• Some examples of the double-entry bookkeeping system can be helpful.

Case 1: Mr. A. Phile pays $65,000 in cash to Jaguar of U.K. for a new XJ8 convertible.

Jaguar deposits the dollars into its U.S. bank account. Current Account = -$65,000 [Imports

(debit)] Capital Account: = $65,000 [Jaguar has increased holdings of U.S. currency (credit)].

Case 2: Dell buys $15,000,000 worth of hard-disk drives from a South Korean company and

sells $25,000,000 worth of computers to another Korean company. Dell now has $10 million

that it lends to Daewoo, which is struggling to build cars. Current Account: $10,000,000

[Exports $25,000,000 (credit), Imports $15,000,000(debit)] Capital Account: - $10,000,000

[Increased loans to foreigners $10,000,000(debit)]

Case 3: I buy $10,000 worth of shares of MushyPeas-R-Us by borrowing money from a British

broker. Capital Account $0 [U.S. Purchase of Foreign Asset $10,000 (debit), Foreign loan to

U.S. resident $10,000 (credit)]

IV. THE BALANCE OF PAYMENTS

• The sum of the current account balance and the capital account balance is referred to as the

Balance of Payments. Note that this is a term distinct from the BOP accounts, This is a

little confusing but such is the arcane world of the BOP accounts.

• The Balance of Payments represents the difference between total receipts from foreign nongovernmental

entities and total payments to foreign non-governmental entities. A negative

value reflects the fact that total receipts from foreigners is less than total payments to foreigners.

A positive value reflects the fact that we total receipts from foreigners exceeds total

payments to foreigners.

• It is also important to distinguish between the bilateral BOP accounts: the state of international

transactions between the U.S. and another country, and the multilateral BOP accounts:

most of our analysis thus far has applied to multilateral BOP accounts.

V. CAN CURRENT ACCOUNT DEFICITS INDICATE THE HEALTH OF AN

ECONOMY?

• One very important artefact of understanding BOP accounting is that it sheds light on some

important public policy debates. Very often these debates ignore fundamental principles of

BOP accounting and can lead to disastrous policy remedies for problems that may not really

exist. For instance, the U.S. has recently been running all time record trade deficits and,

accordingly, pretty sizeable current account deficits as well.

• The public hand wringing over the allegedly disastrous impact of substantial current account

deficits leads to the question of whether having a CA deficit is necessarily a bad omen for the

economic health of a country.

• Should running a current account surplus be a goal that a country should strive to achieve?

Is a country with a current account surplus always better off than a country with a current

account deficit?

• The most important thing to keep in mind is that the current account deficit will be accompanied

by a combined capital account and OSB surplus of equal magnitude. Politicians, and

other “experts” will often bemoan current account deficits and laud capital account surpluses

without realizing that they in fact go hand in hand.

• We have to realize that the underlying causes of a current account deficit can be very different

• Consider the United States in the late 1990s - we had a booming economy, rapidly increasing

stock market and limitless growth prospects. As a result, we would attract a lot of investment

from abroad, bringing about a KA surplus. However, since the U.S. government holds very

few reserves (OSB = 0) this KA surplus MUST be accompanied by a CA deficit.

• Contrast this with Russia in the late 1990s - a shrinking economy, rapidly decreasing stock

market and terrible growth prospects. As a result, Russia had substantial capital flight -

money leaving the country bringing about a KA deficit. If Russia had a flexible exchange

rate (it initially did not, but eventually did) this KA deficit MUST be accompanied by a CA

surplus.

• In the above two examples, the CA deficit was inversely related to the health of the economy:

the strong economy was running a CA deficit and the weak economy was running a CA

surplus. In reality though, there is NO relationship between the two. Two more examples

will help illustrate the fact.

• Consider the country of Sao Tome, a small African country that recently discovered substantial

deposits of oil. In time, Sao Tome will see a substantial increase in exports, bringing

about a CA surplus. In other words economic prosperity will accompany a CA surplus in Sao

Tome.

• Finally, consider the current state of Iraq. With very few exports of oil, it needs to import virtually

all its consumption needs. Iraq will therefore run a CA deficit, and economic weakness

will be associated with a CA deficit.

• Simply put, there is no relationship between CA deficits and the state of the economy. We

only know that CA deficits are associated with surpluses in either the capital or OSB accounts,

i.e. inflows of capital and that CA surpluses are associated with deficits in either the capital

or OSB accounts, i.e. outflows of capital.