Reduce GST to mitigate Coronavirus impact in Australia

There is no doubt that COVID-19 is going to impact the world's economy. International tourism will be hit very hard. There's even a chance that governments will halt airline arrivals and maybe even set up more stringent border crossings. Japan has already closed schools.

In times like this, the parts of any economy that are directly based on tourism will suffer the most. Businesses will go bankrupt, employees will be retrenched. Retail and service industries, very much related to tourism, will also be badly affected. A world wide recession seems highly likely.

Government responses to such problems have varied over the decades. Increasing government spending (Keynesian "Pump Priming") is a very good way to react to this problem. Kevin Rudd's school hall building program of 2008/2009 in the face of the GFC ensured Australia survived the crisis without a recession and helped save the building industry from collapse.

This time around, though, the LNP is in charge, and they are unlikely to respond to the crisis by spending. The LNP has historically relied upon monetary policy to even out the peaks and troughs of an economy, but unless monetary policy changes to have a more direct and radical effect, any changes in interest rate by the RBA are unlikely to make much of a difference at the moment.

Nevertheless one Keynesian solution does present itself for the LNP to seriously consider -a temporary lowering of the GST.

My suggestion is that, faced with a looming economic and financial disaster as a result of the Coronavirus, the LNP should temporarily reduce the GST from 10% to 1%. This large reduction in sales tax will help stimulate the retail and services sector, the sector most likely to be hit by any precipitous decline in tourism. A reduction in the GST would help businesses survive the decline by reducing the amount they need to pay the tax department. With less tax needing to be paid, businesses are less likely to go bankrupt, and more likely to keep employing people. A drop in retail prices will also stimulate more consumption by Australia's households.

Of course the GST is linked to state government revenue. It is a tax administered by the Federal government that is transferred to state government coffers. Would such a reduction in tax end up hitting state governments? My suggestion is that the Federal government still pay the states as though it were 10%. This would mean that every $1 the 1% GST brings in will result in $10 being paid to the states.

So who foots the bill? Reducing government spending is not something I support, so in this case I would simply argue that the best solution would be for the Federal Government to go into debt. The money lost from lowering taxes will be covered by borrowing from the financial market. This will result in higher levels of government debt, but this can be paid back over the long term as follows:

Once conditions have improved, the GST will then be gradually lifted back over 1-2 years to 10% and then finally set at an increased rate of 12%. The extra 2 percentage points means that two twelfths (16.67%) of GST revenue will be used to pay off the debt accrued under the 1%. Once the money has been paid back, the GST resets back to 10%.

Desalination. Part 2.

12 years ago I posted my thoughts on the building of Sydney's Desalination Plant in Kurnell. A few days ago, the NSW Government announced plans to double the size of the output. A doubling of its size was actually planned for when it was designed, so the cost will not be as great.

As a result, the expanded Kurnell Desalination Plant will be able to supply 30% of Sydney's water needs.

Desalination plants are all over Australia. Apart from Sydney, there are plants in Melbourne (33% of supply), SE Queensland (27%), Adelaide (50%) and two in Perth (37%).

But according to the Australian Bureau of Statistics, water consumption by households represents only 12% of water consumption (1,909,075 Megalitres out of a total of 16,558,203 Megalitres in 2016-17). Agriculture represents over 60% of consumption (10,305,491 Megalitres in 2016-17). The rest is used by mining and industry.

In my original article, I pondered the potential of switching over to desalinated water for all of Australia's needs, including agriculture. In the years since, I have learned that the total cost of such a venture would be very, very high. And yet in the face of Australia's worst drought on record and massive bushfires, the cost of not acting may be even higher.

Australia's agricultural heartland is located along the Murray / Darling / Murrumbidgee river areas. These rivers have provided irrigation water for over a century to farmers. Yet it appears as though these rivers will no longer be able to supply the water necessary - even the Murrumbidgee and its reliance upon the water diverted by the Snowy Mountains Scheme is finding it difficult.

The best desalination solution would involve a series of very large desalination plants built on the coast and close to the river systems. These areas would be the mouth of the Murray in South Australia and also the coastal areas of SE Queensland.

As with Kurnell and other Australian plants, these new plants will be built along with renewable energy plants to power them. Solar and Wind farms can be built in appropriate areas and connected to the grid.

Snaking up from these huge desalination plants would be clean piped water, following the river systems through the current agricultural areas. These pipes would snake up the Murray from the Murray mouth, and along the Murray in Western NSW and the Murrumbidgee in the South of NSW. From SE Queensland, the pipes would be built along to the Southern Downs, where it would snake down various tributaries of the Darling such as the Barwon, and would connect up to the pipes from Murray mouth, creating a huge water grid accessible by farmers in SE and SW Queensland, Northern, Western, Southern and South Western NSW, Northern and Western Victoria, and Eastern South Australia.

With a 100% guarantee of water, farmers and farming communities would be assured of their future, along with an assurance of food production in a future where global warming will cause substantial drought all over the world. The presence of water will also allow for the growth of secondary industries and the growth of rural towns. It may be that people will flock to these areas for work, especially if world food prices grow.

Of course there will need to be common sense practices to accompany this. Irrigation water will be delivered through pipes rather than canals - the less evaporation the better. Steps must be taken to ensure that land degradation from salinity and inappropriate crops is minimised. It is also possible that farms in these areas would be covered to reduce transpiration from the crops and minimise insecticide usage.

One concern would be the output of brine from the desalination process. This is something that people have questioned for a while since large scale desalination plants first became operational. Would the brine create a high-salt, low oxygen dead zone around the outfall pipes, killing sealife?

What needs to be kept in mind here are two things. The first is the proportion of water used compared to the amount of water in the world's oceans. The second is the Water Cycle.

The amount of water in the sea is staggering. Compare the amount of water in the world's oceans to the amount of water humans need to survive and the result is, very, very, very large. If humans desalinated all their water needs, the impact it would have on the world's oceans is minimal. The outlet pipes of desalination plants do not release enough brine to poison the ocean - the brine mixes in with normal seawater and moves via currents and wind. The only concern would be if water from an enclosed salty body of water is desalinated - these would include the Dead Sea, the Aral Sea and the Caspian Sea.

The water cycle is also important here. Water, when used, doesn't disappear. Consuming water doesn't destroy it, it just changes form. The water we drink for our bodies to live is matched by the amount of water our bodies produce - sweating, urination, defecation and evaporated water from breathing. In the same way, water used in agriculture is exchanged - transpiration from plants and an increase in groundwater will occur from irrigation. In all these cases, the water we consume eventually makes its way back into the atmosphere and into the ocean.

The cost of creating a network of desalinated agriculture of the sort I have described above will be huge. The cost of building Kurnell was $1.8 Billion. The cost of building my proposal is likely to be over $1 Trillion. But over a build period of, say, 20-30 years, the costs will be manageable and affordable when compared the Australia's annual GDP (which is around $1.4 Trillion today).

In my 2008 article I mentioned the following:

"While spending 5-6 months in drought-stricken country NSW in 2006, I asked a number of farmers about water supply. "Would you", I asked, "be prepared to pay premium prices for water if its supply can be 100% guaranteed?" They all said yes."

I still believe that this is the case today.

Solving Australia's House Price Crisis

The Problem

I used to believe that one of the most solid economic laws that can ever be argued for is the notion that "what goes up must come down". In other words, asset price bubbles (such as property or sharemarket over-investment) will naturally fall back to realistic levels. Tulip mania, the 1929 Stock Market crash... all the evidence is there.

But no longer. Asset price growth in property and shares has continued. Even the correction inherent in 2008 Global Financial Crisis has been exceeded in some areas. I am referring especially in this case to Australia's property price bubble.

Current Monetary Policy, which has evened out the business cycle, is probably to blame here. Controlling levels of inflation by adjusting interest rates has been one of the success stories of the world's post-1980 economy. But modern measures of inflation don't take asset price growth into account. A low inflation economy with a growing asset price bubble has been the norm in many western economies for decades.

One Solution: Higher Interest Rates?

One solution would be to factor in asset price bubbles into inflation measurements. As an indicator, this is fine. But what should be the central bank's response to this changed rate of inflation? Would it be wise to increase interest rates to push down a growing asset price bubble when the rest of the economy probably won't handle such a change? After all, if, say, the Reserve Bank of Australia (RBA) increases interest rates to deal with the growing property bubble, would the effects on the non-property sector of the economy result in a bad recession? Would the cure be worse than the disease?

Of course the real problem here is that interest rates have a very broad effect on the economy. This is inherent to current monetary policy and it can't be avoided. This doesn't mean that adjusting interest rates are somehow a bad thing - there are obviously times when a broad adjustment is going to be required.

But in the case of asset price bubbles, especially in the case of Australia's property market, a different approach is needed. One in which specific monetary goals in that particular market need to have external adjustment. A micro-prudential policy, probably with a dash of micro-monetary policy as well.

A Better Solution: Keep Property Prices Stable

In the case of Australia's overvalued (and now deflating) property market, it is important to neither keep prices rising nor to let prices fall. Property should retain its value over the long term, adjusted for inflation.

For this, an inflation-adjusted property price index should be created, with regular monthly updates. With the index starting at 100, the goal should be a long term price index that has peaks and troughs, but remains at 100 on average.

The advantage of stable property prices is threefold.

Firstly, it means that those who invest in housing will be investing in something that retains its value. All forms of investment exist because people with money wish to gain more. If property prices retain their real value over the long term, people will feel safe investing in them. Obviously such investment needs to be compared to other forms of investment, and the risk/rewards that such investments have, in order for the market to respond appropriately.

Secondly, it creates a disincentive for speculation. Any form of asset price growth leads to speculators who are not so much concerned with actual assets, but whether they can profit from the process of buying low and selling high. Speculation has its place in an economy, but asset price growth in shares or property turns investors into speculators. This results in profits derived from the process rather than the utility of the asset being invested in, and creates a parasitic sort of investment class. This has been one of the great problems in the world's post-1980 economy, with huge asset price bubbles in both shares and property coexisting with lower levels of GDP growth. But if an asset is neither growing nor shrinking in real value over the long term, there is less incentive for speculation.

Thirdly, assuming wages keep rising, it makes for more affordable property prices over the long term. If an economy has rising wages but property prices remain stable, then, by definition, property prices become more affordable. My belief is that property prices are too high, and there are plenty of stories and statistics out there which show how difficult it is for younger people to afford to buy their own accommodation. A long term increase in housing affordability is the best solution here.

So how would this be achieved?

The real property price index would, like the inflation index, be used by a central bank to determine whether to remove or inject liquidity into that specific market. Currently, the adjustment of interest rates is the only current solution, and as I have pointed out above, its usefulness is in its broad effect, not in its narrow effect, making its use problematic in the case of stabilising property prices.

The solution would require a central bank to use two policy tools to keep prices stable. Micro-prudential policy tools would be used to stabilse the peaks and troughs of a typical business cycle, while micro-monetary tools would be used during a serious drop in prices.

Micro-prudential tools

If the index is showing a substantial change in house prices, then the Central Bank would adjust prudential rules that govern mortgages, by increasing or decreasing the minimum deposit required for mortgage holders. This would be based on lending laws that would apply across the entire property market, ensuring that people applying for a mortgage would have to increase or decrease the initial deposit.

In a market of increasing property prices, these micro-prudential rules would have the effect of denying liquidity to the property market, resulting in less money available to invest, and thus cause a drop in prices.

The same micro-prudential policy can be used when prices begin to fall. By decreasing deposit ratios, more liquidity from investors would enter into the market, causing prices to rise.

Micro-monetary tools

In the case of a substantial drop in prices, however, direct monetary policy would be required. Even if micro-prudential deposit rates were dropped to zero, economic conditions might still be so bad that prices keep dropping. When this occurs, the central bank could invest directly in the market itself. This would involve the central bank creating money by fiat, and then using it to purchase property. This is similar to Ben Bernanke's "money by helicopter" theory, except that instead of giving free money out to everyone, fiat money is used by a central bank to directly enter a market. Once prices have begun to stabilise at the 100 index level, the central bank can then begin gradually selling off this property, with any money it gains from the process being "de-fiated" into nonexistence.

Of course such a targeted policy would impact the wider economy, and inflation rates will be impacted by the specific policy tools that the central bank would use to stabilise prices. But these broader effects would best be served by broader policy tools - ie, interest rates.

Summary

To summarise, the current property price bubble in Australia can be solved through the following means:

1. Set up an index which measures property prices adjusted for inflation and update it monthly. This would require work on behalf of the Australian Bureau of Statistics and funds to create it.

2. Grant the Reserve Bank of Australia the power to determine mortgage deposit rates, requiring all registered mortgage lenders to set a minimum rate of deposit. If the rate is set at, say, 20%, this would mean that someone wanting a $1 million mortgage would have to have saved a $200k deposit.

3. Grant the RBA the power to change mortgage deposit rates.

4. Give the RBA the directive that mortgage deposit rates should be adjusted in order to keep real property prices stable over the long term. Specifically, this would be an index number of 100 averaged out over the long term.

5. Grant the RBA the power to purchase property with money created by fiat as another way to keep real property prices stable.

6. Property so purchased by the RBA will be maintained and managed by a separate government body until such time as the RBA sells the property.

7. Property directly purchased by the RBA will be sold once prices have stabilised.

8. Money generated by the RBA's selling of properties is "de-fiated" into nonexistence, and is not part of general government revenue.

I like Obama and I agree with Keynes. But US government debt needs to be paid off sooner rather than later.

Despite the fact I am increasingly finding my own economic understanding being challenged and improved upon through the views of others, I am yet to change my mind over the issue of government debt. I therefore find myself in one of those uncomfortable "middle" places between ideologies and ideas in which I find myself agreeing with people whom I usually disagree with and disagreeing with those whom I respect.

This is the situation: It is my view that US government debt is a serious problem. It is the prime reason why I publish a "debt watch" every month, since hard data is essential in informing my view. Yet by holding the "debt is a problem" view I find myself aligning with populist conservative economists who deride Keynes and hate government while at the same time I find myself disagreeing with people like Paul Krugman and Obama supporters who see the stimulus as a good thing.

For the record I am not dismissive of Keynesian economics. As a non-American I have seen "automatic stabilisers" such as welfare payments and unemployment benefits being enacted by governments and have even benefited from them directly. I have no problem with government deficit spending during recessions, all things being equal of course. Yet it is that last phrase - "all things being equal" - which is the qualifier that has made me oppose the Obama stimulus package and to align with deficit hawks.

So, what is so "unequal" about the American situation? The problem is that for Keynesian economics to work over the course of the business cycle, any deficit run during recessions must be balanced out by surpluses during expansions. This causes a virtuous cycle, whereby increased tax revenues during expansions pay off the debt accrued by the government during recessions, while also creating net government savings once the debt has been paid off. These savings should then, of course, be used as emergency funds to be tapped when the economy moves back into recession. The idea is that over the course of the business cycle, government deficits are balanced out by surpluses, and the amount of debt accrued is balanced out by the amount of savings.

What is obvious though is that this process falls apart when governments act irresponsibly. Irresponsible actions in this case involve governments running deficits and accruing debt during economic expansions. Since 1981 the United States has run up huge fiscal deficits not just during recessions but during expansions. For this I blame the rise of Supply-side economics and the populist tax complainers who advocate it. The idea that reducing taxes would magically produce more tax revenue has destroyed the fiscal standing of the US government since the early days of Reagan.

Yet it seems to me that some non-supply siders have their own magical thinking to deal with. There's no doubt that the Obama stimulus has boosted the economy, but it is illogical to assume that such a boost in economic growth would provide enough increases in tax revenue to pay off the stimulus in the first place. Despite the presence of multipliers, the end result has been and will continue to be a net increase in debt levels. Those who believe otherwise are merely replicating the error of supply-side economics, except that the deficit is created by spending increases instead of tax cuts.

The fact is that public debt in the US is now just over 58% of GDP and debt servicing represents 2.7% of GDP. Just over 19% of Federal government spending is dedicated to debt servicing, an amount which easily exceeds anything spent on NASA, Education or the Environment combined.¹ Debt servicing is only exceeded in size by defense spending, health and human services and social security. Alarmingly, this amount will only increase the more the economy expands, since an expansion will create a higher interest rate environment and force the government to pay even more on money owed.

It is debt servicing which is the real killer behind running large structural deficits over a long period. As more and more debt is accrued by a government, more and more money is spent on paying interest. As time goes by this increase in debt servicing "crowds out" spending on other government programs: education spending gets cut, science gets cut, health care gets cut, environmental protection gets cut, welfare gets cut - and all getting cut without any actual decrease in government spending since these cuts are being balanced out by an increase in debt servicing. And of course who is the beneficiary of government debt servicing? Investors - households and businesses who fronted the billions of dollars in the first place to lend to the government. This is, of course, the rich, mainly. If there is one government policy that rewards the rich over the poor over the long term, it is having a structural deficit adding to increasing national debt levels.

If a household goes into an unsustainable debt spiral, they end up being declared bankrupt. Bankruptcy can also apply to businesses, but businesses also have the option of dissolving. Both the borrower and the lender in this situation are "losers". Sovereign governments do not have the option of bankruptcy or dissolution. Too much debt can be controlled through inflationary seigniorage (since the government controls the money supply) or by defaulting. Markets respond to the threat of default by dropping sovereign debt investments and thus causing a rise in bond rates (eg the recent problems with Greece).

Bankruptcy, dissolution, inflationary seigniorage and defaults are processes which cause massive economic damage. If a sovereign government inflates its debt or defaults, the pain and damage is passed on to the market and to households and businesses, who in turn are rendered bankrupt or are dissolved and the problem escalates. So while the government may survive, the people and businesses it supposedly serves ends up badly hurt.

The US is not close to defaulting on its debt, but it is closer now than at any other time in history. The reason why I believe the Obama stimulus was a bad move was not because I somehow oppose Keynes or have embraced Grover Norquist, but because US debt levels were already too high for such a stimulus package to be sustainable. One of the problems that caused the great financial crisis was lax US fiscal policy, so it seems illogical to assume that loose fiscal policy can be used to solve it. While this may seem merely axiomatic, it is nonetheless important in my thinking on the issue.

One response from stimulus supporters in the face of this complaint can be summed up in one word: Hoover. Didn't Hoover make the depression worse by cutting government spending, and didn't Roosevelt make the depression better by increasing government spending via the New Deal? My retort? I agree - but neither Hoover nor Roosevelt was lumbered with government debt the size and proportion of which Obama was lumbered with when he took office in 2009. Debt levels were already too high before the great financial crisis hit, and they have grown even higher throughout.

At some point the US must deal with its debt decisively. The government must agree to run fiscal surpluses over a long period in order to pay off the "national credit card". Supporters of Obama's stimulus argue that the economy must recover first and that any changes must occur later rather than sooner. I disagree. I can't see the US economy returning to its pre-GFC glory for some time. Financial market imbalances have gone on for too long and have messed up too much money for things to return quickly to 2005-style balance sheets. Unemployment is unlikely to drop below 7% for the next few years and there is always the threat that a second credit crunch might hit and make the current recession even worse. After all, there has been a domino effect of sorts - the subprime crisis of 2007 leading to credit crisis of 2008 leading to the European sovereign bond crisis of 2010 leading, inevitably, back to US households and businesses, a process which looks like it is already hitting with further drops in house prices being experienced.

Yet if I got my way, what would result? Let's say Obama rings me up and says "OSO, you're a wise man. Tell me what to do and I will do it." Well apart from awarding myself a few million dollars to feather my own nest I would:

• Increase taxes, especially on the rich.
• Introduce a Market Capitalisation tax to tax public companies according to their market wealth.
• Cut defense spending by 25% (Iraq and Afghanistan would be handed over to the United Nations and troops brought home)
• Leave spending levels where they are proportionally for the next five years.
  

In short, I would aim to run an immediate fiscal surplus of around 1% of GDP, and then sit back and wait as this surplus increased over time.

Of course such an action would result in an economic contraction. It would push the US into a deep recession. Yet the alternative would be an even deeper and even more damaging recession later on. Moreover, forcing the country into a recession is exactly what Paul Volcker did when he began work as Chairman of the Federal Reserve and it was he who is seen by many as the real reason behind America's 80s recovery and expansion (and not Reagan). If Volcker can cure the economy via harsh monetary medicine then so can Obama and Congress cure the economy via harsh fiscal medicine. Of course such a decision by Obama and Congress (acting on my wise counsel) would push the US into a far worse recession than Volcker ever did, but Volcker's recession resulted from, and cured, 10-15 years of monetary madness, while an OSO directed recession would result from, and would cure, some 30 years of fiscal madness.

The point is, though, that a reckoning has to occur. Had George W. Bush in his first term of office decided to keep taxes where they were and run more Clinton-inspired fiscal surpluses, the current GFC would probably be much milder, or may have never occurred at all. Had Clinton and the Gingrich Republicans in the second half of the 90s been less concerned with White House interns and more dedicated to running fiscal surpluses, the current situation would be even less severe. Had Walter Mondale been inaugurated president in 1985 on the back of fixing Reagan's fiscal stupidity with tax increases (one of his actual election promises that seemed crazy at the time but quite prescient in hindsight), we'd probably never be in this predicament in the first place.

The thing about learning from history is to ensure that we don't repeat the mistakes of the past. In 1996 Australia had 8% unemployment and government debt levels of around 20% of GDP (which at the time was quite high, but is quite low in comparison to other nations now). Despite the economic torpor of the time, the new conservative government chose to cut spending and aim for a surplus within a few years. The immediate result was predictable - the economy barely grew and unemployment increased. But as years passed the economy grew more strongly, unemployment dropped and the government began running regular, healthy budget surpluses. By the mid 2000s the Australian government was debt free.² Comparing Australia to the US has its problems, but there is no doubt in my mind that this conservative government (under PM John Howard and treasurer Peter Costello) did Australia a great favour through running constant, incremental contractionary fiscal policy. Not only did Australia manage to avoid going into recession in 2001 but it has also avoided recession throughout the GFC. The economy has expanded almost continually from about 1994 until the present and unemployment, once always lower than the US, is nearly half the US rate. There are certainly other factors involved (eg the resources boom) but even when those are factored in, there is no doubt in my mind that intelligent fiscal policy has provided Australia with a huge safety net to turn too once the GFC hit - PM Kevin Rudd instituted a stimulus package which has created the potential for economic overheating, a problem certainly NOT experienced by most western countries at this moment. The point I am making here is that Rudd' stimulus, on the back of over ten years of fiscal prudence and the retirement of government debt, was quite sustainable and probably saved the country from recession. Obama's stimulus, by contrast, was not, and will come back to bite.

If the US government institutes fiscal policy of the sort that I am suggesting, the result would be a sharp but short term contraction which, on the back of the current recession, would obviously be quite damaging. Nevertheless this is the harsh medicine that America must swallow if a) it wants to rebalance its fiscal state over the long term, and b) if it wants the government to not expand in its size. This last point can obviously change, and I would not be unhappy if the US instituted:

• A NHS-style universal health care system.
• Building enough renewable energy plants to exceed total US electricity demand.
• Massive industrial biochar production aligned with afforestation programs.
• Doubling public transport infrastructure
• More money into public education
• And other OSO-approved polices that would make me happy.

Of course I would not oppose such spending, but spending of this sort would probably double the size of the US government and for that to succeed without adding to the deficit, it needs to be accompanied by tax increases - tax increases which result in more revenue that is needed to pay for the spending increases. The issue here is not whether government spending should be expanded (I think it should) but whether a surplus should be run (which is absolutely essential). Given that the US hasn't as yet reached my own enlightened levels of social and economic understanding, whatever increases in government spending are enacted should always come second to the need for a fiscal surplus (or, more properly, the need for debt to be paid off over the long term which will, in the short term, require a reduction in the deficit).

<sup>1: MTS Report April 2010, Table 3, "Budget Outlays - current fiscal year to date": Department of Defense-Military $396,452 million, Department of Education $61,232 million, Department of Health and Human Services $503,984 million, Interest on Treasury Debt Securities (Gross) $224,414 million, Environmental Protection Agency $5,586 million, National Aeronautics and Space Administration $10,781 million, Total Outlays $1,998,847 million

2: Debt free here in a net sense. A bond market for government debt was still needed and still continues to operate. Government surpluses since the mid 2000s have been directed instead to a "future fund" which allowed government savings to eventually exceed debt levels. So Australia still had gross debt but no net debt - at least until the GFC hit and returned the government into net debt, although at a very low level.</sup>

Some predictions using real interest rates

My study of real interest rates has been continuing, though without any publishing on this blog due to data collection. There are some predictions though which I have decided to publish today.

I've broken up nations into four groups.

Group 1 - Plunging real interest rates. These are nations whose monetary conditions have dramatically changed over the previous six weeks to promote inflation. These nations are:

• Britain
• Argentina
• Brazil
• Iceland
• Switzerland
• Mexico
• China
• Russia
• Turkey
  

Now of these nations, the one with the lowest CPI is Switzerland, which means that the inflationary growth will not be as serious, while Turkey and Argentina already have high levels of inflation. High inflation levels are bad for an economy because they act to distort prices which, in turn, leads to more inaccurate "money direction" - the choices money holders have in spending or saving or investing or borrowing currency. This inevitably leads to a "peak" in growth, followed by a trough - inflation usually precedes a deflationary economic downturn.

Group 2 - Real Interest rates dropping moderately. These are nations whose monetary conditions have favoured economic growth over the previous six weeks.

• Japan
• Canada
• Euro Area
• Australia
• Ireland
• Spain
• Germany
• France
• Italy
• Sweden
• India
• New Zealand
  

While inflation may result from these monetary conditions such an increase is not likely to be serious. While these conditions do not guarantee economic growth they do act to either improve growth already occurring or to limit any contraction. Of these nations, Ireland is the only one with a contracting economy experiencing deflation, so it is likely that Ireland will experience only moderate contraction and more stable prices in the coming months. Conditions in the Euro Area are improving, which should affect the PIIGS in a positive way. While India's real interest rates have improved moderately, very high inflation continues to afflict them and there is evidence from my data to suggest that India is likely to have some form of economic contraction (ie either a downturn or lower growth rates) soon. Of the nations on this list, Japan and Germany, with price changes close to zero, are more likely to experience sustained growth.

Group 3 - Real interest rates increasing moderately. These are nations whose monetary conditions have favoured economic contraction over the previous six weeks.

• United States
• South Korea
• Poland
  

Again this is not a prediction of economic decline but a contractionary effect upon growth/decline already being experienced. I have collected more data on US CPI and interest rates than any other nation and the data suggests that conditions in the US are not improving. Growth in GDP for Q1 2010 was 3.2%, following on from 5.6% in Q4 2009, which shows that the Obama stimulus of 2009 has passed its peak and is headed on its way down. Real interest rates in the US declined considerably between July and December 2009. In fact "considerably" is too conservative a word to use - real interest rates declined from 5.7% to 0.62% over that six month period. The US would be in "Group 1" in December last year, which indicates that the US economy is beginning to slow down. Considering the speed of the decline and the growth experienced in Q4 2009 and Q1 2010, I would be very surprised if growth ended up exceeding 1.0% for Q2 2010 (which is now).

Group 4 - Real interest rates increasing substantially. These are nations whose monetary conditions have seriously deteriorated over the previous six weeks.

• Greece

Greece has suffered mainly from the market's fear of a sovereign debt crisis - and such a fear is not unfounded. With increasing austerity measures being put into place, Greece's economy looks set to contract - ie shrink - some time this year. Inflation in Greece is still running a little high (3.9%) but increases in bond rates have more than exceeded this amount. Inflation in Greece is likely to turn into deflation as soon as the economy begins to shrink. Growth in the Euro Area, though, is likely to moderate any Greek downturn (and also help Ireland stop its current economic decline).

And that's Stephan Bibrowski in the picture.

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.

Australia slipping into recession

Unsurprising:

Official figures show the Australian economy has gone backwards for the first time since December 2000, putting it on the brink of a technical recession.

National accounts figures out today show the economy contracted by 0.5 per cent in the December quarter. That puts GDP growth for the year to December 2008 at 0.3 per cent. The September quarter's growth figures have not been revised.

I'm pretty certain Q1 2009 will be positive, but I doubt that this will be sustained throughout the year. Fortunately none of our banks are disintegrating.

And -0.5% is actually quite good compared to most nations at the moment.

Aussie Current Account shrinks

I like this news:

Official figures show Australia posted a current account deficit of $6.5 billion in the December quarter.

The figures show the deficit has narrowed by nearly $3 billion, or about a third, from the quarter before.

Australia's Current Account has been in deficit for decades. In the past few years, this deficit has reached around 7% of GDP.

But this situation has changed in the last 2 quarters of 2008. 2008 Q3 dropped to -3.2% of GDP while the recent figures for 2008 Q4 indicate that it probably dropped to around -2.0% of GDP.

A lot of this has to do with the commodities boom - Australia is rich in raw materials - while the 4th quarter is probably due to reduced consumption (3rd quarter GDP was +0.1%).

Now that the commodities boom is over and Rudd has put in a stimulus package, I would expect an increase in the Current Account deficit for the first two quarters of 2009.

Our currency remains low, though, which means our exports should be doing a bit better.

-----

As many readers know, I am a fan of balance. To me, the best situation to be in is to have a balanced current account over the course of the business cycle. Australia, like the US, has been on a borrowing and buying binge. Anything which moves our economy to a balanced current account makes it more sustainable. Any nation with big current account deficits or surpluses are asking for trouble, as Japan and the US can testify.

Australia likely to be in recession by end of year

Despite all the wonderful protestations by business leaders and politicians about how strong Australia's economy is, bad economic news continues to bubble up.

The latest bit of news is that job advertisements in November 2008 have dropped the most on record. Last week, inflation gauges showed prices dropping quickly in October and November, coming at the same time as the Reserve Bank cut rates aggressively.

So we have a considerable fall in inflation accompanied by a considerable decrease in employment demand. Anyone with ECON101 knowledge knows that those figures together indicate a slowdown.

But then we have to add more, namely the recent GDP figures showing 2008 Q3 growing at a mere 0.1%. If that is revised downwards (and it is possible), then 2008 Q4 - which is already looking to be a negative number - could result in a "technical definition" of a recession (two quarters of economic decline).

So. Who to blame? Kevin Rudd? Despite the fact that the guy hasn't really done anything in his first year as Prime Minister you can't blame him for the current downturn. What about John Howard? The former PM and the coalition government did create some good economic conditions - namely a complete removal of government debt - which will give Rudd and the ALP a lot of room to run sustainable deficits. Howard, though, did help create a housing bubble in Australia with the First Homebuyer's grant and the Negative Gearing tax loophole - but then again Rudd hasn't done anything to remove it since winning the Federal Election 12 months ago.

But, of course, Australia is a small economy that is joined to the rest of the world, and as the economic contagion in the US has spread to Europe and Asia, so it has also spread to Australia.

Having said all that I still have some level of confidence in the Australian economy. We certainly won't avoid a recession IMO, but it will be on the upside (the recovery) that Australia's economic strength (or lack of it) will be shown. Unemployment, for example, will not exceed that of the US.

Australia still decoupled

Smarmy Morning Herald:

Australian employers defied analysts expectations and added jobs in October.

The labour force gained 34,300 jobs, seasonally adjusted, compared with a gain of 2200 positions in September, data from the Australian Bureau of Statistics shows. Economists had predicted job losses of 10,000.

The unemployment rate was unchaged at 4.3%, staying near three-decade lows.

All the job gains were accounted for by part-timers, which skewed the overall result.

Employers cut 9200 full-time positions last month, while adding 43,500 part-time jobs. Total employment rose to 10,752,800
Full-time jobs dropped 9200 to 7,688,200, while part-time employment, a sign of weakening demand, increased by 43,500 to 3,080,100.


The Aussie dollar strengthened after the figures were released, adding about half a US cent, to 68.10 US cents, while the share market was little changed.

I find this strange. I always try to have an objective view of Australia's economic strength but I would've thought that things had gotten bad by now.

I still maintain that, in regards to unemployment, the only way is up in Australia.

Australia's unemployment rate is still dropping

Despite the deterioration of the US economy, Australia's economy still seems to be going along well. Today the Bureau of Statistics released the unemployment report for August (link, pdf, 945.1kb) which showed that the unemployment rate dropped to 4.1% seasonally adjusted. This is 2 percentage points below the US (6.1%). I don't know when Australia's unemployment rate was so low in comparison to the US.

All feelings of national pride and schadenfreude aside, I am reasonably certain that unemployment will begin to rise within the next 3 months. Australia is still a small player in the world economy and always will be, and our economic strength is linked with the economic strength of the rest of the world.

With the US in recession and the GDP in the EU dropping in 2008 Q2, it is only a matter of time before Australia's economy gets hit. I think that our slowdown will begin in 2008 Q4. Nevertheless, I would point out that, on a one to one comparison, Australia's economy is structurally better than the US. Australia will certainly undergo a recession but it will not be as deep or as painful as that which America is going to go through.

Bloomberg report here.

Lessons from Italy and Australia

If the United States is to avoid a long term fiscal disaster, it needs to learn from other nations. America cannot continue to ignore the lessons learned from other countries in the blinkered belief that manifest destiny or divine intervention somehow makes it different from the rest of the world and not subject to the same set of rules.

Now usually when I say this sort of thing I am often pushing forward something wonderful that is present in non-American countries that America could use. Universal health care, increased public education and stricter gun laws come to mind here.

This time, however, I am going to use a negative example as well as a positive one. Rather than just showing America what it could become if it does the right thing, I am also going to show what America could become if it does the wrong thing.

In previous posts (here and, more recently, here) I have pointed out that the fiscal irresponsibility of the US Federal government is, by itself, a clear threat to medium-long term economic growth. When combined with other factors (namely Peak Oil, the subprime mortgage crisis and an unsustainable current account deficit), its negative effect is amplified.

When a government does not have enough tax revenue to fund its expenditures, it turns to the market to borrow the required amount. Government bonds are an integral part of credit markets worldwide and function as a baseline measurement for corporate bonds and mortgages and other forms of debt-based activity.

Notwithstanding the part that government debt plays within the world's financial markets, if a government runs deficits over the long term then the debt to GDP ratio increases. In the case of the United States, this number is probably somewhere between 40 and 60% of GDP.

The country that I am setting up as a warning for America to heed is Italy. The following image is one I scanned from a pdf file about the 2007 Italian Budget (download here. pdf, 627.2kb):

This is obviously not a detailed report on the budget, but it gives more than enough information for our purposes.

There are two very important figures in this budget summary. The first is the section marked burden of national debt, which totals €74,564 million. The second is the bottom section marked redemption of national debt, which totals €189,099 million.

That first figure - burden of national debt - represents the interest repayments that the Italian government has to make on its borrowings. Like all bonds, government bonds first have to pay back interest and then, once it matures, the principal. This figure in the budget represents the amount of interest they have to pay on bonds owing. The second figure - redemption of national debt - is the amount of money the government pays back on maturing bonds.

Together, the amount of money the Italian government spends on debt servicing (interest plus paying back principal) is €263,663 million.

Now let's put that number in perspective.

€263,663 million represents a whopping 41.2% of the Italian government's spending in 2007. According to the same document, Italy's GDP in 2007 was estimated to be €1.475 trillion, which means that debt servicing also represents 17.9% GDP.

Such figures almost defy comprehension. Italy's net public debt is around 107% of GDP. Moreover, Italy's public debt has been at this size or even higher for more than a decade (it was 113.6% in 1999).

By way of comparison, America's fiscal irresponsibility is mild. Debt servicing so far represents 15.75% of government spending and 3.13% of GDP - figures that are dangerously high but not as extreme as Italy's.

This is not the place to discuss in detail the reasons for Italy's fiscal nightmare - the nature of Italian politics is probably a major contributing factor. The fact that Italy's political leaders have been unable to find bipartisan support to control government spending has meant impoverishment for their nation.

But just how impoverished is Italy? After all, they are a sophisticated and educated western nation with a high standard of living. That may be true, but the key to understanding how impoverished they are is to examine the opportunity costs of such massive debt servicing.

From a leftist point of view - the point of view which supports high levels of government spending to support universal health care, free and/or cheap public education and so on - the €263,663 million in debt servicing (41.2% of the budget) is money that could have been used for public spending. Education spending in 2007, for example, was €50,066 million. Health spending was €11,661 million. Public order and safety spending was €21,122 million. Every Eurodollar spent in debt servicing was money not spent on improving the nation's social services.

But the leftist view is not the only valid one. From a more economically conservative point of view, that €263,663 million was money that could have been returned to people and businesses in the form of lower taxes. And imagine what sort of tax rates they could have been - 17.9% of GDP not taken up by the taxman.

The message here is clear - governments that have run long term deficits have, over the long term, created a combination of less government services and higher taxes. Money that could have gone into government spending or lower tax rates are instead being used to pay back a national credit card bill that, in the case of Italy, defies logic.

Fiscal responsibility is therefore not a left/right issue. From whatever ideological position you come from, ensuring that public debt does not spiral out of control must be a common goal.

Italy does, of course, have a number of natural advantages. As part of Europe they are in close proximity to an immensely rich and wealthy group of nations that have enriched it through trade. The fact that Italy has adopted the Euro means that any concerns that investors have in Italy's financial position are cushioned by the economic strengths of other nations that have adopted the Euro as well. This fact is tempered, however, by the fact that many other nations in the Eurozone have problems with fiscal irresponsibility as well - though nowhere near that of Italy's (with the notable exception of Belgium).

The good news is that it is possible for politicians - even those in Italy - to work together in a bipartisan way to fix their budgets. The solution is actually simple - either increase revenue or decrease expenditure and run a fiscal surplus over many years. When it comes to politics, however, this is easier said than done, especially when increasing revenue means raising taxes and decreasing expenditure means cutting spending on health, education and public welfare.

While the Clinton years are often seen as a period of intense political partisanship, it is important to remember that the Democratic president and a Republican Congress - for all their bitter fighting - were able to agree very early on to fix the nation's public debt. The result was a series of budget surpluses late in Clinton's second term (helped in no small part by the 1990s Tech boom) and a reduction in national debt. Although Bush and the Republican Congress have ruined this since 2001, there is every reason to believe that a bipartisan solution can be found. Sadly, however, the current political discourse rarely mentions the fiscal imblances which means that, when the next US president takes office in 2009, neither Republicans nor Democrats will see balancing the budget as a priority.

There is one country that has, however, managed to eliminate net public debt - and has done so without resorting to profits from oil but from pure budgetary discipline. That nation is Australia.

Australia's fiscal example should stand as an example to other nations. In 1996 when the conservative Howard government came to power, net public debt was around 20% of GDP. While this was quite small in comparison to other nations - both now and at the time - steps were taken very early to cut spending. So although net debt was comparatively small, it was never allowed to increase. Importantly, cuts to spending were made when unemployment was moderately high - at around 8%. This meant that, when the economy recovered from the effects of the spending cuts, economic growth in the years that followed produced large and growing budget surpluses and steady improvements in unemployment. Moreover, the government could then afford to make incremental tax cuts on an annual basis - a process that was quite politically rewarding. Since 2005, unemployment has dropped below 5%, big budget surpluses are run regularly, income tax rates are lower than ever and net public debt is now negative.

The Howard government did, of course, lose power in 2007, which shows that no poitical party should rely solely upon economic performance to drive their political fortunes. Nevertheless, Australia should serve as an example of what can be achieved if politicians take a long view on important things like fiscal responsibility.

It is likely that the effects of Peak Oil and the subprime meltdown will be far reaching. Countries that are fiscally weak like Italy will either be forced into making painful fiscal readjustments or else run their nations into bankruptcy-in-all-but-name by increasing their deficits. On the other hand, countries like Australia will be in a more flexible position and will have room to cut taxes or increase public spending.

What will become of America, though? While I would like to think that America could avoid Italy's fate I am not at all certain that bipartisan steps can be made to rectify the situation before net public debt hits record levels - say between 75-85% of GDP.

One thing is certain, however, and that is that America's fiscal position will determine its influence in the world over the next 20 years. If America should go down Italy's route, you can almost guarantee that America, as a society and as an economy, will be a pathetic reflection of what it was for most of the 20th century.

In the face of a semi-permanent energy crisis along with the spectre of global warming, what the world of the 21st century needs is a strong, free America. Being fiscally responsible is an important step in that direction.

El Nino seems to be reappearing

Forecasting weather for me can often be as error-prone as forecasting the market. Nevertheless I wish to show here some rather unsettling graphs.

The first is the El Nino Southern Oscillation Index:

This graph (courtesy of the Australian Bureau of Meteorology) is one tool used to predict and determine El-Nino or La-Nina conditions. Any result above 5 indicates La Nina favourable conditions and any result under 0 indicates favourable El Nino conditions. The number used in the index is the difference in Air Pressure between Tahiti and Darwin. A positive number means that the air pressure in Tahiti is greater, while a negative number means that the air pressure in Darwin is greater. Lower air pressure is associated with more rainfall. The fact that the index has moved into negative territory means that Air pressure in Tahiti is dropping below that of Darwin. This means that there is less likelihood of rain in South-Eastern Australia, which matches an El-Nino event.

But the ENSO graph above is not the only one to look at. Here's another important one:

This graph shows temperature throughout the equatorial region of the Pacific Ocean. You can see Papua New Guinea there in the West. If the graph went East more you would see Peru. What is important is the bottom graph which shows temperature anomalies. As you can see, the temperature of seawater in the Eastern Pacific near South America is heating up above normal. Warm seawater is more likely to produce rain while cool seawater is not.

Let me just put this simply, the conditions that we see here are typical of a developing El Nino weather pattern. This means more dry weather for South Eastern Australia, which will probably turn into the worst drought in Australia's history. Not good.

AAAAAAAAA

A blog post with every single category marked (I'm doing this for scribefire)

Advantage Australia?

From the department of slightly:

Commodity exports from Australia, the world's biggest shipper of coal, iron ore and wool, are forecast to gain to a record for a fifth straight year driven by demand for steelmaking raw materials led by China.

Sales may reach A$189.1 billion ($178 billion) in the year ending June 30, 2009, the Canberra-based Australian Bureau of Agricultural and Resource Economics said today in a statement. That compares with a revised A$145.6 billion this fiscal year.

Prices for the nation's top five commodity exports, iron ore, coking and thermal coals, gold and crude oil have risen to records this year, benefiting producers including BHP Billiton Ltd. Robust economic growth is expected in China this year along with strong demand for Australia's resources, the bureau said in a report.

``China is far and away the biggest underlying force'' driving sales, Peter Arden, an analyst at Ord Minnett Ltd., an affiliate of JPMorgan Chase & Co., said by phone from Melbourne. ``The outlook is very, very rosy.''

This is obviously good news, not just because it is "good" that people overseas want our commodities, but because it will help to reverse one of Australia's economic imbalances - the current account deficit. This will, however, be a case of "I'll believe it when I see it" because the current account deficit is one of Australia's most intractable economic problems.

Australia's economy, like all modern economies, buys goods from overseas. It also sells goods overseas as well. The problem is, however, that Australia buys more than it sells. So where does it get the money to buy overseas goods? It borrows it from overseas lenders. In the September quarter last year, Australia borrowed a total of US$49.9 billion. This is called a current account deficit, and that figure represents some 5.4% of GDP. Australia has been borrowing money from overseas for a long time, and the amount of money Australia owes to overseas lenders is now around 53.5% of GDP - over US$610 billion.

Now I'm a great believer in balance when it comes to economics. A deficit is not "bad" but continual deficits are "bad". Similarly, a surplus is not "good" but continual surpluses are, in fact, just as "bad" as continual deficits. The idea is to get things in balance.

In order to reverse Australia's net debt and reduce it to zero, the current account must, at the very least, be reduced to zero as well. In short, this means that Australia needs to export more and import less, to save more and borrow less, to produce more and to consume less.

Since Australia's economy is heavily dependent upon commodities (like coal, iron, gold, copper, etc) as well as agriculture (like wheat and rice), the current commodities boom and increase in grain prices will act to increase the price of the goods we sell. This will, in turn, act to reduce Australia's current account deficit.

One of the more fortunate results of a conservative government that wasn't influenced by voodoo economics is that Australia's public debt (the amount of money all of Australia's governments owe) has basically been erased. Eleven years of fiscal prudence by Howard and Costello has meant that the government can now actually afford to do things like cut taxes and/or increase spending. This is where Australia and America differ.

Nevertheless, there are some weaknesses in Australia's economy.

The first is that inflation is increasing. It is expected that the Reserve Bank of Australia will raise rates to 7.25% today. Australia's economy, unlike America, is still showing signs of strength so our central bank is right to increase rates. Moreover, this increase in rates will do exactly what is needed to reverse the current account deficit - it will curb domestic spending, making us less likely to consume and more likely to save. If things work out okay (and they probably won't), this decrease in domestic spending will be balanced out by the increase in overseas exports mentioned in the news report quoted above.

The second is that, while Australia does not have the same subprime mess that the US has, our housing market is still significantly overvalued - perhaps more so than the US market ever was. I am astounded that housing prices here in Australia have remained stratospheric while they have been crashing in America for over 12 months now. Today's interest rate rise will, at the very least, deflate the bubble slightly. Hopefully it will pop it, and an Australian economic downturn is a possibility.

The third is that it is China and Japan that are buying all the commodities we produce... and both Japan and China turn those commodities into goods that are then sold to America. With the American dollar now low and its economy in recession (face it, it is), it is only a matter of time before Chinese and Japanese industry is affected by America's recession... which will, in turn, reduce the need for Australian commodities. It is this last point which is important because it assumes that the commodities boom will eventually end, leaving Australian mines and mine workers with less work and money.

Regardless of what happens - whether the commodities boom pops earlier or later - the right thing to do is to discourage domestic spending and to reduce the current account deficit accordingly. This will result in, hopefully, higher interest rates over the medium term. Over the long term, however, it will be dependent upon tighter monetary policy which targets inflation at a lower rate - something which has yet to become policy anywhere, mainly because it is my proposal for Absolute Price Stability.

In short, Australia is probably more likely to weather the brewing economic storm than America, but still has some serious shortcomings that need to be addressed sooner rather than later. The current account deficit is the key - reduce that and you will reduce a whole range of economic problems. Increasing interest rates and cooling the economy down is exactly what is needed at this point, even with a global recession heading our way.

A strange message from Australia's Reserve Bank

Mortgage rates are likely to rise again next month, after the Reserve Bank revealed it thinks inflation will exceed its target until 2010.

In a strongly worded quarterly statement on monetary policy released this morning, the bank said there was a rising risk that higher wages and higher inflation expectations would fuel inflation.

"Absent a further shift in economic risks to the downside, monetary policy is likely to need to be tightened in the period ahead,'' it said.

The warning comes less than a week after the Reserve Bank lifted its cash rate to the highest in over a decade to 7 per cent.

The bank has revised up its expectation for inflation this year from 3.25 per cent to 3.5 per cent, well above its target band of 2 to 3 per cent.

Inflation is also expected to remain "uncomfortably high'' for the entire of 2009, at 3.25 per cent.

Even in 2010, inflation is seen to remain high at 3 per cent.

"If this is not reversed reasonably quickly, the recent pick-up in inflation carries the risk of generating an upward drift in inflation expectations, which could feed back into wage- and price-setting behaviour.'' - SMH.

I find this message from the reserve bank strange.

Like many central banks (and unlike the US Federal Reserve), Australia's Reserve Bank uses inflation targeting. Essentially this means that interest rates are adjusted to ensure that inflation remains between an arbitrary amount. The European Central Bank's target is essentially between 0 - 2%, while Australia's target is between 2 and 3%.

But what this report from the SMH says is that the Reserve Bank is expecting inflation to remain above their target for another 2 years. That doesn't make sense to me. Although this media release is being interpreted by the media as an indication of further rises in interest rates (which is a fair enough interpretation), I am perplexed by this sudden allowance by the Reserve Bank of inflation above 3%.

The way all central banks fight inflation is through raising interest rates. But when the Reserve bank says "inflation is forecast to decline gradually from late this year, but would still be around 3 per cent in two years time", it is essentially saying that such levels are, well, unavoidable.

To me that's ridiculous. If the Reserve Bank chose to it could crush inflation altogether through the imposition of even higher interest rates (which, of course, would result in a recession... but that's not the point). But by saying "sorry, but high inflation levels are unavoidable" it is communicating in some strange way that it is no longer using inflation targeting. And if that is so, then what measure is the reserve bank going to use to determine the rate of interest?

This does not fill me with much confidence. We learned way back in the 1970s that the solution to stagflation (high inflation + rising unemployment) was to focus entirely upon inflation and kill it outright. This was what Federal Reserve Bank chairman Paul Volcker did way back in the early 1980s. While this bitter pill led to a massive world recession, the economic recovery was more sustainable than anything done in the previous two decades. Inflation targeting and independent central banks (free from the interference of elected officials) were the natural result. While there have been plenty of economic problems since the early 1980s, inflation has not been one of them.

Now, however, it appears as though central banks are less than happy about dealing with inflation first. The US Federal Reserve has decided that it can ignore any inflationary problems that a currency devaluation will have upon an economic system (problems that have been proven time and time again through bitter experience of non-American nations) and have decided to approach the current crisis by recklessly lowering rates.

And here in Australia, we now seem to have a Reserve Bank that now sees its "inflation target" as merely a suggested guideline rather than a number that, when crossed, will be reduced no matter what.

Letter

In today's Herald:

Under the Howard government house prices reached unsustainable levels, exacerbated by the first-home owners grant and negative gearing - both designed to help people buy houses, but which ended up overheating the market.

To be sure, unsustainable house prices are a global problem and Australia is no exception. Nevertheless it is essential that government at all levels follow common sense policies to cool down the housing market.

The Rudd Government's decision to offer tax breaks to first-home buyers is, sadly, another attempt to curry favour among home owners while pursuing inflationary policies.

Government should have no business either helping or hindering the housing market through subsidies and tax dodges. If Mr Rudd wants to give back some of the surplus, he should raise the tax-free threshold by a modest amount, rather than throwing money at a market that is heading for a meltdown.

Neil Cameron Waratah

The bit that is struck through was a part of the letter that did not get published. Now I look like someone who thinks that Australia's housing problem is not part of the global problem. Oh well.

Intelligent

RBA lifts interest rates again (ABC):

The Reserve Bank of Australia (RBA) has raised its official cash rate 0.25 per cent to 7 per cent, in a move which will increase the pressure on struggling families.

Interest rates are now at their highest level since 1996 after 11 consecutive increases.

In a break with tradition the RBA announced the decision on the same day as its board meeting, instead of waiting 24 hours as has previously been the case.

Economists had tipped a rate rise as a response to Australia's inflation problem, which Prime Minister Kevin Rudd last week proclaimed was the country's "public enemy number one".

The headline inflation rate is at 3 per cent, which is the top of the RBA's target band of 2 to 3 per cent.

I can't tell you how relieved I am that the RBA has done this. With Bernanke and the US Fed cutting rates with no thought of its consequences, I am very glad that the RBA has opted to lift rates to tackle inflation.

Unimpressed with Labor

From the department of wrong-move:

Federal cabinet today approved a scheme offering an effective tax break for aspiring first home owners, giving them incentives to save a deposit.

Treasurer Wayne Swan said cabinet had agreed on the first home saver account, first flagged during the election campaign.

"This is a modest long-term measure to assist more young Australians to achieve their dream of home ownership," he told reporters following a cabinet meeting.

"Young Australians saving for their first home will attract a government contribution equivalent to 15 per cent discount on their marginal tax rate."

The scheme will start in the second half of this year.

The housing bubble has blown up all over the world. There are various reasons for this, but here in Australia the housing market has become overheated due to two bits of government legislation: The first homebuyers grant and negative gearing.

These two policies, designed to supposedly "help" the housing industry, have only made house prices higher. In other words, the stated reason for their existence - helping people to own homes - has made it more difficult. There's an irony there to be sure.

I believe that government can and should intervene in the normal functions of the marketplace if it can be shown clearly that such an intervention would benefit all (government, buyers, sellers, stakeholders). At this present moment in time I do not believe that the government should have any say at all in the housing market (except, of course, ensuring that houses are built according to the rules). The government should basically butt out of the market altogether. The Coalition helped to overheat the housing market because of the first homebuyers grant and negative gearing. Now the ALP is continuing this overheating by giving first home buyers a "tax break".

In order for the property market to act properly, it needs to cool down. House prices have to decrease to more sustainable levels. This act by the ALP will do nothing to help the market cool down - in fact it will simply inflate the bubble and stoke inflation. It may provide a short term "boost" to house prices - which are completely unsustainable as it stands already - but will end up hurting everyone in the end.

By enacting this policy, the ALP have essentially shown themselves to be either a) ignorant of economic facts, b) overly political, or c) both.

Not happy Kev.

$100bn Lost

From the department of if-you-find- it-please-return-it-to-the-ASX:

It has been a day of carnage on the Australian share market, with investors wiping nearly $100 billion off the value of local stocks.

The market has closed down 7.3 per cent - its worst one-day fall since 1989.

Today, investors took their cue from Asia and Europe, where the FTSE fell more than 5.5 per cent.

Wall Street was closed for a public holiday, and there are fears about what is to come when it reopens tonight.

The plunges comes on the back of new fears the US economic slowdown is spreading across the world.

The All Ordinaries dived 409 points to 5,222 and the ASX 200 slumped 394 points to 5,187.

No sectors have been secure from the hammering.

The miners have been deeply in the red on lower base metals prices. Rio Tinto shed 11.6 per cent to $101.

BHP Billiton dropped 6.9 per cent to $31.

As for the financial sector, the ANZ suffered a 7.1 per cent loss to $24.35.

It has been such a volatile day that the website of Australia's largest online sharebroker CommSec crashed after being overloaded with an unprecedented number of trades on the site as the market opened.

I am looking forward in all my supervillain glee to the response from Wall Street. A 7% drop? Not likely. Somewhere between 3-4% is my guess. And that's not a prediction.