Edward Lazear Explains the Trade Deficit with an Identity

James Pethokoukis interviews the chairman of the Council of Economic Advisers:

On the trade deficit: The reason for the trade deficit … is primarily, to my mind, the capital account surplus. It’s not the trade deficit per se. It’s that people want to invest in the United States. … I think of that as a good thing.

It does seem that Pethokoukis left out part of Lazear’s statement so it’s hard to tell what he really said here. But if this captures the essence of what Lazear said, one has to wonder how got a degree in economics. The balance of payments identity states that the sum of the current account and the capital account must be zero unless the Central Bank (for the U.S., the Federal Reserve) is engaging in reserve intervention. In other words, it is true that we have a large capital account surplus that corresponds to the large current account deficit BY DEFINITION. But what is deriving this result? That an identity balances cannot answer this question. My answer has tended to be that we have decided as a nation to save very little so that the degree that we do have investment spending means we have to lean on foreigners to loan us the proceeds. Now if our investment demand was very high – that might be a good thing. But investment demand is not that high.

Our graph shows (gross) investment relative to GDP from 1977 to 2006. This ratio tends to be cyclical so it is a bit higher now than it was in 2002. But also notice that the ratio fell after the 1981 tax cut and is now lower than it was in 2000. Do I blame tax cuts designed to encourage people to consume more that were not accompanied by reductions in government purchases. Both of these periods of fiscal irresponsibility were accompanied by increases in the current account deficit. I guess Edward Lazear is not free to criticize the fiscal irresponsibility of his boss or to discussion the reduction in national savings. So all he is allowed to do is talk about identities as if they can tell us what is cause and effect.