Speech by Fed Gramlich:
The Link
The link between budget and trade deficits can be seen most naturally through the national income accounting framework. Any saving the nation does finances either private domestic investment directly or the accumulation of claims on foreigners. This means that national saving--the sum of private and government saving--equals private domestic investment plus that period's accumulation of claims on foreigners, or the trade surplus. The trade surplus can also be thought of as net foreign lending. All of these relationships are accounting identities--true at every moment in time apart from data inconsistencies captured by a statistical discrepancy.
In equation form, we have
(1) NS = S - BD = I - TD
On the left side of the equation NS refers to national saving, S refers to overall private saving, and BD refers to the government budget deficit. This part of the equation says merely that total national saving equals the sum of all saving done in the economy by the private sector and the government sector. A budget surplus would be treated as governmental saving and added to private saving; a budget deficit would be treated as governmental dissaving and subtracted.
The right side of the equation repeats the familiar open economy identity that national saving equals private domestic investment, I, plus the accumulation of claims on foreigners or less that domestic investment financed by foreigners. As was noted earlier, borrowing from foreigners involves either a reduction of claims on them or an increase of claims on us by them. It is by definition equal to the trade deficit TD. In the equation, then, a trade surplus means that some national saving goes to building up claims on foreigners (national saving is greater than domestic investment) while a trade deficit means that some investment is financed by foreigners (national saving is less than domestic investment).
This identity first demonstrates the all-important role of national saving in shaping long-run economic welfare. National saving is the only way a country can have its capital and own it too. Models of the economic growth process identify national saving as one of the key policy variables in influencing a nation's living standards in the long run.
The identity also makes clear that the budget deficit and the trade deficit can move together on a dollar-per-dollar basis, but only if the difference between private domestic investment and private saving is constant. Typically that difference will not be constant. For example, if there were to be an investment boom, interest rates might rise to induce some new private saving and some new lending by foreigners. The implied trade deficit might rise and, because of the rise in income, the budget deficit might fall. In this case, the trade deficit would increase while the budget deficit fell.
Conversely, suppose that expansionary fiscal policy resulted in a rise in budget deficits. If this expansion were totally financed by borrowing from foreigners, domestic interest rates would not change much, and domestic investment and private saving might not either. In this scenario, there could be a simultaneous dollar-per-dollar change in budget and trade deficits--the classic twin-deficit scenario. Such a situation is most likely to occur in small economies fully open to international trade and capital flows, economies in which domestic interest rates are determined by world capital markets and are independent of domestic economic variables. But if domestic interest rates do change, as they likely would in either a closed economy or a large open economy, private investment and saving would also likely change, and any strict link between budget and trade deficits would be broken. |
