The Budget Deficit, the Current Account Deficit and the Saving Deficit

*Originally appeared as an NCPA Brief Analysis

Economists often refer to the U.S. trade deficit and the federal budget deficit as problems of inadequate domestic saving.  They speak of these deficits "crowding out" domestic investment.  They allude to unspecified relationships between these deficits but seldom explain them, confusing everyone.

What is often left unsaid is that the trade deficit (when more goods and services are imported than exported), the budget deficit (when government spends more than its tax revenues), and the balance between domestic saving and investment are related to each other.  In fact, their sum must equal zero.  A change in any of them affects all of them.  For example, tax incentives to encourage saving would likely stimulate investment, lower both the budget and trade deficits, and also reduce reliance on foreign capital.  Think of three fat men filling up a telephone booth.  When one inhales, the other(s) must exhale.

An Economy without Government or International Trade. To understand the interdependence of these three imbalances, first consider saving and investment in an economy with no external trade and no government.  All saving (income minus consumption) and investment (output not consumed) are domestic.  With different people doing the saving and investing, plans for each are likely to differ.  If so, market forces — such as interest rates, prices and nominal income — will adjust until actual saving and investment balance.  In this closed economy, if planned saving exceeds investment, incentives for saving (that is, interest rates) will tend to fall until saving and investment balance.  Likewise, if planned investment is greater than saving, they will be brought into balance by market forces, if the economy is at or near full employment.

Think of saving as a leakage from the income stream which, other things equal, tends to shrink income.  Think of investment as an injection into the income stream (in addition to consumption); other things equal, it tends to increase income.  Income and other variables will adjust until the leakage of saving matches the injection of investment (I = S), as shown in the top half of Box 1 in Figure I.

An Economy with Government.  Introducing government into the equation creates another leakage similar to saving in its impact; that leakage is taxes (T).  There is also another injection into the income stream in addition to investment:  government spending (G).  If taxes and government spending balance — that is, if the budget is balanced (G = T) — the net impact of government on income is neutral, and private saving and investment will also balance.

The leakages balance the injections, but the individual components aren't necessarily equal.  If government runs a budget deficit (Box 2), it will be matched by an equal surplus of private savings compared to investment (S >I).  This is how a budget deficit crowds out private investment, by competing with private borrowers for savings.  A budget surplus (Box 3) will be matched by an equal deficit in saving compared to investment (S < I).

An Economy with Government and International Trade.  Now, add international trade to the analysis.  When we do, payments for imports become a third leakage from the domestic income stream while income from exports become a third injection.  An imbalance in any of the three pairs will be matched by an opposite imbalance in the other two taken together.  The principle is the same as in previous examples, but the interactions become more complex.

As shown in Box 4 (Figure II), any excess of investment over saving (I > S) is matched by a combination of budget and export surpluses (G < T and X > M).  The budget surplus is positive government saving, and capital flows out to be invested abroad.  This economy is sacrificing some consumption today for greater prosperity tomorrow.

The U.S. Deficits.  Box 5 (not drawn to scale), depicts the current situation in the United States:  The shortage of private savings (I > S) to finance domestic investment is exacerbated by negative government saving (the budget deficit, G > T).  However, both these shortfalls are met by the trade deficit — or, more precisely, the inflow of foreign investment that finances the trade deficit.  In other words, the United States is relying on foreign savings to supplement domestic savings.  The U.S. economy consumes more goods and services than it produces thanks to foreign credit.  One result is that each year's external deficit adds that amount to net foreign holdings of U.S. dollar assets.  This is not necessarily a bad thing.  Foreign investment has historically played an integral part in U.S. economic growth and shows that America is attractive to investors.  In addition, external investment mitigates the crowd-out effect of government borrowing by expanding the pool of available credit.

The situation can become unsustainable, however, because foreign investment is funding increasing government budget deficits (government dissaving) and inadequate private saving.  The growth in foreign claims on the U.S. dollar relative to U.S. claims abroad makes the U.S. economy vulnerable to the actions of foreign central banks and, possibly, sovereign wealth funds.  Better to reduce that vulnerability sooner rather than have to go cold turkey later.

Reducing the Deficits.  What are the policy implications of these interdependent imbalances?  Here are three:

-Tax incentives to encourage saving would likely also stimulate investment and lower both the budget deficit and the trade deficit.

-Reducing the budget deficit would reduce the vulnerability of the U.S. economy to foreign creditors; rising deficits could lead to foreigners dumping dollar assets, causing equities to decline, interest rates to spike and the dollar to plunge.

-Reducing the budget deficit doesn't necessarily mean higher tax rates; marginal rate cuts reinforced by slower government spending growth would be ideal incentives.

Unfortunately, the recent tax "rebates" designed to stimulate the economy dealt a setback to budget discipline.  Most people probably understand that.  What they probably don't understand is that the increased budget deficit will also tend to worsen our international balance of payments and weaken the dollar.  The hip bone is connected to the thigh bone; so policymakers need to study these interconnected deficits.  They need to borrow my boxes.

Comments (7)

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  1. Scott McTeer says:

    Dad, I appreciated this … my understanding of macro-economics was never anything to write home about, so it’s good to read it now.

  2. Loran Baxter says:

    I believe both the US congress and the administration have staff and advisors who understand how economics work. All Ivy League colleges teach economics classes. Unfortunately, politicians believe making the right choice is impossible due to political factors.
    At a time the economy faces a period of readjustment, maybe involving uncomfortable dislocations, congress and the administration should get together and start a “marketing campaign” to educate our population. By couching the argument as shared short term pain, i.e. lower consumer spending, in order to move the economy into a more sustainable course, maybe some of the less courageous politicians could be provided with the cover to do the right thing.
    I appreciate your efforts to start the education ball rolling, and urge you to take every chance to spread the word that sound fiscal and monetary policies will make the United States more prosperous in the future.

  3. […] a nice review of The Budget Deficit, the Current Account Deficit and the Saving Deficit: Reducing the Deficits. What are the policy implications of these interdependent imbalances? Here […]

  4. MiltonF says:

    Thank you, Mr. McTeer. Nice, concise review. I’ll bookmark this one.

    Do you think the current recession (if it is one) will bring consumers back to reality and inspire them to save more and spend less? There is evidence PCE is falling, but there is no guarantee this adjustment will last.
    Also, how much do the recent changes in pension law and resultant practice of companies to automatically enroll new employess in defined contribution plans, play into helping increase the savings rate?

    Again, well done.

  5. Mike Hinton says:

    I was under the impression that our deficits were nothing to worry about. Foreigners own only a small portion of the overall debt for instance, and the demand for our bonds means we’re paying 3-4% for what we’re borrowing. I’m all for tax cuts wherever we can get them, but I don’t think we are at risk for people dumping dollars. It would take a worldwide panic to depress the dollar that way. The resent dollar drop is mostly due to monetary policy, once that turns around in the near future so will the value of the dollar. I don’t think there’s much to worry about in our current situation. But then again, I’m a physicist, not an economist.

  6. supposn says:

    Trade deficits harm any nation's economy. Domestic and imported goods do not differ economically after they arrive at a USA port of entry or a USA producer's shipping platform. To the extent that any portion of goods or services are produced in foreign nations (and regardless of provider’s or producer’s corporate headquarters locations), they are considered as imported rather than as domestically produced. A product or service can be proportionate mix of both domestic and foreign production. The production of goods and services require production support of other goods and/or services. The sources of production support are generally more from within rather than from beyond the producing nation’s borders. Materials and components, their transportation to the domestic producer of the goods or service, the labor, factory, farm or production machinery maintenance, tools, accountants, administration ……… (a numerous list) of production supporting goods and services are more generally produced or acquired within the nation of the final product’s producer. Regardless of its purpose to satisfy domestic or foreign purchasers, all domestic production contributes to a nation’s gross domestic product, (GDP). When a nation suffers a trade deficit, the GDP is denied the production reflected by the trade deficit itself. The GDP is additionally denied all of the production supporting goods and services that are not reflected within the deficit’s amount. USA’s trade deficit is detrimental to the GDP and thus is a net detriment to our economy. Due to the loss of production supporting goods and services the trade deficit’s detriment to the GDP exceeds the amount of the detriment itself. Anything detrimental to our GDP is also detrimental to our median wage. The GDP and median wage are the two most significant medium and long term indicators of USA's economic well being. Warren Buffett wrote of a proposal to significantly decrease USA’s trade deficit. It’s market rather than government driven. It’s self funding, not a tax and grants government no policy discretion. Respectfully, Supposn

  7. Elias Kurian says:

    Dear sir,
    Well written.

    You pointed out 3 policy implications of the imbalances. The first one reads – “Tax incentives to encourage saving would likely also stimulate investment and lower both the budget deficit and the trade deficit.” I understood that tax incentives will lead to higher savings and thus reduce the trade deficit (Box 5).But I failed to understand how tax incentives helps to save lower budget deficit. Can you help me with a clarification?