Maybe my understanding of how the real world works is now clouding my ability to understand the theoretical because I aced this stuff in college, but now can’t wrap my head around it. Yes, I’ve read all the similar questions but I still don’t see a clear answer to the question. I’m guessing I’m getting tripped up the semantics but could use some help in figuring this out.

Why exactly does a trade deficit require foreign borrowing? If I decide to buy some French wine and go to my banker for a loan, who in turn creates a demand deposit, increasing the money supply, why does my purchase of French wine require foreign borrowing? A bottle of French wine to anyone who can help me understand this! Thanks.

  • $\begingroup$ Somebody owes the French wine supplier money, whether it is you or your bank or the Central Bank. So this is foreign borrowing until someone in France uses this money in your country. $\endgroup$ – Henry Jul 29 at 11:47
  • $\begingroup$ When you import stuff, either you pay for it with other stuff, or you still owe them stuff. In the first case the trade deficit balances out. In the second case that counts as foreign borrowing. $\endgroup$ – user253751 Jul 29 at 11:56
  • $\begingroup$ @Henry I guess I’m getting tripped up on “borrowing.” If I pay cash for the wine, why do I need France to purchase goods from US to “pay it back?” I get that we’ll have a trade deficit, but I don’t get why it requires borrowing. Thanks! $\endgroup$ – Mike Jul 30 at 14:07
  • $\begingroup$ @user253751 But if I pay for the stuff with cash, what am I borrowing? Thanks. $\endgroup$ – Mike Jul 30 at 14:08
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    $\begingroup$ If you hand US dollar bills to someone French to pay for the wine then the Federal Reserve suddenly has a debt to a foreigner instead of to you. Whether that counts as foreign borrowing is a matter of semantics, as it is certainly a US foreign liability which did not exist before. $\endgroup$ – Henry Jul 30 at 14:17

The assertion that a trade deficit must be financed by foreign borrowing is technically incorrect (although it is often approximately true).

  • The accounting identity for international transactions has a few extra terms, one of which is grants between governments (foreign aid). A country could run a trade deficit financed by foreign aid.
  • Equity financing also shows up in international transactions. Instead of emitting debt, a country can emit equity.

The reason why the statement is approximately correct is that the largest new flow across borders is the transfer of debt instruments, noting that currency notes are a liability of government. Since net imports had to be paid for with some instruments (possibly bank deposits), there has to have been an offsetting flow of instruments out of the country. Since those instruments are debt instruments, people loosely refer to this as “borrowing,” although it could be the transfer of a bond issued years earlier. Most people do not refer to selling a bond out of their portfolio as “borrowing,” so one needs to be careful of this terminology.

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  • $\begingroup$ Ok I can see that since cash is a liability of the central bank it could be considered “borrowing,” but it sure would be nice if Mankiw explained that in his damn textbook. Not sure why his is considered so good. I aced Macro in college (we read Samuelson) yet am having trouble 30 years later. Thanks for the help. $\endgroup$ – Mike Aug 2 at 18:27
  • $\begingroup$ Realistically, foreigners do not end up owning large amount of banknotes (except for large denomination “hard currency” notes used in the underground economy as well as emergency assets, so they will end up owning what are obviously debt instruments. $\endgroup$ – Brian Romanchuk Aug 2 at 20:26

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