Dog Days: Australia After the Boom (Redback) (6 page)

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 advantages 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.

Australians now have to live with the hangover from the biggest housing, spending and resources booms in our boom-and-bust cluttered history. So far our response has been to take another drink, with no end in sight during the 2013 election campaign. Our spending and our real exchange rate have risen to levels far beyond what is sustainable. The challenge now is to manage their falls in ways that do the least damage to employment, our living standards and the quality of our society.

THE RESOURCES BOOM: THREE PHASES

As discussed in the Introduction, it is useful to think of three overlapping phases of the resources boom: the terms of trade phase, the investment phase and the export expansion phase. The terms of trade phase began in 2002 and affected the Australian economy from 2003. Apart from a break in the year following the Great Crash of 2008, our terms of trade rose rapidly and consistently to a peak in September 2011. The downward slide since then has been as rapid as the rise, and more likely than not in 2014 or 2015 we will see much lower levels still.

The investment phase got underway in 2006, but increased gradually until 2010 and also with a break after the Crash. Resources investment as a share of the economy looks set to reach a peak late in 2013. It will then decline until it is not far above the historical average in about 2017. The effect of this investment on the Australian economy in any year is a mixture of the positive, from the capital expenditure, and the negative, from the corporate tax deductions it allows. The net positive effect of resources investment was probably greatest in 2012 and will become a net negative for a number of years after 2017.

The third phase, the expansion in export volumes, began in 2012 and will continue for a year or so after the end of the investment phase, to about 2017.

If we put these three overlapping phases together, and since we spent most of the increased income from higher export prices as it arrived, we can see the expansionary effect of China’s demand on the Australian economy commencing in 2003 and growing steadily stronger (with the break after the Great Crash) until 2011. The positive impact of the China resources boom on the overall Australian economy ended in late 2011. Since then, the overall impact of the resources sector has been contractive and is likely to remain so for a number of years.

The three phases contribute to the Australian economy in different ways. It is worth looking at each of them in more detail, so as to understand the underlying forces driving big changes in our economy.

THE BIGGEST PHASE: TERMS OF TRADE

Strong terms of trade contribute mainly to government revenue, but they also raise the income of Australians who own shares in resource companies. At their peak in September 2011, the terms of trade were more than double the average of the first twenty years of the floating currency (1983–2002). This added almost 24 per cent to
nominal
gross domestic product.

Yet much of this increase did not directly affect the Australian economy because about three-quarters of the equity in resource companies is owned overseas. The main effect of the higher terms of trade was to raise potential government revenue by around 10–11 per cent of GDP, with about 1 percentage point accruing to the states as royalties and the rest to the commonwealth as corporate income tax, capital gains tax, resource rent tax on offshore petroleum, income tax and withholding taxes on dividends from resource companies. (I say potential, because if the increased revenue is spent, as it was, it raises the cost level of the economy and the real exchange rate, which in turn reduces resource-sector profits and government revenue.)

Separately, the terms of trade raised potential Australian incomes by about 2.5–3 per cent of GDP through increased dividends or increases in the retained earnings of companies whose shares were held by Australians directly or within superannuation funds. There was an additional wealth effect as the price of resource company shares rose in anticipation of higher future earnings. So the total effect of the terms of trade boom from the average of 1983–2002 to the peak in late 2011 was to raise potential average incomes of Australians by more than one-eighth.

Since late 2011 there has been a steady decline in the resources sector’s contribution to Australian incomes. How low will the terms of trade go and for how long? That depends on conditions specific to each industry.

For iron ore, immense investments in supply capacity in Australia and other countries are causing a huge increase in volumes to come to market at a time when the growth in Chinese demand has slowed sharply. This has brought down prices and will take them further as supplies increase considerably from late 2013. Similar dynamics are influencing metallurgical coal.

The extent of the reduction in Chinese production as prices fall will be an important determinant of future prices. There are prospects for average future iron ore and metallurgical coal prices to settle higher than in the late twentieth century, and lower-quality mines will come into production to meet absolutely higher levels of demand. But these prices may be only half the peaks of late 2011 in real terms. There could be early periods when China is undergoing structural change and global supply is increasing rapidly in which prices are temporarily lower than future averages.

Thermal coal use may not grow much, if at all, from late 2011 in China, the world’s largest market, so that increasing global supplies may cause real prices to settle at much less than half the 2011 peaks. Again, much depends on what happens to production from mines in China.

Liquefied natural gas (LNG) exports will become increasingly important, so that gas prices will be influential in determining our terms of trade. Australian gas goes mainly to East Asia, where prices have been determined by formulae linked to oil and are now well above North American levels. Environmental priorities will cause Asian demand for gas to grow more strongly than for Australia’s other commodity exports. At the same time, world capacity is growing rapidly, with big investments in exploration and production applying old as well as unconventional technologies. Large efforts to expand domestic gas supplies in China (not yet certain to have broad success), overland pipelines from central Asia and Russia, new supply capacity in Canada and Mexico (as ways are found to subvert US controls on gas exports), the relaxation of export restrictions from the United States and a huge expansion of seaborne export capacity in Australia, Papua New Guinea, Southeast Asia and the Middle East are all increasing supplies to East Asia. The overall effects of these changes are not clear, but it would be surprising if Australian export prices didn’t settle well below current levels in real terms.

Prices for tourism, education and other services are set in Australian dollars, so they rose for overseas customers as the real exchange rate went up, and will fall as the dollar comes down. This will place a significant drag on the terms of trade. Agricultural prices will generally be moderately higher than in the late twentieth century, reflecting Asian demand and constraints on global supplies.

My best guess is that the terms of trade will settle on average about a quarter higher than the 1983–2002 average, which is a bit more than one-quarter lower than mid-2013. Potential government revenue from resources would be about 7 per cent of GDP below the peak of 2011 (or about 4 per cent below mid-2013 levels). Other potential Australian incomes from ownership of shares in mining companies would contract by 2 per cent of GDP from the peak (or 1 per cent from mid-2013). This means that the ‘permanent’ contribution of the 21st-century lift in the terms of trade to Australians’ average incomes is likely to amount to about 3 per cent of GDP, or about 10 percentage points lower than at the peak of the boom.

The increase in revenues from the boom could have been saved by government. If all of it
had
been saved, pending clarification of how much of the increase was going to be permanent, the main effect of the terms of trade boom would have been to support budget surpluses, mainly in the commonwealth but also in state governments.

As it turned out, almost all of the revenue increase was used for tax cuts or increased spending soon after it arrived. The resulting public and private spending increased the demand for Australian labour and supplies. The economy was already in full employment, so this in turn raised domestic costs and the real exchange rate. That forced the decline of other trade-exposed industries, which freed up the labour that had been employed in these industries. Every announcement of a new mine meant an unannounced closure or failure of a hotel or university department or winery or factory. This process continued until enough investment and production had been shrunk or closed to meet the demands that the higher expenditure was making.

The higher real exchange rate reduced the profitability of resources production (as well as of all other trade-exposed industries). It therefore took away part of the increase in government revenue. But this economic value did not just disappear – the real purchasing power of Australian incomes rose with cheaper imports, and Australian consumption increased to unprecedented levels.

Even with the higher exchange rate taking the edge off government revenues, the increase was remarkable. Corporate income tax receipts alone rose from $27 billion in 2002–03 to $65 billion in 2008–09. That was the high point in real terms: the revised budget numbers released in August 2013 showed that only $69 billion was expected in corporate tax revenue for 2013–14, which is one-eighth lower per Australian in real terms than five years before, in the midst of the global financial crisis.

THE INVESTMENT PHASE

The second phase of the resources boom saw capital expenditure on resources projects rise from historical averages of less than 2 per cent of GDP to more than 8 per cent in 2013. This investment contained a high proportion of imported goods and services, which reduced its impact on the Australian economy by perhaps a percentage point of GDP compared with the same amount of investment in other industries.

The big rise in investment began in 2006, stalled for a year or so after the Great Crash, and reached a peak in 2013. The larger part of the increase in resources investment came after the Great Crash.

Before the Great Crash, much of the increase was funded (directly or indirectly) by capital inflow. After the Crash, more was funded (mostly indirectly) from higher national savings. During this period, household savings increased, partly in response to the uncertainty and anxiety induced by the financial crisis and its long international shadow. Lower consumption reduced the demand for Australian labour, thereby freeing about half of what was required for the growth in mining investment from the Great Crash up to 2013. But the balance of the increase in investment – amounting to about 2 per cent of GDP – increased labour and other costs and therefore further pushed up the real exchange rate.

The investment phase of the boom has affected the economy independently of government decisions on taxation and expenditure. It immediately and automatically increased demand for Australian labour and supplies. This has augmented the effects of spending the income from higher export prices in pushing up local costs as mining outbid other industries.

The higher exchange rate made all of our trade-exposed industries less competitive – in the resources sector as well as in services, manufacturing and agriculture. So some of the investment choked off by the higher exchange rate was in resource projects that did not go ahead. Indeed, the bidding up of executive pay, labour costs and conditions, and land and materials prices in the frenzy of the boom meant that the resources sector experienced even greater cost increases in international dollars than other industries.

Once capital expenditures have been made, investors are able to claim tax deductions for depreciation and amortisation and financing costs. The increased deductions are available over a number of years, eventually accumulating to a ‘loss’ of revenue equal to about one-third of the increase in resources investment. So if the resources boom added an average of about 5 per cent of GDP to investment for eight years, it would lead to a reduction of commonwealth revenue of around 1–2 per cent of GDP per annum spread over perhaps ten years, but later.

These corporate tax deductions are available whether or not the investment is commercially successful. At the height of the boom, many investments were made that turned out to be commercially unsuccessful and were written off as worthless or written down in the accounts of the companies that made them. Some did not even lead to additional production. That happens in the ebullience of a boom.

THE EXPORT PHASE

The third phase of the resources boom – the lift in export volumes – began in earnest in 2012, almost a decade after the terms of trade began to rise. Exports in 2012 increased by 9 per cent for thermal coal, 18 per cent for metallurgical coal and 12 per cent for iron ore: the three main commodities contributing to the boom so far.

How much more will these exports grow? The Bureau of Resource Economics and Energy’s September 2013 projections have been adjusted downwards from those presented at the height of the boom. They now anticipate growth in thermal coal exports of 43 per cent in the five years from 2012–13, and of 43 per cent for metallurgical coal and 59 per cent for iron ore. Even these lower projections of Australian exports (combined with large increases in other countries) would push prices down considerably now that China’s import growth has eased.

Some established or new mines will be forced by the market to operate at well below design capacity. How much of the pull-back will be in Australia? That depends on competitiveness, which is weak with the exchange rate of mid-2013 and after the big exchange-rate falls in other resource-exporting countries, but a large real depreciation would change the story. The Bureau of Resources’ estimates for Australian exports are now built on expectations of a further fall in the dollar to 86 US cents.