CURRENT ACCOUNT: Is a Current Account Deficit Really a Sign of Economic Weakness?

Is a Current Account Deficit Really a Sign of Economic Weakness?

For those of you who don’t know, the current account of the Balance of Payments measures flows of money in and out of a country that arise from trade in goods, trade in services, transfers and hot money flows.

A deficit on the current account of the Balance of Payments can be caused by higher levels of imports than that of exports i.e. a trade deficit. In recent times the UK have ran a current account deficit where we import more than we export.

Therefore, a deficit on the Balance of Payments can arise due to a deficit in any one or more of these which is not compensated for by a surplus elsewhere.

There are those who say that a current account deficit is a sign of economic weakness and there are those who oppose this viewpoint.

The economists that say it is a sign of economic weakness say this where high levels of domestic consumption result in excessive and immoderate spending on imports. This could potentially represent the idea that domestic firms have lost international competitiveness in global markets due to a lack of investment or high labour costs or even low productivity – maybe even all three of these. This would imply that the current account deficit was structural and thus a sign of economic weakness.

On the contrary, there are other economists who point out that there are several factors to be analysed before making a judgement call as to whether a current account deficit can be labelled a sign of economic weakness. Some economists say that it depends what caused the deficit. In the case of trade in goods/services, there are other reasons that explain the deficit other than a lack of international competitiveness. For example, high levels of growth in domestic demand (AD) could actually be considered a sign of economic strength rather than a weakness. In this scenario, then, a current account deficit would be judged as cyclical rather than structural.

Moreover, there are those who say that there may be high levels of investment which have caused a greater level of imports in capital goods. This would in fact indicate strength of an economy because it would generate greater efficiency in the future as well as productive capacity i.e. economic growth. In this case, the deficit would be temporary. So long as a country attracts long term capital flows to finance its deficit it may not actually indicate weakness. This, however, depends on whether or not the capital flows were foreign direct investment (FDI), what attracted the FDI – be it government incentives or the growth of the dark economy as well as how long this FDI lasted.

In evaluating this argument, it should be noted that there may be better indicators of economic weakness i.e. unit labour costs or the exchange rate.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

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