Saturday, January 31, 2009

SATURDAY INSIGHT: Our problems are worse - much worse

Yes, it's the current account deficit. Remember that? It puts us at risk.

What if a weakened financial system and weaker than usual spending are the least of our problems?

What if there's more to worry about that keeping the money flowing and minimising the extent of the recession?

What if our real problems are deeper and have the potential to sink us?

What if we are only dimly aware of them or find it easier to deny them until it's too late?

What if we've been doing that for years?

It's hardly an unlikely scenario.

In the United States a problem which did have the potential to undo the economy was ignored or denied by everyone from the world's most important central banker down.

Investments that seemed too good to be true were investigated and found trouble-free right up to the day millionaire philanthropist and funds manager Bernie Madoff turned himself in.

Welcome to Australia in the first decade of the 21st century.

Welcome to where where we find ourselves at the end of The Howard years...

Back in 1997 when the Howard government was young, financial markets took a set against a a number of Asian countries including Indonesia. Its currency plunged 60 per cent. There was mass unemployment, rioting, regime change, austere medicine imposed by the International Monetary Fund which made things worse and the loss of 13 per cent of GDP.

And yet, as the winner of this year's Nobel Prize in economics Paul Krugman points out in the new edition of his book The Return of Depression Economics, Indonesia's current account deficit at the time was smaller than Australia's. Its standard of living was more sustainable than ours.

A country's current account deficit is the measure of the foreign dollars that it pays out to rest of the world each quarter over and above the foreign dollars that come in. It can only be sustained by ever-growing foreign borrowing.

Since the Asian economic crisis - the bullet that Australia missed - our current account deficit ratio has doubled. What we pay out over and above what we take in now amounts to roughly 6 per cent of our GDP. That's quite an achievement for a nation at the end of five years of an almost-unprecedented export boom. Our imports have climbed faster.

Much of the increased import spending has been on mining equipment and the like - a necessary counterpart to the resources boom.

But much of the rest has been on consumer goods: roughly 50 per cent more on consumer electrical imports such as plasma TVs, almost 70 per cent more on imported food - all within the space of five years.

The Howard government helped, announcing personal income tax cuts in each of 2003, 2004, 2005, 2006 and 2007. Tax breaks - either outright exemptions or concessions - soared from $50 billion to $73 billion. Government spending jumped by one third. At a time when employment generally climbed 15 per cent, the Commonwealth public service (excluding Defence) swelled 25 per cent.

Almost as the fast as each wave of mining-generated cash came in, the government pushed it out where it would be spent. In its dying days it formally adopted as a campaign slogan what by then had long been its unofficial guiding principle - go for growth.

The party that in opposition had hired a "debt truck" to drive around Melbourne streets bemoaning Labor's $200 billion foreign debt, left office with a foreign debt exceeding $600 billion. During its final year we were expanding that borrowing at the rate of $200 million per day.

Much of it was spent on the not-particularly-useful exercise of bidding up the price of Australian houses. After the government halved the headline rate of Capital Gains Tax at the turn of the century Australian house prices doubled. Investors who used to account for only 20 per cent of the loans to purchase housing took out 40 per cent as they swept owner-buyers aside and pushed up prices. It used to take three to four years of a typical household income to buy a Melbourne house. It now takes seven. The US website Demographia lists Melbourne, Sydney, Adelaide, Bundaberg, and Queensland's Gold Coast as among the world's 12 least affordable markets. It identifies Melbourne as being less affordable than New York.

This makes no obvious sense from an international point of view and bears all the signs of a bubble waiting to be pricked. It has also put housing beyond the reach of Melbournians who could have once afforded it, perhaps unsustainably. But it has kept the a larger number of constituents happy. One of John Howard's parliamentary secretaries is reported to have once quipped, “rising prices make for happy voters”.

That happiness fed into a feeling of wealth, and a feeling that (perhaps aided by dipping into housing equity) it was okay for Australians to spend more than they earned each year.

Extraordinarily in 2003 Australia's household saving ratio turned negative after being in positive territory ever since records had been collected. For the first time Australians households in aggregate were spending more than they earned each pay period. We began to literally live beyond our means as our mining boom was taking hold. (Our savings ratio has since returned to positive territory and is now climbing sharply as we shut their wallets ahead of a recession.)

We could have done things differently.

Norway stands alone in the rest of the world in having had as much wealth showered on it as has Australia in the last half decade. No other nation comes close. (Canada, which has experienced the third biggest boost to its terms of trade is a distant third.)

Instead of running up a growing current account deficit, Norway built a rapidly growing current account surplus and is perhaps the most protected nation in the world from attacks by financial markets.

Whereas Australia was blessed with natural gas, coal and iron one, Norway was blessed with North Sea oil. But it knew it wouldn't last. So it moved the windfall tax revenue to an untouchable Norwegian Petroleum Fund, later renamed the Norwegian Pension Fund. Not only could the massive inflow not be paid out in tax cuts or used to expand government programs beyond all reason, most of it couldn't even be brought onshore. (It also has to invest ethically.)

Because the Petroleum Fund invests its money in foreign currencies offshore it neither bids up the Norwegian currency, Norwegian real estate, Norwegian prices nor Norwegian imports.

Norwegians mightn't feel as wealthy as they might have had they gone down the Australian road. But in reality they are much wealthier, with a buffer of continuing earnings that will protect them whatever happens to China and the worldwide demand for resources.

Australia has no such buffer. Australia is in the same situation as a lottery winner who splurges the booty as it comes in spending even more than the winnings in the excitement. Norway is like a lottery winner who keeps the windfall away from the family and won't even let it in the house, banking if offshore as insurance against the day things turn nasty.

And Norway is not alone. Timor has also set up a petroleum fund.

As the globe enters its first co-ordinated recession in half a century, and as the providers of finance become more jittery than they've been in generations Australia finds itself absolutely dependent on the rest of the world to maintain its standard of living, more so than Indonesia was before its currency came under attack during the Asian economic crisis.

China's surge in economic growth - the one thing that bought Australia temporary immunity from attack by financial markets - has stalled, or perhaps stopped.

Marvin Goodfriend from Carnegie Mellon University describes China's boom as “a one-off in the history of the planet earth.”

“We have never had it before in thousands of years of planet earth and we are not going to have it again in a few thousand years,” he said during a visit to Australia.

What if China's boom doesn't restart? What if instead of being a blessing Australia's abundance of resources remains as irrelevant as it is now becoming.

In its recent economic update Access Economics reminded clients that it it has long said that, "if China's surge stumbles then Australia's trading balance will be buggered". It added, "buggered it will soon be."

Access sees Australia's current account deficit jumping to a "Godzilla-like" 9 per cent of GDP next financial year, in part because it believes our recession will be milder than those overseas and we'll continue to expand our imports without the export income to pay for them.

The result might be an orderly collapse in the Australian dollar (Access sees a collapse from US 65 cents to US 56 cents) or it might be an attack on the dollar.

Its easy to understand why foreign funds managers might feel we are good candidate for such an attack. Our current account deficit would be many times the level of the Asian countries caught up in last decade's economic crisis. Our developed legal and banking system need not save us. In 1992 funds manager George Soros successuflly took on the Bank of England, making his reputation and US$ 1.1 billion in the process. Our Reserve Bank carries only small reserves of foreign exchange. It couldn't last as long as did the Bank of England.

On the face of it the United States would be as vulnerable to a capital strike or currency attack as would Australia or Britain. But the US is different. It manufactures the world's currency. It could literally print money to buy itself time.

Earlier this week The Age spoke to seven of Australia's more thoughtful economic observers. They were asked for their thoughts on the best way to stimulate things. But some said that was the wrong question. Melbourne University's John Freebairn said instead we had to get prices, spending and saving back into balance. "I for one am not worried if Australians save any tax cuts," he said. "We've been spending too much."

"Some corrections are necessary. Our housing prices have to fall. These recessions - almost as Paul Keating said, sometimes we need them to get over our bad behaviour."

Cutting interest rates toward zero as the US has done would be a bad idea, Freebairn says. The US did a similar thing at the start of this century in order to escape its 2001 recession. It helped create the sub-prime mortgage boom whose unwinding led to the crisis that is now threatening the globe.

Freebairn wants our leaders to use the present crisis to set up things up for sustainable recovery in the decades that follow. Otherwise, he says, "it's a wasted opportunity".

The former head of the Competition Commission Allan Fels wants the government to do nothing that will make Australia less competitive for the recovery which is to follow. It's already approved the gobbling up of two middle size banks by the majors and is showing signs of handing out money to whatever interest group asks for it first. "The should plan as if the recession will last for three years," he says. "And keep their eye on the sort of Australia that will emerge from it."

Gerry Harvey of the retailer Harvey Norman says he's not that fussed about getting people back into his stores in the short-term. He'd rather the government concentrated on making Australia productive.

With surprisingly little to protect us from what the future has in store after a half decade of riches we will need to work our way out of our problems carefully.


iconoclast said...

A brilliant piece!
Shedding some reality to Australias current predicament.

Anonymous said...

Agreed, this is best description of the current situation I have run across.

Allan Fels is right on the money: govt needs to redefine unbalanced advantages that have crept into the economy and plan for a 3 year downturn.

The current bailout-the-wealthy-out mentality is not logical or practical at any level. It is more of the same that got us in this mess in the first place.

It is tax payer’s monies being used to prop up the economy (some would say property bubble) and it should be accountable. The least the tax payer expects is some equity for these bailouts, and not crap toxic assets, but the premium ones.

Govt, on behalf of tax payers, has every right to demand quality assets from the beggar-bowl banks for the assistance they are receiving.

carbonsink said...

What if China's boom doesn't restart?

Obviously that cannot happen. Just like banks cannot fail, and house prices cannot fall. China must boom. Its a fundamental law of physics.


Tony said...

One of the best pieces I've read about Australia's current economic condition.

Pete (not Peter Martin) said...

"Abouuuut face!"

Look, in these 'situations', it takes time for the public, and the media, to get hold of the situation and for confidence to drop.

Peter, you're a smart enough guy, I just hope that you are one of the people at the front of the media pack, rather than a tag-along that is still shouting "House prices to skyrocket!", or "Stocks severely undervalued" (the market values them on what it will pay for them...simple).

No I wasn't quoting you.

Good luck.

The Doc said...

Excellent article. I wonder if you do share your thoughts with Ross Gittins, who has a perpetual rosy view of the Australian economy. In fact in his latest piece he said it was the media's second by second account of the financial crisis that is causing all this plummeting of confidence. Apparently if we all stay "positive", and just say positive things, we'll wake up one day in July 2009 and everything will be just the way it was before!

Sean Reynolds said...

I think this article admirably demonstrates the difference between the Nordic social democracy welfare states and the Anglosphere casino capitalism, winner take all, near-kleptocrat states. No Australian govt will ever show any real enlightened approach to equality of the
citizenry or real planning for the future, there are too many robber barons running around demanding their disproportionate share of the take, and govt is simply there as a kleptocrat aide to covertly help the elites. And by this I mean the so-called 'Labour' Party just as much as the Liberal party.

After the government halved the headline rate of Capital Gains Tax at the turn of the century Australian house prices doubled. Investors who used to account for only 20 per cent of the loans to purchase housing took out 40 per cent as they swept owner-buyers side and pushed up prices.

This bit isn't entirely true -- the govt replaced a different system of assessing CGT with a simplified 'half of top tax margin' system which actually increased its returns from the previous system, much as GST was calculated to be an increase on the old wholesale sales tax system.

Feverish investor purchasing and general overbidding came about from liberalised credit from lenders at the same time, historically low interest rates, rise of the NBLs, equalisation of interest rates between investment properties and PPORs, and irrational exuberance probably coupled with the actions of seminar gurus, spruikers and marketeers encouraging everyone to pile into property -- and they usually stress the negative gearing tax regime as a loss offsetter ahead of supposed CGT benefits. It just seems that every time lenders liberalise credit, consumers borrow up to the new limit and a speculative boom is born.

Sean Reynolds

Anonymous said...

Long term viability of an economy must be directly proportional to ratio of imports to exports. Would not a Current Account Surplus be a sign of an intelligent, or at least long-term functional society?

Q: How long can an economy continue with ever increasing CAD?

A: Couple of days at most before there is a ‘Take-over’ by that entity/s (our offshore masters) that was funding the downward spiral that is CAD.

Either government is for the community or against it.

From what I see both Libs and Labor are against an economical sound environment. Both have encouraged the debt binge that is now trying to unwind. I say trying to unwind as credit card debt dropped last quarter – that means the average borrower has seen the writing on the wall.

Govt on the other hand cannot bear to see an inflationary environment turn into a deflationary one. All of that unearned income from a never ending asset (read property) bubble – what will become of the free lunch we are used to? That is why they are so keen to pump up the careless and irresponsible banks with tax payer revenue.

Of course, Labor could take this opportunity to clobber the Libs with the scrapping of a number of obnoxious debt accelerants that have fed the CAD parasite. The abolition of debt accelerants, such as loan interest deductions and negative gearing, could be held up to public display as article of good faith.

But then, how interested is the govt in actually solving what is essentially a debt problem in Aus? Some would say – care factor zero.

JonH said...

I agree that this is an excellent piece, but there is one thing that intrigues me.

We have had a current account deficit (an increasing one) for years now. Why? How have we got away with it? Is it that foreign lenders such as Japan which has been running surpluses are quite happy to support our profligate ways, because they need somewhere to invest their surpluses? In the same manner that the world is still buying US treasuries when the US economy is down the toilet, is the world carrying us because they need some fool to park their money with? And when does the crunch come?

(Ok, more than one thing intrigues me.)

Pete (not Peter Martin) said...

Hi Peter,

That you may finally catch on to the real problems does get you some praise, doesn't it?

I particularly like this:

Keep up this attitude and you might win back the respect I had for you when you were with the Canberra times.

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