What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending.  The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

Does a current account deficit really matter?

Should we be concerned if, as an economy, we are running a large current account deficit? The UK has run large current account deficits in recent years with barely any effect on the overall performance of the economy. The United States economy is also experiencing a huge trade deficit at the moment. What are the implications of this?

In the 1950s, 60s and 70s, small balance of payments deficits in the UK caused ‘economic crises’ with periods of strong speculative selling of sterling on the foreign exchange markets and much political instability. The devaluation of the pound in 1967 led directly to the resignation of the then Chancellor, James Callaghan. These days, trade deficits of enormous proportions seem to have little effect in global currency markets.

Some policymakers and economists believe the balance of payments no longer matters because of globalisation and financial liberalisation: in other words, trade and current account deficits can be more easily financed by globally integrated capital markets freed from the capital controls that have been dismantled since the end of the 1970s.

This free movement of global financial capital has allowed countries, in principle, to increase their domestic investment beyond what could be financed by a country’s own savings. Increasingly what we want to consume is produced abroad and if a country wants to operate with a sizeable current account deficit, then provided there is a capital account surplus, there is no fundamental economic constraint.

Britain has been a favoured venue for inward investment (an inflow of capital) and our relatively high interest rates compared to the USA and the Euro Zone has also attracted large-scale inflows of money into our banking systems. In this way the current account has been financed with little obvious economic pain.

UK Foreign Direct Investment
Millions of US dollars
	Inward	Outward
2001	56623	58855
2002	24029	50300
2003	20298	66457
2004	78399	65391
Stock of UK foreign direct investment
	Inward	Outward
1980	63014	80434
1990	203905	229307
2000	438631	897845
2004	771658	1378130
Stock of UK foreign direct investment as a share of GDP
	Inward	Outward
1980	11.8	15
1990	20.6	23.2
2000	30.5	62.4
2004	36.3	64.8
Presence of UK corporations in the world's 100 largest non-financial trans-national corporations
Ranked by foreign assets, 2003
Corporation	World ranking	Foreign assets
Vodafone Group	2	243839
British Petroleum	5	141551
Royal Dutch/Shell	7	112587
Unilever	43	28654
Glasxosmithkline	56	23893
Source: UNCTAD, World Investment Report 2005

The main arguments for being relaxed about a current account deficit are as follows:

• Partial auto-correction: If some of the deficit is due to strong consumer demand, the deficit will partially-self correct when the economic cycle turns and there is a slowdown in spending
• Investment and the supply-side: Some of the deficit may be due to increased imports of new capital and technology which will have a beneficial effect on productivity and competitiveness of producers in home and overseas markets
• Capital inflows balance the books: Providing a country has a stable economy and credible economic policies, it should be possible for the current account deficit to be financed by inflows of capital without the need for a sharp jump in interest rates. The UK has run an average annual current account deficit of £10 billion from 1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and falling unemployment during that time

But

• Structural weaknesses: The trade / current account deficit may be a symptom of a wider structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient investment in new capital or a shift in comparative advantage towards other countries.
• An unbalanced economy – too much consumption: A large deficit in trade is a sign of an ‘unbalanced economy’ typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these “macroeconomic imbalances” have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.
• Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it represents a net leakage from the circular flow of income and spending. Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import penetration, may find it difficult to find new employment.
• Potential problems in financing a current account deficit: Countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year and eventually investors in other countries may decide to put their money elsewhere – this would put severe downward pressure on the US dollar (see below)
• Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment.

The UK has run a current account deficit in each year since 1998 but that the size of the deficit expressed as a percentage of national income (GDP) has actually been falling in the last three years – it is now less than 2% of GDP – a manageable level with few obvious painful consequences. Hopefully our trade balances will improve if:

• UK businesses successfully improve their cost and price competitiveness
• The exchange rate depreciates to provide the export sector with a competitive boost
• The UK manages to take advantage of a forecast acceleration in the rate of growth of world trade in the next few years

In contrast the US economy is operating with a current account deficit on an enormous scale and this is part of the “twin deficit problem” that will have to be addressed in the near term (The US government is facing up to huge current account and budget deficit problems).