The UK and the US have long run large trade deficits. Such a deficit is often thought to mean that a country is, like a household, "living beyond its means". How true is this?

First we need to rehearse some definitions.

The trade balance is often loosely used to describe the current account balance. The latter is, in fact, a broader measure, comprising trade in goods and services; net international income, for instance from dividends and rents; and net payments by governments and international organisations, such as contributions to the EU and overseas aid.

The flip side of the current account is the capital account, which measures net capital outflows. The current account and capital accounts are exactly equal – in this sense the balance of payments always balances. 

A country with a surplus on the current account sees capital outflows of the same amount. This capital is either deposited in banks overseas or used to purchase foreign assets, from government bonds to companies, leading to an increase in the surplus nation's ownership of foreign assets.

China's huge current account surplus, for instance, has its counterpart in capital outflows, much of which have been used to purchase US government bonds. China is now one of the world's major holders of US government bonds.

In the 1970s the oil based trade surpluses of Middle Eastern countries were recycled into purchases of real estate in London and companies in the West. 

So countries, like the UK and US, with current account deficit see inflows of foreign capital.

For a country to import more than it exports sounds undesirable and unsustainable. Yet countries can run current account deficits for very long periods. UK has had a deficit since 1984, the US since 1982 and Australia since 1974.

Perhaps the world's longest running and most benign current account deficit was that run by the US in the nineteenth century. During this period of rapid industrialisation America's need for capital to finance its burgeoning industries exceeded domestic savings. And its own industries were insufficiently developed to meet demand from a growing population.

The result was that America imported more goods than it exported throughout the nineteenth century. Foreigners financed the deficit with huge inflows of capital which helped to build the American economy, particularly its railways.

Having built its capital stock in the nineteenth century America was able to become the world's leading exporter from the end of the first war until the early 1980s. The US ran a persistent current account surplus through most of the twentieth century and used the resulting inflows to acquire foreign assets on a vast scale.

Many other economies have shown the same pattern of current account deficits and capital account surpluses, used to finance investment, during their industrialisation. 

But today's current account deficits being run by the UK and the US are in a different category.

The UK and the US are industrialised economies and their capital inflows do not appear to be financing domestic investment. America's deficit has been partially financed by Chinese purchases of US government bonds, giving rise to the view that America has been engaged in a spending spree financed by Chinese capital. The counterpart to Britain's current account has been heavy inflows of foreign deposits to UK banks and lending by foreign banks to UK residents.

In the 1980s and 1990s, with free market ideas in the ascendant, policymakers tended to take a relaxed approach to the British and American deficits, seeing them as a bi-product of increasing globalisation which would, in time, correct themselves. The view was that if foreign investors were willing to finance deficits by buying assets in a debtor economy, as, for instance, China has in the US, there was no particular problem.  

But now the focus is on "rebalancing" economies towards production and away from consumption. The tendency now is to see the UK and US current account deficits as imbalances which facilitated excessive consumption, credit growth and asset price inflation.

So current account deficits are out of fashion in the West today - everyone wants to export more.

But in a world where trade is growing far faster than economies, and where capital is increasingly free to move in search of the highest return, many countries will run deficits – every current account surplus has its counterpart in another nation's current account deficit. 

Other than in a world of autarky, or national self-sufficiency, the global economy will always have some deficit countries and some surplus countries.

The classical economist, David Ricardo, demonstrated 200 years ago, that specialisation and international trade are mutually beneficial. Thus the globalisation and growth in trade of the last 30 years has delivered sharp declines in the real price of many goods, from clothing to TVs and computers, to the great benefit of consumers.

Current account deficits are an inevitable feature of a world of free trade and capital flows. Perhaps the big risk is that a deficit country faces a sudden, damaging and disruptive adjustment as it reduces its current account deficit.

Countries with large current account deficits run the risk that at some stage overseas investors no longer want to finance the deficit. Foreign capital flight can lead to a collapsing exchange rate, a loss of confidence in the economy and soaring inflation. If such countries do not have industries whose products and services can be sold overseas they would be unable to generate the earnings to pay for imports.

Ultimately the sustainability of a current account deficit depends on the willingness of foreign investors to buy assets and place deposits with the debtor nation. If, for instance, China decided to sell its holdings of US government bonds, America would have a problem.

So for a deficit nation investor confidence is key. Despite having run current account deficits for 30 years, the UK, US and Australia, continue to prove attractive as destinations for foreign capital.

Having a flexible economy and a flexible exchange rate also help – it gives a deficit economy a greater chance of eventually increasing exports and closing a current account deficit. 

So is a current account deficit a problem? Not necessarily – and probably less than most people think - is the short answer. As with so many things in economics, it depends on the circumstances.

MARKETS & NEWS

UK's FTSE 100 ended the week down 1.6% following investor concerns over the potential end of quantitative easing programs.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

  • Shares in emerging market currencies, stocks and bonds fell over investor concerns that the US Federal Reserve may reign in its programme of bond buying in order to drive down interest rates
  • The Bank of Japan increased its expectations for growth for the sixth consecutive month, citing a "pick up" in exports and "resilience" in consumption
  • Germany's constitutional court heard arguments for and against the European Central Bank's (ECB) offer to buy distressed sovereign bonds in the eurozone
  • Ratings agency Standard & Poor's lifted its long-term outlook on the US's credit rating to "stable" from "negative", citing the strengthening US economy
  • The International Monetary Fund (IMF) claimed that an "excessively rapid and ill-designed" deficit reduction plan had slowed growth in the US economy by as much as 1.75 percentage points this year
  • A quarterly jobs survey from recruitment firm Manpower claimed the outlook for UK jobs remains "firmly positive" over the next 3 months
  • Defence and aerospace group BAE Systems announced that almost half of its graduates and trainees hired this year will go in to its cyber and security services business
  • The UK government announced plans for the Ministry of Defence (MoD) to outsource the acquisition and servicing of all its equipment by the end of 2014
  • French president François Hollande declared that "the crisis in the eurozone is over" during a state visit to Japan, saying that "the crisis, far from weakening the eurozone, will strengthen it."
  • Greece announced the immediate closure of the state broadcaster ERT, which employs 2,650 employees at 5 television stations, 29 radio stations and a number of websites, in order to cut costs
  • Three west London local authorities combined to complete their first big outsourcing deal, awarding a £150m services contract to Amey, as part of a "tri-borough" project to combine services
  • Luxury Italian clothing company Prada reported slowing profits, following reduced demand in Asia and weak European demand
  • Research from the Institute of Fiscal Studies (IFS) showed that the over-60s have seen their incomes rise faster than any other age group in the last 30 years
  • Justin King, the chief executive of high-street retailer Sainsbury's, called on the UK government to follow the US by introducing a tax on online retailers, saying that the "burden of taxation falls very heavily on bricks–and–mortar retailers"
  • The UK Statistics Authority upheld a complaint by the Financial Times against the Office for National Statistics' (ONS) recent decision to include Bank of England profits from quantitative easing in public borrowing figures
  • Regulatory filings showed that Goldman Sachs Group accepted almost 15,000 bottles of fine wine as loan collateral from a high-ranking business executive
  • Online fashion retailer Asos reported a 45% annual increase in sales in the three months to 31st May, driven by strong overseas sales, which now account for 67% of all transactions
  • A German bank employee has been reinstated in his job having previously been fired for verifying a payment made by a colleague who had fallen asleep on his keyboard, turning a €62.40 transfer in to a €222m payment – Shift Return

Regards,

Ian

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.