Dog Days: Australia After the Boom (Redback) (8 page)

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.

 

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 b
egan. 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.

FIVE APPROACHES TO RESTORING FULL EMPLOYMENT AND GROWTH

We can identify five approaches to the economic challenge facing Australia: ‘business as usual’, ‘austerity’, ‘budget stimulus’, ‘productivity growth’ and ‘real depreciation’. Any effective strategy will contain elements of more than one of these approaches, but it helps our understanding to separate them out.

Business as Usual

‘Business as usual’ is a continuation of what the authorities were doing from the time that the resources boom passed its peak in 2011 up to the middle of 2013. Budget policy is firm, with historically low real growth in expenditure. Taxation rates are presumed to stay as they are. On the assumption that growth soon resumes and continues at a bit above 3 per cent per annum, it is projected that the budget is back in balance in two to three years. Interest rates are reduced when economic growth is well below trend, the labour market is weak and inflation is in the target band of 2–3 per cent.

The presumption is that good times will return before too long; programmes to increase expenditure are introduced, so long as they have their main impact beyond the four years of the forward budget estimates.

Every six months there are new official forward estimates. Each of these since late 2011 has involved a large downward revision of revenue – for the current year and the several years beyond.

This puzzles official and most private analysts when the data first comes in. Then it is realised that the weak revenues are the result of economic growth being slower than expected, employment weaker than expected, average incomes lower than expected, inflation lower than expected. Company income tax is far lower than expected partly because incomes are lower for all of the above reasons, partly because export prices are low, and especially because the estimates greatly underestimate the size of the tax deductions attached to the resources investment boom. (The huge write-downs in estimates of revenue in the May 2013 budget and the August 2013 revisions mainly reflected receipts from company income tax and resource rent tax falling below expectations.)

Under the old ‘business as usual’, the Labor government made firm and unqualified commitments to securing a budget surplus a couple of years into the future. So, as disappointingly low revenue from a weakening economy showed up in the accounts, six-monthly statement after six-monthly statement, the government responded by announcing tax increases and spending cuts that would have their main effect in the later years of the four-year projections. The budget deficit was always a bit bigger than had been expected, and the return to surplus always remained about as far into the future as it had been when the resources boom started to recede.

There are Labor and Coalition versions of ‘business as usual’. Rhetorically, the Labor government was more cautious about cutting spending than the Coalition. However, in practice the Abbott Coalition government has accepted nearly all of the former government’s spending commitments, rejected some of its proposals for increased taxation, and added some tax cuts and expenditure increases of its own.

The new government’s promises to remove and reduce tax add up to a large unacknowledged long-term expansion of the ‘business as usual’ budget deficit. These promises – to remove carbon pricing and the Minerals Resource Rent Tax (MRRT), and to reduce the company tax rate and the fringe benefits tax on private motor vehicle use – all have increasing revenue effects over time, with their sum much greater beyond the four-year estimates.

Under ‘business as usual’, monetary policy is varied if inflation rates tend higher or lower than 2–3 per cent and the economy is unusually strong or weak. The exchange rate is left to find its own level. If other countries follow unusually expansive monetary policies (even as their real output growth per person comes to exceed Australia’s, as it has recently in Japan and the United States), we accept the higher exchange rate flowing from that. We also accept the higher exchange rate that comes from the central banks of other countries deciding for the first time to hold large amounts of Australian dollars (almost $100 billion to June 2013 by countries other than China and an unknown but large sum by the People’s Bank of China). We accept the loss of competitiveness that comes from rival resource suppliers artificially securing large reductions in their own exchange rates. Interest rates are lowered only after weakness in the economy and low inflation becomes apparent. This means the exchange rate will eventually fall, but may remain uneconomically high for a long period.

The Reserve Bank of Australia has been lowering interest rates behind the weakening economy since November 2011, so that by August 2013 the ‘cash rate’ reductions amounted to 2.25 per cent and the official rate was lower than it had ever been. The lower interest rates helped to bring down the exchange rate from early May 2013, but – because of the exceptional nature of monetary policy in larger developed economies – not by as much as might have been expected. The exchange-rate fall was partially reversed in early September when it became clear that the exceptional monetary expansion of the United States would continue for the time being.

In sum, the increase in activity from interest rate and exchange rate falls so far is helpful but too small to counteract the powerful contraction set in train by the decline in the resources sector’s contribution to the economy. The slow growth and deterioration in employment can be expected not only to continue, but also to feed on themselves. Economic weakness and lower interest rates will eventually see further falls in the Australian dollar.

The Treasury’s and Reserve Bank’s projections envisage a return to normal rates of growth of around 3 per cent per annum and of normal unemployment at about 5 per cent from 2015–16. In the forward estimates, stronger economic growth painlessly removes unemployment and the budget deficit. The forward estimates assume continuation of the exchange rate at the time they were prepared – the latest a few cents below the mid-September level. But what will generate new investment and other domestic spending under these settings as resources investment shrinks? What will generate the increased economic activity that re-establishes full employment and public revenue growth without a large fall in the real exchange rate?

Without real depreciation of the currency, it won’t be investment in the resources industries. It won’t be investment in the other export industries. It won’t be government expenditure under current budget settings. It won’t be consumption: household income is growing at historically low rates and there is no sign of a lower rate of savings.

There will be a contribution from increased resources exports, but this will not do much for economic activity or jobs. There will be a contribution from housing under the influence of low interest rates, but that will need to be monitored for the emergence of a bubble, and in any case it cannot carry the whole economy without creating risks in the external accounts.

‘Business as usual’ would be a good strategy if there were a reasonable chance of a return to trend rates of economic growth, low unemployment and budget surplus by 2016–17 without external payments pressures emerging. Regrettably, the Treasury and Reserve Bank projections are a clock face in which the hands have been moved to a new time without a locomotive mechanism.

It seems more likely that ‘business as usual’ will lead to a continuing deterioration in economic activity, employment and the public finances, at least through the four years covered by the forward estimates. In the absence of a large currency depreciation, I expect the budget deficit for 2015–16 and 2016–17 will be many billions of dollars larger than projected in the treasurer’s Statement of August 2013. Meanwhile, the new Coalition government’s highest-profile commitments worsen the budget problem beyond the four years and increase the challenge of making the required adjustments equitably. At the same time, none of its high-profile policy changes is structured to have a large positive effect on economic activity.

Austerity

The ‘austerity’ approach involves discretionary increases in taxation and structural spending cuts in an attempt to balance the budget quickly. The former Labor government’s final economic and financial statements suggested that it would return the budget to surplus by 2016–17. Its practice in government had been to take steps in that direction and then to let the deficit stay high if revenue was disappointingly low. The new government hasn’t committed itself even nominally to a surplus in 2016–17. Its rejection of austerity is appropriate under the circumstances.

One can envisage forward-looking as well as immediate approaches to austerity – the former would focus on cutting back programmes that affect the structural deficit only in future years; the latter on early expenditures and tax rates.