11 March 2014
The one-trick pony will drop dead without care
Australia's miracle economy is not as complex as it appears. It only has three moving parts, really, and if you understand that then you've gone a long way to gaining insight into where it's headed at any given time.
The three parts are these:
Think of it like this. The resource exports are our national income but that's nothing like enough to keep us living the life to which we've become accustomed. So we leverage that income up by borrowing offshore (or selling stuff to foreigners) and trade houses with one another to share the now inflated resources wealth. When we hit a speed hump, either in the income flows or in our capacity to leverage them, the clean balance sheet of the national budget steps in and guarantees our borrowings.
It's a beautiful animal, not really designed by anyone in particular, but one that has evolved over several decades of good fortune. For a long period, it hasn't needed productivity growth to prosper, it hasn't needed competitiveness or innovation to prosper, it hasn't needed terribly good management to prosper, either.
All that has been needed to continue on the longest stretch of continuous growth that anyone can remember is pragmatism, a certain amoral knack of persisting with the notion that our system remains a functional private economy despite all evidence to the contrary. That delusion is our real competitive advantage.
You can see why, then, that outsiders might struggle to understand what makes the economy tick. We tell them that we have succeeded because of our hard work, our impressive reform track record, our ship-shape budget and AAA rating, which has freed the private sector to drive innovation and investment. We say all of these things and point to the stellar pricing of our assets as proof.
There is even some truth to it. The benefits of the resources income do derive from an entrepreneurial spirit, or perhaps more the speculative spirit of the prospector, and his freedom to pursue obscene wealth without interference. The staggering rise of Australian iron ore supply is not all about proximity and natural advantage. It's also about an openness to chase the dream.
A feeble-minded onlooker could be easily swayed.
But, if you place such an economy into a broader context, what matters most to those lending us the money to live high on the hog is the commodity income that is our real wealth and the strong Budget that results. It is this income stream that keeps our external imbalance in check and guarantees it when it's threatened, reassuring our creditors that we are solvent and that they will get their money back, allowing us to borrow cheaply. It is this simple truth that leads more perspicacious global analysts to conclude that the Australian economy is a one-trick pony.
It's an appropriate metaphor. Resources are the mule upon which we ride. We have loaded it up with a superstructure of stuff to make ourselves feel richer but it is the ass that matters and he is looking more than a little exhausted today. At least for the time being his foam-flecked lips need a break lest he keel over stone dead, and if that happens then our elevated jingling caravan is going to crash along with him.
Enough of the metaphor, you yell, your voice echoing off the barren cliffs of the Pilbara gully in which this discussion is taking place. Tell us what you mean!
I mean this. As iron ore crashes today and enters its great shakeout, in which it is going to surprise everyone to the downside in terms of both price and duration, Australia's primary income stream is in jeopardy. It doesn't matter that that income stream is far larger than it was ten years ago. We long ago leveraged up that pay packet and the remainder of the miracle economy is already inflated to current income levels. What matters is what we do now to boost our incomes in lieu of iron ore. That will determine whether or not our little mule can rise again or will drop dead on the spot.
The likely flow of events from here is as follows. As we enter a new terms of trade shock, national income, nominal growth, corporate profits and budget receipts are going to tumble. This is going to happen despite any fall in the dollar, which does not look like its going to happen with sufficient depth anyway.
This unfortunate outcome is going to combine with the capex cliff to make life extremely difficult for the nascent cyclical rebound that is seeking to build another level upon our already towering golden saddle.
Yes, we'll get support from the little boom in housing investment, foreign and local. We'll also be getting a new income stream from gas in 2015. But it's not going to be enough to prevent rising unemployment and so, to keep consumers spending anyway, interest rates are going to fall further and that, eventually, will deliver the medicine that we really need, a far lower dollar to replenish the reserves of our poor tired mule.
If we manage through this OK then it will be because we've added another layer to our housing bubble superstructure despite the odds. But to prevent this saddle bag from breaking the mule's back in the mean time, the RBA and APRA are going to have to install macroprudential tools.
Meanwhile, the government is in a terrible bind. It needs to blow the Budget so that our near-dead donkey has a marquis under which to rest. But it also needs to be seen to be repairing the Budget so that its guarantee of the stability of the tottering pillion can be taken seriously. It is pursuing the right course by seeking to cut recurrent expenditure and expand investment. But that's taking far too long, is replete with pork and, let's face it, is run by Australian politicians, ergo it'll be stuffed up.