Our friend asks us, what are those deficits that everyone is talking about and how do they affect us?
There are two deficits that everyone is talking about: the trade deficit and the fiscal deficit. Both can affect each other and interact with a third one, which is the deficit (or surplus) in the capital and financial flows account[1].
The trade balance measures the difference between exports and imports. The fiscal balance is the difference between government revenues (taxes) and expenditures. And the capital account balance measures the difference between incoming and outgoing investments. These three balances can offset or reinforce each other as we will see below.
A deficit in the trade balance, that is, when there are more imports than exports, leads to an accumulation of local currency (dollars) in the hands of exporting countries[2].
Here we must bring to the discussion an important concept and that is that of reserve currency, because things work differently if it is reserve currency or not. The U.S. dollar is a reserve currency, which means not only that it is the intermediary currency[3] in trade transactions, but that it is the currency that the rest of the world has the least problem holding on to it, not only because it is stable, safe and easy to invest[4] but because there is strong demand for it.
The effect in most countries with trade deficits would be a depreciation of the local currency due to the imbalance between buyers (importers) and sellers (exporters) of foreign currency (reserve currency). Such depreciation of the local currency would make imports more expensive and exports cheaper, leading to a restoration of the trade balance. In the case of a country with a trade deficit and a reserve currency, this effect is not so marked since there is no purchase and sale of foreign currency (reserve currency).
Here it is worth mentioning the effect of the fiscal balance. A country with a fiscal deficit must issue debt to cover expenses because its tax revenue is not enough. A country with a fiscal deficit and reserve currency (the US) can afford to issue debt in its own currency because there are enough buyers inside and outside the country willing to buy it. This situation fits like a glove for the exporting country that has been accumulating US dollars and needs to invest them safely and liquidly. In this sense, the combination of trade deficit and fiscal deficit, in the presence of a reserve currency, are mutually reinforcing. Fiscal discipline is less important if you can finance fiscal deficits with relative ease.
With this we arrive at the third balance, that of the capital account. Foreign investments in public debt securities are accounted for in the capital account, as are investments in physical infrastructure and portfolio investments in public and private capital markets. The United States has highly developed capital markets and offers many investment opportunities derived from its economic and legal systems and overall dynamism, and for these reasons the capital account shows a surplus of incoming flows, reinforcing the strength of the US dollar, and the possibility of sustaining fiscal and trade deficits.
In short, the current equilibrium that includes a strong dollar, fiscal deficit, and trade deficit is self-reinforcing, but it is not viable in the long run since what was supposed to happen has already happened: deindustrialization, strategic dependence, social problems, and high public debt.
The answer to our friend is to alert him about a change of regime, which can be orderly and gradual or very abrupt, tending towards a new equilibrium where the overvaluation of the US dollar is reduced, which has an impact on the cost and volume of imports and foreign investments, and on the need to pay more attention to the fiscal balance. All the above portend a combination of slightly higher inflation and interest rates, and even the possibility of higher taxes[5].
For a thorough analysis, please review Maurice Obstfeld’s recent paper here: https://www.brookings.edu/articles/the-us-trade-deficit-myths-and-realities/
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] In this note we will use the term capital account combining two concepts that are technically different.
[2] In the causation chain, the foreign exporter retains the dollars or sells them to his bank, which retains them or sells them to the central bank. In the end, someone retains them in the exporting country.
[3] In the case of a Brazilian exporting to Egypt, the Egyptian importer converts his Egyptian pounds into US dollars through his local bank and central bank, the Brazilian exporter receives the US dollars and converts them into Brazilian reals through his local bank and central bank. Brazil’s central bank doesn’t have too much trouble keeping those U.S. dollars.
[4] The market for U.S. Treasury bonds and notes, and their derivatives, is the largest and most liquid in the world.
[5] We tend to think of income taxes, but there are other types of taxes, including tariffs, inheritance, value-added, etc., with which the government could seek to balance its budget.