Trade Deficits Cannot be “Managed”

Writing for the Peterson Institute for International Economics (PIIE), Dr Maurice Obstfeld has a great, non-technical piece addressing some of the claims made by Michael Pettis (among others) that a trade deficit must be “managed.”  Obstfeld details the theoretical and empirical issues with Pettis’s claims very succinctly.  Allow me to supplement Obstfeld’s comments with my own.

First, a technical note: there is a difference between the trade balance (the difference between exports and imports) and the current account (exports, imports, and some financial transactions like income from investments and transfers).  However, for the purposes here, I will not worry too much about that difference; it won’t matter much for the point I am making.  With that out of the way, let’s begin.

In national income accounting, the current account is the difference between national savings and national investment (for those interested in the algebra, you can find it here).  Mathematically, we have:

Current Account = Savings – Investment.

This accounting identity is deceptively simple.  If one thinks a current account deficit (that is, investment is greater than savings, is a problem (an unjustified claim we will get to in a moment), then the solution is easy: either increase savings or decrease investment.  Do that, and the problem is solved.  

But realistically what can a government do?  I emphasize “realistically” because there seems to be some confusion on that point.  Reformers love to propose actions that are utterly divorced from reality.  Realistically, there’s not much governments can do.  Most of the elements of savings and investment are determined exogenously.  It’s not like an individual making a budget.  Rather, national savings and national investment are determined by factors far beyond a government’s control: desires of people within the border, desires of those outside the country, plans made by firms, and countless other factors.  Savings and investment, in other words, are emergent.  They are not things that can be manipulated, not levers to be pulled and tweaked.  It’s not that it is difficult to manage them.  It is impossible to manage them.  That simple accounting equation hides magnitudes of complexity.  

Of course, governments can influence one aspect of the identity: savings.  National savings is made up of private savings and government savings.  Governments can increase their savings (that is, not operate in a deficit) which could, all else held equal, reduce the current account deficit.  Although, even that method has its limitations, as Obstfeld discusses.  Further, governments have sometimes tried to influence private savings and investment through various incentives and capital controls, but incentives are not mind control.  They do not always work and often end up having unintended consequences.

All this assumes that a current account deficit is a bad thing, something to be avoided.  Nothing, however, could be further from the truth.  More often than not, trade deficits are a sign of good things, as Central Washington University economics professor Robert Carbaugh explains:

Often, countries enjoying rapid economic growth possess long-run current account deficits, whereas those with weaker economic growth have long-run current account surpluses.  This relation likely derives from the fact that rapid economic growth and strong investment often go hand in hand.  Where the driving force is the discovery of new natural resources, technological progress, or the implementation of economic reform, periods of rapid economic growth are likely periods when new investment is unusually profitable.  Investment must be financed with saving, and if a country’s national saving is not sufficient to finance all the new profitable investment projects, the country will rely on foreign saving to finance the difference.  It thus experiences a net financial inflow and a corresponding current account deficit.  As long as the new investments are profitable, they will generate the extra earnings needed to repay the claims contracted to undertake them.  When current account deficits reflect strong, profitable investment programs, they work to raise the output and employment growth, not to destroy jobs and production. (International Economics, 18th ed, pg 302, emphasis in original).

Current account deficits are not a bad thing when they reflect profitable investment opportunities like in the US.  It’s why the US has been able to run current account deficits for over 40 years and frequently sets new record levels for industrial production and remains one of the world’s most productive places.  But that could change with Trump’s trade war.  If countries relocate to the US to avoid tariffs, that is because they are, pretty much by definition, less profitable operating in the US than abroad.  Consequently, trade deficits that emerge from the trade war are a worrying sign.