Buoyant Economies

 USA

Bank credit, current account deficit, inflation, wages

and employment  

A diagrammatic explanation of the relationship between the growth of bank credit and the current account deficit is provided in the Impact of the Floating Exchange Rate System on Debt page at paragraph 32.  A mathematical and diagrammatical explanation is provided on the page on Formula for the Current Account Balance.  The sustainability of the monetary growth and the rising foreign debt is considered in Money and Unsustainable Debt.

Further research is still required to more accurately identify the sources of unendowed money in the USA and explain the divergence of the current account deficit from the growth of commercial bank credit in the 1990s.  It may have been due to the intervention of the Federal Reserve in the foreign exchange market.

The strong relationship between the growth of commercial bank credit and the current account deficit implies that the USA is responsible for its own external balance and its rising foreign debt.  This means that the US has the capacity to control the outcome of its current account to its own advantage.  It does not need to rely on other countries such as China or Japan to manage their economies for the benefit of the USA.       

Just as the US was able to reduce its current account deficit relative to its monetary growth between 1991 and 1999, it is possible to grow bank credit and the money supply in such as way as to eliminate the current account deficit.  Note that the Philippines has reversed the relationship between monetary growth and the current account balance and has also raised the rate of economic growth.

The rise in the US current account deficit has been attributed to the rise in its fiscal deficit.  Clearly, the data presented in the graph would indicate that the fiscal deficit has not been a significant factor over this time.  The growth of bank credit is clearly the key factor. The wider implications of this are considered in the Impact of the Floating Exchange Rate System.

As for Australia and New Zealand, the relationship between the growth of the unendowed money supply and the growth of GDP appears to explain inflation in the USA since about 1995, as shown in Figure 2 below.  Note that the data shown is not lagged.  The derivation of the formula used to plot this relationship is explained on the Money and Inflation webpage.

Figure 2:  USA- CPI and Modelled CPI

Figure 3 shows the CPI for the USA since 1913.  It clearly shows the sudden increase in the rate of inflation following the floating of the US dollar in 1973.  Note that most economists would deny that there is any causal relationship between inflation and the floating exchange rate system.

Figure 3:  USA- CPI since 1913 showing the pre and post float price trends

Another important issue is the effect of the floating exchange rate system upon wages. The following graph shows how average weekly wages for private non-farm workers.  Since 1973 when the exchange rate was floated, the wages of these US workers has been fallen dramatically.  Before then, they had been rising. The growth in US wages since 1992 has only been at half the rate it was in the 1960's to 1973.  Average weekly wages for private nonfarm workers in constant 1992 dollars are shown in Figure 4.  

Figure 4: USA- Average Weekly Wages for all private nonfarm workers in constant 1992 dollars

Source: US Bureau of Labour Statistics (1964 to April 2010)

Similarly, unemployment in the USA has been higher since the exchange rate was floated as shown in Figure 5.  (Click on this for the graph of unemployment since 1990.)

Figure 5: USA- Unemployment 1950 to June 2010

These problems are considered in the Impact of the Floating Exchange Rate System on Employment and growth.  They can be rectified using exchange rate systems such as the optimum exchange rate system.    

The situation in the USA between 2008 and early 2010 where the current account deficit is greater than the growth in bank credit suggests that foreign capital inflow could be contributing to the recession.  Consider the effect of capital inflow with the floating exchange rate system in the following model shown in Figure 6 where we assume no growth in bank credit.

The demand for imports (and supply of domestic currency on the foreign exchange market) is given by the M-M line and the supply of exports (and the demand for domestic currency on the foreign exchange rate market) by the X-X line.  Initially, the exchange rate is at e₁ with exports and import equal to 0-A₁.   National income is equal to 0–Z₁ made up of exports of 0-A₁ and income from domestic sales of A₁-Z₁.  

Now assume that the demand for domestic currency on the foreign exchange market rises from the X-X line to the X+K – X+K line.  To achieve external balance the exchange rate rises to e₂ with imports of 0-A_2, exports falling back to 0-A₃ and foreign capital inflow equal to A₃-A₂.   Income is made up of exports plus domestic sales.  As export income has fallen from 0-A₁ to 0-A₃, and domestic sales have fallen from A₁-Z₁ to A₂-Z₁, (replaced by increased imports) national income would fall from 0–Z₁ to 0–Z₂.     

Figure 6: Impact of Capital Inflow on National Income

So when the current account deficit is greater than the growth of bank credit (as currently the case in the USA) it indicates that foreign capital inflow is inflating the exchange rate, making imports cheaper and reducing export income, thereby causing a reduction in income (a recession).

It may be explained by the government deficit being financed from bank credit, but there is no available data to confirm that at this stage. Nor is it consistent with past relationships between the fiscal deficit and current account deficits.

To read more about these and similar issues, see the issues page and papers on the subject.

The data for USA charts showing the linkages to raw data is available here.

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  Last update: 3 August 2010