Americans have a tendency to ignore the international sector of the economy. Although the trade deficit, especially with China, animates a few people, hardly anyone ever complains about the current account deficit, which occurs when imports of goods and services are greater than exports. Yet in many ways, this factor has been at the core of our economic problems and there is reason to believe that it will continue to be so in the future.
In simple terms, when a nation runs a trade deficit it has to be financed. It can be financed two ways — from the earnings on international investments or by capital inflows from foreigners. The Commerce Department calculates these numbers, which usually go unnoticed in the media. They show that our current account deficit rose from $398 billion in 2001 to $803 billion in 2006. In 2009, the current account deficit fell to $420 billion.
The current account deficit is largely driven by the trade deficit; the balance consists mostly of returns to foreigners on their investments here, military operations and foreign aid programs. In 2001, for example, the trade deficit, including both goods and services, was $365 billion. It rose to $760 billion in 2006 and was $379 billion last year.
One problem with analyzing the trade and current accounts deficits is figuring out cause and effect. Most politicians tend to look at the issue from the bottom up, so to speak. They look at foreign barriers to U.S. exports and foreign subsidies for exports to the U.S. Such subsidies may take many different forms — tax benefits, low-cost government loans, etc.— but the biggest “subsidy” is a manipulated exchange rate that is held artificially low vis-à-vis the dollar.
China is, of course, the principal offender. In a free market the Chinese currency would undoubtedly be higher when pitted against the dollar. The Chinese government holds it below market levels by selling as much of its own currency as necessary to maintain its target exchange rate. When it sells its own currency, it mostly buys dollars, thus simultaneously lowering the value of its own currency and raising the dollar. These dollars are in effect lent back to the U.S. because the Chinese use them primarily to buy U.S. Treasury securities, on which we pay them interest.
Thus, to many people, the solution to the current account and trade deficit problems is to get the Chinese to allow their currency to rise. This will make Chinese goods more expensive in terms of dollars and American goods cheaper in terms of Chinese currency. For many years, the Treasury Department has pressured China to raise its exchange rate in order to redress the bilateral trade deficit and reduce political pressure for tariffs and import quotas.
The Savings Imbalance
However, there is another school of thought which says that the trade deficit is merely the manifestation of a deeper issue — the imbalance between domestic saving and investment. When there is insufficient domestic saving — foregone consumption — to finance investment in new plants and equipment, then this ‘saving’ can be imported. This imported saving necessarily takes the form of goods and services that are not available domestically because domestic consumption has preempted the use of domestic production for investment purposes.
Thus the trade deficit is really the result of insufficient domestic saving. And by saving I mean gross national saving — the sum of savings by households, businesses and governments. When any of these groups goes into debt, that counts as negative saving. Therefore, the federal budget deficit is a primary cause of the insufficiency of domestic saving to finance domestic investment.
While it is simplistic to say that the budget deficit causes the trade deficit, there is unquestionably a relationship. Insofar as budget deficits deplete domestic savings that would otherwise be available for investment, they necessitate either the importation of foreign saving or a reduction of domestic investment, which in the long run will reduce productivity and standards of living. (Saving does not per se raise standards of living; it must first be mobilized through investment in tangible and human capital.)
Another complication is that some countries have a surplus of saving over domestic investment opportunities. China is the classic example. Even though it is investing heavily, its people, businesses and governments are saving even more heavily. A recent paper from the Bank for International Settlements estimates the marginal propensity to save in China at an astonishing 50 percent.
Other factors causing some countries to be exporters of saving and others to be importers include demographics (countries with older populations tend to save more than those with younger populations); the quality of financial institutions; and exchange rates, among other things. A recent OECD study examined these dynamics in detail.
When saving is exported, it will necessarily show up in the international accounts as a trade surplus in the exporting country and a trade deficit in the importing country. Remember, saving fundamentally consists of real goods and services. Viewed in this way, a trade deficit may or may not necessarily indicate profligacy, but a better climate for investment than that in the surplus country.
Whether a trade deficit is a sign of strength or weakness depends a lot on what the imported saving (and the imported goods and services it represents) is used for. If it is used to finance consumption, it’s usually bad; if it’s used to finance productivity-enhancing investment, then it’s good.
But even if the imported saving is used for investment, it may have negative consequences if it leads to overinvestment that can’t be sustained by sales of the output produced by the investment. In the U.S. this was clearly the case with housing—too many houses were built, leading to a bubble and a crash. In the 1990s the same thing happened with high-tech companies.
International organizations like the IMF have been concerned for years about the possibly deleterious effects of capital inflows on small open economies because they can generate unsustainable booms that inevitably lead to costly busts. But, historically, a large open economy like the U.S. was thought to be immune from such problems. Now that thinking is changing.
In 2005, both Alan Greenspan and Ben Bernanke discussed the so-called saving glut at length. But absent controls on foreign capital, it’s not clear what the Federal Reserve could have done to prevent capital imports from over stimulating some sectors of the economy. It just happened to have been housing, but could just as easily been some other.
There is a growing body of economic research examining the implications of global imbalances—excess saving in some countries leading to overinvestment in others. The IMF’s latest World Economic Outlook has a chapter on the subject, and economists such as Harvard’s Jeffry Frieden and the University of Wisconsin’s Menzie Chinn are doing cutting-edge research on this topic.
It’s not yet clear what can be done to prevent global imbalances from generating a boom-and-bust cycle. The IMF, which long opposed capital controls, has lately become more sympathetic to them. However, there is one thing all economists agree upon: reducing a nation’s budget deficit will reduce its dependency on foreign capital. A new IMF study finds that a one percent of GDP improvement in a nation’s fiscal balance will reduce its current account deficit by between 0.2 percent and 0.3 percent.
