Causes and consequences of persistent deficit
When deficits become dangerous.
Current account deficit = country buys more from rest of world than it sells (counting goods, services, and income).
Persistent deficit = continues over multiple years.
Causes:
| Cause | Mechanism |
|---|---|
| High domestic demand | Strong AD → high imports of consumer and capital goods |
| Low savings | Domestic saving < investment → must borrow from abroad |
| High unit labour costs | Domestic goods become uncompetitive — exports fall |
| Overvalued currency | Exports expensive abroad; imports cheap domestically |
| Commodity dependence | Country imports critical commodities (oil, food); deficit if commodity prices high |
| Structural — declining industries | Long-term decline of competitive sectors |
| Reserve currency status | (USA) world demands USD assets → US runs deficits as world buys US Treasuries |
Consequences:
Short term:
- Must be FINANCED by capital inflows (borrowing or asset sales).
- Build-up of foreign liabilities (debt + foreign-owned assets).
Long term:
- Foreign debt service drags on income.
- Currency vulnerability if foreigners stop buying assets.
- Sudden stop: capital inflows reverse → currency crisis (Mexico 1994, Asia 1997, Greece 2010).
- May force austerity to restore confidence → recession.
Why moderate deficits can be OK:
- Funding productive investment (capital deepening): debt is repayable from higher future output.
- Permits consumption smoothing during temporary income shocks.
- Reserve currency holders (USA) benefit from world's willingness to hold dollars.
Why persistent large deficits are concerning:
- Funding consumption rather than investment (no future income to repay).
- Asset sales accumulate to large external position.
- Currency mismatch (domestic income, foreign liabilities) creates risk.
Sustainability test: is the country financing INVESTMENT (productive use) or CONSUMPTION (wasteful)? Are creditors willing to keep lending?
Real-world examples:
- USA: persistent large deficit, financed by reserve-currency status. May not always last.
- UK: similar reserve currency role.
- Greece pre-2010: persistent deficit funded by cheap eurozone borrowing → unsustainable when confidence broke.
- Emerging markets: vulnerable to sudden stops when global rates rise (2013 taper tantrum).
- Causes: demand, savings, costs, currency, commodities.
- Consequences: foreign debt build-up.
- Sudden stop risk if confidence shifts.
- Sustainable if funding investment, not consumption.