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Home Publications Blogs Beat the Press Paul Krugman on Savings, Investment, and the Trade Balance

Paul Krugman on Savings, Investment, and the Trade Balance

Saturday, 21 June 2014 08:17

Paul Krugman may have misled readers of his blog yesterday with the comment:

"the trade balance is a macroeconomic phenomenon, determined by the excess of savings over investment."

As an accounting identity the trade deficit is equal to the excess of national investment over national savings. However it would be wrong to conclude that the U.S. trade deficit is caused by our failure to save enough, especially in the current context where the economy is well below its potential level of output.

To take a simple example, suppose that we all become virtuous savers and reduce our consumption by an amount equal to 1 percent of GDP (@ $170 billion annually). This would reduce demand in the economy by $170 billion. In more normal times we might tell a story where this fall in demand would lead to a drop in interest rates, which would in turn spur additional investment. Lower interest rates should also lead to a lower valued dollar (fewer people want to hold dollar denominated assets at a lower interest rate). The lower valued dollar would lead to more exports (our goods are now cheaper to foreigners) and fewer imports (foreign goods are now relatively more expensive than domestically produced goods).

In this story, the end result is that we have the same level of output with higher levels of investment and net exports replacing the lost consumption. We have a somewhat higher level of national savings (the increased investment partially offset the rise in savings) and a lower trade deficit.

That would be the standard story of how a savings-investment balance determines the size of the trade deficit. However, no one can tell this story in today's economy. If everyone started saving more as described above, it would mostly just lead to a fall in output and employment.

The reason is that the adjustment process would not come close to offsetting the loss in demand. With the short-term interest rate already at zero we would see no help there. Long-term rates could fall some, but the reduction in longer term rates would at best have a trivial effect on investment. The dollar may not move at all, both because interest rates will have changed little and also because many countries (yes, China is the biggest) have a policy of targeting the price of their currencies against the dollar. If market forces started to push the value of the dollar down against their currencies they would respond by buying more dollars to keep up the value of the dollar.

In this story, savings will actually rise by considerably less than the initial $170 billion increase in savings because GDP will have fallen. This means that people who had been saving instead find themselves unemployed and spending from past savings (dissaving). The government will also be saving less (running larger deficits), since it is collected less in taxes and paying out more in transfers like unemployment benefits. There would be some reduction in the trade deficit since at lower levels of GDP we buy less of everything, including imports, but for the most part the trade deficit and national savings balance is maintained by lower savings from the reduction in GDP offsetting most of the increased in intended savings.

By contrast, if foreign countries suddenly started buying more of our stuff (say the dollar fell by 20 percent) then we would see an increase in employment and output. This would lead to more savings as formerly unemployed workers get jobs and can now start putting money into the bank. Also government savings increases as increased employment means more taxes and less money paid out in transfers. The net effect is that a lower trade deficit leads to more net national savings.

When considering these accounting identities it is important to keep the stories on causation straight, otherwise you get some really bad policies. Paul Krugman of course knows this and has made the same point many times (here for example), but we must work hard to prevent confusion on the topic.


Note: link fixed, thanks Squeezed Turnip. Also, typo corrected.

Comments (25)Add Comment
Oops: link error
written by Squeezed Turnip, June 21, 2014 11:14
Dean, the first link goes to the same 2012 blog post as the last link.
A question about a sentence
written by PeterE, June 21, 2014 12:20
Not sure what this sentence means: "The net effect is that a lower trade leads to more net national savings."
@ PeterE
written by Larry Signor, June 21, 2014 1:57
I think Dean meant
"The net effect is that a lower trade [deficit] leads to more net national savings."

Which is a point consistent with his analysis.
Thanks for the detailed explanation of the "accounting identity".
written by Another Scott, June 21, 2014 2:21
You often refer to this "accounting identity", but I've had a hard time picturing how it all fits together. "What? A larger trade deficit means a larger federal budget deficit due to an identity? That's not obvious by inspection!" - has been my reaction in the past. This post makes it much clearer.

I guess the point is, if you consider all of the money going in and out, then a trade deficit must to be made up somewhere. It doesn't exist in isolation.

This does, of course, assume that the national accounting statistics are accurate. ;-)

A question, though. According to various measures, the federal budget had a surplus in the last couple of years of Clinton's administration. But we didn't have a trade surplus (the last US trade surplus apparently was in 1975). I suppose I could look up the numbers, but what's your best explanation for what happened to balance the identity in Clinton's case? Is it that we didn't "really" have a federal budget surplus when all the accounts were included, or did other factors (e.g. Y2K and the tech investment bubble) do it?


The zero lower bound and quantitative easing
written by Peter K., June 21, 2014 3:39
What I don't understand is that Bernanke said the zero lower bound doesn't matter because they can do QE. There doesn't seem to be a consensus on this. Bernanke also seems to think they have been successful closing the output gap in a timely matter which I don't agree with obviously. My guess is that they did what they thought was political possible (even though they are supposed to be independent.) Once you hit the zero bound, the Fed starts building a balance sheet which politicians can harp on.

There doesn't seem to be any consensus as a said. The U.S. didn't do QE very much. They'd start and stop and wound down prematurely. But the U.S. seems better off than Europe which didn't do QE and the U.S. had sequestration and austerity. And Abenomics seems to be working in Japan.
written by Jan Smith, June 22, 2014 8:08
I am not an economist but it seems to me that more national saving is not merely one way to improve the current-account balance. At the end of the day, it is the ONLY way. (I am NOT talking here about the NIPA definitions.)

Of course, some thrift policies, such as tariffs, yield a larger improvement in the c-a balance than others, such as VATs. Like tariffs, currency pegs are thrift policies that yield large improvements in the c-a balance. So in your second scenario above, the US saves inefficiently but in response other nations save more efficiently. (I am NOT talking here about allocative efficiency but the effect of a given amount of national thrift on the c-a balance.) Small wonder that in this scenario the USA does not in the end experience much improvement in its c-a balance.

Surely this is the heart of the global tragedy: the world's nations are locked into a thrift race. Each nation saves more in response to more saving by the others; the aggregate result is a stable world saving glut and, hence, world stagnation.

Keynes seems to have anticipated this as early as 1941.

Of course, rising household and government debt can push saving from the present into the future. But rising debt is not stable and eventually must collapse. This collapse, far more than the bank runs, should be the chief lesson of the so-called financial crisis (it was in fact a debt crisis). Since 2008 the world has been feeling the full force of its saving glut.

Which nation will crash next, do you think? A good bet would be China. Of course, China has stored a cushion at the US Dept of Treasury and surely will use it.

Any evidence?
written by Thornton Hall, June 22, 2014 3:16
First, you really should point out that PK has ripped Freshwater guys a new one for making the exact same mistake.

More importantly: you are careful to call this a story. How long can a story be told before somebody decides to look at how the world works? If the answer is: experiments in Econ are hard, then shouldn't this story go in the same category as theories about multiple universes? And if that's true, how on earth do such stories end up in discussions of public policy?

Last inference: has anyone estimated the lives lost as a direct result of Econ stories with no truth conditions being used in policy debates?
thank you
written by ezra abrams, June 22, 2014 6:27
one quibble
after the quote, you reverse sign - a minor point that might confuse someone (eg you go from balance to deficit)
What Thornton said
written by Kenneth Thomas, June 23, 2014 6:06
Thornton is exactly right that Professor Krugman has criticized this before. He even has a paper from 1988 disputing what John Williamson describes as the theory of immaculate transfer. So it really is surprising to see Professor Krugman doing this, though I think it may not be the first time. Here is his discussion, including a link to the 1988 paper: http://krugman.blogs.nytimes.c...osisyphus/
written by Plutowoof, June 23, 2014 11:23
Paul Krugman is correct. "the trade balance is a macroeconomic phenomenon, determined by the excess of savings over investment." The sinister Right are not Right. Himmmm SO Where are the Left? chuckle AND what did they do. Well see its not rocket science they Left. When did they Leave? At the Zero Roman alphabet Time. Sweet Jesus he has Told you a SQuillian [ a small Dy DX number}Times groan. They Left in a helicopter groan and LEFT royalty patients and legal licence fiction nonsense phoney Phonics Cartha gini an cunny Linguist and symantics liar scriptoid spin behind; Reference LETTER still in the Post

written by Plutowoof, June 23, 2014 11:51
Impact is not available as it is occluded by perpendicular MARS acceleration to mention by neutron ionian DARK MATTERS 47 n derivative and counting money NO PLATO ESCAPE AS PYTHAGORAS INVENTED POISSON; SAy what no Ricardo bop and say falls like Galbraith tree in forest trickle reins on himself reference Aristotle is correct So Venusian merchant is flat earth Where is Renaissance groan not Romulan landings as planet is high Voltage Gas
written by Plutowoof, June 23, 2014 12:02
Scotty you are needed in perpetual motion debt room all aboard peace train set phased Phaser on tickle Feather remove imaginary Quadrant Kindergarten Quadrant bi polar duality
written by Plutowoof, June 23, 2014 12:13
BUT we use off balance don't we? No it does not Tally as Split Log is reciprocally Tangential one eyed. Boson is behind Taurus remainder as told by an OLd shepherd
written by asymmetrical , June 23, 2014 12:27
is that u caxton i am looking for bronze age did that heidelberg grab it on silk road
written by JOKE, June 23, 2014 12:32
It was funnier in original papyrus translation
written by Fore Word, June 23, 2014 12:45
Is that u backward bending supply curve for labor
written by Slim pickens, June 23, 2014 12:49
NO but bless your cotton socks
written by Transltion, June 23, 2014 12:59
Says to french Farmer did u ever find where to put those neuter words
written by WEE, June 23, 2014 1:02
no Romans never did Xplain perhaps u can see Y
written by sorry, June 23, 2014 1:10
TRY Z to small n as i was told by mu a friend of TAN who was minding her pees and Queues while shuffling feet
written by sorrys friend, June 23, 2014 1:21
and cards on titanic
no it was stella a friend of stowaway stare stetti statum standing
written by allready noes, June 23, 2014 1:36
no it was stella a friend of stowaway stare stetti statum standing
written by naughty Miss, June 23, 2014 1:43
understands the horse has already left the stable
written by FOX, June 23, 2014 1:48
can the already floan bird be recouped in a finger licking way

written by shred the books, June 23, 2014 1:55
says' he is looking at me unkind of funny

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.