To view the external balance correctly, the focus should be on the domestic economy. The external balance is homegrown; it is produced by the relationship between domestic savings and domestic investment. Indeed, it is the gap between a country’s savings (read: income, minus consumption) and domestic investment that drives and determines its external balance. This fact can easily be seen by studying the savings‐investment identity:
CA = Sprivate – Iprivate + Spublic – Ipublic,
where CA is the current account balance, Sprivate is private savings, Iprivate is private domestic investment spending, Spublic is government savings, and Ipublic is government domestic investment spending. In this form, Sprivate – Iprivate is the savings‐investment gap for the private sector and Sprivate– Ipublic is the savings‐investment gap for the government sector. For a full derivation of the identity in this form, allow me to direct my readers to a piece Edward Li and I authored in the Fall 2019 issue of the Journal of Applied Corporate Finance: “The Strange and Futile World of Trade Wars.”
So, the national savings‐investment gap determines the current account balance. Both the public and private sector contribute to the current account balance through their respective savings‐investment gaps. The counterpart of the current account balance is the sum of the private savings‐investment gap and public savings‐investment gap (read: the public‐sector balance).
The U.S. external deficit, therefore, mirrors what is happening in the U.S. domestic economy. This holds true for any country, even those with significant external surpluses. The U.S. displays a savings deficiency and a negative current account balance that reflects its negative savings‐investment gap. Japan, China, Germany, and Switzerland all display savings surpluses, and all run current account surpluses that mirror their positive savings‐investment gaps.