Turnbull on Dutch disease

A high exchange rate: should we be concerned & what should be done?

Well thankyou very much. Let me start by saying that I’m very honoured to be in such illustrious company for this discussion.

Max Corden, my fellow speaker, is of course one of our nation’s most distinguished economists and his work on industry protection, trade and exchange rates has not only contributed to economics as a discipline, but has also influenced some of our important public policy debates, especially over the true costs of tariffs. He was one of the loose grouping of public servants, academic economists, corporate economists, financial journalists, backbench MPs and others who took on Australia’s long-established commitment to industry protection in the 1960s, and by doing so began the long process of dismantling the increasingly antiquated post-Federation economic institutions.

In 1982 Max proposed the three-sector model that has been revived a number of times, including in the last article that is being distributed today, that most usefully explains what is usually termed ‘Dutch Disease’ or the ‘Gregory effect’. I think it would have been better if it had been called the Gregory Effect , if I could say that. Because one of the problems with the whole Dutch Disease term is that a phenomenon that for most people is actually a profoundly good thing, is presented as a morbid condition – a counterpoint to the virility that you were talking about Gary. I noticed your hair is perfectly combed, by the way. This is of course the phenomenon where higher income and a stronger exchange rate caused by rapidly growing exports from one traded sector (classically, the resource sector) have a negative impact on other traded sectors.^[1] And of course, the argument now is – and Max might touch on this – that the Dutch never suffered from the Dutch disease in the first place. That’s the Treasury’s received view – Martin Parkinson is nodding there.

Bob Gregory of course is here today as well and he’s another of our distinguished economists in the room. He produced the first research about this in 1976, which is why it sometimes known as the ‘Gregory Effect’. He is perhaps known best for his work on the labour market and a former member of the Reserve Bank board. ^[2]

Now they have published recent papers dealing on this and I will come back to these papers in a little while, particularly Max’s. But I just want to say something about the Gregory paper, which he wrote with Peter Sheehan. It looks at the recent divergence between GDP per capita and income-based measures of living standards as an increasing proportion of our growth in material well being having come from gains in the terms of trade (which are not captured in the former calculation or the former metric). He calculates that gap at $7500 per capita in 2011 dollars, which is a large chunk of what has been accrued over the past decade. It is worth pondering, perhaps we can discuss, how enduring that gain will be. ^[3]

Given there are so many great economists here I think I should going to focus my talk principally on the political economy of the matter. There is of course a great politician here, Dr Andrew Leigh, one of the Members from the People’s Republic of Canberra. And it’s good to see him, but I’m sorry you have to leave him before the discussion. It will be a pity.

Let me just outline a few propositions that should serve as constraints in the discussion. And I will say frankly in advance, if you accept them all, there isn’t much space left for a genuine attempt to ‘do’ something about the exchange rate.

The first point is that the wave of emerging market demand for commodities is much bigger than we are.

Everyone agrees that it is the sheer size of this resources boom that distinguishes it from previous commodity windfalls such as the late 19th century minerals boom, the Korean War wool price spike, or the buoyant energy and agricultural prices of the early 1970s.

And we have to bear in mind that the commodity boom that we’re talking about here in Australia is in large measure made up of the demand for the components of making steel. That is to say, iron ore and metallurgical coal. I will come back to thermal coal later. That demand is being driven by the rate of urbanization in Asia and in particular, of course, China. Now the steel intensity of economies peak when urbanization peaks and then over time starts to decline. So this is not going to go on forever. Steel intensity is not coextensive with economic prosperity. America uses much less steel now than it did 50 or 60 years ago. And the same will be true of China. A lot of people don’t reflect on this, but it is very important to bear in mind, particularly when people are trying to persuade you that this is a boom that will never end. I know there are a few people in this room who suspect that, or come close to arguing, that this is the case. So I would just make that point about urbanization, that this is a long term trend. It won’t go on forever, but it is a long term trend. This is not a spike.

The only episode that is comparable in terms of its economic impact was Victoria’s gold rush of the 1850s, which trebled the European population of Australia, made Melbourne into one of the great cities of the British Empire, and helped deliver the highest per capital incomes in the world for the next four decades.

Just in summarizing some of the metrics, and I know everyone here’s very familiar with them. The RBA index of commodity prices tripled between 2003 and 2009. In terms of investment committed or flagged for new resources sector projects, the January investment pipeline reported by Deloitte Access was $912 billion, with work going on at projects involving $415 billion. And in terms of duration, the episode has already outlasted all earlier booms save for the 1850s gold rushes. ^[4]

The bottom line here is, large though our resource industries and endowments are, in the end Australia is a tiny part of the market compared to an increase in demand in China or India. Even without investment in expanding our resources capacity, our exchange rate would still be significantly elevated compared to the period before 2003 given demand has been so strong. To complain about the current level of the dollar is to implicitly oppose not just current expansion of the resources sector, but its ex ante level of production.

In a sense by developing an iron ore or coal industry in the first place while having a floating currency and free capital flows, Australians signed on for the current ride.

The second proposition I want to make is about the dollar. This is the first – and Ric Battellino made this point in a very good speech last year – this is the first big boom, the first boom we’ve had, during which the exchange rate has been floating, and in which, and I’m quoting from his speech, “a significant rise in the nominal exchange rate has been an important part of the economic adjustment. This has added an important degree of flexibility to the economy by allowing the real exchange rate to rise through a means other than inflation.” ^[5] This is not our forst big boom, but it is our first big boom with a floating exchange rate.

Now my next proposition is that in my view, Australians are not going to reverse the past two decade of depoliticizing the exchange rate and interest rates. We’re not going to go back to governments, Paul Howes notwithstanding, setting the exchange rates or interest rates.

The contrast could not be more stark between the 2000s and earlier booms, as Treasury’s David Gruen described in his recent paper on the boom, when the exchange rate was still manipulated by politicians willing to do anything to avoid enraging farmers and manufacturers (which they would if the exchange rate had revalued). The result back then of income shocks was invariably inflation and industrial disputation as the higher wages in the fast growing sector, in the resources sector, flowed on to what max would call the lagging sectors and of course, created or contributed to very damaging inflation. One of these choices was arguably among the most costly policy miscalculations in our history – the Country Party’s repeated veto of a stronger dollar in 1971-72 which stoked the runaway inflation that ultimately averaged 9 per cent annually for the next two decades. ^[6] It took a long time to get over that.

Persistently high inflation combined with political meddling on official interest rates and the value of the currency in turn contributed to the macro-economic instability, recessions and low growth of the 1970s and 1980s.

Compare this with the record since our institutional arrangements were changed – first with the float of the dollar in 1983, and then later with the formalization of Reserve Bank autonomy and independence, and specification of an inflation target.

Since the float Australia has experienced only one recession (if we use the rule of thumb of two consecutive quarters of contraction) and that, in 1990-91, was the result of a conscious policy decision by the soon-to-be-independent RBA to finally break the back of inflationary expectations. The 1990-91 recession was a disaster in terms of human costs, but it did achieve its objective although at very high cost.

Against this backdrop, Paul Howes recently suggested the Reserve Bank’s mandate be altered to focus it on two objectives (price stability would be joined by the real exchange rate).

Given the struggles across much of manufacturing, where most of his members work, and Paul’s very enviable youth, it’s not hard to see why he might arrive at this suggestion. After all, it is quite a while, thankfully, since we have seen serious inflation at work in Australia or engaged in public discussion of its insidious effects.

The first thing wrong with Paul’s idea is that the RBA would be left with one instrument to aim at two targets – which implies one of them would have to be partly or entirely sacrificed at some point.

But an even more important criticism is that Howes implicitly downgrades the value of keeping inflation low, perhaps not realizing that if it edges higher, the costs tend to fall on the most vulnerable.

It is telling – very telling in my judgement and a marker of monetary policy success – that to find a quote best to explain this danger we had to go back to 1990, when Ross Gittins expressed the issue very well in an article. And I quote Ross Gittins:

“Inflation would be less of a problem if everyone had an equal ability to protect himself from its ravages. The ability to protect yourself from inflation, however, varies greatly through the community. Generally speaking, it’s the better-off who have greatest freedom to protect the real value of their income and their wealth. The more you have, the more you can afford to get the advice and do the tricks that keep you ahead … inflation hurts our society: it makes it less fair, with the less powerful and the less astute being the ones who lose out.” ^[7]

And surely the Australian Workers’ Union and its supporters would not want to do that.

Now Max Corden’s recent paper on policy options for a three-speed economy logically and convincingly makes a general argument that in an open economy amid a resources boom, any sector-specific policy we can devise is nothing more than a redistributive measure, either from consumers to producers, or from one group of producers to another. There will be negligible impact on the exchange rate.

He makes the point so compellingly that I think we can dismiss even considering such policies (unfortunately that is not so easy in the real world, where they remain popular). ^[8]

I might simply note for emphasis that invariably the loudest claims for assistance are from industries and firms whose comparative advantage is least apparent and whose history of Government assistance has been the longest, regardless of the exchange rate.

Add all of this up and the very limited scope to ‘do something’ about the high dollar becomes plain.

Max’s paper does propose one other approach – which is a strongly contractionary fiscal policy (Government spends less) offset by accommodative monetary policy (Reserve Bank cuts rates) with the aim being to leave demand at the same level but lower the effective exchange rate.

Of course such a strategy is very challenging to implement at the present time, where the aftermath of the GFC is layered on top of the resources boom, making it particularly difficult to know what ‘neutral’ settings for monetary and fiscal policy might be in Australia, much less what the current trade-off between them is.

Max notes that this could be a useful role for a sovereign wealth fund, a reform I have advocated. My understanding of his position is that he is agnostic as to whether a sovereign wealth fund invested in foreign currency denominated assets (and by that I mean uncorrelated foreign currency assets – so it would make no sense for us to invest a sovereign wealth fund in the RMB) would actually result in effective exchange rate sterilisation. And I think he’s right to be agnostic about that. I note that the Governor of Norges Bank said in 2010 that it is was still unclear, I think he said the jury is still out, whether Norway’s SWF which at $550 billion or thereabouts has been effective in keeping the krone value even lower than it otherwise would be. And bear in mind their sovereign wealth fund, at %550 billion, is around 125% of Norway’s GDP. So a comparable Australian sovereign wealth fund would be a gigantic fund and obviously not something that could be achieved other than after a very long time.

So the exchange rate sterilization argument, in the context of investing in uncorrelated foreign assets I don’t think is a very powerful one. It might have some effect but it’s probably not going to be very material. The better arguments for a sovereign wealth fund relate to financial prudence and remembering that all booms come to an end and ensuring that when that does happen we will have something to show for it.

As to the exchange rate, I agree with Max that in an Australian context an Australian SWF – we already have one of course, the Future Fund. I’m talking about a new one or a second account if you like. This fund would assist in the fiscal consolidation exercise we both endorse and to pick up on something Martin Parkinson said the other day would result in savings being higher than they otherwise would be.

This behavioural aspect of SWFs is rarely discussed. The simple fact is, and we have seen it again and again in this city, that when Governments have money sloshing around they want either to spend it on benefits, invest in infrastructure or give it back in tax cuts. Sticking it in the bank is generally not very attractive, particularly when there is debt to be paid off and we saw this in the last years of the Howard Government when the Keating debt, so-called, had been paid off.

There is nothing wrong with any of those objectives if the spending or the investing or tax cutting for that matter is sustainable, well targeted and represents value for money.

Regrettably that isn’t always the case. Some of you have obviously fainted, shocked, at that proposition. And my argument is that it would be a salutory encouragement to greater thrift if an additional option was built into our thinking about public finances which was to save for our children and grandchildren’s futures. And I say this as someone who’s been part of a Government and made collective decisions about spending. I am giving a behavioural economics perspective. You would struggle to quantify this or justify it in a quantitative way.

From a political point of view, my strong belief is that a commitment to a new SWF would be very much in the spirit of the times and would become a matter of real national pride. But it has to be said there isn’t a lot of support for such a reform outside of the Business Council of Australia and many of its leading members, leading economists both academic and corporate, David Murray, Arthur Sinodinos, Peter Costello, the IMF and implicitly the Reserve Bank itself. And of course the Greens. But apart from that motley crew, there doesn’t appear to be much support for it.

There are many issues to discuss in relation to a new SWF, which of course may simply be another account managed by the Future Fund. These include the governance, the investment mandate of the fund and its nature. Should it be long term saving fund like the Norwegian fund, something we can live off when the oil runs out, probably not applicable to our resource endowment. Or should it be a stabilization fund like Chile’s, which can be drawn down on when the commodity cycle turns down and government revenues decline?

My argument for a SWF as you can see is not driven solely or even largely by a concern about the exchange rate, and we have to always ask ourselves that while we may lament the high exchange rate as we empathise with producers, we should remember that the most important concern of politicians will inevitably be the welfare of consumers.

Of course the consumer benefits of a higher exchange rate are cold comfort if you dont have a job, but if you can combine a rising exchange rate, the sectoral adjustment that causes and yet maintain high levels of employment it is hard to see that the high exchange rate is an unalloyed bad thing as many would have us believe.

Compare the situation in China where you have a number, and Yiping Huang writes a lot about this, a Chinese economist. Or Michael Pettis, at Peking University has written a lot about this so probably a lot of you are familiar with it. But if you think about the Chinese economy, because consumers don’t have the same leverage there that they do in a democracy like ours, there are massive subsidies to producers and to State owned corporations at the expense of consumers. Negative real deposit rates, the transfer of between five and seven per cent of GDP from households to the banks to State owned corporations. That funding not being available to private corporations with a few exceptions that are national champions, like Huawei and others. And at the same time of course the exchange rate benefits exporters at the expense of consumers. So do we really want to do that? Is that the approach we really want to achieve? We have got to think about that, think about the consequences, when we complain about the exchange rate.

Now just consider, when we are told the exchange rate is unreasonably high, it is worth thinking back to the turn of the century when Australians were still being penalized because our economy was not exposed enough to the ‘new economy’ boom, so called.

Because of this and low commodity prices in the year 2000, GDP per capita at market exchange rates was $US35,300 in the US and a mere $US20,800 here.

What a difference the past dozen years and a change in investor perceptions has made.

By 2008 per capita incomes in Australia and the US expressed in market terms were the same, for the first time since 1895 and by 2012, the IMF forecasts GDP per capita of $US49,100 in the US and a startling $US69,000 in Australia. So the reality is that the high exchange rate is a feature in a turn around in economic conditions that has made all Australians wealthier but of course has had serious issues of adjustment. But it is something we should be proud of, that we have been able to achieve that process of adjustment while still maintaining relatively high, historically high levels of employment. And that is something we should be very proud about.

Now I am just going to make one final point because we can talk a lot more in the discussion. But my simple point is this: There is always an attraction to what I used to call many years ago, the ‘Backslash Copy’ school of economic forecasting. Those of you who can remember using Lotus 123, so it’s only the older people in the room who know what I’m talking about. The disruption caused by technology, discover and innovation is not limited to the world of social media.

Just think for a moment of the revolution in natural gas. That is a vast topic for another occasion. It was only a few years ago that the United States was lamenting that it was running out of energy and that it was going to become a massive gas importer. Gas is now cheaper relative to oil, by relative values on a BTU basis, than it has ever been. And of course America will become a major gas exporter. And that is going to have a very material impact on the price of gas in Asia. The price differential in the United States and gas in Asia – because the markets are not presently connected – is gigantic. Now trade will resolve that.

What has made that possible? Horizontal drilling and fracking. Technology has made that possible. The gas has always been there, it has been there for millions of years, no doubt. China is a gigantic coal province, it has more coal reserves than any country in the world. It has, inevitably, equally vast resources of gas – unconventional gas, shale gas, coal seam gas.

Now there are people in Beijing that I have spoken with who believe China will become self sufficient in gas eight years or more from now. And more than that, it could become an exporter of gas. Now we are dealing with high levels of uncertainty here, so I wouldn’t make any financial investments on what I am saying to you, or anything I have said to you. But imagine if China becomes self sufficient in gas. I think that is very realistic. But imagine if China becomes an exporter in gas. America will become an exporter in gas. What does that mean for the value of our gas reserves and the value of our gas exports? What will happen if technologies to make steel without metallurgical coal become available? And there is a lot of work being done, but I think they’re a long way off, but who knows.

We should not assume that rapid disruption is limited to the world of the internet. The world of resources is subject to it just as much. And sometimes those shifts, while perhaps they take a little longer to take effect can be even more momentous. So prudence and thrift are good qualities to bear in mind in these uncertain, but nonetheless very prosperous, times. Thankyou very much.