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AEI on Trade Deficits: The Stunning Conclusion

Summary:
You have all waited with breath which is baited for the resolution. Last week I posted this AEI meme: …and said I thought there was a basic flaw in it, but I didn’t have time to type it up then. (To repeat, I’m sure the economists at AEI know this nuance; my point was just that the above is not right and so that’s awkward in a meme that’s lecturing somebody on trade. Also, to avoid confusing anybody who missed my first post: I am NOT defending Trump’s policies or pontifications on trade here.) In the comments some of you raised interesting points, but nobody hit the particular thing I had in mind. So here it is: A capital account surplus (i.e. net inflow of investment from foreigners) is equivalent to a current account deficit, not a trade deficit. The trade

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You have all waited with breath which is baited for the resolution. Last week I posted this AEI meme:

AEI on Trade Deficits: The Stunning Conclusion

…and said I thought there was a basic flaw in it, but I didn’t have time to type it up then. (To repeat, I’m sure the economists at AEI know this nuance; my point was just that the above is not right and so that’s awkward in a meme that’s lecturing somebody on trade. Also, to avoid confusing anybody who missed my first post: I am NOT defending Trump’s policies or pontifications on trade here.)

In the comments some of you raised interesting points, but nobody hit the particular thing I had in mind.

So here it is:

A capital account surplus (i.e. net inflow of investment from foreigners) is equivalent to a current account deficit, not a trade deficit. The trade balance is only one component of the current account balance. A trade deficit is neither necessary nor sufficient to have a net inflow of foreign investment. Specifically, the U.S. could have a trade deficit as well as a net outflow of capital, and the U.S. could have a net inflow of foreign capital at the same time it runs a trade surplus.

Here’s the Wikipedia entry on the current account, but unfortunately I’ve yet to find an online treatment that is very good. (Also I’ve seen different definitions and ways to handle things like literal transfers of money between the members of countries. It’s also tricky if you look at the movement of gold back on the gold standard.) So I’ll just give enough intuition/rigor in the present post to show why the AEI meme above is not quite right.

We have

capital account + current account = 0

(Again, I’m defining those terms broadly. I’ve seen other treatments that have a separate thing called the “financial account” but in my mind that is confusing. So the principle of what I’m doing in this post is right, but my categories might not line up with other treatments.)

So a capital account surplus (which occurs when foreigners invest more in U.S. assets than Americans invest in foreign assets during the time period in question, let’s say it’s a year) occurs if and only if there’s a current account deficit.

The current account in turn consists of the trade balance (which itself is separated into goods and services, but I’m not worrying about that here), but it also includes the net earnings of Americans on foreign assets. So think of the current account as like “net income,” where Americans can earn income (a) from exporting more than we import, but also (b) from earning more interest, dividends, and profits on our foreign assets than foreigners earn in interest, dividends, and profits on their U.S. assets.

So if foreigners are investing on net in the U.S., we have a capital inflow or a capital account surplus. That means we have a current account deficit, i.e. the current account is less than zero. The AEI meme above would suggest we must have a trade deficit. But no, that’s not correct:

current account < 0

implies…

trade balance + net foreign earnings < 0

(exports – imports) + (American earnings on foreign assets – foreign earnings on U.S. assets) < 0

exports – imports < foreign earnings on U.S. assets – American earnings on foreign assets

OK so far so good. Now is the last line above consistent with a trade surplus? Sure, it can happen that:

0 < exports – imports < foreign earnings on U.S. assets – American earnings on foreign assets

Example #1: U.S. enjoys a capital inflow even though it has a trade surplus.

Suppose Americans hold $10 trillion in foreign assets that yield a 10% return, and that foreigners hold $40 trillion in U.S. assets that yield a 5% return. So Americans earn $1 trillion in foreign income from assets, while foreigners earn $2 trillion in income from U.S. assets. On net therefore the foreigners have $1 trillion in asset earnings coming to them from the U.S.

During the same year, Americans export $800 billion in goods and services to foreign buyers, while Americans only import $200 billion in goods and services from foreign sellers. Thus there is a U.S. trade surplus of $600 billion.

But there is still a net capital inflow of $400 billion into the U.S. Americans were supposed to, on net, ship out $1 trillion worth of goods/services as net income on the different asset earnings. But Americans only sent out $600 billion on net. So foreigners’ holdings of U.S. assets actually goes up to $40.4 trillion.

Example #2: U.S. has a trade deficit while still experiencing a net outflow of capital (i.e. a capital account deficit).

Suppose Americans hold $10 trillion in foreign assets that yield a 10% return, and that foreigners hold $10 trillion in U.S. assets that yield a 4% return. So Americans earn $1 trillion in foreign income from assets, while foreigners earn $400 billion in income from U.S. assets. On net therefore the Americans have $600 billion in asset earnings coming to them from foreigners.

During the same year, Americans export $800 billion in goods and services to foreign buyers, while Americans import $900 billion in goods and services from foreign sellers. Thus there is a U.S. trade deficit of $100 billion.

But there is still a net capital outflow of $500 billion out of the U.S. Americans were supposed to, on net, enjoy an influx of $600 billion worth of goods/services as net income on the different asset earnings. But Americans only imported $100 billion on net. So Americans’ holdings of foreign assets actually goes up to $10.5 trillion.

Conclusion: I’m not saying that in the real world, the AEI statement is wrong. But especially when I’ve seen an editor at the Wall Street Journal saying something that is flat-out false (after clearly being misled by standard free-trade rhetoric), I think professional economists should be a bit more careful when teaching everybody about trade.

Robert Murphy
Christian, Austrian economist, and libertarian theorist. Research Prof at Texas Tech and author of *Choice*. Paul Krugman's worst nightmare.

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