In macroeconomics, there is the balance of payments (BOP) identity …

Imports – Exports = Investments – Savings

This formula is called an identity, not a theory, because it is as true as 1+1=2. The identity basically says if a country imports more than it exports, that is, having a trade deficit, it is because the country does not have enough savings for its investments. (The chart below shows the saving rate of the US in the last few years.) The intuition is this. Foreign countries only have two ways to spend the money they earned from exporting to us, they can either buy our products, or they can lend the money to us. If we have a national saving shortage, we need them to lend us the money, not buy our products. This creates a trade deficit.

Drilling further down on savings …

Savings = Productions – Private consumption – Government spending

The reason that savings in a country could be too low is that private consumption and government spending combined are too large.

If this feels way over your head, let’s look at this extremely simplified potato economy.

Farmer A produces 10 potatoes. He eats 6 of them and feeds his dog (“the government”) 4. He has absolutely no potato savings, but it dawns on him that he needs 2 potatoes for planting or he won’t be able to produce 10 potatoes next year. So he imports them and incurs a trade deficit.

Farmer C also produces 10 potatoes. He eats 4, feeds his dog 2 and has 4 potatoes left for savings. He plants 2 in the ground for next year’s harvest. Then it dawns on him that he still has 2 potatoes left. Not wanting to let them rot, he exports them and incurs a trade surplus.

As you can see, Farmer C is not more cunning or sly, he just eats less (so does his dog) and saves more than Farmer A. Luckily for Farmer A, Farmer C is not asking for gold, he is happy to take Farmer A’s paper in exchange for the 2 potatoes.

By now you should be able to figure out who is Farmer A and who is Farmer C.

Let’s look at the empirical evidence of this. We’ve already known from the chart above that the US saving rate has dropped to 2.5%. The next chart shows that China’s saving rate has been around 40%! The trade deficit is simply the manifestation of recycling Chinese savings for investments in the US.