Public Debt And Current Account Deficits

Yesterday, there was an article at Vox which takes issue with a statement from Donald Trump which connects the US public debt with current account deficits.

Trump ran his campaign on dividing people, is out to destroy health care and wants a regressive system of taxation and so should be resisted. At the same time, a blanket opposition is counterproductive, especially when it is an important matter.

Vox quotes Trump:

For many, many years the United States has suffered through massive trade deficits; that’s why we have $20 trillion in debt.

In response, Vox claims:

The US trade deficit refers to the fact that the US imports more from the world than it exports. The national debt is the result of the fact that the US government spends more revenue than it collects. There’s no direct relationship between the two.

The whole article is written to claim that there is no connection. But anyone who knows the sectoral balances identity will recognize that there is a connection.

So the sectoral balances identity is:

NL = DEF + CAB

where, NL is the private sector net lending, DEF is the government’s deficit and CAB is the current account balance of payments (and is to a zeroth order approximation, exports less imports).

Of course, this is an identity and shouldn’t be confused for any behavioural hypothesis but it’s still useful in creating a narrative around a model (such as an SFC model) with behaviour for households, firms, the financial system, the government and the rest of the world.

On an average the private sector net lending is a small positive number relative to GDP (such as 2%), although it can fluctuate a lot. So for the U.S. economy, we saw that it was negative a lot in the 2000s and then reverted to a large positive just before and during the crisis.

One should of course keep in mind the correct causality connecting the three terms. What connects them is demand and output at home and abroad.

So the government’s deficit is affected by exports and imports. If there’s a large current account deficit, there’s a fall in demand and hence output and hence income and hence taxes leading to a higher government deficit than otherwise. Deficits in turn affects the public debt.

In other words, the U.S. public debt would have been lower, ceteris paribus, had the problem of the U.S. trade imbalance would have been addressed. This would have happened because of higher national income and higher taxes.

People don’t see the connection because they are comparing different nations. So for example, Japan has been successful in international trade and yet has a high public debt. In the other extreme, Australia has had large current account deficits over the years and public debt much lower than Japan (relative to GDP). But one should do a ceteris paribus comparison.

See Part 2 here: Public Debt And Current Account Deficits, Part 2

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