When the Sage of Omaha, Warren Buffet, fretted last year that the trade deficit signified that foreigners were taking over the United States, he echoed common misunderstandings about the excess of U.S. imports over exports and the growing volume of dollar assets held by the rest of the world.

(See: “Warren Buffett fears foreign ownership“)

However, like many, many others, Mr. Buffett did not correctly distinguish between a trade deficit that is in foreign currency and one that is in the currency of the country with the deficit.

The nice thing about the U.S. trade deficit is that it represents the exchange of foreign goods and services for dollars, not foreign money. Dollars (like other money today) is fiat currency. In other words, if you go to the U.S. Treasury with your dollars, they will give you back dollars — not gold, or euros, or Indonesian Rupiah — just dollars.

That means that when the rest of the world gets tired of holding dollars and investing in U.S. bonds and equities, the only way that these dollar-holders can ‘redeem’ the currency is to buy stuff in the United States.

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