Question

The United States has run a persistent current account deficit since the early 1980’s. Most smaller countries and less developed economies fear current deficits if they persist for even a few years. Why are persistent current accounts deficits potentially a problem for these countries?

Answer 1

When countries like the United States run large deficits, businesses, parliamentarians and trade unions are often quick to point fingers at trading partners and make charges about their malpractices. There is tension between the United States and China about which country is mainly responsible for the imbalance in trade between the two.

When a country runs a deficit in its current account, it is building up liabilities for the rest of the world which are financed by flows in its financial account. Gradually, they need to be paid back.If a country wastes its borrowed foreign funds on spending that yields no productive gains in the long term, then its ability to repay the basic solvency might come in question because solvency needs that the country be willing and able to generate sufficient current account surpluses to repay what it has borrowed in order to finance the deficits. So, if a country should run a current account deficit or not depends on the extent of its foreign liabilities and also whether the borrowing will finance investment with a higher marginal product than the interest rate to be paid on its foreign liabilities.

Even if the country is solvent intertemporally which means that the current liabilities will be covered by the future revenues—its current account deficit may become unsustainable if it is unable to secure the financing required. Some countries like Australia and New Zealand have been able to maintain current account deficits averaging about 4.5 to 5 percent of GDP for several decades and several economies during the recent global crisis faced sharp reversals of their current account deficits after the private financing took off during the financial crisis.

Therefore, very large and persistent deficits call for attention, before a country experiences an extreme and painful reversal of financing.