ACCOUNTING FOR AMERICA'S TWIN DEFICITS

Why the U.S. Trade Deficit Must Always Be Balanced - And What Happens When It Isn’t

"The balancing principle". Not everyone will be able to stay awake till the end of this article, but everyone is capable of understanding this simple double-entry bookkeeping principle, as applied to international finance, called "the structural mechanism". It is fundamental to understanding "hyper-financialisation", that we shall look at in the next post....

03 May 2025

At the heart of international finance lies a simple accounting principle:

The current account and the capital account must balance.

It’s not ideology. It’s not economic theory. It’s just double-entry bookkeeping on a global scale. You cannot get away from the fact that differences between your income and expenditure are stored away on your balance sheet - your net worth. Same for countries' accounts.

If a country runs a trade deficit (it's called a current account deficit, it means the country is importing more than it exports), it must run a capital account surplus. Why? Because the money that flows out to pay for imports must flow back in somehow to balance the books. That "somehow" is when foreigners invest back into the exconomy they soild to, or when the importer country borrows from the rest-of-the-world ie lending, or the importer country dips into its balance sheet reserves, or, if necessary, meaning if noone wants to lend to it or if interest rates are more than it can afford, by recourse to the printing press - creating new money out of thin air, expanding the money supply.

This is why the U.S. trade deficit is always matched by strong capital inflows (or printing). For decades, the rest of the world was happy to sell the goods it manufactures to the U.S. and then recycle those dollars back into U.S. assets: government bonds (treasuries), corporate debt (lending to private corporations), equities (eg the S&P 500), property (buying up real estate in foreign capitols, but above all into U.S. Treasuries.

This process has often been described, rather vaguely, as a “structural mechanism” of global finance. But let’s call it what it is: a global settlement cycle anchored in the U.S. dollar.

The U.S. runs a current account deficit. Foreigners receive dollars. They return those dollars to the U.S. by buying dollar assets. The loop closes. The books balance.

Diagram showing
trade deficit →
balance of payments deficit→
capital inflow to balance the capital account

But what happens when the world no longer wants to hold U.S. assets? This is where the Federal Reserve steps in.

If foreign central banks or institutions stop recycling their dollars back into U.S. debt — or if they even start selling the US debt they hold — then someone has to plug the gap. That someone is the Fed. It buys the debt via Quantitative Easing (QE), creating dollars out of thin air. In effect, the U.S. borrows from itself (the government borrows from the Fed). The balance still holds, but confidence in the system gives way to fears of inflation and currency debasement.

Foreigners don't want US debt - Fed QE cycle filling gap left by foreign capital

This pressure is amplified by a deeper fiscal dilemma. The U.S. government faces mounting obligations — welfare, pensions, and defence — that it cannot politically cut. As debt rises, so do fears of inflation and currency debasement. Foreign investors begin to demand higher yields to compensate for the risk of holding dollar-denominated assets.

But the U.S. government cannot afford high interest rates. A rising cost of debt would crowd out spending and destabilise public finances. The solution? The Fed prints the money — buying Treasuries to suppress yields and keep government borrowing costs down.

Fiscal loop - overspending → market doubt → Fed printing

This creates a circular dependency: the government spends, the market doubts, the Fed prints. Byspending, the Fed creates demand for US bonds. Result: Bond prices rise. As prices rise, yields fall, but confidence in and demand for the dollar weakens and in this way, the system edges just a little bit closer to a crisis of confidence.

This is the danger Brent Johnson highlights in the Dollar Milkshake Theory - and that Ray Dalio uses to explain why the U.S.-led global order is in its late cycle....fewer and fewer want US debt.

The accounting identity works, but the participants are changing. The Fed is buyer of last resort. And if trust in U.S. assets continues to weaken, we may find that the world's capital account surplus returns not to US Treasuries, but to gold, commodities, and hard assets. It's happening, perhaps provoked by Trump's Tariffs, but that could be just a surface explanation....we have to wait and see, there is so much uncertainty! (Wait on the sidelines?)

If confidene is lost, the books will still balance, but the system will not look the same.