The Australian Economy: A Deficit of Long-Term Thinking?

The flood levy has caused most of the usual suspects on debts and deficits to come out and spruke their position, whether it's "increasing taxes is always bad" or "deficits are not really a problem for Australia". While my sympathies definitely lie with the latter rather than the former, I can't help but feel that we should have been building a rather large fiscal surplus over the past 20 years 'without a recession'.

While going into deficit was a necessary move by the Rudd government, the real question is whether the fiscal balance should have been in better shape before the crisis, given the mining boom and the long period of growth before the global financial crisis (GFC). Given Australia's recovery from the downturn and the increase in export prices the Gillard government certainly should be aiming to get a large surplus together sooner rather than later.

Being critical of the pro-deficit position is not an argument for less infrastructure spending, but for increased tax on super profits, especially in the mining sector, but perhaps also in the banking sector. Remember that Australia's mineral resources (whether you think we should be mining them or not) are non-renewable. Once they're gone, they're gone forever. They should be seen as the property of future generations as well as the present generation of Australians. Using taxes from mining profits to build infrastructure or to fund research into renewable energy sources makes sense on an inter-generational basis and would contribute to higher standards of living across the Australian population now and into the future.

If we look at GDP growth since the early 1990s it makes it even clearer that we should have built up a big surplus over time.

There have been only three crosses into contraction since the recovery from the early 1990s recession. This is a remarkable turnaround from the situation between 1974 and 1992 when we had three recessions and 2 other downturns. Australia has had a remarkable turnaround since the early 1990s from the seemingly terminal decline of the 1970s and 1980s.

The reasonable fiscal position of the federal government in 2008-09 made a big difference for Australia's ability to ride out the GFC and more importantly not suffer the public debt problems that the Europeans and Americans are now faced with.

But let's not forget the continuing problem of private debt in Australia. As the following graphs clearly show, Australia remains vulnerable to changes in international financial supply.

After a little dip during the GFC, Australians have returned to the unprecedented debt levels of 2007-08. The question that always need to be asked is just how high can debt go? The answer will have a lot to do with external conditions. In an expanding global economy with Asian flourishing, many Australians could probably push their debt out even further. But if this occurs a day of reckoning will eventually come. A growth slowdown in Asia because of a political shock or just the effects of boom and bust may slow growth in Australia causing rising unemployment, more defaults on debts and so on.

The other issue is the graph on the right, which shows the percentage of annual income paid in interest. Now if the Reserve Bank of Australia (RBA) were to increase interest rates because of inflationary fears and you can bet they will if there is even the faintest whiff of price pressure, the pressure on household finances will increase proportionally. The pain of Queensland households has helped to reduce the pain of households in the rest of Australia.
As the following graph shows, household net worth went down considerably during the GFC, while liabilities stayed relatively flat. While dwellings wealth has recovered financial assets have quite a deal to go before they get to pre-crisis levels.

The safe path would be for governments to encourage gradual deleveraging of households (and the private economy in general). Also important is a decreased reliance on foreign funding, perhaps through an increase in the super levy to 12 per cent as mooted in the Rudd government's aborted 2010 tax plans.

If we turn to inflation we can see why the RBA believes that price pressures almost got away from them before the GFC and why it now has a bias towards tightening. As the RBA governor said recently it's been rare that the RBA believes that it tightened too soon.

The high Australian dollar has also helped things on the inflation front. The following graph shows tradable and non-tradables inflation. Tradeables are those goods and services which can be exported or imported, while non tradables are not subject to export competition).

Tradable inflation has helped to keep overall inflation much lower and a higher exchange rate helps this as it makes the costs of imports lower.

There is no doubt that the Australian economy has performed remarkably since the early 1990s. This amazing overall performance (it's important to remember that not everyone has benefited) has been accentuated by the fact that the economy came through the GFC with little long-lasting damage when compared to most of Europe and the United States.

The following graphs on commodity prices make it entirely clear just how big a boost resource exports have given the Australian economy. Base metal prices have done well, but have some way to go before they match their peak, while rural goods have surpassed their previous highs.

Australia's two biggest exports iron ore and coal have increased enormously in value since a long period of stasis before 2000. China's increased steel use has been very good for Australia, but just how long prices can stay at these levels must be exercising the minds of miners in Australia. It should also be a subject of considerable concern for government in Australia given the 'untaxed' super-profits being made by our majority foreign-owned mining sector.

Overall, however, commodity prices have matched their previous peak before the GFC and as the terms of trade shows are now approaching the post-war high associated with wool demand created by the Korean War.

The terms of trade is an 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.

One thing that studying history has helped reinforce in my head is that good times don't last forever and that the history of the Australian economy is a history of boom and bust as the graph of the terms of trade makes clear. From the peak of 1950 until the late 1990s the terms of trade had been on a 50 year downward trend. It would be extremely optimistic to believe that we began a 50 year upward trend 10 years ago. But maybe I'm just being too negative!

All graphs from the RBA Chart Pack

The Debate between Expansionists and Restrictionists

Right now there is an important debate going on in the United States and Europe between those who think the major aim of economic policy at the moment should be to do something about growing fiscal deficits and those who believe that the major aim should be to maintain economic activity.

Mohamed El-Erian argues that we need to go beyond what he calls "the false growth vs austerity debate" He argues that at this his weekend’s G20 meeting

In one corner stand the “growth now” camp, arguing that expansion is a pre-requisite to service their debt sustainably. Without it tax receipts implode, investment is turned away, and meeting future debt payments is harder. This camp abhors Europe’s shift towards austerity, questions Tuesday’s tough UK budget, and urges countries like Germany to adopt expansionary policies. Some advocate additional fiscal stimulus even for high deficit countries, like the US.

This debate he argues is "incomplete" and backward looking and countries need "to adopt both fiscal adjustment and higher medium-term growth as twin policy goals."

Squaring the circle of growth and fiscal stability needs policies that focus on long-term productivity gains and immediate help for those left behind. This means first enhancing human capital, including retraining parts of the labour force, and increasing labour mobility. Then new emphasis on infrastructure and technology investment is needed, with greater support for scientific advances that promise increased productivity. Finally all nations must begin an honest assessment of the social frictions coming in the next few years. In some countries (like the US) this means an urgent bolstering of social safety nets.

...

The world is facing deep structural challenges yet its leaders are stuck in a short-term, cyclical mindset. Until they break out of it we will see little more than fruitless discussions, national policy flip-flops, and a troubling lack of global policy harmonisation. Without action our future will be disappointing global growth and periodic sovereign debt crises. Let us hope this, if nothing else, is enough to bring the two camps together.

Paul Krugman is a major protagonist in this debate on the side of the expansionists. He is very critical of such views, implying that this is simply restrictionism.

In The Long Run, We Are Still All Dead

So, reading Mohamed El-Erian, I’m somewhat at a loss about what he’s actually saying; what, exactly, is the policy recommendation? But in any case, here’s what struck me: he writes,
The world is facing deep structural challenges yet its leaders are stuck in a short-term, cyclical mindset.

I disagree. If anything, we’re suffering from the opposite problem. Talk to German officials about high unemployment and the looming threat of deflation, and they ramble on about the demographic challenge and the cost of pensions.

I mean, why shouldn’t we be focused on the business cycle? We’ve suffered the worst cyclical downturn since the Great Depression; in terms of unemployment and output gaps, we have recovered almost none of the lost ground. Millions of willing workers are idle because of lack of demand; let them stay idle, and we can turn this into a long-term structural problem, but right now it is precisely a short-term, cyclical problem.

So saying that we need to focus on the long term, and not worry our little heads about trivial short-term issues like the highest long-term unemployment rate since the Great Depression, may sound like wisdom — but it’s actually folly.

Oh, and one more point — not about El-Erian, but about quite a few policymakers and economists: the attempt to shift the discussion away from the short run is not, as often portrayed, an act of vision of courage. On the contrary, it’s an act of cowardice, an attempt to evade responsibility for a disastrous state of affairs that we could fix, but choose not to.

Keynes had it right:

But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

What is most interesting for me as I read these debates are the implications for Australia. And just how different the situation is in Australia. This seems to be another 'world' that they are writing about. This is increasingly being explained by the argument that the global financial crisis should be seen as the North Atlantic financial crisis. (NAFC doesn't have as sweet a ring as GFC and makes me think of a football club from Adelaide).

Australia's fiscal position is relatively sound and the nature of the political debate in Australia ensures that even the small level of public debt is seen as a 'problem' that requires immediate action. One of the reasons why the Rudd govt introduced the Super profits tax was to bolster the ability of the budget to return to surplus sooner than originally planned.

We are in a very good position right now, but as always we continue to be vulnerable. Our success (and we could do better) has been built upon long-term growth and increases in national income bolstered by the terms of trade effect (relative increases of export prices over import prices). But eventually what happens in Europe and the United States matters to Asia and to us. China has continued to expand because of a huge fiscal stimulus and in turn growth in Europe and the United States has been bolstered by budgetary stimulus, financial guarantees and bailouts, and low monetary policy.

Without govt efforts the world would now be in a deep financially-induced depression. This is what the restrictionists and ant-govt zealots need to realise. Equally, however, expansionists need to (eventually) think about the growth of govt debt. This will involve both sides of the fiscal equation - spending and taxing.

We now live in a more globalised world economy. One of the benefits of that is that increased growth and the advancement of many developing countries with China and India showing rapid rates of growth. But globalisation increases vulnerabilities to negative effects as well. The aim of the G20 should be to foster the increased economic cooperation necessary to manage an increasingly globalised world economy. But international cooperation is no easy thing! States will have to continue looking after their own interests first, but a bias towards expansion in depressed areas will be beneficial for globalisation in the long-run.

Government Spending, Deficits and Debt

There's been a lot of spurious stuff written recently about the dangers of deficit financing during the Great Recession. Reading some of the more alarmist stuff one would be forgiven for thinking that the world didn't just dodge a huge bullet - a major systemic financial collapse and a serious depression in the developed world, which would have eventually engulfed the whole world. The negative feedback possibilities were extremely scary. Massive fiscal stimulus made a big difference. As growth returns money will need to be paid back. My major concern is with indebtedness across the system, rather than in the govt sector.

The more alarmist writers always refer to govt debt in gross terms rather than in net terms.
Those interested in the detail can read the earlier post "Public Debt (for Nerds)". What really matters is net debt or more to the point net financial worth and net worth.

There is no doubt that govts cannot keep borrowing indefinitely, just like households and corporations.
One of the main differences between public andf private, however, is the capacity to fix finances through taxation. In the US in the 1990s, Clinton shifted the US debt position relatively easily and then Bush messed it up again.

For an excellent counter-intuitive account of these issues see Robert Frank's article "How to Run Up a Deficit, Without Fear" 

Frank drily notes that:

there are really only three basic truths that policy makers need to know about deficits: First, it’s actually good to run them during deep economic downturns. Second, whether deficits are bad in the long run depends on how borrowed money is spent. And third, eliminating deficits entirely would not require any painful sacrifices.

What! You ask, surely this can't be true? The first point comes directly from Keynes who correctly argued that in times of recession govts should do what they can to bolster spending.

Consumers won’t lead the way, because even those who still have jobs are fearful they might lose them. And most businesses won’t invest, since they already have more capacity than they need. Only government, Mr. Keynes concluded, has both the motive and opportunity to increase spending significantly during deep downturns.
Of course, if the government borrows to do so, the debt must eventually be repaid (or the interest on it must be paid forever). That fact has provoked strident protests about government “bankrupting our grandchildren.”
It’s an absurd complaint. Failure to stimulate the economy would mean a longer downturn. That, in turn, would mean longer stretches of reduced tax receipts, increased unemployment insurance payouts, and depressed private investment. The net result? Higher total public borrowing and a permanent decline in productivity compared with what we would have had under effective economic stimulus.

But govts do have to pay the debt back as the economy recovers.

At full employment, extra borrowing often compromises future prosperity, just as critics say. On President George W. Bush’s watch, for example, the national debt rose from $5 trillion to $10 trillion. Some of that borrowing paid for an expansion of Medicare prescription coverage and a financial bailout a year ago, but most went for a war in Iraq and tax cuts that largely just allowed for additional consumption. Our grandchildren will be forever poorer as a result.

What matters is what govt borrowing is used for - govts can usefully make productive investments that will benefit future generations.

After decades of neglect of the nation’s infrastructure, attractive public investment opportunities abound. It’s been estimated, for example, that eliminating bottlenecks on the Northeast rail corridor would generate $12 billion in benefits at a cost of only $6 billion. These are present value estimates. When government undertakes such investments, our grandchildren become richer, not poorer.

Frank then suggests correctly that in normal times, govts should pay for productive investment with savings rather than borrowings.

But they’d be richer in the long run if we paid for those investments with our own savings rather than with borrowed money, for that would allow our grandchildren to benefit from the miracle of compound interest. Many fiscal hawks insist that the only way to eliminate deficits and pay for additional investment is by cutting government spending. But as California’s experience suggests, that approach often backfires. Government programs have constituents. Those that get the ax are often not the least valuable ones, but those whose supporters have the least influence. California’s schools, once among the nation’s best, are now among the worst.

The solution, of course, is taxation. A dirty word for many, but essential for not only a civilized society but a productive one as well.

To eliminate deficits, we need additional revenue. The encouraging news is that we could raise more than enough to balance government budgets by replacing our existing tax system with one that taxes activities that cause harm to others. Called Pigovian taxes by economists — after the English economist Arthur Cecil Pigou — such levies create a burden that is more than offset by the reductions they cause in costly side effects of everyday activities.
When producers emit sulfur dioxide into the atmosphere, for example, the resulting acid rain harms others. As the 1990 amendments to the Clean Air Act demonstrated, the most efficient and least intrusive remedy was to tax sulfur dioxide emissions. Doing so entailed no net sacrifice, because solving the same problem by prescriptive regulation would have been much more costly.
Similarly, when motorists enter congested roadways, they impose additional delays on others. Here, too, taxation is the best remedy. The time that congestion fees save is more valuable than the fees are burdensome.
When the transactions of financial speculators fuel asset bubbles, they increase the risk of financial meltdowns. A small tax on those transactions would reduce this risk.
When drivers buy heavier vehicles, they increase others’ risk of dying in accidents. This risk would be lower if we taxed vehicles by weight. Carbon dioxide emissions contribute to global warming. Here as well, taxation offers the most efficient and least intrusive remedy.
Anti-tax zealots denounce all taxation as theft, as depriving citizens of their right to spend their hard-earned incomes as they see fit. Yet nowhere does the Constitution grant us the right not to be taxed. Nor does it grant us the right to harm others with impunity. No one is permitted to steal our cars or vandalize our homes. Why should opponents of taxation be allowed to harm us in less direct ways?
Taxes on harmful activities would be justified quite apart from any need to balance government budgets. But such taxes would also generate ample revenue for the public services we demand, quieting the ill-considered commentary about deficits.
In the meantime, however, such commentary continues to render intelligent political decisions about deficits less likely. For example, 58 percent of respondents in a recent NBC News-Wall Street Journal poll said the president and Congress should worry less about bolstering the economy than keeping the deficit down, while only 35 percent said economic recovery was a higher priority.
If we really want to bankrupt our grandchildren, that poll charts a promising course.