Saturday, May 16, 2009
"In the midst of the worst global downturn since the Depression, Norway’s economy grew last year by just under 3 percent. The government enjoys a budget surplus of 11 percent and its ledger is entirely free of debt."
Read the full NYT article here.
I have written about the very very clever Norwegian Petroleum Fund here and here and here.
East Timor saw the wisdom of what Norway was doing. Not us.
HT: Marek. Thanks!
UPDATE: Bill Mitchell has problems with the NYT report.
April 29 2009: Treasury thought the China-fuelled resources boom would last decades, but the slump shows how wrong it was and how Australia failed to reap a lasting legacy. Paul Cleary reports.
With the benefit of more than a century of hindsight from Australia's life as a boom-crash commodity economy, it's not unreasonable to expect that the government's economic advisers would get it right.
Surely Treasury's economists told the government the river of gold from China was a temporary surge in income that would sooner or later be followed by a crash? Unfortunately not, as the record of policy advice uncovered by The Australian Financial Review now shows.
The legacy of the most recent resources boom is that Australia failed to stash the cash during a period of glorious economic sunshine, leaving the country in a vulnerable state during the economic downturn.
Instead, what emerges is an unshakeable belief held by many Australian economists - including those in the Treasury - that the China-led resources boom would go on for decades.
Treasury thought the surge in the terms of trade, the weighted average of a country's export prices relative to its import prices, could be considered a "permanent" increase in national income. This view may well have encouraged the loosest fiscal policy since the Whitlam years, in which more than $300 billion in new spending and tax cuts was unleashed between 2004-05 and the 2007 election, fanning higher inflation and interest rates.
The record of policy advice uncovered by a request for documents under the Freedom of Information Act reveals that although Treasury examined the policies of countries that had successfully managed sharp swings in resources income, such as foreign currency sovereign funds, it did not press the government to follow these examples.
Treasury put its view about the commodity boom's becoming permanent in a ministerial briefing to then treasurer Peter Costello in June 2007. The advice to Costello is just one example of the department's forthright thinking at the height of the mining boom.
A year later, Treasury declared in the Rudd government's first budget that the terms of trade, after rising to the highest level in 50 years, would surge by a further 16 per cent in 2008-09, despite the growing global uncertainty. This forecast is certain to be dramatically altered in the budget on May 12.
"Robust growth in the emerging economies is supporting further large rises in Australia's terms of trade from levels that are already the highest in more than 50 years," Treasury wrote in the 2008 budget's economic outlook.
The department expanded on this confident outlook two months later in its first substantial research paper on the boom, which argued that unlike other spikes in commodity prices, this one was likely to be more enduring. Australia need not worry about the so-called "resource curse" and could look forward to higher living standards.
"The prospect of the rise in the terms of trade being sustained therefore need not be considered a 'resource curse' that will simply create problems," the paper's authors concluded. "If well managed, the transition to higher terms of trade presents an opportunity to raise Australian living standards."
Warwick McKibbin is one of the few commentators to have advocated the creation of a foreign currency fund to deal with Australia's boom-bust cycle. Early in 2008, the academic with the ANU and Brookings Institution, who is also on the Reserve Bank board, called for windfall revenue from the resources boom to be parked in a Norway-style foreign sovereign fund.
Unlike the Future Fund, which is restricted to providing for public service pensions, this fund would hold assets in foreign currency and it could be designed to help manage the economic cycle. The money could be brought back into the country when the terms of trade declined, McKibbin argued at the time.
McKibbin says Australia could have amassed a foreign currency fund of between $50 billion and $100 billion had it earmarked additional revenue from the resources boom over the past few years. The money would now be worth considerably more in Australian dollars.
He argues that it was wrong to view the recent boom as permanent, and that viewing it as temporary would have driven an aggressive savings strategy. "You never know if it is permanent," McKibbin says. "By deciding it is temporary you should put some substantial part away - as much as you can."
The reasons policy failed on this front say a lot about the quality of public debate in Australia. McKibbin says special interests that ignored the national interest swamped debate.
McKibbin says he raised the concept of a foreign savings fund at several high-level meetings and plans to canvass it in greater detail in an address to an international conference in June. He believes Australia should start planning for the next upswing in commodities.
As for Treasury's silence on the issue, McKibbin notes that the department had its fingers burnt early this decade when it suffered paper losses from foreign currency investments because the dollar moved against it. Labor in opposition savaged the department for mismanagement, and the experience may have deterred new policy advice on foreign currency investments.
One senior official argues that Treasury refrained from pushing for a sovereign fund because private sector economists and newspaper commentators have not demanded such policy action.
It was difficult for Treasury to push the policy boundaries when many economic commentators were simply calling for the mining boom's billions to be channelled into massive tax cuts, which in turn fuelled inflation. The Australian newspaper, for example, in 2007 went as far as criticising Treasury for having failed to predict the mining boom, thereby denying massive tax cuts to people.
ANZ chief economist Saul Eslake, one of the few economists to have criticised Costello's spending binge, says most economists advocated tax cuts rather than structural reform because this was popular. He alleges Costello's aggression towards his critics made most economists fearful of criticising the government's management.
He also believes that warnings by the then US Federal Reserve chief Alan Greenspan about undue influence of sovereign funds on public companies could have helped suppress any push for an Australian sovereign fund.
Treasury appears to have taken up the US government's concerns about these funds. A briefing in November 2007 for officials attending the Group of 20 meeting said the combined value of the funds, at about $US2.5 trillion, meant there were reasons to fear their power. "There exist concerns due to the sheer size of these investment vehicles, their lack of transparency, their potential to disrupt financial markets, and the risk that political objectives might influence their management," the Treasury paper says.
Another prominent critic of the government's reckless spending was Chris Richardson of Access Economics, a former Treasury economist who called for a much bigger savings effort, but he admits that neither he nor other economists articulated to the government the mechanism for achieving this end. Richardson puts the failure down not only to that of economists, but of political leadership. "Neither side explained to the Australian people that this was a temporary surge," he says. "It was not at all clear that it was permanent."
Rather than highlighting concerns about the pitfalls of windfall resource revenue, Treasury's analysis of the mining boom played down concerns about the resource curse, which is also known among economists as the "Dutch disease".
The department's most substantial work on the most recent boom, a July 2008 working paper titled Structural Effects of a Sustained Rise in the Terms of Trade, says that while previous booms have been "short-lived, there are reasons to believe that the current boom could be more enduring".
The paper, written by Treasury's principal adviser for forecasting, Adam McKissack, and three others from the domestic economy division, appears to be a badly timed piece of research that is already outdated. Senior officials in Treasury, including David Gruen, the executive director for the macro-economic group, also commented on the paper before it was published.
Despite having full knowledge of the Howard government's inflationary spending, the paper argues that "Dutch disease" effects from the high exchange rate have not flowed through to the traded goods sector as "strongly as could be expected".
The paper's only policy recommendations are to address the obvious skill shortages emerging in the resource-boom states of Western Australia and Queensland, in part by boosting immigration.
Its concluding paragraph says the resource boom is here to stay; Australians need not fear any negative consequences and can only look forward to higher living standards.
The paper does not represent policy advice as such, but its views are an echo of what had been put in the high-level briefing note to Costello in mid-2007. Treasury argued in discussions with a delegation of economists from the International Monetary Fund that the government faced a permanent increase in revenue from the surge in the terms of trade.
In the Treasury executive minute to Costello on June 29, Treasury reveals it has argued in the IMF talks that there could be a case for spending the additional revenue from the boom if the surge in Australia's terms of trade could be considered permanent.
In summarising the discussion, the brief to Costello says: "Article IV discussions with Treasury had a strong focus on the appropriate role of fiscal policy during a terms of trade shock. The IMF agree that there is a strong case for spending additional revenue from the increased terms of trade to the extent that the increase is considered permanent."
In defending increased spending, however, Treasury was possibly playing its institutional role as apologist for government policy, although it is unusual to support a loosening of fiscal policy when the economy is approaching full capacity.
The Reserve Bank was much more cautious in its assessment of the boom. In a paper to a conference in Canada in June 2008, governor Glenn Stevens said "no one can know whether a change of this nature is permanent or not". He went on:
"So markets and/or policymakers are often in the position of not knowing how much response to make. They may end up making or accepting a partial response in case it is permanent, but not, initially, the whole response, in case it is not. Indeed, one reason commodity prices across the board are so high is that producers did not anticipate the persistent nature of the stronger demand."
Reserve Bank economists, however, have shown little interest in advocating creation of a fund to help manage the commodity cycle.
* * *
The AFR made an FOI request for all ministerial briefs from January 1, 2005 to May 2008 on the role played by foreign sovereign wealth funds for managing windfall revenue from commodities; all briefs examining Norway's fund; and all briefs over the past year on managing natural resource revenue in Pacific neighbours and East Timor.
The request singled out the developing countries because, unlike Australia, they have put in place systems to deal with commodity income.
The 29 documents identified by the search show that from early 2006 on, Treasury studied best-practice models in several countries, particularly Norway's well-regarded model, but this analysis did not inspire a single ministerial brief to the Treasurer recommending he take note or consider new policy.
The first document - a minute in July 2006 by Kirsty Laurie, from Treasury's budget policy division - notes that Norway's model of investing all the oil revenue into a foreign currency fund "promotes exchange rate stability".
That is, putting the money into foreign currency avoided the pitfalls that inspired the Norway model, namely Holland's experience in the 1970s when a sudden influx of North Sea oil revenue over-inflated the currency and the rest of the economy. This experience gave rise to the term "Dutch disease". Since its float in 1983 the Australian dollar has experienced wild swings as a result of shifts in commodity prices.
Warning about the painful adjustments that result from living on commodity income, Laurie concludes: "Norway appears to be very conscious of avoiding the Dutch disease so that restructuring costs are not excessive when petroleum revenue declines."
Laurie is co-author of an influential paper released immediately after the 2007 election that documented the gross fiscal excesses of the Howard government. The paper, published in the Treasury Economic Roundup in early 2008, shows that from 2004-05 new spending decisions and income tax cuts reduced the budget surplus by $314 billion, out of a total revenue increase of $334 billion.
"Effectively, the additional revenue from the commodity boom has been spent, or provided as tax cuts," the authors conclude.
The analysis shows that one of the main channels for Australia to experience the inflationary effects of the Dutch disease is through excessive government spending. This was noted at some length during the IMF consultations in 2007. The IMF said in its talks with Treasury that Costello's last two budgets were "providing a stimulus in an economy with limited spare capacity".
A second Treasury paper on managing windfall resource revenue - written in August 2007, after the IMF raised its concerns - identified the dangers of being inundated with commodity revenue. The paper, Commodity Hedging for Government, by Michael Bath, said that in these circumstances governments "struggle to avoid pro-cyclical fiscal policies". This is exactly what happened in last years of the Howard government.
Bath's paper focuses on the role of commodity-linked sovereign funds to deal with the "negative side effects associated with a sudden increase in revenue". He says the Norway fund model seeks to "immunise the budget from oil price volatility".
Bath's paper, of which about a page is deleted under Section 22 of the FOI Act, makes clear that Australia's Future Fund does not play a role in insulating the economy from swings in commodity income. The fund, which holds all its assets in local currency, is limited to addressing the impact of population ageing on public finances by building up assets to pay for public service pensions.
Norway's fund has more far-reaching objectives. "It transforms the wealth associated with a non-renewable, finite stock of resources into a perpetual source of relatively steady revenue," Bath's paper says, before concluding that the Norway model is "an excellent case study in managing commodity risk in a manner that maximises fiscal sustainability".
Treasury did succeed in convincing the Howard government to divert some of the windfall revenue into new funds to pay for future outlays for pensions, higher education and health.
But as Bath says, these funds do not help insulate the budget from volatility in commodity income, and nor do they help manage commodity risk. Key differences are the fact that successful models invest only in foreign currency, and the amount of revenue diverted is vastly greater than what Australia has attempted.
The Norway fund was launched in 1996 to manage the revenue from North Sea oil. All Norway's oil-related revenue bypasses the budget and flows directly into the fund, which invests in foreign currency government bonds and blue-chip equities. The government draws down on the fund after seeking approval from parliament. Essentially, the country spends real interest on its natural resources, and it will be able to keep doing this every year, long after the oil resources have been exhausted.
The fund now known as the Government Pension Fund was worth 2275 billion kroner ($473 billion) on December 31, 2008, and has doubled in value since 2004. Sovereign wealth funds, like super funds, have been hit by the global financial crisis, although some have been insulated because they invested solely in government bonds.
Treasury's detailed analysis of international experience also covered examples found in Russia, Chile, Alaska and Papua New Guinea, among others. The analysis shows that other countries were setting up sovereign wealth funds or refining their policy frameworks to squirrel away surplus revenue from the resource boom while in Australia the policy response to the challenge was limited.
A briefing paper in May 2007 by Laura Doherty to Treasury's general manager for the G20, former ANU professor Gordon de Brouwer, notes that in April that year the Russian parliament transformed the Oil Stabilisation Fund into a Future Generations Fund and a Reserve Fund. Russia invested all its assets in high-grade government bonds and foreign securities, the paper observes.
Like Russia, East Timor has invested all its surplus oil revenue into US government bonds and after just two years of saving amassed $US4.2 billion, all of it insulated from the global downturn. The value of East Timor's fund is already about 10 times the size of its non-oil gross domestic product.
Even PNG, which is widely regarded as a basket case of mismanagement and corruption, offers some lessons to Australia. A December 2007 note on PNG's medium-term fiscal strategy by Stuart Kinsella says the 2008-2012 budget strategy creates a new concept of "normal" mineral income, which is the amount of revenue that could be derived in the absence of a commodity boom.
The benchmark is set at mineral income equivalent to 4 per cent of GDP. Income above this level is used to both retire public debt and to fund public investment.
PNG's strategy is clearly used not only to save money during the boom times, but to also protect the country during the down times, Kinsella notes.
"Movements in world commodity prices, particularly on the down side, are an important risk factor to the outlook for PNG revenue over the next few years," he writes.
The policies adopted by PNG and East Timor reflect the influence of Australian Treasury officials who have been seconded to the governments of both countries, although at home the department did not appear to drive similar policy solutions.
It seems extraordinary that while examining international practice in detail, Australia has never considered any of these policy options for managing its commodity income. There might be no better time than now, when the pain of another commodity famine is becoming acute, to prepare a set of policies to deal with the next boom.
The Treasury discounted the cost of the AFR's FOI request in view of public interest considerations.