Keep on Booming

I don't know about you, but whenever I read headlines like "20 year boom", my bullsh-t detector comes on hard and fast. While there can be no doubt about the current status of the boom as one of the biggest in Australia's history, the real question is whether it is going to be sustained into the future. While I think the Australian economy is travelling fairly well at the moment, I just don't have the faith that many seem to have in the projections of endless prosperity.

The last week or so has seen the Head of Treasury and the Reserve Bank Governor both talk about the possibility of a long-term China boom. Students of the Australian political economy wanting a snapshot of official thinking could do far worse than review the recent words of Ken Henry and Glenn Stevens.

So what did Australia's two most important economic bureaucrats actually say?

Henry was at a Senate Hearing into the government's mining tax and the exchange went like this (my emphasis in bold):

Senator HUTCHINS—Can I ask you to give a view about the uneven growth across the economy at the moment.

Dr Henry—It is quite uneven. Certainly there are some sectors of the economy that are growing very strongly and we would expect to see them continue to grow as strongly over the next several years. There are other sectors of the economy that are being affected, particularly by the high exchange rate, who are finding conditions more difficult. There are businesses also that if not affected by the high exchange rate are feeling the impact of rising interest rates and the dampening effect that those rising interest rates are having on demand. So there is some dampening of demand evident in the Australian economy currently. We would expect to see those trends continue for some time—for quite possibly several years.

So it is likely that we will see an Australian economy characterised by unprecedentedly strong rates of growth in some sectors of the economy, particularly in mining, mining investment and mining related construction activity, with other sectors of the economy growing somewhat slower than their historical trend rates of growth as the economy’s factors of production, principally labour but also capital, move from the slower growing sectors to the faster growing sectors of the economy. In this uneven pattern of growth the Australian economy is being restructured, if you like. There is a period of structural change that the Australian economy is going through. I have said publicly on a couple of occasions recently that the external shock to which the Australian economy is adjusting, and by that I am referring to historically high commodity prices and the high terms of trade that come with those historically high commodity prices, will quite possibly prove to be the largest external shock ever to hit the Australian economy, and it is causing quite a deal of structural change. To date, not a lot of that structural change has occurred—some has—but over the few years ahead, we should expect to see quite significant structural change in the Australian economy.

Senator HUTCHINS—So the non-mining sectors appear to need some sort of assistance — not assistance, but maybe they need to be recognised?

Dr Henry—It is not clear that assistance is what is required. After all, what could appear to be assistance to a particular sector that is finding the going a bit tough could translate into even higher interest rates and an even higher exchange rate and could make life even more difficult for those sectors that are struggling now and that would not be in receipt of assistance. I think it is important to recognise that the pattern of growth will definitely be uneven in the next few years and recognise the challenge that poses for the conduct of both macroeconomic and structural policies. It has to be recognised, but you have to be careful that in constructing any form of assistance you do not actually make the problem worse.

Senator HUTCHINS—Would cutting company tax be of assistance to these non-mining sectors?

Dr Henry—Yes, and it is one of the reasons—it is not the only reason—the tax review document recommended a cut in the company tax rate. Another reason was to reduce the cost of capital in Australia in order to provide a more attractive destination for investment. That was a long-term view that was being taken in the tax review. Another reason for the tax review recommending a cut in the company tax rate, in association with a resource super profits tax, was to rebalance the pattern of growth somewhat to provide a lower cost of capital for those sectors of the economy that are feeling the pressure that is being exerted by this very rapidly growing mining sector of the economy.

Senator HUTCHINS—One concern that has been expressed to the committee has been about this so-called Dutch disease, which you may have heard Professor Garnaut comment on in our hearing on Friday. What appropriate measures should be taken? Should they be similar to the measures taken by Norway? Are there other areas that should be explored or are we going down the right track at the moment?

Dr Henry—I have not had the advantage of seeing Professor Garnaut’s comments that he made to this committee on Friday. I think I can anticipate what he would have said in respect of Dutch disease and that is actually what I was referring to earlier when I was referring to the strength of the Australian dollar and the pressure that is putting on other sectors of the economy, particularly the trade exposed sectors of the economy. As to policy responses to so-called Dutch disease, without addressing particular policies I would say that in general terms it might be helpful to reflect on whether the increase in the exchange rate is considered to be only temporary or whether the increase in the exchange rate might reflect a medium-term or even a long-term change in Australia’s terms of trade. Typically the Dutch disease label attaches to instances in which the appreciation of the exchange rate is considered to be temporary but the economic effects of that appreciation are long lasting.

I think it would be sensible on this occasion to contemplate the prospect that there has been a structural change in our terms of trade not a short-lived change in our terms of trade and that that structural change in our terms of trade will have to be associated with any change in the structure of the Australian economy. If that is the case then in general terms, again without talking about a particular policy option, policy would do better to focus on what could be done in order to support the structural change that is going on in the economy in a way that does least damage to people’s lives. That might mean, for example, avoiding temptation to offer support to a particular business which, with these terms of trade, does not really have a long-term future in the Australian economy but to focus instead on programs that would support the transition of workers from that business to other businesses in the Australian economy which do have a longterm future with the sorts of terms of trade that we are confronting. That is a generalisation, I am conscious of that and you asked me about particular policies, but I would not want to at this stage get into arguing the merits of particular policies. I am happy to talk about policy approaches, but I would not want to get into a discussion of the merits of particular options.

The gist of Henry's Senate statement is that the boom will be structural rather than cyclical, which would mean considerable adjustment for Australians as capital and labour move away from other sectors of the economy towards mining. (This is a bit of a problem given mining's low employment to output ratio) It's also a non-too-subtle, even if indirect suggestion that Australia should not offer assistance to the manufacturing sector!

Australia's terms of trade are approaching the highest ever level as this excellent graph from RBA Governor Glenn Stevens' speech "The Challenge of Prosperity" shows. (For those interested I published an article in the Griffith Review entitled "The Politics of Prosperity" dealing with similar themes ... for a similar article but with graphs and tables see "Between Luck and Vulnerability")

I've spent a good deal of the year trying to explain to students in my Globalisation, the Asia-Pacific and Australia class the importance of the terms of trade. Indeed, I asked them in their exam why it mattered. I told them that if they fell asleep Rip van Winkle style for 20 years and wanted to get an immediate picture of the state of the Australian economy one of the best things they could do would be to call: "Get me the terms of trade!!"

It is worthwhile defining the terms of trade because it it is a fundamental measure of boom and gloom. 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.

Why it is important is, as usual, lucidly explained by the Governor.

You may have noticed the Reserve Bank saying a lot about the terms of trade in the past few years. Before I describe the chart, why is it important?

Our terms of trade have a big bearing on national income. In economic commentary, there is typically a very strong focus on GDP – the value of production – as a summary of national material progress. There is also quite rightly an emphasis on lifting productivity – real GDP per hour worked – as the source of our growth of material living standards.

For open economies, though, our standard of living is affected not just by the physical output we can obtain from our resources of labour and capital, but also by the purchasing power of that output over things we want to have from the rest of the world. This is what the terms of trade is measuring. It is the relative price of our export basket in terms of imports. At the extreme, if the economy were open to the extent that we exported all our production and imported all our consumption, then the price of exports relative to imports would determine our living standards entirely, for any given level of productivity per hour worked. As it is, Australia is not that open, and not as open as many smaller economies, but it is considerably more open than the really large economies like the United States, the euro area or Japan. So the terms of trade matter.

When the terms of trade are high, the international purchasing power of our exports is high. To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2,200 flat screen television sets. Today it is worth about 22,000 flat-screen TV sets– partly due to TV prices falling but more due to the price of iron ore rising by a factor of six. This is of course a trivialised example – we do not want to use the proceeds of exports entirely to purchase TV sets. But the general point is that high terms of trade, all other things equal, will raise living standards, while low terms of trade will reduce them.

He then argues that there are 3 key features of the long-term chart of the terms of trade.

The first is the degree of variability in the terms of trade through the middle parts of the 20th century, from about World War I to the aftermath of the Korean War. This was, of course, a period of considerable instability in the global economy, with the attempt to return to the Gold Standard after the ‘Great War’, followed by the 1930s depression, the Second World War, the post war expansion and then the Korean War. I might add that, in those days, with the attempt to maintain a fixed exchange rate, these swings were very disruptive to the economy. Typically, a rise in export incomes would result in a rise in money and credit, a boom in economic activity and a rise in inflation. Then the terms of trade would fall back and the whole process would go into a rather painful reverse. The advent of the flexible exchange rate in the early 1980s made a great difference in managing these episodes.

The second feature is the downward trend in the terms of trade, particularly noticeable from the early 1950s to about the mid 1980s. This was the period of resource price pessimism, the ‘Prebisch Singer hypothesis’ and so on, which held that primary products would tend to decline in price relative to manufactured products. The latter part of this period was the one in which the realisation became widespread that the (apparently) easy gains in living standards of the post-war boom were gone, and in which pessimism about Australia's economic future was probably at its most intense. It was also the period when, under strong political leadership backed by a highly capable bureaucracy and an economically literate media, our determination to press on with various productivity-increasing reforms was greatest. That these two phenomena occurred together was probably not entirely a coincidence.

The third feature is the current level of the terms of trade relative to everything but the all-time peaks over the past century. Measured on a five-year moving average basis, and assuming (as we do) some decline in the terms of trade over the next few years from this year's forecast peak, the terms of trade are as high as anything we have seen since Federation.

To give some perspective on how important this is, let me offer one back-of-the-envelope calculation. The export sector is about one-fifth of the economy. The terms of trade are at present about 60 per cent higher than their average level for the 20th century, and about 80 per cent higher than the outcome would have been had they been on the 100-year trend line. This means that about 12–15 per cent of GDP in additional income is available to this country's producers and/or consumers, each year, compared with what would have occurred under the average or trend set of relative prices over the preceding 100 years (all other things equal). That will continue each year, while the terms of trade remain at this level.

Of course, part of this income accrues to those foreign investors who own substantial stakes in the mineral sector. In this sense, the current boom is a little different from the early-1950s one where most of the income went first to Australian farmers. Nonetheless, a good proportion accrues to local shareholders and employees, and to governments via various taxes. A non-trivial part of it is available to consumers as higher purchasing power over imports, as a result of the high exchange rate.

... On all the indications available, we are living through an event that occurs maybe once or twice in a century.

Stevens then moves onto what should be done. This, he argues, depends on whether the higher income that accrues from a higher terms of trade is long lasting or fleeting.

If the rise in income is only temporary, it would be desirable not to raise national consumption by very much. Instead, it would make sense to allow the income gain to flow into a higher stock of saving, which would then be available to fund future consumption (including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future). Moreover, it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices (and which could come at the cost of reduced investment in other areas).

If the change is likely to be persistent, then income is likely to be seen as permanently higher. Households and most likely governments will probably see their way clear to lift their consumption permanently, both of traded and non-traded goods and services. Structural economic adjustment will also occur as the sectors whose output prices have risen, now being more profitable, will seek to expand, in the process attracting productive resources – labour and capital – away from other sectors whose output will decline as a share of GDP. Australia's floating exchange rate, which tends to rise in line with the increase in the terms of trade, helps the reallocation of labour and capital by giving price signals to the production sector. The higher exchange rate also speeds the spread of the income gains from the terms of trade rise to sectors other than the resources sector, by directly increasing their purchasing power over imports. The resulting rise in imports spills demand for tradable goods and services abroad, which helps to reduce domestic inflation.

All sounds hunky dory, but there is of course a sting in the tale as I summarised in an earlier post.

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's major concern (as Henry argues above in relation to the Dutch Disease) is with a temporary rise in the exchange rate. This is a problem because the rise in the exchange rate may be long enough to force businesses in other sectors of the economy to the wall so that in the wash-up, resource demand is not sustained and important sectors of the economy are then diminished. In contrast, a sustained rise in the terms of trade will lead inevitably to a change in the structure of the economy as investment and people shift into mining and associated industries. This may still cause problems in the future as the economy becomes less diverse and less able to deal with an eventual collapse in the terms of trade.

As Stevens notes in relation to structural change:

It is easy, of course, to speak in the abstract of ‘reallocation of productive resources’, but this means that some businesses and incomes become relatively smaller; jobs growth in some areas slows even as in others it picks up. Some regions struggle more than others. Some sources of government revenue are adversely affected even as other sources see an improvement. This process will be seen, not unreasonably, as costly by those adversely affected, even though the overall outcome is that the country as a whole is considerably better off. (It is also obvious that, if the terms of trade change really is only temporary, it may not be worth paying these adjustment costs from the perspective of the overall economy.) The policy challenge for governments will be whether to help these sectors resist change, or to help them adapt to it.

In other words, interpretation of the sustainability of the current boom matters a lot!

Stevens argues we could try to keep the structure of the economy the same and resist changes, but correctly points out that would be stupid. We wouldn't want an economy dominated by agriculture as it was in the immediate post-war period and for a most of the time before that (gold booms notwithstanding). Remember the fate of wool, which was for so long our most important export and that now is not even in the top 25!

So if the terms of trade do remain fairly high for a lengthy period, the task is going to be to facilitate structural adjustment so as to make it occur in as low cost a way as possible. But that ought to be feasible given that overall income is considerably higher.

Of course we cannot know whether the terms of trade will be high for a long period. History certainly would counsel caution in this respect. We do know that supply of various resources is set to increase significantly over the years ahead and not just from Australian sources. It is for this reason that we assume some fall in commodity prices over the next several years. The assumption underlying the Bank's forecasts published a few weeks ago is that iron ore prices fall by up to about 30 per cent over the next several years. Even if they do, the terms of trade will remain quite high by the standards of the past 100 years in the near term.

Is that assumed fall realistic? There is no way of knowing. Larger falls have happened before. In fact they have been the norm. On the other hand, experienced people seem to be saying that something very important – unprecedented even – is occurring in the emergence of very large countries like China and India. If the steel intensity of China's GDP stays where it is already, and China's growth rate remains at 7 or 8 per cent for some years to come, which appears to be the intention of Chinese policy-makers, then the demand for iron ore and metallurgical coal will rise a long way over the next couple of decades. If India's steel intensity goes the same way as most other countries have, that will add further. Even with allowance for supply responses by other producers and considerably lower prices than we see today, that seems to point to a prominent role for the resources sector, broadly defined, over a longish horizon.

So the most prudent assumption to make might be that the terms of trade will be persistently higher than they used to be, by enough that we will need to accommodate structural change in the economy, but not by so much that we shouldn't seek to save the bulk of the surge in national income occurring in the next year or two, at least until it becomes clearer what the long run prospects for national income might be.

Stevens then explains that Australians are indeed currently saving more than they have for quite some time (hence the poor retail figures out today). "The net saving rate is now seen at some 9–10 per cent of income over the past year or two, up from about −1 per cent five years ago." There's nothing like a crisis to make people more cautious, especially given the fact that Australian households are more indebted than most other countries in the world and certainly vastly more than they ever have been in history.

Stevens speech makes clear that Australia and much of the rest of the world economy are increasingly dependent on China. Why this is not seen as more of a problem never ceases to amaze me! The assumption appears to be that China's growth will continue onward and upward and that India will join China and then surpass as it is better suited demographically for longer-term growth (i.e. more young people).

Given China's growing importance for the much of the world economy and certainly for Asia, there are also increasing indirect effects of Chinese growth on Australia. Our second biggest export market is, like us, more and more tied into Chinese growth. As Rintaro Tamaki, Japan's Vice-Minister of Finance for International Affairs, said: "We are not suffering from excess Chinese imports. We have a complementary relationship. We export parts and China re-exports the assembled products. So when China's exports increase, Japan's exports to China also increase." What this also means is that when China's exports decline, Japan's exports will decline helping to exacerbate the impact of a China slowdown on Australia. The same goes for South Korea as well, which also is increasingly tied into Chinese growth.

Now I don't want to sound too much like a negative vibe merchant here. While Australia remains vulnerable to changes in international demand and to international financial supply (just as it has done throughout its history), the most likely scenario for Australia over the next 20 years is, unsurprisingly, a variable (but higher) terms of trade, meaning a variable national income. Stevens thinks this too:

In the longer term, the economy's increased exposure to large emerging economies like China and India (these two now accounting for over a quarter of exports) – assuming that continues – may also pose important questions. If these and other emerging economies continue to grow strongly on average, but also, as with every other country, still have business cycles, the result may be the Australian export sector, and therefore the Australian economy, having a potential path of expansion characterised by faster average growth in income, but with more variability. That possibility has been noted by some observers. It is worth recording that such concentration would hardly be unprecedented – think about the dominance of Japan in Australia's trade in the 1970s and 1980s, or the dominance of the United Kingdom in an earlier era. Nonetheless, the degree of concentration could be higher than we have seen in the past decade or more, which was a time of considerable stability for the Australian economy overall.

Its probable that China and India will continue to grow rapidly for the next few years and at a slowing rate over the medium term, but it is unlikely that this growth path will be smooth. Capitalism generally means booms and busts. To think that growth will be smooth shows an enormous faith in the ability of the Chinese Communist Party to manage China's state capitalist economy. There is a beautiful irony in the faith that many economic liberals have in Communist economic managment skills! The thing that I think is unlikely is a 20 year boom, which implies no busts. For this to occur would mean that Australian history holds no lessons for Australia whatsoever. It would also mean that economics would have finally trumped politics. If I was a gambling man (and I am) I wouldn't bet my house on it (fortunately I don't own a house). There are just too many potential intervening variables for Chinese and Indian growth to be smooth! Maybe it's because I'm a poli sci major, but ultimately politics rules.


Given the likeliness of variability what should Australian policy-makers do? One solution would be to simply accept variability and deal with the fall out. Indeed this is probably the most likely outcome given the seeming inability of recent Australian governments to think beyond the short term.

But trying to save some of the income would be a better solution, using the proceeds of the boom to fireproof the Australian economy into the future. This would be a good solution regardless of whether the boom is temporary or more long-lasting or a series of boom-busts.

One of the ways of doing this would be to create a sovereign wealth fund like Norway has, which would mean the proceeds of the boom would be invested offshore. The foreign investment out of Australia achieved by a SWF would also help to slow the rise in the Australian dollar from a booming economy and would provide a store of savings for when the terms of trade were lower.

Stevens expresses the case slightly more esoterically:

Another approach would be to reflect the higher income variability in our saving and portfolio behaviour rather than our spending behaviour. We could seek to smooth our consumption – responding less to rises or falls in income with changes in spending and allowing the effects to be reflected in fluctuations in saving. In the most ambitious version of this approach, we could seek to hold those savings in assets that provided some sort of natural hedge against the variability of trading partners, or whose returns were at least were uncorrelated with them. Of course, such assets might be hard to find – the international choice of quality assets with reasonable returns these days is a good deal more limited than it used to be.

It is possible that this behaviour might be managed through the decisions of private savers. There might also be a case for some of it occurring through the public finances. That would mean accepting considerably larger cyclical variation in the budget position, and especially considerably larger surpluses in the upswings of future cycles, than those to which we have been accustomed in the past. There would also be issues of governance and management of any net asset positions accumulated by the government as part of such an approach, including whether it should be, as some have suggested, in a stabilisation fund of some sort. [He means here a SWF].

Of course if the China boom turns to a bust in the short- to medium-term then I get the feeling all talk of SWFs will be soon forgotten. Let's hope that we keep debating whether it'd be a good idea.