The growing imbalance in foreign trade and the “precarious” condition of the current account have become a popular topic of conversation in Lithuania. Government decisions are being judged for their impact on the country’s balance of payments and with respect to Lithuania’s current account deficit. The effects of the current account deficit are viewed as a natural evil, without specifying or analysing them explicitly. What does it mean when the current account and the balance of payments are in deficit? What are the implications? Are government attempts to cut the current account deficit rational? Aren’t anti-deficit measures more dangerous than the deficit itself? These issues are analysed in this article.
Accounting Equilibrium Versus Market Equilibrium
The country’s balance of payments is a statistical reflection of all dealings of Lithuanian people, companies and government with abroad; it is a record of transactions. The balance of payments is typically divided into three accounts – cuurent, capital, and financial, although this distinction is rather relative. The current account records imports and exports of goods and services as well as income from work and investment. The capital and finance account covers investments abroad, foreign investment in Lithuania (including loans), and official reserves.
Experts in corporate accounting may be confused by the term “balance.” The balance of payments is different from a company’s balance sheet, which shows the company’s financial position – assets, liabilities, and equity – at one point in time. A country’s balance of payments is more similar to the statement of cash flows. It reflects movements of assets and liabilities. It implies a balance inasmuch as every transaction is recorded using the double-entry principle according to which for every entry there is a corresponding entry with sign reversed (credits and debits).
For example, exports in the balance of payments is recorded by crediting the current account (liabilities to supply goods abroad) and by debiting the capital and financial accounts (liabilities of a foreign country to pay for the goods supplied). Consequently, a country’s balance of payments, on an accounting basis, must always balance. If it does not, it is because of statistical limitations, for it is impossible to record all transactions. Not so long ago the accounting balance was impossible to calculate due to limited technical capacities, as indicated by the “errors and omissions” entry in Lithuania’s balance of payments .
This, however, is only accounting equilibrium. Some officials are daunted by a different qualification, a deficit of the market balance of payments, especialy a current account deficit. Let us take the same accounting, only without “corresponding” entries. In other words, this market balance of payments shows the amount of foreign currency that flows in and out of the country. If the current account of the balance of payments is in deficit, it means that the amount of money the country’s citizens and companies earned abroad over a given period of time is smaller than the amount of money they spent abroad over the same period.
One should bear in mind that Lithuania as a country does not trade or deals with anyone. It is only individuals, companies and state institutions that trade. Consequently, there is no such thing as “Lithuania’s balance.” It is not “Lithuania’s incomes” that exceed “Lithuania’s expenditures,” but it is John who spends abroad more than Peter earns. It is not “Lithuania’s savings” that are too scarce to finance “Lithuania’s investments”, and it is not Lithuania but a concrete borrower who will be repaying debts.
Putting together Peter’s and John’s independent relationships and generalising them at Lithuania’s level is but an abstraction on paper. Likewise, one could compile the balance of payments – cash flows – of Vilnius, Taurag? or Palanga. Such calculations are rather speculative and so any conclusions must be drawn with reservations. It means that there should be as little as possible reliance on general indicators, such as the balance of payments or the current account in our case. Instead, it is essential to analyse their component elements, the activities of market participants.
For instance, in case of a current account deficit, the blame is put on borrowing, especially consumer credits, which augment the deficit. Yet, neither corporate nor individual borrowing is a bad thing in itself. As a rule, the borrower is he who has better investment opportunities than the lender. There is only one exception to this rule : when the borrower is the state. When the state borrows money, neither investment opportunities nor returns nor responsibility are assessed. It is this very type of borrowing that should be limited.
Talks about the current account deficit are often accompanied by reflections about how it may be financed. Statements about financing deficits should not be taken word for word. The thing is that no intentional, purposeful or earmarked allocation of funds, as financing is often defined, takes place. Not a single individual, entrepreneur or official gives money to “cover the deficit.” Financing of a current account deficit comes from those capital account entries from which, it is believed, importers receive additional amounts of foreign exchange (the amount exporters fail to earn over a given period of time). These are foreign loans and foreign currency reserves held by market participants and the central bank.
Financing of the deficit is not a sacrificial act on someone’s part in the name of Lithuania . It is a result of people’s day-to-day activities, mutually beneficial exchange, and free will and agreement. It is part of everyday life and regular business operations.
We have figured out the meanings of “balance” and “deficit.” Now it should be easy to answer the question whether the economic (market) balance of payments (or the current account) may balance in an open environment in a given territory and at a given period of time. It is a utopian assumption that Lithuanians purchased from abroad, over a given period of time (a quarter or a year), precisely as much as other Lithuanians sold abroad. Or that Lithuanians invested abroad precisely as much as foreigns did in Lithuania. Or, in other words, that money flows to Lithuania equalled money flows out of Lithuania.
Given that the world is a closed system, the ecomomic balance occurs only on a global scale. In an open country, a normal condition is for the balance of payments (and the current account) to fluctuate – to be in surplus or in deficit. Neither a surplus nor a deficit are necessarily good or bad, since all by themselves they suggest nothing about the status of the national economy. A current account surplus, which is traditionally deemed highly desirable, may be indicative not only of competitive strengths of domestic products but also of restrictions on import or trade and of an unfavourable investment climate.
That a balance or a surplus are not valuable by themselves is verified by the fact that either can be achieved by completely cutting off any international ties or by channelling money only in one direction. Similarly, a continued deficit is not symptomatic of possible crises. The fact that the slump of the Estonian securities market occurred alongside a prolonged deficit does not mean that the deficit was the rootcause or a symptom of the downturn. There are countries (the US, for instance) which have had a current account deficit for many years but have not been hit by crises like this. And there are countries with a current account surplus which are having troubled times (for example, Japan). Such premises sound like superstitions, since they are not verified by economic theory, or practice for that matter.
So, in an open market a country’s balance of payments is always in disequilibrium, in surplus or deficit, at a given time. If disequilibrium in either direction continues for a longer period of time than usual, self-regulatory market mechanisms come into action to make money flows change their direction.
Suppose a certain country has had acurrent account deficit for some time. It means that business people of that country buy more abroad than foreigners do in the said country. Consequently, the demand for the local currency declines, all other things being equal, while that for the foreign currency goes up. If the domestic currency has a floating rate of exchange, these changes in demand and supply will be reflected in the exchange rate – the local money will devalue against the foreign one. At that point, the new exchange rate will render exports relatively more attractive, turning the current account balance in the opposite direction.
Adjustment would look differently in Lithuania. Although installed with certain nuances, the currently board system in Lithuania precludes exchange rate fluctuations. Under a currency board, one may imagine, 25 US cents circulate instead of one litas. The central bank may intervene through open market operations, but such interventions are quite restricted (and aimed at objectives other than currency stability). Under a currency board arrangement, the balance of payments is regulated through fluctuations in prices, interest rates included. With an increased demand for the foreign currency comes a corresponding decline in the money supply (litas are exchanged into dollars, while the central bank has no right to print unbacked money) and so a drop in the prices of domestic products. Changes in prices make imports less attractive, reversing cash flows as a result.
Bearing this in mind, it is important that government doesn’t meddle in pricing. The present government has a multitude of tools to control the prices of goods, services, and labour. The central bank on its part seeks to control the price of money, interest rates.
To sum up, a prolonged deficit in a situation of non-interference from the state, all other things being equal, may ultimately lead only to a drop in the exchange rate (under a floating regime) or a fall in the prices of domestic goods. More importantly, the market responds at exactly the right moment and, unlike governments, without relying on bare figures and all kinds of reservations.
State Intervention and Values
Sadly, governments do not like to rely on self-regulatory market forces. They prefer directive, coercive measures. The ends justify the means, so the current account is balanced directively. Classic examples include: exerting an intentional influence on the exchange rate (devaluation), introducing statutory restrictions on currency exchange, keeping imports low by protective import duties or mandatory deposits, restricting foreign borrowing through direct bans or taxes, limiting domestic consumption, etc.
The real forms and effects of these measures are disguised by sophisticated words. When international borrowing is restricted by setting large mandatory reserves or by imposing taxes on interest paid abroad or simply by prohibiting foreign borrowing, for instance, the prices of domestic credit resources and interest rates on loans go up. Meanwhile, many are disgruntled at costly loans and curse predatory banks without knowing who the real culprit is. As a rule, all restrictions are imposed not on the state but on private economic entities. As a rule, all such actions severely circumscribe man’s free choice.
When the government steps in to regulate the market and to achieve a current account surplus, it decides a priori that it is better for Lithuanians to keep money than spend it; to invest in Lithuania, despite the growing disrespect for private property, than abroad. It decides that to borrow money to purchase machines is more worthy than to borrow money to buy cars, etc etc. Trying to instil directive, non-existant “common” values, the state tramples on the most fundamental human values – free choice and the right to live one’s life according to one’s own virtues and principles and to act as one deems best for him or her. Government is reluctant to create normal business and living conditions as this requires reducing taxes and regulations, or curbing government powers and authority. The state chooses a less painful path. It is easier to ban imports than to refrain from borrowing. It is easier to restrict others than to restrict oneself. It is easier to count someone else’s money (as if Lithuania’s) than to balance one’s own income and spending.
Today we witness the state being elevated above man through reviving mercantilistic views of the 16 and 17th centuries which promoted a “powerful state” with sufficient reserves to obtain armaments and foodstuffs in the event of war and encouraged consumption of domestic products as an indisputable good. A prominent role in escalating the topic of a current account deficit has been played by economists of international institutions. No one in this world is so uncannily omniscient as to judge what level of deficit is “precarious” and what is tolerable. Therefore, all actions of the state must rest on arguments other than “a dangerous deficit threshold.” And they must be aimed at objectives other than achieving attractive paper indicators.
Today the Lithuanian government is an active player in the market. It spends more than one third of income generated in the country. It is the largest debtor. It assumes a multitude of unjustified obligations. This is where troubleshooting should start from. Instead of attacking the private sector, government ought to practice what it preaches in the first place. For the requirements it imposes on individuals and companies – requirements of a life without debts, moderate consumption, and expenditures equal to incomes – are applicable only to government itself.