CONTENT » GED Blog » Improving Public Understanding of Economic Globalisation » GED Explains: Three Reasons Why There Shouldn’t be Lasting Current Account Imbalances

GED Explains: Three Reasons Why There Shouldn’t be Lasting Current Account Imbalances
And six reasons why they nevertheless exist

Shutterstock / corgarashu Shutterstock / corgarashu

 

In a few blog posts we have focused on global current account imbalances and export surpluses (here & here). According to textbook economics, such imbalances should only prevail in the short term. Theoretically, there are three key mechanisms that automatically compensate for imbalances in foreign trade.

 

#1 The exchange-rate mechanism

 

The basic concept behind this mechanism is that the exports of a country ultimately have to be paid for in the currency of the exporting country. If German companies export their products to the USA, these companies have to pay salaries, taxes and rents, etc. in euros in Germany.

 

The same applies for German imports from the USA: the imported US products have to be paid for in dollars. For a German importer to hold US dollars, they must offer euros on the international currency markets and exchange them for dollars. The following correlations apply here:

 

  • German exports to the USA create a demand for euros on the international currency markets.
  • German imports from the USA create a demand for dollars and a supply of euros.

 

If the German exports are greater than German imports, the demand for euros exceeds the supply of euros. The high demand means that the price for one euro increases on the foreign currency markets. The euro appreciates. This appreciation has the result that German products become more expensive abroad. This lowers the demand for these products abroad, meaning that German exports contract.

 

The mirror image of a euro appreciation is a dollar depreciation. It means that US products become cheaper in Germany. This raises the demand of German consumers for American products, so German imports from the USA increase.

 

In a theoretical, ideal scenario, these adjustment processes last until the German exports fall in line with German imports and the export surplus disappears (see Figure 1).

 

Figure 1: Significance of a flexible exchange rate for reducing an export surplus. Source: own research. Figure 1: Significance of a flexible exchange rate for reducing an export surplus. Source: own research.

 

#2 Pricing mechanism

 

If Germany exports more than it imports, this means there is a high demand for German products. It results in an increase in the price for these products. The higher price makes it less attractive for foreign consumers to buy German products. Consequently, German exports decline.

 

In a country whose imports exceed its exports (like the USA for example), the opposite scenario arises: the low demand for domestic products pushes prices down. The price decline means that all consumers take a greater interest in US products that are better value for money. For Germany, this would mean greater demand for goods and services from the USA. So German imports would go up.

 

In the theoretical, ideal scenario, the price increase in countries with an export surplus (such as Germany) and the price decrease in countries with an import surplus (such as the USA) would mean lower exports and higher imports for the country with the export surplus. This adjustment in turn lasts until the exports fall into line with the imports (see Figure 2).

 

Figure 2: Significance of flexible goods prices for reducing an export surplus. Source: own research. Figure 2: Significance of flexible goods prices for reducing an export surplus. Source: own research.

 

#3 The interest-rate mechanism

 

An interest-rate mechanism to even out trade imbalances mainly affects countries that import more than they export (such as Portugal). If Portugal imports more than it exports, it spends more in foreign trade than it receives. The country has to borrow the missing financial resources abroad. If Portugal produces import surpluses for several years, its debt versus the rest of the world will rise year-by-year.

 

A growing external debt means that it will become ever more difficult for Portugal to make its interest payments and capital repayments. Portugal’s creditworthiness will fall. International lenders tend to react to lower creditworthiness by demanding a higher interest rate to compensate for the growing risk of a credit default.

 

The higher interest rate, in turn, means that Portuguese consumers are less willing to resort to loans to finance their consumption spending. Portuguese companies scale back their investments on account of the growing costs of capital. Finally, the Portuguese state curtails its spending on goods and services because it has to divert a greater portion of its revenues to make interest payments.

 

The rising interest rates ultimately mean that demand for goods falls throughout the Portuguese economy, which lowers the import demand as well. The decrease in the loan-funded demand for goods reduces the aggregate demand, which means the demand adapts to local production capacities. The excessive consumption is lowered and the trade account balances out in an ideal scenario (see Figure 3).

 

Figure 3: Significance of a flexible interest rate for reducing an export surplus. Source: own research. Figure 3: Significance of a flexible interest rate for reducing an export surplus. Source: own research.

 

So why do we still have lasting foreign trade imbalances?

 

In economic theory there are enough mechanisms that result in an automatic reduction of export surpluses and import surpluses. The fact that economic reality still provides instances of lasting trade and current account imbalances is due to the fact that these mechanisms are blocked in numerous cases. Here are six examples:

 

  1. The exchange-rate mechanism no longer applies in the eurozone since the advent of the single currency, the euro. Were Germany still to have its own currency, for example, by rough estimates it would be worth around a third more, which would curb price competitiveness – and with it German exports.
  2. Exchange-rate mechanisms are also disabled in cases where a country pegs its own currency to another currency. One prominent example here is China’s exchange-rate policy, which for a long time has tied its own currency to the US dollar and thus prevented the yuan from appreciating.
  3. The pricing mechanism is suspended in highly productive industrialized countries showing saturation trends inasmuch as there are excess capacities. This is because excess capacities make sure there are no price increases, in spite of the high export demand. Examples here include the ageing societies of Japan and Germany. But in this context we can also mention the surplus capacities of the Chinese economy, built up over years of high investment.
  4. In countries with import surpluses, the pricing mechanism often does not function because the company is not able or willing to sell its products at prices which fall short of the production costs. What is more, reducing wages tends to be socially unfeasible.
  5. The low-interest policies put in place by many central banks since the collapse of Lehman Brothers has led to the failure of the interest-rate mechanism. The enormous liquidity being pumped into the economy by the central banks prevents interest rates from rising, despite the global increase in debt.
  6. As described in an earlier blog post, the interest-rate mechanism does not apply for the US economy either. This is because the US dollar is the world’s reserve currency. So all countries need dollars. Consequently, the US economy can almost take on unlimited debt in its own currency throughout the rest of the world.

 

Conclusion

 

The high and lasting current account deficits will in all likelihood remain in the future because the key balancing mechanisms are disabled in the most important economies.