For those who don’t know, Max Corden is one Australia’s most eminent economists and a pioneer of thought around Dutch disease. Recently he released a Melbourne Institute paper called “Policy options for a three speed economy” (h/t 3d1k). In it he examines the contemporary case for policy measures aimed at correcting Australia’s current case of Dutch disease:
The principal options are: Do nothing, piecemeal protectionism, and run a fiscal surplus, combined with lowering the interest rate and possibly establishing a Sovereign Wealth Fund. Piecemeal protectionism is likely to be politically popular but there are strong arguments against it. The costs of any measures that successfully moderate real appreciation of the exchange rate and thus Dutch Disease effects are noted, and may be considerable. This is “exchange rate protection”.
The paper concludes that of these three:
The second policy option, of piecemeal protectionism, is understandably politically attractive, but I do not recommend it, especially if we are concerned with the national rather than just sectional or political interests. Thus, some combination of the first and third options would, in my view, be best. Much of this paper has been concerned with analysing in detail the third option – fiscal surplus with low interest rate and, possibly a SWF.
Focusing on this third option, significant fiscal surpluses are hard to obtain for obvious political reasons. But they could moderate the Dutch Disease effects in a relatively non-discriminatory way, at least for a transitional period. One might even consider it as a long-term stabilizing macroeconomic policy…
The key point is that the only way in which governments and central banks can significantly depreciate the exchange rate is through monetary policy – i.e. reducing interest rates – and if inflation is to be avoided reduced interest rates need normally to be associated with appropriately contractionary fiscal policy. Whether such a policy package of fiscal contraction and monetary expansion is desirable depends on the balance of considerations expounded in this paper. Inevitably there would be both gainers and losers, or in the popular journalistic language, job gains and job losses.
Indeed, to reduce the burden on Dutch Disease losers, new losers would be created. Yet this must be seen in the context of the resources boom yielding a net aggregate gain for the people of Australia, at least provided taxation of the resources sector is adequate.
This is a very clearly expressed paper on the economic challenges associated with the high currency. It is well worth reading for those looking for grounding in the issue.
I can only nitpick a few things with this paper. First, the paper makes only passing reference to any division in the capital flows causing the currency appreciation between what might be considered investment versus “hot money” or speculation looking to make an easy buck on the carry trade. I would shift the emphasis a little. Something real is going on in emerging markets that has caused a commodity demand shock. But market pricing for commodities is also significantly mis-priced by global “currency wars”, most especially the deliberate efforts by the US to re-balance its economy to external demand and the countervailing efforts of many others to fend the same re-balancing off. This has led to a not insignificant monetary component to commodity and currency valuation that might be considered “artificial”. Such a framing might lend greater urgency to the cause of intervention.
As the case of Brazil suggests, it is possible to combat hot money without derailing investment flows. Though there are prices for doing so. Which brings me to a second factor outside of the scope of the paper: at no point does it mention private sector debt. For Australia, no discussion of lagging sectors can transpire without reference to yesterday’s staples of growth: housing and retail sales. Yet neither of these is directly affected by Dutch disease. Rather, both have hit something of a wall in the post-GFC global reality that debt-fueled growth has its limits, for a number of reasons. In Australia’s case, much of the debt that funded the previous binge emanated offshore and, as we’ve seen in the recent bout of European nervousness, disrupting external capital flows to our banks results in higher funding costs, inhibiting the transmission of monetary policy.
There is good evidence that the banks are enjoying strong flows of hot money in the form of international deposits. Which is not necessarily a problem if you’re aiming to lower the currency but it does mean that official interest rates would have to keep falling until banks reclaimed their spread as offshore flows declined and high local funding rates remained sticky in response. In the end you’d think the RBA has ammunition enough to engineer lower retail rates without hurting the banks. The danger, in fact, might be the opposite, reigniting another round of housing speculation. So you’d also need to be ready to adjust fiscal or macro prudential settings to prevent that.
But, because the falling dollar is going to be inflationary, the resulting deflationary pulse is going to need to be pretty strong. Importing retail would be especially hard hit as its margins got pinched, which would, in turn, fall quite heavily on the household sector. It would see a simultaneous reduction in government welfare and purchasing power. The tradeable sectors would benefit.
Still, Corden prefers this approach of creating a fiscal surplus by increased taxes on the sectors outside of mining (though he pretty clearly implies that mining taxes are too low on the basis of national equity):
While adequate taxation of the mining sector will be desirable (an issue not discussed in this paper), if a fiscal surplus is achieved by primarily taxing this sector’s profits, the policy package above may not significantly affect the exchange rate and hence the Dutch Disease. This is because the sector may be largely foreign-owned.
Which is true. But not if the tax is big enough to dent investment. Corden reckons this risks “killing the goose”. But as our band of mining commenters likes to point out, there is a large portion of Australian iron ore and coal assets that are very competitive on the cost curve and would be unaffected, in a investment sense, by any large tax. But at the margin an appropriately sized tax could have an impact. The mix of mining winners and losers may change but for the sector any reduction in output is going to be offset by a rise in profitability as the dollar declines anyway.
This approach is far more politically sellable too, though less so since the government buggered up its first attempt in the RSPT.
Spreading the pain through a balance of a big enough mining tax combined with measures to ease hot money flows would serve. But as the paper makes abundantly clear, no path is easy and the political conviction required to do any of it is considerable. And that is in shortest supply of all.
