Understanding the relation between Trade Deficits and Budget Deficits

[MichaelB]

I find this concept interesting and worthy of discussion. What do you all think?

They have it backwards. The capital assets flowing into the US are the trade deficit. That is, what flows out then returns. The part that doesn’t return as trade (the deficit) returns as capital. By definition they have to match and offset.

It doesn’t fund growth and jobs, most of it sits in foreign Centrsl Banks and is invested in US Treasuries. That helps the foreign countries manage their currencies and prevent appreciation.

 

[EastWest Gal]

Does the status of the U.S. dollar as the world's reserve currency help drive countries to sell us their goods, so they can have more of the world's reserve currency, thereby stabilizing their economies? If so, then the U.S. dollar's status as the world's currency may be a big driving factor in causing the trade deficit. On the other hand, in the U.S. we have a plethora of goods available to us because of that very situation.

So is the trade deficit a good or a bad thing? It might be a bit of both.

I still don't see it's relationship to the government's budget deficit, which is becoming a big problem, due to servicing the interest. The largest holder of federal debt is domestic-the Federal Reserve and U.S. citizens. Foreign holdings of our debt has been gradually increasing though.

 

[MichaelB]

Does the status of the U.S. dollar as the world's reserve currency help drive countries to sell us their goods, so they can have more of the world's reserve currency, thereby stabilizing their economies? If so, then the U.S. dollar's status as the world's currency may be a big driving factor in causing the trade deficit. On the other hand, in the U.S. we have a plethora of goods available to us because of that very situation.

Absolutely yes. Foreign countries are lending us the money in our own currency to consume their exports and they expect to be repaid in the future, and there appears to be no limit to how much they will lend (and export). That’s only possible because they feel the loan is safe, and that is in great part because the $ is the reserve currency.

So is the trade deficit a good or a bad thing? It might be a bit of both.

Yes, it is both.

I still don't see its relationship to the government's budget deficit, which is becoming a big problem, due to servicing the interest. The largest holder of federal debt is domestic-the Federal Reserve and U.S. citizens. Foreign holdings of our debt has been gradually increasing though.

A trade deficit causes debt to rise somewhere in our economy. It has to, by definition.

The gov’t increases its deficit, that money is transferred to the private sector and supports consumption, the additional consumption is satisfied with imported goods, which cause a trade deficit.

The question of what comes first, the trade deficit or the public debt, is passionately debated among economists.

 

[MichaelB]

Let's say that everything is in equilibrium. Country A imports from Country B are equal to Country A's exports to Country B and both Country A and Country Bs' federal government budgets are balanced.

Now, the only thing that changes is that Country A decides to give its citizens 100 and it is unfunded so Country A now has a 100 deficit and 100 national debt.

Does Country A now have a trade surplus or a trade deficit or neither? Provide your work.

It feels like I’m back in high school.

Public debt does not automatically lead to a trade deficit. A trade deficit does automatically lead to an increase in domestic debt.

In this case, country A has an $100 increase in debt. It also has an asset, the $100, that needs to be either consumed or saved (invested). If consumed, there are 3 possible outcomes. 1) domestic production rises to meet demand, 2) imports rise to meet demand, or 3) inflation occurs.

 

[Onda]

Trade Deficit ≈ Foreign Investment Inflows + Net Income from abroad OR
Trade Deficit ≈ Foreign Investment Inflows

I don't think any type of formula ties trade defficit and government budget defficit.

 

[Onda]

Absolutely yes. Foreign countries are lending us the money in our own currency to consume their exports and they expect to be repaid in the future, and there appears to be no limit to how much they will lend (and export). That’s only possible because they feel the loan is safe, and that is in great part because the $ is the reserve currency.

That is—if in your mind foreign investment equals lending us money. But keep in mind, foreign investment flows into attractive, investable places—not just out of generosity or habit. The dollar’s reserve status helps, but investors still look for returns, safety, and opportunity.

 

[FD1000]

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 graduated in Computer Science and Economics. The first is science where I worked over 35 years until retirement, the second is BS with many assumptions and predictions that don't work and why I ridicule it.
The only subjects that made sense were accounting and finance.
You can Google it.

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[Onda]

They have it backwards. The capital assets flowing into the US are the trade deficit. That is, what flows out then returns. The part that doesn’t return as trade (the deficit) returns as capital. By definition they have to match and offset.

It doesn’t fund growth and jobs, most of it sits in foreign Centrsl Banks and is invested in US Treasuries. That helps the foreign countries manage their currencies and prevent appreciation.

Treasuries: ~30–40%
Corporate Bonds: ~20–25%
Equities: ~25–30%
Real Estate and other direct investment: ~10–15%

It’s because American exceptionalism attracted that money in the first place—and when 10-year Treasury yields surged while stocks fell, it signaled a reversal of that flow, which is what truly scared our lets call him leader.

 

[MichaelB]

Trade Deficit ≈ Foreign Investment Inflows + Net Income from abroad OR
Trade Deficit ≈ Foreign Investment Inflows

I don't think any type of formula ties trade defficit and government budget defficit.

it’s based on economic accounting identities.

[(M-X) = (I-S) + (G-T)]

 

[Onda]

it’s based on economic accounting identities.

[(M-X) = (I-S) + (G-T)]

Is tis a formula that connects the trade deficit to the government budget deficit? What variables are M, X, I, S, G and T?

 

[MichaelB]

That is—if in your mind foreign investment equals lending us money. But keep in mind, foreign investment flows into attractive, investable places—not just out of generosity or habit. The dollar’s reserve status helps, but investors still look for returns, safety, and opportunity.

I didn’t say that. I am not trying to describe all of the cross border capital flow. We’re looking at trade. The trade surplus creates a surplus of domestic savings in the exporting country. In other words, that money has no place to go in the domestic economy, so it looks for a safe place elsewhere, and that is US assets.

Domestic production in the US is not rising to meet demand, and the return of capital also isn’t being invested in factories and production facilities. This we can see because the trade deficit continues.

Much of that money is being recycled from foreign exporters to their central bank, which buys US Treasuries, They do that to prevent their own currencies from rising, which would make them less competitive.

 

[MichaelB]

Is tis a formula that connects the trade deficit to the government budget deficit? What variables are M, X, I, S, G and T?

Exports (M) minus imports (X) = Investment (I) minus Savings(S) plus Government spending (G) minus Taxes (T).

It’s a accounting identity that has to balance.

 

[GrayHare]

A trade deficit causes debt to rise somewhere in our economy. It has to, by definition.

Interesting discussion, I'm learning lots. I gather it's the economic definitions that drive the connection between trade and budget deficits. For example, if I dig up a lump of gold from my land then trade that gold for an item from a foreign country, an economist counts that as a deficit of mine because I (and my country) no longer have that lump of gold.

 

[MichaelB]

I gather it's the economic definitions that drive the connection between trade and budget deficits.

Yes. That’s what economic theory means with the term “accounting identity”.

For example, if I dig up a lump of gold from my land then trade that gold for an item from a foreign country, an economist counts that as a deficit of mine because I (and my country) no longer have that lump of gold.

It doesn’t really apply to any of us as individuals, it’s meant to describe the working and interconnection between the different entities that make up the economy as a whole.

Following your example, digging up the gold is economic activity, so it contributes to GDP. Importing the good that was consumed was negative economic activity. The net increase (or decrease) in GDP is the value of the gold minus the cost of the import.

 

[Onda]

Exports (M) minus imports (X) = Investment (I) minus Savings(S) plus Government spending (G) minus Taxes (T).

It’s a accounting identity that has to balance.

Ahh got you. I think 2 variables T and G are missplaced.

(X – M) = (S – I) + (T – G)

Where:

• X = Exports
• M = Imports
• S = Private savings
• I = Domestic investment
• T = Taxes
• G = Government spending
  
  So we are kind of both correct. I’m saying that foreign investment naturally leads to a trade deficit, and you’re pointing out that government borrowing also plays a role. but you don’t fix that with tariffs. You fix it by reducing the government deficit. Tariffs will not reduce government defficit.

 

[Closet_Gamer]

I think some of the language is confusing because it is emotive around two big topics: federal deficit and trade deficit, both of which are linked to another emotive topic, personal consumption and LBYM.

Rather government or personal debt, I think of it as societal debt. Consider a two society world.

Society 1 produces X1 and consumes Y1.

Y1 > X1 … there is no free lunch so the difference in consumption had to come from somewhere. Call that difference Z1.

Society 2 produces X2 and consumes Y2.

Y2 < X2 … the production had to go somewhere. Call that difference Z2.

It’s a closed system. The whole system cannot consume more than is produced.

So, Z1 must equal Z2.

All of that difference had to flow from Society 2 into Society 1. There is nowhere else for it to go.

Whether it flowed as a gift, debt (to people, corporations or governments) or as equity (to corporations or real estate) is really a secondary consideration.

As I posted in another thread, I disagree with the belief that had the govt not borrowed it the rest of the country automatically would have because that fails to address incentives. So the leap from the above accounting to government policy is a different question.

 

[MichaelB]

Ahh got you. I think 2 variables T and G are missplaced.

(X – M) = (S – I) + (T – G)

Where:

• X = Exports
• M = Imports
• S = Private savings
• I = Domestic investment
• T = Taxes
• G = Government spending
  
  So we are kind of both correct. I’m saying that foreign investment naturally leads to a trade deficit, and you’re pointing out that government borrowing also plays a role. but you don’t fix that with tariffs. You fix it by reducing the government deficit. Tariffs will not reduce government defficit.

It’s definitely G-T, or net government spending minus taxes.

Tariffs affect other economic variables, such as savings and investment. An economist would say “all other things being equal”, which in real life we know is like magic - not real. So, a tariff could lead to a reduction in gov’t budget deficit, but it is by no means certain, and without complementary measures, not even likely.

 

[pb4uski]

It feels like I’m back in high school.

Public debt does not automatically lead to a trade deficit. A trade deficit does automatically lead to an increase in domestic debt.

In this case, country A has an $100 increase in debt. It also has an asset, the $100, that needs to be either consumed or saved (invested). If consumed, there are 3 possible outcomes. 1) domestic production rises to meet demand, 2) imports rise to meet demand, or 3) inflation occurs.

(emphasis added). I agree with a nit that if consumed it could be a mix of the 3 possible outcomes listed.

From another thread:

The trade deficit and the national debt have nothing to do with each other. Nada. The national debt arises because the federal government spends more than it takes in so it has to borrow to fund the annual deficits. The trade deficit arises because we collectively buy more foreign goods and services than we sell to others. Two totally different things.

And the trade deficit isn't bad. Individually, we all have trade deficits. We "sell" goods and services to a handful of entities but buy from others so each entity that we deal with we have a trade surplus or deficit. Nothing wrong with that.

Gumby said:
No necessarily so. You might want to read economist James K. Galbraith about the fact that will will have a budget deficit so long as we have a trade deficit. It was once discussed at length in this forum - here Understanding the relation between Trade Deficits and Budget Deficits

(emphasis added).

 

[Onda]

It’s definitely G-T, or net government spending minus taxes.

Tariffs affect other economic variables, such as savings and investment. An economist would say “all other things being equal”, which in real life we know is like magic - not real. So, a tariff could lead to a reduction in gov’t budget deficit, but it is by no means certain, and without complementary measures, not even likely.

Hmm that does not add up

Please note: since your left side (X – M) is a large negative number (i.e., a trade deficit), your formula requires T – G (government deficit) to make the right side equally negative. Else the more you spend the less defficit you have.

 

[Onda]

It’s definitely G-T, or net government spending minus taxes.

Tariffs affect other economic variables, such as savings and investment. An economist would say “all other things being equal”, which in real life we know is like magic - not real. So, a tariff could lead to a reduction in gov’t budget deficit, but it is by no means certain, and without complementary measures, not even likely.

I stand corrected. We both are correct since those 2 statements are same:

(X – M) = (S – I) + (T – G) Mine

[(M-X) = (I-S) + (G-T)] Your

I did not observe that you changed all variable not just T and G