The sustainability of Australia's current account deficits—A reappraisal after the global financial crisis

Abstract

The heated debate over the sustainability of Australia's high current account deficit that raged over most of the fixed and floating exchange period was due to the failure of policymakers to shift from the Keynesian Mundell Fleming (KMF) paradigm which has been rendered obsolete by the floating of the Australian in 1983q4 to the Intertemporal Optimization (ITO) paradigm which was more appropriate under the floating exchange rate as advocated by a number of Australian economists in the Pitchford thesis. The Pitchford thesis contended that after the floating of the exchange rate the current account deficit was the residual outcome of rational optimizing decisions of private agents and if there was fiscal balance then the policy of targeting the reduction of the current account deficit based on the KMF paradigm was misconceived. Empirical tests based on the application of the net present value criterion using vector autoregressions, unit root and cointegration econometrics reveals that Australia's current account deficit revealed that the current account deficits were unsustainable during the fixed exchange period and over the whole study period 1960q3–2007q4, but not during the floating exchange rate period post-1983q4. Therefore the empirical results gave credibility to the Pitchford thesis but Australian policymakers continued to target the reduction of the current account deficit because their failure to make the paradigm shift from KMF to ITO to be consistent with the regime shift from a fixed to a floating exchange rate. However, in 2004 after more than two decades feuding Australian policymakers accepted the Pitchford thesis and abandon the policy of targeting the reduction of the current account deficit. But the global financial crisis and global recession has delivered a death blow to the Pitchford thesis by undermining the key assumptions of fiscal balance and rationality that underpins it. The fiscal stimulus package that has been implemented to combat the fall in aggregate demand and restore consumer confidence due to the global recession has resulted in massive fiscal imbalance and the credit crunch has undermined rational behavior and consumer confidence. Therefore, the Pitchford thesis no longer rules the policy roost after the global financial crisis. In this study we draw on the conflicting policy perspectives on the unsustainability of high US current account deficits that tender a malign prognosis based on Salvatore's twin deficit hypothesis and a benign prognosis based on Bernanke's global savings glut hypothesis to identify some key policy challenges that confront Australian policymakers to navigate the Australian economy out of the global financial crisis and recession into a robust recovery phase in the near future.