In an update on Thursday, the Canberra-based economic modelling firm Cadence Economics estimated that each one percentage point fall in China’s long-term growth rate knocks $46.5 billion off the present value of Australia’s national income, making every Australian about $500 worse off in 2035 than they would otherwise have been.
Given that China’s growth rate may have declined by more than 4 percentage points, it is hardly surprising investors showed acute signs of anxiety last week.
And it is also hardly surprising that while Malcolm Turnbull has successfully changed the tone, the economic policy conversation we need to have remains the same — and is still every bit as painful.
No doubt, innovation, agility and creativity are eminently desirable; but in themselves they are no magic wand for resolving stark policy differences.
As those differences, and the underlying policy trade-offs, come to the fore, and as Bill Shorten finds a way of responding to the change in mood, the warm glow will dissipate. Much will then depend on whether Turnbull can do what Tony Abbott found so difficult: convince Australians that by unlocking growth and opportunity, the Coalition’s approach, even with its tough choices, offers the best prospect for the future.
Unfortunately, the international environment will not make that task any easier. Instead of providing a supportive environment for serious reform, patchy and uneven global growth will reverberate in the domestic economy, increasing the urgency of tackling our structural problems. With the honeymoon phase only a memory, Turnbull may therefore well find himself trying to shore up confidence in his government’s reform agenda just as the world’s economic woes accentuate voters’ wariness of change.
The sources of the external pressures are myriad and multifaceted. Understanding them is vital to understanding the threats they create for the Turnbull government. Complex and diverse though they are, they have a common theme, which is that the world economy is reaching the limits of policy-doped growth.
The background is clear enough. After the global financial crisis, governments resorted to an unprecedented range of instruments in an attempt to get economies moving again. Now, those unprecedented solutions are part of the problem.
That was largely predictable. Monetary easing — in which central banks took official interest rates to historic lows, and where that proved insufficient, bought bonds and other financial assets from investors, increasing the money supply — has been at the heart of the policy response; but in the long run, monetary policy doesn’t increase demand, it simply moves it around.
Low interest rates, for example, encourage people to save less and spend more: they therefore shift consumption from the future to the present. Equally, currency devaluation, which easy money induces, increases the cost of imports while making exports more competitive: it therefore transfers demand from countries that have not devalued to those that have. But neither of these effects can durably expand the global pie: they mainly redistribute it in time and space.
Rather, whether growth resumes on a sustainable basis is determined by fundamentals. And if they remain in poor shape, so will economic performance.
Moreover, as with all stimulants, the boost easy money provides tends to wane over time. And on top of that, withdrawing the stimulant creates challenges of its own, with the risk that productive investments may be chilled by uncertainty about how long the extraordinary interventions will last and about how markets will respond as they are scaled back.
The result is a pervasive nervousness that has even affected the US, which is now in its sixth year of recovery from the deep recession that began in December 2007. Last quarter saw US gross domestic product growth accelerate to 3.9 per cent on an annual basis, well above the 2.1 per cent annual growth rate the American economy has averaged from 2010.
However, that 3.9 per cent growth rate is still below the 4.1 per cent annual growth typical of US recoveries. And from the outset, this recovery has been marked by a pattern in which spurts of expansion are succeeded by pronounced slowing, with annualised growth rates falling short of 1 per cent in five quarters since the start of 2010.
Last quarter’s upswing therefore did little to calm anxious investors, who fear faster growth may prove short-lived. But much as that has troubled investors, it pales compared to the apprehensions about the future path of interest rates, with the effective federal funds rate at zero since December 16, 2008.
Until now, the US Federal Reserve has stressed the importance of managing expectations, which it has done by specifying clear targets that will trigger a gradual return of rates towards normality.
However, its main policy-setting body, meeting on September 17, decided to hold rates at zero, despite unemployment dropping to the levels it had previously defined as the point at which it would start raising rates. That decision, along with the Fed’s guarded commentary explaining it, was plainly more ambivalent than already jittery markets expected; it therefore added to what has been the worst quarter for US financial markets since 2011, with the S&P 500 closing on Wednesday some 6.9 per cent down from its level when the quarter began.
The uncertainty created by the Fed’s decision is scarcely desirable; but that doesn’t mean its concerns about the headwinds from global economic and financial developments are unfounded. After all, continental Europe remains trapped in growth so anaemic that it has failed to reduce an unemployment rate more than twice that in the US.
Adding to Europe’s troubles, the eurozone fell into deflation in September. The decline in prices was mainly due to low energy costs, but it strengthens the view that not enough is being done to lift economies out of a recovery European Central Bank president Mario Draghi has described as “weak, fragile and uneven”.
However, the political obstacles within Europe to further action are formidable, with the chaos unleashed by Angela Merkel’s ill-judged initiative on refugees aggravating already serious divisions. Moreover, although they have been worsened by recent crises, the problems are deep-rooted: intra-European trade, whose strong growth propelled European integration, peaked in 1999 and since then has declined as a share of the EU’s trade flows; and instead of income levels converging within the single currency area, the income gaps between eurozone countries are becoming more pronounced. The result is that while the gains from economic integration have decreased, divergences of interest within the union have become increasingly acute, contributing to policy paralysis.
All that feeds the sense, apparent from the Eurobarometer survey of European public opinion, that Europe is failing: it is, for example, increasingly rare for Europeans to view the future with optimism, with 45 per cent of respondents in the euro area now thinking the worst of the crisis is still to come. Those expectations risk becoming self-fulfilling; and with the French presidential election fast approaching, credible action by the EU to overcome its doldrums seems highly unlikely.
Bad as that is, however, perhaps the most troubling news is coming out of China, whose economy now accounts for 16 per cent of global GDP. The disturbing aspect is not the slowing of Chinese growth: no economy can indefinitely expand at 8 per cent or more a year, and a growth rate of 5 to 7 per cent would be eminently respectable for an economy of China’s size and income levels. Rather, it is the perception that the Chinese regime, in responding to that deceleration, is pursuing policies that are both harmful and inconsistent.
That the regime would find slower growth hard to accept was always clear: not only was sustained expansion vital to the solvency of China’s nouveau riche (with the wealthiest 10 per cent of Chinese households receiving 56 per cent of the nation’s personal income, compared to 24 per cent in Australia, and accounting for an even higher share of personal debt); it was also the basis on which the regime built its wider legitimacy. There was consequently always a danger that the regime would fall into the error of trying to keep growth rates far above those its economy could achieve.
It has done precisely that. But to make matters worse, it has, in the process, chosen a policy mix that seems especially toxic.
On the one hand, the regime has reopened the spigot on borrowing. That is partly so as to encourage yet more infrastructure spending by local governments, whose previous borrowing binge, from 2009 to 2013, has left an estimated $US9 trillion in “ineffective investment”; but it is also so as to support a housing bubble that has taken property to nearly 25 per cent of output (compared to a peak of around 5 per cent in the US during the construction boom that led to the GFC).
That renewed flood of borrowing will not just prolong China’s reliance on relatively low productivity investment as the pillar of growth, slowing the transition to an economy driven by consumer demand; it will also increase debt, which has already risen from 130 per cent of GDP in 2000 to 250 per cent of GDP today. With estimates that half of all non-financial debt is property related, that debt’s quality is highly questionable, heightening the economy’s vulnerability to adverse shocks.
Yet the regime, while using the lending spigot to keep borrowers afloat, is at the same time acting in ways that can squeeze liquidity. In particular, the People’s Bank of China — China’s central bank — is supporting the exchange rate of the yuan by selling its dollar reserves for yuan, potentially reducing the money supply.
That the yuan is overvalued has been clear for some time. The Bank for International Settlements calculates real trade-weighted indices for different currencies; as of June, China’s index was 126, up from 111 a year earlier and 105 in September 2012. As its currency strengthened, China’s exports have spluttered, with exports plummeting by 8.3 per cent year-over-year in July. At the same time, capital has been flowing out of China, putting downward pressure on the yuan and forcing the People’s Bank of China to run down its US dollar reserves by a record $US125bn in August as it seeks to protect the exchange rate.
Set against those pressures, the August devaluation, which reduced the value of the yuan by about 3 per cent, was obviously insufficient, leading global investment giant Pimco to estimate that a further 7 per cent fall is required. But with China’s fragile property sector owing over $US1.3 trillion in US dollar denominated debt, the Chinese authorities fear devaluation would unleash a wave of bankruptcies.
China could therefore find itself with the worst of all possible combinations: a slowing economy; a stimulus package that entrenches reliance on debt-fuelled, low quality investment and perpetuates asset price bubbles; and an overvalued exchange rate.
The risks all that poses for Australia are obvious. And they are made all the starker by the treacherous politics of pulling our own fundamentals into shape. It is its ability to make headway despite those politics that will make or break the Turnbull government.
To say that is not to deny that our economy has performed substantially better than those of other commodity-exporting countries: GDP continues to grow, more Australians are in work than ever before and the number of job ads is high. Nor is it to ignore the substantial progress the Abbott government achieved: for example, the 330 budget repair measures it implemented have improved the budget outcome over the forward estimates by more than $84bn. It is thanks to those measures that net debt is projected to peak at 18 per cent of GDP next year and from then on decline, as will the budget deficit.
However, more needs to be done to consolidate existing progress and to deal with longer-term pressures on government spending. On that, virtually everyone seems to agree; but as was apparent at the National Reform Summit and at the Prime Minister’s economic summit this week, there are profound differences as to how the problems are to be addressed.
On one side of that divide are Labor, the unions and the self-styled representatives of those on welfare. Their approach is to increase effective tax rates on middle and upper income earners so to finance further growth in welfare transfers and in spending on the public services that now employ the bulk of union members and underpin Labor’s electoral base.
The damage that approach would impose goes far beyond the harm high tax rates do to the incentives to work and save; rather, by keeping public spending high, it would divert capital and labour from the trade-exposed industries whose output must expand to compensate for the falling terms of trade. A greater part of the burden of adjustment would therefore have to borne by the exchange rate, which would need to depreciate by even more than it otherwise would, reducing real incomes; and with the rigidities inherent in our industrial relations system left untouched, unemployment would inevitably rise.
The alternative is not to spend and tax more, but to spend and tax better. Innovation and competition in the public sector are the keys to providing more with less; as for tax reform, it should be a way of reducing the drag taxes impose on our economy, rather than lightening the wallets of those who already pay for virtually the entirety of the commonwealth’s outlays.
And if moves in that direction can be accompanied by slashing the burden of regulation, including of workplace relations, the $400bn the mining boom poured into our capital stock could be put to good use. But none of that will come easily, all the more so given continued turbulence in the world economy. And as the differences become apparent, the current honeymoon will soon fade.
Staying the course will require the highest calibre of leadership. If Turnbull rises to that challenge, he will more than merit the confidence Australians can and should have in him.
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