Problems of Balance of Payments Disequilibria

Submitted by Anonymous on Thu, 09/16/2010 — 18:01

Many students get very confused with all the different names for the different deficits. This little section should clear things up.

The trade deficit

The trade deficit is the deficit on the ‘trade in goods’ section of the current account. Newspaper columnists often refer to it as trade deficit, or trade gap. because it is a shorter, more, user-friendly, term. Do not] confuse the term ‘trade deficit ‘ with ‘budget deficit ‘ (as many students do). Budget deficit is to do with government taxes and spending. If a government spends more than they collect in taxes over a given year, then their budget is in deficit (hence the term).

The current account deficit

The current account deficit is the more obvious one — it’s where imports of goods, services, investment income and transfers exceed the exports of goods, services, investment income and transfers.

The balance of payments deficit

Some newspaper columnists refer to a balance of payments deficit. As you know, the balance of payments always balances (see the first Learn-It of this topic) so this term doesn’t really make any sense. What they mean when they use this term is that certain sections of the balance of payments are in deficit, causing disequilibria. In particular, they tend to be referring to current account deficits, or sometimes trade deficits. You need to read the context of the text in questions carefully to make sure you understand what type of deficit is actually being referred to when the term ‘balance of payments deficit’ is being used.

In the last Learn-It we looked at the UK’s balance of payments situation and found that the UK tends to record deficits in the current account. Over the long term, the UK does not ‘pay its way’ in terms of earning enough foreign currency from its exports to pay for its imports. But does this really matter?

In the 50s and 60s, when the UK was still part of a fixed, but adjustable, exchange rate system, current account deficits were seen as disastrous given the likely consequences in terms of a devalued pound and future high inflation. Some even say that a series of poor trade figures lost Wilson (the sitting Labour Prime Minister) the 1970 General Election (or was it the fact that England, as holders, lost in the quarter finals of the World Cup to Germany. They were 2-0 up and decided to ‘rest’ Bobby Charlton, their best player)! And yet the deficits were in millions in those days, now they are in billions!

Nowadays, many economists believe that current account deficits do not matter as long as they can be financed through the attraction of foreign direct investment (FDI), especially now that the pound floats against all other currencies. So do current account deficits matter?

Why deficits do matter?

Competitiveness problems

Current account deficits reflect the UK’s poor competitiveness internationally. If UK firms are struggling to compete internationally in terms of exporting goods, this will be a problem in the future given that the UK exports nearly a quarter of its GDP relative to less than 10% in Japan and the USA.

Can the deficit be financed over the long term?

Opponents would say that the UK’s uncompetitiveness doesn’t matter as long as the deficit can be financed in the UK. This may be easy enough at the moment, but may not be true if the deficits become extremely large. Also, the inflows of capital that finance these deficits are notoriously fickle. The tap can be turned off just as easily as it has recently been turned up.

In smaller countries with less sophisticated capital markets, sustained deficits are a real problem. Countries that ‘lend’ them money (through the capital account surplus) will expect to get their money back with interest at some point. If this money does not appear to be forthcoming over the medium term, the lending country may demand to have their money back, and other countries will be less likely to lend further sums of money.

This certainly happened in Africa when Western banks stopped lending money because they couldn’t see when they would get paid back. In fact, some of them never did! Of course, some African countries have never really recovered from this. They can’t borrow to import capital goods to make their own goods. They certainly can’t afford to import consumer goods, and it is difficult to be self-sufficient with such meagre natural resources.

Will the service sector make up for manufacturing in the long term?

Given that the main reason the UK has current account deficits is that its trade deficits (trade in goods deficits) are huge, the question above can be rephrased to ask, does a trade deficit matter?

Another argument as to why these trade deficits do not matter is the feeling that the expanding service sector will create enough jobs to replace those lost in the manufacturing sector, and earn enough foreign currency to pay for the continuing trade deficits.

Some economists find this difficult to accept. To start with, the absolute values of goods and services exported are vastly different. The value of UK exports of services is only about a third of the value of UK exports of goods. Therefore the service sector has to expand much more quickly for any given contraction of the manufacturing sector.

Also, given that the UK’s surplus in services is in only a few areas (financial, engineering and computing services) and with only a few countries (the US, Germany and Japan) it would take a bold man to predict that these surpluses in services will keep making up for deficits in goods. It would be especially worrying if these three countries improve their productivity in these services as much as they have done in the past in the manufacturing sector.

One must not forget the link between the manufacturing sector and the service sector. If a car plant is closed, all the service sector businesses that depend on the incomes of these car workers will suffer. This is more of a local problem, though. Most of the services that trade internationally are based on the ‘knowledge’ economy rather than restaurants and entertainment services that are available in a manufacturing town.

Why deficits do not matter

The good thing about deficits on the trade in goods account (which is the main reason for the current account deficits) is that, in a sense, they allow consumers’ standard of living to increase. Most of the exciting consumer goods that people aspire to own nowadays, like new digital TVs, computers, white goods (fridges, freezers, etc.), computer games, etc. are produced elsewhere.

Importing for future growth

Deficits do not matter if the excess of imports is financing future economic growth. Imports of capital goods may increase the trade deficit in the short run, but there will be longer term benefits in terms of increased domestic production and exports. As long as the economy as a whole is growing faster as an annual percentage in real terms than the current account deficit is a percentage of GDP then the deficit will not be a problem.

The growth of services and investment income

Some economists think that the surpluses in services and investment income will continue and, to a certain extent, cover the deficits in goods. As you can tell from the discussion in the ‘Why deficits matter’ section above, opinions are divided on the extent to which this will happen.

The ease with which the UK attracts foreign capital

The main argument for not worrying about trade deficits (and therefore current account deficits) is that, due to the reasons given in the last Learn It, the UK attracts a lot of inflows of capital (FDI as well as short term ‘hot money’). As long as the UK can keep attracting capital inflows, giving capital account surpluses, then the current account deficits will be easily financed.

This certainly seems to be the consensus view nowadays. In the 50s and 60s, the announcement of trade figures was as big as the announcement of the current Monetary Policy Committee (MPC) on interest rates once a month. Bad trade figures caused a run on the pound causing further problems for inflation. The markets have barely noticed recent huge trade deficits.

The value of the pound nowadays depends much more on the supply and demand for currencies based on short and long term capital flows. The currency used to buy and sell goods and services represents a tiny fraction of daily currency transactions. Whilst daily foreign exchange turnover in the UK is more than 400 billion pounds (!), the total value of goods imported in to the UK is around 200 billion pounds a year !

In the old days, when capital markets were restricted through exchange controls, most currency transactions were facilitating trade. A current account deficit meant that the UK was demanding more foreign currency to buy imports than foreigners were demanding the pound to buy UK exports. The value of the pound inevitably fell. Export prices fell and import prices rose, relatively, which helped solve the trade problem, but the higher import prices pushed up the inflation rate. See the topic called ‘Exchange rates ‘ for much more detail on how the value of the pound is determined.

The relative size of the deficit

One final point to note. When economists talk about the ‘huge’ predicted trade deficit of 25 to 30 billion pounds for the year 2000 (much of which is likely to be offset by surpluses in the rest of the current account anyway), it is always wise to look at this figure in relative terms. 25 billion pounds represents barely 3.5% of GDP. The overall current account deficit is likely to be well under 1% of GDP. Does this really matter ?

If you go to university, you will soon get used to the concepts of surplus and, in particular, deficits. One is, of course, referring to your student bank account. Being overdrawn, or in deficit financially, is obviously a bad thing. Having a surplus, or being in the ‘black’, is obviously a much better position to find oneself in.

This ‘surplus is good’. ‘deficit is bad’ mantra does not really apply to balance of payments current accounts (as opposed to a Barclays or NatWest current account!). There are a number of reasons why a current account surplus is as bad as a current account deficit.

The lack of consumption

If a country has a large current account surplus (like Japan) then domestic consumption is sacrificed. It’s a bit like being a saver rather than a borrower. The saver is being very virtuous and probably has a much more secure future. The borrower is borrowing to spend. He has more fun today, possibly at the expense of hardship tomorrow.

Japan’s large current account surplus means it has a large capital account deficit. In other words, it is investing lots of money abroad (or saving). The huge amount of exports could have been diverted to domestic consumption, or they could have imported more goods, but they have chosen not to. The Japanese love saving and seem to hate spending.

One country’s surplus is another country’s deficit

Also, Japan’s huge current account surplus has implications for the rest of the world. Just like one country’s balance of payments always balances, the world balance of payments has to balance. This means that if Japan is running a big current account surplus, other countries must be running deficits. It is not a coincidence that the USA has the largest deficit in the world. On these grounds, if you believe that current account deficits are bad, then big surpluses have to be bad as well.

The refusal of Japan to allow the USA to export more into Japan has caused conflict. If a protectionist trade war results, everybody will be worse off. See the topic called ‘Why trade?’ .

Implications for the exchange rate

An excessive current account surplus will eventually cause the value of the currency to rise. Whilst it was stated earlier that trade in goods and services accounts for a much smaller proportion of currency trading nowadays, significant and prolonged surpluses and deficits will eventually affect the exchange rate.

In the early 80s, the UK finally started to reap the benefits of North Sea Oil. The UK became a net exporter of oil and the current account was in surplus. In those days, capital flows had only just been freed up, so the effect of these surpluses was to push the value of the pound to high levels. Although this is good for keeping the inflation rate down, it does make exports relatively more expensive abroad. This made the UK’s manufacturing industries more uncompetitive just as the UK was falling into one of the worst recessions since the Second World War.