Question

Why Merchandise trade balance and the current account balance are not good indicators of the basic strength or health of the U.S. balance of payments position?

Answer 1

The balance-of-payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. If all transactions are included, the payments and receipts of each country are, and must be, equal. Any apparent inequality simply leaves one country acquiring assets in the others. For example, if Americans buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding dollars, which they may hold in the form of bank deposits in the United States or in some other U.S. investment. The payments Americans make to Japan for automobiles are balanced by the payments Japanese make to U.S. individuals and institutions, including banks, for the acquisition of dollar assets. Put another way, Japan sold the United States automobiles, and the United States sold Japan dollars or dollar-denominated assets such as treasury bills and New York office buildings.

Although the totals of payments and receipts are necessarily equal, there will be inequalities—excesses of payments or receipts, called deficits or surpluses—in particular kinds of transactions. Thus, there can be a deficit or surplus in any of the following: merchandise trade (goods), services trade, foreign investment income, unilateral transfers (foreign aid), private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactions. The statement that a country has a deficit or surplus in its “balance of payments” must refer to some particular class of transactions.

Because the current account and the capital account add up to the total account, which is necessarily balanced, a deficit in the current account is always accompanied by an equal surplus in the capital account, and vice versa. A deficit or surplus in the current account cannot be explained or evaluated without simultaneous explanation and evaluation of an equal surplus or deficit in the capital account.

A country is more likely to have a deficit in its current account the higher its price level, the higher its gross national product, the higher its interest rates, the lower its barriers to imports, and the more attractive its investment opportunities—all compared with conditions in other countries—and the higher its exchange rate. The effects of a change in one of these factors on the current account balance cannot be predicted without considering the effect on the other causal factors. For example, if the U.S. government increases tariffs, Americans will buy fewer imports, thus reducing the current account deficit. But this reduction will occur only if one of the other factors changes to bring about a decrease in the capital account surplus. If none of these other factors changes, the reduced imports from the tariff increase will cause a decline in the demand for foreign currency (yen, deutsche marks, etc.), which in turn will raise the value of the U.S. dollar (see foreign exchange). The increase in the value of the dollar will make U.S. exports more expensive and imports cheaper, offsetting the effect of the tariff increase. The net result is that the tariff increase brings no change in the current account balance.

Here it is important to point out that when you hear a reference to a country’s trade balance, it could mean the merchandise trade balance, or it could mean the goods and services balance, or it could even mean the current account balance.

Occasionally, one will hear trade deficit figures reported in the U.S. press followed by a comment that the deficit figures refer to the “broad” measure of trade between countries. In this case, the numbers reported refer to the current account deficit rather than the merchandise trade deficit. This usage is developing for a couple of reasons. First of all, at one time, around thirty years ago or more, there was very little international trade in services. At that time, it was common to report the merchandise trade balance since that accounted for most of the international trade. In the past decade or so, service trade has been growing much more rapidly than goods trade and it is now becoming a significant component of international trade. In the United States, service trade exceeds 30 percent of total trade. Thus a more complete record of a country’s international trade is found in its current account balance rather than its merchandise trade account.

But there is a problem with reporting and calling it the current account deficit because most people don’t know what the current account is. There is a greater chance that people will recognize the trade deficit (although most could probably not define it either) than will recognize the current account deficit. Thus the alternative of choice among commentators is to call the current account deficit a trade deficit and then define it briefly as a “broad” measure of trade.

A simple solution would be to call the current account balance the “trade balance” since it is a record of all trade in goods and services and to call the merchandise trade balance the “merchandise goods balance,” or the “goods balance” for short. I will ascribe to this convention throughout this text in the hope that it might catch on.