Knowledge of the balance of payments is all that is needed for analysis of the economic forces that automatically are set in motion whenever there is a disequilibrium in the international sector of the economy. Often, however, analysts are interested in the source of any disequilibrium in the international sector, that is, the relative contributions to an equilibrium position of the various components of the demand for and supply of dollars on the foreign exchange market. Consequently, the balance of payments is broken down into several subsidiary measures, which together are referred to as the international accounts or the balance of payments accounts.

At the most general level, the balance of payments is broken into two accounts, the current and capital accounts, as shown in table 15.1.

The current account measures the difference between the demand for and the supply of dollars arising from transactions that affect the current level of income here and abroad. It has three components:

1. The trade balance, or balance on goods and services, which is the sum of the following:

a. The merchandise trade balance, the difference between exports and imports of goods (e.g., wheat and automobiles).

b. The services trade balance, the difference between exports and imports of services (e.g., insurance premiums, transportation, and tourism).

2. Net investment income from abroad, such as interest and dividend payments.

3. Net transfers from abroad, such as gifts, pension payments, and foreign aid.

Typically, the United States has a deficit on merchandise trade—it imports more goods than it exports—but a surplus on service trade—it exports more services than it imports. Overall, the U.S. balance of trade is usually in deficit.

In the late 1980s the United States became an international debtor and began sending substantial interest payments abroad each year. Consequently, recent annual U.S. net investment payments have typically been in deficit. Net transfer payments also are typically in deficit because the United States sends more humanitarian and military aid abroad than it receives. An exception occurred in 1991 when other countries transferred funds to the United States to pay their share of the U.S. military operation against Iraq.

Because the trade balance is large and volatile relative to net factor payments and net transfers, the trade balance is the prime determinant of the current account and for this reason is the focus of attention in the popular press. In recent years the trade balance and the current account have been in deficit. A deficit on the current account is typically offset by a surplus on the capital account.

The capital account measures the difference between the demand for and the supply of dollars arising from sales or purchases of assets to or from foreigners. When a Canadian buys a U.S. bond, for example, a demand for U.S. dollars is created. The capital account measures capital flows between a country and the rest of the world. A capital account surplus measures a net capital inflow, and a capital account deficit measures a net capital outflow.

When added together, the current and capital accounts produce the balance of payments. In an accounting sense, because the demand for and supply of dollars on the foreign exchange market must balance, a nonzero balance of payments must be matched by changes in government holdings of foreign exchange reserves.

Balance of payments surpluses and deficits arise from changes in the supply of and demand for our dollar on the foreign exchange market. Several variables affect supply and demand activity in this market:

1. Exchange rate. The price or value of our dollar in terms of foreign exchange, called the exchange rate, is determined in the foreign exchange market. If, for example, a dollar can buy five French francs, the exchange rate is five francs per dollar. A balance of payments surplus means that demand for our dollar on the foreign exchange market exceeds its supply, so the price of the dollar (the exchange rate) will be bid up, say to six francs per dollar. The dollar is now more valuable; it buys six instead of five francs. This stronger dollar makes imports cheaper for U.S. citizens, so imports increase—thus increasing the supply of dollars on the foreign exchange market. Similarly, our exports are more expensive to foreigners so exports fall, decreasing the demand for dollars on the foreign exchange market. In this way, the rise in the exchange rate eliminates the balance of payments surplus. The opposite occurs when we have a balance of payments deficit: the exchange rate falls to eliminate the deficit.

2. Income. At a higher level of income, we import more. As a result, our supply of dollars on the foreign exchange market increases, creating a balance of payments deficit and downward pressure on the exchange rate. Note that this result assumes that our rise in income is unique to us; it is not part of a worldwide boom. If other countries’ incomes are increasing at the same time, then our exports should also increase, making uncertain the net effect on our balance of payments and exchange rate.

3. Interest rate. When our interest rate is higher, foreigners are more interested in buying our financial assets, so they demand more of our dollars on the foreign exchange market. This demand creates capital inflows, a balance of payments surplus, and upward pressure on the exchange rate. Two caveats concerning capital inflows are important. First, the result depends on the interest rate increase not being part of a worldwide pattern. If interest rates throughout the world rise, the fact that our interest rate is higher should not entice foreigr ers to switch to our bonds. Second, the relevant difference in interest rates is the difference in real interest rates, not nominal interest rates; investors are concerned with real returns. For more on this topic, see chapter 18.

4. Price level. A rise in our price level increases the price of our exports and the price of import-competing goods and services, so our exports fall and our imports rise. As a result, the demand for our dollars decreases, and the supply of our dollars increases, creating a balance of payments deficit and downward pressure on the exchange rate. Again, such effects occur only if there is no equivalent price increase in the rest of the world.

5. Expectations. If foreigners expect the value of the dollar to rise, they can reap a capital gain by buying our bonds and then selling them again after the exchange rate has risen. This speculation creates an inflow of capital, a balance of payments surplus, and upward pressure on the exchange rate. Such speculative funds are available in large amounts and can be moved very quickly from one currency to another. Indeed, speculative activity is the primary determinant of exchange rates in the short run. Daily volume on the foreign exchange market is about $1 trillion, the bulk of which is speculative.

To summarize, several factors influence activity in the foreign exchange market. The balance of payments summarizes this activity, telling us whether the market is in disequilibrium, in what direction, and by how much, allowing us to predict economic forces for change.

If the borrowing is domestic, then we owe the debt to ourselves, and it seems that overall there is no intergenerational burden. This reasoning is misleading, however. Domestic borrowing to finance a deficit crowds out some investment spending. If the deficit spending is on capital assets such as roads and airports, it is possible that the capital stock passed on to the future generation is of more value than the investment spending that is crowded out.

However, if the deficit spending is on things other than capital assets, such as Medicare and unemployment insurance, then the future generation will receive a smaller capital stock. If the economy is at full employment, more crowding out occurs, increasing the likelihood that future generations will be made worse off. The key feature, however, is the nature of the deficit spending. If the deficit spending is on consumption items rather than investment items, the present generation is “living it up” at the expense of a future generation that will receive a smaller capital stock.

One implication of financing a budget deficit by selling bonds to the public is that as the budget deficit continues, the national debt grows. How worried should we be about this growing debt? Although there is no unique answer to this question, there is some consensus that we should worry about a budget deficit only if its size is such as to cause a long-run rise in the ratio of the publicly held national debt to nominal GDP. This ratio is a crude measure of our capacity to service the national debt, and if it continues to grow, at some stage the economy will not have enough GDP to be able to service the debt, so a major crisis will ensue.

The structural deficit is the part of the current budget that in the long run increases the ratio of the publicly held national debt to nominal GDP. Three adjustments must be made to the current budget deficit to calculate the structural deficit:

1. A correction is needed for cyclical effects that hinder the current deficit’s ability to reflect any long-run trend accurately. For example, if GDP drops below its long-run trend average by $100, it is estimated that tax receipts fall by $25 and government spending on transfers increases by $8, so that $33 of the deficit does not correspond to long-run behavior. It should be noted that there is not a universal definition of the structural deficit. Some textbooks define it as involving only this cyclical adjustment.

2. A correction is needed for real growth and inflation because if nominal GDP is growing the publicly held debt can grow without affecting their ratio.

3. A correction is needed for seigniorage. Each year, an increase in the money supply is required to accommodate money demand increases, allowing the government to finance some of its deficit by printing money. This financing does not affect the publicly held debt.

The best way to explain these corrections is by means of an explicit example. Consider an economy with a 2 percent real rate of growth, a 4 percent inflation rate, 9 percent unemployment, a money supply of $500 billion, a publicly held national debt of $400 billion, a current budget deficit of $43 billion, a money multiplier of 5, and a 7 percent long-run average unemployment rate. The economy’s tax and unemployment compensation systems are such that a one percentage point change in unemployment changes the budget deficit position by $4 billion.

1. Correction for cyclical effects. The economy is currently experiencing an unemployment rate greater than its long-run average, so part of the current deficit does not reflect the long-run contribution of the deficit to the national debt. In this case, the extra deficit is $8 billion, calculated as $4 billion times the two percentage points by which current unemployment exceeds its long-run average. Note that this long-run average is not the NRU. The economy spends more time above its NRU than below, so the long-run average unemployment rate for this calculation is greater than the NRU.

2. Correction for nominal growth. Nominal GDP—the denominator of the ratio of the publicly held debt to GDP—is growing, so the numerator can grow at the same rate without increasing this ratio. In this case, GDP is growing in nominal terms by 6 percent, calculated by adding the real growth rate and the inflation rate. Six percent of the numerator is $24 billion, so this much of the current deficit does not contribute to raising the debt/GDP ratio. Note that this calculation implicitly builds in a correction for inflation decreasing the real value of the debt.

3. Correction for seigniorage. Each year the central bank increases the money supply to accommodate the economy’s nominal growth. This increase allows some of the deficit to be financed by selling bonds to the central bank (printing money) rather than to the public. These bond sales do not affect the publicly held debt and thus do not affect the ratio of the publicly held debt to GDP. In this case, the central bank will be increasing the money supply by 6 percent (2 percent for the real growth, plus 4 percent to sustain the inflation) which equals $30 billion. Because the money multiplier is 5, the increase is accomplished by buying $6 billion of bonds. Note that there is a further correction for inflation inherent in this calculation.

What these numbers mean is that the current deficit would have to be more than $38 billion before it would cause the ratio of the publicly held debt to GDP to rise in the long run.

Before the Great Depression of the 1930s, government spending was less than 5 percent of GDP. Introduction of the “New Deal” during the depression doubled this percentage, and since then it has increased to between 20 and 25 percent of GDP, a range in which it has hovered since the mid-1970s. About 46 percent of the federal government’s revenue comes from individual income taxes, about 12 percent from corporate income taxes, about 5 percent from sales taxes, and about 37 percent from Social Security payroll taxes, accounting in 1998 for over 1.8 trillion dollars of tax receipts. About 17 percent of the government budget is spent on defense, about 22 percent on Social Security, about 10 percent on Medicare, about 6 percent on Medicaid, and about 13 percent on interest payments on the national debt. Other areas of expenditure are much smaller: welfare and foreign aid, for example, are together less than 3 percent of total government spending.

When government spending exceeds tax revenues, there is a government budget deficit, which is financed by selling bonds. The sum of all outstanding government bonds is called the national debt, which grows each year by the amount of the budget deficit. (It would shrink if there were a budget surplus.) Some bonds are sold to the central bank, an agent of the government, so this part of the national debt the government owes to itself; consequently, nobody worries about it. The remaining bonds are sold to the public, augmenting the publicly held national debt. Until the remarkable expansion of the late 1990s increased tax revenues markedly, growth in this debt was of concern.

An important legacy of Keynes is that budget deficits became respectable side effects of efforts to keep an economy operating at full employment. Keynes’s intention was that deficits required to stimulate the economy when it is in recession would be offset by budget surpluses in times of full employment–ensuring that in the long run the national debt would not continually grow.

History has not treated the Keynes legacy kindly. Once initial fears of budget deficits were overcome, politicians went overboard, producing deficits in both good times and bad. In the 1960s the federal budget deficit was less than 1 percent of GDP; in the 1970s this jumped to over 2 percent; and in the 1980s and 1990s, before dropping precipitously, it ballooned to over 4 percent, topping out at 290 billion dollars in 1992. Three main culprits were responsible for the growing deficit:

1. Tax decreases. The ratio of tax revenue to GDP is about 30 percent in the United States, the lowest of all OECD countries. Canada’s ratio is about 40 percent, and Sweden’s is about 50 percent.

2. Growing entitlement expenditures. Social Security and Medicare expenditures cannot easily be controlled because anyone eligible is entitled to coverage. As our population ages, spending in these two categories continually increases, with politicians refusing to increase taxes to pay for it.

3. Higher interest payments. Because of higher interest rates and a higher national debt, interest payments as a fraction of government spending have jumped from about 9 percent to about 13 percent. Recent decreases in interest rates have alleviated this burden considerably.

Because each year a dollar of budget deficit increases the national debt by a dollar, deficits have caused growth in the national debt that has many worried about our future. Even though the budget position moved into surplus in the late 1990s (the 1998 surplus of $69 billion was the first surplus since 1969), this issue remains a fundamental policy concern.

Budget deficits carry both costs and benefits for the economy. Any assessment of their desirability must weigh these costs and benefits carefully.

1. Lower unemployment. Allowing budget deficits permits Keynesian fiscal policy (as described in chapter 4) to keep the economy closer to full employment than might otherwise be the case. Movements into recession are automatically dampened if recession-induced decreases in tax revenues and increases in unemployment insurance payments are permitted to create a deficit. Output lost as a result of unemployment above its natural rate can be substantial and is output lost forever. Furthermore, the human cost of unemployment is considerable by any measure.

2. Public investment. Allowing budget deficits permits the government to borrow to invest in projects that have a high social payoff, such as education or infrastructure. This borrowing is similar to a private corporation borrowing to invest in a project whose payoff is expected to be high enough to pay back the loan with interest.

3. Lower national saving. A deficit requires that the government bid up the interest rate to obtain financing for its deficit, crowding out private financing needs, prominent among which are private investment projects. This crowding out inhibits long-run growth directly by constraining growth in the capital stock, and indirectly by lowering productivity growth. (Chapter 6 discussed how budget deficits reduce national saving.)

4. International implications. Higher interest rates attract foreign investors. To buy our bonds foreigners must first obtain our dollars. This increase in the demand for our dollar increases its value, making our exports expensive to foreigners and their goods cheap to us, as well as making life difficult for exporters and those competing against importers. Furthermore, the associated buildup of foreign ownership of our assets implies that more future income must be sent abroad in the form of interest and dividends. (The international dimension of the budget deficit issue is discussed further in chapter 15.)

5. Debt monetization. Budget deficits create a danger that government will choose to finance them by monetizing them—by printing money—and thereby create inflation. This danger is not high in countries such as the United States that have a central bank quite independent of politicians.

6. Growing national debt. Continued budget deficits increase the national debt. A growing national debt has several important implications:

a. A growing national debt means growing interest payments on that national debt. Over time, the interest payments may become a sufficiently large fraction of the government’s financing needs that they render fiscal policy inflexible. Fiscal policy to attack unemployment, for example, may not be undertaken because financing is not available.

b. A growing national debt inevitably means that tax rates rise as much as politicians dare, to facilitate handling the high interest payments. Tax increases create disincentive effects, as emphasized by the supply-siders.

c. A growing national debt means that we may be placing a burden on future generations who will inherit that debt. Many view this practice as morally wrong. (See section 14.3 for discussion of this issue.)

d. A national debt could grow to the point where it will become too large for the country to service, causing a major crisis in the economy, such as that experienced by New Zealand in the 1980s. One way of measuring whether an economy is headed in this direction is to calculate the structural deficit.

As explained more fully in chapter 16, fixing the exchange rate causes an economy’s money supply to grow at the money-supply growth rate that characterizes its major trading partners. In effect, monetary policy must be devoted to fixing the exchange rate, so control over money growth is lost. Suppose, for example, our rate of inflation is 5 percent and that of our trading partners is 15 percent. If we fix the exchange rate, each year our goods become 10 percent less expensive to foreigners, and foreign goods become 10 percent more expensive to us. We soon experience a dramatic increase in our exports and a decrease in our imports, producing a surplus of foreign currency in the hands of our citizens. When the central bank exchanges the foreign currency for dollars at the fixed rate, these dollars increase the domestic money supply. By targeting on the exchange rate the central bank loses control over the money supply.

When the central bank is not independent, politicians can and do pump up the money supply shortly before an election to buy votes with lower interest rates and a lower unemployment rate. After the election, these short-run effects wear off, however, returning the economy to its natural rate of unemployment but at a higher inflation rate and a higher nominal interest rate. Because of the asymmetry of the Phillips curve, it is often the case that by the time the next election rolls around the economy has not been squeezed back to its original inflation rate, so the next round of politically induced money-supply increases start from a higher base. As this cycle repeats itself, the central bank loses control of the money supply.

Countries with military dictatorships or with central banks that lack independence from politicians sometimes finance a large portion of government spending by printing money. This is a tempting option for any government faced with a budget deficit because printing money reduces interest costs and achieves the political end of avoiding higher taxes. Furthermore, because real growth causes an economy’s demand for money to grow, the money supply should be increased to meet this extra demand for money. Buying government bonds on the open market is how this purpose is accomplished, so that some financing of government spending by money printing is acceptable. This process is formalized by the concept of seigniorage, discussed in curiosity 13.2. Money printing beyond this amount, however, creates inflation. A central bank that promises to finance government budget deficits loses control of the money supply.

It has been common for central banks to adopt a policy of targeting on or fixing the nominal interest rate. Under this policy a shock to the monetary sector that causes a rise in the interest rate would prompt the central bank to increase the money supply to push the interest rate back down. The increase in the money supply may cause people to revise expected inflation upward, a revision reinforced by any actual price increases created by the extra money, which are likely to occur if the economy is near full employment. Higher expected inflation increases the nominal interest rate. Any success the central bank has in pushing down the nominal interest rate will be temporary and likely to be more than offset by a rise in expected inflation. This rise in the interest rate prompts the central bank to increase again the money supply to meet its target interest rate, thus leading to a vicious circle. By targeting on the interest rate, the central bank loses control of the money supply.