Introduction

International Finance, International Macroeconomics, International trades are the results of the fact that economic activities are affected by the existence of nations.

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.

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.

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.

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 decit 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.

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
The U,S. Current Account Balance -115061

-125885 -122459 -131074 -133053

-441952 -465926

-710304 -677134 -381896

CA Balance - India
Indias C.A. Balance:

Nations by their cumulative current account balances over the years 1980-2008:

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.

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 and Ford. to President Nixon

We have almost a crisis in trade and this is the year Congress will try 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.

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 have to pay interest in perpetuity to the Chinese who are accumulating treasuries as well as power over the fate of the dollar.

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.

Go to BOARD 4 R

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

Balance of Payment
Balance of Payment Identities

Current Account (CA) = Exports Imports + 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

 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 < imports: current account < 0 and trade balance < 0
when a country exports less than it imports, it earns less income from exports than it spends on imports net foreign wealth is decreasing (borrowing from the Rest of the World)

Saving and the Current Account

National saving (S) = national income (Y) that is not spent on private consumption (C) or government purchases (G). S=YCG S = (Y T C) + (T G) S = Sp + Sg

How Is the Current Account Related to National Saving?

CA = Y (C + I + G )

implies
CA = (Y C G ) I = S I
current account = national saving investment current account = net foreign investment

A country that imports more than it exports has low national saving relative to investment

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

CA = S I or I = S CA

Countries can finance investment either by saving or by acquiring foreign funds equal to the current account deficit.
a current account deficit implies a financial asset inflow or negative net foreign investment.

When S > I, then CA > 0 so that net foreign investment and financial capital outflows for the domestic economy are positive.

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

CA = S I = Sp + Sg I Sp = I + CA Sg = I + CA + (G T) Private savings are used to finance: private investment, the current account (net purchases to foreigners) and the Government deficit. CA = Sp I (G T) A high government deficit causes a negative current account balance when other factors remain constant. Example: TWIN DEFICITS in the US.

DISCUSSION BOP

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.

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 geared towards 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).

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 Italian company 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)

Example of Balance of Payments Accounting (cont.)

You have a fine dinner at the Restaurant de lEscargot dOr in Paris and pay $200 with your Visa card. First Card, the company that issued your Visa card owes a $200 future payment to the restaurant $200

Meal purchase in France

(Current account, debit, US service import)

Sale of claim on First Card

(financial account, credit, US asset export) +$200

Example of Balance of Payments Accounting (cont.)

You purchase $95 in shares issued by the UK oil giant British Petroleum (BP). British Petroleum receives the payment in its own US bank account at Second Bank of Chicago. Purchase of BP shares (financial account, debit, US asset import) BPs deposit at Second Bank of Chicago (financial account, credit, US asset export) -$95 +$95

 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 account equals 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.

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, or intangible assets like debt forgiveness, copyrights and trademarks.

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

Sum of Four Components

1.
Current Account (CA) records exports and imports of goods, 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

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 (-).

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 abroad are credits (+) Interest, dividends and payments made on foreign assets held in the U.S. are debits (-). (d) Unilateral transfer account: net unilateral transfers such as gifts (transfers) across countries that do not purchase a good or service nor serve as income for goods 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. to other countries, pensions paid to U.S. citizens living abroad count as debits (-).

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 decit 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.

Capital Account
2. Capital account: Records special transfers of assets such as flows of special categories of assets (capital) - typically nonmarket, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks, but this is a minor account for the U.S. A positive value for the capital account is called a capital account surplus, a negative value is called a capital account decit.

Financial Account
3. Financial account: Accounts for flows of financial assets (financial capital), the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. Financial inflow: Foreigners loan to domestic citizens by buying domestic assets. Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction Financial outflow: Domestic citizens loan to foreigners by buying foreign assets. Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction.

Financial Account
Financial account has at least Three (3) subcategories: (a) Official (international) reserve assets (b) All other assets (c) Statistical discrepancy

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

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 (+)

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. So foreigners holding more U.S. currency is treated just like foreigners holding more U.S. assets. Similarly, U.S. residents holding more foreign currency is treated just like U.S. residents holding more foreign assets. Accordingly decreases in holding of foreign 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 (+)

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 domestic central bank are a debit (-) because the domestic central bank can spend less money to cushion against instability.

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.

Official Reserves Assets (Cont.)

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 foreign exchange intervention: Central banks buy or sell international reserves in private markets to affect macroeocnomic conditions (aiming at either a strong or a weak currency)

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 domestic central bank are a debit (-) because the domestic central bank can spend less money to cushion against instability.

Implication of OSB
The negative value of the official reserve assets is called the official settlements balance or balance of payments. It is the sum of the current account, the capital account, the nonreserve portion of the financial account, and the statistical discrepancy. A negative official settlements balance may indicate that a country 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 SEVERE EXCHANGE RATE DEPRECIATION

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.

Official Settlement Balance OR Balance of Payment

The balance of payments accounts therefore seldom balance in practice. The statistical discrepancy is 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.

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

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) of GDP Current Account: $ billion U.S. Current Account Deficit: > U.S.net Liabilities: Aprox.

Is this situation sustainable? Is depreciation of dollar likely?

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?

Dynamics of the Current Account

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

U.S.Interest rate: Low/ high/moderate? Low Approx. (exhibit)

Reserves in China:~$ and exhibit 9a & 9b)

billion increase in 2005 (Case Text

Dynamics of the Current Account

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

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)

Dynamics of Current Account Deficit

By 2006,the U.S current Account deficit at $788 billion, close to 6% of GDP, which was record high for the U.S. in absolute terms. 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 as 60%. Such high levels of net liabilities had occurred in other large 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.

Dynamics Of Current Account Deficit

However, coming to a conclusion on whether to bet against dollar 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-traded goods; prices, interest rates, and exchange rates, and fiscal and monetary policy, is important as a first step in being able to evaluate the decision to bet against the dollar. PERHAPS WE WILL BE ABLE TO RETURN TO THE QUESTION WITH More INSIGHTs TOWARDS THE END OF THE CLASS.

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 about Europe?

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

Balance of Payment Identities

Current Account (CA) = Exports Imports + Investment Income + Other services Income +Transfers Financial Account (FA) = Long-term Capital+ Short-term Capital

Balance of Payment Identities (cont.)

Capital Account & others (KA) Changes in reserves CA+FA+(KA)Change in reserve = 0 CAu.s. = - CArest of world

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 of the world. Board 2.

Cause of large U.S.Current account deficit Board 3a

Capital flows
(benign view)

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

Capital flows (Benign view) Reflects financial flows holds 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 intermediation finance 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

Cause of large U.S.Current account deficit Board 3b

Role of China

Role of China 3b (center)

China engages in currency manipulation to develop Perfect People in the United states enjoy high present consumption Match ! Perfect Match ! But it is important to figure out in this context: WHY the Chinese accumulate so much? Two Possibilities
1.Appreciated dollar In this case, global imbalance likely sustainable for much longer.

2.Have sufficient reserves to avoid financial In this case, China has enough already and Crisis, and steep changes in the exchange rate the U.S. current account deficit is going to .in Sum to dirty / managed float become unsustainable soon

Dynamics of Current Account Board (2) Center

Causes of Large U.S. Current account Deficit Global Imbalances: Sus+ SRest of world = Ius+IRest of World
Domestic= I + (X-M)

Domestic: Sprivat + Sgovernment = I + (X M)

Trade Flows Capital Flows

Rest of the World

Rest of the World

Role of China Europe/ rest of the world

National income Accounts

Dynamics of Current Account Board (2) Center

Causes of Large U.S. Current account Deficit Global Imbalances: Sus+ SRest of world = Ius+IRest of World
Domestic: SPrivate +SGovernment = I + (X-M)
National 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? - Supply factors If investment and private savings remain unchanged, a government deficit must result in trade deficit (GDP View) or current Account (GNP view) -Demand Factors Other countries accumulating reserves. Trade Flows Capital Flows

Rest of the World

Role of China Europe/ rest of the world

The U.S, imports too much, can not produce cheaply / innovatively enough to export goods. (See (See continuation 3a) continuation 3b)

Savings glut Low growth in Europe?

-Role of exchange rate

Question?
How does Macroeconomic forces affect the current account deficit in general and how do they affected the current account deficit in the U.S. in the past in particular, as described in the case.

Macroeconomic forces
How different macroeconomic forces affect the current account deficits in general and how they affected the current account deficits in the U.S. in the past, in particular, as described in the case.

There are three areas that may shed some light on the issues viz. : (i) National Income Account (the relationship between savings and investment) and Trade flows. (ii) Capital flows, and (iii) The role of Asia and the rest of the world.

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 labor as well as net unilateral transfers, which includes private gifts and official foreign aid.

Explanation for the U.S. current account deficit?

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

Explanation for the U.S. current account deficit

If the current account balance is given by (X-M) is negative, a country 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

Role of twin deficit

The case discusses the combination of high fiscal deficit (see case 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 Ricardian equivalance 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).

Re-conciliation of Exhibit 2a and 2b

Exhibit 2a shows gross private fixed domestic investment as 17% of GDP 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. In 2005, net domestic investment amounted to 7% of GDP, gross domestic public investment was 3% of GDP, and depreciation amounted to 13% of GDP. Adding net domestic investment of 7% to depreciation of 13% implies gross domestic investment of 20%. Subtracting 3% gross domestic public investment means that gross private fixed domestic investment is 17%, which is consistent with the value shown in Exhibit 2a.

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%, plus gross investment (I) as a percent of GDP is 17%, I= 17%; plus government consumption as a percent of GDP (G=19%) plus the (approximation of the) current account as a percent 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 not appropriate for calculation of these identities)

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

The so called New Economy of the late 1990s increased investment (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 current account 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 in the late 1990s were driven more by rising levels of investment than by declining savings rate relative to those in the rest of the world.

Continuing Housing Boom

In the late 1990s and through 2004, the U.S. current account deficit 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)

Trade flow of goods and services

What are the most important factors influencing the trade account?

Trade flows of goods and services

What are the most important factors influencing the trade account? 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 2000s responsible for widened CA deficit?
Explain if and how that might have happened

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, although not 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.

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 account balance through a number of channels : higher productivity growth boosted perceived rates of return on U.S. Investments, thereby increasing domestic investment as well as generating capital inflows that boosted the dollar; expectation of further higher returns boosted equity prices, household wealth, and perceived long run income, and so consumption rose and saving rates declined. With increased investment, decreased private savings, and an appreciated dollar, the U.S. current account deficit widened.

Role of supply factors

Using this reasoning, the argument often made that a pick-up in foreign productivity 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 goods production for 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.

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 as foreign 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. exports more competitive).

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

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.

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 of European 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 between exchange rates and the trade balance.

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 through understanding 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 + Irest of 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 financial flow

Please use example from the case (with reference to Exhibit 5-7 of the case) to discuss the relationship between the current account and financial flows.

Link between the CA and the FA

A countrys current account (CA) is the part of the balance sheet that reflects exports and imports of goods and services, the difference between income on foreign labor and capital employed in the home country and the income on home labor and capital employed abroad, and net unilateral transfers such as gifts and aid.

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

A countrys financial account reflects international purchases and 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 other countries fund its purchase of extra imports through buying assets or lending money)

Multiple types of financial assets

The Financial Account consists of multiple types of financial assets. 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 managerial control. Other investment assets and liabilities include bank deposit, trade credits, and loans.

The U.S. Economic Strength

As noted in the case, the 2006 Economic Report of the President focused 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.

Martin Feldstein disagreed with the analysis

Mr. Feldstein (well known0 economist at the time, noted that CA 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 a part 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 eventually decline to a level that leads to a trade surplus.

The U.S. is simply better at producing financial assets than other countries
MIT Economist Ricardo Caballero The U.S. is simply better at producing financial assets than other countries. Economist Catherine Mann gain from the trade should no longer be measured only in the real domain of goods and services, but should also be measured in how increased financial intermediation can improve on the risk and return frontier of the international wealth portfolio availability of greater diversity of financial assets and instruments allowed investors to target the type of risk they wished to undertake. Between 1995 and 2002, for OECD countries (excluding the U.S) external liabilities grew 8% per year while imports grew just 2% per year. Part of the increase in finance relative to trade reflected the build-up of foreign currency reserves by private entities as well as central banks.

Dominance of the dollar

The second important topic related to flows of financial assets is 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 account deficit.

The Value of accumulated financial flows

A third line of discussion relates to the value of accumulated financial 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.

The Value of accumulated financial flows (Exchange rate)

On the other hand as the case describes, the valuation of U.S. external assets and liabilities is affected by differences between U.S. and foreign equity market returns as well as exchange rates. The dollar exchange rate responds in a predictable, systematic manner during phases when the U.S. external position was unsustainable. In other 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 the NIIP (See impact of the dollar depreciation in 2002 and 2003 on the net position). Exhibit 11a, show that while CA deficit between 2001 &2007 totaled $4,242 billion, the NIIP deteriorated by only $573 billion over the same period.

The Value of accumulated financial flows (Exchange rate) (Cont.)

Economist note that large gross cross-holding of foreign assets 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 net assets 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 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 the present? What about Europe? Other Countries.

Student Discussion

Dollar-pegged currencies
Dollar-pegged Asian countries plays important role in maintaining the 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 U.S.

Exhibits 9a, 9b, and 10, show the amounts of funding provided 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 in Asia has re-established the United States as the center country in the Bretton Woods international monetary system.

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
From a domestic point of view : the current account trajectory is sustainable if the impact of the current account balance and NIIP on GDP growth (through consumption and business investment) is weaker than the 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 mostly dollar denominated. Exhibit 4a & Case discussion text: Foreign official investment which would require interest payments in the future, had become increasingly important in recent years. Feldstein in 2006 noted that public funds accounted for an average of only 14% of the capital inflow. He explains that this is misleading.

 Several ways of evaluating how foreign investment flows into the 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)

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 Logic 1. Keep the yen undervalued to grow 2. 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)

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

China
Unilateral 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 country to 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

Policy Coordination
Americans save more; adjust fiscal policy Europeans make structural changes to their economy to improve growth

Asians revalue collectively

Everybody gets something

Orderly solutions of global imbalances China able to prove it is a citizen of the world economy