2006-01-10

Current Account Problems

Today Australia recorded yet another excessively large trade deficit. Some people are worried. Others are not so concerned. I'm one of those who are worried.

To explain - the trade deficit is essentially the gap between how much Australia exports and how much it imports. In this particular case, Australia has exported $15.1 billion worth of goods and services, and imported $17.6 billion worth of goods and services.

When you add the trade balance to the net amount of money entering and leaving Australia due to investments, you get the current account.

Let me put it simply:

Current Account = (Difference between $ exported and $ imported) + (Difference between $ received from overseas investments and $ paid in interest to overseas investors).

According to the ABS, the current account last quarter was $15.207 billion, or around 6.3% of Australia's GDP. When you take the total amount of money we owe to foreign investors, minus the amount owed to us from overseas investments, the figure is $449.696 billion, or around 49.5% of Australia's GDP. And that last figure, remember, is net. The gross figure is around 80.8% of GDP.

Of course, all these numbers and statistics may not mean very much at all to anyone. For whatever reason, one group of economists are unworried at these sorts of figures. They are, after all, the result of the market acting in its best interests - if the market is causing this deficit, then why are we worried?

We need to remember that whenever the Current Account is in deficit, it means that we have borrowed money from overseas to cover the shortfall of money. In this month's case, the $2.5 billion gap was covered by money we - government, businesses, households - have borrowed from overseas investors.

Let me make it even simpler. Let's say your weekly income is $1000, but your weekly expenditure is $1100. Where do you get the extra $100 from? You borrow it - you probably put it on your credit card.

We also need to remember that one nation's deficit is another nation's surplus. If our economy consisted of two nations, and nation A had a current account deficit of $10 billion, then nation B would have a current account surplus of $10 billion. This is where basic accounting comes in - it all balances out.

The problem occurs when a current account deficit is "structural" rather than "cyclical". Deficits and Surpluses occur all the time, but when one nation is perpetually in deficit, then problems begin to arise.

A good example of this recently was Argentina. With growing deficits and net debt skyrocketing, the market began to get "jittery", and the Peso was forcefully devalued to cope. The collapse of the Argentinian Peso caused a major recession.

So can it happen here in Australia? Absolutely... but probably not as badly.

Before I explain this further, I need to use another example of how it all works.

Let's go back to your spendthriftiness - how you earn $1000 per week but spend $1100 per week. If you're running the deficit on a credit card, and if you continue to run a $100 deficit week by week, eventually you're going to owe big money. More than that, there is also interest repayments to consider. Your credit card company does not exist to make you happy, it exists to make money, and as your debt grows, so do your interest repayments.

So what happens? Well, at some point, you're going to find it difficult to pay the interest. What began as a $1100 per week spending habit is now running at $1200 per week when you add the interest charges to your spending. So what do you do? You have three choices - either increase your income, decrease your spending, or borrow more money to cover the extra charges. Let's say you choose option #3 and convince your credit card company that you're okay to pay them back.

Time goes by, and now you're paying back even more money. Interest charges are now forcing you to spend $1500 per week. But at the same time you don't want to decrease your quality of life by reducing your spending, so you go to your parents and get a loan to pay off the credit cards. Problem solved.

Well, actually no. You have to pay your parents back, and you're still spending more than you earn, which means that the credit card debt you've paid off is building again. You convince your parents that they'll get their money sooner or later, but could they wait a while longer for your first payment. You continue to spend and borrow until you're in the same position you were in before with the credit card company.

Let's speed things up a bit and assume that you are able to continue getting lines of credit from family and friends until you end up owing them a lot of money. Finally you don't have any friends to borrow money from, and the credit card company is threatening to cancel your card. So, in a moment of desperation, you borrow a susbstantial sum from a high-interest finance company to pay off the credit card, although they do refuse to pay off your family and friends.

But the interest repayments to the finance company begin to kill you. Eventually your credit card is maxed out again and both the finance company and credit card company are threatening legal action. Moreover, friends and family are screaming for you to pay back what you owe.

Eventually you are declared bankrupt. The credit card company and finance company take your worldly possessions, which were not enough to pay the debt, and you admit to your family and friends that you will be unable to pay them the money you owe. Everyone loses.

So there's the story of what happens if you if you remain spendthrift. Sadly, the same story can be applied to nation-states and their current account deficits.

If Australia were you as a spendthrift, then it would be earning $1000 per week and spending $1165 per week after today's announcement. Moreover, the amount of money sitting on Australia's credit card would be $495.

I think that one of the greatest lessons we learn from economics is balance. $1 spent is $1 gained; $1 saved is $1 borrowed. There is nothing wrong with Australia running a current account deficit per se, but when the deficit is structural - that is, an ongoing situation - then a problem emerges. Eventually things must go back into balance, and the sooner they balance out the better. Conversely, the longer the problem remains, the worse the reversal will be when it happens.

What will exactly happen when things go back into balance? The pain will be felt in the value of the Australian currency - it will devalue in relation to other international currencies. This devaluation will push up inflation and the Reserve Bank will be forced to raise interest rates, which will, in turn, revalue the Aussie dollar. Unfortunately, the higher interest rates will choke off demand, leading to a recession and unemployment.

Think of what you would do as a spendthrift when you realise that you're heading into trouble. You'd have to carefully examine your finances and cut your spending - and use the money left over to not just to pay off the interest, but also the principal of the money you owe. Essentially what you would be doing is cutting your consumption.

Now take that into the macro and apply it to Australia - the increased interest rates choking off demand is essentially the same as you cutting your spending.

Given that this is going to happen, it is better to force it to occur as soon as possible rather than wait for the market to inflict greater pain. If I was Prime Minister, what would I do?

The answer is simple - convince the Reserve Bank of Australia to tighten monetary policy and raise interest rates. The rise in interest rates will choke off demand, which means that Australians will be buying less goods and services overall, which will, in turn, lead to a decrease in the balance of trade. Eventually, Australia would have a trade surplus and, over time, a current account surplus.

This is one reason why I advocate Zero Inflation Monetary Policy.

From the Osostrian School

© 2006 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/


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8 comments:

CraigS said...

Thanks for your thoughts Neil. But your cure may be as bad as the disease. Weaker demand means less jobs, less economic growth - possible recession. These are the very things you are trying to avoid with tighter monetary policy.

Another way to look at it is to realise that a current account deficit represents a capital investment into Australia from overseas. If the capital investment is being spent on wealth generating assets, it should not be an issue...

CraigS said...

The other issue is that raising interest rates tends to also increase the value of the currency, which exacerbates the problem.

I'm not convinced that a high CAD is a problem, but if it is, the only way to address it is a controlled devaluation of the currency...

Dave Lankshear said...

CAD shmad.

I mean, I'm trying to fix my mortgage interest rates anyway, and thanks for the heads up on a possible pre-peak interest rate move. But really, CAD? There are bigger things to write about... like Robert Hirsch of the Hirsch report fame going a bit "doomer".

Robert Hirsch on peak oil: "This problem is truly frightening. This problem is like nothing that I have ever seen in my lifetime, and the more you think about it and the more you look at the numbers, the more uneasy any observer gets. It's so easy to sound alarmist, and I fear that part of what I'm saying may sound alarmist, but there simply is no question that the risks here are beyond anything that any of us have ever dealt with. And the risks to our economies and our civilization are enormous."

Hirsch is not just talking about recession anymore, but risks to our civilization. If anyone is interested, try listening to the GPM interview here

Hey Neil, why not another piece on why credible scientists risk their reputations by going "Doomer" on us? Remember, Hirsch led a team of scientists commissioned by the US DOE to investigate peak oil (and no doubt make it "go away".) Hirsch sounds like he is getting more anxious with each year of government inaction. He did submit his groundbreaking report about a year ago now.

Dave Lankshear said...

Sorry, that link thing did not work, it's at www.globalpublicmedia.com... a few interviews down now.

www.globalpublicmedia.com/interviews/615

One Salient Oversight said...

a controlled devaluation of the currency will lead to inflation, which leads to higher interest rates. Essentially you're saying the same thing as I am.

If the capital investment is being spent on wealth generating assets, it should not be an issue...

I don't think it is. Remember, Australia has had a CAD for about 20 years now, and while our economy has functioned well with all the reforms, I don't think it justifies a CAD of 6.3% of GDP.

I mean, look at the housing industry. Money wasted on property speculation! If we had a lower CAD, then a lot of that investment would have gone into industry and actually produced something.

The other issue is that raising interest rates tends to also increase the value of the currency

True, but the question is whether the boost in consumption gained from the more highly valued currency is greater or less than the cut in consumption caused by higher interest rates. History pretty much tells us that higher interest rates will suppress economic activity over the longer term.

Weaker demand means less jobs, less economic growth - possible recession.

All this is true, but with a CAD that is neutral or in surplus, Australia will rely upon demand from our trading partners to create demand for jobs rather than upon creating that demand ourselves.

As far as a recession is concerned - I'm convinced that creating a recession now by hiking up interest rates will be a far better solution than to wait until it happens naturally further down the track.

One Salient Oversight said...

Dave,

Q. Why did the chicken cross the road?

A. Because there were no cars any more due to the world running out of oil, forcing people to create their own small farms.

-----------------

Remember Dave, I'm able to "take away" the Peak Oil paradigm when it suits me. I'm not going to Peak about everything I write. Besides, having a balanced CAD is actually one small thing Australia can do to help itself when the peak hits - essentially it means a lower currency and more expensive petrol... which should help Aussies invest in alternatives.

CraigS said...

Dave,

If worrying about the CAD is trivial, surely worrying about your mortgage rate is even more so?

But if our civilisation is coming to an end, so be it. Thats what happens to civilisation's, and the human race marches on.

People couldn't believe it when the Roman Empire came crashing down after 700 years. Augustine wrote "City of God" to say "Hey! Your citizenship is in Heaven! Not Rome!"

I love the old negro spiritual -

This world is not my home
I'm just passing through
My treasure and my hope
Are all beyond the blue

Where many of my friends
Have gone on before
And I can't feel at home
In this world anymore


My dear brother, you worry more than a citizen of heaven should...

Dave Lankshear said...

Hi Neil,
thanks for another peak oil joke. A number of peakniks at www.sydneypeakoil.com really enjoyed your previous contributions. I laughed out loud at the Kunstler joke.

"Knock, Knock.
Who's there?
Jim.
Jim who?
Jim Kunstler. A leading advocate of the peak oil movement."

The idea of Kunstler going door to door in a "Knock Knock" scenario still cracks me up. Others laughed at other favourite jokes.

Now, to get serious.

I'm able to "take away" the Peak Oil paradigm when it suits me. I'm not going to Peak about everything I write.

Yes, the CAD article has a degree of concern, expressed both in what you say and in how much detail you take to spell it out, that makes it seem "important", while peak oil does appear to slip off the radar when it suits you.

I am listening to Hirsch now, and he is actually admitting that the report he submitted was too optimistic! The bottom line of the report was to estimate how long it would take to prepare for peak oil, NOT when it might occur. He did not want to invalidate the work by taking a stance in what can be very difficult to know given the closed shop policy of the Sauds.

However, what was his report preparing FOR? He recommends a 20 year crash program (in a highly directed economy) to mitigate peak oil, but what does he assume in peak oil means?

This is the chilling part. For the DOE report he assumed ONLY a 2% decline, when he is now saying the reality may be a 4% or 8% decline per year!

You have to listen to this interview. He sounds genuinely frightened. The 2% decline was just too optimistic.

4% = 30 years of advance crash program mitigation.

8% = 40 or 50 years of crash program mitigation!

"This is really an incredibly difficult and incredibly severe problem!"

He can't quite bring himself to say it, but if you listen carefully he's basically said we are heading for a Greater Depression. Just do the math according to the logic he spells out. As they say, "Go figure".

Robert Hirsch again:
“This is not a pleasant subject. This is an extraordinarily unpleasant subject. People tend to not want to deal with very unpleasant subjects. The other thing is that the subject is complicated and people do not understand energy. They simply do not understand the difference between liquid fuels and windmills, between nuclear power and tractors, they simply don’t really understand how things work. I don’t mean that as a criticism, it just is part of the problem.”

Now let's get back to your CAD article.

I just thought, being the peaknik that I know you really are, you would have said something about CAD being important to do just a little to "mitigate" the real economic crisis coming our way. In my view, preparing a nice CAD might add a few extra lifeboats to this "economic Titanic", but not much more than that.