THE BALANCE OF PAYMENTS - faculty.babson.edufaculty.babson.edu/ricciardi/MMS/BoP2003.pdf · The Balance of Payments 1.0. Introduction Since World War II, international trade flows

Copyright © John E. Marthinsen, 11/14/03 Revised on 11/14/03

THE BALANCE OF PAYMENTS

Copyright © John Marthinsen

2 April 2003


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The Balance of Payments

1.0. Introduction

Since World War II, international trade flows and foreign investments have grown at rates far inexcess of the growth rates for world gross domestic product. Some nations, like the US, thatonce thought they were relatively self-sufficient and independent from the effects of foreigndisturbances have found that the benefits of internationalization only accrue to countries that arewilling to pay the price of greater economic vulnerability. Other nations, like Belgium, Germany,and France, have long known the benefits and exposures created by increased international tradeand capital flows.

The purpose of this chapter is to provide a systematic way to analyze and understand the ever-widening concerns surrounding international trade and investment flows. It begins by describingthe balance of payments, a statement that catalogues the international transactions between onenation and the rest of the world. It then explains the meaning of surpluses and deficits, as well ascorrective measures to solve balance of payments problems. The analytical tools and framework,which are explained in this chapter, are applicable to any nation, regardless of location and time.

Balance of payments statistics are released regularly by official institutions such as theInternational Monetary Fund (IMF), the United Nations, and the commerce departments orfinance ministries of individual nations (e.g., the US Department of Commerce). Because of theirwidespread use and flexibility, this chapter focuses on the reporting methods and terminologyemployed by the IMF. In 2003, the IMF reported, in its monthly publication, InternationalFinancial Statistics, comparative balance of payments statistics for over 200 nations.1 The IMFis one of the most useful sources of international economic information and a logical startingpoint for any country analysis, comparative country study, or international capital marketinvestigation.

2.0. What Is the Balance of Payments?

The balance of payments is a summary of all the transactions between the residents of one nationand the residents of the rest of the world over a given period of time. All transactions, such asthe importation and exportation of goods and services, tourist expenditures, insurance payments,real and financial investments, loans, government defense expenditures, interest earnings, dividendpayments, gifts and aid, are included so long as they are between domestic and foreign residents.

1 “The IFS database contains approximately 32,000 time series covering more than 200 countries and areas andincludes all series appearing on the IFS Country Pages; exchange rate series for all Fund member countries, plusAruba and the Netherlands Antilles; major Fund accounts series; and most other world, area, and country seriesfrom the IFS World Tables.” See http://ifs.apdi.net/imf/about.asp .


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When discussing the balance of payments it is important to remember that these transactions arenot between the citizens of various nations, but rather between their residents. Citizenship is anarrower concept than residency. To be a citizen of a nation, you must have either been bornthere or derived formal citizenship there. Residency implies that your primary center of interestis tied to that country. For instance, if you were a Swiss resident who worked and lived inZurich but traveled often to London, your primary center of interest (e.g., your home, youremployer, and your family) would be in Switzerland. You would be classified as a Swissresident, and all your transactions in London should enter into both the Swiss and British balanceof payments. Conversely, if you were a Swiss citizen, but spent the year working and living (orstudying) in England, your center of interest for that year would be in England, and you would beconsidered an English resident. Therefore, your purchases in England would be excluded fromboth the Swiss and the English balance of payments. Instead, they would be considered domestictransactions between you and other English residents.

While straightforward in concept, the term balance of payments is a bit of a misnomer. Considerthe word balance. When most of us refer to our “balances”, we are discussing the fundsremaining in our bank accounts or the amounts we owe on our credit cards. “Balance” is a stock(i.e., static) concept, measuring a quantity at a given point in time, but the balance of payments isa flow concept. It measures transactions over a given period of time. Using the bank accountanalogy, the balance of payments would record the flows into and out of our bank accounts overa period of time (typically a month, a quarter, or a year).

A second reason the term balance of payments can be misleading is related to the narrowness ofthe word payments. For most of us, a payment implies some form of monetary exchange, but thebalance of payments measures all international transactions -- not just transactions for whichpayments are made. Barter exchanges, credit agreements, and real investments are just a fewexamples of international transactions that enter into the balance of payments, but for which nopayment, in the traditional sense, is made. The implication we can draw from this discussion isthat if we could start fresh, the term flow of international transactions would be much moredescriptive than the term balance of payments, but such a change in terminology is unlikely.2

3.0. Balance of Payments Accounting

In general, nations measure balance of payments deficits or surpluses just as you and I wouldmeasure deficits and surpluses for our households. If we spend more than we earn, we are indeficit, and if we earn more than we spend, we are in surplus. The balance of payments differsslightly from the typical household budget, because it includes all the transactions (betweendomestic residents and foreign residents) and not just the ones that involve monetary payments.

The key to unlocking the accounting logic behind balance of payments transactions (i.e., whether 2 Since the word "balance" is incorrect, and the word "payments" is too narrow, the only descriptively accurateword in the phrase "balance of payments" is the word "of."


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they are entered with plusses or minuses) is to realize that a balance of payments statement isjust like a company's sources and uses of funds statement. Transactions are recorded in thebalance of payments with positive signs if they are sources of funds for a nation, and they arerecorded as negatives if they involve uses of funds for a nation.

For balance of payments purposes, a transaction is classified as a source of funds if it eitherreduces a nation's assets relative to foreign residents or increases a nation's liabilities relative toforeign residents. On the flip side, it is categorized as a use of funds if it either increases anation's assets relative to foreign residents or reduces a nation's liabilities relative to foreignresidents.

Let's pause to understand the common sense of this accounting logic by comparing an individual's(household’s) transactions with those of a nation. Suppose you sold a personal possession, likeyour car. This transaction would reduce your assets (the car would be gone), but it wouldprovide a source of funds, which could be spent as you like. Similarly, if you borrowed from abank, the increased liability would be a source of funds, because you would have new spendingpower in return for your obligation to repay the debt’s principal plus interest to the bank.

What sorts of transactions are sources of funds for a nation? Using Japan as an example, themost important sources of funds are its:

• exports of goods and services,

• earnings on foreign investments,

• borrowings from foreign financial institutions,

• security (i.e., bond and stock) sales to foreign residents,

• real foreign investments (i.e., plant and equipment) in Japan,

• gifts/aid from foreign residents, and

• central bank intervention to raise the value of the Japanese yen (which it would accomplishby purchasing yen with its international reserves).

It is important to understand that sources and uses of funds are not exactly the same as thesupply and demand for a nation’s currency. In other words, there is not a one-for-onerelationship between transactions in the balance of payments and transactions in the foreignexchange market. The balance of payments is a much broader measure, which includes alltransactions between domestic and foreign residents and not just those for which an exchange ofcurrencies is required. Nevertheless, when a balance of payments transaction does involve theexchange of currencies, the general rule is that a source of funds is when individuals supply foreigncurrencies and demand the domestic currency.


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The following examples may help to explain why there is not a strict one-for-one relationshipbetween the transactions in the balance of payments and the forces of demand and supply in theforeign exchange market. Suppose a Japanese auto manufacturer sold cars to a Zurich autodealership on a quarterly basis. These transactions would be counted in both Japan’s balance ofpayments and Switzerland’s balance of payments, because they were between domestic andforeign residents. The value of the purchased cars would be recorded in Japan's (Switzerland's)balance of payments as a source of funds (use of funds), because it decreased (increased) thenation's assets. Nevertheless, if the Japanese manufacturer were willing to accept Swiss francs,rather than Japanese yen, no currency exchange would have to be made in the foreign exchangemarket. In a similar way, if the Japanese manufacturer extended the Swiss dealership a 90-daytrade credit, no foreign exchange transaction would occur. The Japanese manufacturer wouldincrease its accounts receivable rather than its yen bank deposits.

Using Japan, again, as an example, the most important transactions giving rise to uses of funds inthe balance of payments are:

• imports of foreign goods and services,

• dividend and interest payments to foreign residents on their Japanese investments,

• security (i.e., bond and stock) investments abroad,

• direct investments abroad in plant and equipment,

• gifts/aid given to foreign residents, and

• central bank intervention to lower the value of the Japanese yen (which it would accomplishby selling yen and purchasing international reserves).

In general, balance of payments transactions, which are uses of funds, are ones where individualsdemand foreign currencies and supply the domestic currency.


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4.0 What Are the Principal Parts of the Balance of Payments?

For analytical ease, the balance of payments is divided into three main parts: the CurrentAccount, the Financial Account3, and the Reserves & Related Items Account (See Exhibit 1).

Exhibit 1

The Major Components of the Balance of Payments

Balance of Payments ≡ Current Acct. + Financial Acct. + Reserves & Related Items Acct.4

4.1. The Current Account

The Current Account includes: (1) net exports of goods and services (i.e., the value of goods andservices exported to foreign residents minus the value of goods and services imported fromforeign residents), plus (2) net earnings on international investments (i.e., a country's earnings onforeign investments in the form of interest, dividends, and capital gains minus its payments toforeign investors), plus (3) net current transfers (i.e., unilateral transfers or unrequited transfers)resulting from international gifts and aid (i.e., a country's receipts of private and governmentgifts/aid from foreigners minus its payments of gifts/aid to foreigners). See Exhibit 2.

Exhibit 2

The Current Account

+ Net Exports of Goods and Services

+ Net Earnings / Payments on International Investments

+ Net Current Transfers Due to International Gifts/Aid

= Current Account

3 In many balance of payments analyses, the Financial Account is often called the Capital Account. Thisterminology can be confusing, because the IMF has a minor line item in its balance of payments reports called the"Capital Account”. Entries in the IMF's capital account cover a much narrower range of transactions than the entireFinancial Account. They refer "mainly to capital transfers linked to the acquisition of a fixed asset other thantransactions relating to debt forgiveness plus the disposal of nonproduced, nonfinancial assets”. See IMF,International Financial Statistics, January 2003, p. xxi.4 An equal sign with three lines (i.e., ≡) means the relationship is an identify (i.e., it is true by definition)


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4.2. The Financial Account

The Financial Account is a summary of all international investments between the residents of onenation and residents of the rest of the world. For balance of payments purposes, we must becareful to interpret word “investments” very broadly, because it includes not only changes in theownership of company shares, bonds, loans, and direct investments (e.g., factories, machinery,and tools), but also changes in very liquid assets, like cash, checking accounts and savingsaccounts.

Exhibit 3The Financial Account

Direct Investments

+ Portfolio Investments

• Equity securities

• Debt securities

+ Other Investments

• Monetary authorities

• General government

• Banks

• Other sectors

= Financial Account

The Financial Account has three major parts: direct investments, portfolio investments, and otherinvestments (See Exhibit 3). Direct investments include assets, like equity capital, reinvestedearnings, and other intercompany capital transactions between affiliated enterprises.5 Portfolioinvestments include transactions with nonresidents in financial securities of any maturity.6

5 IMF, International Financial Statistics, January 2003, p. xxi.6 The IMF makes no distinction between short-term investments (maturities less than or equal to one year) andlong-term investments (maturities longer than one year). Occasionally, analysts try to separate long-terminvestments from short-term investments in order to gain insight about the ability of a nation to sustain itsinternational position. The "basic balance" (which includes the Current Account and long-term investments) makesthis distinction and has increasingly found its way into many contemporary debates.


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Included are changes in assets, such as corporate securities, bonds, notes, money marketinstruments, and financial derivatives, which are not included in other lines of the balance ofpayments (e.g., direct investment, exceptional financing, and reserve assets).7 Finally, thecategory "other investments" includes currency, bank deposits, loans, and trade credits.

Capital outflows from a nation like Japan are recorded in the balance of payments with minussigns, because they involve uses of funds connected to Japanese residents' purchases of foreigninvestments (i.e., increases in Japanese assets). Capital inflows are reported with positive signs,because they are sources of funds connected to foreign residents' investments in Japan (i.e.,increases in Japanese liabilities to foreigners).

4.2.1. Net Errors and Omissions

Included in the Financial Account is a line item called Net Errors and Omissions, which has littleeconomic significance but is an accounting necessity. Because the balance of payments is asources and uses of funds statement, all uses of funds must equal all sources of funds, and,therefore, the sum of all accounts must equal zero. This topic will be discussed in section 4.6,but for now it is important only to understand that many of the accounts in the balance ofpayments are estimated. When the grand sum does not equal zero, the “Net Errors andOmissions” account is adjusted to make up the difference.

7 IMF, International Financial Statistics, January 2003, p. xxi.


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4.3. The Reserves & Related Items Account

The Reserves & Related Items Account is mainly a summary of the transactions in the foreignexchange market that are carried by official institutions (e.g., central banks and governmenttreasuries) to affect the international value of a nation’s currency. For instance, if the US centralbank (i.e., the Federal Reserve or the "Fed" for short) wanted to increase the international valueof the dollar, it could purchase US dollars (sell foreign currencies) in the foreign exchange market.To purchase US dollars, the Fed would have to already own reserves of foreign currencies, whichit could sell. By supplying these currencies to the foreign exchange market, the Fed would bedemanding dollars. The increased demand for the dollar would raise its value relative to foreigncurrencies (which is the same as saying that the increased supply of foreign currencies wouldlower their value relative to the US dollar).

The US Federal Reserve has unlimited access to US dollars, but these dollars would not help toraise the value of the dollar, because the purchase of dollars with dollars in the foreign exchangemarket would be a self-canceling transaction. It is worth remembering that a nation’s ability toraise the international value of its currency is limited by the amount of international reserves itowns.8

Transactions recorded in the Reserves & Related Items Account include Reserve Assets, the Use ofIMF Credit Lines & Loans, and Exceptional Financing transactions (See Exhibit 4). The value ofthese assets is not included in a nation’s balance of payments, but changes in their value areincluded.

8 A nation could use its hoard of precious metals (e.g., gold and silver) to purchase foreign currencies, and thensubsequently use the foreign currencies to purchase the domestic currency in the foreign exchange markets. Thesales of precious metals would not directly affect the international value of the domestic currency, but thesubsequent sale of foreign currency for the domestic currency would tend to raise the domestic currency's value.


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Exhibit 4US Reserves & Related Items Account

Reserve Assets

• Convertible, non-domestic currencies (e.g., currencies)

• Gold, silver, and other precious metals

• Use of borrowing rights from foreign central banks

+ Use of IMF Credit & Loans

• General Resource Account

• Structural Adjustment Facility

+ Exceptional Financing

= Reserves & Related Items Account

Reserve Assets are liquid external assets, which can be used by monetary authorities to directlyfinance imbalances in the balance of payments. 9 They can also be used to regulate the size ofthese imbalances or their speed of adjustment. Convertible currencies, precious metals, such asgold and silver, as well as borrowing rights from foreign central banks are major components ofnations' reserve assets.

Transactions in the Uses of IMF Credit & Loans Account include a nation’s borrowing rightsfrom the International Monetary Fund under both the General Resource Account and specialborrowing arrangements (e.g., Structural Adjustment Facility). Finally, the Exceptional FinancingAccount includes transactions undertaken by authorities to finance a nation's Overall Balance.10

In an accounting sense, a nation's sales of reserve assets are treated in the balance of paymentslike the export of any good (or service). Since they are transactions with foreign residents thatcause domestic assets to fall, they are recorded as positives (+) in the balance of payments.Likewise, if the central bank sold the domestic currency in the foreign exchange markets to bringdown its international value, the nation's reserve assets would increase, which would be recordedas a negative entry (-) in the balance of payments.

4.4. The Balance of Payments

9 IMF, International Financial Statistics, January 2003, p. xxi.10 The Overall Balance will be explained in Section 5.5.


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Exhibit 5 puts together all the pieces of the balance of payments and summarizes thetransactions that give rise to sources and uses of funds. Notice that Net Errors and Omissionshave been included with the Financial Account transactions. This treatment of Net Errors andOmissions is typical, because the largest estimation errors are usually associated with theFinancial Account.

Exhibit 5Balance of Payments

Sources of FundsPositive Entries

Uses of FundsNegative Entries

Current Account

Goods Exports Imports

Services Exports Imports

Investment Income Receipts Payments

Current transfers Received Paid

Financial Account

Direct Investments From Abroad Made Abroad

Portfolio Investments From Abroad Made Abroad

Other Investments From Abroad Made Abroad

Net Errors & OmissionsWhen minuses exceed

plussesWhen plusses exceed

minuses

Reserves & Related Items Account

Reserve Assets Decreased Increased

Use of IMF Credit and Loans Borrow Repay

Exceptional Financing Borrow Repay


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4.5. Balance of Payments (as a Whole) Must Equal Zero

One of the most important, but relatively unknown, facts to understand about the balance ofpayments is that when taken as a whole, the balance of payments must sum to zero. By now,this fact should have some intuitive logic, because the balance of payments is nothing more than a"sources and uses of funds” or the cash flow statement. Every use of funds must have a source.Because the sources of funds are positive entries in the balance of payments, and the uses arenegative entries, their sum must, when added together, equal zero. This important identity issummarized in Exhibit 6.

Exhibit 6Balance of Payments Identity

Current Account + Financial Account + Reserves & Related Items Account ≡ 0

You might be scratching your head and asking "If the positives always equal the negatives, howcan a nation have a balance of payments deficit or surplus?" The answer is surplus and deficitmeasures are found by looking only at segments of, rather than the entire, balance of payments.The next section describes the most important international measures of international imbalance,but for now remember that a deficit or surplus is simply the net of the pluses and minuses for aspecific segment of the entire balance of payments. If the sum of all the minus transactions isgreater than the sum of the plus transactions, the balance of payments is in "deficit”. If thepositive transactions exceed the negative ones, the balance of payments is in "surplus”.

5.0. Balance of Payments Measures

Five major balance of payments measures are reported by the IMF and used in most discussionsand analyses of international trade and investment flows. These balance of payments measuresare summarized in Exhibit 7, and explained in sections 5.1 to 5.5. In Section 6, these measuresare used to explain Mexico's balance of payments situation for the years between 1992 and 1996.


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THESE BALANCE OF PAYMENTS MEASURES

INCLUDE ALL THE ACCOUNTS THAT ARE ABOVE

THE RESPECTIVE LINES

Exhibit 7Major Balance of Payments Measures

Goods Trade Balance

Services Balance on Goods & Services

Net Foreign Income Balance on Goods, Services, & Income

Current Transfers Current Account

Financial AccountDirect InvestmentsPortfolio InvestmentsOther Investments Net Errors & Omissions Overall balance

Reserves & Related Items AccountReserve AssetsUse of IMF Credit and LoansExceptional Financing

5.1. The Trade Balance

The narrowest of all the balance of payments measures is the Trade Balance (often called theMerchandise Trade Balance). It includes only a nation's imports and exports of merchandise (i.e.,a nation’s purchases and sales of goods relative to the rest of the world) over a given period oftime. Because many nations have a significant number of jobs dependent on the production andexport of manufactured goods, the Merchandise Trade Balance is highly visible and the focus ofmany heated (and often misdirected) debates.


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The main problem with the merchandise Trade Balance is its narrowness. What justification isthere for focusing the international exchange of goods and excluding services? Jobs, productivity,and international payments are just as closely tied to service and direct investment transactions,as they are to merchandise transactions. For nations that are becoming more service-oriented, themerchandise Trade Balance is becoming increasingly less relevant.

What might cause a nation to run a merchandise trade deficit? A few of the most frequently citedcauses are relatively high domestic inflation rates, lagging efficiency (i.e., reduced competitiveedge), deteriorating labor skills, weak educational training, lack of product differentiation, andinternational protectionist policies. Loss of comparative advantage, declining invention, and theinternational diffusion of research and development may also play major roles.

Regarding research, development, and technology, many analysts view international trade assimilar to a global game of leapfrog. An initial competitive advantage is often achieved by onenation when it leaps ahead of its trading partners by introducing new and better products. Intime, these innovative leaders are caught as other nations imitate and begin producing the samegoods. Gradually, production drifts toward nations with the lowest unit costs rather thanremaining in the innovative countries that opened the initial gap. As a result, trade advantagesconnected to research, development, and technology are transitory, and for nations to maintaincompetitive edges, R&D expenditures are needed to continually open new competitive gaps.

Of course, none of the aforementioned factors, by itself, influences a nation’s Trade Balance. Itis only when these variables change relative to a nation’s international trading partners that thebalance of payments is affected. For example, rising inflation, by itself, does not worsen anation’s Trade Balance if the rest of the world has equally high or higher inflation.

5.2. Balance on Goods and Services

A broader, and perhaps better, measure of a nation's international economic position is theBalance on Goods and Services. This measure includes the imports and exports of both goodsand services over a given period of time. The Balance on Goods and Services is one of the fourcomponents of a nation’s gross domestic product.11 The other components of GDP are personalconsumption expenditures ( C ), gross private domestic investment ( I ), and governmentspending ( G ) -- See Exhibit 8. As a result, this economic statistic is closely watched by mostnations, and it is useful for making international comparisons.

11 .


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Exhibit 8Components of GDP

Personal Consumption Expenditures

+ Gross Private Domestic Investment

+ Government Spending

+ Balance on Goods and Services

= GDP

5.3. Balance on Goods, Services, and Income

As its name indicates, the Balance on Goods, Services, and Income includes the Balance onGoods and Services, and also adds (subtracts) the net income earned from (or paid to) foreignresidents. Together, a nation's net international income and gross domestic product equal itsgross national product. (See Exhibit 9).

Exhibit 9Components of GNP

Personal Consumption Expenditures

+ Gross Private Domestic Investment

+ Government Spending

+ Balance on Goods and Services, & Net income

= GNP

A deficit in a nation's Balance on Goods, Services, and Income is often interpreted as a sign thatthe nation is living beyond its means, and invites critical scrutiny of the uses to which thesefunds are put and the methods used to finance these expenditures. To understand why, think ofyourself. If you spent more than you earned, you would be living beyond your means. Tosupport this lifestyle, you would have three basic choices. You could either (1) rely on gifts


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from friends and family to meet your expenditures, and/or (2) borrow the needed funds orliquidate some of your investment assets, and/or (3) liquidate (perhaps pawn) some of yourhousehold assets to make up the difference. Similarly, if you earned more than you spent, youwould be living within your means, and the surplus could be used to (1) provide gifts, aid, ordonations to others, (2) invest in financial or real assets (e.g., stocks, bonds, and income-generating businesses) or repay old debts, and/or (3) repurchase the assets that you pawnedwhen you were living beyond your means.

The same is true of a nation. If a country spent more than it earned (i.e., the net Balance onGoods, Services, and Income was negative), then it would have the same three basic options: (1)finance the expenditures with gifts, donations, and aid, (2) borrow the needed funds frominternational sources or liquidate investment assets, and/or (3) sell assets from its reserves to getthe needed funds. We will return to these three alternatives in the next section when the CurrentAccount is discussed.

5.4. The Current Account Balance

The Current Account (See Exhibit 7) includes imports and exports of goods and services, netinternational income, and net flows from international gifts/aid. It is a popular measure ofnations' international economic positions and is frequently used for international comparisons. Adeficit in this balance is the mirror image of the net amount of international financing and officialreserve depletion required by a nation to support its current (consumption) transactions. Bycontrast, a surplus reflects the net outflows of foreign investments the nation has made over thegiven period of time in foreign nations.

For example, if Brazil were running a Current Account deficit, there would be two major channelsfor securing the needed funding: either through the Financial Account (by liquidating investmentassets or borrowing) or through the Reserves & Related Items Account (by selling reserves orborrowing from official institutions). Similarly, a Current Account surplus for Brazil would meanthe nation was a net international investor over the given period of time. These surplus fundscould have been used to purchase assets such as foreign securities and factories or to repay olddebts (all components of the Financial Account). They could have also been used to increase thenation's international reserves or to repay official debts previously incurred (i.e., components ofthe Reserves & Related Items Account).

Consider a deficit in Brazil's Current Account. If it persisted year after year, one of twoconclusions could be drawn: either the nation's net international debt level was rising or thecentral bank's net international reserves were falling. Both of these effects could have disturbingeconomic consequences. A rising debt level could, at some point, reach a point whereinternational creditors became concerned about Brazil's solvency and/or liquidity (i.e., ability torepay its debts). To acquire further loans, higher interest rates might be demanded to cover theadded risk. Ultimately, international loans could be cut off altogether. Similarly, if Brazilcontinually sold its official reserves and depleted its official borrowing rights, at some point, itcould completely exhaust its reserves and extinguish its ability to intervene at all.


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A good example of the difficulties facing nations that borrow in excess of their abilities to repayis the international debt crisis that faced many of the world's developing nations in the 1980s.The turmoil was due to hundreds of billions of dollars in loans extended to developing nations forwhich repayment looked doubtful. The crisis resulted in sharp reductions of loans and thereversal of net capital flows to many of these nations. The relatively few loans that were madecarried enormous premiums to compensate financial institutions and other investors for theperceived increased lending risks. In countries like Peru, not only was the flow of internationalcapital dramatically curtailed, but also the nation exhausted virtually all of its internationalreserves. The situation in Mexico, Brazil, and other Latin American nations was similar.Without international funding, these nations had few alternatives for funding their CurrentAccount deficits, so many of them declared debt moratoriums on the repayment of their debts.

5.4.1. Factors Causing a Current Account Deficit

In searching for the causes of a nation's Current Account deficit, many analysts focus on closely-related factors, such as unproductive labor, the lack of meaningful research and development, or adeteriorating educational system. Even though these factors are logical and seem to bear a directinfluence on the Current Account, they may not be the true cause of the imbalance, because it ispossible for the true source of a Current Account deficit to be tied to economic shocks in anation's Financial Account and/or central bank policies related to the Reserves & Related ItemsAccount. This insight is crucial for an accurate diagnosis of many nations’ balance of paymentsproblems.

We know from our earlier discussion that, taken as a whole, the balance of payments must sumto zero. The sources of funds for international transactions (i.e., positive flows) must equal theuses of these funds (i.e., negative flows). (See Exhibit 6.) This relationship is a truism; there isno debate over its validity. If the Current Account were positive, then the sum of the FinancialAccount and the Reserves & Related Items Account would be equal in size to the Current Accountand carry the opposite sign of the Current Account. Therefore, it stands to reason that anyeconomic shocks that make the sum of the Financial Account and the Reserves & Related ItemsAccount more positive must make the Current Account more negative.

Consider the US balance of payments situation during the early 1980s. In those years, the USCurrent Account turned dramatically negative, and analysts searched for identifiable causes.Much of their focus centered on factors that directly affected the components of the CurrentAccount. Productivity, innovation, and education were all intensively analyzed, but the majorcause of the Current Account deficit might have had little to do with these factors. Rather, thecause may have emanated from factors that more directly influenced the Financial Account.

During the early 1980s, both tax reform and high real (i.e., inflation-adjusted) US interest ratesattracted significant flows of investment capital to the US. This surge of foreign investmentcaused the US Financial Account to turn sharply positive. At the same time, the Reaganadministration took a hands-off policy regarding the international value of the dollar. This meantthat neither the Federal Reserve nor the US Treasury actively intervened in the foreign exchange


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markets, and therefore the US Reserves & Related Items Account equaled zero (ignoring foreignofficial intervention).

Since we know that the sum of the Current Account, the Financial Account, and the Reserves &Related Items Account must equal zero, the Current Account had to be negative under theseconditions. Of course, changes in market variables (e.g., exchange rates, interest rates, and GDP)also had an effect on the Current Account, but the true source of a negative Current Account maynot have been sluggish productivity or declining expenditures on research and development.

5.4.2. How do Changes in Interest Rates Influence the Current Account?

Let's consider how the movement in real interest rates causes a chain reaction of economic eventsthat ultimately affect the US Current Account. As the return on US investments increases,foreign demand for these investments rises. To acquire US assets, two separate transactions haveto be made. The first transaction involves foreign investors purchasing US dollars with theirdomestic currencies. Once purchased, the second transaction involves using these dollars topurchase US investments. An increased demand for US dollars increases the value of the dollar inthe foreign exchange markets, and a more valuable dollar causes the price of US exports to riserelative to imports. As a result, both US and foreign demand shift away from US companiestowards their foreign counterparts, causing US exports to fall and US imports to rise. As aresult, the Current Account turns negative. Additionally, the outflow of funds in the form ofpayments on investments to foreign residents increases further the Current Account deficit.

5.4.3. Is a Deficit in the Current Account Bad for a Nation’s Economic Health?

There is a natural tendency to associate a surplus with a desirable position and a deficit with anundesirable position. After all, most of us would rather be net creditors (i.e., net lenders) thannet debtors (i.e., net borrowers). One of the first rules of balance of payments analysis is neverassume a positive Current Account is good or a negative Current Account is bad.

Debt is not necessarily a bad thing. The real issue is how the borrowed funds are used. In short,the burden of a debt depends on whether the funds are used to purchase investments that earnsufficient returns or not. If the returns are sufficient to repay the debt and earn a net profit, whyshould they carry any negative connotation?

Instead of looking at a nation, let's start with something much more familiar -- a typical family.Suppose this family borrowed $5,000 to finance a deluxe Disney World vacation. A lifetime offond memories (and some souvenirs) could come from such vacations, but they would not createassets that generate cash flows to repay the loan. By using borrowed funds to finance currentconsumption (i.e., the vacation), the burden of this debt would fall directly on other householdrevenue sources (e.g., the family’s income).

This is not to argue that vacation expenditures are unwise or inappropriate. Most of us put highpremiums on such trips, but contrast the previous situation with one where the family borrows


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$5,000 to finance a start-up business. Assuming the venture is profitable, the family has boughtassets and invested in skills that should generate both a means of repaying the loan and generatinga positive rate of return. The debt in this case would be less burdensome, because it was used toacquire productive assets that generate positive cash flows.

The same is true for a nation. A deficit in the Current Account implies that a country is spendingmore than it is earning. Is that good or bad? The answer is it depends on what assets arepurchased with the expenditures. If the internationally borrowed funds were used to supportcurrent consumption, then the loans would not be self-liquidating. By contrast, if the borrowedfunds were used to finance new factories, then the new assets would provide, hopefully, a readymeans for repaying the debt. Similarly, if they financed the building or rebuilding of a nation'sinfrastructure (e.g., roads, bridges, sanitation, and communications), the investments wouldincrease the productivity of domestic resources and would not be a burden on future generations.

5.5. Overall Balance

The final important measure of a nation's international position is the Overall Balance. It is veryimportant to remember that, in spite of its name, the Overall Balance does not include all theaccounts in the balance of payments. Rather, it includes only the Current Account and FinancialAccount. What is left is the Reserves & Related Items Account, which means the Overall Balanceis the mirror image of the foreign exchange intervention conducted by central banks and/orgovernment treasuries. If the Current Account plus the Financial Account equaled zero, theOverall Balance would equal zero, and this balance would imply the absence of any net officialintervention in the foreign exchange market for the nation’s currency.

By contrast, if the Current Account were, say, positive $100 billion and the Financial Accountwere negative $60 billion, then the Overall Balance would be positive $40 billion, and we couldinfer that a central bank (either the US or a foreign central bank) and/or a federal government(again, either domestic or foreign) was/were intervening in the foreign exchange market by a netamount equal to negative $40 billion (i.e., +$100 billion - $60 billion - $40 billion = 0). In otherwords, if the Overall Balance is positive $40 billion, then the Reserves & Related Items Accountmust be negative $40 billion.

In a nutshell, here is what the positive Overall Balance means for the US. The Current Accountand Financial Account created an excess demand for US dollars (i.e., an excess supply of foreigncurrency) amounting to $40 billion. For the US Federal Reserve Bank to keep the value of thedollar from rising, it would have to supply a proportionate amount of dollars in the foreignexchange market, which means demanding a proportional amount of foreign currencies andputting them into its international reserves. Remember that increases in assets (e.g., internationalreserves) are uses of funds for a nation and recorded in the balance of payments (in this case, inthe Reserves & Related Items Account) as negative amounts (i.e., -$40 billion).


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5.5.1. Raising the Value of the Dollar

Suppose the Federal Reserve wanted to increase the international value of the dollar by directlyintervening in the foreign exchange markets. It would have to either sell its international reservesor use its international borrowing rights to purchase dollars in the foreign exchange market. Eithercourse of action would increase the demand for the dollars, and therefore raise the dollar’sinternational value. But as previously mentioned, a nation can do this only so long as it hasreserves to sell or borrowing rights to draw upon. Commitments to keep the value of a currencyunreasonably high implies the eventual depletion of all reserves and the inability to directlyintervene in the foreign exchange markets until these reserves are restored.

5.5.2. The Overall Balance & its Relationship to a Nation’s Monetary Base & Money Supply

The Overall Balance has an important economic meaning that relates to the domestic and foreignmonetary bases and money supplies. If the Federal Reserve were to buy dollars by selling itsinternational reserves, what would happen? First, private residents (i.e., individuals andcompanies) would deliver their dollars to the Federal Reserve. Consequently, these dollars wouldgo out of circulation and reduce both the US monetary base and US money supply. Second, inexchange for their dollars, these private individuals would receive foreign currency deposits inbanks outside the US. Because these foreign currencies were previously out of circulation(because they were in the central bank), their injection into the world economy would effectivelyincrease the monetary base and money supply of the various foreign nations. It is an ironic twistof roles. Here is a situation where the US central bank, in its attempt to raise the value of thedollar, directly changes not only its own monetary base but also the monetary base of foreignnations.

6.0. Mexico: A Balance of Payments Case Study

Exhibit 10 shows the balance of payments figures for Mexico between 1992 and 1996. A casualglance at these statistics is enough to convince us that something major happened between 1994and 1995, causing huge changes in Mexico's balance of payments situation. Trade deficits thatvaried between $13,481 million and $18,464 million changed in 1995 by over $25,000 million andbecame surpluses of $7,089 million in 1994 and $6,531 million in 1996. Similarly, the deficits inMexico’s net services account fell from $2,529 million in 1993 and $2,722 million in 1994 tosmall surpluses in 1995 and 1996. Finally, Mexico’s Current Account deficit fell from $23,400million in 1993 and $29,662 million in 1994 to levels under $2,000 million in 1995 and 1996.

Over the 1992-1993 period, Mexico was a darling of the international investment community.International investors poured billions of dollars into Mexico with the expectation of earningsound returns. So much was invested that Mexico was able to finance its large Current Account


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deficits and still have enough to fund healthy annual increases in its official reserves.12 Forinstance in 1992, net capital flows to Mexico amounted to $27,039 million. Of this amount,$24,442 million financed the nation's Current Account deficit; net errors and omissions accountedfor a small portion (-$852 million), and the extra $1,745 million (i.e., $27,039 million - $24,442million - $852 million = $1,745 million) funded the increase in Mexico’s official reserves.Similarly in 1993, Mexico's international reserves grew by $7,232.

12 Remember that when a nation acquires assets, the transactions are recorded in its balance of payments withnegative signs, because they are classified as uses of funds. Therefore, the negative entries in Mexico’s Reserves &Related Items Account during 1992 and 1993 were consistent with the nation gaining reserve assets.


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Exhibit 10Mexican Balance of Payments: 1992 – 1996

(Figures in millions of dollars)International

Transactions

1992 1993 1994 1995 1996

CURRENT ACCOUNT -24,442 -23,400 -29,662 -1,576 -1,923

Goods: Exports f.o.b.* 46,196 51,885 60,882 79,542 96,000

Goods: Imports f.o.b.* -62,130 -65,366 -79,346 -72,453 -89,469

Trade Balance -15,934 -13,481 -18,464 7,089 6,531

Net Services -2,684 -2,529 -2,722 65 82

Balance on Goods andServices

-18,618 -16,010 -21,185 7,154 6,613

Net Income -9,209 -11,030 -12,258 -12,689 -13,067

Balance on Goods, Services,& Income

-27,827 -27,040 -33,444 -5,536 -6,454

Net Current Transfers 3,385 3,640 3,782 3,960 4,531

FINANCIAL ACCOUNT 27,039 33,760 15,787 -10,487 4,119

Net Direct Investment 4,393 4,389 10,973 9,526 7,619

Net Portfolio Investments 19,206 28,355 7,415 -10,377 14,698

Other Investment Assets 3,440 1,016 -2,601 -9,636 -18,198

Net Errors and Omissions -852 -3,128 -3,323 -4,248 398

Overall Balance 1,745 7,232 -17,199 -16,312 2,593

Reserves & Related Items -1,745 -7,232 17,199 16,312 -2,593

International Monetary Fund, International Financial Statistics, January 1998, pp. 472-473.

* f.o.b. means "free on board”. It is the value of the exported goods at the border of the exportingcountry. For imports, it excludes freight costs and insurance beyond the border of the exportingcountry (see International Monetary Fund, International Financial Statistics, January 1998, p. xx).


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The positive net investment flows to Mexico slowed considerably in 1994, dropping 53% to$15,787 million from $33,760 million in 1993. The following year, these positive net investmentflows reversed themselves, resulting in net outflows (i.e., capital flight) amounting to $10,487million – a decline of $26,274 million in one year!

What happened? From a trade perspective, it appears as if Mexico’s international financialposition improved. Why else would there have been such a huge positive shift in Mexico's TradeBalance, Balance on Goods and Services, Balance on Goods, Services, and Income, and CurrentAccount? Were 1994 and 1995 years of significant improvements in Mexican productivity? Didoil prices increase, resulting in colossal Mexican export revenues? The answer to both of thesequestions is no.

By focusing on Mexico's Financial Account, the changes that took place in its Current Accountduring 1994 and 1995 can be more clearly explained. Between 1992 and 1993, Mexico was ableto run large Current Account deficits, because it was perceived as an acceptable internationalcredit risk. This acceptability diminished in 1994 and collapsed in 1995, when a series ofeconomic, business, financial, political, and social problems surfaced. International investorsbecame increasingly concerned about the safety and economic viability of Mexican investments.They responded by sharply curtailing new investments in Mexico and liquidating some of theirexisting investments there. Mexican residents also responded to the domestic turbulence anduncertainty by investing funds outside Mexico. In the end, Mexico's Current Account deficit fellsharply because net international loans vanished, and without such loans, the nation could nolonger live beyond its means.

What were the conditions in 1994 that caused Mexico's world to fall apart? Looking at theeconomic fundamentals, it is still not clear (See Exhibit 11). There were both positive andnegative signs, but even the negative signs were not that bad. Mexican inflation had fallen from27% in 1990 to just 7% in 1994. Over the same period, exports grew far in excess of real GDP.The exports were spurred, to a large extent, by the trade liberalization provisions of the recentlyconcluded NAFTA agreement,13 as is demonstrated by their 15% increase in 1994.

The philosophy of liberalization inherent in NAFTA also spilled over to domestic economicpolicies. In 1994, Mexico continued to promote competition and aggressively moved to privatizedomestic industries.14 On the fiscal side, government budget deficits, which had reached over10% of GDP in 1988,15 fell to 5% in 1989, progressively improved, and turned into small

13 NAFTA, the North American Free Trade Agreement, is an agreement among the US, Canada, and Mexico toeliminate the tariffs on most products over a ten-year period. The agreement also addresses the liberalization offinancial investments and services, as well as the protection of intellectual property. The terms of treaty were agreedupon in 1992, and the pact came into effect on January 1, 1994.14 Liberalization was not new to Mexico. During the administration of President Miguel De la Madrid Hurtado(1982-1988), Mexico adopted many market-based policies. This trend toward liberalization continued and gainedmomentum during the (1988-1994) administration of President Carlos Salinas de Gortari.15 Exhibit 11 does not show the 1988 figures.


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surpluses in 1992 and 1993. Though a budget deficit did reoccur in 1994, it was small in relationto Mexican GDP (i.e., only 0.8% of GDP). To put this deficit into some perspective, it was farlower than the average for all OECD nations and well below the 3% Maastricht criterion fornations joining the 1999 European Monetary Union.

Exhibit 11Mexican Economic Conditions

1989 – 1995

1989 1990 1991 1992 1993 1994 1995

Inflation (CPI) 20% 27% 23% 15% 10% 7% 35%

Export Growth 20% 33% 10% 7% 9% 15% 139%

Deficit (-) or Surplus(+)/GDP

-5.0% -2.8% -0.2% 1.5% 0.4% -0.8% -0.7%

Money Market Rates 47% 37% 24% 19% 17% 16% 50.52

Real GDP growth 3.3% 4.5% 3.6% 2.8% 0.7% 3.5% -7%

Current Account/GDP-0.9% -1.1% -2.1% -3.3% -3.1% -3.8% -0.1%

Source: International Monetary Fund, International Financial Statistics, January 1998, pp. 472-473.

One of the (perceived) negative aspects of Mexico’s 1994 economic position was the size of itsCurrent Account deficit, which had grown to about 4% of GDP and was raising questions aboutthe reliability of its financing sources. More importantly, real GDP growth was anemic and outof line with solid performances in other developing economies (e.g., the Asian Tiger nations). Itwas especially problematic in light of Mexico's skewed income distribution that left nearly 50million Mexicans below the poverty line.16 Slow growth meant real suffering and left little hopefor a significant segment of the population. The result was rising social unrest.

Political turmoil and social disorder added to Mexico’s problems in 1994. During the year, twopolitical luminaries (Mexican presidential candidate Luis Donaldo Colosio and Institutional

16 Compared to the US in 1991, Mexico’s per capita GDP was one-tenth as large, life expectancy was seven yearsshorter, and infant mortality four times higher. World Bank, World Development Report 1991 (New York: OxfordUniversity Press 1991).


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Revolutionary Party official Jose Francisco Ruiz Massieu) were assassinated. Formal allegationsof political corruption were leveled against high-ranking officials of the ruling party, and twohighly visible government officials (Special Investigator and Deputy Attorney General MarioRuiz Massieu and Interior Secretary Jorge Carpizo McGregor) resigned their posts. In addition,armed uprisings by Chiapas rebels added a new dimension to the real and perceived economicrisks facing international investors.

These economic, political, and social problems did not escape the attention of internationalinvestors, and the opinions of these investors were crucial for Mexico’s continued health andprosperity. Mexico was vulnerable not just because it was highly dependent on internationalcapital flows, but because the clear majority of these flows were in the form of portfolioinvestments and not direct investments. Exhibit 12 shows the composition of investments madeby foreigners in Mexico over the 1992 to 1994 period. Only about 20% of the total internationalinvestment flows to Mexico in 1992 and 12% of them in 1993 were in the form of directinvestments. The composition of Mexico’s Financial Account changed dramatically in 1994, butthe rise in direct investments to 51% of total capital flows was not a pure reflection of increasedconfidence in Mexico. It was caused just as much by the precipitous decline in portfolioinvestments (by -$20,737 million) as it was by the increase in foreign direct investments inMexico (by $6,584 million).

Exhibit 12Types of Foreign Investments in Mexico: 1992 - 1994

(Figures in millions of US dollars)

1992 1993 1994

Investment Categories Amount Percent Amount Percent Amount Percent

Foreign Direct Investments 4,393 20% 4,389 12% 10,973 51%

Portfolio Investments 18,041 84% 28,919 77% 8,182 38%

Other Investments -947 -4% 4,054 11% 2,302 11%

Total Investments in Mexico 21,487 100% 37,362 100% 21,457 100%


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Source: International Monetary Fund, International Financial Statistics, January 1998, pp. 472-473.

Direct investments are reassuring to nations, because they generally signal a degree of confidenceor permanence on the part of investors. Direct investments in plant and equipment are especiallycomforting because they aren’t going anywhere, and they aren’t sold quickly. Throughouthistory, only in the most extreme cases (like the Soviet Union after World War II) have foreignresidents dismantled and physically taken investments with them when they left.

In light of all the uncertainties surrounding the Mexican economy in 1994 and the increasinglikelihood that the peso might be depreciated, investors (both domestic and foreign) began toshun the Mexican capital markets. Attempts by the Bank of Mexico to support the peso in theforeign exchange markets depleted the nation’s international reserve assets from approximately$25 billion in January 1994 to about $12 billion on December 1, 199417. During December, theBank of Mexico lost an additional $6 billion of its official reserves and was forced to depreciatethe peso.

The year after the devaluation (1995), the Mexican economy seemed to go from bad to worse.Real GDP fell by nearly 7%, causing unemployment to rise. Consumer prices soared by almost35%. Real interest rates climbed steadily from 3% in the early 1990s to over 30% in 1995. Thecombined pressures of rising real interest rates, higher inflationary expectations, and wider riskpremiums forced Mexican nominal (money market) interest rates above 50%.

Devaluing the peso was controversial, and clearly not Mexico’s only alternative. There werevocal critics who felt that, in spite of some obvious short-term problems, the Mexican economywas relatively healthy, and devaluation was the wrong course of action.18 Some of themsuggested that a better policy would have been to employ restrictive monetary policies. Bysubstantially raising Mexican real interest rates, they felt the peso could have been defended.Citing the dismal economic conditions (i.e., falling real GDP, rising unemployment, high realinterest rates, and soaring inflation) that occurred in 1995 (the year after the devaluation), theyargued that virtually any other reasonable alternative would have produced better results.

7.0. A Framework for Understanding the Causes of and Cures for Disequilibria in theBalance on Goods and Services

Over the past decade, the United States has run persistent deficits in its Balance on Goods andServices while Japan has run enormous surpluses. How can a nation cure a chronic

17 December 1, 1994 was the day Ernesto Zedillo was inaugurated as President of Mexico.18 Robert L. Bartley, “Mexico: Suffering the Conventional Wisdom,” The Wall Street Journal, February 8, 1995,p. 15.


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disequilibrium in its balance of payments?

Much political attention has been paid to the cost and benefits of protectionism (e.g., tariffs andquotas) and creating a "level playing field" by requiring foreign nations to reduce either their traderestrictions or trade subsidies. Tariffs, quotas, and subsidies may play major roles in determiningthe flow of international transactions, but let's put these remedies into a broader perspective --one in which these suggested remedies and others (e.g., that the government should balance itsbudget) can be considered.

Our approach will be to draw on some basic principles of national income accounting. Recall thatgross domestic product is the market value of all final goods and services produced by a nationover a given period of time. There are two equally valid and fruitful ways of dividing GDP forfurther analysis. On one hand, GDP can be divided into four major categories of aggregatedemand: personal consumption expenditures (C), business investment expenditures (I),government expenditures (G), and the Balance on Goods and Services (NE). (See Condition 1.)

GDP = C + I + G + NE

Condition 1

Alternatively, GDP can be viewed from the income side of the national income accounts. Forevery product or service produced, some resource has to be paid to produce it. When funds arespent on labor, capital, land, or entrepreneurs, what options do the owners of these resourceshave with their incomes? The answer is that they can use the funds for personal consumptionexpenditures (C), personal saving (S), and/or taxes (T). (See Condition 2.)

GDP = C + S + T

Condition 2


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Combining Conditions 1 and 2, we see that:

C + I + G + NE = GDP = C + S + T

or

C + I + G + NE = C + S + T

Condition 3

Canceling like terms and rearranging the elements in Condition 3 produces the result inCondition 4.

NE = ( S - I ) + ( T - G )

Condition 4

In plain English, Condition 4 implies the net Balance on Goods and Services (NE) is dependenton a nation’s saving/investment rate (S - I) and net national, state and local governments’surplus/deficit (T - G) -- See Condition 5.

Balance on Goods & Services = Net Private Saving/Investment + Gov’t Surplus/Deficit

Condition 5

Focusing on Condition 5, it should be clear that if a nation wanted its Balance on Goods andServices to become positive (or less negative), it would have to increase the sum of net privatesaving and the government surplus. With the private sector investing more than it saves (i.e.,negative net private saving) and the government spending more than it earns in taxes (i.e.,government deficits), there is no way for the Balance on Goods and Services to be in surplus. Inthe absence of economic growth, creating a surplus in the Balance on Goods and Services wouldmean finding ways to restrain government spending, increase tax revenues, reduce businessinvestment expenditures, and/or increase saving (i.e., decrease consumption expenditures). All ofthese policies are problematic, because they would have contractionary effects on a nation’saggregate demand and could lead to an economic recession.


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Turning a balance of payments deficit into a surplus (or lowering a balance of payments deficit)is easier in a climate of economic growth, because there is no longer a zero-sum outcome. Withgrowth, the components of aggregate demand (i.e., personal consumption, business investments,and government spending) only have to be restrained from rising as fast as GDP. They don’thave to be cut.

It is important to notice that Condition 5 makes no specific mention of tariffs, quotas, andsubsidies, which are the policies most people think of when balance of payments difficultiesarise. Their omission is revealing, because Condition 5 implies that the Balance on Goods andServices will become positive only if these protectionist measures, in some way, raise the sum ofnet private saving plus the government surplus to a positive value.

A simple example can illustrate how powerful an understanding of Condition 5 can be. Supposeyou were in Venezuela while it was experiencing severe economic turmoil stemming from hugeinternational payment deficits. Focusing on Venezuela’s Balance on Goods and Services, afriend of yours argues that tariffs on imported goods would reduce the size of Venezuela’sdeficit. She claims that these restrictions would make foreign goods and services more expensiverelative to Venezuelan products and would therefore redirect Venezuelan demand toward the localmarket.

This line of reasoning sounds logical, but let's delve a bit deeper. For instance, how would sherespond if you were to say "I agree that Venezuelan goods and services would become relativelymore attractive as a result of the tariff, but if foreigners are selling fewer products in Venezuela,won't their incomes fall? And if their incomes fall, won’t their demand for Venezuelan goods andservices fall as well? Is it possible that the benefits derived from having tariffs reduce Venezuelanimports might be totally offset by the reduced demand for Venezuelan exports when foreignincomes fall?" Your friend might be up against the ropes with that line of reasoning, because italso seems logical.

Suppose that someone else contributed to the discussion by saying to your friend "I, too,understand your point regarding tariffs, but if Venezuela bought less from foreign nations,wouldn't the Venezuelan demand for foreign currencies decrease? If the demand for foreigncurrencies fell, wouldn't that cause their international values to decline? And if foreign currenciesfell in value, wouldn't that stimulate Venezuelan demand for foreign products? In other words, isit possible that the reduction in Venezuelan imports due to the tariffs might be totally offset byan increase in Venezuelan imports due to the lower valued foreign currencies?" Again, anexcellent point has been made. Your friend might, once more, be fighting for a response.

It seems so simple to say that an increase in a nation’s average tariff rate will improve its Balanceon Goods and Services because imports will be discouraged, but when you begin to trace all therepercussions of the tariffs, this conclusion is not self-evident. The problem is that the core ofyour friend's analysis uses only one cause and one effect rather than a broader framework foranalyzing the issue. People in the same position as your friend soon realize that they are beingyanked from side to side by anyone with a relevant insight. Without the proper framework, the


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effects of tariffs are difficult to conceptualize. It is for this major reason that Condition 5 is soimportant. It provides us with a broader framework for conceptualizing this issue.

Condition 5 indicates that no form of protectionism can be effective at producing a positiveBalance on Goods and Services, unless it makes the sum of net private saving plus the netgovernment surplus positive. Tariffs may have this effect. For instance, they might discouragesome forms of consumption and thereby encourage saving. In addition, tariff revenues mightreduce the government budget deficit or add to the government budget surplus, but note howdifferent the content of this line of reasoning is from the normal line used by your tariff-advocating friend.

Condition 5 gives some interesting additional insights into how a nation might reduce a deficit inits Balance on Goods and Services. For instance, everything else remaining the same, if thenational government provided saving incentives to its residents, such policies would tend tocreate a more positive Balance on Goods and Services. A greater saving rate would lowerconsumption, and if a nation consumed fewer of the goods and services it produced, more ofthem might be available for international exportation.

Using this reasoning, government proposals, such as tax deductions on retirement savingaccounts, a value-added tax (i.e., a tax imposed on an individual's consumption rather than onincome), and tax breaks on college savings accounts, may make sense not only in their own right,but also as a means of reducing a nation’s international payment deficits. In how manydiscussions of international trade problems have you ever heard these solutions recommended?

You might be asking “If the answer to the international deficit problem is so simple, why haven'tnations solved it long ago?” The problem is not that we lack solutions, but rather that thesolutions may be painful and involve tradeoffs among hard choices. Moreover, with everysolution comes new problems, and sometimes these new problems are worse than the old ones.Finally, superimposed on all these decisions is the web of vested interest groups (e.g., unions andlobbies) and political logrolling deals that can play significant roles in our political process. Thisadded political dimension serves to complicate already difficult economic decisions.

For instance, take the suggestion that the United States introduce a value added tax. Such a taxwould discourage consumption (encourage saving) and, by raising tax revenues, might reduce thesize of the budget deficit (or increase the size of the budget surplus). Therefore, it would have adouble-barreled positive effect on the Balance on Goods and Services. But what impact wouldsuch taxes have on public incentives to work? Might they be discouraged? How would youanswer critics who say that government spending should be cut before a single penny more ispaid in taxes? How could you ensure that the taxes would be fair and didn't raise the cost ofliving disproportionately for low-income earners? Any intelligent change in policy shouldaddress a multitude of possible economic effects before it is passed, and only when a majority ofthe vested interest groups are satisfied can reform be made.

7.1. What the International Condition Does Not Say


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Condition 5 does not say that any country with a budget surplus will necessarily have a surplusin its Balance on Goods and Services. Neither does it say that any country with a surplus in itsBalance on Goods and Services must have a budget surplus. From 1989 to 1996 (just before theAsian Tiger crisis), Thailand ran persistent government budget surpluses at the same time that itwas experiencing deficits in its Balance on Goods and Services. Similarly, between 1998 and2001, the US had budget surpluses, but deficits in its Balance on Goods and Services. Bycontrast, in 1989, 1990, and 1993, Japan had budget deficits but surpluses in its Balance onGoods and Services. For years, Switzerland has had government budget deficits but surpluses inits Balance on Goods and Services.19

The cause of the different international positions can be traced to the disparities in these nations'net private saving/investment and net government surplus/deficit. Japan and Switzerland hadsurpluses in their Balance on Goods and Services, because their net private saving exceeded theirgovernment budget deficits. Similarly, the US and Britain had deficits in their Balance on Goodsand Services, because their negative net private saving more than offset their budget surpluses orreinforced their budget deficits.

19 IMF, International Financial Statistics, January 2003.

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THE BALANCE OF PAYMENTS - faculty.babson.edufaculty.babson.edu/ricciardi/MMS/BoP2003.pdf · The Balance of Payments 1.0. Introduction Since World War II, international trade flows