Conference – 1990 Discussion

1. John Pitchford[1]

I find myself in substantial agreement with the analysis Warren Tease has given of the course and significance of the Australian balance of payments magnitudes, in particular the current account deficit, in the 1980s. I want to give a brief summary of his arguments and then to come to some criticisms. I suspect most of these are really just points where he and I might concur that there is scope for further work on the topic.

In the final paragraph he asks: ‘Can Australia's current account deficit be classified as good or bad?’ and answers that: ‘…deficits experienced between the mid 1970s and mid 1980s were generally bad’, reflecting fiscal deficits and increased public consumption; while ‘…it can be argued that the most recent deficits can be classified as good’ because, with the fiscal position in surplus, they ‘have financed a substantial rise in private investment …’[p. 198]. It would appear that these conclusions should be read in conjunction with the two qualifications expressed on p. 197.[2] First, if a ‘bad’ deficit is identified the appropriate response is to treat the cause directly and secondly, changes in sentiment about a country's credit-worthiness may lead to traumatic adjustments. Let us briefly trace his arguments.

At the outset, he rightly adopts the position that current account outcomes must be examined as arising jointly from the external trade and expenditure/income sides of the identity. In this context his analytical framework consists of:

  1. an exploration in a Mundell/Fleming world of the effects on exchange rates and the current account of a rise in expenditure; an analysis about which he is dubious;
  2. intertemporal models of consumption, investment and production, which give rise to dynamic analyses of such processes as consumption smoothing in the face of fluctuating income; and
  3. the Swan-Salter, traded/non-traded goods model of internal/external balance.

He then examines four potential sources of exogenous shocks to the current account, namely, terms of trade, saving/investment shocks, foreign capital flows and monetary policy. Untangling the factors which contributed to the rise in the current account deficit in the eighties is a difficult task and Tease wisely does not try to become too definitive, preferring to dissect the data and the standard arguments and leave them on the table for the reader's inspection. However, let me single out one point which I believe is important and on which he is fairly definite, namely the contribution of real wage reductions since 1983/84 to profitability. This he feels was a significant factor in the rise in private investment and so undoubtedly has had much to do with the rise in the current account deficit and its persistently higher levels since that time.

In the next section he examines the changes in various relative prices relevant to trade and current account issues, summed up as real exchange rates, concluding that resources have shifted in a manner consistent with these relative prices, though this has by no means meant a shift of resources to the traded goods sector.

The penultimate section deals with what he regards as two unresolved questions, namely the significance of Australia's foreign indebtedness and the potential for exchange rate movements to equilibrate the growth in foreign debt. The view that private current account deficits reflect the decisions of rational households and firms and hence do not merit automatic and direct policy action seems to be accepted, but subject to whether the real and nominal exchange rate and the capital markets will react in such a way as to allow appropriate adjustments to the current account deficit. Potential exists for a misallocation of resources because the market can get the exchange rate wrong and capital markets can react with seemingly abrupt irrational changes in sentiment about a country's credit-worthiness. Hence, the conclusions we started with.

Let me list a variety of potential qualifications and additions which I would make to his main argument:

(a) The Theoretical Framework.

I think it is crucial to recognize, as Tease does, the joint determination of the current account balance by external trade issues on the one hand and income/expenditure outcomes on the other. Let me illustrate this in a way which seems consistent with Tease's approach and go on to suggest where he may have omitted some aspects of the picture. Consider the popular model of open economy macroeconomics where the exportable is consumed at home and is the only good produced there, while the foreign good is imported. E is the nominal exchange rate; Q* is the foreign price of the foreign good; and P is the domestic price of the domestic good. Let x(q) be the foreign demand for the home good, m(q,e) the domestic demand for imports, with q (=EQ*/P) the relative price of imports and e total expenditure measured in units of the home good. Gross output y(q) is also measured in units of the home good. The trade balance T and the income expenditure balance S are related by

Treating real expenditure as a parameter in the income expenditure side of the identity, plot T and S against the real exchange rate q. The slopes of the two curves are

Making the standard assumptions about signs (xq>0, mq<0, me>0, yq<0) the figure illustrates the joint determination of the trade balance and the real exchange rate by the two sides of the trade balance identity. For the trade deficit to be reduced nby a depreciation (i.e. dT/dq>0), it is sufficient that the Marshall/Lerner condition (i.e. Tq>0) is satisfied. The figure makes it clear that the trade balance and the real exchange rate are jointly determined by the interaction of the trade and income/expenditure side of the current account identity. Further, with dT/dq > 0, raising the level of real expenditure e appreciates the real exchange rate. Now consider the determination of real expenditure. Notice that this is a real model so that the economy does not depart from internal balance. Real expenditure is taken to be chosen optimally by households in making their consumption/saving decisions and by firms in deciding their investment plans. In so doing these agents simultaneously also make decisions on desired net asset and debt accumulation.

figure illustrates the joint determination of the trade balance and the real exchange rate by the two sides of the trade balance identity

This is all part of the framework Tease uses. The one aspect of the process which I feel that he underplays is the theory of foreign investment. This gets only implicit treatment, but it must be of critical importance. One reason is that acknowledging it alters the nature of the equilibrium which is appropriate to external issues. A long term process of private capital formation financed by foreign saving may mean that static notions of equilibrium are irrelevant. The role of the exchange rate in equilibrating the system in this context may well be to provide a sufficiently large current account deficit to accommodate investment needs, and this could require real appreciation. Only when the profitability of capital importing falls off will a real depreciation become warranted. Interpreting ‘equilibrating’ to mean ‘current account deficit reducing’ could ensure that a search for the equilibrating properties of the real and nominal exchange rate would be misplaced if its role happened to be the maintenance of a large deficit!

But what of policy-initiated adjustments to the nominal or real exchange rate? To change the real exchange rate, the figure implies that macroeconomic policy action would need to either alter the composition of demand for the various classes of goods, cause a departure from internal balance, change aggregate public expenditure without an offsetting change in private spending, or in some way affect private sector choices regarding aggregate real expenditure. None of these policies seems particularly appealing, in that they all appear both costly and in need of justification. Microeconomic policies may well affect the real exchange rate and to be justified it would need to be established that they remedy market failures.

There is another aspect of equilibrating which I would like highlight. Some, at least, of the rigidities and sticky adjustment processes which we observe are due to regulations imposed by governments. In other cases, when the private sector fails to adjust in the way we think it should, we tend to regard it as inflexible and inefficient. However, there is always a chance that the economic theories which suggest the ‘right’ way adjustment should occur are temporarily inoperative or wrong. Slow adjustment by the private sector may look inappropriate to us, but may well be the best process available to risk averse agents in an uncertain world.

Finally, while the Swan-Salter analysis of the traded/non-traded model is a valuable aid to understanding open economy macroeconomic issues, it seems necessary to be wary of the standard policy implications relating to external balance. As I have set out elsewhere, external balance in a flexible exchange rate system is achieved by exchange rate movements.[3]

(b) Consumption/Income Smoothing

Looking only at consumption/saving data, Tease does not find much evidence to support consumption smoothing. However, as smoothing occurs relative to income, I feel that the correct comparison should include income as well as consumption. I used to feel that there was some corroboration in the data for the smoothing hypothesis until I was told that statisticians may have a practice of smoothing the consumption series! However, note that smoothing is not the only possible optimal response. Depending on the expected duration of the income fluctuation in question, optimal responses can take forms very different from smoothing.[4]

(c) Real Wages and the Investment Boom

There seems general agreement that policy action which has reduced the growth of real wages in the 1980s has contributed to increased profitability and hence both to the recent investment boom and employment growth. Unless an argument can be made that it has increased saving as much as it has stimulated investment, it has also contributed to the size of the current account deficit. It seems somewhat paradoxical that on the one hand wage policy may have been encouraging investment, while on the other monetary policy has been attempting to moderate it. My own feeling is that for this and other reasons the sooner Australia can find a way of introducing market forces into wage determination the better.

On this subject, it is also likely that the absorption of the recent relatively high rate of immigration would have been aided by static real wages. The contribution of substantial immigration to investment needs and capital importing is another interesting aspect of the current account issue.

(d) Inflation Correction

The size of both the fiscal deficit and the current account deficit are affected by inflation, particularly through its effect on nominal interest payments. The resulting overstatement of the size of these deficits can be considerable. For instance, Makin in a forthcoming paper in the Economic Record makes calculations which claim that while unadjusted measures show only two Federal budget surpluses in the ten years to 1988/89, when corrections are made for inflation there were surpluses in all but four of those years. Adjustments I have seen made for the current account deficit suggest a similar magnitude of revisions.

(e) Real Exchange Rates

The real exchange rate is a summary measure of relative prices and thought of that way is a pretty broad aggregate. If the traded/non-traded goods distinction is made it would seem preferable to produce at least two indexes, one involving importables and the other exportables. Otherwise terms of trade movements are subsumed in the measure.

(f) Sentimental Financial Markets

In the end, many of the arguments against allowing the private sector to manage its own foreign borrowing amount to a fear that financial sentiment may turn against lending to Australia, with a consequent flight of capital and/or bankruptcies and/or dramatic devaluation. I have examined the basis of such arguments elsewhere so shall not get too detailed here.[5] The threatened problem involves a rare, seemingly irrational, future event. The trouble with this type of argument is that it is so difficult to substantiate. However, on rare occasions financial markets do produce panics and collapses, usually though not inevitably, associated with fundamental economic problems. If much of Australian private foreign debt were associated with speculative or low-profit undertakings there would seem to be reason to be concerned about changing financial market sentiment. These days the non-wage share of GDP is greater than 50 per cent. Leaving aside the effects of tight monetary policy, the impression is that profit rates have been high in Australia for some years and the fact that the private sector has been able to borrow at high rates for at least half a decade surely substantiates this. One could hope that provided the economy is managed so as to avoid significant excess demand and recession, the financial markets would recognize the basic soundness of the private sector of the Australian economy and that businesses would appreciate and adapt their planning both to exchange risk and the inevitability of periodic slow-downs. In addition, if it were established that there were microeconomic problems in capital markets, due to such difficulties as country risk, these should be addressed by the usuai microeconomic tools, such as taxes to correct identified externalities. The alternatives then to managing the economy for internal balance and trusting the resultant saving/investment decisions of the private sector, would seem to be choosing slower growth than the economy is capable of producing either by macroeconomic means or a tax on private foreign borrowing. Would the benefits of such measures justify the costs?

(g) Judging Public Deficits

The OECD and others have suggested that current account deficits arising from fiscal deficits must be regarded as ‘bad’ and so in need of correction. Of course, it is the fiscal deficit which requires treatment if it can be shown to have undesirable characteristics and not the current account deficit as such. Some argue that the fiscal deficits experienced in Australia between the mid 1970s and mid 1980s were in this sense ‘bad’ because they reflected a rapid rise in public spending not funded by current taxation. However, it is still necessary to establish why this judgment is warranted. I do not think it is accepted that public spending should in all cases be matched by taxation. An attractive alternative is that the generations benefiting from public spending should provide the taxation revenue to fund it and this by no means implies a fiscal budget balanced at each point of time. As well, if there is anything in the notion of countercyclical fiscal policy it should be noted that most of the years he refers to were years of depressed growth or recovery from recession. When Makin's inflation adjusted deficit figures are examined the deficits and surpluses of the last ten years look very much as if they were generated by countercyclical policy, though this outcome may be a coincidence!

Footnotes

*Australian National University. [1]

Tease categorises these points as representing the middle ground, but does not say whether he, himself, holds them. [2]

See, Australia's Foreign Debt, Allen and Unwin, Sydney, 1990, ch. 2. [3]

See Pitchford, ‘Optimum Borrowing and the Current Account when there are Fluctuations in Income’, Journal of International Economics, 1989 and ‘Optimum Responses of the Current Account when Income is Uncertain’, Journal of Economic Dynamics and Control, forthcoming, 1990. [4]

See Australia's Foreign Debt, op cit. [5]

2. Jeffrey R. Shafer[*]

One thing that has struck me is how much importance is attached to the current account of the balance of payments in the Australian economy policy debate. There are sharp differences of view on whether deficits should be a concern and, if so, what to do about them. Warren Tease has written a good paper to set the scene for a discussion on the topic. The author has reviewed the facts concerning balance of payments developments over the 1980s. He has also provided an eclectic review of ways to appraise these developments, giving particular weight to the identity relationship between the current account and the gap between saving and investment. He would, I think, come close to saying that we have covered most of the relevant ground in the previous session on Saving and Investment. I have a lot of sympathy with this view, but turning over a set of identities to look at their various faces can be revealing, and it is worth spending some time seeing what may or may not follow from alternative perspectives.

Tease draws some policy conclusions. They are statesmanlike and avowedly in the middle-ground, as befits a central banker giving his views on any subject but inflation. The policy prescriptions are twofold: first, to address directly fiscal imbalances, distortions or externalities that may lie behind a current account deficit; and second, where deficits appear to be unsustainable, to seek to bring forward or soften adjustment, although the means for doing this are not specified. I would endorse these conclusions, as far as they go.

I want to make a few more specific observations about each of the three aspects covered in the paper: What happened? Why did it happen? Does it matter?

As to what happened to the Australian balance of payments in the 1980s, it might be useful to complement the facts in Tease's paper with a couple of observations from an international perspective. The most important fact is that Australia had a current account deficit during every year of the 1980s. The other OECD countries that share this record are Denmark, Greece, Turkey and New Zealand. The preoccupying string of US deficits began only in 1982. Canada, which is often compared with Australia, eked out surpluses for three years of the decade.

No one would want to put all of these countries in the same basket – clearly persistent deficits are not all of a kind. Denmark and New Zealand are most like Australia in being habitual capital importers while commanding the confidence of international lenders and investors. The question is whether there are limits to this and, if so, is Australia approaching them.

One disturbing additional fact is that Australia's deficits have not only been persistent, but they seem to be drifting up over time. As Tease observes, over the 1950s, 60s and 70s the Australian current account averaged a deficit of 2½ per cent of GNP; in the 1980s it averaged twice that. I would add that in 1989 it was 5.7 per cent – the largest of any OECD country by a good margin. Is this a danger signal? In one respect it is clearly not. The financing of this deficit reflects financial market confidence in Australia. One traditional concern is clearly no longer warranted – liquidity considerations do not constrain the Australian external position now as they had seemed to at times in the past. This presumably reflects the new world of liberalised, global financial markets.

There are more informative ways of assessing the extent of debt dependence. Countries, like private debtors, eventually get into difficulty if their debt or debt service grows faster than their potential cash flow. The debt indicators suggested by this consideration have been rising for Australia – the current account deficit would need to drop from nearly 6 per cent to below about 4½ per cent of GDP to stabilise the debt-to-GDP ratio at the current nominal GNP growth rate. The process by which these debt ratios are widening does not bode well for an early stabilisation. Net foreign income payments increased fivefold over the decade of the 1980s, while other current account items remained persistently in deficit. That is, income payments were met by taking on new liabilities, and a bit more on top of this was added to foreign liabilities each year. To stabilise a debt ratio in a country with a deficit, even excluding income payments, requires that GNP or exports (whatever one would have in the denominator of the ratio) grows more rapidly than the rate of return provided to foreign investors. In the high real interest rate environment of the 1980s, this has been a tough standard to meet. The 1990s do not look any more promising from this point of view: new claims on world saving are emerging in Central Europe, and real interest rates appear to be under upward pressure again. Australia is in a somewhat less precarious position than some countries with large net foreign liability positions in that a relatively large share of this is in the form of equity investments in Australia. In the event of economic distress in Australia, the return on these investments would presumably shrink, reducing the current account deficit. This would seem to be little comfort, however. The question is whether something needs to be done to reduce these deficits before they lead to economic distress.

Turning now to why the Australian deficit has been so persistent and has tended to rise over time, the saving/investment view must be true. After all, it is an identity, and identities are the only thing we know for sure in economics. While it is the truth, however, it may not be the whole truth. Once upon a time, much more would have been made of another identity: the current account equals absorption minus output. And, in the event of a deficit, we would have said that demand exceeded supply. Or we would have pursued the implications of this identity through income/expenditure models with elastic supply, assigning critical roles to import propensities and the level of demand. I am with those who would put aside these perspectives for looking at anything but very short-run developments, and the Australian current account deficit is most certainly not a short-run matter. As a general matter in the OECD countries during the period since World War II, demand has adjusted relatively promptly to eliminate excess supply or demand conditions. The current account over the medium term should therefore be considered as being the outcome of saving and investment behaviour at a level of output in line with supply potential – that is, the non-accelerating-inflation path of output.

I have one hesitation about leaving the matter to rest here in the case of Australia in the 1980s. This follows from the discussion in an earlier session concerning the Accord. If this labour market solution has succeeded in putting a lid on nominal wages, has one result been persistent excess demand, as wages have not been able to respond to aggregate demand pressure? Might this account for the rise of the external deficit in the 1980s? I will leave this as a question, and a possible qualification to the view of the current account as the outcome of private saving and investment decisions.

There is also a competitiveness perspective on the current account, which is often thought of as an alternative to the saving/investment perspective. For example, one hears in the US policy debate that either the budget deficit must be cut (thereby raising saving) or US competitiveness must be improved (for example, through dollar depreciation). It is not a question of either/or, however. A shift of the saving/investment balance must be accompanied by expenditure-switching mediated by the competitiveness changes. If nothing else does this, changes in the real exchange rate, resulting from either nominal exchange rate changes or differential inflation rates, will do it. Microeconomic reform that improves productivity or the marketability of national products is an alternative way of improving competitiveness. Indeed, it would seem a more attractive way of adjusting if there are microeconomic impediments hindering performance in international markets, since this would reduce or eliminate the need for a worsening of the terms of trade as a part of the adjustment process. The competitiveness perspective ought not be left in the background. When one looks at how to reduce a current account deficit, one has to ask how competitiveness can be improved as well as how the saving/investment balance can be shifted.

The policy perspective that I would offer follows that of the Tease paper and has been foreshadowed already. I can think of no good reason for the current account, per se, being a policy objective, except the fear that unsustainability will lead to an unpleasant shock. Many would dismiss this concern as fanciful when the government's finances are in order. They argue that rational private borrowers in Australia and informed lenders abroad will ensure that any deficit generates the cash flow to service it. To my taste, this puts too much weight on an a priori argument against historical counter-example, no one of which may fit the case precisely, but they are numerous: Latin American debts may largely reflect irresponsible fiscal policies, but the problems there nevertheless show how much rope bankers will give nations with which to hang themselves. And Chile's debt was largely incurred by the private sector. If you prefer a private sector counterpart, take Alan Bond.

I would not want to conclude that debt unsustainability will become a problem for Australia at any fixed future date. Current debt ratios are not dangerously high. But I do believe that sustainability is a relevant consideration in the debate. Taken one by one, private debtors may be sound risks, but the nation may nevertheless have difficulty shifting resources into exports to meet future debt service without incurring an adverse shift in the terms of trade or declining productivity – especially if this must be done quickly. Debt denominated in foreign currency would become more onerous to service; debt in Australian dollars would decline in value, with the possibility of a vicious circle of depreciation and loss of investor confidence. Timely correction of a deficit that is on an unsustainable course could avert severe economic distress that would otherwise come when the market chose to enforce adjustment.

Although I would dismiss arguments other than that of ensuring sustainability for pursuing a current account target, the current account is nevertheless an indicator of other features of the economy that may be of concern – for example, low national saving that makes inadequate provision for the nation's future. This may be a matter of budget deficits, or it may be a matter of distorted or myopic private sector behaviour. Why look at an indirect indicator when direct data are available? For one thing, data are subject to errors, and looking at identities from various angles makes one aware of how much they may be distorting the picture. For another thing, there is no absolute standard for levels of saving, and the current account provides another quantitative reference point. For example, I would be more at ease with the comforting conclusions drawn by Edey and Britten-Jones in their paper for this conference if their picture of saving and investment trends added up to 1 or 2 per cent of GDP current account deficit, than with a deficit approaching 6 per cent of GNP.

In addition, the large deficit says something about competitiveness, even if there is no one-to-one correspondence. A deficit implies that prevailing real exchange rates are providing a deceptive view of sustainable real income. If performance is not improved through microeconomic policies and adjustment becomes unavoidable, the real exchange rate will depreciate and real income will decline.

I would also not set aside completely the current account as a short-run indicator of demand pressure, and hence of inflation risks. Countries in the OECD where deficits are large at present are generally those where inflation risks are highest – and I would include Australia here.

What needs to be done? Several general guidelines seem applicable to the Australian case. The indicator perspective points to Tease's recommendations – fix what is broken on both the saving front and the competitiveness front. I would say the same thing if the problem is a concern about sustainability – something must be wrong and that is what ought to be identified and fixed. But what if it is simply that individuals don't seem to be sufficiently far-sighted, and it's not just a matter of identifiable distortions? This may not be a relevant case – in my experience, instances of countries where private saving seemed inordinately weak have been ones where clear distortions could be identified. But the response available to governments in such a case, at least to keep within limits of sustainability, would be to run larger public surpluses. Work at OECD indicates that this will not be fully offset, or even nearly fully offset by private saving declines.[1] This is also the most reasonable response to distortions that are not going to get fixed even if they are, in principle, fixable. For example, this is the rationale for full funding of old-age retirement programmes.

Beyond this sustainability concern, however, I do not see why the current account should be a matter for such close policy monitoring as it has been in the past. And certainly, fluctuations around a sustainable long-run level can be important in absorbing macro-economic shocks. Hence the current account should perhaps not be the policy preoccupation that it has been in the past, both in Australia and elsewhere. Still, it would seem risky to dismiss deficits as unimportant for policy when they are as persistent and become as large as Australia's in the 1980s.

Footnotes

Organisation for Economic Co-operation and Development, Paris. The views expressed are those of the author and do not necessarily represent those of the Organisation or of the governments of its Member countries. [*]

Guiseppe Nicoletti, ‘A Cross-Country Analysis of Private Consumption, Inflation and the Debt Neutrality Hypothesis’, OECD Economic Studies, No. 11, Autumn 1988. [1]

3. General Discussion

John Pitchford opened the discussion by saying that the role of the economist was to ensure that the private sector works as efficiently as possible and to go beyond that is to get out of economics and into politics. He noted that economists should avoid using judgemental terms such as the current account ‘improving’ or ‘worsening’ or ‘good’ and ‘bad’ deficits. Warren Tease responded to a number of points made by Pitchford. He noted that he was probably more cautious than Pitchford on the question of whether the current account deficit was a cause for concern because it may result in a large financial market shock in the future which may be costly. He acknowledged, however, that these potential costs could not be quantified.

The general discussion tended to focus on the question of whether the current account deficit was a cause for macro-policy concern and the role of the exchange rate in the adjustment process. On the former point, the discussion focussed on two issues. The first was whether large current account deficits and foreign debt have (or will) impose costs on the economy. Most of the discussion was on whether the external position had resulted in a risk premium on $A denominated assets. The possibility of a large financial market dislocation in the future was also addressed. The second point of discussion was on whether the recent current account position could be classified as ‘good’ because it financed a large rise in investments.

On the issue of risk premiums, it was suggested that short-term real interest rates have been higher than equivalent foreign rates for a considerable period. However, this was not the case with longer-term rates. The relatively high short-term rates were indicative, but not necessarily conclusive, evidence of a risk premium. It was pointed out that there are two elements to any risk premium – country risk and exchange rate risk. Only the former should be relevant to these types of discussions. A number of commentators pointed to potential adverse selection and moral hazard problems due to foreign borrowing. In the former case, high interest rates (due to the risk premium) might lead people to invest in riskier projects than would otherwise be the case. In the latter case, if there is the possibility of the public sector rescuing private borrowers then this may alter the behaviour of those borrowers. There was some discussion of the related issue of possible externalities of foreign borrowing. It was pointed out that the lending market for Australia was small and that there might be contagion effects if large borrowers default on loans. If this is the case, the community as a whole may pay a risk premium because of the collapse of risky borrowers. The discussion did not clarify the issue of whether this was a problem for policy. The point was made that while the current account deficit and foreign debt to GDP ratios were high they had not yet reached critical levels, so foreigners continued to lend.

Some questioned the argument that recent current account deficits are ‘good’ simply because they have financed investment: a good deal of the investment may not have been in the traded-goods sector. Others argued that provided the investment is profitable, then it will cover its borrowing costs irrespective of what form it takes. Even if the investment is in the non-traded goods sector it may aid external adjustment. It will increase the production of non-traded goods and therefore reduce their price relative to traded goods. Over time, this real depreciation will free resources for use in the traded goods sector.

On the exchange rate, it was suggested that the issue depended on ‘how much faith we have in the markets’. It was noted that there is considerable evidence that the foreign exchange market is myopic and may result in a misallocation of resources. This may be a problem for Australia because to stabilise the foreign debt to GDP ratio, there needs to be a very large adjustment on the goods and services account which, in turn, requires adjustment of the real exchange rate. If short-term market-driven phenomena prevent the exchange rate from adjusting, then external adjustment will be impeded. While most agreed that the exchange rate may not respond to fundamentals in the short run, some doubt was cast on the view that ‘irrationality’ in the foreign exchange market did lead to a misallocation of resources. Misalignments may only be short-run phenomena and as such they may not impose resource allocation costs. Finally, one commentator noted that Tease's paper stressed an important point that neither the real interest rate nor the real exchange rate was a policy instrument easily amenable to change over the longer run. They were more correctly viewed as endogenous variables and part of the equilibrating process.

There was a discussion on micro reform and the current account. There was agreement that micro reform, as such, won't improve the current account. However, it was pointed out that since micro reform will make incomes larger in the aggregate, it provides the potential for increased saving. Finally, it was noted that micro reform might lead to further investment which might add to the inflationary pressures.