12 External balance

Overview

External balance is one of the two fundamental objectives of macroeconomic policy in an open economy. Unlike internal balance, which concerns the efficient use of domestic resources, external balance concerns a country's economic relationship with the rest of the world.

Its purpose is not to eliminate international borrowing or lending, but to ensure that a country's external position remains sustainable over time.

The concept is more difficult to define than internal balance because there is no universally accepted benchmark comparable to full employment or price stability. Instead, the appropriate level of external balance depends on economic conditions, exchange-rate arrangements, investment opportunities, and the institutional environment.

Definition

A country is in external balance when its current account is neither

• so deeply in deficit that future repayment of foreign debt becomes problematic;

nor

• so strongly in surplus that other countries face those same difficulties.

External balance therefore refers to a sustainable current account position rather than a balanced current account.

Why isn't a zero current account the objective?

A common misconception is that every country should maintain a current account equal to zero.

The book explicitly argues that this is not generally desirable.

A current account deficit simply means that a country is borrowing resources from the rest of the world.

Likewise, a current account surplus means that a country is lending resources abroad.

Neither situation is inherently good or bad.

The crucial question is whether these international capital flows improve economic welfare.

External balance and intertemporal trade

International borrowing and lending allow countries to trade consumption across time.

Instead of exchanging only goods produced today, countries also exchange present resources for future resources.

This process is called intertemporal trade.

Countries with highly productive investment opportunities may borrow today, invest those resources, and repay their debts in the future using the higher income generated by those investments.

Conversely, countries with relatively poor investment opportunities may save more than they invest domestically and lend those savings abroad, earning future returns on foreign assets.

From this perspective, current account imbalances are not necessarily signs of economic weakness. They can simply reflect an efficient international allocation of savings and investment.

Other reasons for current account imbalances

Current account imbalances may also help countries smooth temporary fluctuations in income.

Suppose a country experiences a temporary decline in output because of a poor harvest or another temporary shock.

Rather than allowing domestic consumption to collapse, the country can borrow from abroad and spread the adjustment over time.

International borrowing therefore allows households and firms to maintain a smoother path of consumption despite temporary fluctuations in national income.

Why governments still care about external balance

Although current account imbalances may be beneficial, governments generally avoid very large deficits or surpluses.

The reason is simple.

Policy makers cannot determine with certainty what the optimal current account should be.

Economic conditions change continuously, investment opportunities evolve over time, and future returns are uncertain.

As a result, governments usually adopt a target current account that avoids excessively large imbalances unless there is strong evidence that those imbalances generate substantial gains from intertemporal trade.

Problems with excessive current account deficits

Large current account deficits become problematic when foreign borrowing finances activities that do not generate sufficient future income.

Examples include:

• excessive current consumption;
• poorly designed investment projects;
• overly optimistic expectations about future profitability;
• unsustainable fiscal policies.

In these situations, future income may be insufficient to repay foreign creditors.

Every country faces an intertemporal budget constraint.

Over time, foreign debt must remain consistent with the country's ability to generate future income and repay both principal and interest.

Persistent borrowing cannot continue indefinitely unless it is supported by sufficiently productive investments.

Sudden stops

One of the main risks associated with excessive external deficits is a sudden stop.

A sudden stop occurs when foreign investors unexpectedly refuse to provide additional financing or demand repayment of existing loans.

When this happens,

• foreign borrowing falls abruptly;
• domestic spending must decline rapidly;
• the economy is forced to adjust immediately.

The larger the initial current account deficit, the more painful this adjustment becomes.

For this reason, governments try to avoid excessively large external deficits before financial markets impose the adjustment.

Problems with excessive current account surpluses

Large current account surpluses may also create economic and political problems.

A persistent surplus implies that domestic saving is being invested abroad rather than at home.

This may reduce domestic investment in productive capital.

Lower domestic investment can reduce:

• future domestic production;
• employment;
• technological spillovers;
• government tax revenues.

Large surpluses may also expose the country to political tensions.

Trading partners running persistent deficits may respond by introducing protectionist measures or trade restrictions.

Therefore, governments generally avoid excessively large surpluses as well as excessively large deficits.

External balance as a policy objective

External balance does not imply

\[CA = 0\]

Instead, governments seek a current account position that remains sustainable over time.

Conceptually,

\[\text{External Balance}=\text{Sustainable Current Account Position}\]

rather than

\[\text{External Balance}=\text{Balanced Current Account}\]

This distinction is one of the central messages of the chapter.

Relationship with internal balance

Internal and external balance are closely connected.

Policies that stimulate domestic demand may reduce unemployment but also increase imports, thereby worsening the current account.

Conversely, policies designed to reduce external deficits often reduce domestic expenditure and may temporarily increase unemployment.

Macroeconomic policy therefore requires balancing domestic objectives with external sustainability.

Connections

Parent node

• Key Concepts

Related nodes

• [[11 Internal Balance]]
• Monetary Trilemma

Related historical nodes

• Gold Standard
• Bretton Woods
• Floating Exchange Rates

Different international monetary systems provide different mechanisms for achieving external balance.

Questions for students

1. Why is a current account deficit not necessarily a problem?
2. What is meant by intertemporal trade?
3. Why is external balance defined as sustainability rather than as a zero current account?
4. What is a sudden stop?
5. Why can excessively large current account surpluses also be undesirable?
6. Why do policies aimed at improving external balance often affect internal balance?

Intuition in one sentence

External balance asks a simple question:

Can this country continue borrowing from or lending to the rest of the world without creating future economic or financial problems?

Key takeaways

• External balance concerns the sustainability of a country's international position.
• A zero current account is not generally the optimal policy objective.
• Current account imbalances allow countries to engage in intertemporal trade.
• Excessive deficits increase the risk of repayment problems and sudden stops.
• Excessive surpluses may reduce domestic investment and generate political tensions.
• Governments therefore target sustainable rather than perfectly balanced current accounts.