by Richard Snow, 22 March 2018
Donald Trump has just announced import taxes on foreign steel and aluminum, because he believes that other countries have been involved in exploiting and taking advantage of the US. The US has a large trade deficit with the rest of the world: around $500 billion a year. In all the discussion of trade, there are two things that aren’t being discussed in American news sites, perhaps because they are technical and a little hard to understand. Those are roles of low savings in the US and budget deficits.
In economics there is an equation that is introduced in every first year college text book on economics. It’s known as the “injections equals leakages equation”, and it says that in every economy, the sum of Investment (I) , Government spending (G) and Exports (X) must equal the sum of Savings (S) , Taxes (T) and Imports (M) . In algebraic form:
I + G + X = S + T + M.
In this context, Investment means expenditure by businesses on new plant, equipment and buildings, and expenditure on new housing units. Consumption is the things you and I buy as consumers. If you or I buy a car that’s consumption. If a business buys a car to use in the business that’s investment, if the government buys a car that goes in G. Savings is after tax incomes not spent on consumption expenditure. I’ll explain how we get this equation and put some links below in the appendix, but to understand it you need to know how to calculate GDP and how we define savings. It will take the average person who remembers their high school algebra about fifteen minutes to understand. Every economist, left right or centre in every country in the world learnt this equation at some point.
We can rearrange the equation by subtracting X, S and T from both sides, in which case we get:
(I-S) + (G-T) = (M-X)
This version tells us that if I-S is a positive number (i.e. the country doesn’t save enough to fund its own investment) and if G-T is a positive number (the government is running a budget deficit), then M-X will be a positive number (the country will be a net importer, that is, have a trade deficit.)
So why does the US have a trade deficit?
Total savings as a percentage of GDP is 17 percent in the US, 22 percent in the EU, 22 in Australia, 27 in Japan, 33 in Switzerland, 27 in Russia, 13 percent in the UK, and 45 percent in China (data from the CIA World fact book here. ) Yes, you read that correctly. China has a savings ratio twice that of the US. The US ranks 105th in the world out of 181 countries in savings as a proportion of GDP. In addition, the US government runs a budget deficit, expected to be about 600 billion this year, and forecast to be a trillion next year. The average budget deficit in the US over the long run is about three percent of GDP each year.
Whenever a government runs a budget deficit, it funds the shortfall by issuing bonds (tradable IOUs which have regular fixed interest payments attached to them.) At any time, the total stock of government IOUs outstanding – total government debt – is the sum of all the past deficits less the sum of any past surpluses. (In surplus years, the government buys back bonds it previously issued.) China holds about US $2 trillion of the $18 trillion in US debt outstanding. In a nutshell, saving in China and elsewhere in the world funds the US budget deficit and any shortfall in private sector savings.
Trump is trying to solve the US trade deficit by imposing tariffs on other countries. That may play well in the media, but it won’t fix the basic problem the US has: low savings rates compared to its trading partners and government budget deficits. The US has a trade deficit with China because China is a high savings country and the US is a low saving country. Almost every working economist knows this.
I’m not surprised that professional economists don’t talk much about this in public. First, it’s not a sexy topic, most people won’t get the connections and it needs some algebra to explain the argument. Second, no TV station is going to explain this on a TV current affairs program. Third, the truth is that economists don’t really have a solution to the question, “How do you get a country to increase its savings ratio by several percentage points?” No one wants to be told there’s a problem with no clear solution. Trump did an economics degree, graduating in 1968, but I don’t know what subjects he did. If he did first year macro-economics, as most people would have done, he almost certainly studied this equation, but I don’t know the curriculum at his college.
In the meantime, some economists and trade experts have expressed the view that by withdrawing from the TPP and advocating tariffs, Trump is “delivering Asia to China” (here, here, and here). Many are worried Trump’s tariffs may result in a tit-for –tat trade war. I don’t think this will happen, because there are enough economists and trade officials around in the developed world who understand how badly that worked in the 1930s.
One reason tariffs on steel may not work is that by raising the price of steel, the price of US made goods which use steel (cars, boats, canned goods) will rise, making foreign goods which are imported with the steel or aluminum already in them relatively cheaper. Spending may be diverted to other imported goods. This may lead to job losses in the industries that produce goods with a high steel content (see here). Every economist knows that import tarriffs raise costs. After all, that is what they are designed to do. By raising the costs of an imported good they allow high cost domestic producers to stay in business at the consumers’ expense.
Sometimes politicians face a problem when introducing a policy. The policy may benefit some voters – the winners – and put a cost on others – the losers. Sometimes the losers are concentrated in one place or industry, suffer a large loss each, can recognize each other, form a lobby group, and change their vote on the basis of the policy. The winners may be geographically widespread, get only a small benefit each, may not recognize each other, and won’t change their vote. That makes it hard for the politician to introduce the policy.
Trump faces the opposite situation. In connection with tariffs on steel, the winners from this policy are easy to identify (steel workers), they are geographically concentrated (e.g. Pennsylvania), they can identify that they are part of a group, and can vote accordingly. The losers (everyone in the US who buys anything in a can) suffer a small cost each, are geographically widespread, don’t recognize each other as part of a group, and no one ever changed his or her vote on the basis of the cost of the can their dog food came in cost a cent more. So it’s easy for Trump to introduce the policy, even though it may be a bad policy.
At the same time, Trump’s tax cuts are going to increase the budget deficit (G-T) to one trillion dollars next year. In the absence of an increase in US savings, the trade deficit must increase. Tariffs on steel aren’t going to change that. The net imports will just increase in some other goods.
In the meantime, I think the world has to come to terms with the fact that Trump’s actions in the international arena may mean that America is giving up leadership it has had for the last 70 years in economic matters, (think TPP, Paris climate accord, free trade in general and so on.) The US has spent the last 70 building up a rules-based international order. Trump seems to be withdrawing from any idea of world leadership. The most likely player to fill that void is China. China’s “One Belt One Road” program is a major infrastructure program to build rail and road links from the west of China through Pakistan and the other “-stan” countries of the former soviet union, out to Eastern Europe. This will enable it to also promote its own communications and rail standards to other countries. Trumps actions may accelerate a trend that is already in motion. With China’s one-party political system, its disregard for human rights, and militarization of the South China Sea, that’s not a future I look forward to.
I said above that I would explain how we get the injections equals leakages equations. There some explanations here and here. But I’ll try to summarize them. To follow this you need to remember from high school algebra how to rearrange an equation and substitute one equation into another.
The first thing you need to know is that economists break up expenditure in the economy on finished goods and services into several categories. (We say “finished” because when we count the value of a final good, we don’t also count the inputs: that will be double counting. So If I buy a poster for $10, we count the $10. Maybe the poster has $1 of ink in it, and $3 of cardboard, but there was only $10 of final product, not $14. We don’t count the $1 and the $3 twice.) We say new, because we count production when the good is first bought. If a farmer buys a new tractor, we count the expenditure that year. If he later sells it to another farmer, that’s the movement of an asset between two owners. It’s not new production, so we don’t count it twice.
Goods that are produced and sold are split into consumption (what you and I buy for our own personal and household needs) investment (business expenditure on machinery, equipment and buildings – shops factories, office buildings) that are used to produce other goods and services), and Government spending on police, the military, schools and hospitals etc). If I pay to have my appendix taken out in a private hospital, that’s consumption expenditure. If my appendix bursts and I go to emergency in a public hospital, and the government foots the bill, it will be counted in government spending. Then to get what we produced in our economy we have to add on exports (we produced the goods but a foreigner bought them) and take off imports (we bought them but they weren’t produced here). In that way we get back from expenditure to production. So Gross Domestic Product, or total production in the economy is given by
GDP = C + I + G + X – M
This says that what got produced in our economy is the sum of consumption, investment, and government spending plus exports minus exports. All we are doing here is breaking expenditure up into categories according to who paid for it and what the purpose was.
The next thing you need to know is how economists define national savings (S). It’s total income in the economy (Y) less taxes (T) , and less consumption (C) , i.e. after tax incomes that weren’t spent on consumption goods and services. (In economics we use Y for income because we use capital I for investment and little i for interest rates.) The income here may be household incomes such as wages, dividends, rental income or welfare payments. It also includes company profits that were not distributed as dividends.
So S = Y – T – C. These incomes that aren’t spent on consumption form a pool of savings that can be lent through the banking system to business to fund investment or to fund the government by buying bonds when the government runs a budget deficit and borrows from the public by issuing bonds. (A bond is just a tradable IOU with a regular interest payent attached to it.)
The last thing you need to know is that when somebody spends something, someone else gets an income, so the total of all the goods and services produced and bought equals the total of all incomes.
Now a little algebra:
GDP = C + I + G + X – M (call this equation 1)
Y = GDP, (equation 2 – the sum of all incomes equals the value of all production) and
S = Y – T – C, (equation 3 – how economists define national savings).
Equation 3 can be rearranged as Y = S + T + C (equation 4)
And therefore C + I + G + X – M = S + T + C (equation 5, by joining equations 1 and 4)
Subtracting C from both sides and moving M to the right hand side gives
I + G + X = S + T + M,
which is the injections equals leakages equation. It may take the average person a couple of read throughs to “get” this but it’s important in the context of the current debate.
Figures on the componemts of US GDP are here. When comparing statistics from different websites, you may see references to household saving ratios, which household saving over household income, and you might see business investment, excluding housing creation, or sometimes just business investment on equipment excluding building of business premises. This makes it a bit difficult to use data unless you know what that website is using, but for those interested in the issue, you ‘ll find plenty of articles on this issue. Now that you understand how we got the injections equals leakages equation, you’re in a position to follow the arguments about savings and why it matters.
Richard Snow is a former economist with the Victorian Department of Treasury and Finance in Melbourne Australia, and taught economics at La Trobe University. He is now studying a Master of International Relations