Causes of a Balance of Payments Deficit and the Difficulties of Reducing Twin Deficits

Answer

Part (a) — Why a country could experience a balance of payments deficit [10]

The balance of payments records a country’s transactions with the rest of the world; a deficit arises when total outflows exceed total inflows. Because the balance has two main components — the current account and the financial account — a deficit may originate in either.

Current account: loss of export competitiveness. A country’s current account is dominated by its balance of trade. If trading partners gain comparative advantage — as China did by attracting capital and producing medium-technology goods more cheaply — the home country’s exports lose price competitiveness, export revenue falls relative to import expenditure, and the trade balance, and hence the current account, deteriorates.

Current account: higher domestic income. Where the home economy grows faster than its partners, rising disposable income raises demand for imports (a normal good), increasing import expenditure. If exports do not keep pace, the trade balance worsens and the current account moves into deficit.

Financial account: relative attractiveness of investment and interest rates. The financial account weakens when capital flows out faster than it flows in. If partners become more attractive to foreign direct investment — through infrastructure and tax incentives that raise expected profitability abroad — capital flows out. Likewise, if domestic interest rates fall below those abroad (as the US Federal Reserve cut rates), residents place funds overseas for higher returns and foreigners withdraw theirs, producing a net outflow of short-term capital. Either deterioration pushes the overall balance of payments into deficit, ceteris paribus.

Part (b) — Do policies to reduce the twin deficits cause difficulties? [15]

The United States runs twin deficits — a current account deficit (import expenditure exceeding export revenue) and a budget deficit (government spending exceeding revenue) — both large and persistent. The policies that address them are contractionary fiscal policy and supply-side policy; whether they cause difficulties turns on their side effects on the other macroeconomic goals.

Contractionary fiscal policy to reduce the budget deficit — and its difficulties. Cutting government spending and raising taxes narrows the budget gap directly. But lower government spending, lower disposable income (higher income tax) and lower after-tax profits (higher corporate tax) all reduce aggregate demand.

Through the reverse multiplier the fall in national income is amplified, raising demand-deficient unemployment and lowering material standard of living — and the resulting rise in unemployment benefits can re-widen the very deficit the policy targets. Higher indirect taxes raise firms’ costs, shifting SRAS left and risking cost-push inflation. These are genuine difficulties for growth, employment and price stability.

Supply-side policy to reduce the current account deficit — and its difficulties. Research grants and subsidies that raise the quality of capital shift long-run aggregate supply right, lowering costs, improving export price competitiveness, and narrowing the trade and current account deficit. The difficulty is fiscal: such grants raise government spending, worsening the budget deficit, and carry an opportunity cost in foregone spending elsewhere. The two targets therefore pull against each other.

The other side — the policies need not cause serious difficulty. Contractionary fiscal policy, by lowering AD and the price level, relieves inflationary pressure where the economy is overheating. Supply-side policy, beyond competitiveness, raises both actual and potential output, lowers the price level, and reduces unemployment — advancing several macroeconomic goals at once with no necessary trade-off, provided the fiscal cost is affordable.

Judgement. On balance the policies do risk difficulties for the United States, but the severity depends on three things. First, the multiplier: with a high marginal propensity to consume, a given fiscal contraction produces a large multiplied fall in output, making the growth and employment cost severe. Second, the state of the economy: in or near a recession, contractionary fiscal policy would deepen the downturn, so the timing is critical. Third, the time horizon: a credibly reduced budget deficit can restore investor confidence and, with supply-side reform, deliver long-run potential growth — so the long-run picture is more benign than the short-run contraction it requires. The defensible verdict is therefore qualified: the policies are not without difficulty, especially in the short run and where the multiplier is large, but a well-sequenced mix — supply-side measures to build competitiveness alongside gradual fiscal consolidation — can reduce the twin deficits while containing the damage.