How party politicking let mining companies wreck our economy

A speech by former Treasury secretary Dr Ken Henry last month was reported as a great call for comprehensive tax reform. But it was also something much more disturbing: an entirely different perspective on why our economy has been weak for most of this century and – once the present pandemic-related surge has passed – is likely to stay weak.

The nation’s economists have been arguing for years about why the economy has grown so slowly, why real wages have been stagnant for at least a decade, why the rate of productivity improvement is so low and why business investment spending has been so little for so long.

Most economists think we’ve just been caught up in the “secular stagnation” – or slow-growth trap – that all the advanced economies are enduring.

But Henry has a very different answer, one that’s peculiar to Australia. Unlike everyone else, he’s viewing our economy from a different perspective, the viewpoint of our “external sector” – our economic dealings with the rest of the world.

What conclusion does he come to? We’ve allowed ourselves to catch a bad case of what economists call “Dutch disease” – but Henry thinks should be renamed Old and New Holland disease.

When a country discovers huge reserves of oil or gas off its coast – or, in our case, the industrialisation of China causes the prices of coal and iron ore to skyrocket – all the locals think they’ve won the lottery and all the other countries are envious. Now we’ll be on easy street.

But when the Dutch had such an experience in the 1960s, they eventually discovered that, while it was great for their mining industry, it was hell for all their other trade-exposed industries.

Why? Because the inflow of foreign financial capital to build the new industry and the outflow of hugely valuable commodity exports send the exchange rate sky-high, which wrecks the international price competitiveness of all your other export and import-competing industries: manufacturing, farming and services.

Not only that. The rapidly expanding mining industry attracts labour and capital away from the other industries, bidding up their costs. Their sales are down, but their costs are up. You’re left with a “two-speed economy”. Remember that phrase? It’s what we’ve had for a decade or two.

Well, interesting theory, but where’s Henry’s evidence that Dutch disease is at the heart of our problems over recent decades?

He’s got heaps. Start with the way the composition of our exports has changed. Between 2005 and today, and in round figures, mining’s share of our total exports has doubled from 30 per cent to 60 per cent. Manufacturing’s share has fallen from 40 per cent to 20 per cent. Everything else – mainly agriculture and services – has fallen from 30 per cent to 20 per cent.

Over the same period, exports grew from 20 per cent of gross domestic product to 27 per cent. This means mining exports’ share of GDP has gone from about 6 per cent to more than 16 per cent. Manufacturing exports’ share has fallen from about 8 per cent to 5.5 per cent.

Next, who buys our exports? China’s share has gone from about 10 per cent to more than 45 per cent. Actually, that was the peak it reached before China’s imposition of restrictions after some smart pollie decided it would be a great idea for Australia to lead the charge of countries blaming China for COVID. Since then, China’s share has fallen to 30 per cent.

Since 2005, mining’s share of total company profits has gone from about 20 per cent to 50 per cent. Manufacturing’s share has fallen from about 20 per cent to less than 10 per cent. Financial services – banking and insurance – have seen their share fall from 20 per cent to less than 5 per cent.

Now, what’s happened to those industries’ share of total employment? Manufacturing’s share has fallen from more than 9 per cent to about 6 per cent. Financial services’ share has been steady at a bit over 3 per cent. Mining’s share has risen from less than 1 per cent to 1.5 per cent. You beauty.

“In summary,” Henry says, “mining employs a very small proportion of the Australian workforce – except in the boom times, when it induces a worker to leave other jobs for mine-site construction work – generates about 60 per cent of Australia’s exports, about half of pre-tax profits (mostly repatriated overseas to foreign shareholders) and exposes the Australian economy to highly volatile global commodity prices and a heavy strategic dependence upon a single buyer, China.”

Not to mention the way mining leaves us heavily exposed to “the risk of global decarbonisation”.

How have we profited from being a mining-dominated economy? Real GDP per person – a rough measure of our material standard of living – has been in trend decline for two decades. In the decade pre-pandemic, “we recorded the sort of growth rates only previously recorded in recessions,” Henry says.

This weakness is largely explained by our poor productivity performance. Though no one else seems to have noticed, our productivity growth is negatively correlated with our “terms of trade” – the prices we get for our exports, relative to the prices we pay for our imports.

That is, when our terms of trade improve, our rate of productivity improvement worsens. And our terms of trade are largely driven by world commodity prices, especially for coal, gas and iron ore.

Now the tricky bit. Why would a mining boom depress productivity improvement? Because of the way it raises our real exchange rate – our nominal exchange rate, adjusted for the change in our rate of production-cost inflation relative to those of our trading partners.

The resources boom increased our nominal exchange rate by about 25 per cent. Then, by 2011, high wages growth and weak productivity growth relative to our trading partners had added a further 35 per cent to the rise in the real exchange rate, Henry calculates.

This caused our non-mining producers to suffer a “profound loss of international competitiveness”. Is it any wonder that, between the turn of the century and 2019, the annual rate of investment by non-mining businesses fell from 7 per cent of GDP to 5 per cent?

The result is that two centuries of “capital-deepening” – increased equipment per worker – have stalled. This move to “capital-shallowing” explains our poor productivity.

And also, our move from current account deficit to current account surplus. “We are exporting [financial] capital because Australia has become an increasingly unattractive destination for doing business in the eyes of foreign investors and Australian [superannuation] savers alike,” Henry says.

“The mining boom has left us with a very big competitiveness overhang that will probably take decades to work off,” he says, including by decades of weak growth in real wages.

What should we have done differently? Had we applied a rational tax to the windfall profits of the mining companies, we would not only have retained for ourselves more of the proceeds from the export of our own natural resources, but also caused the rise in our real exchange rate to be lower.

Remember Kevin Rudd’s proposed “resource super profits tax”? The mining lobby set out to stop it happening, telling a pack of lies about how it would wreck the economy. The Abbott-led opposition threw its weight behind the mainly foreign miners.

Julia Gillard consulted the industry and cut the tax back to nothing much. The incoming Abbott government abolished it.

Petty, short-sighted politicking caused us to sabotage our economy for decades to come.

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We got our cut from the resources boom

Do you realise you've been hearing about the glorious Resources Boom for the best part of a decade? To economists, it constitutes the greatest bit of good fortune to come Australia's way since the Gold Rush. To many of us, however, it hasn't sounded nearly so wonderful.

For one thing, there's that word boom. We know booms can't last. And aren't they supposed to end in bust? For those of us of a certain age, it's not the first commodity boom we've lived through - and the previous ones did end badly.

So a commodity boom is a big improvement in our income that, just as we're starting to get used to it, suddenly disappears, leaving us with a hangover. Great.

And then there's the word resources. It leaves many of us feeling uncomfortable. We were never all that impressed by making our living growing things in the ground and selling them to foreigners, but digging up part of our ground and shipping it overseas seems even more primitive.

Is that the best we can do after 200 years of development? We send our children to school and university for that? How long can we get away with that? Obviously there's a limit to it. Won't it leave us high and dry?

I suspect many of us have drawn perverse satisfaction from the recent pronouncements that the boom has ended. At least the hoopla's over and we're getting back to reality. Time for the reckoning - and the recriminations.

What have we got to show for all that fuss? I'm sure some people must have benefited, but I know I didn't. Surely we should have saved more of that windfall rather than frittering it away on high living? And what do we do for an encore? Haven't we destroyed our manufacturing sector in the process?

These fears are examined in a report by Dr Jim Minifie, of the Grattan Institute, published on Monday. It makes reassuring reading.

If you don't work in mining, or live in Queensland or Western Australia, it's easy to conclude you've seen none of the benefits from this supposedly fabulous boom. But that's because people are conscious only of the benefits that come directly. The trick is that, when we all live and spend in the same economy, the benefits get spread around.

For most of us, the benefits have been indirect, but very real for all that. For instance, many people don't count the high dollar - and its cheaper prices for overseas holidays and other imports - as part of their gain from the boom.

Minifie finds that while people in the mining states did better, those in the non-mining states didn't miss out. Between the 2003 and 2013 financial years, wages rose by 2.7 per cent a year faster than inflation in the mining states and by 1 per cent a year in the non-mining states.

When you switch to looking at income per household, the ratio improves. Household income per person rose by a bit less than 4 per cent a year in the mining states and by 2.4 per cent a year in the non-mining states. Household incomes in the non-mining states grew significantly faster during the boom years than in the previous seven.

Unemployment didn't differ greatly between the mining and non-mining states. They began the period at much the same rate and ended it much the same.

Minifie finds that some regional centres did better than others through the boom, but among centres hit by the high dollar, most still experienced rising employment, thanks to steady economy-wide growth.

Only 14 towns, with a combined population of just 600,000, experienced falls in employment as a share of population, with no town losing more than two percentage points.

We keep hearing that the high dollar has "hollowed out" our manufacturing sector, leaving it incapable of recovering once the dollar comes down. (Tourism and some other industries have been equally hard hit, but no one worries about them.)

Despite a decline in employment in manufacturing, Minifie finds its output didn't fall, mainly because of increased demand from the resources sector. And although its exports fell overall, exports of more sophisticated manufactures grew.

"The experience of other countries that have been through a big shift in exchange rates suggests that Australian manufacturing is unlikely to have suffered permanent damage," he says. "If exchange rates decline, manufacturing is likely to bounce back to [its longer-term rate of growth] within a few years."

Much has been made of Minifie's finding that successive federal governments - Liberal and Labor - saved very little of the higher tax collections they enjoyed as a result of the boom. They gave away most of it in income-tax cuts (thereby improving your standard of living).

But despite the media's efforts to convince you otherwise, the federal budget is not the totality of the economy. Nor did all of the benefits from the boom go solely to the federal government.

The broader picture is that, as a nation, we have saved a high proportion of the proceeds from the boom. Greatly increased saving by households, and increased retention of earnings by companies, have more than outweighed the reduction in saving by governments.

The nation's overall saving rate is now about 3 per cent of national income higher than it was, equivalent to about $50 billion a year. Why are we so easily convinced we're losers?

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Subsidies no way to fix high dollar problem

Emeritus Professor Max Corden, of Johns Hopkins University, formerly of Oxford University and now back at the University of Melbourne, is probably Australia's most distinguished living economist. So when he writes on what we could do about "Dutch disease" we ought to take note.

What follows is my account of his paper for the Melbourne Institute, The Dutch Disease in Australia: Policy Options for a Three-Speed Economy. As is often my custom, it will consist largely of direct quotes, indirect quotes and paraphrases of his paper. This practice is known as "reporting". If I misreport his views, feel free to criticise; but don't be silly and accuse me of stealing them.

Corden is an expert on Dutch disease - the economists' term for a situation where a boom in one export industry leads to an appreciation in the exchange rate, which reduces the profitability and the output of other export and import-competing industries.

He starts by dividing the economy into not two, but three sectors according to how they're affected by the boom. First is the "booming sector" (mining and related industries, in our case), then there's the "lagging sector", consisting of the other trade-exposed industries hard hit by the high dollar (part of manufacturing, agriculture and tradeable services such as tourism and some education).

But then there's the "non-tradeable sector" consisting mainly of those service industries whose prices are determined only by domestic supply and demand. This third sector is important because it's the largest part of the economy and "there are almost certainly net gains" from the boom.

The gains arise because the boom causes increased domestic spending on non-tradeables and because of the reduced prices of imported items.

Corden argues there are three broad options for the government to choose from in responding to the difficulties Dutch disease causes for the lagging sector.

Option 1 is "do nothing". "The real exchange rate appreciation is an inevitable consequence of the terms of trade boom and the capital inflow, both of which have benefits," Corden says.

"Some industries rise and some decline, and some declines, in any case, may be temporary. The government can help in the adjustment process, but should not try and stop or slow up adjustment," he says.

"This is one point of view, though it may not be politically attractive," he says. But "doing nothing" doesn't prevent the government from fostering the flexibility of the economy, improving the skills of the labour force, removing obstacles to people moving, temporarily assisting losers, providing information or improving infrastructure.

Option 2 is "piecemeal protectionism". "Of the various groups of industries adversely affected by Dutch disease it is manufacturing - or perhaps particular manufacturing industries, or even firms - that are usually selected for deserving special assistance, whether in the form of subsidies or import tariffs," Corden says.

But this option is "highly undesirable" and "based on questionable economic thinking". (Note that when Corden uses the term "protection" he's including subsidies as well as import tariffs.)

What's wrong with piecemeal protection? Apart from all the usual arguments against protection, there's one that applies particularly to Dutch disease, but is usually overlooked. Corden calls it the "general equilibrium effect".

"Suppose extra protection is provided for the motor car industry," he says (writing well before last week's announcement of extra assistance to General Motors). This reduces imports of cars, as is the intention of the policy, but will lead to extra appreciation of the exchange rate.

If all manufacturing industries were significantly protected there would be a substantial appreciation, which would actually worsen the Dutch disease effects on other industries in the lagging sector - agriculture, tourism and education exports.

Similarly, protection for selected manufacturing industries would have adverse effects on other industries in the lagging sector, including those parts of manufacturing that didn't receive the extra assistance.

"These losers would thus suffer not only from the effects of the mining boom but also from the political success of their industry colleagues in extracting protectionist measures from the government," he says.

It's been suggested that the miners should be required to source various supplies domestically rather than import them. A similar requirement could be imposed on government spending and on private suppliers to the government.

Such requirements would also lead to greater exchange-rate appreciation than otherwise. They would thus benefit some industries and workers but, through their aggravation of the Dutch disease effect, would damage other industries and workers.

The third option the government could choose in responding to Dutch disease is "fiscal surplus combined with lower interest rate". The government cuts spending or increases taxes to achieve or increase a budget surplus.

This would have a contractionary effect on demand in the economy, but its reduction of inflation pressure would allow the Reserve Bank to ease its monetary policy and lower the official interest rate. This, in turn, would lead to some depreciation of the exchange rate because our lower interest rates relative to those in other countries would reduce the net inflow of capital to Australia.

So the Dutch disease effect would be moderated, but at the cost of politically difficult changes in taxation and spending.

The advantage of this option is that it benefits all lagging-sector industries evenly. But, Corden argues, it's just one way of providing "exchange-rate protection". So it, too, creates winners and losers.

All tradeable industries benefit from the lower exchange rate (including the miners), but the much larger, non-tradeable sector loses from it by having to pay more for imports. The lower dollar also reduces the incentive to invest in Australian development.

I conclude from Corden's analysis there's no easy, costless way to ameliorate the downside that comes with the blessing of the mining boom. There are just options that carry more disadvantages than others.

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Is it our future to be China's quarry? Decision 2010

Australia's traditional economic challenges will be turned on their head in this decade.

WHAT our economy needs in the 2010s is success in balancing supply and demand. Does that sound obvious and not very hard? It's neither.

A big part of the problem is neither you nor I nor the politicians are used to thinking of the economic problem in those terms. And even when we do, we define the problem in conventional terms, failing to take account of the ultimate provider of both supply and demand: the natural environment.

Speaking at the nationwide level, when demand exceeds supply we get inflation. When supply exceeds demand we get unemployment. So we need to keep them in alignment to minimise both problems.

But both demand and supply are moving targets. The economy keeps growing, so we need to keep both demand (spending on goods and services) and supply (capacity to produce them) growing at much the same rate.

If the severe difficulties facing European economies were to spread - including to China, India and the developing world - our problem would be one of deficient demand relative to supply, leading to slow growth and rising unemployment.

But the greater likelihood is that our overarching problem will not be deficient demand but deficient supply as we struggle to greatly expand our capacity to meet developing Asia's voracious appetite for our minerals and energy.

Supply is by far the better deficiency to have. It's the problem of the prosperous and successful, not the waning and struggling. But that doesn't stop it being a problem.

In early 2008, before the global financial crisis hit, we were in the midst of a resources boom. Relative to the prices we were paying for our imports, the prices for our exports were the highest in 50 years.

Our economy was operating at close to full capacity. Unemployment was down to 4 per cent, shortages of skilled labour were emerging, factories and other businesses were flat-chat and real wages were rising, although inflation pressure was building and the Reserve Bank had pushed its official interest rate to a 14-year high.

Mainly because Asia's demand for our exports scarcely missed a beat, but also because our domestic recession was so mild, the likelihood is that the resources boom will soon resume and we'll soon return to full capacity.

Everyone assumes it is hardest to manage Australia's economy in bad times. Recessions are painful and economic managers come in for criticism, but it's the good times that are hardest to manage.

Why? It is easy to stimulate demand - with increased government spending, tax cuts and much lower interest rates - but hard to conjure up increased supply. That requires more skilled workers, housing, machines, factories, mines and offices, as well as more public infrastructure: roads, bridges, public transport, power stations, coal loaders and ports.

In the past the solution was to minimise inflation by using high interest rates or tax increases to suppress demand. But we've usually done too much too late and ended up in recession.

However, past booms have been temporary, "cyclical" events caused by brief periods of strong growth in the developed world. This boom, which began in 2003, seems more lasting ("structural") because it arises from the two most populous countries entering decades of economic transformation from underdeveloped to developed.

We're likely to go through an extended period in which supply grows rapidly - we greatly increase the economy's productive capacity. But we're already close to full employment.

Assuming Asia's strong demand for commodities continues, an increase in our capacity to produce coal, iron ore and natural gas is already in train. Business spending on physical investment will soon take its highest share of gross domestic product in half a century.

But when our labour and capital are already pretty much fully employed, the only way we can put more resources into new mines, gas terminals and related infrastructure is by taking those resources from somewhere else.

Some industries (and states) have to give up resources so the mining industry (and the states it is in) can have more resources. This doesn't necessarily mean other industries and states have to contract in absolute terms, it may just mean the lion's share of future annual growth in employment and physical capital goes to mining and the mining states.

Governments can help by adding to the supply of skilled labour (through increased training and skilled migration), well-located land for home building and necessary public infrastructure. But even though the nation's supply constraint moves out each year, and can be made a little faster, it's still a constraint. It still limits how much more we can do. If we try to exceed that limit, all we get is inflation.

A big part of the political problem governments will face is that, after 30 years of high unemployment, the public is locked into a mentality that our key problem is deficient demand, with the implication that any proposed project claimed to create jobs is unquestionably worthy of government support.

The notion that if project X is to create 500 jobs, those workers will have to be taken from jobs elsewhere is foreign to our thinking. What's more, the higher wages it needs to attract workers could provoke a wages bidding war that adds to inflation.

Can you imagine any politician saying a new project requiring 500 workers didn't sound like such a good idea? Welcome to the future challenge.

The economy has a natural mechanism for helping the needed geographical and industrial change in its structure: the floating exchange rate. By going high during resource booms, it squeezes those export and import-competing industries whose demand isn't booming.

But this automatic mechanism will need reinforcement from overt government policy. Adding to supply often involves adding to demand in the first instance. Demand can be divided into spending on consumption and spending on physical investment.

If supply constrains the demand we can accommodate without inflation, but an increased share of demand needs to be devoted to investment - in business plant, housing and public infrastructure - that leaves less room for consumer spending.

A lasting resources boom needs to constrain growth in consumer spending if it's not to involve runaway inflation. Households need to spend less and save more.

The economic managers have ways of combating inflation pressure and discouraging excessive growth in consumption (particularly spending on consumer durables such as cars and major household items, which are usually bought on credit): raise interest rates.

So the bigger and longer the resources boom, the higher you can expect interest rates to be.

Don't like that solution? A better (but only partial) substitute would be for the federal government to run ever-increasing budget surpluses even after its debt is paid back, with the money invested anywhere but in Australia.

We look like we'll need some unfamiliar and controversial policies from the next and future federal governments if we're to exploit our geological and geographical luck without coming unstuck.

And that's just the conventional analysis, which conveniently ignores the natural environment. Responding to the way economic growth is damaging the ecosystem and starting to feed back adversely on the economy will require an extra dimension of unfamiliar and controversial policies.

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