I make no secret of my disdain for the Pitchford Thesis, that doctrine that says that current account deficits (CAD) don’t matter in an era of floating exchange rates, so long as the resulting debt is in the private sector. This was the notion that led Canberran policy-makers to turn a blind eye to Australia’s enormous household debt build-up over the past decade or more.
For me, the greatest single economic step forward for Australian economic policy-making following the GFC was the repudiation of this thinking.
But, that’s not to say that such notions should not be discussed and last week the RBA’s Assistant Governor, Guy Debelle, who has a soft spot for contemporary financial markets, mounted a spirited defense of CADs and the Pitchford Thesis. He began:
To mount a defence of current account deficits, I would like to provide a bit of context with which to think about this issue. One place to start is with an overlapping generations model of a closed economy,[7] which we can think of as a country. Within this country there are households that are at various stages of their lifecycle. The younger working households save, the middle-aged households borrow, while the older households run down their stock of accumulated saving. So we have ‘imbalances’ across the household sector.[8] The young households have current account surpluses, the middle-aged households like me are in current account deficit. But these ‘imbalances’ are not generally cause for concern. It would not be socially desirable if there were no cash flows between households.
Alternatively, we could consider the Australian states. At any point, there can be large current account positions between the Australian states. There are large financial flows across state borders too. Are we even aware that this is the case and should we be concerned? By and large, we should not. Again it is useful to think about why any such imbalances across the Australian states are not a cause for concern. Here we are straying into the optimal currency literature, most famously associated with Robert Mundell, which is currently getting a fair working over in the context of the problems of the European periphery.
Some of the reasons we are not concerned about the current account ‘imbalances’ of the Australian states is that the Australian states have a common currency, a federal fiscal system, sizeable interstate labour mobility (of which me and much of my Adelaide cohort are a good example of) and generally experience similar economic shocks. These are the main prerequisites identified for an optimal currency area.[9]
The point of the two scenarios I’ve described here is that current account positions, even large ones, can exist that are benign and could not be classified as imbalances. The capital flows that are the counterpart to these current account positions are ‘good’, because they are associated with appropriate intergenerational transfers in the first case, and appropriate cross-border flows in an integrated economy in the second.
All very sensible and fair enough. However, I take umbrage with a couple of assumptions here. First, the most important point about current account imbalances is not that they are always “bad” but that they always increase risk.
Debelle’s example of households in instructive. Sure, it’s normal and perfectly reasonable to expect the lifecycle of households to show a pattern of youthful saving, middle age indebtedness and old age dis-saving. However, what happens when the middle generation is much bigger and more avaricious than the generations that came before and after it? When their borrowing becomes exorbitant and when much of that debt is channeled into assets, primarily houses? When the elder generation begins to rely upon those asset values and hence dis-saves all the more swiftly and the younger generation has to borrow huge amounts too if they’re to meet their expectations for similar lifestyles?
What happens is this: risk is piled upon risk as the debts of the middle-aged generation spark increased debts across the generations.
The same calculus can be applied between states. If one government decides to throw caution to the wind and borrow like mad, spend up big on welfare and infrastructure, sucking in people from other states, how long before other states follow suit?
But that is only half the story. The other half, the half that really matters, is that in any current account imbalance, someone has to be moving the savings of the prudent group to the borrowings of the risk-taking group. And that’s where Debelle turns next:
Max Corden distils the concern that many have about global imbalances down to a concern about the ‘return journey’. Lenders of capital expect to receive the money they have lent back with interest (dividends if it is an equity investment).
One reason that might increase concern as we move from transfers between households to crossing state borders to crossing national borders is that the information asymmetry about the return journey increases. Amongst other things, the geographic separation reduces the ability of the lender to monitor the use of funds by the end-borrower. One could question why this still remains true today, with increased transparency and lower cost of information.
For example, in the recent episode, the funds that made their way to the US housing market over the 2000s had a long and non-transparent chain between the provider of the funds and the ultimate borrower. There were major problems of information asymmetry and failures of due diligence right along the chain.
Yes, indeed there were. But as the household example shows, such failures do not require borders nor “information asymmetries”. No indeed. There are plenty of examples in which banks took the savings of a prudent local group and stuffed them into the latest fad promoted by some other risk-oriented group and they did so not because they didn’t have enough information (across borders or otherwise) but because it made them rich, quick.
In other words, banks quite often, nearly always, in just about every business cycle actually, bugger it up owing to their own greed. If you want to trust that your current account deficit (CAD) is stable, then you’re also going to have to ignore the long and inglorious history of bank greed and bubble-creation. Back to Debelle:
Another reason that borders matter is that the capacity to borrow in one’s own currency is important. The claims across state borders are denominated in Australian dollars, which are easily settled without doubt in the integrated Australian financial system. Indeed, the system is so integrated that there is no easily obtainable measure of cross-border claims for the states.
A further aspect that appears to be a common cause for concern about current account deficits is the economic adjustment that might ensue were they to narrow precipitously. Much of this concern appears to stem from a fixed exchange rate world. In a fixed exchange rate world, sudden stops can (and did) occur that are very disruptive. Capital inflows dry up rapidly and capital outflow increases, necessitating a sharp contraction of domestic demand so that the trade balance moves into surplus. Inevitably, this is associated with a domestic recession.
Such a scenario does not directly translate into a world of floating exchange rates. In that environment, the main mechanism of adjustment is the exchange rate. If global investors reduced their appetite for investment in a particular country, the exchange rate would depreciate until the point where investors would be happy once again with their allocation to the country in their overall portfolio. While the exchange rate might overshoot in this scenario, the depreciation is stimulatory to the economy, whereas in the fixed exchange rate world, the adjustment is contractionary.
Well, yes, but try telling that to Britain or other current account countries, whose experience of the GFC included wrenching current account corrections and huge recessions despite falling currencies. Fact is, when the panic sets in and current account imbalances correct it’s overshooting time. Back to Debelle:
The conclusion I wish to draw then is that there can be perfectly good reasons why current account balances are not zero, and indeed can even be quite sizeable, without them constituting imbalances or being a cause for concern. The accompanying capital flows are often beneficial. This is not to say that they should not be scrutinised but rather that the scrutiny should really be on the nature of those capital flows to examine whether they are being driven by inappropriate policies or distortions.
It’s true. I agree. Some countries being able to borrow and others being able to lend makes everyone more efficient and prosperous, for a time. But the whole box and dice is run by human beings, with all of their foibles, not some rational ubermensch. Those doing the borrowing, those doing the lending and those tasked with monitoring it all with policies that supposedly prevent excesses, all of them, are flawed human beings. They all get swept away sooner or later. Which is exactly what happened here in the last cycle, when the nation went crazy over houses, leaving us with a 170% plus debt to GDP ratio and a calamity averted only by the historic good luck of commodity boom redux.
Resisting a CAD doesn’t solve the problem, but embracing it risks making the day of reckoning much worse.
