Germany’s traditional current account surpluses, which had culminated at 4.8% of GDP in 1989, dis-appeared after unification. In the first full calen-dar year after the two Germanies had merged the current account dropped from a regular surplus into a deficit the size of about 1% of GDP (see Figure 1(a)).
The circular flow model and the identity of leaks and injections, S - I + T - G + IM - EX = 0, provides a first clue as to what had happened.
First note, however, that while we are treating the current account CA and net exports NX as syn-onyms in Chapter 1, and throughout most of the text, this is only an approximation. The main dif-ference between the two aggregates in reality is that the current account also includes transfers across borders that are not related to the export and import of goods and services. Examples are aid to developing countries, a Turkish family living in Germany sending money to their parents in Ankara, or the contributions of the German gov-ernment to international organizations such as NATO, the United Nations, or the European Union.
Since such things also constitute leakages out of the circular flow of income, the current account is actually a more precise measure of a country’s net leakages to the rest of the world than net exports.
It is often argued that the dramatic shift in Germany’s current account was the result of rising government budget deficits triggered by public investment in East Germany’s infrastructure and transfer payments to the East. This interpretation is often motivated by comparing West Germany’s last full budget in the year before unification, 1989, with the years that followed. This implies that unification drove a more or less balanced government budget into deficit by some 3% of GDP. Panel (b) in Figure 1 shows that this is a mis-leading story. The year 1989 is clearly atypical, given that the budget had been in deficit for years before and exceeded 2% of GDP in 1988 already.
Ignoring 1989 as exceptional, unification increased the budget deficit only by about one percentage point from 2% to 3% of GDP.
In terms of the circular-flow identity: while the increase of the budget deficit G T may have caused the current account to deteriorate, its magnitude of one percentage point only partly explains the change in the current account by
some 5 percentage points. What seems to have Figure 1
‰ (b) Government budget surplus (T – G)
–3 (c) Private net savings (S – I) Year
3
mattered much more is the change in private net savings S I documented in panel (c) of Figure 1.
1.2 Essentials of macroeconomic accounting 13
an economic understanding of what determines the decisions of investors, consumers, exporters and importers, other equally valid (or invalid) interpre-tations would be the following:
■ Raising taxes reduces savings by an equal amount (since equation (1.1) could be rearranged to yield S = I - T + G - IM + EX) but leaves invest-ment unaffected.
■ Raising taxes reduces imports (from IM = I - S - T + G + EX).
■ Raising taxes raises exports (from EX = S - I + T - G + IM).
What sets these assertions apart is which variables are held fixed and which ones we allow to change after we changed T. Each version was arbitrary.
Without an understanding of how investment, savings, import and export decisions are being made, there is no way of telling what will actually happen after a tax increase. It is possible that several of the other leaks and injections may change after T rises. To complicate things further, even the width of the circular flow stream, which measures the income level, may be affected by the tax increase.
So if it is to be used in the context of economic analysis, the circular flow equation needs to be combined with thorough economic reasoning. This will be enlarged upon in subsequent chapters. As it is, the circular flow identity Case study 1.1 continued
While private savings exceeded investment by some 6% of GDP before unification, this differ-ence dropped to about 2% after unification. This accounts for the remaining change in the current account that was not explained by the change in the government budget deficit.
Of course, the change in private net savings also reflects government policies towards the eastern part of Germany. Net savings did not fall because savings fell, but because investment increased due to investment bonus packages put into action by the Kohl government. Figure 2 shows that savings were still about the same in 1995 as they had been ten years earlier, while investment had risen by about 4 percentage points.
Using stylized, rounded numbers for the time before and after unification Table 1 summarizes the observed changes: the current account deficit (- CA IM - EX) rose from -4% to +1%. One percentage point of this reflects the change in government spending behaviour, that is, the increase of the budget deficit from 2% to 3% of GDP. The remaining 4 percentage points (that is, the remaining 80%) of the change in the current account reflect the change in net private savings, which dropped from 6% to 2% of GDP.
Table 1 Injections and leakages before and after German unification. Rounded averages for indicated subperiods as % of GDP
S - I + T G + IM - EX = 0
1986–90 6% + 2% + -4% = 0
1991–95 2% + 3% + 1% = 0
Figure 2 0
86 87 88 89 90 91 92 93 94 95 Key Year
10 20
% of GDP
Investment Savings
Table 1.2 The circular flow identity in numbers (2002, as % of GDP). The data decompose the circular flow identity for a set of industrial countries. To permit comparability, aggre-gates are given in percentages of GDP. The data report similarities and differences between countries. Consider Germany and the US. Both countries run virtually the same goverment budget deficit. In Germany this is easily financed by private domestic savings (first column). What sets the two cases apart is that the German government runs into debt against its own citizens, but the US runs into debt against the rest of the world.
S - I in % T - G in % EX - IM (or NX = CA) in %
Belgium 4.54 0.10 4.64
Denmark 0.95 1.70 2.65
France 4.05 -3.20 0.85
Germany 5.45 -3.50 1.95
Greece -4.59 -1.40 -5.99
Ireland -0.06 -0.20 -0.26
Italy 1.85 -2.30 -0.45
Netherlands 3.95 -1.90 2.05
Poland 1.10 -3.60 -2.50
Portugal -1.87 -2.70 -4.57
Spain -1.20 0.00 -1.20
United Kingdom 0.07 -1.60 -1.53
United States -1.13 -3.40 -4.53
China 5.88 -3.03 2.85
Japan 9.84 -7.10 2.74
Source: Eurostat, IMF, International Financial Statistics.
only provides a glimpse at some key structural properties of a country’s economy.
Actual numbers for the components of the leakages and injections com-bined in equation (1.1) and other related variables are assembled in the national income accountsof a country. Table 1.2 presents the sums involved, expressed as percentages of GDP. While country experiences differ, there are some common threads in the data:
■ Most countries still run sizeable budget deficits. Governments spend more than they receive.
■ In the majority of countries private savings exceed private investment. This is one way of financing the government budget deficit (or syphoning off the net injections coming from the government sector). Instead of savings being passed on to firms for investment spending, they go to the govern-ment for financing the deficit.
■ About half of the countries shown here export less than they import. In those countries the net injection from the private and government sectors (the excess of I + G over S + T) is neutralized by a net leakage of spending to other countries. Other countries may appear to refrain from buying our export goods with all the money they receive for our imports from them, but instead lend part of that money to our government and/or firms to finance the national deficit.
Discussion of the twin deficits that were haunting the US economy in the 1980s and 1990s and returned with a vengeance in recent years offers ample real-world examples of uninformed use of the circular flow identity, which
National income accounts report data for GDP and its components.
1.2 Essentials of macroeconomic accounting 15
Figure 1.8 Looking at the inner circle first, we assume that firms use 24,000 hours of labour to produce 6 cars. If e30,000 circulates 12 times a year, annual income and annual spending must be e360,000. Hence the wage rate must be e15 per hour and the price of a car is e60,000. Thus, given all the other factors, the supply of money determines goods’ prices and nominal wages.
Firms Households
Labour: 24,000 work-hours Income: =C 360,000
Goods: 6 cars
Spending: =C 360,000
Price of =C 60,000 connects lower branches Wage rate of =C 15 connects upper branches
the above stylized example attempted to discredit. To some, the US budget deficit causes the current account deficit, and therefore it has to be removed (based on EX - IM = S - I + T - G). To others, Chinese, Japanese and EU import restrictions cause the current account deficit, which in turn forces the US government budget into deficit (based on T - G = - S + I + EX - IM). A third view is that neither is true. Rather, insufficient private savings in the United States drive the current account into deficit (based on (EX - IM) = (S - I) + (T - G)). Again, while there may be a grain of truth in all three explanations, no judgement is possible before we understand how the people who make up the economy make choices.