GED Explains: Global Imbalances and the Role of Savings

Trade deficits as well as current account surpluses are one reason for growing protectionism. A lack of international competitiveness, due to low productivity and high labor costs per unit, is seen as the major reason for trade deficits. As a matter of fact, however, domestic consumption behavior is an important cause of global imbalances, too.

Savings and lack of demand

In a very simple model of macroeconomic relationships; the goods and services produced within one country during one year – the gross domestic product (GDP) – can be either used for domestic consumption of private households and the government (C^domestic) or for investments of the companies (I). In a closed economy – an economy with no international trade activities or other economic cross-border activities – the entire income of the economy can be used for domestic consumption (C^domestic) or for savings (S).

Looking at the domestic market for goods and services, savings can be problematic: If the economy as a whole does not spend the entire income on the goods and services produced within the country, the economy has a lack of demand. If, for example, ten percent of the national income is used to build savings, ten percent of the produced goods and services can not be sold by the domestic companies. If companies are not able to sell their entire output, it is quite reasonable that they lower their production. Reducing the level of output implies a lower level of employment. Hence, savings have a negative impact on production and employment.

The lack of demand caused by savings can be compensated by domestic investment. If companies buy the products which private households do not want, aggregate demand for goods and services equals aggregate supply. Hence we have a market clearance and there is no need for companies to reduce their output and employment.

Saving, investment and excess supply

In case of national savings in a closed economy, the macroeconomic demand for goods and services equals macroeconomic supply only if national investment equals national savings (I = S). If national savings are larger than the entire investment of all companies (S > I), the economy suffers from a lack of demand or an excess supply of goods and services. The only way to prevent a reduction of output and employment is finding additional buyers. In other words, the country has to sell the excess supply to foreign countries.

Working with the abbreviations already used at the beginning of the text, the following relationship can be formulated: GDP = C^domestic + I. In case of an open economy with cross-border trade activities, supply of goods and services is enlarged by the imported goods and services (import = IM). Simultaneous, the exports (EX) of the country constitute an additional element of demand for domestic goods and services. Hence we can reformulate the relationship “GDP = C^domestic + I” as follows:

(1) GDP + IM = C^domestic + I + EX       or

(2) GDP – C^domestic = I + EX – IM

If we take into account that savings are that part of GDP which is not consumed (S = GDP – C^domestic), equation (2) can be reformulated:

(3) S = I + EX – IM       or

(4) S – I = EX – IM

Equation (4) illustrates the macroeconomic relationship between savings, investment and the trade balance:

• If domestic investment equals domestic savings, all goods and services produced by the economy are used by domestic consumers and companies. Hence the exports of the country equal its imports.
• If national savings are larger than domestic investment, the economy as a whole has a lack of demand. The redundant goods and services are sold abroad. Therefore the country has a trade surplus (exports are larger than imports) respectively a current account surplus. Examples for such countries are the Netherlands, Germany and Japan (see figure 1)
• Finally in case of savings smaller than domestic investment, the economy as a whole needs more goods and services than produced within the country. The excess demand needs additional resources from abroad. Hence the country has a trade deficit (exports are smaller than imports) or a current account deficit. Presently, France and the USA are two examples for those kinds of countries (see figure 1).

Consequences for economic policy

The described macroeconomic relationships are relevant if economic policy is aiming at a reduction of trade imbalances:

• In case of a trade deficit, trying to reduce imports by import restrictions is not enough. Simultaneous, it is necessary to increase national savings or to reduce national investment. Without lowering domestic demand, it is not possible to reduce a trade deficit.
• In case of an export surplus, changing exports or imports is not sufficient. Again, it is necessary to modify domestic demand. Increasing domestic demand can refer to consumption of private households as well as to public consumption or to public and private investment.