The BoP accounts should balance
In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.
a simple example
This is a common sense notion. It’s easiest to see if we take a simple, theoretical example. Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)
Further, call the currency of A the $ and the currency of B the @. Let’s take the initial exchange rate as $1 = @1.
a trade/current account deficit…
Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million. It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.
Where does this extra @100 million come from? Not from today’s income-earning activities in country A. Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad. If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million. This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.
…isn’t sustainable forever
This situation can’t go on forever. If nothing else, at some point country A will run out of assets that country B will desire to buy. In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want. Initially, it will “recycle” extra $ into country A’s bonds to get some interest income. But there’s a limit to that, as well. Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.
The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports. If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried. So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter. But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.
In any event, a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency. Country B will demand a premium for continuing to hold $. What happens then?
One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around. That is, the government of A takes action to defend the $1 = @1 exchange rate. It may also have help from country B in doing so, since the government of B may be satisfied with the status quo. In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.
Two possibilities remain–external structural adjustment or internal structural adjustment.
Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods. In practical terms, this means the government raising interest rates and inducing a recession. How so? The problem country A faces is typically that government economic policy is too stimulative. As a result, the country is living beyond its means. Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.
The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible. It’s also very clear to voters exactly who has taken away the punchbowl.
External adjustment means standing aside and letting the currency markets achieve a new equilibrium. In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.
This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed. Why this path? It’s easier politically. Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad. And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.
In academic theory, adjustment through currency devaluation is an illusory process. The economy reverts to its prior state of disequilibrium, only with inflation at a higher level. For smaller countries, I think that this is true in reality as well. In the case of large countries like the US, the reality is more complicated. More about this in later posts.