International Money and Finance Balances - Coursework Example

International Money & Finance International Money & Finance Current account deficit measures trade balance in terms of net investment transfers and incomes, services and goods. In essence, the incidence of deficits in the current account essentially means that the nation is presently importing more than the amount of goods it is exporting. Such an incident needs to be matched by a surplus on the capital and financial account. Financial accounts typically consist of short term and long term capital flows. Economies generally disagree on whether or not there is a need to be concerned about high rate of current account deficit (de Mello, Padoan & Rousová 2011, 15). Notably, the current account deficit is primarily the consequence of decisions made by the private sector. Since the current account deficit is considerably temporary, it can easily be financed; hence there is no need to be overly concerned. This paper will examine the current account deficit, providing evidence of how the private sector is largely to blame and describing why it is mainly noting to worry about. A critical explanation for the increase in the current account deficit in the US is the increasing levels of productivity, which resulted in a pronounced investment boom. The accelerating productivity inherent in US workers compared to that of workers in other countries is a prominent cause of the rise in current account deficit. For instance, productivity in the US grew by at least 4.8% per year in the manufacturing sector (Warnock & Freund 2007, 149). In the year 1999, the US manufacturing sector experienced a 6.4% rise in productivity. This essentially meant that the productivity grew quite substantially between the year 1980 and 1999. This surge in productivity resulted in an investment boom. Since the year 1991, gross private domestic investment as a share of the US GDP has increased quite substantially, achieving a post war high of 18.3% in early years of the 21st century (de Mello, Padoan & Rousová 2011, 18). This increased investment rate was primarily in response to the dramatic changes encountered in the US technological climate, which underpinned the increase in productivity. This is primarily because technological advances have allowed a vast majority of US firms to project productivity to increase momentously. Increased growth in productivity increased the economy’s capacity to produce products and services. The rise in plausible supply translates, over time, into a rise in the real quantity of products and services produced by the economy. This, over time, results in an increase in growth productivity, which consequently enhances the rate of growth in output. However, the production of more output in the future creates great demand for investment in the present. As a consequence, the rate of investment in the US has risen rather dramatically. Accepted economic theory anticipates that when a country encounters a boom in its investment, particularly as a consequence of increased growth in productivity while its trading partners do not attain such booms, the country’s current account deficit will increase substantially (Obstfeld 2012, 37). This means that increased productivity enhances expenditure in domestic investment, causing the net domestic spending to go beyond production in the short term. In order to obscure excessive domestic spending over production, the US is forced to import more products and services than it is exporting. Specifically, increased investment results in increased demand for imported capital goods. As mentioned this incident is primarily noticeable in the short term. Therefore, it is not imperative to be concerned about the high rate of current account deficit presently being experienced in the US. The investment boom typically affects the financial side of the US economy. Therefore, increasing domestic productivity within the private sector results in an increase in real interest rates, which, in turn, boosts the return on domestic assets in relation to foreign assets (Obstfeld 2012, 43). It is not necessary to worry about the present position of the US current account deficit because the increased return on domestic assets will ultimately attract sufficient foreign funds to finance the entire current account deficit. Therefore, accelerations in productivity result in net capital inflows that correspond to the deficit in the current account (Warnock & Freund 2007, 149). On the other hand, another possible benefit of this situation is the appreciation of the country’s currency. Therefore, while the rise in the US current account deficit could be considered detrimental in the short term, the deficit is not disastrous in the long term since it results in the appreciation of the US currency. Most developments experienced in the US economy from the late 20th century to 2000 adhere to these basic predictions of economic theory. In essence, the present US current account deficit has substantially enhanced productivity in the country (Herrmann & Winkler 2008, 16). Additionally, the increase in expenditure on investment has been supplemented by increases in the quantity of capital goods imported into the US as a share of the country’s GDP. Increasing productivity can account for a majority of the movement in the dollar’s exchange rate, which has appreciating rather dramatically in the last few years. This is primarily in line with the academic implications of a technology-led surge in the country’s productivity. However, the immensely rapid appreciation of the US dollar is partly as a consequence of the turmoil experienced in the global financial market. During the course of financial crises, particularly the Latin American and Asian financial crises, international investors considered the US as the safest haven for investment (Obstfeld 2012, 42). The flow of investment funds into the US from the international community results in the rapid appreciation of the value of the US dollar. However, for some time in the past, the value of the US dollar remained comparatively stable. However, in isolation, an increase in the growth of productivity in the US is unable to fully explain this occurrence in the fluctuation of the rate of exchange. Accounting for this form of flattening out inherent in the exchange rate demands the consideration of other factors that cause the current account deficits in the US. Increased wealth resulted in a consumer shopping spree. In the 1990s, a bullish market inherent in US stocks considerably increased the net value of US households. Consequently, the worth of the S&P 500, as well as the Dow Jones Industrial Average increased more than thrice from 1990 to 1999. As a consequence, during the same period, the ratio of net value to disposable income increased by 32.8%. This placed the ratio of income to wealth well beyond former highs. The flow in wealth as a consequence of the stock market created a consumption boom in the US, experienced through the wealth effect provided by economic theorists. Consumer spending continues to grow as a consequence of the current account deficit. During the consumption boom, consumers in the US satisfy most of the increased demand for products and services through imports, buying more and more products from foreign sources (Aizenman & Sun 2010, 37). This resulted in the increased share of imports in total US consumption. When a country enhances its overall demand for imports as a consequence of a consumption boom, economic theory anticipates that the country’s current account deficit will increase and the value of its currency will depreciate substantially. Therefore, when a country’s demand for imports increases, its trade deficit deteriorates, making the country’s current account deficit to increase. In the financial aspect of the economy, increased spending on foreign goods enhances demand for foreign currencies, exerting an upward pressure on the worth of foreign currencies in relation to the value of its domestic currency (Giavazzi & Spaventa 2010, 18). As a consequence, such a country’s exchange rate will fall dramatically. In combination, increased consumer demand for imports, as well as the investment surges, which are driven by productivity can explain qualitatively the recent behavior inherent in the US’s economy’s external sector. These factors are the primary reasons for the heightened value of the US current account deficit. Moreover, in the US, increasing import rates come primarily from the rising costs of gold and crude oil, resulting in increased current account deficit that is well beyond the government’s comfort zone. Furthermore, the combination of these factors may be sufficient to offer a broad overview of the behavior of the US dollar exchange rate. Independently, improved productivity should enhance the exchange rate, whereas the enhanced consumer expenditure on imports should reduce the exchange rate. Economists, as well as policymakers, believe that a high rate of current account deficits does not necessarily call for concern (Ghosh & Ramakrishnan 2006, 44). This is primarily because a high current account deficit can be financed rather easily from flows of long term capital, which is, overall beneficial to the entire economy as a whole. Therefore, inward investment has the potential to enhance the productive capacity of the country’s economy. In addition, there is no need to worry because, in the age of globalization, it is extremely easy to attract adequate amounts of capital flows so as to provide enough financing for the current account deficit. Furthermore, in the event that the deficit becomes extremely massive, it will result in a devaluation, which will, in turn, help to decrease the current account deficit. Moreover, whenever there is a slowdown in the spending tendencies of consumers, deficits in spending will decrease quite significantly (Aizenman & Sun 2010, 38). Another persuasive reason why people need not worry about current account deficit is that a current account deficit typically provides an outlet for domestic demand and ultimately deters the incidence of inflation. This begs the question of whether there is such a thing as too persistent current account deficit. When a country such as the US runs a current account deficit, it is essentially building up its liabilities to the rest of the globe, which are, then financed by capital flows in the country’s financial account. Ultimately, these liabilities need to be repaid. Therefore, common sense posits that if a nation squanders its borrowed foreign funds on expenditures, which do not yield any form of long-term benefits, then the country’s capacity to repay might be questionable, calling into question its overall solvency (Edwards 2002, 28). This is primarily because solvency necessitates that a country be capable and willing to generate enough current account surpluses to enable it repay what it borrowed in order to finance its entire current account deficits. Consequently, whether a country needs to run a current account deficit is primarily dependent on the degree of its external debts of foreign liabilities, as well as on whether such borrowing can finance investments with massive marginal products compared to the interest rates the country needs to pay on its overall foreign liabilities. However, even if such a country is inter-temporarily solvent, which means that current liabilities are covered by future revenues, the country’s current account deficit may prove unsustainable in the long-term if it is incapable of securing sufficient financing. Conclusion Certain countries, for instance, New Zealand and Australia, have been able to sustain their current account deficits at an average of 4.5 to 5% of their GDP for a number of decades. Other countries, as well as several economies in the 2007/8 global crisis witnessed sharp reversals in their current account deficits pursuant to the withdrawal of private funding during the financial crisis. These forms of reversals can prove immensely disruptive due to investment, government expenditure and private consumption need to be reduced abruptly when foreign financing becomes unavailable (Edwards 2002, 36). As a consequence, countries are forced to run massive surpluses in order to repay in a short period, the total amount they borrowed in the past. This is implicit of the fact that, in spite of the reason a country has a current account deficit, massive and persistent deficits call for increasing concern, lest the country encounters a painfully abrupt financing reversal. However, based on the argument provided in this paper, it is clear that current account deficit is not necessarily bad for the economy, but rather poses a number of substantive benefits. Regardless, it is vital that a country deters the incident of massive and persistent current account deficits. References Aizenman, J & Sun, Y 2010, “Globalization and the sustainability of large current account imbalances: Size matters”, Journal of Macroeconomics, vol. 32, pp. 35–44. de Mello, L, Padoan, PC & Rousová, L 2011, “The Growth Effects of Current Account Reversals: The Role of Macroeconomic Policies”, OECD Economics Department Working Papers, No. 871, OECD Publishing. http://dx.doi.org/10.1787/5kgb1mftj6s3-en Edwards, S 2002, Does the current account matter? University of Chicago Press, Chicago. Ghosh, A & Ramakrishnan, U 2006, “Do current account deficits matter?” Finance & Development, December, pp. 44- 45 Giavazzi, F & Spaventa, L 2010, Why the current account matters in a monetary union Lessons from the financial crisis in the Euro area. Herrmann, S & Winkler, A 2008, Financial markets and the current account –emerging Europe versus emerging Asia Sabine, Discussion Paper, Series 1: Economic Studies, No 05/2008. Obstfeld, M 2012, Does the Current Account Still Matter? University of California, Berkeley. Warnock, F & Freund, C 2007, Current account deficits in industrial countries: The bigger they are, the harder they fall? University of Chicago Press, Chicago. Read More