The mining boom and monetary policy

I counsel the Reserve to keep its powder dry until the situation in Europe is clearer. If there is a bad outcome, a cut of up to 100 basis points may well be appropriate, and the Board should give the governor licence to make such a cut. But if Europe somehow finds a sensible solution that allows the Eurozone nations to begin a gradual economic recovery, Australia needs continued overall firm

economic policy.

Australia is experiencing a 'once-in-a lifetime' boom in the terms of trade. The Reserve Bank’s main task is to keep inflation under control. If it were not for the global crisis, the RBA would be raising interest rates. Instead, depending on the Bank’s judgment about events abroad, there could be another rate cut today.

The global crisis is now centred on the potential breakup of the Eurozone. This is no routine crisis. The fundamental point is that having the mighty German economy part of a currency union with ‘Club Med’ nations such as Greece, Ireland, Portugal, Spain and Italy is to create an inherently unstable situation.

The immediate crisis is due to the Club Med nations having accumulated debts they cannot repay during the Age of Consumer Landfill. How these debts are handled is the immediate challenge for whomever within the Eurozone has the authority to impose a solution. The trouble is that there is no-one with this authority, and Germany rightly objects to letting its Eurozone partners lightly off the hook of what it sees as problems of their own making.

The economics says debts should be heavily discounted, which raises problems that economists call ‘moral hazard’. More immediately, such discounting would leave Eurozone banks in great financial trouble and (incidentally) in a legal limbo. Also, the debtor nations need to devalue to give their industries a chance to export more. This, possibility, of course, is ruled out (almost by definition) by membership of the Eurozone.

Political leaders in Europe keep meeting and announcing plans to meet again, and Eurozone is beginning to look like a slow motion train crash. Not surprisingly, leaders elsewhere are beginning to grasp the possibility that the end of the Eurozone will create great damage. Major central banks have agreed to provide liquidity support for the Eurozone, but solvency is another matter.

In fact, experts have spoken of the possibility of ‘deep depression’ within Europe, and such an outcome would impact seriously elsewhere. Recent news from America suggests there is a gradual recovery underway, but a serious European downturn would damage that. China has been slowing its economy amid concerns of overkill, and European depression would heighten such fears.

What is certain is that serious trouble in Europe would impact adversely on the Australian resource boom. Recent local economic news has included far stronger than expected investment plans, stronger retail spending and continued growth of jobs. But house prices continue to slide in most cities (not unambiguous bad news for our children of course).

Treasurer Wayne Swan has announced that the Federal government’s fiscal situation is far worse than previously expected, but also that the government remains committed to achieving a (tiny) surplus in 2012-13. The actions required to do this would impose a measure of austerity, and if this coincided with a further weakening of global economic activity it might well be Australia’s own form of overkill.

Anecdotes suggest that activity in much of the non-mining sector is very weak, as indeed it needs to be if Australia is to take full advantage of the current mining boom. Furthermore, days lost through strikes have leapt alarmingly, and doubts are building about the sustainability of the Gillard government’s ‘Fair Work’ legislation. With large wage increases to senior public servants, and carers, and above average claims granted or requested to other deserving groups such as police, nursing staff and elderly columnists, the message given by policy makers needs to be consistent.

The new mining tax and the even more complicated carbon tax’n’subsidy scheme both provide mixed messages. Taxing the industry that is making Australia rich confuses the small miners and explorers who are important in keeping the boom going. The carbon tax’n’subsidy scheme is very complicated. Why subsidise consumers if the idea is to reduce greenhouse emissions? Why tax greenhouse gas emissions if a major requirement of economic policy is to help industry remain competitive?

Cutting government activity is consistent with the need for non-mining restraint. But the opposite message is sent by industrial relations policy that encourages wage claims. Strikes make Australian industry less competitive, and like new taxes handicap industry.

Amongst all this confusion, interest rate cuts might well be seen as yet another confusing policy change. Given the parlous state of the global economy, it is highly desirable that Australian companies keep deleveraging and getting their balance sheets in better shape. It is also important that households retain their recent rates of saving, itself a highly desirable change from the Age of Consumer Landfill when for many years net saving by households was zero or even negative.

It would be very helpful for political and banking leaders to establish a consistent narrative on these matters. Of course, policies need to be consistent in fact, or a clear narrative would only make household and businesses feel even more confused.

There is a related issue that has been raised by Treasury's Dr David Gruen.

Dr Gruen in late November produced a comparison of two commodity booms – one in the 1970s and the current boom which began with increases in the terms of trade from mid 2002. Australia's terms of trade rose at about the same pace in the four years from the early 1970s as in the corresponding period from mid 2002, but thereafter fell away while in the current decade the terms of trade have continued to rise, although with a setback in the crisis of 2007-08. The overall rise in the terms of trade in the current episode is far larger than that achieved in the mid 1970s.

There are major differences between the two periods in both the policy framework and the economic response. In particular: * Now there is a floating exchange rate, whereas in the 1970s the currency was 'fixed' except when it lurched up (to US$1.49 if memory serves) and then was levered down, in both cases by amounts decided by Ministers/Cabinet with Treasury and Reserve Bank advice. * Now inflation has been low and stable, although early in 2008 there was a massive consumption boom (growth of 9 % in 2008) that nearly created a serious inflationary outbreak despite the RBA having an explicit mandate to contain goods and services inflation. * Government spending as a ratio to GDP fell during this boom whereas it rose sharply in the 1970s. * The rate of unemployment has been falling for most of the current commodity boom, with some modest reversal during the global crisis and perhaps again from now, likely to be especially marked if the Eurozone indeed implodes.

There is one important issue left unanalysed by Dr Gruen. This concerns growth of non-farm GDP, which was faster (though more variable) in the 1970s than in the latest decade. There are two possible hypotheses to explain this apparent anomaly - Australia has caught the so-called 'Dutch disease’ or else in the 1970s there was a Schumpertarian response to the wild and inconsistent economic policy of the Whitlam government. (More on this matter here.)

I suggest that if we do not understand this issue it is very hard confidently to prescribe macroeconomic policy. But if the Eurozone implodes, all bets will be off. China, India and Indonesia surely cannot keep growing at recent rates in the face of renewed developed nation recession, or worse. And if growth in these nations is slower, or negative, Australia will not be immune.

The flexible exchange rate will provide some shock absorbing protection, and (if achieved) continued sensible wage outcomes would also help. But the Treasurer's determination to return the Federal budget to surplus (presumably as advised by Treasury) will in all probability be a drag on economic activity. Quite possibly the currently predicted recovery will be postponed, perhaps for some time.

So I counsel the Reserve to keep its powder dry until the situation in Europe is clearer. If there is a bad outcome, a cut of up to 100 basis points may well be appropriate, and the Board should give the governor licence to make such a cut. But if Europe somehow finds a sensible solution that allows the Eurozone nations to begin a gradual economic recovery, Australia needs continued overall firm economic policy.

Published today in The Australian.

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