In part #1 of this series on international flows, Norway’s trade deficit of the 1960’s was associated with foreign investment coming into their country. So the net trade deficit of the Current Account was matched by the net foreign investment surplus of the Capital and Financial Account.
There is a principle in international income accounting… A country’s Current Account balance is matched by Net Foreign Investment.
But we need to look at the relationship more closely. Which one is driving the other? Does a trade deficit simply determine the amount of net foreign investment? or does the desire of investors in general determine the amount of a trade deficit?
You might find someone saying that the US trade deficit is financed by the US receiving loans and investments from abroad. But we must realize that foreign investors want to invest their money in the US. Their desire can change the level of our trade deficit. The US is safe, even though the returns are lower. There is a risk-return relationship as to why foreign investors want to put their money in US stocks or real estate. And so we need to realize that the changing desire of investors, domestic and foreign, can determine the level of our trade deficit.
So what happens when China runs a Current Account surplus? China is taking the surplus and accumulating financial assets abroad. China could keep the surplus for themselves but what would happen to their currency? With too much demand for their currency from imports, their currency would appreciate making their exports most costly. They want to keep their exports cheap. So China puts that surplus into other countries through the foreign-exchange market. The other countries receive those funds.
If we don’t like receiving so many funds from China, what can we do about it? Well, we could change the Current Account balance that we have with China and other countries. How would we do that?
Savings and Investment
The Current Account balance is equal to the net savings and net borrowing, public and private, within a country. We have the equation…
Current Account deficit (net borrowing from abroad) = (G – T) + (I – S)
G = govt spending
T= tax revenues
(G – T) = net public borrowing
I = private investment
S = private saving
(I – S) = private net borrowing
So, if we wanted to change our Current Account deficit to a surplus, we would have to…
- raise taxes (kind of unpopular and there is a movement against higher taxes).
- lower govt spending (being done as we speak).
- raise private saving (hard to do when labor share of income is falling and returns are so low).
- lower private investment (but the Fed is trying their hardest to raise investment)
Companies like Walmart that rely on cheap imports want taxes to be lower. They want people to be paid less so that savings rates are lower. They want their employees to use government services to raise government spending. They want investment to be financed by money from foreign countries, and not domestic sources. It creates a bigger import market. Companies like Walmart perpetuate the US trade deficit because it increases their business.
You may be able to see that the US trade deficit is a result of lowering taxes and lowering the private saving rate over the years. A situation was created where we did not give ourselves enough domestic funds for govt spending and private investment. So we had to get those funds from abroad, which exacerbated the trade deficit.
But hold on… there are many ways to grasp this dynamic of a trade deficit…
Let’s look at this from an opposite perspective… Maybe the drop in tax revenues and the saving rate was the result of the trade deficit? Let’s face it, if all of a sudden you have these huge imports coming in at low prices, imports will increase. Then all of a sudden you have these foreign countries bringing back those dollars to invest in the US (by the dynamic of Balance of Payments and currency stabilization). Then we realize that the government can lower taxes because other countries are buying its bonds. Then we can suppress real wages, because savings from labor is no longer needed.
But then from another perspective, did imports rise because there was previously a big wave of foreign funds coming to the US?
Let’s go back in time a little further… the early 1980’s
In the early 1980’s, interest rates soared in the US thanks to Volcker. Yes, and returns to investment rose along with them. Foreigners wanted to invest in the US by the truckloads. Private saving was dropping. The US was safe and had long-term growth plans. Japan had money to invest. (I remember the house in Hawaii I was living in went from $130,000 to over $1 million.) Europe had troubles with unemployment and low growth. As more foreign money was being attracted to the US, the US trade balance (Current Account) started to turn negative.
But when did imports start to increase? Imports started to increase in the second half of 1982 into the first half of 1983… as the high interest rates of the Volcker recession were coming down. Coincidence? Not really. The dynamics for equilibrium in the international flows encouraged growth in import markets from tremendous foreign investment in the US. At that point, the US had to find a way to return those foreign investments by way of the Balance of Payments. The money was there to develop the import markets. And the development of those import markets was rapid, as is the beauty of capitalism.
A case can be made that Volcker is to “blame” for triggering the trade deficit by attracting large amounts of foreign investment in US assets. We have had 30 years of rising bond prices and many think the end of that is now. Will foreigners continue to invest in US assets? Will companies like Walmart be able to influence politics in order to sustain low domestic saving, private and public?
The dynamics that created the US deficit and to this day sustains it are thoroughly logical. There is no inherent problem with a trade deficit, but the US trade deficit has its advantages and its risks.