Buying books vs. running a trade deficit with Mexico. sure on a micro level the author can run a deficit with the city of Pittstown and still be OK, just as the US could run a deficit with Mexico and still be Ok. I'm assuming that the author is running a surplus in the city where he earns his living. That is the reason the deficit in Pittstown is manageable. The US is running a large deficit overall and therefore the situation is much less manageable.

This is a better analogy. The author has a job which makes $50k a year, yet he spends $75k a year = earnings < spending.

How does he spend more than he earns? With credit card debt of course. The US issues and sells bonds as debt.

The author argues that a deficit is better than a surplus because credit will eventually be cut, but someone can save forever not living to their full utility (economics term for enjoyment). If these scenarios play out, here are the outcomes.

The person running a deficit is in debt without the earning power to get out. In this situation they have to cut their spending significantly and hope they can afford to feed themselves. Remember they cannot borrow any more and eventually their assets may be repossessed.

The person running a surplus can maintain his current standard of living forever. Depending on the size of his savings, he may be able to quit his job and live off the interest of the savings. He has no debt, only savings, and can most likely increase his utility/standard of living without any further effort or consequences.

Both scenarios are equally good?

That's not a good analogy for a trade deficit. One way of increasing the trade deficit is to borrow money and spend it. If you mortgage your house to buy books, that certainly increases the "trade deficit" with Barnes & Noble. But someone with, say, a $500K/yr. job could easily afford to spend $75K a year on books, and would run a massive "trade deficit" with B&N without going into debt.

It's a potential problem if US individuals or the US government go into massive debt, of course, but whether they use that debt to buy foreign or domestic goods is immaterial. If some of that debt happens to finance the purchase of foreign goods, it drives up the trade deficit, but the problem is the debt, not the deficit.

This looks like a linguistic problem as much as anything---people get so hung up on the word "deficit". Given its pervasiveness, though, I suspect that causation actually goes the other way: mercantilism is so intuitively appealing that the imprecise terminology seems almost inevitable.

The dollar was hugely overvalued (and still is, but less), as a direct result of China (and others) buying all this debt. By the time we repay this debt, the dollar will be less overvalued. This means that China gave us a $1=100 yuan loan, and gets back $1=80 yuan (numbers strictly made up, interest neglected).

To push the analogy way too far, it's as if I bought stuff on a credit card, with payments due in AngryProfessorBucks (which I can print as many of as I want).

So in short, it's good for us, but sucks for China. We get cheap products now, and pay for it with low value currency later.

If A sells to B sells to C sells to A, then they have just created three trade deficits. This is why "the trade deficit with China" is an utterly meaningless concept. Maybe China sells things to the US, which sells things to Mexico, which sells things to China, or any other transitive combination, and voila, a trade deficit.

The only trade deficit that is somewhat meaningful is the trade deficit of a country with the rest of the world, all of it. Now even that trade deficit needs to be taken with a grain of salt. If the US has a trade deficit with the rest of the world, you have to wonder for a minute why on earth the citizens of all those other countries would be so happy to send goods America-bound and not to receive equal value in return. Whence their charity? How come the free lunch?

When a good economist smells a free lunch, s/he smells murky accounting. And indeed, there's murky accounting in the trade deficit. Oftentimes, services are not included. Even if they are, then investment isn't. It just so happens that the US is a good place to invest, relative to other countries, because it has a very well developed economic and financial system that can take advantage of capital well and bring high returns in capital-intensive industries. China, on the other hand, lacks the institutions required to make capital-intensive industries quite as lucrative, but it has cheap labor. Thus both countries specialize, but the Chinese investments flowing into the US bought with the money that Americans paid the Chinese to buy their goods--those investments simply do not count.

Hey! A deficit!

Is it a big deal?

Mwah... no.

Why is this so? Imagine there are only two countries in the world, USA and Japan, and US has a trade deficit. This means Japanese manufacturers sell their goods and do not convert all of what they earn in yen, they keep some part in US dollars. These money are directly or indirectly invested in US: if people keep these money in the bank, the bank invests them. Sorry, I'm not precise, but I hope you get the point.

Now, it doesn't say if the investment is good or bad: the invested money can be happily consumed and the investor could get less or nothing for his money. It doesn't also say who owns (controlls) what: it may turn out that after a while some part of the US economy is owned by Japanese, depending on what they choose to do with their money.

In other words, we would send dollars to country X and receive goods in return. Instead of sending back those dollars to us and receiving goods from us, they would stuff them under a mattress, or in their government reserve vaults, because their own local currency was not considered as trustworthy.

In recent years, foreign governments have begun viewing the euro as a strong, stable currency, and have been diversifying their reserves by getting rid of dollars and stocking up on euros. Two of the recent effects of that phenomenon have been a declining dollar (as with anything, its price goes down when there is a sudden flood of sellers), and high U.S. asset prices (because now the dollars are coming out of the mattresses and vaults, and being used to buy stocks and property).

Usually they take the cash and invest it in US Government Bonds or private stocks and bonds. This high demand for bonds means our government can offer them at really low rates, and there are still takers. (China has something like $300 billion of US Bonds.) This is an added bonus for us. In this way, our currency's primary status is kind of self-perpetuating. Our currency is backed in faith in the solvency of the US Government, and our Government can borrow money really really cheaply to deal with any crisis it needs to, keeping it solvent where other governments would fail.

(For anyone out there that is scared what will happen if the rest of the world started dumping it's dollar-back assets, remember that less than half of the 'National Debt' is owed to foreigners, and many of these countries use dollars to stabilize their own currencies, so this would amount to financial suicide for them.)

The trade deficit shows that the US is importing more than it exports, but the current account deficit shows that the US is spending more than it earns. The problem with a growing current account deficit is that an increasing proportion of US income (GDP) is required for factor payments (ie. interest/dividend payments to other countries for their investments in the US). This is basically what is meant when they say that the US is borrowing from the rest of the world. And obviously it isn't sustainable.

Let's say A, B and C all have balanced trade:

If A sells soda for 1USD to B then: A has a trade surplus of 1$. B has a trade deficit of 1$. C has balanced trade.

If B then sells apples for 1USD to C then: A still has a trade surplus of 1$. B now has balanced trade. C has a trade deficit of 1$.

If C then sells corn for 1USD to A then: A, B and C have balanced trade.

The problem is when B and C trade with something other than dollars. China is keeping a large quantity of USD on hand and not trading them which messes with the value of the USD.

The US won't default on bonds anytime soon. But they are only bulletproof in terms of value when you measure value in US$ - and not in adjusted terms (inflation, purchasing power paritiy, exchange rate, etc).