Why Australia's inflationary boom must come to an end
Stefan M. I. Karlsson
The recent election was a great success for ruling conservative Prime Minister John Howard. Despite opinion polls showing a majority opposing Australian support for the Iraq war, he not only held on to power, but his coalition actually gained seats in the Australian parliament.
The probable cause of this was the strong Australian economy. On a terms-of-trade adjusted basis, national income rose a whopping 7 per cent in Australia in the year to the second quarter, the highest of any rich country except for Hong Kong and Singapore, both of whom were recovering from last years SARS epidemic.
John Howard also brags that the current economic expansion in Australia has lasted for a record 13 years (8 of which has been under his watch.). The labour market is also extremely strong, with an increase in employment of 2.6per cent in the latest year and 28 per cent since 1991, while unemployment has fallen from 9.5 per cent in 1991 to 5.3 per cent in 2004. But just how sound is the current economic expansion?
There are some fundamentally strong sides, including a balanced budget, moderate tax rates and a large influx of skilled labor, which indicate a potential for strong long-term growth and which is part of the story behind the current strength of the Australian economy. These factors indicate that Australia will have a long term growth rate higher than the western average.
But there are two other driving forces behind the current boom which is unsustainable: rising commodity prices and a rapid monetary expansion.
Australia has long been regarded as "The Lucky Country". At no time has this been more true than now. While the volume measure of GDP has risen "only" 4.1 per cent in the year to the second quarter of 2004 the same number adjusted for terms of trade was some 7 per cent
The reason for this improvement can basically be pinned down to one factor: China's economic boom. China has had the world's highest growth rate in the latest 25 years and this growth has accelerated further in recent years.
Moreover China's economy has much higher raw materials content than most other economies. This, along with the falling value of the US dollar is the main driving force behind the rapid increase in commodity prices in recent years. And since Australia is a great net exporter of commodities it has benefited greatly from China's boom.
More than half of Australia's exports are from agriculture, minerals and fuels, while a much smaller share of imports are raw materials.
This is shown partly by the fact that Australian exports to China has increased a whopping 150 per cent over the last 5 years in US dollars terms. By comparison exports to the rest of the world has increased only 20 per cent. China has as a result of this overtaken the United States as Australia's biggest export market. Moreover, since China's boom has raised commodity prices it has also improved Australia's terms of trade with the rest of the world.
Australia's economic future is thus highly dependent upon China's economic future. China's economy is in the long run likely to continue to grow rapidly because of its continuing free market reforms, its extremely high savings rate and its large excess supply of labor but since the extremely high growth rates in recent years has been largely driven by a rapid monetary expansion there is a very high risk of a sharp slowdown in growth. Such a slowdown would drive down commodity prices which in turn would hit Australia very hard.
A perhaps even bigger risk for the Australian economy than a slowdown in China is the incredible monetary induced housing price bubble that Australia has experienced in recent years.
Basic economic theory tells us that a higher money supply will raise prices (provided the newly created money aren't used to increase money holdings)-but the question arises-what prices will be increased? Monetarism simply assumes that all prices will increase equally but this is highly implausible.
Money is created by specific banks (including the central bank) and enters the economy in a specific way affecting some prices more and earlier than others as the receivers of the newly created money spend them in a very specific way.
So House prices have more than doubled in Australia during the latest 5 years, while residential construction are at record level rising from 5 per cent of GDP 5 years ago to 7 per cent of GDP now. This housing boom is partly driven by high immigration driven population growth but the main driving force is a rapid monetary expansion.
The M3 measure of money supply rose 191 per cent between June 1991 and June 2004, an annual average increase of 8.6 per cent RBA Statistic Bulletin. Between June 1999 and June 2004, M3 rose 56.8 per cent, an annual average increase of 9.4 per cent. Total credit has risen from 87 per cent of GDP in the second quarter 1991 to 106 per cent in the second quarter 1999 and to 131 per cent in the second quarter 2004.
What is of particular interest is to which sector this credit has gone to. And if you study the numbers you can see that the entire increase in credit has gone to the housing sector. Housing credit has risen from 22 per cent of GDP in 1991 to 43 per cent in 1999 and 70 per cent in 2004.
Non-Housing credit has in fact been steadily falling from 65 per cent of GDP in 1991 to 63 per cent in 1999 and 61 per cent in 2004 (In absolute numbers non-housing credit has risen slowly).
Thus, Australia's boom has not been a classic Austrian business cycle theory scenario where a credit expansion has helped fuel a boom in capital goods industries. Instead in this case the rapid credit expansion has been fuelling a housing boom because it is into this sector the newly created money has gone to.
The housing price boom and the housing credit expansion have been reinforcing each other. The housing credit expansion has been used to bid up housing prices while the ever increasing housing prices has been fuelling increased housing credit as home buyers need bigger and bigger mortgage loans to buy a home and as existing home owners have been able to use the rising value of their house to take out bigger mortgages.
The housing bubble has also contributed to a sharp decline in household savings as people have been felling wealthier as a result of the doubling of house prices. Household savings have fallen from 5.1 per cent in 1991 to 2.7 per cent in 1999 to -1.7 per cent in 2004 RBA Statistics Bulletin.
While the strengthening of the government budget balance has contributed to making the total national savings rate increase despite declining household savings, this has not been sufficient to cover the investment boom in particularly the housing sector. As a result Australia now has a current account deficit as large (5.7 per cent of GDP) as that in the United States.
Clearly, this cannot go on forever.
Housing prices cannot continue to rise indefinitely at a much higher pace than income and when the housing bubble bursts so will the construction sector and so will the household budgets who depend on the rising house prices. This will clearly drag down the Australian economy.
Just what this will mean for the overall outlook have depends on whether it will coincide with the other big threat to the Australian economy: a sharp slowdown in China. If it does not then there could indeed be a "soft landing" for the Australian economy particularly if the likely continued decline of the US dollar pushes commodity prices higher.
But if the two threats do materialize at the same time it does Australia could suffer a severe recession. When Finland in the early 1990s experienced the combined effect of the bursting of a real estate bubble and the collapse of trade with one of its main trading partners, the Soviet Union, it suffered the sharpest recession (Indeed the word depression is probably adequate) of any western nation since the 1930s, with GDP falling 10 per cent in 3 years and unemployment rising to 18per cent.
Because of the greater flexibility of the Australian economy and because of the likely response from the government with tax cuts, it will probably not suffer such a severe downturn as Finland did, but the 13-year expansion will certainly come to an end at that point.
BrookesNews.Com
Monday 22 November 2004