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Home Publications Blogs Beat the Press The Iron Grip of Accounting Identities

The Iron Grip of Accounting Identities

Wednesday, 28 March 2012 18:55

James Kwak responded in Baseline Scenario to some of the points that I raised in the review of the new book he co-authored with Simon Johnson, White House Burning. I want to focus on one issue in particular because it is really central to how we understand the economy.

I argued in my review that the fundamental imbalance in the U.S. economy is the trade deficit. This deficit is in turn caused by the over-valued dollar. The latter is a direct result of the decision of developing countries to accumulate massive amounts of foreign exchange reserves (i.e. dollars) in the wake of the East Asian financial crisis.

Developing countries saw the harsh treatment of the East Asian countries following the crisis and decided that they did not want to be in the same situation. Their protection against this event was the stockpiling of huge amounts of reserves. They acquire the reserves by running trade surpluses, which they use to acquire dollars. The decision of foreign central banks to buy and hold dollars keeps up the value of the dollar against their own currencies. If they didn't buy dollars, the value of the dollar would fall relative to their currencies.

This matters for our trade deficit because the higher valued dollar means that imports are cheaper for us, which leads us to buy more imports. In addition, the high dollar means that our exports are more expensive for people in other countries. Therefore they buy less of our exports. If we import more and export less, then we get a trade deficit.

This matters for the budget deficit story because if the United States runs a trade deficit, then it means that the United States has negative national savings. This is definitional; as a country we are buying more than we are selling.

If we have negative national savings, then either the private sector must have negative savings or the public must have negative savings or some combination where they both run deficits. All of this is definitional; it necessary follows from the trade deficit.

Right now we are offsetting the trade deficit with large budget deficits. The private sector actually is a net saver at the moment. The combination of business and household savings exceeds annual investment.

However this was not true before the crisis. In 2007, the budget deficit was actually relatively small at just over 1 percent of GDP. Instead we had a very large deficit on the private side of the ledger. This deficit corresponded to the housing-bubble-driven construction boom (residential construction is a component of investment) and the consumption boom that was driven by housing-bubble-generated equity. The household saving rate fell to near zero at the peak of the bubble in the years 2004-2007. I comment in passing in my review that no one could reasonably want to go back to this situation.

Kwak picks up on this issue in his blogpost and holds up 1999 as a model. In that year the government had a budget surplus of 1.4 percent of GDP. The country had a trade deficit of 2.8 percent of GDP and the economy grew at a 4.8 percent rate, so what's the problem? He points to the 2011 trade deficit of 3.8 percent of GDP and says things should not be that different now.

There are two points to make on this. First, the current deficit is lower than it otherwise would be because the economy is operating well below its potential. Imports always fall in a downturn, lowering the trade deficit, and this one was no exception. The trade deficit fell from 5.0 percent of GDP in 2008 to 2.8 percent of GDP in 2009. The main factor behind this drop was the steep recession. If we were back near full employment, the trade deficit would again be close to 5.0 percent of GDP. This leaves us with negative net foreign savings that are roughly 2.2 percentage points of GDP (@$330 billion) higher than what we were looking at 1999.

But the other part of the story is that 1999 was not quite so great. While we had good growth and low unemployment, both great achievements, we also had very low household saving. The measured household saving rate that year was just over 2.0 percent of disposable income. This compares to an average of 8.0 percent in the years before stock and housing bubble generated wealth drove savings rates through the floor.

Furthermore, there is evidence that a mis-categorization of capital gains income as ordinary income overstated actual income in the peak years of the 90s stock bubble. This would imply that savings was overstated, with the actual rate being close to zero at the end of the decade.

This low savings rate matters because it means that people on aggregate are not putting aside any money for retirement. This cannot be considered a desirable situation.

The other part of the story is that investment was in part inflated by the tech frenzy that was causing people to throw money at anything involving the Internet. This was not a healthy situation, as large amounts of this capital was wasted and investors ended up being burned. The NASDAQ fell from a peak of 5000 in March of 2000 to a trough of less than 1200 in the summer of 2002, wiping out more than three quarters of the paper wealth of shareholders.

So, we didn't balance our trade deficit in an especially good way back in 1999 and now we are looking at a trade deficit in the neighborhood of 5.0 percent of GDP, instead of the 2.8 percent deficit we faced in 1999. That doesn't look a pretty story to me.

This is why the over-valued dollar is the fire that I most believe needs to be addressed. In the short-term, it is perfectly reasonably for us to run large budget deficits, ideally building up infrastructure and improving the education and skills of the workforce so that we will have lasting benefits from this boost to demand. However in the longer term, a rich country like the United States should not be running large trade deficits. We should be an exporter of capital to poorer countries where it can help finance development. That would be much better than trying to sustain demand through yet another asset bubble. 

I'm sure that Kwak does not actually want another asset bubble, but I don't see any other way to get us the negative national savings that goes along with a trade deficit, if we do not have a budget deficit. Remember, you can never win a fight with an accounting identity.



Comments (10)Add Comment
Lowering the trade deficit
written by Makarov, March 29, 2012 2:50
Thanks for the excellent explanation.

I wonder, given the state of US manufacturing and policies relating to it, what are some of the solutions for lowering the trade deficit.

If, for instance, we wanted to boost domestic manufacturing of goods we currently import, could it be done without resorting to bi-lateral trade; i.e. applying tariffs to specific goods? Tariffs seem the most efficient approach - raise the price of specific foreign produced goods enough to make domestic manufacturing more competitive.

If there are other, efficient solutions, I'm all ears.
Time for Keynes' bancor?
written by David B. Schuster, March 29, 2012 5:54
Since the dollar is the reserve currency, and other countries can devalue against it, then the dollar is left as over-valued. Nobody wants to buy American goods because they are over-priced. Futhermore, developing countries are forced to stockpile reserves that could otherwise be spent on much needed investment. The dollar reserve system is, in the words of Joe Stiglitz, a system that creates only losers.

This is an issue whose time has come but is anybody willing to talk about it?
Net Saving Identity
written by JSeydl, March 29, 2012 6:40
This is such a curcial issue that people need to understand. And it helps to see a chart. Here's a chart of the total net saving of US dollars aggregated into four categories: (1) the U.S. household and nonprofit sector, (2) the U.S. private business sector, (3) the U.S. public sector and (4) the rest of the world: http://img401.imageshack.us/im...ector.png. These data come from the Fed's Flow of Funds Accounts.

As Dean notes, the sum of net saving by each of these sectors must equal zero. Currently, the U.S. public sector, which includes the federal government as well as state and local governments, is running a deficit of around 8.1% of GDP. This deficit is being offset by positive net saving from each of the other three sectors. It's unlikely that the U.S. household and nonprofit sector or the U.S. private business sector will save less and take on more debt right now -- the deleveraging story will likely continue for a few more years. Ergo, the only realistic way in which we will be able to reduce public sector deficits is if the rest of the world saves less in U.S. dollars -- i.e., we reduce our current account deficit. There is no getting around this. Remember, it's an accounting identity.
written by Robert K, March 29, 2012 7:34
The entire issue of dollar overvaluation and foreign dollar accumulation flows
directly from Triffin's dillemma. It is an inevitable consequence of the exorbitant
privilege of HAVING the reserve currency, that your currency has a natural tendency
to appreciate over time, as international trade flows increase, and with them the demand
for reserves. This trend has an ending, at the point at which so many dollars exist
outside the country that it is realized that they may NEVER be converted to REAL
GOODS at present prices. This is part of the natural life cycle of a fiat currency in
use by a single nation state as a global reserve. The 6 trillion dollars held outside
the US can NEVER be converted to real wealth inside the US without a hyperinflation
of prices, since we consume 4% more than we produce each year at present levels
of consumption. Only the loss of reserve status can, eventually, return us to a
more balanced relationship with the rest of the world.
Myth: US consumers need to borrow $billions from foreigners.
written by Tyler, March 29, 2012 7:57
Fact: US consumers are funding $billions in foreign savings.

While the media continuously bemoans an assumed US dependence on foreign capital, a recap of the actual transactions involved reveals the reverse.

Let’s begin with the example of US consumer buying a German car.

If the consumer pays cash for it, the consumer’s checking account in a US bank is debited and the German carmaker’s account is credited, thereby increasing foreign savings of USD financial assets. Total deposits in the US banking system remain unchanged.

If the consumer borrows to buy the car, the bank makes a loan to the consumer, which results in a loan on the asset side of the bank’s balance sheet and a new deposit on the liability side (loans create deposits). After the car is paid for the German car company has the new bank deposit. Consumer borrowing increased total bank deposits and funded foreign savings of USD.

That’s what the finance behind the trade gap is all about – foreigners desire to net save USD financial assets and sell goods and services to the US to obtain those assets.

Following the above transaction the foreign holder of USD bank deposits may instead desire to purchase US Treasury securities. At the time of purchase, the seller of the Treasury security becomes the new holder of the bank deposit, and the foreigner the new holder of the Treasury security. (If the foreigner buys securities directly from the Treasury the result is the same.)

The US government is now said to have foreign creditors, and the US is said to be a debtor nation.

While this is true as defined, a look past the rhetoric at what the US government actually owes the holder of the Treasury security is revealing. What the government promises is that at maturity the foreigner’s security account at the Fed will be debited, and his bank’s reserve account at the Fed will be credited for the balance due.

In other words, the US government’s promise is only that a non-interest bearing reserve balance will be substituted for an interest bearing Treasury security. This is not a potential source of financial stress for the government.

Warren Mosler

written by JSeydl, March 29, 2012 9:01
Sry, not sure why the previous link I posted isn't working. Here's a link to the chart I was referring to: http://imageshack.us/photo/my-...ector.png/
written by Fed Up, March 29, 2012 12:37
"If we have negative national savings, then either the private sector must have negative savings or the public must have negative savings or some combination where they both run deficits. All of this is definitional, it necessary follows from the trade deficit."

FALSE!!!! You are assuming the currency printing entity is inactive (is zero).

You have:

current account deficit = private deficit plus gov't deficit

IMO, it is actually:

current account deficit = private deficit plus gov't deficit plus currency printing entity deficit (which I'm pretty sure you are assuming is zero). There is no reason that last one has to be zero.

The security image is 1,000 times better! Thanks for that!!!
Private Business Sector Saving = Negative Investment?
written by RL, March 30, 2012 8:54
Thanks both to Dean and Jseydl for laying all this out plainly. The only question I have is whether private business sector saving in that graph Jseydl posted is the same thing as negative investment. It seems like it should be, but then it's hard for me to believe that business investment has been so negative for so long and with such frequency historically. Is that just a reflection of inventory adjustment? Or does private business sector saving involve something more than just investment?

It seems if the government budget deficit and trade deficit (which is what foreign savings is on that chart I believe) are on average zero in the long term, then private sector savings and private business sector saving become the familiar S=I identity, but I'm not certain about all this.

written by JSeydl, March 30, 2012 10:25

Good points. Sorry I should have been a little more specific about how net saving is calculated. Net saving is calculated by subtracting capital transfers and capital consumption from gross saving. In non-econ speak, this means we're subtracting out the funds that firms need to save in order to replace the existing capital stock from normal wear and tear -- e.g., if a machine breaks down, a firm will need to save to replace that machine, but it's not saving that really matters, since replacing that machine will not increase the overall capital stock in the economy. So net saving basically refers to what firms are setting aside to buy new capital and increase the overall capital stock.

Also, the foreign saving measure shown in the chart is technically not the trade deficit; rather, it's the current account deficit. For academic purposes, the trade deficit and the current account deficit are used interchangeably, which is why Dean always mentions the trade deficit in his postings. But in terms of the national saving identity, it's really the current account that needs to balance with public and private sector saving. The trade deficit used to suffice in this context, but with the liberalization of financial markets all around the world in recent decades, from an accounting standpoint, we really need to use the current account in the net saving identity, so that we're capturing financial flows as well as the flows of goods and services throughout the world.
Nice Explanation
written by scott moore, April 02, 2012 10:52
Dean, nice explanation. Could you post a few data links so that we can run the basic calculation you have outlined?

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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.