Credit Code Red
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These departures from prudence were primarily the responsibility of the banks, but the Commonwealth government was also involved, in that it failed to use its powers to curb excessive borrowing. However, it cannot be denied that a surge in consumption demand, though undesirable from a long-run point of view, did serve the immediate purpose of extricating Australia from the 1990 recession.
This raises an important question. How would Australia have recovered from the 1990 recession if prudential regulation had curbed the increase in overseas borrowing and the increase in consumption that it financed? The answer is that the recovery would have been slower. A government pursuing a prudent restructuring policy would have contented itself with a slower increase in living standards, accompanied by a greater level of domestically financed infrastructure investment, including a greater reliance on public investment.
There would have been less private borrowing (both by households and banks) and more government borrowing, including the issuing of government bonds secured against infrastructure investments. If necessary, financial-sector institutions, including superannuation funds, would have been required to hold such bonds — although, in the context of a higher national savings rate, it is likely that the market would have absorbed the bond issues. Again, the finance sector may have been required to be more active in lending to businesses, particularly to companies taking advantage of opportunities created by the enhanced infrastructure investments. In these ways, prudence would have tied finance more closely to productive investment.
It is not for nothing that the virtue of prudence includes the shrewdness to seek and sift the evidence relevant to decisions, and the willingness to learn — including the willingness to abandon preconceptions. Is it too much to hope that political parties will rediscover this virtue and apply it in the pursuit of a more widely distributed prosperity?
Averting or surviving catastrophe
We do not want to be gloomy. We value the Australian achievement of a prosperous, egalitarian, multicultural society, but are acutely aware that the neo-liberal turn has underpinned policies that threaten these achievements. Our gloom is not new; for three decades, we have been concerned for the long-term future of Australia. As Keynesians, we could see that neo-liberal economics, however brilliant it may be as a theoretical construct, is so far removed from reality that it provides a very poor guide to policy. We were unimpressed by the stock-exchange and commercial-property booms of the late 1980s, by the housing boom of the 2000s, and by the mismanaged mineral boom of 2005–2012; we were conscious of the growth of household debt and international debt that accompanied them. We are on record; we published our concerns (in publications such as Beyond Meltdown). Countries can live dangerously for a while, but there always comes a reckoning.
For three decades, we have argued that Australia’s neo-liberal economic reforms, however appropriate as short-term fixes, will bring catastrophe unless modified. The core neo-liberal countries, the United States and the United Kingdom, are already stricken, and the crisis of the Washington Consensus has exposed the fragility of the economic truce that is the European Union. The indicators are all set for Australia to join them in economic catastrophe. As at the end of 2016, we discern two credible alternative scenarios for the Australian economy over the next five to seven years. Both are painful. The first involves the long grind of a severe and lasting recession. The second is more dramatic: it begins with an attempt to muddle through that brings on a financial catastrophe, including a banking collapse and default on overseas debt, which in turn provides the opportunity for radical economic reconstruction. We also cover a third scenario, which, given the current state of Australian politics, we do not consider at all likely. This involves radical economic reconstruction without the cost of catastrophe.
We now consider these scenarios in more detail.
#1: Recession
Since the Second World War, Australia has suffered five recessions: in 1952–53, 1961, 1974–75, 1982–83, and 1990–91. All of them were induced by the policy authorities using various combinations of fiscal and monetary policy to reduce demand. Two of them were implemented to dampen unsatisfactory levels of inflation, while the remaining three resulted from rapid deteriorations in the current-account deficit, which raised the alarm that Australia might run out of foreign exchange and default on its interest and debt repayments. Fear of this type of economic catastrophe forced the Commonwealth government to choose what was then seen as the lesser of two evils — an induced recession that would cut demand for imports and so release cash flow to service overseas loans. The precautionary recessions of 1952–53 and 1961 were implemented by cuts in government expenditures and increases in taxes, complemented by ‘credit squeezes’ that restricted the ability of the banks to make loans. Under the financially deregulated regime of 1990–91, the main instrument to curtail demand was interest rates, with the 90-day bill rate reaching 18 per cent in 1989.
As the Australian treasurer might have said in 1990, these were ‘recessions we had to have’, because there was no other way in which the foreign exchange required to service overseas debt could be quickly and reliably generated. Repeatedly, the Australian public and media failed to understand this; they lacked the imagination to look beyond each recession to the greater disaster that the recession forestalled. All that they could see was that the government of the day had deliberately induced a recession, and they blamed the government for it — more so in 1961 than in 1954, and even more so in 1990. Two factors affected this decay of the public imagination: the loss of living memory of the Great Depression of the 1930s, and the spread of the neo-liberal delusion that markets self-regulate and that balance-of-payments crises are therefore impossible, provided governments leave well alone.
Though it fell to government to precipitate a precautionary recession in 1952, 1960, and 1990, it is always possible that the private sector may initiate a recession that falls short of a full catastrophe. After all, recessions and catastrophes are matters of degree. The banks could bring about a recession by imploding, though it would be very difficult to prevent such implosion from degenerating into catastrophe. Alternatively, the overseas investors who finance the roll-over of Australian debt could require that the Reserve Bank of Australia restore the risk premium over United States interest rates that applied prior to the mining boom. In such an event, Australian interest rates through 2018 and beyond would approach 4 per cent, which by itself would induce a sharp downturn in the economy.
The banking sector — the very sector that, by its imprudent borrowing and lending, has caused Australia’s economic fundamentals to head in a Code Red direction — is aware of this deterioration, and is calling for a precautionary recession. The sector is not so politically naïve as to call directly for a recession; instead, it is urging governments to rapidly reduce their budget deficits by cutting expenditure, including by cutting public-investment and welfare payments. In this spirit, the American ratings agencies, with their neo-liberal obsession with the level of government debt, continue to give Australia AAA credit status, but are puzzled to find that the country’s strong government balance sheet is matched by a weak, over-borrowed private-sector balance sheet. They foresee a ‘low probability’ that foreign lending to Australian borrowers might collapse, and are using this to pressure the Commonwealth treasurer to bring the government budget into surplus, involving tax increases and cuts to social-security payments, not to speak of cuts to education and health services.2
In other words, the spokesmen for Australia’s creditors are already demanding that the standards of living of the population at large should be suppressed in order to cut imports and so release foreign-exchange earnings so that the country can meet its overseas obligations.
A suppression of living standards and increases in unemployment do indeed reduce imports more than exports, and yield a current-account surplus with which to repay overseas creditors. However, the transfer of fu
nds is not always straightforward. In Australia’s case, the problem will be to transfer the flow of funds saved to the banks so that they can repay their debts to their overseas creditors. Some of this transfer will be achieved as households repay their debts to the banks, but with increased unemployment there will be many who will fail to repay. As in the 1990 recession, the banks will be anxious to increase the spread between their lending rates and their cost of funds, and to increase their other charges to cover the cost of these bad debts. They will also be anxious to maintain the value of their portfolios of mortgages, and will be calling for continued immigration and overseas property investment to maintain land values.
Over the next couple of years, as the structural fundamentals of the economy continue to worsen, the calls from overseas lenders and the rating agencies for austerity policies will reach a crescendo. As has been shown in Europe, austerity policies focussing on the government budget deficit are efficacious in bringing on a recession that will, by curtailing imports, release foreign exchange to service overseas debt. The finance sector will blame the recession on the government; it will claim that the recession would have been avoided had the government not allowed its budget to go into deficit in the years following the GFC, thus drawing attention away from the true cause of the recession, the three-decade-long flood of imprudent overseas borrowing by the banks.
The record of precautionary recessions in addressing the structural weaknesses that underlie the Australian propensity to over-borrow overseas is far from encouraging. The recessions of 1952–3 and 1961 did not direct attention towards the need for investment to strengthen the balance of payments, while the recession of 1991 left the financial sector free to resume its imprudent loan policies, now tweaked towards mortgages. Worse, the main political effect of precautionary recessions has been that the media and the opposition (of either party) have blamed the recession on the short-term actions of the government of the day. The effect has been to allow the economic system to continue unreformed. This was certainly the case for the 1991 recession. In 1954 and in 1961, the government of the day was only re-elected because of the lucky coincidence of there being severe political divisions in the opposition. Given these experiences, governments are understandably reluctant to precipitate precautionary recessions, and are therefore inclined to trust to luck and continue with business as usual, even if a Code Red alert is imminent.
To identify an Australian economic crisis that in the long run strengthened the economy, one has to go back more than a century. The economic crisis of the 1890s was caused by much the same factors as are currently pushing the Australian economy towards catastrophe. The responses to that crisis included radically changed economic policies (including a strong government presence in the new national economy that resulted from Federation) and an infusion of prudence into the weltanschauung of the banks. These reforms help to explain why Australia, on balance, maintained its prosperity despite drastically unfavourable external circumstances during the first half of the twentieth century and why it responded with alacrity to the improved world economy of the 1950s and 1960s.3
This is not to argue that it would be wise to return to the Federation settlement. However, a financial and political system that is biased towards crisis is in need of fundamental reform. The depth of this need can best be assessed indirectly by asking a simple question: how severe a precautionary recession is required, in current circumstances, to head off catastrophe? This question can readily be addressed by using our baseline projection. How much should demand be contracted in the economy to rein the Code Red warning back to a moderate danger rating? The answer is that the current-account deficit on the balance of payments would have to be replaced by a current-account surplus. The decline in GDP necessary to achieve a surplus would have to be considerably more severe than what occurred during the 1991 recession, simply because the load of debt is now much heavier. (In 1991, the ratio of gross debt to GDP was less than 50 per cent, with an annual borrowing requirement of around 25 per cent.) As a result of this load of debt, demand would have to be contracted from baseline levels sufficiently to produce a trade surplus of around 2 to 3 per cent of GDP, this being the surplus required to offset the income deficit in the capital account. In turn, this would require a decline in GDP of approximately 5 per cent, which would have to be held stable for at least three years after the onset of the recession. The greater the loss of export capacity and import-competing capacity between now and the crisis, the greater the contraction in GDP required to achieve the trade-surplus target.
The high interest rates required to bring on a precautionary recession are not only attractive to the Australian banks as a source of funds to counter the bad debts inseparable from recession; they are also attractive to overseas lenders, and would underpin continued lending and hence prevent the plunge in the exchange rate that characterises financial breakdowns in over-indebted countries. Despite these attractions, both the banks and the overseas lenders are afraid that efforts on their part to initiate a precautionary recession might spin out of control into a catastrophic depression. They will, accordingly, try to get the government authorities to initiate and control the recession.
However, the chances that an Australian government will induce a precautionary recession today are near zero, since the political parties know that the penalty for inducing a severe recession would be exclusion from office for at least a decade. Perhaps they will take heart from the December quarter of 2008, when the national government faced a Code Red crisis. That government was lucky to escape catastrophe, thanks to the actions of other governments (particularly the Chinese government), which, it should be said, were influenced by the actions of the Australian political leadership on the international stage. Indeed, all governments that responded to the GFC with stimulus packages were no doubt driven by the fear that they would be held responsible for the rise in unemployment. To some extent, they made their own luck — and then spoilt their collective luck by switching too rapidly to austerity policies.
#2: Allow business to continue as usual
Given this history, Australian governments, fearing that they will be blamed whatever happens, will be inclined to let the economy slide till catastrophe occurs. As in 2008, Australia could opt to hold to a steady course despite deteriorating indicators, in the hope that market forces, or luck, will turn the economy around. The hope that market forces will overcome over-indebtedness without a recession is based on neo-liberal theory, which predicts that a deterioration in the balance of payments will cause a reduction in the exchange rate that, in turn, will unleash such a rapid turnaround in the balance of trade that Australia’s debts can readily be serviced. In more practical terms, the neo-liberal-based expectation is that a fall in the Australian dollar to the mid-50–mid-60 US cent range will drive a rapid growth in exports.
This expectation is nonsense. It is true that a fall in the exchange rate would provide the opportunity to resume growth in tourism and education exports, where capacity exists or can readily be created to increase supply. It would benefit rural industries battling the adverse effects of climate change, though there is not much hope of a dramatic increase in supply. It would have the major benefit of keeping in operation some manufacturing capacity that otherwise would have closed, as well as bringing back into production some capacity that had been mothballed rather than scrapped. However, all this would represent only a small step towards what would have to be achieved — namely, large-scale reinvestment in Australia’s non-mining export and import-competing industries. The high exchange rate generated by market forces over the last decade has seriously damaged confidence in the non-mining trade-exposed industries, and it will take many years of sustained low exchange rates for investors to regain the conviction that they can manage the risks inseparable from such investments. Not only will it take time for confidence to recover; the creation of additional capacity in many of these industries is a slow process, involving product
development as well as the construction of manufacturing and marketing capacity.
In technical terms, this means that the so-called J-curve negative effects of a devaluation will be large and lengthy. In the short to medium term, as the exchange rate falls, the current-account deficit will increase, not decline. In particular, the investment required to achieve a long-term reduction in the current-account deficit will have a significant import content. Worse, it was learned in the 1980s that an exchange-rate fall can, in some industries, so increase the costs of capacity expansion as to nullify the direct competitive-advantage effect of the reduced exchange rate. This is particularly likely to be the case for highly capital-intensive industries, and also reflects the cost of hollowing out the manufacturing sector over the past two decades. However, a devaluation-driven increase in inflation can be guaranteed to reduce real incomes and hence demand and imports, even if it stops short of generating another spiral of cost inflation.
Ideally, the current-account deficit would be addressed by transferring consumption from import-intensive purchases, such as overseas travel and motor vehicle transport, to low-import consumption, such as education and health services. However, the scope for this is limited by the availability of acceptable local substitutes for imports. If an economy does not have the capacity to substitute local products for imports, it cannot expect much short-term benefit from a devaluation, other than to reduce demand via price impacts that reduce real incomes. This was one of the reasons, over the second half of the 1980s, for the Labor government of the day introducing a wide range of industry incentives for export expansion and import replacement that, in the context of a low exchange rate, set the scene for a rapid expansion in manufactured exports over the 1990s. Unfortunately, the Coalition government that took office in 1996 dismantled many of these programs, and stood back while the Australian dollar became over-valued.