Saturday, May 22, 2010

Henry's bike has three speeds

Remember the two-speed economy? It's not back. No, with the return of the resources boom we're going back to the three-speed economy.

That's according to an enlightening speech this week from the secretary to the Treasury, Dr Ken Henry.

Assuming the continuing global financial crisis doesn't reassert itself to the point of knocking China and India off their present growth paths - a reasonable assumption - the big non-environmental issue facing our economy over the next few years or even decades is the profound implications of Australia's return to riding on the back of a coal train. Expect to hear a lot more about it.

As we saw during the resources boom that ran for five years before being (briefly, as we now know) interrupted by the global recession in 2008-09, when the global demand for commodities such as coal and iron ore runs way ahead of their supply, this has big effects on our economy.

The leap in the prices the world is prepared to pay for our exports of those commodities greatly increases the nation's real income. The spending of that income (including the part that ends up in the government's coffers because of higher company tax collections) gives a great boost to demand and employment.

As well, we get a huge increase in mining and related construction activity as the high prices they are receiving prompt the miners to greatly expand their production capacity.

At the same time, the improvement in our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - usually leads to a significant appreciation in our exchange rate.

And if all this happens at a time when the economy has little spare capacity and unemployment is low, the Reserve Bank soon starts to worry about rising wages and inflation pressure and begins trying to slow demand by jacking up interest rates.

That's where we were before the global financial crisis hit and it looks like where we will soon be returning.

If you look at how this affects the economy geographically, you see a two-speed economy. Queensland and Western Australia are in the fast lane, all the rest of the country is in the slow lane.

It's only when you divide the economy up by industry rather than by state that you see there are actually three lanes.

In the fast lane are mining and mining-related sectors (the mining services industry and even the heavy construction industry). These industries grow fast because the rise in the prices they're getting far outweighs the adverse effect on them of the higher exchange rate.

In the slow lane are the other trade-exposed sectors, such as agriculture, manufacturing, inbound tourism and inbound education. These export or import-competing industries suffer because their prices haven't increased but the higher exchange rate has reduced their price competitiveness, either by reducing the number of Aussie dollars they receive for exports or by reducing the Aussie-dollar cost of the imports they compete against.

In the middle lane are the rest of our industries, which Henry calls the "non-traded sectors". Most of the non-traded sector is filled by service industries, but it includes goods industries selling stuff that cannot be exported or imported. It accounts for about three-quarters of the economy.

These industries will grow at a rate somewhere between the other two lanes.

Just how fast they grow depends on the relative strengths of the "negative supply shock" - arising because workers and capital are being competed away by the expanding resources sector - and the "positive demand shock" - arising from the nation's better terms of trade and higher real income, part of which raises demand for the non-traded sector's products.

Because these conflicting shocks cause demand and supply in the non-traded sector to be out of balance - with demand stronger and supply weaker - the sector's prices will rise to restore the balance.

This means Australia's inflation rate is likely to rise above the average of our trading partners' inflation rates. And this will cause the rise in the nominal exchange rate (the one we see) to become also a rise in our real exchange rate (which happens when our inflation rate exceeds the average - even without a nominal appreciation).

Fine. But before we start a long debate about the wider implications of a resurgent resources boom the threshold question is: how long will it last? Is it temporary or lasting? No one knows, of course, but Henry says there are three considerations.

The first is the global supply response to the increased demand for resources. "Sustained periods of strong prices and strengthened long-run price expectations can be expected to generate even stronger mining exploration and investment responses over time," Henry says.

"They can also drive a reassessment of the size of global mineral reserves that are recoverable at a commercially viable rate. And technological improvements will continue to place downward pressure on extraction costs."

So some of the short-run increase in prices is likely to be temporary. (The budget forecasts are based on an assumption that terms of trade deteriorate over time by 20 per cent.)

Second, there seems to be a long-term decline in commodity prices. In the last half of the 20th century, non-fuel commodity prices fell on average by 1.6 per cent a year relative to consumer prices.

But Henry argues that particular commodities can buck the general trend over protracted periods. For instance, the real world price of copper roughly doubled between 1930 and 1970.

And you can argue that the prices of non-renewable resources will be forced upwards over time as reserves are depleted and the cost of extraction rises as producers are pushed towards more marginal deposits.

Third, the rapid industrialisation of countries such as China and India still has a long way to run. The likelihood is that they will catch up with the developed countries, just as Japan, Korea, Taiwan and Singapore did before them.

Research says an emerging economy's demand for metals grows strongly until its income per person reaches about $20,000 a year.

Putting these three considerations together, Henry concludes we have at least reasonable grounds for believing that strong world demand for Australian commodities, and favourable terms of trade, will be "sustained for some time".

In the cautious way econocrats speak, "sustained for some time" means quite a few years. That's why we need to have a long think about the implications.