Dog Days: Australia After the Boom (Redback)

by Garnaut, Ross

  The changes of the Reform Era helped to keep growth going and inflation low. The floating dollar moved down decisively and sheltered industries through the Asian Financial Crisis. It floated up to insulate inflation rates from the domestic expenditure boom. A more flexible labour market reduced unemployment associated with the Asian Financial Crisis and the slump around the introduction of the GST.

  But for those who remembered Australian vulnerability to the collapse of credit at times of international financial stress, the high current account deficits, increasing external debt and heavy reliance on wholesale credit markets were a source of concern. The extraordinarily high real exchange rate also caused anxiety for those who recalled the political difficulty, extended timetables, and high unemployment and loss of economic output involved in lowering an unrealistically high cost structure.

  Different views emerged within the economics profession about what was needed to maintain stability. The majority, official and influential view at this time was that the changes of the Reform Era – the floating currency and the more flexible labour market together with the avoidance of deficits on government account – meant that the emerging circumstances of the early twenty-first century were of no concern.

  According to the dominant view, the floating exchange rate had appreciated when the terms of trade and domestic expenditure were strong. It would float down when the economy required a lower rate. The independent Reserve Bank would tighten monetary policy to combat inflation, and loosen it if expenditure fell below levels that were necessary to maintain full employment.

  We were running budget surpluses; any current account deficit was the result of private expenditure exceeding private income. It was therefore the result of decisions by consenting adults. Private businesses would not borrow if the debts that they were incurring could not be repaid out of earnings. And if some private borrowers from international markets ran into difficulties, that would be a problem for them and those who lent to them, not for the general community or the government.

  The alternative view was weakly represented, if at all, within the official family. Economists of this persuasion, including myself, argued that much more of the government revenue from the high terms of trade should be saved and stored. This would do three things. It would reduce the current account deficit. The accumulated savings would give us a large buffer against credit markets suddenly closing and making it impossible to service the large external liabilities that Australia was accumulating. And it would reduce the rise in the real exchange rate by holding down domestic spending, and so obviate the need for painful and risky adjustment at a later date.

  For economists putting forward this alternative view, it was little comfort that the accumulating private debt was held in the private sector. Australia’s own history of financial crises and the recent experience of the Asian Financial Crisis showed that problems in financing large accumulations of private international credit could seriously damage national economic performance. Problems of private debt were quickly socialised in hard times.

  The two views were laid out at length and debated in a meeting of a Senate Committee set up for this purpose in 2005. In the event, the Australian government was comfortable with leaving things where they were. Meanwhile reform had come to an end and productivity was declining. The Great Australian Complacency had permeated the whole of economic policy.

  THE GREAT CRASH IN AUSTRALIA

  The first signs of problems in the financial systems of the United States and the United Kingdom emerged in 2007. However, China’s investment-led growth continued apace and took Australia’s terms of trade to new heights through 2007 and the first seven months of 2008. The largest of all the tax cuts was offered by the Howard government and largely matched by the Opposition in the lead-up to the October 2007 election. Strong growth in output continued. The labour market was as fully employed as it had ever been in July 2008: monthly hours of work per person over fifteen years, 90.7 hours, reached the highest level recorded since the Bureau of Statistics began publishing the series in 1978. Competitive pressures and the demonstration effect of easy fortunes made from financial innovation in the northern hemisphere were influencing the behaviour of Australian financial institutions; the governor of the Reserve Bank, Glenn Stevens, remarked in 2013 that Australia was fortunate the Great Crash of 2008 occurred before bad practices were more deeply entrenched here.

  But we were less damagingly exposed to financial risk for positive as well as negative reasons: the Australian financial system had never had the extreme deregulation of the United States and the authorities had warned of the dangers of excess from the middle of the decade.

  Suddenly, in September 2008, even highly rated Australian private banks were unable to borrow from the international wholesale market. On a Sunday afternoon in October, the Rudd Labor government responded to the distress of the banks by guaranteeing all their wholesale debts, eventually taking on a contingent liability of $178 billion for a fee that was minuscule in comparison with the value contributed by the government’s intervention.

  This enormous and timely intervention saved our banks from financial failure. Recession was avoided by massive fiscal and monetary expansion in Australia, as well as our trading partners, most importantly China. The competitiveness of exports was maintained by quick and large depreciation of the Australian dollar.

  THE BOOM RESUMES

  By the end of 2009 the Chinese economy was growing strongly again and Australia’s terms of trade were back to their earlier heights and rising. Growth in output resumed after a single quarter of decline. In contrast with almost all other developed countries, unemployment remained low.

  Again, the flexible exchange rate and the more flexible labour market supported fiscal and monetary policy in maintaining growth through the most challenging circumstances. Australia narrowly missed great stress, but the absence of recession and the early return of high prosperity confirmed for us that ours was the best of all possible worlds.

  Fiscal policy was tight by historical standards after the Rudd government’s stimulus in response to the Great Crash. Indeed, in 2012–13, leading into an election, nominal (that is, in dollars and not only in real purchasing power) commonwealth expenditure actually fell for the first time in the forty years in which Treasury data are available in comparable forms. This amounted to a fall of over 3 per cent in real terms, or 5 per cent per capita, following a smaller fall in real terms in 2011–12. In contrast with longstanding practice before the Great Crash, the government went to an election without offering income tax cuts, and the Opposition matched the restraint.

  The budget deficit for 2012–13 came down a long way from 2.9 per cent of GDP in 2011–12, but the remaining 1.3 per cent of GDP was a long way short of the surplus that had appeared in the original budget estimates. Extraordinary expenditure restraint could not keep up with the decline in corporate income tax and the shortfall in resource rent tax after the resources boom turned from positive to negative in 2011.

  While budgets were firm after 2009, a tighter budget and lower interest rates from early 2010 would have taken some of the edge off the exchange rate appreciation. But there can be no credible argument that the budget was too loose from mid-2011. In retrospect, interest rates were kept too high under the circumstances of contraction from the resources sector and the commonwealth budget.

  After the Great Crash, household savings returned to the higher levels of the Reform Era, at around 10 per cent of income. This helped to hold external debt at merely high levels as resources investment attained great momentum in 2010. As it became clear that Australia had escaped the severe economic problems of most of the developed world, boom-time seemed to have become permanent. It was unnecessary to heed the caution of a few economists about the problem of competitiveness.

  CHALLENGES TO THE LEGITIMACY OF REFORM

  The strong growth in jobs in the early years of the
Reform Era had conferred legitimacy on reform. More people accepted at face value statements about the effects of further reform by Prime Minister Bob Hawke and Treasurer Paul Keating.

  This source of legitimacy disappeared with the recession in 1990–91. While recession should be expected when short-term interest rates approach 20 per cent and the terms of trade are falling, its arrival surprised the government and was hardly anticipated in the media or by big business. Forewarned is forearmed, and Australians walked into the worst downturn since the Great Depression without protection. Surprise and the absence of an official explanation made the recession especially damaging to the government’s reputation for good economic management.

  Many people who had been uneasy about reform but silent or ineffective while the new policies seemed to be delivering good outcomes were quick to blame reform for recession. ‘Economic rationalism’ became a widely used term of abuse. The Labor government, in its last few years, stopped contesting the critique. Government spokespeople would explain to outsiders that this was not an ‘economic rationalist’ government. The apparent retreat from the application of economic analysis to policy increased the vulnerability of good policy to pressure from populist as well as vested interests.

  There is a strand of modern economics that is extreme in its assertion that markets should not be subject to regulation and, as a corollary, that there is no place for concern for equity in policy. This strand, accurately described as libertarian, has a much smaller place in the professional study of economics than in the popular discourse, but nevertheless has proponents in the discipline.

  Libertarian views played a role in the extreme financial deregulation of the United States and United Kingdom that contributed to the global financial crisis in 2008. But libertarianism has never had a significant place in Australian economic analysis, and was not influential in policymaking during the Reform Era. (Senior figures at the Institute of Public Affairs have recently been describing themselves as libertarian, and may be a vehicle through which extreme views about the role of government become influential for the first time.)

  Australian financial reform was characterised by a strong focus on prudential regulation of a kind that was rejected in the United States and the United Kingdom. This contributed to the Australian financial system’s relatively strong position through the global financial crisis.

  The reaction against the application of economic analysis to policy was assisted by two developments within the economics profession itself. From its earliest days, Australian economists had seen the discipline as a social science, the value of which was measured by its capacity to illuminate developments in the world and be relevant to policy. Over recent decades there has been a large movement away from this tradition. Indeed, relevance to Australian reality and policy has become a drawback for professional advancement. A focus on being published in high-impact ‘international’ journals – in practice mostly US publications – led to a low professional value being placed on contributions to understanding Australian reality. This discouraged younger academic economists in Australia from work on local policy.

  The second development has been the commercialisation of contributions by professional economists. The culture of Australian economics was once set by academic traditions of independence from vested interests. By the early twenty-first century, most contributions to the policy discussion were made by economists employed directly by, or as consultants to, business.

  Some business economists – for example, most of those employed by banks – were usually not required to promote specific policy proposals. However, their incentive structures favoured focus on short-term matters: What will the Reserve Bank do to interest rates at its next meeting? What will the next monthly unemployment figures reveal? What will be the value of the Australian dollar at the end of the year? Other economists had specific policy briefs from their employers. Their work was riddled with undeclared conflicts of interest.

  Sound, disinterested analysis of long-term policy issues was crowded out by daily commentary and the noisy firing of the hired guns of business and political interests. Through the Great Complacency, gruesome examples abounded of economists capable of better things undertaking work of low professional quality on a commercial basis to assist businesses and lobbies that had employed them for this purpose. I mention two cases, not because they were more problematic than others, but because they illustrate two dimensions of the problem.

  A paper prepared for the Department of Foreign Affairs and Trade by well-known economic consultants demonstrated that in trade negotiations, a high proportion of the benefits for Australia would come from reducing US import barriers on sugar and beef. When beef and sugar were later excluded in the course of negotiations, a new paper showed similar benefits but from a source that had been newly introduced into the analysis – the easing of conditions applied by the Foreign Investment Review Board to US investments. As a Senate Committee was advised, this did not pass the ‘laugh test’.

  During the debate on climate change policy, articles were published in the News Corp majority press by people with professional standing in economics who were at the same time principals of a consulting company that had undertaken lobbying work on the issues discussed in their articles. Readers were not informed of this conflict of interest.

  The weakening of the authority of economic analysis and of economists’ independence helped to increase the influence of populism and vested interests on policymaking. And because employment and income growth remained strong until 2011, the dismissal of economic analysis and productivity-raising and stability-enhancing reform seemed to have had no adverse consequences.

  DID ECONOMISTS’ MISTAKES DISCREDIT THEM?

  Did mistakes in analysis contribute to the decline in the status of economics in policymaking? For the most part, reform worked much as economists had led political leaders and the public to expect. But the 1990–91 recession was the result of mistakes in monetary policy. In the early twenty-first century, the spending of the resources boom revenues more or less as they arrived was a mistake. It has left as a legacy the problems that are the subject of this book.

  The deep recession of 1990–91 started the backlash against reform. It resulted from mistakes of two kinds. First, deregulation made it hard to measure monetary tightness by reference to old measures of money supply. This contributed to the policies that left too late both the raising of interest rates and their lowering as high rates placed great strain on the economy. The lesson from this experience was learned early and well: the rate of inflation is a better guide to changes in monetary policy than any measure of the growth rate of the money supply. The Reserve Bank adopted inflation targeting as its main guide to policy from the early 1990s.

  The second source of error was tightening budget policy too little and monetary policy too much in the late-1980s boom. The idea of budget policy being too loose sounds strange when the Hawke government was running surpluses with as big a share of the economy as any before or since. Strange, but in retrospect true. This lesson has not yet been properly absorbed into economic thinking – as reflected in the general acceptance that the Howard surpluses in the bigger private-sector boom of the early 2000s were big enough.

  Few in the community understood either of these issues. It was the recession itself that damaged the standing of economic analysis in policymaking.

  HOW ELECTORAL DYNAMICS AFFECT POLICY

  There is a Gresham’s Law of electoral competition over policy. Bad policy ideas drive out the good. If one of the major parties offers something that is genuinely good for economic fortunes overall but which appears bad to part of the community, electoral fortunes can be won from fierce resistance to change.

  There are several reasons for the electoral bias against reform in the public interest. Negative messages can be simple; reform and its consequences are usually not easy to explain in slogans. Simple messages have adva
ntages in an electoral contest. The power of simple negative messages has been increased by changes in the media landscape since the Reform Era. The status quo is known, while reform inevitably carries uncertainty with it: ‘Better the devil you know’; ‘If you don’t understand it, don’t vote for it.’

  Successful reforms in the public interest invariably hurt one or other vested interest. Those who are hurt know who they are. Ease of identification and concentration place the losers from reform in a good position to invest in opposition – to contribute to negative popular campaigns, to influence policy through campaign contributions, to finance the production and dissemination of misinformation.

  The beneficiaries of reform are diffuse and harder to organise. The greatest beneficiaries may not be present at the time of reform, coming into existence only in response to the policy change.

  In addition, the wider public is generally deeply resistant to the messages of mainstream economic analysis. It believes, or at least wishes, that trade protection increases employment and incomes. It will rarely see great strength in arguments for cutting spending now to reduce the risk of problems at a later date. It sees any immigration as reducing the chances of Australians finding and keeping a job.

  For all of these reasons, reform in the public interest starts a long way behind in an electoral contest. It is only likely to succeed politically if there is effective advocacy of a clearly worked-out reform programme by a leader in a strong political position. The chances of success will be enhanced if a well-developed centre of the polity has absorbed influential people from both sides of the political contest (consensus being an unrealistic hope) who will increase the cost of appealing to populism by exposing the flaws in the simple arguments against reform.

  The change in political culture between the Reform Era and the Great Complacency seems to throw up impossible barriers to far-reaching reform in the public interest. And yet the Reform Era is as much a historical reality as the Great Complacency. Australians now have large reason to return to the approaches to policy that underpinned the Reform Era.