Before we get started, it should be noted that the current government, and recent governments, in the UK do not actually care about the current account deficit. They believe that it will be financed more or less indefinitely. They are much more concerned about the control of inflation. Examiners are keen that you understand how deficits can be reduced, but the following policy measures are not at the forefront of the Chancellors mind at the moment!
These polices were relevant in the 50s and 60s, especially when the UK was part of the Bretton Wood fixed exchange rate system. They are also relevant to any country that cannot finance current account deficits over the long run as easily as the UK seems to be able to do.
Expenditure switching policies
These are policies that a government may use to switch consumers' expenditure away from imports and towards home produced goods. There are two main types - using import controls like tariffs and devaluing the exchange rate. Let's look at these two in turn.
Of course, this policy is not as relevant as it was in the past. Nowadays, the World Trade Organisation (WTO) would not let a country get away with tariffs just because it wasn't very happy with its current account deficit.
If a country levies tariffs (a tax on imports) on various imports, then their prices will rise relative to the home produced goods and so the demand for imports should fall and switch to domestically produced goods. This will be good for domestic producers as well as helping the current account deficit to fall. The foreign firm could absorb the cost of the tariff, take a cut in profits and not raise their price, but this is not a long term solution for them. Tariffs generally cause import prices to rise.
Apart from the fact that this is difficult to implement nowadays, the resulting trade war that is likely if a policy of import controls did get past the WTO would be disastrous.
A devaluation of the exchange rate
Of course, in a world of floating exchange rates, a currency should automatically change in response to a current account surplus or deficit. The change should also automatically correct the balance of payments disequilibria.
A current account deficit in the UK, for example, will mean that the demand for pounds to buy UK exports is lower than the UK consumers' demand for foreign currency to buy imports. The value of the pound will fall, making exports relatively cheap and imports relatively more expensive. UK consumers will switch their purchases from imports to home produced goods, and consumers from other countries will switch their purchases from their home produced goods to UK exports. The UK's current account deficit should reduce back to equilibrium.
A very nice story, which should work in theory, but in the real world life is never that simple!
In the days of the Bretton Woods fixed exchange rate system, the UK would often find itself in a deficit situation. The governments of the time tended to try all other policies to reduce the deficit. Devaluation was the last resort. It was a sign that you had failed. When a country is a member of an exchange rate system, it is the foundation stone around which the rest of government macroeconomic policy is built.
And why do governments avoid devaluation at all costs, even though it makes industry more competitive? The resulting higher import prices lead to higher inflation. Since the Second World War, the inflation rate of the UK has been higher, on average, than all developed countries. It is not a coincidence that the UK has seen the value of the pound fall dramatically over the same period. Devaluation is the easy way out for exporters but is a poor long term option. See the topic called 'Exchange rates' for more discussion on these issues.
Today, the UK has a floating exchange rate. In theory (as explained above) current account deficits should automatically cause the pound to fall in value to help reduce the deficit. But the pound has been strong for the last four years regardless of the trade position of the UK.
As we said earlier, currency transactions as a result of exports and imports account for less than 10% of daily turnover. The key to the value of the pound nowadays is speculation. The 'markets' think the UK economy is doing pretty well, so investors buy the pound instead of other currencies. These investors obviously don't think the current account deficits are a problem otherwise they would take fright and sell their holdings of sterling.
So even if the government wanted to pursue the 'devaluation' policy option to reduce a current account deficit, nowadays, it simply doesn't have the clout in the currency markets to affect the value of the pound. Look what happened on Black Wednesday!
Expenditure reducing policies
Any government policy designed to reduce demand in the economy and so reduce consumer spending in the economy (and on imports in particular) falls into this category. On the fiscal policy side the government could increase taxes or reduce public spending. On the monetary policy side, interest rates could be raised (although this is now the job of the MPC).
If consumer spending falls in an economy, then spending on all goods and services, including imports, will fall. This will reduce a current account deficit.
The big problem with this policy is that the deflation in the economy is likely to cause, at the very least, a slowdown and possibly a recession. In the 50s and 60s UK governments used to announce deflationary measures in almost immediate response to bad trade figures (a rise in interest rates, a tax on luxury goods or a clampdown on bank lending). Nowadays, governments wouldn't dare to announce excessive cuts in government spending or large rises in taxes. Gordon Brown may well sneakily raise taxes on less visible things (like dividends on shares bought to build a pension), but to announce an increase in income tax is considered to be electoral suicide!
Anyone can cure a current account deficit by having a recession (or cure high inflation for that matter - see the last two recessions!). This is why this 'expenditure reducing' policy of deflation was often used in conjunction with something like a devaluation. The deflation would create the spare capacity in the economy and the devaluation would increase aggregate demand again back up to the full employment level. Both policies should, at the same time, reduce the current account deficit.
Policies to improve competitiveness
So, import controls are difficult to impose in today's world of free trade and the WTO. The value of the pound may well fall, but only if the currency markets allow it. Deflation is completely out of the question given the risk of recession and its political difficulties. How else can a government try to reduce a current account deficit?
For most manufacturing firms, it seems the only way to sell more goods abroad and to persuade UK consumers to buy more home produced goods rather than imports is to become more competitive, particularly in terms of 'non-price' factors. In terms of the most worrying 'price' factor, there is not much that they can do about the strong pound.
Governments can help in this field by providing tax relief for capital investment and for research and development. They can provide training to improve the skills of the workforce and invest money into education generally so that the quality of all school leavers improves.
The success or otherwise of a devaluation in terms of reducing a current account deficit depends on the Marshall Lerner condition. This condition said that, for a devaluation to be successful in terms of a reduced current account deficit, the sum of the elasticity of demand for UK exports and the elasticity of demand in the UK for imports must be greater than one.
The J-curve simply shows that, following a devaluation, a country's current account deficit may actually increase in the short run before in falls and disappears.
Both of these concepts need a good understanding of exchange rates. For this reason, details of these concepts can be found in the topic called 'Exchange rates'.