The Individual Analogy

Consider an individual named Rajiv. For an individual, GNP is analogous to Rajiv’s annual income since his income represents the value of goods and services produced with his labor services. Domestic spending is analogous to the value of the goods and services purchased by Rajiv during the year. It corresponds to Rajiv’s consumption of goods and services that serves as a proxy for his welfare level. Trade for an individual occurs whenever a transaction occurs with someone outside his household.

Let’s assume for simplicity that Rajiv earns $30,000 per year. The assumption of no GNP growth in the base case implies that he continues to earn $30,000 in the second period and thus experiences no income growth. The assumption of no trade imbalances implies that Rajiv engages in no borrowing or lending outside of his household. That implies that he spends all of his income on consumption goods and thus purchases $30,000 worth of goods and services. This level of consumption remains the same in both periods, implying that his standard of living is unchanged.

Another way of interpreting balanced trade for an individual is to imagine that he exports $30,000 worth of labor services and afterward imports $30,000 worth of consumption goods and services. Since exports equal imports, trade is balanced.

The Individual Analogy

In case two, our individual, Rajiv, would again have a $30,000 income in two successive periods. In the first period, suppose Rajiv borrows money, perhaps by running up charges on his credit card. Suppose these charges amount to $5,000 and that the interest rate is a generous 10 percent. Assuming Rajiv does not save money in the first period, his consumption level in the first period would be the sum of his income and his borrowed funds. Thus he would enjoy $35,000 worth of goods and services reflecting a standard of living higher than his actual income.

In the second period, Rajiv must pay back the $5,000 in loans plus the interest charges, which, at a 10 percent interest rate, would amount to $500. Thus $5,500 of Rajiv’s $30,000 income would go toward debt repayment, leaving him with only $24,500 to spend on consumption.

In this case, extra consumption, or a higher living standard in period one, is achieved by sacrificing a lower living standard in the future.

Note that in the first period Rajiv imports more goods and services in consumption than he exports in terms of labor services. Hence, this corresponds to a trade deficit. In the second period, Rajiv imports fewer goods and services in consumption than the labor services he exports; hence, this corresponds to a trade surplus.

Evaluation

Case two reflects legitimate concerns about countries that run large or persistent trade deficits. The case highlights the fact that trade deficits, which arise from international borrowing, may require a reduced average standard of living for the country in the future when the loans must be repaid.

An example of this situation would be Mexico during the 1970s and 1980s. Mexico ran sizeable current account deficits in the 1970s as it borrowed liberally in international markets.

In the early 1980s, higher interest rates reduced its ability to fulfill its obligations to repay principal and interest on its outstanding loans. Their effective default precipitated the third world debt crisis of the 1980s. During the 1980s, as arrangements were made for an orderly, though incomplete, repayment of Mexico’s loans, the country ran sizeable current account surpluses. As in case two here, Mexico’s current account deficits in the 1970s allowed it to raise its average living standards, above what would have been possible otherwise, while its current account surpluses in the 1980s forced a substantial reduction in living standards.

It is worth emphasizing that current account deficits are not detrimental in the periods in which the deficits are occurring. In fact, current account deficits correspond to higher consumption, investment, and government spending levels than would be possible under balanced trade. Instead, current account deficits pose a problem only when the debt repayment occurs, which is when the country is running current account surpluses. Trade deficits raise national welfare in the periods in which they occur, while trade surpluses reduce welfare in the periods in which they occur.

In other words, in terms of the national welfare effects, the problem here isn’t large or persistent trade deficits but rather the large and persistent trade surpluses that might arise in the future as a result.

It is also worth noting that trade deficits in this case need not be a problem in the long run if they are not too large. Just as an individual may make a choice to substitute future consumption for present consumption, so might a nation. For example, an individual may reasonably decide while young to take exotic vacations, engage in daredevilish activities, or maybe purchase a fast car, even if it means taking out sizeable loans. Better to enjoy life while healthy, he may reason, even if it means that he will have to forgo similar vacations or activities when he is older. Similarly, a nation, through an aggregation of similar individual decisions, may “choose” to consume above its income today even though it requires reduced consumption tomorrow. As long as the future reduced consumption “costs” are borne by the individuals who choose to overconsume today, deficits for a nation need not be a problem. However, if the decision to overconsume is made through excessive government spending, then the burden of reduced consumption could fall on the future generation of taxpayers, in which case there would be an intergenerational welfare transfer.

The Individual Analogy

The third case is analogous to our individual Rajiv with, say, a $30,000 income in period one. The trade deficit in the first period means that he borrows money using his credit card to purchase an additional, say, $5,000 worth of “imported” consumption goods. Thus in period one the person’s consumption and standard of living are higher than reflected by his income.

In the second period, the GNP rises, corresponding to an increase in Rajiv’s income. Let say that his income rises to $40,000 in the second period. We’ll also assume that all credit card loans must be repaid along with 10 percent interest charges in the second period. Consumption spending for Rajiv is now below his income. Subtracting the $5,000 principal repayment and the $500 interest payment from his $40,000 income yields consumption of $34,500.

The investment story above is similar to the case in which an individual takes out $5,000 in student loans in period one and earns an advanced degree that allows him to acquire a better-paying job. Assuming the educational investment does not add to his consumption pleasures (a seemingly reasonable assumption for many students), his welfare is unaffected by the additional spending that occurs in period one. However, his welfare is increased in period two since he is able to consume an additional $4,500 worth of goods and services even after paying back the student loans with interest.

Evaluation

The lesson of case three is that trade deficits, even if large or persistent, will not cause long-term harm to a nation’s average standard of living if the country grows rapidly enough. Rapid economic growth is often a cure-all for problems associated with trade deficits.

In some cases, it is possible for growth to be induced by investment spending made possible by borrowing money in international markets. A trade deficit that arises in this circumstance could represent economic salvation for a country rather than a sign of economic weakness.

Consider a less-developed country. Countries are classified as less developed because their average incomes are very low. Indeed, although many less-developed countries, or LDCs, have a small, wealthy upper class, most of the population lives in relative poverty. Individuals who are poor rarely save very much of their incomes, therefore, LDCs generally have relatively small pools of funds at home that can be used to finance domestic investment. If investment is necessary to fuel industrialization and economic growth, as is often the case especially in early stages of development, an LDC might be forced to a slow or nonexistent growth path if it restricts itself to balanced trade and limits its international borrowing.

On the other hand, if an LDC borrows money in international financial markets, it will run a trade deficit by default. If these borrowed funds are used for productive investment, which in turn stimulates sufficient GDP growth, then the country may be able to raise average living standards even after repaying the principal and interest on international loans. Thus trade deficits can be a good thing for less-developed countries.

The same lesson can be applied to the economies in transition in the former Soviet bloc. These countries suffered from a lack of infrastructure and a dilapidated industrial base after the collapse of the Soviet Union. One obvious way to spur economic growth in the transition is to replace the capital stock with new investment: build new factories, install modern equipment, improve the roads, improve telecommunications, and so on. However, with income falling rapidly after the collapse, there were few internal sources to fund this replacement investment. It was also not obvious which sectors were the best to invest in. Nevertheless, one potential option was for these countries to borrow funds on international financial markets. Trade deficits that would occur under this scenario could be justified as an appropriate way to stimulate rapid economic growth.

Of course, just because trade deficits can induce economic growth and generate long-term benefits for a country doesn’t mean that a trade deficit will spur long-term economic growth. Sometimes investments are made in inappropriate industries. Sometimes external shocks cause once profitable industries to collapse. Sometimes borrowed international funds are squandered by government officials and used to purchase large estates and big cars. For many reasons good intentions, and good theory, do not always produce good results. Thus a country that runs large and persistent trade deficits, hoping to produce the favorable outcome shown in case three, might find itself with the unfavorable outcome shown in case two.

Finally, a country running trade deficits could find itself with the favorable outcome even if it doesn’t use borrowed international funds to raise domestic investment. The United States, for example, has had rather large trade deficits since 1982. By the late 1980s, the United States achieved the status of the largest debtor nation in the world. During the same period, domestic investment remained relatively low especially in comparison to other developed nations in the world. One may quickly conclude that since investment was not noticeably increased during the period, the United States may be heading for the detrimental outcome. However, the United States maintained steady GNP growth during the 1980s and 1990s, except during the recession year in 1992. As long as growth proceeds rapidly enough, for whatever reason, even a country with persistent deficits can wind up with the beneficial outcome.

The Individual Analogy

Consider our individual, Rajiv, who has an annual income of $30,000 over two periods. This corresponds to the constant GDP in the above example. Rajiv would run a trade surplus in period one if he lends money to others. One way to achieve this is simply to put money into a savings account in the local bank. Suppose Rajiv deposits $5,000 into a savings account. That money is then used by the bank to make loans to other individuals and businesses. Thus in essence Rajiv is making loans to them with the bank acting as an intermediary. The $5,000 also represents money that Rajiv does not use to buy goods and services. Thus in period one Rajiv exports $30,000 of labor services, but imports only $25,000 of consumption goods. The excess is loaned to others so that they may be consumed instead in the first period. It is clear that Rajiv’s standard of living at $25,000 is lower in the first period than the $30,000 he could have achieved had he not deposited money into savings.

In the second period, we imagine that Rajiv again earns $30,000 and withdraws all the money plus interest from the savings account. Suppose he had earned 10 percent interest between the periods. In this case, his withdrawal would amount to $5,500. This means that in period two Rajiv can consume $35,500 worth of goods and services. This outcome also implies that Rajiv’s domestic spending capability exceeds his income and so he must be running a trade deficit. In this case, Rajiv’s imports of goods and services at $35,500 exceed his exports of $30,000 worth of labor services; thus he has a trade deficit.

Is this outcome good or bad for Rajiv? Most would consider this a good outcome. One might argue that Rajiv has prudently saved some of his income for a later time when he may have a greater need. The story may seem even more prudent if Rajiv suffered a significant drop in income in the second period to, say, $20,000. In this case, the savings would allow Rajiv to maintain his consumption at nearly the same level in both periods despite the shock to his income stream. This corresponds to the words of wisdom that one should save for a rainy day. Savings can certainly allow an individual to smooth his consumption stream over time.

Alternatively, one might consider the two periods of the story to be middle age and retirement. In this case, it would make sense to save money out of one’s income in middle age so that one can draw on those savings and their accumulated earnings during retirement when one’s income has fallen to zero.

On the other hand, excessive saving in the first period might make Rajiv seem miserly. Few people would advise that one save so much as to put oneself into poverty or to reduce one’s living standard below some reasonable norm. Excessive prudence can seem inappropriate as well.

Evaluation

The prime example of a country that mimics the first period of case four is Japan during the 1980s and 1990s. Japan ran sizeable trade surpluses during those two decades. As this story suggests, the flip side of the trade surplus is a financial account deficit that implied a considerable increase in the amount of loans that Japan made to the rest of the world. Although Japan’s trade surplus has often been touted as a sign of strength, an important thing to keep in mind is that Japan’s trade surpluses implied lower consumption and government purchases, and thus a lower standard of living than would have been possible with balanced trade. Although trade surpluses can also result in lower investment, this effect was not apparent for Japan. During those two decades of investment, spending as a percentage of GDP always exceeded 25 percent, higher than most other developed countries.

These surpluses may turn out to be especially advantageous for Japan as it progresses in the twenty-first century. First of all, it is clear that Japan’s surpluses did not usher in an era of continual and rapid GDP growth. By the early 1990s, Japan’s economy had become stagnant and finally began to contract by 1998. However, rather than allowing a decline in GDP to cause a reduction in living standards, Japan could use its sizeable external savings surplus to maintain consumption at the level achieved previously. Of course, this would require that Japan increase its domestic consumption and begin to run a trade deficit, two things that did not occur even by 2009.

In another respect, Japan’s trade surpluses may be advantageous over the longer run. Japan, along with most other developed nations, will experience a dramatic demographic shift over the next three decades. Its retired population will continue to grow as a percentage of the total population of the baby boomers reach retirement and people continue to live longer. The size of the Japan’s working population will consequently decline as a percentage of the population. This implies an increasing burden on Japan’s pay-as-you-go social retirement system as a smaller number of workers will be available per retiree to fund retiree benefits. If at that time Japan draws down its accumulated foreign savings and runs trade deficits, it will be able to boost the average consumption level of its population while reducing the need to raise tax burdens to fund its social programs. Of course, this outcome may never be realized if Japan’s economy does not rebound strongly from its recent stagnant condition.

Overall, regardless of the outcome, Japan’s economy today, faced with a potentially severe recession, is certainly in a stronger position by virtue of its accumulated foreign savings than it would be if it had run trade deficits during the past two decades.