RDP 9003: The Balance of Payments in the 1980s I. Introduction

A pre-occupation with the external sector has been one of the abiding themes of Australian economics. “In the long run the rate of growth that can be sustained by the economy will be governed by, perhaps more than anything else, the extent of the good fortune and good management that attends the balance of payments”.^[1] The 1970s saw a respite from the “brooding pessimism”^[2] of earlier decades. Indeed, with the mineral export boom of 1970/71 and the prospect of a repeat in the second half of the decade, the nature of the problem seemed to have changed. This gave rise to the “Gregory Thesis” – that the enhanced export performance would, perforce, require an appreciation of the real exchange rate or a reduction of tariffs, in order to encourage imports. The perceived problem shifted from concern about the difficulty of funding necessary imports, to concern about achieving structural adjustments required to absorb more imports. The problem was summarised this way: “the more successful, in the decade ahead, we prove to be at exporting, the more successful we are also going to have to be at importing”.^[3]

In the event, pessimism about the balance of payments soon returned. The current account deficit increased sharply in the early 1980s, and despite a large depreciation of the real exchange rate and a move into surplus in the government accounts, there was no sustained tendency for it to decrease as the decade progressed. In addition, the method of financing the deficit shifted predominantly to debt and away from equity. As a result, by mid decade the question of excessive external debt was being raised, for the first time in at least a generation. All these developments happened against a background of closer integration into world financial markets and the floating of the Australian dollar.

If the current account problem was a familiar one, both the framework for analysing it and the institutional environment had changed. Before 1980, the short-term problem was seen as a result of either cyclical excess demand “spilling over” into imports, or recurrent terms of trade shocks. These were seen to have their long-term secular counterparts: an import income elasticity substantially greater than one (so that as the economy grew, imports grew more rapidly) and secularly-declining terms of trade because Australia's comparative advantage was in primary goods. With the Swan-Salter^[4] analysis in mind, policymakers had seen the solution to a current account problem in terms of a change in external competitiveness, and they had seen a role for active policies in setting the exchange rate and influencing wages and prices in order to maintain competitiveness.^[5]

By the late 1970s, this view of competitiveness as a policy instrument was changing. While the exchange rate was not floated until December 1983, there was an increasing realisation that the real exchange rate was not a policy instrument directly amenable to change over the longer run. It was an endogenous reflection of the settings of policy and the underlying circumstances of the economy. There was a tendency for some, reinforced after the float of the currency in 1983, to see the exchange rate as a relative price which would automatically equilibrate the external sector. If the current account deficit was excessive, it was because there was a savings/investment imbalance caused by, for example, an overly large budget deficit or some distortion to private sector savings.

This paper records the growing current account deficit in the 1980s and the changing (and various) prescriptions of what should be done. In doing so, one objective here is to reconcile two approaches to analysing the current account. The first, described as the “piece meal” approach to the balance of payments^[6], emphasises income and price elasticities, particularly for imports. The second focuses more on the current account in a general setting with it being a reflection of the relationship between aggregate absorption and aggregate output and that between savings and investment. Gregory (1989) poses the dichotomy this way: “(is) it more productive to think of current account outcomes predominantly in terms of structural shocks to the import competing and export sectors or is it better to analyse current account outcomes in terms of government and private sector savings and investment decisions”. Because each of these approaches is true by identity, this paper adopts the view that the choice of the identity on which to focus is not of primary importance.^[7] The main issue is identifying the exogenous factors that have affected the current account. As well as identifying where the initiating shock lies, we need to explain how the system responded (through relative prices, income, etc.) to maintain each of the identities.^[8]

Section II of this paper sets out a brief summary of theory to illuminate and guide the interpretation of the data. Section III describes the current account in terms of episodes and proximate causes. No attempt is made to identify the initiating shock, or the equilibrating process. Section IV looks at a number of shocks which have impinged on the current account in the 1980s – terms of trade, changes in savings and investment (including changes in government savings) changes in foreign capital flows and monetary policy. Section V draws these results together and examines the response of relative prices, and how the production mix between tradable and non-tradable goods responded to the relative price signals. Not only are the export/import and investment/saving versions of the current account identity held in balance by relative prices and income, there are forces limiting the overall size of current account imbalances. Feldstein and Horioka (1980) observed, almost a decade ago, that domestic savings and investment in most countries are linked together, so that while foreign capital flows provide the opportunity for the two to diverge, in practice there seem to be constraints on the gap between savings and investment. The corollary of this is that current account deficits will also be constrained. Did the more complete integration of Australia into world financial markets remove a constraint which allowed the current account deficit to rise? Section VII looks at some remaining concerns about the balance of payments, principally the question of foreign debt, but also the question of whether the equilibrating process through changes in the real exchange rate can be relied on to bring about costless external adjustment. Section VIII draws the strands together.