Bank credit, the current account and fiscal deficit
Australia: Current Account Deficit, Bank Credit and Currency
While working for a government in the Pacific Islands, Leigh Harkness found a relationship between the growth and bank credit and the balance of payments. On returning to Australia and working in the Treasury Department, he found evidence in the Reserve Bank of Australia statistics on banking of a similar relationship between bank credit and the current account deficit. That relationship is clearly evident in the following graph.
The exchange rate, savings policies (such as superannuation), wages policies, training programs etc have no effect at all on this basic relationship between bank credit and the current account deficit. The actual factors that cause this outcome are explained in the page on the "Formula for current account balance".
While working for a Pacific island country, Leigh Harkness was able to implement policies that controlled the balance of payments. The IMF commended the government for the success of those policies.
Using the principles that proved successful in the Pacific, Leigh has developed an approach to economic management that would enable larger and more complex economies with variable exchange rates to overcome balance of payments problems. That is, it provides for a variable yet stable market based exchange rate without balance of payments problems, low inflation and relatively stable interest rates.
He has found that the Friedman style floating exchange rate system is needlessly constrained. It does not provide for a sustainable stable equilibrium outcome. It has two stable equilibrium points:
Neither of these are sustainable in the very long term. The debtor countries will eventually be called upon to repay their debts and those with the growing foreign assets will eventually wish to draw on those assets. When these changes occur, it is likely to be highly disruptive to the economies concerned.
Also, domestic debt and foreign debt grow faster than the capacity of the economy to repay their debts. So eventually, a country must have a financial crisis under the floating exchange rate system. (See money and inflation.)
For high equilibrium exchange rate countries, foreign net capital inflow cannot exceed the demand for imports as international receipts (from exports and net international capital inflow) must equal international payments (for imports). The demand for domestic products is equal to the income from domestic products (they are essentially the same thing). So the demand for imports must equal the income from exports plus any additional demand generated by creating new money; that is, from bank credit and currency. This has wider implications for the economy.
The Central Bank of the Philippines has been able to overcome this problem with a simple change in monetary policy.
To read more about these issues, look up the papers on the subject.
Click here to load an Excel spreadsheet and go to the Current Account worksheet to view the data used.
Last update: 6 August 2013