Question

How would you address financial/capital account deficits? Evaluate the pros and cons of such policies.

Answer 1

The capital account is one of two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in ownership of national assets.

A surplus in the capital account means money is flowing into the country, but unlike a surplus in the current account, the inbound flows effectively represent borrowings or sales of assets rather than payment for work. A deficit in the capital account means money is flowing out of the country, and it suggests the nation is increasing its ownership of foreign assets.

The term "capital account" is used with a narrower meaning by the International Monetary Fund (IMF) and affiliated sources. The IMF splits what the rest of the world calls the capital account into two top-level divisions: financial account and capital account, with by far the bulk of the transactions being recorded in its financial account.

Pros and Cons :

1. Employment: When a country persistently experiences a trade deficit there are predictable negative consequences that can affect economic growth and stability. If imports are more in demand than exports, domestic jobs may be lost to those abroad. While theoretically, this makes sense, the data suggests that unemployment levels can actually persist at very low levels even with a trade deficit, and high unemployment may occur in countries with surpluses.
2. Currency Value: The demand for a country's exports impacts the value of its currency. American companies selling goods abroad must convert those foreign currencies back into dollars in order to pay their workers and suppliers, bidding up the price of their home currency. As the demand for exports falls compared to imports, the value of a currency should decline. In fact, in a floating exchange rate system, trade deficits should theoretically be corrected automatically through exchange rate adjustments in the foreign exchange markets. Put another way, a trade deficit is an indication that a nation's currency is desired in the world market.  
3. Interest Rates: Similarly, a persistent trade deficit can often have adverse effects on the interest rates in that country. A downward pressure on a country's currency devalues it, making the prices of goods denominated in that currency more expensive; in other words it can lead to inflation. In order to combat inflation, the central bank may be motivated to enact restrictive monetary policy tools that include raising interest rates and reducing the money supply. Both inflation and high interest rates can put a damper on economic growth. Again, the United States as well as Europe have resisted this outcome with historically low interest rates and low levels of deflation over the past decade. However, smaller countries would not fare so well.
4. Foreign Direct Investment: By definition, the balance of payments must always net out to zero. As a result, a trade deficit must be offset by a surplus in the country's capital account and financial account. This means that deficit nations experience a greater degree of foreign direct investment and foreign ownership of government debt. For a small country this could be detrimental, as a large proportion of the country's assets and resources become owned by foreigners who can then control and influence how those assets and resources are used. According to Nobel laureate Milton Friedman, trade deficits are not ever harmful in the long run because the currency will always come back to the country in some form or another, such as via foreign investment.