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Trade Deficits and C+I+G+(X-M)

This letter is to a businessman who heard an interview that I did yesterday on Ross Kaminsky’s show on KOA Radio out of Denver.

Mr. Kevin K_____:

Dear Mr. K_____:

Thanks for listening.

In response to my attempt to calm the fears of those who worry about the U.S. trade deficit, you correctly note that “imports minus exports is part of the GDP equation” and that “if it [imports minus exports] is always negative, then it is dragging down GDP.”  You then understandably ask “How can this be considered ‘good’ in any way?”

You refer, of course, to this identity: GDP = C [consumption spending] + I [investment spending] + G [government spending] + (X [exports] – M [imports]).  Ignore here the many problems that infect the simplistic Keynesian notion of describing the size or health of an economy exclusively by aggregate spending. Instead realize that, contrary to the impression conveyed by the GDP=C+I+G+(X-M) identity, the size of C, of I, and of G are not independent of the size of (X-M).  That is, for a variety of reasons, an increase in the size of the absolute value of (X-M), when X<M – loosely speaking, an increase in the trade deficit – itself likely causes C, I, and G all to rise.

Consider, for example, investment spending.  When foreigners shift the spending of their dollars such that they buy fewer American exports in order to enable themselves to invest more in America – say, by starting or expanding foreign-owned companies in the U.S. – the resulting rise in the U.S. trade deficit is accompanied by an increase in investment spending (I) in the U.S.  Or consider government spending. When foreigners lend more of their dollars to Uncle Sam or to the State of Colorado, not only does the U.S. trade deficit rise, government spending (G) in the U.S. also rises – and it does so without the corresponding fall in consumption (C) or investment spending (I) that would occur had those loans been made exclusively by Americans or had this government spending been funded with hikes in Americans’ current taxes.

The bottom line is that it is incorrect to assume that (X-M) < 0 – again, loosely speaking, a trade deficit – necessarily “is dragging down GDP.”

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

UPDATE: Pierre Lemieux reminds me that the matter is even simpler than I explain in the above letter.  See Pierre’s excellent explanation in the Fall 2015 issue of Regulation.