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THE BALANCE OF PAYMENTS ALWAYS BALANCES

Lesson Overview
Balance of payments accounting is an often misused and misunderstood tool for keeping
track of our economy’s flow of imports and exports. While the data, itself, is neutral, it is
sometimes reported in ominous tones, especially when the numbers total up to a deficit in
the merchandise account. As students learn more about trade, they appreciate that a trade
deficit is not necessarily bad any more than a trade surplus is necessarily good. This
lesson reinforces their appreciation of that reality by identifying the components of the
balance of trade. Learning about the flow of financial assets captured in the capital
account should add a whole new dimension to their understanding of the full scope of
trade. The accompanying classroom activity allows students to explore balance of
payments accounting in a simplified example of trade among 3 states in the U.S.

Key Points:
Keeping the Ledger: The Nuts and Bolts of Balance of Payments Accounting

1. Balance of payments accounting is an accounting system used to measure

international flows of money and products (goods, services, and resources).

 Each exchange is assigned both a positive and a negative value:

o Generally, a positive value (+) is assigned to exports—and that includes

exports of money or other financial assets as well as exports of products.

o Generally, a negative value (-) is assigned to imports—and that includes

imports of money and other financial assets as well as imports of
products.

 The actual accounting simply records the flows as they are measured over any
specified time period.

2. Balance of payments accounting differentiates between products (goods and services)

and financial assets (money).

 The Current account records the flows of goods and services.

o Conversational use of the terms "export" and "import" usually refers to the
Current account.

 The Current account is further divided into Merchandise,

Services, and Private and Government Transfers.

o Historically, the most important category has been

Merchandise – material "stuff and things" like cars,
airplanes, wheat, clothing, iron ore, etc.
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o Generally, and somewhat misleadingly, conversational
and news references to "imports and exports" have
really been references only to the Merchandise account.

 In the latter decades of the 20 th Century and into the 21st, the
service sector has been growing very quickly and is an
increasingly important part of the Current account.

o Examples of items in the service category are tourism,

computer software, technical training (as when Boeing
sends a flight training crew with the sale of new
aircraft to a foreign country), concert entertainers, and
organizational and financial services.

 Private and Government Transfers are gifts or grants to foreign

individuals, organizations, or governments.

o Examples include hurricane disaster relief aid in

Central America, individual Americans' cash donations
to African famine relief, or government humanitarian
foreign aid to India.

 The Capital account records the annual change in financial flows.

3. The balance of payments always balances.

 Goods, services, and resources traded internationally are paid for; thus every
movement of products is offset by a balancing movement of money or some other
financial asset.

o If a U.S. retailer imports $1 million of Japanese televisions, there is a

corresponding or balancing movement of money to the Japanese
producer.

 A surplus in the Current account is by definition offset by a deficit in the Capital

account.

o Another way to think of this is that if we export goods and services, then
we "import" financial assets of the foreigners who purchased those goods
and services.

 Similarly, a deficit in the Current account must be offset by a surplus in the

Capital account.

o In practical terms, if Americans import foreign products, then we "export"

our financial assets to pay for them.

 While the Current account deficit of recent years has received much media
attention, there is little public awareness that this "trade deficit" is accompanied
by a surplus in the Capital account.
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4. The Capital account measures financial flows, or the change in the claims of one
country on the assets of another.

 When Americans purchase foreign goods, American money and other financial
assets flow out of the country to foreigners. (See Visual #3)

o With a few notable exceptions (like oil), American money is only useful
for American purchases. So, we say that holders of American money
have a claim on American assets.

o Foreigners may hold these claims in a variety of forms, including:

 Currency

 Treasury bills and notes

 Stock in U.S. companies

 Government or Corporate bonds

o Or, they could actually purchase American capital assets, like office
buildings, ski resorts, business franchises, etc. (Since they don't move the
assets to their home countries, we don't count them in the current
account.)

 When foreigners purchase American products, foreign money

and financial assets flow into the United States. (See Visual
#3)

o In that situation, then, Americans hold claims on the assets of other

countries.

 In practical terms, this could mean owning part of a British

company, investing in a French winery, buying stock in a
Japanese automaker, or simply holding foreign currency.

5. An example of a simple Balance of Payments account with a single nation. (See

Visual #1 and #2)

6. The realities of international trade mean that the balance of payments model is much
more complex than simple exchange of money for finished products.

 In the increasingly specialized global economy, the import and export of

intermediate goods accounts for an ever-larger portion of trade data.

o For instance, engine parts produced in Mexico are made into engines in
Windsor, Canada, and shipped to Detroit where they become part of
finished cars and then they are sold in Canada, France, Great Britain, and
Germany.

o Another complex example occurs when an American company builds a

factory in another country. Any flow of materials, parts, or finished
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goods between the U.S. parent company and the foreign factory must be
counted in the import/export data.

Interpreting the Data

Contrary to the impression we may receive from gloom-and-doom news reporting,

balance of payments accounting simply offers us a number – a reporting of the
aggregated record of trade flows. The significance of a deficit or surplus in either the
Current Account (goods and services) or the Capital Account (financial flows or claims
on assets) is the subject of ongoing debate because groups and individuals are affected
differently by deficits and surpluses. Without drawing conclusions about which is better
from a policy standpoint, it is possible to use economic analysis to decipher the practical
implications of various configurations in the balance of payments.

7. Current Account Surplus (and Capital Account Deficit): This configuration is

favored by those who believe that we should always export more merchandise and
services than we import.

 This so-called "trade surplus" necessarily means a capital account deficit – an

increase in U.S. holdings of claims on foreign assets.

o In other words, we have sent more goods and services to other countries
than they've sent to us, so we are holding their IOUs in the form of money
or claims on their financial assets.

 In practical terms, this configuration means that:

o American goods and services are competitive and desired in world

markets; foreigners are willing to spend their money on our products.

 Owners and workers in export industries really like this

situation.

o Americans are willing to hold claims (IOUs) on foreign assets, in the

form of foreign currency, stock in foreign companies, foreign bonds, etc.

 This is ok if the countries whose IOUs we're holding have

strong, stable governments and economies, or products we
think we'll one day want.

8. Neither Surplus Nor Deficit in the Current Account: This configuration is favored by
those who believe that our exports to a particular nation should always equal our
imports from that nation.

 This view presumes that there is some inherent value in an equilibrium position or
that an equilibrium somehow equates to "fair" trade. There is no evidence that
either is the case.

 The increasing complexity of global trade, based on comparative advantage and

increasing specialization makes an equal exchange of goods and services between
any two nations highly unlikely.

o Most international trade is multi-lateral.

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 For example, while the U.S. runs merchandise deficits with
Japan, it runs merchandise surpluses with the Netherlands. At
the same time, the United Arab Emirates runs merchandise
surpluses with Japan and deficits with the U.S.

9. Current Account Deficit (and Capital Account Surplus): This configuration is

favored by those who believe that we are better off if we import more than we export.

 In other words, we are buying more goods and services from other countries than
they are buying from us, so they are holding IOUs in the form of American
currency and other financial claims on assets.

 In practical terms, this configuration means that:

o Americans are enjoying foreign goods that are selling at prices below
what they could be produced for in the U.S.

 Owners and workers in import industries, and consumers in

general, benefit in this situation.

o The willingness of foreigners to hold claims on U.S. assets is a source of

investment in American enterprises.

 It is also an indication of foreign faith in the strength of the

American economy and stability of American government.

10. Nations don't trade; people do. Balance-of-payments accounting is simply the
aggregated record of millions of individuals' decisions about what to produce, sell,
and consume.

 Trade policy directed to changing the balance-of-payments does not have a

uniform effect, but impacts the decisions and well-being of different individuals
in different ways.

o It should not be surprising, therefore, that trade policy is the focus of

active, intense lobbying efforts on the part of industries affected by
various configurations of deficit and surplus.

 Policies designed to "correct" the balance of trade ignore the reality that Trade
Creates Wealth.

o Policy actions taken to "correct" or change levels of imports and exports

invariably restrict trade flows.

o While such policies may or may not successfully change the composition
of the balance-of-payments categories, they almost assuredly decrease the
overall volume of trade and thus inhibit the creation of wealth.
Visual #1 6

Sample: U.S. - Canada Balance of Payments Account

Imports Exports Net

(in millions) (in millions) (in millions)
Current -$190,554.73 +$148,207.70 -$42,347.03
Account deficit
(We sent this much
(We bought this (We sold this much more money to
much "stuff" from "stuff" to Canada than they
Canada) Canadians) sent here)
Capital (Canadians (We increased our (Canadian claims on = $0
increased their holding of Canadian US assets are this
Account holding of asset IOUs by) much greater than
American asset US claims on
IOUs by) Canadian assets
+$42,347.03 $0 +$42,347.03
surplus
(1999 data)
Visual #2 7

U.S. Balance of Payments 2005

($ millions)
Current Account -804.9

Merchandise trade balance -723.6

Goods & Services exports 1,272.2
Goods & Services imports -1,995.8
Net Income Payments 1.5
Net Transfers - 82.8

Capital Account +800.9

Increase in U.S. holdings of foreign assets -491.7

Increase in Foreign holdings of U.S. assets 1,292.6

Statistical Discrepancy +4

Bureau of Economic Analysis: http://bea.gov/bea/newsrelarchive/2006/trans206.xls (10/03/06)

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Destinations of U.S. Foreign Sources of Foreign Direct

Direct Investment Investment in the United
States
2005 2005
(percent) (percent)

United Kingdom 16 United Kingdom 17

Canada 11 Japan 12
Netherlands 10 Netherlands 10
Japan 3 Germany 11
Germany 4 France 9
Australia 4 Canada 9
Switzerland 5 Switzerland 7
Bermuda 4 Luxembourg 7
France 3
Mexico 3

All other countries 37 All other countries 22

Bureau of Economic Analysis: http://bea.gov/bea/newsrelarchive/2006/trans206.xls (10/03/06)