ChainWhat it assumes · how to break it
Start
Banks expand mortgage and consumer lending rapidly and relax their lending standards, as many did in the years before 2007.
1
As a result, households and firms can borrow more cheaply and easily, so consumption and investment rise.
consumption · investment · credit creation
consumption · investment · credit creation
Assumes: Households and firms want to borrow more.
But: Households that are already heavily in debt or pessimistic may use easier credit to refinance existing loans instead of spending more.
2
As a result, a large share of the extra spending goes on imported goods, because the UK has a high marginal propensity to import.
marginal propensity to import
marginal propensity to import
Best link to attack
Assumes: The extra spending falls on goods the UK imports.
Assumes: The extra spending falls on goods the UK imports.
But: If the credit mainly funds house purchases and domestic services, little of it leaks into imports.
3
At the same time, demand-pull inflation raises UK prices relative to other countries, so UK exports become less price competitive.
international competitiveness
international competitiveness
Assumes: UK inflation rises faster than in trading partners.
But: If productivity rises or the pound depreciates, UK goods can stay competitive.
4
Consequently, the current account deficit widens, financed by capital inflows, which leaves the economy reliant on foreign lenders.
current account deficit · financial account
current account deficit · financial account
Assumes: Foreign investors keep financing the deficit.
But: A deficit can be financed for many years if investors trust the economy, as the UK has shown, although a sudden loss of confidence would force a sharp adjustment.
End
The current account deficit widens as credit-financed spending sucks in imports and exports lose competitiveness.
Evaluation chain
- E1However, the effect on the trade balance depends on how much of the extra borrowing is spent on imports.
- E2If most of the credit goes on buying existing houses, which are not traded, and on domestic services, little of it leaks abroad directly.
- E3As a result, imports rise by less than the growth in lending, although higher house prices may still raise spending on imports through the wealth effect.
- E4So the current account deficit widens by less than the scale of the credit boom suggests, and by more in economies with a high marginal propensity to import.
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Questions this answers
- Assess the impact of a rapid rise in consumer borrowing on the current account.
- Evaluate whether a current account deficit caused by a credit boom is a problem.
- Discuss the causes of the UK's persistent current account deficit.
Diagram
No standard diagram. Evidence of household debt and the current account balance moving together before 2008 works well.
Reverse and related
Credit crunch → spending and imports fall, so the current account deficit narrows.