Saturday, 22 February 2014

Australia has the 'Dutch Disease'

The Australian economy is sick. Mining exports and the relative strength of the domestic economy have kept the Australian dollar elevated in recent years and stifled manufacturing and other industries that are susceptible to foreign exchange rate movements. In economics this is known as the Dutch Disease.

During the mining investment phase (feasibility and construction of mines), people tend to ignore any of the adverse impacts because of the immediate benefits and spill over benefits being generated. However,  when the mining investment phase ends there is a risk that the dollar will remain high and continue to put downward pressure on other industries. This is what is currently happening within Australia.

The adverse symptoms of this economic ailment include: an unemployment rate that is hovering around 6%, low business confidence, the lowest wage growth on record, low economic growth and a dismal federal budget. The symptoms are treatable and the disease is curable, however the RBA and incumbent government have misread these symptoms and are prescribing the wrong economic medication.

To date, the medication has included low interest rates coated with some liberal/neo classical economic ideology, which has basically involved the twiddling of thumbs while markets work things out, while 'scape goating' the welfare system.

Let us take a look at why the medication ins wrong and what is needed, starting with the RBA.

Typically, central banks lower interest rates with the intention of stimulating aggregate demand.  The RBA has argued, aggregate demand can be increased by stimulating growth in the housing market, which will create jobs for a large proportion of the population as well as increasing the wealth of home owners, which will have flow on effects within the wider economy.

On face value the logic is there, a strong housing sector is integral in pulling countries out of stagnant growth.  In fact a healthy housing market is usually a leading indicator to suggest the wider market is recovering. But unfortunately it is not as easy a+b =c.  Furthermore, focusing on just housing can be dangerous, one only needs to look at Ireland pre GFC then post GFC.

I agree lower rates will create big employment opportunities initially. Approximately 60% of businesses within Australia are small and a large proportion of that 60% would be tradies. However building houses is honestly one of the most unproductive activities for a work force. We have been building houses nearly the same way for over a century and for whatever reason we have refused to adopt, at a large scale, more efficient and affordable approaches such as tilt up construction.

It seems that as a society we have a vested interest in housing because it employs so many people, as a result more efficient and affordable construction approaches have not been adopted because it would minimise jobs. Furthermore we miss out on wider efficienies and growth which could have been achieved if the labor was being directed to more productive industries.

A recent report from the OECD highlighted that while Australia has one of the highest minimum wages out of the developed countries, productivity is relatively low. It seems ludicrous that our Reserve Bank would provide forward guidance that promotes exclusive investment in such an unproductive industry.

The other issue is that this strategy will only increase the wealth for a small number of Australians that can afford to buy a house. First home buyers have essentially been locked out of the market because house prices to incomes are still relatively high. On the other hand the share of investors within the house market has continued to grow. The result is a disproportionately high amount of the wealth being shifted to investors.

So what needs to happen? First the RBA needs to realise that rate cuts will not act as they intended. Instead, they need to take the focus off the housing market and stimulate other parts of the economy. This can be achieved through my easy 2 step herbal cure.

Step 1. Put reforms in place that create a competitive and robust finance markets for startups, R&D and new innovation. Currently these industries are locked out because the big 4 banks are only interested in one thing - increasing their residential mortgage portfolio. This will improve labor productivity and create a more diversified robust economy.
Step 2. Adopt macro prudential policies like in NZ. This means lowering rates and increasing loan to value ratios in the housing market. This will assist wider parts of the economy through cheaper debt and also assist by putting downward pressure on the dollar. In contrast it slows growth within 'arguably' overheating housing markets (Melbourne and Sydney). This will eventually improve the probability of first home buyers owning a home.

The other change that needs to occur is the way the incumbent federal government approaches the challenge of turning around a soft economy. Recently, this government has blamed the poor state of the budget on the ballooning welfare system. However the reality is we spend very little on welfare. Economist Matt Cowgill recently wrote an interesting article in the The Guardian, regarding welfare, he stated:

We spend less on welfare (by which I mean cash payments to households) than just about any other advanced economy. Last year we spent 8.6% of our gross domestic product on welfare. That’s less than Canada (9.1%), less than the US (9.7%), New Zealand (9.8%), the UK (12.2%), and every other member of the EU. Even in 2005, well before the financial crisis sent unemployment soaring in most OECD countries, our welfare spending was below all of these countries, including the infamously frugal US…
Our problem, to the extent we have one, is that our governments don’t collect enough tax. We’re one of the very lowest taxing advanced economies in the world, with revenues about $30 billion a year lower than they were when John Howard left office…

Adding to Matt's comments, the same OECD report as mentioned before, highlighted that the direct taxation revenue from income, profits and wages is higher than the OECD average. Hence, the prescribed medicine from a fiscal viewpoint needs to be lower company taxes and income taxes, which is the best way of reducing the barriers to investment and hiring. Meanwhile expanding GST will increase the taxation base.

It is recognised the total cost of pensions will increase as life expectancy gets higher. As already suggested by the government a debate needs to take place about increasing the retirement age which has not grown in line with life expectancy.

So thats my diagnosis share and like for a lolly pop.

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