Twist and Shrink:

Australia’s Experience of A High External Deficit Has Relevance Here.
Listener: 1 March, 1997.

Keywords: Macroeconomics & Money;

John Edwards, adviser to the Paul Keating when he was Australian Treasurer and Prime Minister, is far too uncritical of his former boss to make his Keating: The Inside Story a great biography. But if the book lacks insight into Keating’s persona, Edwards – an economist and currently Chief Economist for Société Générale in Sydney – provides a fascinating account of the economic policy making.

Especially instructive is the story of the attempt to deal with the large external deficit. Also known as the “current account deficit” (or sometimes wrongly as the “balance of payments deficit”), the external deficit is the excess of imports of good and services plus foreign interest and dividends over exports of goods and services. Although the sustainable deficit is larger for Australia than New Zealand, it became a worry for them in the late 1980s.

Keating’s Treasury advisers favoured the “twin deficit” theory based on the external deficit being equal to the gap between domestic investment and savings. The theory says that increasing domestic savings will therefore reduce the external deficit. A means of increasing savings is the government reducing its spending. So Keating tried to bring the external deficit down by cutting public expenditure. But the deficit resolutely remained above at what was considered a sustainable level. Edwards describes the bewilderment of Keating and his advisers. Why did the theory go wrong?

Economics readers might expect me at this point to go into an account of the complicated interactions, which blunt the policy effectiveness. I want to skip over these and go to what I think is the heart of the issue.

For the twin deficit theory to work, at least one of two conditions have to occur. The first is that the economy shrinks, so there is less economic activity, less spending, and less purchasing of imports. The Australian economy did not, at first, contract. The reasons are complicated, but in the end no politician is going to deliberately shrink the economy unless forced to by a crisis. In any case government spending does not use a lot of imports, so that the spending cut, and the contraction, has to be vicious to work.

The alternative is that economy “twists”, that is the balance between productive sectors change. In particular the tradeable sector of exporting and import substitution has to grow faster than the non-tradeable sector which supplies only domestic markets. Sometimes the non-tradeable sector has to shrink, while the tradeable sector expands.

This twisting, in contrast to a simple shrinking, requires that sectoral profitability changes, signalling increased production of tradeables over non-tradeables. The exchange rate controls the relative profitability. A high exchange rate reduces the profitability of the exporters and import substitutors (who find it harder to compete against overseas suppliers). Thus the twisting alternative involves a fall in the exchange rate.

Such a fall would have compromised the Australian anti-inflation strategy, for their Reserve Bank, rather like New Zealand’s, was consciously managing the monetary system to reduce inflation. But this prevents the twisting of the economy, since some prices, especially for exports and imports, have to rise. Without recognizing the conflict, the Australian Treasuring was pursuing two objectives which clashed in the short run. Edwards reports Keating’s bewilderment. He thought he was following all the right policies, but the desired outcomes were not happening. The mystification is all the more amusing because Keating can be very arrogant. Just a few months earlier he had been skiting how he had the economy under control. Hubris is the fate of politician and adviser.

The Australian lessons will be lost on those New Zealand commentators who have constantly believed the New Zealand economy can defy the laws of economics. Claiming that cutting government spending will bring down the exchange rate is a nonsense, unless the monetary stance is consistent with that outcome. And to be compatible, the monetary authorities will have to tolerate a temporary rise in prices, which could take them outside the current target range. Otherwise the twist cannot occur.

What eventually happened to the Australian economy? After a number of years of good growth the economy collapsed into Keating’s “recession we had to have” of the early 1990s. It shrank, but there has been insufficient twist, so the external deficit remains large (although currently it is probably not as unsustainable as the New Zealand one). Their inflation rate is also higher than New Zealand’s, but like ours it is much lower than it was in the late 1980s. (Australia has a better recent economic growth record, and its growth potential appears to be higher too.)

Unfortunately New Zealand has no such interesting policy insider accounts as Edwards (although we have books which are as hagiographic or, in the case of autobiographies, as auto-hagiographic). We can turn to Keating to get the flavour of just how complicated policy making is, and how different it is from that portrayed at the time by politicians and commentators. The Australian policy experience may also provide guidance to the future path of the New Zealand economy.