Understanding the Balance of Payments

The balance of payments is the measure of all economic transactions between an economy and the rest of the world. As such, it covers the whole economy and should not be confused with the Government Budget.

The balance of payments must always balance and if there is a deficit or surplus in goods, services, or some other component of the balance, it will be met with an equal change in the value of money or other asset. In a free exchange market, for instance, the currency of the country will adjust to alter living standards and the source of any surplus or deficit.

The balance of payments consists of a current account, known as the balance of trade, a financial account, and a capital account. The current account is a record of net exports, plus income from abroad and direct transfers into a country. Many countries, particularly in the English-speaking world, run a deficit on this current account, because consumers and businesses purchase more imports than exports. This may well be due to comparative advantage because using income to buy imports might have a lower opportunity cost than replacing the imports with domestically produced goods or services.

The financial account measures changes in the ownership of intellectual property and whether the owners of domestic assets are within or outwith the country. A country which was selling its assets to foreigners faster than it was acquiring assets from them, and which was not making enough money on the transfer of copyright, trademarks, or patents to fill any gap, would see a deficit on the financial account.

The capital account measures the net flow of hot money and portfolio investment, long term foreign direct investment, and foreign exchange reserves.[1]

It should be obvious therefore that people do use phrases like ‘deficits’ and ‘surpluses’ on the balance of payments but they generally mean deficits in the current account, or balance of trade.

A country can run a deficit on one account if it is matched by a surplus on another. For instance, the United Kingdom, almost traditionally, tends to run deficits on its current account (despite being somewhere between the eighth and twelfth largest exporter on earth by most measures.) This deficit generally arises because, although the UK runs a reliable surplus in services, it runs deficits in imports of goods. The position of the UK may change over the course of 2021-22 since its products at that time will lose tariff-free access to the European Union’s single market, which accounted for around 43% of UK trade in 2019-20.  The UK runs a surplus on the capital account because of large investments into the country, and the flow of money into the City of London and several smaller financial exchanges. In times of instability, UK banks and assets have also been seen as ‘safe haven’ investments.

Similarly, the United States of America runs regular large trade deficits, balanced by investment into the US and purchases of the dollar as a reserve currency that can be used in international transactions. This peculiar situation, however, is only partly created by a ‘productivity gap’ on the part of American exporters. It is also a consequence of running the global world currency, according to theorists who accept the Triffin dilemma, named after a Belgian economist. The Triffin dilemma holds that a country which wishes to benefit from global use of its currency must allow the accumulation of that currency by foreigners through trade deficits and government borrowing in excess of what it removes by exports. Given that world trade has been based around the US dollar since 1944, that the dollar has not been backed by gold by simply by confidence since 1973, and that no other country can supply enough of its own currency to meet domestic and world needs, the Triffin dilemma is a persuasive explanation of why American national and government deficits have not led to dollar collapse.[2] Foreigners fund them.[3]

The self-regulating mechanism of the current account in economics is a free floating currency, providing that the sum total of the elasticities of imports and exports is greater than 1 (the Marshall-Lerner condition.) All other things being equal, if a country is importing more than it exports and is paying foreigners with their own money (that is, if it is not a reserve currency) then it has to buy the foreigners’ money to buy foreign goods.

This process drives up demand for the foreign currency and increases the supply on markets of the domestic currency, so the exchange rate value of the domestic currency falls. This in turn makes exports from the domestic economy cheaper, and makes imports more expensive. That process should return the current account to balance.

Eventually, such a country will be selling so many exports and buying so few imports that its currency starts to rise again, which tempers its surplus and returns the country to balance (unless the country, as above, has a Triffin dilemma because it is the issuer of a reserve currency.)

The process of adjustment by markets to a level of trade in imports and exports that stops such great fluctuations imagines the balance of trade to head down, then curve round into a surplus again, then to head down. A little effort on the graph makes this process look like a ‘J’ or rather a series of smaller and smaller linked ‘Js’ as the current account tends towards a balance. Rather unimaginatively, this development is known as the J-curve effect.

There are two final pieces of economic jargon which need to be explained before any further elaboration. One is the explanation of the phrase ‘terms of trade.’ The Terms of trade are simply a measure of how well or how much a country can pay for its imports with its exports. It is associated with a formula, --

( Index of Export Earnings / Index of import costs ) * 100.

The terms of trade are a somewhat crude measure for what is happening in a country’s economy. If the final value is over 100, for instance, it means that the economy is selling more outside than it is spending on imports, and can be taken as a healthy sign; conversely, if the index is below 100, that means that the country is seeing an outflow of money.

Remember, however, that actually these values can be affected by fluctuations in the exchange rate, and generally they only speak to a subset of the entire balance of payments. An economy is not necessarily unhealthy when running a trade deficit if it has a surplus on the capital account, and indeed, may be reducing the pressure of demand-pull inflation in those circumstances. If a country has a very large loan which it has to repay in a foreign currency, it could be that that country is preventing any fall in the exchange rate, and that this is distorting the balance of trade.

Generally speaking, improvements in the terms of trade will mean that a country can buy more with less, and could reduce cost-push inflation.  This is where the final economic term which you might come across appears—The Prebisch-Singer hypothesis. This is the idea that a country automatically gains in productivity and export value by moving from an agricultural to an industrial production. On this basis, there was for a time a prejudice in markets against those countries, largely developing ones, which were focussed on commodity production of agricultural or mineral items, and in favour of those which were industrial.

In a world where resources are scarce and there is a growing and large population in richer countries which cannot feed themselves—like China, for instance—a moment’s reflection will suggest that the P-B hypothesis does not apply. Instead, it should be obvious that countries which can reliably produce food and minerals in fact will experience an improvement rather than a decline in their terms of trade. Many countries in the global South spent a good deal of the post-colonial second half of the twentieth century in debt, so dependent on developed country markets that the Brandt Commission named an economic theory after them. Today, however, they are not only commodity rich but have had their debt forgiven or rescheduled, and in some ways are poised for a period of stability and growth.

Globalisation, Deglobalisation, Glocalisation, and the development of Trade Blocs[4]

Globalisation is the integration of domestic markets in whole or part into global ones and has been a cyclical process for most of the past two hundred and fifty years or so. Each new burst of integration has tended historically to lead to protectionist backlash or complications with supply chains and international financial and legal structures, which in turn have led sometimes to devastating crashes and the generation of depressions and negative output gaps. By and large, however, the moments of reset and reaction, whilst deeply unpleasant and sometimes leading to war and ‘beggar my neighbour’ protectionism, have never seen an absolute fall backwards in economic development. Each stage has built on the knowledge, innovation, example, or memory of the one before.

The process of globalisation is dependent on development, the accumulation of initial capital, and upon the technology and productivity of communication, manufacturing, and transport. ‘Glocalisation’ is a somewhat ugly term which in recent years has been employed to indicate that many economies are experiencing a retreat from international supply chains, and a ‘re-concentration’ on local employment, manufacturing and services at the expense of outsourcing and international supply. In many places this is accompanied by a rise in protectionism, ‘buy local’ campaigns, or exchange rate manipulation by governments.

An economics student may come across two different terms when encountering this debate. One is expenditure-switching policy, and the other is import-substitution policy.

Expenditure switching occurs when governments find ways to get consumers and companies to spend on domestic rather than foreign goods, and could involve everything from attempts to persuade consumers to regulations and laws that make domestic goods more attractive without formally banning imports. Argentina and the People’s Republic of China, to name two, have become past-masters of this sort of thing in recent years.

Import substitution is a blunter and somewhat more brutal policy, but can be as effective. This is when countries attempt simply to exclude foreign versions of goods, and to substitute domestically produced alternatives.

Sometimes, such policies are attractive and are maintained for national security reasons—with regard to the creation of a stable food supply, for instance. This has been the justification for a good many agricultural import substitution programmes in a number of economies, not least the European Union. Sometimes, they are forced on countries because sanctions imposed by sections of the international communty require them. In the case of the Russian Federation in the early twenty first century, for example, an argumenty can be made that sanctions were actually counter-productive and that they boosted Russian terms of trade (especially since Russian exporters found an inelastic demand for their food and energy in countries like China and Gernany.)

Generally, however, protectionism has tended to decline across time because it raises the price of goods and material in a market, undermines attempts to improve productivity, reduces competitive pressures, and limits supply. As the example of comparative advantage will have shown, it also makes the world in general far less efficient, which is a regressive step because it hurts the poor more than the rich. Arguments can become quite political quite quickly, as in the Free Trade debate in Britain between the 1890s and 1920s, or the policies associeted with the US administration of 2017-2021.

One unarguable exception in the modern industrial period has been the example of protectionism and trade restriction helping the development of economies where they start from a low base, and face being overwhelmed by a much large neighbour if they simply open their borders and lower or eliminate tariffs. The German Reich from 1871, the United States until the 1960s, and both Russia since 1999 and the People’s Republic of China since 1987 did tend to make life harder for importers and easier for exporters. Policies ranged from a managed and undervalued fixed currency to forced joint ventures with domestic companies, tariff walls around the economy, and subsidies or hidden subsidies  for domestic goods. The Japanese, American, and European economies also at one time or another, benefited from proprietorial approaches to various ‘infant industries’ and future global competitiors (which may well be why such policies tend to be associated with developing countries, the arms industry, and high-tech markets based on the latest scientific research.)

Even in this exception, evidence is however mixed. If we draw the most recent period of globalisation as lasting from around 1990 to 2008, give or take a few years, the clear winners have been the countries and peoples who were previously struggling with protected western markets and theories of import substitution, such as those in Africa and Latin America. Similarly, a managed global approach, however distorted by sanctions, has allowed Russia to experience the longest sustained period of growth in her history, and more people have been lifted out of absolute poverty in china by export-driven policies than at any time in history in total or ever. In such circumstances, reports of the death of globalisation should be taken with ‘a pinch of salt.’

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[1] There is a slight degree of confusion in most textbooks and amongst economics teachers concerning these terms. This is because the International Monetary Fund tends to use slightly different definitions of ‘financial and capital account’ from the British markets and many non-American economists. It is rather like the way in which the words ‘billion,’ ‘milliard’ and ‘trillion’ used to mean different things, and arises because the IMF attempted to produce a clear definition at odds with most academic and trader understanding in the sixth edition of its Balance of Payments Manual (2008, p.7)

[2] Although some theorists think that there may be a connection with the desiccation of domestic industry, in part. This is because they argue that, when private investment goes into government bonds and government borrowing, it doesn’t of course go into corporate bonds and venture capital. This is called ‘crowding out’ and leads businesses having to pay more to borrow on a smaller pool of money available. Other modern theorists dispute this, and argue that quantitative easing means that banks have a pool of liquid money to lend to business and consumers, which some might use to buy shares, whilst at the same time  maintaining the value of the dollar without higher interest rates.

[3] Until they won’t. There is no alternative financial market in any one country big enough to provide an alternative, and there has never been agreement in modern times on any alternative ‘global’ currency like the IMF’s Special Drawing Right, created in 1969 and used in some transactions. Adopting gold or silver for a global standard would be ruinous, as there is such a limited supply of such metals that a gold standard would create a deflationary collapse. In 2021, El Salvador became the first country to adopt BitCoin as a form of legal tender, and others now use or allow bitcoin and cryptocurrencies as reserve assets for transactions. It remains to be seen whether this development will allow the world to turn away from US dollars in a fashion which does not crash the dollar and therefore bond and asset markets.

[4] As an aside, ‘bloc’ is the appropriate term for a collection of things whereas ‘block’ is a unit and normally refers to a coherent single obstacle. You may come across some fairly arcane words for bloc as people search through their thesaureses, such as (my favourite) ‘congeries,’ but all of them are little used these days, outside of the USA.