Net exports and net capital outflow each measure a type of imbalance in these markets. Net exports measure an imbalance between a country’s exports and its imports. Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners.
An important but subtle fact of accounting states that, for an economy as a whole, net capital outflow (NCO) must always equal net exports (NX):
NCO = NX
This equation holds because every transaction that affects one side of this equation affects the other side by exactly the same amount. This equation is an identity— an equation that must hold because of the way the variables in the equation are defined and measured.
To see why this accounting identity is true, let’s consider an example. Imagine that you are a computer programmer residing in the United States. One day, you write some software and sell it to a Japanese consumer for 10,000 yen. The sale of software is an export of the United States, so it increases U.S. net exports. What else happens to ensure that this identity holds? The answer depends on what you do with the 10,000 yen you are paid.
First, let’s suppose that you simply stuff the yen in your mattress. (We might say you have a yen for yen.) In this case, you are using some of your income to invest in the Japanese economy. That is, a domestic resident (you) has acquired a foreign asset (the Japanese currency). The increase in U.S. net exports is matched by an increase in the U.S. net capital outflow.
More realistically, however, if you want to invest in the Japanese economy, you won’t do so by holding on to Japanese currency. More likely, you would use the 10,000 yen to buy stock in a Japanese corporation, or you might buy a Japanese government bond. Yet the result of your decision is much the same: A domestic resident ends up acquiring a foreign asset. The increase in U.S. net capital outflow (the purchase of the Japanese stock or bond) exactly equals the increase in U.S. net exports (the sale of software).
Let’s now change the example. Suppose that instead of using the 10,000 yen to buy a Japanese asset, you use it to buy a good made in Japan, such as a Nintendo Wii. As a result of the Wii purchase, U.S. imports increase. The software export and the Wii import represent balanced trade. Because exports and imports increase by the same amount, net exports are unchanged. In this case, no American ends up acquiring a foreign asset and no foreigner ends up acquiring a U.S. asset, so there is also no impact on U.S. net capital outflow.
A final possibility is that you go to a local bank to exchange your 10,000 yen for U.S. dollars. But this doesn’t change the situation because the bank now has to do something with the 10,000 yen. It can buy Japanese assets (a U.S. net capital out-flow); it can buy a Japanese good (a U.S. import), or it can sell the yen to another American who wants to make such a transaction. In the end, U.S. net exports must equal U.S. net capital outflow.
This example all started when a U.S. programmer sold some software abroad, but the story is much the same when Americans buy goods and services from other countries.
We can summarize these conclusions for the economy as a whole.
• When a nation is running a trade surplus (NX > 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO > 0).
• When a nation is running a trade deficit (NX > 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO > 0).
The international flow of goods and services and the international flow of capital are two sides of the same coin.