"Tyler Cowen writes:
This framework makes Conard a revisionist on the U.S. trade deficit. The traditional story is that Americans buy goods from, say, East Asia, and the sellers respond by investing those dollars back in the U.S., a win-win situation. Conard believes that analysis would hold only if people who accumulate cash from foreign transactions invest their funds into risky, innovative enterprises. But too often they buy government securities, and so Conard views the U.S. trade deficit as something that makes the government bigger without making the economy more dynamic. This confounds the traditional libertarian defense of free trade by indicating that we are not really getting market-oriented investments when the funds return.
This is part of his article discussing Edward Conard's new book, The Upside of Inequality.
I'll assume that Tyler is stating Conard's view accurately. If so, Conard is wrong. The trade deficit per se does not make the government bigger or smaller. What makes the government bigger is more government spending, more regulation, etc.
There's another problem. First, let's recognize that when people use the term "trade deficit," they mean "current account deficit." When there's a current account deficit of magnitude x, there's a capital account surplus of magnitude x. This is a mathematical necessity. Second, let's recognize that there is likely to be, for the next few years, a large U.S. government federal budget deficit.
Now to the analysis. For a given size trade deficit, there's a same-size capital account surplus. Let's say there's also a large U.S. federal budget deficit. Whether foreigners buy bonds to finance the budget deficit or Americans buy bonds to finance the budget deficit, the budget deficit is financed. If foreigners buy more bonds, then Americans buy fewer bonds and invest in those "risky, innovative enterprises." So it's hard to see why foreigners buying bonds means that there's less investment in those enterprises.
Now it's quite possible that the higher U.S. federal budget deficit crowds out investment in those enterprises. But then it's the U.S. budget deficit doing that, not the foreigners' choice of U.S. assets to invest in."