Much of the public discussion about the end of the boom has so far focused on the unexpectedly large budget deficits since 2011. If the reaction of the government were simply to cut spending to match the fall in revenue, we would certainly enter a deep recession that would further reduce government revenues by a large amount. It is possible that the budget deficit would not be reduced at all by such spending cuts – it could even increase.
On the other hand, if we seek to maintain full employment with stimulus programmes, as in 2008–09, this will open up large budget and current account deficits. We could not fund this for long in current circumstances and would get ourselves into deep trouble if we tried.
This time, full employment has to be maintained with improvements in competitiveness: we have to switch demand from imports to goods and services produced in Australia; and switch production from the supply of home products to the supply of exports. This will primarily involve exporting Australian services, high-value manufactures and agriculture (probably mainly the adding of value to foodstuffs, as raw agricultural output is governed by weather in the short term). It can also include resource projects, such as processing, that would not have proceeded at the exchange rates of early 2013. Government policy choices and Australians’ responses to them will have a large effect on how long and how far the fall in employment and living standards will extend. The best of policy will secure a large, early real fall in our currency as well as far-reaching productivity-raising reform.
But regardless of whether the large fall in the dollar comes sooner or later, if it is to have the necessary effect on the economy it must be converted into a real depreciation. This is the hard part. Australians on average will have to accept some reduction in real incomes. A 30 per cent fall in the exchange rate that is fully passed through into prices to consumers without any compensating increase in incomes would reduce average incomes by about 7–8 per cent.
A lower real exchange rate will restore competitiveness to all trade-exposed industries. It will take some time for this to lead to higher investment, and longer still for it to be reflected in higher exports.
NOTE: POLICY FOR STAYING FULLY EMPLOYED AND RICH
Some readers will not be interested in the economic analysis underlying the policy choices that I discuss in the next part of the book, so I separate that out here so that those who are comfortable about taking my analytic framework on faith can proceed directly to the next chapter.
The economic challenge facing Australia has two parts: keeping our people fully employed without inflation or dislocations in external payments (at worst, a financial crisis); and doing things efficiently so that we achieve full employment with the highest possible standards of living for ordinary Australians.
The first part of the challenge is macro-economic: the big economic picture of achieving full employment without inflation by maintaining a balance between overall income and expenditure, and foreign income and foreign expenditure. The second is micro-economic: achieving high productivity in the market sector and effectiveness of government.
Chapter 5 outlines the first part of the challenge, the macro-economic. Chapters 6, 7 and 8 deal with what we can do to increase standards of living sustainably, the micro-economic.
Macro-economics can be as complex as we want to make it. Its essence is simple, so let’s make it simple. For economic growth to proceed smoothly with full employment and without unacceptably high inflation, we need to keep a balance in two areas: between total expenditure and the economy’s capacity to generate income; and between expenditure now and expenditure in the future.
We have two policy objectives: maintaining full employment and low inflation now; and avoiding big external payments imbalances so that we don’t store up potential for financial crises and employment and inflation problems.
We have main two levers to pull on the way to achieving these objectives. One is to vary the budget deficit or surplus by changing the level of government expenditure or taxation. The other is to vary the interest rate in order to vary the exchange rate and therefore the relative level of domestic and foreign costs. Changing the interest rate also affects expenditure, which augments or counteracts changes in the budget settings.
The balance between expenditure and income ensures that there is enough demand to generate full employment, but not so much as to give rise to inflation. If this were our only concern, it would not matter whether we controlled demand by changing the budget deficit or surplus, or the interest rate. If demand were too low, we could lower interest rates to lower the dollar and increase demand, or run a bigger budget deficit. It would not matter which.
But the balance between demand and incomes today is not all that matters. If incomes exceed expenditure now – perhaps because the private sector has decided to save more than it invests – we will have a tendency to unemployment. If we fill the demand gap simply by increasing budget expenditure or cutting taxes without lowering interest rates (and therefore the exchange rate), the trade deficit will increase. That is fine if our external financial position is strong and expected to remain so through an increase in the trade deficit. But it is not fine if the external financial position is weak and expected to get weaker.
If we lower interest rates, there will be some increase in domestic expenditure. In addition, the exchange rate will fall – and some of the increase in employment will come from the export- and import-competing industries. The trade balance will be stronger than it would have been if expansion had come only through the budget.
If the terms of trade increase, Australian incomes rise. If we start from a position of full employment and all of the extra income is spent, we will have a tendency to inflation. The appropriate response is to reduce spending. We can do that through running a budget surplus and sterilising it by investing it abroad, or through raising interest rates and therefore the exchange rate. There are two big differences between the two cases. One is that current average Australian incomes rise if the tightening occurs through the exchange rate, but not otherwise. The other is that the cutback in expenditure is spread through government and other non-traded activities with the budget tightening, but disproportionately concentrated in the export- and import-competing industries if it is achieved through higher interest rates. The more we force the cutback on the trade-exposed industries, the larger the trade deficit and increase in foreign debt, and the more we redistribute real incomes and consumption from future to current generations.
Which is better? It all depends. It depends first of all on whether the change that has increased our incomes is expected to be temporary or permanent. If temporary, it will be disruptive if we let real incomes and expenditure rise, and force other trade-exposed industries to reduce their investment and production, and then have to pull them down again when things return to where they were. And we can feel more comfortable about redistributing income away from future and towards current generations if seemingly permanent high terms of trade are going to make future Australians well off.
You never know for sure whether and how much of a change in export prices is going to be temporary. It is a costly error to assume that a lift in export prices is permanent when it turns out to be temporary: to spend the increased incomes and then have to manage down the excessively high incomes, expenditures and real exchange rate. It is much less costly to make the opposite error: to assume that the increase is temporary when it turns out to be permanent. It is therefore wise to be cautious and respond initially to a positive shock with a tighter budget.
I should add another complication in choosing whether to increase the budget deficit or reduce interest rates when we need to increase expenditure and employment. Lower interest rates stimulate expenditure directly as well as lower the exchange rate, and on some activities much more than on others. Housing expenditure is particularly sensitive to interest rates. Worries about a housing bubble may eventually inhibit the Reserve Bank’s
cutting of interest rates when this is warranted on other grounds. In these circumstances, the authorities may need to apply special measures to slow the growth in lending for housing as interest rates are cut lower.
If required, the most straightforward way of restraining house prices as interest rates are reduced is to decrease or remove the unusually low proportion of housing loans that the Australian Prudential Regulatory Authority requires banks to put aside for capital adequacy purposes. The reason why capital adequacy requirements are low is that housing loans are thought to be less risky. This justification falls away when the rise in housing prices has made lending risky.
The best mixture of budget and interest rate policies needs to be worked out case by case. Let’s look at how this has occurred through the China resources boom, so we can understand better what to do next.
We started with full employment and a bit of a tendency towards over-expenditure in the housing and consumption boom. We spent the extra government revenue and private income just about as soon as we received it. The Reserve Bank raised interest rates and the exchange rate rose. This choked off investment and export growth in other export- and import-competing industries – and the more marginal resource projects themselves. Real Australian incomes and expenditure rose. (I’ll leave the years of the Great Crash out of this story, as they are an unnecessary complication.)
When resources investment started to rise strongly, financed partly from new capital inflow and partly from domestic savings (some of which were diverted from non-resource investments that were not now happening), the Reserve Bank further increased interest rates in order to ensure that the extra demand for labour and materials was not inflationary. The fact that other developed countries’ interest rates were being kept close to zero as they tried to encourage growth after the financial crisis meant that our exchange rate went higher still, as it is the difference between Australian and foreign interest rates that drives the foreign exchange value of our dollar.
And then something unusual happened. The central banks of the large developed countries wanted to stimulate economic activity even more, and started pushing more cash into their economies. That drove down their currencies even further – which amounted to driving up the currencies of economies that did not follow such policies. Some foreign central banks that did not engage in the unconventional monetary policy, including the Swiss and Brazilian, resisted the increase in value of their own currencies by intervening in the foreign exchange market in various ways. That made the lift in the exchange rate even bigger for those currencies that did not intervene in any way – Australia foremost among them.
So by March 2013 we were in the position described in Part 1 of the book, with a real exchange rate that has appreciated more than any developed country’s currency ever had, with our terms of trade on the way down, and our resources investment at its peak and about to go down. Export volumes are growing strongly, but total exports not especially so; certainly not enough to fill the gap in economic activity left by retreating terms-of-trade-based expenditures and resource investment. That is the reality that will shape Australian policy choice in the period ahead.
This simple story raises a question about why the official advisers to the government did not push Prime Minister Howard and Treasurer Costello much harder towards budget surplus in the early years of the boom.
Part of the reason was that the wrong lesson was learned about the importance of the mix of fiscal and monetary policy from the boom of the late 1980s and applied in the China resources boom. The Hawke government in the late 1980s ran just about the tightest budget policy in Australian history – as measured by the budget surplus as a share of GDP. Tight, but not tight enough to avoid the emergence of an inflationary boom. The lesson drawn was that the budget instrument was ineffective. In retrospect, the correct lesson was that surpluses were not big enough.
There was another source of error in managing the early stages of the resources boom. There has been overconfidence that the reformed economy will adjust automatically to changes in the terms of trade if large public deficits are avoided, and interest rates are raised when inflation is high and lowered when unemployment is emerging. We will all learn over the next few years whether the downward adjustment of real incomes, expenditure and the real exchange rate turns out to be hard or easy. I fear that it will be hard.
Finally, policymakers early in the resources boom may have thought that developments in China meant that the increase in the terms of trade was likely to be permanent – that this time was different. If so, this was an imprudent assessment.
CHAPTER 5: REFORM FOR FULL EMPLOYMENT AND STABILITY
This chapter examines more closely the big economic policy adjustment that Australia must make if it is to maintain full employment and a base for rising prosperity after the China resources boom.
When the China boom has passed completely into history, it will have left us with a bit more spending power than before it began. But for a while we will have much less spending power than we were enjoying at the height of the boom in 2011, less than we are enjoying as this book goes to print in 2013, and much, much less than Australians came to expect as the normal accompaniment to life in the Salad Days.
This is not the conventional wisdom in the business community and much of the media, which expects a return to comfortable times as ‘confidence’ returns with the end of minority government and the blossoming of resource exports from now on.
Yet Australian employment and incomes face strong headwinds. Among the long-term factors, whatever the permanent increase in incomes from the boom in the resources sector, there will be more Australians to share it. The ageing of the population is beginning to bite, with rising health and aged-care costs; and the increase in the number of dependents supported by each working-age Australian will reduce average incomes by about 0.25 per cent annually for as far ahead as we can see.
Our economy has high levels of foreign debt as a share of the economy – overwhelmingly in the private sector. At some time, international interest rates will rise and the servicing of this debt will be an increased drag on incomes. While the debt is mostly private, commonwealth tax revenue will be affected by higher deductions as interest rates rise.
Climate change is affecting economic growth. The world has been slow to reduce emissions and the cost of dealing with climate change will increase in the years ahead, even in the best of circumstances. Much change is locked in by emissions that are already in the atmosphere or impossible to avoid. For Australia to do its fair share in the global effort to reduce emissions – and therefore reduce future costs of climate change – also has a cost. The lowest-cost approaches to mitigation involving carbon pricing would shave a tenth of a percentage point off incomes growth per annum in the years immediately ahead; direct interventions would cost much more to meet the same targets.
Average productivity growth in all developed countries has been much lower so far in the twenty-first than in the twentieth century. This makes it harder to achieve strong productivity growth in Australia. Of course, we can raise productivity significantly simply by moving closer to the best ways of doing things in other countries. That would help us to retain some of the increase in living standards that has accrued during the Great Complacency. But we are yet to start on a vigorous programme of productivity-raising reform.
As noted, no developed country has experienced as large a sustained appreciation in its real exchange rate as Australia has through the China resources boom – not even the Netherlands during the development of North Sea gas and the fabled ‘Dutch Disease’. In turn, this means that no developed country has ever successfully worked through such a fall in the real exchange rate and associated contraction of incomes.
HOLES IN THE GREAT COMPLACENCY
In short, Australian economic policy and experience has entered unknown territory. The decline from the peak of the China resources boom in late
2011 wasn’t noticed much at first. From 2010 I had started to draw attention to new currents in China and point out the implications for Australia, but this wasn’t the time for these matters to be noticed.
Larger holes began to appear in the Great Australian Complacency from early 2013. Discussion of policy alternatives became possible. The then prime minister, Kevin Rudd, talked about the transition after the end of the boom on the day of his return to office in June 2013. For his part, the then treasurer, Chris Bowen, said in his August Economic Statement, delivered just before the 2013 election was called, that we are in a transition and not a crisis. If this means that we treat the policy choices purposefully and systematically, without panic, then he struck the right note. If it conveys the idea that small, incremental adjustments can solve the problem, then it was unfortunate.
Levels of commonwealth spending and revenue were the prime focus of the government’s August statement on the budget and economic outlook, the Opposition’s response and the arguments of the election campaign. However, in the adjustment to the end of the boom, Australia faces an economic problem, of which the budget problem is a part. The budget problem will be solved in the process of solving the economic problem, or not at all. In any case, if budgetary extravagance was the problem, the tightest budget in at least sixty years would have been a reasonable start on a solution.
It is the competitiveness of Australia’s trade-exposed industries, not the state of the budget in the years immediately ahead, that will determine whether we can restore and maintain full employment. The size of the budget deficit matters much more than the post-election public conversation allows; but the extent of future deficits and their consequences depends crucially on whether or not Australia succeeds in real depreciation and restoring momentum to our export- and import-competing industries.
Dog Days: Australia After the Boom (Redback) Page 8
