Policies to correct imbalances in the current account of the balance of payments

A government can use four broad types of policy to reduce a current-account deficit; they fall into expenditure-reducing and expenditure-switching categories, plus supply-side measures.

Expenditure-reducing (demand-side) policies. Contractionary fiscal policy (higher taxes or lower government spending) or monetary policy (higher interest rates) reduces aggregate demand. With lower domestic spending, households buy fewer imports, so the deficit narrows. The drawback is that reducing AD also lowers output, growth and employment, and it treats the symptom (high spending) rather than the cause.

Expenditure-switching policies. These switch spending away from imports toward domestic goods. A currency depreciation (e.g. engineered via lower interest rates) makes exports cheaper and imports dearer, so exports rise and imports fall — though this only improves the balance if demand is price-elastic, and it causes cost-push inflation. Protectionism (tariffs, quotas) makes imports dearer or scarcer, reducing them — but risks retaliation, higher prices and protecting inefficiency.

Supply-side policies. Measures such as training, infrastructure and support for technology raise productivity and competitiveness, increasing exports and reducing imports. This addresses the root cause of a competitiveness-driven deficit and is the most sustainable cure, improving the current account without the inflation, growth or retaliation costs of the other policies — though it is slow and costly.

The most appropriate policy depends on the cause of the deficit: a deficit from excess demand suits expenditure-reducing policy, while one from lost competitiveness needs supply-side measures (or, faster but riskier, a depreciation).

The source identifies the cause of Country S's deficit as high costs and low productivity — i.e. a loss of competitiveness, not excess demand. The best policy must therefore address competitiveness.

Supply-side policy is the most appropriate. Measures such as investment in training and education (raising workers' skills and productivity), infrastructure (lowering firms' costs) and support for technology would raise the productivity and lower the unit costs of Country S's export industries. As domestic goods become more competitive, exports would rise and imports would fall (domestic firms win back the home market), sustainably reducing the deficit — and without causing inflation or provoking retaliation.

By contrast, demand-side policy (cutting AD) would reduce imports but harm growth and would not fix the underlying competitiveness problem, and a depreciation or tariffs would only mask the problem (and risk inflation or retaliation).

The main limitation is that supply-side policy is slow — it could take years to raise productivity — so Country S might need short-term support alongside it, but for a deficit rooted in competitiveness, supply-side policy is the most effective long-run solution.

A persistent current-account deficit usually signals a deeper problem than a temporary one, so the choice of policy must address its cause. There are three broad approaches.

Expenditure-reducing (demand-side) policy. Contractionary fiscal or monetary policy cuts AD and so cuts imports, narrowing the deficit relatively quickly. However, it lowers growth and employment, conflicting with other objectives, and only treats the symptom (high spending), so the deficit returns once demand recovers. It is therefore poorly suited to a persistent deficit.

Expenditure-switching policy. A depreciation makes exports cheaper and imports dearer, switching spending to domestic goods; protection (tariffs/quotas) reduces imports directly. These can act faster, but a depreciation causes cost-push inflation and only works if demand is price-elastic (Marshall-Lerner), while protection risks retaliation (cutting exports) and protects inefficiency. They can also mask, rather than fix, an underlying competitiveness problem.

Supply-side policy. Raising productivity and competitiveness (training, infrastructure, technology) increases exports and reduces imports by making domestic goods genuinely more competitive. This addresses the root cause of a persistent, competitiveness-driven deficit and does so sustainably, without the inflation, growth or retaliation costs of the others. Its drawback is that it is slow and costly.

Judgement. For a persistent deficit — which usually reflects a loss of competitiveness rather than a temporary demand surge — supply-side policy is the most effective long-run solution, because only it cures the underlying cause without serious side effects. The faster expenditure-reducing and switching policies may be needed to manage the deficit in the short run, but they do not provide a lasting fix and carry significant costs. The most defensible conclusion is that a government should rely primarily on supply-side policy to correct a persistent deficit, supplemented by short-term measures if needed, with the precise mix depending on the deficit's cause and the time horizon.

Whether reducing a current-account deficit should always be a priority depends on the deficit's nature and on the costs of correcting it.

The case for prioritising it. A large, persistent deficit must be financed by borrowing or inflows, leading to rising external debt and future outflows; it may reflect lost competitiveness; and it can undermine confidence, risking a sharp currency fall and a forced adjustment. Reducing it can restore sustainability and external stability, which supports long-term growth.

The case against making it a priority. Correcting a deficit has costs and conflicts. Expenditure-reducing policies lower growth and employment; a depreciation causes inflation; protection risks retaliation. So pursuing the deficit can damage other objectives — especially in a recession, when boosting growth and jobs may matter more. Moreover, a deficit may be benign: if it funds productive investment (imported capital goods) or is financed by stable foreign direct investment, it is sustainable and need not be reduced at all. A deficit caused by strong growth pulling in imports can even be a sign of health.

Judgement. Reducing a current-account deficit should not always be a priority. It deserves priority when the deficit is large, persistent, debt-financed and reflects lost competitiveness, because then it is genuinely unsustainable. But when the deficit is moderate, investment-driven and financed by stable inflows, the costs of correcting it (lower growth, inflation, retaliation) may outweigh the benefits, and other objectives should take precedence. The most defensible conclusion is that the priority given to the deficit should depend on its size, persistence, cause and financing, and on the state of the economy — not treated as an automatic, overriding goal.