Discuss the policy options the Australian Government can use to achieve external stability
In a growing age of globalisation, Australia's economic relationships with the rest of the world play a central role in the nation's economic performance. External stability is a broad term which describes a situation where external indicators such as the Current Account Deficit (CAD), foreign liabilities and the exchange rate are a level where they can remain in the longer term without negative economic consequences (i.e. remain stable). External stability has always been important for Australia, as Australia has always relied to some extent on the strength of its ties with other economies for its economic success. Theoretically, economists have traditionally the major objectives of Australian government economic policy as that of economic growth, internal balance as well as external stability. Governments can choose to pursue a range of policy aims, and often the priorities of government policy shift over time, due to the individual perceptions of each government influenced by contemporary economic conditions. Nonetheless, on many occasions policy setting have been changed primarily with the objective of restraining the growth of the Current Account and Foreign Liabilities, with the belief that the policy response to improve the CAD, will lead to corrections in the other external indicators of the Australian dollar and foreign debt.
However, the economy's external performance has become more important in recent years as Australia has aggressively pursued international economic integration, making Australia more reliant on increased trade and financial flows with other nations. Therefore, there is no single measure of Australia's external balance. External balance is based on a number of short term and long term indicators, in some cases these indicators can give different messages about the overall health of Australia's external performance.
The CAD, which comprises the trade balance plus net income paid to foreigners, is the most widely used indicator of Australia's performance. To account for the impact of inflation and growth of the real economy, it is usually quoted as a percentage of GDP. The major structural factor that has caused Australia's persistent CAD is the net income deficit, which in 2002 was $21.7 billion, or 3% of GDP. Last year, the treasury predicted a deficit of $29 billion or 4% GDP, in 2002-03. Although, the CAD has turned out to be almost 50% higher than expected, at $42 billion, or 5.75% GDP by June 2003. This gives a better sense of the size of the CAD as a proportion of the overall economy. Otherwise Australia would be experiencing record breaking CADs at the peak of every economic cycle, even if they were only the same percentage of the economy, since the size of the economy grows over time.
The Balance on Good and Services (BOGs), measures Australia's trade performance and may be used separately as an indicator of external stability even though it is a component of the CAD. In Australia, large persistent deficits on the net income component of the CAD can obscure our view of Australia's trade performance and international competitiveness. Moreover, in some cases it is important to take into account large one-off purchases, especially if we are just looking at the CAD result for one three month period, like Qantas's purchase of Boeing 747's in the December 2002 quarter. Movements in Australia's Terms of Trade (the ratio of export to import prices). The BOGs tends to fluctuate from surplus to deficit in response to cyclical factors, such as changes in the level of economic growth in Australia and overseas. The BOGs has seen a dramatic turnaround from $0.3 billion surplus in 2000-01 to a $10.8 billion deficit in 2002. Australia's strong growth has lead to increased spending on imported goods and services.
Australia's Net Foreign Liabilities (NFL) is a longer term measure of Australia's external position, reflecting Australia's total financial obligations to foreigners, minus the obligations of foreigners to Australia. There are two components of net foreign liabilities - net foreign debt (borrowings by Australians from overseas minus those funds lent by Australians to overseas borrowers) and net foreign equity (the total value of Australian assets that are owned by foreigners minus foreign assets that are owned by Australians). Net foreign debt, equity and liabilities are each measured in dollar terms and as a percentage of GDP. Both debt and equity create continuing outgoing streams of income to foreigners that are recorded as a debit item on the net income component of the CAD. However, debt is usually seen as a better measure of Australia's external stability rather than equity, because borrowings require frequent servicing (interest payments) while investments in equity effectively pay for themselves i.e. they only lead to income streams when the investment is generating income, <use e.g.> such as dividends from business profits being sent overseas. The Debt servicing ratio, which is the percentage of Australia's export earnings that must be used to service foreign debt and is probably the best longer term measure of the overall sustainability of Australia's foreign liabilities.
However, the most volatile indicator of Australia's external performance is Australia's Exchange Rate, which can be measured on a bilateral basis (i.e. against once currency such as the US dollar, the euro etc) or against a basket of currencies (such as the Trade Weighted Index). Most economist argue that the TWI, is the most accurate measure of movements in the dollar, however, most of Australia's trade and financial transactions involve a currency trade between Australian dollars and US dollars. Movements in Australia's US dollar exchange rate therefore have impacts well beyond Australia's trade relationship with the US. The Treasurer, Peter Costello described it as the 'report card of the economy's while others highlight the highly speculative nature of trade in the Australian dollar,' hence it is a controversial measure of Australia's external performance.
In attempt to stabilize these external indicators, policy options available to the Australian Government, fall under two broad categories of macroeconomic policy, which is intended to have an overall impact on the level of economic activity such as government budgets and changes in the level of interest rates, these policies tend to influence the level of aggregate demand in the economy. On the other hand, Microeconomic policies involve specific measures to improve the operation of firms, industries and markets, by achieving change at the level of individual firms and industries. These policies tend to influence the aggregate supply ...
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In attempt to stabilize these external indicators, policy options available to the Australian Government, fall under two broad categories of macroeconomic policy, which is intended to have an overall impact on the level of economic activity such as government budgets and changes in the level of interest rates, these policies tend to influence the level of aggregate demand in the economy. On the other hand, Microeconomic policies involve specific measures to improve the operation of firms, industries and markets, by achieving change at the level of individual firms and industries. These policies tend to influence the aggregate supply of the economy, which improves the productivity and efficiency so that total supply may be increased. In combination an economic policy mix, is an option the Australian Government can use to achieve external stability.
Government macroeconomic policy is aimed to stabilize fluctuations in the business cycle. Unwarranted fluctuations in the business cycle can lead to severe levels of inflation in booms, which will mean a blow out in the CAD, and excessive levels of unemployment in recessions as shown in Diagram 1.5, this is why macroeconomic policies are known as counter cyclical policies. Governments can use fiscal policy, which involves the use of Commonwealth
Diagram 1.5
income within the community. The Government gives out its budget annually, in a statement about its planned income and expenditure for the following financial year. The budget, includes Direct tax income and company, Indirect Tax e.g. customs and excise and the GST, and other revenues e.g. from government enterprise, which falls under government revenue.
The Budget or Fiscal outcome is an important feature of fiscal policy, giving an indication of the overall impact of fiscal policy on the state of the economy. There can be three possible outcomes, a fiscal surplus where there is a positive balance with the anticipation that Government spending will exceed total government expenditure. A fiscal deficit, is a negative balance, which occurs when total government expenditure exceeds total revenue, and finally, a fiscal balance, occurs when total government expenditure equates to total revenue.
Each year, the levels of spending, revenue collection and the Budget outcome change, reflecting the impact of two key factors, as non-discretional changes (cyclical component) and discretionary changes (structural component). The non-discretionary changes are caused by changes in the level of economic activity, and discretionary are planned changes to government revenue and expenditure, such as the $2.4 billion reduction in personal income tax for 2003-2004.
Budgetary changes that are influenced by the level of economic growth are known as "automatic stabililisers," which are those changes in government revenue and expenditure that occur as a result of changes in the level of economic activity. They are activated by the change in the level of economic activity, and not by a change in government policy relating to revenue or expenditure. The two main stabilizers are, unemployment benefits, which comes into effect during a recession, when the level of economic activity falls, the level of economic activity drops as well, causing a rise in unemployment. This means greater expenditure on unemployment benefits, in the same way that an increase in the level of economic activity will lead to reduced unemployment. The Progressive tax system acts as another automatic stabilizer, taxing those on higher incomes. During a boom, employment generally rises, which lead to greater taxation for revenue for the government. These play an important counter-cyclical role in slowing down demand, and reducing inflationary pressures and the demand for imports, improving Australia's external stability.
In effect, fiscal policy should act to influence Australia's external stability by impacting savings and the CAD as well as foreign debt. When the size of the fiscal deficit increases (certis paribus), simultaneously, the size of the public sector deficit, and this is regarded as negative savings or dissavings, which will reduce the level of national savings, composed of public and private savings. If there are insufficient savings to finance our level of borrowing for investment and consumer spending, then private sector investment will be crowded out, conversely, the inflow of funds must come from overseas. This inflow of foreign savings shows up as an inflow on the capital and financial account. Therefore, when the government runs continuous large deficits, it tends to increase the size of our net foreign debt and our CAD. Due to this relationship, the main aim of fiscal policy has been to sustain fiscal balance, on average over the course of the economic cycle, which should help to encourage a higher level of savings and lower CAD than in previous decades.
Additionally, as apart of macroeconomic policy monetary policy may be used to smooth out the effects of fluctuations of the business cycle as well as to influence the level of economic activity, output, employment and prices, affecting the overall level of demand. Monetary policy involves action by the Reserve Bank, on behalf of the government to influence the cost and availability of money. Monetary policy can be either expansionary or contractionary. The objective of monetary policy is set out in the Reserve Bank Act 1959, which states the RBA should aim for the stability of Australia's currency, which acts to help stabilize Australia's external stability. This involves minimizing domestic inflation and maintaining the stability of the value of the Australia dollar. Inflation is a continuous upward movement in the general level of prices and can impose costs on individuals and the economy as well as reducing the purchasing power of income and wealth. Also, the RBA aims to maintain full employment in Australia, which is 6% unemployment. The RBA is also required to promote the economic prosperity and welfare of the people of Australia by encouraging a sustained level of economic growth. These are long-term objectives, but due to the fast changing nature of economic conditions it is not always possible to pursue and achieve all of these aims in the short-term.
There are two possible instruments for conducting monetary policy; one involves the RBA controlling the growth of money supply in the economy through its control over the money base, which is the hands of the public and deposits of banks and other financial institutions, better known as monetary targeting. However this has been abandoned since the deregulation of financial markets. The RBA now attempts to influence the level of interest rates in the economy by setting a short-run such as the cash rate. The RBA does not directly control or regulate the market interest rates, since the deregulation of the financial sector. The RBA attempts to set short term interest rates, known as the cash rate which is currently targeted at 4.75%.
The main instrument of monetary policy in Australia at the moment is the use of Domestic Market Operations (DMO), which is designed to influence the level of interest rates in the economy. The RBA does not affect the level of interest rates directly, but it's actions influence market interest rates, assisting in achieving its objectives relating to the level of economic activity, inflation and unemployment. The implementation of DMO, involves the purchase or sale of second hand, (privately issued) government securities, which are Treasury notes and bonds by the RBA, in an attempt to influence the interest rates, which will influence the level of spending and aggregate demand, affecting demand for money in the economy. Through exchange settlement accounts, the RBA conducts DMO directly with banks and many major Non Bank Financial Institutions (NBFI). To influence, the supply of funds, and thus the cash rate, by buying or selling second hand government securities in the short term money market to the financial institutions.
It is through this process the RBA creates a shortage or an excess of funds in the short term money market. If the Monetary policy is loosened, the RBA buy second hand government securities from the banks NBFIs, this would create surplus funds and excess liquidity, forcing a downward pressure on Interest rates. The reduction in the cash rate means that it becomes cheaper for financial institutions to obtain funds in the short term money market, reducing the overall cost of borrowing, leading to a expansionary effect in the economy due to increased consumer and investment spending, stimulating economic activity as well as increasing inflationary pressures, which will tends increase the level of imports as well as widening the CAD. Inflation is seen as a problem because it reduces our international competitiveness due to rising costs of production, it causes a decline in the exchange rate, by affecting the demand and supply for Australian dollars in the Foreign Exchange Market. Whereas tightening monetary policy, involves the RBA selling government securities, causing a shortage of funds, putting an upward pressure on interest rates due to the limited funds available for borrowing. Because it is now more expensive to borrow funds, conversely it has a contractionary effect on the economy, by slowing down economic activity.
Monetary policy may be used as a short term instrument to address an external imbalance crisis; however, it is not regarded as an effective tool to address underlying external stability problems. While raising interest rates may reduced import spending in the short term, it also attracts financial inflow on the capital and financial account (as well as having negative impacts on the domestic economy), which in the longer term may raise NFL and therefore, the net income deficit and the CAD. Additionally, financial inflow is likely to cause an appreciation of the Australian dollar, which will erode the competitiveness of export and may put further pressure on the CAD. Exporters are already arguing that the RBA should reduce the gap between Australian and overseas interest rates, in order to ease the upward pressure on the dollar.
The most effective instrument to influence Australia's external performance in the past two decades has been microeconomic reform, which are actions taken by the government to improve resource allocation between firms and industries, in order to maximize output from scarce resource as and promote structural change. In effect, structural change is the process by which the pattern of production in an economy is altered over time, and certain products, processes of production and even industries disappear, while others emerge. Microeconomic reform improves efficiency of the operation of markets on the supply side of the economy. The shift towards microeconomic reform has reflected changes in economic management from demand towards measures to influence supply.
A more efficient allocation of resources minimizes distortions to the market economy, such as the impact of government regulation on prices and wages. The operation of market forces should bring out a more efficient allocation of resources. Achieving allocative efficiency promotes structural change by allowing resources to flow to those areas where they are used most efficiently. Technical efficiency, involves minimizing production costs by adopting the latest technology to free up resources being used elsewhere. With the benefits of dynamic efficiency and innovation, producers are able to respond to the changing pattern of demand in both domestic and world economy by maximizing the level of competition.
In recent decades have seen the deregulation of key sectors of the economy, this involves the removal of legislation and other rules which constrain the operation of market forces, and it aims to improve the efficiency of industries. The government recognises that perfect competition (large number of sellers, selling a homogenous product, in a market where there are no barriers to entry and perfect knowledge) is generally not possible. Therefore, it aims for workable competition, in order to achieve international competitiveness, necessarily reducing the number of firms in an industry. In the past two decades, Australia has deregulated its financial services, telecommunications, electricity, gas, aviation and agricultural industries.
The national competition policy reforms introduced since 1995, are the most extensive single package of microeconomic reforms in Australian history and aim to increase the level of competition in all sectors of the economy. This included, the establishment of the Australian Competition and Consumer Commission (ACCC), reforms to the Professions, Government Business Enterprise Reforms, State Government Instrumentalities, uniform national competition rules and access to rights for essential infrastructure.
Microeconomic reforms have promoted structural change in Public Trading Enterprises (PTEs), through corporatisation and privatisation of PTEs. Corporatisation aims to encourage PTEs to operate independently from government as if they are a private business enterprise. It involves eliminating external political and bureaucratic supervision. E.g. Australia Post Whereas privatisation, is the selling off of PTEs so they become private enterprises, whole or part. Australia has taken extensive measures e.g. QANTAS and the Commonwealth Bank to increase competition and rational management to force businesses to become more efficient.
Most recently, the Howard Government implemented the taxation reform package, including the introduction of a 10% Goods and Services Tax (GST) and the abolition of the Whole sales Tax. Which was aimed at reducing the extent to which the tax system distorts the allocation of resources and imposes costs on Australia Businesses. It is intended to benefit the entire economy, by brining reducing business cost by 2% and reducing costs for exporters by 3.5%, boosting economic growth by 2% over the medium to long to long term, although it had different impacts of different industries. ...
changes to wage determination and labour market.
These changes have been aimed at primarily raising the efficiency of production in Australia so that firms can better compete on global markets, which should in the long term improve Australia's balance of payment problems. Specific policy initiatives, such as Austrade's Export Market Development scheme and Australia's ongoing involvement in bilateral and multilateral trade negotiations are aimed at increasing the number of Australian exporters and increasing their international competitiveness on the world stage.
In recent years, the Government has given a relaxed view of the CAD, which has not given a high priority to external balance issues in recent years, in contrast to the high priority that it had throughout the 1980s and early 1990s. The government argues that external stability is simply no longer a major problem for the Australian economy (because of its effective economic management), giving the government more scope to focus on other domestic economic objectives. The major reason for the reduced focus on external issues has been the growing acceptance of the more relaxed view of Australia's external position, which was first argued when Australia was facing external problems in the late 1980s. The 'new view' placing its faith in global market forces, considers that any imbalance or change in Australia's external position is the result of individual's rational decisions, which should therefore be of little concern to policy makers. The 'new view' argues that while external stability is important for efficient markets, external balance may not be achievable, necessary or desirable for an economy.
However, the major implications to the 'new view,' the imbalance between private saving and investment levels (raising net foreign liabilities, the net income deficit and the current) should not be of concern to policy makers so long as the Government ensures the efficient functioning of markets and the imbalance is not directly subtracting from national savings, the most senior economist in Australia, the Treasury Secretary, Dr Ken Henry argues,
"A large CAD may be evidence of a national savings problem. But, then again, it might not. It may, alternatively, be evidence of a robust, rapidly growing economy, with a plentitude of attractive investment opportunities - more opportunities than should be, on any analysis, financed by domestic residents. Today, the consensus position is that while both national saving and national investment continue to be policy interest, the size of the gap between the (the CAD) is of essentially residential interest" June 2002.
The 'new view' understands exchange rate movements as the result of efficient foreign exchange markets - a rise or fall in the dollar is not necessarily bad. In fact, a depreciating currency, (caused by a widening CAD) may actually help to stabilize a nation's external accounts through the 'J - curve' effect. In recent years, a lower exchange rate reduces the foreign currency price of Australia's exports (or raises the dollar of export revenue if exports are priced in foreign currency) and increase the Australian dollar price of imports. As demand responds to these price changes. Exports should rise, imports should fall and the trade balance should improve. In contrast a rising dollar will undermine competitiveness. A survey conducted this year by the Australian Industry Group found that 36% of Australian manufacturing firms would be adversely affected by a rise in the dollar to US 70 cents, while only 12% would be better off, owing to reduced costs of imported inputs to production.
Despite fiscal, monetary and microeconomic reform measures not being focused on external issues in recent years, they are still compatible with policy of improving external stability. Firstly, the balanced budget aim of fiscal policy will contribute to better outcomes on national savings and reduce Australia's reliance on foreign borrowings. Secondly, the low inflation aim of monetary policy contributes to international competitiveness and a less volatile dollar. Thirdly, the aim of lifting productivity and efficiency through microeconomic reform helps to improve the international competitiveness of Australian exporters.
Nonetheless, critic have argued that more could be done to assist the growth of exporters, for example a more strategic use of policy and more active measures to encourage equity investment in Australia. Despite a outbreak of policy measures in 1997 centered on the Investing for Growth strategy for industry assistance, policy efforts have lapsed in recent years. For instance, the creation of a Strategic Investment Coordinator to attract overseas investment projects was a key part of these reforms in 1997. The position is now all but ignored, and nobody has been appointed to this role since it fell in July 2002.
Assessing the effectiveness of the Government's approach to external stability in Australia is difficult. Improvements in long-term external problems take time, and it is important to view the longer term trends rather than focusing on short term peaks and troughs in the CAD. Little doubt exists that external balance is still a problem. In the decade of 2002, Australia's CAD averaged 4.2% of GDP, well above what is regarded as a sustainable range. For instance, research conducted by the OECD suggests that the sustainable range for CADs is just 2-3%. And while there has been some improvement in a longer term sense, this seems to be much of the result of exceptionally low global interest rates and competitive exchange rate as it indicates Australia's economic fundamentals.
Due to the stabilization of NFL and the return of the Australian exchange rate to its post float average (yet the influence of government policy in both of these areas has been more limited). To the extent that the RBA is able to influence short term exchange rate volatility, it has appeared to have some successes. For example a 2003 RBA research paper found the RBA's defence of the Australian dollar in March 2001 to be a success - with the $3.6 billion purchase of Australian dollars dragging the exchange arte up fro its record low of US47.75 cents. The report by Jonathan Learns and Roberto Rigobon estimated that a $158 million purchase of dollars caused an 1.3-1.8% currency appreciation, suggesting that the RBA's exchange rate policy of 'leaning against the wind' can be successful during a period when the currency is under pressure. However, the RBA can have little influence on the exchange rate in the medium to longer term.
