Savings, Investment & The Deficits

Over the past decade, thanks to fracking, the US has approached self-sufficiency in oil.

Since 2008 the trade deficit in oil fell from over half of the overall trade deficit to under 10% in 2016.

Surprisingly, however the massive decline in the oil deficit did not lead to a contraction of the overall trade deficit. Rather, the non=petroleum deficit expanded to offset the improvement in oil.  Actually, it should not be a surprise as this is a beautiful example of the standard economic analysis that the current account balance  (the trade deficit plus certain capital transactions) equals the gap between domestic savings and investments.

When it first became obvious that the Reagan tax cuts were going to lead to a very large structural federal deficit, mainstream economic forecasters started to talk about crowding out.  If you look at the US economy as a closed system, domestic investments must equal domestic savings and interest rates are the price that changes to ensure that tat identity holds.

We clearly got a massive increase in the federal deficit as after the Reagan tax cuts the federal deficit exploded from -2% to – 6% of GDP. Moreover, this occurred during the time of very strong economic growth that should have caused the deficit to contract. But interest rates did not rise and the crowding out analysis was discredited. Vice President Cheney even went so far to claim this demonstrated that deficit do not matter.

But the view that savings must equal investments only holds in a closed economy. In those days virtually everyone looked at the US economy as a closed system and ignored the international aspects of the economy. In an open economy, however savings does not have to equal investments because foreign capital inflows can finance a gap between savings and investments.  In a closed economy interest rates adjust to ensure this identity.  But in an open economy, both interest rates and the currency can move to ensure that economic identity prevails.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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