The Current Account is defined as “the sum of net sales from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad.” When net sales from abroad is positive, the current account is said to be in surplus. Otherwise, there is current account deficit (Wikipedia).
The Net Factor Income or Income Account is a subaccount of current account. Its various subcategories are related to certain corresponding subcategories in the Financial Account. It is from these links that central banks and economists determine implied rates of return on the various kinds of capital exchanged in the Financial Account (Wikipedia).
On the other hand, financial account is defined as “the net change in foreign ownership of domestic assets.” The domestic country is said to have a financial account surplus when at a certain year, foreign ownership of domestic assets has risen faster than domestic ownership of foreign assets. Otherwise, the domestic country is said to have a financial account deficit (Wikipedia).
Since the Balance of Payment Identity basically states that the sum of the Current Account, the Financial Account, and Changes in the Official Reserves must be equal to zero, any deficit in the Current Account must be balanced by a Surplus in the Financial Account, and Changes in the Official Reserves. However, the changes in official reserves is sometimes approximated as zero since the usual case in US is that it is negligible relative to the Current Account and the Capital Account. Thus, when the current account is in deficit, the surplus in financial account balances it. And as have been taken note above, there will only be financial account surplus if net financial inflows exceed outflows. Thus is the relation of current account to net financial inflows. In fact, the BOP identity operates under the basic principle that “a country can only consume more than it produces (a current account deficit) if it borrows from foreign sources (a financial account surplus).” For instance, US balances its current account deficit through a substantially larger rate of return from foreign capital (net financial inflow) over that of the returns of foreigners from domestic capital (Wikipedia).
However, financial account inflows id not necessarily the one that always responds to a deficit in current account. Whatever changes happens to both set of transactions will induce the other to respond. The manifestation of the other way happened during the late 90’s, when in response to attractive financial opportunities in the US, net financial inflows grew. This caused a dollar appreciation, which in turn caused current account deficit to widen. That was an instance when current account deficit was the one that responded to the increasing financial inflows (Humpage).
U.S. Current Account: A Deficit Problem (answer to question #2)
Having brushed upon the basics of the Balance of Payment, let us now delve further at the current account of the United States of America.
For many years now, the current account of the United States has been in deficit. The latest figures show that from $213.2 billion in the first quarter of 2006, the US current account deficit has already risen to $218.4 billion in the preliminary of this year’s second quarter (Bureau of Economic Analysis).
Basically, the explanation for this would be that the net sales from abroad is negative. Specifically, increases in the goods and income deficit mainly accounts for the increase in current account deficit. From $208.0 billion in the first quarter, the deficit on goods increased to $210.6 billion in the second quarter. For the deficit on income, the rise was from $2.5 billion in the first to $4.1 billion in the second quarter (Bureau of Economic Analysis). The exponential decline in the US net income is attributed to its allowing of dollar price relative to other currencies to be determined by the market to a point where income payments and receipts are roughly equal (Wikipedia). The recent years saw to the same situation for the US current account.
Cause of the 80’s Trade Deficit (answer to question #1)
Let us now view the current account deficit problem by tracing the deficit from a specific component of the current account, peeking at what happened in the early 1980’s, when the US current account started to run in deficit. The Forex Trading identifies Trade balance as the biggest element of the Current Account, almost always. Even the US has went through large current account deficits for decades past mainly driven by high trade deficits.
After decades of postwar surpluses, the US began to run a trade deficit every year since 1976. In 1984, the annually rising deficit reached a record high of $100 billion and reached the summit in 1987 at $153 billion. From then on, the perpetual chain of deficits has induced much of the trade debate in the US. The common theory was that “unfair” foreign trade barriers, lost jobs, and America’s ability to compete in the global marketplace caused the deficit phenomenon in the 80’s (Humpage).
However, Humpage found his own set of causes for the phenomenon, and he found support from other scholars. According to him, the perpetuating deficit since 1980’s was caused by massive federal budget deficits that claimed an increasing share of national savings, which required the importation of savings from abroad so that domestic demand for investment can be met. Allegedly, the inflow of foreign capital prompted by the budget deficit allowed Americans to buy even more goods and services than they sold in the international marketplace. A proof of this was the decline in the US budget deficit during the later part of the 80’s as the federal budget deficit declined (Humpage).
Further, Humpage argues that economic expansion caused the current account deficits. On the contrary, he expounds that recession causes a decline in the deficit as was observed in 1991. This is because when there is a fall in business confidence and companies reduce expansion plans, Americans consume and invest less. Therefore, trade deficit declines with demand for foreign capital and imports (Humpage).
After a decline in current account deficit in 1991, what happened in the 80’s seemed to have repeated in 1994 and had been continuing until today. By analyzing what happened since the 80’s, Humpage hypothezied that going back to recession, encouraging people to save, and decreasing investments will break the long spell of current account deficits.
US International Investment Position: A Downward Trend (answer to question #3)
Taking the trade deficit driven current account deficit, the Balance of Payment Identity points to the international investment position of the US as the source of answer. However, the trend that has so far been established by the international investment position of the US shows no promise.
According to a revised report by the US Bureau of Economic Analysis, the value of foreign investments in the US at year-end 2002 was more than the value of U.S. investments abroad by 2,387.2 billion dollars at the preliminary period. This is with direct investment valued at current cost. Comparing this to the $1,979.9 billion excess of foreign investments in the United States over US investments abroad by the end of 2001, the deficit seemed to have ballooned (Bureau of Economic Analysis).
The downward trend of the US international investment position prove to have continued in the following years as the U.S. net international investment position became (negative) -$2,360.8 billion by the end of the year 2004. In 2005, the case further plummeted to -$2,693.8 billion according to the preliminary report of the 2005 yearend international investment position (Bureau of Economic Analysis).
This downward trend in the international investment position is becoming a problem since it primarily pulls down current accounts along with the deficit in goods.
From Current Account to Business Cycle (answer to question #4)
Amidst all the quandaries and issues, one thing is for sure. Whatever happens with the country’s current account will certainly reverberate to the country’s business cycle.
The business cycle, also called the economic cycle, is the periodic fluctuations of economic activity from its long term growth trend. The cycle consists of shifts between recovery and prosperity (periods of relatively rapid growth of output), and contraction or recession (periods of relative stagnation or decline), which happens over time. Usually, the real gross domestic product is used to measure these fluctuations. The obejective of the government is to reduce these fluctuations (Mantegna and Stanley).
Humpage relates a country’s current deficit and business cycle by noting that current deficit naturally falls during times of recession, and balloons during periods of economic expansion. He explains that when there is a fall in business confidence and companies reduce expansion plans, Americans consume and invest less. Therefore, as demand for foreign capital and imports fall, current account deficit declines. He further identifies expectations as affected by current accounts, and the rate at which the government is able to adjust to issues in current accounts that affects the GDP and the business cycle, as links to the relationship between current accounts and business cycle.
US Adjustments for BOP Issues (answer to question #6)
Given the interrelations that poses graver problems not only for the US Balance of Payment, but also for the entire US economy in the aggregate, one is left to seek about the adjustments that the US is making in response to the BOP deficit issues.
For several years now, US has been carrying a negative current account balance. Some economic analysts have interpreted US maneuvers as financing debt primarily by issuing securities. However, Milton Friedman disputes this data interpretation. He claims that foreign capital that is cheaper and riskier is being exchanged for US capital that is “riskless” and expensive. Further, he claims extra goods and services make up for the difference. Nonetheless, for countries that interfere with the market prices of their currencies through the changes in their reserves, Friedman’s interpretation is insufficient (Wikipedia).
However, we could refer to the classic theories of Adam Smith to know that there will always be adjustments enough to settle the BOP issues. See, the United States uses more of the world’s output than it produces, and imports more goods than it exports while in a current account deficit. However, it offers financial claims against its future output to the rest of the world, in exchange for its excess imports. In short, it pays for the day’s output during the next day (Humpage).
Stocks, bonds, Treasury bills, bank accounts, and other kinds of securities constitute the financial claims that it issues. Foreign governments, their central banks, and international organizations often take up a good portion. of these financial claims, though private organizations could also take part. These transactions would then create a net flow of foreign savings into the US. Amazingly, the result is almost exactly equal to the current account deficit. Economic parameters will adjust to pull them into alignment (Humpage). Afterall, that is why BOP has a B primarily. And this is how everything balances out.