Saturday, April 10, 2010

The Endless Boom?

Booms and busts related to Australia's status as a major commodity exporter are a recurring theme of Australian economic history. There have been 4 major booms since WWII and they all ended pretty badly.
Many serious economic commentators sincerely believe that this boom is different and that it will be sustained over decades by demand from China and India. The Reserve Bank Governor, Glenn Stevens argues that Australia's future economic problem will be dealing with the problems of prosperity.

My contention is that this optimism is a big call in the light of our history. Paul Cleary in The Australian "With resources in the driver's seat, it could be a bumpy ride" canvasses the present debate.  On one side of the debate are those who see nothing but increases in the price of commodities:
When the resources sector really gets going it reaches into every corner of the economy beyond its remote locations in the Pilbara or on the North West Shelf, with its insatiable demand for infrastructure, labour and capital. It delivers generous payola to workers, suppliers and government, and creates an even bigger economic multiplier.
Rio Tinto chief economist Vivek Tulpule predicted this week that global metals demand would double in the next 15-20 years.
Westpac meanwhile, predicts increases in commodity prices of about 20 per cent in both this calendar year and next. Gains of this order are likely to be revealed in next month's budget, along with a resources-driven turnaround in the budget's bottom line.

But commodity prices even in the rosy scenario tend to overshoot.

Australia's increasingly resource-focused economy could be in for an even bumpier ride involving greater highs and even deeper lows, says Brian Fisher, former chief of the Australian Bureau of Agricultural and Resource Economics, who now runs BAEconomics.
Mr Fisher predicts more of what Australia has seen over the past five years: a steep surge in commodity demand and prices, followed by greater volatility and economic instability.
"I think we are headed for a world where there will be much more volatility, periods of high prices and periods of low prices," he says.
"There could be strong surges of growth, followed by macroeconomic instability in the developed world that cascades back on to the developed world, with big swings in prices."
What most of the boomers forget is that price increases encourage supply increases, which then lead to oversupply and falling prices. This is the nature of the commodity cycle. No one knows this better that economist Bob Gregory, who adapting ideas about the so-called "Dutch Disease" - the negative impact resource booms can have on manufacturing sectors largely through a temporary rise in the exchange rate - to Australian conditions in the mid 1970s and which was then designated the "Gregory Thesis".

Gregory would be considered a bit of a pessimist on the impact of resource booms particularly on their effect on employment.
Australian National University professor Bob Gregory, Australia's foremost resource economist for the past 40 years, warns about the fallacy of thinking that the business cycle has gone away, replaced by a so-called commodities supercycle. He argues that some economists make the mistake of thinking the boom will be endless and continue at this rate because they fail to appreciate the supply response from high prices -- more mines.
He also says the demand side is also suspect. China and India will have their ups and downs, he says, and this will affect prices and overall volume demand for Australia's commodities. China is already trying to rein in demand and the effect of this will be seen in perhaps in two to three years' time. "We don't want to make the mistake of thinking that the Australian business cycle will disappear," he cautions.
Fisher is concerned that Australia has become overly optimistic, with many economists thinking there won't be a substantial supply response to sharply higher prices.
"We should be careful not to think there would be no supply response," Fisher says. "People have been behaving as if the supply curve is vertical. Supply curves always have some slope in the medium term."
He predicts a very strong response to the return to high commodity prices. "If you believe in the China and India story, which I do, we are going to see some very serious pressure on prices. Whether such high prices can be sustained, I have my doubts. There's a lot of iron ore in the world, and the current high prices are an enormous incentive to bring more of this resource on line," Fisher says.
The nature of this current boom is really the result of weak supply rather than strong demand, even though the analytical focus has been mainly on the latter.
Weak supply has followed decades of poor returns in the resources sector, which discouraged companies from investing in greater capacity, as shown by the data compiled in 2007 by Reserve Bank economists John O'Connor and David Orsmond.
Their much overlooked paper, "The Recent Rise in Commodity Prices: A Long Run Perspective", shows how the trend for base metals prices was largely flat between the 1920s and the mid-1960s, until the Vietnam War.
From the 1970s onwards there was a steady though volatile downward decline, until the spectacular reversal last decade. A similar pattern is evident for oil, coal and gold, with occasional peaks induced by the OPEC oil cartel and war rising occasionally above a depressing trend line.
The paper by O'Connor and Orsmond is an important one for those interested in the more technical aspects of the debate and I cite them and their research in my book. Basically the long-run trend is for a decline in prices, but the more recent decline seems to have reversed since 2003. A couple of graphs of the terms of trade - the average price level of exports in relation to the average price level of imports - help to provide some perspective.

Chart 1
Terms of Trade
Source: Treasury

Australia’s terms of trade went into freefall after the short-lived mineral booms of the mid-1970s and early-1980s. After gradually climbing from late 1982, it again plummeted over 1985 and early 1986. The current account deficit (CAD) went from a small surplus in 1973 to a deficit in 1974 from which it continued to worsen until the crisis of 1986. The current account is made up of the balance between exports and imports and the flow of interest and dividend payments to and away from Australia. The CAD became the fundamental policy problem for policy-makers for the rest of Labor’s period of office. The implications seemed clear: Australia was in almost terminal decline and external vulnerability was once again the fundamental issue of public policy. Keating’s banana republic warning was the public manifestation of crisis and is worth quoting at length:

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 … the only thing to do is to slow the growth down to a canter. Once you slow the growth under 3 per cent, unemployment starts to rise … Then you are gone. You are a banana republic.
Chart 2
Terms of Trade
Source: Treasury

Many commentators and policy-makers believe that the concerns of the 1980s and early 2000s are no longer an issue for Australia – that the long-term decline in the terms of trade has been permanently reversed. Former Treasurer, Peter Costello, for example argued in 2007 that “our terms of trade will moderate, but will not be in long term decline, which was the story of the 20th century”. To argue that Australia’s terms of trade will remain at these levels would require a shift away from the variability that is evident from Chart 5. If we consider the longer-term there is some cause for concern.

Warning about Australia’s vulnerability to a return to lower prices for commodities should not be construed as a necessarily negative outlook on Australia’s prospects. Over the medium term, there is much to be confident about given Australia’s efficient mining operations. Economic weight has shifted to Asia and because much of Asia is in a developmental mode it will require considerable resource-intensive development. When starting from a low base growth can be very rapid indeed. Asia’s share of world GDP was only 7 per cent of GDP in 1990 (at market exchange rates), increasing to around 15 per cent by 2008. Growth in East Asia has averaged 7 per cent a year during this period compared to 2 per cent for the developed world. As far as industrial production goes Asia has done even better, especially China. In 1990 China’s share of industrial production was 2 per cent, in 2008 the figure was 13 per cent.

So in summary, the major short-term issue is whether commodity prices will stay high or whether they will revert to the long-term trend decline. Even if Asia continues to expand without major reversals or periods of stagnation, it’s likely that resource prices will decline as their supply increases. The most important growing market for Australian resources – China – is actively seeking to diversify its sources of supply. And it’s also possible that technological change could undermine demand, as happened to Australian’s pre-eminent export until the 1950s – wool. Wool is now Australia’s 26th most important export. Coal is currently our most important export, but it is possible that climate change could force the development of alternatives to the burning of coal for energy.

1 comment:

Please be civil ...