Outlook for us and the world is sombre

Australia and the world are experiencing a Micawber moment. The economic prospects aren't reassuring, but there's not a lot we can do except hope something will turn up. Wherever you turn, the outlook is for continuing sub-par growth.

According to Dr Min Zhu, a deputy managing director of the International Monetary Fund, in Australia this week, the post-global crisis growth cycle may be coming to an end. At the peak of the crisis in late 2008, most countries gave their economies enormous injections of fiscal (budgetary) and monetary (interest rate and liquidity) stimulus to get them moving.

It worked. After an unprecedented contraction of 0.4 per cent in 2009, gross world product grew by 5.2 per cent the follow year, by 3.9 per cent the year after, then 3.2 per cent last year. Notice it running out of steam? At this late stage it's expected to slow further to 2.9 per cent this year.

If 2.9 per cent doesn't sound too bad, remember the world economy's long-term average rate of grow is 3.5 per cent a year.

In last month's world economic outlook document, the fund warns that "the major economies must urgently adopt policies that improve their prospects; otherwise the global economy may well settle into a subdued medium-term growth trajectory".

Trouble is, Zhu says most countries - rich and poor - have little "space" left for further fiscal or monetary stimulus. Indeed, the policy action the fund is calling for is more structural than cyclical: "strong plans with concrete measures for medium-term fiscal adjustment and entitlement reform" in the case of the United States and Japan, while the euro area "must develop a stronger currency union and clean up its financial systems".

As for the emerging market economies, many of them "need a new round of structural reforms". China, for instance, "should provide a permanent boost to private consumption to rebalance the growth of demand away from exports and investment".

Well that's fine and dandy. But though structural reforms that improve the functioning of the economy may ultimately have a big payoff, it usually takes ages to come through. And often there are costs up-front.

In the meantime the world's left, like Mr Micawber, hoping we turn out to be luckier than the forecasters expect. And the outlook for our economy isn't all that different.

Reading from a graph in the presentation to the Australian Business Economists' annual conference this week by Dr David Gruen, at the time of the pre-election economic update Treasury was expecting growth of 2.6 per cent this year, improving to 2.7 per cent next year.

That compares with the economy's "potential" growth rate of about 3 per cent - the rate needed to hold unemployment steady. So we can expect a continuing rise in joblessness. And the boss of Treasury, Dr Martin Parkinson, said this week that the prospects for the economy had deteriorated a little since the election.

The pundits seem agreed that the economy could return 3 per cent growth in 2016. But that's just the nice way of saying we look like having to endure three years of sub-par growth. Beaudy.

In theory, we do retain "space" to further stimulate demand with either lower interest rates or increased government spending. But rates have already been cut a long way, and the Reserve Bank seems likely to avoid another cut while we see what difference those earlier cuts make.

As for the budget, it has been in deficit for four years already, so no one is keen to go any deeper. At this stage the Abbott government is following the Labor government's policy of avoiding taking measures to hasten the budget's return to surplus - which would, in any case, be counterproductive to some extent at a time when the economy's weak.

But some of the noises Joe Hockey has been making suggest he's preparing to step in with big spending on infrastructure should the end of the mining investment boom cause a much bigger hole in overall demand than we're expecting. Replacing heavy investment in mining with heavy investment in infrastructure would make a lot of sense.

The main thing we are hoping will "turn up" is a turn down in the dollar. Even the fund said this week it believed the dollar was overvalued by about 10 per cent. An exchange rate with the US dollar in the mid-80s would do a lot to stimulate our trade-exposed industries.

Gruen reminds us that, whereas through most of the noughties exports of resources made a contribution to annual growth in real gross domestic product of about 0.4 percentage points, over this year and the next two or three they will contribute well over 1 percentage point.

The decline in mining investment - which itself will make a big subtraction from growth - will also lead to a decline in imports, since mining investment involves a lot of spending on imported capital equipment. That's a saver.

And for those who worry we may be blowing up a housing bubble, Gruen advises that the median capital-city house price has been roughly steady at four times average household disposable income for the past decade and at present is a fraction below four.

If you look at the graph you don't find the ratio has been steadily climbing over the years. Rather, it was a bit less than three times during the 1990s, but then jumped to four times in the early noughties and has stabilised there.

What happened in the early noughties to bring about this change? The return to low inflation and, with it, low nominal interest rates for home loans. This fall greatly increased the amount banks were prepared to lend people on an unchanged income. Australians used this increase in borrowing power to bid up the prices of our housing.

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Climatic adjustment limits our farmers' Asia boom

The first thing to realise about the rise of Asia is that our farmers are about to join our miners in the winners' circle. The second is that climate change and other environmental problems may greatly limit our farmers' ability to exploit this opportunity. The third is that what we see as a looming bonanza, the rest of the world sees as a global disaster.

According to the government's white paper on the Asian century (which, be warned, shares economists' heroic assumption that there are no physical limits to consumption of the world's natural resources), continuing population growth and rising living standards in Asia will cause global food production to grow 35 per cent by 2025, and 70 per cent by 2050.

Rising affluence is expected to change the nature of Asia's food consumption, with greater demand for higher quality produce and protein-rich foods such as meat and dairy products. This will also increase the requirement for animal feed, such as grains. There'll also be demand for a wider range of processed foods and convenience foods, and for beverages, including wine.

But environmental and other problems will prevent the Asians from producing much of the extra food they'll be demanding. Unlike in the past, Asia is likely to become a major importer of food. And, of course, any delay in increasing food production to meet the increasing demand will raise the prices being charged.

You little beauty. "Australia's diverse climate systems and quality of agricultural practices position us well to service strong demand for high-quality food in Asia," the white paper says. After all, Australia is one of the world's top four exporters of wheat, beef, dairy products, sheep, meat and wool.

"As a result, agriculture's share of the Australian economy is expected to rise over the decade to 2025," we're told, something that hasn't happened for many, many decades.

So, a new age of growth and prosperity for Aussie farmers? Don't be too sure. The environmental constraints the white paper expects to bedevil Asian farmers will also limit our farmers' ability to cash in on Asia's growing affluence.

Also published last week was a determinedly positive but franker assessment of our agricultural prospects, Farming Smarter, Not Harder, from the Centre for Policy Development.

It says "winners of the food boom will be countries with less fossil fuel-intensive agriculture, more reliable production and access to healthy land and soils". That's not a good description of us.

The first question is climate change - the problem so many Australians have been persuaded isn't one. Although other countries - including China - are doing more to combat climate change than the punters have been led to believe, we don't yet know how successful global efforts to limit its extent will be.

What we do know is we're already seeing the adverse effects - hurricane Sandy, for instance - and can expect to see a lot more, even if global co-operation is ultimately successful in drawing a line. At present we're focused on efforts to prevent further change; before long we'll need to focus on how we adapt to the change that's unavoidable.

This non-government report says climate change is projected to hit agricultural production harder in the developing world than the developed world - "with the exception of Australia".

"Rainfall is forecast to increase in the tropics and higher latitudes, and decrease in the semi-arid to arid mid-latitudes, as well as the interior of large continents," the report says. "Droughts and floods are expected to become more severe and frequent. More intense rainfall is expected with longer dry periods between extremely wet seasons. The intensity of tropical cyclones is expected to increase."

So, without action to reduce or manage climate risks, Australia's rural production could decline by 13 per cent to 19 per cent by 2050, it says.

And it's not just climate change. "One of the biggest challenges for Australian agriculture is that our soils are low in nutrients and are particularly vulnerable to degradation ... every year we continue to lose soil faster than it can be replaced."

The productivity of broadacre farming used to grow by 2.2 per cent a year; since the early 1990s it's averaged just 0.4 per cent. Australian farmers use a lot of fertilisers and fuel, the cost of which is also likely to rise strongly. And that's not to mention problems with water.

Meanwhile, those who worry about how the world's poor will feed themselves - or about the political instability we know sharp rises in food prices can cause - don't share our hand-rubbing glee at the prospect of Asia's greatly increased demand for food.

Almost as bad as high food prices are highly volatile prices. The three world price spikes in the past five years each coincided with droughts and floods in major food supply regions. Extreme weather events are likely to become even more frequent. (The growing diversion of grain to produce biofuels is another contributor to higher food prices.)

After the food price spike in 2008, 80 million people were pushed into hunger. But the growing concern with "food security" is often a euphemism for resort to beggar-thy-neighbour policies: countries that could export their food surplus to other, more needy countries decide to hang on to it, just in case.

The Asians' attempts to continue their (perfectly understandable) pursuit of Western standards of living are likely to be a lot more problem-strewn than the authors of the white paper are willing to acknowledge.

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Asia white paper assumes away environment

The most glaring weakness in the Prime Minister' s white paper on the Asian century is its failure to factor in the high likelihood that mounting environmental problems will stop Asia continuing to grow so rapidly as well as limit our ability to take advantage of what growth there is.

To be fair, most of the environmental problems that could trip up Asia s economies and ours do rate a mention in the bowels of the 300-page document.

But it doesn t join the dots. Asia s environmental problems are dismissed merely as among the various challenges to be overcome bumps along the road. As for our own environmental problems, the government s existing policies have them well in hand.

And it would be unfair to single out the Gillard government as unwilling to face up to the seriousness of our problems with the natural environment and start integrating them into its forecasts and projections.

That s just as true of almost all economists and business people. While most economists (and some business people) are prepared to acknowledge particular environmental problems climate change, water, soil, fish stocks, biodiversity they re not prepared to see them as symptoms of a much bigger problem: we may be reaching the physical limits to continued growth in natural resource use.

So, just like the white paper, they continue to put worries about environmental problems in a box marked environment , which they keep separate from the box marked economy , where they do their forecasts and longer-term projections of economic growth.

It s an uncontroversial statement that the global economy the production, consumption and other economic activities of humans exists within, and depends on, the natural environment, the global ecosystem.

And it s obvious to anyone with eyes that certain economic activities are doing damage to the ecosystem, which is already rebounding on the economy in the form of costs and disruption (hurricane Sandy, for instance). It s not hard to believe these costs and disruptions are likely to multiply unless we start organising the economy very differently.

It thus makes all the sense in the world for economists to integrate the environment and the economy when thinking about what the future holds. So why don t they? Because they never have, and find the idea pretty frightening.

Economists standard way of thinking about the economy effectively assumes away the environment. That s because their conventional model which has changed little in the past 100 years is built around the prices charged in markets, whereas most environmental assets clean air, clean water, good soil, reasonably reliable weather can t be bought and sold in markets.

Thus most of the costs and benefits generated by the ecosystem are external to the model and so liable to be overlooked. Schemes such as the carbon tax are attempts to put a price on greenhouse gas emissions and so get them into the price mechanism (and the model).

So you can bolt bits of the environment onto the model, but you have to do it case-by-case, which is hardly satisfactory. As Professor Herman Daly has said, if the survival of your society is external to your model, you probably need a new model .

The funny thing is, if you re still not sure why so many scientists doubt it will be physically possible for Asia to grow as big as economists project, the clues are all there in the white paper. To put things in context, at present the developed world accounts for just 15 per cent of the world s population, but 51 per cent of gross world product.

The 19 per cent of the world s population living in China has a standard of living equivalent to 20 per cent of America s. The white paper expects that to reach 40 per cent in just 13 years.

For India and Indonesia, accounting for a further 21 per cent of the world s population, their standard of living could also double, from 10 per cent to almost 20 per cent. And, of course, living standards in other parts of Asia are also supposed to be rising rapidly, meaning more than half the world s population is applying to join the profligate rich club.

Have you any idea what that would mean in additional use of the world s energy and other natural resources?

The white paper advises that, in the 19 years to 2009, Asia s energy consumption more than doubled and its share of world energy consumption jumped from 25 per cent to 38 per cent. China is now the world s biggest energy consumer.

Having gone from consuming less than half as much energy as the US in 2000, China now consumes slightly more. It accounts for almost half the world s coal consumption. It s the world s largest consumer of steel, aluminium and copper, accounting for about 40 per cent of global consumption for each. It s predicted to be 90 per cent dependent on imported oil by 2050.

In 2009, fossil fuels accounted for about 82 per cent of Asia s energy mix. Asia accounts for about 40 per cent of global greenhouse gas emissions up from 31 per cent in 2001. China recently overtook the US as the world s largest emitter.

The white paper happily assumes effective global action to limit climate change will be forthcoming, so makes no allowance for it in its projections.

It s not the done thing for economists to imagine we could ever run out of natural resources. Prices may rise a bit, but this will merely call forth the solution to the problem, whereupon prices will fall back. And every textbook leaves you thinking this process happens seamlessly.

So, no need to worry. Our faith in unending growth remains unshaken.

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How Asia is catching up with the rich West

Asia's transformation into the world's most dynamic economic region has been a defining development of our time. The pace and scale of its rise have been nothing short of staggering.

That's the story according to Julia Gillard's white paper on the Asian century, and it's right.

"Over the past 20 years, one third of the world's population has re-engaged with the global economy and more are set to do so," the paper says. "Living standards for billions of people in Asia have improved at a rate not previously experienced in human history."

Just between 2000 and 2006, about a million people were lifted out of poverty every week in East Asia alone, we're told.

Japan, South Korea, Singapore and, more recently, China and India doubled their income per person within a decade. Some went on to repeat this achievement two or three times.

By contrast, it took Britain more than 50 years to double its income per person during the Industrial Revolution of the late 18th and early 19th centuries.

Why so long? Because the Industrial Revolution was driven by the invention of new technology and it took a while for new inventions to come along and for their use to spread through the economy.

These days, the economy sitting at this "technological frontier" is the US. In principle, the fastest pace at which America's income per person - its material standard of living - can grow is determined by the pace of what today we call "innovation". And that's not fast - say, 2 per cent a year.

So with the rise of Asia we're seeing a phenomenon economists call "catch-up and convergence". Because all the improved machines and better ways of doing things have already been invented and are sitting on the shelf, so to speak, it's not hard for all the countries well back from the technological frontier to catch up with the leader by employing the new productivity-boosting technology. As they do, their standard of living converges on the leading economy's.

This is what happened in the West in the first 30 years or so after World War II. The economies of Europe (and Japan) grew very strongly and closed most of the gap between their living standards and America's.

Now that process of catch-up - and the global spread of the latest technology - has shifted from the developed countries to the developing countries. Japan was the first, followed by South Korea, Hong Kong, Singapore and Taiwan, with China getting going in the 1980s and India in the 1990s. More will follow.

Of course, transforming your economy from developing to developed can't be as simple as taking new technology off the shelf, otherwise all the poor countries of the world would be growing as fast as Asia is.

So how have the Asians done it? What have they got right that the others haven't?

The various countries' success hasn't followed a simple recipe, the paper says, but some common patterns have emerged in recent decades.

Many economists explain Asia's rise mainly in terms of its switch from the post-war policy of "import replacement" (seeking to grow by protecting your industries from competition with imports) to export-led growth.

If, as part of this, you allow foreign multinational corporations to set up factories in your country, they bring in the capital need to pay for building those factories, as well as access to the latest foreign technology and the knowledge of how to use it, which ends up being transferred to local technicians and managers and spreading to local firms.

But that's not how the white paper tells it. "Nearly all the high-performing Asian economies deliberately set out to support prosperity by investing in people, building capital and undertaking institutional change, including expanding the role of markets," it says.

Asia's young people enjoyed marked improvements in their access to education and its quality as governments invested in their youthful populations and dramatically transformed their education and training systems.

"With the benefits of a good education and employment-creating reforms, large numbers of young people have become productively employed as they reached prime working age."

Open global trading systems (created by the successive rounds of multilateral reductions in protection under the predecessor to the World Trade Organisation, to whose trade-promoting rules China signed up in 2001) and the construction of vital infrastructure to reduce transport costs have been drivers of integration between Asia and the rich economies, but also between the Asian economies themselves.

Intricate regional production networks have emerged, along with increased flows of "intermediate goods" (components) between countries in the region. Specialisation within the region, and the consequent economies of scale, have given the region a powerful advantage, particularly in manufactures.

Here's a point that ought to be obvious to older Australians - since they've been able to observe it over their lifetimes - but too few people understand: Asia's most successful economies have continually evolved.

"As incomes have risen in population-dense economies such as Hong Kong, Japan, South Korea and Taiwan, and as their labour-intensive activities have become less competitive, Asia's high performers have refocused their production on new areas of consumer demand - developing domestic markets and specialising in high-skill activities."

What oldies should have noticed is the way, over the years, the production of simple, labour-intensive goods - such as clothing, footwear and toys - has migrated from one country to another.

Why? Because, contrary to the propaganda of the unions and the Left, Asian workers get their cut from being exploited by wicked "transnational corporations".

As countries' economies grow, workers' real wages rise.

As well, a fair bit of the prosperity is ploughed back into raising the education level of the workforce.

Eventually, the workers' labour gets too expensive to continue using them to produce simple labour-intensive goods, so production of such goods shifts to the next, undeveloped Asian country.

In the first country, production shifts to using the more-skilled workforce to make more sophisticated manufactures. As well, more of the country's production shifts from export to being bought by the now-more-prosperous locals.

The white paper predicts, as this evolutionary process continues, within 13 years - 2025 - China will be the world's biggest economy, India will be third, Japan forth and Indonesia 10th. China will account for a quarter of gross world product and Asia for almost half.

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White paper shows way to Asian century

When governments make grand policy unveilings, as Julia Gillard has with her white paper on the Asian century, it’s terribly tempting for people in jobs like mine to sit back and criticise. After all, unlike you and me governments tend to be less than perfect.

If you’re disposed to criticise, there’s never a shortage of material - particularly if you’re prepared to offer mutually inconsistent criticisms, or shift your angle of attack from one week to the next.

Sometimes the media are so eager to fan controversy they hardly pause to summarise the content of a 300-page document before launching into their own and other people’s criticisms. And no matter how weighty the subject matter, you can bet it’ll be done and dusted within a week.

I prefer to be a little more considered, even more co-operative with our elected leaders (and nor do I regard a diet of unrelieved negativity as a smart way to sell news). So, though I have some major criticisms of my own, I’ll leave them for another day.

Throughout the life of the Rudd-Gillard government people have criticised its failure to articulate an ‘overarching narrative’ - an encompassing story of what Labor stands for and what it’s on about. A vision of the future; something that gives meaning and direction to our national life.

Well, it may have taken five years, but here’s Gillard’s best shot. It’s not, as some have imagined, the report of another committee headed by Dr Ken Henry; it’s a white paper, a firm statement of government policy intention.

So what do the critics say? It’s just more talk. Where are the new decisions? When will we be getting them? What about my pet project?

You may say this is a narrative with an arch that stretches from the economic to the commercial via the financial (and I may agree), but that makes it an accurate depiction of the breadth of this government’s priorities.

Some say suspiciously that the white paper includes a mention of just about every project Labor is working on: the carbon price, the national broadband network, education reform etc. Sure. That’s what overarching narratives do.

It’s a vision of increasing our material prosperity by ensuring we fully exploit the opportunities presented by our proximity to Asia, which is transforming itself from poor to rich within the short space of our lifetimes.

Within that limited purview, it’s on the right track. It’s hard to imagine our equally materialist opposition disagreeing - though you can be sure it will find plenty to criticise.

The white paper says that, to succeed in this objective, Australians need to act in five key areas. First, we need to build on our own economic strengths. In particular, we’ll need ‘ongoing reform and investment’ across ‘the five pillars of productivity - skills and education, innovation, infrastructure, tax reform and regulatory reform’.

Second, we must do more to develop the necessary capabilities. ‘Our greatest responsibility is to invest in our people through skills and education to drive Australia’s productivity performance and ensure that all Australians can participate and contribute.’

Third, we need businesses that are highly innovative and competitive. ‘Australian firms need new business models and new mindsets to operate and connect with Asian markets.’

Fourth, we need stable defence security within the region. And finally, we need to strengthen our relationships across the region at every level. ‘These links are social and cultural as much as they are political and economic.’

It’s easy to say there’s nothing new in the white paper. We already knew about the rise of Asia. And prime ministers have been banging on about our need to get closer to Asia since Malcolm Fraser.

It’s all true. But it misses the point. The experts may be full bottle, but public doesn’t know as much about Asia as it should; this is an attempt to lift our ‘Asia literacy’ as well as getting more study of Asia and its languages into curriculums.

And governments bang on about a lot of things; this is a decision to give our relations with Asia top priority. This is a long-term project and it didn’t start yesterday. It doesn’t hurt to have a grand renewal of our commitment. It maybe old to us oldies, but to our kids it’s new and sparkling.

The white paper seeks to dispel a lot of misperceptions among Australians. For one thing, it’s not just about China. It’s also about India, South Korea and developing Asia in general - and hugely populous Indonesia in particular.

For another, it’s not just about mining. Though the mining boom has further to run, it’s also about selling a lot more food and fibre to Asia at much higher prices, and supplying Asia’s burgeoning middle class with education, tourism, sophisticated niche manufactures and many services.

But deepening our economic (and, inevitably, social and cultural) relations with Asia is two-way street. Exporting more to Asia will mean importing more from it (giving the lie to criticism this is about exploiting the poor people to our north)
And increasing our business investment in Asia will mean accepting more Asian investment in our businesses.

And, as we’ve already seen with the mining boom, maximising our benefit from the rise of Asia will inevitably mean accepting change and upheaval in our economy. The more we try to preserve the world as it was, the more we pass up the opportunities Asia presents.

The other bad news is that full benefit from Asia isn’t something this government or any other can deliver us on a plate. It needs to be a national effort, with most of the heavy lifting done by business, schools, universities, unions and individuals.

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The Asia boom is just getting going

Have you noticed how joyfully the media trumpet the bad news they seek out so assiduously? The latest is that the resources boom is finally busting. O frabjous day! Callooh! Callay!

It's true the prices we're getting for our exports of coal and iron ore, having lifted the terms on which we trade with the rest of the world to their most advantageous level in 200 years in the September quarter of last year, have been falling ever since and have further to go.

It's true China's economy has slowed markedly in recent times and this, combined with the fall in export prices, has prompted some of our smaller mining companies to shelve their plans for new mines.

And last week the Reserve Bank warned the peak in mining investment spending was likely to occur next year and reach a lower level than earlier expected. Fearing a slowdown in the economy, it cut the official interest rate another notch.

So, is this the dumper many people have feared? Is the much ballyhooed resources boom about to disappear into the history books?

Don't be misled. As the secretary to the Treasury, Dr Martin Parkinson, argued last week, it was always misleading to think the resources boom, being just another boom, would soon bust, leaving us in the lurch with nothing to show but holes in the ground.

For a start, it's a bit previous to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to keep growing strongly for another year before it starts to fall back. Even then it will stay way above what we normally see for several more years.

Coal and iron ore prices may be falling, but don't imagine they'll return to anything like what they were. At their best, our terms of trade - the prices we get for our exports relative to the prices we pay for our imports - were almost 80 per cent better than their average throughout the 20th century.

The econocrats now expect that, by 2019, they will have collapsed to a mere 50 per cent above that 100-year average. Nothing to show for it? This means we'll remain wealthier than we were (our exports will continue buying far more on world markets than they used to).

Taken by itself, this lasting improvement in our terms of trade suggests another thing we'll have to show is a dollar that stays well above the US70? or so it averaged in the decades following its float. That means a dollar that remains uncomfortably high for our manufacturers and tourism operators.

All this ignores a further benefit from the resources boom which, though it's already started, is largely still to come: vastly increased quantities of coal, iron ore and natural gas for export. This, too, adds to our wealth.

Before the start of this supposed here-today-gone-tomorrow "boom" - which began almost a decade ago - mining accounted for less than 5 per cent of the nation's total production of goods and services. Its share is now well on the way to 10 or 12 per cent.

At the same time, manufacturing's share will continue its decline from about 15 per cent in 1990 to 12 per cent at the start of the boom and 8 per cent today to maybe 6 per cent by the end of this decade. (Much of this decline, however, is explained by the faster growth of the services sector as we, like the rest of the rich world, move to a knowledge-based economy.)

So yet another lasting effect of this fly-by-night boom is a marked and lasting change in the structure of our economy. To the consternation of some, the non-services part of our economy is becoming less secondary and more primary.

The underlying reason for this shift is the same reason it was always mistaken to imagine this is a transitory commodity price boom like all those we've seen before: the economic emergence of the developing world, led by Asia.

With the industrialisation of China and India, the globe's centre of economic gravity is shifting from the North Atlantic to the Indian and Pacific oceans. It's happening so fast it's visible to the naked eye. All the economic troubles of the Europeans and Americans are speeding it up, not slowing it down.

Remember how the world's richest 20 per cent owned 80 per cent of the wealth? Forget it. The poor countries already account for half the world's annual production of goods and services. Over the next five years, they'll account for three-quarters of the growth in world production.

So we're witnessing a tremendous change in the structure of the world economy, something so big economic historians will still be talking about it in 200 years' time. Is it surprising the effects on our economy are so big and so lasting?

We're greatly affected because of our proximity but also because our economy is so complementary to the emerging Asian ones. We have in abundance what they need in abundance: primary commodities. Their need for our raw materials will roll on for decades, including as Indonesia transforms itself from the world's fourth most populous country to its fourth richest.

This raises the final reason the mining boom shouldn't be lightly dismissed. As Parkinson reminded us, it's just the first wave of change arising from the Asian century. Next comes the rural boom as global demand for agricultural produce surges.

The third wave is the global growth in the middle class - from half a billion to more than 3 billion souls - with its growing demand for better services, goods and experiences. Just another passing boom?

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OK gloomsters, let's run some worst-case scenarios

In the long boom before the global financial crisis, when economists convinced themselves they'd achieved the Great Moderation and everyone was confident the good times would roll on forever, anyone who thought they saw a problem looming was either ignored or dismissed as a fool.

In the North Atlantic economies' continuing agonies since the crisis, it's been roughly the reverse. Excessive optimism has swung to excessive pessimism and anyone who thinks they see a problem looming gets a microphone and loud speaker stuck in front of their face.

Now it's the people who don't think the end is nigh who tend to be ignored. Our cyclical switch to pessimism is being compounded by the media's natural bias in favour of bad news and the tendency of people who dislike the Gillard government to believe everything in the economy has gone to hell.

One person who thinks things aren't as bad as they're being painted is Glenn Stevens, governor of the Reserve Bank. He gave a speech this week in which he begged to differ with the doomsayers. The cogent arguments he advanced deserve more attention than they've been given.

When it comes to dark forebodings, first prize goes to fears of a break-up of the euro. But worries about a hard landing in China are now coming second. Stevens examines the figures and concludes they show "Chinese growth in industrial output of something like 10 per cent, and gross domestic product growth in the 7 to 8 per cent range. To be sure, that is a significant moderation from the growth in GDP of 10 per cent or more that we have often seen in China in the past five to seven years."

But not even China can grow that fast indefinitely and there were clearly problems building up. It's far better the moderation occurs, he argues, if this increases the sustainability of future expansion.

What's more, the Chinese authorities have been taking well-calibrated steps in the direction of easing macro-economic policies, as their objectives for lower inflation look like being achieved and as the likelihood of slower global growth affecting China has increased.

Next he responds to the pessimists' greatest fear of disaster in the domestic economy: a collapse in house prices. He's not convinced they're overvalued by our historical standards. And while, expressed as multiples of annual household disposable income, they seem very high compared with American prices, they are within the pack of other developed countries. It's the US that seems out of line.

But Stevens emphasises he's not saying there's no possibility house prices will fall. "It is a very dangerous idea to think that dwelling prices cannot fall," he says. "They can, and they have." But the ingredients you'd look for as signalling an imminent crash seem even less in evidence now than five years ago.

"Even though we don't face immediate problems, we should ask: what if something went wrong?"

OK, so let's look at some worst-case scenarios. If the thing that goes wrong is a "major financial event" emanating from Europe, he says, the most damaging potential transmission channel would be if there were a complete retreat from risk, capital market closure and funding shortfalls for financial institutions.

This would be a problem for many countries, of course, not just us. But in that event the Aussie dollar might decline, perhaps significantly.

"We might find that, in an extreme case, the Reserve Bank - along with other central banks - would need to step in with domestic currency liquidity, in lieu of market funding. The vulnerability to this possibility is less than it was four years ago; our capacity to respond is undiminished and, if not actually unlimited, is not subject to any limit that seems likely to bind."

An alternative version of this scenario, if it involved the sort of euro break-up about which some people speculate, could be a flow of funds into Australian assets. In that case our problem might be not being able to absorb that capital. But that means the banks would be unlikely to have serious funding problems.

If the thing that went wrong was a serious slump in China's economy, the Aussie would probably fall, Stevens says, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory measures.

"Even if one is concerned about the extent of problems that may lurk beneath the surface in China - say in the financial sector - it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired.

"And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question."

Next, what if house prices did slump after all? In such a scenario people typically worry about two consequences. The first is a long period of very weak construction activity, usually because an excess of housing stock resulting from previous over-construction needs to be worked off. But we've already had a long period of weak residential construction and it's hard to believe it could get much weaker at the national level.

The second common worry is about what a slump in house prices would do to the balance sheets of the banks and other lenders. But this scenario is regularly covered by the Australian Prudential Regulation Authority in its "stress-testing" of the banks.

"The results of such exercises always show that even with substantial falls in dwelling prices, much higher unemployment and associated higher levels of defaults, key financial institutions remain well and truly solvent."

Stevens points out that a lot of the adjustments we're complaining about at present - including households' higher and more normal rates of saving, a more sober attitude towards debt, the reorientation of the banks' funding away from short-term foreign borrowing, and weak house prices - are strengthening our resilience to possible future shocks.

"The years ahead will no doubt challenge us in various ways, including in ways we cannot predict. But what's new about that? Even if the pessimists turn out to be right on one or more counts, it doesn't follow that we would be unable to cope.

"Acting sensibly, with a long-term focus, has as good a chance as ever of seeing us through," Stevens concludes.

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TALK TO FAIRFAX MEDIA SENIOR MANAGEMENT FORUM

Sydney, Monday, February 13, 2012

Greg has asked me to talk to you about the state of the world economy we find ourselves coping with, particularly the problems in the euro zone. But before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

I can say that confident you will take an interest in what I say because everyone already knows economists aren’t good at forecasting but it’s never stopped them asking for another forecast. That’s because the human animal has an insatiable curiosity about the future - an incurable belief that it’s possible to know about the future and the more we know about it the better our chance of controlling it. John Kenneth Galbraith said economists were created to make astrologers look good, but I prefer to say that if people don’t have economists to ask about the future, they’ll settle for asking witchdoctors.

Perhaps economists are modern-day witchdoctors. But I draw a distinction between understanding what’s going on in the economy and predicting what will happen next, so I’m going to focus more on what and why things are happening rather than what will happen next.

I’ll say a bit about China eventually, but I’m sure you realise the big problem area in the world economy at present is the North Atlantic economies, the United States and Europe (including Britain). Most people automatically assume that if these big economies are in trouble that spells trouble for us, but I think it’s important understand the various ‘channels’ by which developments in other countries flow through to us. The first and most obvious channel is via trade: if they reduce their demand for our exports that’s bad for us, of course. But these days the EU accounts for less than 10 pc of our export income and the US for only 5 pc, so direct trade with the North Atlantic shouldn’t be greatly affected. A second channel is via the global financial markets. We know that worries about worries about major problems in the world can push our sharemarket down. And now compulsory superannuation has made a lot more Australians conscious of sharemarket falls. We also know problems with banks can cause some international funds markets to freeze or can push up the cost of overseas funding to our banks, as is happening to a small extent at present. The third channel thru which adverse developments in other economies can adversely affect our economy is via confidence. Consumers and business people hear all the bad news and it tends to make them less confident and more uncertain about the future. Consumers tighten their belts, increase their saving and pay down debts and avoid making new commitments. Businesses put expansion plans on hold, try to improve their gearing, cut non-essential spending such as advertising and maybe lay off staff.

It’s clear this third, psychological channel is the main channel by which worrying developments in the North Atlantic economies become a worrying development in our economy. The more I see of the ups and downs of the business cycle, the more convinced I become that ‘confidence’ - and particularly our collective swings from excessive optimism to excessive pessimism - is the biggest single factor determining the swings in the economy. There are ‘real’ factors at work, of course, but they are greatly amplified by the way business people and consumers are feeling at the time. The trick is that when the way we feel affects the way we act, the merely emotional becomes real. To take an example close to home, when I decide to cut my advertising budget because I’m uncertain about the future, the effect on businesses that sell advertising is very real. And when negative sentiment takes hold, it tends to feed on itself, becoming self-fulfilling and self-reinforcing. This is why, as you may have noticed, in my writing I’m putting a lot more emphasis on ensuring I give our readers a reasonably balanced assessment of how good or bad things are, even tho it’s a lot more fun to scare the pants off them.

Two factors do most to explain why the North Atlantic economies have been in so much bother since the global financial crisis reached its peak with the collapse of Lehman Brothers in 2008, and why they’re unlikely to be completely out of bother for many years. The first is ‘debt’ and the second is the euro. The crisis in 2008 brought an end to a debt-fuelled boom in the developed economies that lasted - with interruptions from mild recessions - for about 20 years. In the US it’s clear households borrowed too much, for housing and to maintain lifestyle; in their efforts to maximise profits banks became too highly leveraged, and the US government ran too many annual deficits and racked up too much debt. In Europe, the banks became far too highly geared and governments were far too undisciplined in their budgeting. When the crisis peaked, governments in the US and Europe borrowed heavily to rescue their banks, then borrowed again to get their economies moving. Coming on top of the already high debts acquired during the long boom, this took most governments to quite unsustainable levels.

But this brings us to a paradox: for individual households or businesses or banks, the best way to get on top of your debts is to tighten your belt; for whole economies, however, the best way is to grow your way out of them. The ideal for governments is to keep growing, while slowly mending your ways. The trouble for governments with lax budgeting records, however, is that markets, German governments and others don’t trust their promises to be good boys tomorrow but not today. This does much to explain the flirtation with policies of austerity which, by making economies even weaker, can make it even harder to reduce budget deficits. Then markets react badly when they see economies weakening. Of course, when a government reaches the point where people are no longer willing to lend to it - as with Greece - it has no choice but to accept austerity.

A point to note is that, because of this debt overhang, it’s idle to imagine (as I suspect some people still do imagine) there’s some way Europe - or even America - can get back to normal rates of growth within a year or two. For a start, the rates of growth we came to regard as normal in the 90s and the noughties turned out to be debt-propelled. It will be a long time before we see its like again. For another thing, the process of ‘deleveraging’ is always protracted. So the only options available to the North Atlantic economies are weak growth for the rest of the decade, or economic disaster for the rest of the decade.

Starting with the US, its households are likely to be preoccupied with getting on top of their debts for many years yet, which will constrain the growth of consumption spending. It has unsustainably high levels of government deficit and debt, but its ‘debt crisis’ is political rather than economic. The two sides in Congress can’t agree on how and when to get its budget under control but, in marked contrast to the Europeans, global financial markets remain so willing to continue financing its deficit that the yield on US Treasury bonds has fallen to 2 pc.

One point I want to leave you with is that the outlook for the North Atlantic economies has improved markedly since late last year. In the case of the US, its recovery faltered in the middle of last year, but has improved a lot since then. The economy grew at an annualised rate of 2.8 pc in the December quarter and the unemployment rate has been falling slowly for the past five months. The US sharemarket is up about 20 pc on its low point in October. Growth isn’t likely to continue at that healthy rate, but all the talk of a double dip has evaporated.

What makes Europe’s story much more worrying that America’s is the euro. The rationale for the single currency area was more political than economic. Even without the addition of the former communist countries, the economies of the foundation members of the area were at far too disparate states of development for this to be a sensible arrangement. The interest rate and exchange rate levels appropriate for Germany and France were never likely to be appropriate for Portugal, Ireland, Greece and Spain - even for Italy. The removal of currency barriers between the 17 members of the euro does increase trade between them and, for a time, the governments of the less developed and less fiscally disciplined members did benefit from being able to borrow in euros at much lower interest rates then they’d been paying.

But, as is now all too painfully evident, all that did was lure Greece and others into borrowing far more than was good for them. And now they’re having difficulty servicing that excessive sovereign debt, the drawbacks of the currency union are painfully apparent: no ability to regain lost competitiveness with the rest of Europe by devaluing your exchange rate rather than cutting nominal wage rates; no ability to set interest rates at levels appropriate to your own needs. And, indeed, no easy way to escape the straitjacket of the currency area. Greek firms that had borrowed in euro would find their debt levels greatly increased when expressed in new drachmas.

The founders of the Euro understood that budgetary indiscipline was the greatest threat to the single currency’s survival, and established deficit and debt limits and targets accordingly. But they failed to live up to or enforce those limits, and now they’re chained together whether they like it or not.

It’s by no means certain the Europeans can make the euro work. And it’s hard to imagine a way it could break up that wouldn’t turn the mild recession they’re already in, into a deep and prolonged recession that worsened the US recovery and made life a lot tougher for us as well. They’re having a lot of trouble agreeing on what they need to do, and the longer they dither the greater the risk of some unexpected but damaging accident.

But having conceded that, I have to remind you of my point that, even with Europe, the situation is now looking a lot less on-the-brink than looked late last year. Under a more pragmatic president, the European Central Bank has provided its banks with huge amounts of cheap three-year liquidity, which has calmed market concerns about the banks. They’ve used much of that liquidity to buy the bonds of euro governments, which has significantly lowered the rates those governments face when they borrow. The euro governments are moving towards a new fiscal responsibility treaty which, at least, seems to have mollified the Germans somewhat. And the Greeks have passed another milestone.

The IMF, the Reserve Bank and Treasury base their forecasts for growth in Europe on the assumption the euro leaders manage to ‘muddle through’ without a disaster occurring. That’s the only sensible basis on which a forecast could be based and, thankfully, it’s easier to see it coming to pass than it was three months’ ago.

I haven’t left myself enough time to talk about China and the rest of developing Asia, but let me make a few quick points. The adverse effect on trade from the North Atlantic economies comes to us mainly via China. So China is the economy whose health we need to be most concerned about. Fortunately the news from the orient is a lot less worrying. It’s true its exports to the North Atlantic have been hit, but many people overestimate its continuing reliance on export-led growth. It’s true the Chinese authorities have been acting to slow their growth and reduce inflation pressure, but they and other emerging Asian economies retain plenty of scope to stimulate domestic demand should the rest of the world slow by more than we’re expecting at present.

The IMF is forecasting world growth of 3.3 pc this year, which is below the average rate of about 4pc, but well above the 2 pc level regarded as a world recession. When you weight that 3.3 pc to take account of the countries to which we send most of our exports, you add 1 percentage point.

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Asia well-placed to withstand global slowdown

Perhaps it's our natural eurocentricity, but we've been hearing a lot more about recession and the risk of worse in Europe than about the resilience of our own region. Fortunately, the International Monetary Fund set the record straight last week.

At a briefing in Washington, the director of the fund's Asia and Pacific department, Anoop Singh, focused on the counter-weight to the weakness in the North Atlantic economies.

If the euro zone is expected to contract by 0.5 per cent this year and the United States to grow by only 1.8 per cent, how come the world is still expected to grow by a not-so-terrible 3.3 per cent? Mainly because "developing Asia" is forecast to grow by a buoyant 7.3 per cent.

Singh made four main points. First, while growth in Asia has slowed, Asian economies have generally proved resilient to the increased turbulence in global financial markets and are helping to support global growth.

Second, there's certainly a risk of contagion to Asia from any further deterioration in global financial conditions.

But, third, the fund believes that, in the event of further slowdown in the global economy, most economies in Asia have room for "a strong policy response" - that is, room to stimulate their economies to offset the effects from abroad.

And fourth, the recent decline in the current account surpluses of China and many other Asian economies is very welcome. Sustained efforts to continue this decline in the medium term will reduce Asia's exposure to the external risks it's experiencing now, thereby maintaining its support for global growth.

"So, in both the short term and medium term, there are positive factors coming from Asia," Singh said.

On his first point, economic activity in Asia has slowed mainly because the growth in its exports has lost momentum, thanks to weaker growth in regional as well as global trading partners. But robust growth in domestic demand is helping offset this drag from external demand.

In China, the two main components of domestic demand - investment spending and consumption spending - have remained resilient, supported by strong corporate profits and rising household income.

And Asian banks have so far used their strong balance sheets to step in and ensure a continued flow of credit and trade finance in the face of the reduction in lending growth by European banks. As growth has slowed in Asia, inflation pressures have waned. So it's not surprising governments have paused the pace of tightening macro policies, or in some cases reversed it. The fund expects inflation to recede further this year.

The fund expects growth in the overall Asia-Pacific region to remain closed to 6 per cent this year, recovering to 6.5 per cent next year. Within this, emerging Asia will remain the fastest-growing region in the world, led by China and India. In China, growth will remain in the 8 to 8.5 per cent range this year, returning close to 9 per cent next year. In India, growth will stay about 7 per cent.

On his second point, these are just the fund's central forecasts. There's a clear risk an escalation of Europe's debt crisis could cause global growth to be 2 percentage points lower than the central forecast of 3.3 per cent.

Were this to happen, Asia would be greatly affected because the usual effect on its exports would be compounded by an adverse effect on business and consumer confidence, as well as by contagion in the financial sector. So there would be a knock-on effect from external demand to domestic demand.

Moving to his third point, were such a deterioration to occur, policy responses by Asia would be needed, without which the impact on Asia's growth would be substantial. But the fund believes many countries have the room to respond.

For many, the room is greater on the fiscal (budgetary) side than the monetary (interest rate) side. The pace at which countries are reducing their budget deficits could certainly be slowed, particularly in those with low levels of public debt, such as China. More than that, some countries could undertake another round of fiscal stimulus.

"Indeed, many Asian countries could advance their plans, which they already have over the medium term, to boost social safety nets and increase consumption and investment," Singh said.

These policies would have long-term positive effects on "rebalancing" - increasing domestic demand and thus reducing reliance on external demand - and growth, as well as reducing income inequality, which remains an issue in many Asian countries.

As for monetary policy, monetary tightening has appropriately been paused in many Asian economies, with some beginning to reverse this tightening. But the room for further easing is limited in economies where underlying inflation pressures remain, such as India. China has little room because it's still absorbing the stimulus from its previous credit expansion of the past two years.

As usual on these occasions, Australia hardly rated a mention. Except for this: "The authorities have certainly committed to return to [budget] surplus by 2012-13, and we have supported that. The authorities have believed that an exit from fiscal deficits is needed to rebuild fiscal buffers and support monetary policy," Singh said.

"Having said that, it is also the case that were downside risks to materialise, with a further slowing of the global economy, in Australia the authorities probably have more policy flexibility than almost any other advanced economy.

"Why? It currently has probably one of the highest policy interest rates, and it probably has the lowest net public debt-to-GDP ratio.

"So, clearly, Australia has the ability to take actions if there were to be a further external deterioration."

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The real action is in the developing world

If the US, the world's biggest economy, starts to contract again and the Europeans' government debt problems prompt more austerity, the world economy will be plunged back into recession. Is that what you think? If so, your picture of the world economy is about 20 years out of date.

There are cultural, historical, family and language reasons why we focus our attention on Europe and the US. The media keeps us well informed about what's happening in their economies. And since, between them, they account for a big chunk of the world economy, it's easy to assume that where they go the rest of the world follows.

Indeed, that used to be true. When I first got into this game, the Organisation for Economic Co-operation and Development used to make forecasts for its 24 rich-member countries, add them up and call it the world economy.

But consider these figures from the Reserve Bank's latest statement on monetary policy. Over the four-and-a-bit years since the March quarter of 2007, the world economy has grown by about 10 per cent in real terms.

The contribution of the North Atlantic economies (the US, Canada, Britain and the euro area) to that growth was near enough to zero. So all the net growth the world's seen in that time has come from the remaining, mainly developing, economies.

Between them, the Chinese and Indian economies have grown by nearly 50 per cent, while east Asia (excluding China and Japan) grew by almost 20 per cent.

The faster the developing countries grow relative to the rich countries, the larger their share of the world economy becomes. An article in The Economist points to the many respects in which the world economy is coming to be dominated by the "emerging economies", as they're increasingly called.

As many as 11 of these economies have emerged to the point where they've been reclassified as developed rather than developing. But when you do that, you understate the extent to which the developing countries are taking over the running. So the figures that follow classify as developing all those countries that hadn't made it to developed status before 1997.

The developed countries account for only about 15 per cent of the world's population, but in 1990 they accounted for 80 per cent of gross world product. By last year that share had dropped to 60 per cent. It is projected to fall to less than half within the next seven years.

But that calculation is based on converting each country's gross domestic product into US dollars at market rates. This understates the developing countries' share of gross world product (GDP) because one US dollar buys a lot more in poor countries than in rich countries.

When you adjust for "purchasing-power parity" you find the developing countries' share of gross world product reached 50 per cent three years ago and is expected to reach 54 per cent this year. Their share of world exports has reached half, which is almost double what it was in 1990.

Much of these exports would be produced by multinational companies operating in developing countries, so it's no surprise the developing countries attract more than half of all the inflows of foreign direct investment.

So far, this conforms to the popular perception of developing countries as economies that make their living selling cheap exports to rich countries. But The Economist observes that "foreign firms are increasingly lured by these countries' fast-growing domestic markets as much as [by] lower wages".

That's the point: developing countries are increasingly standing on their own feet, generating their growth internally.

The mainstays of "domestic demand" are capital (investment) spending and consumer spending. The developing countries now account for more than half the world's capital spending, compared with a quarter 10 years ago.

Last year the US's capital spending was just 16 per cent of its GDP compared with 49 per cent in China. (Ours was 28 per cent.)

The developing countries' share of world consumer spending is only 34 per cent, though this is up from 24 per cent 10 years ago (and would be higher if you allowed for the lower prices they pay for housing and services).

Even so, their shares are: 46 per cent of world retail sales; 52 per cent of all new car sales (up from 22 per cent in 2000) and 82 per cent of all mobile phone subscriptions.

You can see from this how rapidly living standards are rising in poor countries. And when the locals start spending, some of that spending is on imports. Last year the developing countries' share of world imports rose to 47 per cent.

So whereas we're accustomed to thinking of developing countries as dependent on rich countries, it's becoming more the case that the rich countries depend on the developing countries.

Even so, because the developing countries are still at the early stages of developing their economies, their demand for basic commodities - whether locally produced or imported - exceeds their demand for sophisticated goods and services.

They account for 60 per cent of the world's annual energy consumption, 65 per cent of all copper consumption and 75 per cent of all steel use. Yet, as The Economist remarks, there's plenty of room for growth: they use 55 per cent of the world's oil but their consumption per person is still less than a fifth of that in the rich world. (Always assuming we don't run out of oil, of course.)

And here's a pertinent reason the developing countries are likely to continue growing faster than the North Atlantic economies: they're responsible for only 17 per cent of the world's government debt.

No prize for having guessed the punchline: the rich countries likely to do best over the rest of this troubled decade are those most closely plugged into the developing world.

Heard of a poor, cautious, sorry-for-itself country called Australia? It sells less than 10 per cent of its exports to Europe and only 5 per cent to the US, but about two-thirds to developing countries.

Most of those countries are in Asia, of course, the most dynamic part of the world economy. In just the past 10 years, China's share of our exports of goods and services has gone from 5 per cent to 23 per cent, and India's has risen from 2 per cent to 7 per cent.

As Wayne Swan keeps saying, Australia is in the right place at the right time.

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East moves west - more than a miner miracle

You'd need to be living under a rock not to have heard that the world's centre of economic gravity is moving from west to east - towards us. But most of us are yet to appreciate the full ramifications of this change in the globe's economic geography.

The shift is occurring because of the re-emergence of China and India as major economic powers. Why re-emergence? Because in the 18th century - before the West's industrial revolution - the two accounted for almost half of gross world product.

By 1990, China and India's share of world gross domestic product was down to less than a 10th. Today it's about a fifth and expected to be more than a quarter by the end of this decade. By 2030 it may be as much as a third.

Everyone knows the rapid industrialisation and urbanisation of these two countries is the cause of our present resources boom. But as Treasury points out in its annual sermon (otherwise known as budget statement No. 4), there's more to it.

''As China and India continue to develop, the growing cities now driving demand for Australia's mineral resources will be populated by an increasingly wealthy and upwardly mobile middle class, with incomes and tastes to match,'' Treasury says.

''Increasing consumer purchasing power and changing spending patterns will open up new, often unforeseen, opportunities for Australia - well beyond those flowing from the current mining boom.''

One study has estimated that the number of middle-class consumers in Asia could increase by more than 1.2 billion people by 2020. If so, these projections would mean that by the end of this decade Asia would have more middle-class consumers than the rest of the world combined, with China surpassing the United States as the world's single largest middle-class market in terms of dollars.

By 2030, with India following China's lead, the world could have gone from mostly poor to mostly middle class, with two-thirds of the world's middle-class consumers living in our region.

(Like all projections by economists, this one confidently assumes the natural resources and ecosystem services needed to make this possible will be readily obtained - presumably, from another planet. But let's not allow ecological realities to spoil our happy economic analysis.)

In poor countries, spending on basic goods typically accounts for quite a high share of GDP, with household incomes barely covering the necessities of life. Then, in the early stages of economic development, a surge in investment spending causes consumption's share of GDP to fall quite sharply.

In time, however, continued growth allows a larger middle class to devote more money to purchasing luxury goods and services, both in absolute terms and as a share of household spending. As a result, consumer spending's share of GDP recovers as economies reach middle-income status.

China's consumption-to-GDP ratio has declined markedly in recent decades, reaching a low of only 35 per cent in 2009. (Our proportion is about 55 per cent, which is lower than it used to be because of our much higher investment in new mining capacity.)

But China is fast approaching income levels where consumption often turns, and the Chinese government is focused on reforms to foster higher growth in household incomes and to rebalance the economy towards domestic demand. So Treasury says there's considerable scope for a strong rise in the consumption ratio in the medium term.

We know from the earlier experience of countries such as Japan and South Korea in travelling down this road that as the amount of consumer spending grows its composition changes. As they become more affluent, people devote a higher proportion of their spending to services and consumer durables.

The early stages of such a shift are already evident in China. Since the early 1990s, its urban households have devoted a declining proportion of their spending to food and increasing proportions to medical services, transport and communication, and education, recreation and culture.

If you divide urban households into four groups according to their incomes, you find that, as incomes rise, households devote smaller and smaller proportions to food, and bigger and bigger proportions to services.

Urban households constitute a large and growing proportion of China's 400 million households (Australia has 8.5 million). Just over the past 10 years, the proportion of urban households owning a car has gone from virtually none to 12 per cent. The proportion owning microwave ovens has gone from 16 per cent to 58 per cent.

And get this: the number of computers owned per 100 households has gone from eight to 70, while the number of mobile phones has gone from 16 to 188. So ''new technology'' goods are spreading faster than household appliances.

On the ladder of goods and services to which people with growing incomes aspire, after consumer durables come culture, tourism and advanced education.

On overseas tourism, China and India's sheer population size mean they're starting to overtake those countries formerly dominant in providing tourists, the US, Britain and Japan. In 1995, about 4.5 million people from mainland China and 3 million from India travelled abroad for business and leisure.

By 2009, China's travellers had increased tenfold to 48 million, meaning it was close to catching up with the US and Britain. India had experienced a three- to four-fold increase to 11 million travellers a year.

And all this before the rise of the middle class has really got going.

Australia, of course, is already getting its cut. China and India's share of our education exports has risen sharply. China's share of our wine exports is now five times larger than it was five years ago. Tourist arrivals from China have more than trebled in the past decade - overtaking Japan in 2008-09 - and are catching up with those from the US.

Of course, not all the opportunities created by Asia's rising middle class will fall within areas of our comparative advantage. And to maximise even those opportunities that do fit our bill we'll need to continue to change and innovate. Competition with other countries will be fierce. As their own education systems improve, a smaller proportion of Chinese and Indians may seek education abroad.

And Treasury says it's not possible to forecast the exact mix of goods and services that will be demanded, let alone the shape of the global economy that will best service these demands. You can say that again.

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Adapt or die: the high dollar is here to stay

The big ''known unknown'' facing the economy is how long commodity prices and the Aussie dollar will stay so high. That's why some people worry so much about the Chinese economy coming unstuck.

But while the new secretary of the Treasury, Dr Martin Parkinson, acknowledges the risks facing China's economy, his ''central scenario'' is that commodity prices and the Aussie will stay high for a long time.

This means that, though he declined to actually say the words in his speech to the Australian Business Economists in Sydney this week, he's no believer in ''Dutch disease'' - the idea that resources booms lead to a high exchange rate, which wipes out other export and import-competing industries before the boom collapses and leaves you high and dry.

No, Parkinson has a tough message for manufacturers and others asking for assistance to help them cope with the excruciatingly high dollar: get used to it. Adapt.

There are risks facing the Chinese economy, but they are short-term risks around a positive long-term outlook. ''Our central scenario, outlined in the budget, is one of solid medium-term growth for Australia,'' he said, fuelled by high commodity prices and a mining construction boom.

The global economy is undergoing a transformation unprecedented in the last 100 years. Global strategic and economic weight is moving inexorably from the Western advanced economies towards the emerging market economies. And the pace of this transformation is faster than many expected.

The key emerging markets from our perspective are China and India, which together account for slightly more than a third of the world's population. They're growing rapidly and should continue to do so. China should overtake the United States to become the world's largest economy by 2016 and, in turn, be overtaken by India by mid-century.

''There is nothing pre-ordained about these growth paths, and size does not automatically confer economic or strategic weight,'' Parkinson said. ''But these transitions - whether smooth or rocky - have important implications for Australia. Indeed, they constitute probably the most significant external shock Australia has ever experienced.''

Urbanisation and industrialisation in China and India have resulted in strong demand for our energy and mineral resources. The resulting improved terms of trade have increased our real income as the purchasing power of our exports increased.

Looking ahead, a growing Asian middle class will boost demand for our commodities, and for our services exports - education, tourism and professional services - and for niche, high-end manufactures.

But these developments expose our economy to increased macro-economic volatility and, more importantly, to a difficult adjustment process. That's Parkinson's point: it's not just China and India that are economies in transition, it's us, too.

Our terms of trade are now at 140-year highs and the budget assumes they fall back only slowly, by about 20 per cent over 15 years. As for the Aussie dollar, it can be expected to move roughly in line with the terms of trade over the longer term. It's therefore expected to also remain persistently high.

''The implications of a sustained increase in the terms of trade and a persistently high exchange rate are significantly different to those of a temporary shock - particularly for the structure of the economy,'' Parkinson said.

Most Australian businesses are well equipped to deal with short-term exchange rate volatility, but this sustained shift ''will challenge a number of existing business models''.

''Inevitably, this will see calls for support for producers that are suffering from a lack of competitiveness due to a 'temporarily' high exchange rate,'' he said, before going on to explain why such calls should be resisted.

Higher resource prices will see capital and labour shift towards the mining sector, where they are more valuable. This shift will be facilitated by the appreciation of the exchange rate, which shifts domestic demand towards imports and reduces the competitiveness of exports and import-competing activities.

Manufacturing and other trade-exposed sectors that aren't benefiting from higher commodity prices will come under particular pressure, but all sectors will be affected. The longer-term shift away from parts of the traditional manufacturing sector, which began in the middle of the last century, will continue - though it would be wrong to assume all manufacturing will be adversely affected.

And while mining and related sectors (including the mining-related part of manufacturing) can be expected to continue to grow - drawing resources from the rest of the economy - they will be overshadowed by the longer-term shift towards the services sector.

This change to our economy - its structural evolution - reflects a prolonged shift in our comparative advantage that began in the second half of last century, as rapidly industrialising Asian countries emerged as labour-abundant (read cheap-labour) competitors.

The latest phase in this evolution is raising understandable concerns in people's minds: how are the benefits of the boom shared throughout the community? Will our manufacturing sector be ''hollowed out'' and ''lost forever'' leaving us as ''nothing but a quarry''? What if the boom suddenly stops, as all previous booms have?

''Concerns like these are being reflected in calls for measures to protect sectors threatened by the structural shift in our terms of trade,'' Parkinson said. ''They drive calls for strengthening anti-dumping legislation, intervention to deliver a lower exchange rate and increased industry assistance.''

Why is there so much discomfort in the community about this transformation? Because it involves change and change is often difficult. Because the short-term costs of adjustment are concentrated in particular sectors. But also because what's happening - the longer-term structural nature of the change - is not well understood.

People need to be reminded, for instance, that a higher exchange rate helps spread the benefits of the resources boom through the community by reducing the price of imported goods and services.

They need to be reminded the economy is always changing - far more than we realise. Each year, about 300,000 businesses are born and a similar number die. About 2 million workers start new jobs and a similar number leave their jobs. And about 500,000 workers a year change industries.

The gravity point of world trade is shifting closer to us, giving us the opportunity to become a lot richer.

''However, if we are to take advantage of these opportunities it is likely to require more change in the structure [of the economy] and, perhaps more importantly, in the mindset of Australian businesses and the skill sets of Australian workers.''

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It's about China, and steel

You wanna make guesses about what will happen to the economy this year? Here's a tip: forget the floods and take more notice of China.

Australia's business economists have already got the message that China dominates the rest of the world's effects on us, whereas their mates in the money markets are slower on the uptake, retaining their obsession with all things American.

China matters, first, because, with a population of 1.35 billion, it's the most populous country in the world. That gives it 20 per cent of the world's population, making it 11 times larger than Japan.

The second reason China matters is because its economy has been growing so rapidly for so long: an average rate of 10 per cent a year for three decades, meaning it's been doubling every eight years.

This means that, since 1980, it's gone from being the 12th-largest economy in the world to the second-largest. This is measured using "purchasing power parity" - that is, taking account of the fact that one US dollar buys far more in China than it does in the US.

So China's economy has moved from being 9 per cent of the size of America's to about 60 per cent in 2009. The International Monetary Fund is expecting it to reach 90 per cent in 2015. If so, it won't be long before China's the biggest economy.

Of course, this still leaves the average Chinese a lot poorer than the average American. Income per person in China has reached only 18 per cent of American incomes - suggesting the Chinese have scope for a lot more growth yet (provided the world has enough idle resources to make it possible).

When you combine China's huge population with its rapid economic growth you find this growth accounted for a quarter of all the growth in the world economy during the noughties. Get that. America's share of world growth would have been very much smaller.

The third reason China matters so much to us: its economy is in our part of the world and is such a good fit with ours. China needs to buy what we've got to sell, and vice versa.

According to figures from the Department of Foreign Affairs and Trade, last financial year China became both our largest export market and our largest trading partner. Our two-way trade in goods and services grew by more than 18 per cent to $90 billion.

China has been our biggest market for exports of goods for some time but last year it overtook the United States to become our largest market for services as well.

Over the course of the noughties China's share of our two-way trade increased from 5 per cent to almost 18 per cent. Its ascension means Japan is now our second-largest export market. And get this: our third-largest is India.

Our top three imports in 2009-10 were travel ($19 billion), passenger vehicles ($15 billion) and petroleum ($15 billion). But to get back to the point, our top three exports were coal ($36 billion), iron ore ($35 billion) and education ($19 billion).

Why's that the point? Because coal and iron ore are the main things we sell China. Iron ore and coking coal are the main components of steel - and, as part of their economic development, the Chinese are producing huge quantities of steel.

So the well-versed economy watcher needs to know more than a bit about China's steel industry. Its story was summarised by James Holloway, Ivan Roberts and Anthony Rush in an article in the latest Reserve Bank Bulletin.

China is now the world's largest producer and consumer of steel. Ten years ago it accounted for 15 per cent of global steel production; today its share is 45 per cent.

Just how much of a country's gross domestic product is devoted to steel is determined by its stage of economic development. Undeveloped countries don't use much steel and advanced countries aren't very "steel-intensive" because much of their economic infrastructure has been built and most of their growth is coming from expanding services.

In between, however, countries are rapidly industrialising and urbanising. And that's where China is. Remembering its average rate of growth in GDP of 10 per cent a year for the past three decades, its steel production grew at average annual rates of 7 per cent in the 1980s, 10 per cent in the '90s and almost 20 per cent in the noughties.

The Chinese steel industry is highly decentralised, with plants scattered throughout the country and with a small number of large, advanced, state-owned steel makers and a large number of small and medium-sized private firms. The Chinese government's policy is to consolidate the industry, to improve economies of scale and reduce the use of high-polluting facilities.

The industry mainly produces steel directly from iron ore and coking coal using the blast furnace and basic oxygen converter method. This means that, on average, each tonne of steel produced requires about 1.7 tonnes of ore and 0.5 tonnes of coking coal.

China has its own extensive reserves of iron ore, but their ore content averages only about 33 per cent, compared with 62 per cent in Australia and about 65 per cent in Brazil and India, making local ore more expensive. So now more than half the ore used is imported.

Until recently China was self-sufficient in coking coal. But many of its deposits are relatively inaccessible and thus costly to mine. And many of its mines are unsafe. So since 2009 there's been a surge in demand for our coal.

More than half China's annual steel production is used for investment in buildings, structures and machinery. (Total public and private investment spending's share of GDP is a remarkably high 45 per cent - a sign China's in the industrialisation phase of development.)

At least a quarter of steel production is used for manufacturing cars, home appliances and much else. A lot of these would be consumed locally but most are probably exported.

The authors conclude that China's steel-intensive industrialisation phase - and hence its strong demand for our iron ore and coking coal - is likely to continue "over the next decade or so".

One conclusion from this is that the floods' biggest effect on our economy is likely to be the temporary disruption to the Queensland mines' production and export of coal.

Think of China, think of steel; think of Chinese steel, think of Australia making big bucks

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Only part of our fortune is down to minerals

If it exercises my doctor's mind I imagine it occurs to a lot of people: are we a stuffed nation living off our mineral wealth? The thought that we're making a lot of our income merely by digging stuff out of the ground and shipping it overseas seems to worry a lot of people. Is that the best we can do?

Considering the fuss politicians, economists and the media are making about the resources boom, you could be forgiven for thinking mining had taken over the economy, but it isn't true. A lot of people think a nation makes its living by selling stuff to the rest of the world. That isn't true, either. Roughly 80 per cent of all the goods and services Australians produce (gross domestic product) is sold to Australians, not foreigners. Similarly, roughly 80 per cent of the goods and services Australians buy is bought from Australians.

In other words, our economy is roughly 80 per cent self-sufficient. At a pinch, we could make it completely self-sufficient, though this would involve a significant decline in our standard of living. Why? Because we'd be denying ourselves access to all those goods and services that other countries produce better or more cheaply than we could.

Here you see the only reason we need to sell things to the rest of the world: so we can afford to import things from the rest of the world. All of us enjoy those imports, but the notion that 80 per cent of us survive by living off the 20 per cent who produce exports is quite mistaken.

Economies work by a process of specialisation and exchange. We each specialise in producing something we're good at, sell what we produce for money (usually wages), then use the money to buy the things we need from other producers. Most of this trade occurs within Australia, but extending our trade to people in other countries makes both them and us better off, because we've got stuff they want and they've got stuff we want.

Thanks to the industrialisation of China and India - accounting for almost 40 per cent of the world's population - the rest of the world is prepared to pay record prices for our coal and iron ore. Those prices won't stay at record levels but, because the process of industrialisation takes quite a few decades, they're likely to stay a lot higher than they were for a long time.

Though minerals and energy now account for about 42 per cent of our export earnings, this still leaves 58 per cent coming from other parts of the economy: 18 per cent from agriculture, 17 per cent from manufacturing and 23 per cent from services (particularly tourism and education).

When you get down to it, mining accounts for only 7 per cent of the value of all the goods and services Australians produce. That leaves agriculture accounting for 3 per cent, manufacturing for 12 per cent and the services sector for 78 per cent.

We have a lingering tendency to denigrate the services sector because it doesn't produce anything you can see and touch. But this is silly. As our standard of living has risen over the years, services account for an ever-increasing proportion of the things we buy (there is, after all, a limit to how much we can eat and how many cars and TV sets we need). And, as we've seen, it's not even true that we can't export services.

It turns out that 84 per cent of working Australians are employed in the services sector - similar to other advanced economies. And although some service jobs are menial - chambermaids, cleaners, waiters and shop assistants - most of the clean, safe, highly skilled, well-paid and intellectually satisfying jobs are in the services sector: doctors, lawyers, bankers, architects, engineers, managers, consultants, clergy, accountants, journalists, actors, media personalities, academics, teachers and many more.

Take away mining and we wouldn't be quite as rich as we are, but most of the economy would look much the same as it does. Most of us would still have good, secure, well-paid jobs.

In other words, our economy has a lot more going for it than just the good fortune of sitting on a lot of valuable minerals.

In Australia, as in every country, public discussion focuses on the bits that aren't working as well as we'd like them to. The bits that are working well get taken for granted. It would be a pity if all this left people with the impression things in Australia are substandard. They're not.

The level of educational attainment in Australia is high and ever-rising. Tests show our 15-year-olds' literacy, numeracy and science are well above average for the developed countries. Seven of our universities are ranked in the top 200 in the world.

With the notable exception of Aborigines, Australians' health is good by international standards. Our longevity is among the highest in the world. So despite all our complaints, we have a good health system, delivering better results than the Americans' at a much lower cost.

Our material standard of living is around average for the rich countries, but likely to go higher. Our gap between rich and poor is also about average, but not as bad as the other English-speaking countries.

For the past 20 years we've had a particularly well-managed economy, with low inflation, falling unemployment and a rising standard of living. Our banks have been well-supervised and kept out of trouble. Most other advanced economies have huge levels of public debt, but ours is minor.

It's true our mineral riches won't last forever, so we do have to make sure we invest the proceeds wisely, particularly in education. But even without mining we still have a healthy, prosperous economy.

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Our economic challenge will be feast not famine

Perhaps we're seeing the emergence of a new law of elections: the real issues facing the economy in the next term won't bear any resemblance to those discussed during the campaign.

In the 2007 campaign, the Liberal slogan was Go for Growth and Labor wanted the growth to involve more investment in training and infrastructure. In reality, the Reserve Bank was hauling on the interest-rate brakes because of rising inflation pressure, and we ended up spending most of the term fending off the worst global recession in 60 years.

In this campaign, the Libs defined our biggest economic problem as combating Labor's horrendous budget deficits and struggling to overcome Labor's mountainous public debt. They assumed their net cuts in spending (which Treasury and Finance later found to be largely illusory) were the only thing that could return the budget to surplus.

Lacking convictions and the courage of them, Labor - which had done a remarkably good job of shepherding the economy through the global financial crisis - fell in with this bookkeeper's vision of economic management.

But two weeks after the election, the June quarter national accounts have swept away all the nonsense of the campaign. The resources boom is back, the economy is roaring along, the government's filling coffers will soon get the budget back into surplus without the pollies doing any more than resolving not to spend all of it, and the economy's big problem will be growing at full employment without overheating.

Before we explore those challenges that await us, why is economic debate during election campaigns so off-beam?

It's partly because the modern practice of aiming election campaigns almost exclusively at swinging voters in marginal electorates - people known to be uninterested in politics, without ideology, economically illiterate and of a self-centred, what's-in-it-for-me? disposition - means nothing unpleasant or even faintly serious can be raised.

Consider the recent British elections. Anyone taking the slightest notice would have known that whichever side won the election would immediately plunge into sweeping spending cuts and tax increases to hack into a budget deficit that really was a worry. But all sides studiously avoided engaging with the issue.

The other reason election campaigns are so unreal is that even economists can be quite ill-informed about the state of the economy and direction in which it's headed.

Throughout this campaign most economists thought consumer spending and home-building were quite weak, with the worries about the US and European economies, and maybe even the disincentive effects of the new mining tax, putting a question mark over the medium-term prospects for our economy.

Most of those doubts and misconceptions have been swept away by last week's figures, including the survey of firms' capital expenditure plans, which exposed how much the mining companies were lying about the resource super profits tax's supposed threat to their future activities.

I've come to the view that few people - even economists - have a good feel for how the economy's travelling at any moment. It's never very clear what's happening until we see the national accounts. Then, of course, any fool can tell you what the score is.

I suppose it's possible a double dip in the US and lingering weakness in Europe could be sufficient to knock China, India and the rest of emerging Asia off its stroke and thus bring our resources boom to a sudden halt, but I doubt it's likely.

It is likely coal and iron ore prices are near their peak and will fall back as world supply catches up with world demand. But prices could fall a fair way and still settle well above their long-term level. Part of what we lose on price we'll make up on increased volume. And the miners and natural gas companies have maybe a decade's worth of construction projects in the pipeline.

We're back to growing at the trend rate and are already close to full employment. As in all Australian commodity price booms, our big problem will be how we manage the inflation pressure as the extra export income is spent.

Can we keep travelling at full-employment level without overdoing it and having to induce a recession? Rest assured, the Reserve Bank will raise interest rates to whatever level is needed to keep inflation in check, but can we do better than that?

Could we keep tightening budgetary policy to take some of the pressure off monetary policy and interest rates? The bookkeeper's approach to economic management doesn't augur well. The flipside of the nonsense we heard in the campaign is that once the budget's back in surplus, whoever's in government will imagine they're able to spend more freely (just as John Howard did during the first stage of the boom).

To help with the macro management part of the problem, but also to ensure we have something to show for the boom, we need to save a higher proportion of the extra national income. Perhaps we need a sovereign wealth fund to justify ever-higher budget surpluses.

The idea of increasing compulsory superannuation contributions to raise national saving is attractive, but a Coalition government wouldn't go ahead with it and Labor's present scheduled phase-up is too delayed to be of much use.

We need to revisit - more intelligently - the question of population growth, but ask whether meeting the mining industry's need for more labour actually requires open slather on skilled immigration (with all the increased spending on public infrastructure that would necessitate).

Now the election's (almost) out of the way, there's so much we need to debate about economic policy.

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