What Trump Wants Part 2 - How Trade Deficits and Capital Flows Can Harm or Help Countries
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein, and today is episode 516. It's part two of what Trump wants, how trade deficits and capital flows can harm or help countries.

Last week, we covered a challenging topic of trade deficits, currency accords, and why the Trump administration wants a weaker U.S. dollar in order to help U.S. manufacturers. They see this as a national security issue.

One of our PLUS members on the PLUS member forums wrote after listening to the episode that it scared the bejesus out of him. He wrote, I hate to puke everything. In other words, sell all his assets. But there is something scary about rejiggering the economy and the international financial paradigm.

I agree that this intervention, these tariffs, the potential to start taxing or charging a service fee on capital coming into the U.S., that's scary because we don't know what the impact will be. My nephew, after listening to the episode, sent me a thoughtful text and he wrote, considering the U.S. is part of a much larger global economy, is it better for America or Americans in general to pursue which of these two courses? Weaken the U.S. dollar, reduce the trade deficits and help the major...

the manufacturing base while reducing the global economy's reliance on our currency and its stability? Or is it better to maintain the strength of the U.S. dollar, continuing to increase the trade deficit, the capital count surplus, as foreign capital flows into the U.S.? He mentioned it could take years for U.S. manufacturing base to increase and that if it does, costs could be higher. These are complicated topics.

And so I find it helpful to kind of go back to first principles, to review and understand how there are certain accounting identities, certain formulas that just by nature have to be true. We referred to some of those in last week's episode.

as part of that review that I did this week in preparing for this episode, because I'm thinking about this, because it doesn't come intuitively for me. And so I reviewed this past week the work of Michael Pettis. Pettis is an American professor of finance. He's located in China. He's also a non-resident senior fellow at the Carnegie Endowment for International Peace.

and followed his work for years at Money for the Rest of Us and also when I was an institutional investment advisor. And I've referred to his work in earlier Money for the Rest of Us episodes, including eight years ago when we covered a similar topic, episode 144, on trade deficits and trade wars. Pettis is an expert on China and

and on how trade works and capital flows. He's written books on it. And I will reread his work, his essays, one that I will refer to and link to in this episode. He published in 2019, another in 2017. Hopefully you'll find this review helpful as we look at what the administration is trying to do, why they're trying to do it, and think about whether it will work or not. So we're going to go back to first principles and focus on two accounting identities. The first is

is the U.S. current account deficit needs to be offset by the capital account surplus. Current account deficit is mostly trade. The U.S. runs a trade deficit, a current account deficit, because it imposes

imports more goods and services than it exports. The U.S. also takes in more investment capital from overseas than it sends abroad. That's the accounting identity. That deficit, trade deficit, current account deficit, needs to be, has to be, mathematically is offset by the capital account surplus. Last week, we referred to a podcast episode, Fundraising

by Paul Diggle, who's chief economist at Aberdeen, and Luke Bartholomew, who's the deputy chief economist. And they said, it's important to note that the strong demand for U.S. assets keeps the dollar elevated. And that strong dollar squeezes U.S. exports and encourages imports.

And in that sense, you can think of it as creating the current account deficit. That demand to invest in the U.S. creates the current account deficit, which is the natural, necessary mirror image of the capital account surplus that comes from being the reserve issuer. And in particular, it's the manufacturing sector that tends to suffer the most from that strong dollar. It's the most trade exposed part of the economy.

Now, there's the idea is, well, what comes first, the trade deficit or the capital account surplus? In some ways, they move in tandem. There are times when there's just so much capital coming in to an area like Latin America driving those capital flows. It does push the Latin American economy into a trade deficit, but they're related.

Pettis is pretty convinced that most of the time it's the investment flows driving the deficit. And he thinks that's the case with the U.S. Before we continue, let me pause and share some words for one of this week's sponsors, LinkedIn.

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Now, the second identity is that savings equals investment. Every dollar saved across the domestic or global economy is invested. If it's saved, it's invested. Pettis writes, the United States runs trade deficits mainly because the rest of the world exports its excess savings thereof.

there to the U.S. And Pettis outlines why as he describes two roads for a nation to boost its international competitiveness. The first is the high road. It's to increase domestic productivity, to become more efficient at producing things. And that requires investment in infrastructure, education, and technology. And as those investments pay off, workers are able to produce more output per

GDP, the monetary value of that output per capita increases. That's the high road. The low road is to reduce relative wages for the country's workers. They earn less for each item produced. And that could be done by subsidizing businesses. It could be done by weakening the currency or keeping it weaker to make the exports more competitive.

Pettis writes the low road is, of course, easier to embark on quickly and effectively entails reducing the household share of what a country produces directly or indirectly. In other words, households, he writes, receive less total compensation for producing a given amount. They're just not paid as much to produce things. It isn't that the businesses are more efficient in producing things through technology. It's they're just not paying the workers as much.

And that low road can reduce total demand across the economy because the workers are suffering. The capitalists, the business owners, they're doing fine. And so that increases wealth inequality. But because the workers are being held back in terms of their wages, and yet the economy, the country continues to produce, it produces more than it consumes because demand is down. And so what does it do? It exports it. It sends that excess production overseas. And because

because of income inequality in the country, the wealthy have savings and they're sending their capital overseas to invest. Or the businesses that have higher profits, corporate profits equals business savings. They invest those overseas. China and many developing countries take the low road at first because it's easier, but it can be a race to the bottom as China's

China's wages start to become uncompetitive relative to Bangladesh or Vietnam. And so then they have to invest in technology and things to make their businesses more productive. But there's a reason why Treasury Secretary Scott Besson said, we're trying to make China rebalance. China over manufactures and deprives its household sector. The U.S. would like to see the Chinese rebalance their economy so consumption makes up a greater percentage of it. It meant

We mentioned last week, manufacturing makes up 30% of China's GDP compared to half that amount for the U.S. We have a situation where there is excess savings from around the world flowing in to the U.S. to be invested. And when a

a nation runs a capital account surplus, when money is flowing in, it can be invested in two ways. The investments could be done in equity or debt projects that increases business productivity and competitiveness. It leads to higher income growth for the businesses and the workers because these are productivity enhancing investments. The businesses have greater debt servicing capacity.

They're earning more due to their increased competitiveness to pay interest and principal on the debt. It leads to greater income for the nation's workers as they become more productive in using technology. And so these investments are put to productive use. It also earns a solid rate of return for those investors. And there's been times when the

the U.S. needed that, such as in the 19th century when the U.S. was building out its railroad, the savings amount in the U.S. was not large enough to meet the nation's high investment needs.

British, Dutch, and other European savings flowed into the country. The U.S. ran a capital account surplus. It needed to be offset by the trade deficit. But some of that trade deficit, those goods flowing in, were commodities used to build out the infrastructure.

or other capital goods, such as machinery, to increase productivity. Some of it were foreign consumer goods. But that was a time where the U.S. needed the capital. They ran a surplus. It was offset by the trade deficit. But everybody was better off for it because the U.S. became more productive, more wealthier. Investors did fine.

And a lot of developing nations right now are in that situation. There is just ample infrastructure projects and other projects to businesses to help them become more productive that they need that capital. The U.S. is not one of those countries or other developed nations. And as a result, much of the capital flows into the U.S. go to less productive investments or unproductive investments.

It could be capital flowing into treasury bonds to fund the U.S. budget deficit for expenditures to pay out social benefits or for defense. It could be just flows into the stock market, into mega cap stocks, just increasing the valuation of the overall stock market.

Pettis points out there are three types of borrowing. There's household, government, and business borrowing. And he says household borrowing is not self-liquidating, which means as household debt goes up, their productivity doesn't necessarily increase, which means they have to reduce future spending in order to pay back the debt.

The exception would be student loans if it increases the student's ability to earn more. But much of household borrowing doesn't increase household productivity. And so it just leads to a higher debt burden. Points out government debt is the same way unless it's funding productive infrastructure like Germany just announced. Now, that has to be targeted in the right way. But much of government

government spending isn't increasing productivity, which means it's not increasing the nation's ability to service the debt. And so it's a drag, which can lead to a debt crisis. Business debt, on the other hand, usually funds productive investments, and it boosts the business's ability to service the debt because they become more productive. And that

That's what capitalism is. It's investing in businesses. But if the businesses aren't starved for capital, which does seem to be the case for many businesses because their cash balances keep going up, a firm like Berkshire Hathaway, they don't seem like they need capital. They got plenty of cash. And if that capital is used to buy back stocks, that's not productive. It just increases earnings per share because there are fewer stock shares outstanding or just it's invested in nonproductive ways.

Pettis summarizes the situation then. He says, much of the world's excess savings flows to rich countries where these funds are not needed rather than to developing countries that can use them productively. And he points out that's because it's typically the most open, flexible countries, the best governed financial markets.

that receive this capital. We mentioned last week, the U.S. is the deepest financial markets. When there's a flight to quality, it flows to the U.S., but the U.S. doesn't necessarily need that capital. And it leads to the dollar being quite strong, which can hurt the U.S.'s manufacturing base. Before we continue, let me pause and share some words from this week's sponsors.

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Now, here's the other thing when we go back to this accounting identity that savings equals investment. If there are insufficient investment opportunities in the U.S., a capital account surplus with investment flowing into the U.S. from overseas, that will reduce U.S. domestic savings. And Pettis points out how that can be the case. Why is it?

U.S. household savings is so much lower than other areas around the world. And Pettis is saying because savings equals investment, as more excess savings comes into the U.S. from overseas, because there's not sufficient investment opportunities, that lowers U.S. domestic savings rates. And he points out six ways that occurs. One, those net capital inflows may strengthen the dollar. So the dollar is stronger. That was Trump administration's concern. That's it.

Moran. And so with a stronger dollar, households have more income. Their dollar goes further and then they spend it on imports. Consumption leads to bigger trade deficit, larger capital account surplus. Domestic savings could be down in the U.S. because the U.S. unemployment rate may be higher than it would be otherwise because of the cheap foreign imports that create the U.S. current account deficit.

or because of income inequality reduces consumer demand for many workers. Unemployed workers, he points out, have negative savings rate. And so that income inequality and that trade deficit, because it harms the manufacturing base, that leads to lower domestic savings because workers just aren't earning as much or they're unemployed. And

And then if unemployment rises, unemployment benefits, the government often has to run a budget deficit to fund those fiscal transfers. And that money flows to households who spend it and savings decline. Now, oftentimes, if the economy is slowing, the Federal Reserve will reduce its policy rate in order to encourage additional borrowing from households and businesses. And as debt increases, as households borrow or

or businesses borrow, that means their savings less. This savings rate goes down. Capital inflows into the U.S., as I mentioned, that can push up the value of assets, of real estate, of stocks. Households feel wealthier and they spend that.

money due to the wealth effect, and that can increase consumption relative to savings. And finally, U.S. banks, they're lending, giving loans to households, consumer loans for vacation, as the banks might be lowering their credit standards. But there are multiple ways that, and reasons, U.S. savings rate is low, but it mathematically is a function of all this capital coming in from overseas. But it's all connected. It's

Savings rates low because U.S. households are buying cheap imports. Imports are cheap.

because some countries have taken the low road and suppressed wages, and that's led to income inequality in those nations, and the wealthy are taking their excess savings and investing them in the U.S. Pettis writes, notice that these numerous methods of driving down the savings rate can be summarized as one of two, either unemployment rises or debt rises. A lot of the scenarios, it was more borrowing to fund consumption, including the government. It

In the end, Pettis writes, the result of rising income inequality and trade deficits is almost always that debt rises faster than it otherwise would. And that was one of the points that Steve Moran made in his paper that we discussed last week. The inevitable consequence of a too strong a dollar, which is a function of the capital account surplus, is rising twin deficits.

A budget deficit in the U.S. is higher than it would be otherwise because incomes are lower for U.S. workers due to higher unemployment as the U.S.'s manufacturing base is less competitive. But you also have the trade deficit widening for the reasons that we've pointed out. Pettis concludes then, this is a very straightforward and clear relationship.

at the heart of any evaluation of the impact of U.S. trade imbalance. If whatever causes the trade deficit to rise also causes the debt burden to rise or causes unemployment to rise, it's safe to say that a higher trade deficit makes the United States poorer and a lower trade deficit makes the country richer.

That is what the Trump administration is saying, that the U.S. is poorer than it would be otherwise because of this trade deficit, because of the capital account surplus. But Pettis says, on the other hand, if the trade deficit and the capital account surplus causes productive investment to increase, it's the reverse. A higher trade deficit makes the U.S. richer. Back in episode 144, we gave an example of Mexico.

LePereau and I used to stay at a beachfront hotel in Tulum before it got too pricey to stay there. And I'd been there numerous times over the decade. And that stretch of beach or all along the Caribbean coast there on the Yucatan Peninsula is you get sargassum, seaweed flowing in, you have garbage flowing in overnight, and there's workers out there collecting it. And I

I've seen them, one worker out there all day with a shovel and a wheelbarrow. And the last time we stayed there, they had just gotten a John Deere ATV with a big wagon on the back to assist with the collection of the sargassum and the garbage. In other words, here was an investment the hotel made, buying a John Deere. It would have increased Mexico's trade deficit. Now,

Now, if it helped those workers become more productive, and it apparently did because suddenly they were charging $1,500 a night for a room instead of $500. That's why we don't stay there anymore. And if there wasn't a comparable vehicle or ATV made in Mexico, then running that trade deficit actually helped the Mexican economy. So it isn't trade deficits are always bad.

It's trade deficits are bad because the offsetting capital surplus, the investment flowing in can't be used productively. Instead of going into projects that increase domestic productivity, fund innovation, technology, new ideas, if all it does is it pushes up asset prices and U.S. dollar, then it's harmful. Right.

And it makes the U.S. poor. Now, it's hard to figure out. And Pettis admits this. If there are sufficient investment opportunities, productive investment opportunities, much of investment now is going to AI. Will that pay off? We don't know.

But Stephen Moran says the paradox of being a reserve currency is that it leads to permanent twin deficits, a budget deficit and a trade deficit, which in turn lead over time to an unsustainable accumulation of public and foreign debt that eventually undermines the safety and reserve currency status of such a large debtor economy. And that's why the Trump administration...

They haven't announced anything. They haven't really explicitly said this, but I'm sure they're just discussing some type of...

approach to discouraging capital flows. By reducing the deficit, trade deficit, by its very nature, that will reduce the capital surplus, the amount of foreign savings flowing into the U.S. Now, we talked last week, maybe they'll tack on a service fee for governments that invest in U.S. treasury market. They're clearly going to use tariffs. Now, one of the things Pettis pointed out when it comes to tariffs is when, and I guess this should have occurred to me, but

But if the capital flowing in isn't being used productively, it's making the U.S. worse off, households poorer, then if the tariffs adds to the cost of certain goods...

increases their price, it might not necessarily be inflationary because households don't necessarily have more money, in which case they'll buy fewer of other goods and demand overall just shifts and more of the demand or more of the money would flow to some of the tariff goods, but others, maybe they don't get bought. So their prices drop or there's substitutions.

But it's not a given that inflation will increase. Prices might go up once, but we don't know. I mean, that's the biggest...

scariest thing about this. It's this desire to sort of undo what's developed over the past 50 years or so. The current course has led to a higher debt burden, at least for the national debt, because of the budget deficits. Now, again, there are multiple things that drive this. We've just focused on two accounting identities. The trade deficit is offset by a capital surplus and

Excess savings are flowing in to the U.S. often because of income

income inequality overseas because of some nations' approach to suppressing wages to not rebalance their economy. We also know savings must equal investment. Those excess savings, are they being put to productive use or are they just creating asset bubbles and keeping the U.S. dollar too strong? We know the identities. We don't know the details and we don't know the unintended consequences. So we'll keep

monitoring it, reviewing it, and we'll see how it evolves. That's episode 516. Thanks for listening.

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