such a scenario does not directly translate into a world of floating exchange rates. in that environment, the main mechanism of adjustment is the exchange rate. if global investors reduced their appetite for investment in a particular country, the exchange rate would depreciate until the point where investors would be happy once again with their allocation to the country in their overall portfolio. while the exchange rate might overshoot in this scenario, the depreciation is stimulatory to the economy, whereas in the fixed exchange rate world, the adjustment is contractionary. the conclusion i wish to draw then is that there can be perfectly good reasons why current account balances are not zero, and indeed can even be quite sizeable, without them constituting imbalances or being a cause for concern. the accompanying capital flows are often beneficial. this is not to say that they should not be scrutinised but rather that the scrutiny should really be on the nature of those capital flows to examine whether they are being driven by inappropriate policies or distortions. recent changes in the composition of australia ’ s capital flows with the previous discussion in mind, i will now turn to a short analysis of the australian situation. over the past three years, there have been some quite sizeable changes in the size and composition of australia ’ s current account and capital account. graph 1 bis central bankers ’ speeches from the early 1990s until 2007, australia recorded a current account deficit which averaged around 4¼ per cent of gdp ( graph 1 ). 10 there were cycles around that level, with the current account narrowing to 2 per cent of gdp in 2001 in the aftermath of the asian crisis and widening to around 6 per cent of gdp in 2007. at the same time, there was reasonable stability in the major components of the capital account. the inflow arising from the offshore funding of the banking sector was around 3½ per cent of gdp. this led to the common assessment that the australian banking sector was “ funding the current account ”. in my opinion, this analysis is incomplete. as mentioned earlier, a current account deficit and its equivalent capital account surplus is the net outcome of considerably larger gross flows. this is evident in graph 1. through this period there was substantial australian investment abroad, particularly in the form of equity. much of this was the result of the australian superannuation sector investing a sizeable share of their funds in offshore equity markets. at times, there were also sizeable equity inflows to australia. over the past

in an integrated economy in the second. max corden distils the concern that many have about global imbalances down to a concern about the “ return journey ”. lenders of capital expect to receive the money they have lent back with interest ( dividends if it is an equity investment ). one reason that might increase concern as we move from transfers between households to crossing state borders to crossing national borders is that the information asymmetry about the return journey increases. amongst other things, the geographic separation reduces the ability of the lender to monitor the use of funds by the end - borrower. one could question why this still remains true today, with increased transparency and lower cost of information. for example, in the recent episode, the funds that made their way to the us housing market over the 2000s had a long and non - transparent chain between the provider of the funds and the ultimate borrower. there were major problems of information asymmetry and failures of due diligence right along the chain. another reason that borders matter is that the capacity to borrow in one ’ s own currency is important. the claims across state borders are denominated in australian dollars, which are this is the model which olivier blanchard himself taught me! in this stylised world, one could also add the corporate sector to the mix. as they are generally a net borrower, they would be another generator of current account deficits. in the current economic climate in australia, one could think about the possibility of the western australian economy experiencing an exchange rate appreciation relative to the rest of the country to mitigate the adjustment. however, the assessment is that the benefits of a common currency union for the australian states vastly outweigh any costs. bis central bankers ’ speeches easily settled without doubt in the integrated australian financial system. indeed, the system is so integrated that there is no easily obtainable measure of cross - border claims for the states. a further aspect that appears to be a common cause for concern about current account deficits is the economic adjustment that might ensue were they to narrow precipitously. much of this concern appears to stem from a fixed exchange rate world. in a fixed exchange rate world, sudden stops can ( and did ) occur that are very disruptive. capital inflows dry up rapidly and capital outflow increases, necessitating a sharp contraction of domestic demand so that the trade balance moves into surplus. inevitably, this is associated with a domestic recession.