Budget deficit vs current account deficit
A reader of “The Little Book of Economics” asks the following :
“All else equal, does a larger budget deficit imply a larger current account deficit?”
Chapter 7 of my book (“All the world’s an ATM”) notes that when a country spends more than it earns, it must borrow the difference from abroad, or sell foreigners some assets. This produces a current account deficit. Here, I’ll explain how domestic behavior produces a current account deficit.
The economy has three domestic sectors: business, households, and government. Each has its own saving rate: business saving is the difference between cash flow and investment. Household saving is the difference between consumption (including spending on new homes) and family income (wages, stock dividends, Social Security checks, etc.) Government saving is the difference between expenditure and tax revenue. Any of these three sectors could either be running a surplus or a deficit; when you add up the surplus/deficit of all three sectors, and the total nets out to a deficit, how does the country as a whole finance that deficit? By borrowing from a broad. This is the current account deficit.
A budget deficit will produce a current account deficit if the business and household sectors don’t save enough to finance that deficit. This is the situation the United States is in. On the other hand, Japanese households and business save so much that the country runs a current account surplus in spite of a gigantic budget deficit.
All else equal, i.e. if household and business saving remains the same, an increase in the budget deficit will lead to an increase in the current account deficit (or a smaller current account surplus.) But all else is seldom equal. In a recession, businesses and households usually slash spending and save more. But the drop in demand drives up unemployment which causes income tax revenue to fall and spending on things like unemployment insurance to rise. In this case, the recession may result in an increase in the budget deficit, but it may also result in an even larger increase in business and household saving, with the result that the current account deficit falls. This is precisely what happened in the last two years: private saving surged (partly because credit was cut off) by more than the federal deficit, so the U.S. current account deficit shrank. Now, the economy is recovering: in time this will both boost tax revenue and narrow the budget deficit, but also lead to a surge in private demand, and in all likelihood, an expansion in the current account deficit, although probably not to as large as it was before the recession.
In the 1980s and 1990s there was much talk of America’s twin deficits. Yet in the late 1990s, when the budget deficit disappeared, the current account deficit grew. Why? Because there was an investment boom/bubble in the late 1990s which generated windfall tax revenues for the federal government (all those dot com millionaires cashing in stock options). But even once the federal deficit disappeared, there wasn’t enough saving in the United States to finance all those those cool dot-com ideas and all that fiber optic cable. So the current account deficit grew.