Arthur Donner and Doug Peter argued in Monday’s Globe and Mail that Canada’s current account deficit “is far more serious than the fiscal problems facing the federal government,” asserting that the CA deficit “represents a leakage of output, jobs and incomes to other countries.”
This is a popular view that is repeated frequently by public opinion leaders in Canada and elsewhere. It is also incorrect, as a brief perusal of any textbook discussion of international trade will confirm. These arguments are based on mercantilism, a theory that was debunked two centuries ago by David Ricardo.
Until interplanetary trade becomes a reality, the sum of all countries’ current account balances must be zero: Deficits in one country are offset by surpluses in another. The notion that a CA deficit is a “leakage of output” is derived from the broader misconception that international trade is a zero-sum game in which imports are losses to be avoided and exports are gains to be pursued.
This is exactly wrong. The reason why we engage in international trade is to obtain things more cheaply than we can produce them for ourselves. The real benefits from trade are imports; exports are the price we pay for those imports. Moreover, the gains are not zero-sum – both sides benefit.
In a world where capital is not free to cross borders, the current account will always be zero: Goods must be paid for with other goods. So the best way to look at Canada’s CA is not in terms of flows of goods, but in terms of flows of capital.
The current account represents the net change in Canada’s international investment position. A negative CA means that Canadian asset holdings abroad fell, foreign holdings in Canada increased, or some combination of the two. The CA can also be viewed as the net international transfer of savings, and is negative when foreigners shift more of their savings to Canada than Canadians send abroad.
A national accounting identity states that total investment expenditure must be financed by the sum of domestic and foreign savings. Noting that Canada has a current account deficit is the same thing as noting that investment expenditures are larger than domestic savings – the difference is made up by foreign investors.
Capital inflows are not always benign. Foreign savings helped fuel a U.S. housing bubble and contributed to the financial crisis there. Sudden and large inflows of “hot money” have often been destabilizing in countries whose financial markets are not sufficiently well-developed to absorb them. But if foreign savings serve to finance the creation of new productive capacity, then their effect is positive: Output, productivity and wages in Canada will increase.
The available evidence favours the good-news scenario. Investment grew more rapidly than GDP during the 2002-08 expansion, and expenditures on machinery and equipment have recovered their prerecession peak. The Bank of Canada’s recent Business Outlook Survey suggests that firms intend to invest more in the future.
So what would happen if the Bank of Canada decided to abandon its inflation target and work to depreciate the Canadian dollar? Canadian goods would become cheaper on world markets – and so would Canadian assets. The increase in foreign demand for Canadian goods would be accompanied by an increase in the foreign demand for Canadian assets.
The main obstacle to larger and potentially destabilizing inflows of foreign capital is the exchange rate; a high value of the Canadian dollar acts as a deterrent to foreign investors. A policy-engineered depreciation would accelerate capital inflows and could end up fuelling an asset price bubble.
Rebalancing the CA requires a combination of reducing investment, cutting back on consumer spending or increased government austerity. This may happen eventually, or maybe not – we’ve run a CA deficit for most of our history. But forcing a premature rebalancing will likely do more harm than good.
Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l’emploi (CIRPÉE).