Balance-of-Payments Deficits:Measurement and Interpretation

by JOHN PIPPENGER

John Pippenger is Associate Professor of Economics with the University of California atSanta. Barbara. lie received a PhD degree in economics from the University of California at LosAngeles. His major field of interest is international finance, a topic on which he has pub-lished several articles. The author is a visiting scholar at the Federal Reserve Bank of St.Louis while on leave from the University of California for the 1973-74 academic year.

TT%j NTIL a few years ago only a few economistsand public officials were concerned about our balanceof payments. Today balance-of-payments figures arefrequently reported and widely discussed. Unfortu-nately, for most people balance-of-payments tenninol-ogy is a jungle and balance-of-payments statistics arca mystery.

The first part of this article provides an explanationof terms commonly used in discussions of the balanceof payments (BOP). The second part examines threecommon methods of measuring balance-of-paymentsdeficits and attempts to provide a foundation for auseful interpretation of these and other ways of meas-uring a deficit.

TERMS AND CONCEPTSBalance-of-payments terminology, which has evolved

over many years, can be misleading, It is thereforeuseful to examine the terminology in order to under-stand more fully what we read and hear about ourbalance of payments.

In principle, the balance of payments is a record ofthe value of all transactions between domestic andforeign residents over a given period of time, usuallyone year. The balance of payments is based on theprinciple of double entry bookkeeping and the dollarvalue of every transaction is recorded as both a credit

and a debit. In practice, however, many transactionsbetween domestic and foreign residents are only partlyrecorded, are estimated on the basis of surveys, orare missed entirely. We will discuss later some of theproblems caused by incomplete recording of transac-tions. Here we examine the basic principles of BOPaccounting.

Credits and DebitsPartial balance-of-payments statistics probably were

first collected during mercantilist days. Under crudemercantilist doctrine the immediate goal of interna-tional trade was the accumulation of treasure, that isgold and silver. Since exports normally were paid forwith gold or silver (or currencies convertible into goldor silver), exports were viewed as desirable and theexport of anything was entered in the balance of pay-ments as a plus or credit item. Imports normallyrequired payment in gold or silver. They were viewedas something bad and were entered in the balance ofpayments as a negative or debit item. Following thisapproach, when we export more goods than we im-port we call that a favorable balance of trade. Today,as in 1750, the purchase or import of anything froma foreign resident is recorded as a debit or minus en-try in the balance of payments while the sale or exportof anything to a foreign resident is recorded as a plusor credit item.

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FEDERAL RESERVE SANK OF ST. LOUIS

Since exports are recorded as credits and balance-of-payments statistics follow the principle of doubleentry bookkeeping, the payment we receive for ourexports must be recorded as a debit. Since importsare debits, it follows that the payment we make onimports must be recorded as a credit. That is, whatwe give up in every transaction is recorded as a creditand what we get is recorded as a debit.

For example, brush aside the “veil of money” andthink of the United States as importing Japaneseradios and paying for those radios by exporting wheat.The value of the radios we receive from Japan isentered on the debit side of the U.S. balance of pay-ments and the value of the wheat we give up in orderto obtain the radios is entered on the credit side ofthe balance of payments.

If debits and credits are shown independently inthe form of a T-account as in Table I, then debitsare usually shown on the right-hand side and creditson the left-hand side. This, of course, is the reverseof standard accounting procedure. In addition, al-though crediting sales and debiting purchases is con-sistent with standard accounting procedures, thisapproach conflicts with basic economic theory. Fromthe point of view of economics, what we get (import)is the good or plus side of a transaction, while whatwe give up (export) is the bad or minus side.

Subdivisions

Debits and credits in the balance of payments arecollected into groups on the basis of what is exportedor imported. The precise partitioning of these groups’varies between countries and over time. As an intro-duction, we divide the balance of payments into fourtraditional subdivisions: (1) current account, (2) uni-lateral account, (3) capital account, and (4) goldaccount.1

The current account shows the value of all thegoods and services we import or export as well asthe payment and receipt of dividends and interest.

A unilateral account is necessary because a gift is aone-sided transaction. If we export something as agift, there is no payment. In order to meet the re-quirement of double entry bookkeeping, we create aunilateral account and enter in that account whatwould have been the payment for the gift. In addi-tion to a purely accounting function, a unilateral or

tmThe Department of Commerce includes the unilateral accountas part of the current account under remittances, pensions,and other transfers as well as U.S. government grants.See Table II.

NOVEMBER 1973

gift account also helps separate gifts from other trans-actions. It should be understood, however, that aunilateral account does not record what we give orreceive as a gift, but what would have been the pay-ment. Thus, a debit entry in a unilateral account indi-cates that we gave a gift, not that we received one.

The capital account records the import and exportof assets such as bonds and common stocks. More pre-cisely, if the import or export of anything representsa change in claims, then its value is entered in thecapital account.

All official purchases or sales of gold are recordedin the gold account. The import and export of goldfor commercial purposes, however, are entered in thecurrent account.

Capital FlowsShort Term and Long Term — The capital account

traditionally is divided into two parts, short termand long term. Claims such as demand deposits, bonds,and certificates of deposit whose maturity at time ofissue is one year or less are considered short term,and any change in those claims is entered in theshort-term category. Claims in the form of direct in-vestments, corporate stocks, and bonds of over one-year maturity at time of issue, are considered longterm. Any changes in these claims are entered in thelong-term category.

inflows and Outflows — In discussing accounts otherthan the capital account, the tradition is to concen-trate on what is bought or sold. In discussing thecapital account, however, the tradition is to concen-trate not on the bond or other asset bought or sold,but on the payment.

The import of a bond or any other similar asset isa debit item in the capital account. Since its pur-chase results in U.S. residents paying out money orcapital, the import of a bond, like any other debitentry in the capital account, is called a capital out-flow. On the other hand, the export of a bond meansU.S. residents receive money or capital; thus, the ex-port of a bond, like any other credit entry in thecapital account, is called a capital inflow.

If an entry appears as part of the short-term capi-tal account, then the transaction is referred to as ashort-term capital flow. Similarly, if an entry appearsas part of the long-term capital account, it is calleda long-term capital flow. For example, the export ofa three-month U.S. Treasury bill is called a short-termcapital inflow and the import of common stock isreferred to as a long-tenn capital outflow.

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1973

This rule is difficult enough to follow when it isread, and even more difficult to remember. Fortu-nately, the rule follows directly from the basic prin-ciple that all imports are debits and all exports arecredits. Consider the import of a bond. It must be adebit. If it is a foreign bond, the import of the bondrepresents an increase in U.S. claims on foreigners. Ifit is a domestic bond, the import of the bond repre-sents a reduction in foreign claims on the UnitedStates. Therefore, an increase in U.S. claims on for-eigners, or a decrease in foreign claims on the UnitedStates must be debit entries since they are the resultof the import of a bond.

Consider the export of a bond. It must be a credit.If it is a foreign bond, the export of the bond repre-sents a decrease in U.S. claims on foreigners. If it isa domestic bond, the export of the bond representsan increase in foreign claims on the United States.An increase in foreign claims on the United States,or a decrease in U.S. claims on foreigners, therefore1must be credit entries since they are the result ofexporting bonds.

Illustrations

Some illustrations can help us understand howtransactions are recorded in the balance of payments.Each transaction considered here appears in Table Ibeside the number of the example. In example (1) aten-year loan of $1 million is made to Russia; that is,some U.S. resident, or the U.S. Government, buys aten-year Russian bond for $1 million. Normally thiswould be paid for with a check which, again forsimplicity, we assume is deposited by the RussianGovernment in a New York bank. The import of thebond represents an increase in U.S. long-term claimson foreigners and appears as a $1 million debit in thelong-term capital account. This side of the transactionis called a long-term capital outflow.

The other side of the transaction, the payment forthe bond, takes the form of an increase in foreignshort-term claims on the United States (the increasein foreign short-term claims on the United States isalso referred to as •an increase in U.S. short-termliabilities to foreigners). The payment side of this

I

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transaction appears as a $1 million credit entry inthe short-term capital account and is called a short-term capital inflow.

In example (2) consider a $1 million sale of wheatto Russia by a U.S. corporation, where the RussianGovernment uses the money it borrowed in example(1). The export of wheat appears as a one milliondollar entry on the credit side of the current account.The payment for the wheat reduces Russian demanddeposits in U.S. banks (that is foreign short-termclaims on the United States decline), and the pay-ment side of the transaction appears as a debit entryof $1 million in the short-term capital account. Thepayment side of the transaction is called a short-term capital outflow.

It might be instructive before going on with otherexamples to consider the net effect on the balance ofpayments of examples (1) and (2). Since the $1 mil-lion short-term capital inflow in example (1) is justoffset by a $1 million short-term capital outflow inexample (2), the net result of examples (1) and (2)is that the United States has a current account creditand long-term capital debit of $1 million, That is,these two transactions taken together generate a $1million credit on current account that is financed oroffset by a $1 million long-term capital outflow.

In example (3) a U.S. resident receives $2,000 individends from common stock he owns in a Frenchcorporation. For simplicity we assume he deposits thefunds in a French bank. The dividends are recordedas a credit item in the current account. This makessense since dividends essentially represent paymentfor the services of capital. The payment he receivesfor these services takes the form of an increase inshort-term claims on foreigners and it is recorded asa debit item in the short-term capital account.

The following rule determines whetherflow is a credit or debit. If an entry in thepayments is due to an increase in foreignthe United States or a decrease in U.S.foreigners, then it is a credit. If an entryan increase in U.S. claims on foreigners orin foreign claims on the United States, it

a capitalbalance ofclaims onclaims onis due to

a decreaseis a debit.

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FEDERAL RESERVE BANK OF ST. LOUIS

In example (4) the U.S. resident uses the $2,000to finance a holiday in the south of Spain. His touristexpenditures represent purchases of goods and serv-ices from nonresidents and they are entered as adebit item in the current account. The reduction inhis demand deposit at a French bank is a short-termcapital inflow and it is recorded as a credit itemunder short-term capital.

It is useful to consider the combined effects ofexamples (3) and (4). The short-term capital flowscancel each other and there is no net effect on theshort-term capital account. There is a debit entryunder tourist expenditures and a credit entry underinterest payments, but there is no net effect on thecurrent account.

In example (5) the U.S. Government sends $10,000worth of grain to a drought-stricken foreign countryas a gift. The export of grain appears as a $10,000entry on the credit side of the current account, butin this case there is no payment. In order to maintainthe system of double entry bookkeeping, an entry of$10,000 is recorded on the debit side of the unilateralaccount. The wheat, of course, is the gift, but sincethere is no payment for a gift, the unilateral accountis needed to maintain the rule that every transactionmust appear on both the debit and credit sides ofthe balance of payments.

In published BOP statistics, credits and debits foreach category usually are not shown separately. Thenormal practice is to subtract debits from credits andshow only the net balance for each category. The farright column of Table I shows the net balance forthe five examples.

Reported Data

The discussion up to this point has been concernedwith the balance of payments in principle ratherthan in practice. BOP statistics reported by the De-partment of Commerce differ in several importantways from the form discussed above.2

As mentioned above, all transactions are not re-ported and in some cases only one side of a trans-action is reported. If neither side of a transactionis reported, the published BOP figures are simplyincomplete. If only one side of a transaction is re-ported, then the total of reported debits does notequal the total of reported credits and the principleof double entry bookkeeping is violated.

2For a more detailed explanation of the statistics reported bythe Department of Commerce, see David T. Devlin, “TheU.S. Balance of Payments Revised Presentation,” Seruryof Current Buthmess (June 1971), pp. 24-57, 64.

NOVEMBER 1973

In order to maintain the principle of double entrybookkeeping, another account is created called “errorsand omissions.” If, after all the numbers have beencollected, the sum of debit items does not equal thesum of credit items (as is always the case), then thedifference between debits and credits is entered onthe appropriate side of the account for errors andomissions, making total debits and credits includingerrors and omissions equal..

A second difference between the balance of pay-ments discussed earlier and the data reported by theDepartment of Commerce is that the reported figuresdistinguish between liquid and nonliqnid as well asbetween short-term and long-term capital flaws. Ex-cept for certain long-term U.S. Treasury bonds heldby foreign official reserve agencies, long-term claimsare considered nonliquid. In addition, short-termclaims on foreigners of U.S. banks and nonbankingconcerns that are not readily marketable or transfera-ble, such as trade credits and cash items in process ofcollection, are considered nonliqnid. Other short-termclaims on foreigners, such as demand deposits, timedeposits, and negotiable securities, are consideredliquid. All short-term liabilities to foreign residentsof U.S. nonbanking concerns are considered nonliquidand, in practice, all short-term liabffities to foreignresidents reported by U.S. banks are considered liquid.

In addition to the liquid versus nonliquid distinc-tion, published BOP statistics also identify capitalflows according to whether the holder of the claim isa private organization or individual, an official agency,or an official reserve agency. Treasuries, finance min-istries of national governments, and recognized centralbanks are viewed as official reserve agencies. Officialagencies include official reserve agencies plus diplo-matic and consular establishments as well as otheragencies of national governments.

INTERPRETATIONAs emphasized above, BOP accounting is based on

the principle of double entry bookkeeping. Total deb-its must equal total credits, and it is impossible forthe entire balance of payments to show either a deficitor a surplus. The only way we can observe a differ-ence between credits and debits is to select certainitems out of the balance of payments and comparecredits and debits for the given subset of items. What-ever subset we choose, the deficit (surplus) on thatset of items must be matched by an identical balancewith opposite sign on the remaining items. Accordingto current usage, a line is drawn through the balanceof payments and the items selected are said to be

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FEDERAL RESERVE SANK OF St LOUIS NOVEMBER 1973

“above the line” and the remaining items are said tobe “below the line.”

Over the years the line has been drawn at manydifferent places and several different measurementscurrently are reported by the Department of Com-merce. At least three of these are commonly citedand discussed. They are (1) the balance on currentaccount plus long-term capital, (2) the net liqniditybalance, and (3) the official reserve transactionsbalance.3

Enumerating in great detail the items that go aboveand below the line for each of these measures istedious and not very useful for our purposes. Insteadthis section gives a general description of the itemsabove and below the line for each of the three waysof measuring a deficit and suggests a way to interpretthese deficits.4

By placing certain items above and below the linewe define a deficit. Since all such definitions are, in atrivial sense, correct, we must select between alterna-tive measurements on the basis of their usefulness.No way of measuring a deficit is useful in isolation.In order to be meaningful a deficit must be relatedthrough some theory to a relevant problem.

In interpreting a given deficit, it is helpful to asktwo questions. First, what problem is this measure-ment supposed to help me understand? Second, whatexplicit (or implicit) theory underlies this particulardefinition of a deficit? Although we consider only onerelevant problem and appropriate theory for eachdeficit, there are other reasonable interpretations.

Current Account and Long-Term. Capital

Mea-surement — As suggested by the heading, underthis approach long-term capital flows (other than cer-tain official long-term flows) and the balance on cur-rent account go above the line (see Table II). The

tmFor a discussion of these and other ways of measuriug a

deficit, see the following The Balance of Payments Statis-tics of the United States: A Review and Appraisal, Reportof the Review Committee for Balance of Payments Statisticsto the Bureau of the Budget (April 1965); Hal B. Law,Problems of the United States as World Trader and Banker(New York~ NBER, 1963); Richard N. Cooper, “The Bal-ance of Payments in Review,’ Journal of Political Economy(August 1966), pp. 379-95; Walter H. Gardner, “An Ex-change-Market Analysis of the U.S. Balance of Payments,”IMF Staff Papers (May 1961), pp. 195-211; Anne 0. Krue-ger, “Balance-of-Payments Thenry,” Journal of EconomicLiterature (March 1969), pp. 1-26; Walther Lederer, TheBalance of Foreign Transactions: Problems of Definition andMeasurement, Special Papers in Intemational Economics,Princeton University, September 1963; and Devlin, U.S.Balance of Payments: Revised.

4For a detailed description, see Devlin, U.S. Balance of Pay-ments: Revised.

Table II

U.S. BALANCE-OF-PAYMENTS SUMMARY FOR 1972Imillions of dollars)

Net Credit C -t- IItem - or Debit C .

Me’chcnd so Trade baianca $ 6,912Military ti ansactions, not 3,558T’avel ai,d transportation, net 2,853lnvestm,.r.t income, ‘sot 7,862Other services, net 850

Balance on goods or’d services 4,609Remittances, pensions and other transfers 1,570

Ba~csnceon goods, services and remittoncen - 6,179u.S. Gavernment grants (excluding military) 2.174

Balance on cu’rent Account 8,353U.S. Goverr.ment capitol flaws excluding non.

scheduled ‘epayments, net 1,714Nonscheduled repayment of U.S. Government

assets 137U.S. Gavo’nn,enl nonl’quid tiabilities to other

than foreign official raserve agencies 238Long-term pri~otccapitol flows, net 151

Balance on current account and long-term capital 9,842Nanliquid short term private capitol flows, net - 1,637Allocations of speciat drawing rights 710Errors and omissions, net —-3.1 12

Not liquidity balance - 13,882Liquid private capital flows, net 3,542

Off,cia. Reserve transactions balance 10,340Financed by changes in,

liquid iiabilities to fo’eign official agencies 9.720Othtr readily marketable liabilities to fore,gn

official agencies 399Nontnq.sd liabilities to fare ig n officiol reserve

agenties reported by U.S. Government 189U.S. official reserve assets, net 32

i’,,.,, ‘It,.,. .‘.~

remaining items, errors and omissions, short-tersllcapital flows, and changes in official claims, all gobelow the line as financing items.

Problem and Theory — The balance on current ac-count and long-term capital is intended to serve asan indicator of basic or long-term trends in U.S. bal-ance of payments. For this reason it is sometimesreferred to as the basic balance. The problem relevantto this approach is whether or not the balance ofpayments is in equilibrium in the sense that a givensituation can persist through time.

The following ideas appear to underlie this ap-proach. It is generally considered both proper andpossible to finance a current account deficit by in-curring long-term debt or to make long-term foreigninvestment by running a current account surplus. Butit is generally considered neither possible nor properto finance a persistent long-term capital outflowand/or a current account deficit by incurring short-term debt or reducing international reserves. Thisview apparently assumes that there is a limited poolof internationally mobile short-term capital that can-

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FEDERAL RESERVE BANK OF ST. LOUIS

not be relied upon because it moves from country tocountry in response to expectations as well as tomodest and temporary advantages in net yields.

Given this view of the world, a deficit or surpluson current account plus long-term capital financedby a short-term capital inflow is only temporary. Theshort-term capital inflow financing the net debit bal-ance above the line will disappear and perhaps turninto a capital outflow in response to changing inter-national financial conditions, especially changes inrelative short-term yields between countries. A netbalance on current account plus long-term capitaltherefore represents a disequilibrium in the sense thatthis situation cannot be expected to continue.

The quarterly balance on current account and long-term capital from 1960 through the second quarterof 1973 is shown in the accompanying chart. Althoughdeficits were posted generally throughout the 1960s,they were relatively small and did not show any clearsigns of increasing until late in the decade. By 1969the deficits became substantial and then in the sccondand third quarters of 1971 they rose sharply. Towardthe end of 1972 the deficit on currcnt account andlong-term capital fell sharply and remained relativelysmall through eai-ly 1973.

Without some additional theory, a deficit on cur-rent account and long-term capital, such as the $4billion deficit in the third quarter of 1971, does notconvey much information.5 Knowing that a givensituation is likely to change is not very revealingunless we also have at least some indication of howit is going to change and what that change means forthe problem with which we are concerned.

Net Liquidity Basis

Measurement — The Department of Commerce nowreports the deficit on a “net liquidity” basis ratherthan a “gross liquidity” basis. As shown in Table II,in going from the balance on current account pluslong-term capital to the net liquidity balance, errorsand omissions, allocations of Special Drawing Rights,and nonliquid short-term capital flows are movedabove the line. This leaves primarily liquid capitalflows, changes in nonliqnid liabilities to official re-serve agencies, and changes in U.S. official reserveassets below the line to finance the deficit or surpluson the items above the line.

Problem and Theory The relevant problem forthis approach is again whether a given situation can

5AII deficits cited in this paper refer to non-seasonally ad-justed data.

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12 Net Liqoidity Balat 1i111_.J7 —H~

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persist. The theory underlying the approach appearsto be that entries below the line represent largelytransitory items that cannot be relied on to financea persistent deficit or surplus on the entries above theline.

If trade credit and other nonliquid short-termclaims grow essentially automatically with the volumeof trade, and errors and omissions are not dominatedby unreported short-term capital flows, then the netliquidity measurement would appear to be a moreuseful indicator of basic or long-term trends in U.S.balance of payments. If, on the other hand, nonliquidshort-term capital behaves essentially like liquid short-term capital and errors and omissions are dominatedby unreported liquid short-term capital, then thebalance on current account and long-term capitalwould be a more appropriate measure of basicbalance.

The chart presented above shows the quarterly bal-ance on a net liquidity basis from 1960 through thesecond quarter of 1973. The pattern suggests that, atleast in times of crises, errors and omissions as well astrade credit behave very much like liquid short-termcapital flows. During the third quarter of 1971 a deficitof about $4.6 billion on current account and long-termcapital was expanded to about a $10 billion deficiton a net liquidity basis by the inclusion of about a$5 billion deficit in errors and omissions. During the

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NOVEMBER 1973

Alternative U.S. Balance-of-Payments DeficitsStIll,,, ,t belier, u,,e,,,~~ ~,,, Suites, en Delle~i

2 2

- ______________________ 0

.4

1960 1961 1962 1963 1964 1965 1966 1167 196$ 969 1970 1971 1972 1973S,I,,~,’.US.D,p,,i,.,’i ,f C.ss,’v.,S,,~,y

7, S.pi,,’b,, 772)

—Il

-13

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1973

first quarter of 1973 a relatively modest deficit ofless than $1 billion on current account and long-termcapital became a deficit of over $6 billion on a netliquidity basis. This was primnarily the result of anincrease in nonliquid claims on foreigners reported byU.S. banks of over $1.5 billion dollars and a debitentry of almost $4 billion in errors •and omissions.Given the recent behavior of nonliquid short-termcapital flows as well as errors and omissions, it doesnot seem appropriate to place these items above theline.

If we view both the balance on current accountplus long-term capital and the net liquidity balanceas measures of fundamental or long-term trends in thebalance of payments, then the choice between thesetwo approaches depends on what theory we accept.If we believe errors and omissions and nonliquidshort-term capital respond to exchange rate specula-tion and interest rate differentials in essentially thesame svay as liquid short-term capital, then we shouldplace these items below the line and use the balanceon current account plus long-term capital. If, on theother hand, we believe honliquid capital flows anderrors and omissions reflect essentially the same forcesthat determine the volume of trade and long-termcapital flows, then we should place nonliquid capitalflows and errors and omissions above the line anduse the net liquidity balance.

If we believe the relevant problem is different forthe balance on current account plus long-term capitaland the net liquidity balance, then the choice be-tween these two approaches should depend primarilyon our belief about which problem is more important.Explicit separation of the appropriate problem fromthe appropriate theory would go a long way towardresolving the continuing debate over how to measurea balance-of-payments deficit.

Official Reserve Transactions

Measurement — In going from the net liquidity basisto the balance on official reserve transactions, liquidprivate capital flows are moved above the line. Thisleaves changes in official U.S. reserve assets (holdingsby the Federal Reserve and U.S. Treasury of gold,SDRs, gold tranche position at the International Mon-etary Fund, and foreign currencies), changes in U.S.liquid liabilities to foreign official agencies, andchanges in nonliquid liabilities to official reserve agen-cies as the financing items below the line (see TableII).

Problem and Theoru — Under a fixed exchange rate,the problem relevant to the official reserve transac-

tions balance is the amount of pressure on the peggedrate in the foreign exchange market. Under a “dirty”float (flexible rates with official intervention) the rel-evant problem is the direction and magnitude ofofficial intervention. The theory underlying this ap-proach is simple supply and demand.

Suppose there is a dirty float between the dollarand most of our major trading partners. Initially anexchange rate of 3 Deutsche marks per dollar justequates demand and supply for dollars in terms ofD-marks without official intervention, as shown inFigure I by the lines D and S. There is then additionaldownward pressure on the dollar as private demandand supply shift to D’ and 5’, respectively. If theBundesbank (German central bank) intervenes andpartially offsets this downward pressure by buyingMN dollars, as shown in Figure I, then the Bundes-bank acquires claims worth $100,000 which go belowthe line. This $100,000 appears as a credit below theline reflecting a deficit on the items above the line.This intervention therefore generates a deficit of$100,000 on the official reserve transactions basis. Ifprivate demand and supply then shift so as to raisethe D-mark price of the dollar and the Bundesbankpartially offsets that movement, the Bundesbankwould sell dollars and this would contribute to a sur-plus on the official reserve transactions basis.

If, over a given period of time, the official reservetransactions basis shows a surplus, then this is an indi-cation that over the period as a whole central bankshave been selling dollars and, on balance, moderatinga rise or contributing to a fall in the price of thedollar in terms of foreign currencies. A deficit on theofficial reserve transactions basis indicates that cen-

Figure

Demand for Dollars in Terms of Deutsche Marks

3.

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cr5lime

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FEDERAL RESERVE BANK or st. LOUIS NOVEMBER 1973

tral banks have been buying dollars in foreign ex-change markets and thereby moderating the fall oradding to the rise in the price of dollars in terms offoreign currencies.

Although the balance on official reserve transac-tions is positive for some quarters during the 1960s,in most quarters there was a deficit (see chart).Throughout the 1960s the deficits were not large byrecent standards and, perhaps even more important,deficits did not tend to grow.

Looking back we can no\v see that the deficit onan official reserve transactions basis began to growrapidly in 1970. By the first quarter of 1971 the deficitwas larger than it had ever been in the l960s. We caninterpret the growth in this deficit from slightly lessthan $2 billion in the first quarter of 1970 to over$8 billion by the second quarter of 1971 as an indica-tion of large and growing market pressure against thefixed price of the dollar.

With the floating of the German mark and Nether-lands guilder in May 1971, the structure of fixedexchange rates began to crumble. Widespread antici-pation of a general breakdown apparently generatedmassive pressure against the dollar in foreign exchangemarkets. This pressure is reflected in a third quarterdeficit for 1971 of over $12 billion.

With the realignment of exchange rates workedout at the Smithsonian Meetings in December 1971,pressure against the dollar slowly declined throughearly 1972, but then began to increase. In early 1973there was strong pressure against the new structureof exchange rates. The magnitude of the official in-tervention required to protect the rate structureadopted at the Smithsonian Meetings is reflected in adeficit for the first quarter of 1973 of over $9 billion.

By the end of March 1973, most industrializedcountries had stopped pegging the dollar and hadadopted a dirty float, The relatively small surplusin the second quarter of 1973 for the balance onofficial reserve transactions suggests that, on balance,central banks sold dollars and tended to accentuatethe depreciation of the dollar. If speculators had fol-lowed the same policy, their actions probably wouldhave been described as destabilizing.

Although there are problems associated with everydefinition of a deficit, under most circumstances thebalance on official reserve transactions does give atleast a general idea of the direction and magnitudeof official intervention in foreign exchange markets.Whether or not the balance on official reserve trans-

actions is the appropriate deficit to consider dependsprimarily on whether or not you consider conditionsin the foreign exchange market as the appropriateproblem.

Caveats

Even if the problem and supporting theory for agiven definition of a deficit are reasonably well spelledout, using that definition can be misleading.6 Thereare at least four reasons for this.

First, classification of items is highly arbitrary andaccounts often do not accurately reflect the corre-sponding theoretical concept. For example, long-termcapital flows include the import and export of long-term bonds with only three months left until maturity.From a conceptual point of view, a three-month Treas-ury bill and a 20-year bond with three months leftuntil maturity are essentially equivalent assets.

Second, the collection of BOP statistics is a verydifficult and complex task. Many transactions areonly partially reported, estimated on the basis ofsurveys, or missed entirely. As a result, balance-of-payments statistics should be taken with a grain ofsalt.

Third, in measuring a deficit there is a tendencyto think that the balance should be zero. In mostcases, however, there is nothing inherently good abouta zero balance. For example, a deficit on the officialtransactions balance presumably would be preferableto a zero balance enforced by strong trade and capi-tal controls.

Fourth, in addition to all the unavoidable problems,governments often engage in practices (both delib-erately and accidentally) that distort the statistics.For example, suppose a foreign central bank bought$1 billion in the foreign exchange market, but de-posited the dollars in a Eurodollar account in a Londonbank rather than depositing them in the United Statesor buying U.S. Treasury bills. The effect of this inter-vention in the foreign exchange market would notappear in the balance on official reserve transactionsbecause the $1 billion would not be reported as anincrease in U.S. liabilities to foreign official reserveagencies. Instead, it would be reported as a $1 billionincrease in U.S. liabilities to foreign commercial banksand the $1 billion entry would go above the line whenmeasuring the deficit as the balance on official re-serve transactions.

°For a more detailed discussion of some of these problems,see Devlin, U.S. Balance of Payments: Reoised, and Cooper,Balance of Payments in Review.

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1973

SUMMARYThe first part of this article discusses balance-of-

payments terminology. At least three basic points aremade in that discussion. First, the balance of pay-ments is a product of double entry bookkeeping andtotal debits must equal total credits. Second, what wereceive in every transaction (import) is recorded asa debit and what we give up in every transaction(export) is recorded as a credit. Third, imports andexports of assets or claims, such as stocks and bonds,are referred to as capital flows; the import of stocksand bonds is called a capital outflow and the exportof these assets is called a capital inflow.

The second part discusses how we can interpretbalance-of-payments statistics. Since the balance of

payments must balance, a particular way of measur-ing a deficit or surplus is a definition. Like all defini-tions, a definition of what is a deficit must be judgedon its usefulness. In order to be useful, a particularway of measuring a deficit must be linked throughsome kind of theory to a relevant problem.

Without reference to a problem and supportingtheory, a simple statement that the U.S. balance ofpayments is in deficit is meaningless. Even with acomplete specification, a balance-of-payments deficitshould not necessarily generate a call for action toeliminate this deficit. Suggestions or demands foraction can be based only on a specification of thedeficit and an argument as to why this particulardeficit is detrimental.

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