CURRENT ACCOUNT The current account is defined as including the value of trade in merchan-

dise, services, investment income, and unilateral transfers. Merchandise is the obvious trade in tangible commodities. The services category refers to trade in the services of factors of production: land, labor, and capital. Included in this category are travel and tourism, royalties, transportation costs, and insurance premiums. The payment for the services of physical capital, or the return on investments, is recorded in the investment income account. The amounts of interest and dividends paid internation- ally are large and are growing rapidly as the world financial markets become more integrated.

The final component of the balance of payments includes unilateral transfers, for example U.S. foreign aid, gifts, and retirement pensions. The United States records a large deficit on these items, except for 1991 when several foreign countries transferred large sums of money to the United States to help pay for the expense of the war in the Mideast.

Figure 3.2 illustrates how the current account has changed over time. The current account is shown as a fraction of GDP, because of inflation and the growth of the U.S. economy over the time period. The current account deficit growth of the 1980s was unprecedented at the time, but has since been dwarfed by the deficits of recent years. The current account deficit peaked in 2005 2006 with the current account fraction of GDP exceeding 6 percent.

Returning to Figure 3.1 , line 72 shows that there was a current account surplus of $2,824 million in 1960 and a deficit of $470,898 million in 2010. The $471 billion current account deficit of 2010 is the

The Balance of Payments 63

1960-01-01 1961-04-01 1962-07-01 1963-10-01 1965-01-01 1966-04-01 1967-07-01 1968-10-01 1970-01-01 1971-04-01 1972-07-01

1973-10-01

1975-01-01

1976-04-01

1977-07-01

1978-10-01

1980-01-01

1981-04-01

1982-07-01

1983-10-01

1985-01-01

1986-04-01

1987-07-01

1988-10-01

1990-01-01

1991-04-01

1992-07-01

1993-10-01 1995-01-01 1996-04-01 1997-07-01 1998-10-01 2000-01-01 2001-04-01 2002-07-01 2003-10-01 2005-01-01 2006-04-01 2007-07-01 2008-10-01

Figure 3.2 Current account as a fraction of GDP; 1960 2009.

investments have had sizable surpluses so that the current account realized

a surplus in the periods from 1973 to 1976 and from 1980 to 1981. The balance of payments in Figure 3.1 actually ends at line 69. Lines 70 to 72 are summaries drawn from lines 1 to 68. The summaries come from drawing lines in the balance of payments at different places. A line is drawn in the balance of payments schedule and then the debit and credit items above such a line are summed. For example, if we draw a line at the current account balance items ending with unilateral transfers (line 35) and sum all credit and debit entries above, this would give us the current account surplus/deficit. For 2010 we would sum the exports (2,500,817 million dollars) with the imports (22,835,620 million dollars) and the unilateral transfers (2136,095 million dollars). The sum equals 2470,898 million dollars, which is also shown in line 72. Note also that all the entries below line 38 account for financing the merchandise, services, investment income, and unilateral transfers (gifts); thus, the current account indicates whether a country is a net borrower from, or lender to, the rest of the world. A current account deficit implies that a country is running a net

64 International Money and Finance

financial activity (below the line) as well as the value of trade in merchandise, services, and unilateral transfers that are recorded above the line. In a period (year or quarter) during which a current account deficit is recorded, the country must borrow from abroad an amount sufficient to finance the deficit.

FAQ: How big is the U.S. current account deficit compared to other countries? The U.S. current account deficit is the largest in the world in absolute size.

However, the dollar amount of the current account deficit can be deceiving, because the U.S. is the largest economy in the world. A better comparison is to compare the size of the current account deficit/surplus to a country’s GDP. By doing this we put the deficit in comparable terms across countries. The following table shows the current account deficit/surplus for selected countries in 2010. The table shows that the U.S. does not have the largest current account deficit as a fraction of GDP. The countries with serious current account problems are: Greece, Portugal and Iceland. All of those countries have already had to ask for help from the IMF. In contrast, some countries have very large surpluses. Both Norway and Switzerland have current account surpluses that exceed 10% of their GDP.

Country Current Account (as a percentage of GDP) Greece

United States

United Kingdom

France

Mexico

Korea

The Balance of Payments 65

Source: Data are from International Monetary Fund and Eurostat as compiled by tradingeconomics.com , January 2011.

Since the balance of payments always balances, the massive current account deficits of recent years are matched by massive capital account surpluses. This means that foreign investment in U.S. securities has been at very high levels. Some analysts have expressed concern over the growing foreign indebtedness of the United States. The next section reviews the issue.

FINANCING THE CURRENT ACCOUNT Large current account deficits imply large capital account surpluses. The

capital account transactions are recorded below the current account items in the balance of payments. Referring back to Figure 3.1 , lines 40 through 68 record capital account transactions. We see that capital account transactions include both official and private transactions. For ease of understanding, Table 3.1 provides a summary of U.S. capital account transactions since 1960. In this table, the debit and credit items are entered separately so that we can identify the sources of changes in net capital flows (capital inflows less capital outflows). For instance, in 2010 we see that U.S. private security purchases abroad totaled $151,916 million (line 51 in Figure 3.1). This is a capital account debit entry because it involves foreign exchange leaving the United States. Private security purchases in the United States by foreigners totaled $376,881 million in 2010 (lines 65 and 66 in Figure 3.1). This is a credit item in the capital account since it brings foreign exchange to the United States. We can interpret the other capital account items in a similar manner.

Before interpreting the recent history of U.S. international capital flows, we should consider the definitions of the individual capital account items.

Table 3.1 U.S. Capital Account Transactions (capital flows, in millions of dollars) Year Direct

Foreign investment

Bank claims Bank

U.S.

government official assets abroad

investment purchases

purchases in on

liabilities to

assets abroad in U.S. 1960

in U.S.

abroad

U.S.

foreigners

The Balance of Payments 67

government obligations, and foreign commercial and finance paper; liabilities include deposits, certificates of deposit, liabilities to affiliated foreign banks, and other liabilities. U.S. government assets abroad: Changes in U.S. official reserve assets (gold, SDRs, foreign currency holdings, and reserve position in the IMF). Foreign official assets in the United States: Net purchases of U.S. government securities, obligations of U.S. government corporations and agencies, securities of U.S. state and local governments, and changes in liabilities to foreign official agencies reported by U.S. banks. Some capital account transactions are a direct result of trade in

merchandise and services. For instance, many goods are sold using trade credit. The exporter allows the importer a period of time—typically 30,

60, or 90 days—before payment is due. This sort of financing will gener- ally be reflected in bank claims and liabilities, because such transactions are handled by the exporter’s bank. Other capital account items are a result of portfolio management by international investors. Security purchases would fall in this category. Official transactions involve governments and are motivated by a host of economic and political considerations.

The recent capital account transactions are very interesting from an economic viewpoint. In general, one can see that globalization is evident in the sharp increases in the overall size of the transactions. Direct investment in the U.S. and abroad has increased tremendously as compared to the level of the 1970s and 1980s. Note also that even throughout the recent banking crisis, the direct investment continued. In most years the U.S. direct investment abroad has exceeded the direct investment by foreigners in the U.S. However, the security purchases tell a different story. In the 2000s, the foreign purchases of U.S. securities have far out- weighed the U.S. purchases of foreign securities. Similarly, the foreign official purchases of U.S. assets far outpace the U.S. government’s purchases of foreign assets. Thus, the foreigners seem to buy securities whereas the U.S. focuses on direct investment.

Table 3.1 also provides an interesting account of the U.S. financial

68 International Money and Finance

in the U.S. In 2008 this source of funds completely disappeared from foreign private sources, with only official purchases remaining. However, U. S. purchases abroad also became negative, indicating that U.S. investors sold foreign securities to bring home almost $200 billion in liquidity. Similarly, both U.S. and foreign international investors sold bank assets, with both entries taking on negative values. By 2010, the unusual negative values disappeared and the international accounts are once again looking like they did in the mid-2000s.

CURRENT ACCOUNT The current account is defined as including the value of trade in merchan-