Saturday, February 25, 2006

Statistical Illusions

Don Boudreaux at "Cafe Hayek" is the best on the web at explaining economics.

The argument – or, at least, my argument, and I dare say Arnold Kling's argument – that the trade deficit is a red herring is not an argument that an individual, a family, or a firm that consistently spends more than it earns need not worry. Nor is it an argument that the level of savings and investment doesn’t matter. Nor is it an argument against the proposition that Uncle Sam’s profligate spending is wasteful and harmful.

Instead, the argument is that any nation that is reasonably free and open is not a salient economic unit.

Suppose that South Dakota and North Dakota each cede from the U.S. Each of these former states is now an independent country. One is the Republic of South Dakota; the other is the Republic of North Dakota. Happily for the citizens of each of these countries, their respective governments leave them free to trade domestically and internationally – but, for whatever reason, the people of each country of Dakota choose voluntarily not to trade with citizens of the other Dakota. (This last assumption is made only to keep the arithmetic of this example clean, as I hope will become clear below; it is not at all necessary for the validity of my point.)

Further suppose that for each of the past several years citizens of the Republic of South Dakota export $150 worth of goods and services and import $110. Statisticians working for the government of the Republic of South Dakota find that this country runs a current-account surplus of $40.

But the citizens of the Republic of North Dakota, for each of the past several years, export $100 and import $160. Statisticians for the Republic of North Dakota find that this country runs a current-account deficit of $60.

Conventional wisdom says that South Dakotans’ trade is “sustainable,” while North Dakotans' trade is “unsustainable.” This wisdom praises South Dakotans for their thriftiness and enterprise, and warns North Dakotans of their profligacy.

Now let the two countries merge politically to form the independent Republic of the Daktotas. Let each person’s, each family’s, each firm’s – as well as the now-unified-government’s – income-earning activities, spending, saving, and investment practices remain unchanged in light of this political unification.

Statisticians for the newly formed Republic of the Dakotas will find that this country runs an annual current-account deficit of $20. The reason is that total exports are $250 (made up of $150 worth of exports from the southern part of the country and $100 of exports from the northern part) and total imports are $270 (made up of $110 imports into the southern part of the country and $160 imports into the northern part).

Is the welfare of any citizen of the Republic of the Dakotas materially changed because each now lives in a country that officially runs a current-account deficit? Were Dakotans in the southern part of the country in sound economic health before the political unification but now in economic distress after unification? Are people in the northern part of the country better off after unification because now their country’s current-account deficit is only $20 (rather than the $60 that is was before unification)?

Answers: no, and no.

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