Writing for the Peterson Institute for International Economics (PIIE), Dr Maurice Obstfeld has a great, non-technical piece addressing some of the claims made by Michael Pettis (among others) that a trade deficit must be “managed.” Obstfeld details the theoretical and empirical issues with Pettis’s claims very succinctly. Allow me to supplement Obstfeld’s comments with my own.
First, a technical note: there is a difference between the trade balance (the difference between exports and imports) and the current account (exports, imports, and some financial transactions like income from investments and transfers). However, for the purposes here, I will not worry too much about that difference; it won’t matter much for the point I am making. With that out of the way, let’s begin.
In national income accounting, the current account is the difference between national savings and national investment (for those interested in the algebra, you can find it here). Mathematically, we have:
Current Account = Savings – Investment.
This accounting identity is deceptively simple. If one thinks a current account deficit (that is, investment is greater than savings, is a problem (an unjustified claim we will get to in a moment), then the solution is easy: either increase savings or decrease investment. Do that, and the problem is solved.
But realistically what can a government do? I emphasize “realistically” because there seems to be some confusion on that point. Reformers love to propose actions that are utterly divorced from reality. Realistically, there’s not much governments can do. Most of the elements of savings and investment are determined exogenously. It’s not like an individual making a budget. Rather, national savings and national investment are determined by factors far beyond a government’s control: desires of people within the border, desires of those outside the country, plans made by firms, and countless other factors. Savings and investment, in other words, are emergent. They are not things that can be manipulated, not levers to be pulled and tweaked. It’s not that it is difficult to manage them. It is impossible to manage them. That simple accounting equation hides magnitudes of complexity.
Of course, governments can influence one aspect of the identity: savings. National savings is made up of private savings and government savings. Governments can increase their savings (that is, not operate in a deficit) which could, all else held equal, reduce the current account deficit. Although, even that method has its limitations, as Obstfeld discusses. Further, governments have sometimes tried to influence private savings and investment through various incentives and capital controls, but incentives are not mind control. They do not always work and often end up having unintended consequences.
All this assumes that a current account deficit is a bad thing, something to be avoided. Nothing, however, could be further from the truth. More often than not, trade deficits are a sign of good things, as Central Washington University economics professor Robert Carbaugh explains:
Often, countries enjoying rapid economic growth possess long-run current account deficits, whereas those with weaker economic growth have long-run current account surpluses. This relation likely derives from the fact that rapid economic growth and strong investment often go hand in hand. Where the driving force is the discovery of new natural resources, technological progress, or the implementation of economic reform, periods of rapid economic growth are likely periods when new investment is unusually profitable. Investment must be financed with saving, and if a country’s national saving is not sufficient to finance all the new profitable investment projects, the country will rely on foreign saving to finance the difference. It thus experiences a net financial inflow and a corresponding current account deficit. As long as the new investments are profitable, they will generate the extra earnings needed to repay the claims contracted to undertake them. When current account deficits reflect strong, profitable investment programs, they work to raise the output and employment growth, not to destroy jobs and production. (International Economics, 18th ed, pg 302, emphasis in original).
Current account deficits are not a bad thing when they reflect profitable investment opportunities like in the US. It’s why the US has been able to run current account deficits for over 40 years and frequently sets new record levels for industrial production and remains one of the world’s most productive places. But that could change with Trump’s trade war. If countries relocate to the US to avoid tariffs, that is because they are, pretty much by definition, less profitable operating in the US than abroad. Consequently, trade deficits that emerge from the trade war are a worrying sign.
READER COMMENTS
Ahmed Fares
Mar 27 2025 at 1:57am
re: Maurice Obstfeld struggles with accounting identities
First, may I kindly suggest that you go through your article and change all instances of the word savings in the plural to saving in the singular. Saving, the flow variable, is the correct term to use when discussing investment, unlike savings which is a stock variable. You’ll notice that the pdf file you linked to correctly uses the singular form when discussing the identity. This from Wikipedia:
The article by Maurice Obstfeld that you link to has the following paragraph in reference to claims made by Michael Pettis:
The error that Maurice Obstfeld makes is that in the same paragraph, he has switched from a 2-sector model to a 3-sector model, then conveniently ignores the 3rd sector which is domestic private saving. This is the 2-sector model, where S is national saving:
(S – I) + (M – X) = 0
This is the 3-sector model, where is S is now domestic private saving:
(S – I) + (T – G) + (M – X) = 0
If you look at the first chart in the link below, you’ll notice that as soon as the federal budget went into surplus, the domestic private sector went into deficit. That’s a bad thing, not a good thing. National saving, the sum of the first two sectors in the formula above, was still “forced” to be in deficit.
The Spinning Top Economy
Jon Murphy
Mar 27 2025 at 7:09am
I don’t see how it’s a bad thing. You need more evidence. Again I>S is a typical sign of a growing, healthy economy.
I don’t see how. You need more evidence. I see evidence of government crowding out private investment, but I don’t see evidence, to Pettis’s point, of “crowding out” savings.
In short, I don’t see the “error” you claim he’s making.
Ahmed Fares
Mar 27 2025 at 1:55pm
Stephanie Kelton explains (emphasis in the original):
The Untold Story Of How Clinton’s Budget Destroyed The American Economy
I don’t see how it’s a bad thing. You need more evidence. Again I>S is a typical sign of a growing, healthy economy.
Jon Murphy
Mar 27 2025 at 4:06pm
Not going to lie, citing people like Pettis and Kelton are not helping you. They’re very fringey and rely on incorrect theories.
Warren Platts
Mar 28 2025 at 5:41pm
Pettis is the best living economist on Planet Earth. Yes, true, he’s not an actual economist, he’s finance. So he knows how to actually make money. I’m surprised the Chinese haven’t kicked him out yet. I wish he would come home: I hear the Honeymoon Killers are going on a reunion tour!
Jon Murphy
Mar 27 2025 at 8:30am
Here’s the big thing to remember:
An accounting identity is not a theory. It’s an accounting identity. This whole “crowding out savings” angle fundamentally misunderstands that point.
Warren Platts
Mar 28 2025 at 6:26pm
That’s the other thing: if we’re going to run a trade deficit, it’s almost better if the government runs the debt because they at least have more ways to deal with it than the private sector (e.g., printing money, inflation, etc.) If the private sector has a debt crisis, the government will bail them out, to be sure, but the bailed out guys, they will be the bankers and not the little guy, low-propensity voter who will vote for Trump.
Warren Platts
Mar 29 2025 at 5:24pm
You are overthinking this. The fundamental equation is S = I in a closed economy. Planet Earth is a closed economy. Therefore, if some countries insist on running massive trade surpluses, that mathematically entails other countries must run trade deficits. The question is who is the chump here?
Thomas L Hutcheson
Mar 27 2025 at 7:28am
“Realistically, there’s not much governments can do.”
Oh yes there is. It can reduce the fiscal deficit, especially if it replaced taxation of income ( individual and corporate income tax and the wage tax that funds SS and Medicare) with an individual consumption tax and VAT for SS/Medicare.
Of course the reason to reduce the deficit is to promote growth (a lower deficit = lower capital inflow = weaker dollar also shifts relative prices in favor of tradable like manufactures for those who care about THAT issue) not to “manage” the trade balance; there is no reason to care what the trade balance, per se, is.
Jon Murphy
Mar 27 2025 at 9:02am
Agreed. I try address that point (albeit imperfectly and not as succinct as you) about halfway through (the paragraph beginning “of course…”)
BatNat
Mar 28 2025 at 6:59am
The imbalance is due to 1st and even many 2nd world refusing to import our inferior shit. We’re brainwashed to believe MADA IN USA means best, yet advance world knows if it’s food its full of toxins, preservatives, pesticides, steroids, carcinogens banned in their nations. If it’s products, it’s made by overworked, underpaid, nonunion, poorly trained workers forced to use cheapest materials.and doesn’t help having deranged buffoon as president.
Craig
Mar 28 2025 at 10:59am
“But realistically what can a government do? I emphasize “realistically”” <– definitely an important qualification, but perhaps a brief thought experiment? As a prelude to my thought experiment let’s say that you came to me for financial advice because you were mired in debt. We would likely examine your finances, but ultimately my advice would be, generally, increase income and decrease expenditures to the extent practical. Perhaps a second job on the weekend or perhaps moving to a place with lower living costs, establishing a budget, etc. At the end of the process you would work more (export) and spend less (import) less using a broader definition of import/export than commonly used but just applied to your own household. In some way one could say that, at the household level, I would essentially be advising you to run a trade surplus with the rest of humanity. And you’d likely have a trade surplus with your employer(s) and you’d likely still have a trade deficit with such important suppliers/vendors as the local grocery store.
Now that we experiences such a success turning around your finances, our fatal conceit gives us the bright idea, “Hey, we should be running EVERYBODY’s finances because we’re do good at it!” And we propose public policies that compel people to right their financial ships. Now I would definitely reject such a thing and we could very well presuppose that people would individually come to this conclusion on their own, but naturally your post is about whether the trade deficit could be ‘managed’ which I guess implies the federal government.
Indeed your qualifier ‘realistically’ is very important of course, but I would suggest that the government could increase social security tax and create a sovereign wealth fund, which while I would suggest is currently unlikely to happen, it is at the very least on the fringe of the Overton window. Nevertheless, if each individual either voluntarily, or forced by government, did what I am hypothesizing we would do to improve your individual financial situation, is it too far fetched to suggest that if every single individual ran a ‘household trade surplus’ that, in the aggregate, it would be very likely the nation as a whole would also have a trade surplus and everybody would be better off?
Warren Platts
Mar 28 2025 at 6:00pm
The U.S. trade deficit is managed alright. But it’s managed by Germany and China — not the United States. Their industrial policies are our industrial policies for only one reason: because we let them do it. NX = S – I so the problem is the capital inflows (that equal asset sales).
Warren Platts
Mar 28 2025 at 6:07pm
Here it is: Does the United States suffer from a lack of investment monies? No it does not. Granted, that stretch through I-70 in Indiana really needs to be redone. But that’s just a political problem. If you got a good idea here, the venture capitalists will FIND YOU. Therefore, the argument that trade deficits are a good thing maybe works for developing countries like the USA in the 19th century, but that does not entail that the USA’s 21st century MASSIVE trade deficit is a good thing.
Warren Platts
Mar 29 2025 at 1:12pm
And I think this is Pettis’s entire point: If the government ended its fiscal deficits, the current account deficit would remain the same because its “managed” by the surplus countries.
Ahmed Fares
Mar 29 2025 at 3:27pm
Warren,
The following quote from Pettis about Germany, for example, supports your argument. The whole article is worth reading.
Trade Balances and Trade Interventions and Trade Protectionism
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