In 2008 the world economy went through what is known as the global financial crisis (GFC). A lot of commentators had forecasted the GFC but there was a common assumption that the crisis would be caused by persistent current account imbalances. However it was poor regulation of financial markets and excessive risk-taking that were the root cause of the crisis and not current account imbalances. This becomes apparent when you look at how deficit and surplus countries were impacted by the GFC:
Eurozone – current account deficit countries went through a major recession
Australia had a consistent current account deficit – averaging 4% of GDP – but went through the crisis years without experiencing a recession. Australia has to thank China’s insatiable demand for natural resources.
Switzerland had significant current account surpluses which has averaged 7.8% since 1981 – peaked 14.9% in 2010 – but the GFC had a major impact on its economy. This was mainly because it hit the country’s two biggest banks.
What do current account imbalances mean?
Current accounts are endogenous in nature, driven by numerous factors. However many commentators tend to take a very simplistic view of what causes a deficit. A good example of this is Donald Trump’s accusation of Germany’s current account surplus being funded by America’s deficit and the assumption that reducing German’s surplus will improve America’s deficit. This rationale would mean that the US deficit is exogenous and the German surplus is endogenous.
Furthermore some have challenged the view that Germany’s surplus reflects the country’s superior productivity and stagnant wage growth. Although German does have high earnings from overseas it is what Germany does with these surpluses that is the issue – rather than spend on imports, which would reduce the current account deficit, it saves a large part of these surpluses.
The definition of the current account balance found in most textbooks is the difference between export earnings and import payments of the 4 accounts – Goods, Services, Income and Transfers. This tends us to focus on the comparative advantage that a country may have and it dependence on certain imports. According to Paul Krugman competitiveness encompasses not only prices of goods and services, but also their quality, production costs, and how they are delivered in the market place. Furthermore a firms’ business strategies and the labour market impact greatly on price competitiveness.
But if you just focus on prices it is difficult to comprehend why Switzerland retains a large current account surplus even though it has a strong Swiss Franc – a strong currency makes exports more expensive and imports cheaper. Additionally the US has had a current account deficit since 1984 even with the fluctuating US dollar – US deficit today = $116.8 bn but the currency is not seen as overvalued. Competitiveness is more a symptom than a cause of what is happening in the economy so should not be seen as what drive current account imbalances.
A better explanation
The definition that reflects more closely the primary concern of current account deficits is a country’s saving or borrowing from the rest of the world. Excessive borrowing from overseas will continue as long as deficits keep persist until the country is unable to repay its debts.
However if the make-up of the imports is generally capital goods then they add value to the economy as it will improve the competitiveness of the country’s products. Therefore if the rate of return on imports exceed the cost of borrowing to buy them it makes sense to borrow more in the long-run. Australia have experienced this situation and has little difficulty in servicing its debt. On the contrary if a country borrows to to support spending the implication is that consumers are borrowing from different trading banks. The risks are more prevalent if the trading banks borrow from overseas and have to default to foreign lenders if borrowers become less likely to pay back their debt.
Governments are much more likely to become highly indebted as unlike consumers / businesses countries cannot be closed down or forced to sell its assets. Furthermore they may political leverage to enable them to borrow more. Foreign lenders may stop lending to a country with large external debts making it impossible for that country to finance it’s ongoing deficit and consequently lead to a crisis like that in the eurozone. There are three important observations:
- It usually takes too long for questions to arise about whether countries that borrow excessively are competitive.
- Whether motivated by carelessness or expectation of a bailout if things go wrong, imprudent lending is always the root cause of persistent high deficits that finance private or public spending in excess of earnings.
- Large and persistent deficits create vulnerability as borrowers start to become dependent on access to funds.
Are surpluses bad?
It is generally regarded that surpluses are harmless but if households, firm, or governments spend less than they earn the surpluses must be invested abroad. However investments abroad can be very risky especially in volatile countries so prudent investment is essential.
For a lot of countries the purpose of exports is to generate revenue so that they can buy imports of goods which they may not produce – or could produce but relatively less efficient. In China a surplus does keep the export sector industries employed but suggests there is a strong presence for saving or weak domestic demand. More balanced trade would increase the level of imported goods into a country and increase real incomes as the value of its currency rises. This will allow for more inflows of foreign capital from abroad stimulating growth in the domestic economy. It would help a sluggish world economy if surplus countries, like China and Germany, were to spend more on imports.
All current account imbalances are note created equal. In the 19th century the US had large persistent deficits in order to fund the growth and development of the country – inter state highways, national parks, hydro dams etc. Therefore these imbalances were creating value for the economy and highly productive. By contrast Greece ran large deficits to assist private consumption which doesn’t add any productive potential to the economy or value creation. Furthermore it left lenders exposed to bad debts who had to be bailed out.
Source: The Deficit Tango – Charles Wyplosz – Project Syndicate