Monday, January 30, 2012

Europe has serious troubles, but we don’t

The economic news from Europe in recent days hasn’t been good. And it could get worse as the year progresses. Those guys have big problems. But let’s not spook ourselves by imagining it to be any worse than it is.

Unfortunately, there’s been a tendency in parts of the media to convey an exaggerated impression of how bad things are and of the extent to which Europe’s problems translate into problems for us.

Take last week’s downwardly revised forecast for the world economy in 2012 from the International Monetary Fund. We heard a lot about the fund’s dire warnings of what could happen if the Europeans didn’t get their act together, but what wasn’t made clear was that the fund’s actual forecast was for global recession to be avoided.

Though the forecast for growth in the world economy this year WAS cut significantly from the forecast in September, at 3.3 per cent it’s below the long-run average rate of about 4 per cent, but still comfortably above the 2 per cent level generally regarded as representing a world recession.

No one thought it necessary to tell us - even though Wayne Swan reminded journalists of it at his press conference - that, from our perspective, the fund’s revisions were old news. They were surprisingly similar to the revised forecasts the government adopted in its mid-year budget review last November.

The fund has the United States growing by 1.8 per cent this year; Treasury had it at 2 per cent. The fund has the euro area contracting by 0.5 per cent; Treasury had it contracting by 0.25 per cent. For China, the fund has growth of 8.2 per cent, whereas Treasury had 8.25 per cent. For India it’s the fund’s 7 per cent versus Treasury’s 6.5 per cent.

Bottom line? The fund has the world growing by 3.3 per cent, whereas Treasury had it at 3.5 per cent.

Journalists are always criticising politicians for repeatedly re-announcing new spending programs, thus leaving the public with an inflated impression of how much is being spent. But journos aren’t above doing much the same thing.

We get a fuss when the government revises down its forecasts in November, then another fuss when the fund announces essentially the same revisions. And in between we get a fuss when the World Bank announces its revisions. Three for the price of one.

Actually, you can understand why the uninitiated got excited about the bank’s revisions. Whereas Treasury had forecast world growth of 3.5 per cent, the bank revised its forecast down to just 2.5 per cent. But no one remarked on that, just as they didn’t seem to notice when, only a week later, the fund put its prediction at a seemingly healthier 3.3 per cent.

So which one is right? They all are. That’s to say, they’re all saying the same thing. I find it hard to understand how anyone who knew their business could bang on about how low the bank’s forecast was without pointing out that it does its forecasts on a different and inferior basis to everyone else.

Whereas our Reserve Bank and Treasury, and the fund, add each country’s gross domestic product together using exchange rates that take account of the US dollar’s widely differing purchasing power in each country, the World Bank doesn’t bother. It uses market exchange rates.

So it perpetually understates the rate of growth in the emerging economies of Asia, thereby understating world growth, since most of it has for quite some years come from Asia. But not to worry. If you took the fund’s country-by-country forecasts and added them together the same misleading way the bank does, what would you get? Growth of 2.5 per cent. Same forecast on either basis.

The trouble with all these forecasts and pronouncements from international agencies is it’s hard for the public to assess what they amount to by the time they reach our shores. These pronouncements rarely mention Australia. And shock waves from Europe have to come to us via China, India and the rest of Asia.

I think the media could try harder to bridge this gap rather than leaving us with the vague impression disaster for Europe means disaster for Australia. Actually, what matters for us is not world growth so much as the growth in our major trading partners, with each partner’s contribution weighted according to its share of our exports.

When Treasury did this sum in the mid-year review, growth in the world economy of 3.5 per cent translated to growth in our major trading partners of 4.25 per cent. All this despite Europe’s recession.

Fran Kelly of Radio Nation Breakfast did go to the trouble of asking the lead author of the fund’s World Economic Outlook, Jorg Decressin, what the revised forecasts meant for us. His reply deflated most of the hype we’ve been subjected to.

‘Australia will be affected by these downgrades only to a limited extent,’ he said. Oh. ‘At this stage, growth in output for Australia is still reasonably strong.

‘Growth in Australia is importantly driven by major investment projects that are in the pipeline and these are funded by strong multinationals that don’t have problems assessing funding.’ Oh.

‘There is no advanced economy - or maybe there are one or two - that is as well placed as Australia in order to combat a deeper slow down, were such a slowdown to materialise and that’s because, well, you still have room to cut interest rates if that was necessary and you also have a very strong fiscal [budgetary] position,’ he said.

Do you get the feeling you’ve heard all this before? Maybe it’s true.

Saturday, January 28, 2012

All hail mighty Aussie dollar, as it's here to stay

This year we'll see more painful evidence of Australian businesses accepting the new reality: our dollar is likely to stay uncomfortably high for years, even decades.

It has suited a lot of people to believe that just as the resources boom would be a relatively brief affair, so the high dollar it has brought about wouldn't last.

If there were no more to the resources boom than the skyrocketing of world prices for coal and iron ore, that might have been a reasonable expectation. But the extraordinary boom in the construction of new mining facilities makes it a very different story.

The construction boom is likely to run until at least the end of this decade, maybe a lot longer. The pipeline of projects isn't likely to be greatly reduced by any major setback in the world economy. That's particularly because so much of the pipeline is accounted for by the expansion of our capacity to export natural gas. The world's demand for gas is unlikely to diminish.

Last time I looked, the dollar was worth US105?, compared with its post-float average of about US75?. But that's not the full extent of its strength. At about 81 euro cents and 67 British pence it's the highest it's been against those currencies for at least the past 20 years.

In the context of the resources boom, the high exchange rate performs three economic functions. First, it helps to make the boom less inflationary, both directly by reducing the prices of imported goods and services and indirectly by lowering the international price competitiveness of our export- and import-competing industries.

Second, by lowering the prices of imports, it spreads some of the benefit from the miners' higher export prices throughout the economy. In effect, it transfers income from the miners to all those consumers and businesses that buy imports, which is all of them. So don't say you haven't had your cut.

Third, by reducing the price competitiveness of our export- and import-competing industries, it creates pressure for resources - capital and labour - to shift from manufacturing and service export industries to the expanding mining sector.

That is, it helps change the industry structure of the economy in response to Australia's changed "comparative advantage" - the things we do best among ourselves compared with the things other countries do best.

As businesses recognise the rise in the dollar is more structural than temporary and start adjusting to it, painful changes occur, including laying off workers. Paradoxically, this adjustment is likely to raise flagging productivity performance.

Economists have long understood that the exchange rate tends to move up or down according to movement in the terms of trade (the prices we receive for exports relative to the prices we pay for imports). This explains why the $A has been so strong, for most of the time, since the boom began in 2003.

But here's an interesting thing. In the December quarter of last year, our terms of trade deteriorated by about 5 per cent as the problems in Europe caused iron ore and other commodity prices to fall. They probably fell further this month.

This being so, you might have expected the $A to fall back a bit, but it's stayed strong and even strengthened a little. Why? Because when the terms of trade weakened, other factors strengthened. The main factor that's changed is the rest of the world's desire to acquire Australian dollars and use them to buy Australian government bonds.

Indeed, the desire to hold Australian bonds was so strong it more than fully financed the deficit on the current account of the balance of payments in the September quarter. It may have done the same in the December quarter. Among the foreigners more desirous of holding our bonds are various central banks.

Remember that, at the most basic level, what causes the value of the $A to rise on any day is that people want to buy more of them than other people want to sell. The price rises until supply increases and demand falls sufficiently to make the two forces equal.

So economists' theories about what drives the value of the $A are just after-the-fact attempts to explain why the currency moved the way it did. We know from long observation that there's a close correlation between our terms of trade and the $A.

But we also know this correlation is far from perfect. There have been times when the two parted company for a while. It's apparent the dollar is driven by different factors at different times.

And it now seems apparent that our relatively superior economic performance and prospects are taking over as the main factor driving the dollar higher (even though our terms of trade would have to deteriorate a mighty lot further before they were back to their long-term average).

There are various reasons why foreign investors (including central banks with currency reserves that have to be parked somewhere) would like to increase their holdings of Australian government bonds.

For a start, we're now one of the few "sovereigns" (national governments) still with a AAA credit rating. For another, the yield (effective interest rate) on Australian 10-year government bonds is almost 4 per cent, compared with about 2 per cent on US Treasury bonds or German bunds.

And the present and prospective state of our economy is a lot healthier than that of the North Atlantic and Japanese economies. Why are our prospects so much brighter and our interest rates higher? In short: the mining construction boom, of course.

It seems clear the world's financial investors are shifting their portfolios in favour of $A-denominated financial assets. And remember, because they're so much bigger than we are, what's only a small shift for them is a big deal for us.

All this suggests the Aussie will stay strong, even as our terms of trade fall back. Remember, too, the huge spending on mining construction over the years will require a lot of foreign financial capital to flow into Australia, helping keep upward pressure on the exchange rate.

This doesn't say the $A has become a safe-haven currency. Were some sudden disaster to occur in Europe it would probably take a dive as frightened investors rushed to the safe haven of US Treasury bonds.

But it probably wouldn't take long for the Aussie to recover - just as it didn't take long after the sudden disaster of the collapse of Lehman Brothers in 2008.

Wednesday, January 25, 2012

Economic fixes must offer a fair go for all

When you listen to street interviews with people in the troubled countries of the euro zone, a common complaint emerges: whereas some people waxed fat in the boom that preceded the crisis, it's ordinary workers who suffer most in the bust, and they and even poorer people who bear the brunt of government austerity campaigns intended to fix the problem.

In other words, achieving a well-functioning economy is one thing; achieving an economy that also treats people fairly is another. Economists and business people tend to focus mainly on economic efficiency; the public tends to focus on the fairness of it all.

Fail to fix the economy and almost everyone suffers. But offend people's perceptions of fairness and you're left with a dissatisfied, confused electorate that could react unpredictably.

The trick for governments is to try to achieve a reasonable combination of both economic efficiency and fairness. Fortunately, but a bit surprisingly, the need for this dual approach has penetrated the consciousness of the Organisation for Economic Co-operation and Development - the rich nations' club which is expanding its membership to include the soon-to-be-rich countries.

New research from the organisation deals with ways governments can get their budgets back under control without simply penalising the vulnerable and ways they can improve the economy's functioning and increase fairness at the same time.

Much of the concern about fairness in the hard-hit countries of the North Atlantic has focused on bankers. In the boom these people made themselves obscenely rich by their reckless, greedy behaviour, eventually bringing the economy down and causing many people to lose their businesses and millions to lose their jobs.

But their banks were bailed out at taxpayers' expense - adding to the huge levels of government debt the financial markets now find so unacceptable - and few bankers seem to have been punished. Some have even gone back to paying themselves huge bonuses.

It's a mistake, however, to focus discontent on the treatment of a relative handful of bankers. The fairness problem goes much wider. In most developed countries, the long boom of the preceding two decades saw an ever-widening gap between rich and poor.

In the United States, almost all the growth in real income over the period has been captured by the richest 10 per cent of households (much of it going to the top 1 per cent), so that most Americans' real income hasn't increased in decades.

It hasn't been nearly as bad in Australia. Low and middle household incomes have almost always risen in real terms, even though high incomes have grown a lot faster.

Looking globally, a lot of the widening in incomes has come from the effects of globalisation and, more particularly, technological change, which has increased the wages of the highly skilled relative to the less skilled. But a lot of the widening is explained by government policy changes, such as more generous tax cuts for the well-off.

The euro zone countries need not only to get on top of their budgets and government debt, but also to get their economies growing more vigorously. So the organisation has proposed structural reforms - we'd say microeconomic reforms - which can foster economic growth and fairness at the same time.

One area offering a "double dividend" is education. Policies that increase graduation rates from secondary and tertiary education hasten economic growth by adding to the workforce's accumulation of human capital while also increasing the lifetime income of young people who would otherwise do much less well.

Promoting equal access to education helps reduce inequality, as do policies that foster the integration of immigrants and fight all forms of discrimination. Making female participation in the workforce easier should also bring a double dividend.

Surprisingly - and of relevance to our debate about Julia Gillard's Fair Work Act - the organisation acknowledges the role of minimum wage rates, laws that strengthen trade unions, and unfair dismissal provisions in ensuring a more equal distribution of wage income.

It warns, however, that if minimum wages are set too high they may reduce employment, which counters their effect in reducing inequality. And reforms to job protection that reduce the gap between permanent and temporary workers can reduce wage dispersion and possibly also lead to higher employment.

Systems of taxation and payments of government benefits play a key role in lowering the inequality of household incomes. Across the membership of the organisation, three-quarters of the average reduction in inequality achieved by the tax and payments system come from payments. Means-tested benefits are more redistributive than universal benefits.

Reductions in the rates of income tax to encourage work, saving and investment need not diminish the inequality-reducing effect of income tax, provided their cost is covered by the elimination of tax concessions that benefit mainly high income earners - such as those for investment in housing or the reduction in the tax on capital gains. Getting rid of these would also reduce tax avoidance opportunities for top income earners.

So it's not inevitable that the best-off benefit most during booms and the worst-off suffer most in the clean-up operations after the boom busts. It's a matter of the policies governments choose to implement in either phase of the cycle.

You, however, may think it's inevitable that governments choose policies that benefit the rich and powerful in both phases.

But we're talking about the government of democracies, where the votes of the rich are vastly outnumbered by the votes of the non-rich. So if governments pursue policies that persistently disadvantage the rest of us, it must be because we aren't paying enough attention - aren't doing enough homework - and are too easily gulled by the vested interests' slick TV advertising campaigns.