18.1How Government Borrowing Affects Investment and the Trade Balance

The purpose of The Higher Education Act of 1965 was to build the country’s human capital by creating educational opportunity for millions of Americans. The three criteria that the government uses to judge eligibility are income, full-time or part-time attendance, and the cost of the institution. According to education.org, in the 2011–2012 school year, over 80% of all full-time college students received some form of federal financial aid; 43% received grants; and another 41% of students aged 15–23 received federal government student loans. The budget to support financial aid has increased not only because of more enrollment, but also because of increased tuition and fees for higher education. In 2022, the government generally took an approach of increasing student aid through programs such as Pell Grant expansion, while also taking steps to ease student loan debt. Governments have many competing demands for financial support. Any spending should be tempered by fiscal responsibility and by looking carefully at the spending’s impact. When a government spends more than it collects in taxes, it runs a budget deficit. It then needs to borrow. When government borrowing becomes especially large and sustained, it can substantially reduce the financial capital available to private sector firms, as well as lead to trade imbalances and even financial crises. The Government Budgets and Fiscal Policy chapter introduced the concepts of deficits and debt, as well as how a government could use fiscal policy to address recession or inflation. This chapter begins by building on the national savings and investment identity, which we first introduced in The International Trade and Capital Flows chapter, to show how government borrowing affects firms’ physical capital investment levels and trade balances. A prolonged period of budget deficits may lead to lower economic growth, in part because the funds that the government borrows to fund its budget deficits are typically no longer available for private investment. Moreover, a sustained pattern of large budget deficits can lead to disruptive economic patterns of high inflation, substantial inflows of financial capital from abroad, plummeting exchange rates, and heavy strains on a country’s banking and financial system.

18.1 How Government Borrowing Affects Investment and the Trade Balance

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the national saving and investment identity in terms of demand and supply
• Evaluate the role of budget surpluses and trade surpluses in national saving and investment identity

When governments are borrowers in financial markets, there are three possible sources for the funds from a macroeconomic point of view: (1) households might save more; (2) private firms might borrow less; and (3) the additional funds for government borrowing might come from outside the country, from foreign financial investors. Let’s begin with a review of why one of these three options must occur, and then explore how interest rates and exchange rates adjust to these connections.

The National Saving and Investment Identity

The national saving and investment identity, which we first introduced in The International Trade and Capital Flows chapter, provides a framework for showing the relationships between the sources of demand and supply in financial capital markets. The identity begins with a statement that must always hold true: the quantity of financial capital supplied in the market must equal the quantity of financial capital demanded. The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings. These include the inflow of foreign financial capital from abroad. The inflow of savings from abroad is, by definition, equal to the trade deficit, as we explained in The International Trade and Capital Flows chapter. We can write this inflow of foreign investment capital as imports (M) minus exports (X). There are also two main sources of demand for financial capital: private sector investment (I) and government borrowing. Government borrowing in any given year is equal to the budget deficit, which we can write as the difference between government spending (G) and net taxes (T). Let’s call this equation 1. Governments often spend more than they receive in taxes and, therefore, public savings (T – G) is negative. This causes a need to borrow money in the amount of (G – T) instead of adding to the nation’s savings. If this is the case, we can view governments as demanders of financial capital instead of suppliers. In algebraic terms, we can rewrite the national savings and investment identity like this: Let’s call this equation 2. We must accompany a change in any part of the national saving and investment identity by offsetting changes in at least one other part of the equation because we assume that the equality of quantity supplied and quantity demanded always holds. If the government budget deficit changes, then either private saving or investment or the trade balance—or some combination of the three—must change as well. Figure 18.2 shows the possible effects.

FIGURE 18.2Effects of Change in Budget Surplus or Deficit on Investment, Savings, and The Trade Balance Chart (a) shows the potential results when the budget deficit rises (or budget surplus falls). Chart (b) shows the potential results when the budget deficit falls (or budget surplus rises).

What about Budget Surpluses and Trade Surpluses?

The national saving and investment identity must always hold true because, by definition, the quantity supplied and quantity demanded in the financial capital market must always be equal. However, the formula will look somewhat different if the government budget is in deficit rather than surplus or if the balance of trade is in surplus rather than deficit. For example, in 1999 and 2000, the U.S. government had budget surpluses, although the economy was still experiencing trade deficits. When the government was running budget surpluses, it was acting as a saver rather than a borrower, and supplying rather than demanding financial capital. As a result, we would write the national saving and investment identity during this time as: Let's call this equation 3. Notice that this expression is mathematically the same as equation 2 except the savings and investment sides of the identity have simply flipped sides. During the 1960s, the U.S. government was often running a budget deficit, but the economy was typically running trade surpluses. Since a trade surplus means that an economy is experiencing a net outflow of financial capital, we would write the national saving and investment identity as: Instead of the balance of trade representing part of the supply of financial capital, which occurs with a trade deficit, a trade surplus represents an outflow of financial capital leaving the domestic economy and invested elsewhere in the world. We assume that the point to these equations is that the national saving and investment identity always hold. When you write these relationships, it is important to engage your brain and think about what is on the supply and demand side of the financial capital market before you start your calculations. As you can see in Figure 18.3, the Office of Management and Budget shows that the United States has consistently run budget deficits since 1977, with the exception of 1999 and 2000. What is alarming is the dramatic increase in budget deficits that has occurred since 2008, which in part reflects declining tax revenues and increased safety net expenditures due to the Great Recession. While deficits were controlled as the economy began to recover in the mid-2010s, the budget deficit increased again in 2020 during the pandemic, and forecasters expect deficits to remain high for the foreseeable future. (Recall that T is net taxes. When the government must transfer funds back to individuals for safety net expenditures like Social Security and unemployment benefits, budget deficits rise.) These deficits have implications for the future health of the U.S. economy.

FIGURE 18.3United States On-Budget, Surplus, and Deficit, 1952–2020 ($ billions) The United States has run a budget deficit for over 30 years, with the exception of 1999 and 2000. Military expenditures, entitlement programs, and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major contributors to the dramatic increases in the deficit after 2008. (Source: Office of Management and Budget, https://fred.stlouisfed.org/series/FYFSGDA188S) A rising budget deficit may result in a fall in domestic investment, a rise in private savings, or a rise in the trade deficit. The following modules discuss each of these possible effects in more detail.

18.2 Fiscal Policy and the Trade Balance

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Discuss twin deficits as they related to budget and trade deficit
• Explain the relationship between budget deficits and exchange rates
• Explain the relationship between budget deficits and inflation
• Identify causes of recessions

Government budget balances can affect the trade balance. As The Keynesian Perspective chapter discusses, a net inflow of foreign financial investment always accompanies a trade deficit, while a net outflow of financial investment always accompanies a trade surplus. One way to understand the connection from budget deficits to trade deficits is that when government creates a budget deficit with some combination of tax cuts or spending increases, it will increase aggregate demand in the economy, and some of that increase in aggregate demand will result in a higher level of imports. A higher level of imports, with exports remaining fixed, will cause a larger trade deficit. That means foreigners’ holdings of dollars increase as Americans purchase more imported goods. Foreigners use those dollars to invest in the United States, which leads to an inflow of foreign investment. One possible source of funding our budget deficit is foreigners buying Treasury securities that the U.S. government sells, thus a trade deficit often accompanies a budget deficit.

Twin Deficits?

In the mid-1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially. Figure 18.4 shows the pattern. The federal budget deficit went from 2.6% of GDP in 1981 to 5.1% of GDP in 1985—a drop of 2.5% of GDP. Over that time, the trade deficit moved from 0.5% in 1981 to 2.9% in 1985—a drop of 2.4% of GDP. In the mid-1980s an inflow of foreign investment capital matched, the considerable increase in government borrowing, so the government budget deficit and the trade deficit moved together.

FIGURE 18.4U.S. Budget Deficits and Trade Deficits In the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins. The trade deficit grew smaller in the early 1990s as the budget deficit increased, and then the trade deficit grew larger in the late 1990s as the budget