Most students are aware that the current account measures the net flow of:
- Trade (visible and invisible)
- Net income flows
- Unilateral transfers
So a current account deficit implies a net transactional outflow to other countries and is often indicative of “living beyond its means”.
But do you know that the current account can also be expressed as the difference between national (both public and private) savings and investment?
To understand this, we first go back to the basics.
The National Income Accounting identity.
The current account as defined, can be expressed as:
Current Account = (X – M) + Net Income from Abroad
And all students will also know that:
GNP = GDP + Net Income from Abroad
(and therefore) Net Income from Abroad = GNP – GDP
Therefore we can express the following:
Current Account = (X – M) + GNP – GDP
We know also that:
GDP = C + I + G + (X – M)
Therefore we can also express the current account as:
Current Account = (X – M) + GNP – C – I – G – (X – M)
= GNP – C – I – G
As the difference between GNP and C+G is S (national savings):
Current Account = S – I
And therefore through manipulation of the National Income Accounting Identity, we have shown that the current account can indeed be expressed as the difference between national savings and investments (domestic and foreign).
The implication of a current account deficit.
Is a current account deficit always bad?
In the traditional derivation (current account as expressed in terms of trade balance, net income and unilateral transfers), pro-protectionism folks would certainly be inclined to argue in favour of that, especially for persistent deficits.
But this other approach discussed for the current account reveals that a current account deficit reflect a low level of national savings relative to investment or a relatively high rate of investment – or both.
When I > S, the domestic savings level is lower than the total investments in the economy, and the current account is in deficit.
Such a case can only be achieved with foreign savings invested to the economy to make up the shortfall, which appears as net inflow to the capital account in the balance of payments sheet.
There are 2 key implications then:
- Trade protectionism has no effect in correcting the current account deficit since it is caused by a savings shortfall relative to investments.
- The ability of the economy in sustaining current investment levels depend ultimately on the willingness and ability of its trading partners to top-up on the required foreign capital.
Implication 1: The trade war is misguided.
The first implication suggests that the Trumpian trade war with China are likely to be barking up the wrong tree as far as the oft-cited trade deficit with China is concerned.
The current account deficit is instead the result of the saving-investment gap in USA and is fundamentally independent of trade, strictly speaking.
Implication 2: The real deal lies behind global imbalances and its sustainability.
A current account deficit implies that foreign savings are utilised to finance the difference between domestic savings and total investments in the country.
What if its trading partners are no longer willing or able to finance these investments?
In that case, the investments that the country would be able to make, will be constrained by its level of national savings, which spells bad news for countries with low levels of national savings such as the USA, whose relative national savings have been declining for decades, as seen in the graph below (courtesy of the Peter G. Peterson Foundation):
Why or when countries with current account surplus might not be willing or able to finance counterparts with current account deficits, is beyond the scope of this post, and many others (such as FP and CNA) have written really great pieces that you may refer to.
If such a scenario comes to pass for a country with low national savings, investments will have to fall precipitously to match domestic savings and this will have severe short and even long-term repercussions on the economy.
So clearly, for all the focus on trade imbalances, many are missing the bigger and “scarier” picture – that massive global imbalances and inequality amongst (and within) nations are driving the current account imbalances.
The voluminous literature surrounding this topic generally agrees that this spells trouble. But perhaps more worryingly, few are able to (or will even attempt to) predict when it might happen.
This is because, like most economic phenomena, many factors drive and complicate these imbalances, such as politics.
For example, while there are strong economic reasons why China might be willing to continually finance USA’s current account deficit (through purchases of the US Treasury bills), there are certainly subtle political undertones that go with it.
There is general consensus that China is not interested (at least in the near future) of overtaking USA as a “superpower”, and will therefore avoid redressing the capital imbalances too much to ensure the boat isn’t rocked too much in the international context.
While we unfortunately painted a generally gloomy picture, with a different approach to interpreting the current account, we hope that you have gained a greater insight to such issues and appreciate the immense problems at hand.
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