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Australia’s terms of trade boom and recession
Gerard Jackson
Treasurer Peter Costello recently warned that “Terms of trade booms have got Australia into trouble in the past”. He is obviously flagging trouble ahead for the economy. The problem is that he’s confused a symptom with a cause.
The sequence usually goes like this: A booming terms of trade fuels wage rises and inflation that eventually bring about a bust followed by rising unemployment. While the boom endures the terms of trade move significantly in Australia’s favour by raising the exchange rate. This process raises imports and squeezes domestic producers.
But what really happens? Let’s start with the terms of trade which is the ratio of export prices to import prices. As the ratio rises the country finds it can import more for the same unit of exports. Thanks to China the terms of trade started rising about seven years ago. Beijing triggered a massive boom that is largely driven by huge amounts of bank credit. It is this boom that sparked off our resources boom.
In a sense, therefore, our mining sector has to a certain degree become integrated into the Chinese economy’s higher stages of production. It ought to go without saying that when the Chinese boom ends so will our resources boom, unless some other emerging economic giant picks up the slack.
It’s being argued by some that by generating a boom in the resources sector the terms of trade could cause inflationary pressures if restraint is not imposed on other parts of the economy. This is a peculiar argument. In the absence of a monetary expansion so-called overheating cannot occur. What would happen is that other lines of production would have to curb their activities (assuming no additional capital goods were made available) as capital and labour were bid away by mining companies and those firms that service them.
Some also argue that because we have a floating exchange rate, an independent Reserve Bank and much more flexible labour markets the economy is far more capable of dealing with the expansionary effects on the economy of the boom in the terms of trade. What advocates of this view have apparently missed is that it is at heart a monetary argument.
On a truly floating exchange rate an influx of foreign currency would not add to the money supply and so inflate the economy: or overheat it as the process is now described. This is because someone bringing in foreign currency needs to find someone who will buy it with Australian dollars. Therefore the money supply remains unchanged no matter how much foreign exchange enters the country. Or does it?
Those who articulate this view are overlooking the untidy fact that it has been upset by the Reserve’s reckless monetary policy. Since March 1996, when Howard won his first federal election, until this March M1 has grown by about 120 per cent, currency alone expanded by over 84 per cent.
Hence we find that the neat little arrangement that a floating currency was intended to bestow on us has been subverted by the Reserve. Although it no longer prints money for the purpose of buying foreign currency, it has done the next best thing by providing it through the banking system.
Therefore the “unsustainable housing and consumption boom” was not the result of a surge in the terms of trade but a surging money supply the consequences of which have yet to work their way through the economy.
A short time ago I wrote that the Australian boom had reached its peak. I still adhere to that view. I also believe that the “terms of trade boom” generated by China’s demand for resources delayed the day of reckoning. By raising the terms of trade imported capital goods became cheaper. According to the Treasury about 66 per cent of imports are capital goods (including intermediate goods). Cheaper capital goods may therefore have temporarily lessened the pressure on manufacturing costs.
One of the symptoms of a boom at its peak is a decline in productivity even as real wages are still rising. Eventually the growth in wages and the demand for labour begin to slow, after which manufacturing starts cutting production and shedding labour. This is how the Clinton boom played out and it looks very much that our boom is about to repeat the same pattern.
Note: Some readers have misinterpreted the what I meant by the peak of the boom. They seem to think that once the peak is reached the economy immediately contracts. No economist ever made such a claim. There really is no way of calculating how long an economy will remain at the peak of a boom before it begins to contract. One needs also to take into account the reaction of the monetary authorities to any sign of a slowdown.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 20 March 2006