The Political Economy of Trade Balances: Too Simple to Understand!
The issue of bilateral trade balances between the United States (U.S.) and its trading partners (not enemies!) has dominated the discussion of transatlantic trade relations in the past 18 months. President Trump sees a big problem in the U.S. trade deficit and has accused China and the European Union (EU)—in particular Germany—of unfair behavior. As a consequence, he has waged a highly risky trade war. It seems clear that he is not bothering to look at the full picture.
To fully understand both the political economy and the dynamics of these relations, it is necessary to analyze the balance of payments in its entirety. At the heart of the debate, we find the following identity, which cannot be logically altered:
Exports minus imports = Savings minus investments,
which alternatively can be expressed as
Current account = Capital account plus change in foreign exchange reserves.
This identity raises three interesting questions in this context, the first asking how U.S.-EU trade relations look once we also include trade in services as well as the flow of yields on foreign portfolio and direct investments. The second question asks whether bilateral balances can be interpreted meaningfully. Finally, the third question deals with the causes of a current account imbalance and thus with the political instruments to reduce such imbalances.
As for the first question, we must add the balance of services trade as well as the balance of capital yields to the trade balance and consolidate this as the current account. In this context, it has been shown that the U.S. has been running a modest current account surplus with the European Union since 2008. The bilateral trade balance is passive from the U.S. perspective, but the U.S. runs a sustainable surplus in trade in services. In addition, U.S. citizens earn much more income on U.S. investments in Europe than European investors earn in the United States. Thus, focusing on trade in goods exclusively is misleading.
Regarding the second question, it is very difficult to interpret a bilateral imbalance. U.S. citizens and firms deal with partners all over the world. The export portfolio of some countries may well be much more attractive to them than other countries’ offerings. To illustrate this point, let us conduct a thought experiment: imagine the world consists of three countries with limited but generally balanced trade: Germany is only buying oil from Saudi Arabia and selling only machinery to the U.S., which is additionally selling telephones to Saudi Arabia. Germany runs a trade deficit with Saudi Arabia, the U.S. with Germany, and Saudi Arabia with the U.S., respectively. It seems reasonable not to worry about any of these balances, since all three reflect comparative as well as competitive advantages and preferences.
Not only from this perspective are bilateral deficits meaningless. They regularly appear and disappear, as the European trade balance throughout the early 2000s shows: In 1999, the EU ran significant trade deficits with East Asian emerging economies. These disappeared when China entered the world market and built up a bilateral trade surplus with the EU. Customers and producers in the EU strongly benefitted from the new market participant and shifted their demand from their former suppliers to Chinese companies.
The third question asks what drives a trade surplus or a trade balance in general. To approach this question, one should first consider that a country’s balance of payments (BoP) is the aggregate of its citizens’ individual transactions with partners abroad. Thus, it makes sense to assume a microeconomic foundation of this macroeconomic balance.
This is given by the intertemporal approach to the BoP, which suggests that citizens and firms decide about their savings and investments (home or abroad) mostly simultaneously with their decision to buy or sell; however, it is plausible that the financial decisions precede the real transactions logically. The financial transfer then leads to an international movement of purchasing power as well as real and nominal exchange rate movements. A country with net capital inflows (i.e., savings are lower than investments) will experience a real appreciation of its currency, which encourages imports and discourages exports (everything else equal). The opposite happens in a country with net capital outflows.
From this perspective, one cannot argue that a trade deficit is a problem per se. It strongly depends on the need for foreign capital and the use of capital inflows; countries with a young population and in need of capital should aim at net inflows, causing a trade deficit. Only if these capital inflows are not invested does a problem occur, as can be seen in case of the Greek borrowing after joining the Eurozone, which has mainly been spent on salaries and not on investments.
Aging societies should rather invest part of their savings abroad, automatically achieving a trade surplus. Needless to say, an aging society with significant unemployment and infrastructure gaps should still invest the bulk of its savings at home.
This logic can be easily seen in transatlantic relations. It has been rightly stated (see for instance, an op-ed by Maurice Obstfeld) that Germany does not invest enough, so investment abroad in combination with high savings (in an aging society) drives the German current account surplus. Indeed, although Germany should have a moderate surplus, it is by far too high—but not because of beggar-thy-neighbor-policy. The country is in urgent need of more private and public investments.
In the U.S., on average, young citizens do not save a high share of GDP but business investment is strong, so savings drive the current account deficit. Again, the U.S. deficit may well be judged as being too high—but again, not because of other countries’ unfair practices but because of low savings in the U.S. The public sector as well as many private agents are highly indebted. Savings should rise.
In sum and to apply the three questions to transatlantic relations, the bilateral U.S. trade deficit toward the EU (1) is restricted to trade in goods, (2) has only a limited logical meaning, and (3) is obviously not rooted in trade-related policies.
This renders trade policy an ineffective tool to reduce imbalances. As long as the new U.S. tariffs do not change the intertemporal calculus, i.e., savings and investments in the U.S., the U.S. deficit in the general current account will not change. Tariffs only lead to reduced imports, which then cause (1) the U.S. dollar to appreciate, (2) less purchasing power in other countries, (3) other countries to impose counter tariffs and (4) a price increase for inputs for U.S. producers. As a consequence, U.S. exports also fall (leaving its current account unchanged).
In addition, it may well be expected that the U.S. tax reform with a tax policy favorable for business will attract more capital from abroad. In our identity, savings do not change and investment rises. This also leads to a rising current account deficit (via real exchange rate movements).
Put differently, the White House’s policy mix—consisting of reduced taxes and increased tariffs—is likely to increase the American trade deficit. It might be interesting to see how the president will react in this scenario.