Monday, April 7, 2014

Middleweight to Heavyweight? The Growing Importance of Asia in the World Economy

Asia's rise has been Australia's economic gain. The rise of Japan, followed by South Korea and Taiwan, Singapore, Malaysia, Thailand and other non-communist countries of Southeast Asia had provided significant export markets for Australian commodities, though not a sustained structural increase in their value. Then along came China, changing everything. Not only did rapid Chinese demand increase the prices Australia received for its exports, but also Chinese manufacturing production helped to decrease the price of Australian imports. Manufactured goods made (or assembled) in China became significantly cheaper. Chinese competitive pressures also helped to keep in check the prices manufacturers throughout the world could charge for their goods.

Currently there are several narratives about Australia’s economic future. The first is an acceptance of Australia’s role as a resource exporter built on the back of long-term Asian demand and a high exchange rate. Alongside this story is one about a growing Asian middle class, which will be increasingly receptive to utilising Australian services. This view means that there will be an alternative market for Australian exports after the Asian giants become less resource intensive economies as they progress up the income ladder.

All of these positive narratives are based on a projection that Asia's remarkable rise over the past half century will continue over the next half. The possibility that Asia may not continue its rapid economic rise is largely dismissed as a narrative, although the likelihood that Asia will become conflict-ridden is common in international relations, foreign policy and security studies.

To understand where Asia might be headed we need to fathom how far it has come since the end of World War II.

This post shows that if current GDP trends were to continue, even at a moderated pace, Asia will become the world's most important economic region and China the world's largest economy. Emerging market and developing economies have overtaken the advanced economies on a purchasing power parity basis. The major component of this GDP convergence has been the rise of developing Asia, particularly China. Asian GDP (both developed and developing) is now approaching the GDP of the European Union and the United States combined.

Economically, a continuation of present trends would provide amazing opportunities for Australia, although politically it might heighten concerns amongst Australians about the implications of Western and American relative decline.

The Great (Re)convergence

The rise of developing Asia has been a major component of the so-called rise of the rest, which has led to the reversal of the great divergence between the advanced and developing economies that began with the industrial revolution. The great convergence is profoundly reshaping the world economy. Given that the world economy on the eve of the industrial revolution was dominated by Asia - particularly China and India we should perhaps consider the current period as the great reconvergence.

Gregory Clark in A Farewell to Alms outlines the Malthusian world (from the Stone Age to 1800), which he argues exhibited “a counterintuitive logic” where:
anything that raised the death rate schedule –war, disorder, disease, poor sanitary practices, or abandoning breast feeding – increased material living standards. Anything that reduced the death rate schedule – advances in medical technology, better personal hygiene, improved public sanitation, public provision for harvest failures, peace and order – reduced material living standards. 
In other words, vice equalled virtue and virtue equalled vice. Even gradual improvements in technology increased population and therefore did not lead to lasting increases in living standards. Hobbes, Clark contends, was wrong; man was better off in his natural state. 

The Industrial Revolution, whose most remarkable feature is the “all-pervading rise in incomes per person”, changed all that and led to a remarkable divergence between rich and poor countries. The gap between the living standards of the rich and poor countries grew from 3-4:1 before 1800 to 40-50:1 in the late twentieth century.

World Economic History

Source: Clark

The commercial revolution from the late fifteenth century shows that global economic weight is not necessarily an indication of global power. Asia's dominance of the world economy until the early nineteenth century could not stop it from being overrun by European colonial powers from the sixteenth century. Economic dominance was overcome by military superiority. 

Gross economic weight is clearly not everything, but there can be no doubt that economic relativities are changing, which provides the possibility that the West's period of dominance is coming to an end. 

Growth in Asia since the 1960s has been nothing short of remarkable. Economic success, however, was far from universal. Until the late 1980s, authoritarian capitalist states and authoritarian communist states divided Asia. Countries under US tutelage embraced an authoritarian form of capitalism with a strong developmental ethos. The success of capitalist economic development provided a stark contrast to the failures of the socialist centrally planned development model. 

China attempted to collectivise and control economic development from the centre, Vietnam struggled with war and its aftermath, and India fostered autarkic import substitution policies that led to stunted growth. Even before the end of the Cold War, the Communist and insular states realised that shifts in economic direction were vital if they were going to replicate the high growth rates of capitalist Asia. China began its long march to capitalist dynamism in 1978 and Vietnam switched economic direction in the mid-1980s. 

By the early 1990s, Japan appeared to be set to overtake the US economy, but unfortunately the 1990s were a decade of stagnation after the excessive property and stock market boom of the late 1980s. In the late 1990s, the region suffered a severe financial crisis which threatened to derail Asia’s rise, but by the early 2000s it was clear that the crisis was only a temporary set back on Asia’s phenomenal economic rise. 

From the mid-1990s, China became the major economic story in the region because of its sustained high growth rates. China's continuing growth during the economic crisis that began in 2007 cemented Asia's place as the centre of world economic dynamism. Growing regional production networks initially developed by Japan in the 1980s, followed by South Korea, Taiwan, Singapore and Hong Kong and now centred on the Chinese economy have reinforced Asian dynamism. Despite assertions about decoupling, final goods demand from outside the region still matters for Asian growth. 

In recent years, many analysts have argued that India will join China as a major Asian success story. Developing Asia has been joined by other emerging economies to transform the world economy since the 1980s. The countries of Eastern Europe, Brazil and South Africa have led to the great reconvergence. 

Emerging market and developing economies now account for over 50 per cent of the world economy on a PPP basis, surpassing the total weight of the developed economies. This is a remarkable change from 1990 when the emerging market and developing countries accounted for a little over 30 per cent. Since 1990 emerging and developing economies have been on an ever-upward trajectory, with the global crisis beginning in 2007 thus far affecting mainly the United States and Europe.

All Graphs
Gross Domestic Product (Purchasing-Power-Parity)
Share of World Total

Source: IMF World Economic Outlook (see here for definitions of country groups)

The bulk of the increase in the emerging and developing country share has been accounted for by developing Asian economies, particularly China. 

The Asian economies combined - both developed and developing - are approaching the economic weight of the European Union and United States combined. Given projected relative growth rates Asia should overtake the EU and US in the near future. The EU and the US combined has declined from 55.8 per cent of the total in 1980 to 37.4 per cent in 2013.  

The rising economic weight of Asia has mainly been a result of rapid growth in China, although India and the ASEAN 5 have also contributed. China's increased weight has been at the expense of Japan. (Developed Asia includes Japan, South Korea, Singapore, Taiwan and Hong Kong)

Comparing the top 5 plus the EU we can clearly see the significant changes to relative weights since the early 1990s. These trends have been strengthened since the global crisis. The advanced capitalist countries have lost ground to China and India.

The Future

Ideas about an Asian ascendancy are not new. US President, Theodore Roosevelt, writing in 1903 argued that: “The Atlantic era is now at the height of its development and must soon exhaust the resources at its command. The Pacific era, destined to be the greatest of all, is just at its dawn.” (YahudaWar and the dilemmas of decolonisation made Roosevelt’s prediction premature, but the post-war world has seen Asia rise to the world’s most dynamic economic region. The general assumption today is that the Asian ascendancy will continue, even if the breakneck speed of growth moderates in coming years. 

In 1994, Paul Krugman compared the growth of the newly industrialising countries of Asia to Soviet growth in the 1950s and 1960s, a period when it appeared that the Soviets were on the brink of challenging the United States economically as well as militarily. He argued that ‘perspiration not inspiration’ had been the major factor. He saw Japan, however, as different: 
Japan, unlike the East Asian “tigers”, seems to have grown both through high rates of input growth and through high rates of efficiency growth. Today’s fast-growth economies are nowhere near converging on US efficiency levels, but Japan is staging an unmistakable technological catch-up. 
Krugman argued that while Japan was experiencing an unmistakable ‘growth slowdown’, he underestimated the extent to which Japan would stagnate over the rest of the 1990s and early 2000s. If Japan had continued to grow at the rates achieved over the period, 1963–73, he predicted it would have overtaken ‘the United States in real per capita income by 1985, and total Japanese output would have exceeded that of the United States by 1998!’. Krugman also noted the differences of the Chinese growth story to that of the Asian tigers. Significantly, he pointed out that, ‘its population is so huge that it will become a major economic power if it achieves even a fraction of Western productivity levels’. By the early 1990s, it was clear that China’s shift in direction was leading to rapid and sustained economic growth. 

The Japanese story should at least alert us to the dangers of the belief that the recent past and the present provide clear guides to the future. While the Asian challenge to Western dominance will probably be the issue of the twenty-first century, we should be wary of substituting a possible future for the present. Asia still has a long way to go and many hurdles to negotiate before its global economic influence matches its growing economic weight. 

The contemporary structure of the world 'political' economy has been shaped by the advanced economies, particularly the United States. This liberal economic order has 'allowed' the rise of developing countries, who are now demanding a larger say in global economic institutions such as the World Trade Organisation. 

But domestic political developments could be just as important. Over the next generation, how the advanced countries deal with challenges to their economic supremacy and counter the negative domestic consequences of globalisation will shape the future trajectory of the world political economy. 

Protectionist responses to relative decline and growing inequality in developed economies would be damaging in an integrated and thus interdependent world economy.Global and regional production structures would exacerbate the impact of protectionist responses, although their existence could also make any shifts toward protectionism more costly and therefore less likely. Whatever the case, the ability of the developed world to influence structure remains paramount. An ironic, if unlikely, turn away from globalisation in the advanced economies would negatively affect export-oriented economies disproportionately.  

Asia's ability to avoid conflict.will also be paramount for a continuation of current trends. Asia’s current situation is unprecedented. Three major powers – China, Japan and India, together with the United States – will shape the future of the region. Australia has alliances with two of the powers, is an important contributor to China's economic rise and has much to offer India as well. Australia stands to benefit greatly from continued economic expansion in Asia and to lose enormously if economic crisis, political instability or environmental catastrophe override economic development. 

Australia has a role to play in helping to establish the regional institutions and diplomatic environment for peaceful relationships. Bilateral relationships will also be very important. But much of the action will take place regardless of our wishes. Australia needs to prepare for the possibility of conflict and economic downturn, while working and hoping for the best. If peaceful development continues, Australia will be fortunate to be geographically adjacent to the world’s most dynamic economic region. Australia’s prosperity is now dependent on continuing Asian economic growth. What happens in Europe and North America still matters for Australia, but nothing matters to us more than Asia. 


Advanced economies
Composed of 35 countries: Australia, Austria, Belgium, Canada, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hong Kong SAR, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malta, Netherlands, New Zealand, Norway, Portugal, San Marino, Singapore, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Taiwan Province of China, United Kingdom, and United States.

Major advanced economies (G7)
Composed of 7 countries: Canada, France, Germany, Italy, Japan, United Kingdom, and United States.

Other advanced economies (Advanced economies excluding G7 and euro area)
Composed of 14 countries: Australia, Czech Republic, Denmark, Hong Kong SAR, Iceland, Israel, Korea, New Zealand, Norway, San Marino, Singapore, Sweden, Switzerland, and Taiwan Province of China.

European Union
Composed of 27 countries: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Romania, and United Kingdom.

Emerging market and developing economies
Composed of 153 countries: Afghanistan, Albania, Algeria, Angola, Antigua and Barbuda, Argentina, Armenia, Azerbaijan, The Bahamas, Bahrain, Bangladesh, Barbados, Belarus, Belize, Benin, Bhutan, Bolivia, Bosnia and Herzegovina, Botswana, Brazil, Brunei Darussalam, Bulgaria, Burkina Faso, Burundi, Cambodia, Cameroon, Cape Verde, Central African Republic, Chad, Chile, China, Colombia, Comoros, Democratic Republic of the Congo, Republic of Congo, Costa Rica, Côte d'Ivoire, Croatia, Djibouti, Dominica, Dominican Republic, Ecuador, Egypt, El Salvador, Equatorial Guinea, Eritrea, Ethiopia, Fiji, Gabon, The Gambia, Georgia, Ghana, Grenada, Guatemala, Guinea, Guinea-Bissau, Guyana, Haiti, Honduras, Hungary, India, Indonesia, Iran, Iraq, Jamaica, Jordan, Kazakhstan, Kenya, Kiribati, Kosovo, Kuwait, Kyrgyz Republic, Lao P.D.R., Latvia, Lebanon, Lesotho, Liberia, Libya, Lithuania, FYR Macedonia, Madagascar, Malawi, Malaysia, Maldives, Mali, Marshall Islands, Mauritania, Mauritius, Mexico, Micronesia, Moldova, Mongolia, Montenegro, Morocco, Mozambique, Myanmar, Namibia, Nepal, Nicaragua, Niger, Nigeria, Oman, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Poland, Qatar, Romania, Russia, Rwanda, Samoa, São Tomé and Príncipe, Saudi Arabia, Senegal, Serbia, Seychelles, Sierra Leone, Solomon Islands, South Africa, South Sudan, Sri Lanka, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Sudan, Suriname, Swaziland, Syria, Tajikistan, Tanzania, Thailand, Timor-Leste, Togo, Tonga, Trinidad and Tobago, Tunisia, Turkey, Turkmenistan, Tuvalu, Uganda, Ukraine, United Arab Emirates, Uruguay, Uzbekistan, Vanuatu, Venezuela, Vietnam, Yemen, Zambia, and Zimbabwe.

Developing Asia
Composed of 28 countries: Bangladesh, Bhutan, Brunei Darussalam, Cambodia, China, Fiji, India, Indonesia, Kiribati, Lao P.D.R., Malaysia, Maldives, Marshall Islands, Micronesia, Mongolia, Myanmar, Nepal, Papua New Guinea, Philippines, Samoa, Solomon Islands, Sri Lanka, Thailand, Timor-Leste, Tonga, Tuvalu, Vanuatu, and Vietnam.

Composed of 5 countries: Indonesia, Malaysia, Philippines, Thailand, and Vietnam.

My definition of Total Asia includes Developing Asia plus Japan, Korea, Taiwan, Hong Kong and Singapore. 

Thursday, March 20, 2014

Public Debt in Australia 1853-2013

The following graph from a recent RBA article puts the whole recent obsession with public debt in Australia into perspective.

As Peter Lindert points out in his authoritative two volume study on social spending and economic growth since the eighteenth century: Growing Public: Social Spending and Economic Growth since the Eighteenth Century :
There is no clear net cost to the welfare state, either in our first glance at the raw numbers or in deeper statistical analyses that hold many other things equal … It turns out there are many good reasons why radically different approaches to the welfare state have little or no net difference in their economic costs. Those reasons … boil down to a unified logic: Electoral democracy, for all its messiness and clumsiness, keeps the costs of either too much welfare or too little under control.[1]
Lindert also points out that ‘the history of economic growth is unkind’ to those with a suspicion that higher taxes and social spending are necessarily bad for productivity. Beyond this basic fact is another unpleasant one for those who argue that the welfare state must be cut in the interests of growth or productivity: ‘people in the countries with higher social budgets get to enjoy more free time every year and retire earlier’.[2] Well educated, healthy workers have the potential to be more productive workers. Parents with access to childcare and leave can continue careers sooner or later and maintain their productivity. Providing even more options in this area enhances the productivity of a large section of the population with parental responsibilities.

[1] Peter H Lindert (2004) Growing Public: Social Spending and Economic Growth since the Eighteenth Century, Cambridge, Cambridge University Press, p. 6.
[2] Ibid., pp.17-18.

For a primer on public debt in Australia see here and the links contained within ... 

Tuesday, February 18, 2014

Australia's China Dependence and Whether India Could be the Next Big Thing

"No country will ever replace China at number one in economic importance to Australia". So says Geoff Raby, a former ambassador to China. One could imagine an Australian High Commissioner in the United Kingdom saying the same thing in the 1930s or perhaps even the 1950s. Perhaps they might have said it about Japan in the 1970s or 1980s. The difference, many point out, is that China is a considerably larger entity than the UK ever was. For a very long time - since the beginning of the industrial revolution - population size was not the most important variable for economic power. Now that China has unleashed its economic potential, however, the consensus seems to be that China will soon become (and remain) the world's largest economy.

As China becomes richer, optimists argue, it will demand more than just Australia's resources, moving onto tourism, education and business services. They might even buy environmental services form Australia if we could find a way to encourage the industry's development in Australia.

Whatever the future possibilities, China's growth hitherto has benefitted Australia significantly. As the chart below shows much better to have been China dependent since 2007 than dependent on 'growth' in Europe or the United States.

No doubt Australians could have benefited further if there were a decent mining tax regime on a Australia's 80 per cent foreign owned mining industry. But such good news comes with a little bit of bad news if you worry about the impact of the associated high exchange rate on other areas of the tradeable economy or the vulnerabilities that come with an over-reliance on resources and on a 'single' country. And reliant we are on both.

Australia is now the most China dependent economy in the world. This is mainly because Australian resources have helped to generate a Chinese growth rate of around 10 per cent a year for 30 years. For the mathematically inclined among you that means its economy has doubled in size every 7 and a bit years. If it could just keep doing this for another 10 years then Australia's economic vulnerabilities would surely be a thing of the past.

Indeed, our policy-makers appear to be true believers in the China dream. There is widespread faith in the economic policy skills of Chinese Communist Party leadership and their ability to keep managing their economy to benefit Australia. And why not I suppose. It's worked so far. I can't help but feel, however, that the CCP leadership has produced an economic structure of over-investment and under-consumption that will eventually have to rebalance. Picture a rubber band being stretched further and further. The question is really about when it snaps and who it recoils on most. Just because it hasn't broken yet doesn't mean it won't. Eventually.

These charts got me thinking: who could be our next great trading partner? India is often mooted as a likely candidate but the relationship has long been seen as either 'emerging' or 'underperforming'. Policy-makers and commentators like to talk about the 'potential' of the Australia-India relationship, before arguing that 'much needs to be done' and that the relationship shouldn't 'be taken for granted'.

For Australian exports to India to increase rapidly in the near future, India would need to embark on a massive infrastructure spend like China has done in recent years. There is considerable scope for infrastructure development in India, but not the funds nor the inclination. It's important to remember that China's long-running economic growth and export prowess provided the wherewithal for its amazing investment surge (that may now be on the wane).

The most recent trade data on Australia's exports to India have not been encouraging, with exports declining by 12.9 per cent. However, the trade relationship has improved markedly over the past ten or so years. Coal and gold exports have declined in recent years. Copper has increased from 2008-09, but dropped off last year. Vegetable exports have also increased and could be a future possibility for major growth. Service exports are an important source of growth in trade between Australia and India, especially education. According to DFAT: "there were 37,400 Indian students studying in Australia as at the end of March 2012: India was the second largest source country for overseas students in Australia, after China.

In 2012-13, Australia's biggest exports to India were:
  • Coal $4.75 billion
  • Gold $2.98 billion 
  • Copper ores & concentrates $1.12 
  • Education-related travel $1.2 billion
  • Vegetables $404 million

Major imports were:
  • Personal travel excl education $555 million
  • Medicaments (incl veterinary) $183 million
  • Passenger motor vehicles $180 million
  • Information technology $177 million
  • Pearls & gems $173 million
  • Jewellery $141 million

Australia was India's 31st most important export destination and the 14th largest source of imports in 2012-

Our biggest overall export by far these days is iron ore and concentrates. In 2012-13 we exported nearly $42 billion worth to China. Australia only exports a relatively small amount of iron ore to India because it too has significant reserves of iron ore. In recent times, however, Indian iron ore production and exports have been negatively affected by a series of bans aimed at cracking down on illegal mining. This has been good news for Australian producers.

Australia ran a massive surplus with India of around $10 billion in 2012-13, down from over $14 billion in 2009-10. Total exports to India were $11.5 billion in 2012-13 compared to $78 billion for China. We run a surplus of $33.5 billion with China up from $2.3 billion in 2008-09. 

The following tables show recent key merchandise (goods) trade items with India and China. 

India is Australia's 7th most important destination for services exports. It is the 17th most important source of services imports. The trend over the last 5 years has been a decline of 8 per cent.

The latest trade in services publication covers transactions up to the end of 2012. The most important services export, education-related travel expenses fell from $3.01 billion in 2009 to $1.28 billion in 2012.

The graph below shows recent trends in Australia's key trade relationships as a point of comparison of Australia's trade with India. The dotted lines represent imports, the continuous lines are exports.

India might become Australia's most important trade relationship in the future, but it is unlikely to happen anytime soon. Despite recent economic growth and increasing trade, India remains a poor country with a low level of trade compared to China.

Continuing economic growth will be most important for the future of bilateral trade. Increasing wealth in India would translate into increased services exports, especially travel and education, and perhaps financial and business services. Increasing growth would also mean greater incentives to spend on infrastructure, which would benefit the Australian resources sector. There would also be an enlarged marker for Australia's agricultural producers. 

Thursday, January 23, 2014

Australia's Terms of Trade in Historical Perspective

The Reserve Bank has recently published a historical comparison of the terms of trade in Australia entitled "Macroeconomic Consequences of Terms of Trade Episodes, Past and Present" by Tim Atkin, Mark Caputo, Tim Robinson and Hao Wang.

Now while such articles may make many people's eyes glaze over, there are few concepts that are more important in understanding the Australian economy than the terms of trade and Australians could learn a lot by reading this excellent paper. The authors' conclusion (quoted below) is on the optimistic side of the debate about Australia's economic future and it doesn't canvass the possibility that the extended duration of a high terms of trade and exchange rate have caused significant damage to non-mining sectors of the tradable economy.

The terms of trade is the index-measure ratio of the average price level of exports to the average price level of imports. It effectively reflects the capacity of a given quantity of exports to pay for a given quantity of imports, and provides an important indication of the strengths and weaknesses of the economic structure. A rising or falling terms of trade indicates the possibility of improving or declining living standards, because if what we sell earns relatively more than what we buy, we will be relatively wealthier. Because the terms of trade is a ratio, increases can be a result of export prices increasing at a greater rate than import prices, or export prices increasing while import prices are declining, or export prices declining at a slower rate than import prices. Of course, a rising terms of trade doesn’t stop us from buying more things than we sell, which we have made a habit of for much of our history! Improvements in the terms of trade are not reflected in GDP figures, but improvements do contribute significantly to increases in national disposable income.

Basically Australia has been lucky enough to have a high terms of trade for an extended period of time, but the ratio is now on the way down, with the consequence of declining income for Australians. The extent and rapidity of the descent will have a very large bearing on the economy and by extension on all of us.

The mid-1980s' low point for Australia’s ‘terms of trade’ provided an indication of the extent of the structural crisis of the economy. This terms-of-trade crisis spurred Australian policy-makers to quicken the pace of liberalisation and to make a conscious effort to globalise the economy. The most famous statement about the supposed end of Australian resource prosperity was Labor Treasurer Paul Keating’s “banana republic” radio interview in May 1986. It is worth quoting at length to show how much the rise of China has changed Australia’s economic circumstances. 
We took the view in the 1970s – it’s the old cargo cult mentality of Australia that she’ll be right. This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through … In the 1970s …we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart … We must let Australians know truthfully, honestly, earnestly, just what sort of international hole Australia is in. It’s the price of our commodities – they are as bad in real terms since the Depression … If this government cannot get the adjustment, get manufacturing going again and keep moderate wage outcomes and a sensible economic policy, then Australia is basically done for … If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well being, that it doesn’t deal with these fundamental problems … Then you are gone. You are a banana republic.
Keating used the sense of crisis to further the case for economic reform. The subsequent financial, trade, competition and labour reforms of the 1980s and 1990s helped Australia deal with the current boom, providing a flexibility to adjust to externally derived price shocks. 

Keating was wrong, however, that the era of resource wealth was over. He was not alone. Many commentators believed that the era of resource wealth was over. Arguments about the rise of the information economy seemed to preclude the possibility that resources - apart from oil - could once again substantially increase in price.  

Form the 1960s, the rise of Japan, followed by South Korea and Taiwan, Singapore, Malaysia, Thailand and other non-communist countries of Southeast Asia had provided significant expansion of export markets for Australian commodities, but had not led to a sustained structural increase in their prices.

Then along came China, changing everything. Not only did rapid Chinese demand increase the prices Australia received for its exports, but also Chinese manufacturing production helped to decrease the price of Australian imports. Manufactured goods made (or assembled) in China became significantly cheaper. Chinese competitive pressures also helped to keep in check the prices manufacturers throughout the world could charge for their goods. Interestingly, the prices of food and raw materials have not reached their 1970s peaks.

In 2000, Australia was pilloried as an ‘old economy’ too reliant on resources and unable to take advantage of the coming technology boom. The tech boom, however, soon turned into a tech wreck and Australia benefitted from two other booms – a resources boom fuelled by China and a credit boom that went largely into increasing the price of Australian houses.

Before we make the mistake of going too far back in the other direction away from the possibilities of information technology, the internet is now sparking another structural change that will profoundly affect the retail sector as consumers increase online purchases. While the technology boom got ahead of itself at the turn of the millennium, the impact of technological change will accelerate over coming years. Thus far, however, the level of online sales remains relatively small, even if it is growing rapidly from a low base
Betting on China

The major story of recent years, however, has been the rise of China. It is possible that China, India and most of the rest of Asia will continue to grow rapidly as the authors suggest for the next decade or so, but it is unlikely that this growth path will be smooth. China is actively seeking to diversify its sources of supply of the key resources it imports from Australia. Price increases eventually produce supply increases, which often then lead to oversupply and falling prices. And so on. This is the nature of the commodity cycle. China currently appears to be slowing and restructuring its economy away from commodity-intensive development. The debate over the extent of these changes is controversial but the outcome will be very important for us. 

The paper provides many excellent graphs that show the significance of change in the Australian economy. 

The historical snapshot of the terms of trade reveals important periods of boom and gloom in the economy. Especially important is the period from the early 1970s to the mid-to-late 1980s, which caused Keating's despair.

The graph on Australia's goods exports shows just how significant the transformation of exports has been from rural to resource exports. It also highlights the short period of adjustment in the 1990s towards more manufactured exports, which was overtaken in the 2000s by the continuous increase in the value of resources particularly iron ore and coal. Iron ore prices, for example, increased from $12.68 in 2001 to a high of $179.26 in 2011. 

This graph captures not only the extent of the shift to Japan, the rest of East Asia and China since the 1950s, but also the massive dependence on the UK before this. 

The next graph shows the correlation between the real exchange rate and the terms of trade. The manufacturing and tourism sectors will be hoping that the terms of trade declines and that the real exchange rate declines with it. 

Consumer price inflation has been subdued during the latest sustained rise in the terms of trade. 

A long-term look at public debt shows that the current situation is relatively benign when compared with the past, despite continual scare-mongering by policy-makers and commentators. According to the authors: "The primary reason for the large size of public debt in the past was the legacy of major conflict and the ‘settler nature’ of the Australian economy, the latter requiring high rates of social and economic infrastructure. In contrast, public debt in the current episode is at low levels. It could be argued that there is significant room to move to build the physical and mental (health and education) infrastructure to make Australia an economic powerhouse in the 21st century. But this certainly can't happen when public debt is seen as bad regardless of how it is used.

Another major difference of the recent boom was that earnings did not increase in tandem with the increase in commodity prices, as they had done in previous episodes. Undoubtedly, this helped macroeconomic management. Given the hefty wage increases in mining related industries it begs the question as to who was keeping the average down. Obviously some workers were not doing quite so well! According to the authors
The institutional structure of the labour market during the current episode has been the most flexible over any expansion since Federation; a considerable increase in relative wages in the resources sector and a more decentralised industrial system facilitated a relatively low unemployment rate during the upswing in the terms of trade without creating substantial inflationary pressures. 

The authors conclude:
Australia’s current terms of trade cycle has parallels with earlier episodes. Historically, large movements in the terms of trade were mainly driven by changes in export prices, particularly wool, which reflected strong demand from industrialising economies, coupled with adverse supply developments, such as drought. Upswings in the terms of trade have generally boosted domestic demand, usually with a sizeable contribution from investment, probably reflecting both a direct response to higher commodity prices and the associated improvement in wealth and confidence. In some episodes, growth in immigration and pent-up demand following war also supported growth in investment. Typically, net exports have contributed little to economic growth during the upswing in the terms of trade; sluggish supply responses are exacerbated by the real exchange rate appreciation, which dampens growth in other exports and supports imports. Many of these features have been present in the current episode.
The current episode, however, has some distinct features. One is that it has been mostly related to bulk commodities, instead of rural commodities. Consequently, the sluggish response of supply partly reflects the characteristics of resources investment – namely long periods to plan and gain approval for projects and the need to develop infrastructure. However, just as Australia was the world’s major source for internationally traded wool throughout previous episodes, today it is the world’s largest exporter of steel-making materials and it is likely that Australia will also become a major source of liquefied natural gas exports in the coming years. A decline in the terms of trade is therefore, to some extent, the result of new supply from Australian producers coming on-line.

The most recent upswing was the largest sustained increase of the terms of trade on record, and the Australian economy is likely to continue to be a beneficiary of strong growth in Asia. Indications suggest China’s industrialisation and urbanisation process, which has underpinned the increase in demand for steel-making commodities, is likely to continue for a number of years, although it may well grow more slowly than in the past. Chinese infrastructure needs remain large; an example is that steel demand for residential construction is not estimated to peak until around 2024 (Berkelmans and Wang 2012). While the path of economic development is not always smooth, it is important to remember that this is not the first episode during which one country and a narrow range of commodities have been of particular importance to the Australian economy; rather, that is the norm.

Another stark difference is that despite the unprecedented movement in the terms of trade, the macroeconomic adjustments in Australia have been relatively smooth. Inflation, for example, has remained contained, in contrast to many previous experiences, such as the Korean War wool boom. Furthermore, inflation expectations have remained relatively low and stable. Factors facilitating this include the greater flexibility present in the labour market, the inflation-targeting regime adopted by the RBA, and the flexible nominal exchange rate, which has enabled the necessary appreciation of the real exchange rate to occur in a less disruptive manner.

Historically, for several years following a peak in the terms of trade, growth in investment and output per capita tends to be below average. As we have emphasised, the real exchange rate and the terms of trade generally move together.

Consequently, the expected easing in the terms of trade, reflecting growth in the global supply of the bulk commodities, may be accompanied by falls in the real exchange rate. More generally, an increase in Australia’s competitiveness would help facilitate the macroeconomic adjustments necessary during the transition from the investment to production phase by providing support to sectors outside of the resources sector, thereby helping to rebalance growth in the economy. Reflecting the unparalleled magnitude of the expansion, the transition necessary is considerable and is likely to pose challenges to both firms and policymakers. The current policy frameworks and institutional structures, which were important in facilitating better macroeconomic outcomes during the upswing than occurred historically, may also assist this transition.