Dog Days: Australia After the Boom (Redback) (9 page)

Under austerity, economic activity would be weaker in the short to medium term. Budget revenues would fall further. Recession in the near term would be likely. This could then lead to a shift towards a ‘real depreciation’ approach, but maybe only after a long period of economic underperformance.

Budget Stimulus

Using the budget to stimulate the economy in the face of recession would involve large, early measures to stoke domestic demand. It would see the government respond to a deteriorating economy and rising unemployment with a version of the policies adopted in response to the Great Crash of 2008: increased commonwealth expenditure, and probably some tax cuts. The reduction of interest rates would be lessened and therefore would do less to lower the exchange rate if accompanied by an expansion of the budget deficit. A bigger budget deficit from stimulus would be counteracted to some extent by higher government revenue from the increased economic activity. So why not do it?

The binding constraint is Australia’s external accounts over the longer term. If we seek to return to full employment through greater spending – whether public through the budget or private through low interest rates – but without a large real depreciation, sooner or later the current account deficit and foreign debt as a share of the economy will blow out to unsustainable levels.

There are two good reasons to be cautious about an approach that requires increased foreign debt. First, average Australian spending and incomes are higher now than they are likely to be for a number of years. Increased debt would have to be repaid by future generations who may not be as well off as ourselves, still warmed as we are by the embers of the resources boom.

Second, our immediate external financial position is weaker now, after the peak of the China resources boom, than it was following the Great Crash. If we seek to restore full employment over the next few years simply by increasing spending, with no sustained improvement in international competitiveness, the current account deficit will rise to an unusual and risky proportion of GDP. This deficit was over 3 per cent of GDP in the first nine months of 2012–13: not exceptionally high by recent Australian standards, but uncomfortably large given likely developments in the years immediately ahead. The increased spending to return the economy to full employment will increase imports, while the large corporate tax deductions from the investment phase of the resources boom will be mostly paid out to overseas owners or lenders. Furthermore, the normalisation of global interest rates after their fall following the Great Crash will increase the costs of servicing Australia’s external debt and add 1 to 2 per cent of GDP to external payments. The net external-payments effect of the reduced resource investment and the increased expenditure that takes its place will cancel each other out. Total export volumes are unlikely to rise fast enough to offset the negative effects, especially since only a modest proportion of export receipts stay within the domestic economy.

Under these circumstances, Australia will have to finance a current account deficit that is high by historical and global experience, at a time of economic underperformance and when our international halo from the China boom is fading. There will be no prospect of doing this for long without increased costs of debt and without doubts arising about our capacity to service it. These factors will have their own negative effects on the economy.

This perspective contradicts an alternative view that still has considerable support in Australia: that the growth in export volumes during the production phase of the resources boom will solve our external payments and growth problems. There is nothing especially advantageous about mining over other exports unless prices are high enough to generate large economic rents that are collected for the public revenues. To the contrary, the high foreign components of resources production mean that the domestic contribution per dollar of exports is somewhat smaller than that of services, agricultural and manufactures exports.

As noted, the large increase in resource exports, especially after 2011, has been offset by the cessation of growth in other exports. And while the total volume of Australian exports can be expected to grow as new resource projects come on-stream over the next half a dozen years (perhaps by about 6 per cent per annum), this will not be an unusually high rate – not, for instance, as high as the average in the seventeen years of the Reform Era. It’s not an export boom in historical context.

A variation on the stimulus theme suggests that we increase domestic economic activity by government investment in productivity-raising infrastructure. The treasurer, Joe Hockey, has suggested that investment in infrastructure be increased to offset the decline in activity associated with the fall in resources investment. This is different from increased government consumption expenditure to the extent that the investment will lead to higher productivity growth in the economy as a whole than would otherwise be the case. If this condition is met, increased borrowing (and the extra will be foreign borrowing) will be a bit easier to secure on reasonable terms, in turn making it easier for future Australians to repay. It is more reasonable for contemporary Australians to ask their successors to service a debt if it arises from expenditure that gives them an improved standard of living.

For us to have confidence that such an investment will be genuinely productivity-raising for the economy as a whole, it will need to have been subject to independent, transparent and rigorous cost-benefit analysis and full engineering design in advance of the need for it. Keynes suggested in his General Theory that public works were especially valuable in boosting expenditure in a downturn, and elsewhere suggested that governments should keep proposals for such works ready to go. Early post-war Australian governments followed this wise practice.

The stimulus strategy involves a bigger budget deficit and by implication higher interest and exchange rates for any given level of domestic expenditure. This is what distinguishes it from real depreciation. It is associated with lower levels of investment and production in the trade-exposed industries – and this is reflected in greater exposure to the exigencies of external financial markets.

Productivity Growth

‘Productivity growth’ recognises that increasing productivity is the only sustainable source of continuously rising living standards. It focuses on reversing the decline in productivity growth over the Great Australian Complacency.

The early 21st-century slump in growth productivity has been larger in Australia than in most developed countries. A comparison with other resource-rich developed countries is perhaps more relevant. The decline in productivity from 2006 to 2010 was identical in Canada and Australia (1.1 per cent per annum). However, productivity growth remained positive in the other resource-rich developed country, Norway, with its incomparably different approach to collecting resource rents for the public revenue and saving them for future use.

There is rich potential for gains from reform. However, reform to increase productivity can play only a supporting role in the early years, because there are speed limits to productivity growth. At the high point in the harvest years of the Reform Era in the 1990s, productivity was rising at 2.5 per cent per annum. That is as high as can reasonably be expected in modern times. Australia would be doing extremely well if its productivity growth were one percentage point above the average of other developed countries. But even with such stellar performance, it would take decades for us to achieve the required improvement in competitiveness through productivity growth alone.

Real Depreciation

This approach places priority on a lower exchange rate for the dollar, and converting this into a real depreciation.

How low is low enough? The real exchange rate will have to fall enough to induce enough investment in other export industries to fill the hole left by the decline in the resources sector. The market will sort out how large the depreciation needs to be: when we see the investor response to a lower dollar, it will be clear whether or not the exchange rate needs to fall further. At the end of the 2013 March quarter, when the Australian dollar was valued at $US1.05, I expressed the view that a real depreciation in the range of 20–40 per cent would be required to maintain high levels of employment with a sustainable current account deficit. This would mean a value of 63–84 US cents.

How can we secure the rest of the necessary devaluation? Interest rate cuts in May and the anticipation of more contributed to a fall in the dollar. By June, the effects of lower interest rates on the dollar were being supported rhetorically by the prime minister, other senior ministers, and senior officers of the Reserve Bank and the Treasury. This contrasted with the defence of a high dollar from some of these officials early in the year.

The restored prime minister, Kevin Rudd, initially made adjustment to the end of the China resources boom the central element in a renewed focus on economic reform, but this became simply rhetorical once the election was called for early September. By then, the dollar had fallen by about 10 per cent against major currencies – around half of the minimum fall that I had suggested.

Weakness in the economy and the reductions in interest rates that follow under ‘business as usual’ will eventually bring down the dollar by a large amount. But there is a large difference between a fall in the dollar that happens in
response
to economic weakness and one that happens in
anticipation
of it. This can be the difference between recession accompanied by high unemployment, and a moderate economic downturn.

We will learn through 2014 and afterwards whether the lowering of interest rates and fall in the dollar were too little, too late to avoid a major dislocation in Australian prosperity. But even if it turns out that we are too late to avoid uncomfortably high unemployment, the downturn will be less severe and end sooner if the exchange rate falls earlier rather than later and more rather than less, and if policy and community responses turn the fall into a real depreciation.

How can we get an earlier rather than later depreciation in the exchange rate?

More interest rate cuts are the first step. This is easy to justify while the economy is growing slowly and employment per person falling, as they have been through 2013. The cuts will be more effective if clear messages are put out by the Reserve Bank and the new government that a fall in the dollar is welcome. This reduces the risk in the minds of people investing in a lower dollar that the authorities may take action to prevent the dollar from falling. As discussed in the Note at the end of Chapter 4, it may be necessary to adopt prudential measures to constrain risky lending for housing as interest rates fall.

Will the weakening economy, the easing of interest rates and official rhetoric take the dollar low enough, soon enough? The answer depends partly on what happens in other countries. A return to reasonably strong economic growth and more normal monetary policies in Europe, Japan and the United States would raise their exchange rates against Australia. At some point, the realisation that the Australian dollar is likely soon to fall by a large amount would reduce its attraction as a reserve currency. Otherwise, intervention along the lines of that taken by the Swiss central bank should be contemplated if lower interest rates, official rhetoric and monetary policy changes in other countries do not do the job.

The Reserve Bank needs to be concerned about the inflationary effects of lower interest rates. But it is not the Bank’s only responsibility. Here there is a governance issue that has been discussed less than its importance warrants. The law under which the Reserve Bank operates requires it to give at least as much priority to full employment as to inflation. The Reserve Bank since 1996 has operated within instructions from the Australian treasurer to hold inflation within the range 2–3 per cent. The Bank would be in breach of the law if it acted on an instruction from a member of the Executive that was in conflict with an Act of the Parliament. (Seeking to do just this cost Charles I his head.)

In any case, the Bank has been prepared to overlook temporary inflation deriving from a large fall in the exchange rate. It did this during the Asian Financial Crisis.

TURNING A LOW DOLLAR INTO A REAL DEPRECIATION

A 20–40 per cent fall in the foreign exchange rate without any pass-through into domestic costs and prices reduces the real incomes of many people and firms. Turning a nominal into a real depreciation is the most difficult part of a successful adjustment to the end of the boom. If the exchange rate falls without strong leadership from government to avoid the pass-through of costs, there is likely to be a drift into continuing inflation and rising unemployment.

Monopoly pricing, which has denied Australian consumers the full benefits of the dollar’s rise by holding prices for imported goods and services well above those in other countries, may have an opposite effect on the dollar’s way down. Suppliers of imported and other goods and services who expanded profit margins when the dollar was strong may allow their compression as the dollar weakens. Evidence from earlier, smaller and less durable depreciations suggests that at least a few per cent of real depreciation may be achievable through these mechanisms without a fall in the standard of living of ordinary Australians. Otherwise, it is the task of leaders to explain that restraint to avoid the pass-through into domestic costs of an increase in prices of imports and exportable goods and services is in the interests of nearly all Australians. This is more likely to be successful as part of a programme of wider reform aiming at securing sustainable prosperity.

EARNING OUR LUCK IN THE ASIAN CENTURY

The old model of China’s growth greatly increased demand for a few resource products that Australia was uniquely well placed to supply. Continued strong growth, particularly in China, but also India, Indonesia and much of the rest of developing Asia, will expand our opportunities for exports from non-resource industries, as well as place a historically high floor under some of the mineral and energy commodities that were at the centre of the China boom.