John Hearn blog: Current account deficit on the balance of payments: the most damning statistic!

25 July, 2016

Things are not always what they seem. When measuring the long term health of an economy the most overlooked and the most important statistic is the balance on the current account of the balance of payments.

If you want to understand how an economy is performing and how sustainable its economic growth is, then look at the current account balance. Officially it is often ignored and there are attempts to play down its significance. After all, it is always only just a few years away from an election so the very short term is considered much more important than the long term strength and economic health of the economy.

Dire straits is not an underestimate of the current damaged state of the UK economy and indeed many other western economies. The statistic that tells us most about this damage is 7.6%. This is the last quarter`s deficit on the current account of the balance of payments as a proportion of the real gross domestic product (RGDP). I recently read that an eminent economist could not understand why the UK was continually in deficit on the current account when economic theory says that the foreign exchange rate should always correct imbalances. Now he was a Keynesian economist and the whole of their macroeconomic theory is founded on a number of fallacies (see “Sad day when I have to say I told you so”) but before I explain why the UK has had a continuing deficit alongside a floating exchange rate system I will unravel the accounts on the balance of payments, explain how they are related and their relative importance to long term sustainability of living standards.

The balance on each account of the balance of payments is always the difference between two totals. It never tells you how big the totals are, it just measures the difference. Overall the balance of payments will always produce a zero balance which prompts some people to ignore the accounts when analysing the state of the economy. However it is the balance on each account that is important and none more so than the current account balance.

Over time the separate accounts on the balance of payments have been given different names, sometimes, may I suggest, to draw attention away from their relative importance. The easiest way to understand the overall balance is to separate it into two accounts: the current account and the capital account:

• The current account balance is the difference between the total value of goods and services sold abroad (exports) and the total value of imports purchased from abroad. It is measured in the domestic currency over a specified period of time.

• The capital account includes all the transfers of ownership of assets plus loans and deposits made between countries. Inside the capital account is the number that will produce the overall zero balance. In the UK it is the official financing number that offsets the deficit or surplus when all other inflows and outflows are valued.

The 7.6% deficit to RGDP that we referred to earlier translates into a current balance deficit of £96 billion for 2015. The reason that the current account is significant while the capital account is insignificant relates directly to current standards of living. Putting it simply we consumed £96b of imports last year that were not paid for by selling exports. In one sense that was a very good year for our standard of living, but it is unsustainable as we had to borrow from other countries or sell our assets to cover the gap and we have only a finite number of assets to sell and all monies borrowed in foreign currency will require repayment and interest charges to be covered.

Now let us look at the cause of our problem. We noted earlier that some economists are confused by the fact that changes in the foreign exchange rate of sterling are not correcting the imbalance on current account. Before we progress with the analysis it is necessary to define two terms clearly so that there is no confusion:

• a current balance deficit refers to the value of imports exceeding the value of exports over a specified period.

• a fiscal deficit refers to a domestic imbalance on the government`s budget where their expenditure exceeds revenue from taxation over a fiscal year.

To explain things clearly it is useful to return to the days of the fixed exchange rate pre-1972. During this time it was not possible to run a large or sustained fiscal deficit without imposing financial pressure on the exchange rate. The reasoning behind this is that a domestic fiscal deficit expands aggregate demand. This increases the demand for imports and makes the domestic market more profitable for potential exports which are redirected back into the home market. The ensuing current balance deficit indicates an overvalued exchange rate and this makes it difficult to maintain a fixed value for the currency. This expansionary process needed to be reversed and this was the actual cause of the post WW2 stop-go cycle.

It is necessary to look at what happens when the exchange rate is floated. It is now possible to run a fiscal deficit and let the exchange rate take the strain. Only one fiscal deficit will probably lead to a downward adjustment in the exchange rate before the current balance deficit is corrected. The problem is that, as well as a lot of other variables, there is a tendency for one fiscal deficit to follow another and the exchange rate ends up trying to play catch-up. Various techniques can be, and have been used, to slow down the adjustment to a lower rate of exchange. For example, if interest rates are kept slightly above world rates then the country in question will attract asset purchases and deposits that can cover the short fall of foreign currency caused by the current balance deficit. Alternatively as happened in 2009 (Keynesian) economists persuaded the G20 countries to run fiscal deficits which damaged their domestic economies (the fallout is still being felt) but tends to leave relative exchange rates unscathed.

To conclude: a deficit on the current account of the balance of payments is the sign of a significant and unsustainable malaise in an economy. Since the exchange rate was floated in June 1972, the main cause of current balance deficits is governments overspending on their budget. The fiscal deficit precedes the current balance deficit and a series of fiscal deficits continues to cause current balance deficits which in turn push the exchange rate ever lower as the economy weakens. The obvious solution is to legislate against governments being able to run fiscal deficits and force them to balance their budgets over a 3 year term.

John Hearn is an author and lecturer for the 'Financial Services: The Commercial Environment' module at ifs.