February 25, 2019
Neil Irwin had an interesting Upshot piece pointing out that concerns about budget deficits have receded dramatically in recent years. This is, of course, true, as politicians of both parties have largely given up their concerns about the deficit. Many prominent economists have also moved away from previous positions that held that budget deficits were a major problem.
While the government can clearly run much larger budget deficits, without negative economic consequences, than many economists had previously viewed possible, for some reason the role of the trade deficit in this story is never mentioned. This is really front and center.
As every intro economics student learns, the components of GDP are consumption, investment, government spending, and net exports. If net exports are a large negative, in other words, we are running a large trade deficit, it means that GDP would be much lower, other things equal. If none of the other components rises, then we would have a large gap in demand.
It is this gap in demand that creates the room for larger budget deficits, without triggering inflation. If we envision a world where trade was balanced, instead of the United States running a $630 billion annual trade deficit (3.1 percent of GDP), we would almost certainly be seeing rapidly rising inflation with current budget deficits, unless the Fed offset the impact with high interest rates.
It is remarkable that the role of the trade deficit is almost always left out of this discussion. It is very basic economics.
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