Since Trump was elected to office, conversations about the trade deficit and tariffs have been top of mind for investors, corporations, consumers, and anyone affected by the trade disputes that Trump has pursued during 2018. In this article, we aim to build a better understanding of the economics and underlying drivers that lead to a trade deficit or surplus.
Defining the Trade Balance and Relationship to Net Capital Flows
In our articles on GDP and the relationship between government purchases and investment, we have discussed the national income accounts. Please refer to these articles for additional detail on the national income accounts prior to reading this article.
GDP (Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (NX)
Consumption is spending on durable and non-durable goods and services by households. Investment is spending on fixed assets by businesses and new homes by households. Government purchases represent spending by federal, state, and local governments.
Net exports represent exports of goods and services to foreign countries less imports of foreign goods and services to the domestic economy:
Net Exports = Exports – Imports
In a closed economy that does not trade with foreign nations, the C + I + G accounts represent expenditures on domestic goods and services only. However, in an open economy that does trade with foreign nations, the C + I + G accounts include expenditures on both foreign and domestic goods:
Consumption (C) = Cf + Cd
Note: Cf = Consumption of foreign goods and services and Cd = Consumption of domestic goods and services
Investment (I) = If + Id
Government Purchases (G) = Gf + Gd
Since GDP is a measure of domestic output, we must eliminate Cf + If + Gf from our calculation of GDP:
Imports = Cf + If + Gf
Note: By subtracting Imports from the calculation of GDP, we can isolate the spending on domestic goods and services only
Let’s rearrange our GDP formula:
GDP (Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (NX)
Y = C + I + G + NX
Y – C – G = I + NX
When we take output (Y) and deduct consumption (C) and government purchase (G), we are left with the national savings (S) of the domestic economy. The national savings is the combination of private savings and public savings (savings of the government). Private savings is calculated as Y – T – C, where T represents taxes paid to the government and C is consumption, so private savings is equal to output less taxes less consumption. Public savings (savings of the government) is calculated as taxes (T) less government purchases (G). Let’s now substitute Savings (S) for Y – C – G:
S = I + NX
S – I = NX
This equation shows us that the difference between national savings and investment is equal to net exports. In other words, if the domestic economy has savings that are higher than investment, then, this amount is lent to foreigners in order to fund foreigners purchase of our exports.
Let’s use a simple example of an economy that includes just the United States and China. Let’s assume that the US savings level is $1000 and the US expenditure on investments is $1200. This must mean that the US has a trade deficit with China of $200. In other words, the US imports $200 more in goods/services to China than the US exports to China.
If the US investment of $1200 exceeds the national savings of $1000, then, this means the US must borrow the money to finance the $200 deficit. In this simple example with only one trade partner (China), the US borrows $200 from China to finance the deficit.
This brings us to the concepts of net capital outflow and net capital inflow. If S exceeds I, then, this excess capital is lent to foreigners, who use the capital to finance their purchase of our (US) net exports. If the US, for example, is running a trade surplus, then, this excess capital is lent abroad. This is referred to as net capital outflow. However, when the US is running a trade deficit (S falls short of I), then, the US must finance this deficit. Foreigners lending money to the US (or purchasing US assets) to finance the trade deficit results in a net capital inflow into the US.
How do Government Policies affect the Trade Balance?
We’ve established that S – I = NX. And S = Y – C – G. Therefore:
Y – C – G – I = NX
In this simple model, we are making a simplifying assumption that we are operating in a small open economy at full employment, where the interest rate is determined by the prevailing ‘global’ interest rate. Therefore, we know that:
- Y (output) is fixed and is a function of capital and labor
- C (consumption) is fixed and is a function of output less taxes
- G (government purchases) is fixed and is a function of government policy
- I (investment) is fixed and is a function of the global interest rate
*Note: In our article on government purchases crowding out investment, we utilized a model based on a closed economy, where investment is determined based on the interest rate in the closed economy. We assumed that the interest rate in this closed economy will find equilibrium at a level where savings and investment match. However, in this example, we are now looking at a small open economy, where the interest rate will be fixed based on the prevailing global interest rate. In other words, the small open economy will borrow and lend at the same rate that the rest of the world does.
From this, let’s see what happens if:
Lower Taxes – If the government lowers taxes, this increases disposable income available for consumption, which encourages higher consumption to occur. Higher consumption leads to a lower value for NX. Therefore, government policies that lower taxes contribute to lower net exports (higher trade deficit).
Increase in Government Spending – If the government increases its spending, this increases the government purchases account, which in turn lowers NX. Therefore, higher government spending contributes to a lower net exports (higher trade deficit).
Increase in Government Spending by Foreign Governments (or lower taxes by foreign governments) – If there is a large increase in spending by foreign governments, this reduces the savings level globally. The lower level of savings leads to an increase in the global interest rate. The higher global interest rate results in lower investment expenditures domestically. The lower value for I results in a higher NX. Therefore, higher government spending by foreign governments contributes to higher net exports (higher trade surplus).
Increase in Investment – There could be an increase in investment caused by an advancement in technology or government tax incentives that encourage investment. This increased demand for investment occurs irrespective of the interest rate. The increased value for I results in lower NX. Therefore, increased demand for investment contributes to lower net exports (higher trade deficit).
Overall, we can see that government policies that result in lower savings or higher investment levels lead to higher trade deficits.
Why has the United States Run Large Trade Deficits?
US trade deficits started to increase in the early 1980s driven by the Reagan tax cuts, which coincided with a multi-year trend of increasing federal budget deficits. The federal government experienced a surplus from 1998 to 2001, but then, went back into deficit following the Bush tax cuts in 2001 and 2003 combined with increased government spending on the wars in Iraq and Afghanistan.
Below is a chart of the federal government budget deficit or surplus since 1950:
Below is a chart of the US trade deficit since 1950:
You will notice that the increasing trade deficits over time are directionally consistent with increasing federal budget deficits over time. As we’ve noted above:
Net Exports = Savings – Investment
Unless lower taxes are offset by lower government spending, the effect of lower taxes is to reduce domestic savings since the higher disposable incomes in the hands of consumers encourages higher consumption. Higher consumption reduces savings and thus reduces the net export level (higher trade deficit).
The other variable that goes into the net export equation is investment. Investment can fluctuate significantly over the course of economic cycles. For example, during the late 90s Internet boom, the federal budget went into surplus, but the trade deficit continued to increase. Despite savings going up due to federal budget surpluses, the level of investment more than offset the increase in savings during the late 1990s. This increase in investment during the Internet boom drove increasing trade deficits.
Another interesting divergence can be observed during the 2008 financial crisis. At this time, the federal budget deficit increased significantly as federal tax receipts fell and the federal government increased spending on bailout programs. This created decreased domestic savings, which would serve to increase the trade deficit. In reality, the trade deficit decreased significantly during the 2008 recession because the decrease in savings was more than offset by an even bigger decrease in investment.
The significant decrease in investment during 2008 led to an increase in the net export level.