TCS Daily

The Balance of Saving

By Arnold Kling - November 18, 2003 12:00 AM

"Isn't it just a little twisted that the United States, the world's richest country, is on track to borrow more than $500 billion from abroad this year? Isn't it even stranger that this borrowing includes sizable chunks from countries such as India and China, many of whose 2.3 billion people live on less than a dollar or two a day?"
-- Ken Rogoff


On the subject of the trade balance, politicians and economists do not think alike. As a result, the political solutions to the trade deficit are almost always bad economics.


Politicians think of our trade deficit (the excess of imports over exports, which has reached $500 billion a year or about 4 percent of GDP) as evidence that we have lost a "trade war." They blame enemy tactics, such as low wages, tariffs, or unfair trade rules.


Economists, such as the International Monetary Fund's former chief economist Ken Rogoff, view the trade balance as determined by an equation involving aggregate saving:


Private Saving plus Government Saving equals Trade Surplus


Government saving is negative whenever the government runs a Budget deficit, which is typical. Only if private saving is greater than the Budget deficit can a country run a trade surplus. If the Budget deficit soaks up more than the savings provided by domestic sources, then a country must borrow from abroad. When it borrows from abroad, it runs a trade deficit.


One way to see this is to think in terms of currency flows. When we buy goods from, say, China, the Chinese obtain dollars. Those dollars will be used either to buy U.S. securities or U.S. goods and services. When the dollars are used to buy U.S. securities rather than goods and services, we run a trade deficit. Our trade deficit with China reflects the fact that they buy more of our securities than we buy of theirs. It reflects a balance of saving in which China is a creditor and we are a debtor. As Rogoff puts it,


"We save less of our income than any other rich economy. China's citizens save more than 40 percent of their income; the United States would be lucky if its citizens ever decided to save at half that rate. No matter how rich you are, if you continually spend more than you earn, you are eventually going to run into problems."


Think National Saving


By focusing on the balance of saving, economists come up with a completely different set of policy prescriptions than the ones that are popular with politicians. Increasing exports relative to imports is not a matter of beating up on China to live up to its commitments in the World Trade Organization. It is not a matter of prohibiting U.S. firms from outsourcing to India. It is a matter of increasing national saving.


One way to increase national saving is to reduce the government Budget deficit. This may be a low priority while the economy is weak and in need of stimulus, but it will become a high priority if the rebound that apparently began in the third quarter maintains its momentum. Some combination of spending cuts and tax increases will be needed during the next Presidential term.


Reduced government borrowing is only part of the solution. We also need higher private saving. Private saving consists of personal saving and corporate saving. In these areas, it is the obsession with "progressive" tax policies that stands in the way.


Compared with other major industrial countries, we have lower sales tax rates and higher corporate income tax rates. Thus, our mix of taxes punishes private saving more and consumption less than the mix of taxes in other countries. It could well be that this tax mix is the biggest reason that the United States is a debtor nation with massive trade deficits.


If we could stop thinking of taxes on consumption as taxes on "the poor" and taxes on capital income as takes on "the rich," we could create a tax system with incentives to become the supplier of capital to the rest of the world that Rogoff argues is our proper role. Moreover, the details of the WTO and other microeconomic policies would not matter. If our savings rate were higher, the United States would run a trade surplus, regardless of whether other countries use tactics that are "fair" or not.


The Economists' Solution


The trade deficit is political dynamite. Any moment, demagogues from either party could blow up the world trading system by enacting trade barriers, perhaps causing other countries to "retaliate." (Economists, who think of a trade barrier as a nation shooting itself in the foot, are reluctant to adopt the term "retaliation" to describe responding in kind when another nation punishes itself.)


The economists' optimal solution to the U.S. trade deficit is to try to take the best and reject the worst ideas from supply-side economics. We should try to increase both private saving and government saving.


The best idea from supply-side economics is to use tax policy to encourage work and thrift rather than as a tool to redistribute income. We should change the mix of taxes to favor saving rather than consumption. That would increase private saving.


The worst idea from supply-side economics is to cut taxes without cutting government spending. This increases government deficits, reduces national saving, and increases the trade deficit. If tax revenues are going to be reduced by lowering some tax rates, then either other tax rates must be increased or government spending must be restrained. Otherwise, supply-side economics is just a cover for government deficits, making it the problem rather than the solution for the trade deficit.


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