Just 20 years ago Paul Keating’s loose tongue produced what may have been his most important remark as treasurer: in a radio interview he declared that, with the current account deficit (CAD) running around 6 per cent of GDP, Australia was in danger of becoming a banana republic.
This was a [wake-up] call to his ministerial colleagues that the Labor government needed to put an end to the celebration of its 1983 electoral victory, which it had done with large real increases in government spending and large deficits. With Finance Minister Walsh leading the way, the next three years saw real budget expenditure fall about 7 per cent, budget surpluses were achieved and a start made in other serious economic reforms.
By contrast, although Treasurer Peter Costello has delivered a budget containing a forecast CAD of 6.25 per cent of GDP in 2006-07 [(following sixes this and last year)], his budget speech did not even refer to that. Nor did he mention our net foreign debt of $450 billion now being about five times what it was in 1986-87. Yet, for the third successive year, real federal expenditure will increase about 4 per cent.
Was Mr Costello wrong in not addressing the CAD and debt situations, which Labor claims remain a serious problem?
Any analysis of the CAD situation should recognise there is nothing inherently wrong with borrowing overseas: the issue is whether such borrowings are put to productive use and whether governments can readily adapt policies to handle major changes in economic conditions. If investors lose confidence in an economy’s capacity to sustain existing trends, they become reluctant to hold Australian currency. That may cause an exchange rate crisis and lead to government action to impose harsh restrictions on spending, ending, inevitably, in a recession.
In 1986 many countries had experienced such problems and the threat prompted Keating’s May 1986 warning. The cost of servicing Australia’s net foreign debt had risen from 8.4 per cent of exports of goods and services in 1982-83 to 15.5 per cent in 1986-87 and the exchange rate (Labor floated the currency in December 1983) had fallen by around 30 per cent without correcting the CAD.
Clearly, the economy was not adapting to the increasingly competitive international environment by shifting resources into producing more exports or replacing imports. As a senior treasury officer, my contacts in international banks confirmed my assessment that major remedial policy action was needed and I sent Treasurer Keating advice to that effect.
However, while the remedial action taken was mostly appropriate, it was too little, too late to effect the needed adjustments, let alone stop net servicing costs rising to nearly 20 per cent in the late 1980s.
Since then the worldwide reduction in inflation and hence interest rates - together with further big improvements in domestic economic policies (some started under Labor) - has produced a vastly more adaptable economy. In relative terms, debt servicing costs are now about half what they were in 1986-87.
Those policy improvements include: the adoption of a low inflation target for monetary policy and the associated disappearance of the economically ignorant industrial relations commission as a determiner of aggregate wage increases; the large reduction in protection and associated improvement in industry competitiveness; and the acceptance by both major political parties that Keynesian “fine tuning” of the economy is inappropriate and that budgetary policies should normally not aim for deficits.
Related to that, virtually all net foreign debt is now owed by the private sector where the capacity to repay is more adequately assessed. In particular, the principal debtors - banks- are much better managed than their 1980s counterparts, some of which thought financial deregulation meant lending to all and sundry. Alan Bond even told one bank chief executive that he was “under-lent” to him!
Senior treasury official David Gruen argues in Economic Roundup, Summer 2006, that improved policies have brought a higher rate of domestic saving. This might be expected to lead to a lower CAD (which is by definition the addition to our saving from overseas), although Gruen also points to our higher rate of investment than in comparable overseas countries. This higher draw on savings by such investment should produce higher net exports, which provides some support for Treasurer Costello letting the high CAD issue pass.
However, a justifiable worry continues as to why the CAD has now increased each year since 2001-02. Shouldn’t our higher rate of investment have effected the necessary resource shifts to the external sector before now? Further, isn’t our rate of saving lower than it should be because government policies, especially the high hand outs of social welfare, are encouraging consumption? Does our high CAD explain why our interest rates are almost the highest amongst OECD countries?
True, international capital markets are not currently sending amber warning signs. But, as David Gruen points out, net foreign liabilities cannot continue to rise forever. In due course policy changes may be needed, not of the 1980s type but those relevant to the 21st century.