Moratorium on new coal mines makes economic sense

What are we meant to do about coal? For some time now it's looked like Australians face a painful choice between doing the right, moral thing by the rest of the world and continuing to make a living from our rich endowment of natural resources.

The burning of coal is by far the biggest source of the greenhouse gas emissions that are causing climate change. Australia is one of the world's biggest producers of coal.

Greenies have been arguing for years that, although it's too much to ask that we just stop exporting the stuff, we should at least get in no deeper by ceasing to build any new mines or expand existing mines.

In August, Anote Tong, President of the Republic of Kiribati, called for an international moratorium on new coal mines as a way of underpinning the efforts to get increased commitment to reduce emissions at the Paris summit in December.

Not surprisingly, Tong's call for a moratorium has been supported by 11 other Pacific island nations worried about rising sea levels. But he's also winning support from such influential figures as the Nobel Prize-winning scientist Peter Doherty and the British economist Lord Nicholas Stern.

For such an international moratorium to be effective, we'd have to be part of it. At present, we have 52 proposals to build new coals mines or expand existing ones.

But isn't it too much to ask us to leave all that black gold in the ground? Mining and exporting coal is an important way this economy makes its living.

The developing countries – including China and India – have a lot more developing to do, meaning they'll need a lot more energy, much of which will be coal. What's so bad about them trying to get rich like us? And why shouldn't it be we who supply that coal?

We need more jobs, and think of all the jobs building more big mines would create.

So what's it to be? Conscience or self-interest? Well, how about both?

The Australia Institute think-tank has begun campaigning hard for a moratorium, and a forthcoming paper by its chief economist, Richard Denniss, argues that economic and political considerations actually say we should be joining the moratorium.

Why? In a nutshell, because coal's days are numbered. The rapidly falling price of renewable energy such as wind and solar, combined with the growing resolve of China, the US and others to reduce their emissions, put a dark cloud over the future of coal.

Coal mines are intended to have lives of 50 to 90 years. Will coal prices be high enough in 30 or 40 years to make continued production profitable? If not, investors in new coal mines won't get their money back, but will be lumbered with "stranded assets" – assets that no longer earn much of a return.

Denniss says it's now widely accepted by international agencies that meeting the goal of limiting global warming to 2 degrees requires keeping most fossil fuels unburnt and in the ground.

All this helps explain why the world's big banks, including our own, have become markedly less enthusiastic about financing new coal mines. That – plus the present flat state of the world coal market.

According to the BP company's energy outlook, global coal consumption grew by just 0.4 per cent last year, well below its 10-year average growth rate of 2.9 per cent.

Within that, China's consumption grew by just 0.1 per cent. And Professor Ross Garnaut, of the University of Melbourne, is predicting a significant decline in China's demand for coal for the foreseeable future.

Were we to build all our proposed new mines, we'd double our annual exports. According to Denniss, just proceeding with the five biggest projects in Queensland's Galilee Basin would increase the world's seaborne coal trade by 18 per cent.

What do you reckon that would do to world coal prices at a time when coal demand is weak?

See the point? In such circumstances, preventing further coal development – including by governments declining to subsidise new mine railways and ports – wouldn't just reduce future greenhouse gas emissions.

By avoiding causing further decline in coal prices, it would also benefit the owners of existing mines, the banks that have lent to them and those who work for them, as well as the owners of present and future renewable energy projects. Not to mention the governments dependent on revenue from price-based mining royalties and company tax collections.

On its face, by causing coal prices to be higher than otherwise, it would harm the users of coal and coal-fired electricity. But when you remember that, without something like a carbon tax, the price of coal fails to include the cost to the community of the environmental damage that coal-burning does (including the death and ill health caused by the particulate air pollution from power stations), that's not anything to feel bad about.

But what about all the jobs that building new mines would have created? They're temporary and often exaggerated by the projects' proponents. Once they're built, open-cut coal mines employ surprisingly few workers.

The construction workers not employed to build more mines than are good for us could be better employed building more useful infrastructure.

When you think it through, the case for a moratorium on new coal mines has a lot going for it.

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Resources boom not done yet

If you think the resources boom is all over bar the shouting, someone who ought to know begs to differ. He thinks the last phase of the boom is just getting started. But even he thinks the boom leaves us with stuff to worry about.

In a speech this week, Mark Cully, the chief economist of the federal Department of Industry and Science, says the resources boom actually consisted of three booms.

The price boom lasted for about eight years and peaked in 2011. The overlapping investment boom lasted for about six years, with $400 billion worth of resources projects. Overall, business investment spending peaked in the last quarter of 2012 at an astonishing 19 per cent of gross domestic product.

By now we're in the early stages of the production boom, making the whole thing more of a "super-cycle" than a common or garden boom.

We're well aware that resource prices are still falling from their 2011 peak and that mining investment spending is rapidly coming to an end. But, according to Cully, the production boom is set to last far longer than the others did.

As always, it's a story of global prices being determined by the interaction of global demand with global supply. World prices shot up because demand grew faster than supply could keep up with.

Eventually, however, the world's producers of resources such as iron ore, coking and steaming coal, liquefied natural gas and petroleum responded to the high prices in textbook fashion, desperately expanding their production capacity so as to cash in on the bonanza.

It took a while for that extra capacity to come on line. But, as the textbook predicts, once supply started catching up with demand prices started falling back. And, adding to the pressure for lower prices, world demand started to fall off.

So, isn't that the same-old, same-old end to the story of the boom? And if we get to the point where world supply actually exceeds world demand, doesn't that mean prices could have a lot further to fall?

Not if it's turns out to be true – as I and others have believed – that this commodity cycle is being driven more by a longer-term change in the structure of the global economy than by the usual shorter-term cyclical mismatch between supply and demand.

Many people see the resources boom as caused by the rapid development of China, whose economy is now growing more slowly. But Cully sees China as just the first act, with other countries to follow.

"Economic growth in the highly populated emerging economies of Asia will continue to be a defining theme of this century," he says.

Per-person consumption of energy and materials in most countries in Asia lags the developed nations by a large margin and so is almost certain to grow. As incomes rise and they attract infrastructure and commercial investment, Asia's consumption of resources will grow by volumes that far outweigh whatever's happening in the rich countries.

Iron ore and coking coal are used to make steel, of course. Cully says China's steel production is estimated to have reached a record last year. He expects it to fall in the short term but, over the medium term, to reach a new peak almost 10 per cent higher by 2020.

"This will be required for China to continue expanding its infrastructure networks, especially rail, build more housing and grow its capital stock," he says.

Then there's India. Its Ministry of Steel wants present production to be four times higher by 2025. It may not achieve that target, but this still suggests rapid growth.

There've been highly publicised falls in the world price of iron ore in recent times, but Cully expects it to remain low this year and next before rebounding over the medium term as higher-cost producers exit the market and demand continues to grow. Australia has some high-cost producers, but most are in other countries, leaving Rio Tinto and BHP Billiton as the world's lowest-cost producers.

Turning to steaming coal, Cully questions the environmentalists' optimistic belief that world demand for it is on the way out. More than 300 gigawatt (one billion watts) of coal-fired electricity generation capacity is being constructed or has been approved in developing countries.

"Barring major policy adjustments," he expects coal-fired power to remain a primary source of generation in China and India. Japan, South Korea and Taiwan are increasing their use of steaming coal, while Indonesia, Malaysia, Vietnam and Thailand are increasing by even more.

Australia is likely to play an important role in meeting this increased demand because our coal's higher energy content makes it more suitable for use in advanced generators. Cully expects our exports to have increased by 15 per cent by 2020, making us the world's largest exporter of steaming coal.

Finally, natural gas. Cully's team projects that our exports of natural gas will increase more than threefold to about 75 million tonnes a year in 2019-20. By that time Australia would be the world's largest exporter of gas.

The increased volume of gas exports is likely to be the principal driver of growth in Australia's export revenue. Looking across all the mineral commodities, increases in the volume (quantity) of exports are expected to outweigh further decreases in prices, so that the value of these exports (price times quantity) increases by about a third through to 2019-20.

So what could there be to worry about? Well, it's worth remembering that, although we're exporting more thanks to the resources boom, our share of global exports is actually falling. Other countries' exports must be growing faster than ours.

More concerning, while we've been becoming global export leaders in iron ore, coal and natural gas, our range of exports has become even less diversified than it was before the boom.

Considering how dependent we are on exporting fossil fuels, that ought to worry us more than it does.

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Materialist era a qualified success

Tired of obsessing over what happened in the economy yesterday? Let's go to the other extreme and look at what's been happening in the past 200 years, and broaden the focus from poor, ailing Australia to the world.

In October, the Organisation for Economic Co-operation and Development published a report, How Was Life? Global Well-Being Since 1820. It's an extension of the work of great economic historian Angus Maddison.

His life work was to piece together estimates of real gross domestic product for all the big countries and regions of the world between 1820, which he took to be the end of the (first) industrial revolution, and 2000.

This latest study has extended the GDP figures to 2010, but also tried to estimate measures of various other socio-economic indicators of well-being.

It paints a picture of the way economic development has spread throughout the world, raising living standards, widening but then narrowing the gap between incomes, fostering population growth and, when you combine the two, causing great damage to the globe's natural environment.

The world's population was about 1 billion at the start of the 19th century, but has grown to more than 7 billion today. That growth was both a cause and a consequence of economic development and the technological advance it promotes.

Advances in public health, particularly sewerage and clean water, led to falling death rates, which slowly encouraged people to have fewer children. Then advances in medical science took over, eventually including more effective means of contraception.

However, these improvements took a long time to spread from Western Europe and the "Western Offshoots" (Maddison's name for the United States, Canada, Australia and New Zealand) to the rest of the world.

This is the story of the huge challenge the world economy has faced in the past 200 years: how to feed, clothe and house this growing population. Overall, we've done it.

Between 1820 and 2010, the world's average real GDP per person increased by a factor of 10. Multiply that by the sevenfold increase in population and world real GDP rose by a factor of 70.

The first weakness in this materialist success story is obvious: this economic growth was spread very unevenly. In 1820, the richest country, Britain, was at most five times as wealthy as the poorest countries. By 1950, the richest countries were more than 30 times as well off.

Only recently has the spread of industrialisation to China and India, which between them contain about one-third of the world's population, caused global income inequality to begin to decline.

Another indicator the study examines is the movement in the real wages of unskilled labourers. They rise more or less in line with real GDP, suggesting that some income does indeed trickle down, even if it has to be helped along by government interventions such as minimum wages.

During the first half of the 19th century, unskilled wages were above subsistence level only in Europe and the Western Offshoots. Now, however, world unskilled real wages are about eight times what they were then.

They were always highest in the Western Offshoots, with Western Europe catching up only since World War II, and they are still low in south-east Asia and Africa.

Turning to education, in 1820 less than 20 per cent of the world's population was literate, and most of these were in Europe and its offshoots. Today, literacy is nearly 100 per cent almost everywhere, although in south-east Asia, the Middle East and North Africa, it's about 75 per cent, and in the rest of Africa it's only 64 per cent.

Much of the increase in literacy has been achieved since the war and decolonisation. It has been accompanied by rising average years of education in all parts of the world. Levels of global inequality are much lower for education than for income.

At the start of the industrial period, average life expectancy was about 40 years in Europe and its offshoots, and 25 to 30 in most of the rest of the world. Only after the late 1890s did life expectancy start to rise significantly. Now, it's about 80 in the rich countries. Elsewhere, the catch-up started after the war, with most of the other world regions now up to about 60 to 70, and only Africa lagging significantly behind.

Income inequality within particular European and offshoot countries has followed a U shape, declining between the end of the 19th century and about 1970, since when it has risen sharply. In other parts of the world, particularly in China, recent trends have led to greater income inequality.

However, when we look at global income inequality, it was driven largely by increasing inequality between countries, as opposed to within them. It worsened until the 1950s, but has since stabilised.

The other big weakness in the success story is, of course, what we have done to the quality of the environment. There has been a long-term decline in biodiversity worldwide. Emissions of carbon dioxide have been rising since the industrial revolution, with its shift to fossil fuels such as coal and oil.

Although almost all the greenhouse gases that have built up in the atmosphere since the early 19th century are the result of economic activity in the developed countries, China's huge population and remarkably rapid industrialisation mean that it has now taken over from the US as the world's largest emitter.

Something tells me that, from here on, climate change and other environmental damage will be the main factor limiting the spread of industrialisation and prosperity to the remaining less-developed parts of the world.

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A good deal, but China wins on climate

At last, something to be positive about. Of all the Abbott government's efforts to improve our economic prospects over the year and a bit since its election, none compares with the benefits likely to flow from its remarkable trade agreement with China.

I'm not expecting to see any noticeable gains from the G20 leaders' pledge to increase economic growth by 2 per cent over the four or five years to 2018 - not directly as a result of our government's promised measures, nor indirectly as a result of the other governments' promises.

Those pledged actions don't seem to amount to much. And with Turkey taking over leadership of the G20 next year, it's possible this is the last we'll hear of them.

But the free trade agreement with China is of great substance, with phased reductions in China's tariffs (import duties) against many of our exports and, equally beneficial, in our tariffs against imports of certain manufactures from China.

It's likely to add significantly to our trade with China, increasing our ability to benefit from its growing middle class with ever more Western tastes, and giving us freer access to its ever more sophisticated manufactures. A coup for our tireless Trade Minister, Andrew Robb.

To be truthful, I've never been a great enthusiast for bilateral free trade agreements. They're greatly inferior to multilateral agreements, mainly because they're preferential agreements - you and I favour our mutual trade over trade with other people - contrary to what the term "free trade" implies.

This means they're capable of diverting and distorting trade, as well as generating red tape as rules are established to determine how much of an item that claims to be from China actually is.

But with efforts to achieve another round of multilateral trade improvements having been stalled since 2000, it seems we must accept that a spaghetti bowl of bilateral agreements is the best we're likely to get.

Australia has now negotiated quite a few of these deals, including John Howard's agreement with the United States in 2004 and Robb's agreements with South Korea and Japan earlier this year, but they amount to little compared with the China deal.

That's partly because China is fast becoming the world's biggest economy, partly because China is our largest trading partner - first on imports as well as exports - and partly because our economies are so complementary, but mainly because China is a still-developing country that joined the World Trade Organisation only in 2001 and so has many trade barriers still able to be reduced.

But it's a pity the government's ability to pull off such a good deal with the Chinese is not matched by a willingness to acknowledge the global good news embodied in last week's agreement between the US and China on measures to reduce greenhouse gas emissions after 2020.

This meeting of minds of the two most influential players in the world's efforts to contain global warming has boosted confidence that we may yet be able to limit the industrial-age increase in average temperatures to 2 degrees Celsius and that major progress is possible at the next meeting of countries in Paris next year.

To hear our leaders seeking to avoid short-term embarrassment by denigrating the agreement and misrepresenting China's efforts to limit its own emissions is terribly disappointing. Joe Hockey let himself down with his claim that China will continue increasing its emissions until 2030.

This suggests he's as well briefed on the subject as a radio shock-jock. Should he care to raise his understanding to the level we expect of a federal treasurer, he could read a speech that Professor Ross Garnaut, a noted expert on the topic, gave as long ago as August.

As such a vocal advocate of economic growth, you'd expect Hockey to understand that China is committed to raising its people's material standard of living to a greater fraction of that Australians and people in other rich countries have long enjoyed.

This has inevitably involved much increased use of fossil fuel, with China's rapid economic growth during the noughties meaning it has become the largest contributor to annual growth in the world's greenhouse gas emissions.

But at the meeting in Copenhagen in 2009, China committed itself to reducing the emissions intensity of its economic growth by 40 to 45 per cent between 2005 and 2020. That is, each extra yuan worth of production would involve the emission of less greenhouse gas.

Garnaut points out that, relative to what would otherwise have happened, this represented a larger reduction than any other nation promised. And his calculations imply that the Chinese will achieve their commitment.

They have moved to a new economic strategy in which less of their growth comes from investment in factories and infrastructure and more from consumer spending, especially on services. This should involve less use of energy, particularly from fossil fuels, and so fewer emissions.

Garnaut's projections of China's electricity generation to 2020 - which accounts for most but by no means all of its emissions - suggest that its burning of steaming coal will actually fall a fraction between 2013 and 2020.

So, far from China still increasing its emissions in 2030, Garnaut believes they are likely to have peaked by 2020. You should have known that, Joe.

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Mining boom makes little sense

Conventional economic analysis assumes the behaviour of businesses is always rational but, in reality, the booms and busts that cause the ups and downs of the business cycle are driven by emotion more than rational calculation: unwarranted optimism, greed, impatience, short-sightedness and herd behaviour. Consider our resources boom.

The ideology of economic rationalism says private enterprise can do no wrong; ill-advised behaviour by business arises only through its rational response to distorted incentives created by the misguided interventions of governments.

This confers on the demands made by business a sanctity the captains of industry are quick to exploit. But their demands often aren't in the community's wider interest.

Now we're emerging from the decade-long resources boom it's easier to view the process with greater insight and make a more sober assessment of its costs and benefits.

What happened was a huge jump in the world prices of coal and iron ore as China's period of rapid economic development of heavy industry and infrastructure caused global demand to outstrip global supply.

The surge in China's demand caught the world's mining industry unprepared.

Like miners in other countries, our largely foreign-owned miners lapped up the huge increase in prices and profits.

But it didn't take long for greed ("the profit motive", if you prefer) and the irrational optimism that drives the world's entrepreneurs to take over, with companies seeking to exploit the high prices to the full by expanding their production capacity as much as possible as fast as possible.

What then kicked off was a multibillion-dollar race - between rival companies in a country, but also with the many companies in other countries, all expanding their capacity as fast as they could.

It takes a long time to build new mines and bring them into production. So the chances of your mine being completed in time to enjoy the super-high prices aren't great - the more so because it's essentially a self-defeating process: the more companies join the race and the harder they try to be among the first to complete, the sooner supply catches up with demand and prices start falling.

If mining companies were more rational, fewer would join the race. But companies are just as subject to herd behaviour as investors in a booming sharemarket. A mining chief who didn't join the comp would be subject to heavy criticism.

This is where the irrational optimism comes in. Each individual entrepreneur is in no doubt he'll be among the race's winners. We're gonna make a motza.

But while the miners are busy gearing up, their foreign customers are just as likely to be coming towards the end of their own boom in investment and construction. The inevitable result is that the global mining industry moves from a starting point of undercapacity to an end point of overcapacity.

This is the eternal story of mining. Only in passing is it ever in equilibrium; it's almost always in either under or oversupply - probably spending a lot more time over than under, the less profitable of the two conditions.

Now, this cycle isn't news to conventional economics, with its familiar "cobweb theorem" and "hog cycle" seeking to explain the phenomenon. But these models put too much of the blame on the unavoidable delays in increasing production, and too little on animal spirits.

And they don't prepare us for all the waste and inefficiency involved in a resources boom. In the miners' race to be first in and best dressed they compete furiously for resources, bidding up hugely the prices of labour, equipment and materials, and ending up with mines that cost them far too much to build.

They also develop lower-grade mineral deposits, the exploitation of which becomes uneconomic as soon as the world price drops back from its record heights.

In the aftermath of the boom, many acquisitions are written off, the chief executives who presided over these excesses get the chop and are replaced by bosses whose main skill is cost-cutting. They make speeches about how excessive Australian wages are.

Anyone who has followed the fortunes of our big three - BHP Billiton, Rio Tinto and Glencore Xstrata - will know just what I'm talking about.

In their race-driven frenzy to start new projects, the miners always portray themselves as impatient for God's will to prevail, with any politicians or community members who have doubts about allowing them to rip up the environment denounced as agents of the anti-progress devil.

In the aftermath of such booms we realise we should have refused to be rushed. Why does no economist ever warn us to be less short-sighted? Their faulty model.

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Chinese economy overtaking US and getting more like it

It isn't so many years since I used to berate the denizens of the financial markets for their lack of interest in the economy that had so much influence on ours: China. How things have changed. So has China.

After averaging growth of 10 per cent a year for 30 years, China's economy is now struggling to achieve its reduced target of 7.5 per cent. The financial market participants' role has been to watch on with concern.

And this week comes news that, though the International Monetary Fund sees China coming close to target this year, it expects it to slow to 7.1 per cent growth in 2015 and slow further in following years.

More surprisingly, the fund says that China should slow down to give it a chance to work on its big problems, rapidly growing debt and a rapidly contracting real estate market. Fumble those and growth could be even lower.

But while so many of us have been so focused on China's difficulty maintaining its rate of growth, we've lost sight of how big it is and how fast it's still growing compared with the rest of us.

Compared, say, with the world's biggest economy, the United States. Except that, according to the calculations of Euromonitor International, China will overtake the US this year. That's when you compare the two economies using "purchasing-power parity", which makes allowance for the fact that one US dollar buys a lot more in China than it does in the land of the free.

With China biggest and the US second, then come India, Japan, Germany, Russia and Brazil. We come in at 17th, not far behind Indonesia. The world certainly is changing.

Of course, the Chinese and American economies remain very different. China is big because of its much bigger population - 1.4 billion versus 300 million. Its income per person remains a fraction of America's. A not unrelated fact is that the US's productivity (measured as gross domestic product per worker) is more than nine times higher than China's.

And the two countries' industry structure is also very different. Agriculture contributes 10 per cent to GDP in China but just 1 per cent in the US. But get this: it accounts for almost a third of the workforce, compared with just 1.4 per cent in the US.

Manufacturing makes up 30 per cent of China's GDP, but only 13 per cent of America's. That tells us a lot about why China's rise, and the growth in its exports of manufactures, has affected so many other countries as well as maintaining downward pressure on world prices.

But the biggest difference between the two economies is their relative emphases on consumption and investment. Euromonitor International estimates that this year private consumption will account for 68 per cent of GDP in the US, compared with 37 per cent in China.

Here, however, we get to the really important news: the Chinese authorities have embarked on a process of "rebalancing" the economy, increasing consumer spending and domestic demand and reducing the roles of exports and investment in heavy industry.

The Economist notes that consumer spending has already begun its expansion, with its share of GDP rising from less than 35 per cent in 2010 to more than 36 per cent last year. And this year it has accounted for more than half the growth in GDP.

A big reason for stronger consumer spending is rapid growth in wages. Get this one: over the five years to 2013, real wages in manufacturing rose by about 2 per cent in the US, but by 45 per cent in China. As always happens, the benefits of economic development do flow eventually to ordinary workers.

This strong growth in consumption involves faster growth in the services sector, with manufacturing's share of GDP having peaked at almost a third in 2007.

This structural change means people following the ups and downs of the Chinese economy ought to be following a different set of indicators, as Peter Cai of China Spectator noted last week with help from Guan Qingyou, an economist at Minsheng Securities.

Cai says the main reason Chinese policymakers care so much about the rate of growth in GDP is their belief that the economy needs to grow by at least 7.2 per cent to absorb 10 million new entrants to the labour market each year.

But this correlation has been breaking down since 2010. Slower growth in GDP has not led to weaker job creation. Gaun suggests this is because the expanding services sector has a greater capacity to absorb new job seekers.


More fundamentally, China seems to be approaching its "Lewis turning-point", where a developing country runs out of its supply of surplus rural labour. This would also help explain the rising real wages.

Financial market participants focus on the growth in "industrial production" (manufacturing, mining and utilities) as a predictor of GDP growth, and on the manufacturing PMI (purchasing managers' index) as a predictor of industrial production.

But Cai says the strong correlation between industrial production and GDP is breaking down because the services sector is growing a lot faster than the industrial sector. Last year, for instance, the services sector contributed 47 per cent of the annual growth in GDP, whereas the industrial sector contributed less than 40 per cent. So, it's better to focus on the services sector PMI.

A big problem for China-watchers is that you don't know how much faith to put in official statistics. Earlier in his career, Premier Li Keqiang let it be known that he, too, had his doubts. So he focused on railway freight volumes, electricity consumption and bank lending as offering a better guide.

Now others have developed a "Li Keqiang index". But here, too, Guan argues that its reliability has declined, because of changes in the structure of industrial electricity use and changes in financing. China is changing.

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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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