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Itís the foreign debt stupid!

By Nicholas Gruen - posted Monday, 16 February 2009


In a stand-up routine, Woody Allen is about to be lynched by the Ku Klux Klan. His life passes before his eyes. The childhood in Kansas, swimming, fishing, eating cat-fish with gingham-clad sister Mary-Lou. Does this sound like Woody’s childhood to you? As he explains, “They're gonna hang me in two minutes, the wrong life is passing before my eyes.”

We’re having a Woody Allen economic crisis. Our debt is passing before our eyes. But it’s the wrong debt.

Both economists and politicians are focusing on government debt. But our government is free of net debt thanks to 25 years of responsible fiscal management, umpteen privatisations and the revenue dividend, first from micro-economic reform and then from the minerals boom (remember that?).

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Two thirds of the recent stimulus will fund small scale rapid fire investments. They’ll leave us with a tad more government debt, (less than 3 per cent of GDP). But we’ll own more assets. Given that their construction will employ otherwise unemployed labour, the projects only need to be of reasonable quality - which they are - to render the exercise a no-brainer. It’s like doing renovations on your house during a work layoff.

While we’re waiting for the renovation rescue, the last two stimulus packages have doled out around $20 billion to Australia’s low and middle income households. The evidence from similar exercises elsewhere suggests that about two thirds of the money will be spent within about six months. The annual interest on both cash splashes and the investments amounts to around $100 for each Australian. Is that so scary?

Compare this with the foreign debt - the debt which featured on the Liberals’ “debt truck” as they took power in 1996. But once the Liberals took office and exposed their predecessors’ cover-up of the deteriorating budget, and the difficulty of reducing foreign debt, they had a Woody Allen moment. They decided that they’d been passing the wrong debt before our eyes and switched their critique to government debt. Insert dark mutterings about “Beazley’s black hole” here.

Meanwhile ANU Professor John Pitchford had shown economists why the previous policy preoccupation with external deficits looked like an anachronism with a floating exchange rate allowing markets to equilibrate our foreign debt. If Australian “consenting adults” borrow overseas, why worry? It’s a good question, but as Pitchford himself said, it’s not the last word. Especially when crises threaten, some consenting adults’ financial transactions can unleash systemic shocks.

But the political and intellectual landscape is changing. Fast. A decade of bipartisan fiscal populism anathematising government debt - even for the obviously sensible purpose of building assets - has evaporated as the world’s governments scramble to rescue their economies.

The next casualty might be - might have to be - our complacency about net foreign debt, which was 38 per cent of GDP or just less than $200 billion on the debt truck in 1996. Last sighted at $658 billion or about 60 per cent of GDP, it will surge as we prime the economy while demand for our exports falters. Our current account deficit (CAD) - already smacking gobs at 6 per cent, will soon be gasting flabbers at 9 per cent of GDP.

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Will it end in tears? The good news is that New Zealand’s going guinea pig (sound familiar?). Having overwhelmingly rejected compulsory super, its CAD tops 8 per cent - even amid domestic recession. With net foreign debt already around 90 per cent of GDP, Standard and Poors have it on watch for a credit downgrade. The bad news is that if New Zealand is dumped by international markets, the contagion could spread here as screen jockeys genteelly poke through their goat entrails pondering which nearby economies are sufficiently similar to deserve similar treatment.

So our growth path from recession should be focused on investment, particularly in traded goods and services. That’s why I’d like to have seen faster interest rate cuts (and a correspondingly lower exchange rate) and continued vigorous rate cuts. And we could ramp up the recent investment allowances further and include R&D. But to minimise windfalls for existing plans I’d focus it on firms that were substantially increasing investment. We might be able to bring forward large foreign direct investments by allowing major projects to cash out their shareholders’ imputation credits as lower company tax - as a prelude to doing it more generally.

Now converting investment into strong net export growth also requires higher saving which can be delivered with further increases in compulsory super. Doing so now would worsen the downturn. But committing now to doing it in two years would help address a question foreign lenders on whom we’re increasingly reliant must already be asking themselves.

What’s Australia’s plan to get out of this mess?

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First published in the Australian Financial Review on February 9, 2009.



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About the Author

Dr Nicholas Gruen is CEO of Lateral Economics and Chairman of Peach Refund Mortgage Broker. He is working on a book entitled Reimagining Economic Reform.

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