ECON102: Principles of Macroeconomics

Government budget balances can affect the trade balance. As The Keynesian Perspective chapter discusses, a net inflow of foreign financial investment always accompanies a trade deficit, while a net outflow of financial investment always accompanies a trade surplus. One way to understand the connection between budget deficits and trade deficits is that when the government creates a budget deficit with some combination of tax cuts or spending increases, it will increase aggregate demand in the economy, and some of that increase in aggregate demand will result in a higher level of imports. A higher level of imports, with exports remaining fixed, will cause a larger trade deficit.

That means foreigners' holdings of dollars increase as Americans purchase more imported goods. Foreigners use those dollars to invest in the United States, which leads to an inflow of foreign investment. One possible source of funding our budget deficit is foreigners buying Treasury securities that the U.S. government sells. Thus, a trade deficit often accompanies a budget deficit.

Twin Deficits?

In the mid-1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially. Figure 18.4 shows the pattern. The federal budget deficit went from 2.6% of GDP in 1981 to 5.1% of GDP in 1985 – a drop of 2.5% of GDP. Over that time, the trade deficit moved from 0.5% in 1981 to 2.9% in 1985 – a drop of 2.4% of GDP. In the mid-1980s, an inflow of foreign investment capital matched the considerable increase in government borrowing, so the government budget deficit and the trade deficit moved together.

Figure 18.4 U.S. Budget Deficits and Trade Deficits In the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins. The trade deficit grew smaller in the early 1990s as the budget deficit increased, and then the trade deficit grew larger in the late 1990s as the budget deficit turned into a surplus. In the first half of the 2000s, both budget and trade deficits increased. However, in 2009, the trade deficit declined as the budget deficit increased. Through the 2010s, the trade deficit remained relatively stable as the budget deficit declined. While the budget deficit increased in 2020, there has been hardly any change in the trade deficit.

Of course, no one should expect the budget deficit and trade deficit to move in lockstep because the other parts of the national saving and investment identity - investment and private savings - will often change as well. In the late 1990s, for example, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms. In the first half of the 2000s, the budget and trade deficits again increased together, but in 2009, the budget deficit increased while the trade deficit declined. Through the 2010s, as there were bigger changes in the budget deficit, the trade deficit remained stable. The budget deficit and the trade deficits are related to each other, but they are more like cousins than twins.

Budget Deficits and Exchange Rates

Exchange rates can also help to explain why budget deficits are linked to trade deficits. Figure 18.5 shows a situation using the exchange rate for the U.S. dollar, measured in euros. At the original equilibrium (E₀), where the demand for U.S. dollars (D₀) intersects with the supply of U.S. dollars (S₀) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar, and the equilibrium quantity traded in the market is $100 billion per day. Then, the U.S. budget deficit rises, and foreign financial investment provides the source of funds for that budget deficit.

International financial investors, as a group, will demand more U.S. dollars on foreign exchange markets to purchase U.S. government bonds, and they will supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D₀ to D_1, and the supply of U.S. dollars falls from S₀ to S₁. At the new equilibrium (E₁), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.

Figure 18.5 Budget Deficits and Exchange Rates Imagine that the U.S. government increases its borrowing, and the funds come from European financial investors. To purchase U.S. government bonds, those European investors will need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D₀ to D₁. European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S₀ to S₁. The equilibrium exchange rate strengthens from 0.9 euros/dollar at E₀ to 1.05 euros/dollar at E₁.

A stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.

You can also imagine interest rates are driving the exchange rate appreciation. As we explained earlier in Figure 18.8, a budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in the supply of U.S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. U.S. dollar appreciation leads to a larger trade deficit (or reduced surplus). The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: a larger budget deficit can result in a larger trade deficit, although do not expect the connection to be one-to-one.

From Budget Deficits to International Economic Crisis

We lay out step-by-step the economic story of how an outflow of international financial capital can cause a deep recession in the Exchange Rates and International Capital Flows chapter. When international financial investors decide to withdraw their funds from a country like Turkey, they increase the supply of the Turkish lira and reduce the demand for the lira, depreciating the lira exchange rate. When firms and the government in a country like Turkey borrow money in international financial markets, they typically do so in stages. First, banks in Turkey borrow in a widely used currency like U.S. dollars or euros, then convert those U.S. dollars to lira, and then lend the money to borrowers in Turkey. If the lira's exchange rate value depreciates, then Turkey's banks will find it impossible to repay international loans that are in U.S. dollars or euros.

The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand, which causes a deep recession. Many countries around the world have experienced this kind of recession: along with Turkey in 2002, Mexico followed this general pattern in 1995, Thailand and countries across East Asia in 1997–1998, Russia in 1998, and Argentina in 2002. In many of these countries, large government budget deficits played a role in setting the stage for the financial crisis. A moderate increase in a budget deficit that leads to a moderate increase in a trade deficit and a moderate appreciation of the exchange rate is not necessarily a cause for concern. However, beyond some point that is hard to define in advance, a series of large budget deficits can become a cause for concern among international investors.

One reason for concern is that extremely large budget deficits mean that aggregate demand may shift so far to the right as to cause high inflation. The example of Turkey is a situation where very large budget deficits brought inflation rates well into double digits. In addition, very large budget deficits at some point begin to raise a fear that the government would not repay the borrowing. In the last 100 years, the government of Turkey has been unable to pay its debts and defaulted on its loans four times. Over the past 175 years, Brazil's government has been unable to pay its debts and defaulted on its loans seven times; Venezuela, nine times; and Argentina, five times. The risk of high inflation or default on repaying international loans will worry international investors since both factors imply that the rate of return on their investments in that country may end up lower than expected. If international investors start withdrawing funds from a country rapidly, the scenario of less investment, a depreciated exchange rate, widespread bank failure, and deep recession can occur. The following Clear It Up feature explains other impacts of large deficits.

Using Fiscal Policy to Address Trade Imbalances

Suppose a nation is experiencing an inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms. In that case, there may be no substantial reason for concern. After all, many low-income nations around the world would welcome direct investment by multinational firms that tie them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private sector investment in an economy.

However, governments should be aware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country's exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche, a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.

Reducing a nation's budget deficit will not always be a successful method of reducing its trade deficit because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/18-2-fiscal-policy-and-the-trade-balance
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