Home > Economics - General > General Glut and Australia’s CAD

General Glut and Australia’s CAD

June 6th, 2005

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.

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  1. June 6th, 2005 at 23:54 | #1

    Off the top of the head, in looking at the Anglo differences, and the smaller Oz trade deficit cw the US, intuitively it seems that the two countries are on a collison course over China et al, with demand for our trade in commodites conditional upon the US continuing to absorb East Asia’s consumer exports, putting us at odds with current US pressure on China to gain protection by forcing Asian currency appreciations. In other words, is there not the potential for the US adjustment to wreck ours?

  2. abb1
    June 7th, 2005 at 02:21 | #2

    This is not about computer aided design, correct?

  3. davidm
    June 7th, 2005 at 10:16 | #3

    John, thanks for the excellent explanation. This sums up my sticking point with Stephen Kirchner:

    “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.”

    He seems determined to believe that we have borrowed to invest in machinery and equipment rather than dwellings, despite the forest of new apartment buildings in every Australian suburb.

    I am no economist, but I have more than a passing interest in the CAD and the value of the AUD. I am a software developer that exports >95% of our Australian-developed products to the US and elsewhere. We are forced to price in USD so our margins halved over the course of 2003 (with the steep rise in the AUD) and haven’t improved. I am tired of hearing about capacity constraints at ports as an explanation for our poor export performance. The reason is simple: Its the dollar stupid!

  4. Pat
    June 7th, 2005 at 10:52 | #4

    Over the term of the Howard Government, the value (in Australian dollars) of consumer goods imported has risen by 133.5%, of capital goods by 73.4%, and of intermediate goods by 48.7%. As a result, the total outlay on imports has shifted over time towards non-value creating items (i.e., consumer goods) relative to goods necessary to fuel capital accumulation.

    Obviously, if the price of capital goods was falling relative to consumption goods the story would be slightly different (the volumes argument). But I suspect this is not the case.

  5. June 7th, 2005 at 11:39 | #5

    John, you are keeping some interesting company!

    A Central Down Under

    Letter to the Editor
    By Desmond Lachman
    Posted: Monday, June 6, 2005

    The Economist
    Publication Date: June 2, 2005

    Sir–You waxed lyrical about Australia’s 15 years of continuous economic growth. However, you gloss over the fact that Australia’s external imbalances have never been larger, even at a time when international commodity prices are booming and China is expanding rapidly. You also failed to note that Australia’s housing bubble and consumer over-indebtedness make the United States look like a paragon of frugality. A more balanced view might have asked what happens to Australia when commodity prices ebb and when China’s investment bubble bursts?

    Desmond Lachman is a resident fellow at AEI.


  6. derrida derider
    June 7th, 2005 at 12:19 | #6

    One possible view is that it’s not the Anglosphere that is doing the “wrong thing”, but the stagnant non-Anglo developed countries who are saving too much for their own and others’ good. Consume, you silly bastards!

  7. James Farrell
    June 7th, 2005 at 13:04 | #7

    ‘…our high level of existing debt makes us more vulnerable to an adverse shift in sentiment.’

    And also to an adverse shift in world interest rates, let’s not forget. By my reckoning, a three percent rise in average world rates would increase our current account deficit by about one percent of GDP (at the current level of debt), to say nothing of the effect on the solvency of our debtor businesses and households.

  8. davidm
    June 7th, 2005 at 13:19 | #8

    The AEI is a right-wing think tank no? Who said right-wingers can’t get things right occasionally!

  9. James Farrell
    June 7th, 2005 at 13:38 | #9

    As I’ve noted before, there’s a distinct ‘right’ analysis of the current account, focussing on the distoting effect of welfare on household saving, and a ‘left’ one focussing on market imperfections and inadequate regulation of financial merkets. This sort of thing happens all the time, so it shouldn’t be a surprise. Left and (conservative) right critiques of US foreign policy both led to condemnation of the Iraq invasion, but for different reasons.

  10. June 8th, 2005 at 11:00 | #10

    John, I’m not (yet) convinced by your view that volumes don’t count. An important question is whether the IT investment is in the tradeable or non-tradeable sector. In fact the CAD may be better off if this investment takes place in the _non-tradeable_ sector.

    If IT investment is becoming more productive in a tradeable sector, then the international competitors will be experiencing the same productivity gains – leading to a drop in the world price for the final outputs of that sector. That is, the productivity gains will not yield as much of a export income increase as might be expected and this is not a good result for the CAD.

    On the other hand, increased productivity in a non-tradeable sector (think mobile phones) will lead to a price drop in these outputs. If the substitution elasticity is high enough then consumers will substitute towards these domestic services (retailers have argued that this is happening), reducing their demand for imports. This story is a good result for the CAD.

  11. Razor
    June 8th, 2005 at 13:57 | #11

    I still think there is too much ‘Chicken Little’ in your discussions of the CAD. If we are not investing in export creating ventures and there is a fall in the demand for our currency then there will be two outcomes – Australians won’t be able to afford to buy imported goods leading to substitution for domestic goods, and a fall in the value of the AUD means our exporters become more competitive. I had a farmer sitting in front of me last week complaining about the strong AUD because it was hardly worth shearing his sheep at the current wool/AUD price. (And this in the face of some of the best Autumn rains in at least a decade over here in WA).

    I also find the Unions’ push for protection highly hypocritical – it is ggod for us to export Australian goods, but not good to import from other countries – what a bunch of tossers.

  12. Katz
    June 8th, 2005 at 14:18 | #12

    My attitude coincides with Razor’s.

    As a citizen I face no debt risks because state and federal governments are running large surpluses.

    Private debt, which is huge and growing, is widely distributed. If my next door neighbour is declared bankrupt owing to an inability to service her debts, it has no impact at all upon my financial well-being.

    Driving around the outskirts of Melbourne this morning I saw my first real estate realisation auction noticeboard since the early 1990s. The feckless and the unfortunate, it appears, will face growing difficulties servicing their mounting debts. Meanwhile, the cashed-up can look forward to fat pickings.

  13. Razor
    June 8th, 2005 at 14:41 | #13

    Katz – are you yanking my chain? I know we agree on AFL, but isn’t this going a bit far?

    A question for JQ – if you are going to treat Canada as part of the US, what stops you just amalgamating any countries you like in order to fit in with your analysis. Should Australia and NZ be lumped together? Why not Australia, PNG and Indonesia? What happens when we start running surpluses, while the rest of the “Anglosphere” stays in deficit – then will we be seen as part of the US in order to maintain the “Anglosphere’s” naugthy deficits.

  14. Katz
    June 8th, 2005 at 14:50 | #14

    I was a sincere as I could be Razor.

    As an anarcho-libertarian I love human autonomy.

    I like social democrats because they do a lot of grunt work maintaining institutions that protect me from national, sexual and religious authoritarianism.

    I wish social democrats didn’t have to exist. But they do have to exist because the world is full of right wing monsters who want to destroy my liberty.

  15. jquiggin
    June 8th, 2005 at 15:00 | #15

    Razor, it would be perfectly reasonable to aggregate Australia and NZ since the two economies are highly integrated, and similar in most respects. For the same reasons, it wouldn’t make sense to aggregate Australia and Indonesia.

    PNG is a bit of a special case – an analysis of the PNG economy that didn’t take account of Australia’s role would be unsatisfactory, but it’s not sensible to simply aggregate the two.

    Bruce, I don’t think your argument works. You rely on the fact that non-traded goods can substitute in demand for other countries’ exports. But our import-competing products are a closer substitute.

  16. June 8th, 2005 at 17:21 | #16

    I also find the Unions’ push for protection highly hypocritical – it is ggod for us to export Australian goods, but not good to import from other countries – what a bunch of tossers.

    A somewhat gratuitous swipe Razor. Remind me now, who exactly was PM when trade barriers were lowered? And what role exactly did the ACTU take at the time?

    In fact, it could be argued that unions have absorbed a lot of punishment down on the ground for supporting former union leader Hawke’s trade initiatives. Even the policy of the AMWU today is not able to be characterised in the way you have thrown off.

    So, who is the real tosser?

  17. Razor
    June 8th, 2005 at 19:52 | #17

    cs – I fully agree that it was Hawke and Keating who made significant economic reforms that have under-pinned Australia’s ongoing economic performance. The wets in the Liberal party and the economic nationalist/hansonite types on the far right certainly aren’t a great advertisement for ongoing economic reform. In terms of the politics of reform, an ALP government easily can get reforms, such as floating the AUD, through a Coalition dominated Senate, a Coalition Government can’t do the same with an ALP dominated Senate.

    Areas that still need improvement – all tarrifs and sin taxes on cars should be removed – the only reason we keep them is political, nothing more.

    cs – due to my lovely bride’s family I regularly socialize with CFMEU and Miscos Officials and ALP politicians and staffers. I even donated to and worked on the campaign for a State ALP Cabinet Minister ie the father-in-law (backed a wineer there!). As these people know that I am a gentleman of the highest moral standing they know that anything they say in front of me goes no further. This gives me an interesting insight into the minds of both ALP and Union members. For instance I was suprised at the level of animosity between the CFMEU and, I think, the AWU – they hate each other more than the Coalition. I also know that they yearn for the return of protectionism and things like the Government Railways workshops to train apprentices and get union members. It gets a bit willing after the 2nd bottle of red occaisionaly, but they love a good stoush, as much as I do.

  18. alx
    June 8th, 2005 at 21:36 | #18

    Branches of the CFMEU hate other branches of the CFMEU too. Any time there’s two people involved in anything, they hate each other, and the capacity of hate grows exponentially with population & power.

  19. June 8th, 2005 at 22:58 | #19

    Cheers Razor.

    I will add that you ain’t seen nothing. Try working for a coalition government (yes, I’ve done two). Always figured it was the ideology of individualism fully unleashed. Never seen so much intense personal hate. It’s tribal in the alp, and so I was stunned to discover that conservative politicians really do much more personally hate each other.

  20. Razor
    June 8th, 2005 at 23:38 | #20

    cs – you ain’t wrong there – you should see the idiots we’ve got running the factions in the WA Liberal party. They are the main reason I’m not a Liberal member, apart from the wife probably not speaking to me for a month, and their position on trading hours, daylight savings, one-vote-one-value, age of consent. . .I could go on.

    JQ – thanks for the prompt answer. I have always supported CER with NZ but don’t agree on having one currency because of the problems as demostrated by the Euro in terms of differing government fiscal policies, let alone the removal of monetary policy as an effective tool.

  21. kyangadac
    June 9th, 2005 at 00:52 | #21

    Umm… I wonder if the reason for the conflicting opinions about whether the CAD is due to ‘investment’ or ‘consumption’ may be caused by the ineadequacies of some of the categories being used. Computers and computer operated machinery might be purchased as ‘home products’ (consider knitting machines) but be used for businesses. Mobile phones are (anecdotally) said to have had a significant impact on tradespeople’s productivity.

    Another issue that may confuse the tea leaves may be the impact of the internet on some kinds of business being able to partially complete jobs overseas – in W.A. for instance, prospective writers and publishers are as likely to use a printer in Singapore or a web desginer in India, as one locally (Obviously this increases the CAD:-( and, of course, Indian telecentres are a notorious place for the likes of Optus et al. to waste money.

    Lastly the price of machinery has been falling in real terms because of the impact of Chinese and third world production of tools in particular. Last year, WA Salvage had angle grinders on special for $20. The considered opinon of the Albany chippies and sparkies guild was that they ‘had to be prison labour’ to be able to sell them that cheap. But they worked OK and who looks a gift horse in the mouth…

  22. jquiggin
    June 9th, 2005 at 06:57 | #22

    You’re quite right about the crossover between investment and consumption, kyangadac, though you could call home computers and similar “household capital”, which would get around the problem.

    Another important point is that, when computers are important, you need to look at net rather than gross investment as computers depreciate so fast.

  23. Stephen
    June 9th, 2005 at 13:52 | #23

    “Private debt, which is huge and growing, is widely distributed. If my next door neighbour is declared bankrupt owing to an inability to service her debts, it has no impact at all upon my financial well-being.”

    I’m not economist, but I don’t think this is generally true. If a substantial portion of the population gets into trouble because of excessive debt and cut back their expenditure anyone who’s income is not almost entirely sourced from overseas is in trouble.

    For example I have saved money every year for a decade, and if a lot of people do run into trouble with their debt I may well benefit, as house prices will tumble and I will finally be able to buy. Unless that is, quite a few of them decide that before (or as well as) selling their houses they also will cut their subscriptions to magazines. Of course I am sure the readership of the magazines I work for are much smarter than the average Australian and haven’t got the same debt problems – but if by some chance they have and our sales fall 20%, well I am out of a job and my savings will be poor consolation.

    I’ve tried to be as fiscally responsible as possible, but “no man is an island” and if the economy goes belly up things are going to be grim for me, and for most others in my position.

  24. James Farrell
    June 9th, 2005 at 14:15 | #24

    Quite right, Stephen. No man’s an island is called market externalities, in the jargon. If foreigners suddenly decide to stop lending to us, and sell their shares in our companies, the dollar depreciates sharply. If you have a loan denominated in foreign currency you may be unable to service it and become insolvent. If you produce any kind of non-tradeable good and are dependent on tradable (imported or import-competing) components or materials, you may suddenly become unprofitable and go out of business. Real wages will fall due to the higher CPI, putting pressure on money wages and non-tradables prices. The RBA will respond to both the depreciation and the inflation by raising interest rates, which will reduce demand for both consumer and producer goods. All of these ramifications will cause lay-offs, and unemployment will produce its own multiplier effects. Everyone will be hurt, including the virtuous. Ask the Thais. Of course if we all become miners overnight, we might be OK, but instanatneous adjustment is more common in textbooks than in the real world.

  25. Katz
    June 9th, 2005 at 15:06 | #25

    Stephen, the phenomenon you are describing is debt deflation. And, of course, when an economy exhibits debt deflation, it will affect many non-debtors as well as debtors.

    My statement about “no-impact” is indeed too sweeping. It was designed as a shorthand and is inaccurately phrased.

    Non-debtors, or persons who are able to service their debts during periods of debt deflation cannot axpect to carry on as if nothing has happened. They will have to adjust their behaviour or suffer consequences. This is a truism that applies universally, not only during periods of debt deflation.

    During debt deflation, as a magazine seller you may have to reallocate your resources as well as you can to take advantage of changes in patterns of demand and in changes in asset prices. This my involve cessation of your trade in magazines. And this may be psychically threatening.

    But assuming that your freedom of financial choice has not been nullified by debt deflation, then there are financially beneficial choices open to you regardless of how severe the episode of debt deflation may be.

    On the other hand, financial causes have non-financial effects, such as the effects of hyperinflation and debt deflation on the fate of the Weimar Republic between 1923 and 1933.

  26. gordon
    June 10th, 2005 at 14:39 | #26

    Interesting that Prof. Quiggin thinks that “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…”.

    Back in March (post “Back to the 1950s”) I said I was “…Still trying to find a 4-digit ANZSIC breakdown of manufacturing investment, preferably with a long-term timeline…”. I wonder if Prof Quiggin has found such a breakdown at last?? If so, it would be nice to know where all the investment money actually went. Bet it wasn’t into ETM tradeables.

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