November 25th 2006

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Articles from this issue:

COVER STORY: CLIMATE CHANGE: An appeal to reason: the economics and politics of climate change

EDITORIAL: Water infrastructure needed, not gimmicks

AUSTRALIA'S DROUGHT: COAG's free trade in water threatens farmers

CANBERRA OBSERVED: Howard's loyalty to U.S. faces severe test

UNITED STATES: U.S. voter backlash against Bush's Iraq war

IRAQ WAR: Bush runs out of options

THE ECONOMY: Wishful thinking about agriculture, manufacturing

WESTERN AUSTRALIA: Taped calls incriminate ex-premier, minister

STRAWS IN THE WIND: Sinister side to lunatic fringe / The gentle art of blackening reputations / Faces of vulnerability / The old refrain?

HUMAN CLONING: Patterson's curse - the Frankenbunny

Lies, cowardice and cloning (letter)

Bouquet and brickbat for News Weekly (letter)

Optional preferential voting rejected (letter)

Greenhouse superstitions (letter)

Using children as spies (letter)

BOOKS: INSIDE THE ASYLUM: Why the UN and Old Europe are Worse Than You Think, by Jed Babbin

BOOKS: THE BATTLE FOR SPAIN: The Spanish Civil War 1936-1939, by Antony Beevor

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Wishful thinking about agriculture, manufacturing

by Colin Teese

News Weekly, November 25, 2006
Experts assure us that the predicted decline in Australia's mineral exports will be easily offset by a strong recovery of our agriculture and manufacturing. Former deputy secretary of the Department of Trade Colin Teese pours cold water on such facile optimism.

Random reporting in the Australian Financial Review a couple of weeks ago demonstrated (if demonstration was really needed) to what extent, in economic terms, everything is connected with everything else.

The AFR - up to and including its editorial pages - made much of the headline aspects of an Access Economics study. In particular, it welcomed the idea that the economy was likely to continue in boom mode.

Access Economics is a well-regarded, Canberra-based economic research organisation. Having regard for that reputation, the AFR was willing to take its overall findings on trust - observing, in passing, that Access's assessment was more optimistic than the AFR's. All downsides or qualifications which Access Economics identified were passed over.

Certain qualifications aside, the Access study did in fact make bullish predictions about short-term prospects for our economy. (Nobody seems any longer foolish enough to publish long-term forecasts since they have so often been proved to be hopelessly unreliable.)

Yet even with a short-term framework, and, qualifications aside, using the premises upon which Access Economics based its forecast, it is hard to justify its conclusions. Access Economics judged (no doubt correctly) that the mining boom is petering out; but believed that that outcome would not necessarily disturb the onward march of economic growth. According to Access, there were other strings to the Australian economic bow; these would ensure the economy continued to play a merry tune.

For example, as the mining boom loses strength, the value of the Australian dollar (our exchange rate) would decline, relative to those of our major trading partners. The good news arising from this consequence is that our farm produce and manufactures would become more competitive in export markets. Presumably, Access Economics believes these two sectors could be expected to make up for any loss accruing to our external trade balance as a result of the receding demand for our minerals.

Certainly, that is one possible consequence; but it is by no means the only, or even the most likely, outcome.

Consider first, farm exports. It is still the case, despite what we may be led to believe as a result of our bilateral free trade agreement with the United States, that our access to major markets for our farm exports remains heavily restricted. A lower exchange rate would certainly help us meet competition in export markets - we could, for example, offer lower prices in the currencies of export markets and yet retain the same return in Australian dollars.

But that benefit is only one side of the equation. There is another important and adverse balancing effect. Farm output relies heavily on imported inputs into its production process. And a lower Australian exchange rate means that such necessary imports will become more expensive for our farmers. So, not all of the gains from a falling exchange rate will fall into the hands of our farmers. We can't easily calculate how much of their potential gains will be lost in this way, but it certainly will be some.

None of this, of course, takes any account of drought circumstances on either farm output or the costs of farm production. Surely, we must assume some decline in total farm production, and we know from what has been explained earlier that farm production costs will rise even without drought factors. And should we not assume that, with a reduced output available for sale and rising prices domestically because of shortages, farmers will choose to redirect their limited output away from exports towards the domestic market?

Okay, so, to that extent, farmer incomes will be better off, but there will be a diversion of output away from exports and towards the domestic market. The domestic economy might gain from this, but, unless you believe that domestic sales are better than exports, then, overall, we will be worse off. Certainly, our trade performance, already dismal, will suffer.

It is also possible that farmers will lose out as well if the water shortage makes it impossible for them to realise maximum output from their farms. Even better prices may not fully compensate them for any such loss. So much for agriculture.

Access Economics is even more optimistic about the prospects for manufacturing industry as a result of the lower exchange rate arising from a receding minerals boom. But how realistic is this expectation? Considered in isolation, a lower exchange rate would certainly help manufactured exports - in two ways.

First, it would enable our manufacturers to better meet import competition. And, second, it would give them a better chance to enter export markets.

Against that undoubted benefit must be balanced the same disadvantage as is faced by farmers. A great part of any manufacturing output depends upon imported componentry - and this is true of manufacturing to an even greater extent than of farming. Overall, the degree to which our manufacturing sector will be helped by a fall in the exchange rate is difficult to assess.

But there are even more important considerations to take into account. Our manufacturing industry - under a policy of benign neglect by government - has been in decline from the time we began cutting tariffs some 30-odd years ago. In the scale of comparative industrialisation, as measured among OECD countries, we once ranked among the most industrialised. We now languish around the bottom of the table, alongside Turkey. Whereas once some 20 per cent of our output was accounted for by manufacturing, it is now down to 11 per cent.

Free trade theory

There are a number of reasons for this decline, all of them associated with government policy - or the absence of it. By far the most decisive has been our wholehearted commitment to free trade theory. Consequences flow from the practical application of this theory - and especially there are implications for investment in Australian manufacturing - both by Australian and overseas investors.

Since we have removed effectively all barriers to imports of manufactures (and, for that matter, of agricultural products) - apart from one or two exceptions, most notably motor vehicles - our ability to attract manufacturing investment has been seriously affected.

Why would any potential investor in manufacturing choose Australia? Unlike almost all others, our market is completely open to imports. Any manufacturer wishing to enter our market faces no impediments to importing.

Why would we be the preferred destination of any potential investor? Surely they would prefer to invest in one of those markets into which access for imports is more difficult and export their surplus to Australia?

And that is precisely what is happening: because, as it happens, most markets for manufactured exports are by no means as open as ours. As a result manufacturers, including those based in Australia, are actively discouraged from investing in the home market and looking to establish offshore.

But that is not the only factor working against manufacturing industry in Australia. Deregulation of the financial markets and the consequent uncoupling of our currency from any fixed relationship with other currencies is also a factor working against manufacturing. No manufacturer operating in Australia, either to service the local market or to export, welcomes a moving exchange rate which is beyond anticipation or control. This situation hits the Australian economy especially hard.

The Australian dollar is a relatively small currency and naturally subject to fluctuations because our export fortunes are so linked with the prices of our commodity exports - which, of themselves, are subject to fluctuation.

The small size of our currency market, and its tendency to fluctuate is, in a deregulated environment, a magnet to speculators. Thus the fluctuations in our currency tend to be greater and more frequent than they are in stronger currency markets.

This factor, combined with an almost completely free market, provides a most inhospitable climate for manufacturing industry.

Accordingly, it is not at all certain that we should be as optimistic as is Access Economics about the possibility of manufacturing and agriculture taking up any slack in economic growth which might be left by a decline in minerals exports - especially as we see more and more manufacturing move offshore.

Overseas lending

If economic growth does continue to power on, the driving force is more likely to be - as it has been for so long already - consumer credit fuelled by overseas lending. Access Economics to some extent acknowledges this, but does not go on to draw the obvious conclusions.

Economic growth, based on this circumstance, is premised on two propositions. The first of them is the continued willingness of overseas lenders to keep funding our spending spree. Thus far, they have not shown any reluctance to continue with their lending. Growth expectations rest heavily on their continuing willingness to do so.

But there is a second consideration, still more worrying. It is the capacity of consumers to continue servicing their debts. There is already evidence that they are gradually reaching the limit of this capacity and, with prices likely to increase because of drought as well as other factors, including interest rate rises, consumers may find it necessary to tighten their purse strings sooner than we think.

If that happens, then the growth expectation for our economy in a post-mining boom world would certainly need to be recast. And the optimism inherent in the Access Economics assessment would not be realisable.

- Colin Teese is a former deputy secretary of the Department of Trade.

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