A (possibly) helpful way of thinking about the trade deficit

That foreign currency has to go somewhere.

Economics, what is it good for? (Huh!) Much of the field is just common sense grafted to math.

But one area where economists and, well, normal people differ is foreign trade, in particular the trade deficit. It’s not hard to explain in accounting terms. But those explanations are typically not very helpful, because the underlying intuition remains murky.

So, in that light, here’s a stab at making things more understandable. (I’m not too proud to admit that, as someone who hasn’t taken macro in a looong time, this started as a way to make things more understandable to myself.)

But I’m not going to start in the United States and I’m not going to start with trade in goods and services.

Let’s start with people living in, say, Japan. A country that’s friendly to the U.S. and has incomes and an economy that’s fairly similar to our own.

Let’s imagine that people in Japan have a certain level of income. And with that income they can do two things: they can spend it or they can save it.

Now let’s imagine that the Japanese save a lot – typically, they do. In fact, they save so much so that they’re run out of really productive investments to make within Japan itself. All the good ones are taken, so the return on the marginal investment isn’t so hot.

So, seeking to make a decent return on their savings, they look to other countries to invest.

One great place to invest is the United States. On reason is our rule of law and our sophisticated financial markets.

But another good reason to invest in the U.S. is that we Americans aren’t huge savers. We like to spend a lot, and the federal government likes to spend even more.

Our habit of spending rather than saving means that we don’t save enough to fund all the potential investment in the U.S. As a result, there are attractive investments in the U.S. just waiting to be funded.

So the Japanese use their money – the Japanese currency is called the Yen – to invest in America. These Japanese investors use their Yen to buy stock in American companies, to invest in startups, to purchase U.S. Treasury bonds and so on. The Japanese get those assets and, in exchange, we Americans get their Yen.

Now, this presents a problem: we can’t spend Yen in America. In fact, we can’t spend Yen anywhere except for in Japan.

And we’ve got two options for spending those Yen. We can purchase Japanese goods – cars, cameras, steel, electronics and so on – or we can invest in Japan, by buying stock in Japanese companies, funding Japanese startups, or purchasing bonds issued by the government of Japan. In other words, pretty much the same choices Japanese had when those Yen were in their own pockets.

But here’s the difference: the Japanese are savers while Americans are spenders.

So, while the Japanese would be more likely to save their Yen, we’re more likely to buy things with them.

The end result is that the United States runs a trade deficit with Japan, meaning a deficit in the exchange of goods and services.

But one reason that trade deficit exists is because we run a capital surplus with Japan, meaning that more investment flows from Japan to the U.S. than flows from the U.S. to Japan.

And a big reason for that capital surplus is simply that the Japanese save a lot and Americans don’t. When Japanese invest in the U.S. economy and give us Yen in return, we could simply turn around and invest those Yen back in the Japanese economy, becoming owners of Japanese businesses, startups or government bonds.

But we don’t, and a big reason for that is simply that we’re big spenders. If U.S. households chose to save more – or, more importantly, if the federal government chose to borrow less – than the capital surplus flowing into the U.S. would decline, because there would be enough domestic saving to satisfy all the profitable investments that could occur in the U.S.

But until such a time as we get budget deficits under control, that capital surplus is likely to exist. Without it, American factories would go unbuilt and American research would go, well, unresearched. The U.S. economy would grow more slowly and Americans would become poorer than we’d otherwise be.

And – this seems like a ripe time to remind people – being poorer is worse than being richer.