Reinert/Windows on the World Economy, 2005 Accounting Framework CHAPTER 12

Reinert/Windows on the World Economy, Introduction International trade refers to the exchange of merchandise and services among the countries of the world International finance refers to the exchange of assets among the countries of the world  Global exchange of assets in the world economy has at times been nearly 100 times larger than the exchange of merchandise and services

Reinert/Windows on the World Economy, Open-Economy Accounts View an economy as being aggregated into one giant sector  For example, we’ll treat the Mexican economy as being composed of Firm account Household account  Relationships between these two accounts are summarized as a circular flow diagram of a simple, closed economy “Closed” means the absence of any trade and financial interactions with the world economy Production process of the Firm generates income that accrues to the Household  Income (Y) consists of wages, salaries, and payments for the use of property assets  Given the simple assumptions of this chapter, Y is also equal to both the nominal gross national product (GNP) and the nominal gross domestic product (GDP) of Mexico  Consumption process of the household generates consumption expenditures that accrue to the Firm (C)

Reinert/Windows on the World Economy, Figure 12.1 A Circular Flow Diagram for a Simple, Closed Economy

Reinert/Windows on the World Economy, Open-Economy Accounts To inject more realism we need to add three new accounts  Capital Income not consumed, which is available for use in investment Financial intermediary in the savings-investment process  Banks, mutual funds, and brokers that receive funds from savers and use these funds to make loans or buy assets  Government  Rest of the World Captures the interactions of the Mexican economy with the other countries of the world Results in a circular flow diagram for an open economy with government, savings, and investment

Reinert/Windows on the World Economy, Figure 12.2 An Open Economy with Government, Savings, and Investment

Reinert/Windows on the World Economy, Expenditures in Open-Economy Accounts Production process of the Firm generates income that accrues to the Household Household has three types of expenditures  Consumption of goods and services (C)  Household savings (S H ) accrues as income to the Capital account  Taxes paid to the government (T) Government makes two alternative expenditures  Government spending (G)  Government savings (S G ) In many cases S G are negative  Flow is reversed—from Capital to Government Capital has a single expenditure (I)  Funds provided to firms for investment purposes

Reinert/Windows on the World Economy, Open-Economy Accounts The Rest of the World interacts with the Mexican economy  Makes an expenditure that accrues to the Firm account in the form of its purchases of Mexico's exports (E)  Receives income in the form of Mexico's purchases of imports (Z)  Makes an expenditure that accrues to Capital in the form of foreign savings (S F )

Reinert/Windows on the World Economy, Capital Account Capital account has one expenditure—domestic investment Capital account has three types of receipts (savings flows)  Domestic savings Household Government  Foreign savings Expenditures must equal receipts for the Capital account, or  Expenditure = Receipts or  I = (S H + S G ) + S F or  Domestic Investment = Domestic Savings + Foreign Savings Helpful to rearrange this equation by subtracting domestic savings from both sides  Domestic Investment – Domestic Savings = Foreign Savings Any gap between domestic investment and domestic savings is made up for by an inflow of foreign savings

Reinert/Windows on the World Economy, Rest of the World Account Has two expenditures  Mexico’s exports  Foreign savings Single receipt in the form of Mexico’s imports Equation expressing the equality between expenditures and receipts for the Rest of the World account  E + S F = Z or  Exports + Foreign Savings = Imports  Helpful to rearrange this equation by subtracting exports from both sides Foreign Savings = Imports – Exports or Foreign Savings = Trade Deficit Gap between imports and exports (any trade deficit) has a counterpart in and inflow of foreign savings

Reinert/Windows on the World Economy, Capital Account and Rest of World Equations Both have foreign savings on one side Can combine into a single relationship  Fundamental accounting equation for open economies Domestic Investment – Domestic Savings = Foreign Savings = Trade Deficit  Can also be written as  Domestic Savings – Domestic Investment = Foreign Investment = Trade Balance

Reinert/Windows on the World Economy, Table Domestic Savings, Domestic Investment, Foreign Savings, and the Trade Balance

Reinert/Windows on the World Economy, Fundamental Accounting Equations What do the fundamental accounting equations tell us? Suppose that Mexico’s domestic investment exceeds its domestic savings  Shortfall in domestic savings is made up for by a positive inflow of foreign savings  According to the first equation, there must be a trade deficit Mexican economy is importing more merchandise and services in value terms than it is exporting Therefore, Mexico must sell something else other than merchandise and services to the rest of the world to make up the difference  Assets: government and corporate bonds, corporate equities, and even real estate  Purchase of Mexican assets by the Rest of the World generates the inflow of foreign savings into Mexico

Reinert/Windows on the World Economy, Fundamental Accounting Equations Suppose that Mexico’s domestic savings exceeds its domestic investment  Generates a positive outflow of foreign investment by Mexico According to the second equation, there must be a trade surplus  Mexican economy is exporting more merchandise and services in value terms than it is importing  Therefore Mexico must buy something else other than merchandise and services from the rest of the world to make up the difference Assets—purchase of foreign assets by Mexico generates the outflow of foreign investment to the Rest of the World

Reinert/Windows on the World Economy, Fundamental Accounting Equations—Summary Relate domestic investment, domestic savings, and the trade deficit or surplus  Trade deficit will be associated with an excess of domestic investment over domestic savings  Trade surplus will be associated with an excess of domestic savings over domestic investment  Fundamental equation provides a link between Mexico’s interactions with the Rest of the World (the trade balance) and Mexico’s economic aggregates of domestic investment and domestic savings Link is foreign savings  If domestic saving falls short of investment, the gap is made up for with foreign savings, which we know is associated with a trade deficit  If domestic saving exceeds domestic investment, the excess is lent abroad  This negative foreign savings is associated with a trade surplus

Reinert/Windows on the World Economy, The Balance of Payments Accounts Focus on the relationship of the country with the Rest of the World Rest of the World equation  Foreign Savings = Trade Deficit  Subtract the trade deficit from both sides of this equation Balance of Payments: Trade Balance + Foreign Savings = 0 or Current Account + Capital Account = 0 Capital account  Records the net balance of transactions involving the exchange of assets between Mexico and the Rest of the World  When foreign savings is positive, there is a net positive purchase of Mexican assets by investors in the Rest of the World Means by which the inflow of foreign savings takes place Current account of the balance of payments  Records the net balance of transactions between Mexico and the Rest of the World not involving the exchange of assets Only trade transactions and is equal to the trade balance  Includes more items than exports and imports

Reinert/Windows on the World Economy, The Balance of Payments Equations A current account surplus must be accompanied by a capital account deficit A current account deficit must be accompanied by a capital account surplus A common allegation about the place of the United States and Europe in the world economy is that the future lies in low-wage countries  Attracting the bulk of world financial capital Implies that the countries will have capital account surpluses  Running large trade surpluses Implies that the countries will have current account surpluses Logical fallacy because this is impossible

Reinert/Windows on the World Economy, Table Mexican Balance of Payments, 1993 (billions of US dollars)

Reinert/Windows on the World Economy, Analysis of Table 12.2 Table 12.2 gives the approximate balance of payments accounts for Mexico in the year 1993  1993 is the last year before the Mexican balance of payments crisis in 1994 Current account includes items 1 through 6  Item 1—total Mexican exports Reported in gross terms as US$61 billion  Item 2—total Mexican imports Reported in gross terms and has a value of $77 billion  Item 3—trade balance Reported in net terms—in 1993, Mexico had a trade balance of – $16 billion or a trade deficit First term of the balance of payments equation above

Reinert/Windows on the World Economy, Analysis of Table 12.2  Item 4—net factor receipts Residents of Mexico, either households or firms, own factors of production located in the Rest of the World and receives income or profits from this factory  Known as factor receipts or factor service exports Alternatively, residents of foreign countries own factors of production located in Mexico, and they receive payments from Mexico  From Mexico’s point of view, these are factor payments or factor service imports  Item 5—transfers and is recorded in net terms Possible transfer items are foreign aid, remittances of expatriates and foreign workers from one country to another, and international pension flows

Reinert/Windows on the World Economy, Analysis of Table 12.2 The sum of the net items 3 through 5 composes the current account balance and is entered into the accounts as a major balance in item 6 of Table 12.2  In 1993, Mexico had a current account deficit of $23 billion  Since the accounts between Mexico and the rest of the world must balance There were other transactions in the balance of payments offsetting or financing the current account deficit

Reinert/Windows on the World Economy, Analysis of Table 12.2 Capital account consists of transactions involving the exchange of assets  Type of asset exchanged and who exchanges them determines the capital account item in which a transaction is recorded For example, item 7 is direct investment or direct foreign investment— consists of money that corporations invest in firms they own in other countries  Portfolio investment Includes government bonds of various maturities, corporate equities, corporate bonds, and bank deposits  Unlike direct investment, portfolio investment does not involve an element of control Can be divided further into  Long-term capital  Short-term capital  More volatile than long-term capital There was a net inward flow of portfolio investment in 1993 of $29 billion  Much of this was of a short-term nature and contributed to a crisis in 1994 and 1995

Reinert/Windows on the World Economy, Analysis of Table 12.2  Official reserves balance (Item 9) Does not show up at all in the open-economy accounts relationship of the balance of payments equation above Reflects the actions of the world’s central banks  Central banks need to hold reserves of foreign exchange  Other countries’ government bonds and accounts at foreign central banks

Reinert/Windows on the World Economy, Analysis of Table 12.2 Transaction on the official reserves balance occur in four instances:  Mexico’s central bank sells foreign exchange holdings Generates an inward flow of funds and income or receipts on Mexico’s official reserve balance (positive entries)  Mexico’s central bank buys foreign exchange holdings Generates outlays or expenditures on the official reserve balance (negative entries)  Foreign central banks sell their reserves of Mexico’s currency Generates an outward flow of funds and an outlay or expenditure on Mexico’s official reserves balance (negative entries)  Foreign central banks buy reserves of Mexico’s currency Generates an income or receipts on Mexico’s official reserve balance (positive entries)

Reinert/Windows on the World Economy, Analysis of Table 12.2 Up to this point  Current account balance is –$23 billion  Direct investment balance is $4 billion  Portfolio investment balance is $29 billion  Official reserves balance is –$7 billion Sum is $3 billion, yet the current and capital accounts must sum to zero  What has gone wrong?  In most all cases, collecting balance of payments data is a difficult and imprecise activity  Many transactions cannot be measured accurately or simply “slip through the cracks”  Consequently, there needs to be an honest accounting of errors and omissions, recorded as a net balance of –$3 billion in item 10

Reinert/Windows on the World Economy, Balance of Payments Accounts as a Diagnostic Tool Help identify patterns of relationships of the country in question with rest of world that might not be sustainable  For example, if a country is financing persistent current account deficits with short-term portfolio investment or by selling foreign reserve holdings May be cause for alarm  Economist can turn to the open-economy accounts to explore how the external imbalance is associated with domestic (household and government) savings and investment

Reinert/Windows on the World Economy, Table The Mexican Balance of Payments, (billions of US dollars)