The balance of payments always balances. That's why they call it the balance of payments.
Constant balance (not to be confused with equilibrium) results from double entry accounting where total debits always equals total credits. Each international transaction results in a new debit and a matching new credit; an equal reduction in debits and credits; or offsetting debits (one plus; one minus) or offsetting credits (one plus; one minus). This in itself is no great revelation, but it does impose a useful discipline in thinking about international transactions. It keeps you honest, so to speak.
Because the two columns of debits and credits always equal in total, we can draw a horizontal line (a row) at any height and a net debit or credit balance above the line will be exactly matched by the opposite credit or debit balance below the line. Typically, we draw a horizontal line just below exports and imports of goods, or merchandize, to get a trade balance understood to be trade in goods only. The opposite balance below the line shows how the trade balance was "financed."
More usefully, we can also draw a horizontal line below exports and imports of goods and services to give us a balance of trade in goods and services. Below that line shows how that balance was "financed." The balance on international trade in goods and services gives us a good idea of whether foreign trade is expanding or contracting our GDP-not that that's the most important factor. (Standard of living is related, but different, and more important.)
The measure that approximates the total demand and supply of foreign currency for all international transactions would be a little lower and would include unilateral transfers, remittances, earnings on foreign investment, foreign earnings on their U.S. investments, etc. That gives us what we call the "current account" balance. The opposite balance below that line shows how any current account imbalance is "financed."
In general, below the horizontal line are capital account transactions that largely reflect the financing of the above the line trade transactions. Those capital transactions are passive, and are what they are because of trade. They are simply the mirror image of the trade balance above the line. However, some capital transactions are "independently motivated" transactions rather than just passive financing transactions. They are still a mirror image of the trade taking place above the line. Those pesky independently motivated capital account transactions keep us from drawing sweeping conclusions regarding trade by itself. Independent capital transactions bring the possibility of trade adjusting to capital flows as well as capital flows adjusting to trade. The reality is that trade and capital flows are mutually determined as is their influence on exchange rates and domestic aggregate demand and GDP generation.
Examples of Trade and Capital Account Matching:
If I buy a BMW from a German seller and pay with a check on my bank account, in the first instance, U.S. imports (a debit) are posted above the line and my bank's debt to the German exporter (a credit from our point of view) is the offsetting entry below the line. It is a credit from our point of view because the German exporter is lending to my bank (holding my bank's deposit liability).
That situation is likely to be temporary. When the German exporter deposits my check into his German bank, my bank now owes the German bank-the same categories are involved. The German bank will probably sell its new U.S. dollar balances to someone else. The final location of the owner of the U.S. bank obligation is hard to anticipate, but, wherever it ends up, it still remains a credit in our balance of payments that offset the debit of the imported BMW.
While we are busy buying BMWs and other German cars, Germans are busy buying goods and/or services from us. (For simplicity, think of us as the only two trading countries.) The export credits in our balance of payments will be matched by increasing U.S. "loans" to German importers. To the extent that our imports and exports of cars and other goods and services offset each other in dollar value above the line, so do the financing transactions below the line. You could say we are paying for our imports with our exports and the Germans could say the same. There is a tendency toward trade balance or equilibrium, but it is unlikely to be a perfect match. A small net residual imbalance above the line in real trade will be matched by a small net imbalance below the line in financing.
If, over time, the U.S. imports more goods and services than it exports, as it has been doing for many years, either foreign claims on U.S. banks or other U.S. entities will build up or U.S. claims on foreign banks and other entities will be drawn down. Either way, it represents a capital inflow that finances our trade deficit. From the foreign perspective, it is a capital outflow that finances their trade surplus. We are borrowing money or selling financial assets, like bank balances, bonds, and equities.
Each year we run a current account deficit, that amount is added to our net debt to foreigners or reduced from their debt to us. Either way our net international indebtedness rises. For many years prior to the mid-1980s, the United States had a cumulative net surplus in its current account trade and was thus a "net creditor nation." That is, its financial claims on foreigners (debt, equity, etc.) exceeded comparable foreign claims on the United States.
I recall the lines crossing in 1985 when we became a net debtor nation. Since then our net debtor position has become larger with each passing year. Subsequent data revisions may have changed the transition date from 1985, but it wouldn't have changed much. The mid-1980s would still be close enough for government work. I'll look it up and include it in a follow-up post soon.
Becoming a net debtor nation, by itself, may not be such a bad thing, but it does seem unnatural for the richest major industrial country in the world to be importing capital from poorer countries. The U.S. has been a net borrower or importer of capital from the rest of the world since the lines crossed in the mid-1980s. The U.S. balance of payments has the profile of a developing country.
Net U.S. debt to foreigners is generally thought to be more burdensome that debt to U.S. residence because to "pay it off" would involve shifting from current account deficits to current account surpluses. That is a pretty big deal and is probably desirable. I say probably because, as with all debt, its advisability depends in large part on what you do with it. Debt to promote investment and growth is one thing. Debt to finance consumption and mere living beyond your means is quite another thing. I'm afraid we fall more in the latter category.
Turning to the financial crisis and its aftermath, there seems to be a consensus that many of the institutions of the world took on too much debt and became over leveraged and that the world is now undergoing a great deleveraging. One might argue that the net indebtedness position of the United States vis a vis the rest of the world is another example of too much debt and leverage at the national or international level, and that this is just one more area where painful deleveraging is needed.
The reduction of our trade and current account deficits in the past several months has reduced the rate at which we are going into international debt, but our foreign indebtedness won't be reduced until we start running current account surpluses. That won't be easy since some of our largest trading partners rely on their export sectors for growth and will resist becoming a net importer.
We can't run a surplus with the rest of the world without the rest of the world running a deficit with us. In terms of current standards of living, that's not a bad position for us to be in. We get to consume more that we produce. The bad part comes if and when it can no longer be sustained and an abrupt adjustment must take place. Even if we can't go all the way back to being a net creditor nation any time soon, it still seems highly desirable to continue our recent progress in shrinking our external deficits. For the stability of the international economy, it should be done in the context of world trade growth rather than shrinkage.