Official figures next week could show that the current account deficit, the amount the UK borrowed from overseas, reached 5 per cent of GDP in the second quarter - close to a record. You might be forgiven for thinking this shouldn't matter in a globalised economy. Such a deficit is only 0.7 per cent of total world savings, and the UK should surely be able to borrow such a paltry sum without difficulty.
Recent history, however, tells us that deficits do matter. To see why, consider the deficit as a percentage of GDP averaged over three years; doing so reduces the noise of quarterly movements. Since 1994, this measure of the deficit has been hugely correlated with consumer price inflation in the following three years. The correlation coefficient has been minus 0.72, with a one percentage point bigger deficit associated with average annual inflation being 0.6 percentage points higher in the following three years.
The deficit has also been correlated with subsequent GDP growth, with a one percentage point bigger deficit leading to annual GDP growth being 1.2 percentage points lower on average in the following three years.
Deficits, then, predict higher inflation and slower growth. They matter.
One reason for this is that there has been a correlation (of 0.54) between the deficit and subsequent three-yearly moves in sterling's trade-weighted index; a bigger deficit has led to a weaker pound. However, while this helps explain why a deficit leads to higher inflation, it doesn't account for why it also leads to slower growth. Three other things might explain this.
First, a current account deficit is a sign that domestic demand exceeds supply - that there are supply constraints upon UK growth or that there is a mismatch between the goods and services the UK can produce and those that Britons and foreigners want. Such supply constraints and mismatches can reduce future growth and raise inflation.
Second, a current account deficit means that the UK is borrowing from overseas. This can lead to slower growth simply if borrowers decide to reduce their borrowing at cut spending. For example, the counterpart of the deficit recently has been big government borrowing, which the government has tried to reduce - with obvious effects upon growth in 2010 and 2011.
Third, a UK current account deficit means that the rest of the world is running a surplus. And this - by accounting identity - means that foreigners' domestic saving exceeds their domestic investment. This could be a sign of long-term structural problems such as a dearth of profitable capital spending opportunities or (in the eurozone) a broken banking system or overly restrictive fiscal policy. All these might mean persistent weak overseas demand and hence slower UK growth.
We have, therefore, both empirical evidence and theoretical reasons to worry about the deficit. Which raises a problem. To some extent, the history of the last 10 years has been one in which people worried about risks that didn't materialise (systemic dangers of hedge fund blow-ups or inflation) but didn't worry about risks that did materialise (a banking collapse). Perhaps a lack of concern about the current account deficit is a continuation of this pattern.
