Is New Zealand bankrupt?

New Zealand is anindebted nation that persistently runs current account deficits.   This raisesthe questions, what is a current account deficit and should we be concernedabout it?

The best way to think of the currentaccount deficit is to relate it to your own spending as a household.   When thecountry is running a current account deficit it is borrowing to fund currentspending – just like if you were spending more than you earned then you wouldhave to borrow.  

Just like an individual, a nation may spendmore than it earns because (as a whole) it wants to consume more now, orbecause it wants to invest for the future.   It appears that the recent increasein our current account deficit is the result of both rising consumption andrising investment.

On the investment side, the idea ofborrowing now to fund capital expenditure is a fairly mundane concept.   Thebenefit of an investment project will materialise over time, while adisproportionate portion of the cost is incurred straight away.   As long as thebenefit of the investment exceeds the cost over the investments lifetime, andthe risks are known, then there is no reason to be concerned about this form ofborrowing.

An example of how this works for a householdis as follows.   If you wish to buy an expensive asset (eg a car or, house) youcan either save up the funds or you can borrow and pay back the funds overtime.   The risk from borrowing is that you have made a commitment to repay theloan, which might become difficult if, say, you lose your job.   On the otherhand, if you pay for everything out of savings you miss out on all theopportunities – say from having a car today instead of waiting several years.  

Over the past five years, the New Zealand dollar has been especially strong, and the world price of capital equipment hasbeen surprisingly low.   In this type of situation it makes sense that New Zealand businesses have invested in assets by borrowing – thereby taking advantage ofthis opportunity while it was available.  

Unless we believe that businesses areincapable of making sensible decision regarding their own investment, thenthere really is no problem with having a current account deficit that fundsprivate investment activity.

On the consumption side, a nation may spendmore than it earns because it either anticipates that it will grow in thefuture or it may substantially favour spending now ahead of spending in thefuture.   As the goal of policy should be to maximise society’s lifetimehappiness, if individuals want to consume more now (to the detriment of futureconsumption opportunities) they should be allowed to.

For a household, this type of borrowing isequivalent to "smoothing" the amount you consume over time.   When you areyoung, you expect your lifetime earnings to increase in the future – as aresult it is in your interest to borrow now.   As a nation, we expect ourlifetime earnings to increase in the future – and as a result, if we areoffered credit at attractive rates we will be willing to borrow now.

There is an issue of fairness associatedwith borrowing to consume; economists term this "intergenerational equity".   Ifyou and I borrow now to consume and don’t pay it back in our lifetime, thiswill create a debt that future generations are burdened with.  

But if we expect the economy to continuegrowing over time and if we value the lifetime happiness of our children asmuch as ourselves, it may still make sense for households to redistributeincome over time in this way – because growth will increase future incomes.   Aslong as we believe that households can borrow sustainably, then there is noproblem with a current account deficit stemming from individuals choice ofconsumption.

The decision to borrow in order to fundconsumption and investment has built up a stock of debt in New Zealand that is equivalent to 86% of the countries income (gross domestic product).   Asa result, a major determinant of our current account deficit each year is theinterest payments that head overseas.       However, this stock of debt is theresult of consumption and investment choices in the past.   In a householdsense, this is equivalent to paying off the interest on your mortgage or a hirepurchase.

The current account deficit is merely theresult of the borrowing, consumption, and investment decisions of everyhousehold and firm in the economy.   As long as these households and firms arefully informed of the risk and return associated with their borrowingdecisions, is there really any reason to fear the spectre of a current accountdeficit?   To answer my own rhetorical question – it appears not.

 

 

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