A commodity shock for incomes

Last year, the Australian Treasury released research showing that around half of the growth of average incomes experienced over the 2000s was caused by the one-off rise in the terms-of-trade (commodity prices), and that income growth and the economy would face stiff headwinds in the future as the terms-of-trade unwinds (subtracting from national income) and Australia’s population ages (see below charts).

Essentially, the sharp rise in the value of Australia’s export commodities – in particular iron ore and coal – since the early-2000s meant that Australia received a pay rise, since more imports could be bought with a given volume of exports. In turn, real (inflation-adjusted) average personal disposable incomes increased at a much faster rate than justified by the growth of the Australian economy, as measured by real per capita GDP (see next chart).

The growth of per capita real GDP and real disposable income tracked each other closely until 2003, when real disposable income surged ahead. Again, the huge growth in Australia’s terms-of-trade was akin to Australia receiving a massive pay rise for the exports (commodities) that it produces, inflating personal incomes in the process, since more imported goods could be purchased from a given level of income.

The sharp rise in commodity prices has also underpinned government budgets, which have reaped the benefit of rising personal and company taxes, as well as resource rent taxes. Some of this extra taxation revenue has been re-distributed to households via tax cuts and welfare payments, thereby further inflating disposable incomes.

Today, Peter Martin has posted an interesting article, based on the Treasury’s testimony before the Senate’s economics committee, explaining how the Federal Budget is now bleeding from the decline in commodity prices and the terms-of-trade:

A profits squeeze of historic proportions lies behind the government’s deteriorating budget position according to the federal Treasury, which says things haven’t been as bad since the global financial crisis…

Australia’s budget position had deteriorated swiftly because commodity prices had crumpled while the Australian dollar remained high.

“We would traditionally have expected the exchange rate to fall as well,” [Treasury Secretary, Dr Martin Parkinson] said. “The fact is the exchange rate has stuck up.”

“What that has meant is that for firms in sectors such as mining where revenues are in US dollars and costs are in Australian dollars, their margins are squeezed. It’s a profit squeeze that is flowing through into particular types of revenue.”

Treasury’s head of Australian macroeconomics David Gruen said income growth was its weakest relative to economic growth since the global financial crisis…

In the past year nominal gross domestic product had grown far slower than real gross domestic product. Nominal GDP is the dollar value of what’s produced and earned. It’s the measure that drives tax revenue. Nominal GDP grew just 1.9 per cent in the year to December, far below real GDP growth of 3.1 per cent.

“It is extremely unusual for the dollar value of the economy to grow slower than real value,” he said.

“Our quarterly national accounts data goes back to 1959. There are only two quarters in that time in which nominal GDP growth was that far below real GDP growth – both were in the global financial crisis.”

The only other times nominal GDP growth fell behind real GDP growth were in the economic slump of 1961 and the 1997 Asian economic crisis.

Sliding commodity prices knocked four per cent off Australia’s terms of trade in the three months to September, leaving the volume of goods Australia exported high, but slashing the amount it earned from those exports. Local prices were also depressed as as retailers and wholesalers cut margins in order to move goods.

Real GDP was likely to remain depressed for the two years.

Clearly, while the commodity boom has provided strong support to the Australian economy, any protracted downturn in commodity prices, brought about by a slowing Chinese economy and/or an increase in global commodity supplies, could potentially have equally harmful impacts via reductions in incomes, jobs and government revenues as the terms-of-trade deteriorates and planned mining investments are cancelled.

In my view, a sharp decline in both commodity prices and mining investment is not only inevitable, but also the biggest risk facing the Australian economy.

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