The following article is the third in a ten part series written by Emeritus Associate Professor W. Raymond Mills.

National Savings is defined as that part of national production that is not consumed in the time interval. It is left over, during this time period. In the year 2006, Gross Domestic Product was 13, 399 billion and Consumption was 11,416 billion (both public and private) resulting in a Savings of 1,983 billion. This is money that can be used in a subsequent time period or it can be stored. (The above description of National Savings is conventional wisdom and it is wrong. It will be accepted as valid for the purpose of understanding the causation issue. See the end of this discussion for a correct interpretation of what is left over after Consumption is subtracted from Gross Domestic Product).

The equation we are working with is GDP = Consumption + Investment + Trade Balance. When we move consumption over to the left side of the equation we have GDP –Consumption = Investment + Trade Balance. By definition, the two sides of an equation are equal. Therefore, Savings is also equal to Investment + Trade Balance. The numbers for the year 2006 are 1,983 = 2,752 – 769 (these numbers are taken from the National Accounts provided by the U.S. Bureau of Economic Analysis. They differ slightly from the numbers taken from IMF and WTO. Also they refer to total imports and exports, not just goods).

Some people (who are misguided) think that the level of Savings (1,983) controls or determines the level of Investment minus the Trade Deficit (2,752 – 769). This is the direction of causation controversy. How we decide the direction of causation in this equation is important. For if Savings controls the level of the other two variables, and investment is controlled by the expenditures business firms make on equipment, building and software, it would follow that the level of the trade deficit is controlled by the level of Savings. That would mean that the U.S. must increase Savings in order to reduce the trade deficit. Free trade advocates prefer this answer to the direction of causation question because it means that the trade deficit cannot be reduced by restricting imports or subsidizing exports. If Savings in the controlling variable, the U.S. can’t do anything about the size of the trade deficit because the level of national savings is so very difficult to change.

If, on the other hand, the trade balance is controlled by the size of imports and exports, then the U.S. can change the level of the trade balance by restricting imports or subsidizing exports.

The trade balance and investment are both calculated from numbers collected from businesses and Customs Agents. Savings, on the other hand, is derived from other numbers found in the equation. Numbers created by manipulating other numbers in an equation are called endogenous – dependent for their size on other numbers in the same equation. It seems reasonable to assume that the numbers used to determine the size of savings are in fact controlling the size of savings. How the numbers are created tells us which numbers are controlling.

The conclusion is that the size of Savings depends upon the size of the Trade Balance and Investments and not the other way around. It is also true to say that the size of savings depends upon how wide the gap between Consumption and Gross Domestic Product. GDP can only be larger than consumption when the combination of investment and the trade balance force GDP to be larger than Consumption. A nation like China has a large level of national savings because both investment and the trade surplus are large relative to consumption. The Chinese government wants to use funds received from the trade surplus to increase investment. In addition, the low level of wages in China suppresses consumption.

Compounding one error with another, some writers assume that the level of investment in a given time period is controlled by the level of savings in that same time period. The level of investments at any time period is controlled by investor’s decisions as to the likelihood of a good return on the investment. The money to pay for the investment in a given time period is assembled independently of the savings in that time period. After all, Savings, by definition, are not spent during the time period Savings is recorded. There can be no connection between the level of Savings in time period X and the level of spending for investments in time period X.

A further extension of this silly logic is to say that when savings is less than investment in a given equation, a trade deficit is necessary to provide the funds needed to fund investment. This is doubly silly: 1) Investment is not funded from funds created in the time interval of the investment and 2) A trade deficit does not increase the net financial position of the nation experiencing the trade deficit. Just the opposite. A trade deficit creates a net flow of financial funds from the deficit nation to the surplus nation.

An increase in financial assets in the trade surplus nation is created when financial assets flow from the deficit nation to the surplus nation in payment for goods and services. The trade deficit nation gets more goods (worth 881 billion to the U.S. in 2006); the trade surplus nations get more financial assets (881 billion dollars distributed among many nations).

The trade surplus nations prefer to exchange these dollars for other financial instruments, such as U.S. Treasury certificates, stocks or bonds or ownership of real estate or companies. This flow of funds back to the U.S. is mistakenly seen as increasing net financial assets in the U.S. only if the observer ignores the ownership certificates that flow in the other direction. Accounting conventions requires that a flow of funds across international borders is always matched by a flow of something else of equal value back in the other direction. When financial instruments are exchanged for financial instruments between nations there is no change in the net financial position of either nation.

It is simply wrong to assert that a trade deficit provides funds to the trade deficit nation that can be used for any purpose, especially not to fund investment during the period the trade deficit is experienced. This issue has tangled the thinking of many economists.

“Oh what a tangled web we weave, when first we practice to deceive”.

The material covered in this post clears the way for the U.S. government to manipulate factors that influence the level of imports or exports without fear that savings or some other financial entity are controlling the level of imports and exports.

Note: The conventional wisdom as to what is left over after Consumption is subtracted from Gross Domestic Product is wrong. Subtracting Consumption from Gross Domestic Product allows us to separate current production into that part that serves the needs of the present versus that part of current production that serves the needs of the future. Investment is money spent today to increase future production ability and capacity. The trade balance shows deviation of current production from what is required to balance exports and imports. A positive deviation creates production knowledge and tools in the present that lay the foundation for future growth in domestic production. A negative deviation reduces the knowledge and tools existing in the present that can be used as a foundation for future growth in domestic production (compared to what is achieved with equal trade).

Everything in the formula for Gross Domestic Product is a form of production. No room is left for surplus money that is not used in production.

On the other hand, domestic production does create additional wealth in the nation. Our problem is that economists, thus far, have not devised a satisfactory way to measure it. We know how much Net Wealth is added to households during each quarter (Federal Reserve Board data). We do not know how to separate this total gain into that part that is created by domestic production.

Summary thus far: 1. A trade deficit reduces the growth of an economy and its financial assets, compared to what would be achieved with equal trade. 2. The larger the trade total for each nation engaged in equal trade, the larger the contribution of trade to the growth of that nation’ economy. 3. The Free Trade ideal is torpedoed by the advantages nations gain from a trade surplus. 4. Expansion of National Savings (as conventionally defined) is not needed to reduce the trade deficit because the size of the trade balance controls the size of savings. The trade balance also shows the contribution of current production to creating the knowledge and tools needed to expand future production.

Click here to read the first article in this series.

Click here to read the second article in this series.

W. Raymond Mills is an Emeritus Associate Professor of City and Regional Planning at The Ohio State University. Mills’ Ph.D was in Sociology from the U. of Michigan (in 1958), his specialty was forecasting economic and population growth in metropolitan areas in the U.S. He can be contacted via email: wrmills@wideopenwest.com

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