09 Jul 2018

AEI on Trade Deficits: The Stunning Conclusion

All Posts, Trade 16 Comments

You have all waited with breath which is baited for the resolution. Last week I posted this AEI meme:



…and said I thought there was a basic flaw in it, but I didn’t have time to type it up then. (To repeat, I’m sure the economists at AEI know this nuance; my point was just that the above is not right and so that’s awkward in a meme that’s lecturing somebody on trade. Also, to avoid confusing anybody who missed my first post: I am NOT defending Trump’s policies or pontifications on trade here.)

In the comments some of you raised interesting points, but nobody hit the particular thing I had in mind.

So here it is:

A capital account surplus (i.e. net inflow of investment from foreigners) is equivalent to a current account deficit, not a trade deficit. The trade balance is only one component of the current account balance. A trade deficit is neither necessary nor sufficient to have a net inflow of foreign investment. Specifically, the U.S. could have a trade deficit as well as a net outflow of capital, and the U.S. could have a net inflow of foreign capital at the same time it runs a trade surplus.

Here’s the Wikipedia entry on the current account, but unfortunately I’ve yet to find an online treatment that is very good. (Also I’ve seen different definitions and ways to handle things like literal transfers of money between the members of countries. It’s also tricky if you look at the movement of gold back on the gold standard.) So I’ll just give enough intuition/rigor in the present post to show why the AEI meme above is not quite right.

We have

capital account + current account = 0

(Again, I’m defining those terms broadly. I’ve seen other treatments that have a separate thing called the “financial account” but in my mind that is confusing. So the principle of what I’m doing in this post is right, but my categories might not line up with other treatments.)

So a capital account surplus (which occurs when foreigners invest more in U.S. assets than Americans invest in foreign assets during the time period in question, let’s say it’s a year) occurs if and only if there’s a current account deficit.

The current account in turn consists of the trade balance (which itself is separated into goods and services, but I’m not worrying about that here), but it also includes the net earnings of Americans on foreign assets. So think of the current account as like “net income,” where Americans can earn income (a) from exporting more than we import, but also (b) from earning more interest, dividends, and profits on our foreign assets than foreigners earn in interest, dividends, and profits on their U.S. assets.

So if foreigners are investing on net in the U.S., we have a capital inflow or a capital account surplus. That means we have a current account deficit, i.e. the current account is less than zero. The AEI meme above would suggest we must have a trade deficit. But no, that’s not correct:

current account < 0


trade balance + net foreign earnings < 0

(exports – imports) + (American earnings on foreign assets – foreign earnings on U.S. assets) < 0

exports – imports < foreign earnings on U.S. assets – American earnings on foreign assets

OK so far so good. Now is the last line above consistent with a trade surplus? Sure, it can happen that:

0 < exports – imports < foreign earnings on U.S. assets – American earnings on foreign assets


Example #1: U.S. enjoys a capital inflow even though it has a trade surplus.

Suppose Americans hold $10 trillion in foreign assets that yield a 10% return, and that foreigners hold $40 trillion in U.S. assets that yield a 5% return. So Americans earn $1 trillion in foreign income from assets, while foreigners earn $2 trillion in income from U.S. assets. On net therefore the foreigners have $1 trillion in asset earnings coming to them from the U.S.

During the same year, Americans export $800 billion in goods and services to foreign buyers, while Americans only import $200 billion in goods and services from foreign sellers. Thus there is a U.S. trade surplus of $600 billion.

But there is still a net capital inflow of $400 billion into the U.S. Americans were supposed to, on net, ship out $1 trillion worth of goods/services as net income on the different asset earnings. But Americans only sent out $600 billion on net. So foreigners’ holdings of U.S. assets actually goes up to $40.4 trillion.


Example #2: U.S. has a trade deficit while still experiencing a net outflow of capital (i.e. a capital account deficit).

Suppose Americans hold $10 trillion in foreign assets that yield a 10% return, and that foreigners hold $10 trillion in U.S. assets that yield a 4% return. So Americans earn $1 trillion in foreign income from assets, while foreigners earn $400 billion in income from U.S. assets. On net therefore the Americans have $600 billion in asset earnings coming to them from foreigners.

During the same year, Americans export $800 billion in goods and services to foreign buyers, while Americans import $900 billion in goods and services from foreign sellers. Thus there is a U.S. trade deficit of $100 billion.

But there is still a net capital outflow of $500 billion out of the U.S. Americans were supposed to, on net, enjoy an influx of $600 billion worth of goods/services as net income on the different asset earnings. But Americans only imported $100 billion on net. So Americans’ holdings of foreign assets actually goes up to $10.5 trillion.


Conclusion: I’m not saying that in the real world, the AEI statement is wrong. But especially when I’ve seen an editor at the Wall Street Journal saying something that is flat-out false (after clearly being misled by standard free-trade rhetoric), I think professional economists should be a bit more careful when teaching everybody about trade.

16 Responses to “AEI on Trade Deficits: The Stunning Conclusion”

  1. Andrew says:

    Stupid question: Why do those things have to add to zero?

    Let’s look at a time period with a single transaction: Argentina buys $100 worth of corn from Brazil and therefore Brazil has a trade surplus of $100. Where does the -$100 go in Brazil’s balance of payments? Is it considered a capital outflow or a loss on foreign assets? Or am I missing something?

    • Bob Murphy says:

      Well if you’re thinking of a literal transfer of a $100 bill from people in Argentina to Brazil, then that might be a “financial transaction.” (Again I’m not sure how people use that category because I saw what seemed to be inconsistent treatments.)

      In the framework I posted, we would say that Brazilians invested $100 more in acquiring Argentinian assets than vice versa. In this case, the asset was a $100 bill.

      • Andrew says:

        It’s interesting because the Wikipedia article that you link above claims that capital account and financial account are synonymous.

        Thanks for the response Bob. That is what I was thinking the answer was but the meme you posted above and all of the similar arguments we’ve been seeing lately have seemed very strange to me. It’s like reciting an accounting tautology in response to a policy proposal: “These guys that hate the trade deficit are so silly. Don’t they know that the opposite of a positive number is a negative number?”

    • Bill Drissel says:

      Andrew: You have asked the question that everyone who pontificates on the “balance of payments” question should know how to answer. My personal experience with ordinarily-informed people is that no one can.

      When Argentina buys $100 Argentine of corn from a merchant in Brazil, that $100 Argentine can be redeemed for real value ONLY in Argentina. The Brazilian corn merchant must find someone who wants $100 Argentine to buy something from Argentina. (Foreign exchange markets are a great help here.)

      We suppose the Brazilian corn merchant finds that someone (thru intermediaries) and he trades his $100 Argentine for the equivalent in Brazilian money. (Foreign exchange markets are a great help in determining that equivalence.) The Brazilian corn merchant now has Brazilian money with which he can pay his workers. (He could not pay them in Argentine money.)

      If the new owner of the $100 Argentine buys goods from Argentina, then neither Argentina nor Brazil has a merchandise trade deficit or surplus due to the corn transaction. BUT, if the new owner of the $100 Argentine makes an investment in Argentina, then Brazil has a merchandise trade surplus of $100 Argentine AND Argentina has a merchandise trade deficit of $100 Argentine. This is because *capital money flows* are in a different accounting category from *money flows for the exchange of goods*.

      The spreadsheet at: https://www.bea.gov/iTable/iTable.cfm?reqid=62&step=1#reqid=62&step=6&isuri=1&6210=1&6200=1 tells the story for the US. An hour spent understanding the forty-odd lines will leave you knowing more about international transactions than anyone you know and more than 99% of the people pontificate in the media.

      You should come away with a couple of important points:
      Any nation that imports capital must run a merchandise trade deficit. (In practice. It’s possible to jiggle the numbers so a contrived situation shows a capital surplus and trade surplus.)
      Americans don’t save much. To provide well-equipped jobs for the millions entering the workforce every year, the USA must import capital (= run a merchandise trade deficit.)
      For the USA in our lifetimes, the merchandise trade deficit is a Good Thing.

      Bill Drissel
      Frisco, TX

  2. Transformer says:

    So in simple terms if Americans own lots of foreigner property that they rent out and spend all the rent on foreign goods that are shipped back to the US then there could be a merchandise trade deficit with no inward investment at all ?

  3. Silas Barta says:

    I’ve heard people make similar remarks, and it annoys me.

    I mean, in the trivial case, say two countries never trade. Then some rich guy in country A makes an equity investment it Scrooge’s factory in country B. They export its output. Net positive foreign investment, net export of goods. Are the clouds going to open to reveal a giant finger wagging at us now?

    There are similar arguments about how there can’t be net saving unless the government issues debt. Like I can’t drop some pennies in my piggy bank or something.

    • Tel says:

      If they are fiat pennies then they are indeed recorded as government debt (or central bank debt if you want to be pedantic) although you cannot call on that (i.e. your fiat penny only gets you another fiat penny in exchange) but you can pay your protection money so it’s worth something (because government says they are worth something). Issued fiat currency is recorded as a liability to the central bank.

      If they are gold coins (i.e. with intrinsic value, not fiat) then you don’t need government debt to keep gold (you do need government permission if you don’t enjoy confiscation).

    • Bob Murphy says:

      Silas on the last point (people claiming government deficits are necessary for net private saving) I think I did a good job of showing how silly that is in this article.

  4. Tel says:

    China has done quite well out of what would outwardly appear to be mercantilism. It’s pulled them out of a backyard agricultural economy and into an industrial and technology economy.

    They brought in huge amounts of foreign investment, many companies have brought technology to China, and set up factories there. At the same time they have various ways to ensure their balance of trade leans toward exports. They protect their local industry by imposing rules that foreign investors must partner with local Chinese business and must transfer some technology to the locals. The Chinese government imposes restrictions on capital flows and they use protectionism as a tool to control the consumption of their own people.

    Can any economist explain why it sometimes works out OK?

    FWIW personally I don’t think China can keep doing what they have been doing, they are going to need to shift to more internal consumption and less aggressive saving, and that is happening.

    The latest Peter Shiff episode he lists all the advanced goods that America imports from China, as a way of showing how much the US economy is struggling, but wait, if we all know that mercantilism is such a useless dud idea, why does even Shiff admit that China is beating the USA in so many industries? They should be failing with this dud strategy, right?

    • Andrew says:

      Personally, I don’t buy a lot of the anti-Mercantilist arguments. But if the question is, “Why does China outcompete the US in so many industries?” then I think that trade policy can only be a very small piece of the answer. In my view, US government fiscal policy and industrial regulatory burden have a much larger impact on why the US has trouble competing with China.

      • Tel says:

        Agreed, there are many factors.

        The union situation favours industry in China instead of the USA. Pretty much all labour laws are more relaxed in China. Also minimum wage laws in China are (very sensibly) set by local jurisdiction and are relatively low compared with world standards. For example… Australia has a stupid system of federal wage fixing (at high levels) which eviscerates the jobs in country towns, so the country kids have to either leave home and rent a room in the city or stay home and sit out of work depressed… Environmental laws are much more relaxed in China. The Chinese education system is heavily geared towards teaching vocational skills, rather than abstract feminist collective basket weaving.

        Some things still favour the USA: a huge technological head start, awesome know-how and probably the world’s most developed system for investment finance. Remember that only two generations ago China was murdering anyone wearing glasses or who could play a musical instrument because those people were dangerously educated. You don’t rip the most intelligent and creative people out of your gene pool and then bounce right back into technological leadership.

        My position is that division of labour gives diminishing returns. So if you are a household and you want to operate on your own with minimal trade then you have to sacrifice a lot of productivity to achieve that. If you are a small nation like Hong Kong or Singapore then trade becomes very valuable because you can take a small cut out of a large flow volume. At the other end of the scale, if you are a large nation like USA, Russia, China then you can benefit from trade but you can live without it easily enough. Take it or leave it.

        Also, if government needed to depend on tariffs for revenue, they would quickly learn not to increase that tariff too much, because the Laffer Curve problem bites hard on a tariff collector.

        • Andrew says:

          I think that tariffs are obviously preferable to income tax as a means of raising government revenue. And Bob agrees. He admitted it in his debate with Vox Day.

        • Harold says:

          An important point here, I think is that educated does not mean intelligent. Killing the educated is not the same as removing the intelligent from the gene pool, especially where the level of education was generally quite low.

          On your point about trade and size of trading bloc, it seems right, but maybe to be precise we could say that large bloc can have nearly all trade internal rather than external, but small blocs require lots of external trade.

    • Benjamin Cole says:

      I agree. Singapore does even better, and the more you know about Singapore, the more you know they are miles and miles from a free markets-free trade economy.

      It seems that having a pro-business government is very successful, even if free markets are trampled on right and left.

      Another observation: Suppose you want to invest a few billion in a new factory and need financing, In China perhaps you work with government to ensure a market and financing.

      In the US, the financiers say, “Whoa! You compete with China? Sorry we will not lend.”

      So what happens to R&D? Capital investments?

      China also has a pro-growth central bank, that sometimes buys bad loans from banks. This prevents their banks from seizing up.

      Maybe none of this would work in the US.

  5. Warren Platts says:

    Good points on the current account. What I disagree with Perry’s meme is that it assumes that a bunch of foreign investment due to a current account deficit is a good thing. It is not necessarily. A big developed country like the USA should be running a modest surplus, and it should be we that are investing in the ROW, particularly in Latin America and Africa. Those places have much greater scope for economic growth, thus the returns on investment there should be greater than in the US. The profits from those investments will then flow back into the USA further boosting our current account. Better to have foreign profits flowing in than American profits flowing out.

    imho ymmv

  6. Daniel R Grayson says:

    Re: “I’m defining those terms broadly”

    Hmm, what is the definition of “current account”?

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