INTERNATIONAL ECONOMICS

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Francisco L. Rivera-Batiz

BAU International University

Section 6. The National Income Accounts

March 7, 2018

Graded Midterms Exams returned today.

No class next week (Spring Break).

Readings for this section:

Rivera-Batiz and Rivera-Batiz, International Finance and Open Economy Macroeconomics, chapter 11.

Andrea Pescatori, Damiano Sandri and John Simon, “No Magic Threshold,” Finance & Development, June 2014, 39-42.

Thomas Herndon, Michael Ash and Robert Pollin, “Does High Public Debt Consistently Stifle Economic Growth?: A Critique of Reinhart and Rogoff,” Working Paper, Department of Economics, University of Massachusetts at Amherst, April 2013.

Dennis Tao Yang, “Aggregate Savings and External Imbalances in China,” Journal of Economic Perspectives, Vol. 26, No. 4, Fall 2012, 125-146.

Carmen M. Reinhart and Kenneth S. Rogoff. 2010. "Growth in a Time of Debt" American Economic Review, Vol. 100, No. 2, May 2010, 573-577.

The last section examined the concept of a current account balance deficit from the point of view of the balance of payments accounts.

In this section, we will adopt a different point of view on the U.S. current account balance deficit.

We will focus on the national income and product accounts, which describe the various production and spending outcomes of an economy over a certain period of time (say, a year).

Income is mostly obtained from production, so we will focus on studying national production.

The main concept used to measure national production is Gross National Product, GNP.

What is GNP?

GNP = The value of all (final) goods and services produced by a country’s residents in a given time period (YN ).

GNP = GDP + R

where GDP = Value of (final) goods and services produced domestically (YD ) and

Where R = Net factor income from abroad = Goods and services produced by domestic residents abroad minus goods and services produced by foreign residents (including multinational corporations) in the domestic economy.

Gross Domestic Product = The value of all (final) goods and services produced domestically in a given time period (YD ).

This output can be purchased by two groups:

(1) Purchases of domestic goods and services by foreign residents (domestic exports, X ),

(2) Purchases of domestic goods and services by domestic residents. Let us look at this last component in more detail.

Purchases or expenditures of domestic residents on domestic goods and services

Total purchases or expenditures of domestic residents (called domestic absorption, A)

Minus

Total purchases or expenditures of domestic residents on foreign goods and services (domestic imports, M )

So, with these definitions:

Output of Spending of Spending of

Domestic = Domestic Residents + Foreign Residents

Goods and on Domestic Goods on Domestic Goods

Services (YD) and Services and services (X)

↓

Total spending Spending of

of Domestic - Domestic Residents

Residents on Foreign Goods and

(A) Services (M)

Therefore:

YD = A - M + X

= A + X - M

So: YD = A + X - M

But YD is GDP. We want GNP, YN .

GNP = GDP + R

Or:

YN = YD + R:

Therefore:

YN = A + X - M + R

But by the definition of the current account balance (excluding unilateral transfers):

CAB = X - M + R

So: YN = A + CAB

Or: CAB = YN - A

This states that a current account balance deficit (CAB < 0) means that a country’s residents are spending more than they have available as income ( A > YN ).

On the other hand, a current account balance surplus means that a country’s residents are spending less than they have available as income ( A < YN ).

Why? Let us look at it from the perspective of a household.

Just as we did before, consider a household as if it were a country and let us look at its “international” transactions.

Household X “International Transactions,” 2016

Salary for job (exports of services) $20,000

Yard sale (exports of goods) 1,000

Purchases of food (Imports of goods) -15,000

Maid hired (imports of services) -10,000

Home mortgage interest payments -10,000

(foreign investment interest payment)

--------------

Current Account Balance $-14,000

Household X “International Transactions,” 2016

Salary for job (exports of services) $20,000 income

Yard sale (exports of goods) 1,000 income

Purchases of food (Imports of goods) -15,000 Spending

Maid hired (imports of services) -10,000 Spending

Home mortgage interest payments -10,000 Spending

(foreign investment interest payment)

-------------- --------------

Current Account Balance $-14,000 $-14,000

The U.S. current account balance deficit means that the U.S. is spending in excess of its income.

This “excess” spending surfaces as an “excess” of the value of imports of goods and services relative to American exports.

This excess spending relative to income could also be seen as a failure of Americans to save a high enough fraction of their income.

Let me show you this.

We have already established this relationship:

YN = A + CAB

↓

Income of Total Spending Current

Domestic = of Domestic + Account

Residents Residents Balance

(called absorption)

Let us talk a little bit more about the total spending of domestic residents, or absorption, which we symbolize by A.

What are the major categories of spending?

Total spending of domestic residents (A )

Private Consumption spending (C )

Private Investment spending (I )

Government spending (G )

So: YN = A + CAB

= C + I + G + CAB

Let us look at the case of the United States.

Which one do you think is the most important factor determining GNP in the United States (consumption, C, investment, I, government spending, G, or net exports to the rest of the world, as represented by the current account balance, CAB (excluding unilateral transfers)?

United States National Income Accounting, 2016, in Billions of US$

Gross National Product 18,751

Private Consumption 12,758
Private Investment 3,036
Government Spending 3,277
Current Account Balance -320

(excluding unilateral transfers)

Getting back to the GNP (national income) identity:

YN = A + CAB

= C + I + G + CAB

Let us now also decompose government spending into its consumption and investment components:

G = CG + IG

Where CG is equal to government consumption spending (spending on health, defense, etc.) and

IG is equal to government investment spending (spending on roads, equipment, physical plant, etc.)

For the United States, how much does the government invest relative to what it consumes?

U.S. Consumption and Investment Expenditures, 2016

______________________________________

Category Consumption Investment

______________________________________

Total 15,413 3,899

Private 12,758 3,277

Government 2,655 622

______________________________________

Source: Bureau of Economic Analysis, U.S. National and Income Accounts, 2016.

So, let us now change our GNP identity to decompose government spending into its consumption and investment components:

G = CG + IG

From before, remember that:

YN = C + I + G + CAB

= C + I + CG + IG + CAB

= C + CG + I + IG + CAB

Or: CAB = YN - ( C + CG ) – (I + IG )

↓ ↓

CAB = National Savings – National Investment

A Current Account Balance deficit (CAB<0) means that national savings are less than national investment.

The country is consuming too much (saving too little) relative to its income. As a result, domestic investment expenditures exceed the domestic funding available through savings.

Let us look at the data for the U.S.

In presenting the statistics, let us divide both sides by national income (or GNP) in order to adjust for the growing size of the American economy:

CAB = National Savings – National Investment

CAB/GNP = (National Savings/GNP)

– (National Investment/GNP)

Explaining the U.S. Current Account Balance Deficit, 1991-2016

_______________________________________________________

Year CAB/GNP National Savings/GNP Natl. Investment/GNP

________________________________________________________

1991 0.000 = 0.171 - 0.171

1999 -0.025 = 0.181 - 0.206

-0.037 = 0.141 - 0.178

-0.020 = 0.139 - 0.159

2016 -0.017 = 0.178 - 0.195

________________________________________________________

Source: National Income and Product Accounts of the US, 2017.

Note: The CAB (current account balance) in this table excludes unilateral transfers.

In the 1990s, the US current account balance deteriorated largely because of rising investment.

In the 2000s, the US current account balance deteriorated because of declining savings.

But why was there a decline in the savings rate of the U.S. in the 2000s?

Returning to our national accounting identity before, remember that the current account balance is equal to the excess of the income over spending of domestic residents:

CAB = YN - ( C + I + G )

Let us modify this relationship by adding and subtracting this term: (TR – TX), where TR represents transfer and other payments from the government to the private sector and TX are the tax revenues of the government.

CAB = YN + (TR – TX) - ( C + I + G ) - (TR – TX)

Reproducing the equation here:

CAB = YN + (TR – TX) - ( C + I + G ) - (TR – TX)

Or:

CAB = (YN + TR – TX - C) - I + ( TX - G - TR )

↓ ↓ ↓

Private Savings Private Government

Investment Budget Balance, B

CAB = (Private Savings - Private Investment) + B

If the government has a budget deficit, then this will tend to have a negative impact on the current account balance.

If the government has a budget surplus, this will tend to reduce the current account balance deficit.

Does the U.S. has a government budget deficit?

How much is it?

The U.S. Government Budget Deficit, 2016

In Billions of US$

_______________________________________________

2016

_______________________________________________

Government Revenues, TX, 5,346

Government Expenditures, G +TR, 6,278

Government Consumption 2,655

Government Investment 622

Government Transfer Payments 3,001

and Other Expenses

Government Budget Balance, B, -932

_______________________________________________

Source: National Income and Product Accounts, 2017.

What has happened in the U.S. in terms of explaining the Current

Account Balance Deficit using the new relationship we derived above?

CAB = (Private Savings - Private Investment) + B

Let us adjust the equation on both sides, as we did before, by dividing

by GNP:

CAB/GNP = (Private Savings/GNP - Private Investment/GNP) + B/GNP

What are the data for the US?

The U.S. Twin Deficit Disorder Syndrome, 1991 to 2017

_______________________________________________________

Year CAB/GNP B/GNP (Private S-I)/GNP

________________________________________________________

1991 0.000 -0.050 0.050

1999 -0.025 0.007 -0.032

2007 -0.042 -0.029 -0.013

-0.037 -0.063 0.026

-0.020 -0.085 0.065

2016 -0.017 -0.050 0.033

________________________________________________________

Source: National Income and Product Accounts of the US, 2017.

In the 1990s, the US increased its current account deficit mostly because the private sector was carrying out huge amounts of spending in the form of investment.

During this time period, the government stopped over-spending and eventually generated a budget surplus.

But in the 2000s, the US increased its current account deficit mostly because the public sector began to over-spend.

During this time period, the private sector initially also had an excess of spending (private investment exceeds private savings) but this was sharply reversed as the economy entered into crisis, with private investment declining below private savings.

It is the government that is over-spending over the last few years.

Government Budget deficit/GNP, 1991 to 2016

_______________________________________________

Year B/GNP

_______________________________________________

1991 -0.050

1994 -0.037

2000 0.015

2002 -0.040

2004 -0.045

2008 -0.063

2011 -0.096

2012 -0.085

2016 -0.050

_______________________________________________

Source: National Income and Product Accounts of the US, 2017.

Are the U.S. current account balance deficits a problem?

We talked about this before, but let us revisit it now with the new perspectives.

There are several possible problems with current account balance deficits:

First, they need to be financed, as we have shown before.

The excess purchases from the rest of the world need to be paid for.

As debt accumulates, the risk attached to domestic investments rises and foreign capital may suddenly stop, creating a stressful domestic financial situation (in the form of rising interest rates, declining economic activity, etc.), which could emerge into a full-blown crisis.

In the case of the U.S., the growth of debt has been fueled by government, sovereign debt since the early 2000s.

Is there a level of government debt that burdens a country in such a way that it cannot grow, recuperate from the indebtedness trap?

Is it 50% of GDP or 100% of GDP or 150% of GDP or what?

In their book: This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009, economists Carmen Reinhart and Kenneth Rogoff examine this issue.

So, Reinhart and Rogoff conclude that when high-income countries reach public debt of about 90% of GDP, then this would have a negative –not positive– effect on economic growth.

What is the situation in the US?

U.S. Government Debt as a % of GDP

But more recently,

a study

has argued that

Reinhart and Rogoff

are wrong.

Why?

Effects of Higher Debt on GDP Growth Rates

________________________________________

Debt/GDP Mean GDP Mean GDP

(%) Growth (R-R) Growth (H-A-P)

________________________________________

0-30% 4.1% 4.2%
30-60% 2.8 3.1
60-90% 2.8 3.2
Above 90% -0.1 2.2

________________________________________

Sources: R-R (2010), H-A-P (2013).

This is also the result that is obtained by the more recent paper by Andrea Pescatori and co-authors in the journal Finance and Development in your readings:

“No Magic Threshold,” Finance & Development, June 2014.

The other question about the macroeconomic impact of growing debt to GDP ratios is that, in contrast to Reinhart and Rogoff’s initial (and incorrect) conclusion, some countries have managed very high debt to GDP ratios without rising interest rates, inflation, or a collapse of their economies.

In fact, they have managed to grow moderately even with sky high debt to GDP ratios.

Which major country has been able to sustain huge debt to GDP ratios and still grow in recent years, even though moderately?

Japan, Government Debt as a % of GDP

Japan, GDP per-capita (adjusted for inflation, in US$)

Some also believe that the U.S. is

a special case.

President Obama said a couple of

years ago: “I believe in American

exceptionalism with every fiber of

my being.”

He was not really referring to

economic exceptionalism, and his

view –very popular among American

foreign policymakers-- was widely

criticized.

But is the U.S. a special country in the

economic arena, a uniqueness which

may also allow the government to

sustain high levels of debt for a much

longer period of time than say Greece

or Argentina?

What makes the U.S. exceptional?

Because the dollar is by far the most popular reserve currency in the world, foreigners, including foreign central banks, have been willing to continuously increase their holdings of U.S. assets, including government debt, virtually without any additional risk premia.

But the demand for international reserves by foreign central banks could eventually dry out.

So, the question is how far can the U.S. sustain its borrowing spree.

Can this continue or is there a crisis in the future?

And the answer to this question is:

We don’t know!