To understand the current account, recall the national income identity:  C+I+G+X-M = Y, where C, I, G denote consumption by households, investment by business and spending by government, respectively. Also, X denotes exports and M represents imports (remember, M has to be in here to adjust for the fact that C, I, and G represents in each case spending on both domestic and foreign goods.)

We can rewrite the national income identity as Y – C - G = I + CA, where the current account, CA, is CA = X-M. If we divide this expression by Y on both sides, we end up with

(Y-C-G)/Y = I/Y + CA/Y.

Let’s call the object on the left, the National Saving rate. It’s what is produced, minus what is used up in consumption by households and by government (I’m ignoring the fact that some expenditures by households, such as on cars, is actually a form of investment and some expenditures by government, such as on roads, is also a form of investment). It’s a rate, because it is divided by Y.

From the first lecture we found that since 1980 the CA/Y has fallen sharply into negative territory. According to the above formula, this can happen either because investment has risen or national saving has fallen, or both. The following graph shows the data on the national saving rate, as well as on CA/Y and I/Y since 1960. Note the pronounced fall in CA/Y since 1980 (we already saw this in lecture 1). The graph shows that behavior of I/Y has not chanted much since 1960. The rate of investment, I/Y, has fluctuated pretty steadily around a value of 0.17. At the same time, the national saving rate changed significantly in 1980, when it began to fall. So, the current account deficit seems to reflect a fall in the national saving rate.

From the definition of the national saving rate, it can fall because consumption or government expenditures, or both, have gone up. To see why national saving began to fall in 1980, consider the following graph. It shows that G/Y has been falling steadily since the late 1960s. Clearly, if anything government spending has been a force for raising the current account deficit, not for decreasing it. The graph makes it clear that the reason why national saving has dropped is that C/Y began to rise in 1980. It increased about 8 percent of GDP from 1980 to the present. If government spending had not declined, the current account would have been minus 8 percent of GDP. (The data for the graphs may be found in this excel file.)

For the current account to be negative means that M > X. This has been so most of the time since 1980. Imports mean that Americans supply foreigners with dollars in exchange for goods. Foreigners use those dollars to pay for their purchases from Americans, i.e., to pay for X. Since M > X, on balance foreigners are accumulating dollars. In most cases, they don’t just hold on to those dollars (although in many cases they do, since dollars are used in transactions in some other parts of the world). Instead, they send them back to the US, where they use them to buy US financial assets: privately issued stocks and bonds, as well as US government debt. Because the US current account has been in deficit so long, the quantity of US financial assets held by foreigners is growing faster than is the quantity of financial claims on foreigners held by Americans. In fact, standard measures of these claims indicate that foreigners now hold more claims on Americans than Americans hold on foreigners. According to US government records, at the end of 2004, American liabilities to foreigners totaled $8.9 trillion. At the same time, foreign liabilities to Americans totaled $4.4trillion.

It’s interesting to see what form these obligations take. Of the $8.9 trillion in US liabilities held by foreigners, 18% is titles on businesses that foreigners bought in the US (this is called foreign direct investment), 21% is US government debt, 19% is equity shares in US corporations and 19% is in corporate bonds. The income payments that foreigners earned from Americans in 2003 on these assets came to $273.9billion.

Of the $4.4trillion in foreign liabilities held by Americans, 50% is in the form of equity holdings and title on foreign firms. The income payments that Americans earned on their foreign assets came to $329billion in 2003.

It is interesting that foreigners are paying Americans more interest income than Americans are paying to foreigners. In part, this could be because foreigners are relatively risk-averse and prefer lower-yielding American assets (note how much US government debt they hold, which pays low interest, but is highly secure). Another explanation may be that the value of US holdings abroad may be understated. These were acquired a relatively time ago (when Americans saved more!) and it is harder to identify the market value of something that was purchased a long time ago.

(Note: the data on the quantity and composition of foreign assets held by Americans and vice versa can be found in Table L.107, p. 67 in the following government document (the Flow of Funds accounts). The data on the income flows associated with these assets can be found in Table F.107 (see lines 3 and 7) of the same government document.)

There is an interesting question why C/Y began to climb in 1980. There are many possible explanations. One is that it has something to do the changes in the system of financing retirement that occurred at the time. Before 1980, retirement was taken care of by a person’s employer. In effect, the amount that individual Americans saved was not up to them. When Americans were given the choice over how much to save, it appears that they chose to save less. It’s an interesting question why this happened. But, we can leave that for another time!

To conclude about the current account, the basic story seems to be this. The supply of good investment opportunities in the US seems to have been pretty steady throughout the period from 1960 to the present. Before 1980 these investment opportunities were largely financed by Americans (then, national saving was roughly equal to investment). In 1980, for some reason Americans decided to save less. If there had been no foreigners, perhaps investment opportunities in the US would have gone unexploited. Instead foreigners took over the financing of investment that Americans did not want to do. That financing shows up in the data as a negative current account.