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The Twin Deficits: Myths and Truths

Tags Free MarketsTaxes and SpendingU.S. EconomyFiscal TheoryValue and Exchange

09/02/2004Sean Corrigan

Open the business section of a newspaper today and you are likely to find some mention of (a) America’s wide trade gap; (b) the increasing Federal budget deficit; and often (c) the two of these, yoked together as ‘The Twin Deficit" problem.

Indeed, such is the current focus that listed in the NY Times non-fiction best sellers list for much of the past month or so has been Peter G. Petersen’s "Running On Empty: How The Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It." Mr. Petersen, once Commerce Secretary under President Nixon, is decidedly a man with first-hand knowledge of how political expediency can wreck the process of wealth creation.

As usual with such issues, there is a deal of truth in the figures marshaled by the commentators and there is, indeed, a good deal of substance to the anxieties to which the numbers are giving rise. However, there is also enough false logic on display to fill a major law practice and, consequently, there is no shortage of erroneous prescriptions dealing with how to address the matter.

It might be worthwhile to see if we can review the subject with seriousness.

Are the Deficits related?

Firstly, let us ask whether the two deficits are related causally, rather than being a coincidence. In other words, if the US government spends more than it routinely steals from its citizens, does this necessarily imply that trade balance will plunge into the red?

Well, no—not exactly.

We ask where does the government get the money it wants to use for the resources it buys?  If it sells government—owned assets to raise the funds, the purchasers of those assets will presumably have decided that they would prefer to own a piece of real estate, or a set of mineral rights, say, to having money in the bank, or to acquiring all the other goods that same money could buy.

Thus, if the denationalized property is sold to its own residents, the state can use the money to buy the very things these domestic investors set lower down on their shopping list than the assets being divested.

In this instance, nothing goes across the borders and hence the government deficit has no effect on the trade deficit.

Alternatively, the government may seek to borrow the money, by issuing Treasury bills and bonds to the public.

Now, to the extent that individuals, pension fund managers, or investment officers at insurance companies, make a conscious decision to forego present consumption, in favor of tucking away a little nest-egg lined with government promises to pay, there are, again, no implications for the trade deficit.

However, suppose that the private sector is reluctant to save—indeed that its members, also, are spending more than they earn. How will the accounts be settled? From whence will the extra goods arrive? Now, we are getting to the heart of the issue.

If the government seeks to spend more than it earns and if, at the same time, the domestic private sector cannot be persuaded to forego present consumption in order to accommodate the increased demands of the state, then one of two things will happen.

The needed money is created from nothing

The government can choose to issue promises to pay and this newly created credit is eagerly accepted in the banking system. Alternatively, it can print more of its little green pieces of paper. More money has now been called into existence, but, of course, no more goods have been voluntarily set aside for the purpose. Ergo, prices are likely to go up as a result of this inflation.1

By doing this, as prices rise at home, (a) imports may become relatively cheaper and (b) exports less profitable, due both to the rise in costs and to the home-grown competition to buy such extra goods as are required.

Thus, this process may well be expected to widen the trade gap, unless the currency first reacts by falling far enough to offset the relative price shifts. A falling dollar would be welcome by some producers and politicians but the country’s consumers would be left with no more goods than before, and just higher prices. This is the legacy of an insidious transfer of wealth out the hands of the private sector and into those of the state and of its creatures.

Money is supplied from outside

On the other hand it may be that foreign suppliers are happy to lend the country the money it needs to pay for their exports so that the government does not resort to creating money from thin air.

Thus, the Chinese or the Canadians, the Czechs, or the Kuwaitis, could ship their goods to America and take the dollars they earned either directly to their US bankers, to be invested in Treasury paper. This is generally seen as a Good Thing as the US "attracts foreign capital".

Here, again, the trade gap has gone up because the excess of demand in the US has, via the mechanism of credit, been met by foreign saving this time conducted honestly, if not necessarily prudently.

Alternatively, the foreign exporters might persuade their own central bank to swap the dollars for Yuan, Loonies, or Koruna, or Dirham. Then the central bank can send these dollars to the US, to be similarly parked in government securities. This is generally seen as a Bad Thing, as the sneaky foreigners strive to prevent America’s currency from falling.

The drawback with the operation of this mechanism is that America’s initial inflation has now been duplicated by the exporters’ own central banks.2

In all this, the key thing is to note that though we have shown that the Federal government deficit may well contribute to the trade deficit, it will only do this to the extent that it helps exhaust the monetary savings being made elsewhere in the system.

Thus, the Deficit Twins, are, at best, fraternal, not identical.

Theory in practice

Just how large is this American trade imbalance? If one were to take the excess inbound shipping containers from just the Los Angeles and Long Beach harbors and lay them side by side, they would cover half the area of the city of San Francisco. To what extent is Washington responsible for this imbalance?

Let us remember first that if private savings is big enough, the government deficit will not have an obvious influence on the trade gap.

In looking at private savings in America3, and far from setting anything aside for a rainy day, Mr. and Mrs. Public are going in the hole by an additional $300 billion or so a year.

Against this total, however, we can neatly – and wholly fortuitously - offset a near exact match of around $300 billion in the retained cash flow (profits plus depreciation less taxes, interest and dividends) made by the corporate sector.

Though our relief should be partly tempered by the fact that at least half of this sum comes from the financial industry—and so is largely an artefact of inflation, rather than representing the fruits of genuine wealth creation or of real income generation—at least for accounting purposes, the private sector in the US is square: borrowers equal lenders and there are no surplus savings for Uncle Sam to tap.

Sadly, however, as we all know from the headlines, Uncle Sam is attempting to do exactly that – and to the tune of something in excess of $500 billion a year; a gap, by the way, that to close it, it would cost each household around $4,250 a year in extra taxes.

At the same time, the trade gap has opened up something of a chasm, these past twelve months, reaching a monstrous $535 billion in June. We shudder to say it, but the gap in goods alone is now a whisker away from $600 billion.

Thus, in this case – though by dint of circumstance and not through an unavoidable linkage of cause and effect – in some senses the Twins are indeed joint offspring of the same womb.

Ironies and consequences

In the last six years, US defense spending has risen 60%and four-fifths of this increase has taken place just since the present Administration took office. US defense spending has now hit a running twelve-month total $522 billion—a gargantuan sum which is almost a dollar-for-dollar partner to the trade deficit and which is a fairly good match for the total Federal budget deficit. Thus, not only do we have Twin deficits at present, but one of the Twins wears combat fatigues and carries an M-16 rifle.

Regardless of ones political views of the situation4, America today finds itself just about able to provide its citizens with the all the Butter it wants (alas--only on the basis that the dairyman extends his customers credit every time he sells them a pound), while then relying on foreigners to give it the wherewithal with which to buy its Guns.

One can easily see that this state of affairs contains within it a series of vicious circles and gives rise to heightened risks, both military and economic.

Back in the late 1990s foreigners could be persuaded that they were wisely investing in the new technological frontiers being carved out in Silicon Valley. And indeed, they sent their surplus dollars their exporters earned straight back into the US stock and bond markets.

We all know how dramatically that illusion was dispelled, but, so far, it has not fully dawned upon them that, in place of buying bogus claims on a more prosperous tomorrow, America’s foreign suppliers are now merely working for the purpose of supplying the arsenals and to fill the commissariats of a mighty US war machine. Further, they do not see such militarism as either a direct or an implicit threat to their own disparate interests.

America’s vendor finance agents are not doing themselves much good neither on economic grounds5 nor on geopolitical ones.

Correspondingly, the US is diverting so much of its people’s toil and treasure to the legions that it is risking both financial exhaustion and physical capital anemia.

Even more deficits

To the twin monetary deficits of budgets and trade, perhaps we should add two other, less quantifiable, but much more dangerous siblings:

The mental deficit which has leads otherwise reasonable men and women into this hazardous entanglement and the moral deficit which allows them to continue along this path, regardless of the longer-term consequences.


We face enormous gaps between what government spends and what it taxes, between what people make and what they buy and between free commerce and coercion. In mitigating these risks, we can hope for a  steady and sustained economic readjustment and we fear  a sudden financial upheaval. Lastly, a return to collective sanity must be the subject of our prayers.

In the meantime, though not all of these problems are confined to the United States, the sheer intensity, scale, and interaction of their American manifestation mean that we must continue to position ourselves in the belief that:

  • there is a decided possibility that—whoever wins the election in November—the pursuit of an ever weaker dollar will once again become a matter of deliberate policy;
  • private foreign demand for the currency will continue to lessen;
  • there is a small but significant chance that any such decline, once started, will begin to accelerate;
  • American monetary drunkenness and fiscal irresponsibility will mean US inflation runs unchecked and that
  • the Asians’ paranoia over the fate of their export sector means this inflation will probably magnified by official attempts to counter the corresponding rise of their own currencies which would otherwise result

In conclusion, the belief that the US dollar is the least sound of the major currencies and the faith that money and credit will everywhere continue to be created much faster than the hard-won fruits of toil can accumulate – and hence that these latter will go on rising in price - will remain a guiding principle of our investment policy, as it has for some good while past.

  • 1. Note that prices going up, of and in themselves, are an effect of inflation, not inflation itself.
  • 2. The foreign central bank issues more of its own currency with which to buy the newly-issued new dollars—a process which the eminent French economist and Gold Bug, Jacques Rueff, dubbed "the monetary sin of the West".
  • 3. After stripping out several of the phantom entries in the standard personal income and outlay accounts (the so-called "imputations"), and cross-checking these with separately collated numbers for net financial asset formation
  • 4. We limit ourselves here to what Ludwig von Mises would have called "wertfrei", or non-value, purely economic judgements.
  • 5. Military outlays are, by their nature, among the least productive of all expenditures.

Contact Sean Corrigan

Sean Corrigan is the author of 'Money, Macro & Markets' newsletter & Consultant to Hinde Capital.

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