by Peter Brain
The EC has specified a threshold for each indicator (for some, two thresholds, upper and lower), defined as the value of the indicator that, if exceeded for a period of time, has the potential to push the country into crisis. If several of the threshold levels are exceeded simultaneously, and if further investigation of other aspects of the economic position corroborates the indicator findings, an alert may be issued that a crisis threatens and that it would be prudent for the authorities to make whatever policy changes might be possible to avert the danger.
Rated by the EC indicators, Australia’s performance ranges from exemplary to atrocious.7
Australia assessed by the EC indicators
Indicators of satisfactory performance
The EC indicator for which Australian performance has been most exemplary is government debt. The EC threshold for this indicator is set at 60 per cent of GDP. Above this level, the EC considers that current and future economic-growth prospects may be diminished by expenditure reductions and/or tax increases required to keep faith with government creditors. At 28 per cent, Australia’s current level of national, state, and local government borrowing is at less than half the level that would ring alarm bells at the EC. Australian governments have been less addicted to borrowing to finance tax cuts and expenditure increases than their equivalents in Europe, not to speak of the United States. This is not to argue that all is well: the tax cuts that accompanied the early phase of the mining boom are now widely regretted as imprudent, while the expenditure constraints have seriously curtailed government infrastructure investment. Again, the trend is unfavourable, and the current level of 28 per cent is the highest recorded over the years since 1992.
This said, the media rarely congratulate Australian governments on their exceptionally low deficits, nor do they point to the scope for government borrowing to finance infrastructure investment. Indeed, analysts either directly or indirectly associated with the finance sector have been allowed to dominate public discourse on economic policy, and spend their time harping on the dangers of government-sector debt, so diverting attention from the accumulating debt of the private banks.
A second area where Australian performance has been reasonably good compared to the EC threshold is the labour market. The EC sets a threshold for the unemployment rate of 10 per cent, with higher levels indicating a lack of adjustment capacity in the economy. Australia, as a whole, has not recorded this level of unemployment since 1992.
A related indicator is the three-year percentage increase in unit labour costs, where the EC threshold is set at 12 per cent. Above this rate, the EC fears that inflation will rise to the point where profits and investment are compressed, and economic growth is curtailed. Once again, Australian performance over the past quarter-century has been good, with the indicator rising above the threshold level in only three years: 2006, 2008, and 2011.
A further indicator measures the competitiveness of a country’s exports by the change in its share of the market in the countries to which it exports. Australian performance on the basis of this indicator has again been satisfactory, but the indicator does not take into account the fact that, as a commodity and particularly a minerals exporter, Australia is subject to wild fluctuations in the prices it receives for its exports.
By contrast with government debt, labour-market flexibility, and, with caveats, export competitiveness, Australia’s performance has been less than satisfactory when measured by two groups of indicators, both closely associated with the generation of financial crisis via bad debts: its financial relationships with the rest of the world, and the level of household debt.
Indicators of unsatisfactory performance: international trade
The EC scoreboard includes three indicators of a country’s economic relationships with the rest of the world. The first relates to the volatility of its exchange rate, as measured by the three-year percentage change in its real effective exchange rate against the currencies of other countries. Two thresholds apply. If the exchange rate rises by more than 11 per cent over three years, there are likely to be unmanageable price pressures on domestic producers, resulting in long-run loss of competitiveness. In the other direction, if the exchange rate falls by more than 11 per cent over three years, there are likely to be unmanageable inflationary pressures. Australia has suffered both these evils. In six of the past 25 years, the exchange rate has been more than 11 per cent below the rate applying three years previously, and in nine of the past 25 years it has been more than 11 per cent above. An exchange rate that gyrates like this is a severe handicap to long-term planning in trade-exposed industries, so it is no wonder that Australia’s trade performance has been less than satisfactory and has resulted in a dangerously high level of overseas debt.
Second, the EC measures the flow of overseas borrowings by the three-year backward moving average of the current-account balance, taken as a percentage of GDP. (The current account offsets foreign exchange received from export earnings, income earned overseas, and gifts from overseas against foreign exchange spent on imports, income payable to overseas investors, and gifts to overseas.) When seriously negative, this is an indirect indicator of unsustainable overseas borrowing or, at best, an indicator that international investment in Australia is growing too rapidly for comfort. The threshold here is set at -4 per cent. There is also an upper threshold, of less relevance to Australia: if the current-account balance rises above +6 per cent, the EC argues that the country is engaged in unsustainable lending. Between 1992 and 2010, the Australian economy more often than not exceeded the 4 per cent current-account-deficit threshold. At the end of 2016, commodity prices rallied to produce a relatively low current-account deficit for 2016–17. However, the rally was due to temporary factors that are expected to fade, including the unfortunate combination of waning demand for commodities as world growth falters and increases in their supply as capacity-enhancing investments come on stream.
The third of the group of three indicators covering relationships with the rest of the world is the net international investment position (excluding equity investment) as a percentage of GDP. The EC threshold is 35 per cent; above this level of debt, a country is likely to have difficulty managing any crisis in international banking that may come its way. As a consequence of its persistent current-account deficits, Australian performance on this indicator has been consistently woeful, with the threshold value exceeded by at least 14 percentage points in all of the past 25 years. Currently, the indicator value is 57 per cent compared to the threshold value of 35 per cent. Australia has elected to live with the high-level risk that its external borrowing will prove to be unmanageable.
Indicators of unsatisfactory performance: debt
The obvious question is, why has Australia borrowed so much? Thanks to the imprudent behaviour of governments in the United States and Europe, the international literature comes close to making it axiomatic that excessive overseas borrowing arises from government deficits. Australian governments have, relatively speaking, controlled their deficits, so why is the level of overseas borrowing so dangerously high? The answer lies with the private sector, which the EC scoreboard covers with a further three indicators.
The first of these indicators of private-sector debt accumulation is private-sector credit flow as a percentage of GDP. The EC threshold for this indicator is 14 per cent, above which level there must be grave doubts as to the quality of the loans being made. Australia has exceeded the EC threshold for ten of the past 25 years, chiefly in the late 1990s, the mid-2000s, and in 2013, 2014, and 2015.
The EC scoreboard also includes gross private financial liabilities (excluding equity) as a percentage of GDP. Excessive private debt constrains both business investment and household expenditures, and hence constrains economic activity. The EC threshold is 160 per cent of GDP, a level that Australia reached in 1998. The level has since risen to 245 per cent, providing a counterpart to the high level of overseas borrowing.
Most of the increase has been due to borrowing by the household sector that, having in 1992 accounted for one-third of private-sector debt, was responsible for 55 per cent of such debt by the eve of the Global Financial Crisis. This proportion has been maintained since.
One of the major influences on household borrowing is the level of house prices. The EC scoreboard includes the annual change in real house prices (that is, the excess of house price increases over the consumer price index). Increases in real house prices encourage households to borrow: households aspiring to ownership borrow more to cover the enhanced prices, while households that are already owners are encouraged to borrow because of their increased wealth. Mild increases in relative house prices are manageable, but rapid increases are associated with destabilising bubbles. Reinhart and Rogoff list real housing prices along with changes in the real exchange rate as the best available warnings of an imminent banking crisis.8 The EC has set its threshold of manageability at 6 per cent a year. Taking house prices nationally (and so disregarding the differences between its many geographically separate house markets), Australia exceeded this threshold in eight of the past 25 years — the early 2000s and, of more concern, every year from 2013 to 2015.
Currently, five of the 10 original EC scoreboard indicators for Australia are flashing red. That is, they exceed their threshold values. The EC has found that, typically, in the European Union countries that had recently fallen into crisis — namely Greece, Spain, and Ireland — the thresholds of five or six indicators had been exceeded on the eve of their crises. There has been little improvement since: in 2014, Ireland was in breach of six indicators; Spain, five; and Greece, four.
The European Commission’s macroeconomic-imbalance scoreboard accordingly identifies Australia as a candidate for economic breakdown. The next step in the EC procedure would be to conduct an in-depth review that takes auxiliary indicators and trends into account, to judge whether Australia suffers excessive imbalances warranting the implementation of a corrective-action plan. These EC processes are highly political and far from perfect — corrective-action plans have not been imposed on the three countries that are running excessive current-account surpluses — but they at least serve to put EU member countries on notice that they, and the union more broadly, need to take action to avert crises.
Australia is not a member of the EU, and therefore will not be subject to an in-depth review. However, the EC indicators serve as an alert, not only to borrowers in Australia but to lenders overseas, that the time has come to think deeply about Australia’s financial structure. Such a re-think cannot undo history, but requires an assessment of the path by which Australia has acquired its current unenviable EC indicator values. We resume the discussion of the EC indicators in Chapters 3 and 4. Before then, we need to look at how Australian economic institutions evolved after the end of the Second World War.
2
Financial deregulation
During the Second World War, and not least in Australia, a great deal of effort was expended on planning for post-war reconstruction. It was agreed that the world should not be allowed to return to the conditions which had led to war; there was to be full employment and economic growth. To this end, Russia and China continued with a form of central planning that had no use for a finance sector independent of government. In Russia, central planning gradually ossified, while China experimented with variously disastrous mixtures of central and local planning, including the Great Leap Forward and the Cultural Revolution.
On the American side of the Iron Curtain, the finance sector regained some of the autonomy it had lost during the war: in the United States, in the name of freedom; and in Catholic countries, in the name of subsidiarity or the localisation of decision-making. The restoration of financial autonomy was far from complete — the memory of the role of finance in generating the Great Depression was too raw, as was the memory of the success of government planning in mobilising resources to win the war. There had also been an important intellectual development: interpreting the experience of the Great Depression, John Maynard Keynes had shown that free markets do not guarantee economic stability. He argued that circumstances can arise when wise governments should intervene in markets to ensure that demand — purchasing power — is adequate to support a full-employment level of production. Governments, that of Australia included, seized on this analysis in their eagerness to avoid a repeat of the Great Depression.
In Australia, the strategy for full employment concentrated on economic growth; the accumulation of both capital and labour to add to the natural resources of Australia’s considerable land mass. The sense of national unity generated during the war required that all citizens, including recent immigrants, should both contribute to development and share in its benefits — hence the importance of full employment combined with progressive taxation and social security. Development was seen to require a substantial public sector, responsible for most services in health, education, and the public utilities, and an equally substantial private sector responsible for production in the pastoral, farm, mining, and manufacturing sectors — in other words, for most goods then entering into international trade — as well as for the production of retail and many other services. Australia was to be a mixed economy, taking advantage of the strengths of both the public and private sectors. However, below the level of broad strategy it was not to be a centrally planned economy. This was in part ensured by the division of responsibility between the Commonwealth and the states, but also by a political system that divided power between the champions of private and public enterprise.
In pursuit of this overall strategy, the Commonwealth government maintained substantial controls over the finance sector. The grant of limited authority to the sector had the practical benefit of removing political influence from the administration of personal financial assets, small loans, and enterprise-level risks. This decentralisation allowed individuals and businesses to decide for themselves whether or not to save, and provided a source of funds for individuals and businesses that wanted to spend more than could be financed from their current income by borrowing from the general pool of savings.
In general, borrowing is of overall economic benefit when it finances the borrower to produce goods or services to a value greater than the amount borrowed and so yields a flow of funds both to repay the loan with interest and to add to the borrower’s income. The availability of bank loans and venture capital to start-up businesses is a major source of the dynamism of capitalism and hence of rising living standards.
In principle, nothing changes when borrowing and lending crosses national boundaries; the idea is still that net benefits arise when funds are transferred from savers to those who have opportunities to put savings to productive use. The parties involved are not necessarily financial intermediaries — direct loans are made between branches of multinational firms, and wealthy individuals also borrow and lend across national boundaries — but many cross-border flows of funds involve banks and other providers of financial services. Additional complexity arises thanks to the involvement of different currencies issued under the aegis of different governments, and the involvement of more than one public service in the administration of the web of commercial obligation.
Australia has a long history of borrowing from overseas, much of which has been wisely invested so as to add to the incomes of both the borrower and the lender. In the post-war period this established practice continued. However, it was recognised that the current account is of great importance for Australia’s financial stability. If the current account is in deficit, Australia — the total of its businesses, governments, and households — is borrowing more from overseas than it is investing overseas. As noted in Chapter 1, this borrowing can take relatively benign forms — particularly foreign direct-equity investment — but may also take dangerous forms, particularly short-term loans or ‘hot money’, which increase the country’s vulnerability to crisis.
During the post-war period the current account was, as always, hostage to international events. The Korean War famously brought a windfall benefit to Australia in the form of high prices for the country’s then chief export, wool, and was followed by an equally traumatic bust when wool prices returned to normal. Windfalls such as these are summarised by changes in the terms of trade, which are favourable when export prices go up and import prices go down, and adverse when prices change in the other direction. An adverse change in the terms of trade tends to result in an adverse change in the current account: reduced export prices mean reduced revenue from exports; increased import prices raise the cost of any given flow of imports.
The classic response to a serious deterioration in a country’s terms of trade is a devaluation of its currency, which reduces imports by increasing their price to domestic buyers, and increases exports by reducing their price to overseas buyers. However, post-war governments avoided this mechanism; they were anxious to maintain fixed exchange rates, for two reasons. First, experience during the 1930s had indicated that, if currency devaluation becomes popular as a means of export promotion, international trade quickly descends into a mayhem of competitive devaluations. Second, a fixed exchange rate provides a foundation for long-term planning both by governments and business. It encourages governments — including Australian governments, both Commonwealth and state — to seek to strengthen their economic position by adopting long-term policies to underpin the current account. They may diversify export and import markets, and nurture exporting and import-competing industries. Much of this can be done in the course of the regular interaction of the public and private sectors; for example, public investment in transport infrastructure can be tweaked in the interests of export-competitiveness, and education policies can be shaped to keep in mind the needs of trade-exposed industries.
