Austerity v Keynesianism

John Quiggin has a short article in Crikey on the economic theories supported by Rudd and Abbott and makes the excellent point that:

The only major governments to undertake and sustain Keynesian fiscal stimulus were those of China and Australia. Supporters of the classical view have sometimes argued that Australia’s stimulus had no effect, and that our economy was rescued by strong demand from China. This amounts to the nonsensical claim that fiscal stimulus in China was effective enough to provide a substantial flow-on benefit to Australia, but that fiscal stimulus in Australia had no effect.

Quiggin also contends that Labor has conceded too much ground to the austerity argument:

The stimulus package introduced in 2009 included, quite appropriately, a strategy for a return to surplus as the economy recovered. Unfortunately, after committing to an optimistic timetable, former treasurer Wayne Swan treated the return to surplus as an end in itself, not a tool of macroeconomic management. This effectively conceded the ground in the macroeconomic debate to Abbott and the opponents of Keynesian stimulus.

To win the election Rudd needs to move beyond attacks on the specifics of Abbott's policies (or the lack thereof). He must explain why the Keynesian and social democratic policies he espoused and implemented in his first term as PM are the right way forward for Australia, and why the Howard government policies of consistent surpluses, regardless of economic conditions, represent a recipe for disaster next time there is an economic crisis.

Abbott, he contends, is a committed austerian:

Although Abbott presents himself as favouring "practical solutions to practical problems" rather than "market theory", his position is derived from the "classical" free-market economic theory that held sway before the Great Depression, and was revived as "New Classical economics" in the 1980s. In the classical view, recessions and depressions in a market economy are self-correcting. Government attempts to stimulate the economy can do no good, and may do positive harm by "crowding out" more productive private investment.

Well worth a read.

 

 

The Economic Structure Debate

The RBA Governor Glenn Stevens made a speech in Brisbane today, basically arguing that virtually all of us benefit from the mining boom and that we better get ready for interest rate increases!

The first is that the impact of the resources sector expansion does get spread around, in more ways than might immediately be apparent. Obviously mining employs only a small share of the workforce directly – less than 2 per cent. But to produce a dollar of revenue, companies spend about 40 cents on acquiring non labour intermediate inputs, primarily from the domestic sector. Apart from the direct physical inputs, there are effects on utilities, transport, business services such as engineering, accounting, legal, exploration and other industries. It is noteworthy that a number of these areas are growing quickly at present.

Once the costs of producing the output and other factors – such as taxes – are taken into account, the remaining revenue is distributed to shareholders or retained. While a significant proportion of the earnings distributed goes offshore, local shareholders also benefit. In fact, most of us are shareholders in the mining industry through our superannuation schemes. We don't get this income directly to spend now – it is in our superannuation. Nonetheless, it is genuine income and a genuine increase in wealth.

A good proportion of the earnings retained by companies is used to fund a further build up of physical investment, which imparts demand to construction and manufacturing. Based on the industry liaison the Bank has done, around half – give or take – of the demand generated by these projects is typically filled locally, though, of course, this amount varies with the nature and details of any specific project.

So there are effects that spill over, even though it is not always easy to spot them. In the end the combination of the resources sector strength and all the other factors at work in the economy has, to date, produced a national rate of unemployment of around 5 per cent, and in Queensland only a bit over 5 per cent. There are regional variations in unemployment rates, but at this point these look comparable to what has been seen at most times in the past 10 years – a period that has seen both lower average unemployment rates and lower variation in unemployment rates than the preceding decade.

While it is this section of the speech that will attract attention, I'm more interested in his arguments about economic structure. Currently there is an important debate going on about the nature of the current boom and whether it will be sustained or not. In other words, will Australia's income continue to be boosted by Chinese (and general Asian) demand for our resources long into the future or will this boom like all others in Australian history be followed by a bust.

The most important statistical measure of this is the terms of trade discussed regularly on this blog. See Boom, Boom, Boom and Keep on Booming.

Right now Australia's terms of trade  is the highest it's been (on a 5 year average basis) since the Gold Rushes of the nineteenth century. So really it's at the highest level ever for Australia as a Federation. The purple trend line provides a good indicator for why many Australian policy-makers thought we were in deep trouble in the 1980s and 1990s because the things we were selling were declining in value and the things we were buying were increasing in value. Since then as the yellow line makes clear the opposite has occurred although most of the steep ascent is due to increasing prices for the things we sell, particularly iron ore and coal.
Stevens argues that there are two components to the China boom - cyclical and structural:

[T]he industry make-up of our economy is continually changing. While this is often a slow process – almost imperceptible in most years – these shifts have been significant over time. There is little doubt that trade-exposed manufacturing firms not linked to the resources sector are facing tough conditions at present. But many people might be surprised to learn that the peak in manufacturing's share of Australia's GDP was in the late 1950s – more than five decades ago. Its fastest rate of relative decline, so far, was probably in the second half of the 1970s. On the other hand ‘business services’ – including things such as accountancy, legal and numerous other services – have grown fairly steadily and now are credited with more than twice the share of GDP of manufacturing. Several of these sectors are being boosted by the flow-on effects of the resources boom at present.

As for the mining sector itself, its share of GDP has tended to rise since the late 1960s, having been quite low in the mid 20^th century. But in 2010, the mining sector's share of GDP was still only about the same as it was in 1910. It will surely increase noticeably over the next five years, though will remain much smaller than it was in the gold rush era.

Again, none of this is to deny that there are differences in performance by industry and region. It is simply to give some perspective on what we see.

The point about long term shifts reminds us to look beyond the immediate conjuncture, and to think about the magnitude of the event through which we are living. For a good part of the change in our terms of trade is a manifestation of a large and persistent change in global relative prices. Let me be clear here: there is a cyclical dimension to the China story, and it is important that we remember that. But there is also a structural dimension. And the associated change in relative prices constitutes a force for significant structural change in the economy. I think we have all only begun to grasp its implications relatively recently.

One of the major ways that the mining boom affects economic structure is through the exchange rate. A higher dollar is great for travelling overseas, but not so great for Australian non-resource exporters (including the domestic tourism and education industries) or import competing industries.

For as well as conveying a rise in purchasing power to consumers, the high exchange rate is exerting a powerful force for structural change. I think we are seeing this in the retail sector. The rapid growth of internet commerce – from a very small base – has been the topic of considerable discussion. This was bound to happen anyway with technology. But with the higher Australian dollar, the component of the retail ‘product’ that is added in Australia – the local distribution and retailing overheads that are required to provide the retail ‘experience’ – has become both much more visible, and much higher relative to the production cost of the good itself. So the incentive for the consumer to avoid those overhead costs has increased quite noticeably. The retail sector is therefore under pressure to reduce those costs. 

Finally, Stevens correctly reminds us that the problems of structural change that we face are better than the problems of many other advanced economies where unemployment is high and growth anaemic. While we might complain about a 2 speed economy, it's much better than a no-speed economy!

Predictions of Doom 2

Nearly all posts about the potential for doom in the Australian economy revolve around housing, either directly or indirectly. The best writers on potential housing trauma are Leith van Onselen who writes a brilliant blog backed by reasoned argument and a myriad of data (some of which I had referred to in my book so I know it's right!!). Other excellent doomsters are David Llewellyn-Smith and Delusional Economics. All believe that Australian house prices are over-valued and that household debt is a real problem for Australia. If you are inclined towards bearish sentiments about housing then these writers will seriously make you worry. While the housing market is obviously very important I want to focus on some bigger picture variables that will undoubtedly affect not just the housing market but the wider Australian economy.

Now the point is no one really knows what will happen to the Australian economy this year but we do know what factors will matter. Former RBA governor Ian Macfarlane once argued that if you only had one variable to understand the Australian economy then the variable you would choose would be the international economy. But the problem with this simplistic (but reasonably accurate) scenario is that the variable itself has changed. In other words the international economy as a variable affecting Australia has changed. The part of the international economy that matters most for Australia is now China and Asian generally. It would have seemed absurd 10 years ago to have a US economy in severe crisis and the Australian economy to be experiencing a boom, but the Chinese economy has changed the global economy enormously.

But as I've written continually the real question for Australia is how the sub-variable China is affected by the wider variable of the international economy, which is still dominated by the Western economies, despite the rise of the developing world over the last 20 years or so. Can China continue to grow in 2011 if the US and Europe remain affected by financial woes and hamstrung by low growth. This is the so-called de-coupling debate.

I've written previously about decoupling. Indeed I wrote in January last year that:

2010 will provide some further evidence for the long-running debate over decoupling. The financial crisis bolstered the anti-decoupling case as world financial markets were universally shaken by events in the United States. Since this time, however, the decouplers' argument has looked more sound as some began to talk of a North Atlantic financial crisis rather than a GFC. Certainly, Asia did well in 2009 compared to what many thought lay ahead at the end of 2008. Govt stimulus in China has helped enormously, but even in China this can't go on forever.

No doubt we shall get further evidence about whether China and the rest of Asia is ultimately as export dependent as economists like Stephen Roach contend and whether the issue of final Western demand really does continue to matter.  

Well it looks like the 2010 evidence is that decoupling had some legs over the course of last year, but at the risk of taking liberties on extensions (and to mix the metaphor) I think that the jury is still out. 2011 will provide further evidence because recent US tax cuts notwithstanding, the impact of fiscal stimuli throughout the world will be further unwound and the need to pay off debts will continue. Debt really is the thing to watch in 2010, not just public debt as the media wants to focus on, but household debt as well, not to mention the seemingly forgotten problem of foreign debt.

As David Barbosa writes in the NYT (via Michael Pettis):

For nearly two years, China’s turbocharged economy has raced ahead with the aid of a huge government stimulus program and aggressive lending by state-run banks. But a growing number of economists now worry that China — the world’s fastest growing economy and a pillar of strength during the global financial crisis — could be stalled next year by soaring inflation, mounting government debt and asset bubbles.

Now this is a common theme of China bears but Pettis is even more bearish:

I have almost no doubt that during 2011 all the growth expectations are going to be revised sharply downward. By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.

Do I believe these lower numbers? Not really. About a year and a half ago I wrote in a Financial Times article that, assuming consumption growth could be maintained at 8-9% a year, Chinese GDP growth would average 5-7% annually over the rest of the decade.

My prediction caused a lot of strong disagreement and accusations of being overly pessimistic, but the truth is I think I was being optimistic. If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range. But I do think the consensus next year will migrate down to the 6-7% range, even though next year’s growth should remain high – probably in the 9% range.

Barbosa argues that Chinese problems will have significant ramifications for the rest of the world economy (a reversal of the traditional Western-led 'coupling' or 'globalisation' argument).

A sharp slowdown in China, which is growing at an annual rate of about 10 percent, would be a serious blow to the global economy since China’s voracious demand for natural resources is helping to prop up growth in Asia and South America, even as the United States and the European Union struggle.

And because China is a major holder of United States Treasury debt and a major destination for American investment in recent years, any slowdown would also hurt American companies.

Pettis does not agree with Barbosa that a slowdown in China will be bad for the world or for the US:

I am not sure why Chinese holdings of USG bonds suggest that a Chinese slowdown will hurt US companies, but I have already explained why I do not think a sharp slowdown in Chinese growth is necessarily bad for the world. It will be very bad for commodity exporters – or at least non-food commodity exporters, since I think the demand for food from China will continue strong – but the overall effect on the rest of the world depends on the evolution of China’s trade balance. A contraction in the surplus creates net demand for the world, and so might even be marginally positive.

This marginally positive outcome won’t be evenly distributed, of course. Non-food commodity exporters will be badly hurt, while commodity importers and manufacturers will benefit.

I don’t even think such a rapid slowdown in Chinese growth will be bad for China. Again it depends on how it takes place. If there is a serious attempt at rebalancing the economy by raising wages, interest rates and the currency, China can manage a much slower GDP growth rate while still maintaining a fairly high growth rate in household income and consumption. I discussed this in more detail in an entry last month.

Non-food commodity exporters obviously means Australia (although we do export food as well).

Pettis then provides some notes on what is worth watching in 2011. Wisely he does not call them predictions.

First, although I do not believe inflation [in China] is going to be as big a problem as many think (I believe the Chinese financial system has a built-in inflation-stabilization mechanism – see my November 18 entry), if I am wrong and inflation continues to rise, this will create a real problem for monetary policy.

Second, debt levels are worryingly high and are starting to act as a serious constraint on the rebalancing process. My friend Victor Shih at Northwestern University has done great work in trying to figure out the government balance sheet, and he worries, correctly, in my opinion, that it is becoming increasingly difficult for the PBoC to raise interest rates without creating a great deal of financial distress in government-related entities. Even the PBoC balance sheet is a real problem. How can they raise RMB interest rates without running a huge negative carry?

Third, the trade constraints are going to get worse, not better. Ashoka Mody and Franziska Ohnsorge have a very interesting piece on Vox that suggests that we shouldn’t count too heavily on consumption growth in the developed world to boost global demand. That means we are going to spend the next few years fighting over anemic demand growth, and we will be apportioning that demand via trade disputes.

Fourth, although GDP growth rates next year will be very high to see off the current leadership, I am pretty sure that by the end of the year there will be much more concern about the rebalancing process and what that will mean for growth rates. In order to get those high growth rates, I don’t think we need to take the 2011 lending quota too seriously. Whatever it is, it will be breached.

Another China-focused economist is Andy Xie who argues:

By the middle of 2011, most analysts may declare that the world has finally put the financial crisis behind.

The reality is quite different. The global economy is kept afloat by massive monetary and fiscal stimulus around the world. The main problem in the global economy – high costs and declining competitiveness in the developed world, and inflation plus asset bubbles in the developing world continue unabated. Either inflation in the developing world or unsustainable sovereign debt in the developed world will spark the next crisis.

...

The most likely candidates to trigger the next global crisis are the U.S.'s sovereign debt or China's inflation. When one goes down first, the other can prolong its economic cycle. China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.'s trade deficit can drop dramatically, maybe by 50 percent, due to lower import prices. It would boost the dollar's value and bring down the U.S.'s treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

This coming year is China's opportunity.

The best way for China to deal with inflation, according to Xie, is to address its property bubble.

China's inflation problem stems from the country's rapid monetary growth in the past decade. That is due to the need to finance a vast property sector, which is, in turn, to generate fiscal revenues for local governments to finance their vast expenditure programs. Unless something is done to limit local government expenditure, China's inflation problem is likely to get out of control.

The government now recognizes inflation as the country's main challenge. It has raised interest rates once, deposit reserve ratios several times, and announced its intention to introduce price controls. The barrage of unconventional measures is due to the belief that China's economy is different from others and the conventional measure of raising interest rates may not be effective or necessary. The reluctance to change the price of money and the willingness to change the price of goods and services has not worked well so far.

...

The ineffectiveness of the recent measures casts doubts on the government's sincerity in fighting inflation. The constant and marginal policy announcements could be interpreted that the inflation fighting is now largely a propaganda job. Such perceptions could spark popular panic, which would cause the household sector to hoard goods like rice and cooking oil. When the masses flee from holding money, a full blown crisis will unfold.

So at the beginning of 2011, we are in a similar position to the start of 2010. Debates about China will produce much heat in Australia, the real question is whether they'll produce any light. For what it's worth I think that economic liberal commentators have too much faith in the Chinese Communist leadership to manage the Chinese economy without booms and busts. While China will probably continue to grow rapidly over the medium term, the belief that it can continue to grow uninterrupted by poor policy decisions and the reality of economic cycles is pure fantasy.

I also have no doubt that by this time next year we'll have a clearer position on the debates about globalisation and decoupling and about the ability of Australia to profit from a long-term mining boom.

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.