Does the “Current Account Deficit” Matter?

Does the “Current Account Deficit” Matter?

January 8, 2006


Does the U.S.’s (or any country’s) “current account deficit” matter?


The simple answer is: no.


However, especially in this environment of floating currencies, that answer is, as Einstein might say, a bit too simple.


What is a “current account deficit”? It sounds horrible. After all, who wants a “deficit” of anything?


The first thing to recognize is that all trade is balanced, by definition. A trade, as opposed to a gift, is a situation in which one thing is traded for another. Since the act is voluntary, each participant considers himself a little better off than he was before, or, to put it another way, that the thing received is a little more valuable than the thing offered. We can average this out a bit and conclude that the values of the things traded are perceived to be roughly equal, at the time of the trade. Thus, there can never be a “trade imbalance.”


OK, then, so what are these trade/current account imbalances that everyone is talking about?


We categorize the things that can be traded into basically two types: goods and services, and financial assets. This categorization is natural because the two classes of tradeable things have different characteristics. If you trade goods and services for goods and services, e.g., an apple for a banana, then after the transaction, the two traders have no more relationship with each other. They can go their separate ways and never see one another again. However, financial assets (primarily stocks and bonds) tend to create a long-term relationship. If you buy stock in a company, you become a part owner, and you then have a relationship with the other owners for as long as you own the stock. If you obtain a debt asset (i.e. someone owes you money), then you have a relationship with the borrower until the debt is paid off. Real estate can be considered a “good,” but its owner, if foreign, will have a long-term relationship with tenants, local governments, etc.


Thus, if an entity, on net, trades financial assets (typically debt) for goods and services, that entity is said to have a “current account deficit.” On net, its debt with the Rest of the World is increasing.


Is this a bad thing?


It might be. It might not be. “Nobody ever got rich by going into debt,” certain anti-current-account-deficit-types like to claim. (Bill Bonner has been carrying the torch most eloquently lately, with his new book Empire of Debt.) This is a nice Puritan sort of homily, but it is not necessarily true. Borrowing money can be a wonderful way to get rich. Ask Donald Trump! Or any bank in the U.S. Financials now produce something like 40%+ of all the profits of the S&P 500.


There is “good debt” and “bad debt.” “Good debt” is debt that is used to acquire/create an asset which returns more than the interest on the debt used to create it. If you borrow $100 million dollars at 8%, and purchase/create an asset that pays 15% on capital invested, then the asset pays for the debt and then some, making the equity holder rich. And how would this equity holder get even more rich? Simple: borrow $1 billion at 8% and purchase/create and asset that pays 15%.


This is what banks do. They borrow money from depositors at perhaps 3%, and lend it at 7%. The big banks have “gone into debt” to the tune of hundreds of billions of dollars, which should produce plenty of profits as long as the borrowers pay the money back.


This is also what most large companies in the U.S. do. They borrow at 6% or so, then take the money and build a business that makes more than 6% in the form of cashflow. Part of the money goes to pay the interest on the debt, and the rest goes to shareholders. While corporate debt as a percentage of GDP or a percentage of shareholder equity has gone both up and down over the years (mostly up), the total nominal amount of non-financial corporate debt has gone in only one direction: up. “Going into debt” has been the preferred method of building wealth for the last two hundred years or so.


But sometimes, an entity takes on “bad debt.” “Bad debt” is created when you borrow money and then squander it on something that produces no return or value, leaving only the debt to repay. You can probably name some individuals who are addicted to “bad debt.” Or some governments? Oh yeah. Some corporations too, although they tend not to stick around.


Consumer finance tip: DO NOT take on “bad debt.” About the only “good debt” that most consumers are exposed to is a mortgage. The “cashflow” in a mortgage is what one would have otherwise paid in rent. This becomes “bad debt” if the total costs of owning are in excess of what one would pay in rent. Consumer finance tip 2: In terms of monthly expenses, buying should be a little cheaper than renting, even when using a long-term fixed-rate mortgage. A car is another possible “good debt” (buying compared to leasing), although in practice, if you can’t pay cash for a car, then you probably shouldn’t buy it.


Thus, when an entity has a “current account deficit,” it is typically borrowing money. This might be “bad debt,” and might get the entity into trouble.


What is this “entity” that I keep talking about? It might be a household. When you buy a house with a mortgage, you personally run a giant “current account deficit” as your trade with the Rest of the World consists of: I will trade you this debt obligation for a house. Thanks! When you put “money in the bank,” you are in effect loaning money to the bank, and receiving a debt asset, which is the bank’s obligation to pay you back with interest. Your trade with the ROW may consist of trading your labor to an employer (goods and services) for a debt asset, producing a personal “current account surplus.” A corporation might run a “current account deficit” when it borrows to fund capex. “I will trade you this debt obligation for the goods and services that allow me (the corporation) to create a new productive asset.” If the corporation pays back its debt, it runs a “current account surplus.” A government might also run a “current account deficit” when it borrows money to finance a war in the Middle East.


Except for some oddities, that about sums up the various sorts of entities out there: households, corporations, and governments. All of these entities have assets and liabilities, income and outflows, all of which themselves are predicated on ownership.


Note that a “country” is not on the list. Everything is done and owned by the “entities” listed above: households, corporations and governments. The “country” does not have assets or liabilities, income or outflows, or ownership. A “country” is merely the jurisdictional area for a government.


Are you beginning to sense the oddity of saying that the “U.S. has a current account deficit”? The U.S. does not exist, as an economic entity. It is a statistical abstraction.


Let’s think about the people in the neighborhood. Maybe the Johnsons are hardy Puritan savers, and run a constant “current account surplus” as they accumulate savings at a bank. The Smiths, however, are running a “current account deficit” as they buy their now home entertainment system on credit. The Robertsons are running a “current account deficit” as they purchase wildly overpriced real estate with bank debt. The Jacksons are also running a “current account deficit” as they buy real estate that not only pays for its debt via cashflow but produces excellent surplus cashflow on top of it.


Now, maybe the Smiths’ “current account deficit” gets them into big trouble when Mr. Smith loses his job and can’t make the payments on the plasma TV, leading to personal bankruptcy. This is unfortunate for the Smiths, but no big deal for the Johnsons, who are essentially unaffected. The Robertsons also go bust trying to keep up on their negative-cashflow-producing property, which turns out to be a good thing for the Jacksons, as they are able to add to their real estate holdings by buying the Robertsons’ property at a great price in the ensuing bank workout.


Now, here’s the question: is the neighborhood as a whole running a current account deficit or surplus? And is that a good thing or a bad thing?


“Who knows?” you say. “And who the hell cares? As long as I’m a Johnson or a Jackson, what the Smiths and Robertsons do is their problem, not mine.”


So what you are saying is that the aggregate “current account balance” for the neighborhood as a whole doesn’t really matter, right?


That’s enough to chew on for this week. More next week.