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The Polemics and Empirics of the Sustainability of Australia’s Current Account Deficit - Revisited

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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File URL: http://www.uq.edu.au/economics/abstract/364.pdf
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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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Date of creation: 2008
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Handle: RePEc:qld:uq2004:364
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Web page: http://www.uq.edu.au/economics/
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  1. David Gruen & Amanda Sayegh, 2005. "The Evolution of Fiscal Policy in Australia," Oxford Review of Economic Policy, Oxford University Press, vol. 21(4), pages 618-635, Winter.
  2. Maurice Obstfeld and Kenneth Rogoff., 1994. "The Intertemporal Approach to the Current Account," Center for International and Development Economics Research (CIDER) Working Papers C94-044, University of California at Berkeley.
  3. Des Moore, 1990. "Debt - Is It Still A Problem?," Australian Economic Review, The University of Melbourne, Melbourne Institute of Applied Economic and Social Research, vol. 23(3), pages 17-32.
  4. Ghosh, Atish R & Ostry, Jonathan D, 1995. "The Current Account in Developing Countries: A Perspective from the Consumption-Smoothing Approach," World Bank Economic Review, World Bank Group, vol. 9(2), pages 305-33, May.
  5. Dickey, David A & Fuller, Wayne A, 1981. "Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root," Econometrica, Econometric Society, vol. 49(4), pages 1057-72, June.
  6. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," Cowles Foundation Discussion Papers 785, Cowles Foundation for Research in Economics, Yale University.
  7. Perron, P, 1988. "The Great Crash, The Oil Price Shock And The Unit Root Hypothesis," Papers 338, Princeton, Department of Economics - Econometric Research Program.
  8. John Y. Campbell, 1986. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," NBER Working Papers 1805, National Bureau of Economic Research, Inc.
  9. A. J. Makin, 1989. "Is the Current Account Deficit Sustainable?," Australian Economic Review, The University of Melbourne, Melbourne Institute of Applied Economic and Social Research, vol. 22(2), pages 29-33.
  10. Trehan, Bharat & Walsh, Carl E, 1991. "Testing Intertemporal Budget Constraints: Theory and Applications to U.S. Federal Budget and Current Account Deficits," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(2), pages 206-23, May.
  11. Bergin, Paul R & Sheffrin, Steven M, 2000. "Interest Rates, Exchange Rates and Present Value Models of the Current Account," Economic Journal, Royal Economic Society, vol. 110(463), pages 535-58, April.
  12. Gruber, Joseph W., 2004. "A present value test of habits and the current account," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1495-1507, October.
  13. J. D. Pitchford, 1989. "Does Australia Really Have A Current Account Problem?," Economic Papers, The Economic Society of Australia, vol. 8(4), pages 25-32, December.
  14. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
  15. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
  16. Kim, Kunhong & Hall, Viv B. & Buckle, Robert A., 2006. "Consumption-smoothing in a small, cyclically volatile open economy: Evidence from New Zealand," Journal of International Money and Finance, Elsevier, vol. 25(8), pages 1277-1295, December.
  17. Jacques Miniane & Benoît Mercereau, 2004. "Challenging the Empirical Evidence From Present Value Models of the Current Account," IMF Working Papers 04/106, International Monetary Fund.
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