Explain how the US trade deficit was caused by reduced savings in 1980s and increased investment in 1990s.?

Question

I need help in understanding the relationship between saving and investment and the trade deficit (where imports are larger than exports). Please help. Colin

Answer 1

If this is a homework problem I'll probably give the "wrong" answer, but here's the straight scoop. The trade deficit was NOT caused either by reduced savings, or by increased investment. The paradox of your question gives a good indication of how many pundits and economists misunderstand these issues.

Say an American has a sum of money (or an income stream) and has to decide whether to 1) buy an imported car or 2) save that money in his bank. OK, suppose he chooses to buy the car. Compared with the alternative choice of saving the money, the net result of this decision upon checking the statistics is 1) less savings and 2) more imports. (If it were a domestic car, he would neither have saved money nor imported anything.)

These two statistics occur as a result of the choice to consume an import rather than to save or to buy a domestic car. But the import does not "cause" a lack of savings, and a lack of savings does not cause an import to occur. There is another cause of both of these effects: a consumer's free choice to buy a car made in another country. But you can see the relationship: a person can either save money or spend it -- there is no third choice. If he spends it on an import, this contributes to the trade deficit.

Now to the investment. "Investment" in this context refers to businesses making investments -- buying capital equipment, building factories etc. There is only one direct way that investment relates to a trade deficit: that is if an American company imports equipment made abroad. But that's NOT what is meant in your question.

Your question refers to a more roundabout relationship: foreign companies buying American assets, whether building a factory here, or buying an American company, or buying bonds, etc. This is NOT part of the trade deficit. But ask yourself, where do foreign companies get the money to invest in American assets? Largely from importing their goods to Americans (hence, the trade deficit).

So say, Toyota sells a bunch of cars to the US. They receive US dollars from those transactions. They can't spend US dollars in Tokyo anyway, so what do they do? Toyota turns around and uses its dollars to build a plant in San Antonio, Texas. And maybe buy some US treasury bonds for their corporate accounts.

Here's where a lot of professionals get it wrong. They think that Americans must require this foreign investment in order to afford to buy imports. This is wrong, and confuses cause and effect. In truth it's just the opposite: foreigners can afford to make investments in the US, because they have successfully imported things to the US, and that business further encourages them to more directly participate in the US market (hence Toyota's Texas factories). So investment does not cause a trade deficit; rather, imports TO the US enable foreign investments to be made IN the US.

Answer 2

Reduced savings was purely down to the now mentality - wanting everything now regardless of whether they can pay or not - credit was available to all and sundry! Investment in the 1990s was a quick fix to try and pay for all the spending - again greed. Well not quite but the 1990s was the era of the IT boom and the resulting over priced equity for anything IT. So guess what, all and sundry decided to get on the band wagon to make a quick buck or two to recoup their losses from too much credit but we all know what happened there!