RDP 2007-02: Current Account Deficits: The Australian Debate 3. The Australian Policy Debate

The policy debate in Australia needs to be understood as occurring against a backdrop of changing views about the macroeconomic framework, particularly in an open economy context. There were three broad aspects to this. First, there was the realisation that demand management should be directed towards the control of inflation over the medium term, and that this was the best way to support employment, which would be determined in the longer run according to a vertical Phillips curve. Second, in a world of internationally mobile capital and flexible exchange rates, there was no longer a ‘balance of payments problem’ per se, but concerns about vulnerability to external shocks, and the related question of long-run solvency remained. And third, in a world of flexible exchange rates, Mundell-Fleming models (and later more sophisticated variants) highlighted that monetary policy should be directed at inflation control, though fiscal policy was relevant to questions of international solvency.^[10]

3.1 An Evolving Policy Framework: The Late 1980s

Up until the mid 1980s, during the period when the exchange rate was fixed, current account deficits had been a cause of concern for policy-makers to the extent that large deficits made it difficult to achieve the goals of internal and external balance. These deficits needed to be financed out of net capital flows and foreign currency reserves, while large swings in net capital inflow could hamper policy-makers' efforts to contain growth in domestic liquidity. With the float of the Australian dollar, these particular difficulties were largely removed, not the least because policy-makers now regained control over the setting of domestic interest rates. By the mid 1980s, large current account deficits were becoming the norm and the Australian-dollar value of foreign debt was building up at a rapid pace. At this stage there was less concern regarding the implications of the deficit for the implementation of policy, and instead the current account deficit for a time became an objective of policy in its own right.

At the heart of this concern was the widespread sense that the pace of foreign borrowing was unsustainable. It was feared that it could ultimately impose a constraint on economic growth, and in the meantime, the domestic economy would become more susceptible to the vagaries of international investors while debtors would face higher borrowing costs. This gained further credibility when the credit rating agencies downgraded Australian Commonwealth debt (Gruen and Stevens 2000). It was at this time in 1986 that the Australian Treasurer, Paul Keating, made his famous ‘banana republic’ remark. The reaction in the markets to this comment was probably greater than the reaction to the downgrades themselves.

Of course the current account deficit was clearly not the only ‘problem’ facing the Australian economy. Inflation, which had risen at the time of the first oil price shock, persisted at a relatively high rate into the 1980s. Improving Australia's international competitiveness through tariff reduction and the dismantling of other protectionist measures was also deemed necessary. Notwithstanding efforts to reduce tariffs in the 1970s, Australia's legacy of protectionist policies were being blamed in part for the emergence of the ‘balance of payments problem’.

During the 1980s, the fiscal authorities largely took a lead role in the setting of policies relevant to the current account. In line with the ‘twin deficits’ argument, a key strategy was fiscal consolidation aimed at reducing the call on foreign funds by the public sector.^[11] Restrictive fiscal policy was also expected to ultimately allow an easing in domestic interest rates. Reforms to improve international competitiveness were also introduced, such as the phased reduction in trade barriers and the continuation of the Prices and Incomes Accord; the latter being used to restrain wages growth. As already mentioned, it is plausible that the prominence given to the current account throughout this period may have in part reflected its usefulness as an argument to pursue other worthwhile reforms (Edwards 1996). Of course, the value of such a strategy would have eventually weakened as it became increasingly apparent that policy was ineffective at reducing the trend in the current account deficit.

As the more flexible tool, monetary policy was to be directed to general demand management, such as containing cost and price pressures and ensuring stability in financial markets, until other policies had time to take effect. It was also hoped that restrictive monetary policy would reduce the demand for imports, thereby assisting a rise in the trade balance (Commonwealth of Australia 1988, pp 43, 53). The rest of this section outlines monetary policy's role in the response to the current account deficit.

The role carved out for monetary policy in the second half of the 1980s was highly ambitious. The belief that monetary policy should be guided by a single quantity was called into question towards the end of the monetary targeting period of 1976–1985, particularly after financial deregulation when the already tenuous relationship between monetary aggregates and inflation broke down (Johnston 1987, p 6). In its place, the RBA instituted a ‘checklist’ approach, which included ‘all major economic and financial factors – present and prospective’ (Johnston 1987, p 6). Among other things, the balance of payments was listed as an explicit factor and was given a high weight in monetary policy settings (see RBA annual reports in the second half of the 1980s).

With the floating exchange rate, policy needed to be mindful of the effects that the exchange rate could have on inflation and Australia's international competitiveness and the potential feedback from interest rate settings to exchange rates (Grenville 1997; Macfarlane 1991). These factors, along with more general concerns about stability in financial (and exchange rate) markets, variously influenced policy. Nonetheless, the RBA believed it could operate policy as a ‘potent demand management tool’ (RBA 1989, p 7), with inflation and current account deficits being symptoms of excess demand.

However, over this period, there was a sense of dissatisfaction by the authorities with what monetary policy could achieve. While it was thought that higher interest rates could reduce import demand and therefore the current account deficit in the long run, the short-term effects were less clear and could even operate in the opposite direction if higher interest rates produced an exchange rate appreciation. It was always believed that the other arms of government policy – fiscal restraint and micro reforms – were the more effective tools to bring about a lasting reduction in the deficit, and the RBA came to question whether monetary policy was able to contribute to the adjustment process at all.

Towards the end of the 1980s, persistent high inflation increasingly became the main focus of the RBA, though the current account deficit still rated a mention in policy discussions.^[12] This shift in focus also reflected evolving views within the RBA about the appropriate policy framework. Against the background of dissatisfaction with the checklist approach, the emerging view was that the single instrument of monetary policy could only be effectively directed to a single objective, namely inflation (Macfarlane and Stevens 1989, p 8; Phillips 1989). It was believed that ‘[m]onetary policy can best contribute to a sustainable external position in the same way that it can best contribute to overall growth, namely by providing an environment of low inflation’ (RBA 1991, p 4). By early 1993, the RBA had adopted a flexible inflation-targeting framework, and shifted the policy time horizon from relatively short-term demand management to a medium-term objective of containing inflation (Stevens 1999).

By the end of the 1980s, it was apparent that, despite the concerted joint efforts of policy-makers, no permanent reduction in the current account deficit had been achieved. The current account deficit was back to 6 per cent, roughly around the level that sparked concern in the first place. This was despite an impressive turnaround in the Australian Government's annual budget position of around 5 percentage points of GDP between 1983/84 and 1988/89 (reflecting both fiscal restraint and strong growth) and significant microeconomic reform. The fact that these policies had had no (persistent) effect on the current account lent weight to the emerging view of academia.

3.2 The Challenge from Academia

During the second half of the 1980s, Australian academics began to debate whether the current account deficit was an appropriate target of macroeconomic policies and whether the view that the deficit was unsustainable was correct. This debate was led by John Pitchford; however, the ‘Pitchford thesis’, or ‘consenting adults’ view as it is commonly known in Australia, can be traced back to Max Corden who had expressed very similar views in his 1977 book (Corden 1977).

The Pitchford (1989b, 1989c, 1990) thesis rests on the understanding that the current account balance is the net result of investment and saving decisions that have been made by agents within the economy. If these decisions are made optimally, then any resulting current account deficit (or surplus) cannot be considered a cause for concern. After all, a deficit merely represents households deciding to consume now rather than later and firms deciding to take advantage of profitable investment opportunities in Australia. These decisions are optimal – therefore welfare maximising – and households and firms have made these decisions with every expectation that they will have the capacity to repay. The foreign investors lending the money are obviously of the same mind. The deficit, therefore, is the result of decisions between ‘consenting adults’. At the time these arguments were being put, the Australian Government was running a budget surplus and the public sector borrowing requirement was low, and therefore the current account deficit could be largely considered the outcome of private decisions.

The Pitchford thesis fundamentally countered established thinking on the current account deficit – that is, the notion that large current account deficits are always unsustainable or can ultimately impose a constraint on growth. Rather than imposing a constraint on growth, a current account deficit is a means by which advantage can be taken of profitable investment opportunities, thereby raising potential growth. Capital flows into Australia are presumably the result of foreign investors seeking high returns, benefiting both the borrowers and lenders in the process.

The key message from Pitchford and others was that there was no role for macroeconomic policies to respond to current account deficits and that current policies aimed at reducing the current account deficit might be severely misplaced. If there was a role for government at all in addressing the current account deficit, it would be to remove distortions and externalities adversely affecting decisions of private agents. Even then, the first-best solution would be to use micro-based policies to remove the identified problems at their source.^[13]

The rationale behind existing policy strategies was also challenged. The ‘twin deficits’ argument – on which the fiscal consolidation strategy was seemingly based – was convincingly refuted as it assumes that private behaviour will not change in response to changes in government behaviour (for example Argy 1990). This does not imply that fiscal consolidation is inappropriate, just that it would not necessarily reduce the current account. The argument that microeconomic reforms would necessarily lead to a reduction in the current account deficit was also disputed. Such reforms might make markets operate more efficiently, but does that mean agents would invest more or less? Save more or less? This ambiguity led to the view that microeconomic reform, while worthwhile for its own sake, should not be pursued in order to influence the current account. Otherwise, you might not undertake reforms if they are likely to lead to an increase in the current account deficit but are otherwise beneficial (Pitchford 1989a, p 11).

3.3 The Response

While many were to side with Pitchford in his thinking, other academics and policy-makers did not, particularly with regards to the ‘hands-off’ approach. Some questioned the new framework and viewed it as untested, instead suggesting that policy should be based on the more established way of thinking (see, for example, Nguyen 1990). Most arguments, however, did not question the framework but rather emphasised practical considerations (see, for example, Corden 1991).

First, it was argued that private agents are not always able to make optimal decisions. Distortions and externalities exist, which interfere with incentives and provide a rationale for policy intervention. Moore (1989) argued that there were plenty of examples in history of excessive borrowing by nations that had ended in a debt crisis. Second, an agent's decision that leads to an increase in external debt may impose costs on other borrowers in the form of higher interest rates through the imposition of a risk premium applying to the country as a whole. Third, there were risks to the economy if there was an adverse swing in sentiment of foreign investors, possibly resulting in a sharp and possibly severe adjustment process. In this case, it was preferable that some adjustment was undertaken pre-emptively through appropriate restrictive policy settings (Argy 1990).^[14]

While many of these counter arguments have valid elements, in many cases they are not concerned with the current account deficit per se, but see it as a symptom of another underlying problem. The appropriate policy response, then, is to address the underlying problem, be that overspending or the distortions and externalities themselves.^[15]

The intellectual weight of the Pitchford thesis started to be acknowledged by policy-makers by the late 1980s. In September 1989 and again in June 1990, the then Deputy Governor of the RBA, John Phillips, gave credence to the Pitchford argument stating that the balance of payments was a reflection of the ‘community's attitudes to savings, consumption, investment and debt’ (Phillips 1989, 1990), and as a result, the current account deficit was not an appropriate target of monetary policy. Instead, the appropriate role for monetary policy was controlling inflation and the RBA's stated concern that the current account deficit was unsustainable started to wane. A few years later, the Government also expressed the view that monetary policy should not be used to target the current account (see, for example, Commonwealth of Australia 1991, p 2.33).

In the early 1990s, the Australian Government acknowledged the broader implications of the Pitchford thesis, but had reservations about how well it would apply in practice, in line with many of the arguments outlined above (see, in particular, Commonwealth of Australia 1991, p 2.36).^[16] While strategies such as micro reform and fiscal consolidation were important in their own right (and for broader goals such as raising national saving), they were continually framed as strategies to address the current account deficit ‘problem’.^[17]

Likewise, the RBA did not at this time entirely accept the view that the current account deficit should not be a concern at all. It was deemed to be ‘… a medium-term problem …’, where deficits of around 5–6 per cent probably were not sustainable (Fraser 1994, 1996). Since 1996, the current account deficit has no longer featured as part of the monetary policy debate. In 2004, Glenn Stevens, the then Deputy Governor, restated the RBA's view as thus: ‘… whether the current account deficit should be a target of any policy is not obvious – it would need to be argued. But whatever one's view on that question, the current account is not, and should not, be an objective of monetary policy’ (Stevens 2004, italicised as per the original).

The dissenting voices to the Pitchford view – in both academia and policy institutions – from within Australia have now largely disappeared. If concerns are raised, they generally herald from international organisations, such as the Organisation for Economic Co-operation and Development (OECD) or the International Monetary Fund (IMF), in their assessments of the external vulnerabilities facing Australia.

3.4 External Recommendations

The IMF and the OECD have made regular assessments of the Australian economy since at least the early 1980s. Reports from the IMF have, however, only been publicly available from the mid 1990s. The OECD in the 1980s concurred with Australian authorities that Australia's current account deficit and external debt position were unsustainable, that such concerns needed to be the overriding priority of policy (OECD 1987), and recommended reducing public sector debt and improving Australia's international competitiveness (see, for example, OECD 1984, pp 50–51; also see various issues of OECD Economic Surveys for Australia for the 1980s and 1990s). With regards to the latter recommendation, the OECD pointed in particular to a need for real wage moderation and reduced trade protection. With regards to fiscal policy, the OECD acknowledged that the Australian Government had made substantial progress in reducing its deficit, but pressed for greater efforts to be made in this regard by state and local governments.

OECD concern regarding Australia's current account deficit moderated in the 1990s. In OECD (1994), the current account deficit is described as sustainable in view of current government policies, but throughout the 1990s the OECD raised concerns about the potential for high external debt to affect credit ratings and increase external risks; the latest OECD report, however, presents a more sanguine view (OECD 2006). The IMF reports from 1995 onwards describe Australia's net external debt position as sustainable and the external risks as manageable, but recommend that Australia's external debt position requires continued careful monitoring. Also, these IMF reports often attribute weight to either the narrowing or widening that had been recently observed in the current account deficit, without always an appreciation that most of these movements are part of a standard cyclical pattern around a longer-term average.

Since the time of the Asian crisis, IMF staff have stressed the potential risk from a shift in market sentiment, particularly since around one-half of Australia's foreign debt has a relatively short-term maturity. The IMF has a standard set of external vulnerability indicators that they use for a variety of countries in assessing external risks. Over time, the IMF has acknowledged the argument that the ‘one-size-fits-all’ approach fails to recognise some special factors relevant to the Australian situation, including, for example, the fact that the external debt is denominated in Australian dollars or hedged, that private balance sheets are in a strong position, and that the Australian economy has proven to be relatively resilient to large adverse domestic and external shocks, including through the operation of the flexible exchange rate regime.

Footnotes

Discussions of these and related issues include Grenville (1997), Gruen and Stevens (2000), Horne (2001), Gruen and Sayegh (2005) and Macfarlane (1999, 2006a). [10]

See Gruen and Sayegh (2005) for a discussion of Australian fiscal policy since the 1980s. [11]

This sentiment was also reflected in comments by the Treasurer, Paul Keating, in his 1988/89 Budget Speech: ‘… while the balance of payments deficit is Australia's number one economic problem, inflation remains Australia's number one economic disease’ (Keating 1988, p 4). [12]

While the Government undertook a lot of micro reforms during the 1980s, Pitchford (1989b, p 2) claimed that the relevant microeconomic policies were largely in a class that were not at that time being considered. [13]

Argy (1990, p 79), the then Director of the Economic Planning Advisory Council, suggested that this view was shared ‘by many of us in Canberra’. [14]

Responses to other arguments can be found in the many papers that constituted this debate (see, for example, Corden 1991 and Pitchford 1989c). [15]

Certainly, broader community feeling was that the deficit should be regarded as a concern, and this led to the Government initiating a formal enquiry in October 1991 into the causes and consequences of Australia's current account deficit and overseas debt (the Langmore 1991 report). [16]

Many of these issues were also raised in the government-commissioned Fitzgerald (1993) report, which outlined a strategy for improving national saving, in part to help reduce Australia's current account deficit. [17]