First, its not just the trade account, its the whole current account. Capital account transactions are transactions with financial strings attached ... typically financial strings valued as roughly equivalent to the size of the transaction.

IOW, a capital transaction is an exchange of financial assets now for a promise of some service, typically including some flow of financial assets in the opposite direction, later.

In what might be the paradigmatic capital transaction, an international sale of a commercial bond (debenture), the later flow of financial assets is the regular interest payments, which continue until the bond is purchased by someone from the originating country. If the price of the bond has not changed, that means that a transfer of assets from A to B starts a flow of assets from B to A, which continues until there is a canceling transfer of assets from B to A to extinguish the international liability.

Current transactions do not have these strings attached. They include exports and imports, where the current obligation is provision of a good or service, income payments, where they satisfy an existing obligation ... often generated by a previous capital transaction, sometimes involving hire of labor from overseas ... and unilateral transactions like overseas remittances.

If country A has a trade deficit but an equal surplus on the rest of the current account, so it has a balanced current account, there is no special impact from that trade deficit. In that case, the trade deficit amounts to simply consuming the income from abroad.

OTOH, if country A has a current account deficit, through whatever combination on the trade account, income account and unilateral transfers, that is when international money starts to be something other than a neutral medium of exchange.

If there is no net official account transactions ... in particular, no accumulation or draw down of official foreign exchange reserves ... then a current account deficit requires an equal capital account surplus. That entails accumulating net additional international financial obligations (whether they are obligations of the government or private citizens, and whether they are held by governments or private citizens abroad, is a second-order question ... sometimes quite important, but still subsidiary to the main international double entry book-keeping).

In broad outline, this can be treated like other entities taking on external financial obligations in order to outspend their current financial income ... a business making a capital investment, or a household taking out a second mortgage to go to Disney World.

(1) If what is bought as a result of the external finance results in later income that exceeds the required interest payments, the debt is self-funding. This is, of course, the ideal that a commercial corporation ought to be aiming for.

(2) If there is no financial benefit from the acquisition, then this is discounting away future income in order to engage in current consumption.

(2a) This can be done without a loss in future standard of living if the funding comes from future income growth ... to simplify from above, if Mom just got a raise in her salary, and the vacation in Disney World will be easily paid for out of the first two years of the raise.

(2b) Otherwise, this is trading away a higher standard of living now for a lower standard of living in the future. Taking out of second mortgage to take a trip to Disney World because capital price inflation in the housing market makes the second mortgage possible, while both Mom and Dad are working in dead end jobs with a high risk of being laid off if a recession should raise its ugly head.

So that is a rough framework to raise the first order questions about a current account imbalance:

(1) In real terms, is the current deficit real investment in productive capacity, or is it a combination of current consumption and debt service for previous consumption?

(2) If the current deficit is consumption or debt service, is its future funding going to come from economic growth, or from future sacrifice of the standard of living of some or all of the residents of the deficit nation?

From a ecological economic perspective, therefore, a current deficit that is requiring the capital account to finance current consumption or debt service is either a contribution to growth addiction or trading away future standard of living in nations that do not at present have a sustainable technology for maintaining their current standard of living.

And where do foreign exchange reserves come in? They are in the official account transactions that were held in balance in order to make it easier to focus on the current/capital account relationship.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.