ECONOMICS: by Colin TeeseNews Weekly
Rising interest rates create speculative bubble
, November 14, 2009
The problem of foreign debt has bobbed up again, following a book written by Professor Ross Garnaut.
Garnaut is well remembered as the driving force behind the Hawke/Keating government's determination to embrace free market ideology, with its program of privatising of public utilities, deregulating financial markets and slashing tariffs. Subsequently, John Howard's Coalition government took on the same ideas with equal enthusiasm.
In the context of discussing the global financial crisis, Garnaut's new book The Great Crash of 2008
(Melbourne University Press) identifies his concern about the level of Australia's foreign debt. Our economy, he suggests, could be crippled if foreign lenders decline to keep lending us the necessary rollover money to keep the debt alive.
Dr Ken Henry, Secretary of the Commonwealth Treasury, however, disagrees with Garnaut. He believes that foreign investors are so impressed with the way we run our economy that they will never withhold rollover money - even more so today, given how well our economy has held up in the face of the financial crisis and the ensuing worldwide slump. Henry argues that we have performed better than almost any other OECD country.
Ideologically-committed free market economists, such as Garnaut and Henry, did not anticipate that the fall-out from the deregulationist experiment would be an ever-mounting debt burden. Theory insisted that, even if tariff cuts devastated certain industries, all would not be lost. New, internationally competitive industries would be bound to emerge from the wreckage and offset our mounting import bill.
Politicians were told to be patient. When patience ran out, politicians had to swallow the unpalatable truth: in our deregulated economy, an ever-increasing debt burden was part of the package. They made the best of it. Yes, it was conceded, debt was rising; but rapid growth was making all of us better off.
They were assured that, most important, it was private sector borrowing, not government borrowing. Former Treasurer Keating characterised private sector borrowing as a debt obligation between "consenting adults". A wide body of sympathetically-inclined economists agreed. John Howard, when in government, bought the same idea.
Happily, Ross Garnaut's recent book rejects that nonsense. Garnaut is right to remind us that, given the high level of Australia's indebtedness, any overseas withholding of rollover funds could plunge us into a steep downturn. In reality, our economy is at the mercy of foreign investors.
Ken Henry's contrasting optimism is misplaced, even naïve. Tim Colebatch, the Melbourne Age
's economics editor, reminds him and us that, as the financial crisis hit our banks, foreign lenders stood ready to withhold rollover funds.
The banks informed Prime Minister Kevin Rudd that they had been handed an ultimatum: unless the Government guaranteed the banks' offshore borrowings, foreign investors would call up the loans as the debt became due. (The Age
, October 27, 2009).
In that event, lending would come to a halt, the banks' very survival would be threatened and the economy would be plunged into recession.
All of a sudden, our private sector foreign debt was an issue going beyond the responsibility of "consenting adults". It turned out - as the better informed had always known - that, in any sort of crisis, the Government would have to become the underwriter of last resort.
Dr Henry's belief that the foreign investors were so enamoured of our economic management that they would not deny us rollover money, fell, as it were, at the first hurdle.
Not that Ross Garnaut is much help. The level of our foreign debt is a serious problem, we are told; but he can suggest no more than we try to promote real savings by business, households and governments. He does not suggest how this could be achieved, or how it might help.
He seems to have forgotten that our economic growth is built on two basic planks: export income generation, mainly by means of exporting minerals and importing tourists, and fee-paying university students, backed up by consumption expenditure based on cheap imported consumer goods. Since our export income is insufficient to cover our vast import bill, we have had to borrow the difference. Accumulated shortfalls over 25 years have resulted in our current level of net foreign debt.
According to Garnaut, this debt must be cut back to head off the risk that our economy might be pushed into slower growth by the actions of foreign investors. But won't his solution deliver a similar outcome by different means?
The real solution is, in essence, much simpler, but less palatable to our economic ideologues. To solve the debt problem, we must export more or import less - in whatever combination we can manage. Exporting more hardly seems to be possible in the foreseeable future. If it could be done with our existing economy, we would already be doing it.
That being so, the alternative is to import less, and make more of what we consume at home. To achieve that, we would need new manufacturing industries built on the back of an industry policy.
For any of the above to happen, we would need to recast our entire approach to economic life, and throw off our blind faith in the old free-market orthodoxy, which has had every chance and has come up wanting.
As to the immediate future, the financial press is urging us to be as optimistic as Ken Henry. Apparently, the Reserve Bank of Australia (RBA) Governor Glenn Stevens has the same view. In fact, so fearful is he of a break-out in consumer price inflation, that he broke ranks with normal RBA practice and virtually told us that the bank would increase the official bank rate early in November.Mixed signals
He is also hinting that this increase may be the first of a number. His reasoning? Governor Stevens believes that the economy is hotting up, and heading off consumer price inflation must be the first priority. Precisely how he reaches this conclusion is not clear - certainly, the signals are mixed. Parts of the economy seem to be flourishing; others are not.
In effect, we are being asked to trust his instincts. But the RBA's track record is not all that good. We know that it previously misread the inflation signals and held interest rates too high for too long, almost pushing the economy into recession.
At the same time, the bank stood passively by while burgeoning asset price bubbles over-inflated both real estate and share prices.
How well is the RBA reading the signs this time? It does not seem that any inflationary surge driven by wages is on the horizon. We know that unemployment is high and understated - since part-time jobs are wrongly measured as full-time employment.
Meanwhile, there is the puzzle of Australia's overvalued exchange rate. For any sort of economic observer, this is the sort of puzzle that should immediately start ringing alarm bells. The $A is approaching par with the $US. In fact, the RBA tells us it could surge beyond parity. In older and more settled times, a strong currency was associated with economic health. But that was before the era of unregulated free markets.
An overvalued currency is a matter of serious concern for Australia. It makes our exports of farm products and manufactured goods more expensive on world markets and therefore less competitive. It affects our capacity to attract tourists and quite possibly the number of fee-paying overseas students to our universities. Apart from minerals, they are the main source of our foreign exchange earnings.
An overvalued dollar also makes imports cheaper, which would drive us deeper into debt.
The single most important factor pushing up our exchange rate is that our Reserve Bank has kept its official interest rates higher than those of most of the Western economies. The US Federal Reserve is keeping US interest rates low to help its economy recover. Central banks in other Western economies, except Australia, are doing the same.
This is bad news for us. Foreign investors can borrow cheap at home and lend expensive here, and that is exactly what they are doing.
The RBA seems not to understand that this is encouraging a huge flow of speculative foreign investment funds into Australian shares and real estate. Not only is this distorting our economy, but it also adding to our foreign debt.
Is it the case that, once again, the RBA has its eye on the wrong ball? Is it chasing the myth of consumer price inflation and overlooking the real threat - another bubble break-out in our share and real estate markets?
Ken Davidson of the Melbourne's Age
tells us that $41 billion worth of investment has gone into our banks. Banks now represent 40 per cent of the value of all shares traded on our stock exchange. The banks' share prices have increased by about 80 per cent, while the overall share index has risen about 30 per cent.
Why are foreign investors targeting our banks? Because our Government stands behind their investment. Our banks are fully protected. Buying into our real estate with their cheap money offers another safe haven.
These developments, if allowed to proceed unchecked, could fuel new speculative bubbles in both shares and real estate.Asset-price inflation
And, in terms of destabilising economies, asset-price inflation may now be more important than consumer-price inflation. If this is so, putting up interest rates makes it worse.
Furthermore, in a deregulated financial market system, central banks must march in tune. If other countries' central banks are holding official rates down, ours must stay in line or risk destabilising our economy - which is precisely what is happening now.
The Government, with its overall responsibility for economic management, should be weighing up the appropriate policy responses to these developments.
Again, according to Ken Davidson, Brazil's government, facing the same problem has acted promptly and imposed a levy of 10 per cent on speculative foreign investment flows, which is returnable only after 12 months.
This may or may not be the appropriate solution for us, but we would hope that our Government is doing something more than merely watching it all unfold.Colin Teese is a former deputy secretary of the Department of Trade.