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I've been reading Henry Hazlitt's Economics in One Lesson and he said something about free trade and tariffs that I don't quite understand.

He uses the example of buying cheaper English sweaters over more expensive domestic sweaters. He says, "By buying English sweaters they furnish the English with dollars to buy American goods here. This is in fact the only way in which the British can eventually make use of these dollars."

I guess this another way of saying current account deficit = capital account surplus. That makes sense. What I don't understand is why importing goods from other countries necessitates that they invest that money back in the US. In his example, why are we able to pay other countries in American dollars instead of, say, British pounds, but the British are only permitted to pay the US in US dollars?

I hope this question makes sense. Thanks for any clarification you can provide.

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    $\begingroup$ Hazlitt's claim is oversimplified at best. Buying American goods is not the only way for British people (or indeed any other people) to make use of dollars. Take $10,000 to pretty much any country you like and you will have your counterexample. $\endgroup$ – afreelunch Mar 16 at 17:13
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The author is simplifying things a bit, of course, given the concise nature of the publication.

I believe the main point he is trying to make is that in the long run, current accounts will be balanced. Suppose, following the author, that the domestic economy (us) is the U.S. So, if we buy cheaper British sweaters today, eventually American goods will be purchased in return.

The idea, is that the US dollar is legal tender only (or primarily) in the United States. The British may accept the dollar as payment for their sweaters, but only because they know it will be accepted as legal tender by others (e.g. the U.S.) and others accept it only because the U.S. accepts it. This circular thinking only closes with the U.S. and hence with U.S. goods being purchased at some point. If the U.S. stopped accepting dollars, then dollars would stop being accepted (almost) everywhere.

The British may also pay the Americans in pounds. However, the same logic applies. Americans only accept pounds, because eventually those pounds will be accepted elsewhere as payment, which hinges on the UK accepting pounds as legal tender. They are eventually only (or primarily) accepted in the UK then, e.g. for buying British sweaters. However, this case already starts with American goods being purchased, which is the author's point.

Another alternative would be the Americans paying in pounds. However, for Americans to get pounds, they would have had to sell good to the British in some form at some point.

In all cases, trade (through cheaper products abroad, e.g. British sweaters) involves American good eventually being purchased.

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  • $\begingroup$ Would any of the calculus change if you had a universal currency like gold? $\endgroup$ – namarino Mar 20 at 4:33
  • $\begingroup$ No, the principles would stay the same. $\endgroup$ – BB King Mar 24 at 9:58

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