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Striking parallels: divergent paths

By Saul Eslake - posted Thursday, 11 May 2006


There are some striking parallels between political and economic developments in Britain and Australia over the past 25 years, despite their respective locations at opposite ends of the globe.

Both countries undertook substantial economic reforms in the 1980s, in response to decades of economic underperformance, which saw their average standards of living decline relative to those countries with which they had typically compared themselves. In the early 1990s, the prime mnisters who had led those reforms were both overthrown by their respective treasurers, who each went on to lead their parties initially to unexpected election victories, but then to substantial defeats from which neither of their parties has subsequently recovered.

Australia and Britain both experienced severe recessions in the early 1990s, but these were followed by prolonged periods of strong economic growth, accompanied by low and relatively stable inflation and interest rates.

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After incurring large budget deficits in the early 1990s, both saw a return to fiscal surpluses by the end of the decade. Despite this both experienced a substantial deterioration in their current account balances: to the point where in recent years Britain and Australia have been running the second and fourth largest current account deficits in the world, in absolute terms, in the past three years.

Reforms continued in both countries during the 1990s, and in each possibly the most important reform was the granting of formal independence to their respective central banks. It ended decades of political interference in the setting of interest rates and has contributed to the lower and more stable inflation and interest rates which both have since enjoyed, in marked contrast to their common experience in the 1970s and 1980s.

The emergence of low and stable interest rates combined with sustained growth in real labour incomes, innovation in both countries’ mortgage markets, and high levels of immigration, resulted in both countries experiencing housing booms of unprecedented magnitude, breadth and duration. These booms came to an end at roughly the same time in both countries - towards the end of 2003 and the early part of 2004 - although house prices have plateaued rather than declined precipitously, as they did at the end of the late 1980s property booms in both countries.

And of course in both countries the prime ministers who led their respective parties to major electoral victories in the second half of the 1990s have attained milestones of incumbency matched by very few of their predecessors. And in both countries one of the on-going political fascinations is the frustrated aspirations of treasurers who could have been leaders of their respective parties in the mid-1990s and who now feel that their time has come.

Yet in some other very important respects the course of events in Britain and Australia has begun to diverge in recent years.

Britain’s economy has slowed significantly since the property market peaked. UK real GDP grew by just 1.8 per cent in 2005, the slowest since 1992; while recorded unemployment rose by an average of 7,000 per month last year, the first year in which unemployment has risen since 1992. In response to this slowdown, the Bank of England cut interest rates last August.

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Britain’s fiscal position has also deteriorated significantly, partly as a result of conscious policy decisions but also in response to the slowdown in economic activity.

In contrast, although Australia’s economy also slowed somewhat in the aftermath of the end of our property boom, it was “only” to 2.5 per cent in 2005, and all the indications are that it is picking up again in the first half of 2006. The Reserve Bank of Australia raised interest rates in March last year, and again last week.

And of course Australia’s budget remains in surplus, of the order of about 1 per cent of GDP.

So what is the reason for this difference in the recent economic experience and the economic prospects for two economies whose experience over the previous two decades or so had been so uncannily similar?

The answer is geography and resource endowment.

Britain’s economic fortunes have, over the past 30 years or so, become increasingly intertwined with those of its fellow members of the European Union. The problem this poses for Britain is that the European Union has become increasingly sclerotic, unable to contemplate let alone undertake the reforms required to address deep-rooted structural problems which have undermined its long-term economic performance and prospects.

By contrast, Australia’s geographical location and its bounteous endowment of natural resources have made it almost uniquely well placed to benefit from the rapid growth and industrialisation of China.

Although China’s economy will almost certainly experience cyclical fluctuations in its growth rate (in my view China may well experience a downturn after the Beijing Olympics), there is no reason why it cannot achieve economic growth averaging somewhere in the range 6 to 9 per cent a year over the next decade and possibly the decade after that as well.

As a result, China will almost certainly move past the United States to become the world’s largest economy sometime between 2013 and 2018.

China is for the most part a net importer of commodities and a net exporter of (a growing range of) manufactured goods. And it is now large enough a participant in global markets for the things that it exports and imports to be exerting significant upward pressure on the prices of the former and downward pressure on the prices of the latter.

Australia, by contrast, and somewhat unusually for a “First World” economy, is the exact opposite - a net exporter of commodities and a net importer of manufactured goods (and services). Nature has richly endowed this country with many of the things China needs and cannot produce for itself; while we have relatively fewer of the industries which are increasingly vulnerable to competition from China than the United States or Europe (or, for that matter, other Asian economies).

China has therefore, almost single-handedly, reversed one of the most relentless and detrimental long-term trends in Australia’s economic experience - namely, the persistent tendency for the prices of Australia’s exports to decline, either in absolute terms or relative to the prices of our imports (which economists refer to as the “terms of trade”).

By the end of last year Australia’s “terms of trade” were more favourable (ie, the prices we were receiving, on average, for our exports were higher relative to the prices we were paying, on average, for our imports) than at any point since the March quarter of 1974.

The improvement in Australia’s terms of trade so far this decade has lifted Australian real per capita gross disposable income by over $2,600 per head.

The “China effect” has therefore helped to sustain growth in the Australian economy beyond the end of the residential property boom - in contrast to the experience in the UK; and in contrast to what I expect will be the experience in the United States when its housing boom comes to an end, as I suspect it will later this year.

It has done so not only by raising the incomes of commodity producers themselves.

It has also done so by boosting the tax revenues of the Federal Government (which through the company income tax system takes 30 cents of every additional dollar that higher commodity prices adds to the profits of companies such as Rio Tinto or BHP Billiton), which in turn has handed almost over every additional dollar it has thereby reaped to households in the form of tax cuts or increased cash benefits.

And it has done so by exerting downward pressure on the prices of imported consumer goods, thereby helping to keep inflation and interest rates lower than might otherwise have been the case. And also by stimulating a significant increase in capital expenditure by the resources sector and in its associated infrastructure.

The only real downside from the “China effect” is that by keeping the exchange rate for the Australian dollar higher than it might otherwise have been, the international competitiveness of Australia’s trade-exposed manufacturing and services sector has been eroded. In effect, these sectors have been “squeezed” (pdf file 50KB) to make room for an expansion in Australia’s resources sector in the context of greatly diminished “spare capacity”.

Thus Australia, unlike the UK to some extent, finds itself at a very auspicious point in the business cycle with low unemployment by the standards of the preceding decade or so; rising real incomes; record corporate profits and share prices; and buoyant government revenues keeping budgets in surplus.

The only arguable “black spot” on our contemporary economic report card is that, despite the currently highly favourable conjuncture of export and import prices, Australia is still running a current account deficit in excess of 6 per cent of GDP - in large measure because buoyant domestic demand is spilling over into imports.

The striking thing about this is that we have been here before - in 1960, in 1973, in 1981 and in 1989. With the exception that inflation and interest rates are much lower than they were in 1981 and 1989, the description I’ve just given of the current state of the Australian economy also accurately summarises the condition of the Australian economy on each of those four previous occasions.

And yet within less than two years of each of those four occasions, Australia found itself in one of the four serious recessions we’ve experienced in the past 50 years.

That hasn’t happened by accident; it has happened because whenever the Australian economy has previously enjoyed such a felicitous combination of circumstances, governments and their agencies have made three fatal policy mistakes.

The first has been that of allowing wages growth significantly to exceed productivity growth as “bargaining power” in the labour market has swung from employers to unions.

That mistake seems unlikely to be made on this occasion - partly because of the government’s industrial relations reforms; and partly because structural changes in the labour market - highlighted by the fact that there are now more owners and managers of businesses than trade union members in the labour force - have helped to cement an understanding that pushing for wage increases which are not underpinned by productivity gains is a sure route to widespread job losses.

The second mistake which Australian governments have always made at this stage of the business cycle is that of failing to permit the Reserve Bank to raise interest rates “a little bit” in the early stages of a cyclical acceleration in inflation, and thus ultimately forcing the bank to raise interest rates to recession-inducing levels in order to get inflation down to tolerable levels once more.

I say governments have made this mistake - rather than the Reserve Bank itself - because until the early 1990s de facto, and 1996 de jure, the Reserve Bank used to have to go cap-in-hand to the treasurer of the day to get his permission to raise interest rates; and the treasurer of the day, being a politician, was always reluctant to give that permission if an election was in the offing or until inflation had itself become a serious political issue. It is inevitable that inflation will rise a lot further - and the costs of bringing it down will be much higher - than if you “nipped it in the bud”.

It’s therefore fortunate that the Reserve Bank no longer needs the treasurer’s blessing before raising interest rates. And so the likelihood that the second of the mistakes which has always been made at this stage of previous business cycles will be made in this one is minuscule.

The third mistake which Australian governments have always made at this stage of the business cycle is that when, as now, their coffers are overflowing with tax dollars, they just can’t help themselves from spreading it around in the form of tax cuts or increases in spending - even though this is precisely the stage of the business cycle when fiscal stimulus is least needed and most risky.

This third mistake is one which, unlike the first two, is not being avoided by the present Australian government.

The China-driven resources boom has substantially increased the revenues being collected by the Federal Government. For example, when the government first made an estimate of total tax revenues for the current (2005-06) fiscal year, in the 2002-03 budget papers, they were projected at $187.6 billion.

By the time of the most recent estimate, made in last December’s Mid-Year Economic and Fiscal Outlook, that estimate had been revised up to $203.8 billion, an increase of $16.2 billion (or 8.6 per cent).

Similarly, the estimate of total tax revenues for the forthcoming financial year, 2006-07, has been revised upwards from $193.1bn when it was first published in the 2003-04 budget papers to $212.9 billion in last December’s MYEFO, an increase of $19.8 billion (or 10.3 per cent).

In total revisions to the budget estimates that are the result of anything other than a Cabinet decision, since the 2002-03 budget was handed down, have added $97.5 billion to the resources available to the government over successive rolling four-year forward estimates periods.

“Policy decisions” taken by the government over the same period are projected to “cost” $98.8 billion (in terms of revenue foregone through tax cuts or additions to expenditures).

In other words, the government has spent every dollar - plus an additional $1.4 billion - that the resources boom has dropped into its lap over the past four years.

Now I’m not so naïve as to suggest that the government should or could have “saved” every unforeseen dollar of additional revenue it has adduced since the 2002-03 budget.

Had the revenue windfalls which have come the government’s way as a result of the commodities boom been used in ways that strengthened the capacity of the Australian economy to withstand the inevitable eventual downturn in commodity prices, then there would perhaps be less grounds for concern at the fact that every dollar of this windfall has been dissipated.

But I have to confess that I genuinely struggle to think of anything of lasting value that has been done with it.

And yet the suggestion that the government should have “saved” (that is, added to the surplus) a large proportion of these windfall gains, or at least should have used them in a way that contributed positively to the Australian economy’s longer-term growth potential, is hardly either novel or radical.

Indeed, the idea that “20 per cent of the produce of the land during the seven plenteous years [should be] laid up … as a reserve for the land against the seven years of famine which are to befall the land … so that the land may not perish through the famine” Genesis 41: 34-36 was originally put forward by someone who could perhaps be regarded as the first proponent of counter-cyclical fiscal policy, the biblical prophet Joseph, as recorded in a source that the treasurer (for one) would presumably regard as impeccable.

Since the present government is making only one of the three mistakes that previous governments have made at the corresponding stage of previous business cycles, there are good grounds for optimism that the current cycle will not end as miserably as the four previous cycles have done.

I mean no disrespect to say that from an economic perspective (if not a literary or a culinary one) I’d rather be in Britain than, say, France or Italy; but that (again from the same perspective) I’d also rather be in Australia than Britain.

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This is an edited version of a talk to a luncheon hosted by the
Australia-Britain Chamber of Commerce in Sydney on April 27, 2006. The full transcript is available here (pdf file 64KB).



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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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