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

1972-1986

(2006-07=100)

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

1901-2009

(2006-07=100)

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.

Military spending in pictures

The following is from David McCandless's informationisbeautiful.net and a blog he contributes to run by The Guardian called Datablog. Some of the graphics that McCandless produces are simply magnificent.

The following graphics of miltary spending are typically stunning and revealing as well.
They show just how dominant the United States is in the military arena, but how (relatively) easily it maintains this spending compared to other militarised countries.

As you may know from earlier posts I think that US 'declinism' is overdone by the popular media, the more sensationalists elements of academia, anti-American commentators of the left, and isolationalist US nationalists of the right.

The government's insulation scheme and fiscal stimulus

If you're looking for a balanced view of the govt's insulation or Building the Education Revolution schemes, The Australian newspaper is not the place to find it. The Australian has been running hard on a campaign against the govt, worried perhaps that the Opposition under Tony Abbott is not doing an effective job.

There is no doubt that there has been some significant rorting and that some builders have made inordinate amounts of money. The BER and the insulation schemes will provide important lessons for govt schemes and contracting, but they do not negate the important role of the stimulus during the worst of the crisis. Although the govt could have done a better job in its management of the contracts, the improvements in school infrastructure will be overwhelmingly beneficial.

A good way to consider the impacts of these schemes is to imagine the normal practice of building and insulation instalment and consider accident rates, fires, rorting etc and then consider these percentages in relation to the significant increases in the rate of building and instalment. Only then will we get an accurate representation of the problems associated with the programs.

If you want a more balanced account of these developments then I think it is worth reading Rodney Tiffen's "A mess? A shambles? A disaster?"

TO EVALUATE the achievements and failings of the scheme, it is important to recognise that home insulation was already a sizable industry. The government’s policy did not introduce new activities; it radically increased the scale of existing practices. So, in assessing the government’s responsibility for developments during 2009 and early 2010, the task is to disentangle which problems arose from an accentuation of existing sub-standard practices and which occurred because of an emphasis on quantity over quality and a drop in standards as new operators flooded into the industry. While some conclusions – for example, that the standard of work fell – are plausible, we can’t know for certain because there are no baseline measures of previous practices and outcomes.

In 2008, 3.18 million Australian dwellings (or 61 per cent) had insulation, and approximately 67,000 homes were insulated each year. The largest number of insulated homes had batts in the ceiling; a minority used foil. On average, between eighty and eighty-five fires per year were attributed to insulation faults, but no breakdown is available to show which of these arose from newly installed insulation and which from longer-standing insulation.
The Rudd government’s scheme was unprecedented in its scope, aiming to insulate two million homes in two and a half years at a cost of $2.45 billion. By the time the program was suspended last month, 1.1 million homes had been insulated with $1.4 billion approved for payment. These installations amount to roughly half the number of homes that had no insulation in 2008. It should also be remembered that the work done was disproportionately in older dwellings, which no doubt added to the difficulties of safe installation.

The benefits of home insulation have not been questioned by any of the program’s critics. The Department of Environment estimated that insulation would cut the normal household’s energy bills by around $200 a year. According to one estimate during the controversy, putting ceiling insulation in 2.2 million homes would save as much energy as taking a million cars off the road; a more conservative estimate said that 1.1 million insulated homes was the equivalent of taking 300,000 cars off the road. Another estimate said that ceiling insulation cuts household energy use by up to 45 per cent, while the Total Environment Centre said it would cut it by 25 per cent in centrally heated homes and 18 per cent in space-heated homes. Whatever the actual figures, the environmental benefits are clearly substantial.

When the program began, home insulation had few special regulations, although it was, of course, subject to normal work and safety provisions and employers’ duty of care. No certification was needed to enter the field, and indeed insulation was frequently installed by householders themselves. The lack of licensing and training in the area allowed sub-standard work to be completed and sub-standard occupational safety procedures to be followed. Although the numbers and proportions of each almost certainly increased as a result of the stimulus, the lack of existing safeguards also meant that an unknown number of instances of both shortcomings probably occurred in the past but had passed beneath the public radar.

Both licensing and training have been dramatically improved as a result of the program. As the increased scale and perhaps the decline in the quality of some work exposed more problems, the department mounted a national training and audit program, largely filling the regulatory vacuum that had permitted the previous abuses and problems. At best there is a grey area here. On the one hand it can be argued that it would be unreasonable for the department to anticipate all of these issues, and it can be argued that it acted fairly quickly once problems became apparent. On the other, should it have anticipated that such an expansion of funding would attract problematic operators and practices, and therefore acted pre-emptively?

“Every new fire and its front page headline will remind voters of the Rudd government’s recklessness and ineptitude,” the Australian’s columnist Janet Albrechtsen has written. Politically, she is surely correct, but that will happen largely because of the media’s innumeracy and lack of historical perspective. Under the program, the number of installations rose from 67,000 a year to 1.1 million; the number of fires rose from around eighty to 120. In other words, as Crikey’s psephological blog Pollytics has demonstrated convincingly, there is no statistical evidence that the existing problem of fires became worse with the program. Rather, because fires from insulation were now newsworthy and previously hadn’t been, this was seen as a new problem, one caused by the new policy, whereas in fact the number of insulation-related fires increased only slightly in absolute terms, and there was a decrease from previous patterns in proportional terms.

I think in coming years, commentators will look back on Australian economic policy during 2007-09 and realise that the govt  and the Reserve Bank did a pretty good job in keeping the Australian economy out of recession.

We can't blame the media for being sensationalist, but we don't have to play their game and believe the hype.