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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