Tuesday, December 13, 2011

Finally, the importance of current account balances is being discovered!

This blog has argued since inception that, more than budget deficits, external debt, etc., it is the current account balances of Eurozone countries (specifically Greece) which need to serve as the starting point for any discussion of long-term solutions to the structural problems within the Eurozone (actually, in the entire world, because what happens between Greece and the rest of the world is only a miniature version of what is happening between the US and the rest of the world).

So far, the focus of the debate was on the Eurozone's debt problems and possible solutions to it while the issue of current account balances has been more or less ignored. However, the debt problems are only the symptoms; the major underlying cause are the current account balances. Without current account imbalances, there can be no cross-border debt! With current account imbalances, the cross-border debt is the consequence!

Of late, there have been "awakenings" to the issue of current account balances. Dimitris Kontogiannis wrote an article in the Ekathimerini. John Mauldin published an analysis by Anatole Kaletsky, Charles Gave and Francois Chauchat (GaveKal). Stephen King published one in the Financial Times. And those who are interested in simple, common-sense explanations should refer to Warren Buffett's tale about Thriftville & Squanderville. All focus on the right issue even though they come to somewhat different conclusions.

Let me briefly state, once again, what a country's "current account" really is. The English expression for it could not be worse. The German expression translated into English would be something like "the international operational performance balance of a country" and that comes closer to the truth.

In essence, the current account is the cross-border cash-flow-from-operations-statement of a country. The table included in this post explains how it is composed. That is economics, but now to mathematics: a negative current account balance MUST find its corresponding entries in the capital account of a Balance of Payments (capital imports), as must the positive current account balance (capital exports). In short, if a country's cash-flow-from-operations is negative, it needs to import capital and vice versa.

Confusion with a country's trade balance must be avoided because the trade balance is only one part, albeit the most important part, of the current account balance. If a country manages to compensate the negative trade balance with operational incomes through services (e. g. tourism), the current account can be brought into balance.

A country's negative current account balance represents the transfer of wealth from it to the rest of the world. Greece, for instance, transferred 199 BN EUR of her wealth to the rest of the world between 2001-10 (and all of that "wealth" which she transferred abroad was first borrowed from abroad). Note: this is only wealth transferred abroad out of operations. It does not include wealth transferred abroad via capital flight!

As with a company, a negative cash-flow-from-operations is not bad per se; it all depends what the cash is used for. If the cash is used for investments in revenue-generating projects, today's cash-flow-deficit will in the future lead to cash-flow-surpluses. If it is used for consumption, the cash disappears but the debt remains.

Some opinion-leaders (particularly Greek ones) have attempted to construe present day's problems of Greece as a German conspiracy to "exploit" Greece. Facts do not support this because Germany, from 2007-10, has accounted for only 15% of Greece's current account deficit. What Greece has to do, as she makes a long-term macro-economic plan for her economy, is to analyze her ENTIRE current account balance, i. e. not only the 15% with Germany but also, and foremost, the other 85% with the rest of the world outside Germany.

GraveKal come to an astonishing conclusion. They say that the bulk of the Periphery's current account problems is not a function of deficits with Northern Eurozone-countries but, instead, a function of essentially oil and imports from China. If that is true, then it represents a REAL problem!

If current account deficits are driven by the import of cheap products which could also be produced domestically or products which are not essential for the domestic economy, a strategy of import substitution through new domestic production or import controls could quickly show positive results. On the other hand, if the deficits are driven by the import of products essential to the domestic economy (oil, cars, etc.) or products where one cannot compete due to pricing (China), the task of correcting the current account deficit assumes enormous dimensions.

What applies to Greece applies also to the other deficit countries: the current account deficits must be brought under control! If free market forces cannot accomplish this, then the process needs to be "managed". Countries which have the industrial base to stimulate exports must focus on that (Italy). Countries which do not have an industrial base must do other things (Greece). Here is just one proposal what Greece could do. Greece's opinion-leaders should feel obligated to discuss intensively what other proposals should be considered. Without addressing the issue of the current account deficit, an economy like that of Greece has no chance to sustain a reasonable standard of living because, at some point, foreigners will no longer transfer cash through the capital account which cash is lost (wasted?) through the current account.

A final anecdote
Half a century ago, we had a most interesting history professor in an Austrian Gymnasium. Since the teaching of history, then, ended with the year 1918 (because Austrians did not want to teach about their role in the 1930s/40s...), our professor had much time to teach us other things. One of the things he taught us was how the Austrian economy worked after 1945. Here is his story:

"Children", so he called us teenagers, "we (Austrians) don't have oil and we don't produce cars, but we need oil and want to drive cars. Thus, we have to import a lot. Since we need foreign currency to pay for those imports we must find ways to obtain foreign currency. Thus, we have to try to export as much as possible but, as a small economy, we cannot export enough to pay for all the imports. So we have to find other ways to obtain foreign currency and one of them is tourism. The more tourists come to our country and the more foreign currency they leave here, the better our chance to close the hole between the imports we need and the exports we have. And since that hole cannot be closed even after tourism, we need to be a very attractive place for foreign investment so that foreign investors bring us their money and the government needs to keep its household in order so that it can borrow money abroad".

That sort of says it all!


  1. GraveKal come to an astonishing conclusion. They say that the bulk of the Periphery's current account problems is not a function of deficits with Northern Eurozone-countries but, instead, a function of essentially oil and imports from China. If that is true, then it represents a REAL problem!

    Genau so hatte ich mir das gedacht. Deshalb wäre es gerade auch für die Südländer absolut kontraproduktiv, die deutsche Exportfähigkeit zu ruinieren. Die Märchen von Flassbeck, Fricke, Horn usw., dass Deutschland die Südstaaten ruiniert, wären damit widerlegt.
    Andererseits: vielleicht nicht so ganz.
    Wenn wir keine Exportüberschüsse haben, können wir denen kein Geld mehr leihen; damit könnten die nichts mehr in China kaufen.
    Dann druckt Draghi Geld (bzw. tut er ja jetzt schon) wie Ben Bernanke - und irgendwann fliegt die ganze Sch'e in die Luft!

    Aber wer, bitte, ist GraveKal?

    1. Siehe Namen im 3. Absatz und Link zu deren Artikel.

  2. Hello Mr. Klaus,

    I understand the importance of current account but does the capital account has the same importance since it is part in the balance of payment?

    With regards to Greece, I often read in the news that Greece will ran out of money, may I know where exactly can I get the facts regarding a country's cash balance?

    Best regards,


    1. Capital account balance is offsetting current account balance. If no longer surplus in capital account (because no more foreign funding), current account comes into balance by the force of mathematics (imports collapse).

      You cannot get facts about country's actual cash balance (unless you are an insider). Also, it is not only a question of how much cash there is but also which payments can be deferred. A state has many ways to preserve cash for some time. And who says the Greek State won't find a Greek bank to lend it some money and the Greek bank gets that money from the ECB?