Australia faces difficult times. The budget is out of control and large parts of industry have become uncompetitive, to the point where many large mining projects are being cancelled. We need a concentrated effort to restore the federal government’s fiscal situation. We also need to reduce costs as measured in foreign currency, which will have to happen through some combination of productivity increases and a lower dollar without flow-through increases in domestic wages and prices.
The mining boom has driven the Australian dollar well beyond any sustainable level. But domestic costs have also increased beyond costs elsewhere, and recent calculations by Professor Ross Garnaut have demonstrated what I call “double digit disequilibrium” in our cost structure relative to competitors.
Whether Australia can avoid a serious recession depends on policies from here and, in my view, how government handles communication with the Australian people and the response of businesses, unions and the non-union workforce. But the word crisis is not too strong to describe what is coming.
Australia’s wealth is partly because of an abundance of natural resources and partly because Australia’s leaders have generally governed wisely. In particular, we have followed the dictates of free market economics including the law of comparative advantage, which is to focus on what the nation does best. The best exposition of this subject I have seen is the recent book by Ian McLean, Why Australia Prospered, which I discussed in the March Quadrant.
I raise two questions here. First: Can it be helpful for key industries to be discouraged for years by an excessive exchange rate, then encouraged for years by a low exchange rate? The market will ultimately decide these things, but discouraging a clearly over-valued currency, as now, by allowing completely free trade in capital is like a fanatical observance of the Ten Commandments. Second: How is Australia going to rectify this problem?
Before discussing the contribution of economic policy to coping with our looming crisis, I would like to note some issues of political economy.
In the ideal world of the free market economist, there are no wars and no trade embargoes, no barriers facing Australian producers in global markets, and everyone works in a job where her or his value is greatest, people and firms specialise and the nation exports what it makes most cheaply and imports other things. Australia has adopted the modern economist’s almost religious belief in universal free trade more thoroughly than most comparable nations.
This dogma of course falls short of recommending absolute free trade, just as few Christians consistently obey the Ten Commandments. Few voters, and fewer economists, recommend free trade in labour—witness the near hysteria about alleged over-use of 457 visas and the deep opposition to large numbers of people arriving in remote locations in small boats. Free flow of people across national borders is clearly a policy that would improve global efficiency while maximising opportunities for people in poverty-stricken nations. But economists (and other Australians, it must be stressed) have their limits.
Trade in agricultural products is another exception to the dogma of global free trade. In this area Australia is one of the few countries to accept the case for free trade.
The Global Financial Crisis (GFC) dealt a blow to free market capitalism that has not yet been fully realised, nor have the full effects been experienced. Many financiers embraced financial deregulation with a disregard of previous standards of prudence and a level of greed that boggles the mind. Massive profits went with massive salaries and bonuses, and when financial companies got into serious trouble governments were forced to rescue them.
Most of the managers of these failed financial enterprises escaped without punishment, able to leave with accumulated pension entitlements and bonuses intact, presumably impervious to the criticism of ordinary folk whose taxes paid for their rescue. It was (and probably still is) a badge of honour for high-flying financiers to avoid paying too much tax, so they were doubly rewarded. This is a dramatic illustration of what economists call “moral hazard”.
The final chapters of my book Great Crises of Capitalism outlined policies to combat “moral hazard” as well as more conventional policies to better regulate the financial system. More recently I have been researching how monetary policy influences asset inflation. This research shows that monetary policy indeed influences asset inflation but in a different, and somewhat surprising way than it influences goods and services inflation. So asset inflation must be regulated differently from goods and services inflation.
Virtually all developed nations are operating with near zero interest rates and “quantitative easing” (the current euphemism for printing money). Low bond rates prevent the funding of large deficits from becoming impossible. If government debt relative to GDP is 100 per cent, bond yields at 6 per cent mean interest payments will take 6 per cent of GDP, leaving no scope for deficit spending. More likely, of course, is that the non-interest budget will need to run a surplus of at least 3 per cent of GDP to maintain the confidence of bond investors, greatly limiting those governments’ ability to spend on programs other than interest payments.
The various innovations to monetary policy will all eventually create goods and services inflation, as they are already fuelling asset inflation, especially share price inflation. Conspiracy theorists suggest that inflation is just what is needed to erode unsustainable levels of government debt. Imagine the damage if the whole developed world experienced serious inflation, is our answer to such theorists; and surely Ben Bernanke and other global leaders are not deliberately creating inflation in order to rob creditors?
The global central bankers are presumably acting in the sincere belief that they are rescuing their economies from severe recession, but the great unanswered question is: How do the developed nations restore a normal monetary policy? Even hints that central banks might at some stage begin to normalise monetary policy produces sharp falls in share prices and costly increases in bond yields, and the financial carnage if this were to be a new policy is likely to be great.
Australia’s monetary policy has so far avoided unsustainable cuts to near-zero interest rates, although the new record low in cash rates of 2.75 per cent is a move towards the inflationist position. Global investors are seeking yield. Australia is politically stable with relatively sensible economic policies, and yields among the highest in the developed world. Despite recent falls in commodity prices, which previously would have caused the Australian dollar to fall more or less in parallel, global investors seeking yield have been pouring money into the country.
The net result is a high dollar that is making Australian industry uncompetitive. The official view is that the lack of competitiveness will be solved by firms and individuals working harder or smarter. The official view, propounded recently by RBA deputy governor Philip Lowe, seems to be that what doesn’t kill you makes you stronger.
One can agree with Mr Lowe and others that the pressure of a high dollar (on top of generally high costs) will make some enterprises stronger, but many others will be forced to downsize or give up. Recent news has included fruit growers bulldozing their trees as the big food retailers have sourced cheaper product overseas. A government or a central bank that endorses such outcomes is irresponsible, especially since agriculture is one industry that is not practising global free trade.
The RBA has in times past been tempted to cut interest rates when what was regarded as undue pressure on the currency arose with recovery from the mild recession of the mid-1980s. In the late 1980s rates were eased inappropriately and the result was an eventual sharp tightening of monetary policy and the “recession we had to have”.
If the RBA takes the line of least resistance now it will be forced to cut cash rates further, meaning Australia will join the ranks of inflationary nations. The cost of reversing inflation will be great, and will compound the very issue of an uncompetitive economy that rate cuts will mistakenly seek to overcome.
Many economists say the first response to our current greatly distorted position should be the orthodox one of cutting interest rates. This is to go down a slippery path. My hard question is this. Would you be willing to take Australian cash rates to zero, the only rate at which Australian yields would equate to US yields, and therefore remove the excessive capital inflow—seeking yield—that has been driving our dollar far higher than is desirable?
The great monetary economist Milton Friedman said: “Monetary policy cannot serve two masters.” Monetary policy needs to focus on overall stability of the economy, with low and stable goods and services inflation. Trying also to use monetary policy to engineer a lower value for the Australian dollar is fraught with difficulty. It can only work in unusual circumstances, and then not for long.
Friedman was not laissez-faire on the management of money. As Edward Nelson and Anna J. Schwartz pointed out in 2008, Friedman “argued explicitly that governments did have a role in monetary management … His critique of 1930s policy was that the government was deflationary in monetary management instead of providing the monetary-stability function expected of it.”
If an excessive dollar is putting this “monetary stability” objective at risk, the RBA or the government needs a sensible way to rein in the high dollar. In my view, the simplest and least harmful way would to impose a flexible but uniform tax on capital inflow.
Germany in the 1960s imposed controls on capital inflow, slowing but not halting the rise in its currency. Industry continued to flourish, driven by stunning increases in productivity. Brazil did the same thing more recently, and China has just announced it is doing something similar.
Despite the overwhelming acceptance of free trade as a theoretic ideal, the IMF’s recent endorsement of controls on capital flows marks a partial reversal of the theoretic status quo. Just as we reserve the right to decide who comes here and on what terms, capital inflow can and should be controlled. While there are undoubted practical difficulties, especially in seeking to control capital movements in offshore markets, it can be done more efficiently and cleanly than undesirable immigrants can be controlled. At a time of fiscal crisis, one imagines that the government would welcome the revenue it would generate, as global investors do not vote in Australia’s elections.
Here are two elegant variations on the idea of directly discouraging capital inflows, one to supplement the effect of such a tax, another requiring a more radical revision of present practices.
1. Make it easier for ordinary Australians to invest offshore. Create a sovereign wealth fund that invests offshore (or an offshore fund of the Future Fund) in which retail investors can invest, plus the government, when budgets are again in surplus. If really bold, such investments would attract a tax break equal to franking credits on dividends earned by business in Australia.
2. More radically, establish (wide) limits to the flexibility of the Australian dollar, limits that might change over time but which now might be 70 to 90 cents to the US dollar, or 65 to 95. If the RBA began the process of topping and tailing the currency at the right time it would build a war chest to allow it to offset excessive swings in the opposite direction.
Whatever the policy, or mixes of policies, the aim should be to prevent the current situation in which Australia’s industry structure is pushed strongly in one direction for years, then, when the dollar falls dramatically (as it may be in the first stages of doing now), industry structure is pushed in the opposite direction.
Free market enthusiasts will point out that the Australian dollar will eventually fall, and probably by a large amount, as asset markets frequently overshoot a sensible equilibrium. Doing nothing but allowing (with easier monetary policy) costs to keep rising will eventually weaken global investors’ appetite for Australian assets. It will also weaken the inherent competitiveness of Australian industry, a weakness that will not necessarily be overcome by even a large fall in the currency.
As already noted, a large fall in the exchange rate relative to the US dollar may already be under way, although this is so far very small relative to the overall picture, in what is called trade-weighted terms. Competitiveness will only be restored by a fall in costs measured in foreign currencies, and this will only be achieved after a large devaluation by smaller increases in domestic costs of all kinds. In the absence of explicit cost containment policies (as achieved in the 1930s and 1980s) this will only be achieved by tough, possibly very tough, monetary and fiscal policies.
Far better to head off the reduction of competitiveness in the first place by maintaining firm (but not “tough”) domestic policies, buttressed by controls over capital inflows to prevent a rising exchange rate eroding competitiveness. Of course, we are where we are, and the competitiveness of many industries has already been eroded.
A large fall in the dollar could be triggered by the spread of information about Australia’s worse-than-expected fiscal position, or by further weakening of the Chinese economy, with further falls in commodity prices, or expectations that the Reserve Bank has gone soft on inflation, or by a wage break-out by unions attempting to improve their members’ wages before the arrival of a new government expected to take a tougher line on matters industrial.
Whatever the precise cause, or mix of causes, a large fall in the dollar would create fresh dilemmas for the Reserve Bank. In recent times, the strong dollar has kept traded-goods inflation low. Low traded-goods inflation has coexisted with non-traded-goods inflation of around 4 per cent. The net result has been overall goods and services inflation comfortably within the RBA’s target zone.
But a large fall in the dollar would mean traded-goods inflation would jump, and non-traded-goods inflation would also rise more quickly. The RBA might well find that its target “inflation zone” was unable to be achieved by modest increases of interest rates under official control.
The Reserve Bank struggled to find a good answer when the effects of financial deregulation destroyed its ability to achieve the “money growth projections” imposed by government from the mid-1970s to the mid-1980s. The bank now, following a large fall in the value of the dollar, would have to at least suspend the inflation target, or exclude traded goods (assuming non-traded inflation was not too high for policy to reduce it quickly), risking red faces or worse.
I am in broad agreement with mainstream economists’ analyses of actions needed by Australia’s current government, or the Abbott government if there is a change of government on September 14. I shall first discuss fiscal policy and productivity policy, and then come to a vital point that is in no economics textbook that I have read, and has been almost totally ignored by the Rudd and Gillard governments.
Earlier this year I outlined a three-part process that I would recommend to deal with the fiscal issues.
1. Rigorous expenditure evaluation and real spending cuts.
A tried and true method is for the Expenditure Review Committee of Cabinet (ERC) to meet at 8 a.m. on Monday every week. Department heads are required to outline how to save (say) 5, 10 or 15 per cent of their costs, articulating the national benefits to be forgone. Initially they will say this is an impossible task, but if the ERC persists, this approach will produce very good results.
2. Begin a review of the bloated income tax Act.
A useful approach to this activity would be to start with the 1970 Act and ask Treasury and the ATO to defend every major change since then. Taken seriously, this would produce a simpler and fairer income tax. Tell the voters this will be the approach.
3. Announce that, if (but only if) spending cuts are insufficient to balance the books with a simpler and fairer income tax, there will be a widening of the GST and possibly an increase in its rate.
This announcement will avoid a promise not to do this anyway, but also will put pressure on the ERC and public service chiefs to perform well in the review of spending. Tony Abbott has already said that the GST will not be changed by his government before putting it to the electorate, so the idea that any such action will be a last resort is already accepted by the alternative government.
Increasing competitiveness by reducing costs or increasing productivity is actually a far greater challenge than fixing budgets. Australia substantially increased competitiveness in the early 1930s and again (to a lesser extent) in the 1980s. So it can be done, but it will only be done with least pain if the government takes the people into its confidence.
There is one powerful point to be noted. Feasible productivity improvements of around 2 per cent per annum would seem to be the most that any policy reforms could produce. With Australia’s competitiveness in double-digit disequilibrium, as shown by Professor Garnaut, realistic policy action will need to focus on limiting the pass-through of wage and cost increases generally following a large currency devaluation. Whether this can be achieved without a severe recession will depend on the response of households, businesses and unions.
I would like to emphasis two further points. The first concerns the vital need for better communication by government. One of the great faults of the Rudd–Gillard governments has been lack of effective communication of proposed changes to policy, with clear discussion of why the changes are needed. Establishing an effective narrative about the needs of policy was a feature of the Hawke–Keating and Howard–Costello governments, but this is not a matter much discussed in the economics textbooks.
So I hope that whichever party is in government after September 14 is aware of this issue and is prepared to bring the nation into its confidence about what is needed and what the process will be to change policy.
Second, there is a desperate need for more imaginative analysis by officials. The recent controversy over rapidly changing and over-optimistic forecasts by the Australian Treasury exposes at least one basic flaw in their current approach to managing the economy, a flaw at least as serious as potential or actual explicit political bias.
I strongly advise Treasury to adopt an approach used by the best forecasters. Always prepare and present to government, “realistic worst case” forecasts as well as “best guesses”. I offer my belief, as an experienced forecaster, that “realistic worst case” predictions for Australia are far less rosy than current predictions.
If we are lucky, we shall have time to prepare for the necessary actions to restore competitiveness. If, however, the global bond and currency vigilantes decide Australia is in need of some economic discipline and that no government is likely to provide it, bond and currency markets will turn ugly, and action might be needed faster than we will be comfortable with.
Crisis creates opportunity, as it did in my day as a policy adviser, with respect to both floating the dollar and handling the “banana republic” crisis. If Australia does experience a crisis, I hope we are ready with firm decisive action, not locked in debate about what to do. But if the discussion has not been undertaken, whoever is governing will face some very difficult times, as will we all.
P.D. Jonson’s book Great Crises of Capitalism is published by Connor Court.