Trade Balances and Capital Flows

This is Unit Seven of Principles of Macroeconomics: trade balances and capital flows. Unit six measured the price level. This unit measures what a country buys from the world, and what it owes for the difference. Carry one idea through. A trade deficit is a country borrowing from the rest of the world, and borrowing is neither good nor bad in itself: what decides the outcome is what the money funds, and how quickly the lenders can leave. The accounting is settled early, the identity makes it mechanical, and the capstone puts four countries in the same accounting position with four different endings. By the end you will compute the current account from its four components, say which way capital flowed, use the saving and investment identity, read a trade statistic without over-reading it, and judge when a deficit is healthy.

Four entries on what is actually measured: goods alone, the broader account, the three accounts, and adding them up.

The figure most often reported.

MAC 0601 The Trade Balance

The merchandise trade balance counts goods alone: exports minus imports, for things that cross a border in a container. It is the figure most often reported, though services are more than half of output in rich economies. Reporting goods alone can make a country look worse at trade than it is, if it sells services abroad.

The broader measure.

MAC 0602 The Current Account

The current account is the broader measure. It adds services, income earned on assets abroad and paid to foreign owners, and one-way transfers such as foreign aid, charity and money sent home by workers. Four components, then: goods, services, income, and transfers. The current account is the one the exam means by trade balance.

Where that account sits.

MAC 0603 The Three Accounts

The balance of payments records every transaction between residents and foreigners, in three accounts: the current account, the capital account, and the financial account. The financial account records investment flows: deposits abroad, loans, purchases of foreign stocks and bonds. Older books call that the capital account. Today the capital account is a small separate item, mainly debt forgiveness and similar transfers.

Adding the current account up.

MAC 0604 Computing the Current Account

Add the four components with their signs. Goods and services each give exports minus imports, so a country importing more goods than it exports enters a negative number. Income is receipts from assets owned abroad minus payments to foreign owners of assets at home. Transfers are one-way payments, negative when money flows out. Take goods at minus five hundred, services plus one hundred and forty, income plus ninety, and transfers minus one hundred and thirty: the total is minus four hundred, a current account deficit. Notice the merchandise balance was minus five hundred, so the two differ by a hundred. A question that gives you all four components is testing whether you use all four.

Three entries on what a deficit means: borrowing, why the accounts must offset, and which way the capital moved.

What a deficit actually means.

MAC 0605 A Deficit Means Borrowing

A current account deficit means a country buys more from the world than it sells, and the difference is financed by borrowing from abroad. So a deficit is a net inflow of financial capital, and a surplus is a net outflow. The country with the deficit is the net borrower; the one with the surplus is the net lender.

Why the accounts balance.

MAC 0606 The Balance of Payments Identity

Because every purchase abroad is paid for, the accounts balance. A current account deficit is matched by an equal net inflow recorded in the financial account: goods come one way, and the claims that pay for them go the other. The two are not two facts but one fact recorded twice, which is why they must offset.

Reading the direction of a flow.

MAC 0607 In or Out?

To say which way capital moves, ask who ends up owning a claim on whom. If a foreigner acquires an asset here — a bond, a building, a share of a company — capital has flowed in. If a resident acquires an asset abroad, capital has flowed out. Then check against the current account: a country with a current account deficit has, on net, capital flowing in, because that is how the deficit is paid for. Gross flows go both ways at once, and only the net direction is fixed. Capital flowing in is not money arriving as a gift: it arrives as a claim, and claims are repaid with interest or dividends, which is why the income component grows as past borrowing accumulates.

Three entries on the identity behind all of this, and the unit's hardest claim.

The identity behind it.

MAC 0608 The Saving and Investment Identity

The national saving and investment identity says the supply of financial capital equals the demand for it: private saving plus the inflow from abroad equals private investment plus government borrowing. The inflow from abroad is the trade deficit, imports minus exports. Terms switch sides when signs change, so a budget surplus makes government a supplier of capital rather than a borrower.

Putting it to work.

MAC 0609 Applying the Identity

Rearranged, the identity explains the trade balance: the trade deficit equals investment minus private saving minus the government surplus. Hold every term but one fixed and read off the result. If investment rises with saving unchanged, the extra funds come from abroad and the deficit widens. If private saving rises with investment unchanged, the deficit narrows. If the budget deficit widens with saving and investment unchanged, the trade deficit widens with it. Take private saving of five hundred, investment of five hundred, and a government deficit of two hundred: the trade balance is minus two hundred, and halving the budget deficit halves the trade deficit too. The identity holds always, so it never says which term caused which.

The unit's hardest idea.

MAC 0610 The Trade Balance Is Macroeconomic

The trade balance is set by saving and investment across the whole economy, not by how well particular industries compete and not by trade policy. A tariff can change which goods are traded without changing the balance. This is the unit's hardest idea, and unit seventeen returns to it when trade policy is argued about directly.

Four entries on what moves the balance, and on borrowing that works, borrowing that does not, and the fastest way it goes wrong.

What does move net exports.

MAC 0611 What Moves Net Exports

Net exports move with a few things: incomes here and abroad, relative price levels, the exchange rate, trade policies, and shifts in what buyers prefer. When incomes abroad rise, foreigners buy more, so exports rise. A country's own income rising raises imports, which is why a boom tends to widen a trade deficit and a recession to shrink it.

Borrowing that works.

MAC 0612 Borrowing That Pays

Borrowing from abroad can pay for itself, if what it funds raises the country's ability to produce and so to repay. The United States ran deficits through most of the middle eighteen hundreds while building railroads. South Korea did the same in the nineteen seventies, borrowing heavily, investing heavily, and running surpluses later.

Borrowing that does not.

MAC 0613 Borrowing That Fails

Borrowing can also fail. If the funds go to consumption, or to investments that do not raise productivity, the repayments still come due. Several countries borrowed heavily in the nineteen seventies and eighties and were left with debt and no extra growth. The deficit itself did not decide the outcome: what the borrowed money was spent on did.

The fastest way it goes wrong.

MAC 0614 Sudden Stops

The sharper danger is a sudden stop: foreign lenders who were willing yesterday withdraw quickly, and the borrowing that funded spending disappears at once. Several East Asian economies went through this in nineteen ninety-seven and ninety-eight, and deep recessions followed. What makes a sudden stop possible is short-term lending that can leave fast, which is why unit thirteen returns to it.

Three entries on the other side of the ledger, two measures often confused, and how to read a published figure.

The other side of the ledger.

MAC 0615 Surpluses Are No Guarantee

A surplus is not proof of health either. It means a country saves more than it invests at home and sends the difference abroad. Japan has run large surpluses since about nineteen ninety alongside slow growth. Investing abroad instead of at home can be a sign that domestic opportunities are scarce, which is not good news.

Two measures often confused.

MAC 0616 Level of Trade and Balance of Trade

The level of trade and the balance of trade differ. The level is how much a country trades; the balance is whether exports exceed imports. A country can trade very little and run a large deficit, or trade heavily and run a surplus. The level depends mostly on size, geography and history: big economies trade more inside themselves.

Reading a published figure.

MAC 0617 Reading a Trade Statistic

Before drawing a conclusion from a trade figure, ask four things. Is it goods alone or the full current account, since the two can differ substantially? Is it measured in money or as a share of output, since a deficit that doubles while the economy triples has shrunk? Does it describe the level of trade or the balance, which are independent? And which way was the economy moving, since a boom widens a deficit and a recession narrows one without anything structural changing. A headline reporting a record deficit in dollars may be smaller against output than a decade ago, may be the goods figure with a services surplus left out, and may have widened because the economy grew faster than its partners. None of these questions is about whether trade is good or bad.

One entry to close the unit: four countries in the same accounting position, and what actually differed.

The judgement the unit builds to.

MAC 0618 When Is a Trade Deficit Healthy?

Here the unit's governing idea is at work. A trade deficit is a country borrowing from the rest of the world, and borrowing is neither good nor bad in itself. The identity settles what a deficit is: private saving plus the inflow from abroad equals private investment plus government borrowing, so a deficit means the country invests more than it saves and the gap is filled from outside. What the identity cannot settle is whether that is wise, because it says nothing about what the borrowed funds are doing. Borrowing pays for itself when it funds something that raises the capacity to produce, because the same investment that created the debt also creates the means to service it. It fails when it funds consumption, or investment that does not raise productivity, because the repayment still falls due and nothing new has been built to meet it. Four countries, one accounting position. The first borrows to build railroads and ports, and a generation later the freight pays the interest several times over: the United States for much of the nineteenth century. The second borrows to buy imported consumer goods, and when the loans mature it has the debt and nothing that earns. The third borrows to invest, invests well, and later runs surpluses: South Korea. The fourth borrows short term from lenders who can leave in a week, and when sentiment turns the funding vanishes, the currency falls, and a deep recession follows: East Asia in the late nineteen nineties. All four ran deficits, and only the length of the loans and the use of the money differed. Three cautions carry forward. A surplus proves nothing on its own, as Japan's decades of surpluses beside slow growth show. The maturity of the borrowing matters as much as its use, because long-term investment cannot be withdrawn in a week while short-term money can. And the deficit is not a scoreboard of competitiveness: it is set by saving and investment across the whole economy, so a policy aimed at particular industries changes which goods cross the border without changing the balance.

Look at what you can now do. You can compute the current account from all four of its components, and notice when the goods figure alone would have told a different story. You can say which way capital flowed by asking who ends up owning a claim, and check it against the current account. You can use the saving and investment identity by moving one term at a time, remembering it says which things move together and never which caused which. You can read a trade statistic by asking about the measure, the scale, the level against the balance, and where the economy was in its cycle. And you can judge when a deficit is healthy, by what the borrowing funds and how fast it can leave. Unit eight turns to the model that explains output and prices together.