Trade Imbalances: Micro to Macro

In a recent discussion on a blog post, someone made a comment that no Government would be able to allow its nation to run trade surpluses forever, because the people of such a nation would one day get tired of producing more for others than they do for themselves.  This draws on the MMT idea of seeing exports as a real cost to residents and imports as a real benefit.  Taking this view, it is perhaps natural to ask why a nation would want to run a trade surplus forever.  On the face of it, such a policy would mean that nation must lose out in the long run.

I don't want to go into the context in which the comment was made, but it raised an interesting point about the dynamic role of deficits.  I thought this was worth exploring a bit, particularly looking at the relationship between individual saving and that of the nation as a whole.

To do at this, I used a very simple model based on overlapping generations.  I started by looking at a domestic economy with a single household.  I assumed that the household lived for 30 periods and spent a constant amount each period.  However, the household only worked and earned for the first 24 periods, during which it earned a constant income.  It therefore had 24 periods of saving and 6 periods of running down savings.  The amount spent in each period was just enough to totally eliminate its assets by the end of its life.  Since this household makes up the entire economy, its income and expenditure make up the trade balance and its wealth is the net foreign assets.

The pattern is shown below:

Clearly for the single household, we get a pattern of trade surplus followed by trade deficit (almost by assumption really).  Assets build up during the household's productive years and are then eroded.

The next step is to extend this to subsequent generations.  I did this by assuming that, in each period, a new household starts out on the same life-cycle as the first.  This carries on indefinitely.  The aggregate surplus and net assets this produces are shown below:

Now, we no longer get any deficit.  The surplus builds up as more households join the economy, then falls back as the original ones start to become inactive.  Eventually it reaches a balanced budget, where the saving of younger households matches the run-down of assets by the older ones.

The next step is to introduce some growth.  I did this by assuming each new generation had a slightly higher income than the previous, growing at a constant rate.

In this scenario, we see that, although the surplus falls once we are up to a full complement of households, it does not fall to zero.  We have a growing economy and households that want to save income until later in life.  This requires a growing stock of assets, which can only be achieved through a running a small surplus.

So far, I have ignored any return on the assets, so the final element I looked at was the inclusion of interest on the balance of assets.  In particular, I assumed an interest rate greater than the growth rate.  Household income is now higher, due to the interest income, so their expenditure is also higher.  This scenario is illustrated below, with an additional series illustrating the current account balance, to distinguish it from the trade balance.

In this final case, we get a trade deficit.  We still have growing assets, but this is fed by a current account surplus due to the interest income.  It should also be clear that the trade deficit depends on the interest rate exceeding the growth rate.  The level of current account deficit is dictated by the need for asset accumulation; subtracting the interest income then dictates what the trade deficit needs to be.

So in this instance, after the initial accumulation, we have a permanent trade deficit.  However, it is worth noting that one person's trade deficit is another's surplus.  So in a two economy world, this would imply that the other country is running a permanent trade surplus.  Maybe their people would not like it, but unfortunately it would be the inevitable consequence of being a debtor nation.

My model economy consists only of households that save.  If I were to add in firms, governments and other net borrowers, then the nation's net financial assets would reduce, or it might become an overall debtor nation.  But the analysis would be essentially the same.

In the real world, surpluses and deficits do come and go, although it is clear that they can persist for some time.  Hopefully, this analysis shows that this is not such an unexpected result and how trade imbalances of appropriate size could in theory last forever.