US Current Account Deficit

Balance of Payment Balance of Payments (BOP)— is an accounting

record of a country’s trade in goods, services, and financial assets with the rest of the world during a particular time period (year or quarter)

Balance of payments issues such as trade deficits and

foreign indebtedness : provide insights into the country’s economic

performance relative to the rest of the world. allows proper evaluation of the various arguments and

government policies recommended to eliminate trade imbalances.

BOP follows the accounting procedure of double-entry bookkeeping (debits & credits)

A credit entry records an item or transaction that brings foreign exchange into the country.

A debit entry represents a loss of foreign exchange.

BOP will always balance A BOP deficit (surplus) means that the debit entries

exceed (are less than) the credits. This imbalance applies only to a particular account or component of the BOP.

Components of the BOP Current Account Capital Account Financial Account

Current Account The current account includes the value of trade in

merchandise, services, income from investments, and unilateral transfers

Merchandise—tangible goods (largest contribution) Services—include travel and tourism, transport

costs, and insurance (related to payments to land, labor).

Income from investments—interest and dividends (physical capital).

Unilateral transfers—include foreign aid, gifts, and retirement pensions.

U.S. Current AccountHistorical Trends Figure needs to be put in From 1946 to 1970, the U.S. had a merchandise

trade surplus. The merchandise trade balance has been in deficit

since 1971 (except 1973 and 1975). The U.S. became a net borrower in 1985 for the first

time since World War I because of the huge current account deficits in the 1980s and the debt crisis

Components of BOP Capital Account: is relatively small for the U.S. and

includes primarily transactions involving debt forgiveness and financial assets accompanying migrant workers as they enter or leave the country.

Financial Account includes: Direct Investment, Purchases of Equity and Debt Securities, Bank Claims and Liabilities, U.S. Government Assets Abroad and Foreign Official Assets in the U.S.

National Saving, Investment,and the Current Account

Given the national income accounting identity:

Y=C+I+G+X where Y is national income or GDP, C is consumption spending, I investment, G government spending, and X is net exports or the current account,

we can rearrange this identity as: Y-C-G=S=I+X where Y –C –G is national income less consumption less government spending, which we can call national saving S. Thus, saving equals the sum of investment and the current account.

Rearranging further, we get: X=S-I

This states that if domestic saving exceeds investment, there will be a current account surplus A country that spends more than its income (I > S) will experience a current account

deficit. This overspending must be financed by foreign investment, so there will be a financial account surplus to match the current account deficit.

Factors causing Disequilibrium in the Balance of Payments

Economic factors

- Development disequilibrium

- Capital Disequilibrium

- Secular Disequilibrium

- Structural Disequilibrium

Political factors Sociological factors

DEVELOPMENT DISEQUILIBRIUM

•Large-scale development expenditures •increase in the purchasing power, •aggregate demand and prices, •Resulting large imports.

CAPITAL DISEQUILIBRIUM•Cyclical fluctuations are the reasons for the balance of payments disequilibrium.•A country enjoying a boom ordinarily experiences more rapid growth in imports than its exports, But productionin the other countries will be activated as a result of the increased exports to the boom country.

SECULAR DISEQUILIBRIUM

•If the disposable income is very high and,therefore, the aggregate demand, production costs, wages too, isAnd prices are very high. •High aggregate demand and higherdomestic prices results in the imports being much higher than the exports.

STRUCTURAL DISEQUILIBRIUM

Structural changes include the•development of alternative sources of supply•the development of better substitutes, •the exhaustion of productive resources,•the changes in transport routes and costs.

It all started with development….

Rapid industrialization of US led to account imbalances which was good for an emerging economy. Large funds were invested by Britain into building major public works, canals, railroads etc in US.

Britain served as the “Bankers to the world “ Already well settled and industrialized Great Britain with

its account surpluses helped emerging economies like US.

This way Britain also played the role of the hegemonic power over International Monetary policy and control.

The Gold(en) EraOrigin of the Gold standard: On December 22, 1717, Sir Isaac Newton,

established a set dollar value for a certain amount of gold. This established an exchange rate for money to gold or gold to money.

If one country has an established price for a certain amount of gold and another country does too then it only stands to reason that the amount of currency is of the same value.

Therefore the Global gold standard fixed major currencies against one another

Citation of gold as an exchange medium

After the United States adopted the Gold Standard in 1900, the exchange ratio between the British Pound and American Dollar was fixed,

For e.g. - if the ratio of gold per Dollar or Pound did not change.

- 1 Dollar was exchanged to 23.22 grains of gold, and 1 Pound Sterling was exchanged to 113 grains of gold.

- Thus 1 Pound would be 113/23.22 = 4.87 Dollar under the International Gold Standard

The recession pre world war Rise of Deflation – Gold supplies grow more slowly than economies

because the output of goods grow faster than the stock of gold therefore gold standard is highly deflationary.

The gold standard became a source of mild benign

deflation in periods 1880-1900 in United States which underwent periods of deflation lasting as long as 14 years after switching to a gold standard.

Beginning of the fall of Gold The Interwar Period (1914 – 1939) led to the commencement of

the POLITICAL DISEQUILIBRIUM

The gold standard started to fall as financing the war needed higher capital and therefore US had to spend more than they can back in gold and print more currency than they can cash out in gold. To continue to attempt this would result in huge amounts of inflation of the currency.

Similar situation in Europe: As after World War One when debts depleted gold reserves and costs of the war exceeded their ability to pay creating a large national debt

After Effects of WWI Fragility of the Gold Standard starts to reflect -

Post war Great Britain: Withdrawal of Pound: Massive gold and capital outflow from

the country during war led to high inflation and overvaluation of pound and also leading to the inability to raise interest rates to curb outflows, Britain withdrew pound from the Gold standard

Perceived weakness in its Balance of Payments (current account) resulted in a run on sterling Bank of England was reluctant to raise interest rates in defence Sterling convertibility was suspended on 19 Sept 1931, and was

never resumed

…the fall contd in US

Post war United States:

Excess credit given to US: Large investment from Great Britain led to major stock market boom in the US

Federal Reserve attempted late to increase the rates in response to the speculation Giving way to the Great Depression 1929 – The gold standard held responsible for the U.S. banking panics of the late 19th century

and for the monetary contraction of 1929–33. The U.S. monetary contraction of 1929–33 is the prime example of a harmful Deflation

along with the combination of a weak banking system and a befuddled central bank

United States maintained convertibility until April 1933 – US became the new ‘banker to the world’

Credibility of US commitment to Gold Std was in doubt after 1932 election: with loss of gold reserves and Roosevelt declared a `bank holiday’ in March 1933

Bretton woods exchange rates US becomes the new “banker to the world”

• Similarities to the Gold Standard – Pegged exchange rates (to facilitate recovery of trade) – Gold the ultimate enumerative (dollar pegged to gold at $35 per ounce)

• Differences with the Gold Standard – Only U.S. pegged to gold; all others pegged to the U.S. dollar – Contained explicit provisions for changing exchange rates – Allowed restrictions on short-term capital movements encouraged – Int’l capital mobility was not an integral part of the system – Provided coordinated oversight of national policies via a new international organization - the IMF

Outset of Capital disequilibriumBalance-of Payment problem-Recession of 1958 Up till 1949, US ran huge trade surpluses and aided Europe

with post war recovery By 1950 the European recovery complete, the US trade

surplus declined and BOP turned into deficit. Up to 1957 - the dollar shortage period, the deficit being

small, European nations were able to build their dollar reserves

Since 1958, increase in capital outflows and decrease in European purchases of American raw materials due to recession in Europe led to major deficit

Severe effects of military spending in Vietnam on current account balance

Increased direct foreign purchases of food, services and finished goods to supply the military effort.

US surplus on current account fell from 8.5 billion dollars in 1964 to 4.8 billion dollars in 1967

Greater purchases of foreign goods to be used as inputs in US defense production

Deterioration in the US net exports, due to both war-stimulated inflation and to supply bottlenecks in those sectors of production most affected by the increased spending

Breakdown of Bretton Woods Rising capital mobility Beginning 1971, expectation of the dollar to be devalued in face of huge

US deficit made several European central banks to convert part of their dollar reserves

Hence US imposed 10% import surcharge to prevent exhaustion of its gold reserves

Loss of confidence The fundamental cause of the collapse is to be found in problems of

liquidity, adjustment and confidence. Most of the increase in liquidity (i.e. international reserves) under Bretton

system was in the form of US dollars arising from US BOP deficits US being unable to correct the deficit problem and too many unwanted

dollars accumulation in foreign hands, confidence in dollar was lost and the system collapsed.

‘Closing the Gold Window’ When speculation against dollar flared up in March

1973, exchange rates were left free to float except for some official intervention and are still floating today

The world currencies became independently floating, no longer backed by gold