Twelfth or Eighteenth? Measuring Australia's Economic Weight

No one could accuse Australia's politicians and economic bureaucrats of being shy or inscrutable when it comes to analysing the Australian economy. Treasury and the Reserve Bank provide regular commentary on the current state and future prospects of the Australian economy and make a wealth of statistical information freely available.

Some commentators argue that Treasury and the Reserve Bank of Australia are too optimistic about Australia's economic prospects, but having read most of the commentary that has been produced in recent years by economic policy-makers I think that there is a certain amount of hedging going on. The RBA Governor says that "Australia's glass is at least half full".

At the most basic level, policy-makers are optimistic because they believe that current shift of economic weight to China and emerging economies generally will continue indefinitely into the future. In other words, the belief is that future performance will be consistent with past performance.

Members of the Gillard government, as you would expect, are also regular contributors to economic debate hoping that advertising the success of the Australian economy will reverse the government's poor showing in opinion polls.

Treasurer Wayne Swan recently noted that Australia was now the world's twelfth largest economy and that during Labor's period of office it had moved up 3 places, whilst during the Howard government's tenure it lost 3 places.

In the past five years Australia’s economy has surpassed the economies of South Korea, Mexico and now Spain. Our economy has grown around 11 per cent since the end of 2007 while the US has grown only around 1¾ per cent and many European countries are still substantially smaller due to the massive recessions they have suffered. Inhabiting a place among the top dozen largest economies on the planet is particularly impressive when you consider that we have only the 51st biggest population.

This is a truly impressive performance, but one of the reasons we've improved our ranking is because of the appreciation of the Australian dollar against the US dollar. In 2007, the Australian dollar averaged 83.89 US cents compared to an average of 103.43 cents in 2012 up to the 12th October.

If economies are measured on a USD exchange basis, then if a country's currency appreciates against the USD then the economy 'increases' in size as well. 

If the Australian dollar were to fall substantially over coming years, other things being equal, the 'size' of our economy would also decrease.

This US dollar exchange measurement, therefore, is clearly only a partial way to measure the real size of economies, let alone wealth or development.

Swan bases his projections on the IMF's World Economic Outlook Database, the latest of which has just been released. The figures for 2012 are estimates, obviously, and the IMF provides further estimates out to 2017.

An alternative way of measuring the size of economies is by purchasing power parity (PPP). According to Vogel:

A purchasing power parity (PPP) is a price index very similar in content and estimation to the consumer price index, or CPI. Whereas the CPI shows price changes over time, a PPP provides a measure of price level differences across countries. A PPP could also be thought of as an alternative currency exchange rate, but based on actual prices.

A PPP index provides a way to convert national accounts to a common currency - called Geary-Khamis or international dollars - based on purchasing power. GDP is adjusted to reflect different costs of living and production within different economies. As most travellers and international investors know, goods and services and production costs are considerably lower in some countries than they are in others. The most widely known index is The Economist's Big Mac Index and there is an iPod Index as well. Both are gross oversimplifications of PPP.  

If we consider the top 20 countries on PPP and USD terms we get vastly different results.

The IMF calculates the GDP share of the total for every economy on a PPP basis, but the USD figures have to be constructed. For both tables I have ranked countries on the basis of their 2012 'results'.

China is half the size of the United States on a USD basis compared to a little over three-quarters on a PPP basis. Measured by PPP, China is estimated to overtake the United States by 2017, but on a USD exchange basis it would still remain substantially smaller (21.3 per cent of the total for the US and 14.3 per cent of the total for China in 2017).

The IMF only makes estimates out to 2017, but the general impression is that China is inevitably destined to overtake and then leave the United States in its wake.

According to the latest PPP estimates for 2012, India has passed Japan as the world's third largest economy, although in terms of the USD measurement its economy remains less than half the size of the Japanese economy and only 10th overall only 2 places above Australia (2.7 per cent compared to 2.2 per cent of the total).

In 2017 (PPP), India is projected to leave Japan behind, although it will still only be a third of the economic weight of China. Australia falls slightly to 1.1 per cent of the total.

In 2017(USD), India will be 6th, just behind Brazil. Australia will move to 13th one place behind Indonesia.

Since 1990, Japan has fallen rapidly down the league table of economies as more than 20 years of slow growth and recession have taken their toll. The World Bank online databases only go back to 1999 and projections were only made at this time for one additional year, but we can be reasonably sure that projections based on past performance would have had Japan challenging the United States for supremacy in the 1990s based on 1980s performance.

Paul Krugman, writing in 1994, noted that: “at the growth rate of 1963-73, Japan would overtake the United States in real per capita income by 1985, and total Japanese output would exceed that of the United States by 1998!”.

While China and Japan have profoundly different political economies, assertions about inevitability and irreversibility seem to have a horrible habit of coming unstuck.

Australia is twelfth, as Swan suggests, in terms of the USD measurement, but 18th on PPP terms, just behind Iran. With the recent collapse of the Iranian currency, it is unlikely that Iran will score so well on a USD basis in coming measures.

Recently, Secretary to the Treasury Martin Parkinson argued that Australia now has a smaller economy than Indonesia's, but this is only true if measured via PPP. In terms of USD it still has a smaller economy than Australia's (2.2 per cent of the total compared to Indonesia's 1.3.

Based on current projections Indonesia will have a slighter larger economy than Australia's in terms of US dollar exchange in 2017. Of course this might well change if the Australian dollar falls relative to the US dollar in coming years, as it probably will. This relativity will depend as well on what the Indonesia rupiah does against the US dollar in the next few years.

Over time, of course, PPP indexes must also be recalculated and these undertaken by the International Comparison Program of the World Bank. As economies develop, the costs of living and production increase, making even PPP comparisons problematic at best and inaccurate at worst.

It suits Wayne Swan to use the USD exchange measurement - twelfth sounds much better than eighteenth - and it suits Parkinson to use PPP to make his points that emerging economies are now a much more important part of the global economy, and that Indonesia might leave us behind if we don't improve our productivity and tax system.

What this all means is that measures of economic weight should be taken as indicative rather than absolute and that future projections should carry the same warning as investment products that "past performance is no guarantee of future results".

Economic 'progress' is another thing entirely and we need to consider measures such as GDP per capita, human development and environmental sustainability to get a more accurate picture of the state of play.

For GDP per capita, the distinction between the two methodologies is significant with Australia ranking 6th on a USD exchange basis and 15th on a PPP basis in 2011.

On the Human Development Index, which includes a range of including life expectancy, literacy, education and GDP per capita, Australia ranks second behind Norway. In the 2011 HDI rankings, China came 101st, Indonesia 124th and India 134th.

Improvements in productivity - the efficiency of labour and capital - and an egalitarian distribution of the fruits of that productivity are what matters for the long-term. Getting our policy-makers and the wider population to realise that the two are not contradictory is the short-term challenge.

United States Debt: Who Buys It?

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US debt purchases have become an important story in the world political economy and a symbol of supposed US powerlessness in the face of a relentless Chinese ascendancy. I think this equation is overdone and instead think that the fact that the Chinese feel obliged to buy US debt as a sign of continued Chinese weakness in their economic structure rather than strength. But it undoubtedly is a complicated debate.

But let us at least get a few facts on the table.

The first is to look at figures for the purchases of US Treasury Securities from an article by Floyd Norris of the NY Times: "For a Change, U.S. Debt Is Staying in the U.S."

The most interesting fact is that Americans themselves are now buying most of this debt. This is not unusual. Most of Japan's debt for example is bought by the Japanese themselves. This amounts to what Hugh Stretton calls "borrowing from ourselves" and therefore removes foreign risk. It also helps to keep interest rates lower.

According to Norris:

Before the financial crisis struck in 2008, neither Americans nor private foreign investors showed much eagerness to finance Washington’s deficits.

In calendar year 2007, the Treasury borrowed a net $237 billion. Of that, 81 percent came from foreign governments, mostly from central banks. Private foreign investors took up the rest, as American companies, banks and individuals reduced their combined Treasury holdings by $13 billion.

In the first six months of this year, the Treasury numbers indicate that foreign governments reduced their holdings of Treasury securities by $10 billion. Not since 2000 — when the United States government was running a surplus and did not need additional funds — have foreign governments been net sellers for a full calendar year.

But then again in a globalising financial world, Norris notes also that often it is not exactly clear who the buyers may be:

The figures are estimates by the Treasury and are subject to substantial revision. And they need to be interpreted with caution, because they do not necessarily reflect the ultimate ownership of securities. Holdings of a London-based money manager are attributed to Britain, even though that manager’s clients could live in New York, Hong Kong or Paris.

The trend, however, is clear:

Over all, domestic investors purchased more Treasuries than did overseas ones — including foreign governments — in 2009 and again in the first half of this year. Those purchases came as government borrowing rose to pay for bailouts and recession-related spending.

By contrast, during the six years from 2002 — the first year that the United States ran a significant deficit after the years of surpluses — through 2007, three-quarters of the $1.7 trillion in new borrowing came from abroad, with $1 trillion of that coming from foreign governments.

In the two and a half years since the end of 2007, the Treasury has raised twice that amount in new money, $3.5 trillion. More than half of that came from American companies and individuals, double the proportion they contributed in the earlier period.

Still more than 46 per cent of debt is held by foreigners, down from 46 per cent in 2008:

Even with those increased domestic purchases, 46 percent of the publicly issued Treasury debt is held overseas. That is down from 49 percent in early 2008, just before the financial crisis began, but it is way above the 31 percent proportion at the end of 2001.

The figures also don't include debt bought by the Federal Reserve itself, which involves a notion called quantitative easing, colloquially known as "printing money"

The figures exclude Treasury securities owned by the Federal Reserve or other United States government agencies. As a result, Fed purchases and sales are not counted.

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.

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"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.

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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.