Canberra is fighting the last war

In recent days, Ross Gittins delivered a spirited defense of the Australian Treasury’s embrace of Dutch disease. He based his defense on an endorsement of a speech delivered by the Head of Treasury’s Macro Group, David Gruen. I haven’t seen the speech before today but read it this morning and it’s got some fascinating material.

The structure of the speech is a juxtaposition of the current commodities boom and that of the 1970s. It makes terrific reading and really does show the strides made in economic flexibility in the intervening years. It includes the following charts on inflation and the labour market:

Very impressive, certainly. There are also two brilliant charts showing the constituent sectors of GDP growth before and after the mining boom:

More great stuff. Though a more useful way of chopping the data might have been by tradable and non-tradable goods sectors. And here’s why, Gruen puts the divergent performances down to this:

Unfortunately, the economic impetus provided by the strongly rising terms of trade, without any offset from the exchange rate, was very destabilising for the macroeconomy [in the 1970s].

In the current episode, by contrast, the exchange rate was rising strongly before there had been much of a rise in the terms of trade, presumably because markets were anticipating that the gathering strength of the world economy as it recovered from the early 2000s recession would sooner or later generate significant rises in the terms of trade of raw-material exporting countries like Australia. As events turned out, that expectation turned out to be broadly correct – even though the importance of sustained Chinese growth for the Australian terms of trade was not appreciated until later.Since the June quarter 2002 (quarter 0 for the current boom), Australia’s nominal trade-weighted exchange rate has appreciated by about 45 per cent, and has been above its post-float average for 30 of the past 38 quarters. As everyone is aware, what we are dealing with now is not a short-lived appreciation, but a sustained shift. And, of course, this difference has important implications for the response of the trade-exposed sectors.

In short they must shrink. All good, according to Gittins. However, addressing the same speech, a more objective assessment and question was asked by Henry Thornton:

The really interesting graph shows growth of non-farm GDP. Dr Gruen notes that ‘Non-farm GDP grew by an astonishing 8.8 per cent over the year to the March quarter 1973, at a time when the economy was already operating at close to full capacity. Non-farm GDP growth then turned briefly negative on two occasions following the 1970s terms of trade peak – in 1975 and again in 1977.

‘As Chart 4 shows, economic growth has been much less volatile this time around, with a standard deviation of non-farm GDP growth in the current episode only a little more than half that during the 1970s one.

‘The lower volatility of economic growth this time around is all the more impressive given the much bigger, and more sustained, current terms of trade shock, as well as the unwelcome arrival of the global financial crisis in the middle of it’.

However, my reading of the graph suggests that average growth has also been lower this time round. Less volatility certainly, but a steady decline in growth except when the boom almost got out of hand in 2006, with subsequent experience including two years of near zero growth including the current year’s likely outcome.

This point is not made by Dr Gruen, but it is just possible that lower average growth, despite far stronger terms of trade, is a symptom of an Australian version of the ‘Dutch disease’. This is a highly controversial statement, but one that cannot be ducked. There is an extensive literature on this matter, sometimes presented as ‘the rersource curse’.

Exactly, and I will go further. As we know, the Western world has passed an historic moment when credit driven growth is no longer viable. We are in the early years of a decades long deleveraging. And, as we know from the sectoral balances of macroeconomics, an economy can only grow through the expansion of the external sector or by expanding credit in either the government or private sectors. Is it useful, therefore, to be comparing Treasury’s triumphant victory over the seventies bogies of wage breakouts and inflation via a tradable goods destroying currency appreciation when the world is now set on a course in which the ONLY economic growth that has lasting value in this new milieu is that driven by expansion in the external sector?

For me the answer is absolutely not.

Treasury is busy fighting the last war. The new war is for export revenues to drive investment and growth to offset the enormous debt stocks that exist in the public and private sectors of Western economies, including Australia. That’s why destroying parts of your tradable goods sector in order to make room for other tradable goods is about as sensible as cutting off a leg so that you’ve lost weight. Sure you have, but now you just gonna sit there and eat.

Treasury should be looking beyond the currency for ways to “make room” for mining.

2237 Speech