The real source of trade deficits

It's probably not what you think (unless you're an economist)

Note: this blog post is based on my recent Econ Quick Takes video.

Today, I’ll illuminate the real source of trade deficits. Think of a few possible reasons why a country could have a trade deficit (which means it’s exporting less abroad than it imports). What probably doesn’t come to mind are that country’s savings and investment decisions. But these are actually fundamental for determining trade deficits. Let’s unpack this with some simple math.

A country’s production or GDP is defined as:

Y = C + I + G + E – M

This identity says that a country’s total production, Y (measured in dollars), consists of consumers’ expenditure on goods and services, C, investment expenditure, I, government purchases, G, plus the value of exports, E, minus the value of imports, M. The difference between exports and imports is called “net exports”. Positive net exports means that the country has a trade surplus – on the whole, it’s exporting more than it’s importing. Negative net exports means that the country has a trade deficit.

As an aside, the reason we subtract imports is not because they lower total output but because imports are included in consumption C. So in order to not have imports increase GDP, we subtract them. Therefore, imports do not affect GDP, all else equal. Also, investment here means spending on things that will produce more stuff in the future—like building factories, machines, or new housing—not the purchases of stocks and bonds.

Back to the equation. Let’s denote net exports by NX and isolate it on the right-hand side. We then have:

Y – C – G – I = NX

I promised you this would be about savings and investment. Well, Y-C-G is called national savings. It’s the output that’s left over after consumers have made their consumption decisions and the government has made its purchase decisions. Let’s call this S. In an economy that doesn’t trade with anyone, this remainder would be exactly the amount of investment made. But in what we call an “open economy” with trade, we’re now left with the following identity:

S – I = NX

What this is saying is that an economy’s savings minus investment always equals its net exports. Note that this equation is not a theory or a statistical relationship, it’s an identity that always holds, aside from data imperfections.

What’s the intuition for this identity? Well, if a country saves more than it invests, that extra money is going to be invested abroad somewhere. For example, the extra US dollars might be used to buy foreign currency, stocks, bonds, or even fund factories overseas.

Why would this translate into a trade surplus? Foreign countries receiving those net investment inflows will turn around and use those dollars to buy more US goods and services than the US is buying from them. In this case, the US would be exporting more than it’s importing—and have a trade surplus.

Now let’s consider the opposite situation—a country with a trade deficit, like the US. First, the identity tells us that this means investment in the US economy exceeds domestic savings. Where does the money to fill this gap come from? From the rest of the world—through the US borrowing or selling assets. In return, the US is importing more than it exports, which shows up as a trade deficit.

What this relationship means is that countries with big trade surpluses will typically be big savers or small investments or a little bit of both. Countries with big trade deficits, like the US, will tend to be big investors or big borrowers or both. We’re not being cheated by countries who sell us more than we sell them. We are borrowing from them to finance investment that domestic savings are insufficient to finance, and the trade deficit is a result of that. Increase domestic savings and/or decrease investment and the trade deficit will fall as well.

What we should therefore realize is that trade deficits aren’t inherently good or bad. For example, if the demand for investment in the US suddenly increases and domestic savings do not, the US will need to borrow from abroad to fund that investment, which will also increase its trade deficit. But borrowing to fund strategic investment could be a very good thing, so we may not be concerned about the larger trade deficit.

Another reason a trade deficit could grow is if government expenditure increases. This is because higher government expenditure lowers national savings. In that case, domestic investors have to rely more on foreign funding, all else equal, and the trade deficit will grow as a result. Now that could also be a good thing if the government is increasing expenditure to fight a recession, but it could also be a sign of fiscal irresponsibility. So to determine if a larger trade deficit is a problem or not, we have to look at what’s causing it on the savings-investment side and decide whether that’s good or bad.

The big takeaway point is that trade imbalances aren't really due to trade policies. Instead, they’re fundamentally connected to how much people save, how much businesses invest, and how the government manages its budget.