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.

Tuesday, January 21, 2014

A New Sustainable Housing Boom?

Bank lending is on the increase again and the housing market is back in boom territory. My prediction  last year was that the housing market would boom and then crash. The question is how long this play will take to work itself out. Too long a delay means the prediction is almost worthless. My guess is that the boom will continue over most of 2014 before crashing in 2015 as the economy tanks due to declining demand from China and the difficulty of increasing credit as a percentage of disposable income.

From the RBA:

The renewed boom has been associated with increasing concerns about housing affordability for younger buyers. According to a report in The Australian, the wealthy account for a growing percentage of housing stock, with "the top 20 per cent of income earners owning 36 per cent of Australian homes".

Another question is whether increased home lending is 'crowding out' business lending. To answer this we would need to understand whether the problem is one of supply (the banks) or demand (small business). I'm guessing that if banks can make easy money lending for houses it decreases their willingness to lend to risky small business.

One simple solution that would help affordability and possible crowding out: get rid of negative gearing.

From Leith van Onselen at Macro Business:

While it is clear that the mining boom has ended, my conjecture is that a new housing boom is unlikely to have long legs. This view is reinforced by the high levels of household debt as a percentage of disposable income.  One possible mitigating factor could be foreign purchases of Australian houses. Although there are restrictions on foreigners buying houses in Australia, these seem to be regularly bypassed by foreign investors through a variety of means. According to Martin North:
One factor which is driving the residential property market, especially in the major centres of Sydney, Melbourne and Perth is a rise in overseas purchasers. They may be Australian residents, overseas purchasers buying property for investment through an approved development, or locals acting for overseas purchasers, who are attracted by the sustained house price growth and relative economic stability. China is often identified as a major source for potential purchasers.
The ratio of debt to income increased enormously over the 1990s and 2000s and it is hard to imagine it repeating these increases over the next 10 years. A similar level of growth would see household debt to income increase to well over 200 per cent. (Such a ratio is possible, however, as The Netherlands shows, but it does set a country up for an inevitable rebalance as debt becomes unsustainable.)

Australia has benefited from a virtuous circle as the credit boom interacted with the mining boom. This is likely to turn into a vicious circle over coming years as commodity prices, particularly iron ore prices, decline over coming years.

Australia has been lucky in the timing of various booms - credit, consumption, housing and mining - over the past 10-15 years and who knows what new factor could intervene to damn all predictions and continue the luck.

The major factor affecting Australia given our growing export dependence will be the trajectory and form of Chinese growth. A less investment intensive Chinese growth model will lead to lower demand for resources and have negative effects on Australia.

The left field factor that I think will be very important over coming years is the fossil fuel revolution that has already had significant impact in the United States, putting it on the path to energy independence.

Rising prices and new technologies have made previously economically nonviable sources of supply viable. These technologies will eventually have an impact throughout the world, lessening the prices Australia receives for gas. Increased demand increases prices, which in turn increases supply, which eventually leads to lower prices. We are approaching this stage for many of our key resources. What Australia needs is continuing and sustained demand to balance lower prices with increased export volumes.  Over the longer term, lower prices mean that further supply is less viable and the cycle begins again. However, given the sustained nature of this commodity super cycle and the massive increase in supply it has encouraged, it is likely that it will be a while before there is a new investment boom, especially given Australia's status a high cost country.

While it might seem a long shot to connect these factors to the housing market, lower prices for Australian resources, particularly gas, could lower Australian incomes and expose high levels of indebtedness.

The saving grace for households (as the chart above shows) has been low interest rates leading to a lower ratio of interest paid to disposable income. Given the low level of inflation and the uncertain prospects for the world and Australian economies, low interest rates are likely to continue for a while.

The major reason for the absence of a crash in the Australian property market has been the simple fact that we've avoided a recession and thus avoided the development of a negative spiral where increasing unemployment leads to declining demand and increased difficulty in households meeting debt repayments, which leads to further declines in spending and further declines in demand. And so on.

Monday, January 20, 2014

US and Australian Employment Trends and the Future of Jobs?

Reading "The Future of Jobs" from The Economist I came across this graph showing the trends of sectoral employment since 1948.

The situation in Australia since the 1980s is this:

Agricultural, Manufacturing and Mining Employment
Percentage of Total Employment 1984-2013

Total service employment in Australia has increased as the decline in manufacturing and agricultural employment has gathered pace. (Remember that the graphs show percentage of the total rather than absolute employment levels.

The decline in manufacturing employment is not only due to technological change but the decline in its contribution to GDP and the growth of other forms of employment.  A successful and growing manufacturing sector in Australia might not necessarily employ a lot of people in the future because of increasing automation. The mining sector is also increasingly shifting to automation so there'll be fewer jobs in that sector as well.

The trend towards increased service sector employment is likely to continue, but perhaps we're heading towards a world where the wealthy and time poor pay more and more for services that mostly need to be performed by humans, creating opportunities for some and low wages for others.
So technological progress squeezes some incomes in the short term before making everyone richer in the long term, and can drive up the costs of some things even more than it eventually increases earnings. As innovation continues, automation may bring down costs in some of those stubborn areas as well, though those dominated by scarcity—such as houses in desirable places—are likely to resist the trend, as may those where the state keeps market forces at bay. But if innovation does make health care or higher education cheaper, it will probably be at the cost of more jobs, and give rise to yet more concentration of income.
Generally, however, I'm not a technological pessimist or a Luddite. That doesn't mean the transition towards new forms of employment will be smoothe or easy for large sections of the population.

The Economist makes a list of the jobs most vulnerable to computerisation:

Incidentally, The Economist argues that technological change eventually produces new employment after periods of often painful adjustment.
Even if the long-term outlook is rosy, with the potential for greater wealth and lots of new jobs, it does not mean that policymakers should simply sit on their hands in the mean time. Adaptation to past waves of progress rested on political and policy responses. The most obvious are the massive improvements in educational attainment brought on first by the institution of universal secondary education and then by the rise of university attendance. Policies aimed at similar gains would now seem to be in order ... 
Everyone should be able to benefit from productivity gains—in that, Keynes was united with his successors. His worry about technological unemployment was mainly a worry about a “temporary phase of maladjustment” as society and the economy adjusted to ever greater levels of productivity. So it could well prove. However, society may find itself sorely tested if, as seems possible, growth and innovation deliver handsome gains to the skilled, while the rest cling to dwindling employment opportunities at stagnant wages. 

Sunday, January 5, 2014

The US Economy in Three Charts and a Quote

I've long thought that the US economy would be the first major developed economy to emerge from the Great Recession, but the 'recovery' has been far from even. Wealth holders have fared best as profits and stocks have soared and wages stagnated. 

The NYT provides a series of graphs that it says explain the US in 2013. Here are three of them that explain why the US remains in severe trouble beneath the veneer of recent growth. 

In the last year, house values have increased benefitting investors and home owners. Business investment remains subdued, despite sustained low interest rates. 

In recent years, workers have not been benefitting from rising productivity. 

All in all, a mixed bag.  The US appears to be going through a new 'gilded age'. Social problems existing before the great recession and disguised by the general economic malaise in its aftermath are now being coated with a thin veneer of 'gold' - lucky for some. 

From Mark Twain novel The Gilded Age: A Tale of Today, written with Charles Dudley Warner, published in 1873.
Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark: 'I wasn't worth a cent two years ago, and now I owe two millions of dollars.”