Understanding the relation between Trade Deficits and Budget Deficits

[kyounge1956]

I'm now on my third attempt at reading The Predator State, by James K. Galbraith, and for the third time I've gotten stuck on chapter 5, with the relation between trade and budget deficits. The author writes

"There is a basic relationship in macroeconomics, as fundamental as it is poorly understood, that links the internal and the international financial position of any country. A country's internal deficit, that is, its "public: deficit and its "private" deficit—the annual borrowing by companies and households—will together equal its international deficit."

It's not at all clear to me why this should be so, and the author doesn't explain it. Of course, having failed to understand this, I'm completely mystified by what follows. The author ends the chapter,

"In sum...balancing the budget is a mission impossible... For practical purposes, the realized budget deficit no longer depends on federal budget policy decisions, but rather on international trade and the financial position of the private sector. So long as American foreign trade remains in a permanent state of deficit—which it has to do, so long as a growing and unstable world economy requires dollar reserves—the federal budget deficit is basically permanent. Policymakers and pundits can say what they like about budget deficits. Nothing sustainable can or will or even should be done about them, except through a change in the world's financial system. ...it is in the global financial system, and not in the halls of Congress, that the future fiscal balance of the U.S. government...will be decided."

I don't get it! Why would the two deficits be "so closely related...that they usually amounted to two aspects of the same thing"? Is there a cause-and-effect relationship, and if so, which deficit is the cause and which the effect?

I tried posting this question over at bogleheads, but the thread got deleted . The PM I got notifying me of the deletion had a different thread title in it than I used, so I hope this is just a mix-up and it gets reinstated, but in the meantime, I thought I'd ask here too. Maybe if someone puts the idea in different words the light bulb will come on for me.

 

[haha]

I'm now on my third attempt at reading The Predator State, by James K. Galbraith, and for the third time I've gotten stuck on chapter 5, with the relation between trade and budget deficits. The author writes
It's not at all clear to me why this should be so, and the author doesn't explain it. Of course, having failed to understand this, I'm completely mystified by what follows. The author ends the chapter,

I don't get it! Why would the two deficits be "so closely related...that they usually amounted to two aspects of the same thing"? Is there a cause-and-effect relationship, and if so, which deficit is the cause and which the effect?

I tried posting this question over at bogleheads, but the thread got deleted . The PM I got notifying me of the deletion had a different thread title in it than I used, so I hope this is just a mix-up and it gets reinstated, but in the meantime, I thought I'd ask here too. Maybe if someone puts the idea in different words the light bulb will come on for me.

I wish I could comment, but I also find this sort of macroeconomics to be very difficult to grasp. It tends to leave my mind kind of dizzy.

I just called and this book is at my branch library, so I will have a look at it starting today!

Ha

 

[rescueme]

I tried posting this question over at bogleheads, but the thread got deleted .

Sounds about right. They don't wish to discuss the "hard stuff", or stay away from anything that could cause them to violate their "holier than thou" view (guess you can see why I left that forum )...

As to your question, I really don't have an answer - but I do have an opinion.

Let's take cars as an example. Even though a foreign badged car may be assembled in the U.S. (by U.S. folks), a good deal of the parts may be imported from the "home country" of the brand. Additionally, even though a new car has several manufacturing components (e.g. parts, labor, and overhead) the profit still goes back to the home country.

While the U.S. may benefit greatly to the extent of having a person here build/assemble the vehicle, the costs of that person are still carried on the books of the country of origin; taxes on any profits may be kept within the home country, or kept in the country of assembly (in this case, the U.S.) but in reality, are reported as a line item on the corporate office balance sheet and that's where the actual profit is reported. The reason that profits are not sent back to the home country/organization is often due to various tax laws on international operations.

I wor*ed for a company that was owned both by U.S. concerns, along with foreign concerns later on. The method of showing profit/expenses was always shown on the balance sheet of the "home country", as the results of a U.S. subsidiary. For all intents even though I was a U.S. citizen, working in a building located in the U.S. and all expenses were shown in U.S. currency on the local level. By the time it got rolled to the annual report of the foreign country, all profit/losses/expenses were shown as being part of the "country of corporate origin". No separate report was shown for the U.S. (or the other 80 some countries around the world where the company had a presence). BTW, all operations in the U.S. were shown as Euro's in the annual report balance sheet.

I would think that if you wanted to "normalize who owns what", you have to look at where the operations are actually reported - not necessarily just where the action is.

GM has operations in Canada and Europe, yet corporate reporting is in the U.S.

Ford (at one time) had operations in Sweden and still does in Europe. Those profit/loss figures still are rolled up into the corporate balance sheet within the home office, located in the U.S.

Depending on the "balance of payments" measured between countries, we indeed may have an ongoing challange of always showing more going out rather than coming in, using accounting rules.

Just my musings on this lazy Saturday afternoon...

 

[Gumby]

I once heard Galbraith speak about this topic before he wrote his book. As I understood him (which may not be very well), the argument is as follows:

1. In a closed economy, the total of public savings and private savings always equals the total of public consumption and private consumption. There is an allocation between public and private savings and consumption, but the totals are equal. You theoretically could have all public savings and consumption or all private savings and consumption. If public consumption (govt. spending) goes up, public savings (taxes) go up and private consumption and savings go down. The budget deficit is merely an indication that the public consumption exceeds public savings. There will necessarily be a corresponding and offsetting imbalance between private consumption and saving. Adjusting government spending and taxes merely shifts the line between the percentage of savings/consumption done by the public versus private savings/consumption.

2. However, in an open economy, total savings (public plus private) can exceed total consumption (public plus private), in which case the excess is invested overseas and we have a trade surplus. The converse is also true. If total consumption exceeds total savings, foreigners finance part of the consumption and we have a trade deficit.

3. One thing to keep in mind is that the trade deficit is essentially created by private consumption; we buy more Chinese stuff at Walmart than we sell to the Chinese. But it is financed publicly; the government sells bonds to the Chinese and, as a result, taxes are lower than they otherwise would be.

4. Assume we want to eliminate the budget deficit without selling bonds to the Chinese, so we raise taxes. Now, in order to finance our Walmart habit, we private consumers would need to borrow directly from the Chinese. But of course we can't do that easily or cheaply, so we demand lower taxes in order to have more money in pocket.

5. That is why (I think) Galbraith says you can't really fix the budget deficit by internal fiscal policy. Rather, it is issues affecting the balance of trade that drive the deficit.

6. In order to eliminate the trade deficit, we would need total consumption to drop below total savings. i.e. - stop buying too much stuff at Walmart. Galbraith assumes we won't.

Here is a speech by a Federal Reserve Governor that tackles this in greater detail

FRB: Speech, Gramlich--Budget and Trade Deficits: Linked, Both Worrisome in the Long Run, but not Twins-- May 14, 2004

 

[dex]

Quote:
"There is a basic relationship in macroeconomics, as fundamental as it is poorly understood, that links the internal and the international financial position of any country. A country's internal deficit, that is, its "public: deficit and its "private" deficit—the annual borrowing by companies and households—will together equal its international deficit."

It's not at all clear to me why this should be so, and the author doesn't explain it. Of course, having failed to understand this, I'm completely mystified by what follows.

Below is how I think of it and you need to keep other variables out of the discussion.
Net deficit spending Fed/business/individual = 0 then no international money required - no international deficit

Net deficit spending Fed/business/individual greater than 0 then international money needed to finance it.

Quote:
"In sum...balancing the budget is a mission impossible... For practical purposes, the realized budget deficit no longer depends on federal budget policy decisions, but rather on international trade and the financial position of the private sector. So long as American foreign trade remains in a permanent state of deficit—which it has to do, so long as a growing and unstable world economy requires dollar reserves—the federal budget deficit is basically permanent. Policymakers and pundits can say what they like about budget deficits. Nothing sustainable can or will or even should be done about them, except through a change in the world's financial system. ...it is in the global financial system, and not in the halls of Congress, that the future fiscal balance of the U.S. government...will be decided."


I don't get it! Why would the two deficits be "so closely related...that they usually amounted to two aspects of the same thing"? Is there a cause-and-effect relationship, and if so, which deficit is the cause and which the effect?

This is how I think of it - again keep other variable out of it:
The US Federal budget is in deficit. To change that the Fed would have to increase taxes shifting the deficit to businesses - they would have to borrow to expand - and households (want to buy a car - higher income taxes took away some of your $ so you need to borrow). So, the international deficit does not change.

 

[clifp]

+1 to what Gumby said.
Now I don't even have to look for my old macroeconomics textbook.

 

[kyounge1956]

thanks gumby. No light bulb yet, but maybe the speech will help. I think it will take me a while to digest it though.

 

[kyounge1956]

I once heard Galbraith speak about this topic before he wrote his book. As I understood him (which may not be very well), the argument is as follows:

1. In a closed economy, the total of public savings and private savings always equals the total of public consumption and private consumption. There is an allocation between public and private savings and consumption, but the totals are equal. You theoretically could have all public savings and consumption or all private savings and consumption. If public consumption (govt. spending) goes up, public savings (taxes) go up and private consumption and savings go down. The budget deficit is merely an indication that the public consumption exceeds public savings. There will necessarily be a corresponding and offsetting imbalance between private consumption and saving. Adjusting government spending and taxes merely shifts the line between the percentage of savings/consumption done by the public versus private savings/consumption.

So far, so good. I think I get this much of it, except possibly a bit of confusion about what is meant by "savings". Public "savings" in the above descriptions appears to refer to all money taken in by government, which I would call "revenue" or "total taxation" or something along those lines, but maybe it is just a different word for the same thing. But I am not sure about the last sentence. In the book, Galbraith disagrees with the idea that changes in government policy don't affect total GDP. I think he would say that adjusting government policy may affect the overall size of the pie, as well as the size of the slices. I am also not quite sure whether by "private savings" he means all money taken in by private individuals and companies (corresponding to what is included in public savings) or whether "savings" has its more usual meaning of "that portion of income which is not spent".

2. However, in an open economy, total savings (public plus private) can exceed total consumption (public plus private), in which case the excess is invested overseas and we have a trade surplus. The converse is also true. If total consumption exceeds total savings, foreigners finance part of the consumption and we have a trade deficit.

Must the excess go overseas? Couldn't we just carry over a surplus to the next year, or reduce taxes, or pay down the national debt? Or is a trade surplus simply what usually happens in these circumstances, not what has to happen?

3. One thing to keep in mind is that the trade deficit is essentially created by private consumption; we buy more Chinese stuff at Walmart than we sell to the Chinese. But it is financed publicly; the government sells bonds to the Chinese and, as a result, taxes are lower than they otherwise would be.

This is where I really start getting lost. Is there no other way to balance things than selling bonds to the Chinese? Isn't there any country any more that we have a trade surplus with? Then we could say to that country, "pay the amount which you owe us, to the Chinese". But maybe we are so far out of balance that even after calling in everything that other countries owe us, we would still be in arrears with China?

4. Assume we want to eliminate the budget deficit without selling bonds to the Chinese, so we raise taxes. Now, in order to finance our Walmart habit, we private consumers would need to borrow directly from the Chinese. But of course we can't do that easily or cheaply, so we demand lower taxes in order to have more money in pocket.

Why would we not instead reduce our imports from China? Why would we not put a tariff on Chinese products, simultaneously reducing the quantity imported (because Chinese products would cost more, making other sources competitive) & hence our trade imbalance with them, and raising additional revenue which could be used to reduce the budget deficit without raising taxes. I suppose the reason we don't do this now is because we owe the Chinese so much money that they are in a position to retaliate in a devastating fashion. But why didn't we do it while we still could have, instead of painting ourselves into a corner?

5. That is why (I think) Galbraith says you can't really fix the budget deficit by internal fiscal policy. Rather, it is issues affecting the balance of trade that drive the deficit.

6. In order to eliminate the trade deficit, we would need total consumption to drop below total savings. i.e. - stop buying too much stuff at Walmart. Galbraith assumes we won't.(snip)

He doesn't just say that the deficit won't be reduced, he says it can't be. I think, based on the second quote I took from the book, he believes the dollar would have to be replaced as the reserve currency for this to change. Maybe it is not only that Americans are addicted to cheap Chinese imports, but also that the rest of the world is addicted to stable American dollars? How do we get out of this mess?

I haven't had time yet to read the speech. All those equations made it stiff going. Not tonight (choir practice) or tomorrow (Ash Wednesday service)....maybe Thursday.

 

[Gumby]

I have been thinking about a better way to explain this for the past few days. Let's set up a hypothetical with country A and B, which are the only two countries in a world where total world income and spending are equal at any point in time.

Assume first that country A has no government. All income and spending is done privately. The citizens of country A spend internally and also buy from and sell products to country B. It so happens that the citizens of country A really like the products of country B and they buy more products from B than they sell to B. Thus, the citizens of A collectively are indebted to B. They have a trade deficit. And necessarily B has a trade surplus because total world spending equals total world income. (Note that this assumes no time shifting of consumption).

Now, assume that country A has a government to do governmental functions that the citizens of A value. The governmental budget is balanced, in that taxes equal governmental spending. The government does not buy or sell anything internationally. However, the citizens of A continue to collectively buy from B more than they collectively sell to B. They have a trade deficit, financed by B. Note that there is not a government budget deficit in country A, but there is a trade deficit.

But, as we know, it is difficult if not impossible for each of the citizens of A to run an account with B. If they do manage to convince B to lend them each money to buy B's products, the lending cost will be high. A lower cost alternative is to have the government of A borrow the money on behalf of the citizens of A, by selling bonds to country B.

Now, however, the government of country A has a budget deficit, because they owe the collective amount of the trade deficit to country B. But the citizens of A can't pay more taxes, because they are already spending all their income (recall that they were previously borrowing directly from B to buy the B products and were therefore spending more than their income).

You might say "well, shrink the government and lower taxes accordingly." But all that does is shift the balance of economic activity from more public to more private. In fact, you could shrink the government function down to nothing, but the government would still owe the bond amount to country B. You're back to the situation where you owed the debt collectively but privately.

Again, you cannot solve the budget problem unless and until you solve the trade problem. As you noted, the citizens of A can lose their infatuation with the products of B. They can impose tariffs on imports to help shift demand to higher cost domestic products. They can also devalue their currency, thus making imports cost more, resulting in lower demand. But the essential thing to keep in mind, and Galbraith's point, is that these are all actions directed toward correcting the trade imbalance. That is what is necessary to solve the budget deficit.

Note that I used countries A and B above. A is, of course, the USA. But B is collectively all the other countries in the world, not just one country. My initial use of China for an example may have been misleading.

I think the issue of the dollar as a reserve currency is that it (a) makes it very easy for the government to borrow money at low cost and (b) props up the price of the the dollar relative to other currencies, which makes imported goods more attractive to Americans. A loss of reserve currency status would, I think, cause a precipitous drop in the dollar and solve our problem, although we would need to become accustomed to a lower standard of living.

 

[Free To Canoe]

I once heard Galbraith speak about this topic before he wrote his book. As I understood him (which may not be very well), the argument is as follows:

1. In a closed economy, the total of public savings and private savings always equals the total of public consumption and private consumption. There is an allocation between public and private savings and consumption, but the totals are equal. You theoretically could have all public savings and consumption or all private savings and consumption. If public consumption (govt. spending) goes up, public savings (taxes) go up and private consumption and savings go down. The budget deficit is merely an indication that the public consumption exceeds public savings. There will necessarily be a corresponding and offsetting imbalance between private consumption and saving. Adjusting government spending and taxes merely shifts the line between the percentage of savings/consumption done by the public versus private savings/consumption.

2. However, in an open economy, total savings (public plus private) can exceed total consumption (public plus private), in which case the excess is invested overseas and we have a trade surplus. The converse is also true. If total consumption exceeds total savings, foreigners finance part of the consumption and we have a trade deficit.

3. One thing to keep in mind is that the trade deficit is essentially created by private consumption; we buy more Chinese stuff at Walmart than we sell to the Chinese. But it is financed publicly; the government sells bonds to the Chinese and, as a result, taxes are lower than they otherwise would be.

4. Assume we want to eliminate the budget deficit without selling bonds to the Chinese, so we raise taxes. Now, in order to finance our Walmart habit, we private consumers would need to borrow directly from the Chinese. But of course we can't do that easily or cheaply, so we demand lower taxes in order to have more money in pocket.

5. That is why (I think) Galbraith says you can't really fix the budget deficit by internal fiscal policy. Rather, it is issues affecting the balance of trade that drive the deficit.

6. In order to eliminate the trade deficit, we would need total consumption to drop below total savings. i.e. - stop buying too much stuff at Walmart. Galbraith assumes we won't.

Here is a speech by a Federal Reserve Governor that tackles this in greater detail

FRB: Speech, Gramlich--Budget and Trade Deficits: Linked, Both Worrisome in the Long Run, but not Twins-- May 14, 2004

Thanks,

Have to digest.

Free to canoe

 

[GregLee]

A loss of reserve currency status would, I think, cause a precipitous drop in the dollar and solve our problem, although we would need to become accustomed to a lower standard of living.

I hereby cast a vote for continuing our problem at the cost of a higher standard of living.

 

[kyounge1956]

(snip) A loss of reserve currency status would, I think, cause a precipitous drop in the dollar and solve our problem, although we would need to become accustomed to a lower standard of living.

I hereby cast a vote for continuing our problem at the cost of a higher standard of living.

Is that what we really want to do? Is it any better for a country to live beyond its means than for an individual, a household, or a business to do so? If we keep on going in that direction, won't we eventually get so far in debt it will be obvious to everyone there's no way we can repay everything we owe, at which point the precipitous dollar drop and loss of reserve status will happen anyway. Wouldn't it be better to try to shift gradually to sharing the reserve currency status among several countries or all countries even if this caused a gradual decline in living standard? Maybe this is the change in the world's financial system that Galbraith refers to as necessary before deficits can end.

 

[kyounge1956]

I have been thinking about a better way to explain this for the past few days. Let's set up a hypothetical with country A and B, which are the only two countries in a world where total world income and spending are equal at any point in time.

Assume first that country A has no government. All income and spending is done privately. The citizens of country A spend internally and also buy from and sell products to country B. It so happens that the citizens of country A really like the products of country B and they buy more products from B than B sells to them. (snip)

OK you just lost me right there. If A & B are the only two countries in the world, how can the citizens of A buy more from B than B sells to them? Where else are they going to get "made in B" products?

Or do you mean A buys more from B than A sells to B?

 

[clifp]

Or do you mean A buys more from B than A sells to B?

Pretty sure that is what he means. Nice example Gumby

 

[Gumby]

OK you just lost me right there. If A & B are the only two countries in the world, how can the citizens of A buy more from B than B sells to them? Where else are they going to get "made in B" products?

Or do you mean A buys more from B than A sells to B?

Yes. I'm sorry. I'll fix my post.

 

[GregLee]

Is it any better for a country to live beyond its means than for an individual, a household, or a business to do so?

Yes, lots better.

 

[kyounge1956]

(snip)6. In order to eliminate the trade deficit, we would need total consumption to drop below total savings. i.e. - stop buying too much stuff at Walmart. Galbraith assumes we won't.(snip)

Wouldn't it be possible instead to increase total savings until they match total consumption? Suppose country A discovers a way to expand their economy. Without increasing tax rates, the government would receive greater tax revenues (same size slice of a bigger pie) and could pay off the trade deficit as soon as it arose, without creating a budget deficit. (Is this what used to happen before the closing of the "gold window"?) Or, if A had no government, wages and/or business profits would rise, so that the citizens and/or businesses of country A could import as much as they want from country B without going into debt.

The problem is finding a way to expand A's economy. In years past, I suppose country A would have done this by conquering or buying some additional territory. I suppose it might happen nowadays by discovery of a huge new reservoir of some natural resource in the territory of country A, or creation of a new industry that didn't previously exist (e.g. development of the computer industry in the late 20th century). But in a way those are changes to the trade balance too, aren't they? The new discovery of natural resources means country A no longer has to import that item from B; the new industry means an increase in demand for A's products in country B. Either way, A is reducing their trade deficit with B. But what if the economic expansion were completely internal? For example, what if country A discovered a way to increase crop yields without raising production costs? (For purposes of the example, I have assumed that country A does not import food from B—the agricultural change simply means the citizens of A eat more or better afterwards than they did before.) Food would be cheaper and/or farmers' profits would be higher. Given a sufficiently large increase in farm production, the citizens or the farmers or both would have more money left after taxes to pay for their imported B products without going into debt or creating a budget deficit. Yes?

 

[kyounge1956]

Is it any better for a country to live beyond its means than for an individual, a household, or a business to do so?

Yes, lots better.

Why?
or were you being sarcastic?

 

[haha]

Is that what we really want to do? Is it any better for a country to live beyond its means than for an individual, a household, or a business to do so? If we keep on going in that direction, won't we eventually get so far in debt it will be obvious to everyone there's no way we can repay everything we owe, at which point the precipitous dollar drop and loss of reserve status will happen anyway.

We are likely past the point of no return already, as it is easy to think of all the things the government should provide for us, but very hard to give up any of this. It is a truism of democracies that nothing gets done until the gun is at our head, and there are always demogogues to explain to us why it isn't really that way, so party on. These things always happen happen suddenly- for a many many years it will appear that everything is fine, then BANG!, we are dead.

The US is quite far from being overwhelmed by federal debt service, but it should not be supposed that we will always be able to borrow at today's very low interest rates. Our federal debt is weighted toward the short end, so if short rates were somehow to return to the historical US average of near 5%, with only our current debt we might be looking at debt service of 15% or so of federal revenues pretty quickly. But our debt is already on schedule to massively increase, as O-Care kicks in and other baked-in spending programs are fulfilled. Combine this increased level of debt with normal interest rates and kapow!

Incidentally, a currency can be undermined even by a government with a positive trade balance. I think the yen is a test case for this. Their governemnt debt is at 1900% of govt revenue, and fortunately at very low interest rates and mostly owned by their own people. Much of this is due to QE-x style government spending to prop up banks and to keep the economy from slipping into deflation. But as Japan is undergoing a demographic implosion, will its citizens continue to have the means and the desire to finance Japanese govt bonds at tiny nominal interest rates?

There is a construct called the Keynesian endpoint, when government debt service consumes the entire government income. Japan may test this idea in the not too disant future.

Ha

 

[GregLee]

Why?
or were you being sarcastic?

No, I was serious, but I hesitate to try to fill in detail, because (1) it seems so obvious, and (2) since I don't know economics, my reasoning will be homespun. Well, in the analogy you want us to make, an individual is ruined because his creditors insist on payment, a court order is obtained, the sheriff arrives to seize his possessions, which will be auctioned off, and his children are bundled off to foster homes. A most unfortunate affair, especially if he is the most powerful and influential individual in his country, whose fall will bring down many of his neighbors. Now, can anyone fill in the analogy, replacing our hapless bankrupt with some plausible future USA? What are the foster homes? Who is the sheriff, and so on?

I just don't see how it can happen.

 

[MichaelB]

Excellent job by Gumby explaining something that is not intuitive and mostly concerns economists, not people.

When you have a trade surplus you make more than you spend (as a country) and the difference you can lend to your government to fund the deficit. (Like Japan)

If your gov’t ran a surplus it would lend you the money to finance your trade deficit. (Like Hong Kong)

When you have both a trade deficit and a gov’t deficit you don’t have any money left over to lend so your gov’t has to borrow from someone else .

The problem is finding a way to expand A's economy.

Right. Except you need to invest new money to do that, and with public + private deficits, there isn’t any money for that either. So you need to turn to foreigners once again, asking them to come in and invest in your country. Hopefully, through employment, additional consumption, and taxes you will generate enough economic activity to get back on track.