Australia needs to slow down

Australia has weathered the global financial crisis better than most. GDP figures out today show a 0.9% increase in 2009 Q4. Couple this with 5.3% unemployment and you have a remarkable set of figures. Most western nations - including the US - would find Australia's situation far more preferable than their own.

Australia's success has to do with a combination of good policy and luck. Good policy includes a strict adherence to Washington Consensus policies for the past 25 years - privatization of selected government owned industries (Commonwealth Bank, Qantas, Telstra), an intelligent regulatory framework for the financial industry, fiscally prudent government spending, a broad-based tax system - as well as the recent Keynesian stimulus package undertaken by current PM Kevin Rudd. Luck includes a high demand for Australian minerals and ore, which has come mainly from China: their recent stimulus package, alongside renewed consumer demand from the US, has created both an internal and external demand for raw materials that Australia can provide.

Australia: Bloody beautiful mate.
Let's throw another Western economy on the barbie.

So Australia is riding high, but there are nevertheless economic imbalances that need to be addressed, lest Australia fall. One example of this is Ireland, whose economy performed well for over a decade before it crashed so badly during the current financial crisis, exposing its fragile economic underbelly.

For Australia to avoid a future imbalance, steps must be taken to reduce domestic demand - to slow down.

Go slower when conditions are poor.
This applies to road conditions and economic conditions

The two indicators of Australia's economic problems are, firstly, the property market and, secondly, the current account.

One of the triggers of the global financial crisis were overvalued property prices in America and other parts of the world. Once property prices collapsed, households and financial institutions were lumped with bad debts which, in turn, led to a credit crisis - an absence of lending and borrowing (an essential pillar of a market economy). Eventually these economies fell like the proverbial house of cards. Yet despite Australia's own property bubble being popped, there are signs that it has begun to inflate again. Home loan affordability in Australia has improved drastically since June 2008, but recent signs indicate an injudicious addiction on behalf of the financial industry towards property. Government policies such as the First Home Owners Grant and Negative Gearing, which were instituted under the Howard Government and continued unchanged under the Rudd government, have created the conditions for overheating. I would argue that prices still have far to drop in relation to average income before property prices reach a more sustainable level. Steps therefore need to be taken to prevent this growing bubble.

Do we really want to fuel house prices?

The second problem with the Australian economy is the current account - which has been in deficit for over 25 years. The current account basically measures Australia's debt with the rest of the world. Last quarter, Australia's current account deficit was $18.48 billion, which is 4.2% of Australia's GDP. Moreover, net foreign debt levels (that is, how much Australia owes the world in total, minus what the world owes us, as a percentage of Gross Domestic Product) are 51.8% of GDP, which is better than the 56.3% figure 12 months previously. Certainly Australia's debt position to the rest of the world has improved slightly in the last year, and that can be seen in the household savings rate - the more Australian households have saved, the more money was paid off external debt. It is imperative for Australians to maintain a high savings rate if net external debt is to be reduced to zero.

People get very annoyed when debts get too high

Let me explain this further: In a currency area it is essential that a balance of savings and borrowings be maintained. If one currency area has an overbalance in borrowing, which is indicated by a large current account deficit, or if it has an overbalance in saving, which is indicated by a large current account surplus, then that currency area has a structural problem. In a currency area that borrows too much there will be an increase in consumption alongside an accumulation of debt; in a currency area that saves too much there will be an increase in production alongside an increase in the savings rate. Both of these are bad, since one currency area's deficit is another currency area's surplus. Each currency area should have a balance for it to remain strong. In Australia's case, high levels of external demand for raw materials has not resulted in a current account surplus. For Australia to have a more balanced economy there needs to be less domestic spending and borrowing in relation to external demand. This can be achieved either by an increase in exports (eg China demanding even more raw materials and prices going through the roof) or by a decrease in domestic demand. Since Australia cannot rely upon China (and thus the US) to make commodity prices rise even higher than they are now, it is up to the Australian Government to step in and reduce domestic demand.

Just say no to buying and borrowing.
It's the noble thing to do

Reducing domestic demand can be achieved both through fiscal policy (government spending) and monetary policy (interest rates set by the Reserve bank). In the former case, there seems little need for any sort of further fiscal stimulus on behalf of the Rudd government. Rudd's fiscal stimulus has undoubtedly contributed to Australia's economic stability, but now is not the time to increase it. Furthermore, in order to prevent any potential property bubble from inflating, policies such as the First Homeowners Grant and Negative Gearing (both of which involve government money being funnelled into the property market) should be stopped. While I would not rule out any increase in government spending on welfare, health care or education, I would argue that such increases in government spending would be a systemic increase rather than a temporary Keynesian stimulus and would thus require an increase in taxes to cover.

It's all a matter of balance.
And that's a fair cop.

In the latter case, the Reserve bank must be instrumental in promoting Australian frugality by increasing interest rates. This it has managed to do just yesterday, increasing rates to four percent. More increases are needed for me to feel settled. Increasing interest rates will stimulate household savings which will, in turn, act to reduce external debt and, by decreasing demand, act to bring the current account into balance or into surplus (the latter being the preferred way of paying off levels of external debt Australia currently has). Such an activity will, of course, slow the economy down but that is actually a good thing in the long term, as it will ensure that Australia relies more on external demand and exports than upon internal demand - which of course is needed as Australia's economy is geared more towards consumption and borrowing than upon production and saving.

Australia's answer too.

Of course if the Reserve Bank took my advice and raised interest rates further (I would feel happier with rates at 5% currently) then it would need to justify its actions as it would be acting outside of its stated objective of keeping inflation between 2 and 3% (see here for an example of this). My response to this is simple - the inflation target is too loose and needs to be tighter. Inflation needs to be kept below even 2%.

Which is, of course, just another way of me arguing that Absolute Price Stability (prices neither increasing or decreasing over the course of the business cycle) should be the sole monetary goal of Western nations.

† This does not apply to individual countries within an optimum currency area such as the Eurozone. My argument is that nations within the Eurozone can have many current account differences, with the only important factor being the current account of the entire Eurozone itself. Individual nations within the Eurozone function the same way as individual economic zones do within a nation using a common currency (eg states and counties in the USA) . Since the Eurozone current account has been running at less than ±1% for the past decade, I do not believe that the Eurozone has a current account problem. It has plenty of other problems (huge levels of government debt for a start), but external debt and the current account are not among them.

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