U.S. CA Case Study Lecture

7/28/2019 U.S. CA Case Study Lecture

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Introduction

International Finance, International

Macroeconomics, International trades are the

results of the fact that economic activities areaffected by the existence of nations.


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Introduction (Cont.)

Because of International trade as well as

borrowing and lending, economic opportunities

are expanded and households have better

opportunities to effectively use their income.

However, as the Existence of Banks makes

bank panics possible, so does the existence of

international finance system makes

international financial crises possible.


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International Finance Covers Many Topical

Issues

As a subject, International Finance / International macroeconomics cover many

topical issues, for example:

Is the current account deficit too large? What has or will happen to the dollar/

euro /INR?

Should China devalue its Yuan (RMB)? Should Sweden give up its currency to join Euro?

Should emerging market economies liberalize their financial markets?

There are basic forces that underlie the flow of goods, services and capital

between countries and are related with key political, economic and cultural factors.

Businesses, politicians and policy makers all realize the importance of these trades

and capital flows recorded in the Balance-of-Payments (BOP) statement.

They pay attention to Balance-of-Payments (BOP) and especially to the massive

and continuing U.S. Trade deficits.


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The Current Account Deficit of the United States

The case examines a macroeconomic phenomenon: the U.S.

current account deficit of the 80s, that was often referred to as:

(a) A Paradox

(b) A Threat

(c) A Conundrum (has only conjectural answer)

The U.S. current account deficit was / is considered the core

of so-called global imbalances and is a cause for a feeling of

distress or fear(consternation) among policy makers and

business around the world.


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CA deficit as a % of GDP

In 1986 1987, The U.S was running a current account deficit

of over 3% ($300 + billion) of GDP. This was considered to be very

large figure at the time. By 2005/2006, the current account

deficit had reached over 5% of GDP. The U.S. runs a substantial current account deficit since the

early 1980s with the exception of couple of years around early

1990s. In 2011, the deficit had declined to approx. U.S.D 466

billion or about 3% of GDP.


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U.S. Current Account Balance

2007 2008 2009 2010 2011

Exports of goods and services and income receipts 2488394 2656585 2180553 2518767 2847988

Imports of goods & services and income payments -3083637 -3207834 -2439990 -2829645 -3180861

Unilateral current transfers, net -115061 -125885 -122459 -131074 -133053

The U,S. Current Account Balance -710304 -677134 -381896 -441952 -465926


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CA Balance - India

Indias C.A. Balance:


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Nations by their cumulative current account

balances over the years 1980-2008:


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Continuing large U.S. Current account deficit

The massive and continuing U.S. deficits are of

considerable concern not only for the U.S. but

internationally.

Although, the government policies regarding foreign exchange

are often geared towards dealing with balance-of-payment

problem, many people and experts disagree (controversy) on

the nature of the trade deficit problem and their solutions.These controversies are illustrated by the following quotes

related to the current account deficits of mid 1980s.


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Controversies are illustrated

I had a trade deficit in 1986 because I took a vacation in France. I

didnt worry about it; I enjoyed it.

Herbert Stein: Chairman of the Council of Economic Advisor to President Nixon

and Ford.

We have almost a crisis in trade and this is the year Congress willtry to turn it around with trade legislation

Lloyd Bentsen: U.S. Senator.

Despite all the cries for protectionism to cure the trade deficit,

protectionism will not lower the trade deficit

Phil Gramm: U.S. Senator.

More recently, Warren Buffett was among the many individuals

with concerns about the U.S. current account deficit.


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Deficit Hawks Vs. Doves

Deficit hawks raise three objections to persistent federal

government budget deficits:

a) they pose a solvency risk that could force to

government to default on its debt;

b) they pose an inflation, or even a hyperinflation, risk;

and

c) they impose a burden on our grandkids, who will haveto pay interest in perpetuity to the Chinese who are

accumulating treasuries as well as power over the fate of the

dollar.


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Deficit Hawks Vs. Doves (Cont.)

The deficit dove positions include:

1. Since government spending is merely a matter of changing

numbers in bank accounts on its own spread sheet, there is

no solvency issue or sustainability issue.2. The right size deficit is the one that coincides with our stated

goals of full employment and price stability.

3. Interest rates for government are set by the government, and

not by the market place.

Bang for the buck considerations are moot as the size of the

deficit per se is not an issue.


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Go to BOARD 4 R


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Income Identities

National Income Accounting Identities

GDP = C+I+G+(X-M)

GDP-C-G = I+(X-M)

GDP - (C-T) (T-G) = I+(X-M) Sprivate + Sgovernment = I+(X-M)

Under GDP definition of income, (X-M) = Trade balance

Under GNP definition of income, (X-M) = closer to current account

Global Accounting Identities Sworld = Iworld

Su.s +SRestof world = Iu.s. + IRest of world


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Balance of Payment

Balance of Payment Identities

Current Account (CA) =ExportsImports +Investment Income +Other services Income +

Transfers

Financial Account (FA) =Long-term Capital+Short-term Capital

Capital Account & others (KA)

Changes in reserves CA+FA+(KA)Change in reserve = 0

CAu.s. = - CArest of world


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When production > domestic expenditure, exports >imports: current account > 0 and trade balance > 0 when a country exports more than it imports, it earns more

income from exports than it spends on imports

net foreign wealth is increasing (lending to the Rest of the World)

When production < domestic expenditure, exports I, then CA > 0so that net foreigninvestment and financial capital outflows for thedomestic economy are positive.


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How Is the Current Account Related toNational Saving? (cont.)

CA = SI = Sp + SgI

Sp = I + CASg

= I + CA + (GT)

Private savings are used to finance: private investment,the current account (net purchases to foreigners) and theGovernment deficit.

CA = SpI(GT)

A high government deficit causes anegative current account balance when other factorsremain constant.

Example: TWIN DEFICITS in the US.


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DISCUSSION BOP


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Balance of Payment (BOP)

A countrys account for its payments to and its receipts from

foreigners is recorded in the Balance Of Payments (BOP)

accounts. The Balance of Payment is an accounting statement

(document) of a country that shows in the summary form all the

economic transactions between residents (Public & Private

Sectors) of the home country and residents of all other

countries i.e. all payment and receipts of the country vis--vis

the rest of the world.

An international transaction involves two parties, and each

transaction enters the accounts twice: once as a credit (+) and

once as a debit (-) i.e. double entry book keeping.


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Political, economic & culture affect flow of

goods and services between countries

There are basic forces that underlie the flow of goods,

services and capital between countries and relate these flows to

political, economic and cultural factors.

Government foreign exchange policies are often gearedtowards dealing with balance of payments problems.

Domestic and world economies (such as GDP / GNP,

consumptions, savings, capital formation) are linked to financial

(money, currency, exchange rates, etc.) and real activities

(macroeconomic activities related to aggregate supply and

aggregate demand in an economy).


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Double entry bookkeeping

BOP statements are based on double entry book-keeping i.e.

every economic transaction recorded as a credit brings about an

equal and offsetting debit entry, and vice versa. It ensures that

debits equal credits, i.e. the sum of all transaction is zero. The

sum of the balance on the current account, capital account and

financial account must equal zero.

Example of Balance of Payments Accounting: You buy an ink-jet fax machine from the Italiancompany Olivetti and pay for your purchase with a $1,000 check.

Olivettis salesperson deposits the check in Olivettis account at Citibank in New York.

Fax machine purchase -$1,000

(current account, debit, US good import)

Sale of bank deposit by Citibank +$1,000

(financial account, credit, US asset export)


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Example of Balance ofPayments Accounting (cont.)

You have a fine dinner at the Restaurant de lEscargotdOr in Paris and pay $200 with your Visacard.

First Card, the company that issued your Visa card owes a $200 future payment to the restaurant

Meal purchase in France(Current account, debit, US service import) $200

Sale of claim on First Card(financial account, credit, US asset export) +$200


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Example of Balance ofPayments Accounting (cont.)

You purchase $95 in shares issued by the UK oil giant BritishPetroleum (BP).

British Petroleum receives the payment in its own US bank accountat Second Bank of Chicago.

Purchase of BP shares(financial account, debit, US asset import) -$95

BPs deposit at Second Bank of Chicago +$95(financial account, credit, US asset export)


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Implication of Double Entry Bookkeeping

Double entry bookkeeping methodology implies that any

movement in the current account must be reflected in an equivalent

change in the countrys net foreign asset position i.e. current accountequals the difference between a countrys purchase of assets from

foreigners and its sale of assets to them, which is the sum of the

capital account (KA) & financial account.


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Three Broad Accounts

The Balance Of Payments (BOP) accounts are separated into

THREE (3) broad accounts:

1. Current account: accounts for flows of goods and

services (imports and exports).2. Financial account: accounts for flows of financial

assets (financial capital).

3. Capital account: flows of special categories of

assets (capital): typically non-market, non-produced, orintangible assets like debt forgiveness, copyrights and

trademarks.


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Must Balance

The Balance of Payments Accounts must Balance

Due to the double entry of each transaction, the balance of

payments accounts will balance by the following equation:

current account +

financial account +

capital account = 0


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Sum of Four Components

1. Current Account (CA)records exports and imports ofgoods, services and international receipt of income /payments /

unilateral transfer (gifts/aids.) transactions.

Basically it involves current income and expenditure. CA

consists of: (a) Trade (goods) account,(b) Service account, (c)

Income account. and (e) Unilateral transfer account


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Sum (a+b+c+d) = Current Account Balance

(a) Trade (goods) account: record flows of goods - imports and exports

merchandise (goods like DVDs)

Exports of goods are credits (+) to the current account

Imports of goods are debits (-) to the current account

(b) Service account: records import and export of services (payments for

legal services, shipping services, tourist meals, tuition paid to universities by

international students, money spent on travel by tourists, banking, insurance,

consulting services etc.)

Exports of services are credits to the current account (+)

Imports of services are debits to the current account (-).


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Sum (a+b+c+d) = Current Account Balance

(c) Income account: income receipts (interest and dividend payments,

earnings of firms and workers operating in foreign countries)

Interest, dividends and other income received on U.S. assets held abroadare credits (+)

Interest, dividends and payments made on foreign assets held in the U.S. aredebits (-).

(d) Unilateral transfer account: net unilateral transfers such as gifts (transfers) acrosscountries that do not purchase a good or service nor serve as income forgoods and services produced, military aids, technical knowhow.

Remittances by U.S. citizens working abroad, unilateral aid to the U.S. from other

countries pensions paid by foreign countries to their citizens living in the U.S.Count as credits (+).

Remittances by foreigners working in the U.S., unilateral aid from the U.S. toother countries, pensions paid to U.S. citizens living abroad count as debits (-).


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Current Account Balance

The sum of these components (a+b+c+d) is known as the

current account balance. A negative number is called a current

account deficit and a positive number called a current account

surplus.

Intuitively, think of credits to the current account as

transactions involving receipt of income to U.S. resident and

debits to the current account as transactions involving payment

of income to foreigners. The transactions can involve goods,

services, investment income, pension income or other unilateral

transfers.


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Capital Account

2. Capital account: Records special transfers of assets such as

flows of special categories of assets (capital) - typically non-

market, non-produced, or intangible assets like debt forgiveness,

copyrights and trademarks, but this is a minor account for theU.S.

A positive value for the capital account is called a capital account

surplus, a negative value is called a capital account deficit.


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Financial Account

3. Financial account: Accounts for flows of financial assets

(financial capital), the difference between sales of domesticassets to foreigners and purchases of foreign assets by domesticcitizens.

Financial inflow: Foreigners loan to domestic citizens by

buying domestic assets. Domestic assets sold to foreigners are acredit (+) because the domestic economy acquires money duringthe transaction

Financial outflow: Domestic citizens loan to foreigners by

buying foreign assets. Foreign assets purchased by domesticcitizens are a debit (-) because the domestic economy gives upmoney during the transaction.


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Financial Account

Financial account has at least Three (3) subcategories:

(a) Official (international) reserve assets

(b) All other assets

(c) Statistical discrepancy


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Financial Account

1. Purchase and Sale of Assets

Purchases of U.S. assets by foreigners are credits to the capital account (+)

Purchases of foreign assets by U.S. residents are debits to the financialaccount (-)

What counts as an asset? Purchases of stocks or bonds (financialinvestment) or purchases of a part or whole of foreign based companies(direct investment). The capital account is where the BOP accounts starts toget tricky. Since U.S. residents can also sell some of the foreign assets theyhad purchased before, we need to track the sale of assets as well. Theeasiest way is to record the sale of assets in the BOP in the exact oppositeway we record the purchase of assets (i.e. think of a $500 sale as a purchaseof a -$500 asset).

Sales of U.S. assets by foreigners count as debits to the capital account (-)

Sales of foreign assets by U.S. residents count as credits to the capital account (+)


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Financial Account

2. Making and Repaying Loans :

Sales of U.S. assets by foreigners count as debits to the capital

account (-)

Sales of foreign assets by U.S. residents count as credits to the

capital account (+)

As with assets, we have to track repayment of loans as well as

tracing new loans. Thus, repayment of existing loans has to be

recorded in the exact opposite fashion as the making of a new loan.

Decreases of loans to U.S. residents (U.S. repayment) by foreigners is

a debit (-)Decreases of loans to foreigners by U.S. residents (foreign

repayment) is a credit (+)


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Financial Account

3. Changes in Holdings of Currency

Increases in dollar holdings by foreigners counts as a credit to the capital account(+)

Increases in holdings of foreign currency by U.S. residents counts as a debit (-)

The easiest way to think about currency is to treat it as another asset. Soforeigners holding more U.S. currency is treated just like foreigners holding moreU.S. assets. Similarly, U.S. residents holding more foreign currency is treated justlike U.S. residents holding more foreign assets. Accordingly decreases in holding offoreign currency are treated like sales of assets.

Decreases in dollar holdings by foreigners counts as a debit to the capital account(-)

Decreases in holdings of foreign currency by U.S. residents counts as a credit (+)


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Reserve Assets

Official (international) reserve assets: Foreign assets held by

central banks to cushion against financial instability. Assets

include government bonds, currency, gold and accounts at the

International Monetary Fund.

Official reserve assets owned by (sold to) foreign central

banks are a credit (+) because the domestic central bank can

spend more money to cushion against instability.

Official reserve assets owned by (purchased by) the domesticcentral bank are a debit (-) because the domestic central bank

can spend less money to cushion against instability.


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Official Reserves Account

Change in the official reserves measures a nations surplus or

deficit on its current, Financial and capital account

transactions by netting reserves liabilities from reserve assets.

A surplus will lead to an increase in official holdings of foreign

currencies and / or gold.

A deficit will normally cause a reduction in these assets.


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Official Reserves Assets (Cont.)

Official (international) reserve assets: foreign assets held bycentral banks to cushion against financial instability.

Assets include government bonds, currency, gold and accounts at theInternational Monetary Fund.

Official foreign exchange intervention: Central banks buy or sellinternational reserves in private markets to affect macroeocnomicconditions (aiming at either a strong or a weak currency)

Official reserve assets owned by (sold to) foreign central banks are acredit (+) because the domestic central bank can spend more money tocushion against instability.

Official reserve assets owned by (purchased by) the domestic centralbank are a debit (-) because the domestic central bank can spend lessmoney to cushion against instability.


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Implication of OSB

The negative value of the official reserve assets is called the officialsettlements balanceor balance of payments.

It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statisticaldiscrepancy.

A negative official settlements balance may indicate that acountry is depleting its official international reserve assets or

may be incurring large debts to foreign central banks so that

the domestic central bank can spend a lot to protect against

financial instability.

RISK FOR A CURRENCY CRISIS DUE TO SEVEREEXCHANGE RATE DEPRECIATION


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Statistical discrepancy

Statistical discrepancy reflects errors and omissions in

collecting data on international transactions.

The discrepancy may coincide with worrisome foreign events

such as war, civil unrest / upheaval.

Many experts believe that the statistical discrepancy is

primarily the result of foreigners surreptitiously moving

money into what they deem to be a safe political country.


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Official Settlement Balance OR Balance of

Payment

The balance of payments accounts therefore seldom balance

in practice. The statistical discrepancyis the account added to or

subtracted from the financial account to make it balance with

the current account and capital account.

The negative value of the official reserve assets is called the

official settlements balance (OSB) or balance of payments.

It is the sum of the current account, the capital account, the

non-reserve portion of the financial account, and the statistical

discrepancy.


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Dynamics of the Current Account

Warren Buffett was among individuals with concerns about the

U.S. Current Account Deficits. He increased the value of its

foreign exchange contracts, consisting predominantly of short

positions against the dollar.

Student vote:

How many of us think that betting against the dollar was:

good idea

bad idea

Not sure /uncertain


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Now Lets look at the basic facts

Board (1) Left side

Why bet Against the Dollar?

U.S.GDP: $ trillion (2005)

U.S.GDP: $ trillion (2007)

Current Account: $ billion

U.S. Current Account Deficit: > of GDP

U.S.net Liabilities: Aprox. Is this situation sustainable?

Is depreciation of dollar likely?


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Now Lets look at the basic facts

Why bet Against the Dollar?

U.S.GDP: $12.6 trillion (2005 Ex. 2a)

U.S.GDP: $14.0 trillion (2007 Ex. 2a)

Current Account: $ -746 billion (Ex.4a)

U.S. Current Account Deficit: > 5% of GDP (Ex. 4b,2a,4a)

U.S.net Liabilities: Aprox.15% (Ex. 8, 2a) (1932/12600)

Is this situation sustainable? Is depreciation of dollar likely?


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Other data:

U.S.Savings (2005): Low, % of GDP= Net Investment

+ net export {(Net Export= negative & 2b : net domestic

investment = %)}. Less than 1% of GDP in 2000 (text (Page:6))

U.S. fiscal deficit (2005): Approx. (exhibit 3a

&3b)

U.S.Interest rate: Low/ high/moderate? Low

Approx. (exhibit)

Reserves in China:~$ billion increase in 2005 (Case Text

and exhibit 9a & 9b)


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Other data:

U.S.Savings(2005): Low Aprox: 2% of GDP=Net Investment

+ net export {(exhibit 2a : Net Export= negative 6% & 2b : net

domestic investment =8%)}. Less than 1% of GDP in 2000 (text

(Page:6))

U.S. fiscal deficit (2005): Approx. 2.5% (exhibit 3a

&3b)

U.S.Interest rate: Low/ high/moderate? Low

Approx. 4% (exhibit 1b)

Reserves in China:~$200 billion increase in 2005 (Case Text

and exhibit 9a & 9b)


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Dynamics of Current Account Deficit

By 2006,the U.S current Account deficit at $788 billion, closeto 6% of GDP, which was record high for the U.S. in absoluteterms.

Persistently high current account deficits were unheard of in

large industrial countries. Further more net liabilities were around 17% of GDP. Some

economists were forecasting net liabilities to rise as high as60%. Such high levels of net liabilities had occurred in otherlarge industrial countries, but were uncommon. There were

questions about whether this situation was sustainable. If not, a depreciation of the U.S. dollar was considered very

likely.


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Dynamics Of Current Account Deficit

However, coming to a conclusion on whether to bet againstdollar is more complicated.

Understanding the Dynamics of the current account,particularly the relationship among domestic savings and

investment, trade and international capital flows,international growth and productivity in trade and non-tradedgoods; prices, interest rates, and exchange rates, and fiscaland monetary policy, is important as a first step in being ableto evaluate the decision to bet against the dollar.

PERHAPS WE WILL BE ABLE TO RETURN TO THE QUESTIONWITH More INSIGHTs TOWARDS THE END OF THE CLASS.


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Why is the US Current Account in Deficit?

How does the current account deficit relate to

domestic versus international factors? Pattern Of

Consumption? savings? Investment? Trade? Is China

a Problem? Or is China A solution? What aboutEurope?


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National income Accounting Identities

GDP = C+I+G+(X-M)

GDP-C-G = I+(X-M)

GDP - (C-T) (T-G) = I+(X-M)

Sprivate + Sgovernment = I+(X-M)

Under GDP definition of income, (X-M) = Trade balance

Under GNP definition of income, (X-M) = closer to current account

Global Accounting Identities

Sworld = Iworld

Su.s +SRest of world = Iu.s. + IRest of world


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Balance of Payment Identities

Current Account (CA) =

Exports

Imports +

Investment Income + Other services Income +Transfers

Financial Account (FA) =

Long-term Capital+

Short-term Capital


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Balance of Payment Identities (cont.)

Capital Account & others (KA)

Changes in reserves

CA+FA+(KA)Change in reserve = 0

CAu.s. = - CArest of world


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Collect Comments in three sections.

Examine the Causes of Large U.S. current

account deficit

The Three areas are: (a) i. National income

accounts (the relationship between savings

and investment) and ii. Trade flows; (b) capital

flows, and ( c) the role of China and the rest ofthe world. Board 2.

C f l S C d fi i


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Cause of large U.S.Current account deficit

Board 3a

Capital flows

(benign view)


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Cause of large U.S. Current account deficit (3a)

Capital flows(Benign view) Reflects financial flowsholds the market: shares of US equities

in world equities has increased, so shares of us equities in neutral investor

portfolio should also increase.

Greenspan: Globalization means more financial intermediationfinance bigger deficit as Home Bias declines.

U.S. better at producing financial assets

Bernanke: Global savings Glut

Asian countries (esp. China) concerned about maintaining exports

to U.S.

Ability of U.S. to borrow in its own currency

C f l U S C d fi i


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Cause of large U.S.Current account deficit

Board 3b

Role of China


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Role of China 3b (center)

1.Appreciated dollar

2.Have sufficient reserves to avoid financial

Crisis, and steep changes in the exchange rate

.in Sum to dirty / managed float

In this case, global imbalance likely

sustainable for much longer.

In this case, China has enough already and

the U.S. current account deficit is going to

become unsustainable soon

Perfect

Match !

China engages in currency manipulation to develop

People in the United states enjoy high present consumption

Perfect Match !

But it is important to figure out in this context: WHY the Chinese accumulate so much?Two Possibilities


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Dynamics of Current Account Board (2) Center

Domestic= I + (X-M) Rest of the World

National income Accounts Trade Flows Capital Flows Role of China Europe/ rest of the world

Causes of Large U.S. Current account DeficitGlobal Imbalances: S

us+ S

Rest of world= I

us+I

Rest of WorldDomestic: Sprivat+ Sgovernment= I + (XM) Rest of the World

Dynamics of Current Account d ( )


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Dynamics of Current Account Board (2) Center

Domestic: SPrivate +SGovernment = I + (X-M) Rest of the WorldNational income Accounts

-Little Savings:

( Low private savings, high consumption

in the U.S)

Low Public Savings (Government deficit,war, tax cuts, etc.)

-Investment : high, low?

If investment and private savings remain

unchanged, a government deficit must

result in trade deficit (GDP View) orcurrent Account (GNP view)

Trade Flows

The U.S, imports too

much, can not produce

cheaply / innovatively

enough to export goods.

- Supply factors

-Demand Factors

-Role of exchange rate

Capital Flows

(See

continuation 3a)

Role of China

(See

continuation

3b)

Europe/ rest of the world

Savings glut

Low growth in Europe?

Other countries accumulating

reserves.

Causes of Large U.S. Current account DeficitGlobal Imbalances: Sus+ SRest of world = Ius+IRest of World


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Question?

How does Macroeconomic forces affect the current account

deficit in general and how do they affected the currentaccount deficit in the U.S. in the past in particular, as

described in the case.


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Macroeconomic forces

How different macroeconomic forces affect the currentaccount deficits in general and how they affected the currentaccount deficits in the U.S. in the past, in particular, asdescribed in the case.

There are three areas that may shed some light on the issuesviz. :

(i) National Income Account (the relationshipbetween savings and investment) and Trade

flows.(ii) Capital flows, and

(iii) The role of Asia and the rest of the world.


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National income accounts (for use in board 2)

S = Sprivate + Sgovernment = I +(X-M)

In a simplistic way this identity equates the current account

to the trade account (X-M).

In reality, the current account also includes net factor

payments from abroad which is the difference between

income earned on capital and labor working outside the home

country and income earned in the home country by foreign

capital and laboras well as net unilateral transfers, whichincludes private gifts and official foreign aid.


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Explanation for the U.S. current account deficit?

Does the above relationship help explain the U.S. Currentaccount Deficit? How?


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Explanation for the U.S. current account deficit

If the current account balance is given by (X-M) is negative, acountry must borrow from foreigners (or sell assets to

foreigners), given the same level of savings and investment. In

this case i.e negative (X-M), the U.S. appears to be spending

beyond its means


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Role of twin deficit

The case discusses the combination of high fiscal deficit (seecase exhibits 3a and 3b for details on fiscal deficit) with high

current account deficit during the 1980s. The high fiscal

deficits in the 1980s were largely caused by tax cuts rather

than increased government spending. Although, the Ricardianequivalance proposition states that tax cuts should have no

impact on savings or the current account, it is clear from the

identity above that a decrease in government savings (no

matter what the cause) would need to be off set by an

increase in private savings; otherwise domestic investment

need to decline or the current account deficit would increase

(or both).


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Re-conciliation of Exhibit 2a and 2b

Exhibit 2a shows gross private fixed domestic investment as 17% ofGDP in2005. In Exhibit 2b, net domestic investment shows up at 7%of GDP. Why is the difference? Please clarify.

Footnote to the exhibit explained that the net domestic investment

refers to public and private investment and is net of depreciation. In2005, net domestic investment amounted to 7% of GDP, grossdomestic public investment was 3% of GDP, and depreciationamounted to 13% of GDP. Adding net domestic investment of 7% todepreciation of 13% implies gross domestic investment of 20%.

Subtracting 3% gross domestic public investment means that grossprivate fixed domestic investment is 17%, which is consistent withthe value shown in Exhibit 2a.


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Exhibit 2a (case) explains the identities

How can we explain the following identities based on Exhibit 2a,which shows gross numbers:

(a) GDP = C + I+ G + (X-M)

(b) Sprivate + Sgovernment = I+ (X M)

(a) For 2006, Household consumption (C) as a percent of GDP is 70 %, i.e. C =70%, plusgross investment (I) as a percent of GDP is 17%, I= 17%; plus government consumptionas a percent of GDP (G=19%) plus the (approximation of the) current account as apercent of GDP ((X-M) = -6%). (70% + 17% +19% -6% = 100%)

(b) Gross domestic savings as a percent of GDP (Sprivate + Sgovernment =11%) equals

gross investment as a percent of GDP (I = 17%), plus the(approximation of the) current account as a percent of GDP ((X-M)=-6%). (17% - 6% = 11%). Exhibit 2b shows net values and are notappropriate for calculation of these identities)


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The U.S. appeared to be an oasis of prosperity

The so called New Economy of the late 1990s increasedinvestment (both from local sources and foreign sources) while

decreasing private savings opening up ween two variables.

With an increase increase in government savings not large enough

to offset the gap, in order for the identity to balance, the currentaccount balance, the current account deficit also needed to

increase.

The U.S. appeared to be an oasis of prosperity at the time, rather

than simply spending beyond its means.

See case Exhibit 2b, it appears that large current account deficits inthe late 1990s were driven more by rising levels of investment than

by declining savings rate relative to those in the rest of the world.


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Continuing Housing Boom

In the late 1990s and through 2004, the U.S. current accountdeficit was driven by low government savings and low private

savings driven by continuing housing boom than high levels of

investment.

( Feed to column 1, board 2)


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Trade flow of goods and services

What are the most important factors influencing the tradeaccount?


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Trade flows of goods and services

What are the most important factors influencing the tradeaccount?

1. Role of Supply factor

2. Role of Demand factors for U.S. goods

3. Role of real Exchange rate

Was good U S economic health in the early


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Was good U.S economic health in the early

2000s responsible for widened CA deficit?

Explain if and how that might have happened


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Trade flow of goods and services

Role of Supply factors:

Supply Factor include Economic growth, productivity,

competitiveness.

A study by Federal Reserve Vice Chairman Mr. Ferguson, Jr.

argued that the surge in U.S. productivity growth, althoughnot explaining all of the deterioration in the trade balance

between the mid-1990s and 2005, accounted for more of that

deterioration than the fall in government and private savings

combined.


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Trade flow of goods and services (cont.)

Role of Supply factors (cont.): The study explains that the surge in U.S. productivity (see

case exhibit 1a) served to deteriorate the current accountbalance through a number of channels : higher productivitygrowth boosted perceived rates of return on U.S. Investments,thereby increasing domestic investment as well as generatingcapital inflows that boosted the dollar; expectation of furtherhigher returns boosted equity prices, household wealth, andperceived long run income, and so consumption rose and

saving rates declined. With increased investment, decreasedprivate savings, and an appreciated dollar, the U.S. currentaccount deficit widened.


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Role of supply factors

Using this reasoning, the argument often made that a pick-up in foreignproductivity growth rates, relative to the U.S. rates, should lead to a

closing of global imbalances.

Some economists (Obstfeld, Rogoff), however, argue that this would be

the case only if the relative productivity jump were in non-tradable goodsproductionfor example, if foreign retailing productivity levels started to

catch up to those of the U.S., which experienced a retailing productivity

boom during the 1980s and 1990s rather than tradable goods

production. They argue that, contrary to conventional wisdom, as the

global recovery rebalances towards growth in Europe and Japan, the U.S.current account deficit could actually become larger rather than smaller,

at least initially.


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Role of supply factors(cont.)

The reason is as follows:

faster foreign productivity growth

in non-tradable goods would raise foreign income, which could

be spent on the U.S. exports; faster foreign productivity growth

in tradable goods would exacerbate the U.S. current deficit asforeign tradable goods become more competitively priced.

Furthermore, Obstfeld and Rogoff argue that faster traded goods

productivity growth in the U.S. would help shrink the U.S.

current account deficit (presumably, by making U.S. exportsmore competitive).


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Trade Flows of goods and services

Role of demand factors for U.S. goods GDP growth in the U.S. increased U.S. Imports more than

foreign GDP growth increase U.S. export.

The asymmetry was more extreme for imports and exports of

goods.

For import and export of serevices it was reversed


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Role of demand factors for U.S. goods (cont.)

The overall asymmetry implied (assuming constant exchange rate)that even if the U.S. and the rest of the world grew at the same

rate, the U.S. current account deficit would continue to widen (see

Exhibit 4c split between goods and services)

Explaining the asymmetry The U.S. has large immigrant

population (aprox. 10% of total population. Which tends to prefer

and import products from their home countries and also tend to

send remittances back to home countries.

l f l h


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Role of real exchange rate

Exchange rate impacts on trade flows

Has immediate impact on the valuation of the U.S. assets

abroad.

For example: A depreciation of the dollar against the euro and

pound would be expected to decrease U.S. imports ofEuropean goods and increase U.S. Exports to Europe.

The real exchange rate is influenced by a number of factors

including productivity growth rate. See case Exhibit 4b, for

graphical representation suggesting the relationship betweenexchange rates and the trade balance.

Flow of financial assets


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Flow of financial assets

Sus + Srest of the world = Ius + Irest of the world

Another way to examine the U.S. current account deficit is throughunderstanding international flows of financial assets.

The current account (CA) in the U.S. Must be equal to -CA of the rest of

the world.

The relationship Sus + Srest of the world = Ius + Irestof the world , it is clear that the

problem could be too much investment or too little savings in the U.S. or

too much savings or too little investment in the rest of the world.

Relationship between the current account and


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Relationship between the current account and

financial flow

Please use example from the case (withreference to Exhibit 5-7 of the case) to discuss

the relationship between the current account

and financial flows.

Li k b h CA d h FA


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Link between the CA and the FA

A countrys current account (CA) is the part ofthe balance sheet that reflects exports and

imports of goods and services, the difference

between income on foreign labor and capitalemployed in the home country and the

income on home labor and capital employed

abroad, and net unilateral transfers such asgifts and aid.

Li k b h CA d h FA (C 1)


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Link between the CA and the FA (Cont. 1)

A countrys financial account reflects international purchasesand sales of financial assets.

The financial account represents the difference between

foreign purchase of local assets and resident purchase of

foreign assets. A countrys current account and financial account, after

adjusting for omissions and errors, essentially sum to zero. In

other words, a country with high current account deficit will

have a high financial account surplus (in essence, as othercountries fund its purchase of extra imports through buying

assets or lending money)

M lti l t f fi i l t


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Multiple types of financial assets

The Financial Account consists of multiple types of financialassets. Short-term or portfolio investments include purchase

and sales of stocks, bonds, and derivatives. Long-term or

direct investments including purchase and sales of production

facilities and equity investments that lead to managerialcontrol. Other investment assets and liabilities include bank

deposit, trade credits, and loans.

Th U S E i St th


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The U.S. Economic Strength

As noted in the case, the 2006 Economic Report of the Presidentfocused on international financial assets rather than current

account deficit.

The report entitled The U.S. Capital Account Surplus, noted that

strong inflows of capital represented U.S.Economic strengths.

It notes that the key issue concerning U.S. foreign capital inflows is

not absolute level but the efficiency with which they are used.

Provided capital inflows promote strong U.S. Investment,

productivity, and growth, they provide important benefits to the

U.S. as well as to the countries that are investing in the U.S.

U.S.capital inflows can continue indefinitely.

M ti F ld t i di d ith th l i


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Martin Feldstein disagreed with the analysis

Mr. Feldstein (well known0 economist at the time, noted thatCA deficit can continue indefinitely only if the resulting

growth of the external debt does not exceed the growth of

GDP.

A current account deficit can continue indefinitely but only if apart of the resulting interest and dividends owed to foreigners

is financed by a trade surplus.

So, even if global capital markets permit the current account

surpluses to continue indefinitely, the dollar must eventuallydecline to a level that leads to a trade surplus.

The U.S. is simply better at producing financial


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p y p g

assets than other countries

MIT Economist Ricardo Caballero The U.S. is simply better atproducing financial assets than other countries.

Economist Catherine Manngain from the trade should no longerbe measured only in the real domain of goods and services, butshould also be measured in how increased financial intermediation

can improve on the risk and return frontier of the internationalwealth portfolio availability of greater diversity of financial assetsand instruments allowed investors to target the type of risk theywished to undertake.

Between 1995 and 2002, for OECD countries (excluding the U.S)

external liabilities grew 8% per year while imports grew just 2% peryear. Part of the increase in finance relative to trade reflected thebuild-up of foreign currency reserves by private entities as well ascentral banks.

D i f th d ll


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Dominance of the dollar

The second important topic related to flows of financial assetsis the dominance of the dollar as international medium of

exchange, implying that the U.S. could borrow in its own

currency.

Important in discussing sustainability of U.S. current accountdeficit.

Th V l f l t d fi i l fl


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The Value of accumulated financial flows

A third line of discussion relates to the value of accumulatedfinancial flows.

The U.S. net internal investment position (NIIP) increased

rapidly into 2004, and that this increase would imply future

high net U.S. income payment to foreigners. These income payments would serve to deteriorate the

current account deficit even further.



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(Exchange rate)

On the other hand as the case describes, the valuation of U.S. externalassets and liabilities is affected by differences between U.S. and foreignequity market returns as well as exchange rates.

The dollar exchange rate responds in a predictable, systematic mannerduring phases when the U.S. external position was unsustainable. Inother words, as the NIIP grows too large, the U.S. Dollar will depreciate in

order to increase the value of U.S. external assets in response.

The depreciation of U.S. Dollar in the early 2000s kept NIIP in check.

Exhibit 11b shows the impact of the exchange rate in the valuation of theNIIP (See impact of the dollar depreciation in 2002 and 2003 on the netposition).

Exhibit 11a, show that while CA deficit between 2001 &2007 totaled$4,242 billion, the NIIP deteriorated by only $573 billion over the sameperiod.



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(Exchange rate) (Cont.)

Economist note that large gross cross-holding of foreignassets and liabilities means that the valuation channel of

exchange rate adjustment has grown in importance, relative

to the traditional trade balance channel. They also note that

exchange rates have a much faster impact on the value netassets than on trade.

Exhibit 12, demonstrate that this effect is mitigated

somewhat by the fact that approximately 50% of foreign

assets were denominated in U.S. dollar, so their value does

not increase as the dollar depreciates.

The Rest of the world and the role of managed


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g

currencies in China (Asian Countries)

Why are the Chinese accumulating so many dollar reserves? Why does China get from or out of this policy?

Is this a match made in heaven: one country wants to have

everything and keep its currency undervalued so that it can

export, and another that just wants to consume in thepresent? What about Europe? Other Countries.

Student Discussion


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Student Discussion

Dollar pegged currencies


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Dollar-pegged currencies

Dollar-pegged Asian countries plays important role in maintainingthe U.S. current account deficit.

China played an important role in allowing the U.S. to maintain a

high trade deficit. By pouring money into U.S. Bonds, the Chinese

central bank was able to keep its exchange rate against the dollar

stable and therefore grow U.S. import of Chinese products.

This sratagy was adopted by the Chinese to allow its export sector

to expand in order to incorporate millions of poor Chinse

agricultural laborers in a major economic transformation of the

country U.S. trade deficit with China were continually reaching new record

levels as a result.

Funding provided by Asian central banks to the


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U.S.

Exhibits 9a, 9b, and 10, show the amounts of fundingprovided to the U.S. by selection of Asian Central Banks.

Certain Economists dubbed it as a revived Bretton Woods

explaining:

The economic emergence of a fixed exchange rate periphery inAsia has re-established the United States as the center country in

the Bretton Woods international monetary system.

Sustainability of the U S Current Account


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Sustainability of the U.S. Current Account

Is the U.S. Current Account deficit Sustainable? Is this a source of concern?

Will all of this unravel?

What is the worst case scenario economically?

What is the worst case scenario Politically?

Concept of Sustainable


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Concept of Sustainable

From a domestic point of view : the current account trajectory issustainable if the impact of the current account balance and NIIP on GDPgrowth (through consumption and business investment) is weaker thanthe impact on GDP growth from other macro economic forces.

Exhibit7: Shows, the U.S. had a fairly balanced share of equity

and bonds in the liabilities. The U.S. liabilities are mostlydollar denominated.

Exhibit 4a & Case discussion text: Foreign official investmentwhich would require interest payments in the future, hadbecome increasingly important in recent years.

Feldstein in 2006 noted that public funds accounted for anaverage of only 14% of the capital inflow. He explains that thisis misleading.


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Several ways of evaluating how foreign investment flows intothe U.S. might continue.

The U.S. current account absorbed only about 6% worlds

savings, leaving the impression of plenty room for future

investment in U.S. assets by foreigner.

Student comment on board five (board 5)


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Student comment on board five (board 5)

Sustainability of U S Current account deficit (Board 5)


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Sustainability of U.S. Current account deficit (Board 5)Sustainable

Risk is borne by foreigners, who

are holding the dollars.

The 1980s fiscal deficits were as

big

Global financial markets

Decreasing home bias

Diversification finance, not

development finance

Attractive investment

opportunities, high rates of return

Global savings glut is here to stay

U.S. safe haven

Not Sustainable

Not politically sustainable political

vulnerabilities; behavioral; practice

of foreign central banks.

Not economically sustainable:

Accounting

The difference from previous

episodes is the private savings,

which have disappeared

The Manufacturing base is

disappearing

The U.S.is financing consumption,

not investment

Increasing inequality withinU.S.

(AFLCIO have stated the trade

deficit is a weight around workers

neck)

Already the beginning of the end:

world wide diversification from the

dollar and dollar based assets

Chinas Logic1. Keep the yen undervalued to grow2. Keep the U.S. economy importing

3. Have lots of reserves to avoid a financial crisis

Solutions to U S Current Account Deficit (6 C)


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Solutions to U.S. Current Account Deficit (6 C)

US

Increase savings

-Private unlikely

(Consumerism culture, low

savings, feelings of high

wealth, etc.

-Public savings unlikely

(commitment to lower taxes,

social security, invasions,

etc.)

Push China to appreciate

Grow

ChinaUnilateral Appreciation

-But the size of required n for

a unilateral correction of the

U.S. current account is

proportional to 1/size

-Unrealistic for one countryto take entire burden

Europe-Save less /invest more

-Grow the economy

(important that growth takes

place in the right sector

tradable versus non-tradable)

US+China+Europe+Rest of the World


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US+China+Europe+Rest of the World

Policy Coordination Americans save more; adjust fiscal policy

Europeans make structural changes to their economy toimprove growth

Asians revalue collectively

Everybody gets something

Orderly solutions of global imbalances

China able to prove it is a citizen of the world economy

Documents

U.S. CA Case Study Lecture