If you think surpluses are always good, prepare for great news

Don’t look now, but Australians’ economic dealings with the rest of the world have transformed while our attention has been elsewhere. Business economists are predicting that, on Tuesday, we’ll learn that the usual deficit on the current account of the balance of payments has become a surplus.

If so, it will be the first quarterly surplus in 44 years. If not, we’ll come damn close.

You have to be old to appreciate what a remarkable transformation that is. Back in the 1980s we were so worried about the rise in the current account deficit and the foreign debt that it was a regular subject for radio shock jocks’ outrage. They knew nothing about what it meant, but they did know that “deficit” and “debt” were very bad words.

By the 1990s, Professor John Pitchford, of the Australian National University, had convinced the nation’s economists that the rises were a product of the globalisation of financial markets and the move to floating exchange rates, and weren’t a big deal.

By now, economists have become so relaxed about the “balance of payments” that it’s rarely mentioned. So news of the disappearing deficit will be a surprise to many.

To begin at the beginning, the balance of payments is a summary record of all the monetary transactions during a period that have an Australian business, government or individual on one end and a foreign business, government or individual on the other.

The record is divided into two accounts, the current account and the capital and financial account.  The balance on the current account is always exactly offset by the balance on the capital account. If one has a deficit of $X billion, the other must have a surplus of $X billion, so that the balance of (international) payments is in balance at all times.

As a Reserve Bank explainer says, the current account captures the net flow of money resulting from our international trade. The capital account captures the net flows of financial capital needed to make all the exporting, importing and income payments possible. These flows during the period change the amounts of Australia’s stocks of assets and liabilities at the end of the period.

To work out the balance on the current account, first you take the value of all our exports of goods and services and subtract the value of all our imports of goods and services, to get the balance of trade.

Then you take all the interest income and dividends we earnt from our investments in foreign countries and subtract all the interest and dividend payments we make to foreigners who’ve lent us money or invested in our companies.

The result is the “net income deficit” which, after you’ve added it to the trade balance, gives you the balance on the current account. As Michael Blythe, chief economist at the Commonwealth Bank, noted this week, that balance has been a deficit for 133 of the past 159 years.

Why do we almost always run a deficit? Because our land abounds in nature’s gifts, and there’s great opportunity to exploit those gifts and earn wealth for toil. What we’ve always been short of, however, is the financial capital needed to take advantage of all the opportunities.

Moving from poetry to econospeak, for pretty much all of our modern history Australia has been a net importer of (financial) capital, as Reserve deputy Dr Guy Debelle said in a revealing speech this week.

Because we don’t save enough to allow us to fully exploit all our opportunities for economic development, we’ve always drawn on the savings of foreigners – either by borrowing from them or letting them buy into Australian businesses.

Blythe says “the shortfall reflects high investment rather than low saving. By running current account deficits, we have been able to sustain a higher [physical] investment rate than we could fund ourselves. Economic growth rates and living standards have been higher than otherwise as result.”

True. And Debelle agrees, noting that Australia’s rate of saving is on par with many other advanced economies. (So don’t let any silly pollies or shock jocks tell you a current account deficit means we’re “living beyond our means”.)

Be sure you understand this: a current account deficit is fully funded by the corresponding surplus on the capital account, which represents the amount by which we needed to call on the savings of foreigners because the nation’s physical investment in new housing, business plant and structures, and public infrastructure during the period exceeded the nation’s saving (by households, companies and governments) during the period.

But if all that’s true, how come we’re expecting a current account surplus in the June quarter? It’s a combination of long-term changes in the structure of our economy that have been working to reduce the deficit, and temporary factors that may push us over the line.

Debelle says that between the early 1980s and the end of the noughties, the deficit averaged the equivalent of about 4 per cent of gross domestic product. But it’s narrowed since 2015 and is now about 1 per cent of GDP.

Most of this change is explained by the trade balance. It averaged a deficit of about 1.25 per cent of GDP over the three decades to 2015, but since then has moved into surplus. It hit record highs during the three months to June, totalling a surplus of $19.7 billion for the quarter.

The resources boom has hugely increased the quantity of our minerals and energy exports, and there’s been a temporary surge in the price we’re getting for our iron ore. At the same time, the end of the investment phase of the resources boom has greatly reduce our imports of mining and gas equipment.

The rise of China and east Asia also means protracted strong growth in our exports of education and tourism.

At the same time, the net income deficit has widened a little in recent years but, at 3.4 per cent of GDP, is in the middle of its range since the late 1980s.

The marked reduction in the current account deficit overall means that Australia’s stock of net foreign liabilities (debt plus equity in businesses) peaked at 60 per cent of GDP in 2009 and has now declined to 50 per cent. But that’s a story for another day.

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Our dealings with the world have reversed, for good or ill

One of the most remarkable developments in our economy in recent times is also the most unremarked: after endless decades of running a deficit on the current account of our balance of payments, for the past two years we’ve been running a surplus. Which looks likely to continue.

Because a “deficit” sounds like it’s a bad thing, and the media know their audience finds bad news much more interesting than good news, I guess it’s not so surprising this seemingly good news hasn’t attracted much attention.

But one thing economics teaches is that, contrary to popular impression, not all deficits are bad and not all surpluses are good. It depends on the circumstances. But regardless of whether they regard a current account surplus as a good sign or a bad one, I suspect most economists think there are more important issues to worry about.

This week the Australian Bureau of Statistics revealed a record trade surplus of $10.5 billion in just the month of June.

We recorded a current account surplus of $17.6 billion during the March quarter this year. That compares with a peak deficit of $23.5 billion in September quarter, 2015.

Since the bureau started publishing the figures in 1959, we’ve run 221 quarterly deficits, but just 26 surpluses. Eight of those have come over the past two years.

But let’s start at the beginning. A country’s “balance of payments” is a summary record of all the transactions during a period of time between, in our case, an Australian on one side and a foreigner on the other. Those on either side could be businesses, governments or individuals. Mainly they’re businesses.

Conceptually, the balance of payments is recorded using double-entry bookkeeping, where one side of the transaction is recorded as a debit and the other as a credit. So, when you add up all the debits and add up all the credits, the two amounts should be equal. Thus the balance of payments is in balance at all times.

This matters because the balance of payments is divided into two main accounts, the “current account” and the “capital and financial account”. The value of transactions involving exports or imports of goods and services goes in the current account, as do payments – in or out - of income such as interest and dividends.

But the other side of each of those transactions involving exports, imports or income payments, the amount someone has to pay – the financial side of the transaction – goes in the capital account, as do purely financial transactions, such as when one of our banks borrows from or lends to some overseas bank, or when one of our superannuation funds buys or sells shares in a foreign company.

Bear with me. The income we earn from foreigners who buy our exports or pay us dividends or interest is recorded as a credit, whereas the money we pay to foreigners for our imports or as dividends on the Australian shares they own or interest on the money they’ve lent us is recorded as a debit.

When we sell them shares in an Aussie business, borrow from them or sell them some real estate, that’s a credit in the capital account. When they sell us shares or land or lend us money, that’s recorded as a debit.

An account where the debits exceed the credits is in deficit. When the credits exceed the debits it’s in surplus.

There had to be a reason for explaining all this, and we’ve reached it. Historically, we almost always imported more than we exported, running a deficit on trade in goods and services. Likewise, we always had to pay more in dividends and interest to foreign owners and lenders than they had to pay us on our foreign shareholdings and loans to them, thus causing us to run a “net income deficit”.

Put the trade deficit and the net income deficit together and you get the balance on the current account, which was always in deficit. Oh no!

But here’s the trick. Since the double-entry system means the debits always equal the credits, if we always ran a deficit on the current account of the balance of payments, that means we always ran an equal and opposite surplus on the capital account. Yippee!

So if you think it’s good news that our current account is now in surplus, what do you think of the news that our capital account is now in deficit? Time to stop assuming all deficits are bad and all surpluses good.

In all the decades that our current account was in deficit, economists never thought that a bad thing. They knew Australia was – and should be – a “capital-importing country”. We always had a lot more investment opportunities than we could finance with our own saving, so we invited foreigners to bring their savings to Oz to participate in our economic development.

This continuous inflow of foreign capital gave us a continuous surplus on the capital account and thus allowed us to import more than we exported. Naturally, we had to pay big dividends and interest to those foreign investors.

So, why has all that reversed? Well, the reversal began in about 2015, long before the pandemic. Its first main cause is the rapid industrialisation of China, which has greatly increased our exports of minerals and energy and, until the pandemic, education and tourism.

But a second, less-favourable development has been our part in the rich economies’ slowdown in economic growth since the global financial crisis in 2008. This has involved increased saving and reduced investment spending – both of which have helped move our current account towards surplus and our capital account towards deficit.

Economists at the ANZ Bank predict the current account will fall back towards balance over the next few years. But we won’t return to our accustomed capital-importing status until we and the rest of the rich world escape the present low-growth trap.

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We're investing more overseas than foreigners are investing here

 For pretty much all of Australia’s modern history, our strategy for getting more prosperous was to be a “net importer of [investment] capital” from the rest of the world. But four years ago, that was turned on its head, and we became a net exporter of investment capital.

If you think that doesn’t sound like a good thing, I agree with you – though probably not for the same reason as you. I think it does much to explain why the economy – and the productivity of our labour – have grown so weakly over the past decade. And are likely to continue growing slowly once the Reserve Bank has beaten inflation out of our system.

How come you haven’t heard about this historic turnaround? Because, though economists hate to admit it, economics is subject to fashions, and for many years they haven’t been much interested in talking about what’s happening in the economy’s “external sector”, which accounts for about a quarter of the whole economy.

All of Australia’s households’, businesses’ and governments’ economic dealings with the rest of the world during a period are summarised in a document called the “balance of payments” – payments to foreigners and payments from foreigners.

The balance of payments is divided into two accounts, the “current” account and the “capital and financial” account.

The current account shows the value of our exports of goods and services ($171 billion in the latest, March quarter) less the value of our imports of goods and services ($129 billion), to give us a trade surplus for the quarter of $42 billion.

But then it takes account of our interest and dividend payments to foreigners of $57 billion, less their payments of interest and dividends to us of $24 billion, to give us a “net income deficit” of $33 billion.

Subtracting this deficit from the trade surplus of $42 billion leaves us with a surplus on the current account for the quarter of $9 billion.

So, we ended up making a profit during the quarter, as we have in every quarter for the past four years, whereas for almost every year before that we ran deficits. We’ve made some progress.

Is that what you think? Sorry, as the father of economics, Adam Smith – born 300 years ago this year – spent his life explaining, this “mercantilist” notion that a country gets rich by trying to export more than it imports is wrong.

We benefit from importing the things that other countries do better than we do, and they benefit from us exporting to them the things we do better than they do. Economists call this the “mutual gains from trade”.

In any case, like the accounts of every business, the balance of payments is based on “double-entry bookkeeping”, where every transaction is seen as having two, equal sides, a debit and a credit. So, it’s wrong to think that debits are bad and credits are good.

Similarly, it’s wrong to think that the resulting deficits (debits exceed the credits) are bad, and surpluses (credits exceed the debits) are good.

And remember that the “current” account is only one half of the balance of payments so, since the debits and credits are always equal, if we’re running a surplus on the current account, we must be running a deficit of equal size on the other, capital and financial account.

Until four years ago, we always ran a surplus on the capital account, but now we’re running a deficit. But what does this switch actually mean?

It means that, until recently, our households, businesses and governments always spent more on investment – in new housing, new business equipment and structures, and new public infrastructure – than they could finance from their own savings.

(Households save when they don’t spend all their income on consumption. Businesses save when they don’t pay out all their after-tax profits in dividends. Governments save when they raise more in taxes than they spend on their day-to-day activities.)

How can we, as a nation, spend more on new physical investment than we’re able to finance with our own saving? By getting the extra savings we need from abroad. We can borrow it, or we can allow foreigners to own Australian businesses or real estate.

And that’s exactly what we did until four years ago. We borrowed overseas and let foreigners own “equity” in our economy. This is what it means to say Australia was a “net importer of capital”.

Why did we do that? Because we had more opportunities for economic development than we could finance from our own saving, and figured that allowing foreigners to join us in investing in our economy would leave us better off.

The consequence was that, for more than 200 years, our economy grew faster and our standard of living improved faster than if we’d kept everything to ourselves.

So, what’s changed? Why have we switched to being a net exporter of investment capital? Why have we begun investing more of our savings in other countries than they’ve been investing in Oz?

Partly because the build-up of our compulsory superannuation system means we, as a nation, are saving a lot more of our income than we used to.

Now here’s the killer: but also because, particularly since the end of the mining investment boom a decade ago, we’ve been investing a lot less in improving and expanding our businesses.

You wonder why, until the government and the Reserve Bank mistakenly caused the present brief inflationary surge, the economy’s growth was so weak? Now you know.

You wonder why the productivity of our labour’s been improving so slowly? Because we haven’t had enough business investment in new and better machines. Or in research and development, for that matter.

And the main thing we’ve got to show for this deterioration is a current account surplus. You beaut.

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We should get a fair share of foreign investors' profits

Australia has been a recipient of foreign investment in almost every year since the arrival of the First Fleet in 1788. Yet for much of that time the idea of foreigners being allowed to own so much of our businesses, mines, farms and land is one many ordinary Australians have found hard to accept.

For older Australians, the thought of “selling off the farm” to foreigners makes them distinctly uncomfortable. Why can’t we do it ourselves and own it ourselves?

The short answer is, we could. But had we chosen that path we wouldn’t be nearly as prosperous today as we are. As the Productivity Commission reminds us in a paper published this week, you need money to set up a business, let alone a whole industry.

That money has to be saved by spending less than all your income on consumption. And had we been relying solely on our own saving, we’d have been able to develop much less of this vast continent than we have done. So, from the days when we were a British colony and had no say in the matter, we’ve invited foreigners to bring their savings to Australia and join us in exploiting the golden soil and other of nature’s gifts with which our land abounds.

Total foreign direct investment – that is, where the foreigner owns enough of the shares in a company to have some control over its management – is now worth about $1 trillion. The largest sources of direct investment are, in order, the United States, Japan and Britain. In recent years, of course, most of the action – and the angst – comes from China.

The less poetic way to put it is that Australia has been a “net importer of capital” for more than two centuries. It’s thus not so surprising that, despite whatever reservations ordinary Australians may have, the dominant view among our politicians, business people and economists has been that we must keep doing whatever it takes to attract the foreign investment we need to keep the economy expanding strongly.

For many years it was felt that we always run a deficit on our balance of trade in goods and services with the rest of the world, so we always need to attract sufficient net inflow of foreign capital to be sure of financing that trade deficit – as well as covering all the regular payments of dividends and interest we need to make to the foreigners who have invested in local businesses or have lent us money.

This mentality made sense in the days when we had a “fixed exchange rate” – when the government, via the Reserve Bank, set the value of our country’s currency relative to other countries’ currencies – particularly the British pound and, later, the US dollar – and changed that value only very rarely in situations where it couldn’t be maintained.

The point is that when you choose to fix the price of your currency, you do have to worry about getting sufficient net inflow of foreign capital to cover the deficit on the “current account” of the “balance of payments”. Should you fail to attract sufficient inflow, you’re forced into the ignominy of cutting the price you’ve fixed.

Now, this problem went away a long time ago. In 1983, after we’d been having a lot of trouble keeping our exchange rate fixed and our balance of payments in balance, we decided to join most of the other advanced economies in allowing the value (or price) of our currency to float up and down according to the strength of the rest of the world’s demand for the Australian dollar (the Aussie, as it’s called in the foreign exchange market) relative to the supply of it.

From that day, the two sides of our balance of payments – the current account and the capital account – were in balance, the deficit on one matched exactly by the surplus on the other, at all times. How? Because the price of the Aussie adjusted continuously to ensure they were.

The “balance of payments constraint”, which had worried the managers of our economy for so long, just evaporated. But here’s the point: the attitude that we must always be doing as much as we can to attract as much foreign investment as possible continued unabated.

There’s this notion that, in the now highly competitive, globalised financial markets, if poor little Australia doesn’t try really, really hard, we’ll miss out.

This, of course, is the reasoning behind the unending push by big business for us to cut the rate of our company tax. Our system of “dividend imputation” means Australian shareholders have nothing to gain from a lower company tax rate. The only beneficiaries would be foreign shareholders because they aren’t eligible for “franking credits”.

We’re asked to believe that how well the level of the nominal rate of our company tax compares with other countries’ rates is the main factor determining whether we get all the foreign investment we need. Not even how the tax breaks we offer compare matters much, apparently.

I don’t believe it. It’s a try-on. As the Productivity Commission’s paper reminds us: “Foreigners invest in Australia because of our fast-growing and well-educated population, rich natural resource base, and stable cultural and legal environment.”

Just so. Mining companies flock to Australia because we have the high-quality, easily-won minerals and energy they need. The idea that global companies such as Google or Amazon would give Australia a miss because our company tax rate’s too high is laughable. Especially when they’re so adept at minimising the tax they pay in advanced countries.

We should take a more hard-nosed, business-like attitude towards foreign investors such as the miners, which make huge profits but employ very few workers. When state governments fall over themselves building infrastructure for them and offering royalty holidays and other inducements, it matters greatly how much company tax they pay before they ship their profits back home.

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Thrift paying big dividends on current accounts

The nation's econocrats have been pondering the resources boom for years, but one thing they've been expecting isn't coming to pass: we're not getting huge deficits on the current account of the balance of payments.

Last week's figures showed a deficit of just $5.3 billion for the June quarter, about half what it was in the March quarter. This included a surplus on the balance of (international) trade in goods and services of

$7.5 billion - the fifth quarterly surplus in a row - offset by a deficit on net income payments (our payments of interest and dividends to foreigners less their payments to us) of $12.8 billion.

Switching to the year to June, the current account deficit was $33.6 billion, down from $53.3 billion the year before. Expressed as a proportion of gross domestic product, this was an amazingly low 2.4 per cent, down from 4.1 per cent the year before.

So why were the econocrats expecting bigger deficits? Because most of the money to finance the surge of investment in new mines and natural gas facilities would have to come from foreigners, thereby adding to the surplus on the capital account of the balance of payments which, with a floating currency, is always exactly balanced by a deficit on the current account.

And why haven't the big deficits come to pass? Because household saving has been a lot greater than the econocrats were expecting. The more the nation saves, the less it has to call on the savings of foreigners to finance its investment spending.

Last financial year's current account deficit is down because saving is up while the mining investment boom is only just getting started.

As that boom gets under way, the current account deficit is likely to grow. This year's budget forecast a deficit of 4 per cent of GDP for this financial year, rising to 5.25 per cent in 2012-13. Even so, those figures are smaller than the econocrats had been expecting before they realised how much more households were saving.

Last week's national accounts showed households saving a net (that is, after allowing for the year's depreciation in the value of household assets) 10.5 per cent of household disposable income. This is unlikely to be an aberration; it's more likely to be a reversion to our earlier thrifty habits.

If you're more used to thinking about the current account deficit in terms of exports and imports, I should explain that these days economists tend to look on the other side of the coin, which shows saving and investment.

The current account deficit equals the capital account surplus, which represents the net inflow of foreign financial capital to the Australian economy. As we've seen, we call on the savings of foreigners to finance that part of our investment in new physical capital than can't be financed by our own saving.

This net inflow of foreign financial capital allows us to import more goods and services than we export, including imports of capital equipment.

The net capital inflow also helps us finance our net payments of interest on the nation's net foreign debt and our net payments of dividends on net foreign equity investment in Australia's businesses - though the ultimate justification for our foreign borrowing is the profits we make from our physical investments.

The nation's annual investment spending includes not just business investment in equipment and structures, but also public investment in infrastructure and households' investment in the construction of new homes.

Similarly, the nation's annual saving includes not just the amount saved by households, but also the saving companies do when they retain part of their after-tax profits rather than paying them all out in dividends and the saving governments do when they raise more in revenue than they need to cover their recurrent spending.

According to an article in the federal Treasury's latest Economic Roundup, in the decade or so before the first stage of the mining boom began in 2003, the current account averaged 3.7 per cent of GDP. During the first stage it averaged 5.7 per cent, but since the global financial crisis it's averaged 3.3 per cent.

Before the mining boom, gross national investment spending (that is, before allowing for the annual depreciation of assets) averaged 24.3 per cent of GDP. Since the start of the mining boom it's averaged 27.9 per cent.

Had the level of gross national saving stayed unchanged, that would have increased the average current account deficit by 3.6 percentage points. In fact, national saving has increased from 22.2 per cent to 24.5 per cent.

While households have been saving a lot more in the period since the global financial crisis, federal and state governments have fallen into operating deficit, meaning they've gone from saving to dissaving. As they get their budgets back to operating surplus in the next year or two they'll be adding to rather than subtracting from national saving.

Company profits have been high in recent years and many companies have been saving a fair bit. Mining companies, in particular, have been reinvesting a lot of their after-tax profits in expanding their activities. (To the extent that those retained earnings are owned by foreign shareholders, and were initially counted in the balance of payments as capital outflows, their reinvestment is counted as foreign capital inflow, even though the actual dollars never left the country.)

Australia's persistent current account deficit has always reflected a high rate of national investment rather than a low rate of national saving. Although our household saving rate was quite low during the decade or so to the mid-noughties, our overall, national rate of saving has been around the average for the developed economies.

Point is, should our current account get a lot bigger in the next few years, it will be because the mining construction boom involves a lot more investment spending, not because we're saving less.

We've done much hand-wringing lately about ''the cautious consumer'' (especially when we imagined consumer spending was weak, which we learnt last week it isn't), but the fact that increased household saving has stopped the strong growth in household income translating into booming consumer spending has some big advantages.

If we can avoid a consumption boom occurring at the same time as an investment boom, the Reserve Bank won't need to increase interest rates as much to control inflation and this, in turn, will avoid adding upward pressure to the Aussie dollar.

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Current account deficit improves without us noticing

They say a watched pot never boils, so maybe it's a good thing we now spend so little time worrying about the current account deficit. While our attention's been elsewhere, it's got a lot smaller.

This news comes courtesy of the International Monetary Fund's latest country report on Australia, issued this week.

Settle back. The nation's "balance of payments" is a statement summarising all the transactions between Australians (whether businesses, governments, or individuals) and the rest of the world.

It's divided into two main accounts. First is the "current account", which summarises exports and imports of goods and services, plus inflows and outflows of income, particularly payments of dividends and interest on loans.

Then there's the "capital and financial account" which, as its name implies, summarises the inflows and outflows arising from the financial-capital dimension of the transactions included in the current account.

Because the balance of payments is calculated using the accountants' double-entry bookkeeping system of debits and credits, the balance of payments is always in balance. So if the current account sums to a deficit, the capital account must sum to a surplus of the same size.

The fund's report acknowledges that Australia almost always runs a deficit on the current account, with an offsetting surplus (net capital inflow) on the capital account.

This is because we've always invested a lot more each year (in new business equipment and structures, homes and public infrastructure) than we (businesses, households and governments) have saved each year, so we've always needed to call on the savings of foreigners to make up the gap.

Foreigners' savings come as either loans (known as "debt capital") or the purchase of shares in our businesses or real estate ("equity capital").

Worries about the size of the deficit on the current account go back to the days before 1983, when the Australian dollar's rate of exchange with other currencies was fixed at a certain level by the government.

It was the government's job to defend that fixed rate by making sure the current account deficit and the capital account surplus were never too far apart.

This "balance of payments constraint" meant that if the current deficit got too big relative to the capital surplus, the government would have to crunch the economy so as to get imports down and thus help it keep the dollar's value unchanged.

If this didn't happen, the government would suffer the ignominy of devaluing our dollar and hoping this would get the current deficit and capital surplus back together.

When, in 1983, we decided to allow the value of the dollar to "float", however, this allowed it to move up or down automatically and continuously by however much was needed to keep the current deficit and the capital surplus exactly equal at all times.

It took until some years after the float for economists to realise that, in the new, more globalised world of floating currencies and unrestricted flows of financial capital between countries, there was much less reason to worry about the excessive size of the current deficit.

The necessary "devaluation" of the exchange rate would be brought about by the foreign exchange market, not the government.

The fund's report notes that, in the 1960s and '70s, the current account deficit fluctuated around 1 and 2 per cent of gross domestic product.

During the 35 years since the float, however, the current deficit blew out, averaging about 4 per cent of GDP. In consequence, there was a huge increase in our foreign liabilities, particularly our net foreign debt – to a mere $990 billion at last count.

This is what worried many people – until the economists and politicians decided to stop talking about it and focus on something different, the federal government's budget deficit and net government debt.

But here, at last, is the news: the fund reports that, since the global financial crisis in late 2008, the current account deficit has been a lot smaller. It's expected to have been only 2 per cent in 2017.

Why the improvement? Since the current deficit and the capital surplus are two sides of the same coin, you can explain changes by looking at either side – or both. The report offers two reasons for the smaller current deficit and three for the smaller capital surplus.

On the current account, it says we suffered a larger slowdown in growth in domestic demand (spending on consumption and investment goods) following the crisis than did our major trading partners (which, remember, are mainly fast-growing Asian economies).

So our imports from them weakened by more than our exports to them.

As well, the current deficit has been reduced by a lower "net income deficit" – gone from 3 per cent of GDP before the crisis to 1.5 per cent since – because world interest rates are so much lower, and our interest payments to foreigners far exceed their interest payments to us.

On the capital account surplus – representing the amount by which national investment exceeds national saving - the report notes that households have been saving a higher proportion of their incomes since the crisis than before it (even though they're saving less now than they were a few years back).

Second, since the crisis, our companies have saved more by retaining more of their profits rather than paying them out in dividends and, despite the surge in investment spending by mining companies that's only now ending, other companies haven't been investing much until recently.

Finally, the tightening up of international capital adequacy requirements in reaction to the crisis has obliged our banks to increase their saving by retaining more of their profits.

The report foresees the current account deficit stabilising at about 2.5 per cent of GDP in the next few years – which would be almost back to its modest levels when our exchange rate was still fixed.

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Why surpluses aren't necessarily good, or deficits bad

According to the Essential opinion poll, only 6 per cent of people regard the size of the national surplus as the most important indicator of the state of the economy. I think that’s good news, but I’m not certain because I’m not sure what “the national surplus” is – or what the respondents to the poll took it to mean.

They probably thought it referred to the balance on the federal government’s budget. But the federal budget is not yet back to surplus and, in any case, it can’t be the national surplus because it takes no account of the budgets of the state governments that, with the feds, make up the nation.

Assuming respondents took it to be the federal budget balance, its low score is good news about the public’s economic literacy, but bad news for Scott Morrison and Josh Frydenberg, who are hoping to make a huge political killing when, in September next year, they expect to announce the budget finally is back in surplus.

The pollies are assuming that voters know nothing more about the economy than that anything called a surplus must be a good thing, whereas anything called a deficit must be very bad.

Actually, no economist thinks all surpluses are good and all deficits bad. Sometimes surpluses are good and sometimes they’re bad. Vice-versa with deficits. It depends on the economy’s circumstances at the time.

But the confusion doesn’t end there. There are lots of measures in the economy that can be in deficit or surplus, not just governments’ budgets. When I wrote a column some weeks back foreshadowing that the current account on the nation’s balance of payments would probably swing into surplus for the first time in 44 years, some people assumed I must be referring to the federal budget.

Wrong. The federal budget records the money flowing in and out of the federal government’s coffers – it’s bank account. The “balance of payments” summarises all the money flowing into and out of Australia from overseas – covering exports, imports and payments of interest and dividends in and out (making up the “current account”), and all the corresponding outflows and inflows of the financial payments required (making up the “capital and financial account”).

The trick is that, thanks to double-entry bookkeeping, the balances on the two accounts making up the balance of payments must be equal and opposite. So the longstanding deficit on the current account was always exactly offset by a surplus on the capital account.

And that means the (probably temporary) current account surplus was matched by the capital account swinging from surplus to deficit. Oh no.

Although Australia has been a net importer of (financial) capital almost continuously since the arrival of the First Fleet, for the June quarter we became a net exporter, lending or investing more money in the rest of the world than the rest of the world lent or invested in us.

If you tell the story of this change in plus and minus signs from the current account perspective, it’s mainly that the resources boom has greatly increased our exports, while the slowing in the economy’s growth means our imports of goods and services are also weak.

But there’s also a story to be told about why the capital account has gone from surplus to deficit. As Reserve Bank deputy governor Dr Guy Debelle explained in a speech at the time, the composition of the inflows and outflows of financial capital have changed a lot since 2000.

Since Australia has always been a recipient of foreign investments in our businesses, by June this year, the value of the total stock of that equity investment amounted to a liability to the rest of the world of $1.4 trillion.

But the value of our equity investments in the rest of the world amounted to assets worth $1.5 trillion. So, when it comes to equity investment, the latest figures show we had net assets of $142 billion.

The fact is, the value of our shares in them overtook the value of their shares in us in 2013. That’s a remarkable turnaround from the previous two centuries of being a destination for foreign investment.

Why did it come about? Mainly because of our introduction of compulsory superannuation. Our super funds have invested mainly in local companies, but they’ve also invested a lot in the shares of foreign companies.

For the most part, however, our seemingly endless string of current account deficits has been financed by borrowing from the rest of the world. By June, our debt to foreigners totalled $2.4 trillion. Their debt to us totalled $1.3 trillion, leaving us with net foreign debt of a mere $1.1 trillion.

There was a time when Coalition politicians carried on about that debt – owed more by our banks and businesses, than our governments - rather than the (much smaller) debt of the federal government, only about 55 per cent of which is owed to foreigners.

Why does our huge net foreign debt rarely rate a mention these days? Because it’s always made economic sense for a young country with huge development potential to be an importer of financial capital – it’s part of what’s made us so prosperous.

Because all the debt we owe is denominated in Australian dollars or has been “hedged” back into Aussie dollars – meaning a sudden big fall in our dollar would be a problem for our creditors, not us.

But also because, though our net foreign debt keeps growing in dollar terms, our economy is also growing – and hence, our ability to pay the interest on the debt. That’s a sign that, overall, the money we’ve borrowed has been put to good use.

Adding our net foreign assets to our net foreign debt gives our net foreign liabilities. Measured against the size of the economy (nominal gross domestic product), our net foreign liabilities reached a peak of about 60 per cent in 2009, but have since fallen to about 50 per cent.

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RECENT DEVELOPMENTS IN AUSTRALIA’S EXTERNAL SECTOR

UBS HSC Economics Day, Sydney, Tuesday, June 2, 2015

Australia’s external sector – measured by the balance of payments, the current account deficit and exports and imports – is an important part of the syllabus and, indeed, the economy. Australia would be a very much poorer country if we had no trade with the rest of the world or no flows of capital to and from the rest of the world. And yet with the exception of discussion of the terms of trade and the exchange rate, the external sector – and particularly the current account deficit and net foreign debt – is these days rarely mentioned in the economic debate, presumably because most economists don’t think there’s much there to worry about. But this lack of interest conceals the fact that, particularly in the years since the height of the global financial crisis in late 2008, the current account deficit has been a lot smaller, and the net foreign debt seems to have stabilised as a percentage of GDP.

Is the current account deficit a worry?

To many people anything called a ‘deficit’ must be a bad thing; all deficits must be bad, just as all surpluses must be good. But I trust you’ve learnt enough economics by now to know that sometimes deficits are good rather than bad, and sometimes surpluses are bad rather than good. It all depends on the economy’s circumstances at the time and whether a deficit or a surplus is more appropriate to those circumstances.

The fact is that Australia has run current account deficits in 128 of the past 150 years, which suggests such deficits can’t be too bad or by now we’d be in a lot more trouble than we are, and we don’t seem to be in much trouble at all. And, indeed, most economists think it’s a good thing rather than a bad thing for us to be incurring all those deficits. Why? Because what they mean is that Australia is a ‘capital-importing country’ and we’d be a poorer country if we weren’t.

Remember that if we’ve been running deficits on the current account of the balance of payments for all those years we must also have been running surpluses on the capital account of the balance of payments for the same period. The key to making sense of the current account deficit is to remember that, with a floating exchange rate, the current account deficit is at all times exactly offset by the capital account surplus. In other words, the current account deficit and the capital account surplus are opposite sides of the same coin. So the current account can be analysed by looking at its components: exports, imports and the ‘net income deficit’, which is our payments of interest and dividends to foreigners minus their payments of interest and dividends to us. Or it can be analysed by looking at the changes in the components of the capital account surplus.

Components of the capital account surplus

When you think about it, the capital account surplus represents the net inflow of foreign capital to Australia. Another way of putting it is that the net inflow of foreign capital represents our call on the savings of foreigners. And our call on the savings of foreigners represent the amount by which national investment during a period exceeds national saving during that period.

It’s become a lot more common these days for economists to explain movements in the current account deficit by reference to changes in national investment and national saving and their components, but we’ll have go at doing it both ways.

Before we do, however, let me finish the point about Australia being a ‘capital-importing country’ since the beginning of white settlement. The proof that we’re a capital importer is all those years of capital account surplus, of inflows of capital almost invariably exceeding outflows of capital. Why has all that foreign capital flowed into our economy? Because, from the outset, the opportunities for investment in the economic development of our vast, resource-rich country have always far exceeded the amount that Australians could save to finance the exploitation of those investment opportunities. So, from the outset, we have always invited foreigners to bring their capital to Australia and join us in developing our economy’s potential. And when inflows of financial capital exceed outflows, this allows us to import more than we export, including imports of the physical capital equipment need for new development projects.

Our current account deficits – and our foreign debt and other foreign liabilities – got a lot larger in the 1980s after we floated the dollar, much larger than we’d been used to. It took us a few years to realise that the international shift to floating currencies was part of financial globalisation – the growing integration of national financial markets – which was making it easier for financial capital to flow around the world and so achieve a more efficient allocation of global capital. Some countries (eg Germany, Japan) save more than they have profitable domestic development projects to invest in, whereas other countries (eg Australia) have more profitable investment projects than they can finance with their own saving. So both classes of economy should be better off as a result of higher flows from surplus economies to deficit economies.

Recent developments in the CAD and net foreign debt

Over the 30 years since the floating of the dollar in 1983, the current account deficit has averaged about 4.5 pc of GDP, with peaks of about 6 pc and troughs of about 3 pc. In the five years leading up to the GFC it averaged more than 6 pc, so it seemed to be getting a lot higher. As you see from the table, however, in the six financial years since the GFC, however, it has averaged 3.6 pc, close to the historical trough. And in the 2014 calendar year it was 2.8 pc.

As you also see from the table, the past decade shows our net foreign liabilities – that is, our net foreign debt plus net foreign equity investment in Australia – seem to have stabilised at about 55 pc of GDP. That is, the dollar value of our liabilities is now growing at about the same rate as nominal GDP.

Why has our current account deficit been significantly lower since the GFC, to the point where our accumulated foreign liabilities seem to have stabilised as a percentage of GDP?

Well, explaining it from the current account side of the balance of payments, our export earnings were at first boosted by the exceptionally high prices we were receiving for our exports of minerals and energy as our terms of trade improved to their best in a century or two. It’s true that prices reached their peak and started falling in mid-2011, but they remain much higher than they were in earlier decades. And the volume of our mineral exports has been growing particularly strongly in the past year or two as the many new mines and natural gas facilities we’ve been building have finally started coming on line and increasing their production.

Turning to imports, imports of capital equipment to be used in our new mines and natural gas facilities grew strongly for most of the period although, with the construction phase of the resources boom now coming to an end, imports of mining equipment are now falling sharply. And while mining construction has been strong for most of the past five years, consumer spending and business investment spending in the rest of the economy have been growing at below-trend rates.

Finally, remember that, because exports and imports offset each other, most of the current account is accounted for by the net income deficit. It has declined to its lowest percentage of GDP for several decades, mainly because Australian and overseas interest rates are so low.

But now let’s try to explain the decline in the current account deficit from the capital account side – that is, from changes in national investment and national saving. Remember that the nation’s investment spending in any year has three components: the household sector’s investment in new home building, the corporate sector’s investment in equipment and structures, and the public sector’s investment in new infrastructure such as roads, railways, bridges, schools, hospitals and police stations.

The nation’s saving in any year also has three components: saving by households, saving by companies and saving by governments. Companies save when they retain part of their after-tax profits rather than paying them out in dividends to shareholders. Governments save when they raise more in revenue than in needed to cover their recurrent spending (the spending needed to keep the daily activities of government rolling on).

Looking at national investment, households’ investment in new homes since the GFC has been weaker than normal, whereas the mining construction boom has meant corporate investment spending has been much stronger than usual. And government spending on infrastructure since the GFC has be greater than usual. Adding that together, national investment has accounted for a higher percentage of GDP in recent years.

Turning to national saving, households are saving a far higher proportion of their disposable incomes since the GFC, with the household saving ratio rising from zero or about 10 pc. Companies have been saving more as mining companies retain most of their after-tax profits for investment in their new projects and non-mining companies retain earning to reduce their ‘gearing’ (their ration of borrowed capital to shareholders’ equity). Only governments – federal and state – have been saving less – dissaving, in fact - as their budgets have fallen into recurrent (‘operating’) deficit. Adding that together, national saving has accounted for a much higher percentage of GDP in recent years.

So though national investment is higher than it was, national saving has increased by more than national investment has, meaning the economy’s saving/investment gap has narrowed, the capital account surplus is lower and so is the current account deficit.

The budget papers show the government is expecting a current account deficit of 3 pc of GDP in the financial year just ending, 2014-15, rising to 3.5 pc in the coming year, 2015-16, and then falling to 2.75 pc in 2016-17.

In the coming year, the government is expecting the volume of exports to grow by 5 pc, whereas the volume of imports falls by 1.5 pc, thanks to the lower dollar and weak imports of investment goods. However, the terms of trade – export prices relative to import prices – are expected to deteriorate by 8.5 pc. And the net income deficit will stay low because of low Australian and world interest rates, plus lower profits payable to the many foreign owners of our mining companies.

Financial year CAD NFD NFL

         % of GDP

04-05 6.5 46 55

05-06 5.8 49 54

06-07 6.1 49 57

07-08 6.7 51 56

08-09 3.4 49 55

09-10 5.0 52 58

10-11 3.1 48 54

11-12 3.3 50 56

12-13 3.9 52 55

13-14 3.1 55 55

Calndr 14 2.8 58 54

NFD = net foreign debt

NFL =  net foreign liabilities (debt + equity investment)

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