Policies to Achieve External Stability (HSC SSCE Economics): Revision Notes
Policies to Achieve External Stability
Introduction: The changing policy focus
External stability in Australia refers to achieving sustainable outcomes on the current account, managing foreign liabilities, and maintaining a stable currency value. While external stability was once a major policy concern, it has declined in importance as a specific macroeconomic objective in recent years.
This shift reflects two key developments. First, economists and policymakers have increasingly adopted the "consenting adults" view of the current account. This perspective holds that current account deficits (CADs) and foreign debt arise from private sector decisions rather than government policy failures, and therefore do not necessarily require direct government intervention. Second, Australia's medium-term export prospects have improved significantly, with the economy experiencing several current account surpluses. Increased household savings have also reduced concerns about external vulnerability.
The "consenting adults" view represents a fundamental shift in how policymakers think about external imbalances. It suggests that if private individuals and businesses choose to borrow from overseas, this reflects rational economic decision-making rather than a policy problem requiring government intervention.
However, this does not mean external stability is unimportant. Rather, policymakers now treat external stability as a long-term objective addressed through Australia's broader policy framework. The focus has shifted from short-term interventions to establishing policy settings that reduce the risk of external shocks that could damage Australia's access to global financial markets.
Monetary policy and external stability
Monetary policy is not currently used to address Australia's external imbalances. This represents a significant shift from past approaches.
Why monetary policy is ineffective for external stability
In previous decades, the Reserve Bank of Australia (RBA) would implement contractionary monetary policy (raising interest rates) to reduce consumer spending on imports. The logic was straightforward: higher interest rates would reduce household consumption, leading to fewer imports and therefore a short-term improvement in the balance on goods and services.
This approach is now considered ineffective for several reasons that demonstrate the limitations of using monetary policy to target external stability:
- Temporary impact: The improvement in the balance on goods and services is only short-lived, as spending patterns eventually adjust
- Economy-wide slowdown: Contractionary monetary policy affects the entire economy, not just import consumption, potentially causing broader economic harm
- Perverse effects on capital flows: Higher interest rates can attract increased capital inflows from foreign investors seeking better returns. This generates higher net primary income outflows (interest payments and dividends leaving Australia), which can actually worsen the current account deficit
- Structural limitations: Monetary policy cannot address the long-term structural causes of Australia's external imbalances, such as low productivity or lack of international competitiveness
The RBA now focuses monetary policy exclusively on its inflation targeting mandate, leaving external stability to be addressed through other policy channels.
Fiscal policy: Improving national savings
Fiscal policy plays an important role in addressing Australia's historically low level of national savings. The key mechanism is fiscal consolidation.
Fiscal consolidation strategy
Since the late 1990s, Australian governments have adopted a fiscal consolidation approach, which involves running balanced or surplus budgets over the course of the economic cycle. This strategy aims to reduce the government's call on private savings over the medium term.
How fiscal consolidation supports external stability:
When governments borrow less (or save more through surpluses), they leave more savings available for private sector investment. This has important implications for external stability:
- Reduced government borrowing means less competition for domestic savings
- Lower public debt reduces upward pressure on interest rates
- This helps avoid "crowding out" of private borrowers, where government borrowing pushes up interest rates and makes it harder for businesses to borrow for productive investment
Recent fiscal developments
The COVID-19 pandemic necessitated a significant increase in government borrowing to support the economy. This temporarily increased public debt levels, which negatively affected national savings. However, Australia's fiscal strategy has returned to consolidation in the post-pandemic period.
Public debt projections show a declining trend: from 39.5% of GDP in 2020–21, public debt is projected to fall to 32.3% of GDP by 2033–34. This reduction should limit upward pressure on interest rates and reduce the crowding out effect on private borrowers, supporting both domestic investment and external stability.
Superannuation guarantee: Boosting national savings
Australia's superannuation guarantee (compulsory superannuation) has been one of the most effective policies for improving external stability by substantially expanding the pool of national savings.
How the superannuation guarantee works
The policy requires employers to contribute a minimum percentage of employee wages to superannuation accounts. Since its introduction in the 1990s, this has created a large and growing pool of retirement savings.
The superannuation guarantee has multiple effects on external stability:
- Increased national savings: As more money flows into superannuation funds, Australia's overall savings rate increases
- Overseas investments: Superannuation funds invest a significant portion of their assets overseas, increasing Australia's foreign assets
- Improved net primary income: Australia's overseas investments generate financial inflows (dividends, interest) that partially offset the outflows from foreign investment in Australia, improving the net primary income account
Recent changes to contribution rates
The superannuation guarantee has been gradually increasing:
- July 2023: increased to 11% of wages
- July 2024: rising to 11.5% of wages
- July 2025: reaching 12% of wages
These increases will further expand national savings and strengthen Australia's external position by reducing reliance on foreign capital to finance domestic investment.
Microeconomic reform: Addressing structural causes
Microeconomic reform represents the most comprehensive approach to improving external stability because it addresses the structural problems that cause Australia's external imbalances.
The competitiveness challenge
The fundamental issue is that Australia needs to improve the international competitiveness of its goods and services. If Australian producers can compete more effectively in global markets, the country will export more and potentially import less, improving the current account balance.
Key microeconomic reform strategies
Improving infrastructure and reducing capacity constraints
Investments in transport, energy, and communications infrastructure help Australian businesses operate more efficiently. When capacity constraints are reduced, firms can expand production without facing bottlenecks that increase costs and reduce competitiveness.
Addressing skills shortages
Labour market reforms and education policies aim to ensure Australian workers have the skills needed by modern industries. Reducing skills shortages prevents wage inflation and productivity constraints that would harm competitiveness.
Removing protectionist barriers
Historically, tariffs and other protections shielded some Australian industries from foreign competition. Removing these barriers forces domestic producers to become more efficient or exit the market. While this can cause short-term adjustment costs, it improves overall economic efficiency and international competitiveness.
Labour market reforms
Policies that increase workforce participation (getting more people into employment) and lift productivity (producing more output per worker) directly enhance competitiveness. More flexible labour markets allow businesses to adjust to changing conditions and compete more effectively internationally.
Why microeconomic reform is most effective
Unlike monetary or fiscal policy, microeconomic reforms target the root causes of poor export performance and high import dependence. By making Australian industries more productive and competitive, these reforms create lasting improvements in the current account balance rather than temporary adjustments.
Maintaining international investor confidence
One of the best measures of external stability is the extent to which Australia maintains the confidence of international investors. If global financial markets lose confidence in Australia's economy, the country could face higher borrowing costs, currency depreciation, or even difficulty accessing foreign capital.
Policy settings that sustain confidence
Governments aim to sustain international confidence through consistent, medium-term policy frameworks:
- Inflation targeting regime: The RBA's credible commitment to keeping inflation within the 2–3% target band reassures investors that Australia maintains macroeconomic stability
- Budget surplus goal: The commitment to fiscal consolidation signals responsible public finances
- Continued microeconomic reform: Ongoing efforts to improve productivity and competitiveness demonstrate that Australia is addressing structural weaknesses
This approach has been largely successful in maintaining international confidence in Australia's economy over recent decades. Even during periods of current account deficits, Australia has generally retained access to global capital markets on favourable terms.
Lessons from the Global Financial Crisis
The Global Financial Crisis (GFC) of 2008–09 provided an important lesson about the connection between private and public sector borrowings, challenging the "consenting adults" view to some extent.
Private debt can become public responsibility
Even when foreign debt is the result of private sector borrowings, governments can be forced to take responsibility for those borrowings to prevent systemic collapse. During the GFC, financial instability threatened to cause a meltdown of entire financial systems and trigger economic depression.
A critical lesson from the GFC:
In Australia's case, the Government felt it necessary to guarantee all private borrowings of Australian banks in 2008. This meant that if Australian banks defaulted on their foreign debt, the Australian Government would be responsible for repayment. In effect, the Government guaranteed the nation's private sector foreign debt.
This experience demonstrates that in times of extreme financial instability, an external imbalance – regardless of its origins – can make an economy more vulnerable to external shocks.
Implications for external stability policy
This experience undermines, to some extent, the argument that private sector foreign borrowings do not matter. It demonstrates that in times of extreme financial instability, an external imbalance – regardless of its origins – can make an economy more vulnerable to external shocks.
However, policymakers also recognise that economic shocks can have both positive and negative effects. Australia's external accounts in recent years have shown this duality, with favourable commodity price movements and other factors sometimes improving the external position.
Recent shifts in Australia's balance of payments
Australia's external position has undergone significant changes in recent years. According to RBA analysis, "as savings have exceeded investment over the past few years, the current account shifted from a deficit to a surplus."
Factors driving the shift
Key factors behind Australia's changing external position:
End of mining boom investment phase
The mining boom involved a massive investment phase during the 2000s and early 2010s. As mining projects were completed and production came online, investment declined while export volumes increased. This improved both the balance on goods and services and reduced the need for foreign capital inflows.
Higher domestic savings during the pandemic
COVID-19 led to increased household savings as spending opportunities were limited and government support payments boosted incomes. This higher savings rate contributed to the shift from current account deficit to surplus.
Australia as net capital exporter
With excess savings, Australia has become a net exporter of capital. Superannuation funds and other investors have increased portfolio equity outflows (Australian investment in foreign shares and assets). Simultaneously, Australian banks have reduced their offshore borrowing. As a result, the capital and financial account has shifted from a surplus to a deficit – the mirror image of the current account surplus.
This represents a fundamental change in Australia's external position and demonstrates how the factors affecting external stability can shift significantly over time.
Summary
Key Points to Remember:
-
External stability is now a long-term objective rather than a primary focus of short-term macroeconomic policy, reflecting the "consenting adults" view and improved export prospects
-
Monetary policy is not used for external stability because it only has temporary effects and can worsen the current account through increased capital inflows and net primary income outflows
-
Fiscal consolidation (balanced budgets over the economic cycle) helps improve national savings by reducing government's call on private sector savings and avoiding crowding out effects
-
The superannuation guarantee (currently rising from 11% to 12% by July 2025) substantially boosts national savings and creates income from overseas investments
-
Microeconomic reforms address the structural causes of external imbalances by improving international competitiveness through infrastructure investment, skills development, removal of protectionist barriers, and labour market reforms
-
The Global Financial Crisis demonstrated that even private sector foreign debt can become a government responsibility during crises, maintaining some concern about external vulnerability despite the "consenting adults" view