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Unbalanced economy a challenge for the RBA

By Henry Thornton - posted Tuesday, 4 June 2013


Australia is no longer the miracle economy, and seems to be heading almost heedless into very difficult times. The Reserve Bank may feel constrained to help relieve the pain by cutting interest rates further, but going too far in this direction will just increase the disequilibrium caused by the major difference in costs of doing business in Australia compared to doing business elsewhere.

Most public discussion has focused on the high value of the Australian dollar, which seems finally to be falling. But domestic costs have also been rising faster than cost increases in both competitor and customer nations. This has inflicted double-barrelled, double-digit cost disequilibrium on Australian businesses.

Assuming it continues, the fall in the Australian dollar will not solve the problem of competitiveness, because what is needed is a reduction in costs measured in foreign currency, which requires future increases in domestic costs to be severely restrained. Further cuts in interest rates will encourage cost increases, not restrain them. This is the major dilemma facing the Reserve Bank.

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A falling exchange rate combined with restraint of costs happened at a time of deep depression in the 1930s and to a lesser extent during the "Banana Republic" crisis of the 1980s. The feature of both episodes was careful and believable explanations by government of the sacrifices needed to minimise the costs of recovering competitiveness.

The current government has, in strong contrast, steered Australia into a situation of great economic disequilibrium whose main manifestation is loss of competitiveness of Australian businesses.

Constant description of Australia as having the "strongest economy in the developed world" allied with grandiose plans to "reform" various aspects of this "miracle economy" by spending taxpayers' money has provided no preparation for the sacrifices that will be necessary to restore Australia's economic competitiveness.

The budget has fallen apart and has been shown to be in far worse shape than Treasury or the government -- which have been engaged in an orgy of mutual backslapping about the economy -- believed until recently.

The cost disequilibrium can be illustrated most clearly by the cancellation or postponement of many large mining projects. But the health of many other industries is worse.

Ford closing its Australian operations, farmers bulldozing fruit trees, major declines of exports of wine and processed foods, tourist departures greatly outpacing tourist arrivals, the plight of small business generally and the difficulty new graduates face in finding jobs all tell a story that has recently been documented more formally by professor Ross Garnaut.

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The short explanation is that the global financial crisis has finally come to Australia.

The GFC has meant that virtually all developed nations are operating with near-zero interest rates and engaging in "quantitative easing" (a euphemism for printing money). This approach is, in my view, a mistake, but this will only be proven by the judgment of history. Meanwhile, it has created the high dollar that is one of the "barrels" of Australia's economic disequilibrium.

The various innovations to global monetary policy will all eventually create goods and services inflation, as they are already fuelling asset inflation, especially share price inflation.

Recent hints by the US Fed that it will at some stage begin to normalise monetary policy have produced sharp falls in share prices and costly increases in bond yields.

Better economic news in the US and Japan has been one effect of massive monetary expansion, but the financial carnage when this policy is reversed is likely to be great. Having Australia's cost base so out of line when there is sure to be a difficult transition to a more normal global monetary policy is the second barrel of our current double-barrelled disequilibrium.

Australia's monetary policy has so far avoided unsustainable cuts to near-zero interest rates, although the new record low in cash rates of 2.75 per cent is a move towards the inflationist position.

Despite recent falls in commodity prices, which previously would have caused the Australian dollar to fall more or less in parallel, global investors seeking yield have been pouring money into the country. The net result is a high dollar that is making Australian industry uncompetitive.

The RBA has in times past been tempted to cut interest rates when there was what was perceived as undue pressure on the currency, such as in the recovery from the mild recession of the mid-80s. In particular, in the late 1980s rates were eased inappropriately and the result was an eventual sharp tightening of monetary policy and the severe "recession we had to have".

Orthodox economists say the first response to our current, greatly distorted position should involve cutting interest rates. My hard question for the Reserve Bank is this: would you be willing to take Australian cash rates to zero, the only rate at which Australian yields would equate US yields, and therefore remove the excessive capital inflow -- seeking yield -- that has been driving our dollar far higher than is desirable?

Regular readers will be aware that I have been urging the Reserve Bank to keep monetary policy firm and to manage the dollar down by controls over excess capital inflow.

This is an unorthodox policy proposal, but safer than embracing the dangerous path to a highly inflationary monetary policy.

Competitiveness will only be restored by a fall in costs measured in foreign currencies, and this will only be achieved after a large devaluation if domestic costs are seriously restrained.

Such an outcome usually requires tough, usually very tough, monetary and fiscal policies. Minimising the cost in terms of lost jobs requires unions and non-unionised workers alike to accept lower wage hikes and governments to provide smaller welfare increases than the inflation which will be a consequence of the currency depreciation.

In an age of entrenched entitlement it is hard to see this happening.

Far better to head off the reduction of competitiveness in the first place by maintaining firm domestic policies, buttressed by controls over capital inflows to prevent a rising exchange rate eroding competitiveness.

Of course, we are where we are, and competitiveness of many industries has already been eroded.

There are many events which could trigger a major fall in the value of the Australian dollar. Whatever the precise cause, or mix of causes, a large fall in the dollar would create fresh dilemmas for the Reserve Bank.

In recent times, the strong dollar has kept traded goods inflation low. Low traded-goods inflation has co-existed with non-traded goods inflation of about 4 per cent. The net result has been overall goods and services inflation comfortably within the RBA's target zone.

But a large fall in the dollar would mean traded goods inflation would jump, and non-traded goods inflation would also rise more quickly.

The RBA might well find that its target "inflation zone" was unable to be achieved by modest increases of interest rates under official control.

The Reserve Bank struggled to find a good answer when the effects of financial deregulation destroyed its ability to achieve the "money growth projections" imposed by government from the mid-1970s to the mid-1980s.

The bank now, following a large fall in the value of the dollar, would have to at least suspend the inflation target, or exclude traded goods (assuming non-traded inflation was not too high for policy to reduce it quickly), risking a major loss of credibility.

Clearly Australia is heading into largely uncharted waters. A policy of realistic recognition and frank discussion of the challenges and the likely costs of different policies is badly needed and long overdue.

The Reserve Bank is on the horns of a major dilemma. What will it do? Probably sit pat for now but with a bias towards further cuts. Choosing the slippery slope.

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This article was first published in The Australian.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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