Date created: 5/4/05
Last modified:5/4/05
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John Quiggin

No reserve for rainy days

Australian Financial Review

18 November 2004

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.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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