Balance of payments identity

Why must a country that buys more than it sells be selling something it barely notices?

A country runs a trade deficit year after year. It imports more goods and services than it exports, and the newspapers describe the gap as money "flowing out." That description is doing something odd, though: money that leaves has to arrive somewhere, and whoever receives it now holds a currency they can only spend on that country's things.

So follow the money rather than the goods. If foreigners are not spending it on exports — that is what a deficit means — what are they buying instead? The claim I want to reason toward is that they are buying something, necessarily, and that the deficit country is therefore a seller in a market it rarely thinks about.

Begin with the conserved quantity, because that is what makes the argument work. Every international transaction is recorded twice, once as a credit and once as a debit, exactly as in ordinary double-entry bookkeeping. A German car arriving in Ohio is a debit on the US current account; the payment for it is a credit somewhere else in the accounts. The sum of all entries is not usually zero, or typically zero. It is zero by construction, the way a ledger's two columns are equal because that is what a ledger is.

Now use that constraint the way you would use any conservation law. In physics, if energy seems to have vanished from a system, you do not conclude it was destroyed — you conclude you are looking at too small a boundary and go hunting for where it went. Do the same here. The current account — goods, services, investment income, transfers — shows a shortfall. The identity says the accounts must sum to zero. So the shortfall has to reappear, with the opposite sign, in the only place left: the financial account, which records purchases and sales of assets.

Ask what that means in concrete terms. The dollars a US importer paid for the car reach a German firm which does not want dollars for their own sake. It can buy US goods — but that would close the trade gap, and by assumption it does not. So it does the other thing available: it acquires a dollar-denominated asset. A Treasury bond. A share of a company. A warehouse in Ohio. A deposit in a US bank, which is itself a claim on that bank. Each of these is the country selling a claim on itself.

That is the answer to the original question, and it is worth stating plainly: a current account deficit is a net sale of assets, viewed from the other side of the same ledger. The two are not cause and effect. They are one transaction described twice.

Now the honest caveats, because an identity is a treacherous thing to reason with. First, it tells you nothing about causation. The identity is equally consistent with "Americans consumed too much and had to fund it" and with "the rest of the world wanted safe dollar assets, which bid up the dollar and made imports cheap" — the second is roughly Ben Bernanke's 2005 savings-glut argument. The accounts cannot arbitrate between those stories; only the behaviour behind them can.

Second, "selling assets" spans very different things. Selling a bond means promising future interest out of future output. Selling equity or land transfers a share of future profits. Issuing currency that foreigners simply hold is closer to receiving an interest-free loan. Lumping these together as "the country going into debt" flattens distinctions that matter a great deal for whether the deficit is sustainable.

Third, the real books do not balance. Measured world current accounts do not sum to zero, and every country's statistics carry a line called net errors and omissions to absorb the discrepancy. The identity holds by definition; the data holds only approximately, because trade is easier to count than capital flows.

So why does the asset sale go unnoticed? Because a shipping container is a physical event with a photograph attached, while the purchase of a bond is an entry in a settlement system. The two halves of the same transaction have wildly different visibility, and we form our intuitions from the half we can see.

A few corrections that this identity is most often asked to make.

A trade deficit is not, by itself, evidence of losing at trade. It is evidence of a mismatch between what a country produces and what it spends, financed by asset sales — which can be an investment boom worth having, or consumption that will need repaying, and the identity does not say which.

Nor does a bilateral deficit mean much. The identity constrains a country's total accounts, not the pairwise ones. Running a deficit with one partner and a surplus with another is arithmetically unremarkable, so bilateral gaps are a weak basis for policy.

And a policy that changes only one side changes the other by force. A tariff that suppresses imports without changing saving, investment or the exchange rate will tend to be offset elsewhere in the accounts — typically through a stronger currency that suppresses exports too. That prediction follows from the identity plus the constraint that the total cannot move.

• Why a currency that the world wants to hold changes the terms of the whole arrangement.
• What determines national saving and investment, since their gap is the current account under another name.
• How countries with fixed exchange rates absorb the same imbalance through reserves instead.

Every term the collection defines is gathered in the glossary.