Revision - Does a Current Account Deficit Matter?

A current account deficit measures the balance of trade in:

• goods
• services
• net investment incomes and transfers

A deficit on the current account means a country is importing more than we are exporting. This will have to be matched by a surplus on the financial and / or capital account.

The financial account comprises of 2 main features:

• a) Short Term Capital flows e.g. hot money flows and purchase of securities
• b) Long Term Capital flows e.g. investment in building new factories

Some economists argue we need not worry about a current account deficit. This is because:

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.
2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.
3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.
4. A current account deficit provides an outlet for domestic demand and prevents inflation.

Reasons to Worry about a Current Account Deficit.

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.

• US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
• If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.

Basically to correct the deficit would be a painful experience for the US economy and result in a slowdown or possibly recession

3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector. This is particularly a problem in the Eurozone where the exchange rates are permanently fixed.

4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

 

US current account deficit reached 6% of GDP in 2006. This reflected strong domestic demand and a decline in competitiveness. The credit crunch caused a reduction in US current account deficit.

Example of Iceland's Current Account Deficit

Iceland is an example of a country with a large current deficit which later imploded.
In the years leading up to 2008, there was a sharp inflow of capital to Icelandic banks. This enabled Iceland to run a record current account deficit. Iceland was spending more than they were earning. When capital flows dried up, banks lost money and there was a rapid deterioration in the current account. 

Current Account Deficits in the Eurozone

In the Eurozone, current account deficits are a bigger cause for concern because countries have a permanently fixed exchange rate (common currency). Therefore they can't devalue to restore competitiveness. Therefore countries may have to pursue internal devaluation (deflation) to restore competitiveness.

Conclusion

It depends on the size of the current account as a % of GDP. Clearly in Iceland's case, over 20% of GDP was unsustainable. But, in US case 6% of GDP later shrank to a more manageable 3% of GDP.
A current account deficit is often a signal of another underlying problem. For example, a banking boom (in Iceland's case). A boom in domestic demand or a lack of competitiveness in Eurozone.