“MAPping The Future” Column in the INQUIRER – 24 November 2008 Financial Markets - the Growing Unpaid Debts by Aurelio O. Angeles Economies are like people. They work, they have a good time, they save, they borrow. After all, people make up the economy and economics is about people working, having a good time, saving or borrowing. It is the same with the US economy. Now, the US economy is in a crisis. This crisis in whatever form it takes pertains to debt repayment or failure to meet financial obligations. If we understand the root causes of the crisis, then we are closer to knowing the medicine to cure it. This is the aim of this article. Borrowing and over-borrowing When does a person borrow? We borrow when we spend more than we earn. There is certainly nothing wrong about borrowing if we are able to repay it. Now, when does a person over-borrow? We over-borrow when our net earnings in the future are not enough to pay for our borrowings today. As a result, we resort to refinancing our old debts as we continue to incur new debts until we simply default on loan repayments. When this happens, bubbles start bursting and we are in a crisis. It's the same with the economy. How is that? Exports minus Imports First, we need to understand basic concepts on economics. How does the economy earn? And how does the economy spend? In the global economy, an economy earns when its people sell goods and services to the rest of the world in dollars and when it receives dollar income for its people's work and investments abroad. Simple enough. The capability of an economy to generate foreign currency revenues from its business with the rest of the world determines the economy's ability to pay for its financial obligations with the rest of the world. We will call this revenue generation EXPORTS. This same economy incurs expenditures when it buys or imports goods and services from the rest of the world and when it pays foreigners factor income for their work or investments within the economy. We will call these expenditures IMPORTS. The difference between an economy's annual EXPORTS and its annual IMPORTS is called CURRENT ACCOUNT BALANCE. Please do not confuse CURRENT ACCOUNT BALANCE with Merchandise Trade Balance which pertains only to the difference between exports and imports of goods and is only a part of CURRENT ACCOUNT BALANCE. Current Account Balance There is nothing fancy in the term, CURRENT ACCOUNT BALANCE. Just to show how simple it is, it is called CURRENT because it pertains to activities within the year. What happens when EXPORTS are greater than IMPORTS? It means that the people in the economy have net earnings or savings. What happens when IMPORTS are greater than EXPORTS? It means that the people in the economy have incurred borrowings! Why so? Well, it's because they spent more than they earned and the difference is funded by borrowings. When EXPORTS are greater than IMPORTS, then the economy enjoys a CURRENT ACCOUNT SURPLUS. When EXPORTS are less than IMPORTS, then the economy suffers a CURRENT ACCOUNT DEFICIT. Again, please do not confuse CURRENT ACCOUNT DEFICITS or SURPLUS with fiscal deficits or savings which pertain to the difference between government expenditures and government revenue collections. International finance But who lends money to the economy when it goes on CURRENT ACCOUNT DEFICIT? Banks, of course, and other financial markets operators. Where do the financial markets operators get their money? They get it from the real economy's savings earned from centuries of work and wealth accumulation! How do banks lend to foreign banks? And how do local banks collect their debts? Well, first, banks must develop trust among themselves. Then, they agree on their collaterals and the amount of their transactions in foreign currency. Then, they record payments by mere book entries. Book entries! You won't believe this until you realize that no physical money is shipped in planes and boats in payment of transactions among banks across oceans. What happens when banks start failing to pay their obligations to other banks? Then we have a crisis, and credit becomes hard to get. The equation in international trade and finance Now we know the two sides in international transactions - international economics on one side and international finance on the other. The first side is net EXPORTS which represent total exports minus total imports of real goods and services and earned income generated by the real economy for the year. We call this transaction CURRENT ACCOUNT BALANCE (CAB). The second side refers to FINANCIAL FLOWS representing net savings or net borrowings resulting from the status of the CAB. There are two formulas to describe these status: - CAB = Financial Accounts or + CAB = - Financial Accounts When the CAB of an economy is negative or in deficit, then that economy is borrowing from the rest of the world. Or, it may also mean that the economy is reducing its net savings in the rest of the world. When the CAB of an economy is positive or in surplus, then that economy is incurring savings and/or is repaying its borrowings with the rest of the world with the use of these savings. If you want to go back and read the explanation again, it's alright. After all, you have gone through one of the most esoteric concepts in economics. (For a more detailed and practical explanation of the CAB and for the list of my US academe sources on the topic, may I refer the reader to the chapter on Current Account Surplus in the book, The Philippine Economy: Do Our Leaders Have A Clue?) Banks are sharper than Mr. Scrooge Like people, it is alright for an economy to go on debt, provided that the economy has a way to pay it in the future. Stated another way, it's alright for an economy to operate on deficit for this year and the next provided that these deficits are paid by the surplus of future years. Otherwise, like people, economies will go on default and banks will run after their assets. Then, a crisis will erupt and even banks may run out of funds to meet their own obligations. Think of Argentina and Thailand and now Iceland. They all suffered major CURRENT ACCOUNT DEFICITS and all went under the blade of the big banks. Truly, big banks can be sharper than Mr. Scrooge! Believe it or not, the citizens of these economies have only one way to go: "Produce positive CAB and then pay the debts of your respective economies!". Otherwise, they go back to the Middle Ages. Now, what has all this got to do with the US financial crisis? The thesis of this article is brief and clear: the major cause of the financial crisis is the USA's CAB. USA's Current Account Balance Consider these latest CAB figures of the USA based on the website of the Bureau of Economic Analysis of the US Department of Commerce (http://www.bea.gov/international/xls/table1.xls). From positive figures of earlier years, the USA's CAB turned negative starting 1977 and continues to do so till now in massive profusion! Except for 3 years, 1980, 1981 and 1991, when the US economy earned positive CAB totalling $10.244 billion, the US CAB has been negative every single year in the past 31 years with an accumulated figure of $6,706.288 billion. That's 6.706 trillion! Please note that I have limited myself to the discussion of foreign debts of the US economy arising from its negative CAB. The government's fiscal deficit (revenues minus expenditures) for the same period from 1977 to 2007 reveals the same message: the US government has been spending more than it is earning. For the same period of 1977 to 2007, the US government incurred savings only in 5 years (1979, 1998, 1999, 2000 and 2001) for a total of $537 billion. For the rest of the period, it has been on deficits every year totalling $4,408 billion. That's $4.408 trillion! (Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=84&Freq=Qtr&FirstYear=2006&LastYear=2008) Don't belittle the size of this debt. With our OFWs' remittance of $15 billion a year, in how many years would they pay off all the sum of these deficits of $11.114 trillion? Seven hundred forty years!
Pages to are hidden for
"Financial markets - The growing unpaid debts - Part I"Please download to view full document