General Glut and Australia’s CAD
General Glut turns his attention to Australia’s current account deficit, a topic that’s also being debated in a number of threads over at Stephen Kirchner’s blog. There’s a lot to cover here, so I’ll list the main points I’m going to cover up front
* Martin Wolf makes a point I’ve also been going on about for some time, that the Anglosphere dominates the consuming and borrowing side of the global trade balance
* Although Australia and the US have similar CAD/GDP ratios, the underlying stats are very different
* The claim that Australia’s CAD is being used to finance non-dwelling investment doesn’t stack up well when you look at actual expenditures, rather than volumes derived from dubious price adjustments
To start with the Anglosphere, I’ll quote GG’s summary of Wolf
The Anglosphere — especially the US, UK and Australia — is the global engine of consumption, running huge trade deficits, even huger current account deficits, big housing bubbles, low household savings, and a dominant finance capital sector.
The United States, formerly a big net exporter, has been in deficit for twenty years or so. The deficit has now reached 5 per cent of GDP despite a continuing recession/slow recovery. The UK has mostly run deficits for the past twenty years or so, though it still has strongly positive net investment income, reflecting its century or more as the main source of world investment. Australia and New Zealand are consistent deficit countries. Canada is an apparent exception, but its surplus is entirely due to a positive balance with the US. In the context of the Anglosphere vs the rest, it’s probably best to treat Canada and the US as a unit (apologies to any Canadian readers for this, but it’s correct as an analytical device).
The shift towards large deficits for the Anglosphere as a whole is a relatively recent phenomenon, going back to the 1980s, and the last few years have seen big growth in current account deficits for most English-speaking countries. I’d offer the following explanations
* for the last twenty years as a whole, financial deregulation leading to expansion of credit and declining household savings
* for the last few years, the fact that the Anglosphere countries have enjoyed fairly strong growth fuelled by expansionary monetary policy, while the Europeans and Japanese have had weaker growth and tighter money
I don’t think much of the view that investors are attracted to the dynamism of Anglosphere economies, for the simple reason that the big growth of overseas obligations has been in fixed-interest debt rather than in direct or portfolio investment. A bondholder doesn’t care about dynamism, only about the expectation of repayment and the possibility of currency depreciation. I must admit, I find it hard to see why bondholders should not expect the $US in particular to depreciate (more) but I’ll leave that for another day.
The main analysis made by General Glut deals with the differences between Australia and the US, which he sees as being mostly in Australia’s favour. Because we’ve been in the game longer, most of our CAD consists of payments on existing debt, and our trade deficit is smaller. In addition, our trade share of GDP is larger. All this means that a return to a stable debt/GDP ratio requires a much smaller adjustment in the balance of imports and exports than for the US, where imports exceed exports by almost 50 per cent. Against this, our high level of existing debt makes us more vulnerable to an adverse shift in sentiment. Given the similar situation of the Anglosphere countries, gloom about the US could easily have a contagion effect on Australia.
Of course, there is no sign of this happening right now, and people like me have been worrying about it for years. But the dotcom bubble and the Tokyo land bubble ran on for years after it had become apparent they were unsustainable. In the absence of an obvious path to a soft landing, I can’t say I’m reassured by the fact that we haven’t crashed yet.
In looking at the sustainability or otherwise of our current account deficit, it’s important to begin with the observation that a deficit on the current account is necessarily matched by a surplus on the capital account, that is, by borrowing or investment from overseas. In trying to explain a deficit, we can look either at factors leading us to import more than we export or at factors leading overseas owners of capital to be more willing to supply debt and equity capital to Australia. Both factors are relevant in the current case. There’s plenty of evidence that low rates of interest, arising in the first instance from expansionary monetary policy, have driven household savings to record low levels and even, on some measures, into negative territory. OTOH, the ‘global savings glut’ analysis of the US deficit put forward by Ben Bernanke, focusing on the desire of Asian countries to build up their net overseas position in the wake of the Asian financial crisis, is equally relevant to Australia.
The other big question is what we are doing with the money we borrow. The ideal case for a current account deficit is one where we are attracting foreign debt or equity capital for new direct investments in the tradeable goods sector, which will, in due case, generate exports that will permit repayment of the capital invested without any requirement for adjustment elsewhere in the economy. The least appealing case is one where borrowings are used to finance current consumption, implying the need to reduce consumption in the future. An intermediate case is that where borrowing finances new investment, but is allocated to the non-traded sector, for example, residential housing.
Unfortunately, the economic statistics on all this are ambiguous. A number of commentators have pointed to the volume measures in the national accounts to say that investment is booming, and that the biggest growth area is that of machinery and equipment. However, looking at actual current expenditures, we find that capital and equipment investment is flat or declining as a share of GDP, and that the big growth area is dwelling investments. The latter view is obviously more consistent with the anecdotal evidence.
In trying to resolve this apparent paradox, basic economics tells us that, if volumes and values are moving in opposite directions. the relative prices of investment goods in the dwelling and equipment sectors must be diverging, and indeed this is the case. In the last four years the price index for machinery and equipment has fallen by 20 per cent, while the price index for investment dwellings has risen by 20 per cent, as has the index for non-dwelling construction.
The obvious explanation for the declining price of equipment is the steady improvement in the power and speed of computers, which is recorded as a reduction in price in the hedonic adjustment method used by the Australian Bureau of Statistics. In fact, this item probably explains too much. The equipment price index is falling by only 5 per cent per year, but the price index for computers is falling by about 20 per cent a year as shown in this PDF file Since computers and related equipment now account for more than 25 per cent of total equipment investment, and the amount spent on computers has been rising over time, it seems likely that the price of other machinery and equipment is rising and that the volume of investment is static or falling.
If the 20 per cent annual decline in computer prices translated into a 20 per cent increase in computer productivity (for computers of any given price), there wouldn’t be much of a problem here. But optimistic as I am about computers, I find this hard to believe. In any case, the decline in computer prices is pretty much the same everywhere in the world. There’s no way an increase in measured investment volumes arising from this source can justify Australia in running a large current account deficit, any more than any other country.
I still need to get all this organised. But I’d appreciate any comments.