To understand the balance correctly, we should direct our attention to the domestic economy.
To understand the balance correctly, we should direct our attention to the domestic economy.
E arlier this month, we learned that the U.S. trade deficit rose to record levels, soaring at an annual growth rate of 27 percent. Predictably enough, many reporters expressed concern about U.S. dependence on foreign countries. This is nothing new. Journalists have been spinning this same story in the same way for years, confusing their readers and wrapping the trade balance in a shroud of mystery. Why the confusion and mystery concerning America’s negative external balance? After all, the U.S. has run a negative external balance every year since 1975, and the sky has not fallen.
This wrongheaded mercantilist view of international trade and external accounts has its roots in watching how individual businesses operate. A healthy business generates positive free cash flows — revenues exceed outlays. If a business cannot generate positive free cash flows on a sustained basis, take on more debt, or issue more equity to finance itself, then it will be forced to declare bankruptcy.
Typically, most people employ this general free-cash-flow template when they think about the economy and its external balance. For them, a negative external balance for the nation is equivalent to a negative cash flow for a business. In both cases, more cash is going out than is coming in.
But this line of thinking represents a classic fallacy of composition — the belief that what is true of a part (a business) is true for the whole (the economy). Alas, economics is littered with fallacies. These cause most people to confuse their own arguments about international trade and external balances almost beyond reason.
The negative external balance in the U.S. is not a “problem,” nor is it caused by foreigners engaging in nefarious activities. The U.S.’ negative external balance is “Made in the U.S.A.”: a result of its savings deficiency.
To view the external balance correctly, we should direct our attention to the domestic economy. The external balance is homegrown; it is produced by the relationship between domestic savings and domestic investment. The national savings–investment gap, composed of the public savings–investment gap and the private savings–investment gap, determines the current-account balance. The U.S. external deficit, therefore, mirrors what is happening in the U.S. domestic economy.
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. To get the full picture, we must look at the savings–investment gap’s components.
The U.S. private sector generates a savings surplus, which reduces our current-account deficit. Yet at the same time, the government accounts for a cumulative savings deficiency that is almost twice the size of the private‐sector surplus. Clearly, then, the U.S. current-account deficit is driven by the fiscal deficits of the government (federal, plus state and local).
So, why did the record U.S. trade deficit come as no surprise to me? I’ve kept my eye on the U.S. federal government’s fiscal deficit, given that it’s the largest contributor to the U.S. savings deficiency and is the driver of the U.S.’ negative external balance. What I’ve seen is that fiscal deficits over the last two years have surged to record levels — $3.1 trillion and $2.8 trillion in fiscal years 2020 and 2021, respectively. In other words, again, our record U.S. trade deficit is made in the good old U.S.A., and is made primarily by the U.S. federal government’s fiscal deficit.