Weekly Geopolitical Report – Reflections on Trade: Part II (May 8, 2017)

by Bill O’Grady

In this multi-part report, we offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims.  In Part I, we laid out the basic macroeconomics of trade.  This week, in Part II, we will discuss the impact of exchange rates and examine the two models of economic development, the “Japan Model”[1] and the “American Model.”[2]

The Japan Model of development calls for policies that drive up household saving.  This is usually done through financial repression and wage suppression.  This model is designed to provide cheap investment funds to build up the productive capacity of the country.

In contrast, the American Model of development relies on foreign investment.  In this arrangement, the trade deficit is an import of foreign saving for investment.

As a review from Part I of our report, the following saving identity means that the private investment/savings balance (I-S) plus the public spending balance (Govt-Taxes) is equal to the trade account, M-X (Imports less Exports).

(M – X) = (I – S) + (G – Tx)

If a nation’s saving equals its investment and it runs a balanced fiscal budget, then it will run a balanced trade account.  It doesn’t matter what the exchange rate is or what trade policy is in place; if the private and public sector balances, there will also be balanced trade.

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[1] We call this the Japan Model because it has been adopted by Asian nations for development.

[2] We call this the American Model because it is how the U.S. acquired saving during its industrial revolution, which began in earnest in 1870.