If you don’t like trade deficits – tax the rich?

Has the word ‘deficit’ done more damage than any other in economics? Deficits are bad, surpluses are good. In economics, nothing could be further from the truth. How can there be virtue, if every virtuous act requires a sin? Yet for every surplus there has to be a deficit.

The Eurozone has been the greatest victim of this great German economic fallacy. The policy response to the Eurocrisis was premised on the inconsistency that all governments should run budget surpluses, and all countries should run trade surpluses. This is not possible, unless we open a trade account with Mars, and Martians are willing to run a deficit. This flawed logic played a significant part in propagating the cyclical damage wrought by the Eurocrisis.

Even well-trained thoughtful economists will advocate budget surpluses during ‘good times’. But it seems so much harder to argue the necessary counterpart – that the private sector should run a deficit. A fiscal ‘conservative’ must be a private sector spendthrift.

To make it clear how foolish the ‘deficits are bad’ argument is, consider not just that for every country with a trade surplus there has to be one with a deficit, but every country that has a current account deficit also must have a capital account surplus on its balance of payments, in other words it receives more in inward investment than it sends overseas. In principle, Trump could reduce the trade deficit by making the US a lot less attractive to invest in. In fact, the evidence has shown for a very long time that the capital inflows which America receives on average receive very poor returns, so much so, that America manages to have net external assets. It would make more sense for the Chinese population to complain that its capital is being wasted financing the US government, for a near-zero real return.

These observations follow from the simple fact that one person’s spending is another person’s income. Imagine a two-person economy, consisting of only you and I. My income is generated by either working for you or selling you things, and you make your income in the same way. The reason we trade is because we are different – have different skills, perhaps, or we own different resources. Now if I want to spend more than I earn, and run a ‘trade deficit’, you will have to lend me the money, and spend less than you earn. This is a simplified illustration of Megan Greene’s superb analysis in the FT, linking the US trade deficit to the balance between domestic US investment spending and savings.

As a result, for every deficit there is a counterpart surplus. Every country or region that runs a trade surplus can only do so because another runs a deficit. If the government runs a budget surplus, the private sector must run a deficit. It is possible in an open economy that the government and private sector both run surpluses, but only if the rest of the world runs a deficit with that country.

Trade wars and budget deficit arguments are even sillier than this. The unit of ‘nation’ or ‘public sector’ is ultimately arbitrary. We can break the economy down into cities (as Paul Krugman does here) or countries within a nation, observing that Scotland has a ‘deficit’ (and surplus!) with England.

Every economic entity either spends more or less income than it receives – nations, governments, the private sector, firms, households. But why not break it down further – to individuals? Every individual runs a ‘trade’ surplus or deficit with the rest of the economy. The super-rich can run quite large trade surpluses – in other words, they sell far more to others than than they spend. Bill Gates runs a massive trade surplus with the rest of America. In fact, his cumulative trade surpluses are the reason he has accumulated $91bn in assets. He spends far less than he earns, he is huge saver.

Now Donald himself isn’t the richest man in America. He’s no Gates, Buffett, or Bezos. He also clearly has a penchant for more conspicuous consumption than the almost puritanical likes of Buffett. But despite his predilection for excess, he still spends far less than he earns. In other words, or perhaps in his own words, he is a ‘trade cheat’. The only way to tackle this group of prize ‘offenders’, would be with brutally high personal tax rates.

The consequences and likelihood of an escalating trade war are evident for all to see, as detailed in this superb piece by Soumaya Keynes in The Economist. The reality is that we would all be a lot worse off if it wasn’t for deficits and surpluses – they are the basis of all trade. There would be little point having markets without them. It is also clear that dividing the world into economic nation-states is arbitrary. But it shouldn’t really surprise us that the latest attempt at policy-making from neo-nationalists is bereft of thought.