A balanced conversation about the economy

A couple of days ago I posted an article suggesting that Australia needed to have a bit more of a mature conversation about the structure of our economy in order to set the agenda for the future. The article had a very good response and, as usual, started some intelligent dialog in the MacroBusiness community.

Given that interest I thought I would spend some time looking at some details in the balance of payments data from the ABS in order to provide a more informed background to what we are seeing in the economy. There is a lot to go through and many concepts to discuss so this will be a multi-part post, with half today and half on Monday.

As you may know I tend to describe the economy in 3 parts, the government sector , external sector and the private sector. The reason I do this is because it fits with the national accounts data and the national accounting identity of sectoral balance.

For those who aren’t sure about the sectoral balance equation you can read this article, but the basic premise is that there is an accounting rule flowing for the calculation of national GDP that states that there  is a direct and unbreakable relationship between the government budget balance (deficit/surplus), the external sector balance ( current account ) and the private sector (businesses and households) budget balance over an accounting period.

For reference here is the Australian government sector balance as a proportion GDP since 1979 through early 2011:

The balance of payments data is basically a balance sheet of our nation’s net borrowing or supply, in dollar terms of goods, services and financial assets, to/from the rest of world. The major component of the balance of payments is the current account:


You can see Australia began making net payments to the world sometime around 1974 and has never looked back. Even the recent surge in Australia’s terms of trade stemming from the mining boom hasn’t been enough to get the account into the black.

So how can this be ? Well we need to dig a little deeper into the data to get the details.

The balance of payments is made up of three accounts. The Current Account, the Capital account and the Financial account.

a ) Current account

According to the ABS

Transactions between Australia and the rest of the world in goods, services, primary income, and secondary income are recorded in this account. It is distinguished from the capital and financial accounts.

The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit, and it is called the “current” account because it covers financial transactions occurring  “right now”, meaning these transactions don’t give rise to future claims.

The current account is broken down further into the balance of trade in goods and services, primary income and secondary income. You can see the breakdown of the account from the summary section of the latest balance of payments.

Balance of trade is self explanatory, while Primary income:

The primary income account shows primary income flows between resident and non-resident institutional units. The international accounts distinguish the following types of primary income:

  • compensation of employees;
  • dividends;
  • reinvested earnings;
  • interest;
  • investment income attributable to policy holders in insurance, standardized guarantees, and pension funds;
  • rent;
  • and taxes and subsidies on products and production.

and Secondary income.

Secondary income include current transfers that offsets to the provision of resources that are normally consumed within a short period (less than twelve months) after the transfer is made. Examples include food aid, remittances from residents temporarily abroad, and remuneration received by international students undertaking university studies.

b) Capital account

This is usually a very small component of the balance of payments as it records both acquisitions and disposals of non-produced, non-financial assets and capital transfers. This includes things such as patents, leases and licenses for use of products, but not the actual value of any actual products themselves.

c) Financial Account

According to the ABS

This account records all transactions between residents and non-residents, associated with a change of ownership of foreign financial assets and liabilities during the period including the creation and liquidation of financial claims.

This account is further broken down into:

  • Direct investment
  • Reserve assets
  • Portfolio
  • Financial derivatives
  • Other investment

So basically, when the external sector is in deficit the current account and capital accounts tell us how we are spending the money and the financial account tells us how we are funding the bill. The equation is

Current account + Capital account = Financial account

Which is why it is called the “balance of payments”.

So now you have the background let’s have a look at the data. If you have a look at the current account breakdown it is easy to see that the terms of trade are having a positive influence on the account. That is, in dollar terms, we are exporting more goods and services than we are importing.

However, what you will also notice is that our primary income is negative and of a greater magnitude than our balance of trade is positive. In other words, even though we are in the midst of a commodities boom money is still flowing out of the local economy via the external sector:

So where is it all going ? Well if we breakdown primary income into its component parts we get the result below. This tells us that the major components of our primary income deficit are from direct investment income and portfolio interest payments to the rest of the world:

Which basically means that in aggregate Australia sends massive amounts of dividends and interest payments to the rest of the world. In fact it is so large that it is dwarves our trade in goods and services, resulting in a net loss  to the external sector even during the historically high terms of trade. The most important thing to note is that these are payments stemming from previous foreign investments meaning Australia is continuously making payments to rest of the world somewhat independently of the balance of trade.

Finally, the financial account tells us that in order to maintain this current account deficit, Australia continually relies on foreign direct investment capital flows along with sales of equities:

The latest statement of the financial account gives a fairly good example of how we are footing the bill for the capital outflows.

The balance on financial account, in original terms, recorded a net inflow of $9.2b, with a net inflow of $11.6b of equity and a net outflow of $2.4b of debt.

The financial account surplus increased $1.4b, from $7.7b in September quarter 2011 to $9.2b in December quarter 2011.

Direct investment recorded a net inflow of $18.5b in December quarter 2011, an increase of $12.7b from the net inflow of $5.9b in September quarter 2011, where:

– direct investment liabilities recorded an inflow of $23.9b, an increase of $4.4b on the inflow of $19.6 in September quarter 2011

– direct investment assets recorded an outflow of $5.4b, a decrease of $8.3b on the outflow of $13.7b in September quarter 2011.

Portfolio investment recorded a net inflow of $15.0b, a decrease of $6.3b on the net inflow of $21.3b in September quarter 2011, where:

– equity and investment fund shares recorded a net outflow of $5.6b

– debt securities recorded a net inflow of $20.6b,

where portfolio investment liabilities, debt securities increased $1.2b from $18.8b of issues in September quarter 2011.

Financial derivatives recorded a net outflow of $0.2b, a decrease of $17.7b from the net outflow of $17.9b in September quarter 2011.

Other investment recorded a net outflow of $20.4b, an increase of $19.3b from the net outflow of $1.2b in September quarter 2011.

Reserve assets recorded a net outflow of $3.7b, an increase of $3.4b from the net outflow of $0.3b in September quarter 2011.

So in other words we sold lots of new financial assets to foreigners so we could pay them the interest we owed them stemming from their previous purchases. Sounds a little ponzi-ish doesn’t it? But let’s not get ahead of ourselves.

I think that is enough for today, there is already a lot to digest and I think it is important to truly understand the structure of the external account before moving on. I also think it is important that we continue to have adult conversations about the structure of the economy, so on Monday I’ll put together another post explaining the implications of all of this, including the flow-on effects and relationships with the other sectors of the economy.

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  1. Good grief. That was like a prematurely ended romantic encounter…just when it was getting really good, it’s over!

    Definitely looking forward to Monday’s edition. If the MSM are going to pick up wholesale anything here from MB, I reckon it will have to be this series – which may prove required reading for youngish ‘economics journalists’, the jaded rusted-ons and even a Treasurer (aspirant Treasurer) or two.


    • Yes, well the truth is I ran out of time but thought it was worth posting this as it cuts it into easily digestable pieces.

      There is lots to go through, but it is fundamentally important to understand it if we are every going to get past the name calling. 🙂

    • And required reading for everyone else. As an ‘amateur economist’ just trying to comprehend the worlds financial system and Australia economy I find this blog completely addictive. Combine it with Yves at Naked Cap and then a trawl through the recommended links from both sites…No wonder productivity is suffering!
      Thanks from me as well.

      • As an ‘amateur economist’ just trying to comprehend the worlds financial system and Australia economy I find this blog completely addictive.


    • Speaking of copying stuff off of your work, Jessica Irvine’s article today seemed a bit similar to some of the things I have read here recently. 😛 Not a blatant copy atleast, but thinking along the same lines it appears.

  2. Given the reliance on overseas funding by domestic banks – it would be interesting to note how much our mortgages are contributing to the financial account.

    It would be depressing if we have indebted ourselves to overseas lenders merely to buy ever more expensive houses from each other and spend the rest on imported consumption.

      • They don’t call Economics the ‘Dismal Science’ for nothing…

        Hey DE, that was probably the best explanation of the BoP I have ever read!! Roll on Part 2 indeed.
        I’m printing this out (sad, I know!).

    • Then I’m afraid you won’t like the news.

      Not only did we piss the receipts of a mining boom up the wall, we leveraged those same receipts to bid up the price of our existing housing stock.

    • Occam It is not quite THAT simple but close! I reckon DE will get to it however just for the moment….
      We set interest rates at zero to negative RAT over a long term. This causes high demand for credit. Keen shows that Banks can create credit,in fact, anyone can. I do every day in my business (we try to control it) The credit growth has been way above GDP growth for many years running at something like 14 or 15%. Where does the extra credit go if not into inflation? Into imports and thus increasing the CAD.

      Remember money in the economy goes in circles. Depending on where you are sitting in the circle can influence how you think the CAD is created.
      So given that everything is going in a circle the CAD seems to me to have had two main causes.
      First, as is mostly surmised here, Banks borrow from O/S and lend out for housing which results in more money circulating. We spend about 23% of GDP on imports. I suspect the marginal increase in imports per $ extra credit is probably 35% or more (anyone with actual figures please add them)

      Banks create credit out of thin air as per Keen’s “Cavaliers of Credit” As the money circulates it ends up in the hands of Hardly Normal or businesses like mine who import. When we sell the goods we go to the Bank armed with our A$. They borrow USD to give to us for the A$ and that is when the international transaction occurs.

      Both ways are legitimate enough. In the circular thinking it all ends up the same (I think)

      Now of course we have a third factor. The Govt is running a deficit that it is financing by O/S borrowing!
      Govt deficits, again, result in extra imports in the same way as created credit.

      Mainly remember there is no straight line from right to lrft. It is all a big circle with spin offs into Taxation, imports (external account), savings…all of which have there own mini circles and money re-enters the system.
      Hope I haven’t cut across your bows too much there DE

      • P.S. In summary, however, the CAD and resultant sales of any and everything to foreign buyers is, in the final analysis the result of interest rates being too low so that we over-consume, under-save and under produce.

      • Flawse, I would like to add to the circular model the speed the circles are spinning is what supports the capacity of the economy to repay debt.

        That is why the slowing means big trouble for lender and borrower alike.


        • Tony
          Thank you for raising the issue of velocity

          …a proposition just for thinking purposes!
          I’m thinking that velocity only determines the rate at which domestic debt gets repaid. Where we are running a CAD every time that circle spins, it spins off a heap of money to the external account. Thus Foreign debt is increased.
          It seems to me there is a great deal of confusion about what constitutes REAL debt repayment. I think that redistribution of savings and Government deficits are being confused with real debt repayment. I’m interested in DISCUSSION on this topic of velocity and debt repayment. Perhaps once everyone has inwardly digested DE’s posts in this series!
          Again…thinking….imports are more responsive to velocity than exports so again this may exacerbate the above situation.

          In practice an economy with high velocity does suck in more imports and if you think about an economy with a CAD as your spinning circle the faster the money goes round, for a given set of economic settings, the faster we import, and the faster external debts rise.
          Please give the idea a bit of thought. I’d be really interested on your take in response.

  3. The great thing about MB, and this article exemplifies it, is that it speaks to all levels of financial expertise. You chaps neither lecture to, nor speak-down to, those of us who have nothing to gain except having our knowledge reinforced or challenged. Roll on, Part Deux!

  4. A+ for taking something so complex and making it so easy to understand by someone like me.

  5. Great post. Timely and much needed.

    So we are selling the farm to meet our debt obligations? Surely not sustainable.

    This also suggests to me that AUD strength must be highly influenced at present by speculative activity. From a BoP perspective, net selling of AUD has never been greater. Or is that an over simplification?

    • Yes Ben….underpinned by our willingness to make it an almost one-way bet by beint willing to sell any and all assets at any time to fund our over-consumption.

  6. Thanks. Great article and looking forward to the rest.

    This post leads to consideration of our Net International Investment Position, which is pretty poor for a country selling so much non-renewable resources.
    It also leads to questions about even the short term value of the AUD and TWI and likely ongoing costs of funds for banks.

    I believe it also calls into question the economic policies under Costello as treasurer (and RBA at the same time) in having setting which while allowing reduction in Government debt allowed a huge increae in nominal prices of housing and escalation in private debt, particulalry household debt.

    While under MMT the Australian government could replace foreign banks at will, it would be a confidence destroying thing to do.

    Looking back, maybe Rex Connor was right to try to buy back the farm, even if he went about it the wrong way.

    • So it turns out the Rudd government was on the right track about introducing the mining tax

      Can we please leave this envy driven mining tax argument out of this post by DE who is attempting to explain some basic truths.

    • Buy back the farm by Foreign borrowings is not the right thing to do.
      Buy back the farm by saving, running a Current Account Surplus to provide the foreign currency needed to pay out the Foreign interests IS the right thing to do.
      Of course that involves higher interest rates that we are not prepared to allow!

      Choices! Choices! Choices! Hard choices!

  7. So it turns out the Rudd government was on the right track about introducing the mining tax. Why no one mention that? Now we can only watch the national income flowing abroad and cheering the our shortsightedness.

  8. Australian housing peaked at the same time (Dec 2010) that Australian stocks stopped moving in lock-step with US stocks & began to under-perform. Now 25% lower than the US in that time period.

    If this is this not evidence at that housing has driven the economy then it’s at least evidence that the same forces that have driven housing, have also driven the economy.


  9. “You can see Australia began making net payments to the world sometime around 1974 and has never looked back. Even the recent surge in Australia’s terms of trade stemming from the mining boom hasn’t been enough to get the account into the black.”

    Actually DE is somewhat understating the time scale of the problem. We ran one Current Account Surplus in early 1970’s. It is the only year since 1959 we have not run a CAD. How do you now correct such a cultural norm of over-consumption and under-production that is now so entrenched after generations of accepting this as the norm? (We have too many Norms!!! 🙂 )
    Maybe a question for a later post in the series.

    Thanks DE!!!! Really good stuff.

      • Yep DNE but after 50 years most parents and even, now grandparents (Boomers) are themselves rampant consumers! Who is to teach whom?

        I’ve told the story in other forums before about the moment I heard that housing had been switched from the consumption section of the national accounts and became investment. I think it was during that clown Malcolm Fraser’s years. I nearly drove my old Tojo into a ditch!!! I had already recognised the the con game in the external account buy I knew the whole economic con game was complete as far back as that moment.
        Nobody has put the real truth before the Australian people since!
        Keating made one attempt and it destroyed him!

        • dumb_non_economist

          I can’t argue with you about that. I had a very austere upbringing due to my old man’s gambling habits, just the same I have known plenty in my age group who did it just has hard and are now big spenders lots of debt and give their children who are now in early adulthood, EVERYTHING. Oh, you’re going to uni- poor thing, here’s a new car, while I’m at it have this new ipad, your other one is 6 mths old now. They haven’t learnt to control there spending or their desires for what they can’t afford. Mum, Daddy and the bank will provide!
          But, in answer to your question, who are meant to be the adults?

  10. I hear what you are saying – playing devils advocate though, is this necessarily a problem. Let me put an example…

    There is a really great mining project which could get going but Australians dont have the money or risk appetite to fund it. They borrow from o/s and the project gets built and operated with local labour. Once built, the income from the mine is split between labour (Australia) and capital (O/S people). Overall Australia is better off for the money coming here to labour even though we are sending dividend/interest checks back o/s right?

    If you then take this example and think that we have been expanding this “project” since 1970 and continue to make it bigger then is this an explanation for our position? Therefore is it such a bad thing?

    • >I hear what you are saying – playing devils advocate though, is this necessarily a problem. Let me put an example…

      Actually thanks for playing devils advocate, it is a good question and definitely something I will address on Monday.

    • Agreed mining man, made the point many times when people bleat about 80% ownership of miners etc., 20% of something is better than 100% of nothing. The problem is that funding housing is a national sport, so for decades there has been local underinvestment in miners, tech companies etc.

  11. Another question, how is any of this data put togethor? What is the source? Payment data at the RBA? A survey? Taxation receipts? What drives how you make up these flows? Could these economic accounts be garbage in garbage out?

  12. Ironic in mid 80s Labor govt. and Dawkin’s established policy to reduce balance of payments deficits and dependence upon primary industries through development of service industries. That was international education, with spin off effects for tourism etc.

    25 years later the present government (high AUD aside) is doing its utmost to sabotage international education due to race card, population growth, immigration etc. politics for opinion polls and short term political gain…….. our political and media class seem to have returned to the 50s…….

    • hmmm aiecquest… you also have to maintain a higher educational standard than is available in the home countries. This is now clearly not the case. The cooks and hairdressers scheme leading to permanent residency of the Howard years was a disgrace. At least Labor have largely put a stop to that nonsense.

  13. rurounimaikeru

    Great article. A nice complement to my macro 2 lectures. (although yours are much easier to digest. )

    Also, in the sentence above the balance of payments equation do you mean financial account is how we finance rather than capital account? Or have I missed something?


    • >Also, in the sentence above the balance of payments equation do you mean financial account is how we finance rather than capital account? Or have I missed something?

      No you missed nothing , I have updated the post


  14. Agree with other comments. This is a v interesting topic.

    I heard someone say (I think it was on ABC radio this morning) that foreign ownership of companies is good for Australia because if more dividends go O/S then fewer imputation credits are claimed from ATO.
    Seemed a bit strange to me because I thought foreign owners would pay tax in Australia on income earned in Australia, and thus would claim the credits.

    In my little bubble of knowledge there is a growing list of countries that have not run a Current A/c Surplus for 40+ years. E.g. France.
    I’ve heard the question asked and answered a few times in MSM, but I still don’t understand which countries don’t have a deficit. A few Arab countries? If you dig deep enough everyone else seems to owe money (e.g. Japan seems to have a huge debt, but mostly owed to itself, I think¿). Even China seems to have heaps of hidden debt within its system.

    • but I still don’t understand which countries don’t have a deficit

      you could probably get this information if you google “current account deficit nations” or something.

      Norway, Switzerland, Singapore, Chile (for part of the last decade), Arab states, Japan, China …it is a reasonably large number since by definition it has to balance the number — or the aggreggate $ at least — of the deficit nations.

      • Funnily enough I think it is the CIA keeps, and publishes, quite extensive stats on the subject!!!!
        Certainly there are other sources. I just find it a bit interesting!

        • The CIA factbook is a source used on many online data sites e.g. wolfram alpha, but I thought google would probably be better. I have come across a google run site with this informaiton but I do not have the link handy.

      • “by definition it has to balance the number — or the aggreggate $ at least — of the deficit nations”

        I wondered about that. So there’s no fractional lending going on at the national level?

        The list of Current A/c balances by country:
        CIA’s The World Factbook
        Country Comparison : : Current Account Balance

        There’s 198 countries on the list.

        USA = 198
        Australia = 188
        NZ = 173
        PNG = 157
        East Timor = 46
        Indonesia = 45

        Top 20 (all with Current A/c surplus):

        Algeria (20)
        South Korea
        United Arab Emirates
        Saudi Arabia
        China (1)

        This is a bit dated but some of the charts are interesting:
        Economic Roundup Issue 1, 2010
        Australia’s current account deficit in a global imbalances context
        Phil Garton, Matt Sedgwick and Siddharth Shirodkar

    • You’re right 49er. There is great confusion between a Govt deficit and debt and a CAD and Foreign Debt. Govts can run deficits and not run Foreign debt if the private sector saves sufficiently.
      During the Howard/Costello years we did the opposite. The govt ran surpluses but the Private sector went on a credit spree.
      I know who I’d rather owe debt to!
      Japan’s Govt owes the debt to its own citizens because the people have always saved like crazy and it has run Current Account Surpluses since forever. The same applies to China. That makes their debt a very different kettle of fish to CAD countries who owe the debts to China the Arabs et al (as you observe). MOst of Asia has run CAS since the Asia meltdown. They determined they were never again going to make themselves vulnerable by being reckless. It’s a pity we didn’t learn something at the same time. We just congratulated ourselves on avoiding the meltdown by continuing to sell our assets!
      Note also the natural propensity for saving amongst Asian people. Singapore with absolutely ZERO natural resources runs a CAS through diligence industry and saving.
      Just a note…you will be told by economics professors of note that the Current Account has no correlation with the value of a currency. That’s solely because the effect is swamped by capital flows of short and long term and, in the interests of coming up with the answers they want, a bit of picking and choosing what they correlate.

      Not sure how their theory would hold up is you took Japan and Australia as your examples. I remember a time when the A$ was worth 240 yen!!! It may seem a long time ago to young whippersnappers here but it was only 30 years ago!
      At the same time they have managed to accumulate a large swathe of our mining industry through capital investment.

      As DE will no doubt get to this whole era is drawing to a rapid close and we are totally unprepared for the consequences.

  15. Rumplestatskin

    Great post. It’s good to take a step back from the day-to-day data flow and see how the big picture of the Australian economy has developed, and where it looks like heading over a longer time period.

    Can I make some request for part two?

    1. Which countries have a CAS, and what sort of institutions and rules do they put in place to achieve it?

    2. What happens when we have no more domestic assets to sell to foreigners to fund our previous foreign debts? (the end game for the foreign accounts ponzi) The way I see it we either simply nationalise some foreign owned assets, or sell off WA.

    3. How do global CAD/CAS balaces interact with military allies? I see a bit of a pattern in that since creditor nations are typically more productive, larger, more manufacturing centred, globally politically powerful, the CAD countries are often the energy and minerals resource-supplying little brother of the big boys. Hence our need to keep close ties with the US.

  16. Unfortunately, learning more about Australia’s economy makes for depressing reading. It would be good to highlight a bit of advice for investors given what could unfold. For example, the AUD’s strength appears to be partly speculative (and cyclical) so i assume buying USD, SGD could be a good move.

  17. “So in other words we sold lots of new financial assets to foreigners so we could pay them the interest we owed them stemming from their previous purchases.”

    Good points.

    There is a further reason endemic current account deficits is that it acts as bleeding from the circular flow of national income.

    For example, if the nation had imported lesser, the consumer would have purchased a domestic product. Seeing higher sales, the producer would have hired and invested more and higher wages would have led to more consumption etc.

    Also, the current account deficit leads to increase in net indebtedness and Australia has been too bad regarding its “external debt” – more appropriately its international investment position is 60% of GDP (with a negative sign in non-Aussie convention). Also mentioned by a commentator here.

    • “endemic current account deficits is that”

      … should have been endemic current account deficits is bad – it is that …