Weekend Musings: FutureBoom!, Genworth

Another weekend, another whirling of things around my thunktank. I am pretty busy this weekend so here’s a few short thoughts.

FutureBoom! economics

One of the things we talk a lot about at MacroBusiness, which tends to spark many “interesting” discussions, is the effect of the mining boom on the economy. I can’t really add to the discussion about mining in any meaningful way as I know very little about it, apart from the fact they have cool trucks. However I have noticed what is missing from many of the posts about Futureboom! is a discussion of the macroeconomic dynamics at a functional level.  Given I don’t have much time for this post I though I would just present a few charts with some initial discussion and then revisit this topic later in the week.

As most would be aware the large increase in mining exports and its associated price increases has created a strong demand for the Australian currency because it is required by foreigners to purchase the exported goods. This in turn has also led to a level of currency speculation which has also increased the demand and therefore value of the currency.

The high AUD had a two fold effect on the rest of the economy, firstly exports in foreign currencies have become more expensive, which has meant that other exporters have become less competitive compared to foreign competition. Secondly imports have become less expensive in comparison to local providers of the same goods so they have also increased. So while mining companies are receiving increasing revenues many other parts of the economy are receiving less. What you will notice however is that if the value of exports is rising faster than that of exports then the nation as a whole will becoming richer. Taking a look at Australia’s imports and exports you would expect this to be the case.

There was a positive $2 billion difference between exports and imports in April. So you would therefore expect that the nation as a whole should be getting richer even if some sectors were suffering from the consequences of the adjustment, that is certainly the government’s line. However if you take a look at Australia’s current account you will notice something quite odd that  I think most people have missed. Australia is not getting richer as a whole. In fact, in March, Australia net borrowed $8 billion dollars from the rest of the world. Australia has actually been running a current account deficit for decades, and even with historically high terms of trade continues to become further indebted.

There are various reasons for this deficit which I will examine in a future post. But I will leave you with a few worlds from Martin Wolf why running current account deficits are a problem.

Why is running current account deficits so dangerous? There are four reasons: first, it often means unsustainable asset price bubbles in the capital-importing country; second, it means unsustainable build-ups of debt in the private and public sectors of the capital-importing economy; third, it often means an unsustainable expansion of the financial system, characterized by excessive leverage and excessive build-ups of risky assets financed by supposedly risk-free liabilities; finally, it also often means a build-up of currency mismatches within the economy, particularly in the financial system, which makes the economy extremely vulnerable to currency collapses.

Any of that sound familiar ?

Genworth bullishness

The latest Genworth report on mortgage trends is out and worth a read. I note it has had a little bit of a run in the MSM.  I think that 1000 people is probably too small a sample to get a real assessment, but even so the results are pretty surprising in my opinion.

According to the latest RBA financial stability review the level of household debt-to-income in Australia is near an all time high.

A quick glance at markets will tell you that there is a solid deflationary trend setting in, with Perth and Brisbane showing the worst of it.

And as noted by Bullion Barron yesterday, the number of properties on the market and for rent (something I have also mentioned previously) continues to climb as the churn rate falls. But according to what I can see in the Glenworth report, this all seems like quite positive news to the average Australian.  They seem quite unconcerned about falling house prices.

Nearly 50% believing it is a good time to buy:

And 60% still believe there is high potential for property price rises:

Now it would be fairly obvious to my readers that I would have answered all of those questions very differently, and I have to add that I think it is unlikely that the RBA would ever let that sort of exuberance off-the-leash even if it could occur in the face of the demographic effects that will hit the market over the next 10 years. Accepting that the survey is representative, we can take the bullishness of the report in one of two ways. First, it could be indicative of late-stage bubble-psychology and suggest that housing will have to much further to fall before sense returns to the Australian community about housing. Second, it might also be indicative of a large cohort of Australians that remain ready to risk their savings on housing investment, which might be interpreted as bullish.

I’ll take both.

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Comments

  1. “……the large increase in mining exports and its associated price increases has created a strong demand for the Australian currency as it is required by foreigners to purchase the exported goods…..”

    Minerals are generally denominated in USD as are many of the obligations of the mining companies. So not all revenue is converted into AUD. But even if all the mining income were converted into AUD, this would not in itself account for the rise in the currency.

    Action in the foreign exchange market is overwhelmingly related to financial portfolio flows, rather than settlement of trade and other items on the current account.

    Were the value of the AUD determined by net settlements on the current account, it would have depreciated. (This is implicit in the trade data depicted in the graphs.)

    I have been laborious on this point, I know. But it is completely misleading to attribute changes in the exchange rate to the value of mineral exports.

    What you can say is that foreign demand for Australian exports is adding greatly to national income (a balance of trade effect) and that prices of exports have risen to a greater extent than prices of imports (a terms of trade effect).

    One result of AUD appreciation is that real household incomes in Australia have been supported, even in those parts of the economy that derive no direct income at all from exports. The most obvious examples are transport fuels, motor vehicles and computers, which are much cheaper now than they otherwise would be.

    Incidentally, the high AUD depresses the nominal AUD income of all exporters….farmers, miners, fishers, and manufacturers alike. Likewise, miners are not the only exporters receiving high USD prices for their goods. Prices for rural exports are also at high levels.

    By the way, the converse of a current account deficit is a capital account surplus. The Swiss run a perennial capital account surplus. It is a problem for them: their currency is often over-valued and they occasionally intervene in the market to sell the franc. This is in spite of the fact that they usually run a current account deficit.

    Surely the point about having a surplus on the capital account – as Australia invariably does – is what happens to the money. In Switzerland they hold it in bank deposits. In Australia, we have built a lot of houses and shopping centres….and mines.

    • “Minerals are generally denominated in USD as are many of the obligations of the mining companies. So not all revenue is converted into AUD. But even if all the mining income were converted into AUD, this would not in itself account for the rise in the currency.

      Action in the foreign exchange market is overwhelmingly related to financial portfolio flows, rather than settlement of trade and other items on the current account. ”

      You are correct and I apologise, I was completely over simplying because I had no time to flesh the issue out,I have not statement my position well here.

      Having said that however I think it is quite clear, at least to me, that these “portfolio transfer” as you call them, are occurring because of the strength of mining. So, in fact the mining sector plays a large part in both pieces of the puzzle.

      >Were the value of the AUD determined by net settlements on the current account, it would have depreciated. (This is implicit in the trade data depicted in the graphs.)

      I agree, but again the financial trade in the currency and the actual trade in the currency are , in my opinion, absolutely related.

      >One result of AUD appreciation is that real household incomes in Australia have been supported, even in those parts of the economy that derive no direct income at all from exports. The most obvious examples are transport fuels, motor vehicles and computers, which are much cheaper now than they otherwise would be.

      Yes but this is a two way street, as I stated in the post imported goods are cheaper for the locals, all good unless you are one of the locals who is suffering from the fact that everyone is now buying the products you sell from overseas, or you happen to price in a foreign currency ( software is a good example )

      >Surely the point about having a surplus on the capital account – as Australia invariably does – is what happens to the money. In Switzerland they hold it in bank deposits. In Australia, we have built a lot of houses and shopping centres….and mines

      Um, I am not sure about this one. Australia doesn’t have a surplus on the current account, that is the point of my post. We currently have a trade surplus, but Australia has a pretty unique current account where our net primary income deficit is much larger than our trade surplus.

      http://www.abs.gov.au/AUSSTATS/[email protected]/Lookup/5302.0Main+Features1March%202011?OpenDocument

      I take your point about banking the money, instead of blowing it on houses, that is exactly what we should be doing, and I hope to discuss this point in a later post.

      But what is actually happening at this point in time is that the country is becoming more indebted as a nation, even with the current ToT.

      Thanks for your comments they were most valuable

      • david is correct, Australia does have a surplus on the capital account. Thats how the balance of payments works.

          • Hi DE excellent article. Great replies.

            Here’s one with graphs and explanations.

            The Sector Financial Balances Model of Aggregate Demand and Austerity
            http://neweconomicperspectives.blogspot.com/2011/06/sector-financial-balances-model-of.html

            Also we often look to the CAB (current account balance) to see if a trend is developing, i.e. if the CAB is moving/trending from deficit to surplus then foreign capital is selling and leaving. Loose rule of thumb and not to be used in isolation. More a warning indicator.

            I agrre with David on the currency. Too many “carry trades” with a plethora of senior currencies relatively cheap to AUD.

      • DE, the point about the balance of payments is just that: our external accounts balance.

        When we run a deficit in the current account, we axiomatically run a surplus in the capital account. This surplus is made up of inflows of two kinds: debt and equity. We have been large borrowers, but not particularly large recipients of direct foreign investment. It is arguable that our external position would be stronger if we took on more equity and less debt, because equity investments are longer-term and, if things get tough, do not have to be repaid. Debt, as we all know, has to be repaid come what may.

        As well, a lot of the borrowing is short-term in nature and has been used to create long-term assets – housing loans, especially. As a result, the intermediaries in these flows, our banks, have been borrowing short and lending long. This entails higher risk for the borrower. This is one reason why Australian interest rates are always so much higher than money-centre rates, even though we have an excellent credit rating and a well-regulated financial sector.

        As I have pointed out before, the volume of transactions in the foreign exchange markets is truly vast compared to the flows needed to settle transactions in the current account, so on a day-to-day basis, these have only a very slender impact on the exchange rate.

        I think it is just self-evident that the foreign exchange markets are USD-centric. Almost every asset/ store of value/ commodity/ currency is priced in terms of the USD. About the only exception is wool, which is denominated in AUD.

        When portfolio investors become USD-averse, it automatically follows that non-USD instruments go up in price. Nearly all the appreciation in the USD can be attributed to USD weakness.

        Having said this, your point is still valid. Foreign investors are more willing to hold AUD than they otherwise would be because of the strength of our trade position and because the AUD is a proxy for Asian economic growth.

        This accounts for a part of the strength of the AUD, and, notably, part of its recent weakness too, as growth expectations have been moderated.

        http://www.abs.gov.au/AUSSTATS/[email protected]/Glossary/5302.0

        • Thanks for that david.. I apologised further up the thread for misreading your initial comments on the capital account as being about the current account.

          I think your point about what we do with the equity/debt from foreign sources is the problem, as you said initially.

          >Surely the point about having a surplus on the capital account – as Australia invariably does – is what happens to the money. In Switzerland they hold it in bank deposits. In Australia, we have built a lot of houses and shopping centres….and mines

          In theory the mining component is fine. It is the housing/shopping centre parts I obviously have issues with, but as Martin Wolf points out is the tendency of nations with CADs.

          The issue we have now, which I want to expand on in the future, and maybe you can provide further comment on is whether the current economic environment is supportive of the transition away from “housing and shopping centres”, when the net primary income position is larger than the net trade position.

          This suggests we have got ourselves into a position where the payments on our equity/debts is much greater than our trade surpluses even with ToT so high. Maybe this is because mining still in its “capital intensive phase”, but to me it would seem that we need some further adjustments in policy to lower the net primary position.

          • DE,

            “…..it would seem that we need some further adjustments in policy to lower the net primary position….”

            I think the RBA has got exactly this matter in the front of its collective mind. They are prepared to hold policy just tight enough to let some pressure out of the housing market, push up domestic savings and restrain consumption.

            Over time, this will see Debt:GDP come down in an orderly way and the risk to our economy of violent external shocks will abate.

            There are two things that have to happen for our external indebtedness to come down with relatively little pain. First, we have to maintain our improved trade performance. Second, we have to reduce externally-sourced, consumption-driven borrowing.

            Of these two, the variable that is within our control is the second factor: reducing our appetite for borrowing. This translates into having the housing sector deflate over time. This is exactly what is happening. As long as it is gradual and orderly, we should all be happy enough about this. It does mean that the domestic financial sector will experience a phase of reduced growth in their assets and profits, and it does mean that wealth-driven consumption spending will decline. It does mean that household savings and the AUD should remain at historically high levels.

            Restraint – it is the new black.

          • I think you’re right – this is the balancing act RBA are trying to pull off.

            And restraint is preferable to austerity!

    • Hi David,

      “What you can say is that foreign demand for Australian exports is adding greatly to national income (a balance of trade effect) and that prices of exports have risen to a greater extent than prices of imports (a terms of trade effect).”

      What about the change to spot prices, from the previous contract system that BHP/Rio/etc. negotiated as that does boost mining income, and tax revenue as a result. I’m just thinking there is a new multiplier now with high demand, and higher prices. It’s nominally in USD so that takes some shine off, but China is asking for a change to the Renminbi. Have you looked at this effect? I expect that PBoC might make changes to the Renminbi before long so that is another issue in the pipeline. I’m not sure Australia will agree to the Renminbi, but others like Russia have done so for some trades.

  2. Also, by way of thinking about exports and the exchange rate, take the case of the US. US exports are up, the trade deficit is falling. And the currency……is also falling.

    Once again, the exchange rate is not determined by trade flows. These are just too small in comparison to portfolio transfers.

    This is not to say that exchange rates and trade are unrelated. They are related. I would say the relationship is the opposite to that which is usually expressed in Australia.

    That is, trade flows depend on exchange rates (among other things). The US is a case in point. The lowered USD has enabled a growth in exports of all kinds, especially capital goods. So far at least, this improved trade performance has not had a noticeable effect on USD-depreciation.

    • trade flows depend on exchange rates (among other things)

      So … in Australia the exchange rate rose first, and that’s depressing our non-resource exports and enabling growth of imports?

      Hmmmm.

      FWIW, I think you can come up with all kinds of explanations for these things, but in the end markets don’t always behave rationally, so all rational explanations are meaningless.

      Try explaining Nikkei 1989, Nasdaq 1999, or iron ore 2011. You can’t.

      Surely the exchange rate is determined by a mix of interest rate differentials, relative inflation rates, terms-of-trade, balance of payments, government debt, and a healthy dose of speculation.

  3. Genworth? LMAO

    They hold the wee wee can when we go Ireland/Espana/USA.

    Nothing to see here folks, I’m the biggest holder of Aus/RuddPrime mortgagen insurance in the country!

    I AM THE MORTGAGE INSURANCE GIMP!!!

    LET ME FEEL YOUR PAIN!

  4. Despite Martin Wolfe’s fears though, we have been running a fairly persistant CAD for a VERY long time, and most of that has been accompanied by a high household savings rate and no major financial instability.

    I think Wolfe needs to be careful in singling out the CAD as bad and dangerous.

    For a country like ours, the current account moving from deficit into surplus doesn’t necessarily indicate something positive – it may mean that the consumption of imports is falling sharply, which would not be good news for an economy driven 60% by domestic consumption and which relies heavily on imports for the source of the goods consumed.

    I’m not saying that exporting mainly dirt, rocks, gas and food while importing everything is else a desirable situation in itself – but it is the current reality.

    There isn’t enough of Wolfe’s statement there to judge if he is making a blanket statement or not but my assesment is that a CAD might be good or bad or neutral, or carry both positives and negatives depending on the situational context. To argue that a CAD is “bad” and needs to be “fixed” might be similar to the widely accepted meme that a government deficit is bad and needs fixing – the reality that it just isn’t that simple.

    • I agree there isn’t enough in Wolfe’s statement. It was very broad and definitely requires further discussion, but some of it is relevant to Australia.

      >Despite Martin Wolfe’s fears though, we have been running a fairly persistant CAD for a VERY long time, and most of that has been accompanied by a high household savings rate and no major financial instability.

      Yes, but it has also been accompanied by a very large and ever-growing private sector debt, which tends to lead to financial instability.

      • That’s only a very recent phenomonen though DE. Most of the CAD years have been accompanied by high household savings and very much lower debt than has become normalised over the past 15 years – many people try and draw an automatic relationship between the existence of a CAD and all manner of problems. As far as I can see, no such automatic relationship exists.

        How does every country run a current account surplus at the same time? It isn’t possible unless there is life on Mars that desires to buy/borrow more from us than they sell/lend to us. The irony that many people in CAS countries probably fail to grasp is that their own CAS can only exist due to the existence of someone else’s CAD. If foreigners did not desire to buy more from them than they sold to them, the CAS would be impossible.

        If Australia wants to run a permanent external surplus and maintain a high material standard of living, then we had better start looking for arguments for protectionism.

        • Lefty, you are spot on here.

          As well, of course, we have a liberalised financial sector. We could run a permanent trade surplus if we chose to, but we would have to restrict capital flows and regulate the exchange rate, as used to happen in the good old days.

          The price we would pay would be a smaller economy financed mostly with domestic savings, a fixed exchange rate (meaning much bigger swings in the business cycle) and lower living standards.

        • Left in response to a couple of things you said..

          >That’s only a very recent phenomonen though DE. Most of the CAD years have been accompanied by high household savings and very much lower debt than has become normalised over the past 15 years – many people try and draw an automatic relationship between the existence of a CAD and all manner of problems.

          I think the key thing about the “recent phenomonen” relates to the use of a floating exchange system.

          >As far as I can see, no such automatic relationship exists.How does every country run a current account surplus at the same time? It isn’t possible unless there is life on Mars that desires to buy/borrow more from us than they sell/lend to us. The irony that many people in CAS countries probably fail to grasp is that their own CAS can only exist due to the existence of someone else’s CAD.

          You are correct about this, I have talked about this point in regards to Greece and the rest of Europe.

          My issue with CADs is that there seems to be a relationship between them and indebtedness, which inevitably leads to some sort of financial crisis. It is obvious to anyone who bothered to look that Australia is punching above its weight on private sector debt and as you say have a very long running CAD. Those two things are not independent in my opinion, but I don’t see anyone else in Australia discussing that point.

  5. Nice to see these issues getting an airing, DE. Thanks for your post. Thanks esp. to david as well, for his comments.

    Good to get beyond blaming mining for all our woes.

    • Yes I absolutely agree, there is far more too it than just mining. The economic system plays a big part, which is why it NEEDS to be discussed.

      And I agree, Davids comments have been very valuable. Even if I misread them 🙂

      • Thank you, DE, for creating the platform for this discussion. This is the only place I know of where these very interesting and topical issues can be discussed by any-old-blogger. It is just great.

      • This is defintely a great subject to discuss and it is nice to see that people are able to voice their opnions on here without them getting delete unlike one of the other publishers on here.

        I got a question about this. Now would the higher dollar be eating into the Miners profits because they are selling the resources in USD or am I have got it turned around. My question is doesnt the high AUD also hurt the miners as well?

        • Yes. It hurts Australian miners in particular.

          However, if they were a Chinese or Singapore owned mines, they would suffer higher costs (because of the high Australian dollar) but they would be able to prosper more than Australian owned mines would because they allow additional money to flow into their economies.

  6. I was told that the way the ABS calculates the current a/c deficit is quite misleading. From memory, they treat the repatriation of profits to overseas firms as debt payments (which obviously they aren’t). i.e. they treat all outflows as evidence of indebtedness. I shall look into it, been meaning to for a while. It would explain why the disparity between the export/import balance and the supposed evidence of our great indebtedness in the current a/c

    • Repatriation of profits and interest payments are similar in an accounting sense: they are both reductions in the liabilities of the payer.

      In this sense, there is nothing misleading about the RBA’s methods.

      I think there is confusion in the public mind abut the meaning of the balance of trade, the balance of payments, the foreign debt and how all these things fit together with the (constantly fluctuating) exchange rate and the interest we have to pay on our mortgages and credit cards.

      Of course, the detailed net foreign assets and liabilities position is seldom mentioned. The fact is Australia is also a “foreign investor” – mostly of direct equity investments – and is a recipient of foreign income flows (as distinct from capital flows.)

      This is also true of the US, who are the world’s largest creditor nation, but whose corporations are also the largest direct external investors.

      In part, what this says is that US (and Australian) corporations own stuff. They get their returns in the form of profits – returns to equity. Returns on equity are usually significantly higher than returns on debt. So they try to position themselves at the lucrative end of the risk/return curve. Equity capital tends to have to work harder and smarter than portfolio debt, and must attract a premium because it entails more risk. If it does not earn an adequate premium – that is, a return well above its opportunity cost – it will be liquidated.

      The other thing about profits is they are not necessarily repatriated. In fact, they are most often not repatriated, but are re-invested offshore.

      So in a sense the data about our external income/expenses and assets/liabilities tends not to state the full picture, which is possibly why policy-makers and markets have been fairly relaxed about our foreign debt.

  7. > Genworth bullishness

    I am not sure why you came to the conclusion that that there was a bullish message in the Gentworth report. Here are a few comments and excerpts from it:

    Chart 2 – some 13% resondents extremely concerned and 31% somewhat concerned about their financial situation.

    chart 5 – 21% found it difficult to make mortgage payments during some months.

    chart 13 – 73% think that prices are too high to buy now.

    Table 1 – 42% believe now is a good time to buy and the main reason is a good supply of housing stock according to chart 12.

    “An interesting dynamic in many countries is the desire to pay down debt faster than is required. This phenomenon is particularly prevalent in India and Australia where an average of more than 40% of borrowers surveyed were overpaying their mortgages.”

    This seems to indicate that people are worried about their future financial situation and try to reduce their debt.

    “Worryingly, even among potential FHB respondents who don’t yet have a mortgage, levels of debt are high. In particular, in the US, Canada, and Australia, at least one in five potential FHBs thought they were already spending more than half their after tax income on debt repayments, suggesting that the rising cost of living is making it harder for people to buy a home in these countries.”

    See above.

    “While future property price growth can act as an incentive for investment-minded individuals, overall the high cost of property was a major disincentive for those who felt that now was not a good time to buy a home. This was particularly true in India, Australia and Canada, where higher property prices are keeping some buyers out of the market.”

    “Personal finances appeared to be more of a concern than the economy, with 44% of Australian respondents troubled
    at some level about their personal finances. The concern is mainly due to rises in the cost of living and petrol
    prices, cited as a cause by 84% and 77% of concerned respondents respectively. Food prices have certainly been
    affected following recent flooding and cyclone damage, which has increased. Outside of consumer goods, housing affordability was an issue for Australian
    respondents, with 30% of concerned respondents citing this, second only to India among the surveyed countries.”

    The findings of the reports seem to be consistent with the deleveraging trend shown in the latest official credit reports and too me they are anything but bullish.

    • JPK

      If you haven’t already seen it, here is Steve Keen talking on (ir)responsible lending practices on the part of the Australian Banks, the growth in mortgage indebtedness and the fact now that we have people living in ‘mansions’ simultaneously living in relative poverty.

      http://www.youtube.com/watch?v=Cg2m9oiFwUw

      Cheers.

      • I personally know people in this situation. Their household income is MUCH larger than ours (resource sector job) but their outgoing mortgage expenses (1 principal place of residence and one investment property) are so much larger again that their material standard of living (apart from a big, flash house) is significantly lower than ours and they have recently concluded that the financial burden is just too much, so they are selling the IP. Even if they sell it for as much as the agents have assured they can ask, they will still have such a large mortgage that it will entirely cancel out the extra household income they earn over and above us (though they should have a very large deposit in the bank).

        The IP is just a little shoebox, small and old but structurally sound and in a nice spot. It would have been a perfect house for first-time buyers but if they manage to sell it for the $400 0000 + they have been told they can get, there won’t be too many first time buyers who will able to afford it ever again (unless prices fall here in this LNG boomtown as well). Not my business of course but it shits me to see affordable housing being turned into unaffordable housing for the next generation so that my own generation can stuff it’s own pockets with money in the here and now.

        • It would be interesting to see the effect of rising fuel prices on households such as this. More money going in fuel means less for other things, and if you drive to work that expenditure on fuel may be difficult to reduce. I wonder what impact the fuel price rises will have on House prices.

          • They had a 4WD which they sold because the fuel costs were too great. How can a household with a pre-tax income of around $180 000 pa. possibly be concerned about the cost of fuel?

            Unless they have a mortgage debt of a size I would consider dangerous.

            The most concerning thing for over-leveraged households IMO would be a weaking economy which was beginning to replace full-time employment with part-time employment – just like the one we appear to have right now.

            Such overstretched households would have very little ability to absorb the impact of one partner losing working hours, let alone losing a job, notwithstanding that the RBA would slash interest rates in the event of the economy completely stalling.

          • Just as imagine, as some desiring an end to strength in the resources sector would have it – a return to an exchange rate of 70cent to the USD – right now. Oil at around USD100 and possibly rising – there’d be quite a few more with fuel cost issues then.

          • Agree 3d1k….but aren’t we likely to experience a significant drop in the value of the $AUSD in the event of a recession despite the mining boom in any case?

            Who would bother parking their money here while interest rates were being slashed for starters?

            Sounds like a conundrum doesn’t it? The RBA slashes rates to try and kickstart a failing economy but the falling dollar offsets the attempt as the cost of petroleum spikes and the economy spiralls down anyway as a result.

            But then I have no formal economic training so I could be wrong about all of this. It would suck badly if it came about.

          • Plus the price of all other imports spikes as well, further supressing consumer demand.

          • Good question – my gut feel is that if push came to shove – the RBA would favor an interest rate environment supportive of resources. It doesn’t want it to get to that stage, hence the balancing act so well described by david, but if it does (assuming resources sector remains so strong) the view that we will undergo a period of transition – there will be some discomfort or even demise(in terms of individual businesses) that is the ‘price’ of transitioning to their 21st century economic model.

            A lot of eggs in one basket.

            Just my 2c.

          • It’s an intruiging hypothetical isn’t it?

            A lower $AUSD would make our dirt exports more competitive – but at the expense of the non-resource portion of the economy, which in real times I think would be about 95% or so.

            Which keeps coming back to my original point – can mining soar like an MX missile while the general economy recesses? As noted in the link posted by Lorax, Linfox appears to think that it’s happening already.

            We don’t need to get rid of mining or argue that it’s completely worthless – but we do need to question the true extent to which mining adds juice to the general economy.

          • Well that is the $4 trillion dollar question. Can you make the transition without a crash?

            As David said above

            “I think the RBA has got exactly this matter in the front of its collective mind. They are prepared to hold policy just tight enough to let some pressure out of the housing market, push up domestic savings and restrain consumption. Over time, this will see Debt:GDP come down in an orderly way and the risk to our economy of violent external shocks will abate. There are two things that have to happen for our external indebtedness to come down with relatively little pain. First, we have to maintain our improved trade performance. Second, we have to reduce externally-sourced, consumption-driven borrowing.Of these two, the variable that is within our control is the second factor: reducing our appetite for borrowing. This translates into having the housing sector deflate over time. This is exactly what is happening. As long as it is gradual and orderly, we should all be happy enough about this.”

            I completely agree with this. But there are two big question.

            1 ) Is the mining sector a big enough counter-measure to $1.2 trillion dollars of housing debt. Given that the only tool in the shop to steer the transition is very blunt and slow feedback tool of interest rates ( or at least the threat of them ).

            I have covered this previously

            http://macrobusiness.com.au/2011/05/steering-godzilla’s-seesaw-with-a-mallet/

            2 ) Can it be gradual and orderly ? H&H has previously stated the RBA is counting on investors being irrational about their investments, that is continuing to hold on to them in the face of mounting losses. If this in fact the RBA’s plan, then how long will it take for the truth to leak out ?

            From a financial stability perspective maybe we should just stop talking now, and never mention this topic again 🙂

          • DE

            The $1.2 trillion of housing debt – if rates rise say 2% how much of this debt would be affected. Not all I assume – would have no impact on my position, nor many that I know but I acknowledge a devastating impact on many others. 2% may be way over the top – what do you think is a likely scenario?

            Cheers.

          • DE
            Ignoring the problem will not bring about stability. In the long run it will create greater instability.

            It is possible to provide money for the economy to grow and repay its debt, without raising debt. For example, the Reserve Bank could buy foreign currency to hold down the value of the dollar. Immediately that would inject money into the economy. This money would not be based on debt. It would be based on foreign assets. It would be based on national savings.

            It would raise income from exports and reduce imports, shifting demand to domestic products, raising incomes and providing employment. It would raise GDP and lower net debt.
            Such money would not be as inflationary as money from bank credit. Inflation is caused when money grows faster than GDP. Money from export growth raises money and GDP.

            I have suggested a more long term approach in an earlier post.
            http://macrobusiness.com.au/2011/04/leigh-harkness-an-optimum-exchange-rate-system/

            However, I am pessimistic about the Reserve Bank doing anything about it. It is not aware that there is anything wrong with the current monetary system. Hence, just as in the USA and Europe, eventually we can expect a crash. We could look to South America for examples of what finally happens to economies that adopt Harvard style neo-classical economics.

          • 3d1k
            “The $1.2 trillion of housing debt – if rates rise say 2% how much of this debt would be affected”

            Gees thinks of how much that would push up the arrears if rates went up 2%. Think that would cause a major crash. What do you think DE?

          • That is what I wonder – I know recent borrowers with high LVRs would face difficulties but there must be a largish segment of mortgage holders that could accommodate several basis points higher. Interesting to know the respective bands.

        • Daniel at home

          Thanks go to all of you – you have articulated a concern/ dynamic I have been confounded by for some time. I returned to aus some 5 years ago through work – my family did what we have done in other parts of the world – rented a home near town (Woolstonecraft in this case) and settled in to life, school and work.
          We rented without a RE agent being involved and got to know the landlord quite well – nice guy. The house was a big rambling 4/5 bedroom federation place that he bought shortly before we signed up – for just under $3m. Our rent then was $1300 a week. The maths never made sense.
          But what really bothered me was, for a house of that price range, how “poor” the overall fixtures and fittings were. I mean we are talking bunnings plastic and worse. The place just had no money put in it for a long time by the look of it.
          Don’t get me wrong it wasn’t a dump, the mansion with $5 doorknobs.
          The owner sold and we moved on – he made a killing, the previous owners made a killing and the plastic curtain knobs are probably still falling off every time someone opens a sticky window.
          I drove past the place a while back and it’s up for sale again.
          The front fence has finally fallen over and REA’s sale board looks more permanent.
          And so it goes – at least I sort of understand why now.
          Cheers

  8. DE
    You say “that if the value of exports is rising faster than that of exports then the nation as a whole will becoming richer.”

    Our floating exchange rate system is designed to prevent money coming into our economy. Money is a measure of our income, wealth and debt. If we increase our money income by raising exports, we must reduce our money income by buying an equivalent amount of imports (or increasing our investment overseas – as the Japanese have done). The exchange rate varies to ensure that this is the case.

    As the Treasurer explained in the budget speech, we are having a mining “investment” boom. He made no mention of a mining boom.

    Imagine if we suddenly found vast quantities of oil near the coast that could be cheaply accessed. When we exported that oil, our exchange rate would rise. Every dollar we earned would have to be spent off-shore on imports. That would kill our import competing industries. It may also kill off other exporters such as farmers and many minerals exporters.

    The floating exchange rate system is like the cap and trade system for restraining carbon emissions. The cap and trade system provides licenses for a fixed amount of carbon emissions. If an industry wants to increase its carbon emissions, it has to buy them from another industry willing to reduce their carbon emissions and sell their license.

    In the floating exchange rate system, there are zero net emissions of money allowed in or out of the country. It was intended to prevent the emission of currency out of the country. But it is just as effectively prevents money coming in. If one industry is to increase its money receipts, another industry has to give up its receipts.
    The current account deficit has nothing to do with our wealth. The way money works is that when we sell the products and services that we produce, the money we earn enables us to buy an equivalent amount of products and services. For the nation this means that money constrains the nation’s expenditure to its income. When banks create additional money, that additional money enables the country to buy more than it has produced.

    The only way a country can buy more than it has produced is to import more than it exports. So the additional money from bank lending causes current account deficits.

    I have a blog that provides a formula for the current account deficit. It is available at:
    http://www.buoyanteconomies.com/CAD_Formula.htm

    • Leigh, you said.

      >If one industry is to increase its money receipts, another industry has to give up its receipts.

      I think that is what I said in my post ?

      >The current account deficit has nothing to do with our wealth. The way money works is that when we sell the products and services that we produce, the money we earn enables us to buy an equivalent amount of products and services. For the nation this means that money constrains the nation’s expenditure to its income. When banks create additional money, that additional money enables the country to buy more than it has produced.

      I can’t really understand this one Leigh.

      You are saying that a CAD has nothing to do with wealth, yet then say that “when the banks create additional money that enables a country to buy more than it produces”. Banks “creating” additional money is debt. So what you are saying is that you need indebtedness to create a CAD.

      If that is the case then the statement “The current account deficit has nothing to do with our wealth.” seems to be false.

      Am I wrong about that ?

    • As the Treasurer explained in the budget speech, we are having a mining “investment” boom. He made no mention of a mining boom.

      And its this coming-any-moment-now investment boom that has the RBA so hawkish, not the income from current production.

      Interestingly, as Tim Colebatch pointed out last month, the miners have consistently failed to deliver on their promised investment plans…

      Yesterday’s Bureau of Statistics survey of business investment reveals a widening gulf between what mining companies say they will invest and what they actually invest.

      Three months ago, they said they had invested $22 billion in the six months to December 31. But they told the ABS they would invest $35 billion in the six months to June.

      Uh-huh. Well, three months later, we find they invested only $10 billion in the March quarter.

      Sure, there was a cyclone and floods, and yesterday’s figures are only preliminary. But 2010-11 will be the fifth consecutive year in which mining investment will stop well short of the forecast.

      It matters because the miners forecast $83 billion of investment in 2011-12 – twice what they’re investing now.

      It goes without saying that the miners will pull the plug on much of this investment if commodity prices collapse, but the RBA is behaving as if the money is already spent.

      Futureboom! indeed.

      • Lorax

        There is a boom – near record tonnage and $value. Evidenced by (if nothing else satisfies you) the healthy profits to the major producers and windfall billions to government revenues . The investment spend is the next phase and as I have suggested here before, has been a little slower than desired to get going – but you go to the northwest of WA and see the extent of projects underway, you may revise your view. Infrastructure development is happening right now and, assuming no calamities, will continue – big time.

        If commodity prices crash tomorrow there is no doubt there would be an impact on infrastructure development. Something not to be wished for but not entirely impossible. This is resources – something the industry accepts could, in extreme circumstances, occur. But you have to take best indicators and go for it – still looks good for a while longer yet. Despite the death wish of some…

        No doubt, should an economic disaster occur – and that’s what it would be, essentially a China crash landing, there would be considerable global implications – we would lose one of the country’s best performing sectors – with nothing remotely possible to replace it.

        The RBA would revise policy and attempt to steer the country through a severe recession.

        Thank god for resources.

        • Thank god for resources.

          I have no doubt, no doubt whatsoever, that when the history books are written about this period of our history, the decisions that allowed our economy to hollow out and become totally dependent on resources, will be judged as a monumental policy error.

          Thank God for the non-resources exporters. Thank God for Cochlear and CSL. Thank God for the small businesses who still eke out a living exporting goods and services to the world despite the most unbelievably difficult circumstances.

          Because by God, we’re going to need them when this house-of-cards comes down.

          • Lorax

            I assume the emboldened text indicates your heartfelt response. Mine too.

            We are not in the desperate situation you imply – we are in a period of stagnation with some prospect for decline in some sectors. That is it. Someone here commented a while back the RBA are prepared, if necessary, that post 2009 purchasers may ‘burn’. That may not yet happen, but if rates rise, will.

            Truth is the global financial position is faced with a number of potentially adverse possibilities – the Eurozone debt crisis, the US fiscal route and a China hard-landing. Any one of these could precipitate turmoil in the derivative markets.

            As we speak, not one of these events has unfolded and in my view that only one is likely to in the near future. This all buys time, as resources inflows to government buys time. If you take the figures as reported thus far, retail sales patchy, property some declines but patchy, employment – remains at historical lows in percentage terms. Inflation, by measures used to define it, lowish. Not doomsday, may never be doomsday.

            Again you mention Cochlear and CSL (are these the only two in all of the country) and I remind you that there has been ample time and opportunity to develop robust niche markets, largely not done. We have launched into services with gusto – and they ain’t enough. This is a collective lack of vision on the part of entrepreneurs, financiers and investment groups (governments, unions and educators) – we are all responsible – risk averse it would seem. Well guess what, miners take risks and sometimes they really pay off!

            It is how we manage this extraordinary period that will be read in history books. If Treasury and the RBA have got it right – I guess it’s hallelujah then – hate to bring it up, but without a SWF all the benefits of the mining boom will evaporate – I am still of the view, longer term, services are not enough for an economy to survive.

            We are in a position of having no concrete future outlook – we’re bulls or bears. Hence my position, it is what it is…until, if ever, it isn’t.

            So cheer up, open a bottle of good Australian wine and chill. We’re not Ireland.

            And thank god for resources.

          • Gees Lorax you know how to hit the hammer right on the nail. That is my exact feeling about this whole Australia is the lucky country BS. All I hear from wife’s family and other friends how the US is screwed( agree with them on that) and Australia isnt. I tell them pretty much the same thing you stated.

            “I have no doubt, no doubt whatsoever, that when the history books are written about this period of our history, the decisions that allowed our economy to hollow out and become totally dependent on resources, will be judged as a monumental policy error”

          • LBS

            That’s assuming it all goes to the dogs…what if it doesn’t. In any case, what do Lorax and you think should be done to avoid such an interesting (in historical perspectives) outcome. We are where we are. We are part of the globalised world. What do critics of current policy suggest.

            Cheers.

          • 3d1k, Its real simple the govt needs stop all forms of stimulus anything. Figure out a way to get company’s here and overseas to invest in other areas of the economy(Except mining) maybe tax breaks something but dont go and put money in peoples hands to spend. For gods sake dont offer any more first time housing stimulus. Concentrate on other areas in the economy besides mining and propping up housing. I dont have the formula.

          • The RBA has mentioned mining-boosted income millions of times in its rate rises. That’s one part of jawboning consumers – don’t spend boosted incomes.

            There is no doubt that we’re better off with the mining boom than without. Unless you think that extreme austerity is preferable to restraint.

            If there’s anyone in this country that is against hollowing out, it’s me. But your tirade is losing my support.

            You are confusing poor management of the boom with no boom at all.

            Australia had a financial crisis in the GFC. IT was manageable because of low government debt and the problem was on the liability side of the banks’ balance sheets. If we didn’t have mining massively boosting the trade balance since, then that would have morphed into a longer term current account crisis that would have fundamentally reset the Australian economy and its relationship to the global markets and capital.

            We will still have that moment in the future when the commodity boom ends but it will be half as disastrous as it would have been.

          • 3d1k: Actually the bold was supposed to be italic … dunno what happened there.

            H&H: I maintain that without resources, we’d be a bigger, more economically diverse New Zealand. Not Ireland, not Spain, and not Greece.

            New Zealand doesn’t have a current account crisis, or collapsing house prices, or runaway unemployment. Its not good over there, but its no disaster either.

            We will still have that moment in the future when the commodity boom ends but it will be half as disastrous as it would have been.

            What concerns me is if we continue down this path of ‘hollowing out’ without saving for a rainy day (via a SWF or whatever) when the correction comes, our non-resources sectors will have been so weakened by the resources boom, that we’ll be unable to recover.

            I know that if I lose my key engineers now, I can’t replace them when conditions become more favourable. These guys have been with me for more than 10 years. They simply can’t be replaced overnight if China bombs and the dollar crashes to 60c. I can’t innovate and create new products and services if my key people have left to design better shovels.

            Replicate my story a hundred thousand times across the country and you have an economic tragedy playing out.

            Ok, so my language might be emotive and a bit OTT sometimes, but I’m not going to just lie down and die because Ross Gittins! says I should.

            This is real for me. Its not something I just write about on a blog, or punt on in the sharemarket. Its my livelihood!

  9. DE
    When banks create money, they are adding the borrowers’ debts to their assets and deposits to their liabilities. That is neutral as far as net debt is concerned. Similarly, the borrowers are increasing their debt and increasing their assets (deposits in the bank.)

    Where the problem comes in is that the borrowers have is a future obligation to supply products to the economy. However, the deposits (money) they receive are a current entitlements to buy goods now. So banks are creating current entitlements against future obligations. It is that practice that causes a country to buy more than they produce and so cause a current account deficit.

    • >When banks create money, they are adding the borrowers’ debts to their assets and deposits to their liabilities. That is neutral as far as net debt is concerned. Similarly, the borrowers are increasing their debt and increasing their assets (deposits in the bank.)

      Leigh, I understand net debt doesn’t change at any time unless someone defaults on their credit, but my point is that it would seem from your statement that by running a CAD the private sector has to become more indebted ( to the private sector banks ).

      This being the case then by running long running CADs and therefore growing foreign debt the financial system becomes more unstable until the point of crisis, for all/some of the reasons mentioned by Martin Wolf in my post.

      This certainly matches some of what I see in the Australian economy.

  10. DE, David, and all,

    This is one of the best posts I’ve read, and you never see this real understanding of the economy in mainstream.

    • Yes, Totally Agree. Thank you to all who have contributed. This has been fascinating reading and a great discussion of ideas. I hope this blog can keep up the outstanding quality of blogger posts and associated readers comments.

  11. DE
    I agree that in Australia’s case, it is the private sector that is currently borrowing from the banking system and is becoming more indebted (to the private sector banks). However, it does not matter if it is the private sector or the public sector that borrows from the banks.

    Note that the domestic debt to the banks is a different debt to the foreign debt needed to finance the current account deficit. One dollar of domestic debt to the banks is most likely to create an additional dollar of foreign debt to finance the current account deficit.

    That doubling of debt is contributing to the instability of the financial system.
    What appears to cause this instability is that as the debt grows, people and businesses need a greater share of the money they earn to service their domestic and foreign debt transactions. This means that a smaller share of the money being created is available to initiate purchases of products which generate income. Hence, as the debt grows, it reduces the capacity of the economy to earn income to service their debts. That is a recipe for instability.

    • Dave From Pakenham

      what do you propose the debt is being used for? Future consumption?

      It is funding current consumption. Its not somehow leaving the system.

      WHat debt does is the opposite it produces too much income for a moment in time that does not recur therefater, people receiving this income spend it, and base this as a norm, as though it goes on forever. See 23 year old 60k ute driving tradies..

  12. Alex Heyworth

    Leigh, upthread you said

    “Imagine if we suddenly found vast quantities of oil near the coast that could be cheaply accessed. When we exported that oil, our exchange rate would rise. Every dollar we earned would have to be spent off-shore on imports.”

    Couldn’t the dollars earned be spent on acquiring off-shore assets? Isn’t this the point of the argument for a SWF?

  13. Yes. That is what Norway does. However, that is really just deferring the pain. You get nothing other than a happy feeling when you buy the off-shore assets. When you sell the assets to bring in the money, you have to increase your imports.

    It is better to have a stable monetary system that allows the country to prosper from trade. That is how our economy prospered from gold, sheep, wheat etc in the past.

    • Dave From Pakenham

      In your model, there is no investment. Just consumption. Even a subsistence, with no bartering, economy stores food through winter….

      • I am concerned about investment.

        In economics, we have two types of investment: physical investment and monetary investment. The first is about hardware: injecting new physical capital into the economy. The second is about software: injecting new money into the economy.

        Australia has resources, skilled people and plenty of physical capital to be a very prosperous country. I am not concerned about our ability to create additional physical capital.

        What I am concerned about is the software (the monetary system). All I am suggesting is that the monetary system be managed in such a way that investment (injections of new money into the economy) be done in such a way that they equal to savings.

        At the moment investment (of money) is proceeding without adequate savings, and we are going deeper into debt. That debt has become such a burden that it threatens to destroy our economy.

        • Sounds good to me, Leigh.

          Really sounds more sensible, just and sustainable than all the “clever” (read: ultimately wealth-transferring and collapse-tending) systems we otherwise try to conjure…

          My 2c

  14. Great discussion everyone. I enjoy these weekend “musings” enormously – it really adds to the quality of MacroBusiness.

    Leigh, your take on monetary management is very interesting: it seems like a number of other financial and economic subjects (e.g competition theory, EMH, CAPM, secondary asset market supply/demand dynamics) that the Emperor’s of the “dismal science” are truly naked.

    There seems to be a religious faith attached to have a floating currency, yet why do HK, Singapore and China – arguably the most successful capitalist nations of the last century – continue to prosper without one?

    I’m slowly working through Leigh’s blog, which is fascinating – its hard to “lose religion” and contemplate a non-floating currency, even though, like almost every other G20 nation, Australia has only had one for 30 years….

    • Prince

      Milton Friedman wrote “A system of flexible or floating exchange rates is absolutely essential for the fulfilment of our basic economic objective: the achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade.”

      Possibly one of the more interesting questions is why the countries that have adopted the floating exchange rate system such USA, Europe, UK, Japan, New Zealand and Australia are not prospering.

      It was President Nixon that implemented the floating exchange rate system and it was not because it would achieve prosperity for the USA.

      You might like to read:

      http://www.buoyanteconomies.com/DebtIncome.htm

  15. > There seems to be a religious faith
    > attached to have a floating currency,
    > yet why do HK, Singapore and China –
    > arguably the most successful capitalist
    > nations of the last century – continue
    > to prosper without one?

    My hypothesis is that floating currencies do not work to support nations but rather to support global capital. The main effect of globalisation has been decoupling of private capital and national interests. Since the capital can freely move between countries industrial production moves to countries with lower cost of production and weaker currencies. If you can prevent your exchange rate from appreciating, then even if the cost of labour, measured by the local currency, grows the cost of export grows slower since the exchange rate does not appreciate. This will only stop when the economies of importing countries are completely hollowed and no longer able to buy imported goods in quantities that support exporting countries with fixed exchange rate currencies.

  16. It’s good to see that this issue (current account imbalance) provokes so much response from everyone. IMHO it is THE issue Australia faces. During the Asian crisis Larry Summers said that “close attention should be paid to any current account deficit in excess of 5% of GDP, particularly if financed in a way that could see rapid reversals”.
    Australia has had a CAD close to an average of 5% of GDP for nearly the last 3 decades. As a consequence we also have one of the highest external debt to GDP ratios in the world.

    The problem with the CAD, as someone else pointed out with the Martin Wolfe quote, is that the external imbalance always means an internal imbalance somewhere inside the economy. Consumption is either too high relative to income, or investment too high relative to saving. This internal imbalance is a sign that something needs to change, but if the government no longer regulates the capital account (as has been the case here basically since the float) it is possible that the economy can get locked into a situation where inflows reinforce the current account imbalance which then allows the internal imbalance (in Australia’s case household leverage) to get worse and worse. Accumulated CAD’s will increase the stock of external debt, and at some point its servicing cost will feed back into the CAD. Projected CAD’s will rise and if the trade balance worsens, international investors will demand a greater risk premium to hold Australian assets. At that point the current account will reverse causing a credit crunch, a fall in imports, investment and output.

    In the speech posted on MB a couple of weeks ago, Battelino basically said that the CAD doesn’t matter because of the floating exchange rate and the fact that almost all foreign liabilities are in AUD or effectively hedged. This is so far off the mark. Nobody is suggesting that the CAD poses a currency risk. At a guess (not sure if this has been measured), Australia is probably net long foreign currency (foreign currency denominated assets exceed foreign currency denominated liabilities). So any depreciation will actually help the Net International Investment Position. The CAD poses a funding risk which would cause a severe credit crunch and recession. And the only way to reverse the trend is to re-orient the economy towards the production of traded goods and household saving.

    • >The problem with the CAD, as someone else pointed out with the Martin Wolfe quote, is that the external imbalance always means an internal imbalance somewhere inside the economy. Consumption is either too high relative to income, or investment too high relative to saving. This internal imbalance is a sign that something needs to change, but if the government no longer regulates the capital account (as has been the case here basically since the float) it is possible that the economy can get locked into a situation where inflows reinforce the current account imbalance which then allows the internal imbalance (in Australia’s case household leverage) to get worse and worse. Accumulated CAD’s will increase the stock of external debt, and at some point its servicing cost will feed back into the CAD. Projected CAD’s will rise and if the trade balance worsens, international investors will demand a greater risk premium to hold Australian assets. At that point the current account will reverse causing a credit crunch, a fall in imports, investment and output.

      That is a great wrap up sweeper and is pretty much the way I see it too.

  17. i’m a laissez faire sort, but do not believe that ricardo’s stipulations are satisfied in today’s paper money regimes.
    there exist prolonged periods of currency over and undervaluaton (pace friedman), which tend to correct very suddenly.

    short of restoring a world gold standard (will return eventually), there is no definitive cure.

    australia has always depended on external capital, the critical question is the destination of same. is it in productive assets – farms, mines, business, or housing and other consumer items?

    if we’ve got a housing bubble, the rba is the cause. the supply side (developers, state governments’ dripfeed of land, green policy etc.) only causes high prices, not pricing errors.

    this, on hollowing out:
    http://brookesnews.com/unemployment/american-jobs-factories-and-investment-the-picture-is-grim/