by Peter Brain
It is inevitable that these policies would, in the short term, slow the rate of economic growth. However, increased investment in areas that strengthen the competitiveness of the economy would mean that strong trade-driven growth is not implausible in the 2020s, while simultaneously generating reasonable expectations that the current-account deficit will be returned to sustainable levels so as to restore and maintain the confidence of foreign investors.
To do this, expenditures on physical infrastructure, research, education, training, and industry development would be sharply increased, while social expenditures would also be increased to ensure that lagging regions and medium-income to low-income households who have not greatly benefitted from the debt-driven wealth boom of the last two to three decades are not further impacted. A necessary quid pro quo would be increased taxation on high incomes and in favoured regions.
The industry-development instruments would focus the tax rate by offering tax concessions in the form of (1) investment grants, accelerated-depreciation, and industry-modernisation incentives for strategic industries that are or will be important for the required export expansion or import-replacement efforts; (2) export-market-expansion assistance; and (3) assistance for research and development, and for innovation commercialisation.
In order to create resources for expenditure increases within the balance-of-payments constraint to growth, an overall target rate of GDP growth of between 1.5 and 2.0 per cent would need to be adopted, while private consumption would be controlled and private savings increased by:
Relatively high interest rates (maybe not much higher than currently) to puncture the housing bubble and so release resources from dwelling construction while encouraging household savings, partly by increasing the reward to savings, but mainly by reducing access to credit for consumption and by deflating household nominal wealth (and expectations of capital gains) by reducing housing prices; and
Increases in high-end marginal tax rates and the rapid scaling-back of high-income tax expenditures such as negative gearing and superannuation, along the lines currently being debated by members of both major political parties.
The impact on the unemployment rate could be softened by substantial cutbacks to the immigration rate, and by the expansion of working-age social-security support. The impact on the housing market would create an interlude in which housing policies could be revised to overcome the failure of existing policies, based on mortgage lending, to increase housing supply while maintaining affordability.
The main objective of this strategy would be to increase the household discretionary savings rate to between 5 and 10 per cent of household income after income tax and superannuation. This savings increase would make possible a reduction in reliance on foreign savings in the form of reductions in the current-account deficit. It would also finance the reductions in government savings (increase in government borrowing) that would be necessary to drive the increased allocation of resources to infrastructure and education. This is the exact opposite of current mainstream proposals to arrest the drift towards Code Red by reducing government consumption and investment expenditures, presumably to allow current levels of household consumption and private (mainly dwelling) investment to be maintained.
In its 2016–17 budget, the federal government proposed to improve the medium-term competitiveness of the economy by the simple expedient of reducing company tax rates over the next decade. This policy is inefficient compared to the proposed alternative, especially since most of the benefit would flow to foreign equity-holders and bring an immediate and direct increase in the current-account deficit. Worse, nearly 30 per cent of the benefit to domestically owned companies would accrue to finance-sector corporations, at least until such time as their profits were diminished by recession or disappeared in catastrophe. This is the one sector where further expansion has no hope of making any positive contribution to the required restructuring.
This said, it may be granted that any credible plan to return Australia to stable prosperity will involve a reduction in the effective corporate tax rate. However, this is most effectively done by ensuring that the tax cuts are limited to businesses that invest in improving Australian competitiveness. Tax concessions should therefore be limited to businesses that undertake the types of industry-development expenditures outlined above, while leaving the statutory tax rate unchanged.
Conclusion
Economic catastrophe brought about by excessive overseas borrowing is, thankfully, an unusual event, but it is by no means impossible. Over the past forty years, such catastrophes have occurred in over thirty countries, in some of them more than once. Australia suffered a catastrophe due to over-borrowing in 1890 and again in 1930, though it is arguable that the 1930 plunge in GDP was not due so much to Australian over-borrowing as to economic mismanagement in the United States and other North Atlantic countries.
For each economic catastrophe due to over-borrowing, hindsight reveals clear warnings that were ignored at the time. When a country’s GDP plunges and its creditors suffer defaults, all parties regret that they did not take heed earlier. To highlight the dangers we have prepared a set of crisis risk alerts, not as prophecies of doom but to draw attention to weaknesses that require attention if catastrophe is to be avoided.
Recent studies by the European Commission, the International Monetary Fund, and others have identified a number of warning signals, not as portents of inevitable collapse, but rather as measures signalling avertable danger. Building on these studies, which identify the major source of potential catastrophe for Australia as its overseas over-borrowing, we have identified two summary indicators that measure the current distance from the threshold of catastrophe: the year-ahead foreign-exchange-cover ratio, and a crisis-risk indicator that summarises the macroeconomic indicators watched by overseas lenders. The foreign-exchange-cover ratio measures the availability of defensive funds with which the authorities can counter any disruptive loss of confidence by Australia’s creditors, while the crisis-risk indicator summarises macroeconomic variables that, over the past three decades, have portended breakdown in medium-sized indebted countries.
Much like bushfire warnings, these indicators can be rated to show the level of danger and hence the appropriate type of action needing to be taken to evade them. When the warning signal reaches Code Red, meaning that a catastrophe is more likely than not during the next five years, nothing short of emergency action will stave off the crisis. Indeed, it may be better to treat the crisis as inevitable and use it as an opportunity to re-structure the economy for better performance over the coming decades.
Bushfire warnings change hour by hour. Vulnerability to economic catastrophe changes less rapidly but can certainly alter considerably over the course of a year. Not only is the level of alert likely to change; it can also be forecast. We have accordingly supplemented the warning level based on current indicator values with two other warnings:
A warning based on the future indicator values generated in conventional five-year economic projections similar to those included in Australia’s Commonwealth budgets; and
A warning based on an assessment of whether current economic policy is calculated to ameliorate the level of vulnerability or worsen it.
By late 2016, the risk of breakdown within the next five years was moderate — say, around 15 per cent — but the trend was adverse. Taking into account the likely actions of the United States government over the next few years, we expect the indicators to reach Code Red status by 2021 or thereabouts. This reflects our assessment that current Australian economic policies are set to worsen the nation’s level of vulnerability.
There would not be much point in us issuing these alerts if nothing can be done about them. We have identified three strategic scenarios that might ensue, but we fear that the only one offering the prospect of a low-cost, long-term solution is the one least likely to be pursued. The authorities will either
engineer a pre-emptive recession, which is likely to be long and deep, yet ineffective in bringing about the needed structural reforms, or they will hope for the best (while quietly expecting the worst) by allowing business to continue as usual, and will hence court disaster — at which point they may find the courage to address the real issues. The third scenario is to set about wide-scale economic restructuring that will have upfront costs but which, after a few years of purposeful savings and investment, will result in a much sounder Australian economy.
It remains to be seen whether the Australian political system has the resilience to consider prudential restructuring as an alternative to recession or catastrophe. The signs are not good; the vested interests whose economic status would be threatened by reform are rapidly learning the dark arts of political paralysis from their American mentors.
This means that catastrophe may be inevitable. In this case, the real tragedy will be if a chastened Australia fails to respond by abandoning outdated ideology and restructuring its financial system — indeed, its whole economy — for greater resilience and sustainable prosperity.
Appendix
The role of financial deregulation in the accumulation of debt
In Chapters 3 and 4, we argued that financial deregulation was responsible for Australia’s excessive accumulation of household debt and overseas borrowing, in that it removed constraints on the sale of new debt to households and on borrowing from overseas. In this appendix, we provide a more technical demonstration of the relationship, based on flow-of-funds data.
We have calculated the impact of financial deregulation on the increase in gross foreign debt using a flow-of-funds model of the economy that documents the relationship between five financial subsectors (the Reserve Bank, other banks and deposit institutions, pension and insurance funds, other financial institutions, and investors from the rest of the world) and three non-financial sectors (general government, households, and non-financial corporations). Since 1988, the Australian flow-of-funds statistics, published as part of the National Accounts by the Australian Bureau of Statistics, have estimated the annual flow of funds, via transactions in financial instruments, between each of the five defined financial subsectors and the three non-financial sectors. These data allow the estimation of the average inter-sector financial-flow coefficients that applied between 1988 and 2015. The average pre-1985 structure of financial flows can then be substituted into this model, based on the flow-of-funds data published by the Reserve Bank for the years from 1953 to 1985.
Taking the net lending of the three non-financial sectors as given, total gross foreign debt excluding equity investment can then be calculated for the post-deregulation years, using the 1953–85 coefficients and compared to actual gross foreign borrowing. The difference is 43 per cent of GDP, which may be interpreted as an estimate of the increase in gross foreign debt that has resulted, so far, from the change to the structure of the Australian financial sector wrought by financial deregulation. This is a little less than half the increase in gross foreign-debt liabilities, the other half being largely due to continuing current-account deficits.
Acknowledgements
This book would not have been possible without the dedicated public service of officers of the Australian Bureau of Statistics, particularly those who work on the National Accounts. The bureau is under constant budgetary attack by people who would rather remain in ideological ignorance. We trust that our readers will give it political support whenever they have the opportunity.
Within the National Institute of Economic and Industry Research, special thanks are due to Jane Cunningham for her work on the analysis of National Accounts data. Thanks are also due to Sonja Mazurkiewicz for secretarial assistance, and to Scribe’s publisher, Henry Rosenbloom, whose editing considerably improved the readability of the text.
Among our mentors, we are particularly grateful to John Nevile (University of New South Wales), J.E. Isaac (University of Melbourne), C.T. Kurien (Madras Christian College), and Max Neutze (Australian National University). It is not their fault that economics retreated into ideology during the 1980s. We hope that this book will help to nudge the discipline back towards the reality which they so capably represented in their work.
Notes
Introduction
1 G. Monbiot, How Did We Get Into This Mess?, London, Verso, 2016, p. 3.
2 For the fundamentals of the framework, see P J Brain, The Macroeconomic Structure of the Australian Economy, Melbourne, Longman Cheshire, 1986; for a brief account, see P Brain and I Manning, ‘An overview of the national, state and regional modelling system’, National Economic Review No 66, September 2011, pp. 1–13. Forecasts have been published regularly in Natonal Economics conference and working party documents and in the National Economic Review. National Economics is the trading name of the National Institute of Economic and Industry Research (NIEIR).
3 P J Brain, Beyond Meltdown, Melbourne, Scribe, 1999, p. 206.
4 M Grubb, Planetary Economics, London, Routledge, 2013.
Chapter 1: Economic breakdown as a threat to prosperity
1 R J Barro and J F Ursua, ‘Macroeconomic Crises Since 1879’, National Bureau of Economic Research working paper 13940.
2 Op. cit.
3 C M Reinhart and K S Rogoff, This Time is Different: eight centuries of financial folly, Princeton, Princeton Uiversity Press, 2009, p. 280.
4 European Commission occasional paper 92, 2012, ‘Scoreboard for the surveillance of macroeconomic imbalances’. Statistical values for the indicators discussed in this chapter are available on the National Economics website, nieir.com.au.
5 EC staff working paper, 2012, ‘Completing the Scoreboard for the Macroeconomic Imbalance Procedure’.
6 EC staff working paper, 2015: ‘Adding employment indicators to the scoreboard of the macroeconomic imbalance procedure to better capture employment and social developments’.
7 Data to support the following assessments has been generated by the ABS (especially Cat 5204.0 and Cat 6203), with a summary available on the National Economics website.
8 Reinhart and Rogoff, p 280.
Chapter 2: Financial deregulation
1 P J D Wiles, Economic Institutions Compared, Oxford, Blackwell, 1977, p. 321.
2 I Manning, Incomes and Policy, Sydney, Allen and Unwin, 1985.
3 ACTU/TDC Mission to Western Europe, Australia Reconstructed, Canberra, AGPS, 1987.
4 Wiles, op cit., p. 322.
5 Names associated with the Austrian school include E Böhm Bawerk, L von Mises, and F Hayek. The latter’s cri de coeur, which was written under the shadow of Hitler and Stalin, and emotively mistitled The Road to Serfdom (originally published 1944, with numerous editions since), condemns all forms of economic planning as lying on a slippery slope towards authoritarian government. The book has curiously little to say about how authoritarianism equates to serfdom, in which the mass of the population become debt-slaves, or about the threat that financial systems may impose debt-slavery on their borrowers.
6 P Lawrence, QE 64, comment on ‘The Enemy Within’ by Don Watson, Quarterly Essay 64, p. 86.
7 J B Gewirtz, ‘The Cruise that Changed China’, Foreign Affairs, November–December 2016, pp. 101–9.
8 For the story of this transition, see G Hand, Naked Among Cannibals, Sydney, Allen and Unwin, 2001.
Chapter 3: Financial deregulation and household debt
1 Strictly comparable estimates are not available — see RBA occasional paper no 8, table 3.2.
2 For data, see www.nieir.com.au/credit code red
3 ASX Australian share price movements, 1982 to date.
4 M Kohler and M van der Merwe, RBA bulletin 9/15, p. 21.
5 M Gizycki and P Lowe, ‘The Australian Financial System in the 1990s’, paper presented at an RBA conference, 2000, p. 181.
6 National Economics, S
tate of the Regions 2013–14, report for the Australian Local Government Association, 2013, chapter 8.
Chapter 4: Financial deregulation and overseas debt
1 EC 2002, p. 11.
2 Op. cit., p. 10.
3 T Kryger, Australia’s foreign debt, data and trends, 2009, table 9.
4 2016 estimate from ABS National Accounts, national balance sheet.
5 Paul Keating on ABC Lateline, 1 October 2008; more recent RBA analysis has tended to downplay the problems at the big four banks, see D Rogers, ‘Credit Losses at Australian Banks 1980–2013’, RBA discussion paper 2015–06; also Gizycki and Lowe 2000 (op cit.).
6 Hand, 2001.
7 R Belkar, L Cockerel, and C Kent, ‘Current Account Deficits, the Australia Debate’, RAS discussion paper, 2007, p. 15.
8 P J Brain, Beyond Meltdown.
Chapter 5: Australia under credit watch
1 An alternative treatment would be to add bank overseas holdings of short-term assets, discounted for their hedging function, to official holdings of overseas reserves. We have elected to subtract them from the borrowing requirement, because this focusses attention on the adequacy of official reserves. To make this allowance, we discount bank overseas holdings by the ‘hedging ratio’, defined as the ratio of bank holdings of foreign financial assets (discounted by 80 per cent) to foreign liabilities excluding foreign-equity liabilities. This increased from 20 per cent in 1996 to a third in 2007, fell to a quarter in 2010, and climbed back to 36 per cent in the final quarter of 2015.
2 L A V Catao and G M Milesi-Ferretti, ‘External Liabilities and Crisis’, IMF working paper, May 2013.
Chapter 6: Crisis vulnerability over the next decade