Tuesday, January 31, 2012

Rock, Paper, Scissors in Queensland: Manufacturing Beats Mining

The ABS has recently put out 1312.3 Queensland at a Glance, which provides a wealth of information on Queensland for the year ending 2009-10. While there are many newer stats on the various topics available this publication brings them all together.

What interested me, apart from the fact that the significant migration to Queensland that occurred for most of the 2000s has significantly slowed, is the percentage contributions of industry sectors to employment and total sales and service income. See here.

What might be an interesting exercise before you look at the figures is to imagine what you think they might be roughly. Most Queenslanders, I imagine, would think agriculture would be bigger than it is; most would assume that mining would be bigger than manufacturing and retail trade. Contrary to these perceptions, agriculture is now a small sector of the economy and manufacturing is still larger than mining, especially when it comes to employment. Both mining and agriculture are of course more important when it comes to exports.

The ABS doesn't provide percentages so I added the data to excel, converted to percentages and sorted by size to provide a more meaningful assessment of relative contributions.

See here for some data on relative contributions of various industry sectors for Australia as a whole.

As you can see below, retail trade is the biggest employer, followed by construction, accommodation and manufacturing at 9%. Compare this to mining, which employs 1.9%. Now obviously some of the construction sector and retail jobs are dependent on mining, but so are these service sectors dependent on manufacturing, albeit not to the same degree at the moment because of the colossal amount of investment in infrastructure going on in the mining sector.

For a long-term and more up-to-date account of Queensland employment see here.

When it comes to contributions to sales and service income, mining is vastly more important, but still only the fifth largest industry contributor. Wholesale and retail trade account for 31% of income, with manufacturing contributing almost double mining's share.

As with the Australian economy as a whole, the real structural change that has been going on for the past half century is the shift to services. But let's not forget that manufacturing is still vastly important to the Queensland and Australian economies, not just in terms of employment, but in terms of contributing to a more diverse economy.

While we should avoid protectionism, governments at all levels, local, state and federal, need to think of ways to assist industry sectors without feather-bedding them. Assisting innovation, cutting red-tape, facilitating industry linkages (between industries and between industry and research institutions) and providing support for education, training and research would seem to be a good start. At a human level working on ways to keep employment high and long-term unemployment low is also vital.

Economic Austerity is Not Good for You: Forgetting the Lessons of History

Who would have thought cutting government spending in the middle of a slump would lead to lower growth? Anyone with half a brain that's who. I'm not talking about Australia here, but Britain. However, Britain provides an example of what could have happened in Australia if simple-minded austerity politics had operated as per the Coalition's critique of Labor's fiscal expansion during 2008-09. Certainly the fact that the Chinese didn't believe in austerity helped our cause as well.

While China certainly came to the rescue after the slump, according to Treasury (see this also), it is the fiscal expansion that kept Australia out of recession during 2009. Despite revisionist views that it was all about China, it was fiscal expansion that helped Australia to avoid a downturn in business and consumer confidence during 2008 and 2009, which may have led to a negative spiral of increasing unemployment and declining consumption.

Here as a reminder is how bad things were late last decade on a global scale

As Steve Morling and Tony McDonald point out:
As stark as these annual growth figures are, they disguise the speed and extent of the decline in the second half of 2008. In through-the-year terms, world growth fell from 3.8 per cent in the June quarter 2008 to -2.8per cent in the March quarter 2009, a 6.6 percentage point turnaround. The extent of the slowdown over this period was quite similar in the advanced and emerging economies.
A couple of other charts from their paper make interesting viewing.

The first chart shows that the fiscal expansion, hit when it was needed most, during the second half of 2008  and first half of 2009.

If the global economy goes pear shaped in 2012-13, then the government should and probably will make the government contribution to growth help us avoid the severe downturn that will occur elsewhere. Still, what happens in China matters more and more, not just the direct impacts of Chinese demand on Australia but the indirect effects of Chinese demand for the goods and services of other Asian countries, which also helps us to keep growing. Even if Asia has decoupled from the rest of the world (which in the medium term I don't think it has), the countries of Asia have not decoupled from each other.

This second chart shows that the downturn badly affected China as well and our major trading partners in general. During this period of time, Australia was not being saved by China or the rest of Asia.

On a per capita basis Australia's growth performance was not as exemplary. Remember that GDP per capita is a much better measure of progress than aggregate GDP, which can be bolstered, as it has been throughout Australian history, by population increases.

Another interesting chart shows the differences between Australia's economic structure and the OECD average. In the 1980s these differences were seen as likely to lead to Australia falling down the rankings of of advanced economies. Now they are seen as a fundamental factor in our economic success. It is possible, if Australian policy-makers don't work to diversify the economy, that in 20 years time we might be making the same arguments about the Australian economy that were made in the 1980s.

Labor's determination, therefore, to produce a surplus sooner rather than later is not the same thing because of Australia's better and sustained recovery (so far) from the downturn on the back of Asian demand (remember the Asia story is much more than just China). The government was right to get the budget balance in order, while the sun's been shining. Indeed, they might have had a better shot at this if they'd raised taxes on mining profits sooner rather than later.

Wayne Swan and Treasury realise that if global growth falls off a cliff then they have room to manoeuvre to again support the economy through fiscal expansion (i.e. government spending).

While there may be too much focus on Europe's possible negative effects on Australia at the moment, it's important to remember that Europe as a whole accounts for about 40 per cent of global GDP. (The European Union itself is a larger economy than the United States).

The difficulty in the face of a return to a renewed global recession might be in ignoring those who believe that governments should be more like virtuous households - with a keen saving and protestant work ethic.

Instead they will have to make a case that increasing government spending will be a necessary move to avoid a downward economic spiral that could be caused by stupidly believing that austerity is a suitable policy during a slump. Expect the Coalition to go on about unsustainable public debt. Just make sure you realise that this is rubbish. The aim of government fiscal and monetary policy during a downturn should be to maintain aggregate demand. The Rudd government and the Reserve Bank did a good job during the last global recession, let's hope that they do an equally fine job during the coming downturn.

The major example of stupid austerity has been Britain, which has gone from bad to worse as far as growth is concerned. Paul Krugman nicely captures the perverse reasoning in the UK of so-called "expansionary austerity", wherein advocates argued that cuts in government spending would encourage confidence in the business sector and lead to investment, jobs and finally consumption. Krugman begins by quoting UK PM, David Cameron:
“Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”
But this is faith of the highest order, based on the same sort of logic as the Laffer Curve.
How could the economy thrive when unemployment was already high, and government policies were directly reducing employment even further? Confidence! “I firmly believe,” declared Jean-Claude Trichet — at the time the president of the European Central Bank, and a strong advocate of the doctrine of expansionary austerity — “that in the current circumstances confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today.”
Such invocations of the confidence fairy were never plausible; researchers at the International Monetary Fund and elsewhere quickly debunked the supposed evidence that spending cuts create jobs. Yet influential people on both sides of the Atlantic heaped praise on the prophets of austerity, Mr. Cameron in particular, because the doctrine of expansionary austerity dovetailed with their ideological agendas.
Instead what has happened has been - surprise, surprise - lower growth. According to a recent National Institute of Economic and Social Research press release:
output [in Britain] grew by 0.1 per cent in the three months ending in December after growth of 0.3 per cent in the three months ending in November. This implies the economy expanded by 1 per cent in 2011, half the rate of growth experienced in 2010 (2.1 per cent).
Krugman highlights an interesting graph from the NIESR (but doesn't show it) that reveals that in terms of growth Britain is doing worse than during the Great Depression.
Last week the National Institute of Economic and Social Research, a British think tank, released a startling chart comparing the current slump with past recessions and recoveries. It turns out that by one important measure — changes in real G.D.P. since the recession began — Britain is doing worse this time than it did during the Great Depression. Four years into the Depression, British G.D.P. had regained its previous peak; four years after the Great Recession began, Britain is nowhere close to regaining its lost ground.
Here's the graph:

Given the rhetoric of the Conservatives one would think that Britain's public debt situation is unparalleled. In terms of British history it is not even close to the high debt levels of the past.

The problem for the present and near-term is that low growth is not confined to Britain, which is still an important economy in the global scheme of things despite its long term relative economic decline. Other still important economies are also doing poorly.
Italy is also doing worse than it did in the 1930s — and with Spain clearly headed for a double-dip recession, that makes three of Europe’s big five economies members of the worse-than club. Yes, there are some caveats and complications. But this nonetheless represents a stunning failure of policy.
And it’s a failure, in particular, of the austerity doctrine that has dominated elite policy discussion both in Europe and, to a large extent, in the United States for the past two years.
O.K., about those caveats: On one side, British unemployment was much higher in the 1930s than it is now, because the British economy was depressed — mainly thanks to an ill-advised return to the gold standard — even before the Depression struck. On the other side, Britain had a notably mild Depression compared with the United States.
Even so, surpassing the track record of the 1930s shouldn’t be a tough challenge. Haven’t we learned a lot about economic management over the last 80 years? Yes, we have — but in Britain and elsewhere, the policy elite decided to throw that hard-won knowledge out the window, and rely on ideologically convenient wishful thinking instead.
Krugman goes on to talk about the United States, whose policy-makers he believes need to be more focused on expansion, despite the high level of government debt. Those following the US debate know that many economic and political commentators believe that there needs to be austerity à la Britain if the United States is going to break out of along period of low growth.

But this is madness, at least in the short-term. Krugman is thankful that the Obama Administration did not follow the expansionary austerity stupidity.
Which is not to say that all is well with U.S. policy. True, the federal government has avoided all-out austerity. But state and local governments, which must run more or less balanced budgets, have slashed spending and employment as federal aid runs out — and this has been a major drag on the overall economy. Without those spending cuts, we might already have been on the road to self-sustaining growth; as it is, recovery still hangs in the balance.
And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year.
The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.
Too many people think of an economy as just a big household. It's a good thing for families to increase their savings during a downturn - it's a little boring perhaps, but a good idea - because if times get even worse, i.e. if you lose your job or get fewer hours, then extra savings will perhaps help you and your family get through tough times.

This is not true, however, for an economy as a whole. The more people save the less they spend, leading to what Keynes called the 'paradox of thrift', wherein ‘virtuous’ efforts to reduce debt cause a decline in demand and a downturn in the economy. 

Remember that GDP = private consumption + gross investment + government spending + (exports − imports). That is:

GDP  = C  + I + G + (X - M)

Simple maths would tell you that if you reduce private consumption or government spending and don't get a corresponding increase in investment, then the end result will be an economic contraction.

The problem for Australia, as I highlighted recently, is the end of the debt-fuelled growth model that spurred growth from the early 1990s til 2007. This is a major structural change for the Australian economy, although it might be better seen as the end of an earlier structural change that began with financial liberalisation and gathered pace as credit markets expanded over the 1990s and kept going until 2007 when the music stopped and not everyone found a chair.

As I outlined in that late 2011 post:
The growth of household debt as a percentage of disposable income grew rapidly over the 1990s and 2000s rising from:

48% in September 1990 to 156.7% in June 2007 to 150.8% in September 2011.
Debt for housing is 89.7 % of total household debt.
Investor housing debt is 29% of total household debt.
Interest payments as a percentage of disposable income reached a high of 13.4% in June 2008 to a low of 9.3% in June 2009 to 11.4% in September 2011. (see my article Structural Shenanigans for graphics).
So ... household debt remains at high levels and the inability to continue to grow debt even further undermines an important source of growth over the past 20 years.
Think about it.

The growth that occurred after the recovery of the 1990s recession was augmented, buttressed and sometimes driven by the expansion of household debt by around 100% of disposable income.
If we were to have the same favourable conditions over coming years this would mean that household debt as a percentage of disposable income would have to go to 250% of income.
While I've always been a keen user of credit cards, even I couldn't sustain the amount of debt repayments as a percentage of disposable income that this level of debt implies.

While households in aggregate have less room to move in terms of increasing GDP (the C part of our GDP equation), government in Australia (the G part of the equation) has much more room to move if things go badly in Europe, Asia and the United States.

We must hope that those successful communists in China keep managing their economy in such a way that benefits Australians. Over the short and medium-term it continues to be important that we debate the wisdom of increasing reliance on the mining sector and on China.

Thursday, January 12, 2012

The Chinese Economy: A Drag on Australia in 2012?

One of the most interesting commentators on the Chinese (and global) economy is Michael Pettis. A consistent theme of his newsletter (which you can receive by asking him to send it to you!) is that many economic commentators don’t understand or at least downplay the significance of global imbalances and the concept of the balance of payments.

I’ve long argued to my students in the course Power in East Asia that Chinese purchases of US bonds are not a straight forward indicator of growing Chinese power (indeed I might have been a little more forceful than that). The belief that the Chinese could simply stop purchasing US bonds would require them to change their growth model and is not likely to happen anytime soon. But even if they did, it would not be the disaster for the US economy that many commentators seem to think.

Pettis writes:
One of the more absurd fears that still pops up every few months is the panic over the possibility that foreign central banks (i.e. the Chinese) might stop “lending” to the US government. If they ever decide to stop buying US Treasury bonds, the argument goes, US interest rates would soar and the US government would suddenly find itself unable to fund its fiscal deficit

Chinese “lending” to the US government is not a discretionary decision that they can choose or not choose to do – it is the automatic consequence of a growth model that requires a trade surplus to absorb domestic overcapacity – the idea that the US government needs foreign funding is based on a very fundamental misunderstanding of the balance of payments. The US government does not need foreign buyers for its bonds. On the contrary, it is in Washington’s best interest that foreign central banks sharply reduce their purchases of USG bonds.
He then explains why recent reduced purchases of US bonds have not led to an increase in interest rates.

US interest rates have very little to do with foreign purchases of US government bonds.

Why? Because foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding.  Capital account inflows must exactly match current account outflows.

The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall. The difference between domestic US investment and domestic US savings, of course, is equal to the net amount of foreign savings imported into the US, and is also equal to the US current account deficit. In this case soaring US investment causes the US to have a current account deficit and leads foreigners to fund this excess investment.
But as he then points out the direction of causality is not clear cut. While the CAD is equal to saving minus investment, rising ‘investment’ might be spurred by capital inflows, rather than the other way round.

But the direction of causality can also run the opposite way. Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow. 

There are several ways this can happen. One way is for the surge in foreign capital inflows to cause a sharp rise in what otherwise would have been unnecessary or unfunded investment – the real estate bubbles in Spain and the US might be obvious examples of this. Another way is for foreign savings to displace domestic savings, perhaps by funding a credit-fuelled consumption boom. 
But Pettis argues that in some ways this beside the point, what many commentators miss is the simple maths involved. Net capital imports equal a current account deficit. The real issue for the US and China at the moment is what happens if foreigners, particularly the Chinese stop buying bonds. Rather than cause interest rates to rise and a collapse of the economy, the result is actually beneficial for growth. This is because:
if there is a reduction in net foreign capital inflows there must also be a reduction in the US current account deficit. 
The results are not necessarily benign.

In Spain, for example, it will happen as a collapse in domestic demand and high levels of unemployment.

For the US, however, the result is likely to be better because reduced capital inflows will further reduce the value of the dollar leading to an increase in exports and therefore a rise in employment.

US interest rates on the other hand are likely to remain unaffected

First, the decline in US unemployment will result in a decline in fiscal expenditures since the main reason for fiscal expansion is to reduce unemployment. Second the reduction in unemployment and the increase in business profits will increase tax revenues. Lower spending and higher revenues means less borrowing, and so fewer foreign purchases of US government bonds will be matched by fewer US government sales of bonds.
Remember that saying that the US needs more foreigners to buy US government bonds in order to keep interest rates low is exactly the same as saying the US needs a bigger current account deficit in order to keep interest rates low.This cannot be true.

So the question of whether the China buys US bonds or not is more dependent on the Chinese growth model of running current account surpluses.
… this is hard to predict since it is based more on political factors than economic ones.  China’s current account surplus has contracted quite dramatically in the past four years, not because of domestic rebalancing, of course, but because of forced foreign rebalancing, and there are many who think the trade balance may actually go into deficit next year. 
Pettis thinks it is unlikely that China will slow export growth anytime soon because of the view that this would be a disaster.

Huo Jianguo, head of the Ministry of Commerce's research unit, was much more explicit. Last week he warned about the consequences of slow export growth.

China needs annual export growth of at least 15 per cent to ensure stable economic expansion as the rate of domestic investment cools, the head of the trade ministry's think-tank said in comments published yesterday. "We just can't tolerate the simultaneous fall in investment, consumption and exports," Huo Jianguo, head of the Ministry of Commerce's research unit, told the Shanghai Securities News. "A growth rate of 15 per cent [in exports] is basically a benchmark and any growth below that would start to affect employment."

Beijing has pledged to stabilise exports and boost imports next year to balance trade as part of efforts to bring equilibrium back to the economy and insulate it from the effects of deteriorating external demand.  Many international economists believe China's growth has been fuelled by a reliance on investment spending, creating asset bubbles and overcapacity problems that pose more serious structural challenges than shifting external trade conditions. But Huo said concerns about falling exports were growing.

"In fact, the investment-driven model of 2009 has changed, exports are playing an incremental role in overall growth - so when export growth eases, people get nervous." Huo noted that at least 80 million jobs are related to exports - many of them held by migrant workers and therefore vital for social stability.
This is likely to lead to an increase in trade tensions. Remember the basics of global trade: not everyone can run a trade surplus. If the US and countries like Spain in Europe want to run a surplus or reduce their deficits, this will mean that China, Japan and Germany etc will have to reduce their surpluses.

Chinese and German trade surpluses must be matched by deficits elsewhere. Chinese and German export success must be matched by a willingness of other countries to buy their products. Now in an ideal world, a country’s trade surpluses would lead to increases in the value of its currency. In Europe this can’t work for individual members of the Eurozone and between the US and Asia equilibrating mechanisms are restricted both by Asian currency policies and perceptions of the US as a safe haven for capital.

Pettis then turns to the growing costs of debt service in China caused largely by excessive infrastructure investment. Growing debt is a real problem for China.

As we saw in the last debt crisis, a decade ago, debt-servicing costs are only manageable in China thanks to financial repression – i.e. extremely low lending rates funded by even lower deposit rates -- which implies a huge transfer, equal to several percentage points of GDP annually, from household savers to corporate and government borrowers. Households, in other words, typically clean up banking messes.

The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.
The solution of increasing consumption in China is often seen as a relatively simple phenomenon that will occur over time, almost as a matter of course. But recent years have seen decreases not increases in consumption. (although see here for an alternative view)

Indeed, one of the growing narratives by the Gillard government and particularly Treasurer Wayne Swan is the opportunities created by China that go beyond the mining boom. Swan argues that the growth of the Chinese middle class will create an export bonanza for Australia.

Of course, the mining boom is only one part of a much bigger and evolving story about the influence of China's rise on the world. The China story is not just a mining story; it's also a story of its dynamism and the spectacular growth we're seeing of its middle class. China's rapid growth is delivering hundreds of millions of people into a burgeoning middle class.

It's important here to distinguish between the complex and subtle process of ‘middle classing' and the simple process of ‘urbanising'. Some of China's many millions of internal migrants have achieved lifestyles that qualify as middle class, but the vast majority have not, at least not yet. It is the present and prospective shift of China's current working class and working poor into empowered consumers that will mean so much to Australia.
This, according to Pettis, might be a longer-term project than Swan seems to think.
Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010. 
Policies aimed at boosting consumption by offering incentives to purchases household goods and cars will no doubt increase spending on these items but …

since those subsidies were ultimately paid for by the household sector, the policies did not translate into an overall surge in consumption because there was no net increase in household wealth. In fact during both of those years consumption continued to decline sharply as a share of GDP.
The problem for China is not excessive saving, given that they save at about the same rate as other Asian countries. Instead the real problem is that household income is such a low share of GDP.

This means that the only way to boost consumption is redistribution from rich to poor or from the state to households.

When we add in the possibility of a continued decline in house prices throughout China, we may start to feel some kind of wealth effect dragging consumption growth down even further as a share of GDP, although I am not sure I am too worried about that. The housing boom seems to have mainly benefitted speculators, and I don’t think that it translated into a significant increase in consumption when housing pieces were on their way up. In that case it shouldn’t matter too much on the way down either, although it is better to wait and see what happens.
In the case of houses, prices are definitely falling in China, according to Pettis.

So it is debt that is the big problem, but past options used to 'solve' earlier debt problems are probably not available again.

This time however I really doubt that the debt crisis can again be resolved by financial repression, since household wealth is already far too small a share of GDP, and expected GDP growth prospects much lower than in the past. Remember that if GDP growth slows sharply, the only way households can continue permitting that their share of GDP declines, as it has for the last thirty years, is if household income growth drops to zero or even goes negative.

Slower growth and an already-low share of GDP will mean that it will be politically very difficult to force households to clean up the mess another time. Add to this the problem of illiquidity in the banking sector, which is going the become an increasing problem over the next few years as borrowers have trouble repaying loans and will require more-or-less permanent ever-greening, and I think there will be much greater appetite for a real liquidation of bad debt.
Australia is vulnerable to these potential problems in China and Australians are increasingly dependent on the Chinese Communist Party managing a rapidly growing, but increasingly unbalanced economy! But lots of people have thought that the Chinese growth model was unsustainable before, so I wouldn't take too large a bet on it collapsing.

Although given the reasonably high percentage of equity (shares) in my super accumulation fund I am in a way betting on Chinese growth continuing for a little while at least. Over the longer-term it is likely that China will continue to demand resources from Australia. It's the medium-term - the next 2-4 years that worries me.  

If you wanted to short the Chinese economy - that is a take abet against continuing high levels of growth in China -  then shorting Australian resource stocks would be a good strategy.

For what it's worth I think the Chinese authorities are likely to be able to cover up problems for a little while yet. Next year, however, is another betting opportunity.