Account Balance 1a) the Model

¶ … Account Balance 1a) the model presented illustrates that the current account is equal to net foreign investment. Net foreign investment and therefore the current account is equal to national saving less investment. The equation essentially begins with national income, which is made up of several components. Essentially, national income the value of production. This is a combination of domestic expenditure and net expenditure by foreigners. The current account thus reflects whether a nation is a net importer or exporter of goods and services.

If the savings rate is low, the nation will be a spender and therefore is likely to be a net importer. 1b) This relationship implies that a current account deficit is the product of net capital outflow, in other words the country is a net importer. A current account surplus indicates a capital inflow, in other words the country is a net exporter. This suggests that foreign investment is controlled by domestic considerations, including consumption and export policy.

In the U.S., for example, we have a situation where open securities markets have allowed for strong net outflows as foreigners invest in the U.S. economy. This creates a set of economic circumstances whereby U.S. consumption continues to grow. Savings rates are declining, and investment rates have not kept pace with the worsening of the current account deficit, leading to the conclusion that foreign investment has been responsible for the current account deficit.

1c) Eatwell and Taylor propose that the 90s were marked by a rapid expansion of the current account deficit. They attribute this to several factors. One is that the other major economic actors, the EU and Japan, have seen increases in their current account. In Japan, this was caused by the economic stagnation. The result of such stagnation was a net outflow of funds as investors sought to achieve returns elsewhere. In the EU, the economy was also relatively stagnant. The U.S.

economy's expansion was propelled at the beginning of the 90s by the Gulf War, but for the rest of the decade it was propelled by consumer consumption, in particular growth in the housing market. During the Gulf War, government was responsible for much of the spending, but as government deficits became unfashionable, the burden was shifted to consumers. In the 1980s, the situation was different. Domestically, the U.S. government was responsible for a greater share of the burden of expansion.

This was a result of, among other things, Cold War spending during the Reagan era. As well, the other major economic actors were less inclined to current account surpluses. Japan's economy, for example, was still expanding for much of the decade. Europe had also seen growth in that time period, and carried a current account deficit into the early 90s. The shift in the 90s towards the consumer bearing the brunt of the burden for economic expansion is tied to a sharp decline in savings rates.

Eatwell and Taylor illustrate that the ratio of household debt to disposable income increased from 0.89 in 1993 to 0.98 at the end of 1997. This is reflected in both an increase in credit card debt and sharp increases in housing prices. The latter is the single largest source of debt for most consumers, and increases in housing prices have meant that increasing proportions of incomes have been diverted away from savings and into mortgage debt.

When combined with governmental aversion to deficit budgets, the result is not only a strong increase in current account deficit but that this is being born almost entirely by consumers. The implications of this according to Eatwell and Taylor is looming economic ruin. They view the present situation as essentially unstable, in particular compared to the situation in the 80s. They approach the issue from the perspective of U.S. domestic economic policy.

They assume no major change in Japan's situation, and only a modest reduction of current account surplus in Europe, stemming from the adoption of the Euro and expansion of the EU into the eastern parts of the continent. In light of this, their view is that the U.S. must continue its present level of current account deficit for the foreseeable future. The burden, they feel, should be shifted back towards government.

They view the consumer as unable to sustain their present debt levels, so the governments must run deficits in order to make up the difference. The economic policy in recent years mirrors in many ways the policy in the 1980s. The war on terror, in particular the Iraq situation, has increased U.S. government spending. The federal government is no longer averse to deficit spending, which is akin to the Cold War spending-fuelled deficit budgets of the Reagan era.

The result of this has been a shift back towards the government and away from the consumer, of the burden of.