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The Australian economy and its current account deficit
Gerard Jackson
The current account deficit is about 6 per cent of GDP, and it would be much bigger if it were not for the increase in demand for commodities. The real question is whether deficits matter. They don’t, in themselves. However, a deficit can be the product of an inflationary monetary policy. After all, those surplus dollars have to go somewhere.
Some commentators argue that because Australians apparently rely on debt to a considerable degree to bolster their standard of living the country must suffer a higher level of foreign ownership of industry. This then leads to the conclusion that we must protect our industry from subsidised exports.
This argument obviously assumes that free trade is the cause of the deficit. This is appalling economic nonsense. Trade occurs because of differences in prices. This observation should be the starting point for any argument about the flow of goods and services. So what we need to do is examine those forces that influence the prices of exports and imports.
In a free market where money stocks and therefore currencies are stable exchanges rate will be stable. The key is money supply. Once any country begins to expand its money stock while others remain constant there will be a downward pressure on the exchange rate. In plain English, the inflating country will find that its currency will depreciate against other currencies.
When the exchange rate is falling imports become more expensive and exports cheaper. In these circumstance changes in the money supply have also brought about an unfavourable change in the terms of trade. Now this assumes that the exchange rate is allowed to freely float. However, if a country tries to maintain an overvalued currency its exports will decline and imports will increase.
But imports must be paid for. Although it is true that exports are ultimately the price of imports money is the intermediary through which this process is accomplished. But where the currency is overvalued payments must come through the capital account. In other words, borrowing.
So long as the currency remains overvalued the country will continue to accumulate a foreign debt. This is has happened to Australia whose foreign debt stood at $354 billion, about 50 per cent of GDP, in December 2002. It is now about 60 per cent of GDP.
Therefore the problem is not free trade, subsidised imports or and an “insatiable rise in consumer spending”, it is a loose monetary policy. From February 1996 to September 2005 M1 increased by 112 per cent while the credit component rose by 122 per cent.
(Although a world of rapidly changing money supplies and severe political uncertainty complicates the situation it would still not halt the fundamental economic forces at work).
Those who focus on consumer spending and debt never stop to ask where this debt is coming from. They would never stop to ponder how debt can actually exceed what was saved. The answer, once again, is credit expansion.
The central bank has been keeping interest rates artificially low which has let the banking system recklessly expand credit which in turn fuelled the housing boom, domestic borrowing and rising imports. But nowhere in our media does one see any evidence that “money matters”.
What we get are comments such as “the lion’s share of the current account deficit is net investment income rather than the trade deficit” and that nearly all of the foreign debt is now private. It completely eludes these commentators that there is a monetary link here.
The first thing to note is that Australia imports a great many of its capital goods. This means that when the Reserve Bank triggers a credit boom demand for these goods rises which also stimulates foreign borrowing. In the meantime, foreigners can use their newly acquired dollars to buy Australian assets and repatriate the profits.
Not only does monetary expansion distort the pattern of domestic production it also distorts the pattern of international trade. The possibility emerges that by changing demand conditions loose monetary policies undermine the legitimacy of the theory of comparative advantage causing some lines of production to unnecessarily shift their operations offshore.
I don’t want to go into the debate that Robert Torrens’ conflicted views on comparative advantage and changing demand conditions gave rise to in the 1840s. I just want to stress that in his Three Lectures on Commerce and one on Absenteeism (1835) the very remarkable Mountifort Longfield drew attention to the possibility that a change in the pattern of spending could bring about an unfavourable change in the structure of investment.
Longfield pointed out that if absentee landlords spent their rents on buying French dresses and lace for their lady friends instead of investing in their Irish farms this could alter the factorial terms of trade for Ireland. A little economic reasoning indicates that a loose monetary policy could have the same effect by artificially stimulating the demand for foreign consumption goods. In 1970 Samuel Brittan, an economics writer for the Financial Times, drew attention to this possibility.
Unfortunately the intellectual situation is so bad in Australia that there is not a single politician in the country who is aware of this line of thinking. For this we can thank the narrow-mindedness of our establishment rightwing.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 28 November 2005