Friday, June 17, 2011

Australia's Economic Vulnerabilities Revisited

"There is no harm in being sometimes wrong — especially if one is promptly found out" Keynes 1933

Recently a friend said that she hoped the mining boom will last longer than I said it would. Well I'm already wrong on this one. I thought that this mining boom would have been badly damaged by the global recession and would have had a longer period of lower prices before recovering.

That story has been the history of resources boom in Australian history and I still think it will be the case for this boom eventually, at a base level simply because of the laws of supply and demand. Increased demand encourages increased supply, which in turn leads to lower prices. The mitigating factor is that China and India have a lot of demand to come.

While I think that over the longer-term commodity prices will remain above recent averages over the next 10-15 years, I underestimated the extent to which government action would counteract the worst consequences of the global financial crisis. This is especially the case for China, where government spending and forced lending helped to maintain growth in China, which, in turn, has had a positive effect in the rest of Asia.

I can't say that I predicted that commodity prices and the terms of trade would recover to pre-crisis levels like they had or that China would be able to continue to grow so strongly despite the problems of the United States and much of Europe. Those problems by the way are still with us. Europe is in deep trouble and the United States remains stuck in low gear with high unemployment and continues to deal with the consequences of high levels of private and public debt. The jury is still out on the consequences of China's fiscal and monetary stimuli and we may yet see problems emerge in China, which will of course have deleterious effects in the rest of Asia.

My focus in recent years has been on economic vulnerabilities, rather than attempting to accurately predict what will happen. I'm quite happy to admit that I have little idea about what will really happen and if I did I would no doubt be a lot richer than I am!

I think that there are just too many variables to accurately predict the future and tend to believe that those who did predict the crisis before 2007 were working on variations of concepts of vulnerabilities that eventually had to be exposed. But as Keynes also once said "Markets can remain irrational a lot longer than you and I can remain solvent." Nevertheless, the build-up of debt was bound to end sometime and the real question in 2006-07 was whether there would be a crisis or a soft unwinding of debt.

My question to students in 2006-08 was what level of debt to disposable income or foreign debt to GDP was the high point at which time deleveraging (the unwinding of debt) would have to occur.

So what are the economic vulnerabilities that continue to be an issue for Australia?

The three that I referred to in the book are our vulnerabilities to:
  • changes in international demand for commodities
  • changes in international financial sentiment and supply
  • rising inequality
Of course we should add a fourth, our vulnerability to climate change and the policies required to deal with them. This fourth vulnerability undoubtedly affects the first one because dealing with climate change will affect our exports of raw materials and particularly coal, although it has and will continue to boost demand for Australian gas. What it should also do is increase our willingness to fund basic research in renewable energy technologies. Success in this latter category will unfortunately affect our exports of coal.
Recognising these vulnerabilities should be the starting point of any long-term analysis of the Australian economy, but such worries tend to get lost in the euphoria of booms, especially long-lasting booms like this one.
We also need to be aware of the distributional consequences of adaptation to the global economy and changing technology. Openness can underpin productivity and prosperity but the political process must ensure the spreading of benefits and the sharing of costs. Globalisation does not necessitate a smaller role for government as the crisis clearly shows. Without the prescient actions of policy-makers and an understanding of the Great Depression this crisis would have been more severe.
The future of globalisation is ultimately dependent on effective redistribution. In democracies and even in authoritarian systems, globalisation must produce the goods (and services).

Scholars like Peter Lindert point out that the development of the welfare state in Western democracies has not undermined growth nor productivity.

Socially sustainable globalisation is the best way to ensure that there is no retreat to past solutions such as protectionism or worse dangerous nationalism.

The Three Major Economic Vulnerabilities in More Detail

Firstly, Australia remains vulnerable to changes in international demand. This is a long-standing condition of the Australian economy.

Resources have helped to make Australia rich but the income earned from mining and agriculture is variable and volatile.

We’ve done very well in recent years off the back of Asian demand, but until about 2002 countries like Australia exporting raw materials or simply transformed resources were seen to be on a losing wicket as prices declined.

Now China’s seemingly insatiable demand for resources has transformed these negative perceptions.

But the question for the future is whether this high level of demand and prices will continue and reverse the long-term trend for commodity prices to decline.

Chinese demand, despite moves to increase domestic investment and consumption, is still heavily dependent on final demand in the advanced capitalist nations.

A prolonged global recession will mean that Chinese cannot sustain their demand for resources and commodity prices will fall significantly.

Even if increases in demand continue, it is likely that supply will eventually increase meaning that prices will still fall.

Climate change presents another challenge for Australia given that our two major exports – coal and iron ore – play a big role in the production of greenhouse gases in the atmosphere.

It is unlikely that coal will become less important any time soon, but if even the more prosaic predictions about the impact of climate change come true, pressures will increase to cut the amount of coal burning that exists. A world of restricted output of carbon pollution will be beneficial for Australians eventually, but the transitional costs could be high.

Secondly, Australia remains vulnerable to changes in international financial supply.

While public debt is the issue for many Australians, of more concern is the level of private foreign and household debt. Foreign (private) debt has grown from negligible levels in the early 1980s to well over 50 per cent of GDP today. Total external liabilities are well over 60 per cent and without a massive, sustained improvement in the current account deficit is likely to reach 70 per cent of GDP in a few years.

The question is what level of foreign debt is unsustainable. What really matters is what international financiers think.

If they think Australia’s debt or CAD is a problem then it is a problem.

Self-fulfilling or at least reinforcing prophecies can dominate in the financial sector.

Ultimately, the sustainability of high levels of debt is dependent on the ability of the debtor to pay off or roll over that debt. Australia as a nation needs to fund its current account deficit and to do this it is reliant on international investors. The massive increase in government debt has heightened competition for funds throughout the world. The US government alone will demand trillions of dollars of international investors’ capital.

Household debt as a percentage of disposable income is at historically unprecedented levels.

It is still over 150 per cent of disposable income.

The one positive of the economic downturn was a sharp decline in interest payments as a percentage of disposable income. This period of grace is now over and the RBA will increase interest rates further if the boom continues. Interest payments as a percentage of disposable income still above the level reached during the huge hike in interest rates in the late 1980s.

Many people are surprised by the resilience of the Australian economy given these levels of debt, but as the Treasurer might say, we’re not out of the woods yet and we still have to deal with some of the negative consequences of a sustained boom

Quite a few things could go wrong. The housing market is, as predicted, going through a period of retrenchment, which makes homeowners feel poorer and in turn impacts on spending.

Australians are saving more and trying to pay-off debt, creating a reduction in demand and leading to what Keynes called the paradox of thrift, wherein ‘virtuous’ efforts to reduce debts cause a decline in demand and a downturn in the economy.

Finally, Australia remains vulnerable to an increase in inequality.

Not only is it a poor outcome on its own terms if a wealthy country does not provide widespread opportunities across society, allowing inequality to rise could have a detrimental effect on Australians’ receptivity to globalisation and engagement with Asia.

It also matters for productive reasons. It’s not productive to have significant sections of the population disengaged and reactionary. It’s not productive to have poor health outcomes and education opportunities restricting the participation of current and future working generations

Australia has indeed been a lucky country since the nineteenth century, but it is Australia’s institutions and an ethos of egalitarianism that has contributed to the spreading of that luck across the Australian population.

While Australia should never go back to protectionism, it should retain some of that spirit of egalitarianism that meant that Australia remained a lucky country for many and not just a few as is the case in some countries around the world.

One can argue that redistribution in Australian history could have been more extensive in the past, but it is important that Australia now develop a new model of egalitarianism that underpins support for a dynamic, outwardly focused globalising economy.

Despite reservations about the ability of Australians to adapt to a changing world in the 1980s, Australian policy-makers abandoned economic insularity and embraced liberalisation and globalisation. This faith does not necessarily extend to the population at large.

The long period of growth since 1991 has aided Australians’ receptivity to the changes, but despite the boom there are still major areas of disadvantage in Australia that are often forgotten or put in the too hard-basket to deal with effectively. Any prolonged downturn in the future will test this support and provide ammunition for those wanting a retreat back to insularity and preferment.

Adaptability is an important asset in today’s global economy and the best way to maintain Australians’ preparedness to adapt to changes in international demand is to support through the supply of high quality and comprehensive public infrastructure both physical and mental. The two things that matter most are access to high quality public health care and high quality public education.

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