between its domestic production and its total domestic spending for goods and services— consumption, domestic investment, and government. Any shortfall must be matched by an equal net capital inflow from abroad. Roughly speaking, the country’s ability to “live beyond its means” in a particular year must be financed through borrowing from abroad.<sup>46</sup> Likewise, a country with a current-account surplus must have saving that exceeds its domestic investment and thus makes a net addition to national holdings of foreign assets.

An identity is simply a relationship that must hold at all times; it is not a theory that relates cause and effect. In practice, many economic variables can adjust simultaneously to maintain the relationship described by the identity. These include not only the components of the identity but also variables that influence them, such as interest rates, exchange rates, and capital-market development. Moreover, if a new policy changes one variable directly, other induced changes may offset its impact. For example, if a country attempts to improve its trade balance only by raising all tariffs on imports, thus reducing imports, induced changes might include an exchange-rate appreciation, which would in turn encourage imports and reduce exports. But the identity does show how the external imbalance relates to aggregates in the domestic economy, and particularly national saving. No set of policies can reduce the U.S. current-account deficit unless they result in higher national saving, lower domestic investment, or both.<sup>47</sup> A country’s saving consists of two parts: private saving and government (public) saving; government saving is equal to the fiscal surplus or deficit. Private saving in turn consists of household saving and corporate saving. This decomposition is significant because the growth of U.S. current-account and trade deficits have occurred in tandem with rapid declines in U.S. national saving. But although U.S. saving dropped during both periods of bilateral conflict, the causes of the two drops were different.<sup>48</sup> In the 1980s, the growth of the U.S. bilateral trade deficit with Japan occurred during a period when the federal budget deficit was also growing, the current-account balance. In practice, movements in the U.S. merchandise trade balance (our main focus elsewhere in this paper) are closely linked to movements in the current account.

46 More precisely, foreign acquisitions of U.S. assets in that year must exceed U.S. residents’ acquisitions of foreign assets. However, equities and similar ownership claims do not reflect borrowing and lending. For example, “foreign acquisitions of U.S. assets” can include greenfield construction of new foreignowned manufacturing facilities in the United States or sale of an interest in an existing U.S. business to foreign investors. The statement may also be misleading in implying that it is international borrowing that must adjust to cover the gap between domestic production and domestic demand for goods and services.

> 47 See McCulloch (1990) on the macroeconomic roots of the U.S.-Japan current account imbalance in the 1980s.  Ito (2009) compares the U.S.-Japan imbalance of the 1980s with the U.S.-China imbalance in the 2000s.  His empirical analysis confirms a significant causal role of budget balances in determining current-account imbalances.  However, he also concludes that the Japanese current-account surpluses of the 1980s were driven by underperformance of investment rather than over-saving.

48 U.S. Bureau of Economic Analysis, National Income and Product Accounts, Table 5.1, shows the decomposition for each quarter of U.S. saving into private saving and government saving.

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