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PaperclipPerfector  17d ago (text post)   32228 thread views

Culture War Roundup for the week of April 14, 2025

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John Cochrane opines on deficits (trade and budgetary) and tariffs

I'll start where he describes what is perhaps the most fundamental driver of cross-border investment:

For various reasons, many countries around the world including China wanted to save. For various reasons, additional domestic investment did not seem like a good idea. Chinese savers did not want even more Chinese factories. One of many reasons for this saving (more later, but it helps to make the story) is that China is aging and has little safety net, so its middle age workers want to put money aside, to withdraw when they get old. So, those savers chose to invest in the US.

This seems like a perfectly fine thing. If there are reasons that make investing in China look less attractive to retirement savers, they should look elsewhere. It would actually be a promising thing for the US if they found that investing in US businesses was comparatively attractive. He then highlights "three bedrock principles of economics":

  1. The capital and current account must add up. If the US imports more than it exports, it has to give foreigners something valuable in return. Even China doesn’t send us stuff for free. We give dollars, treasury securities, or stocks and bonds in return. And if other countries like China want to accumulate US securities, they must send us more goods and services then we send them, to get dollars they can use to buy securities.
  1. Money is a veil. Understand the underlying movement of goods and services. To understand economics, look beyond money and watch the underlying flow of real stuff. To invest in the US, other countries must put things on boats and send it here (or sell us services). One Chinese person can buy a stock from another Chinese person, but China as a whole cannot accumulate US assets without putting goods on boats (proverbially).

...

  1. The overall trade (goods and services) deficit equals the difference between savings and investment plus the government deficit [(M-X) = (I-S) + (G-T)]

Put these ideas together. What happens if other countries decide they want to save more, and invest in the US? They buy US assets, which sends up the real exchange rate.

He then squarely aims at the G term in that equation:

The US reacted to the offer by other countries to borrow from them (sell them assets) at very low interest rates, not by building factories, but going on a consumption binge. Just as Greece had done. Most of that is due to the actions of the federal government. The total trade deficit is about $1 trillion. The US budget deficit is about $1.3 trillion. All of that extra saving is going to the federal government. And the federal government is not building a trillion dollars a year of productive investment with the money. The federal government is, by and large, sending checks to its citizens to support current consumption. The federal government saw an amazing opportunity to borrow cheaply, sometimes even at negative real rates of interest. Borrow it did, and sent checks to happy voters.

The Chinese are not, it turns out, financing their retirement from the profits of a new generation of factories. They are hoping to finance their retirement from the US federal government’s willingness to tax its citizens in excess of spending, some day in the far future, in order to reverse the whole process and put stuff back on boats to send to China.

...

The foreigners in the US don’t know or really care where the resources to pay them back come from. A promise to fund Chinese retirements with US taxes is just as good to them as a promise to fund them from profitable factories.

...

We have all sorts of contrary policies against saving, against investment, and for consumption. Huge budget deficits, absorbing our and foreigners savings, are sent as checks to people likely to consume. We subsidize home mortgages. We tax savings and rates of return pretty heavily, including corporate taxes, taxes on interest, dividends and capital gains. Food stamps and agricultural subsidies encourage consumption. Our Keynesian policy establishment spent twenty years pushing extra consumption, via fiscal “stimulus,” fears of “secular stagnation,” and under multiple banners that government debt never has to be repaid.

How do tariffs play in?

Tariffs are not likely to fix any of this. If we cut off all net trade, as the current tariffs seem to aim to do, this process will have to come to an end.

But how? The US will no longer be able to finance $1.3 trillion budget deficits from foreigners, and will have to do it from domestic savings. Or, it will have to cut $1.3 trillion of spending, or raise $1.3 trillion of durable tax revenue.

I'd sum this up in going back to the fundamental equation he presented: [(M-X) = (I-S) + (G-T)]. If you want to make the left hand side of that equation go to zero, then you must make something on the right hand side change, too. My last sentence was a bit too heavy on "agency of the theoretician", as though one can simply grab one of those variables and turn it up or down. In reality, the complex interaction of transactions will necessarily bring the equation to equality, and you might not get to choose how it gets there. Policy-makers sort of get to directly tweak G and T, but they have less direct tools for I and S. I read him as saying that the LHS is about $1T and that (G-T) is about $1.3T, meaning that (I-S) is presumably about -$0.3T. So, where is that $1T change coming from? Policymakers can cut G or raise T, naturally pissing off every voter who is living high on the deficit, but they obviously don't have to. If they don't, his conclusion is that we're in for a world of change when it comes to I and S. About $1T worth of change.

He does not spell it out, but seems to assume that the natural mechanism that interacts with I and S is the interest rate.

Interest rates will spike, and that’s the point. Higher interest rates encourage domestic saving, and discourage budget deficits and corporate investment, to bring investment plus government spending back in line with savings. But the spike in interest rates require to do this would be huge. And the trade shock will cause a sharp recession, or worse, putting even more stress on the budget. A debt crisis is likely along the way as the US finds it impossible to roll over debt.

If the influx of foreign investment, which was keeping interest rates low, dries up, companies will have to look to domestic savers. But those domestic savers didn't want to save at the current interest rates! If they did, they would be! So companies (and the gov't) will have to offer higher interest rates. That will be necessary to draw American savings. At the same time, having to pay higher interest rates means that companies can't invest as easily in more speculative, longer-timeline opportunities. Note that it doesn't make sense that they're suddenly going to invest more in domestic factories; if those domestic factories were profitable at the current, lower interest rates, they'd already be doing it! Instead, they're going to invest in less. Thus, fewer jobs, less innovation, and thus, recession. That is how I read the predictions. (He also thinks that rising interest rates will hit the federal government, as well, precipitating a debt crisis.)

Cochrane has been a fiscal "hawk" for a while. The fundamental thing to him is that the government has been borrowing tons of money to subsidize American consumption. It's been doing this for a while. At some point, you've gotta find a way to pay the piper. You can try not to, but the equation will balance itself. He just thinks that forcing the LHS to zero by gov't policy creates significant difficulties along the way.

I'd sum this up in going back to the fundamental equation he presented: [(M-X) = (I-S) + (G-T)].

These NIPA I & S terms are probably some of the more pointlessly confusing things in macro econ. The whole thing is an identity because it starts with the basic concept: someone's spending ≡ someone's income, and then slices & dices that in various ways. The 'S' is not any colloquial version of savings, like your money in a bank account. It's "gross saving", which is a really bizarre terminology for income. Meanwhile in the usual national accounts equation, they cancel out the consumption spending & consumption income parts. So it ends up as I being non-consumption spending, and S being non-consumption income. (So even if you know this is 'spending' and 'income', the letters are literally flipped...very helpful).

In financial terms, (S-I) is the domestic private sector financial surplus. Green on this sectoral balances chart. (G-T) in red, the government deficit, is pretty clearly the 'source' of both the private sector surplus and the foreign sector financial surplus (M-X) (blue). So arranged more usefully, (G-T) ≡ (S-I) + (M-X). The foreign sector and the domestic private sector both want to earn more dollars than they spend, so the government ends up spending more dollars than they earn (aka net issuing new IOUs in the form of USD reserves/bonds/bills/notes/coins/whatever, which our households/businesses and the chinese both want to get our hands on).

I couldn't say what level of confusion Cochrane was on there, when he insinuated that the source of the government's deficit is partially the foreign sector's surplus. So in that chart, we're suggesting that if the blue goes to zero, our government won't be able to be in such a deficit? That's certainly a take. It just won't need or be forced to run such a deficit, and/or our green part of that chart will gobble up the extra dollars.

Tariffs are not likely to fix any of this. If we cut off all net trade, as the current tariffs seem to aim to do, this process will have to come to an end.

But how? The US will no longer be able to finance $1.3 trillion budget deficits from foreigners, and will have to do it from domestic savings. Or, it will have to cut $1.3 trillion of spending, or raise $1.3 trillion of durable tax revenue. Interest rates will spike, and that’s the point. Higher interest rates encourage domestic saving, and discourage budget deficits and corporate investment, to bring investment plus government spending back in line with savings.

Just more confusion from Cochrane coming from the NIPA "saving" term. It would sound pretty stupid if he got this right, and properly wrote "without foreigners having large net incomes, we'll have to finance the government deficit by our domestic private sector accepting larger net incomes". Homer Simpson indeed there.

edit a few hours later: I guess I was typical-minding and literally forgot that some people might be using a 'loanable funds' framework of how money and credit could be imagined to work (as if they're finite goods), such that deficit spending requires being 'financed' by borrowing someone else's pre-existing 'savings' that they're willing to lend. The chain of logic where current accounts deficits disappearing leads to problems is still confused in multiple ways, but I guess it wasn't necessarily a confusion just from the national accounts 'S' term.

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