Is a Current Account Deficit Harmful?

Recently the US the current account has reached an unprecedendented level, reaching nearly 6% of GDP. Despite the record levels of deficit many in the US administration have argued that there is nothing to worry about, confident the US will continue to recieve capital inflows to finance the deficit.

In the UK the Balance of Payments on current account has been in persistent deficit for the past 19 years. However compared to the US it is a relatively smaller % of GDP (2.5%)

This essay examines whether economists should be concerned with a current account deficit.

* Current account measures

i) Balance of trade in goods

ii) Balance of trade in services

iii) Net Investment incomes

iv) Net Current Transfer

If a country has a deficit on the current account it must haves a surplus on the Financial / Capital account

The Financial Account (used to be called the capital account) comprises of

i)Net Long term investment

ii)Other financial flows (usually short term) e.g. hot money flows

A current account deficit therefore has to be financed by either

1. Attracting Direct foreign investment into the economy

2.Attracting short term flows of money into the banking sector

Reasons why a deficit may be harmful to the economy

1. If the current account had to be financed by borrowing or running down reserves this is unsustainable in the long run. This may participate a depreciation in the currency as the demand for sterling will be less than the supply of sterling.

A rapid depreciation can cause problems such as inflation and falling confidence in the UK. A depreciation also reduces living standards making imported goods more expensive.

2. Low Competitiveness

It could be argued the persistent deficit in the current account suggests fundamental weaknesses in the UK and US economy,

i) declining competitiveness

iii) lack of productive capacity.

iv) Declining comparative advantage in many manufactured goods

These factors could adversely effect job creation in the UK and lead to lower growth.

3. Foreigners have an increasing claim on Domestic Assets

To finance the deficit the UK has mostly relied on attracting foreign investment, this means foreigners have an increasing claim on UK assets. This could leave the UK vulnerable if an economic crisis caused foreign firms to withdraw their investment. However this is unlikely, despite a recession in Japan, firms have not withdrawn their investments.

4. Capital Flows may Dry Up

The US has been able to finance its deficit by attracting capital flows from Asian countries, in particular Japan and China. What is suprising is that the US has been able to sell large quantities of debt, whilst interest rates. Usually interest rates would need to be higher to attract this borrowing. However at the moment it happens to suit the Japanese and Chinese. Both countries are willing to buy dollar assets because they don't want their currency's to appreciate and therefore reduce their competitiveness. - How long this continue though is uncertain.

5. Could lead to lower Economic Growth

If the deficit is due to excessive consumer demand a recession or slowdown should help to reduce the problem. Consumers cannot go on spending in excess of their income for ever. Eventually they have to control their spending and start saving again to improve their own finances. - To reduce the US current account deficit could require both higher interest rates and significant reductions in consumer spending, this could even push the US economy into recession.

Reasons not to be concerned about the deficit

1. Britain has sustained current account deficits of much larger proportions in the past and this has not provo ked a major crisis of confidence in the international financial markets. Britain has one of the most open capital markets in the world. Thus far the country has proved to be a favoured venue for overseas investment - and financing a trade deficit in goods and services has not triggered a sharp collapse in the value of sterling.

2. The US has also a reputation for being a safe place to save. Thus they have been able to attract large flows of capital. But as mentioned above this may not continue for a long time. Also the US is currently helped by the fact that oil is still priced in dollars. (Although this may not continue for ever)

3. Current Account deficit is partly financed by long term capital investment.

Long term investment has benefits for the economy.

i) increased productive capacity

ii) Better working practices of Japanese firms

iii) More jobs

Richard Pettinger

Auth or:: Richard Pettinger
Keywords:: Economics
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