International_Economics_Tenth_Edition (1)

to build up its financial assets or to reduce its liabilities to the rest of the world, improving its net foreign investment position (its net worth vis-a-vis the rest of the world). The home nation thus becomes a net supplier of funds (lender) to the rest of the world. Conversely,a current accountdeficit implies an excess of imports over exports of goods, services, investment income, and unilateral transfers. This leads to an increase in net foreign claims upon the home nation. The home nation becomes a net demander of funds from abroad, the demand being met through borrowing from other nations or liquidating foreign assets. The result is a worsening of the home nation's net foreign investment position.

The current account balance thus represents the bottom line on a nation's income statement. If it is positive, the nation is spending less than its total income and accumulating asset claims on the rest of the world. If it is negative, domestic expenditure exceeds income and the nation borrows from the rest of the world.

The net borrowing of an economy can be expressed as the sum of the net borrowing by each of its sectors: government and the private sector, including business and households. Net borrowing by government equals its budget deficit: the excess of outlays (G) over taxes (T). Private-sector net borrowing equals the excess of private investment

(I) over private saving (S). The net borrowing of the nation is given by the following identity:

An important aspect of this identity is that the current account deficit is a macroeconomic phenomenon: It reflects imbalances between government outlays and taxes as well as imbalances between private investment and saving. Any effective policy to decrease the current account deficit must ultimately reduce these discrepancies. Reducing the current account deficit requires either decreases in the government's budget deficit or increases in private saving relative to investment, or both. However, these options are difficult to achieve. Decreasing budget deficits may require unpopular tax hikes or government program cutbacks.

Efforts to reduce investment spending would be opposed because investment is a key determinant of the nation's productivity and standard of living. Finally, incentives to stimulate saving, such as tax breaks, may be opposed on the grounds that they favor the rich rather than the poor.

Decreasing a current account deficit is not entirely in the hands of the home nation. For the world as a whole, the sum of all nations' current account balances must equal zero. Thus, a reduction in one nation's current account deficit must go hand in hand with a decrease in the current account surplus of the rest of the world. Complementary policy in foreign nations, especially those with large current account surpluses, can help in successful transition.

Impact of Financial Flows

on the Current Account

In the preceding section, we described a country's capital and financial flows as responsive to developments in the current account. However, the process can, and often does, work the other way around, with capital and financial flows initiating changes in the current account. For example, if foreigners want to purchase u.s. financial instruments exceeding the amount of foreign financial obligations that Americans want to hold, they must pay for the excess with shipments of foreign goods and services. Therefore, a financial inflow to the United States is associated with a If.S, current account deficit.

Let us elaborate on how a U.S. current account deficit can be caused by a net financial inflow to the United States. Suppose domestic saving falls short of desired domestic investment. Therefore, U.S. interest rates rise relative to interest rates abroad, which attracts an inflow of foreign saving to help support u.s. investment. The United States thus becomes a net importer of foreign saving, using the borrowed purchasing power to acquire foreign goods and services, and resulting in a like-sized net inflow of goods and services-a current account deficit. But how does a financial inflow cause a current account deficit for the United States? When foreigners start purchasing more of our assets than we are purchasing of theirs, the dollar becomes more costly in the foreign-exchange market (see

330 The Balance of Payments

Chapter 11). This causes U.S. goods to become more expensive to foreigners, resulting in declining exports; also, foreign goods become cheaper to Americans, resulting in increasing imports. The result is a rise in the current account deficit, or a decline in the current account surplus.

Economists believethat, in the 1980s, a massive financial inflow caused a current account deficit for the United States. The financial inflow was the result of an increase in the u.s. interest rate relative to interest rates abroad. The higher interest rate, in turn, was mainly due to the combined effects of the U.S. federal government's growing budget deficit and a decline in the private saving rate.

Is a Current Account

Deficit a Problem?

Contrary to commonly held views, a current account deficit has little to do with foreign trade practices or any inherent inability of a country to sell its goods on the world market. Instead, it is because of underlying macroeconomic conditions at home requiring more imports to meet current domestic demand for goods and services than can be paid for by export sales. In effect, the domestic economy spends more than it produces, and this excess of demand is met by a net inflow of foreign goods and services leading to the current account deficit. This tendency is minimized during periods of recession but expands significantly with the rising income associated with economic recovery and expansion.

When a nation realizes a current account deficit, it becomes a net borrower of funds from the rest of the world. Is this a problem? Not necessarily. The benefit of a current account deficit is the ability to push current spending beyond current production. However, the cost is the debt service that must be paid on the associated borrowing from the rest of the world.

Is it good or bad for a country to get into debt? The answer obviously depends on what the country does with the money. What matters for future incomes and living standards is whether the deficit is being used to finance more consumption or more investment. If used exclusively to finance an increase in domestic investment, the

burden could be slight. We know that investment spending increases the nation's stock of capital and expands the economy's capacity to produce goods and services. The value of this extra output may be sufficient to both pay foreign creditors and also augment domestic spending. In this case, because future consumption need not fall below what it otherwise would have been, there would be no true economic burden. If, on the other hand, foreign borrowing is used to finance or increase domestic consumption (private or public), there is no boost given to future productive capacity. Therefore, to meet debt service expense, future consumption must be reduced below what it otherwise would have been. Such a reduction represents the burden of borrowing. This is not necessarily bad; it all depends on how one values current versus future consumption.

During the 1980s, when the United States realized current account deficits, the rate of domestic saving decreased relative to the rate of investment. In fact, the decline of the overall saving rate was mainly the result of a decrease of its public saving component, caused by large and persistent federal budget deficits in this periodbudget deficits are in effect negative savings that subtract from the pool of savings. This indicated that the United States used foreign borrowing to increase current consumption, not productivityenhancing public investment. The U.S. current account deficits of the 1980s were thus greeted by concern by many economists.

In the 1990s, however, u.s. current account deficits were driven by increases in domestic investment. This investment boom contributed to expanding employment and output. It could not, however, have been financed by national saving alone. Foreign lending provided the additional capital needed to finance the boom. In the absence of foreign lending, U.S. interest rates would have been higher, and investment would inevitably have been constrained by the supply of domestic saving. Therefore, the accumulation of capital and the growth of output and employment would all have been smaller had the United States not been able to run a current account deficit in the 1990s. Rather than choking off growth and

The sizable u.s. current account deficits that have occurred in recent years have prompted concerns that American jobs are in jeopardy.

Increasing competition in the domestic market from low-cost Asian imports could put pressure on U.s. firms to layoff workers. Exporters such as Ford, whose sales decline as a strong dollar raises the price of its autos in foreign markets, could also move to restrict employment. Finally, jobs in export-oriented firms such as Boeing were hurt by the 1997-1998 recession in Asia, which weakened the demand for U.S. goods. Adding to concerns about the employment effects of the current account deficit is the fear that increasing numbers of U.S. firms will shut down domestic operations and shift production to other countries, largely to take advantage of lower labor costs.

Nevertheless, although export and import trends raise concerns about u.s. job losses, employment statistics do not bear out the relationship between a rising current account deficit and lower employment. During the 1990s, the unemployment rate declined steadily, reaching a 25-year low in 1998, while the current account deficit mounted. Are the concerns over u.s. job losses from international trade misplaced?

According to economists at the Federal Reserve Bank of New York, the u.s. current account deficit is not a threat to employment for the economy asa whole. A high current account deficit may indeed hurt employment in particular firms and industries as workers are displaced by increased imports or by the relocation of production abroad. At the economy-wide level, however, the current account deficit is matched by an equal inflow of foreign funds, which finances employment-sustaining investment spending that would not otherwise occur. When viewed as the net inflow of foreign investment, the current account deficit produces jobs for the economy as a whole-both from the direct effects of higher employment in investment-oriented industries and from the indirect effects of higher investment spending on economy-wide employment. Viewing the current account deficit asa net inflow of foreign investment thus helps to dispel misconceptions about the adverseconsequences of economic globalization on the domestic job market.

Source: Matthew Higgins and Thomas Klitgaard. "Viewing the Current Account Deficit as a Capital Inflow," Current Issues and Economics and Finance, Federal Reserve Bank of New York, December 1999, pp. 1-6.

employment, the large current account deficit allowed faster long-run growth in the u.s. economy, which improved economic welfare.

Business Cycles, Economic

Growth, and the Current

Account

How is the current account related to a country's business cycle and long-run economic growth? Concerning the business cycle, rapid growth of production and employment is commonly associated with large or growing trade and current account deficits, whereas slow output and employment growth is associated with large or growing surpluses. For example, the u.s. current account

improved during the recessions of 1973-1975, 1980, and 1990-1991, but declined during the cyclical upswings of 1970-1972, 1983-1990, and 1993-2000. This reflects both a decline in demand for imports during recessions and the usual cyclical movements of saving and investment.

During a recession, both saving and investment tend to fall. Saving falls as households try to maintain their consumption patterns in the face of a temporary fall in income; investment declines because capacity utilization declines and profits fall. However, because investment is highly sensitive to the need for extra capacity, it tends to drop more sharply than saving during recessions. The current account balance thus tends to rise. Consistent with this, but viewed from a different angle, the trade

332 The Balance of Payments

balance typically improves during a recession, because imports tend to fall with overall consumption and investment demand. The opposite occurs during periods of boom, when sharp increases in investment demand typically outweigh increases in saving, producing a decline of the current account. Of course, factors other than income influence saving and investment, so that the tendency of a country's current account deficit to decline in recessions is not ironclad.

The relationship just described between the current account and economic performance typically holds not only on a short-term or cyclical basis, but also on a long-term basis. Often, countries enjoying rapid economic growth possess long-run current account deficits, whereas those with weaker economic growth have long-run current account surpluses. This relationship likely derives from the fact that rapid economic growth and strong investment often go hand in hand. Where the driving force is the discovery of new natural resources, technological progress, or the implementation of economic reform, periods of rapid economic growth are likely to be periods in which new investment is unusually profitable. However, investment must be financed with saving, and if a country's national saving is not sufficient to finance all new profitable investment projects, the country will rely on foreign saving to finance the difference. It thus experiences a net financial inflow and a corresponding current account deficit. As long as the new investments are profitable, they will generate the extra earnings needed to repay the claims contracted to undertake them. Thus, when current account deficits reflect strong, profitable investment programs, they work to raise the rate of output and employment growth, not to destroy jobs and production.

Historically, countries at relatively early stages of rapid economic development-such as the United States in the 1800s and Argentina, Australia, and Canada in the early 1900s-have enjoyed an excess of investment over saving, running large current account deficits for long periods. The same general pattern has held in more recent times: Faster-growing developing countries

have generally run larger current account deficits than the slower-growing mature economies.

The link between trade, current account deficits, and economic growth is also confirmed by comparing the u.s. trade balance with those of other major industrial countries from 1992-1997. Figure 10.1 shows a negative correlation between output growth and the trade balance, and between employment growth and the trade balance, respectively. During this period, the United States enjoyed the fastest output and employment growth-and the largest trade deficit-among the countries shown. Conversely, Japan had the largest trade surplus, but the second-slowest rate of growth. Trade surpluses were also the norm in Europe, where growth of output and employment was disappointing.

Can the United States Continue to Run Current Account Deficits Year After Year?

In the past two decades, the United States has run continuous deficits in its current account. Can the United States run deficits indefinitely? Because the current account deficit arises mainly because foreigners desire to purchase American assets, there is no economic reason why it cannot continue indefinitely. As long as the investment opportunities are large enough to provide foreign investors with competitive rates of return, they will be happy to continue supplying funds to the United States. Simply put, there is no reason why the process cannot continue indefinitely; There are no automatic forces that will cause either a current account deficit or a current account surplus to reverse.

U.S. history illustrates this point. From 1820 to 1875, the United States ran current account deficits almost continuously. At this time, the United States was a relatively poor (by European standards) but rapidly growing country. Foreign investment helped foster that growth. This situation changed after World War 1. The United States was richer, and investment opportunities were more limited. Thus, current account surpluses were present almost continuously between 1920 and 1970. During the last 25 years, the situation

has again reversed. The current account deficits of the United States are underlaid by its system of secure property rights, a stable political and monetary environment, and a rapidly growing labor force (compared with Japan and Europe), which make the United States an attractive place to invest. Moreover, the U.S. saving rate is low compared to its major trading partners. The U.S. current account deficit reflects this combination of factors, and it is likely to continue as long as they are present.

At the turn of the century, America's current account deficit was high and rising. By 2003, the U.s. current account deficit was just over 5 percent of GDP, the highest in the country's history, as seen in Figure 10.2 on page 334. Even in the late 1800s, after the Civil War, America's deficit was generally below 3 percent of GDP. During the budget deficits of President Ronald Reagan in the 1980s, the current account deficit peaked at 3.4 percent of GDP. Because of relatively good prospects for growth in the United States compared to the rest of the world, international capital was flowing to the United States in search of the safety and acceptable returns offered there. However, capital was not flowing to emerging markets as in the

1990s. Europe faced high unemployment and sluggish growth, and Japan faced economic contraction and continuing financial problems. Not surprisingly in this

setting, capital flowed into the United States because of the relatively superior past performance and expectations for future growth in the U.S. economy. Simply put, the U.S. current account deficit reflected a surplus of good investment opportunities in the United States and a deficit of growth prospects elsewhere in the world. However, many economists feel that economies become overextended and hit trouble when their current account deficits reach 4 to 5 percent of GDP.

However, some maintain that because of spreading globalization, the pool of savings offered to the United States by world financial markets is deeper and more liquid than ever. This allows foreign investors to continue furnishing America with the money it needs without demanding higher interest rates in return. Presumably, a current account deficit of 5 percent or more of GDP would not have been readily fundable several decades ago. The ability to move that much of world saving to the United

States in response to relative rates of return would have been hindered by a far lower degree of international financial integration. In recent years, however, the increasing integration of financial markets has created an expanding class of foreigners who are willing and able to invest in America.

The consequence of a current account deficit is a growing foreign ownership of the capital stock of the United States and a rising fraction of U.S. income that must be diverted overseas in the form of interest and dividends to foreigners. A possibly serious problem could emerge if foreigners lose confidence in the ability of the United States to generate the resources necessary to repay the funds borrowed from abroad. As a result, suppose that foreigners decide to reduce the fraction of their saving they send to the United States. The

initial effect could be both a sudden and large decline in the value of the dollar as the supply of dollars increases on the foreign-exchange market and a sudden and large increase in Ll.S, interest rates as an important source of saving was withdrawn from financial markets. Large increases in interest rates could cause problems for the U.S. economy as they reduce the market value of debt securities, cause prices on the stock market to decline, and raise questions about the solvency of various debtors. Simply put, whether the United States can sustain its current account deficit over the foreseeable future depends on whether foreigners are willing to increase their investments in U.S. assets. The current account deficit puts the economic fortunes of the United States partially in the hands of foreign investors.

Although the appropriate level of the U.S. current account deficit is difficult to assess, at least two principles are relevant should it prove necessary to reduce the deficit. First, the United States has an interest in policies that stimulate foreign growth, because it is better to reduce the current account deficit through faster growth abroad than through slower growth at home. A recession at home would obviously be a highly undesirable means of reducing the deficit.

Second, any reductions in the deficit are better achieved through increased national saving than through reduced domestic investment. If there are attractive investment opportunities in the United States, we are better off borrowing from abroad to finance these opportunities than forgoing them. On the other hand, incomes in this country would be even higher in the future if these investments were financed through higher national saving. Increases in national saving allow interest rates to remain lower than they would otherwise be. Lower interest rates would lead to higher domestic investment, which, in turn, would boost demand for equipment and construction. For any given level of investment, increased saving would also result in higher net exports, which would again raise employment in these sectors.

However, shrinking the U.S. current account deficit can be difficult. The economies of foreign nations may not be strong enough to absorb additional American exports, and Americans may be reluctant to curb their appetite for foreign goods. Also, the U.S. government has shown a bias toward deficit spending. Turning around a deficit is associated with a sizable fall in the exchange rate and a decrease in output in the adjusting country, topics that will be discussed in subsequent chapters.

Balance of International

Indebtedness

A main feature of the U.S. balance of payments is that it measures the economic transactions of the United States over a period of one year or one quarter. But at any particular moment, a nation

will have a fixed stock of assets and liabilities against the rest of the world. The statement that summarizes this situation is known as the balance of international indebtedness. It is a record of the international position of the United States at a particular time (year-end data).

The U.S. balance of international indebtedness indicates the international investment position of the United States, reflecting the value of U.S. investments abroad as opposed to foreign investments in the United States. The United States is considered a net creditor to the rest of the world when U.S. claims on foreigners exceed foreign claims on the United States at a particular time. When the reverse occurs, the United States assumes a net debtor position.

The terms net creditor and net debtor in themselves are not particularly meaningful. We need additional information about the specific types of claims and liabilities involved. The balance of international indebtedness therefore looks at the shortand long-term investment positions of both the private and government sectors of the economy. Table 10.5 on page 336 gives examples of the U.S. balance of international indebtedness.

Of what use is the balance of international indebtedness? Perhaps of greatest significance is that it breaks down international investment holdings into several categories so that policy implications can be drawn from each separate category about the liquidity status of the nation. For the short-term investment position, the strategic factor is the amount of short-term liabilities (bank deposits and government securities) held by foreigners. This is because these holdings potentially can be withdrawn at very short notice, resulting in a disruption of domestic financial markets. The balance of official monetary holdings is also significant. Assume that this balance is negative from the U.S. viewpoint. Should foreign monetary authorities decide to liquidate their holdings of U.S. government securities and have them converted into official reserve assets, the financial strength of the dollar would be reduced. As for a nation's longterm investment position, it is of less importance for the U.S. liquidity position because long-term

investments generally respond to basic economic trends and are not subject to erratic withdrawals.

United States as

a Debtor Nation

In the early stages of its industrial development, the United States was a net international debtor. Relying heavily on foreign funds, the United States built up its industries by mortgaging part of its wealth to foreigners. After World War I, the United States became a net international creditor. The U.S. international investment position evolved steadily from a net-creditor position of $6 billion in 1919 to a position of $337 billion in 1983. By 1987, however, the United States had become a net international debtor, in the amount of $23 billion, for the first time since World War I; since then, the United States has continued to be a net international debtor, as seen in Table 10.5.

How did this turnabout occur so rapidly? The reason was that foreign investors placed more funds in the United States than U.S. residents

invested abroad. The United States was considered attractive to investors from other countries because of its rapid economic recovery from the recession of the early 1980s, its political stability, and its relatively high interest rates. U.S. investments overseas fell because of a sluggish loan demand in Europe, a desire by commercial banks to reduce their overseas exposure as a reaction to the debt-repayment problems of Latin American countries, and decreases in credit demand by oilimporting developing nations as the result of declining oil prices. Of the foreign investment funds in the United States, less than one-fourth went to direct ownership of u.s. real estate and business. Most of the funds were in financial assets such as bank deposits, stocks, and bonds.

For the typical U.S. resident, the transition from net creditor to net debtor went unnoticed. However, the net-debtor status of the United States raised an issue of propriety. To many observers, it seemed inappropriate for the United States, one of the richest nations in the world, to be borrowing on a massive scale from the rest of the world.

1.The balance of payments is a record of a nation's economic transactions with all other nations for a given year. A credit transaction is one that results in a receipt of payments from foreigners, whereas a debit transaction leads to a payment abroad. Owing to doubleentry bookkeeping, a nation's balance of payments will always balance.

2.From a functional viewpoint, the balance of payments identifies economic transactions as

(a)current account transactions and (b) capital and financial account transactions.

3.The balance on goods and services is important to policy makers because it indicates the net transfer of real resources overseas. It also measures the extent to which a nation's exports and imports are part of its gross national product.

4.The capital and financial account of the balance of payments shows the international movement of loans, investments, and the like. Capital and financial inflows (outflows) are analogous to exports (imports) of goods and services because they result in the receipt (payment) of funds from (to) other nations.

5.Official reserves consist of a nation's financial assets: (a) monetary gold holdings, (b) convertible currencies, (c) special drawing rights, and

(d)drawing positions on the International Monetary Fund.

6.The current method employed by the Department of Commerce in presenting the U.S. international payments position makes use of a functional format emphasizing the following partial balances: (a) merchandise trade balance, (b) balance on goods and services, and (c) current account balance.

7.Because the balance of payments is a doubleentry accounting system, total debits will always equal total credits. It follows that if the current account registers a deficit (surplus), the capital and financial account must register a surplus (deficit), or net capital/financial inflow (outflow). If a country realizes a deficit (surplus) in its current account, it becomes a net demander (supplier) of funds from (to) the rest of the world.

8.Concerning the business cycle, rapid growth of production and employment is commonly associated with large or growing trade and current account deficits, whereas slow output and employment growth is associated with large or growing current account surpluses.

9.The international investment position of the United States at a particular time is measured by the balance of international indebtedness. Unlike the balance of payments, which is a flow concept (over a period of time), the balance of international indebtedness is a stock concept (at a single point in time).

1.What is meant by the balance of payments?

2.What economic transactions give rise to the receipt of dollars from foreigners? What transactions give rise to payments to foreigners?

3.Why does the balance-of-payments statement "balance"?

4.From a functional viewpoint, a nation's balance of payments can be grouped into several categories. What are these categories?

5.What financial assets are categorized as official reserve assets for the United States?

6.What is the meaning of a surplus (deficit) on the (a) merchandise trade balance, (b) goods and services balance, and (c) current account balance?

7.Why has the goods and services balance sometimes shown a surplus while the merchandise trade balance shows a deficit?

8.What does the balance of international indebtedness measure? How does this statement differ from the balance of payments?

9.Indicate whether each of the following items represents a debit or a credit on the U.S. balance of payments:

a.A U.S. importer purchases a shipload of French wine.

b.A Japanese automobile firm builds an assembly plant in Kentucky.

c.A British manufacturer exports machinery to Taiwan on a U.S. vessel.

d.A U.S. college student spends a year studying in Switzerland.

e.U.S. charities donate food to people in drought-plagued Africa.

f.Japanese investors collect interest income on their holdings of U.S. government securities.

g.A German resident sends money to her relatives in the United States.

h.Lloyds of London sells an insurance policy to a U.S. business firm.

I.A Swiss resident receives dividends on her IBM stock.

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Table 10.6 summarizes hypothetical transactions, in billions of U.S. dollars, that took place during a given year.

TABt.E tlD.1

International Transactions of the

United States (Billions of Dollars)

a.Calculate the U.S. merchandise trade, services, goods and services, income, unilateral transfers, and current account balances.

b.Which of these balances pertains to the net foreign investment position of the United States? How would you describe that position?

11.Given the hypothetical items shown in Table 10.7, determine the international investment position of the United States. Is the United States a net-creditor nation or a net-debtor nation?

TABt.E tlD.'I

International Investment Position of the

United States (Billions of Dollars)