In this paper the polemics and empirics on the sustainability of Australia’s high current account deficits and foreign debt that prevailed during the period 1959q3-2007q1 is revisited. The paper contends that the forces of globalization brought about a policy regime shift culminating in the floating of the Australian dollar in 1983q4. However, the policymakers failed to abandon the static old paradigm, the Keynesian-Mundell-Fleming model, which had been rendered obsolete by the policy regime shift. The policymakers continued to distill their activist policies to reduce the high current account deficits from an outmoded paradigm. The proponents of the rival new paradigm argued that the current account imbalances were the residual outcome of rational optimizing decisions of private sector agents and therefore the use of activist policies to target the reduction of the current account deficits as proposed by the adherents of the old paradigm were misconceived. The ensuing clash between the proponents of rival paradigms fuelled the policy polemics during almost a decade after the paradigm shift that occurred at the same time as the floating of the exchange rate. The activist policies failed to halt the rise in the current account deficits and foreign debt and the predicted dire economic consequences from the failure to rein in the current account deficit never materialized. Today, the current deficits and the foreign debt are at record high levels by historical standards, but they do not seem to grab the attention of the policymakers or make media headlines as in the past. The empirical results offer qualified support for prevalence of consumption smoothing during both the pre and post-float periods. The finding in favour of consumption-smoothing during the pre-float era is at odds with the findings of other studies. There appears to be evidence supporting the hypothesis that a regime-shift due to globalization and it occurred at the same time as the float and was reflected in an increase in consumption-tilting. Post-float and during the entire study period Australia, appears to have satisfied the intertemporal budget constraint and remained solvent. Furthermore, both over the whole sample period and post float period Australia appears to have engaged in effective consumption-smoothing notwithstanding the polemics and some empirics to the contrary. The solvency and consumption smoothing dynamics observed for Australia during the study period supports the new paradigm’s non-activist policy stance towards high current account deficits. However, it should be noted that this passive policy stance that is intertemporally optimal for achieving current account sustainability in Australia may not be applicable in other countries with high current account deficits because they may idiosyncratic features that differ widely from those prevalent in Australia.
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Paper provided by School of Economics, University of Queensland, Australia in its series Discussion Papers Series with number
364.
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