Brian Fallow: Spending for today, saving tomorrow

It is easy for journalists to talk about the current account deficit in terms that imply moral disapproval: we are spending more than we earn in our dealings with the rest of the world. Living beyond our means.

We are dependent on other people's savings and piling up debt.

It would be easy to conclude that as a country we are hopelessly improvident, living for today and heedlessly mortgaging the future.

And indeed the conventional wisdom is that current account deficits above 5 per cent of gross domestic product send the red light flashing, especially if they are financed with short-term debt and if they reflect a high degree of consumption spending, as by and large ours is and does.

But a more subtle and sanguine view of whether we have "a current account problem" is advanced in a recent paper by three economists, Viv Hall and Kunhong Kim from Victoria University and Bob Buckle of the Treasury.

Their starting point is the notion of consumption smoothing.

At the level of an individual, this is familiar enough. It makes sense for people to borrow at certain stages of their life, to get a degree, set up a business or buy a home - or to cope with unexpected financial vicissitudes.

Instead of always living within one's means and saving up for things, borrowing allows a steady or improving standard of living over a lifetime despite swings in income.

How much it is rational to borrow will depend on having realistic expectations of what one's future income track will be.

Hall et al apply the same idea to the economy as a whole, with the current account deficit representing our collective borrowing from the rest of the world.

They look at the 1980s and 1990s, a period which included shocks in the form of radical economic reform and later the Asian financial crisis.

It was also a period with big swings in the current account, with deficits ranging from 1 to 9 per cent of GDP.

In the light of those shocks and the expected track for national income, their model tells them how much the deficit/borrowing needed to be each year to smooth consumption.

The model fits closely what actually happened, in terms of the fluctuations in the current account deficit.

"On balance, our results are consistent with New Zealand having optimally smoothed its private consumption by using the current account as a buffer against unexpected temporary movements in net output," they conclude.

But does this still hold true? Hall et al only use data up to March 1999.

We are in the throes of another deterioration in the current account, recording a deficit of $9.4 billion, or 6.4 per cent of GDP, for calendar-year 2004, compared with $3 billion and 2.5 per cent of GDP in 2001. It is expected to get worse before it gets better.

Whether this is the response to some unexpected shock is not immediately apparent.

So that leaves the more encouraging possibility that it reflects expectations of sustainably higher future incomes.

The deterioration in the current account over the past three years has been driven by a worsening trade balance.

It's troubling that this has been in a period when the terms of trade (the ratio of export to import prices) have been particularly favourable.

But offsetting this is the fact that business investment has been strong by historical standards and that has required importing a lot of plant, machinery and equipment.

That augurs well for future growth, essential if we are to service mounting international debt and still be better off.

Undeniably, though, much of the deterioration in the current account position reflects a consumer and, especially, a housing boom.

Much of the money that flows in to fund the deficit comes through the banks and is lent to home buyers and to people drawing down the equity in their homes to fund consumer spending.

Several other countries that have enjoyed a housing boom in recent years have recorded deteriorating current account positions as well: Australia, Britain, France, Spain and, famously, the United States.

In a speech this month, Ben Bernanke, a Federal Reserve governor sometimes mentioned as a possible successor to Alan Greenspan, offered an "unconventional" explanation of the blowout in the US current account deficit, which has dragged the greenback down.

He locates the principal cause of the problem outside the US, namely in the emergence of a "global savings glut" in search of places to invest.

This is coming from three sources. One is rich countries with ageing populations saving for retirement and that already have plenty of capital deployed in their industries. Japan and Germany are the main examples.

But their surpluses are not nearly enough to cover the rapidly increasing deficit of other developed countries.

Between 1996 and 2003, industrial countries' collective current account position went from a US$46 billion surplus to a US$342 billion deficit, a US$388 billion deterioration.

That included a US$410 billion increase in the size of the US deficit (it has continued to swell since then).

So the bulk of the increase in the US current account deficit was balanced by changes in the current account position of developing countries, which moved from a collective deficit of US$88 billion in 1996 to a surplus of US$205 billion in 2003 - a net change of US$293 billion.

The net flow of capital, in short, is from developing countries to developed ones.

What is wrong with this picture?

In the longer term, the flow should be in the other direction.

Developing countries have younger and faster-growing workforces and relatively low capital-to-labour ratios - conditions that imply returns to capital could be quite high, says Bernanke.

He attributes much of this shift to the fall-out from the Asian crisis and its echoes in Russia and Latin America.

Countries that had been importers of capital either chose or were forced to build up large foreign exchange reserves and continued to do so even after constraints imposed by the halt to capital inflows from global financial markets were relaxed.

In addition, countries such as China built up large foreign reserves.

Bernanke's story is that up until the sharemarket collapse of 2000 the US could absorb much of this increase in global savings as capital investment by businesses increased while greater wealth reduced households' perceived need to save.

After the tech-wreck, capital spending decreased but global saving remained strong, so that world interest rates fell, which again encouraged Americans to spend more and save less.

What worries Bernanke about this - and the same applies to New Zealand - is what the inflow of capital is used for.

It is showing up in higher house prices and more construction.

Higher house prices have in turn encouraged increased consumption, through the wealth effect.

Nothing wrong with that per se.

But in the long run, productivity gains and the export income needed to service and repay foreign debt are more likely to be driven by non-residential investment, such as businesses buying new machines.