Does the “current account deficit” matter? Part II
January 22, 2006
Previously, we talked a bit about the “current account deficit.” To refresh, an economic entity can have a “current account deficit” or a “current account surplus,” which, in the accounting terms used for individual entities, is analogous to “generating cash” or “consuming cash.” Neither is a good or bad thing in all situations. While it may seem that “generating cash” is a good thing, there are many “activist” investors who are now pressuring corporate managements to “consume” their cash in more productive ways! Indeed, high cash consumption is often a sign of a plethora of investment opportunities, and thus of general good times.
That said, there is no “economy” besides the activities of these economic entities, which we broadly categorized as households, corporations and governments. An “economic entity” is my term for an entity that is legally recognized to operate as an economic unit, and has its own, unified assets and liabilities, inflows and outflows, as represented for example in financial statements. This in turn is defined by the legal status of ownership and obligation. Assets are that which one owns; liabilities are obligations. Inflows involve taking possession, and outflows involve relinquishing possession. Given that one could have a lively debate (of the sort that goes on every day in boardrooms) about whether a single economic entity should generate or consume cash, once again consider the absurdity of trying to come to a meaningful conclusion about whether the imaginary statistical abstraction known as a “country” should, in aggregate, generate or consume cash! All that one can really conclude is that, if a borrower decides to borrow, and a lender decides to lend, then they do so because they see mutual benefit in that arrangement. A “current account deficit” is merely a situation in which the total amount of cash generated by those entities, within a statistical area like a “country”, is less than the total amount of cash consumed by those entities which choose to be cash-consumers. A “current account surplus” is the opposite condition.
I am painting a picture here of what the world economy (there is only one economy) actually consists of, which is kazillions of economic entities, as opposed to the metaphor you read about in the newspaper of this or that “national economy” connected by some weird plumbing of “international finance” with other “national economies.” Each economic entity may choose to operate on the basis of a certain currency, which is provided by governments or government-sanctioned institutions such as central banks (at the present time, though this was not the case in the past), or an entity may operate on the basis of several currencies, as is common with corporations and governments, and many households as well.
“Current accounts” are, as noted, typically given for aggregates of individual entities. One can think of many groups for which one can aggregate current account information. California dentists have a current account surplus of $2.5 billion, while divorced real estate agents living in New York City have a deficit of $1.75 billion. Latinos in Los Angeles have a current account surplus of $5 billion, but Latinos in Florida have a deficit of $2 billion. It may seem frivolous to denote the “current account balance” for Latinos living in Los Angeles, a group of perhaps 4 million people or so, but is it no less frivolous to denote the “current account balance” of the 1.4 million Estonians living in Estonia? What about Estonians that aren’t living in Estonia?
It can be observed that, among entities sharing the same currency and general legal jurisdiction, such “current account balances” are largely meaningless. Certainly Connecticut has such a balance, as does Massachusetts. Official record may even be kept somewhere, although I’ve never seen them. That’s because I’ve never looked for them, because they are irrelevant. This is interesting: we don’t pay any attention to the current account balance of California, for example, even though, if it was a separate country, California would be one of the ten largest countries in the world in terms of GDP.
That said, it is true that the effects of certain trends appear in the current account information, and thus, to the extent that a trend may portend something unfortunate, one can say that the current account information portends something unfortunate. For example, governments are often big borrowers, i.e., consumers of cash, and thus a country whose government consumes a lot of cash will often tend to consume cash on an aggregate basis, or in other words, run a “current account deficit.” Since governments today spend vast amounts of resources for little or no gain whatsoever, financing such expenditures with debt constitute “bad debt” (as described last week). When governments are deeply in debt, or are running large budget deficits, they tend to do things which are bad for all those living and operating within their jurisdiction, such as raising taxes and playing games with the currency.
Likewise, the main generators of cash in any economy tend to be households. Since, as noted, “bad debt” is the rule rather than the exception with regard to household debt (the exception being debt used to finance the purchase of reasonably priced shelter, or to engage in cash-generating investments) low or no cash generation by households may indicate the accumulation of large amounts of “bad debt” or a low level of liquid assets in general. This also contributes to a “current account deficit” on a country aggregate level. While we noted earlier that, on the personal level, your neighbor’s financial problems do not affect you very much, when enough people do the same thing that it shows up on the country-level aggregates such as the “current accounts”, it may result in an economic event such as a recession that certainly does affect you.
Corporations mostly engage in “good debt,” with the amount of debt they take on often related to the economic opportunities available. This “cash draw” also influences the aggregate current accounts, but may indicate positive conditions.
To make a long story short(er), “current accounts” begin to become meaningful when they describe transactions that take place between parties whose accounts are based on different currencies. Typically these entities are located (or affiliated) with different countries, and thus the aggregate country current account describes the amount of “cross border” (actually cross-currency) contracts being created. Now this is the crux of the matter, for as noted previously, net capital flows between countries create long-term relationships, which simple trade does not. This relationship can be distorted in some pretty awful ways by changes in currency value.
In no way does international investment (i.e. “current account imbalances”) inherently cause changes in currency value. This is easy to see in the case of different countries that use the same currency, such as the dollarized countries of Latin America or the countries of the eurozone. No matter how big the “current account imbalance” becomes between France and Germany, the euro is not going to shatter into two separate currencies because of it, any more than the “current account imbalance” between Arizona and New Mexico, or El Salvador or Ecuador, is going to cause the dollar bills in people’s pockets to burst into confetti. The problem is, when currency values change for some other reason, there can be a lot of people that get into big trouble if they have lots of contracts denominated in foreign currencies. Indeed, in the process of getting into trouble, within today’s chaotic environment of floating currencies, the problem can become even more exacerbated. That is a second risk between such cross-currency interaction: when more and more people are affected by a move in currencies (and there are always moves in currencies in today’s floating world), there is a greater and greater likelihood that many people experiencing the same stimulus will react in a similar fashion, causing a “stampede” of one sort or another and generally making the situation more unstable.
This is not the fault of cross-currency investing (“current account imbalances”) per se, but the fault of incompetent central banks that are not willing or able to manage their currencies in a prudent manner.
Conclusion: A “current account imbalance” does not inherently cause economies to implode or currencies to collapse. The U.S. ran a “current account deficit” for well over a hundred years, every year, from the colonial era to World War I, as European capital flowed into the New World. The dollar was on a gold standard for nearly all of the 19th century, and the economy flourished. Today, the “current account deficit” is a reflection of wasteful government spending, financed by debt, and a housing/consumer boom, also financed by debt. These may cause problems later, although not because of the “current account deficit.” There is some risk, however, that because so many people outside the United States now hold dollar-denominated paper, and are thus exposed to the same stimulus of foreign exchange rates, that they may all decide to do the same thing at the same time. Even this would not be a problem if the Fed was a competent manager of currencies, but it is not, and that, not “current account imbalances,” is likely to be the root cause of any economic instabilities going forward.