by Bill O’Grady

In the first part of this report, we discussed the evolution of foreign reserves from gold to the dollar, with a historical focus.  This week, we will use the macroeconomic saving identity to analyze the economic relationship between China and the U.S.  Next week, using this analysis, we will discuss the likelihood that China will “dump” its Treasuries and potential repercussions if it were to do so.  From there, we will examine the impact of such a decision by China to reallocate its reserves.  Finally, as always, we will conclude with market ramifications.

The Macroeconomic Identities
Here is the basic macroeconomic identity—Gross Domestic Product (GDP) is equal to consumption (C), investment (I), government spending (G) and net exports (X-M):

GDP = C + I + G + (X-M)

All things produced must fall into the above equation’s components—everything produced is either consumed by households, represents investment for firms, consumed by the government or consumed by foreigners via exports.  But, from the uses perspective, the economy comprises consumption (C), saving (S) and taxes (Tx).  In other words, the funds for investment come from saving from current consumption.  Consumption is further reduced to supply the government with funding.

GDP = C + S + Tx

So, by equating these two together, we get the following:

C + S + Tx = C + I + G + (X-M)

Rearranging again gives us this identity:

S + Tx + M = I + G + X

Simplifying and rearranging again:

(M-X) = (I-S) + (G-Tx)

This identity means that the private investment/savings balance (I-S) plus the public spending balance (G-Tx) is equal to the trade account.  This is true in the same way a balance sheet is true—the numbers will simply add up that way.  However, it doesn’t tell us the direction of causality!

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