An Econometric Evaluation of the Sustainability of Australia's High Current Account Deficit

Abstract

In the mid-1980s Australia' Current Account Deficit (CAD) as a ratio of GDP reached 5 percent, that is double the historic average. Policymakers regarded this high CAD and the associated foreign debt was unsustainable and advocated the use of all policy levers to rein in the high CAD. Activist policies that targeted the reduction of the CAD received theoretical support from the dominant Keynesian-Mundell-Fleming (KMF) paradigm based on a fixed exchange rate regime. However, in 1983Q4 the forces of globalization that resulted in the increase of cross-border capital mobility led Australia to float the dollar causing a regime-shift that rendered obsolete the dominant KMG paradigm because it resulted in the 'Open Economy Trilemma'. A group of Australian economists argued that activist policies that targeted the reduction of the CAD, after the regime-shift cause by the dollar float, was misplaced. Based on the theory of the Intertemporal Optimisation Model (IOM) they argued the CAD and the resulting foreign debt was the residual outcome of optimising decisions of rational agents and required no policy action to render them sustainable. A heated debate erupted between the proponents of the rival paradigms and it occupied the centre stage of the Australian policy debate for nearly a quarter of a century. This paper revisits the policy debate on the sustainability of CAD and tests whether it satisfied the net present value criterion of consumption smoothing as subsumed in the IOM, during the study period using VAR and cointegration techniques. The emprircal tests over the case study period, reveals that the CAD satisfied the sustainability criteria only after the float of the dollar in 1983Q4 and not before.

Keywords: Current Account Sustainability, Intertemporal Optimisation, Open Economy Trilemma

JEL Classification: C32, E13, E21, F32, F41, N10