I’m noticing a trend among some commentators who are increasingly linking the trade deficit with China to the US government budget deficit. “For a generation, we got cheap crap from China—and they got our debt,” notes Batya Ungar-Sargon. The idea that trade deficits and budget deficits are connected goes back to the great Martin Feldstein, who as chair of President Reagan’s Council of Economic Advisers argued that the increase in the trade deficit in the early 1980s was the result of the budget deficit. In 1992, however, he wrote an NBER paper called “The Budget and Trade Deficit Aren’t Really Twins,” concluding that an increased budget deficit could also manifest as a reduction in private investment instead of net exports, especially in the longer run.
Today’s commentators are not so much trying to blame the trade deficit on the budget deficit, although some such as AEI’s Michael Strain support the connection by casting the trade deficit as a symptom of the budget deficit, somewhat in the spirit of Feldstein. What I’m more concerned about is the suggestion that the US government budget deficit is the result of the trade deficit. The trouble with accounting identities in macroeconomics is that causality can run in either direction!
It’s definitely not correct to think that a trade deficit must necessarily lead to a government budget deficit or even contribute to it. What is true is that if one country runs a trade deficit with another country, it must also run a capital account surplus with that country, which is to say that the foreign country will accumulate financial claims on the home country. These financial claims could be in the form of debt, but they could also take the form of equity investments, foreign direct investment (FDI), real estate, or other assets.
In particular, suppose the US runs a trade deficit with China, specifically because China, for whatever reason, produces large quantities inexpensive goods that US consumers demand. (Calling this “crap” is a semantic choice.) What the trade deficit does is increase foreign demand for US financial assets, since more dollars end up abroad as a result of the import transaction—and those dollars must ultimately go somewhere. This increased foreign demand for US financial assets will lower the interest rates available on debt for US borrowers, or the cost of capital for US businesses, or both. When foreigners have more dollars to invest, the supply of investable dollar funds shifts outward, lowering the financing costs for those who want to raise capital in dollars.
The idea that this demand for US assets causes the budget deficit is like discovering that you’re heavily in debt and then blaming the credit card company for having offered you a low introductory rate. The US government didn’t have to respond to heavy demand for dollar assets and low interest rates by running massive budget deficits. If it hadn’t, then more of that money would likely have ended up in the private sector, financing productive private investment to a greater extent and supporting business growth and job creation.
Hopefully, the idea of blaming the US government’s massive budget problems on the trade deficit with China won’t take off, but I worry that it will be an appealing scapegoat. The only parties to blame for the looming budget crisis are the US government and the US voters who put them in office. Put another way, we can’t blame the bartender for our hangover.