Solving external stability

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External stability is all about ensuring Australia can manage its financial relationships with other nations.

In practice, external stability is all about three questions:

  1. Is the CAD too large?

  2. Is the level of foreign debt too large?

  3. Is the $A at an acceptable level?

Great. So how do we solve external stability?

“To improve external stability, the government could use fiscal policy to reduce the need for foreign debt by the public and private sectors.”

For all three questions, monetary policy (the Reserve Bank of Australia’s use of the cash rate to affect the level of economic activity) isn’t really useful. It’s too much of a blunt tool.

For example, using contractionary monetary policy to improve external stability will seriously slow the whole economy. Not a great outcome. (Ask me more about this in the comments.)

Let’s look at fiscal policy instead. This is the use of the federal budget to achieve economic objectives.

To improve external stability, the government could use fiscal policy to reduce the need for foreign debt by the public and private sectors.

For the public sector, the federal government could run budget surpluses (where taxation revenue exceeds government spending), create a nice pool of domestic savings for itself, which it can then use to fund investment — without having to call on (bring in) foreign capital.

So that will reduce the public sector part of foreign debt, and hopefully improve the CAD (less need for capital outflows, less primary income outflows). External stability improves!

For the private sector, the government could use fiscal policy to boost domestic savings by increasing the rate of compulsory superannuation.

Compulsory super is the Australian retirement scheme where employers are forced to put a portion of an employee’s wages into a retirement fund. The money cannot be touched until retirement. BUT! The superannuation funds, who hold the money, can invest it to earn a nice return for their members.

So a higher rate of compulsory super will increase the domestic pool of savings and again reduce the need for capital inflows to fund investment. Thus, external stability improves.

One more option. The federal government can try and make exports more competitive so Australia can sell more exports, put BoGS into surplus more often, and improve the CAD. The government can do this through microeconomic reform, supply-side policies that will allow firms to produce more at lower prices (represented by an increase in aggregate supply).

Or the government could do nothing. Capital inflows and a CAD are funding vital investment in Australia, that we could not otherwise fund. Why stop the party?