Examine reasons for a deterioration in the current account deficit.

A deterioration in the current account deficit implies a growing current account deficit: i.e. the value of imports increases at a faster rate than exports.

1. Higher levels of economic growth. Higher growth implies higher levels of consumer spending. Therefore, this will lead to an increase in imports. This is a significant factor in the UK because we have a high marginal propensity to import. Basically this means that a rise in income causes a bigger % increase in spending on imports. (imports tend to be luxury goods.)
2. Appreciation in the exchange rate. This causes exports to be more expensive and imports to be cheaper. Therefore quantity of exports fall. However, the effect depends on the elasticity of demand. If demand is inelastic, then more expensive exports will have little impact on reducing quantity.
3. Loss of competitiveness. If exports become less competitive, due to lower productivity then demand for exports fall. This is likely to explain a long term deficit. It has occured to a large extent in the UK because of globalisation. E.g the UK has lost comparative advantage for the manufacture of many goods to Asian countries like China.

• Reasons for Current Account deficit in UK
• What Causes US Current Account deficit
  

Labels: current account

A look at factors that have contributed to the US current account deficit which has been over 6% of GDP for several years

1. US consumer spending has been rising rapidly due to a combination of
   
   • Tax cuts
   • Low interest rates
   • Rising house prices (although this is now being reversed)

Therefore with rising consumer spending the US has been increasing the value of imports bought into the economy. Furthermore the US has a high marginal propensity to import. Many luxury good like electrical goods and cars tend to be imported. It is these kinds of goods which are bought when incomes rise.

2. Decline in competitiveness. US manufactured goods have been losing comparative advantage to Asian economies. The primary reason is that wage costs in US are much higher than Asian economies. In particular China has seen its trade surplus with America grow due to its low labour costs.
   
   
3. Dollar Relatively High compared to current account deficit. Dollar has not devalued as much as you would expect for an economy with a large current account deficit. The US has remained an attractive location for Capital investment. In particular China has been buying a lot of US government securities. Therefore this inflow of capital has financed the current account deficit and encouraged America to keep buying imports. The inflow of capital has also enabled interest rates to remain low. Because China has bought so many US government bonds the US has been able to finance its national debt whilst keeping interest rates low. These low interest rates have encouraged consumer borrowing and consumer spending; a major cause of the current account deficit. In the past 12 months the dollar has been in decline but to reduce the current account deficit it would need to fall by more than 20%

Labels: current account, US economy

A current account deficit measures the balance of trade in

• goods
• services
• Net Investment incomes

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.


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.

1. 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.
2. 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.

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.

See also

• Is the US economy heading towards recession?
  
• Do Current Account deficits matter?
• Do Current Accound deficits matter? Axel Merk, May 23rd 2006

Labels: current account, economics explained, US economy