Looking over the edge

Another big blowout in the current account, the trade account and foreign debt. Costello is blaming it all on the appreciation of the dollar but the housing boom on which the government won re-election is at least as much to blame. Here’s my take, from the Fin a couple of weeks ago.

Although they are not particularly tightly linked with respect to trade and capital flows, the economies of English-speaking countries seem to share common characteristics, though not the same characteristics over time. In the 1970s, it was common to see reference to the ‘English disease’ referring to high levels of strike activity and cost-push inflation. More recently, most of the comparisons have been favourable, comparing dynamic English-speaking economies, with sclerotic Europe and chronically depressed Japan.

There is, however, a cloud on the horizon. With the exception of Canada, all the major English-speaking countries are running large trade and current account deficits, and most have done so consistently for a number of years. A deficit on the current account implies an equal and opposite surplus on the capital account, which in turn corresponds to an excess of national investment over national saving. A gap between investment and saving might arise from high imports of capital goods, reflecting the existence of more opportunities for profitable investment. The output produced by these investments would be expected to boost future exports, returning the trade balance to surplus, and thereby permitting the servicing of the debt created in the present deficit phase.

An important point, not sufficiently appreciated at present is that, while current account deficits may be sustained indefinitely, imports and exports of goods and services must balance out in the long run. Assuming, as is generally the case, that the rate of interest on foreign debt exceeds the nominal growth rate of the economy, consistent trade deficits imply explosive growth in the ratio of debt to GDP, which cannot be sustained indefinitely.

Those who regard the current account deficit as not being a matter of serious concern have commonly asserted, or assumed, that this is the case. In fact, however, business investment levels have not been particularly high. In Australia, a good deal of investment has gone into the housing sector, which does not produce tradeable outputs that can be used to service debt. Exports of manufactured goods have actually been declining in recent years.

The crucial fact explaining the large external deficits of the English-speaking countries is that all have experienced rapidly declining national savings, primarily as a result of declining household savings. Australia is in the almost unparalleled situation of having negative household savings. In the United States, household savings are a little above zero, but are cancelled out by large and growing government budget deficits.

The position of the US is bolstered by the fact that it is the world’s largest financial centre and the $US is a reserve currency. In fact, it’s hard to imagine that any other country could sustain such massive imbalances without running into a financial crisis.

The possession of a reserve currency is something of a double-edged sword, however. A shift from a dollar-based global economy to one in which either the euro or some sort of composite basket played the role of reserve currency would be hugely disruptive. Although the pain would be felt globally, the US would inevitably be most severely affected and the adjustment could take many years. Britain’s decades of malaise in the 20th century were in part an aftershock from the decline of the pound.

The other problem with possession of a reserve currency is that it reduces the pressure to resolve imbalances. Although President Bush has promised to cut the deficit in half, no one seriously believes that this goal can be achieved with his current policies. And the US Congress has passed a string of bills laden with pork barrel spending and targeted tax concessions, with more to come. The longer adjustment is delayed, the more painful it is likely to be.

Australia is, in important respects, in a stronger position than the US. Australian governments are generally running small surpluses, and the government balance sheet is strong, with substantial positive net worth for the government sector as a whole. Since our negative net saving is due primarily to borrowing against increased values, a soft landing for the housing sector would presumably imply a gradual increase in saving.

As the ‘Asian tigers’ learned, however, it’s easy for markets to change their views of an entire group of countries in a very short time. If the current relaxed view of US trade and current account deficits were to change, it is likely that all the English-speaking countries would face exchange rate pressure and a sharp increase in interest rates. Australia is not well-prepared for such a shock.

50 thoughts on “Looking over the edge

  1. Not likely Ray. The current major restraint on our export performance is lack of infrastructure to export the commodities the world wants. Demand is strong and looks like remaining so. Hence, no slow down. As much as some people don’t like it, our comparative advantage in this world is in diggin up raw resources and shipping them out.

  2. For all the doomsayers, our current experience is nothing new.
    (1) The current account deficit (CAD) is cyclical – it is high when the economy is growing strongly because this is when imports are particularly strong and there is some diversion of output to satisfy domestic demand rather than exports. Currently the CAD is at a cyclical peak.
    (2) This is not the highest peak CAD as a percentage of GDP – it was much higher in the 1980s and was higher at various times during the mid to late 1990s when the economy was growing strongly.
    (3) Typically, as the economy slows the current account deficit improves. With housing investment at its peak and signs of slowing in growth in retail sales, there is a reasonable expectation that growth in the Australian economy will slow over the next year or so. The current account deficit will then improve.
    (4) Interestingly, the markets reacted yesterday to news of slowing in growth by marking down the $A, when slower growth is likely to improve the CAD.
    (4)As John Humphries argues, Australia is still a good place to invest. Contrary to what has been said in some earlier posts, the level of investment in machinery and equipment and non-dwelling construction has been quite healthy in the last few years.
    (5)Does it matter if household savings is at an all time low if Government savings are at an all time high? The two are balancing each ther out. One could argue that the shift from public to private provision of health, education and other services might have at least some influence on this shift between public and private savings.

  3. Given the trends in business financing I outlined above, it is probably high time the ABS surveyed business proprietors to ascertain just how much business investment is really disguised as consumer debt. Economists might be in for a pleasant surprise, which probably shouldn’t really be a surprise, given the lowest unemployment rate for a generation.

    If you think ABS annual business surveys are of any real use in this regard, you’ve got to be joking. I always pull out last years Company return, as I’ve never got this years ready by Sept and attempt to fit some sort of coherent figures into their blessed forms, without it appearing not to add up. To properly survey business financing the ABS would need to use face to face surveys, but that’s probably cost prohibitive. Might be worth a once-off though, to get the big picture on the true state of business investment.

  4. The optimistic analyses above all ignore – as far as I can see – John’s main point, that the trade balance can’t be negative forever. It has averaged about minus 1 percent of GDP for the last forty years, and has been positive very rarely. This pattern is quite unique in the OECD and if it continues indefinitely, then at some point we’re in a debt trap. One can make this point witout insisting that disaster is just around the corner, and no one in the above discussion is doing that.

    And as John also points out, a high rate of fixed capital accumulation is only an excuse, as it were, for a big debt, if that investment is in sectors producing tradable goods that will ultimately be used repay the debt. Australia does have a reasonably high investment rate – higher than the UK or the US, for example – but the proportion devoted to housing construction is much higher. This means that investment in plant and equipment, despite having risen in the last few years, is lower (in fact the two are about equal, at around 6-7 percent of GDP as I recall). And apart from a few flea-infested illegal backpacker flats in Bondi, there’s no way housing can be interpreted as a tradable good. The fact that people (including foreigners) are prepared to pay so much for real estate indicates, when all’s said and done, precisely that resources are expected to continue flowing toward non-traded goods and services, including accommodation.

  5. Responding further to Mark, I don’t think the late 80s are a very appealing example for CAD optimists. The subsequent experience, including one of the deepest recessions in Australian history, certainly shows that current account deficits get stabilised in the end, but not necessarily in a comfortable fashion.

    The big question is whether this was entirely the fault of misconceived monetary policies or whether large imbalances always carry a substantial risk of painful adjustment like this. The successful management of the banana republic crisis in 1996 was taken as evidence that the policies adopted then, a short sharp shock in interest rates would work again next time. Similarly the macro policy successes of the mid-90s have produced a level of hubris which will now be tested (to be fair, the Reserve Bank has been consistently more concerned about risks to stability than has the government).

  6. Still working it out — I know how capital is allocated, and still see no reason for believing it is being allocated worse than how you would allocate it.

    Consumption is not waste. Indeed… there would be little point investing and producing and never consuming. We do not consume for the purpose of making sure people can produce. We produce so that people can consume. There is necessarily nothing wrong with borrowing to consume.

    You’re correct that not all borrowed money will increase GDP. But there is more to life than GDP. If it was, then we would all be happier if we worked 22 hour days and never consumed. I know few people who believe that.

  7. That should be: there is not necessarily anything wrong with borrowing to consume.

    Also, if there is a capital misallocation problem — then we should worry about that and not continue the myth of the ever-evil CAD.

    I wonder if this makes me a CAD-sceptic? 🙂

  8. A lot of consumption is waste, but you’re right in pointing out that the aim is to maximise utility, not output, over time.

    As for your second point, the capital misallocation problem and the CAD problem are just two ways of describing the same thing. The CAD is a problem if capital is misallocated, and the pessimists are saying that capital is indeed misallocated. To respond by invoking the invisible hand is just empty sloganeering.

  9. I was told this was the worst deficit on record.
    At least in the 80’s we had the excuse of a the terms of trade falling like a WMD however we now have the strongest Terms of trade in 30 years.
    not something I would normally associate with a record current account deficit.

    I must say talk of all this productive investment reminds my of the old 80’s days when the same reasons were given.

  10. John Humphreys,

    I agree with both the points that you make

    there is not necessarily anything wrong with borrowing to consume

    if there is a capital misallocation problem — then we should worry about that and not continue the myth of the ever-evil CAD.

    I feel that there has been a capital misallocation, mainly because of the housing boom. Basically my point is that we are not investing productively enough to justify our high CAD, and the simple evidence of this is as John Quiggin points out “that the rate of interest on foreign debt exceeds the nominal growth rate of the economy”. If we were growing rapidly I would seen no problem with the high CAD. It would mean we are able to afford it.

    In other words, the return we are getting on our investments (our rate of growth) is less than the interest we have to pay on the money we borrowed (the CAD) to make those investments. The difference will have to come from somewhere.

    The analogy is borrowing $200k to buy a property at 7% and getting a total yield (rent + capital growth) of 5% and then constantly increasing the size of the loan to cover the shortfall. At some point it becomes unsustainable.

  11. I can’t see that it is valid to look at the debt issue without also looking at the asset question. This also applies to Jeremiah Quiggin’s comment in his initial post “while current account deficits may be sustained indefinitely, imports and exports of goods and services must balance out in the long run”. If the excess of imports over exports results in the accumulation of an equivalent value of assets, surely the books are balanced?

  12. John

    All I was saying was that CADs are cyclical and so while we are at a peak in the current CAD cycle, the economy will slow and the CAD will improve – a fairly obvious point, I agree, but seemiongly overlooked by other commenters. Over the last 45 years the average for the CAD has been a 3.5 per cent deficit. When growth is above average the CAD is higher, when it is below average it is lower.

    The late 1980s was driven by strong investment in both dwellings and office blocks. The subsequent slowdown was an extreme example. It would have happened anyway but was then exacerbated by draconian and, in my view, misguided monetary policy. Since then we have had successive peaks and troughs in the CAD (with a 3.5 per cent average) primarily associated with peaks and troughs in the dwelling cycle. However, in the current cycle while dwelling invesmtent is extremely strong machinery and equipment investment is also at an all time high. This should make some of the pessimists less concerned.

    To summarise, we should not be so worried whether the current level of the CAD is sustainable (it is not) but whether the average over the economic cycle is sustainable (echos of the Federal Government’s sustainable fiscal policy mantra).

  13. Alex, a couple of points of rhetorical advice.
    (1) Don’t mix serious requests for clarification with sarcastic epithets
    (2) The term ‘surely’, usually indicates ‘I’m not sure but I want this to be right’.

    Coming to substance, your claim is either tautologically true, but irrelevant, if you are deriving asset values as the present value of the flow of services they generate, or relevant and false, if you ae valuing assets at cost.

  14. Yikes! I bet I use ‘surely’ too much. Better attend to that. I wish Word would challenge one on such things, instead of complaining about the passive voice in situations where it’s obvious to anyone but a machine that the active is unworkable.

  15. Sorry, JQ, wasn’t intending to cause offence, just picking up on the pessimistic tone of your post. I’d appreciate it if you could elaborate slightly more on your comments. Particularly as to why what I said is “tautologically true, but irrelevant”.

  16. BTW, on an issue slightly related to this thread, there’s a theory (I believe associated with Schumpeter) that one of the weaknesses of capitalism is that it is prone to overproduction and underconsumption, which gives rise to periodic recessions. Interested to hear your comments on this, JQ. If you agree with this thesis (or even if you don’t) I wonder if you’d like to comment on the proposition that the current consumption orgy by Australia and the US in particular may be a good thing because it counterbalances the underconsumption/overproduction of a number of other economies.

  17. I just found out that again costeelo beats Keating and this current account deficit as a % of GDP is larger then in the bananna republic days or in the days it casued Cozzy anger!

    Mark,
    Yes it is cyclical ( it used to be called a restraain on growth when I was young) but why does the economy slow after this ?

  18. Homer

    Don’t quite understand your point/question. The cyclical behaviour of the CAD coincides with the cyclical behaviour of housing investment. So because housing investment is at a cyclical peak, we can expect that it will begin to decline and the CAD will improve.

  19. I’ll agree with a lot of the comments on here regarding unproductive consumption – I still can’t believe how many people have bought $4,000 plasma TVs. But if it makes people happy, then why shouldn’t they?

    Firms presumably know that they’ll need to produce goods/services in the future, so they must have been investing in capital; I doubt the entire productive side of the economy is expecting just to use up existing capital stock and then go broke. A *lot* of investment has been happening.

    Just on a side note, Razor mentioned that our comparative advantage is digging stuff up. While true, I wonder if a lot of recent investment hasn’t been in human capital? Certainly a lot of investment done through my own business and that of the firm I work for (to supplement my income) has been in skills and technology, which have a tendency to (1) increase consumption and (2) exaggerate the CAD.

  20. “In fact, however, business investment levels have not been particularly high. In Australia, a good deal of investment has gone into the housing sector, which does not produce tradeable outputs that can be used to service debt. Exports of manufactured goods have actually been declining in recent years.”

    That concurs with what i thought was the case but ive been scratching my head since Alan Kohler wrote in the SMH last week:

    “The current account deficit is 6 per cent of GDP because there is an
    extraordinary investment boom going on. As HSBC’s John Edwards points out,
    investment is a record 25 per cent of GDP, domestic savings are steady at 19
    per cent and the difference (6 per cent) comes from offshore. Edwards says
    Australia’s investment boom is almost as big as China’s (proportionately) –
    the greatest in 40 years, and it’s why we have a high current account
    deficit despite very good terms of trade.”

    Huh? Last time i looked at the RBA chartpack business investment was around 12% which is around the long term norm except for recessions & the savings rate had fallen below zero. Or has Kohler included housing investment in the numbers?

    Kohler also refers to a double counting problem with housing expenditure that technically eludes me at the moment? I came here as a potential source of explanation?

  21. thersites, the difficulty is that a lot of small to medium businesses are now required by the banks to use their homes as collateral when borrowing for business purposes. Thus a good deal of what is actually borrowing for investment gets counted in official statistics as borrowing for housing.

  22. Alex

    I would be suprised if this miscounting of business investment were the case. Even if homes were being used as collateral, the statistics would be based on the purpose of the loan.

  23. Thersites, Kohler has included dwelling investment in the numbers, and his whole position is based on the premise that current house values are sustainable.

    The double counting problem refers to the fact that maintenance expenditure on housing (and other capital goods) is treated as a current cost rather than an investment. If I understand correctly, substantial renovations are treated as investment. All this is standard, and doesn’t go far to allay concern about a negative savings rate.

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