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Beware of Celebrating Decreases in the Current-Account Deficit

Keynesians – or, more generally, economists obsessed with aggregate demand – are fond of exports because foreigners’ expenditures on exports are demand for ‘our’ country’s goods and services.  Aggregate-demand-obsessed economists also dislike imports because ‘our’ consumers’ expenditures on imports is demand, not for output produced at home but, rather, for output produced abroad.  Unless that ‘demand’ returns to the home economy in the form of foreigners’ demand for ‘our’ exports, then aggregate-demand-obsessed economists are unhappy because the sum of C+I+G+[Xports-Mports] goes down.

This obsession with aggregate demand leads to a special fear of trade deficits because, by definition, a trade deficit occurs whenever Mports > Xports.  The term in the bracket (in the equation above) is negative!  Aggregate demand is less than C+I+G.

But not so fast….

Suppose this year Americans spend a total of $1M on imports.  Foreigners, in turn, immediately spend this entire $1M buying Texas land from a Texan living in Texas.  Mr. Texan then spends the entire $1M of his land-sale proceeds buying South Carolina peaches, California wines, Massachusetts web-designs, and oodles of other American-made (and only American-made) goods and services.  In this case, America will run a $1M trade deficit, but C will, as a result, rise by exactly the same amount that (X-M) falls: by $1M.

Now consider a second scenario.  As before, Americans this year spend $1M on imports, but now foreigners spend this entire $1M buying American exports.  America, in this second scenario, runs no trade deficit.  Unlike before, C doesn’t rise; but also unlike before (X-M) doesn’t fall by $1M.

The total dollar value of C+I+G+[X-M] is the same in the second scenario as it is in the first.

Even within the excessively simplistic C+I+G+[X-M] framework, therefore, the issue of trade deficits misleads.  Even if all you care about is aggregate demand, then you should still be aware that a current-account (or ‘trade’) deficit is not necessarily a ‘leakage’ of aggregate demand from the domestic economy.

Therefore – and this point gets to the little debate that I had with Pingry in the comments section of this earlier post – a change in the trade deficit, by itself, tells you nothing of the larger picture; it tells you nothing about what’s happening to aggregate demand.

Perhaps a lower trade deficit results in higher aggregate demand, but – as the two altnerative scenarios above show – this relationship is hardly necessary.  In the second of the above scenarios, the trade deficit is lower than in the first scenario by $1M – indeed, in the second scenario, trade is “balanced.”  But aggregate demand in the second scenario is neither higher nor lower than it is in the first scenario.

So Paul Krugman’s celebration of a falling manufactured-goods trade deficit (even if we follow Pingry’s interpretation of this celebration as being, really, a celebration of a falling trade deficit more generally rather than being a Donald-Trumpian celebration of the ‘return’ of American manufacturing) is inappropriate.  How does Krugman know that the higher demand for American exports results in higher aggregate demand for the American economy?  He doesn’t know.  He can’t possibly know.

Indeed, in today world of national currencies foreigners who sell things (“imports”) to Americans but who do not buy (as many) things (“exports”) from Americans are likely investing in dollar-denominated assets whatever dollars they don’t spend on American exports.  This fact means that much, if not all, of America’s trade deficit manifests itself in America as investment spending.

So to the extent that investment spending in America today is composed of dollars that foreigners could but don’t use to purchase American exports, a decrease in America’s trade deficit tomorrow might not increase aggregate demand in the U.S. even if it does increase demand for goods and services recorded in America’s current account.