So, what about the trade deficit?

Why do some people overseas keep sending Australians money when all we do is spend, spend, spend?

Back in the 1960s the big bad bogeyman of Australian macroeconomics was the Balance of Payments. Credit squeezes were applied to slow down demand for imported goods and services whenever our newly re-named Reserve Bank's stock of foreign currency was being run down because of insufficient exports or inflows of foreign investment. When our exports boomed, as in the early 1950s when wool prices went through the roof and in the mid 1960s when our first 20th century mining boom occurred, credit could be eased, import restrictions relaxed, and inflation aside, we could enjoy our wealth in imported goods and services.

Until exchange rates became more malleable in the 1970s, the “external constraint” remained a bind on our economic growth. Once the International Monetary Fund (IMF) began to allow relatively easy movement of exchange rates, an import boom could be restrained partly by depreciation of the exchange rate, making foreign goods and services more expensive and our exports cheaper abroad, and relative to imports, at home. This meant we had less need for credit to be squeezed simply to balance the external books.

However, the game changed completely when the developed world began to shift over to market determined exchange rates. It wasn't until Paul Keating became Treasurer that an Australian government had the “bottle” to overturn bureaucratic opposition in Treasury and float the little Aussie battler. Once that was done, and the Australian dollar (AUD) was freely floating, the Balance of Payments was no more: by definition it was always in balance and so dropped out of sight. What did that leave to stress-out about on the external account?

Two things came to prominence: the first was the international value of the AUD; the second, the balance of trade in goods and services. Both these have had their time in the sunshine of popular angst in our not-so-sophisticated media. Remember the “J-curve”? Wasn't it the focus of policy, that said our exports would boom ... eventually ... as the AUD fell against our trading partners?

Well, it did, in the end ... and the J-Curve disappeared from public comment. Then there was the alarm about the falling value of the little Aussie battler. Now, there's alarm at how high it is relative to the $US (though it's still much the same devalued currency with respect to our major trading partners). And that leads us to the current alarm about the way the rest of the world keeps sending us stuff - goods and services - without asking us to pay for them. That's what is called the Trade Deficit.

What is this thing called the Trade Deficit? It is the situation where the value of the goods and services that we export to other countries is less than the value of goods and services that we import. The Balance of Trade is simply the difference between these two figures. Our exports are first, goods produced in Australia, whether by a local or a foreign firm, that are sold for overseas delivery, whether to a foreign or even an Australian firm.

Exports include gifts, for example, private or government foreign aid or gifts from an Australian family to an overseas family. Exports include payments for services rendered by providers in Australia to users of these services overseas. Financial services are a large and growing part of our exports, as is education. Spending by tourists in Australia, just as spending by overseas students here, is an important export. Our imports are the exact converse of our exports.

How can we have an imbalance of trade? There are many reasons. Trade credit terms may systematically mean we are granted more credit than we have to extend, or vice versa. Business firms and governments may borrow overseas to finance imports to Australia. Overseas firms may send goods and supply services in order to set up and extend their businesses in Australia: this is called foreign investment. They also might retain in Australia profits earned by their activities here (When they retain their profits here, they notionally buy foreign currency with those profits and use that currency to buy goods and services, i.e. imports).

This is an important element in our foreign investment inflow. As well as all that, there are very substantial flows of income to Australia from our own investments overseas. The Current Account Balance is the balance, not only of trade in goods and services, but also in these flows of income. In fact, trade flows are only about half of the current account flows. The trade account can be, and usually is, in deficit, even if the whole current account is in surplus, which it is sometimes, but not usually.

This imbalance of trade in goods and services, and income flows, called the current account, is brought into balance by foreign investment flows. Because the only way goods and services can be paid for is by purchasing local currency with which to buy them, the imbalance in trade is offset exactly by loans - foreign investment. If we have a trade surplus, we are a net investor in the rest of the world. The usual case for Australia is that we are a net borrower: the rest of the world lends us funds that we call foreign investment.

Governments have always borrowed overseas. If this was a large part of our foreign indebtedness, we could have problems, as governments of economically failing countries, “banana republics”, cannot renounce their financial obligations by falling into bankruptcy. Governments that find their obligations are too onerous have only the IMF to call upon - and the IMF is rarely very accommodating. The IMF routinely demands that governments reduce essential social spending in order to pay foreign capitalists their interest.

Fortunately, Australian governments' overseas borrowings and debt are trivially small, thus our risk of falling under the IMF's baleful glare is also very small. Our foreign debt and investment inflows are virtually entirely the business of business. When a business goes bust, so does its obligation to pay its creditors. When Allan Bond's businesses went belly up, our foreign debt shrank appreciably. We don't have a “banana republic” problem - of dictators borrowing from US banks and stashing the funds in Swiss banks. Governments here have been, all in all, too timid about borrowing for spending on economically beneficial public works - such as public infrastructure.

Why do we have a long-term trade and current account deficit? Why does the rest of the world send us all this stuff that we don't pay for? There are three possible explanations. Each explanation has its enthusiasts, and each has different implications for our future. The first is that we are incorrigible consumers, and spend (on credit) like there was no tomorrow. We hate saving and love consuming, and will consume all, and more of our incomes unless we are forced to save instead.

If this is the case, there must be incorrigible lenders overseas who delight in getting our businesses into hock, regardless of their ability to repay the loan: it will all end in tears, someone has to tell us to stop spending. The expectation of those who push this theory, mainly the “tabloid” media, is that government will have to crack down by raising interest rates and cutting public spending. In addition, we should be bullied into buying Australian, as a patriotic duty, or not buy anything unless it is Australian made. We might call this “the Dick Smith solution”.

The second explanation is that our costs of production are too high, our wages too high, holidays too long, there is too much union power and our workers are too lazy, so overseas producers, naturally, produce more cheaply and flood our markets with these cheap goods and services. This explanation did long service for the bosses and the conservative parties during the century and a half of fixed exchange rates. They never mentioned the poor levels of investment in capital equipment and low level technologies used in manufacturing industries that characterised Australian industry when it was protected by high tariffs (1908-1990).

This explanation has fallen out of favour, except in Sunday newspapers and commercial talkback programmes. Because our exchange rate is market determined, the absolute level of costs, of whatever kind, is irrelevant to whether we have a current account surplus or deficit. Particular cost levels will mean that some activities will be less profitable than others. For example, it is unlikely that Australia will ever be a major exporter, or even producer, of sugar beet or spruce timbers for the masts of tall ship replicas.

The third explanation is the one that makes some sense. It is that the rest of the world sees Australia as a place to make profits in the future. Their capitalists, be they the great multinational companies, or Belgian dentists seeking a good place to invest their superannuation, are willing to take their chances buying into Australian business activity, directly by setting up and maintaining businesses, or by buying shares in firms listed on the Australian Stock Exchange (or managed funds with such shares).

That's why they send us stuff. It may be machines for making money like computers, mining equipment or airliners. It might be buying AUD to pay wages here, which are then spent on everything that wages are spent on, including imports. The large size of a recent monthly deficit was due to some ships purchased; other months it is aircraft. These investment goods will directly add to our ability to earn income. But even if all we consumers wanted to import was cheese from Camembert, it wouldn't make a jot of difference, given that capitalists and businesses are risking their own money lending it to Australia.

The trade deficit, like the exchange rate of the AUD, will cycle up and down as time goes by. As long as we have good macroeconomic policies - interest rates and government spending and taxing - and good policies for an orderly and free society, we don't have to stress too much about decisions of the plutocrats to send us money and stuff, or not. Any cataclysms will come from elsewhere, like global warming, oil wars in the Middle East and collisions with asteroids. If we are going to stress about macroeconomics, it should probably be about the state of our tax system, which, despite its delivering revenues, welfare spending and government services, is not economically efficient, equitable or simple to administer.