Until relatively recently, few aspects of economic news were as eagerly awaited as the balance of payments statistics. The details of a country's financial and economic interaction with the rest of the world were regarded as among the most important in assessing its health, alongside its gross domestic product. Although we are no longer as obsessed by balance of payments statistics as we once were, they remain the ultimate guide to a country's international economic relations.

Given that the balance of payments accounts for all the trade that flows into and out of a country, including money injected into it from overseas nations or, for instance, sent out to families and business counterparts living in foreign countries, its importance can hardly be overstated. The balance of payments shows whether a country is borrowing and over-extending itself over a period of time or lending out cash to others in exchange for goods. Ultimately, it will reveal whether a country has a prosperous future ahead of it or, conversely, whether it will have to seek help from, say, the International Monetary Fund in order to stay afloat.

Current and capital accounts The balance of payments is made up of two main parts: the current and the capital accounts.

The Current Account
The current account measures the flow of goods and services into and out of a country. These are often called visible trade (physical goods) and invisible trade (cash paid for services such as legal advice, advertising, architecture and so on). If a country imports significantly more goods and services than it exports, it will have a large current account deficit. Since the 1980s the US and the UK have operated large current account deficits almost every year, as they have invariably imported more than they have exported to the rest of the world. Countries with large current account surpluses, on the other hand, have been major exporters: Germany and Japan, historically, and, more recently, China, which has earned the label as the world's workshop because of the massive quantity of goods it sends out around the world. Also included in the account are any unilateral transfers in money overseas, for instance foreign aid and gifts, as well as cash sent by workers to families overseas.

The Capital Account
Although a country can have a deficit in its current account, this has necessarily to be balanced out elsewhere (hence balance of payments). If Japan sells a million dollars' worth of cars to the Americans, it will then be left with those dollars and will need to spend them, either on American investments or by putting them in US bank accounts. So, for instance, China, which throughout the 1990s and 2000s has had a massive surplus on its trade with the US and other Western countries, has used this dollar mountain to buy trillions of dollars' worth of US investments -- everything from government debt to shares in major companies.

Harmless Deficits

A current account deficit, which typically comes hand in hand with a trade deficit, indicates that a country is borrowing from other nations in order to fund itself, its appetite for consumption having outweighed its ability to produce goods to satisfy its demands. This might appear somewhat worrying, but it need not be - in small measures at least. Some degree of current account deficit can be an entirely healthy phenomenon in a country.

Throughout the 1980s, and again in the early 2000s, much publicity surrounded the American current account deficit, which swung to a record high of 6 per cent of gross domestic product -- over three-quarters of a trillion dollars. The UK was burdened with a similar-sized percentage deficit.

Some warned that the countries might experience a full-blown balance of payments crisis. This happens when one part of the balance of payments -generally the current account -- cannot be funded by the other. This has happened a number of times, for instance in the Asian financial crisis in the late 1990s and in Russia at the same time. These countries had large current account deficits and, as investors around the world realized that they were heading for a major slide, they started refusing to buy anything denominated in roubles, baht and so on. It meant that the capital account could no longer balance out the current account deficit. Such circumstances inevitably entail a serious and inescapable economic crisis.

However, most deficits can be safely sustained for many years. What usually ensues when a country runs a large current account deficit is not a crisis but a decline in its currency's value against others. As the exchange rate drops the nation's exports become cheaper and therefore more attractive to foreigners; this, in turn, boosts that country's sales abroad, which should bring down the current account deficit. So, in an international system of floating exchange rates, current account deficits are inevitable, but they are also supposed to be self-correcting.

Keeping an Eye on Deficits

This is not always the case. As mentioned in the previous chapter, at various points in history there have been fixed exchange-rate systems, most famously, the Gold Standard in the 19th and earlier 20th centuries, followed by the Bretton Woods system of fixed exchange rates from 1945 to the 1970s. During these periods, countries running current account deficits had to slow down their economies in order to bring them back into balance. Politicians and economists would scrutinize the balance of payments statistics to detect whether they augured well or ill for the economy.

Even if the world does not move back to a system of fixed exchange rates, it remains important to monitor whether countries have deficits or surpluses in their current accounts, and to identify the structure of their balance of payments -- such statistics provide a yardstick for a nation's future prosperity.