Accounting 101 for Donald Luskin

Brad DeLong catches Donald Luskin failing to understand that “deficit” means the annual increase in “debt”:

When an American (1) labors or invests to earn money, (2) chooses to spend that money on foreign goods, and (3) the foreign maker of those goods doesn’t spend that money on American goods, somehow debt is created. I don’t see it. Where’s the debt? Or at least, where is the debt that arises uniquely in virtue of the trade deficit?

Brad seems to be wondering if Luskin really is the stupidest person alive given all the competition from his National Review colleagues, but I’d rather help this clearly confused person out as well as to see if he has any point in his confused rant. In a way, one has to start at the beginning with the simple notion that to intelligently opine on any issue first requires one understands the concepts including the appropriately terminology and then one has to know how to apply these concepts to real world data. Brad is noting that Luskin has skipped the freshman college lecture on the concepts before jumping into application. So forgive me for some rather obvious balance sheet and income statement ideas that apply to nations as well as to individuals.

One’s wealth can be thought of as the sum of one’s real assets and one’s net financial wealth. Savings (S) represents the flow increase in wealth with investment (I) representing the flow increase in real assets. The difference, often defined as a surplus, represents the flow increase in financial wealth. If a person – or a nation – investments more than it saves, then its financial wealth declines over time. In one way, a nation is a collection of individuals with one caveat (which will be important later) being that the nation’s population likely is growing over time. For a nation, the current account is defined as S – I, that is, national savings minus investment.

Luskin may be trying to argue what some conservatives claimed over 20 years ago – that the large current account deficits of the early 1980’s were not bad as they represented strong investment relative to moderate savings. If one goes back to 1980, the U.S. was described as the world’s largest creditor as our net financial wealth was quite high. Five years later, however, our net financial wealth was virtually zero. And we have continued to experience current account deficits, which implies that our net financial position is one of substantial debt. But haven’t we accumulated substantial real assets in the process according to Luskin’s “logic”.

To see why his logic does not apply well to the American economy, let’s consider a couple of hypothetical examples as we also remember what James Hamilton noted. In both of our examples, assume net national product is $10 trillion and consider the implications of a current account deficit equal to $0.5 trillion. In the first example, assume national savings is $3 trillion so investment is $3.5 trillion. In the second example, assume national savings is $0.3 trillion so investment is $0.8 trillion. Luskin seems to be talking about the first example where real assets are growing rapidly even relative to a growing population. While a net investment to NNP ratio may be a good description of the Chinese economy, the U.S. economy is more akin to the second example where real asset growth barely matches population growth. On a per capita basis, our real asset to worker ratio is not rising but our indebtedness to the rest of the world is.

Hamilton does a very nice job of explaining what the issues are. If an economy is investing a lot with most of its investment being from savings, then what Luskin has tried to express – albeit poorly – might make sense. But Luskin really does need to understand the real world point that U.S. savings is quite low.