In today’s globalized world, it is highly likely that your car was made in Japan, your software comes from the U.S., your pension fund has invested via London, and the rest of you stuff…. probably comes from China.
To understand the effects of globalization, using the standard measurement, gross domestic product, or GDP for short, is not enough.
As an economist I use the Balance of Payments to understand what is going on in the global economy.
This framework complements GDP and is essential for any serious macro-economist.
So, if you want to understand the global economy, rather than just that of specific nations, then keep watching this video, because in it, I will introduce you to the balance of payments framework.
If you prefer to consume this story in video format, check it out here:
The balance of payments is an accounting framework that is used to measure international money flows. In short, the balance of payments categorizes payments flows between a country’s residents and the rest of the world. It records whether a transaction is the consequence of international trade or investment and it also records whether financial flows are outgoing or incoming flows.
Let’s look at an example. A Dutch company exports an advanced chip making machine to the United States for ten million Dollars. How do economists record this in the balance of payments?
First, they think about where the money if flowing. In this case, it is going to the Netherlands. So on the Dutch balance of payments this registers as an inflow of ten million Dollars. On the U.S. balance of payments this registers as an outflow. Since the machines went the other way, you can see that the balance of payments tracks inflows and outflows of payments, not of goods and services.
It’s useful to keep this simple principle in mind to correctly interpret the plusses and minuses that accompany the various transactions recorded in the balance of payments.
As you can imagine, there are all sorts of transactions that cause payment inflows and outflows. Those regarding transactions associated with trade of goods and serves, such as the machine transaction from the example, are registered in the current account. Besides payments for goods and services, income from interest, dividends or wages, and even gifts such as development aid or workers sending money to foreign family members are all registered in the current account. Basically, how I try to remember it, is that most transactions that regular people (not investors) would do, are recorded in the current account.
Capital and financial account
But, this is not the whole story, there is a separate category on the balance of payments that is used to keep track of investment flows. This is where the capital and financial accounts come in, often briefly called the ‘capital account’. Some of these investment flows are a consequence of trade flows. Most famously, the United States has consistently imported more than it exports.
How does it pay for this?
In short, this is only possible because citizens of other countries invest more in the U.S. than the other way around. In our example, it could very well be that the Dutch exporters will keep the proceeds of its sale as an investment in U.S. bonds. For that reason, the current account deficit of the U.S. is matched by a capital account surplus of all other countries.
This may sound intimidating … but it basically translates to: if the U.S. imports more than it exports, this difference must be financed by other countries. Of course the reverse also holds, it is well known that countries like Germany and the Netherlands consistently exports more than they imports. A fact that politicians in these countries seem to take great pride in. However, the balance of payments reveals that both countries have persistent capital account deficits. Again, the jargon sounds intimidating, odd even in this case. But, a current account surplus and capital account deficit basically means that Germany and the Netherlands are financing other countries so that these can keep importing goods from them.
Gross capital flows
Okay, so now, let’s move on to the last important part of the balance of payments: offsetting capital account transactions, also known as Gross capital flows.
This one is a bit confusing. So much so, that economists have only recently begun to realise its importance. I’ll try to clarify it with an example. Let’s say that an oil refinery in Saudi Arabia wants to borrow some money to buy some oil from another Saudi Arabian company. In the oil business, even inside Saudi Arabia, the U.S. dollar is the preferred currency. So, it makes sense that the Saudi firm goes to a New York bank to borrow some U.S. dollars. If this happens, money creation takes place and the New York bank will simultaneously record a loan to the Saudi firm and create a Dollar deposit account for it. Because money crosses borders, this transaction is captured in the balance of payments of both the U.S. and Saudi Arabia. If we look at the Saudi BoP, we will see that on the capital account: there is an inflow recorded (this is the deposit account), we also see that there is an outflow recorded for the loan. The U.S. capital account will record the opposite, an outflow for the deposit account, and an inflow for the loan.
you might now see that this doesn’t show up in the capital account balance.
But, if this happens a lot, you can imagine that economists still want to know about it, because it means that a lot of debt is building up between the U.S. and Saudi Arabia.
So, this was brief overview of the balance of payments. It is an accounting framework that records all international transactions. It makes a distinction between transactions that result of a financial nature (recorded on the capital and financial accounts) and those that result from regular economic activities, which are recorded on the current account.
Now, if I study the international economics of a country, there are two crucial balance of payments aspects that I look at first.
To see if there are problematic trade imbalances, I take a look at the current account balance over time. Remember that, this is the mirror image of the capital account balance. After that, to see if large financial imbalances are building up, I take a look at all in-coming and outgoing flows on the capital account.