Saturday, August 10, 2013

What is Trade?

A lot of discussion of trade is heard in the media, from pundits, from economists, and those in the financial sector.  But what exactly are they talking about?  And are they all taking about the same thing?  Unfortunately, what passes for trade today isn't really trade, and this fundamental misunderstanding is at the root of many of our trade problems today.

Trade: "An exchange of property usually without use of money".  That's the classic dictionary definition.  It's pretty simply really.  Its just like when you traded baseball cards as a kid.  I'll give you Micky Mantle for that Babe Ruth (we wished ;).  Or if you go to a swap meet.  I'll trade that casserole dish for that crock pot.  When applied to nations trade is fundamentally the same, but with a slightly different mechanism to execute the trade.  Trade between nations is the exchange of goods and services produced in one nation for some goods and services produced in another nation.  For example, let's say John in the US produces lamps and Luigi in Italy produces soccer balls.  John wants some Italian soccer balls and Luigi wants some cool American lamps.  So, they get together and agree on a trade, John will trade 10 lamps for 50 soccer balls, to which Luigi agrees.  They make the exchange and the goods are delivered.  The trade is then settled, with each side getting what it agreed to.  This is key, the trade is settled.  There are no outstanding claims and their business is done.

Trade between nations is a bit more complicated than the previous example as it is very difficult to match up two parties that have exactly the goods each other wants.  In practice this never happens.  Instead, trade between two nations is performed using the currencies of the two nations involved.  Trade between nations isn't an exchange of property as in the definition above, rather trade is a set of  two-currency purchase and sale agreements.  In other words, the financial sector is interposed between every trade.  That is, banks and currency exchanges participate in the trade, and this is the source of most of our trade problems today.  Let's revisit the example of John and Luigi. Under this new method, John still has lamps he wants to get rid of and get soccer balls, and Luigi still has soccer balls he wants to part with to get lamps.  The sequence of events changes however with the introduction of money.  Now, John exports his lamps to Italy and sells them for EU700 to, as it happens to Luigi, but John doesn't want Euros as he lives in the US, he wants dollars.  Luigi exports his soccer balls to the US and sells them for $1000, which John then buys, but similarly Luigi doesn't want dollars because he lives in Italy, he wants Euros.  At this point both sides have sold of the goods that they have to trade, and purchased the goods they wanted.   But, they both had to dig into their savings in their own currency to buy the goods, and they are sitting with the foreign currency in hand for the goods they sold.  Why would they agree to do this?

Because they know that they can exchange the foreign currency for their home currency.  In this case, $10 exchanges for EU7, so the $1000 Luigi has is exchanged for EU700 that he wants, and similarly for John.  They both go to a local bank or currency exchange and exchange the foreign currency for their local currency which they can use.  Both of them then replenishes their savings accounts and the trade is settled.  That is the key here.  The trade is only settled when the goods are exchanged AND the money accounts are balanced.  Until that happens the trade is NOT settled.  This is the major part of the trade problem of the US today.  We have a large, ongoing unsettled trade, known as the trade deficit.  That will be dealt with in a future post.

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