Monday, October 18, 2010

Welcome to the harsher, tougher economy

Our high dollar - which could easily go higher - is imposing considerable pain on our farmers, manufacturers, tourist operators and education providers. The pain will intensify over time, but guess what? The econocrats think it's a good thing.

The pollies don't mind either, because the punters think parity with the US dollar is Christmas come early.

Remember, too, that about three-quarters of Australian industry is non-tradeable - it neither exports nor competes against imports. So it is not directly affected, except to the extent that it uses (the now cheaper) imported components and capital equipment.

A higher exchange rate is anti-inflationary and thus does a similar job to a rise in interest rates. It lowers the price of imported goods and services, which reduces consumer prices directly (though, these days, the process is quite attenuated, with foreign suppliers and importers tending to absorb rather than pass on the short-term ups and downs in the exchange rate).

As well, a higher dollar helps to ease inflation pressure by redirecting some domestic demand into imports (for instance, it makes locals more inclined to holiday abroad than at home) and by dampening production of exports (such as accommodation for foreign tourists or education for foreign students).

So, to some extent, a higher exchange rate is a substitute for further rises in the official interest rate. But I wouldn't take this to mean a further rise in rates this year is now unlikely. At best it could mean a rise in early December rather than Melbourne Cup Day.

And I wouldn't even count on that. It might mean one less rise over the next year.

But these short-term considerations for monetary policy (interest rates) are just part of the story. The econocrats - Treasury as well as the Reserve Bank - are very conscious that, thanks to the mildness of the recession, we're fast approaching full employment, which they take to be an unemployment rate of about 4.75 per cent (though no one knows precisely where the point is).

This is happening at a time when the resources boom is back with a vengeance, with our terms of trade (export prices relative to import prices) at their most favourable in a century (ignoring the two-quarter spike in wool prices during the Korean War).

The initial effect is a huge increase in the nation's real income which, as it is spent, threatens the inflationary blowout we've experienced in all previous resources booms. If it doesn't happen this time it will be partly because of the vigilance of the authorities. (Now you know why the Reserve is so concerned about inflation even though the underlying inflation rate is within the 2 to 3 per cent target.)

But it will be mainly because, this time, we have a floating exchange rate and it has done what the textbooks promise it will do: appreciate significantly, thus easing inflation pressures. One part of this mechanism is that the higher dollar effectively transfers real income from the miners to all those industries and individuals who buy imports.

Here you see a further reason why the econocrats think a high dollar is good, not bad, in our present circumstances. But I'm trying to get from the immediate cyclical issue to the longer-term structural one. Sooner or later, coal and iron ore prices will fall back from their present dizzy heights, though they're likely to stay well above their long-term average.

The second element of this boom - the thing that distinguishes it from previous commodity booms, giving it a medium-term, structural element - is the unprecedented boom in mining investment that's about to get started, coming on top of a level of business investment spending during the downturn that was already remarkably high.

Even if some of these projects are abandoned and some are delayed, we're still talking about a huge expansion in our mining sector that constitutes a historic change in Australia's industry structure, affecting the oil and mining industry, the mining services industry and - for a decade or more - the engineering construction industry.

This will require a huge application of resources: labour and financial and physical capital. But because it comes at a time when we're already at full employment then, to the extent we're not adding to our supply of skilled labour via immigration, this will require a reallocation of resources within Australia.

Labour and capital will need to move from non-mining industries to the mining sector and from the non-mining states to the mining states.

The textbook, closed-economy way for this to happen is for the mining sector to bid up wages and other ''factor'' prices until it gets what it needs and can still afford. But in an open economy, the textbook promises the process of reallocation will be assisted by a high exchange rate, which will cause the non-mining tradeables sector to contract, thus releasing labour and other resources to shift to the mining sector.

Now do you see the other reason the econocrats want a high dollar? It is a key part of the market mechanism by which the industrial restructuring of our economy will be brought about without it exploding.

So don't bother telling yourself the dollar is overvalued because of the ''currency war'' (so far its effect on our trade-weighted index is small) or because our rates are so high (our rates are always and inevitably high because our returns on investment are high relative to other countries).

All this says is that times are going to be very tough for people in the non-mining tradeables sector. It's true; there is no denying it.

But whether this weak Gillard government - goaded at every point by an utterly unprincipled opposition - has the courage to stick with good policy is another matter.