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NX ≡ (S-I) + (T-G)

Read this as “the trade balance (net exports) is identical to the sum of net savings (savings minus investment) and the government’s budget surplus or deficit (taxes minus spending).” This is not a theory of what causes what; it’s an identity, different ways of expressing the same “what”.

http://econospeak.blogspot.com/2016/12/the-identity-equals-causation-fallacy.html?m=1

Since the government spending less won't impact negatively savings, especially if savings is already low (people will save more because they will want insurance, etc.) and won't necessarily lead to companies spending a lot more to offset it, it will most of the time lead in a reduced trade deficit. It seems that although cause/effect relationship in a large system is complex and goes both ways, the government spending less will in almost all cases lead to a reduction in trade deficit. Is this true?

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  • $\begingroup$ You have made statements that are debatable, then ask whether they are true. This is not a good format for questions, since it muddies up what you are asking. An added problem is that even if cutting government spending most likely reduces the trade deficit, the effect may not be large. I will try to answer, but the question phrasing raises difficulties. $\endgroup$ – Brian Romanchuk Jun 15 at 15:54
  • $\begingroup$ I am asking this in this format, because the equation seems to imply it heavily. Although, the equation doesn't imply causation, it does imply correlation, and because (S-1) does not completely offset a reduction or increase in (T-G) a reduction in (T-G) will likely reduce NX. $\endgroup$ – blackbird Jun 15 at 15:56
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I will give an overview based on the analysis of Chapter 6 of “Monetary Economics: An Integrated Approach to Credit, Money Income, Production and Wealth” by Wynne Godley and Marc Lavoie. This is a Post-Keynesian textbook; neoclassical economists might debate the exact model structure, but their models probably give qualitatively similar results.

There’s a lot of issues buried in your question. One immediate problem is that we should not really look at just the government deficit: what the government is doing also matters. For example, the government could decrease spending in aggregate, yet greatly increase its imports (e.g. defense spending) and so the trade deficit could get worse. We will assume that something like that is not happening.

Arguing that government spending “will not impact savings” (as the question is now stated) is incorrect. Savings desires might well be unchanged, but changing government spending changes incomes, and so actual saving will change. Furthermore, cutting spending presumably has some multiplier effect (the precise level of the multiplier is hotly debated), and this will affect investment plans.

In the model in “Monetary Economics,” cutting government spending reduces the trade deficit. Since it is a multi-equation system that is solved simultaneously, one needs to be careful about verbal descriptions of mechanisms. However, I would describe the mechanism as follows: reduced government spending reduces national GDP, and this implies less imports (since imports are a fixed propensity to import out of all spending). As a result, the trade deficit falls, but it is not 1:1 with the reduction in spending - as your question phrasing (at the time of writing this answer) suggests.

One could debate the model structure, but I cannot think of many model structures that would suggest that the trade deficit would widen in response to government spending cuts. The implication is that the real debate is about the coefficient that relates the size of the cut in government spending to the trade deficit reduction. In almost any model, that coefficient would be parameter dependent, and so one would need to look at observed data to come up with a prediction for the real world.

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  • $\begingroup$ Ok, actually, you seem to agree with me. For example, Japan spending 100% of its money in in U.S. military equipment, would increase the deficit even if they cut the spending by 50%, but reducing spending will most likely reduce the trade deficit. $\endgroup$ – blackbird Jun 15 at 16:14
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    $\begingroup$ The issue is that your question is phrased (now) that the reduction is 1:1 under normal circumstances, which is not close to what typical model parameters (and observed data) suggest. I.e., the adjustment is mainly in the (S-I) term. $\endgroup$ – Brian Romanchuk Jun 15 at 16:23
  • $\begingroup$ Yeah, actually, I didn't imply or think it was 1:1, because for example some people will spend recklessly even if they don't have health insurance. $\endgroup$ – blackbird Jun 15 at 16:27
  • $\begingroup$ “Spending recklessly” is not how to characterise national saving. You can’t just look at individual actions, you need to look at the entire system. A reduction in income will reduce savings, even if savings desires are unchanged. $\endgroup$ – Brian Romanchuk Jun 16 at 12:41

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