RECENT DEVELOPMENTS IN AUSTRALIA’S EXTERNAL SECTOR

UBS HSC Economics Day, Sydney, Thursday, June 5, 2014

Australia’s external sector – measured by the balance of payments, the current account deficit and exports and imports – is an important part of the syllabus and, indeed, the economy. Australia would be a very much poorer country if we had no trade with the rest of the world or no flows of capital to and from the rest of the world. And yet with the exception of discussion of the terms of trade and the exchange rate, the external sector – and particularly the current account deficit and net foreign debt – is these days rarely mentioned in the economic debate, presumably because most economists don’t think there’s much there to worry about. But this lack of interest conceals the fact that, particularly in the years since the height of the global financial crisis in late 2008, the current account deficit has been a lot smaller, and the net foreign debt seems to have stabilised as a percentage of GDP.

Is the current account deficit a worry?

To many people anything called a ‘deficit’ must be a bad thing; all deficits must be bad, just as all surpluses must be good. But I trust you’ve learnt enough economics by now to know that sometimes deficits are good rather than bad, and sometimes surpluses are bad rather than good. It all depends on the economy’s circumstances at the time and whether a deficit or a surplus is more appropriate to those circumstances.

The fact is that Australia has run current account deficits in 128 of the past 150 years, which suggests such deficits can’t be too bad or by now we’d be in a lot more trouble than we are, and we don’t seem to be in much trouble at all. And, indeed, most economists think it’s a good thing rather than a bad thing for us to be incurring all those deficits. Why? Because what they mean is that Australia is a ‘capital-importing country’ and we’d be a poorer country if we weren’t.

Remember that if we’ve been running deficits on the current account of the balance of payments for all those years we must also have been running surpluses on the capital account of the balance of payments for the same period. The key to making sense of the current account deficit is to remember that, with a floating exchange rate, the current account deficit is at all times exactly offset by the capital account surplus. In other words, the current account deficit and the capital account surplus are opposite sides of the same coin. So the current account can be analysed by looking at its components: exports, imports and the ‘net income deficit’, which is our payments of interest and dividends to foreigners minus their payments of interest and dividends to us. Or it can be analysed by looking at the changes in the components of the capital account surplus.

Components of the capital account surplus

When you think about it, the capital account surplus represents the net inflow of foreign capital to Australia. Another way of putting it is that the net inflow of foreign capital represents our call on the savings of foreigners. And our call on the savings of foreigners represent the amount by which national investment during a period exceeds national saving during that period.

It’s become a lot more common these days for economists to explain movements in the current account deficit by reference to changes in national investment and national saving and their components, but we’ll have go at doing it both ways.

Before we do, however, let me finish the point about Australia being a ‘capital-importing country’ since the beginning of white settlement. The proof that we’re a capital importer is all those years of capital account surplus, of inflows of capital almost invariably exceeding outflows of capital. Why has all that foreign capital flowed into our economy? Because, from the outset, the opportunities for investment in the economic development of our vast, resource-rich country have always far exceeded the amount that Australians could save to finance the exploitation of those investment opportunities. So, from the outset, we have always invited foreigners to bring their capital to Australia and join us in developing our economy’s potential. And when inflows of financial capital exceed outflows, this allows us to import more than we export, including imports of the physical capital equipment need for new development projects.

Our current account deficits – and our foreign debt and other foreign liabilities – got a lot larger in the 1980s after we floated the dollar, much larger than we’d been used to. It took us a few years to realise that the international shift to floating currencies was part of financial globalisation – the growing integration of national financial markets – which was making it easier for financial capital to flow around the world and so achieve a more efficient allocation of global capital. Some countries (eg Germany, Japan) save more than they have profitable domestic development projects to invest in, whereas other countries (eg Australia) have more profitable investment projects than they can finance with their own saving. So both classes of economy should be better off as a result of higher flows from surplus economies to deficit economies.

Recent developments in the CAD and net foreign debt

Over the 30 years since the floating of the dollar in 1983, the current account deficit has averaged about 4.5 pc of GDP, with peaks of about 6 pc and troughs of about 3 pc. In the five years leading up to the GFC it averaged more than 6 pc, so it seemed to be getting a lot higher. As you see from the table, however, in the five financial years since the GFC, however, it has averaged 3.6 pc, close to historical trough. And in the 2013 calendar year it was 2.9 pc.

As you also see from the table, the past decade shows our net foreign liabilities – that is, our net foreign debt plus net foreign equity investment in Australia – seem to have stabilised at about 55 pc of GDP. That is, the dollar value of our liabilities is now growing at about the same rate as nominal GDP.

Why has our current account deficit been significantly lower since the GFC, to the point where our accumulated foreign liabilities seem to have stabilised as a percentage of GDP?

Well, explaining it from current account side of the balance of payments, our export earnings were at first boosted by the exceptionally high prices we were receiving for our exports of minerals and energy as our terms of trade improved to their best in a century or two. It’s true that prices reached their peak and started falling in mid-2011, but they remain much higher than they were in earlier decades. And the volume of our mineral exports has been growing particularly strongly in the past year or two as the many new mines we’ve been building have finally started coming on line and increasing their production.

Turning to imports, imports of capital equipment to be used in our new mines and natural gas facilities grew strongly for most of the period although, with the construction phase of the resources boom now coming to an end, imports of mining equipment are now falling sharply. And while mining construction has been strong for most of the past five years, consumer spending and business investment spending in the rest of the economy have been growing at below-trend rates.

Finally, remember that, because exports and imports offset each other, most of the current account is accounted for by the net income deficit. It has declined to its lowest percentage of GDP for several decades, mainly because Australian and overseas interest rates are so low.

But now let’s try to explain the decline in the current account deficit from the capital account side – that is, from changes in national investment and national saving. Remember that the nation’s investment spending in any year has three components: the household sector’s investment in new home building, the corporate sector’s investment in equipment and structures, and the public sector’s investment in new infrastructure such as roads, railways, bridges, schools, hospitals and police stations.

The nation’s saving in any year also has three components: saving by households, saving by companies and saving by governments. Companies save when they retain part of their after-tax profits rather than paying them out in dividends to shareholders. Governments save when they raise more in revenue than in needed to cover their recurrent spending (the spending needed to keep the daily activities of government rolling on).

Looking at national investment, households’ investment in new homes since the GFC has been weaker than normal, whereas the mining construction boom has meant corporate investment spending has been much stronger than usual. And government spending on infrastructure since the GFC has be greater than usual. Adding that together, national investment has accounted for a higher percentage of GDP in recent years.

Turning to national saving, households are saving a far higher proportion of their disposable incomes since the GFC, with the household saving ratio rising from zero or about 10 pc. Companies have been saving more as mining companies retain most of their after-tax profits for investment in their new projects and non-mining companies retain earning to reduce their ‘gearing’ (their ration of borrowed capital to shareholders’ equity). Only governments – federal and state – have been saving less – dissaving, in fact - as their budgets have fallen into recurrent (‘operating’) deficit. Adding that together, national saving has accounted for a much higher percentage of GDP in recent years.

So though national investment is higher than it was, national saving has increased by more than national investment has, meaning the economy’s saving/investment gap has narrowed, the capital account surplus is lower and so is the current account deficit.

The budget papers show the government is expecting a current account deficit of 3.25 pc of GDP in the financial year just ending, 2013-14, rising to 4 pc in the coming year, 2014-15, and then falling to 3.75 pc in 2015-16.

In the coming year, the government is expecting the volume of exports to grow by 5.5 pc, whereas the volume of imports grows by only 2 per cent. However, the terms of trade – export prices relative to import prices – are expected to deteriorate by 6.75 pc. And the net income deficit may rise because about 80 pc of the mining industry’s increasing profits are owned by its foreign owners.

Financial year CAD NFD NFL

         % of GDP

04-05 6.5 46 54

05-06 5.8 50 53

06-07 6.1 50 56

07-08 6.7 51 56

08-09 3.4 49 55

09-10 5.0 52 58

10-11 3.0 47 55

11-12 3.2 49 56

12-13 3.6 50 54

Calndr 13 2.9 55 53

NFD = net foreign debt

NFL =  net foreign liabilities (debt + equity investment)

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Changes to HECS debt: a users' guide

There is one glaring exception to the rule that Tony Abbott’s budget cuts are designed to protect higher income-earners at the expense of lower income-earners: the changes to university fees.

Although uni students like to see themselves as part of the deserving poor, it’s overwhelmingly the sons and daughters of people in the upper part of the distribution of income who go to university, and do so with the goal of acquiring the qualifications that will allow them to take their own place in the upper reaches of the distribution.

So the irony of the government’s efforts is that it’s predominantly the children of the better-off who’ll be hit by the expected significant increases in the cost of a uni education. And those increases raise the hurdle faced by those wishing to join the echelon intended to benefit most from the government’s budget reordering.

Only about 17 per cent of uni entrants come from a lower socio-economic background – a proportion that has changed little over the decades. The Whitlam government’s abolition of fees was intended to increase the proportion of poor kids getting to uni, but didn’t.

The Hawke government’s reintroduction of fees was predicted by some to reduce the proportion of poor kids, but didn’t – mainly because of the success of an invention by Professor Bruce Chapman, of the Australian National University, specifically designed to ensure it didn’t: the "income-contingent loan", known to us as HECS.

Much the same was predicted when the Howard government greatly increased uni fees, but HECS ensured it didn’t happen. That was chicken feed compared with this decision to allow unis to set their own fees. If this one doesn’t reduce the proportion of poor kids at uni, it will be because of the continuing magic of HECS.

That, plus the new requirement that 20 per cent of the unis’ additional revenue be used to set up "Commonwealth scholarships" to assist students from disadvantaged backgrounds. (Where have I heard that name before? Maybe because I had one in my uni days, before Whitlam. This government is nothing if not retro.)

These days, going to uni means not so much paying fees as taking on a debt. Loans have three key variables: the size of the principal borrowed, the rate of interest charged, and the term of the loan.

Abbott’s changes will affect the first two, with major implications for the third. Once the unis are let off the leash, there’s no telling how high they’ll lift their fees. Between them, they have a monopoly over the provision of a high-status, high-value product in high demand.

And it’s not just the changes planned to take effect in 2016. The further the government cuts its funding to unis, the more the unis will up their fees. And they may not stop at covering the cost of teaching, but also require students to subsidise their lecturers’ research. So suggestions that fees could double or treble aren’t far-fetched.

That covers the principal. At present under HECS there’s no formal interest rate, but outstanding debt is indexed to the consumer price index. To economists, this says the debt is subject to a "real" interest rate of zero.

Now there’s to be a formal interest rate set at the long-term Commonwealth bond rate, 4 per cent at present, but capped at 6 per cent. This implies a real interest rate of between 1.5 per cent and 3.5 per cent.

So whereas at present outstanding debt merely keeps pace with inflation, now it will grow in real terms – will compound, particularly while no repayments are being made. (This change will apply to everyone still with a HECS debt, not just present and future students.)

Commercial loans have a fixed repayment period, with a fixed rate of repayment calculated to ensure all interest and principal is paid by the end of the period. HECS debt has no fixed repayment period.

Rather, debtors pay nothing until their annual income exceeds about $50,000. Initially their repayments are set at 4 per cent of their income, but this increases as their income rises, to a maximum of 8 per cent. (Hence the term income-contingent loan.)

So the time it takes people to repay their HECS debt varies mainly with the level of income they attain after leaving uni. The lower your income, the longer it takes to repay. This means the imposition of a real interest rate is "regressive", hitting lower-income debtors harder than those on higher incomes.

It also means that, leaving aside differences in the size of the initial principal, the people who’ll end up with the biggest debts under the new rules will tend to be students who stay at uni for a year or two before realising tertiary education isn’t for them, graduates who take time out of the workforce to raise children and then work part-time for a bit, and graduates who go overseas. These last will face an ever-growing disincentive to come back.

But none of this contradicts Abbott’s claim that a HECS debt will still be "the most advantageous loan they ever receive". That’s why it never made financial (as opposed to filial) sense to repay HECS early under the present rules, and only rarely will it make financial sense under the new rules.

People’s debt will be much bigger and they’ll stay owing it for many years longer, but their repayments will never be onerous, thanks to the loan being income-contingent.

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Hockey crafts our first decadal budget

This is the 40th budget I've studied, and it's unique. The only decadal budget we've ever had, a budget only an incoming, Coalition government would deliver, a budget with big political costs up front, but a big pay-off way into the future.

It's obviously the budget of a new government, one confident it can blame its predecessors for its harsh cuts and broken promises. But it's such a slow-burn, delayed-reward budget that only the party that knows it's born to rule - that's confident it will stay in office for at least a decade - would have the front to introduce it.

The legendary Labor finance minister Peter Walsh was proud of persuading the Hawke-Keating government to introduce budgets showing the "forward estimates" for the three years following the budget year. At last governments would be obliged to reveal the longer-term consequences of their decisions.

That was fine until the Gillard government, struggling to reconcile its big-spending proclivities with its foolhardy promise to return the budget to surplus in 2012-13, came up with the "fiscal bulldozer" it used to push its ever-mounting spending commitments off to the years beyond the forward estimates, where they couldn't be seen.

By last year's budget this trick was wearing thin, so we saw the emergence of the antidote, the latest attempt to keep governments honest, the 10-year "medium-term budget projection". We've seen that projection in every budget-cycle document since, so we must hope it's permanent.

This is the first budget we've had built around that 10-year projection. In concept, this budget is simple: it doesn't reform spending programs or drop many programs. Rather, it shifts some of the cost of programs off onto others, including the states.

It does this partly by introducing or increasing user charges, but mainly by changing indexation arrangements.

As one of the budget's glossy spin documents reveals, the changes to university funding are "part of a government-wide decision to streamline and simplify indexation for programs". That's one way to put it; I call it changing the indexation in any way that favours the government.

A remarkably high proportion of the measures in the budget involve fiddling with indexation: suspending it for a few years, introducing it where to do so would favour the budget, changing its basis where that's what would favour the budget. You don't get this budget unless you get its preoccupation with indexation.

Why indexation? I can imagine why. The new treasurer arrives and the Treasury boffins sit him down to explain the budgetary facts of life. They start by showing him the medium-term projection, which shows that, on unchanged policies, we won't be back to surplus even after 10 years.

There's worse. You must understand, minister, that returning to a healthy rate of economic growth won't reduce the deficit. Your plan to increase productivity would be great for the economy, minister, but will do little to help the budget balance.

Really? Why? Because higher productivity soon translates into higher real wages. That's great for tax collections, particularly income tax. Trouble is, it also pushes up the spending side of the budget.
Directly or indirectly, almost all spending programs are linked to wages.

Wages are by far the greatest component of operating costs throughout the public sector - federal and state, education, health, even non-government welfare organisations.

To top it off, we index pensions to wages.

Suddenly, someone gets a bright idea. I know, we'll cut the Gordian knot by shifting from indexing to wages to indexing to prices. With one bound, Joe broke free. Even the huge cuts in overseas aid can be seen as a switch from indexing to gross domestic income to indexing to prices.

The thing about the indexation solution is that the initial savings are small, but they compound with each year that passes. So provided you're still in power, you clean up down the track.

Take the resumed indexing of fuel excise: a huge political stink over a tiny tax rise, but once that's past the revenue grows inexorably without anyone noticing.

As well, this budget creates scope for big future savings, such as discretionary increases in user charges. With universities' fees off the leash, there's huge scope for further cuts in federal funding, including pushing research costs on to students.

And anyone who thinks the maturation of the new Medical Research Future Fund won't prompt the feds to cut other grants for medical research is terribly trusting. (Whoever came up with that ruse deserves the Public Service Medal.)

One small weakness in the 10-year projection approach (about which the Treasury secretary has warned): it's just a mechanical projection, and assumes we'll go for 33 years without a severe recession.

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ENTRY FOR THE COMPANION TO THE AUSTRALIAN MEDIA, ED BRIDGET GRIFFEN-FOLEY, 2014

2014

Reporting, economic focuses on reporting developments in the national economy - and, occasionally, the state economies - and the efforts of governments and their agencies to influence the economy. It covers economic policy, micro-economic as well as macro-economic. It is to be distinguished from business (formerly financial) reporting, which focuses on the activities of listed companies and the stock exchange. Economic journalists devote most of their time to reporting and interpreting movements in the wide range of economic indicators published by the Australian Bureau of Statistics, covering unemployment, inflation, wages, retail sales, housing activity, gross domestic product, trade and much else. Other economic indicators are published by the Reserve Bank of Australia, while the commercial banks sponsor regular surveys of such things as business and consumer confidence.

Economic journalists also report announcements concerning the federal government’s budget, official reports, speeches and press releases by senior economic ministers and bureaucrats, including announcements of changes in official interest rates by the Reserve Bank, as well as statements from business lobby groups.

Because most of these announcements are made in Canberra, most economic reporting is done from the federal parliamentary press gallery. This is true of most reporting of Reserve Bank announcements, even though the bank is headquartered in Sydney. The main national and metropolitan newspapers have specialist economics correspondents in the gallery, most of them with university qualifications in economics. In smaller gallery bureaus the reporting is done by political correspondents.

The financial deregulation of the 1980s had the effect of greatly expanding the choice of sources available to economic journalists, with its growth in financial-market economists keen for publicity and need for the Reserve Bank to be more active in media relations. Growth in think tanks and university research centres has also helped reduce Treasury’s former dominance of economic information.

The distinction between financial and economic reporting was probably pretty blurred until the late 1960s and early 1970s, when economics became seen more clearly as a specialty within federal political journalism. During the 17 years he spent as financial editor of the Sydney Morning Herald, Tom Fitzgerald combined editorials and commentary on economic management with his path-breaking exposes of corporate mismanagement. When he left to join the Australian in 1970 he was replaced by both a financial editor and an economics editor, although the SMH had employed the British journalist J. C. Horsfall as its economics editor for several months before he became the foundation editor of the Australian Financial Review in 1951. By contrast, from the time Max Newton left Treasury to join the SMH in 1957, he would always have written more about the economy in a political context than about the world of companies.

Referring to SMH editors of the 1950s, Horsfall complained in his book, The Liberal Era, published in 1974: ‘The trouble with most editors was that the subject of economics which had become the main stuff of politics was largely a mystery to them’. It was this dawning realisation that led to greater media interest in reporting the management of the economy and the changed perception of it as part of political reporting rather than business reporting. This perception was mightily reinforced in 1974 when, in the aftermath of the first OPEC oil shock, the advent of ‘stagflation’ - simultaneous high inflation and high unemployment - led governments in all the developed economies to a loss of confidence in the simple Keynesian remedies of the post-war era and a period of experimentation with solutions as different as incomes policies and control of growth in the stock of money. The restoration of low inflation and low unemployment was to dominate those governments’ concerns throughout the remainder of the 1970s and the whole of the 1980s - longer in Australia’s case. Tracking the ups and downs of the economy has remained a major media interest to this day, even without the added impetus of the global financial crisis in 2008 and the lingering Great Recession it precipitated.

The rise of economic journalism as a specialty within political journalism can be traced in the careers of its leading practitioners. Kenneth Davidson worked for Treasury before becoming the Australian’s Canberra-based economics correspondent in 1965 and the Age’s economics editor in 1974. Only a few years earlier, Alan Wood, who had been a Canberra economics correspondent for the AFR, became economics editor of the SMH. After a period out of daily journalism he returned eventually as economics editor of the Australian. P. P. McGuinness joined the AFR as an economics writer in 1971, left to work for the Whitlam government, then returned as economics editor in 1974. When the author, who had worked as a chartered accountant, joined the SMH as a cadet in 1974, he was encouraged to focus on economics rather than business, sent to Canberra late that year as economics correspondent and returned to Sydney in 1976 to replace the departing Wood as economics editor.

Whereas in recent decades governments have sought to discourage contact between journalists and bureaucrats, the technical nature of their task my help explain why economic journalists have been able to maintain active contact with senior econocrats, including those of Treasury and the Reserve Bank. Although almost all economic reporters are located within the Canberra press gallery, the major papers are divided on whether their economics editors - whose work chiefly involves economic commentary - should be stationed in Canberra or at the paper’s head office. At present the economics editors of the Age, the Australian and the West Australian are based in Canberra, whereas those for the AFR and the SMH are based in Sydney.

American practice is for movements in economic indicators to be reported in neutral terms, accompanied by balanced quotes from experts saying the figures are good while others are quoted saying they are bad. In Australia, however, reporters are more likely to take their own stand on whether the movement is good news or bad. This may be because, in Australia, the reporters are more likely to have economic qualifications and on-the-job training in the interpretation of statistics. But this can lead reporters and their editors into the temptation of judging movements according to their perception of whether readers would regard the change as good or bad. Movements in interest rates, for instance, are almost invariably judged from the perspective of readers with a mortgage rather than those dependent on interest income from investments. An overused formula in modern times is for movements in indicators to be judged according to whether they make an increase or decrease in the official interest rate at the next meeting of the Reserve Bank board more likely or less likely. Since the indicators are volatile, this can generate headlines that show the prospect for interest rates rising, falling and rising again in the same week. Falls in the dollar are usually taken to be bad and rises good, mainly because of their effects on the prices of imports and overseas holidays; effects on the competitiveness of Australian industries tend to be ignored. A fall in unemployment during an election campaign may be billed as ‘good news for the government’ rather than good news for those seeking jobs.

Perhaps because there is so much room for interpretation of economic developments, economic journalism tends to involve more analysis and commentary than in other specialist areas of journalism. This is largely the role of economics editors, who tend to do little reporting and even less editing. Whereas political journalists strive to appear even-handed in their commentary - telling Labor how to win one week then the Coalition the following week - economics editors rarely hesitate to push their own view of what constitutes good policy, even to campaign in favour of particular economic reforms. The line they take generally reflects the economic orthodoxy they were taught at university, which is regularly reinforced by their bureaucratic contacts. Historically, it is less likely to reflect their paper’s editorial line than for their line to be reflected in the editorials. The economics editors’ ethic, however, is that their line should seek to advance the public interest according to their own economic beliefs and personal values, not any private party-political sympathies, much less their personal interests. It can thus be argued that the work of economic journalists played a part in the rise of economic rationalism in the 1980s and 1990s and the various micro-economic reforms it led to, particularly the phasing out of protection against imports.

References

Gittins, Ross (1995) The Role of the Media in the Formulation of Economic Policy, Australian Economic Review,  4th quarter, Institute of Applied Economic and Social Research, Melbourne, Wiley-Blackwell.

Gittins, Ross (2011) Economic Journalism: How Influential are Journalists, Economic Papers, vol 30, no. 4, December, Economic Society of Australia, Wiley-Blackwell.

J. C. Horsfall (1974) The Liberal Era: A political and economic analysis, Sun Books, Melbourne.

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ECONOMIC POLICY, EMPLOYMENT AND STRUCTURAL CHANGE

June 2014

The structure of the economy – particular industries’ relative shares of GDP and total employment, but also the age, gender and full-time/part-time structure of the labour force, and the role and relative size of government – is always changing. It’s always changing because the forces for change bearing down on the economy keep changing. But those forces seem particularly numerous and strong at present.

So I want to talk about those structural changes, about how the government is responding to them with its economic policy, and about the prospects for the economy, particularly employment.

Sources of structural change

Among the many sources of structural change affecting the Australian economy, the two biggest and most general are globalisation and technological advance. Globalisation is the process by which the natural and man-made barriers between national economies are being broken down, partly by deregulation but mainly by advances in technology.

One part of globalisation is the rapid economic development of Asia, which is increasing our access to cheaper imports of manufactures, from clothing to electronic goods and cars, but also increasing the demand for our exports of minerals and energy. The growth of Asia’s middle class will increase demand for tourism, westernised foodstuffs and niche manufactured items.

The internet, the advent of e-commerce and the digital revolution are beginning to have big effects on industries such as recorded music, cinema, book selling and publishing, the post office and the retail sector generally, not to mention newspapers and the rest of the news media, and the advertising industry.

Households went through a protracted adjustment to financial deregulation – which greatly increased the availability of credit – and the return to low inflation in the early 1990s, which significantly reduced nominal interest rates, prompting a housing boom and leading households to greatly increase their housing debt, reducing the household saving rate to zero. But this untypical behaviour couldn’t go on forever. It started to end before the global financial crisis, but continued in earnest after it, with the household saving ratio returning to 10 per cent, where it seems to have settled.

Demographic change – the decline in fertility and the retirement of the baby-boomer bulge – is changing the economy’s ratio of workers to dependents, making a slower rate of growth over the next 40 years more likely as the participation rate falls for demographic reasons and highlighting the need to make the labour market more female-friendly and older worker-friendly.

Another structural change is climate change. The Labor government responded to this by introducing a carbon tax that was to turn into an emissions trading scheme in July this year. It bolstered this by raising the Howard government’s renewable energy target to ensure that 20 pc of Australia’s electricity comes from renewable sources by 2020. However, the Abbott government, which includes many climate change deniers, is seeking to abolish the carbon tax and replace it with ‘direct action’ in which businesses are offered incentives to reduce emissions. The renewable energy target is being reviewed by an avowed climate change ‘sceptic’.

The resources boom, stage III

But the biggest and most immediate structural change affecting both the structure of the economy and its year-to-year macroeconomic management is the resources boom, itself a product of globalisation and the rapid economic development of Asia, particularly China.

The resources boom began in 2003 and was divided into two parts by the global financial crisis of 2008-09. The boom has had three stages: first, much higher prices for our exports of coal and iron ore, causing our terms of trade to reach their best for 200 years. Second, a historic surge of investment spending to greatly expand our capacity to mine coal and iron ore and extract natural gas. And third, a considerable increase in the volume (quantity) of our production and export of minerals and energy.

The first stage is now over, with coal and iron ore prices reaching a peak in mid-2011 and the terms of trade falling about 20 pc since then. Now the second stage, the growth in mining investment spending, has reached a peak and begun to decline, making a negative contribution to growth. This is being only partly offset by the commencement of the third stage of the boom, the rising volume of mineral and energy exports as the newly installed production capacity comes on line.

The boom has greatly expanded our mining sector, taking its share of total production (GDP) from 4 pc to about 10 pc, although the industry is so highly capital-intensive its share of total employment is still only about 2 pc. The industry has been, and remains, highly profitable. Since its direct contribution to the employment of Australians is so small and since the industry is about 80 pc foreign-owned, it is important that it contribute to the economy by having its economic rent adequately taxed. The Labor government responded with a minerals resource rent tax, but mishandled its introduction, allowing the three main companies paying it to minimise their payments in the early years by getting generous tax deductions up-front. The Abbott government is seeking to abolish the tax.

The rapid expansion of the mining sector has required the transfer of labour and capital from elsewhere in the economy, a process of structural adjustment which the high dollar, brought about by the marked improvement in our terms of trade, has helped to facilitate by exerting painful contractionary pressure on our other tradeable industries, particularly manufacturing.

In its early stages, the boom presented the macro managers with the challenge of ensuring the jump in our real national income brought about by the high export prices didn’t lead to an inflation blowout as had happened with previous commodity booms. This possibility was avoided, particularly because our floating exchange-rate regime allowed a big rise in the dollar, which constrained our other tradeable industries, reduced inflation directly by lowering import prices and directed excess consumer demand into imports.

In the later stages of the boom, however, the macro managers now face roughly the opposite challenge: ensuring the fall in national income as export prices fall back, and the pipeline of mining and natural gas investment projects starts to empty, don’t cause the economy’s growth to slow too far and lead to a big rise in unemployment.

The need for the economy to make a ‘transition’ from mining-led growth to growth led by other industries and other categories of demand has been preoccupying the macro managers for at least a year and is likely to be their main focus of attention for at least another year. The falloff in mining investment spending is expected to subtract significantly from domestic demand in the coming financial year, 2014-15, and the following year. The need to encourage growth in the non-mining economy has so far been made more necessary and more difficult by the failure of the dollar to fall by as much as the fall in mining export prices and deterioration in our terms of trade had led us to expect. The dollar did fall back after April 2013, but in more recent times has been surprisingly strong, possibly because of the continuing ‘quantitative easing’ in the United States and elsewhere.

The continuing preoccupation with successfully negotiating the transition from mining-led to broader-based growth is the dominant consideration in the settings of both monetary policy and fiscal policy.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

After the GFC reach its height in late 2008, the RBA feared we would be caught up in the Great Recession that hit other economies, so it quickly slashed the cash rate from 7.25 pc to 3 pc. By October 2009, however, it realised we would escape the recession, so began lifting the cash rate from its emergency level, reaching 4.75 pc in November 2010.

In November 2011, the RBA decided the resources boom was easing and would not push up inflation. It realised growth in the non-mining sector of the economy was weak - held down particularly by the dollar’s failure to fall back in line with the fall in export prices – at a time when mining-driven growth was about to weaken. So it began cutting the cash rate, getting it down to a historic low of 2.5 pc by August 2013.

The RBA is trying to counteract the dampening effect of the high dollar by using lower interest rate to stimulate demand in other parts of the economy, particularly housing and consumption, but also non-mining business investment. It is having some success with housing investment, but not much with consumer spending and none with business investment. Barring a sharp fall in the dollar, it’s likely to keep interest rates low until it is confident the economy has made the transition to broad-based growth successfully.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Abbott government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

The Labor government proved unable to keep its promise to get the budget back to surplus in 2012-13, not because it was spending too much (though it did have big plans for increased spending in the second half of the 2010s), but because the sharp falls in mineral export prices slowed the growth in nominal GDP and so caused the recovery in tax collections to be far weaker than expected.

Mr Hockey’s first budget included many cuts in government spending, big increases in user charges for GP visits, pharmaceuticals and university education, a shift from indexing payments and benefits to wages to indexing them to prices, a return to indexing the fuel excise and a temporary deficit levy on high income-earners.

The budget deficit is expected to fall from $50 bil in the financial year just ending to $30 bil in the coming year, 2014-15, then to $17 bil the following year and $3 bil in 2017-18. The budget’s 10-year ‘medium-term projection’ shows it returning to a balanced budget in 2018-19, then with a surplus growing each year until it reaches 1.5 pc of GDP in 2024-25.

From a fiscal policy perspective the budget has two key features: 1) A slow pace of fiscal consolidation. The budget’s new measures and revisions to forecasts are expected to improve the budget balance by just $4 bil in the budget year and by $7 bil in each of the following two years, but by $26 bil in 2017-18. This slow start is intended to avoid the budget having a dampening effect on growth while the economy is expected to be growing at a below-trend rate.

2) A switch in the composition of government spending. While spending on transfer payments leading to consumption is reduced, spending on infrastructure investment is increased by $12 bil. About half this is spent on an ‘asset recycling initiative’ intended to encourage the states to increase their own infrastructure spending. The goal is to help fill the vacuum left by the fall in mining investment.

All this means the ‘stance’ of fiscal policy adopted in the budget is contractionary, but only to the most minor extent. The government knows the economy will be hit by big cuts in mining investment spending over the next two years, and so is delaying its plans to return the budget to surplus.

The outlook for growth and employment

The government is expecting the economy to grow by 2.75 pc in the present financial year, slowing to 2.5 pc in the coming year, but rising to 3 pc in 2015-16 and 3.5 pc in the following two years.

The economy’s medium-term trend rate of growth is 3 pc. This is consistent with growth in employment of 1.5 pc a year and the rate of unemployment at its lowest sustainable rate (the NAIRU) of 5 pc.

So below-trend growth this financial year and next is expected to see unemployment creep up to 6.25 per cent by June 2015, and stay high until it returns to 5.75 pc by June 2018.

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