Net Investment and Trade Deficits.

You can't have one without the other.

Trade deficits are a hot topic, yet one key point is often overlooked or poorly explained: net investment into an economy creates a trade deficit—there’s no way around it.

For the U.S. to attract more global investment, it must run larger trade deficits. Conversely, reducing trade deficits requires less net global investment. This relationship isn’t immediately obvious and is frequently misunderstood. So, let’s break it down properly.

At its core, this all comes down to how much people in an economy save and invest. That’s where we begin.

Aggregate Savings

If you had to write a formula to track your personal savings, what would it be?

Well, let’s think it through: The amount I save each month depends on how much I earn and how much I spend. To save, I have to spend less than I earn. An equation to capture this would therefore be something like the following:

Income - Spending = Savings.

In casual conversation, we say we “invest” our “savings” in stocks or retirement plans or bonds or whatever. But economists distinguish between savings and investments.

In economics, individuals or households “save” for the future by putting money under their beds (at zero return) or in a bank savings account (at small return) or in stocks or bonds (at hopefully a better return) and so on. The individual here is trying to “save the money” for future use. Those things we commonly call investments are the vehicles through which individuals save.

When it comes to savings, what is true at the individual level is true for the economy as a whole,

Aggregate Income - Aggregate Spending = Aggregate Savings.

For a macroeconomy, “income” is GDP (Y). GDP reflects the total market value of all goods and services produced and sold by an economy. Those goods and services are sold to domestic residents (that amount is called “consumption”, C) or to the domestic government (called “government expenditures”, G). Some of those goods are also sold to foreign countries (called “exports”, EX). Additionally, in a free and open world, domestic residents can also buy goods from abroad, import them, and consume them at home, that’s called imports (IM).

We can write this formula, Aggregate Income - Aggregate Spending = Aggregate Savings, using the notation introduced above:

• Aggregate Income = Y

• Aggregate Spending (on domestic goods) = C + G + EX - IM¹

• Aggregate Savings = S

Now,

Aggregate Income - Aggregate Spending = Aggregate Savings

Y - (C + G + EX - IM) = S

Y = C + G + EX - IM + S.

So, we’ve accounted for the total savings available to an economy. Y - (C + G + EX - IM) = S tells us that savings is what is available after we take our income (Y) and spend on everything we want/plan to buy (C + G + EX - IM).

We, of course, have control of this. If I personally want to save more this month, I can’t really control my income nor can I control what the government spends, but I can control my own consumption. So, to save more this month, I can lower my consumption. Doing so frees resources for my family to save for our future. If I want to save less, I can raise my consumption. Over very long horizons, I can try to control my consumption and raise my income, but that’s not generally an option at any point in time. The same is true for an entire economy. You can’t just decide to double GDP overnight. Government spending is fairly rigid at any point in time. The main choice is to consume more or less.

Aggregate Investment

Economists do use the term “investment” but we reserve it to describe businesses investing in capital, equipment, and technology. And where do they get the money they need for such investments? They get it from the savings of households.

Broadly speaking, all the financial institutions (banks, stock markets, bond markets, etc.) simply match people wanting to save with businesses wanting to invest. How does a corporation raise funds for a new manufacturing plant? It either (1) sells stock, (2) issues bonds or (3) borrows from individuals, other businesses, or banks. In all three of those cases, it can only succeed to the extent someone else in the economy is interested in saving and is willing and able to buy those stocks or bonds or to lend (via banks) the amount needed at the return/interest rate offered.

In a very meaningful sense then, Aggregate Savings = Aggregate Investment. The limiting factor is usually the savings side. Total investment is limited by the total amount people are willing and able to save².

Since S = I, we can rewrite Y - (C + G + EX - IM) = S as Y - (C + G + EX - IM) = I, which is known as the “National Income Identity” and everyone who takes principles of economics learns it, usually written as: Y = C + I + G + (EX - IM) . That last, international, piece is called “net exports” (NX) so that NX = EX - IM.

Aggregate Savings = Aggregate Investment and Trade

All this makes sense. The total amount of resources available to businesses to invest comes from resources people want to save, but where is trade involved? Well, on the savings side. Net exports (NX) turns out to play a pivotal role in all this.

When NX is negative (i.e., an economy imports more than it exports) we say the economy is running a “trade deficit” and when it’s positive (i.e., it exports more than it imports) we say it’s running a “trade surplus”. When NX = 0 we say it has a trade balance.

Let’s look at a super simplified example that will clarify why and how trade balances are related to savings and investment in an economy. To do this, let’s imagine a simple economy in a world with only one currency and no trade restrictions. This way we aren’t worried about exchange rates or any of that, although adding it has absolutely no effect on the results we’re about to cover.

Further imagine, for simplicity, that the economy produces 100 goods. We can imagine them as physical goods like food, clothes, and other materials that are either consumed by people (to eat, wear, drive, etc.) or used by the government (clothes for soldiers, materials to build bridges and roads, etc.). Whatever extra remains is what the people are collectively saving for future use. Financial markets get this “savings” over to businesses who then transform these items into capital and equipment.

One final point is that the investment businesses do is what creates more future production capacity. So, if the economy wants to produce more than 100 goods in the future, it must invest today to make new factories and equipment, expanding the productive capacity of the whole economy, allowing it to make more goods in the future. So this “investment” piece is vital for everyone’s collective well being.

This is EXACTLY how the real world works, by the way. We only simplified (a) by assuming only the physical goods (not the dollar value of them) and (b) by normalizing things so there are 100 goods which are easy to count and track. If you prefer, you can imagine 100 trillion goods. No problem.

To show the trade effects clearly, let’s also start with a trade balance so that NX = 0. The easiest case for this to hold is when both EX and IM are zero, so let’s start with that: NX = EX - IM = 0 - 0 = 0.

Our national income identity captures all this, and we can plug in our imaginary numbers: Y = 100, let C = 80, I = 10, G = 10, and, finally, EX = IM = 0

Y = C + I + G + (EX - IM)

100 = 80 + 10 + 10 + (0 - 0)

In this case, we produced 100 goods, people consumed 80 of them and the government used 10. Total “spending” then is 90 and “Agg. Income” (100) - “Agg. Spending” (90) leaves 10 that people are “saving”, S = 10. This amount of savings is available for businesses to transform into capital and equipment, which economists call “investment”, so S = I = 10. That exhausts our 100 goods produced. Nothing is exported or imported.

Now suppose a new government is elected to this economy. It’s an amazing, beautiful government with big plans for the economy. But to grow and do all the amazing things it wants to do, it needs to increase investment in capital and equipment. Not only that, but suppose this hypothetical government wants all those expanded businesses to be located domestically!

How can we increase investment today into domestic businesses? We can either increase domestic savings or attract international investment.

1. Option 1 to Increase Domestic Savings: We can cut government spending, G. This would free up some resources. But there’s a bottom limit to this since we need some government (i.e., it can’t be zero). But maybe we can cut government by 5 goods, from G = 10 to G = 5. Now, we’d have increased domestic savings (Y - C - G) by 5 goods and could increase domestic investment by 5. This will have no effect on the trade balance. It’s likely, however, that if you cut government spending overnight by half - which is our example here - that you’d run into a recession. Look at any economy that successfully cut government spending. It’s worth it in the long run, but it will drive a recession in the short run by reducing demand initially and reallocating that demand to different goods and services. That transition takes time.

2. Option 2 to Increase Domestic Savings: We can cut domestic consumption, C. This would also free up some resources. There’s also a bottom limit to this since C = 0 would mean everyone would starve to death. But, it is totally feasible to imagine reducing consumption by 5 goods in our example from C = 80 to C = 75 and this could allow domestic investment to increase by 5. This will also have no effect on trade balances. It’s 100% domestically financed. But, it also generally drives a recession initially. And, you can imagine voters’ reactions when we announce: “We want to invest in new technologies and manufacturing ! (yeah, yeah) And to do that, we just need all your families at home to cut household consumption by about 6%! (boo, boo)”³.

3. Option 3: We can attract foreign investment into the domestic economy. No local pain and suffering needed! We can literally have our cake and eat it too (yeah, yeah)!

For Option 3 we can imagine, say, the Japanese wanting to invest in a domestic steel company (we could call it “Nippon Steel”, just to make something up) or other companies agreeing to pour money into the domestic CHIP manufacturing and so on. We could even imagine a German car company opening a production plant in Alabama, but we don’t want to get too crazy here with our stories.

The point is, domestically, we’d love to have foreigners finance the extra investment. We wouldn’t have to cut our consumption or government spending and nothing would be causing a domestic recession. This is truly a “win -win” and everything we’ve written here is 100% accurate even for large, complex economies like the American one. But, it requires that we run a trade deficit.

So, foreigners get excited by the new opportunities and the domestic government is thrilled to have this inbound global investment, and everyone’s happy. Suppose, to keep with our example, global investors are willing to finance an increase in investment of 5% of GDP, or 5 goods in our case. I = 10 goes to I = 15 and we write:

Y = C + I + G + (EX - IM)

100 = 80 + 15 + 10 + (0 - 0)

Oops! Even though foreign investors are happy to finance it, we only produced 100 physical goods, 80 of which is consumed, 10 of which is already going to investment and 10 is being used by the government. We need to increase investment first to expand capacity and produce more than 100 goods but to increase investment we need 5 more goods than we have. Despite the generous financing, where do we get the PHYSICAL GOODS that need to be used to build a new steel or car or chip factory?

Answer: Imports.

We must import the extra resources. All the money flows and financial investments in the world don’t make a new factory. Those money flows finance the purchase of the goods and services that physically go into that factory. They are also used to hire labor to work on building the factory and that labor was presumably already working somewhere else. We haven’t even begun to think about re-allocating human resources. You could import them too via in-bound migration or, if you have really high unemployment, there could be a pool of extra labor sitting around waiting for an opportunity. It’s an additional point, the effects of which are worth considering, but we’ll sidestep them for now, even though it only strengthens my broader point that we are asking more of our economic resources by increasing investment.

Some domestically might even argue that “we’ll just make all the extra goods needed domestically! And that’ll be a domestic boom and revival” and that’s fine, but you can’t expand production until you’ve first invested in the additional buildings and equipment needed. Even if you took a manufacturing plan that exists but has been left vacant for some time, you would first have to renovate it, add the right equipment, etc.

There is no way around this physical constraint. In open-economy macroeconomic models the national income identity frequently appears as what we call the “domestic resource constraint” for exactly this reason.

In the end, if you want to increase investment by +5 goods today, you must import +5 goods.

Y = C + I + G + (EX-IM)

100 = 80 + 15 + 10 + (0 - 5)

Now the left side, 100, equals the right side, 100, and everything is accounted for. And, the inbound net foreign investment drove a trade deficit, NX = -5.

Bi-Lateral Trade Deficits vs. Aggregate Trade Deficits

It’s worth pointing out that the foreign funding economy and the foreign economy from which we import do not need to be the same and usually are not. And, we need not even import the exact goods we need for investment. But we have to import some resources to free up other resources domestically for the investment to happen.

The Japanese could finance the +5 investment. This would be a financial flow into, say, the United States. And the +5 investment could all be done by redirecting goods and services from domestic consumers. Instead of buying wood to build a fence at home, that wood goes into walls in the new Japanese-funded facility in middle America somewhere. And now that I’m not spending 5 on wood, I buy 5 bottles of French wine instead, just to make up an example.

We can’t see behind the aggregate numbers of 80, 15, 10, and -5. But it’s important to recognize there are all sorts of combinations. Maybe the Japanese fund the investment, we don’t change anything as local consumers and, instead, import 5 units of wood from Canada. That’s also 100% possible.

Conclusion

The key point is that we have finite resources and we are constrained at any point in time by that. The inbound foreign investment is a win-win. We can finance new investment without having to sacrifice any consumption today. When that investment materializes in the future as more production capacity, we pay back the foreign investors and can also now produce more than the 100 we are making today. So, in the future, we’ll be able to both repay our investors and also consume more. Everyone is better off and the TRADE DEFICIT allowed it all to happen.

This point is often overlooked. Countries go out and seek global investors. They beat their chests bragging about how global investors recognize their great economy and the potential. And that’s all 100% true. But you can’t both do that and reduce your trade deficit. It will increase your trade deficit, all else equal.

And, as I hope the example illustrates, focusing on any bi-lateral deficit (US and France or US and Canada in my above examples) is foolish and potentially dangerous since those bi-lateral trade deficits are allowing the loosening of the exact domestic resource constraint you want loosened to allow higher investment.

Finally, countries that grow their economies by running massive trade surpluses, like Japan did, Germany did, and China does, run into a very different problem that, I hope, is also clear from the above discussion. A trade surplus will require extra goods produced domestically that aren’t consumed domestically. That means extra domestic savings that is not finding enough domestic investment opportunities and hence is “saved” abroad as investment in foreign countries⁴. If this is large and persistent over time, your economy will be “underinvesting” domestically and this leads to slower capital and equipment formation domestically. So, anyone telling you that the US wants to run big, beautiful trade surpluses is also arguing that US savers should be investing their money in other countries and less in the United States itself!

Thank you for reading!

APPENDIX

For those who had enough, stop here and I hope this column provided some insight. For those still curious or wanting a little more on this topic, below I explain the other common case driving trade deficits that, while technically the same, is the case that raises more concern. Again, it is not the trade deficit per se that’s the problem, it’s the resulting investment flows.

The other reason countries often run growing trade deficits is because they want to increase consumption today without yet having the extra income (GDP). This is the same reason we all run up our credit cards: I want to go on vacation and spend more this month than I earn. This requires negative savings and to bring money into my household from somewhere outside my household (i.e. “from abroad”) like a bank. That’s 100% fine if I run a surplus over the next months and repay my credit cards. But it is not okay if I run a deficit every month without any effort to repay and instead just roll-over my debt, paying my Amex with my Mastercard and my Mastercard with my Visa and so on.

Y = C + I + G + (EX - IM).

Suppose Y = 100, C = 80, I = 10, and G = 10, so EX = IM = 0 again. To make the best case, if everyone in our economy again believes we’re in for a domestic boom where Y will rise a lot in the coming years, we might want to increase consumption today in anticipation of that.

I give my students the example of them in their senior year signing a contract in April to start work at a big company on June 1st, after graduation for, say, $200,000. Then in May, they might be willing to go travel, buy some new clothes, maybe even a car, who knows, all fully expecting to have the income in the future to pay for everything. They would borrow on their credit cards in May, expecting income in June.

Same thing for the economy. If everyone is expecting Y = 110 in the near future, then they might be willing to raise C today to 85. But we don’t have the extra +5 goods today. They’ll only be produced in the future. So today, that requires, again, that we run a trade deficit:

Y = C + I + G + (EX - IM)

100 = 85 + 10 + 10 + (0 - 5)

We import the extra 5 goods we want. Again, they could all be domestic goods we consume in which case we take 5 from what we were investing and the businesses import the 5 from abroad. We can’t see that detail at this aggregate level, but the trade deficit loosened the aggregate resource constraint allowing us to increase consumption without any other real sacrifice.

If GDP indeed rises by +10 next year, then we’ll be able to repay the 5 we bought/borrowed from abroad today and still have an extra 5 for consumption. So we’d successfully keep C = 85, higher than our initial C = 80.

The problem arises when GDP doesn’t rise by that much. Then we must either cut consumption to repay our debt or borrow again from abroad.

You can imagine similar problems if, every year, we think future GDP will rise even higher so we keep increasing current consumption (C) faster than GDP, running perpetual deficits. If GDP really does continue to rise, this could run a perpetual deficit that’s being repaid each period and will be fine. But something that sounds too good to be true usually is.

The USA seems to have been in this situation for many years. We borrow internationally to finance domestic investment, consumption, and massively increasing government spending, G. As long as we really will grow in the future, it’s all fine, but we’ve been doing it for a very long time and everyone continues to wonder if there is indeed some limit.

The point here is that there are legitimate reasons to worry what the US trade deficit means, but it has nothing to do with buying too much from foreigners or being treated equally in trade deals or any of those other things that are dominating the news. It has to do with the implied massive increase in borrowing, mostly coming from the US government, and whether we can repay it. China and Japan buy most of our government debt. Today, annual interest payments on our debt are larger than our entire defense budget. That REQUIRES either a massive trade deficit or massive cuts to domestic consumption. It’s valid to ask how sustainable that is. Just not for the reasons people seem to be discussing in the news.

Thanks for reading!

1. The reason it’s negative is because we want “consumption” to capture all consumption and, when we consume, we consume both domestic and foreign goods. But in tracking where all DOMESTIC production goes, we want to remove those foreign goods from the accounting since they weren’t made at home. So, we subtract them. Now, C - IM = consumption of domestically produced goods and services only.

2. Note that if the business owner saves and self-finances the business’s investment, we still have S = I, it’s just the S and the I are coming from the same person.

3. 5/80 = .0625 or 6.25% of total consumption (C = 80). Or 5 is 5% of total GDP. Either argument isn’t going to win friends and influence people in the way this fictitious government might want.

4. Call domestic savings, S = Y - (C + G). Now, Y = C + G + I + NX, can be rewritten as Y - (C + G) = I + NX, or S = I + NX. Finally, S - I = NX. If you save domestically exactly what you need for investment, then S = I and NX = 0 (trade balance). But if you want a trade surplus, NX > 0, then you must have S > I. For example, S = 15 and I = 10 will generate an NX surplus of +5. Logically the savings domestically was the surplus above and beyond what we wanted to consume today, hence our attempt to save it. But if investment opportunities are too low in our economy, we save that money by giving it to foreign investors, investing in their countries. Our “surplus” is indeed our trade surplus and it is also our net investment in foreign businesses.