Mankiw: Thanks, China, for the Money

On his blog, Greg Mankiw offers some perspective on the US trade deficit with China:

Suppose the U.S. President were to propose the following policy: "My fellow Americans, I have just asked the Congress to increase taxes on all of us. After they pass my tax increase, I will instruct the Treasury to lend the additional tax revenue to the government of China."

Most Americans would, I suspect, be opposed to this proposal. They would see it as beneficial to China but without much benefit to the United States. With America eager to lend, China would enjoy lower interest rates. Why should Americans pay higher taxes to finance Chinese borrowing and spending?

I agree that this would be a strange and not very sensible policy for the U.S. government to pursue. But isn't it a bit odd that many Americans today are objecting to precisely the opposite of this policy. China is not borrowing from the U.S. government but is instead lending to the U.S. government by buying large quantities of Treasury bonds. The money used to buy these bonds could be returned to Chinese citizens in lower taxes. In other words, Chinese taxpayers are financing American spending and keeping our interest rates lower than they otherwise would be. And many Americans, including the President and Treasury Secretary, are complaining.

As a professor of economic principles, Mankiw understands the identity: the current account + the capital and financial account = 0, so a current account deficit implies a capital and financial account surplus (aka a "capital inflow"). The main part of the current account is net exports (exports - imports), while the capital and financial account is investment - net savings. Net savings is private savings less the part borrowed by the government (on the rare occasions when the government runs a surplus, it adds to net savings).

US: Trade deficit / Capital inflow
China: Trade surplus / Capital outflow

The essence of the US-China economic relationship is that China is sending goods to the US (we have a bilateral trade deficit), and is getting financial assets (e.g. government bonds) in return. Or, another way of saying the same thing is that China is buying American financial assets and paying for them with goods. China's purchases of assets finance investment in the US in excess of our national savings (which is low, partly due to the federal budget deficit). If we weren't able to borrow from the Chinese (and others), interest rates in the US would have to rise to equate our domestic savings with investment (i.e. increase savings and reduce investment until an equilibrium is attained). So, as Mankiw points out, arguably its the Chinese who should be unhappy with the US-China economic relationship.