Saturday, September 11, 2010

Debt is good when it means investment

One of the most remarkable, but unremarked, features of the election campaign was the extraordinary fuss made about a net federal government debt expected to peak at a mere $90 billion, while not a word was said about Australia's net foreign debt of $670 billion - and rising.

Similarly, despite all the feigned concern about the size of federal budget deficit, nothing was said about the current account deficit, which is almost always much bigger.

This just proves politicians carry on about what it suits them to. It hasn't suited the opposition to bang on about the current account deficit because it was consistently high throughout the Howard government's 11 years - meaning the net foreign debt just kept getting bigger.

But the Liberals - and Labor, for that matter - aren't alone in not wanting to talk about the current account deficit (which is the amount by which our imports and income paid to foreigners exceed exports and income received from foreigners) and the resulting net foreign debt (which is the money Australians owe foreigners, less the money they owe us).

These days, the nation's "external accounts" hardly rate a mention in the media, either. So surprisingly little has been made of the news that, at $4.2 billion, the current account deficit for the June quarter was the lowest in almost a decade.

It turned out our export earnings were up 24 per cent on the previous quarter, whereas our imports were up 6 per cent, causing the trade balance to swing from a deficit of $2.8 billion to a surplus of $7.8 billion. Trade surpluses aren't all that common, and this one was our biggest since 1973.

For good measure, our net income payments to foreigners (covering interest payments on the foreign debt and dividend payments to foreign owners of Australian businesses) were down by a bit under $1 billion to about $12 billion, yielding the current account deficit of $4.2 billion. Wow. Why such an improvement? Because everything went right with our exports. For a start, there was a big increase in the prices we received for our exports of coal and iron ore. The volume of coal exports was up, as were exports of gold. Exports of oil were up as two new oil fields off the coast of Western Australia came on line.

But it's not such a bad thing the media didn't make a fuss about the improvement. Why? Because it can't last. It's the calm before the storm.

When our terms of trade improve - when export prices rise relative to import prices - as they have mightily this year, people always expect this to lead to an improvement in our trade balance and current account deficit, but it rarely does. They think this because they forget to ask one of the great economists' questions: but what happens then? You never get the right answer until you take account of what economists call "second-round effects".

What happens then is the rise in exports leads to a rise in imports. This happens several ways. First, the improved terms of trade represent an increase in the nation's real income. As this real income is spent, a fairly high proportion is spent on imports: imports of consumer goods, but also imports of components and capital equipment.

This process is accentuated because an improvement in our terms of trade usually leads to an appreciation in the exchange rate. The higher dollar makes imports cheaper, thus encouraging people to buy more of them relative to locally produced goods and services.

Second, a rise in world prices for minerals and energy encourages our mining industry to expand its production capacity, building new mines and natural gas facilities. A high proportion of the equipment needed for these expansions is imported. Take the coming Gorgon natural gas project on Barrow Island. It's expected to involve investment spending of about $50 billion over five years. Roughly half that money will go on imports.

The truth is the return of the resources boom is expected to involve a return to the big current account deficits (and thus faster-rising levels of foreign debt) we have seen since the start of the boom in the early noughties. So whereas the current account deficit got down to the equivalent of just 1.6 per cent of gross domestic product in the June quarter, the econocrats are expecting it to go back up to 5 or 6 per cent during the rest of the decade.

To see why this isn't as worrying as it sounds - and to debunk the Liberals' dishonest implication that anything labelled "deficit" or "debt" must always be bad - it's useful to pull another economists' trick and switch the discussion of our "external imbalance" from the language of exports and imports to the language of saving and investment.

Huh? Just as Australia almost always imports more than it exports, so the nation also spends more on investment (in new housing, business equipment and structures, and public infrastructure) than it saves (whether by households, companies or governments).

All physical investment spending has to be financed from savings, and when we don't save enough to finance all our investment we make up the difference by borrowing the savings of foreigners. This is why Australia runs a surplus on the (financial) "capital account" of our "balance of payments" to and from the rest of the world, which exactly matches and finances the deficit on the "current account" of the balance of payments.

The current account deficit is low at present because private sector investment spending fell somewhat in the economic downturn, while the mining companies are saving (as retained earnings) much of their extra income from higher world commodity prices.

Soon enough, however, national investment spending will boom as households build more houses, ordinary businesses invest in better equipment and, in particular, as the miners hugely increase their investment spending.

All this is likely to happen without much increase in the nation's rate of saving. If so, the capital account surplus is likely to be much bigger as we call more heavily on the savings of foreigners - and so is its mirror image, the current account deficit (as we import more capital equipment).

If the worsening in the current account comes from higher investment spending rather than lower national saving - as happened in the first part of the resources boom and is expected to happen now - we don't have a lot to worry about. Eventually, the investment will pay for itself.