The connection between budget deficits and trade deficits

Last time, we derived the identity Savings — Investment = Net Exports, or

S — I = NX

We then explained how, when a country saves more than it invests, it will run a trade surplus. And when it invests more than it saves, it will run a trade deficit. Today, I want to take this one step further and explain how government budget decisions affect the size of the trade deficit or the trade surplus.

Savings can be split into two parts: private savings (by households and businesses) and public savings (by the government). Government savings is the amount of tax revenue the government takes in minus total expenditure on goods and services. If the government runs a surplus, that’s positive government savings. If the government runs a deficit, that’s negative savings or borrowing.

What this means is if the government runs a deficit, that lowers total savings and pushes the country toward a trade deficit-unless private savings increase or investment decreases to offset it.

Government deficits are a key source of the trade deficit in the US. The US has run large government deficits for many years. At the same time, private savings haven’t been especially high while investment has remained strong. That gap-where total US savings fall short of investment-is made up by borrowing from the rest of the world and also results in a trade deficit.

The identity S — I = NX tells us that, unless the US reduces its budget deficit (which is looking highly unlikely) OR private savings increase (which is hard and potentially undesirable for the government to control) OR investment falls (which is unlikely to be good for the US economy), the US will continue to run a trade deficit, regardless of what trade policy the government adopts.

You might be thinking, “I understand the identity, but how is it possible that policies like tariffs don’t affect the trade deficit? Won’t they lower imports?” The key link is the foreign exchange rate. Tariffs will absolutely lower imports, but they will also cause the country’s currency to appreciate, which will make exports more expensive and lower exports. Tariffs will reduce the amount of total trade but leave the gap between exports and imports-the trade deficit-unchanged.

As we said last time, a trade deficit is not a fundamentally good or bad thing. In some cases, it reflects strong investment, for example. But a trade deficit could also be symptomatic of a problem. Persistently running a budget deficit, a key cause of the trade deficit in the US, is likely to be harmful in the longer run. The US has enjoyed low borrowing rates for a while, which may have justified more borrowing on the margin. It also makes sense to run government deficits during recessions.

But as US debt accumulates, so do interest payments. And at some point, investors may start worrying about the ability of the US to pay all its debt and demand a higher interest rate, making paying the money back harder. For all these reasons, it’s almost surely a good idea for the US to strive for a lower budget deficit when there’s not a recession. As a bonus to those who care about trade deficits, that will also help shrink it.

Note: this is a lightly edited transcript of my latest Econ Quick Takes video.

Originally published at https://mytwocentsandcounting.substack.com.