Free traders love quoting Adam Smith’s dictum that “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” And rightly so. If it’s inefficient for a household to bake its own bread, sew its own clothes, and generate its own electricity, why should a nation aspire to that same miserable fate?
The insight underlying Smith’s line is the division of labor. We don’t produce everything we consume. Instead, we specialize in the jobs we’re best suited to perform, then trade for the things that we aren’t as efficient at producing. Families do it. Firms do it. So do nations.
But lately, protectionists have taken to throwing Smith’s maxim back in our faces. “Would you run persistent trade deficits with other households?” they ask. “Of course not. Eventually, you’d hit your borrowing limit, or worse, bankruptcy. Why should a country be any different?”
It’s a clever retort, but it misses a critical distinction between individual households and a nation’s economy.
Yes, a family running monthly deficits—spending more than it earns—must cover this shortfall either by drawing down savings or taking on debt. A dad can’t, say, sell equity stakes in his children’s future income to foreign investors.
But nations aren’t households. American companies routinely sell equity to foreign investors, and with economy-expanding results.
When the U.S. runs a trade deficit, it’s not necessarily because Americans are recklessly swiping the national credit card. It can be because foreigners are eager to invest in American assets such as commercial stocks. That capital inflow is the mirror image of the trade deficit.
Here’s one way it can and does play out. First, foreigners send us more goods than we send them, and in return, they receive equity claims on American businesses—not future IOUs, but ownership stakes in a positive-sum economy they’re helping to grow.
“Claims” on our productive capital still sounds vaguely negative, as if a repo agent is entitled to collect his pound of flesh. But it’s only negative if the economy is zero-sum. Thankfully, it’s not. Those capital inflows don’t just fund our consumption. They also fuel production and the creation of new wealth. When foreign capital inflows enable a company to build a new factory in Tennessee, that’s recorded as part of the capital account surplus. It’s also a trade deficit. But is it a loss? Hardly. That factory hires American workers, pays American wages, and produces goods that raise American living standards.
This hypothetical isn’t all that hypothetical. The U.S. has run persistent trade deficits for half a century, all while output has grown, real wages have risen, and living standards have soared. Foreign investment has helped fuel this prosperity, not by indebting us to foreigners, but by letting them partner with us.
Protectionists get this relationship all wrong. They see the trade deficit and assume a hollowing out of the domestic economy. But trade deficits (capital inflows) aren’t hollowing out American production. They’re infusing it with better tools and new life. When foreigners want to invest in U.S. assets, that’s not a sign of weakness but a vote of confidence.
To be fair, protectionists aren’t entirely wrong—for households and governments. We readily grant that neither families nor governments can borrow and spend their way to prosperity. (U.S. government, take note).
Where protectionists go wrong is in drawing a direct parallel between a household’s or government’s budget deficit and the economy’s trade deficit. Trade deficits are not budget deficits. They aren’t necessarily a debt that must be repaid.
The real folly lies not in running a trade deficit, but in misunderstanding what it is. We don’t fear capital inflows when they show up as new jobs, new factories, and new opportunities. Nor should we fear the trade imbalances that reflect them.
Smith’s wisdom remains undefeated, just not in the way protectionists imagine. Trade deficits aren’t our undoing. They’re a sign the world still wants a stake in the American dream.
