Twin Deficit Dilemma

Investment Advice Hilton Head

The market tends to maintain a balance between budget deficits and trade deficits. Increasing the budget deficit while reducing the trade deficit disturbs that balance. Rest assured, the market will ultimately trend towards balance once more, but we may not like the results.

While we try to avoid commenting on politics, I thought it might be useful to discuss the economics behind some of the policies currently being debated in Washington. Populist views consider the trade deficit (the United States importing more goods than we export) a bad thing for American workers and something in need of correction. Concurrent with the more recent tariff debate, congress has continued to raise the debt limit and the administration has called for increased infrastructure spending; both of which would increase the budget deficit (spending more than is collected in taxes). Neither of these policy goals are particularly harmful on their own, but the twin deficit theory tells us they are unlikely to work successfully in tandem.

When US companies import goods, they are in effect exporting US dollars to foreigners. Here’s another way to look at the trade deficit: the US is a net exporter of US dollars. Since foreign US dollar holders are buying fewer US goods than the dollars they hold, foreigners use the surplus cash to buy US stocks and bonds. To simplify- our budget deficit is being financed, in part, by our trade deficit.

The counterargument is that it is possible that without foreign buyers, the price of bonds would fall causing the yields to rise, which would attract more domestic buyers and enable further deficit spending. The problem with this scenario is that this could dramatically increase the cost of all the government’s borrowing.

Neither trade deficits nor budget deficits are inherently bad on their own, they are simply two sides of the same coin; but policies that ignore this relationship altogether are likely to be either fruitless or costly.