Dog Days: Australia After the Boom (Redback) (7 page)

The Bureau’s export projections for LNG show the largest increase: nearly 300 per cent, mostly between 2015 and 2018. This is possible given the Chinese government’s encouragement of gas for environmental reasons, as well as the setback to nuclear energy in Japan caused by the Fukushima disaster.

These official forecasts are within the realm of the possible, after several years of being unrealistically high. There are still risks on the downside, especially if there is no large depreciation. The possibilities of surprise on the upside depend on a large real depreciation. Taking into account that iron ore, coal and LNG are not the whole of resources exports, and that resources are not the whole of exports, with the real exchange rate remaining at its mid-2013 level it is possible to envisage total export volumes rising by about 6 per cent per annum in the export expansion phase of the resources boom, between 2012–13 and 2017–18, with resources contributing almost the whole of the increase.

Only a modest proportion of this increase in resource export volumes contributes to the Australian economy. State government revenues grow relatively strongly, because their royalties depend on the value and not the profitability of exports. Higher volumes and moderately higher prices together will cause state revenues from resources to be larger by over 1 per cent of Australian GDP than before the boom. This revenue goes first to the export states, especially Western Australia and Queensland, but then is ‘equalised’ across the states and territories by our unique system of revenue distribution.

The commonwealth’s revenue depends on profitability, and the new exports have much higher costs than the old. The commonwealth may receive less revenue from the increased export volumes than it loses from falls in price and increases in investment-related tax deductions until the early 2020s.

AVERAGE EMPLOYMENT IS ALREADY DECLINING

Spending the temporary bounty of the resources boom has caused the exchange rate to rise exceptionally. At its peak in early 2013, the real exchange rate was almost 70 per cent above the 1983–2003 average. The extent of the increase is unique in our history. Even after the substantial falls in the dollar in the second quarter of 2013, the real exchange rate was still one-half above that long-term average.

Such a lift caused other industries producing exports or competing against imports to contract. This is the phenomenon known as the ‘Dutch Disease’ or ‘Gregory Effect’. The rapid increase in net exports in these industries as a share of the economy from the mid-1980s went into reverse, and by 2013 we were pretty well back where we had been before the Reform Era. Similarly, there was a switch from buying goods made in Australia to buying competing imports, and from producing goods and services for export to producing them for the home market.

If there is no adjustment of the real exchange rate and no budget stimulus (as discussed in Chapter 5), we can expect a smaller resources sector contribution to the economy in late 2017 than in 2013, which itself is lower than in 2011. The immediate impacts will lead to reductions in demand for other domestic goods and services, thereby magnifying the decline.

There has been a noticeable deceleration in the Australian economy since late 2011. Economic output has increased at less than long-term average rates and consistently below official estimates. Much of the decline has been felt as a fall in government revenue – with both commonwealth and state revenues consistently and steadily falling below estimates every six months since the second half of 2011. The main locus of the iron ore boom, the state of Western Australia, had its credit rating downgraded in September 2013. National employment grew less rapidly than the adult population, with monthly hours worked per adult falling from 89.1 to 86.8 between the peak in October 2011 and August 2013. Growth in real household income per adult has fallen from an average rate of around 2.5 per cent per annum in the decade to mid-2011 (a period without any productivity growth) to a third of that since then.

Australians continue to expect higher incomes, more services and lower taxes, but our economy’s capacity to deliver these things to the average Australian is declining. In other words, Australia has been in the Dog Days since late 2011. Successive prime ministers and treasurers have been correct in saying that our economic conditions are among the best in the world. Yet Australian expectations of ever-increasing standards of living are now being disappointed.

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.)