The Australian Economy in 2012

When the world economy recovered strongly in 2010, many commentators believed that the great recession was over. In Australia, we still have commentators who fully dismiss that there was any need for action to bolster the Australian economy during 2008 and 2009. This is despite the fact that government guarantees kept the banks afloat (no thanks from the banks for that now), the Reserve bank's monetary stimulus bolstered mortgagees' spending power and Treasury's fiscal stimulus bolstered confidence just at the right time.If you have a look at the graph below you will see that the world economy contracted during this period - an unusual event - and the Australian economy did not.

Successful fiscal stimulus is a bit like averting a terrorist attack. People don't really appreciate what might have been if the action to avert the problem had not been taken.

The subsequent reinvigoration of the Chinese economy through government action also acted to bolster the economy further in 2010, making many people argue that there was no value in the building of school facilities that followed. Anyone who has a child at school or goes to a university will realise that there have been some marvellous facilities built that will benefit students far into the future. The Building the Education Program may have been rushed and it may not have been an effective form of fiscal policy, but it was in the main an effective piece of infrastructure development in Australia.

One building company owner in South Australia made it clear to me that without the prospective work, layoffs would have been significant in his company. So we've been doing fairly well, despite some real and significant problems associated with structural change in the Australian economy.

The Reserve Bank is a prolific publisher of research and its key figures regularly give speeches on the state of the Australian and world economies. Phillip Lowe, the Deputy Governor, gave a speech this morning on "The Forces Shaping the Economy Over 2012.

The first thing to note is that the world economy is expected to do worse than thought in September 2011. Most forecasts have been revised downwards in recent times.

But compared to 2009, this is still a good performance. Europe remains the major problem. According to Lowe:

Working through the various challenges is taking the Europeans time. The process has been frustratingly slow and we have witnessed some missteps along the way. But for all of that, we should not lose sight of the fact that progress is being made. Late last year there was a palpable sense that something might go badly wrong over our summer. Clearly, that has not happened. Instead, government bond yields for some of the troubled countries in Europe have declined a little (Graph 2). Equity markets have picked up and confidence has improved a bit. And significantly, bank debt markets are functioning again, although the cost of issuing bank debt, relative to government yields, is higher than it was in the middle of last year.



Lowe notes that one of the problems for 2012-13 is the fact that many countries are undergoing fiscal consolidation at the same time, providing a significant drag on growth, although he doesn't want to sound too much like a booster.  

Over 2012 and 2013, fiscal policy is set to be quite contractionary in both Europe and the United States as governments attempt to put their public finances on a sounder footing. Indeed, the aggregate fiscal contraction across the advanced economies is likely to be the largest seen for many decades. This is not because the size of the fiscal consolidations in individual countries is unprecedented, but rather because the consolidations are occurring simultaneously in a large number of countries. Unusually, they are also taking place in an environment where output in the affected countries is considerably below potential.

The economic literature is mixed on the effects of fiscal consolidation on growth. There are certainly some examples where consolidation has been associated with fairly strong GDP growth. But in most of these examples, the countries undertaking the fiscal consolidation have benefited from some combination of robust growth in their trading partners, an easing of monetary policy and a depreciation of their exchange rate. Given the nature of the current situation, it is unlikely that the advanced economies, as a whole, can benefit from these factors. There is therefore a material risk that fiscal consolidation weakens growth in the short run, which leads to more fiscal consolidation in order to meet previously announced targets and, in turn, yet weaker growth. We are currently seeing this dynamic play out in a couple of the countries in southern Europe. If it is not to be repeated on a wider scale, the fiscal consolidation in the North Atlantic economies will need to be accompanied by reforms to the supply side that lift the underlying rate of growth of these economies.

In other words widespread fiscal contraction provides a big risk of a negative spiral and a long period of stagnation. All of which is going to be exacerbated by continuing household and wider private sector deleveraging.

The US is increasingly being seen more positively, but it might be too early to open up the champagne just yet.

The US is paying off debt more quickly than many other countries as a recent McKinsey report noted.

Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse

The report argues that the US is further down the path of deleveraging than Spain or the UK, but the default part of the equation is perhaps no reason to be jumping for joy. McKinsey bases their assumption on a historical trend line of increasing debt and argue that the US may be half way through the deleveraging process.

But think about it this is a trend line from 1955. Eventually the trend line will reach 130% of GDP, perhaps by 2040, which would mean deleveraging during the 2050s could involve a decline from an above trend 140% of GDP ... or whatever. The point is the assumption of an ever-expanding trend line is a furphy. Credit really takes off in the early 1980s with financial liberalisation and the massive expansion of credit that followed. Believing the trend line would mean accepting that eventually. perhaps by 2100, that household debt at 200% of GDP was sustainable.

Comparison with deleveraging in Sweden after their severe financial crisis is quite illuminating. It also makes clear that the UK and Spain also have a long way to go before their episodes of deleveraging are finished.

But anyway the report is well worth a read, just to see why this period of economic stagnation may be a long one. For a look at some comparable figures on Australian household debt see here.

Lowe downplays the impact of China  in the speech:

The Chinese economy is also continuing to grow solidly. The pace of growth has slowed, but it has done so in line with the authorities’ intentions. Inflation in China has also moderated. Across the rest of east Asia, the recent data have been mixed. Nevertheless, for the region as a whole, growth in 2012 is expected to be around trend, with domestic demand likely to play a more important role in generating growth than it has for most of the past two decades.

Let's hope his anodyne assessment is correct.

Lowe then moves to the Australian economy and notes the significance of the once in a lifetime investment that is happening right now.

As you can see from the graph the projected level of investment is huge, belying the regular scare-mongering from the resources sector.

But as many of you will now know this investment has been heavily concentrated in the resource sector and is part of the equation leading to a higher exchange rate.

 

I used to amuse students with stories of the Australian dollar at around 1.50, which seemed rather ridiculous at the turn of the millennium when it hovered around 50%.

Given the importance of the RBA in managing the Australian economy it is worthwhile considering how they see these developments.

The effects of the high exchange rate are evident in the manufacturing, tourism and education sectors, as well as some parts of the agriculture sector and, more recently, in some business services sectors. With the exchange rate having been high for some time now, more businesses are re-evaluating their strategies, as well as their medium term prospects. In some cases, this is prompting renewed investment to improve firms’ international competitiveness. But in other cases, businesses are scaling back their operations in Australia and some are closing down. These changes are obviously very difficult for the firms and individuals involved.  

Both the investment boom and the very high level of the exchange rate are historically very unusual events. This makes it difficult to assess their net effect. It seems, however, that over the past year these forces have balanced out reasonably evenly. 

In other words, don't worry, be happy. While it was slightly cool to be a pessimist before the crash it's now much cooler to be an optimist as a range of recent articles and books have pointed out.

Debt, Inequality and Financial Crises

Paul Krugman is a figure of hate for the right in American politics. He is a liberal in the American sense of the word. But he is also an intelligent economic liberal, which means that he realises the benefits of markets and the necessity of government intervention.

In a recent blog post he counters views that he only talks about the Bush property bubble, while ignoring the Clinton stock bubble.

Except I did. Actually, back then the WSJ editorial page was flogging Dow 36,000 and telling readers that anyone who had doubts about the level of stock prices must hate capitalism.

Beyond that, there are some real differences between the Bush and Clinton bubbles.

One is that Bush presided over only four years of job growth, 2003-2007 — and those were all bubble-driven years. Clinton presided over eight years of job growth, with job growth at roughly equal rates in the first and second halves of that eight-year period, and the Internet bubble inflated only in the second half.

Another difference, which is really crucial, involves the debt implications. Here’s non financial debt, public plus private, as a percentage of GDP.

Have a look at those years of debt growth and which Presidencies they are associated with. 

One of the arguments that I find most interesting about the growth of debt, beyond the significance of financial liberalisation, is the clear association of increasing debt with income stagnation.

During a period of income stagnation households increase their level of debt to maintain their living standards or to keep up with new consumption norms (often based on the consumption patterns of those on upper income levels).

Another interesting argument is that higher inequality might, therefore, be an important factor in creating the conditions for financial crises.

Michael Kumhof and Romain Rancière in Finance and Development argue that

Long periods of unequal incomes spur borrowing from the rich, increasing the risk of major economic crises.

The United States experienced two major economic crises over the past 100 years—the Great Depression of 1929 and the Great Recession of 2007. Income inequality may have played a role in the origins of both. We say this because there are two remarkable similarities between the eras preceding these crises: a sharp increase in income inequality and a sharp increase in household debt–to-income ratios.

Kumhof and Rancière argue that there are two major policy options for governments to deal with high levels of household indebtedness.

There are two ways to reduce ratios of household debt to income.

The first is orderly debt reduction. What we have in mind here is a situation in which a crisis and large-scale defaults have become unavoidable, but policy is used to limit the collateral damage to the real economy, thereby leading to a smaller contraction in real economic activity. Because this implies a much smaller reduction in incomes for any given default on loans, it reduces debt-to-income ratios much more powerfully than a disorderly default. Still, a long-lasting trend toward higher debt-to-income ratios resumes immediately after the debt reduction, because workers continue to have a reduced share of the economy’s income.

The second possibility, illustrated in Chart 4, is a restoration of workers’ earnings—for example, by strengthening collective bargaining rights—which allows them to work their way out of debt over time. This is assumed to head off a crisis event. In this case, debt-to-income ratios drop immediately because of higher incomes rather than less debt. More important, the risk of leverage and ensuing crisis immediately starts to decrease.

Any success in reducing income inequality could therefore be very useful in reducing the likelihood of future crises. But prospective policies to achieve this are fraught with difficulties. For example, downward pressure on wages is driven by powerful international forces such as competition from China, and a switch from labor to capital income taxes might drive investment to other jurisdictions. But a switch from labor income taxes to taxes on economic rents, including on land, natural resources, and financial sector rents, is not subject to the same problem. As for strengthening the bargaining power of workers, the difficulties of doing so must be weighed against the potentially disastrous consequences of further deep financial and real crises if current trends continue.

Restoring equality by redistributing income from the rich to the poor would not only please the Robin Hoods of the world, but could also help save the global economy from another major crisis.

It certainly makes intuitive sense, irrespective of the economic modelling.  Mix easier access to credit with stagnating incomes and a culture of conspicuous consumption and you have a major factor in why the developed world is in crisis at the moment.

It also returns to my long-standing point that Australia's greatest generally unremarked vulnerability is our vulnerability to rising inequality. 

Inequality, not just poverty, does matter, and research like that above makes clear that it presents real dangers to economies as well as societies.


 

 

Sub-Standard and Poor in Cartoons

The reputation of Standard and Poor took a big hit when they rated toxic mortgage securities as AAA grade. They've now downgraded US debt from AAA to AA+, but US debt remains in significant demand despite the political crisis in the US.

These cartoons tell the story fairly neatly ...  and a Peanuts for good measure