Not a happy camper

Ross Garnaut has been highly critical of the FTA with the US and the way it has been debated. He has now broadened this criticism into a more generally pessimistic view of the Australian economy. Since Ross has historically been an optimist, this is quite a shift. He points to excessive domestic demand, the current account deficit and signs of incipient inflation, masked by favorable movements in terms of trade.

Garnaut argues that our impending decline is due to the abandonment of microeconomic reform. In my discussion of the Howard government in Robert Manne’s book of the same title, I also observed that microeconomic reform has slowed down substantially under Howard. However, I’m much less of a fan of microeconomic reform than Garnaut – the Kiwis had reform in spades, and it didn’t do them any good. In diagnosing the same imbalances, I’d point to causes such as the deliberate promotion of a boom, then a bubble in the housing market.

In addition, while I don’t believe in mechanistic business cycle models, I think there is some truth to the idea that, the longer an expansion goes on, the more fragile it becomes. A good run of luck breeds complacency, which encourages unsound investments and unwise consumption, and thereby brings about its own downfall. Garnaut rejects this view, saying “no economic expansion is doomed simply on account of its longevity”.

24 thoughts on “Not a happy camper

  1. JQ,

    I’m not sure that Garnaut disagrees with you. He goes on at length about the imbalances in our economy as a result of the consumption and borrowing boom of the last decade. I think his opinion is that the current expansion is not NECESSARILY doomed, but his commentary suggests it will be.

    The undercurrent to his line of argument is that if there had been greater micro reform in the latter half of the 1990s, we would have produced a stronger export performance, and been better able to pay our way out of our current account problems. That’s debateable, but I think you’re both on the money when you point to the excess demand built up in the economy, at a vulnerable point in time given the likely direction of interest rates.

    If the Howard government had done its fiscal job through the late stages of the expansion with counter-cyclical policy, instead of pro-cyclical policy (e.g. tax cuts, first-home owner grant, capital gains tax relief, baby bonus etc.), we might not have been placed in such a vulnerable position.

  2. Since the Kiwi’s were mentioned, I’ll make a slightly OT request: can anyone point to a good account of how and why New Zealand went backwards, either on-line or in book form?


  3. While we are on New Zealand, can some-one explain how the CER with Australia has been a net positive to the NZ economy. It does not appear to have been a magic cure on the face of it. I’d like to know how taking over NZ banks by Australian banks and much else of their industry besides has been a boon to the NZ economy.

    From this end in my experience as an investor in Australian companies I tend to grimace when I hear one of my companies is going to take over a NZ company.

    I’m genuinely confused.

  4. Interesting example of zeitgeist synchronicity: both Age economic commentators, Hywood and Davidson, have expressed reservations about the durability and sagacity of the boom.
    Hywood is fearful about the evapouration of passion for micro-economic reform. He sees salvation in the “creative class”.
    Davidson thinks that FTA-tying ourselves to the in-hock US consumer is not a good idea.
    In both one gets the sense that a large part of the nineties/naughties boom has been good luck more than good management.

  5. Sorry forgot to include links to the Hywood and Davidson articles.
    Whilst on the subject, my 2c on the causes of the long post-Hawke economic boom:
    Domestic Capital: relaxation of controls on bank lending created a splurge of home and consumer borrowing, and wealth-effect hike in consumption spending.
    Domestic Manual: collapse of Trade Unionism and growth of Human Resources & enterprise bargaining led to micro-eco efficient allocation of labour supply, and reduced CPI wage-price pressure.
    Domestic Tradeable-Goods: dropping of trade barriers and outward focus of manafacturing led to large growth in exports of high-valued tradeables.
    Domestic Intellectual: large increase in the social extent, and duration, of tertiary education has increased the stock of human capital.
    Foreign Technological: sharp drop in the price, and improvement in quality, of coding, computing and communicating devices, coming out of the US-led New Economy.
    Foreign-Industrial: massive economic boom-led demand for Aust minerals & services in the East Asian littoral, from Bombay to Peking.
    Thus a good part of the source of the boom is either foreign-enabled (technology) or domestic-dodgy (finance).

  6. Garnaut highlights the real worry which is the totally depleted level of national savings:

    The savings share of household income fell in the boom of the late ’80s, but remained in the range of 8 per cent to 10 per cent. It was minus 3 per cent in the March quarter of 2004.

    The shortfall in short-term savings can only be made up for by an increase in long-term liabilities as we sell our assets and/or borrow more from foreigners.
    If economic opportunities were such as to warrant such a rise in debt then this would be a reasonable course of action. Unfortunately, neither the level of corporate profits or the level of business investment in industry indicate that we are in the middle of a real production-led economic boom.
    Its all too obvious that the borrowing has financed a housing bubble, the proceeds of which are financing much higher consumption expenditure.
    This living beyond our means is bordering on insanity. There will be tears when the money lending musical chairs stops.

  7. Strocchi is right on. The erosion of savings (and the decline in marginal propensity to save) is really what we should be looking out for. The trade deficit isn’t so bad anymore, but the overall current account is looking dreadful.

    Maybe we should be encouraging more managed funds or at least building up our (physical/financial) asset base for the next major shock.

  8. Declining personal savings eh? Maybe that compulsory super idea isn’t working so well after all?

    Our current account deficit is simply our net foreign investment… the more the better! And if Australians don’t want to save as much as some foreigners, then so be it. I have no faith that the government knows the ‘correct’ savings rate any more than the people do.

    As for Garnaut complaining about the quality of the FTA debate… I can point to several outright errors in what he’s said (not least of which his argument that diversion exceeded creation in our modelling) and I can’t point out as many retractions. And I can’t say I was impressed by the introduction of a “laugh test” in economics.

    Maybe there should be a theory that links the length of a boom to the amount of economists that are predicting a recession? šŸ™‚ While slightly different, there is an old joke that says that the business sector has predicted 8 out of the last 2 recessions.

  9. “And I can’t say I was impressed by the introduction of a “laugh test” in economics. ”

    Especially when it is one’s own work that is being laughed at.

  10. A word of caution to the Micawbers. Every successful businessman I know has a mortgage on his house for investment purposes. Firstly this is the cheapest money you can borrow and secondly it makes sense for high marginal rate taxpayers to negatively gear. Indeed those who are skeptical of the returns from PPPs, are really arguing for govts to do what businessmen do now with their borrowing and investment decisions.

    You also need to understand that computer software is not treated as a capital item. It is a fully deductible expense in the year it is purchased. Similarly with the cost of learning new software which is an expense. So I can spend(or borrow on my house) say $10,000 to purchase a CAD package and incur the expense of half a man year getting up to pace with it and be seen as a profligate nincompoop, compared to another Micawber who sticks with a drawing board and calculator. Are you sure about that? I’ll give you a big clue about businessmen. The more successful you are, the more absolute debt you have. That doesn’t mean as proportionally indebted as the school-leaver with the new credit card.

  11. There was a small piece by Phil Ruthven in the BRW recently. It had current household savings at -2%, to which he then added super at 5% per household for a net on +3%

  12. Observa,
    negatively gearing by definiton means one’s borrowing costs exceds the return one is getting on the investment.

    Unless something has passed me by this means people now have put a higher premium on reducing tax than on investment.
    either these people have too much money to waste and should give it to a charity and get the tax deduction or people are starting to go completely bananas.

  13. Very interesting discussion. A key point is whether our low savings is a bad thing or not. If you look at our balance sheet our net real assets per person have been growing at 0.6% per year in the last 10 years, though interestingly it was flat in 2002-03.!OpenDocument
    It is true that because our savings rate is low, we have been financing part of our investment by each year borrowing from overseas, but we have not borrowed so much that it leads to a decline in our net assets (Net assets are total assets minus liabilities. Liabilities are our debts to overseas people/companies).
    If we saved more, our real net assets per person would increase, but who needs or wants that to happen? I’m quite happy with my level of wealth. Why should I save more so at to increase it?

  14. Homer,
    Negative gearing(or simply tax deductible interest payments) makes sense for income earners paying nearly 50% marginal tax rates because it effectively halves the cost of borrowing(or if you like doubles the effective rate of return for an investment proposition)High income business earners are setting up self administered super funds(SASF) in droves for such purposes as storing a capital gain component for retirement. You have to be careful of running foul of the ‘arms length’ investment rules, but this gets hard for the ATO to police. For example you may run a private company, paying yourself a high wage, which incurs high marginal tax. You rent your premises at say 8-9% per annum rental return to the landlord. You could borrow at about the same investment rate to buy your own premises, but it is line ball until you take deductibility/negative gearing into account. Also you can set up a SASF to buy or build your premises(with some added principal residence mortgage funds at say 6%)and lease it to your company(at arms length???) Notice any extra capital gain accrued is not taxed until you sell, usually in lower income retirement. Indeed you may simply decide to continue to rent out your investment property in retirement. You control your own super and get a nice healthy return. As I said, negative gearing, tax deductibility of interest or untaxed capital gain are all the preserve of our income tax system. I can assure you that untaxed capital gain on such geared investments, is much more lucrative on a million dollar commercial premises, than a half a million dollar one. You can give your ‘income’ away if you like Homer.

  15. John Humphries retains a blind faith in the efficacy of market mechanisms to efficiently allocate resources.

    Our current account deficit is simply our net foreign investment… the more the better!

    Show me the money, John!
    I am pretty sure that Australian gross business investment as a ratio of GDP has probably gone down over the course of the housing bubble, with predictable results for Multi-factorial Productivity. Certainly sci-tech R&D has plummetted as funds have gone after bubble time capital gains.
    Such cappital investment as has occurred over the past few years has been concentrated in housing (including huge sums spent on rennovation). These invvestments are not warranted by the current rate of rental earnings, which are less than half the real rate of interest.
    In fact, the inflow of foreign capital is financing a huge burst in domestic consumption, which is largely the result of realising windfall capital gains on inflated housing values.
    In return, Australian borrowers are incurring long-term liabilities associated with assets which do not have tremendous income growth prospects to service these debts.
    Unless rental rates pick up, or interest rates halve, these investments will have caused a reduction in capital productivity.
    This is not a good advertisement for capitalism.

  16. My faith is not blind Jack. Never has been. The fact that CAD = KAS = NFI is an economic identity… hardly something I’m going to spend long trying to prove. But you make the correct point that domestic savings has reduced. I’ll repeat what I said originally – so what? God hasn’t told me the divine level of savings yet, so I am not able to assess whether the current savings is wrong.

  17. Observa,
    firstly you cannot borrow for superanuation purposes and my guess is that if you used such a strategy for a self managed fund then the ATO will be looking over that dubious proposition very closely.

  18. Micro economic didn’t benefit NZ??
    Of course it has,I am in the building industry at the pointy end of capitalism and I can tell you that the grass is much greener in NZ.
    Cheap workers comp and public liability insurance,no capital gains tax,lower tax rates,no stamp duty and no unions!!
    Plus the rates are much better in NZ,the arse dropped out the big money in australia 20 years ago.

  19. marklatham, I’m not so concerned about what the Kiwis have done to themselves. What I want to know is whether opening their economy to us and vice versa has produced the economic growth for them that free trade advocates tell us it should.

  20. Homer,
    I’m no expert on self managed super although I would agree you can’t borrow for this. What typically occurs is husband and wife directors of their business company, accrue a nest egg in normal super, say $100k each as their business builds and they are high income earners. They set up a self managed super fund, transferring their entitlement into the fund. Now they aren’t allowed to lend(invest?) this sum back to themselves, at less than commercial terms, as this would not be arms length in the view of the ATO. Note this was the objection to the shonky practice of private and public companies investing their employees super funds, back to the company on very favourable terms. What they can do is invest(lend) this in a commercial property that the company rents and pays the normal commercial return to the super fund. They can also borrow on their home at best rates to top up the investment, usually negatively gearing to further leverage long term capital gain. None of this flouts the current interpretation of tax law. What it often does mean is, the more wealth you have the more indebted you are in absolute terms.

  21. observa, Homer I took most of my money out of super when the Goss government kicked me out as surplus to requirements on S11 1991. With the remaining $55K I set up a self-managed fund with the intention of share trading. After having shrunk the capital to about $42K I went back to traders school and meanwhile invested more conservatively. Having built it up again I killed the fund last year and put it in a diversified managed fund.

    The problem is that as a self-managed fund you have to do what is virtually a company return each year and it costs. Alternatively if you put it in a managed fund the fees can amount to about 2% per annum. So the breakeven for a managed fund is about $150K to $200K because the cost of the return will be much the same. But you have to get the investment decisions right, whereas with managed funds you can diversify across a few fund managers and select funds who further diversify internally across other fund managers and investment categories.

    Leveraging share investments is OK, but better if you can get tax breaks from franked dividends and can write off your interest costs against a highly taxed income stream. Again it is essential to be both conservative and diversified. 8-15 different companies is about optimal, I find. That way you get a balance between diversity and administrative complexity, plus you can keep up with monitoring.

    Her endeth lesson No 1 in investment strategy. I suspect Homer knows all this.

  22. Observa,
    My memory has it that SLAB 3 & 4 meant a lot of what you are talking about can’t happen now.

    There are a lot on limitations on ‘investment’ that a self manged fund can do now however I am neither an accountant ( don’t have the personality) nor a lawyer ( don’t have the morals).

    Brian, you are right they told us that at business school and we did it in funds management.

  23. Like the US, Australia’s problems go back more than thirty years and fundamentally derive from the attempt to “fight inflation” by hiking interest rates and “damping down” the economy. All that did was produce, first, stagflation, and then shift domestic inflation to the balance of trade/payments. In the process, we – both the US and Australia – gutted our industry, crippled our rate of fixed-capital investment, abandoned full employment, burdened ourselves with massive debt, etc etc. A major adjustment – a mild term for collapse – is inevitable in the US and, sadly, Australia too, probably quite soon.

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