The twin pillars of our discontent

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As the absurdly overdue angst about the dollar and manufacturing jobs gathers intensity and the incredibly overblown angst about bank interest rates prepares to enter blowoff, one can only wonder about where everyone has been and why everybody treats these as separate issues. These two pillars of discontent are the base for our entire economy.

At the macroeconomic level it never pays to analyse anything in isolation. By definition the macroeconomic context effects everything. Pull on one lever over here and you’re sure to see a reaction beyond your immediate target. A classic example of this was the Howard/Costello years. When Costello eased capital gains taxes on property in the late 1990s perhaps he had in mind boosting investment in housing construction. Instead he unleashed a deluge of investment property speculation. That, in turn, drove a debt-accumulation and consumption growth model for the entire economy. Banking and retail demand boomed and so did capacity building in those sectors.

Of course the result of this was a huge blowout in the current account deficit as the Australian banks could not keep up with the demand for credit using local funding sources. They had to borrow money from outside the economy and did so in droves. A similar phenomenon hit consumer goods production and imports soared. We simply lived beyond out means on borrowed dough and goods.

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This model for growth disintegrated in the GFC. We are are now paying the price for that in the raised costs of funds for the banks in the offshore funds that the drove the model. Notwithstanding Europe and other global ructions, investors simply want more money for the clearly increasing risk of lending to our banks as they attempt to sustain yesterday’s growth model without imploding.

But it’s also important to understand the reason why investors are still prepared to take this risk at all. That’s where we come to our second pillar of discontent. The amazing levels of investment associated with the resources boom is giving Australia the chance of shift its growth model to the one which is now in favour with global markets: the export driven growth model.

This is vital to understand if we are going to manage the current transformation to a different model of growth for the economy, resource investment leading to exports and the downsides that that brings, a high currency and carnage in tradable goods like manufacturing.

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Tim Colebatch (who never gets the billing he deserves at Fairfax) today summarises the options for controlling the currency:

One option is to do what others do: get the central bank to drive the dollar down. That’s possible. They can do that by printing money – but that’s the recipe for inflation.

There’s two other ways, both unpalatable: invest overseas, as China does, or stop wage growth, as Germany once did.

Our best chance was the mining tax. A 40 per cent tax on superprofits in all mineral sectors, as originally intended, would have sharply slowed mining industry growth, reducing the upwards force on the $A and allowing other industries more room to grow. But Tony Abbott said no, Labor backed off, and even its emasculated tax is yet to pass Parliament.

Ah, music to my ears, as regular readers will know. But is it true? The RSPT deliberately adopted a very complex model so that it did not distort investment decisions. That is, it did not seek to change or delay investment. It’s virtue largely lay in the government taking a larger slice of the profits without slowing the boom.

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I believe by and large that that is true. The campaign against the tax, that it would cause a mass exodus of capital and thus terribly distort investment decisions, was a PR campaign mounted by the miners.

The implication, then, is that the RSPT would only have diverted a larger percentage of the miner’s dividends into government revenues than would otherwise have been the case. That would have lowered stock prices and dividend flow but with the mining 80% foreign owned, the latter might have been negligible. These impacts do not seem to me to have been likely to greatly effect the value of the dollar given the levels of investment were unaffected.

And indeed, given the revenues were earmarked for redistribution as tax cuts for other sectors, boosting their investment metrics, then one possible outcome may have actually been even more upwards pressure on the dollar as more sectors remained buoyant.

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No, the RSPT was not what was required. It simply wasn’t big enough. If fiscal policy is to hit the dollar it must dent the boom.

But remember, we’re still trying to find macroeconomic settings that enable us to manage our transition from credit-driven growth, to export-led growth without destroying manufacturing. We could cut interest rates of course as, Paul Howes suggests today at the AFR. Yes, we could. At The Cupboard today, Judith Sloan explores that idea:

So let us assume the dollar is overvalued. Is its value high enough to justify intervention? The RBA is likely to take a cautious approach before acting.

The key criteria a central bank is likely to follow are: rapid upward movement of the currency; extreme overvaluation; and threat of deflation.

Switzerland provides an example of central bank intervention aimed at lowering the value of a currency.

The high value of the Swiss franc has had a major impact on the economy, particularly the manufacturing sector and tourism, which competes with eurozone countries. And there has been (and is) a danger of deflation.

Swiss monetary authorities have instituted a currency peg (it’s really a cap), the value of which is higher than many Swiss would regard as comfortable but is guaranteed as the maximum conversion rate of the Swiss franc to the euro.

Is Australia’s case parallel to Switzerland’s? The short answer is no – there is no imminent risk of deflation, for instance.

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True enough, especially since out fiscal settings remain unchanged from the old credit-driven growth model. Lower rates enough to hit the dollar and you risk another blowoff in property speculation. So, if you’re going to lower rates, you must also reverse the Costello capital gains tax concession on investment property.

Could we prevent the dollar rising using direct fiscal measures? Yes. We could try Tobin taxes, capital controls and raising the tax rates on foreign deposits at the banks. But could we do that without further raising the cost of funds for the banks? I don’t think so. The banks are enjoying a very nice flow of carry trade funds as deposits. Which in my view is one of the reasons why Canberra won’t canvass such ideas.

The point of this post is not to depress non-resource exporters. It is show that the twin pillars of our discontent are actually columns holding up the same structure. It’s not simply the “free market” at work. Nor is it simply government lassitude. It is a series of macroeconomic settings that have favoured some sectors over others – banks and resource firms over manufacturers for many years. If you really want to change that you need to tackle the settings in their entirety, as well as the interests that support them.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.