The shocking trade deficit for January has focused on the sad fact of Australia’s lack of competitiveness in trade and the consequent rapid build up of international debt. Some of the headlines have read: “Big current account deficits the villains in debt tale”; “More vulnerable to the next economic shock”; and “Miners the only winners in record trade collapse”.
The trade deficit for January was adversely influenced by the hurricanes in the northwest of Australia, which inhibited mining exports. But we are running out of excuses on the trade deficit. Export volumes have been predicted to rise for years now - for example by Treasury in successive budget estimates. But there has in fact been little overall increase, and some sectors, such as manufacturing exports, have fallen while drought has decimated rural exports.
The situation has been masked by the substantial rises in the prices of mineral exports, as Australia experiences what is increasingly looking like a once-in-a-century mining boom. The obvious question is what happens when resource prices stop rising and begin to fall. Other things being equal this will produce a blow-out in the trade deficit from levels that are already in the amber zone.
The trade deficit is not the whole story, however. Australia’s net international debt has been rising to the point where it was a whopping $493 billion at the end of December. This is slightly over 50 per cent of GDP, compared to less than 40 per cent a decade ago when the Liberal “Debt Truck” was rumbling around the nation. The net income deficit will keep growing while the trade account is in deficit and (as a rough approximation) will keep rising as a ratio to GDP while the current account deficit exceeds 3 per cent of GDP.
There is another point of potentially greater concern. The rapid accumulation of international debt has occurred at a time of record low international interest rates, and global interest rates are now on the increase.
What the policy makers need now are sensible five year projections of Australia’s current account, net debt and the ratio of net international debt to GDP. The base case would start with continuation of recent trends for growth of import volumes, export volumes, import and export prices and global interest rates. The alternative scenarios would allow for lower export prices and higher global interest rates. I conjecture that the debt and interest rates would blow out to a point where the only sensible prediction would be for a collapse of the currency to restore competitiveness of Australian industry and a rise in domestic interest rates to effect a reduction of imports so that the trade account moved from deficit to surplus. In short, “a recession we have to have”.
Exactly this exercise was done by the Reserve Bank’s Research Department in 1986 and led to the then Treasurer’s famous “Banana Republic” call to arms. It also led to cuts in government spending, cuts in real wages and a touch on the monetary brakes in what was one of Australia’s most successful examples of economic policy fine tuning.
Current conventional wisdom has it that virtually any current account deficit is manageable because, with the Federal Government’s accounts in modest surplus, the external deficit reflects the decisions of the private sector. But full analysis requires us to examine what is really going on. The private sector is spending more than it earns and borrowing (and selling assets) to enable this to continue. The point is that these trends are sustainable only for as long as international investors think they are sustainable. A substantial adverse shock would lead investors to take money out of Australian markets, the currency would fall and lead to further sales of Australian assets in a vicious cycle that would be best described as a debt induced collapse. It would require strong policy action to limit the damage.
The policy action in response to the “Banana Economy” call to arms was not enough to prevent, although it certainly delayed, the larger adjustment that precipitated “the recession we had to have” in the early 1990s. The key to lasting recovery was to “break the stick of inflation”, which was the welcome side effect of our most recent recession. The abolition of inflation restored Australia’s international competitiveness and laid the basis for the record period of sustained prosperity that Australia is still enjoying.
This column has argued that a tougher monetary policy in recent years would have limited the growth of domestic costs, kept imports under better control and limited the growth of Australia’s international debt. This approach would have made our economy even stronger, with less risk of a debt induced collapse. But it would not have created faster real growth. Real, sustainable growth is created by reforms that encourage hard work, extra saving and investment (both by individuals and businesses) and additional entrepreneurial activity.
There is now a welcome widespread discussion of the desirability of real tax reform, as opposed to piecemeal tax cuts designed to give back some of the Federal budget surplus. The Treasurer has publicly questioned whether we can afford large-scale tax reform, which shows he has not forgotten the message that he was seeking to drive home with the debt truck all those years ago.
Real reform, as symbolised by a serious cut in the top marginal rate of tax to 30 per cent, would if done all at once, add to domestic demand and raise the chances of a debt induced collapse. If it were announced to be implemented gradually over several years, it would buttress the confidence of international investors to the point that Australia might very well be able to remain on its current strong economic trajectory. That is the essence of what we are playing for as we debate real tax reform at this stage of Australia’s history.
The question we should be asking is: “Can we afford not to embark on real tax reform?”
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