Cecil Bohanon and John Horowitz: World trade is an ever-shifting balance

President Trump’s tariffs, announced April 2, have rocked financial markets and the world economy. There is so much to examine we hardly know where to begin. We will focus on some fundamental facts about the balance of payments.

The balance of payments is an accounting device used to track a nation’s financial/economic interactions with the rest of the world. Its basic form has two major components: the current account and the capital account. In the simplest terms, the current account is the balance of trade in goods and services, and the capital account is the balance of trade in financial assets. A nation’s balance on its current account is offset by an equal and opposite balance on its capital account.

Suppose the United States sells $3 trillion of goods and services to the rest of the world and buys $4 trillion of goods and services from the rest of the world. In other words, the USA has a trade deficit of $1 trillion, where U.S. imports are $1 trillion more than exports, which creates a current account deficit of $1 trillion and a $1 trillion capital account surplus.

The $1 trillion capital account surplus is because the United States had net imports of $1 trillion, and in return, the rest of the world acquired $1 trillion in claims on U.S. goods and services that can be redeemed in the future. The $1 trillion is an asset to the rest of the world. The balance of payments equals zero since the current account deficit equals the capital account surplus.

From the above example, it is easy to think the capital account balance is a passive by-product of the current account balance. But that is not necessarily the case. Typically, foreigners do not hold the excess dollars earned as cash. At the very least, they deposit them in dollar bank accounts or U.S. government bonds to earn interest. They also use the dollars to buy U.S.-based portfolio assets, such as U.S. common stocks, businesses in the U.S., and U.S. real estate.

Foreign investment in the United States increases the U.S. capital account balance and decreases the current account balance. Indeed, the balance of payments can be driven by the desire of foreigners to buy U.S. assets, with the trade balance being an afterthought. Did the trade deficit cause foreign investment in the United States, or did foreign investment in the United States cause the trade deficit? We’ll leave that to another column.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to [email protected].