Thursday, 5 April 2018

Questions about foreign trade

Foreign trade issues are very hard.  A student asks me

If changes in the trade balance are a consequence of changes in investment and domestic savings, what causes those two factors to change if it is not economic growth? 
For example, why would the US have higher domestic savings or less investment in 1970s or since 2006 than it did in the 1990s?

Good question.

Let's go back to basics.

One of the reasons that economics is such a powerful way of answering questions is that it is clear on three different types of statements. Statements about
  1. technology
  2. accounting definitions or identities
  3. behavioural hypotheses
 A statement about technology is something like "it takes Z workers at a point in time to produce X tonnes of output".  Note that a statement like "it takes five 10 year-old boys in a Victorian mill to produce 100 yards of cloth per hour" is a statement about technology.  A statement like "it's dreadful that 10 year-olds should have to work in factories" is a statement about philosophy, not technology.

Lets suppose the economy is a giant farm, growing wheat and raising livestock.  There are two things you can do with output. First, you can replant some of it for next year or let the animals reproduce.  That's a statement saying future output comes from current inputs, which we shall define as investment.  Second, you can bake bread or eat meat: that's consumption.

Accounting definitions and identities
Given the two things you can do, then all the output of the farm can go to only two purposes, consumption and investment.  So we can write an accounting identity which says

 where the value of output, consumption and investment is Y, C and I.  This says nothing about the split between C and I, but simply that values have to add up.  If the economy produces £100 worth of output, C and I cannot be more than £100.  Or, if C is only £50, the rest of the output is left over for replanting or used for reproduction.   

Another identity.  Let's define saving as Y-C.  It's just a definition: if people don't eat the crops they are saving them.  Thus we can write


that is, savings equal investment.  Again, this is just a definition, since anything that is not eaten or killed is defined as saving, but the same is defined as investment they must be equal.  This is not saying that saving is too high or too low or good or bad.  It's just a definition.

 Accounting definitions and identities in an open economy
Now suppose the economy can import and export.  We have to be careful about what we mean by output in this case: define output to be output of the domestic economy (as opposed to world output which is domestic plus foreign output).  Now there's another thing you can do with output, you can export it: Y=C+I+X where X is the value of exports.  That makes sense: exports are not available for C or I so if Y is still 100, then C and I must fall.  But if you can also import wheat/livestock, then there is more wheat and animals around for C or I.  So we can write  Y+M=C+I+X where M is imports.

This gives the value of domestic output, a familiar equation from economics text books as 


but in some ways the expression


is helpful.  An economy who has bad weather for example, reducing Y, would have to reduce C and I and X, unless it imports a load of goods.

We can now write in terms of saving
 in words what does this say?  Consider an economy who produces £100, as before, and does not import, but who chooses not to consume a lot. Thus Savings S are high.  Suppose as well that it does not invest a lot. It then has lots of wheat/livestock "left over".  What can it do with them? It can export them.  In an accounting sense then, saving lots of wheat, but not investing (replanting it) "makes room" for the scope to invest.  Again, this isn't saying there is anything good or bad about this behaviour, just that things have to add up.

Behavioural assumptions.
Finally, we can make assumptions behaviour.  For this we need theories of consumption, investment, imports and exports.  Here are some examples.

  1. Consumption.  Individuals like consumption, but it is subject to their incomes. So if their incomes fall, their consumption falls.  But they are sophisticated: if the fall in income is temporary, they will not reduce their consumption, but save less until incomes go back up again.  
  2. Investment. Firms invest when interest rates fall or if they get more optimistic about the future.
 and so on, other theories are available. 

 Turning to the question above, we might say this
  1. Behavioural statement: since the financial crisis, firms and consumers have got more cautious.  Investment has fallen and desired consumption per unit of income has gone down.
  2. Accounting statement.  Incomes have also fallen, so overall savings has been about the same. 
  3. Accounting statement.  now look at the data (From Tim Taylor,

As Tim says: we can now make a load of statements that follow from the identity, not whether this is good or bad.
  1. In the 1970s, S=I.  So from the identity, X=M.
  2.  in the 1990s, S<I.  So from the identity, X<M.  Go back to the farm example.  If you save very little wheat but want to plant lots for next year, you will have to import it.
  3. in the 2010s, S has fallen, I has fallen, but I more than S. So the trade deficit, from the identity has narrowed (slightly).