Why the Trade Balance ‘Mystery’ Is Not a Mystery

To view the external balance correctly, the focus should be on the domestic economy. The external balance is homegrown; it is produced by the relationship between domestic savings and domestic investment. Indeed, it is the gap between a country’s savings (read: income, minus consumption) and domestic investment that drives and determines its external balance. This fact can easily be seen by studying the savings-investment identity:

CA = S_private – I_private + S_public – I_public,

where CA is the current account balance, S_private is private savings, I_private is private domestic investment spending, S_public is government savings, and I_public is government domestic investment spending. In this form, S_private – I_private is the savings-investment gap for the private sector and S_private– I_public is the savings-investment gap for the government sector. For a full derivation of the identity in this form, allow me to direct my readers to a piece Edward Li and I authored in the Fall 2019 issue of the Journal of Applied Corporate Finance: “The Strange and Futile World of Trade Wars.”

So, the national savings-investment gap determines the current account balance. Both the public and private sector contribute to the current account balance through their respective savings-investment gaps. The counterpart of the current account balance is the sum of the private savings-investment gap and public savings-investment gap (read: the public-sector balance).

The U.S. external deficit, therefore, mirrors what is happening in the U.S. domestic economy. This holds true for any country, even those with significant external surpluses. The U.S. displays a savings deficiency and a negative current account balance that reflects its negative savings-investment gap. Japan, China, Germany, and Switzerland all display savings surpluses, and all run current account surpluses that mirror their positive savings-investment gaps.

U.S. data support the important savings-investment identity. The cumulative current account deficit the U.S. has racked up since 1973 matches the amount by which total savings has fallen short of investment. But, that is not the end of the story. Disaggregated U.S. data are available that allow us to calculate both the private and government contributions to the U.S. current account deficit. The U.S. private sector generates a savings surplus — that is to say, private savings exceed private domestic investment — so it actually reduces (makes a negative contribution to) the current account deficit. The government stands in sharp contrast to the private sector, with the government accounting for a cumulative savings deficiency — that is to say, government domestic investment exceeds government savings, resulting in fiscal deficits — that is almost twice the size of the private-sector surplus. Clearly, then, the U.S. current account deficit is driven by the government’s (federal, plus state and local) fiscal deficits. Without the large cumulative private-sector surplus, the cumulative U.S. current account deficit since 1973 would be almost twice as large as the one that has been recorded.

The U.S. government’s fiscal policies, which promise ever-widening fiscal deficits, simply mean that the trade deficit will continue to balloon as far as the eye can see, particularly in the COVID-19 era. Protectionists in the While House, whomever they may be, can bully countries they identify as unfair traders and can impose all the restrictions on trading partners that their hearts desire, but it won’t change the current account balance. The U.S. current account deficit is solely a function of the savings deficiency in the U.S., in which the government’s fiscal deficit is the proverbial elephant in the room.