact that no American is obligated to deliver anything to Mia in exchange for her dollars means that it cannot reasonably be claimed that any American is indebted 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 acted this way, Mia would be left 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 dollars in the US to buy goods, services, or assets. Many Americans will be eager to acquire Mia's dollars by giving up their goods, services, or assets. However, it is crucial that, 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 paying off a debt.

Americans who sell goods, services, or assets to Mia are not paying off any debt they 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 who sell to Mia would be harmed if, just before completing the sale, 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 didn't have those dollars, would be available for Americans to purchase. The result is a loss for Americans.”

So it seems. 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 lost her dollars—or if the government prevented her from spending or investing them in the US—some Americans, in their role as producers, would suffer. The losses suffered by American consumers as a result of Mia spending her dollars in the US are more than offset by the gains of those who sell her goods, services, or assets.

How do I know that the gains of US sellers are greater than the supposed losses of US consumers? (I say “supposed losses of US consumers” because Mia's spending of dollars does not cause any US citizen to lose anything to which they are legally entitled.) Easy. No US buyer was willing to pay as much as Mia paid for the goods, services, or assets she acquired from the US. The value of what US 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. US sellers got more in exchange for selling to Mia than any US buyer was willing to give.

Language is important and influential. By calling foreign holdings of US dollars “US debt,” the impression is given that such holdings represent a burden on Americans. And from this impression, it is a short, albeit reckless, step to the conclusion that the US government should restrict Americans' trade to protect them from creating that burden. However, this impression is false: foreign holdings of US dollars do not constitute US debt at all.

Donald J. Boudreaux, The Daily Economy