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 Account
Historical 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.
SECULAR DISEQUILIBRIUM
•If the disposable income is very high and,
therefore, the aggregate demand,
production costs, wages too, is
And prices are very high.
•High aggregate demand and higher
domestic prices results in the imports
being much higher than the exports.
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 production
in the other countries will be activated
as a result of the increased exports
to the boom country.
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) Era
Origin 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 disequilibrium
Balance-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