Australia’s Prospects in a World of Soaring Debt

In cumulative terms, between 2006 and 2011 China’s income levels increased by 65 per cent and India’s by 46 per cent. Australia’s income levels grew by 14 per cent, while other developed nations showed little or negative growth, Greece standing out with a 15 per cent reduction and further losses expected.

Australia’s economy has outperformed those of other developed countries but has vastly under-achieved the potential levels set by the booming Asian economies to which it is tied. A major reason for this is our failure to match the successful economies in savings and investment, a failure resulting from government spending policies and its creation of regulatory risks.

Those economies with flexible wage systems, notably the USA, saw lower per capita GDP translated into lower earnings. Where wages are less flexible, lower levels of real income are reflected in increased unemployment. Unemployment levels are at 25 per cent or above in Spain and Greece. The USA’s relatively flexible wage structure has also resulted in a lower overall income loss than in Europe. However, wage flexibility even in the USA remains far less than it once was. Thus, in the recessions of 1894, 1908 and 1921, the USA’s GDP fell by over 10 per cent but, unlike today, came surging back. During those earlier periods, not only were wages more responsive to supply and demand but the redistributive state, then in its infancy, did not corrupt the adjustment incentives of income producers and welfare recipients.

Economic flexibility was significant among the factors behind the relatively sudden economic take-off that took place first in the seventeenth century. Savings, and their investment, were crucial. Savings in Britain increased from around 3 to 6 per cent of GDP in 1688 to 14 per cent by the turn of the nineteenth century. At the same time real per capita growth increased from around 0.2 per cent a year in the two centuries before 1700 to a then staggering 1.3 per cent between 1830 and 1870.

Behind the increased savings was a greater confidence among individuals in the security of their property from seizure. Such confidence was also important to other income-boosting activities including technological innovation and for capitalising on trade.

Savings represent consumption deferred to provide for children, old age, mishaps and other considerations. Individuals have some ideal or optimal trade-off between immediate consumption (including substituting less work for more leisure) and providing for the future. This optimal level of saving is reduced if there are doubts about the security of property rights, fears that future taxes will rise or, indeed, if there is increased confidence that the government (that is, other taxpayers) will be a future income provider. Increased government spending is likely to reduce overall levels of savings and investment, partly because this is usually focused on consumption rather than investment.

Even when investment is the focus of government spending, economic growth may not be its reward if the investment is misdirected. Investment in the communist countries of old was notoriously inefficient. The Soviet Bloc had high levels of recorded savings, but much of these savings were invested in white elephant facilities that badly corresponded to demand and suffered from the inefficiencies endemic with an absence of a profit driver and competition. The communist countries also disguised much of their defence expenditures as investment.

Outside centrally planned economies regulatory distortions also undermine the productivity of investment. Thus in Australia, tariff protection previously canalised expenditure into areas of poor competitiveness, and we have contemporary horror stories of years of delay and cost blow-outs due to environmental and labour market regulations.

Measures that shift expenditure into housing (really a form of consumer expenditure) can have similar distortionary effects. Commonly regulations, especially on land use, create an artificial scarcity, bringing price escalation. This reduces the quantity of new housing, but also boosts spending on housing and absorbs savings that might otherwise have been directed to productive investment.

Regulations might also have the opposite affect and divert savings away from consumer durables, especially housing. This was the case in Japan during its post-1945 growth surge when tax-free interest was paid on small post office savings and the post office bank was obliged to invest in enterprises rather than housing. This amplified the productivity of Japanese savings (though the Japanese were less well housed than comparable nations, a matter that led to some disquiet when a leaked EC report allegedly said the Japanese were workaholics who lived in rabbit hutches).

Although there is almost universal recognition of the central role of investment in generating growth, since the Keynesian revolution in economics and the government monetary and spending boosts it validated and nurtured, views on how best to bring this about have changed. The prevailing view among most Western policy advisers is that the current recessed circumstances require government measures to increase bank credit and higher government spending, unmatched by tax receipts. Such measures are supposed to bring about a recovery in demand and increase income as under-employed capital and labour resources are brought into production. Once that process is under way, it is maintained that we will see increased demand for investment goods, and savings, which are presently “lying idle”, can be productively used.

The alternative view is that the bubble economy created by excessive credit and regulatory measures (especially affecting US housing) stems from under-investment and investment that does not fit the market demand. It is certainly true that the monetary and fiscal expansions that have recently characterised most OECD economies have failed to lift them out of recession.

It is conceivable that government measures involving injecting demand into the economy or offering support to failing financial institutions can be successful by restoring business confidence. Confidence of businesses in future demand and their capability of meeting it can ignite a virtuous cycle of investment and growth. But lighting the touch-paper can exacerbate the crisis by transferring resources to unproductive expenditures and further lowering investment. In this respect, it would certainly seem to be counterproductive to pursue dis-saving policies currently recommended by the Bank of England’s deputy governor, Charles Bean, when UK household savings ratios have fallen from a low 2.8 per cent before the financial crisis to 0.23 per cent in 2013.

Savings and their investment remain the key to growth. The savings share of GDP in China is a colossal 50 per cent—above the 40-plus per cent registered in Japan and Singapore at the height of their growth surges. India also has a high savings rate. India might also be able to achieve more output than China with its savings, since it has a lower share of investment in state-controlled enterprises, which, though corporatised, are likely to have efficiency deficiencies. Unless their savings rates fall it is likely that the growth propulsion in both China and India will be maintained.

Among developed economies, Australia and Germany save around 24 per cent of GDP, rather more than most other countries (the UK and USA save only 12 per cent of GDP). Ironically, it was once maintained that low-income countries would be prone to save less than high-income countries because they needed a larger share of their incomes for basic necessities. Recent economic history has shown this to be a myth.

These saving levels are reflected in the measured investment shares (investment being savings plus or minus capital inflow). Again the OECD countries, excluding Australia, have seen a reduction (substantial in the case of Greece, Japan, Spain, the UK and the USA) in gross investment shares over the past four years. Significant falls in investment shares of GDP will mean an ageing capital stock and lower productivity.

The size of government has grown considerably over the past century or so from the 10 to 20 per cent of GDP (8 per cent in the USA) commonly seen in the Western world before 1914. It remains well under 30 per cent in China and India compared with 35 to 40 per cent in Japan (where it is rising rapidly), the USA and Australia. In Europe the government share of the economy is commonly over 45 per cent, with France at 56 per cent.

Government spending’s share of GDP has risen since the Global Financial Crisis (GFC) of 2007. This is partly due to the inertia in government budgetary systems and partly because of discretionary spending by governments in the mistaken belief that such expenditure would kick-start their economies. Government borrowing to finance this expenditure aggravates its negative effects, since most borrowings—certainly those fuelling the expanded share of OECD countries’ government spending—represent current consumption financed by future levels of income. Unfortunately those future incomes are likely to be reduced from previously expected levels by the policy-induced reduced saving and investment. The debt must therefore be serviced by lower available income.

Budget deficits are 8 to 10 per cent of GDP in the USA, Greece, Spain and the UK. India also has a budget deficit in this league and, though India’s high borrowings are more affordable because of its high national savings, those borrowings nonetheless detract from investment and must suppress growth.

Australia (for the present) and Italy have more manageable borrowing levels, while China glows with a deficit of only 1 per cent of GDP (and the Germans are even more prudent). Greece’s well-documented problems started with its budget deficits and consequent borrowing requirement, and progress towards a balance is very slow.

Finally there is gross debt. British sovereign debt in 1815 was, at 250 per cent of GDP, higher than that of any country today (only Japan, after twenty years of economic slumber, approaches the British 1815 debt level). But the 1815 debt was run up, as in 1919 and 1945, to finance an existential crisis, which is not the case today. Moreover, following the Napoleonic Wars the British government ensured budget surpluses by cutting spending to the bone. The Prime Minister, Lord Liverpool, was even reluctant to allocate funds to suppress the Barbary Coast pirates who were enslaving British subjects. Spending restraint and taxes led to social unrest, notably the “Peterloo” riots of 1819, but were followed by an economic boom from the 1820s.

Close to debtless in 2006, Australia still has debt at only 24 per cent of GDP. France, Germany, Spain and the UK have government debt levels at 80 to 100 per cent of GDP, while the USA and Italy exceed this. Furthermore, the level of non-sovereign debt 200 years ago was relatively low compared with today. The inclusion of private debt is particularly significant for some countries. Thus Spain has public debt levels at 70 per cent of GDP but has private non-financial-sector debt at 220 per cent. This, together with a lower determination than in the past to close budget deficits, means little comfort should be taken from comparing present levels of public debt with previous historical highs.

The concern about the combined effect of private and public debt has been documented by Carmen Reinhart and Kenneth Rogoff. Having studied aggregate debt levels across the global economy they point out that, “Led by European countries, the surge in external debts since the early 2000s is unprecedented in history and dwarfs the late 1970s to early 1980s lending boom to emerging markets”. Aggregate public debt in 2010 exceeded the 1945 proportions of GDP.

Disquieting though this level is, Reinhart and Rogoff also show that private debt is far greater than public debt, and the combined level of the two has risen since 1970 from 25 per cent of GDP to 250 per cent. Although this data goes back only forty years, the size of present-day debt levels is unlikely to have an historical precedent.

These numbers and their trends reveal a great deal about economic prospects. Greece is in a tailspin which will be very difficult to correct. Its debt is high, its GDP is falling, its savings are shot, it has a 9 per cent budget deficit and has hardly made a dent in its government spending share.

But Greece is only the stand-out case among nations that share many of its symptoms of distress. The general drift of policy, at least in democracies, towards redistribution and regulation brought the current slow growth rates. The acceleration of those measures powered by a misplaced belief in the potency of government spending and policy manipulation has greatly exacerbated the present downturn from which no end is presently in sight. The modern locomotives of growth are the Asian developing economies and there is every sign that they will continue to grow rapidly for some years—or until they too catch the OECD chill of redistributive and anti-business regulatory policies.

The world of high debt levels and reluctance of governments to trim their expenditure would seem to foreshadow increased economic instability, particularly among the poorly governed countries which comprise most of the OECD members. Australia is reasonably well placed in this environment. Budget deficits are lower than elsewhere and responsible monetary policies have been followed. This owes much to a strong pre-2007 fiscal legacy and to Australian businesses grasping the opportunity to transform the economy into a valued appendage of China and India. China and India themselves (together with other Asian countries such as Indonesia and Vietnam) are continuing to follow strong growth paths fuelled by high domestic savings.

Australia has higher living standards than those rapidly growing countries and many claim that this constrains achievable growth rates. Such claims should be treated with caution since they rest on further claims that some limit has been reached in productivity enhancing new investment. This is unlikely to be the case. In the past, for example in the late nineteenth century, the USA outpaced most other world economies, notwithstanding its already relatively high living standards.

Even though Australia is said to have dodged the bullet of the GFC, its growth has not matched that of the Asian nations to which it is now overwhelmingly partnered, and its continued resilience is not assured. Current relatively low government spending and debt shares are increasing. And additional baggage has been placed on Australian industry’s ability to respond to the opportunities: even more stringent environmental and labour laws, the new Mineral Resources Rent Tax, the carbon tax and a host of foreshadowed expenditure augmentations for education and disability funding.