RDP 9001: Is Pitchford Right? Current Account Adjustment, Exchange Rate Dynamics and Macroeconomic Policy 1. Introduction

As Australia enters the 1990's, the current account deficit stands at near record levels. According to many commentators, this deficit – and especially the high levels of foreign debt that previous deficits have generated – is the most important economic issue facing the nation. Australia is said to be facing a “debt crisis”. Of particular concern is the fear that the country is falling into an “unsustainable debt trap”.^[1]

The response of economic policy to this external imbalance has been to attempt to diminish the current account deficit via reductions in aggregate demand, principally through contractionary fiscal policies. Accordingly, the net public sector borrowing requirement has been turned around from a deficit of 6.7 per cent of GDP in 1983/4 to a surplus of one per cent in 1988/89.

The normative basis for these policies is grounded in the belief that large current account deficits are undesirable, per se. Consequently, policy has been set to achieve a reduction in the current account deficit consistent with a stable, and suitably low, ratio of foreign debt to GDP (although few commentators are prepared to articulate precisely how low this ratio needs to go before the “crisis” has abated).

Recently, these views and policies have been the subject of some criticism, most notably by Professor John Pitchford of the Australian National University.^[2] The Pitchford critique may be stated in two parts:

1. Contrary to the conventional wisdom, abnormally large current account deficits are inherently temporary events. Concerns about “unsustainable debt traps” are therefore without solid foundation. The reasoning behind this argument is that since the fiscal accounts are now in balance, Australia's current account deficit is the result of borrowing by private individuals and firms. This borrowing must be financing either private investment or a desire for present over future consumption.

   Consider the case of investment. If this investment turns out to be profitable, it will yield a return sufficiently high to pay back the debt so incurred. Ex-ante, this must be the case, or the investment would not have been made in the first place. Ex-post, due to either bad lack or bad management, the returns from the investment might indeed be insufficient to pay back the debt. In this case, however, the borrower has the option of bankruptcy, and the debt is simply written off by the creditor.

   In the case of borrowing for present consumption, no income is generated with which the debt can be repaid in the future. It is unclear, however, why this should be a problem for public policy, if this borrowing only reflects individual preferences for intertemporal consumption. The individuals concerned will need to reduce their consumption in the future to pay back their debts, but this is a problem only for those particular borrowers (and their creditors).

2. Macroeconomic policies ought not to be employed to reduce the current account deficit, since that deficit merely reflects the savings and investment patterns of private economic agents. The possible existence of distortions and externalities implies that the current account balance, perhaps, does not reflect optimal private borrowing. However, the correct policy response in this event is to attack the problems at their source, via microeconomic policy. The blunt instruments of macroeconomic policy will, at best, be unhelpful, and may in fact worsen economic welfare.

The Pitchford view represents one end of the spectrum in the debate on Australia's current account. By contrast, one or two academic economists and some private sector analysts believe that a debt crisis is almost upon us, and that remedial action needs to be taken forthwith.^[3] These “debt pessimists” not only explicitly reject the idea that the current account reflects anything like optimal savings and investment decisions, but also implicitly adopt the view that the private sector is neither willing nor able to change its spending and saving propensities (even sub-optimally) when faced with debt.

The issue of whether the private sector can be expected to adjust its behaviour as foreign debt begins to accumulate is what is pivotal to the contemporary debate on Australia's current account. The important questions are whether the current account and exchange rate dynamics can be expected to lead to an equilibrium in the balance of payments, whether that equilibrium is efficient, and if not, whether government policy can improve social welfare.

In this paper, I employ a simple macroeconomic model to examine these issues. I find that Pitchford is correct about (i), but incorrect about (ii). A debt trap is shown to exist in only the most implausible of circumstances; the beliefs of the debt pessimists are therefore inconsistent with any reasonable view of economic behaviour by the private sector. However, when the real exchange rate is slow to adjust to real shocks that change its equilibrium value, fiscal policy can lead to a welfare improvement by altering the dynamic path of domestic consumption, and hence the current account. Thus a beneficial role can be found for macroeconomic policy in relation to the external debt.

The rest of the paper is organized as follows. Section 2 presents a model of debt and exchange rate dynamics in which all markets are assumed to clear instantaneously. A sticky real exchange rate is introduced into the model in section 3. Welfare and policy issues are examined in section 4. Section 5 contains some concluding remarks.

Footnotes

An unsustainable debt trap eventuates when the income available to meet repayments on the debt falls short of the interest on that debt. In such a case, the level of debt eventually becomes infinite. [1]

See e.g. Pitchford (1988, 1989a, 1989b, 1989c) [2]

See e.g. Arndt (1989), Macquarie Bank (1989) and Access Economics (1990). [3]