Monday, October 25, 2010

Trade Deficit = Capital Inflow = BOP = 0

We hear a lot about the U.S. "trade deficit" or the "current account deficit," but we don't hear as much about the offsetting "capital account surplus" or "capital inflow" that has to exist when there's a trade deficit.  For example, a Google search reveals three times more results for "current account deficit" (775,000) than for "capital account surplus" (224,000).  

The current account and capital account are the two main components of the U.S. Balance of Payments (BOP), which is a record of all international transactions for both: a) trade flows and b) capital flows in a given period.  Every international transaction (e.g. export, import, U.S. investment abroad, foreign investment in the U.S.) is recorded on a double-entry accounting basis, so that each transaction involves both a debit and credit.  Under double-entry accounting, debits have to equal credits, which applies to BOP accounting, where:

BOP = CURRENT ACCOUNT + CAPITAL ACCOUNT = CREDITS - DEBITS = 0

The chart above displays annual figures for the U.S. capital account (brown line) and current account (blue line) back to 1980, and shows graphically that the CURRENT ACCOUNT = CAPITAL ACCOUNT = BOP = 0. 

For the year 2007, we had a current account deficit or "trade deficit" of about $700 billion, and a capital account surplus, or capital inflow of approximately the same amount, of about $700 billion (statistical discrepancies account each year for any differences).  Americans in 2007 purchased $2.35 trillion of goods and services from foreigners, which was more than the $1.65 trillion foreigners spent on U.S. goods and services in that year.  On the other hand, foreigners invested more than $2 trillion in U.S. assets in 2007 (stocks, bonds, real estate, Treasuries, direct investment), which was more than the approximately $1.4 trillion invested by Americans overseas in foreign assets, resulting in a net capital inflow of about $700 billion into the U.S. that year.  

In other words, the $700 billion "trade deficit" in 2007 was exactly offset by a $700 billion capital account surplus, or capital inflow, and the overall BOP = -$700 billion + $700 billion = 0.  What are the lessons from this?

1. There are no BOP deficits once we account for all international transactions, both for: a) goods and services, and b) financial transactions.  For all of the one-sided coverage in the press about the "trade deficit," you would almost never even know that there is an offsetting "capital surplus" or "capital inflow."  It's important for the general public to understand that trade deficits are offset by capital inflows on almost a 1:1 basis, resulting in a "balance of payments" for international transactions.  When the public constantly hears about "trade deficits" without any understanding of the offsetting surplus, that economic ignorance allows politicians and special interest groups to exploit the general public, by advancing and promoting protectionist trade policies aimed to reduce the "trade deficit," or by refusing to approve trade agreements between Colombia, Panama and Korea, etc.  

2. The "trade deficit" generates so much negative coverage, that the significant advantages of capital inflows from abroad get frequently overlooked.  Since 1980, the U.S. has attracted almost $8 trillion of foreign investment, which has provided much-needed equity capital that has allowed U.S. companies to start or expand, has provided much-needed debt capital that has also funded the expansion of American companies, along with providing debt capital for U.S. consumers in the form of mortgages, student loans, and car loans.  Some of the $8 trillion of investment includes billions of dollars of Foreign Direct Investment, which has funded thousands of new projects in the U.S. (Toyota factories for example) and created hundreds of thousands of jobs.             

26 Comments:

At 10/25/2010 4:30 PM, Blogger Steve said...

Yes, so we sell less than we buy, and the difference is made up of money flowing into the country in the form of capital, which allows us to buy more than we sell this period.

That is fine in the short run, but is that functional over the long-term?

If the long-term current account surplus is actually investment capital that generates productivity increases, or builds production base, or educates a workforce, then all is well.

But when that capital inflow is in the form of debt used to buy unproductive assets or services, and which won't be used to structurally increase future wealth, then is that capital account surplus a result of a good trade structure, or an unsustainable one?

 
At 10/25/2010 4:53 PM, Blogger PeakTrader said...

Steve, what if foreigners pay you to borrow their money?

 
At 10/25/2010 7:22 PM, Blogger rufus said...

A loan is not the same thing as investing.

They're sinking us. And, we're making up silly stories about "investing."


We're the stupidest people in the history of the solar system.

 
At 10/25/2010 7:42 PM, Blogger juandos said...

"They're sinking us. And, we're making up silly stories about "investing.""...

So rufus I'm guess this particular YouTube clip might possibly speak volumes to you, right?
Chinese Professor

 
At 10/25/2010 11:01 PM, Blogger Hydra said...

So trade is a zero sum game?

 
At 10/25/2010 11:08 PM, Blogger Hydra said...

A loan is not the same as investing? Sure it is. You borrow to invest in your future. The bet being your investment pays more than the leverage it costs.

As a business, if you don't borrow enough then you yield customers to your competitors. If you borrow too much then you risk the enterprise. You face risk either way, and the issue is to price risk correctly.

 
At 10/25/2010 11:17 PM, Blogger Hydra said...

The Chinese professor is an obvious work of fiction. Once again juandos illustrates his tenuous discretion in reality.

 
At 10/26/2010 1:08 AM, Blogger rufus said...

We're borrowing money (via treasuries) for consumption (of Chinese-made goods,) and to give it to the rent-seekers on Wall Street, the Pentagon, and the rest of the Federal Bureaucracy.)

The Companies that make the money importing said Chinese goods transfer the profits to overseas subsidiaries, where, courtesy of our inane tax laws, it stays.

Meantime, investment in our own plant is becoming, virtually, nonexistent, and jobs are flying to India, and China.

This is idiocy of the highest order.

There is not an amoeba on Jupiter's farthest moon without more common sense than the Collective- Americana.

We deserve what we're going to get.

 
At 10/26/2010 1:11 AM, Blogger rufus said...

In answer to the above poster:

Borrowing for investment is good.

We're not borrowing for investment; we're borrowing for Consumption. That's a One-Way Ticket to the Poor House.

On the "Express" Train.

 
At 10/26/2010 2:27 AM, Blogger PeakTrader said...

This comment has been removed by the author.

 
At 10/26/2010 2:27 AM, Blogger PeakTrader said...

Rufus, how does lower prices and lower interest rates make Americans poorer?

It's rational to buy more when prices fall and borrow more when interest rates fall.

Would you prefer higher prices and higher interest rates to spend less and save more?

Here's what James Fallows said about China:

James Fallows studied American history and literature at Harvard, where he was the editor of the daily newspaper, the Harvard Crimson. From 1970 to 1972 Fallows studied economics at Oxford University as a Rhodes scholar.

January/February 2008

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China.

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. The average cash income for workers in a big factory is about $160 per month. On the farm, it’s a small fraction of that. Most people in China feel they are moving up, but from a very low starting point.

This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on.

 
At 10/26/2010 7:30 AM, Blogger Sean said...

I agree with PeakTrader's last comment, with the observation that consistently consuming beyond what we produce is not a healthy arrangement for us. It begets bad habits and distorts our economy towards specific service jobs that will be vulnerable when the spigot stops flowing.

 
At 10/26/2010 9:03 AM, Blogger juandos said...

"The Chinese professor is an obvious work of fiction"...

Doh! Really?!?!

What gave it away? The date of 2030 AD?

"Once again juandos illustrates his tenuous discretion in reality"...

Coming from you hydra, well that's rich!... ROFLMAO!

Aren't wondering about the people who produced it or are they not part of your template?

 
At 10/26/2010 2:11 PM, Blogger PeakTrader said...

Sean, I can help you with your "bad habits." Give me your extra consumption, until you feel you're consuming enough.

 
At 10/26/2010 3:57 PM, Blogger Buddy R Pacifico said...

Praise be to Rufus, excellent comments.

 
At 10/26/2010 4:43 PM, Blogger PeakTrader said...

Rufus says: "We're the stupidest people in the history of the solar system."

Who are "we're?"

 
At 10/26/2010 7:06 PM, Blogger Craig said...

But when that capital inflow is in the form of debt used to buy unproductive assets or services, and which won't be used to structurally increase future wealth, then is that capital account surplus a result of a good trade structure, or an unsustainable one?

Unsustainable, most likely. But you do recognize that the problem is with the government's fiscal deficit and not with trade flows, don't you?

 
At 10/26/2010 7:12 PM, Blogger Buddy R Pacifico said...

Peak Trader asks Rufus "who are we're?" (we're the stupidest people).

Peak Trader makes Rufus' point with James Fallows 2008 quote:

"In effect every person in the (rich) United States has borrowed about $4000 from someone in the (poor) People's Republic of China."

Peak Trader, here is a chart showing US per Capita GDP growth compared to US per Capita Debt growth (YIKES).

 
At 10/26/2010 7:24 PM, Blogger juandos said...

Hey Buddy, I'm not disbeliving that graph at all but I got to ask you what your opinion of Rubino is?

 
At 10/26/2010 8:38 PM, Blogger Buddy R Pacifico said...

This comment has been removed by the author.

 
At 10/26/2010 8:54 PM, Blogger Buddy R Pacifico said...

Juandos, I really don't know much about Rubino. The chart is supposedly from the Federal Reserve.

 
At 10/27/2010 2:52 AM, Blogger PeakTrader said...

Buddy, household assets increased faster than household debt.

Moreover, GDP reflects only the production side of the economy. The gains on the consumption side were even greater.

 
At 10/27/2010 2:06 PM, Blogger Sean said...

PeakTrader,

Sean, I can help you with your "bad habits." Give me your extra consumption, until you feel you're consuming enough.
Or... I can save that money and invest, despite psychological incentives not to.
Meanwhile I'll be telling my kids that they really shouldn't do their chores or let them help out around the house, but I'd like to give them their allowances anyway until they turn 18. Then I'll kick them out on the street.

 
At 10/27/2010 3:47 PM, Blogger Bo Zimmerman said...

"And they’ll be protected from the risk of potentially catastrophic hyperinflation"

I thought the observation that "inflation is any time and every where a monetary phenomenon" was a settled issue. In 19th century America, growth was DEFLATIONARY. What credibility does this guy have in claiming it is INFLATIONARY?!

 
At 10/28/2010 8:05 AM, Blogger Eric said...

The US has gone from being the largest creditor nation to the largest debtor nation. This was done largely by government sale of debt to our trading partners (capital inflow) to meet the difference between tax revenue and expenses. These debts are real and must be paid back; I don't think Cochrane's policy of "flowers and chocolate" (default?) is realistic. What are our options for repayment if our trading partners are merchantilist and will not import from us? Trade deficits matter and economic theory fails to deal with them realistically.

 
At 11/05/2010 2:16 AM, Blogger Rider I said...

1. It's important for the general public to understand that trade deficits are offset by capital inflows on almost a 1:1 basis, resulting in a "balance of payments" for international transactions.
This leaves out numerous calculations from the trade deficits creating real value economics compared to financial sector economic power.

“economic ignorance” Ah professor your small little algorithm does not give you the proper equated power to say economic ignorance as ignorance is done by those who merely scratch the surface.
2. The trade deficit incurs negative public feedback. Now so will the improper balancing of this country’s economic sheets based on this theory I see which misses many calculations?
“has provided much needed debt capital that has also funded the expansion of American companies, along with providing debt capital for U.S. consumers in the form of mortgages, student loans, and car loans” This debt capital you speak of has nothing to do with actual international competition which the trade deficit is based on for the US to be allowed to have a higher Growth rate. With your economic ignorant theory professor since you feel to call names. You would have us believe that we should keep up the high trade deficit, because of debt capital coming in from foreign countries. However, again based on your theory the US’s growth rate has barely been sustainable during the times of your data sets. As such, this is mainly due to trade deficits. As trade surpluses create a reserve in capital. Were as trade deficits create a negative balance that gets bigger as our capital inflows are based on other countries deepening our debt by interest for the US to keep moving forward. Along with that debt capital if I understand you correct means that the foreign investors buying our debts, our real estate, and our other factors of foreign aid are funding our loans. Which is much different from our competitors who are funding their own loans on monetary reserves which the US and other free markets do not have because they use debt capital as given by purchasing debt of the US from other countries; meaning we are at their mercy and whims for our economics.
I would say that this blog calls not for those worrying about trade deficits on economic ignorance. As trade deficit is not worried about balance sheet economics. Yet many other factors, such as capital reserves, capital debts, help to create developing countries which takes reserves to do, and a myriad of other things that this blog post Professor shames me to hear you call economic ignorance of your opposition opinion. Name calling should be backed by much more than a 3 piece addition mathematic problem that does not have any variables or other proper multipliers or out of the box equations.

Rider i

 

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