Lucky country's fortunate run could still end in tears

AUSTRALIA has won the lottery. The terms of trade are now higher than virtually at any other time since federation.

AUSTRALIA has won the lottery. The terms of trade are now higher than virtually at any other time since federation.

And compared with previous short-lived spikes in the ratio of export to import prices (often based on a single commodity -- think Korean wool boom) the current improvement in Australia's terms of trade is spread over a number of commodities and has lasted a number of years.

But just as winning the lottery can lead to unhappiness and ruin for the lucky ticket holder, the key question now is: will Australia blow it?

The first thing to say is there are a number of reasons why the Australian economy should prove more resilient to a surge in the terms of the trade than was the case in the past. With a fixed exchange rate, rising export prices quickly translated into increased liquidity, rising inflation and upward pressure on the exchange rate -- pressure that was often resisted by the politicians of the day. And centralised wage fixation ensured that wage gains achieved in the booming export sector quickly flowed through to all workers. Higher interest rates would follow and the boom would quickly end in bust.

There is no doubt that the institutional arrangements that are now in place -- a floating exchange rate, an independent central bank and more or less decentralised wage fixation are all helpful in terms of sustaining the boom.

This said, there is still a distinct possibility that it will still end in tears. The reasons are three-fold:

lPoor fiscal policy, in combination with poor quality public spending;

lPersistent skill shortages that will delay and/or increase the cost of some projects, while threatening the macro outlook for wages; and

lInappropriate responses to uneven economic outcomes across the states.

Before further outlining these threats, the point has to be made that the appropriate policy responses to the explosion in the terms of trade depend, to some degree, on the expected duration of the boom. A short boom would mean some slight adjustment to policy settings but a long boom -- say 10 years or more -- requires a major reallocation of resources to enable the surging sectors to continue to expand. Some sectors will need to shrink; it is absolutely pointless for the government to be subsidising these sectors -- the automotive industry, for example -- when resources are needed elsewhere. Now Julia Gillard has publicly stated she expects the boom to be long-lasting. And analysis of economic and social trends in China, India and a number of other countries is consistent with this point of view. Even if the terms of trade were to fall somewhat, the position would still be vastly superior to the situation Australia faced at the end of 1990s.

Working then on the assumption that the improvement to the terms of trade will continue for some time, there is a case for even more rapid fiscal consolidation than that planned by the federal government. After the event, it was clear the Howard government overspent the proceeds of the first phase of the resources boom to the extent it was actually running a structural budget deficit, even though the gross figures pointed to a surplus.

Today, there is a clear case for returning the budget more quickly to surplus. A budget deficit, albeit a declining one, involves the government continuing to make a positive call on resources. A mini-budget, containing a number of cuts to expenditure, particularly in relation to middle-class welfare and industry assistance, is called-for. The examples of a number of European countries show that swinging cuts to government spending are possible when they are deemed to be necessary. It is not just the overall state of the budgetary position that matters but also the quality of government spending. As Ken Henry, Secretary to the Treasury, has rightly pointed out, projects for which the costs exceed the benefits must lower community wellbeing. Moreover, the timing of the massive NBN could not be worse, absorbing workers to dig trenches in regional areas when they should be moving to Western Australia and Queensland to work on the new mining projects.

Generally speaking, government reports on skill shortages and future occupational demands are not worth the paper on which they are printed.

Looking back on past reports, it is quite amusing to see how inaccurate the predictions have turned out to be. And the more ambitious the remit -- at the level of the Australian economy, for instance -- the less valuable are the findings.

But one report that appears to have more credibility than the average report has just been released by the National Resources Sector Employment Taskforce, chaired by Gary Gray. By 2015, it is predicted there will be a shortage of some 36,000 tradespeople in the resources industry and that the only plausible way of meeting the shortfall is through the use of migrant workers, including on temporary visas.

The government is currently working furiously to see if the conditions attached to these visas can be streamlined lest the shortages worsen even further. There is clear evidence that wages growth is beginning to pick up significantly in the resources sector -- in off-shore oil and gas, for instance. And Woodside has recently announced the deferral of a development in the Browse Basin because of rapidly rising costs.

The growth of overall labour costs, however, remains relatively moderate although there are some early signs of a tick-up. Wage cases before Fair Work Australia -- for gender pay equality covering community services and low pay bargaining in aged care are two important examples -- are a worrying development both in terms of the magnitude of the pay rises being contemplated and the non-market principles that apply.

No doubt, the RBA will be watching the movement of wages as it looks at its monthly decisions.

A final point relates to the response of the federal government to the uneven economic outcomes in the resource-rich and other states. One argument is that Australia's system of horizontal fiscal equalisation, as implemented by the Commonwealth Grants Commission, is an ideal mechanism to offset the harmful impact of having a single interest rate that applies in all the states (and which, of course, use the same currency).

While there may be an element of truth to this proposition, it would seem that CGC has lost the plot on the extent of HFE it recommends. A much better way of distributing the GST proceeds would be on a per capita basis, which would still have an element of subsidy to the weaker states.

In this way, the states with the comparative advantage -- and one expected to persist for many years -- are not penalised for the prosperity they generate. As well, incentives are created for the citizens of Australia to move to these states. The alternative runs along the following line: as Tasmania has been to the rest of Australia, Victoria and NSW will be to Western Australia and Queensland. And what has Tasmania achieved with all that over-funding -- a shrinking relative population, a disproportionately large public sector and the highest rate of welfare dependence in the country.

So will Australia blow it?

It is a close call. One can assume that the advice that the government is being given is pretty good, but the politics of some of the actions required are doubtless a bit messy.

With a strong and clear narrative, most Australians would be happy to go along with a strategy that will guarantee higher per capita income and wealth for themselves, their children and their grandchildren.

Professor Judith Sloan is an economist and company director