Credit Code Red

by Peter Brain

  Accordingly, in conjunction with the compulsory deportation of undocumented workers, the trade-barrier policies run the risk of creating inflationary bottlenecks. It is likely that the demand-diversion policies will not only prove to be weak in terms of direct stimulatory impact, but that they will stimulate inflation, and therefore enhance the rise in interest rates over and above the increase required to control the excess liquidity injected into the economy from the higher fiscal deficits. We have already identified increased interest rates as a hazard for Australia.

  It gets worse. If, by their protectionism, the Republicans start trade wars and succeed in reducing the level of world trade, and particularly if they curtail Chinese exports, Australia can look forward to additional vulnerability over and above that caused by the increase in world interest rates. Australian exports to China will suffer if the United States succeeds in reducing the Chinese rate of economic growth, and may suffer doubly if the Chinese government takes the opportunity to discriminate against Australia — whether directly, as punishment for Australia’s alliance with America, or indirectly, through a decision to discriminate in favour of emerging market economies as part of China’s cultivation of the leadership of a new ‘silk road’ economic bloc.

  China could also respond to increased protectionism by intensifying the role of import replacement in driving its economic growth. If in the process it substituted domestic iron ore and coal for imports, there would be a further significant reduction in Australia’s terms of trade.

  Interest rate increases aside, the most serious long-run negative impact of the Republican program is that it will further accentuate the inequality of the distribution of income. The OECD has calculated that the existing high level of inequality significantly reduces American productivity growth. The Republican policies can only make matters worse.8

  We conclude that the greater the short-term lift to GDP growth in the United States that results from Trump administration policies over 2017 and 2018, the greater the probability of adverse effects on Australia. These adverse effects will increase the probability that Australia will move to Code Red status in or before 2020, and will also intensify the catastrophe when it occurs.

  Crisis-risk parameter adjustments

  In Chapter 6, we considered a range of strategic risks that threaten our ‘business as usual’ baseline economic projection for Australia. We found that two of these strategic risks were sufficiently serious to justify modification of the business-as-usual scenario. We specified probability distributions for these two strategic risks — the risk of world financial instability (a second GFC), and the risk that, for whatever reason, Australian exports to China will be less than expected — and generated a revised scenario based on the balance of the probabilities. We now apply the same methodology to the risks raised by the Republican Party platform as it unfolded in early 2017, and re-assess Australia’s crisis vulnerability as augmented by the American election.

  As explained above, we expect the Republican policies to increase the probability of world financial instability. In Chapter 6, we identified this as a threat to our baseline projection. To adjust the macroeconomic-crisis indicator for the Republican platform, we kept the range of possible values of the VIX index constant, but adjusted the probability of each value. We reduced the probability of stability in the index to zero, retained the probability of moderate instability at 0.1, increased the probability of a moderate GFC from 0.2 to 0.3, increased the probability that the GFC would be replicated from 0.2 to 0.3, and increased the probability of a more severe GFC from 0.1 to 0.3. The resulting mean expectation is that the GFC will be duplicated sometime over the next five years.

  The second threat to the baseline projection identified in Chapter 6 was the possibility that the assumed level of exports to China will not be achieved. The Republican platform contains indirect threats to these exports. We now estimate that the chance that baseline exports to China will be achieved is reduced to 20 per cent, with an 80 per cent chance that there will be varying levels of shortfall. The mean expectation is a most likely shortfall in exports of 6 per cent by 2021.

  In addition to its effects on world financial stability and on Australia’s exports to China, the advent of the Republican administration is likely to affect Australia adversely by raising interest rates and reducing trade opportunities.

  We now expect that the increase in the United States’ fiscal deficit (or public-sector borrowing requirement) to between 3 and 5 per cent of GDP will generate more rapid increases in interest rates than are required by world GDP growth, inflation, and financial instability. In the event of a full implementation of the Republican fiscal program, we assess a 20 per cent probability of an increase of 0.5 percentage points in United States interest rates; a 30 per cent probability of a 0.8 percentage point increase; a 40 per cent probability of a 1.2 percentage point increase, and a 10 per cent probability of a 1.5 percentage point increase. The mean probability is an increase of approximately 1 percentage point; however, we scale this back by an estimation that no more than half of the fiscal program will be implemented.

  Revised United States trade policies are also expected to directly reduce the growth of world trade and hence to depress world economic growth, in addition to their impact on interest rates and financial instability. We assess there is a 20 per cent chance that revised Republican trade policies will have no impact on world growth; a 30 per cent chance that they will reduce world average annual GDP growth over the next five years by 0.1 per cent per annum; a 20 per cent chance that the reduction will be 0.2 per cent per annum; and a 10 per cent chance of reductions of each of 0.3, 0.4, or 0.5 per cent per annum. The mean expectation is a reduction of 0.2 per cent per annum.

  A shift to greater reliance on managed trade by the United States, China, and other countries following their lead will have a direct impact on Australia’s terms of trade, over and above the impact of reduced world growth. This will be because of the reduced role of global demand and supply in determining world prices. The mean expectation is that this will result in a reduction of 9 per cent in Australia’s terms of trade compared to the original case without the political disruption of 2016.

  Increased financial instability will also have its effect on the year-ahead foreign-exchange-cover ratio. As international investors perceive increased risks in exposure to Australian dollars, they will become less willing to make loans in domestic currency. Our probability settings are for a 10 per cent chance that the share of foreign debt denominated in domestic currency will decline by 20 per cent; a 30 per cent chance that it will decline by one-third; a 30 per cent chance that it will decline by 40 per cent; and a 20 per cent chance the decline will be between 60 and 75 per cent. Our mean expectation is a decline of 50 per cent, which means that that the share of foreign debt denominated in domestic currency would fall to 15 per cent.

  The final parameter requiring adjustment is the share of Australian capital outflow as a percentage of GDP. Our probability settings are a 10 per cent chance of no increase; a 20 per cent chance of an increase of 1 percentage point; a 30 per cent chance of a 2 percentage-point increase; and a 40 per cent chance that the increase will be between 2.5 and 3.5 percentage points, with a mean expectation of a 2 percentage-point increase. This will also cover the case where American capital flows back to the United States as a result of one-off tax measures to encourage the repatriation of the foreign-held financial assets of American corporations.

  It is important to note that the combined impact of these changes would not be dramatic if the Australian economy were to maintain the relatively strong position it held at the beginning of 2016. For example, even after adjustment for the economic consequences of Trump, the average world growth-rate over 2016 to 2021 would be 2.9 per cent per annum, similar to average world growth from 2014 to 2016, and quite manageable for a strong economy.

  However, as we showed in Chapter 6, the underlying tre
nds are adverse, and the various downward adjustments we are making apply to a weakening economy. The mean expectation for the terms of trade, for example, is that import prices will rise more rapidly than export prices, reducing the purchasing power of Australian exports, so that in 2021 a constant quantity of exports will buy only 70 per cent of the imports that it would have financed at the peak of the mining boom in 2012. (The overseas purchasing power of the Australian dollar had already fallen 80 per cent of its peak value by the end of 2015.) Importantly, United States short-term market interest rates are now expected to double from 2.2 per cent at the end of 2015 to 4.2 per cent by 2021. Against the background of high and increasing indebtedness and generally increasing Australian vulnerability, this will have serious implications for the Australian economy.

  Our adjustments to the drivers of the vulnerability indicators due to the expected revisions to American economic policies are all unfavourable to Australia, and generate a 60 per cent probability that the macroeconomic crisis indicator will flash Code Red for at least four quarters in 2020–21. The year-ahead foreign-exchange-cover ratio also deteriorates, falling to 0.12, likewise a Code Red value. Australia’s position could easily worsen more rapidly than this, with 20 per cent probability that Code Red status will arise by the end of 2018. In other words, economic breakdown will be more likely than not within a few years. The projections imply the following 2021 values for key economic indicators: a fall in the Australian dollar to 53 US cents; a current-account deficit of 8 or 9 per cent of GDP; and a gross foreign debt-to-GDP ratio of just under 200 per cent. One does not need an economic model to acknowledge that catastrophe would then be imminent.

  These dire projections depend on an important assumption, which is that the Australian policy authorities try to maintain an average annual growth rate of 2.2 per cent per annum over the five-year period to 2021 by a combination of expansionary monetary and fiscal policies, and so attempt to maintain the growth trajectory set out in the 2016 budget, ignoring the risks that prevailed before the 2016 United States election, and similarly ignoring the new risks arising from the election. Whether these dire predictions for Australia come to pass will depend chiefly on whether the overseas drivers we have outlined are realised, but also on the discernment and agility of the Australian body politic.

  The events of 2016 have increased the risks to the Australian economy to the extent that attempts to maintain a trend GDP growth rate of around 2.2 per cent a year while retaining the neo-liberal reforms of the past thirty years will raise the probability of economic catastrophe to at least 50 per cent. Even if by some miracle Australia manages to escape an economic catastrophe, or the alternative of a severe recession in the five years 2017–2022, it is likely to come to grief later in the 2020s.

  In its 2017 budget, the government edged in the right direction by financing increased redistributive expenditures from increased tax revenue, and by directing borrowing into infrastructure investment. However, it failed to increase household saving and curb imports of consumption goods. Australia’s slide towards Code Red continues.

  The political responsibility for crisis vulnerability

  If an economic catastrophe occurs within the next five to seven years, it will have been decades in the making, with contributions by a succession of Commonwealth administrations. Since Australia’s vulnerability to crisis derives from its accumulation of foreign debt, a simple measure of the contribution of successive administrations to the risk of crisis is the annual average increase in net new foreign debt that took place under their aegis. The net change is calculated after adjusting for the impact of exchange-rate changes, and is best expressed as a percentage of nominal GDP for the period.

  The highest average annual increase occurred under the Coalition administration, led by John Howard and Peter Costello, that was in power from June 1996 to March 2007. This administration has been regarded as one of the most economically successful of recent times, but this is because its performance has been evaluated on the basis of only one criterion — the reduction in net national government financial obligations. Net national general government liabilities declined from 20.5 per cent of GDP in the June quarter of 1996 to -1.5 per cent in the June quarter of 2007. However, this achievement was more than counterbalanced by the increase in the household stock of equity-withdrawal borrowing, which rose from 15.4 per cent to 57.8 per cent of GDP by the June quarter of 2007. Between 1996 and 2007, the rate of equity withdrawal averaged just under 10 per cent of net household disposable income a year, peaking at 16 per cent in the December quarter of 2004. The average net discretionary savings ratio was -6.7 per cent over the period.

  The Coalition administration succeeded in reducing public-sector liabilities by allowing the banking sector to expand lending rapidly, increasing house prices and driving down net household savings rates as a mirror image of the increase in public-sector savings. Debt did not fall; it merely switched sectors. From this broader perspective, far from being a successful period of economic policy, the Coalition under Howard will be judged to have made a disproportionate contribution to Australian economic vulnerability.

  Although overseas debt accumulated most rapidly under the Coalition, the build-up towards Code Red over the last thirty years has been a general government responsibility rather than that of a particular party. It was the Labor administration of the mid-1980s that unleashed financial deregulation, admittedly on a bipartisan basis. Similarly, had a Labor administration been in office from 1996 to 2007, it likely that it would have exhibited similar complacency towards household equity withdrawal, since the trend was well under way between 1992 and 1996, and continued between 2007 and 2013.

  What were the factors underlying this bipartisan responsibility? The play of vested interests would doubtless have contributed, along with short-term political strategies, but underlying all other influences is the current mode of thought. The world is complicated, and people inevitably simplify it in their attempts to gain understanding. During the era of imprudent accumulation of overseas debt, neo-liberal theories were fashionable in Australia, the United Kingdom, and the United States. Though intellectually rigorous within their own closed system, and useful as an intellectual weapon in the Cold War, these theories were so abstract that they assumed away the possibility of economic catastrophe brought about by excessive overseas borrowing.

  We have argued that neo-liberal policies have stored up trouble for the Australian economy as a whole. In concentrating on these risks, we have not drawn up a comprehensive table of the winners and losers from such policies — when catastrophe occurs, all Australians will lose. The current position is that the Labor Party is showing some signs of repudiating its neo-liberal past, while the Liberal/National parties are reconfirming their allegiance. However, as with the Republican support base in the United States, important groups of Liberal/National supporters are beginning to perceive themselves as disadvantaged by aspects of Washington Consensus policies. Just as both sides of politics repudiated neo-liberalism during the Second World War, and both returned to neo-liberalism in the early 1980s, the time has come for both to move on.

  Table B: Annual average change in new foreign debt (per cent of GDP)

  Administration

  Number of quarters

  Labor

  Coalition

  September 1988 to March 1996

  30

  3.4(a)

  June 1996 to March 2007

  44

  6.7

  June 2007 to September 2013

  26

  4.5

  December 2013 to December 2015

 
9

  3.1

  Note: (a) At this stage, because of the lack of direct data consistency, the period from March 1983 to June 1988 has been excluded.

  Conclusion: the risk rating of current Australian economic policy

  In indebted economies such as Australia’s, the major risk of economic catastrophe arises from over-borrowing. We have concluded that, by its heavy reliance on overseas finance, Australia is courting such risks. We have introduced the idea of crisis alerts, and developed two main indicators on which to base such alerts — the crisis risk-indicator for macroeconomic trends, and the year-ahead foreign-exchange-cover ratio for the capacity of the authorities to respond to an incipient crisis. The current values of these indicators are not seriously alarming, but the trends are. To assess these trends, we developed a baseline projection similar to that included in the Commonwealth budget for 2016–17, and concluded that the trends are indeed adverse, such that there is a strong likelihood that Australia has no more than a few years to take action to defend itself against an economic catastrophe. We then reviewed the baseline projection and found a couple of risk factors that, when included in the projection, underlined our conclusion that it would be, to say the least, prudent to take prompt action to reduce the nation’s reliance on overseas borrowing. These and other risks have been enhanced by the 2016 US election result.