The business news is full of trade deficits, current account surpluses and budget shortfalls. It’s very confusing. And not all of it is related. As in: sometimes, not at all.
So this is an attempt to break it down into digestible chunks.
First things first: “deficit” just means “in the red”
“Deficits” and “shortfalls” are descriptive terms for a situation where a relationship between two more-or-less-opposite economic forces is unequal in a negative way. Just as “surplus” is inequality in a positive way.
Which is the first source of confusion – because talking about negatives and positives in the macroeconomic sense is purely a matter of political affiliation.
The important relationships that usually get discussed:
1. Government Spending and Tax Collection
If you pictured the economy as a closed room where we’re all having a party, the government would be the giant holding the gun in the centre of the room. If your country has an oil industry, or a very-developed finance sector, you’d have another two giants swilling cognac on the side. The rest of us would be mice, scrambling around and chittering. Interspersed with a few rats and the occasional cat guarding the punch bowl.
The government giant spends his time taking some of the punch from the rats, cats and other giants at gun point (tax collection), and then giving it to the struggling mice on the fringe (government spending).
“Fiscal deficits” arise when the government dishes out more punch than he can confiscate.
“Fiscal surpluses” happen when a government gets punch-drunk.
2. Saving and Consumption
When you look at Japan and their Abenomics story, a common interpretation is that the “frugal” Japanese have plunged themselves into zero-growth by saving too much money. Abenomics is an attempt to break that frugal mentality by threat*, coercion** and persuasion***. Once broken, the steady stream of consumption (spending) would lift demand and, like, rising tides…
*the threat is confiscation of buying power through accelerated inflation – which would be the QE arm of Abenomics.
**Coercion is by literally paying people more through fiscal stimulus. As in “Here’s more money. You see? You don’t need to save. Go forth and spend”.
***Persuasion is the promise of structural reforms.
We don’t really talk about deficits and surpluses when it comes to savings and consumption. But we do talk about over-consumption (where you’re using borrowed money – that is, negative savings) and so on.
3. Imports and Exports
Current account deficits and trade surpluses – they all relate to this.
Exporters make/grow products that they can sell abroad; importers buy products that they can sell in their home countries. The general assumption is that you’d only import what you can’t make at home; and you’d only export what you don’t need at home.
The implication: if you import more than you export, then you’re an ocean of need (hence, a trade deficit and/or a current account deficit). And if you export more than you import, you’re an independent woman (hence, a trade surplus and/or a current account surplus).
4. Foreign Investment (the Incoming and Outgoing varietals)
But not all money moving in and out of a country is for trade. Some of it is for investment. So when you hear the term “capital account” being discussed, then this is what they’re going on about.
Examples: “hot money flowing in to a company’s stock market”, “China buying a mine in Chile”, etc.
So How Does This Relate To The Balance of Payments?
Well – the first two relationships have nothing to do with the Balance of Payments. The BOP is all about transactions between countries, where consumption, spending and the role of government are all domestic matters.
So now that’s clarified, you’d need an equation. There’s some debate around it, but here’s my version:
Current Account + Capital Account + “balancing item” = Change in Foreign Reserves
Sometimes, it gets written as:
Current Account + Capital Account + “balancing item” = 0
Although in that second scenario, someone has just made “change in foreign reserves” part of the Capital Account. Which I think is a bit not-particularly-useful, seeing as economic commentators love to talk about foreign reserves when interviewed on live television.
The principle behind the BOP is this: when you transact with other countries, either through trade (the current account) or investment (the capital account), you either end up spending foreign money (decrease in foreign reserves) or collecting foreign money (increase in foreign reserves)*.
*And as for the “balancing item” – that’s the error term. I believe that many countries now call it “net errors and omissions”, in order to, um, reduce confusion. That aside, the point is that trade and investment are measurable, as is the change in foreign reserves (those are held by the Reserve Bank). So when they don’t all add together, you must have made some statistical errors somewhere along the way.
In deficit/surplus terms, decreases in foreign reserves are deficits and increases in foreign reserves are surpluses.
And somehow, this all relates to the exchange rate…
Which will be part 2.