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Friday, August 22, 2003


Before reading this article, it will have helped --- no, been indispensable really --- to have read the two previous articles . . . which are parts one and two that, together with part three here, form a coherent mini-series on the US balance of payments. The two previous parts looked at the various causes of the large and persistent US trade deficit. This one deals with some technical aspects and is much more concerned with the question whether or not we should worry about the annual deficits here.

Some Technical Observations about the US Balance of Payments

There are essentially three ways to understand the balance of payments, and in particular for a country like the US, how it persistently runs large current account deficits --- the sum total of exports and imports in goods, services, and gifts or unilateral transfers like foreign aid or Mexican workers in the US sending US dollars back home. Each has their uses. Understanding them will help us answer our main concern here: should we be worrying about these trade and current account deficits? The answer, as you'll see, might be surprising to those of you who aren't economists or specializing in that discipline in university studies.


The first way is strictly definitional, the manner in which the balance of payments --- which records all economic transactions between the residents in a country (the US) and the rest of the world each year --- functions as a double-entry accounting system.

Since the balance uses double-entry bookkeeping, it follows that every debit item --- importing a foreign good or spending dollars on foreign services (travel, a foreign broker or insurance company, a foreign film etc) --- will be offset by a credit item of similar size somewhere in the balance of payments. On the very bottom line, therefore --- as with any double-entry bookkeeping --- all debit items = all credit items . . . which is another way of saying that all debit items - all credit items = zero. It's where the debit and credit items occur that take on economic significance, though economists and policymakers differ on what is significant or not and even on the causal relationships that produce surpluses or deficits somewhere. As a general thing, most of us are interested first and foremost in the current account balance: the sum total of imports and exports in goods, services, and unilateral transfers (or gifts).



Definitionally, then, when a country imports more goods, services, and gifts from abroad than it exports over the entire year, then it will run a current account deficit with the world; and that deficit will be offset by a similar-size surplus on capital account --- an inflow of short- and long-term capital from abroad --- plus any statistical discrepancy. More concretely,

-- The import and export of goods is called the trade balance; add in services and gifts (foreign aid, money sent by foreign residents home etc) and it's called the current account balance

-- Because of double-entry bookkeeping, a country like the US that is running current account deficits is paying for these by selling financial and fixed assets (treasury securities, a bank account at City Trust, Microsoft stock, MGM, Rockefeller Plaza, land and materials for Mercedes to build a factory in Georgia and so on) . . . even as American households and American firms are buying German bonds, Japanese corporate equities, and a Brazilian factory, or are building a new state-of-the-art plant for manufacturing semi-conductors in Taiwan or Malaysia.

-- In the process of running a current account deficit that is offset by a net inflow of foreign investment from abroad over the year, a country like the US will be incurring foreign debt to the outside world. That annual debt, viewed in net terms --- which means more foreign investment is flowing into the US than American investment is flowing abroad --- is exactly equal every year to the deficit on current account. In balance of payments accounting terms, then, the US will end the year, say, 2003, in deficit on current account and in surplus on capital account.

-- Viewed from another angle, think of foreigners sending Yen and euros and Yuan and rupees and pesos to the US as we sell them various US financial assets --- which is to say we're exporting financial assets to them. Such assets are American IOUs, exactly like your purchase of a corporate bond from General Motors forf $10,000 is an IOU offered by GM that it will pay you $10,000 at some point in the future, plus interest. And hence when we sell or export US financial assets (IOUs) to foreigners, we are incurring financial liabilities to them that have to be paid in the future, along with interest on them.



When national spending exceeds national income (or national production or national output, all the same thing), then the country --- the US --- is said to be living beyond its means, and it will import the gap in the goods and services between what we are spending and trying to consume and invest on one side, and produce on the other, in order to match the spending that constitutes national income: whether personal consumption, private business investment, and government consumption and investment.

--- The magnitude of how much it imports here to bring national spending and national production in line with one another will be exactly equal to the magnitude of the current account deficit.

-- Similarly, the US pays for the imports of foreign goods and services by selling financial assets like US stocks and bonds and real estate and factories to foreigners who are investing money in our country.

-- This means the US is paying for its higher national spending by incurring more foreign debt that year.


Now note something about deficits and employment:

Viewing the current account deficit in this way helps explain what will happen to national employment in the process. It might fall, it might rise, or it might stay the same. It depends. Specifically,

-- Assume national spending rises next year. Assume, too, that national production (employment, investment, sales) go up too.

--Then, even though national spending might rise faster than national production and the country, say, the US ,will therefore run a current account doesn't mean that national employment has to fall off at all. As long as national production or ouput is itself rising, then a current account deficit need not entail unemployment at all. Note something else here. Countries with trade and current account surpluses may stagnate. The two biggest industrial countries with big surpluses, Japan and Germany, have done poorly in the 1990s compared to the US in GDP growth and in creating jobs. Japan has grown less than 1% a year despite massive trade surpluses, and Germany has grown about 2.0% a year (vs. the US 3.1% since 1991): hence export-led growth may not be an elixir at all (especially if, as in the case of Japan, it is partly a result of massive protection around much of its low-productive industries).

True, the larger the trade deficit component of the current account deficit, the more import competition there will be in import-competing industries in the US, and some workers there are bound to be hurt. But the economy itself could be raising the aggregate level of employment all the same


Is it a bad thing to incur increasing financial liabilities to foreigners this way to sustain current spending each year?

It all depends. If the US were largely using the capital inflows to sustain high levels of consumption above and beyond what we're capable of producing each year, then yes . . . it would be undesirable. Ultimately, we have to pay back the stock and bonds and the interest payments on them, just as foreign multinationals --- like US multinationals abroad --- will repatriate the profits earned by their multinational branches back to their home countries. In effect, this is what happened in the 1980s: the huge trade deficits from 1981 until the late 1980s helped sustain national consumption: national investment levels, despite the Reagan tax cuts, didn't rise beyond the average for previous post-WWII levels in the upswing of the business cycle.

By contrast, if the current account deficit leads to an inflow of equivalent foreign capital to sustain higher than average levels of national business and government investment (infrastructure, education and the like), then importing the foreign capital is more than worth it. US GDP will rise in subsequent years faster than it would have otherwise, thanks to the foreign capital that helps keep interest rates lower and sustain higher levels of business and public investment. Essentially, this is what happened in the US in the 1990s with the ever increasing levels of current account deficits. (Note that these trade and current account deficits rose irrespective of the decline in federal deficits from 1993 on, and rising federal surpluses from 1997 on. That indicates the size of the trade and current account deficits is not directly engendered, as most economic theory suggested, by the size of the US federal deficit: whether it's up or down or even in surplus. See the informative up-to-date analysis of this by Benjamin Friedman, a World Bank publication.

Hence the secret of sustaining trade deficits and current account deficits is to keep national investment at high levels in the economy, even as consumption remains robust so business can sell its products . . .and simultaneously, to steer the economy with proper monetary and fiscal policies.



The above analysis leads to a third way of understanding a current account deficit. In particular, if national investment exceeds national savings, then the country will import the necessary savings (capital) from abroad on capital account, and it will run a corresponding deficit on current account. How precisely does the explanation work here?

The Answer: Ponder These Points

1) There are two ways to measure GDP: on the product side by what's called the National Product Accounts, and on the income side National Income Accounts. The two equal one another (by definition).

2) The Product side measures the production of consumption good (C), investment goods (I), government goods like defense and education (G), and Exports minus Imports (X-M). Remember, X and I refer to exports and imports of both goods and services.

3) On the Income side, the accounts measure person income---which all goes into either consumption spending (C), savings (S), or taxes (T) . . . unless, as in Japan now, people start hoarding income and hide it under their mattresses. (Sidebar comment: On hoarding money, which Keynes first identified as a problem in the Great Depression, see the buggy article of July 26th, 2003 Part IV, The US Economy's Prospects . Hoarding seems to have existed in the US in those dismal days of the 1930s, but no longer; it also seems to characterize Japan in the last several years as deflation has occurred there, amid a huge plunge in Japanese confidence in their banking system that is compounded by stagnant GDP growth and a hornet's nest of market inefficiencies that built up over a half century of post-WWII growth).

4) The two accounts must equal one another;

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

5) Subtract the C from both sides (if you want subtract C on the right from the left side): they cancel out. Then subtract G from the left side and add it to right. Do the same with I on the left side too. The resulting equation:

X-M =S-I +T-G

6) To simplify further, assume now that government spending on the right side is exactly balanced by taxes. Hence there is neither a governmental fiscal surplus nor defict, only a balance of inflows and outflows of expenditure. That is, T-G = zero. (Remember, G refers to government spending.) The revised result:

X-M = S-I.

7) To interpret the meaning of this equation --- which is strictly an accounting identity for national product and income accounts --- it will help if we reverse the order to read:

S-I = X-M


How To Interpret This

* First, note that he above equation defines whether a country over the year will run a current account surplus or deficit (or exactly a balance on both). The US, for instance, traditionally invests more than its saves nationally. That is, on the left side of the national accounts, the net figure is a MINUS something. Specifically, last year, net national investment exceeded net savings by about $375 billion dollars. That means, by definition, that the US imports of goods and services on the right side would exceed US exports by $375 billion too. See the table of this at the Bureau of Economic Analysis at the Commerce Department.

* Enter the causal link between the need to import capital from abroad to compensate for insufficient national savings --- compared, remember, to intended national investment: the exchange rate of the dollar.

Specifically, to buy US financial assets, foreigners will convert Yen and euros and Pesos and Rupees and Yuan into dollars. That pushes the price up of the dollar compared to their currencies. The net result? Exports from those countries to the US will rise in proportion to the dollar's rise in currency markets (depending on the US marginal propensity to consume and on whether those other countries have any excess capacity for diverting domestic inputs into more exports). This leads to rising US imports. Simultaneously, costlier US exports will lead to declining sales overseas. This will go on, presumably, until the current account deficit equals the capital account surplus over the year for the US. (This, I add, is a simplified account. There are also problems that arise from what used to be called "autonomous" capital investment by foreigners in the US and "induced" capital investment. The latter refers to what happens on the T-accounts of US banks as Americans write more and more checks for foreign imported goods and services: essentially, the liabilities side of a US bank, say the Bank of America, shows a continued switch of owing money to American depositors and more and more to foreign firms and commercial banks and even central banks. Double-entry bookkeeping causes this, as well as the fact the US $ functions as the world's key currency.)

* Note, next, that had we invested less, we would have had to import a smaller amount of foreign capital . . . say, $180 billion, half of all total US investment by the private sector and government at all levels. In that case, we would have also seen a halving of the current account deficit by 50% too. Would that have been desirable? Does anyone think that? Our GDP growth was 2.4% for the year --- far below what was needed to keep unemployment from rising over the entire year despite the technical end of the three-quarter recession in 2001 in the fall of that year. What exact harm follows from letting foreign savers --- Japanese, Chinese, Germans, Italians, and so on (all citizens of countries with higher savings that can't be as profitably invested there as in the US in their view) --- send their excess savings to us.

* Note as a fourth thing that those countries we mentioned, say, Japan and Germany, are net national savers. The accounting equation S-I = X-M would read, on the left side, a strong plus. Hence they have excess savings; and if they didn't invest them abroad, then what would have happened is that their own GDP would have fallen to bring S and I into line. In the process, they would have not experienced current account surpluses, and their GDP growth --- derisory in both countries --- would have been worse. (The causation here, I agree, is complex, and explaining it would require some technical matters that aren't our concern.)

* Note, fifthly, that contrary to what neo-mercantilist think and hope --- that a current account surplus is necessarily something good or says something profound about national competitiveness compared to countries running persistent current account deficits (the US) --- German and Japanese employment wasn't boosted by their current account surpluses in the 1980s and 1990s; oppositely, despite our current account deficits, American employment and job-creation soared in the 1980s and 1990s. Similarly, whereas German and Japanese per capita income grew more rapidly in the first 40 45 years than the US after 1945 --- something fully predicted by convergence catch-up growth theory, in which follower countries with lower levels of productivity and per capita income will grow faster than the lead country once they are launched onto a path of sustained growth --- they fell way behind the US after 1990. Essentially, German and Japanese per capita income --- which was above 85% of the US level by the mid- and late-1980s --- fell back to about 70% by the end of the year 2000. See the EU Competitiveness Report 2001. , chapter one.

Sidebar observation: The official Japanese statistics for national unemployment have to be used with care. Officially, the level looks about the same right now as the US's, around 6.0%. For at least two decades now, though, both Japanese and foreign economists have noted that the Japanese figures have to be upped somewhere between 50% and 100% to arrive at comparable figures. This is far greater than any gap between the ways EU governments officially calculate unemployment levels and the way the Bureau of Labor does here. (In Japan, for instance, if you've worked for one day last month, you're counted as fully employed. And especially women especially --- but also more and more older men too, particularly as hard times have fallen on the Japanese and more and more retired workers who leave their jobs as required after 55 years with meager returns on their private pensions --- are used as a buffer in the labor market and will be given part-time jobs when business is good or let go when business is bad.)

* As a final thing, note that the calls issued regularly by lots of economists and financial specialists in this country --- to wit, that the US needs to save more, which is another way of saying that Americans need to reduce their consumption levels --- may be wrong. If more national savings are desirable, then why have the high saving countries in West Europe and Asia --- at least Japan and maybe even now Singapore, Taiwan, and South Korea --- encountered a marked slow down in GDP growth and job-creation in the last decade or more? (Asian growth rates were slowing down noticeably, even apart from Japan, before the 1997 financial crisis hit the region; that's also true of China since 1996, whatever the true rate of its GDP growth has been ever since.) And why, oppositely, have the US and Britain --- the latter, a low saver by EU standards --- done better on both scores in this period?

Viewed differently, the high-saving Asians and EU countries would seem to be better off if they actually reduced their savings --- especially in terms of personal income --- and found ways to encourage personal (household) consumption as a way to accelerate domestic-led economic growth?

True, there may be a point in the future when American liabilities to foreigners rise to such a high percentage of GDP that they could, conceivably, begin to worry about the American ability to pay the principal and the interest on their investments here. Observe the qualifier: conceivably. It's theoretical at best. For one thing, Doubting Thomases and Cassandras have been predicting for almost two decades that this theoretical limit had been reached, with a precipitous sell-off of US financial assets looming menacingly just over tomorrow's horizon . . . followed by a collapse of the US $ in exchange markets and soaring inflation as a result. In fact, the dollar fell by almost 50% from its huge over-valued rate by 1985 over the next six years, with US exports about doubling in consequence; and there was no rise in US inflationary rates, nor any noticeable rise of interest rates in this country --- another sign, presumably, that foreigners were rushing out of US dollar-denominated bonds and stocks. For another thing, Americans owe US dollars to foreigners who invest here. That is at the polar opposite of what countries in Southeast Asia or Latin America or the Russians experienced, say, after 1997.


Some Final Observations

The reasons why countries vary in their savings rates are complex. Among other things, they reflect:

* cultural habits --- pessimistic peoples save more than optimistic peoples like Americans ---

* ease of access to credit and to mortgage loans,

* bankruptcy laws,

* social stigmas or not attached to bankruptcy,

* and government saving (fiscal surpluses) or dissaving (fiscal deficits).


Nor is that all. Savings rates across countries also reflect different:

* depreciation rates, which are especially important in calculating net national saving . . . if only because, to clarify this, the figures for net national saving in any country are arrived at by calculating the figures for net national investment in the country and abroad. In Japan, for instance, net national investment by private businesses is inflated by American standards because replacement capital --- say, on a new machine to replace a worn-out machine --- isn't calculated on the basis of the cost of the new machine, but rather of the old machine being replaced. Hence, on that basis, net investment would be higher on the same machine in Japan as in the US.

* For that matter, net national business investment also reflects the levels of capital productivity across countries. If, for instance, the Japanese and Germans have traditionally invested at much higher rates in the business sector than American business firms have, it's in large part because the productivity of capital investments in those countries turned out to be much lower --- roughly two-thirds of the US level. (There's an excellent comparative study of this put out in 1996 by the McKinsey Global Institute


All of which brings us to a final influence on national savings rates:

  • governments, particularly those where political leaders want to rely on export-led growth will naturally discourage domestic consumption in order to hike personal savings and hence export the excess savings abroad . . . in large part to the US.

  • Japan, to single it out again, was notorious for discouraging higher levels of domestic consumption in various ways for decades, including official and unofficial barriers to cheaper imported goods that compete with Japanese, cartel-like arrangements that boosted the prices of even Japanese-made goods in Japan higher than they sold for in the US, and drastic limits on consumer credit . . . the aim being, in neo-mercantilist manner, to let export-oriented giant corporate firms borrow money and invest at extra-low interest rates. German governments, it's true, were less active this way, but the various constraints on business hours and days as well as restrictions on discount firms and foreign competition through the Internet have dampened domestic consumption noticeably in any case. And in both countries, for that matter, the stigma attached to going bankrupt --- either by an individual or business firm --- has operated as a further noticeable damper.

    The Japanese economy, observe finally, has paid an especially big price for these restraints on personal consumption --- witness the prolonged slump in GDP for over a decade, recession essentially since 1996, and even households' hoarding their money rather than spend it.


    One Last Observation: A Political Problem with US Trade Deficits

    Are there no major hitches then to the US relying on foreign capital inflows to sustain higher levels of investment and hence faster rates of GDP growth in the future?

    Yes, at least one: when the trade deficit soars in one or two years and its impact is felt especially in certain industries that are grouped regionally --- the case with textiles now and wood furniture, under the bursting inflow of Chinese imports in these industries, with our bilateral trade deficit running well over $100 billion last year and this year (projected). In that case, we have to expect a political backlash, and it would be wrong --- even for free-trade zealots in Washington --- to downplay the seriousness here . . . even though the political desire of Presidents and Congressmen to get re-elected in the future will likely lead to some sort of government intervention. It need not, though, have to be outright long-term protection (or subsidies). Instead, as the buggy prof has argued in the article published here earlier this month (August 2nd, 2003) on China's Impact on the US: Short-Term Economic Problem, Long-Term Promise , there are less harmful forms of assistance to the workers being laid-off or threatened this way in the future: new forms of trade adjustment assistance (dependent on the laid-off workers finding alternative jobs), safeguard clauses in the WTO Charter that the government can invoke as part of a transitional strategy for restructuring these industries, and pressure on the Chinese government to re-value the Yuan . . . now a badly undervalued currency, kept at a pegged rate of 8.3 to the US $ that has required Beijing to sell up to $300 million worth of Yuan daily for months to maintain the peg.

    But note: even bursting inflows of foreign imports may not be a problem generally if the US economy is performing near capacity and near full-employment . . . which, as we now know, can be somewhere below 5.0% and probably even lower than 4.5% without generating new inflationary pressures. That is what happened in the late 1990s: unemployment was near or at 4.0%, the lowest level in decades, with no sign of inflationary breakthroughs (let alone of an accelerating sort) --- all thanks to the big improvement in productivity. As a result, the doubling of the US trade deficit between 1997 and 1998 --- which resulted from a huge inflow of exports from Asian countries, whose currencies had gone through the floor during the financial and currency crisis that started in mid-1997 --- produced no serious political backlash at all.  

    Brief Addendum:

    Originally, this article referred to a fourth way to understand the balance of payments and hence a current account deficit or surplus: the monetary approach, very much in vogue in the 1970s and early 1980s. A brief section here then sought to spell out and clarify this approach, only --- on reflection --- for the buggy prof to delete it. The chief reason? It didn't do justice to a complex and fairly technical way of analyzing the balance of payments; and there's no way around, it appears --- if the approach is to be clarified properly --- to avoid some technical forays into the monetarist view of the world . . . including the aggregate demand and supply of money in a country and how they interact on these scores with other countries.

    Essentially, though --- in bald, stripped-down terms --- the monetary approach looks at a country's total demand for money and the supply of it, and then analyzes a deficit or surplus on current account as a residual balancing influence. More specifically, rather than directly probing the total demand for goods, services, and financial assets --- and the supply of them --- as the determining influences of whether a country is running a current account deficit or surplus, it studies the net balance of money flows in and out of the country to bring into line the aggregate demand and supply of money on the part of its population. What follows? Economists who use this approach argue that a persistent US current account deficit would be due to excessive money creation here.

    Not only does this seem wrong, given the absence of any noticeable inflationary pressures in the US for years now, but for this and other reasons, the monetary approach has more or less gone out of favor in economic circles . . . or so it seems

    Replies: 1 Comment

    Buggy -

    You argue well indeed. From now on I will more carefully read your comments. Suppose your argument is correct about caution on the deficit, though we are an older country than in 1980 or 1990, the least that has been happening in this Administration is that the well-being of middle class households is being threatened. The budget policy of this Administration is designed to undercut social benefit programs by cutting taxes and making the tax system flat to regressive in impact. This Administration has had an awful economic agenda to go with an awful environmental agenda, and foreign aid agenda, and on and on and on.

    Posted by Anne F&B @ 08/24/2003 04:53 PM PST