The Australian economy is unique. Perhaps its closest peer is Chile or Norway (though they are better managed), not Canada. It is an economy that runs on commodity income that is leveraged up through offshore borrowing and blown on houses. This wealth supports the bloated and over-priced services sector from where most of the economic activity springs.
The key to it, then, is the transmutation of export income into domestic activity via national leverage.
Looking at it in more detail offers up two vital insights. The first is that much of the leverage used to be achieved via the banking system, in offshore bank borrowing and offshore investors buying our RMBS. But the GFC changed that because offshore investors rediscovered risk pricing. Even today, as global yields collapse all around us to record lows, the yield demanded of Australian bank bonds and RMBS is 6 or 7 times higher than it used to be.
It was prevented from becoming too expensive by the government. During the GFC, and ever since, the government has guaranteed Australian bank borrowings. But the borrowing is still much more expensive than pre-GFC, which is why our banks have had to fatten their interest rate spread to the cash rate and use up a lot of our monetary policy ammunition to stay profitable. As well, any shortfall in offshore borrowing in the private sector has been made up for by public sector offshore borrow and local spend. And so the economy has kept on keeping on.
There are three vulnerabilities in this model. The first is that the income underpinning the borrowing could decline. This is the China shock scenario. The second two follow on and refer to credit quality. At some point the housing quango could run out of steam. It may be happen because it’s unaffordable or, like Moody’s warns today, it may be that offshore investors get spooked by rising prices and the threat of a bubble implosion. In that event the cost of offshore credit that drives the system will get more expensive and growth suffers as a result, chronically and then suddenly.
What prevents this is the government keeping a clean public balance sheet and AAA rating as the guarantor of the bank’s borrowings. For that to work, the same credit rating agencies have insisted that we must “aim for surplus across the cycle”. The government, whomever they may be, has no choice but to put the Budget on a surplus trajectory in reasonable time, or the downgrades will flow and credit will get more expensive for the banks.
Herein is the straight jacket. Whether its public or private borrowing it can no longer grow sustainably or at a high enough levels to support the standards of living we are used to in our domestic economic activity. So when Moody’s warns about house prices and the Government warns about Budget tightening both are pulling the straps of the same straight jacket a little tighter from opposite sides.
So, what’s the answer? It’s threefold:
- competitiveness must be improved on every front, nominal and real, most especially via raising productivity. That will help “back-fill” the current account deficit growth model as new capital (not debt) is deployed in investment;
- aim every micro and macro tool at boosting exports in every possible sector, and
- cycle the Budget by raising public investment on productivity-enhancing rising infrastructure while cutting the distortions of rort spending, and tax resources properly.
Over the next decade we could fix ourselves. The alternative is crappy growth and falling living standards as far as the eye can see.
