FIVE APPROACHES TO RESTORING FULL EMPLOYMENT AND GROWTH
We can identify five approaches to the economic challenge facing Australia: ‘business as usual’, ‘austerity’, ‘budget stimulus’, ‘productivity growth’ and ‘real depreciation’. Any effective strategy will contain elements of more than one of these approaches, but it helps our understanding to separate them out.
Business as Usual
‘Business as usual’ is a continuation of what the authorities were doing from the time that the resources boom passed its peak in 2011 up to the middle of 2013. Budget policy is firm, with historically low real growth in expenditure. Taxation rates are presumed to stay as they are. On the assumption that growth soon resumes and continues at a bit above 3 per cent per annum, it is projected that the budget is back in balance in two to three years. Interest rates are reduced when economic growth is well below trend, the labour market is weak and inflation is in the target band of 2–3 per cent.
The presumption is that good times will return before too long; programmes to increase expenditure are introduced, so long as they have their main impact beyond the four years of the forward budget estimates.
Every six months there are new official forward estimates. Each of these since late 2011 has involved a large downward revision of revenue – for the current year and the several years beyond.
This puzzles official and most private analysts when the data first comes in. Then it is realised that the weak revenues are the result of economic growth being slower than expected, employment weaker than expected, average incomes lower than expected, inflation lower than expected. Company income tax is far lower than expected partly because incomes are lower for all of the above reasons, partly because export prices are low, and especially because the estimates greatly underestimate the size of the tax deductions attached to the resources investment boom. (The huge write-downs in estimates of revenue in the May 2013 budget and the August 2013 revisions mainly reflected receipts from company income tax and resource rent tax falling below expectations.)
Under the old ‘business as usual’, the Labor government made firm and unqualified commitments to securing a budget surplus a couple of years into the future. So, as disappointingly low revenue from a weakening economy showed up in the accounts, six-monthly statement after six-monthly statement, the government responded by announcing tax increases and spending cuts that would have their main effect in the later years of the four-year projections. The budget deficit was always a bit bigger than had been expected, and the return to surplus always remained about as far into the future as it had been when the resources boom started to recede.
There are Labor and Coalition versions of ‘business as usual’. Rhetorically, the Labor government was more cautious about cutting spending than the Coalition. However, in practice the Abbott Coalition government has accepted nearly all of the former government’s spending commitments, rejected some of its proposals for increased taxation, and added some tax cuts and expenditure increases of its own.
The new government’s promises to remove and reduce tax add up to a large unacknowledged long-term expansion of the ‘business as usual’ budget deficit. These promises – to remove carbon pricing and the Minerals Resource Rent Tax (MRRT), and to reduce the company tax rate and the fringe benefits tax on private motor vehicle use – all have increasing revenue effects over time, with their sum much greater beyond the four-year estimates.
Under ‘business as usual’, monetary policy is varied if inflation rates tend higher or lower than 2–3 per cent and the economy is unusually strong or weak. The exchange rate is left to find its own level. If other countries follow unusually expansive monetary policies (even as their real output growth per person comes to exceed Australia’s, as it has recently in Japan and the United States), we accept the higher exchange rate flowing from that. We also accept the higher exchange rate that comes from the central banks of other countries deciding for the first time to hold large amounts of Australian dollars (almost $100 billion to June 2013 by countries other than China and an unknown but large sum by the People’s Bank of China). We accept the loss of competitiveness that comes from rival resource suppliers artificially securing large reductions in their own exchange rates. Interest rates are lowered only after weakness in the economy and low inflation becomes apparent. This means the exchange rate will eventually fall, but may remain uneconomically high for a long period.
The Reserve Bank of Australia has been lowering interest rates behind the weakening economy since November 2011, so that by August 2013 the ‘cash rate’ reductions amounted to 2.25 per cent and the official rate was lower than it had ever been. The lower interest rates helped to bring down the exchange rate from early May 2013, but – because of the exceptional nature of monetary policy in larger developed economies – not by as much as might have been expected. The exchange-rate fall was partially reversed in early September when it became clear that the exceptional monetary expansion of the United States would continue for the time being.
In sum, the increase in activity from interest rate and exchange rate falls so far is helpful but too small to counteract the powerful contraction set in train by the decline in the resources sector’s contribution to the economy. The slow growth and deterioration in employment can be expected not only to continue, but also to feed on themselves. Economic weakness and lower interest rates will eventually see further falls in the Australian dollar.
The Treasury’s and Reserve Bank’s projections envisage a return to normal rates of growth of around 3 per cent per annum and of normal unemployment at about 5 per cent from 2015–16. In the forward estimates, stronger economic growth painlessly removes unemployment and the budget deficit. The forward estimates assume continuation of the exchange rate at the time they were prepared – the latest a few cents below the mid-September level. But what will generate new investment and other domestic spending under these settings as resources investment shrinks? What will generate the increased economic activity that re-establishes full employment and public revenue growth without a large fall in the real exchange rate?
Without real depreciation of the currency, it won’t be investment in the resources industries. It won’t be investment in the other export industries. It won’t be government expenditure under current budget settings. It won’t be consumption: household income is growing at historically low rates and there is no sign of a lower rate of savings.
There will be a contribution from increased resources exports, but this will not do much for economic activity or jobs. There will be a contribution from housing under the influence of low interest rates, but that will need to be monitored for the emergence of a bubble, and in any case it cannot carry the whole economy without creating risks in the external accounts.
‘Business as usual’ would be a good strategy if there were a reasonable chance of a return to trend rates of economic growth, low unemployment and budget surplus by 2016–17 without external payments pressures emerging. Regrettably, the Treasury and Reserve Bank projections are a clock face in which the hands have been moved to a new time without a locomotive mechanism.
It seems more likely that ‘business as usual’ will lead to a continuing deterioration in economic activity, employment and the public finances, at least through the four years covered by the forward estimates. In the absence of a large currency depreciation, I expect the budget deficit for 2015–16 and 2016–17 will be many billions of dollars larger than projected in the treasurer’s Statement of August 2013. Meanwhile, the new Coalition government’s highest-profile commitments worsen the budget problem beyond the four years and increase the challenge of making the required adjustments equitably. At the same time, none of its high-profile policy changes is structured to have a large positive effect on economic activity.
Austerity
The ‘austerity’ approach involves discretionary increases in taxation and structural spe
nding cuts in an attempt to balance the budget quickly. The former Labor government’s final economic and financial statements suggested that it would return the budget to surplus by 2016–17. Its practice in government had been to take steps in that direction and then to let the deficit stay high if revenue was disappointingly low. The new government hasn’t committed itself even nominally to a surplus in 2016–17. Its rejection of austerity is appropriate under the circumstances.
One can envisage forward-looking as well as immediate approaches to austerity – the former would focus on cutting back programmes that affect the structural deficit only in future years; the latter on early expenditures and tax rates.
Under austerity, economic activity would be weaker in the short to medium term. Budget revenues would fall further. Recession in the near term would be likely. This could then lead to a shift towards a ‘real depreciation’ approach, but maybe only after a long period of economic underperformance.
Budget Stimulus
Using the budget to stimulate the economy in the face of recession would involve large, early measures to stoke domestic demand. It would see the government respond to a deteriorating economy and rising unemployment with a version of the policies adopted in response to the Great Crash of 2008: increased commonwealth expenditure, and probably some tax cuts. The reduction of interest rates would be lessened and therefore would do less to lower the exchange rate if accompanied by an expansion of the budget deficit. A bigger budget deficit from stimulus would be counteracted to some extent by higher government revenue from the increased economic activity. So why not do it?
The binding constraint is Australia’s external accounts over the longer term. If we seek to return to full employment through greater spending – whether public through the budget or private through low interest rates – but without a large real depreciation, sooner or later the current account deficit and foreign debt as a share of the economy will blow out to unsustainable levels.
There are two good reasons to be cautious about an approach that requires increased foreign debt. First, average Australian spending and incomes are higher now than they are likely to be for a number of years. Increased debt would have to be repaid by future generations who may not be as well off as ourselves, still warmed as we are by the embers of the resources boom.
Second, our immediate external financial position is weaker now, after the peak of the China resources boom, than it was following the Great Crash. If we seek to restore full employment over the next few years simply by increasing spending, with no sustained improvement in international competitiveness, the current account deficit will rise to an unusual and risky proportion of GDP. This deficit was over 3 per cent of GDP in the first nine months of 2012–13: not exceptionally high by recent Australian standards, but uncomfortably large given likely developments in the years immediately ahead. The increased spending to return the economy to full employment will increase imports, while the large corporate tax deductions from the investment phase of the resources boom will be mostly paid out to overseas owners or lenders. Furthermore, the normalisation of global interest rates after their fall following the Great Crash will increase the costs of servicing Australia’s external debt and add 1 to 2 per cent of GDP to external payments. The net external-payments effect of the reduced resource investment and the increased expenditure that takes its place will cancel each other out. Total export volumes are unlikely to rise fast enough to offset the negative effects, especially since only a modest proportion of export receipts stay within the domestic economy.
Under these circumstances, Australia will have to finance a current account deficit that is high by historical and global experience, at a time of economic underperformance and when our international halo from the China boom is fading. There will be no prospect of doing this for long without increased costs of debt and without doubts arising about our capacity to service it. These factors will have their own negative effects on the economy.
This perspective contradicts an alternative view that still has considerable support in Australia: that the growth in export volumes during the production phase of the resources boom will solve our external payments and growth problems. There is nothing especially advantageous about mining over other exports unless prices are high enough to generate large economic rents that are collected for the public revenues. To the contrary, the high foreign components of resources production mean that the domestic contribution per dollar of exports is somewhat smaller than that of services, agricultural and manufactures exports.
As noted, the large increase in resource exports, especially after 2011, has been offset by the cessation of growth in other exports. And while the total volume of Australian exports can be expected to grow as new resource projects come on-stream over the next half a dozen years (perhaps by about 6 per cent per annum), this will not be an unusually high rate – not, for instance, as high as the average in the seventeen years of the Reform Era. It’s not an export boom in historical context.
A variation on the stimulus theme suggests that we increase domestic economic activity by government investment in productivity-raising infrastructure. The treasurer, Joe Hockey, has suggested that investment in infrastructure be increased to offset the decline in activity associated with the fall in resources investment. This is different from increased government consumption expenditure to the extent that the investment will lead to higher productivity growth in the economy as a whole than would otherwise be the case. If this condition is met, increased borrowing (and the extra will be foreign borrowing) will be a bit easier to secure on reasonable terms, in turn making it easier for future Australians to repay. It is more reasonable for contemporary Australians to ask their successors to service a debt if it arises from expenditure that gives them an improved standard of living.
For us to have confidence that such an investment will be genuinely productivity-raising for the economy as a whole, it will need to have been subject to independent, transparent and rigorous cost-benefit analysis and full engineering design in advance of the need for it. Keynes suggested in his General Theory that public works were especially valuable in boosting expenditure in a downturn, and elsewhere suggested that governments should keep proposals for such works ready to go. Early post-war Australian governments followed this wise practice.
The stimulus strategy involves a bigger budget deficit and by implication higher interest and exchange rates for any given level of domestic expenditure. This is what distinguishes it from real depreciation. It is associated with lower levels of investment and production in the trade-exposed industries – and this is reflected in greater exposure to the exigencies of external financial markets.
Productivity Growth
‘Productivity growth’ recognises that increasing productivity is the only sustainable source of continuously rising living standards. It focuses on reversing the decline in productivity growth over the Great Australian Complacency.
The early 21st-century slump in growth productivity has been larger in Australia than in most developed countries. A comparison with other resource-rich developed countries is perhaps more relevant. The decline in productivity from 2006 to 2010 was identical in Canada and Australia (1.1 per cent per annum). However, productivity growth remained positive in the other resource-rich developed country, Norway, with its incomparably different approach to collecting resource rents for the public revenue and saving them for future use.
There is rich potential for gains from reform. However, reform to increase productivity can play only a supporting role in the early years, because there are speed limits to productivity growth. At the high point in the harvest years of the Reform Era in the 1990s, productivity was rising at 2.5 per cent per annum. That is as high as can reasonably be expected in modern times. Australia would be doing extremely well if its productivity growth were one percentage point above the average of other developed countries. But even with such stellar performan
ce, it would take decades for us to achieve the required improvement in competitiveness through productivity growth alone.
Real Depreciation
This approach places priority on a lower exchange rate for the dollar, and converting this into a real depreciation.
How low is low enough? The real exchange rate will have to fall enough to induce enough investment in other export industries to fill the hole left by the decline in the resources sector. The market will sort out how large the depreciation needs to be: when we see the investor response to a lower dollar, it will be clear whether or not the exchange rate needs to fall further. At the end of the 2013 March quarter, when the Australian dollar was valued at $US1.05, I expressed the view that a real depreciation in the range of 20–40 per cent would be required to maintain high levels of employment with a sustainable current account deficit. This would mean a value of 63–84 US cents.
How can we secure the rest of the necessary devaluation? Interest rate cuts in May and the anticipation of more contributed to a fall in the dollar. By June, the effects of lower interest rates on the dollar were being supported rhetorically by the prime minister, other senior ministers, and senior officers of the Reserve Bank and the Treasury. This contrasted with the defence of a high dollar from some of these officials early in the year.
The restored prime minister, Kevin Rudd, initially made adjustment to the end of the China resources boom the central element in a renewed focus on economic reform, but this became simply rhetorical once the election was called for early September. By then, the dollar had fallen by about 10 per cent against major currencies – around half of the minimum fall that I had suggested.
Dog Days: Australia After the Boom (Redback) Page 9