What do exchange rates and trade deficits actually reveal?

The money that bought less than last month

Picture sending part of a paycheck home. A worker abroad wires the same amount to family every month, and this month the transfer bought noticeably less at the shops back home than it did the month before, though the number of dollars leaving the account never changed. The home currency simply went further in the spring than it does now. Walking through a market in that same home country, the person might notice something else that nags. Nearly everything on the shelves was made somewhere else, stamped with the name of a factory in another country entirely, and very little of what the family uses each day was produced by anyone they know. Two worries grow out of those two observations, and they tend to arrive together. The first is close and personal: why did the money shrink? The second is larger and vaguer: if we buy everything from abroad and make so little of what we use, is the country falling behind?

Both worries rest on the same two numbers a person reads about without ever quite being told what they mean, the exchange rate and the trade balance. This chapter is about what those numbers actually reveal, and the answer to both worries turns out to be steadier than the worry. The money shrank because a currency is a price set by where the world’s savings want to go, not a report card on how hard the country works. And a country that buys more from abroad than it sells is not being drained. Its trade deficit is the accounting shadow of money flowing the other way, into the country, and reading it as a loss mistakes a neutral tally for a scoreboard.

What a currency is the price of

An exchange rate is a price like any other, the price of one country’s money in terms of another’s, and like any price it is set by what people will pay. The confusing part is who the buyers are. Only a small share of the daily demand for a currency comes from tourists and importers who need it to buy goods. Most of it comes from investors moving money across borders in search of a return, and that is what makes an exchange rate so hard to read as a verdict on a country’s effort. When money can be parked anywhere in the world, it flows toward wherever it is paid the most to sit, and one of the biggest levers on that flow is the interest rate a country’s central bank sets. Raise rates well above the rest of the world’s and capital comes looking for the yield, bidding up the currency on the way in. Hold rates far below and the money drains out, and the currency sinks with it.

A recent illustration is the fall of the Japanese yen. For most of a decade the Bank of Japan held its interest rate just below zero while the American Federal Reserve, fighting inflation, raised its own rate above five percent in the space of two years. The gap between what a dollar earned and what a yen earned widened from almost nothing to more than five percentage points, and money did exactly what the logic predicts: it flowed out of yen and into dollars, and the yen lost roughly a third of its value.

That is why the money wired home shrank, and it had almost nothing to do with the people back home. A currency reflects a country’s interest rates, its inflation, and the balance between how much it saves and how much it wants to invest, all of which govern whether the world’s capital is flowing toward it or away. What it does not reflect is virtue. A country does not earn a strong currency by working harder any more than it earns a weak one by working less, and a rate that halves in a year is not a moral verdict delivered on the population. It is a price responding to where returns are, and the returns are set as much abroad, in a decision by a foreign central bank, as at home.

Interest rates are among the loudest of the forces on a currency but not the only one, and naming the others guards against trading one oversimplification for another. A currency also carries a country’s inflation, since money losing value quickly at home loses it against other currencies too, which is why the currencies that fall hardest tend to belong to the countries printing the most. And because investors are betting on the future, an exchange rate moves on what they expect a central bank to do as much as on what it has already done, which is why a currency can climb on the mere anticipation of higher rates, and why the yen stayed weak into 2024 even after the American rate began to come down. Through all of these forces a currency stays a price, one that pools a country’s saving, its inflation, and the returns the world expects, quoted in a market that never closes, rather than any verdict on how hard its people work.

The deficit is a mirror, not a scoreboard

The second worry, that a country buying more than it sells must be losing, rests on a picture of trade as a contest with a running score, exports as points won and imports as points conceded. That picture is wrong at the root, for the reason an earlier chapter set out at length: an exchange is not a transfer, and both sides can come out ahead, which is the whole reason trade happens across a border at all (Frameworks, on whether the economy is zero-sum). But there is a second, tighter reason a trade deficit cannot be read as losing, and it comes not from economics but from accounting. A trade deficit is bound, by an identity that cannot be argued with, to something flowing the other way.

The identity is short, though the quantity it pins down is a little broader than the trade balance by itself. Everything a country earns from its output is consumed, invested, or saved, and a little arithmetic on the national accounts yields a fact with no exceptions: a country’s current account, its trade balance plus the net income it earns on its dealings with the world, equals the gap between what it saves and what it invests at home. For most countries the trade balance is the bulk of that current account and moves with it, which is why the everyday term trade deficit stands in for the whole here. A country that invests more than it saves, that wants to build more factories and houses and roads than its own savings can pay for, must get the difference from somewhere, and the only place left is the rest of the world. It imports the missing savings as foreign capital, and those incoming funds are the exact counterpart of that deficit. The country buys more goods from abroad than it sells, and in the same motion the world buys more assets in the country than the country buys abroad. The two are not two events that happen to offset. They are one event, recorded twice.

Seen this way, the trade balance stops being a scoreboard and becomes a description of a country’s saving and investment. A deficit says the country is investing more than it saves and drawing on the world’s capital to do it. A surplus says the reverse, that the country saves more than it invests at home and sends the surplus abroad, which is why a lender nation like Germany or Japan runs a surplus not because it is winning but because its people and firms save more than they spend at home and park the rest overseas. Neither sign is a victory or a defeat. Each is a fact about the balance between saving and investment, and that balance can reflect health or trouble depending on what lies underneath it.

Why the richest country runs the largest deficit

Consider the identity of the country that runs the biggest deficit of all. The United States has imported more than it exported in nearly every year for four decades, running the largest sustained trade deficits in the world, and over exactly those decades it has remained the wealthiest large economy on earth. The deficit persists not because America is being drained but because it spends and invests more than it saves while the rest of the world is willing to make up the difference by holding American assets, its government bonds, its companies, its property. To acquire them the world sends in more capital than it takes out, which is the same thing as the country buying more goods than it sells. The deficit is the counterpart of that gap between what America saves and what it spends, not a sign that anything is being taken from it. A country can run a deficit for a generation, as the United States and Australia both have, and grow richer the whole way.

None of that makes a deficit automatically safe. The same inflow that lets a country invest beyond its own savings can, if the borrowing funds consumption rather than anything productive, leave it owing more each year with less to show for it, and a country that has come to depend on foreign capital is exposed to the day that capital changes its mind and leaves. Several currency and debt crises began exactly there, with a sudden stop in the inflow that a deficit had come to rely on (Volume V, on what happens when a currency actually collapses). The point is not that a deficit is good, but that its sign tells you nothing about which case you are in. A deficit financing new factories and a deficit financing a consumption binge look identical on the trade balance and could not be more different underneath. Reading the number as a scoreboard misses the only question that matters, which is what the borrowed savings are doing.

It also misreads the cost of living the worry started from. When foreign capital pours into a country and lifts its currency, the strong currency that results makes everything imported cheaper, which is why the shelves are full of affordable foreign goods in the first place. The same strength that fills the shelves makes the country’s own exports dearer abroad and can hollow out the industries that compete with imports, a double edge this series takes up where a resource boom drives it (the chapter on the resource curse). The imported goods on the shelf and the factory that closed down the road are two faces of the same exchange rate, and a person can resent the second while enjoying the first without seeing that they are the same fact. What the trade balance reveals is not whether the country is winning but what it is choosing, to consume now and pay later, or to save now and be paid later, and neither choice is written on the sign of the number alone.

Where the argument goes next

Exchange rates and trade balances describe a country moving through the world in ordinary times, saving and investing, borrowing and lending, its money priced by where capital wants to go. They say less about a different and more frightening kind of question, the one a country faces when the machine that produced a generation of growth quietly stops producing it, and a rising income gives way to a plateau that lasts for decades. Why booming economies stall, and whether a country that stalls the way Japan did is doomed to it, is the subject of the next chapter. The cost of a trade shock to the particular towns and workers who bear it, as opposed to the country as a whole, is a question a later chapter on regional decline takes up in its own right.