bop crisis explained
TRANSCRIPT
A View of the household/Country
• Let us assume an economy where a country is represented by a household
• The Man (corporate) of the house sells vegetables which are grown in the garden
• The Woman (government) of the house manages the upkeep of the house and associated infrastructure
A View of the household/Country
• The Man (corporate) buys supplies (fertilizer, seeds) to produce the vegetables
• The income generated from selling vegetables (GDP) is then shared with the woman (tax)
• The woman's share (tax) is used to then buy supplies necessary for the running of the household (government spending)
A View of the household/Country
• Internal mechanics of household– The man (corporate) has to ensure that he produces maximum
vegetables with minimum production supplies (profit motive)– The woman (government) has to ensure that she creates a conducive
living environment with minimum House supplies. (government budget)
A View of the household/Country
• External mechanics of household
– The sale of vegetables is nothing but the exports of a country
– The purchase of house supplies and farming supplies are the importsof the country
A View of the household/Country
• External mechanics of household
– When Imports > Exports ; We have a Current Account Deficit. The household/Country has to find ways to finance this gap. It is typically done through foreign debt.
– When Imports < Exports; We have a Current Account Surplus. The savings of the household can be used to invest in other households/countries
The Beginning of a BOP crisis
• Let us assume a world economy with 2 countries/households.
• Household ‘T’ produces tomatoes
• House hold ‘C’ produces carrots
The Beginning of a BOP crisis
• These 2 households engage in trade
• For the sake of simplicity, let us assume that 1 carrot = 1 tomato
• They sell 3 units of each to the other household
The Beginning of a BOP crisis
• Initially , household ‘C’ cannot produce 3 carrots and gives an IOU note to compensate for the shortfall
• Household ‘T’ has a Current account surplus ( more exports than imports)• Household ‘C’ has a Current account deficit (more imports than exports)• The gap is funded by foreign capital/debt (The IOU note)
The Beginning of a BOP crisis
• This continues for many years, until household ‘T’ no longer has faith in the capacity of ‘C’ to make good on the IOU notes
• The cumulative value of the IOU notes is sovereign debt
• This will result in a BOP crisis
• In real life this is what has happened betwen US-China; Dubai-AbuDhabi; PIIGS-Germany. Where one side has behaved like the ‘C’ household, running up deficits until they are no longer sustainable
The Crisis
• This typically results in ‘T’ saying that if ‘C’ wanted tomatoes they would have to sell them at a discount.
• In other words start paying back the mounting debt
• Now ‘T’ sells only one tomato but gets 2 carrots in return (the extra carrot is repayment of existing loans/IOU)
The Crisis
• In real life this manifests through a currency devaluation• The currency becomes weak, this results in exports becoming cheaper
(more carrots) and imports becoming dearer (less tomatoes). • A few examples are the Asian Tigers devaluation (1997); Mexican Peso
crisis etc.
The Aftermath
• After the short term pain subsides, the country/household starts the healing process
• The household adjusts to become more efficient and can produce 2 carrots with just one tomato
• In a few years the household ‘C’ produces 4 carrots and trades it for 3 tomatoes and an IOU note from household ‘T’
The Aftermath
• The roles have now been reversed
• Household ‘T’ is a Current account deficit country
• Household ‘C’ is a Current account surplus country
• In a few years the BOP crisis strikes again
Deviations/Distortions in cycle
• The previous chain of events would imply that the countries will keep oscillating between surplus and deficit as long as market forces are allowed to correct unsustainable imbalances
• However short term pain is always the enemy of political motives. The government is heavily incentivized to distort this economic cycle
• A few methods employed are explained in the next slide
Deviations/Distortions in cycle
• Monetary stimulus: – this is where the government prints money.
– This is the equivalent of the woman in the household injecting hormones in the carrot to make it look bigger/ more valuable
– In the long run household ‘T’ will call this bluff and there will be no change in the trading terms of the economy
Deviations/Distortions in cycle
• Fiscal stimulus : – this is where the government spends on infrastructure hoping to
revive the economy.
– The household equivalent is , the woman using her share of the money (tax) to embellish the house / make fancy dinners
– This gives the impression that there is nothing wrong with the household even though the economy is now facing a BOP crisis.