1
Economic breakdown as a threat to prosperity
Australia has long been a country of high incomes, one in which it is easy to take prosperity for granted. However, neither God nor nature guarantees the Australian standard of living.
It is now certain that Australians who are currently children will face the challenge of responding to climate change, which will involve modifying the way of life to which they have been born. Whether this can be done without permanent sacrifice of their standard of living is unknown and at present unknowable.
Australia has had little experience of environmental limitations to prosperity, though it has had some: right across the country at a latitude of 30 to 35 degrees there stand the ruins of farmhouses abandoned due to drought, often in combination with a sheen of salt on once-fertile paddocks. In the course of their long occupation of the island-continent, the Aboriginal peoples survived an Ice Age and a major rise in sea levels, while today, across wide swathes of the country, the former Aboriginal hunter-gatherer lifestyle is no longer possible due to loss of the plants that Aboriginal people gathered and the animals that they hunted. The threat of climate change is real, but this is not a book about it — not, that is, until we discuss policy responses in the last chapter.
A second threat is easier to imagine, because there are instances of it in the historic record, though no longer within living memory. This is the threat of war. During both the First and Second World Wars, the Australian standard of living fell appreciably. Consumption fell by 24 per cent between 1913 and 1918, and by 30 per cent between 1938 and 1944.1 During wars, resources are diverted from consumption to defence, so the decline in the value of Gross Domestic Product (GDP) was less, though still significant — 12 per cent during the First World War, and 15 per cent during the Second. As with climate change, the threat of war is real, but this is not a book about it, either.
And then there is the threat of economic breakdown, which is the subject of this book.
The concept of economic breakdown
Economic breakdowns come in a great variety. The closure of a single factory can be enough to break the economy of a country town; the closure of an industry can break the economic prospects of a generation of skilled workers. A breakdown may be regional — a dust bowl, a rust belt — but it may equally be nationwide, or indeed part of a worldwide slump. Apart from the two World Wars, Australia has twice experienced national economic breakdown. Between 1891 and 1897, GDP fell by 27 per cent, and between 1928 and 1933 it fell by 22 per cent.2
There are two sources of economic breakdown widespread enough to affect whole countries, rather than merely particular regions or industries. One source is overseas, in the form of depressed export sales for a wide range of industries and regions (as, for Australia, in the Depression of the 1930s); the other source is domestic, lying in the mismanagement of the two sectors that have dealings right across the national economy. These two sectors are government and finance (which, in Australia, were jointly responsible for the Depression of the 1890s).
Needless to say, a breakdown can have mixed causes — an adverse external shock is much more likely to tip a country into economic breakdown if its public or finance sectors have been mismanaged, and when a breakdown originates overseas, the government and finance sectors quickly find themselves at the centre of events. The reason why the government and finance sectors are so central is that economic breakdown arises from bad debts. Borrowing and lending are central to the capitalist system, and, thanks to the uncertainty of economic affairs, carry an unavoidable risk that debts will go bad. Economic crises arise when so many debts threaten to go bad that the system breaks down.
Though economic breakdown always involves defaults and threats of default that are generalised to the whole economy via the public sector, the financial sector, or both, they vary in their origin. They may be generated primarily overseas, or in the domestic government or financial sectors; they may generate different flow-on combinations of economic woes, including unemployment and inflation; they may be mild or severe. In their book on the international history of financial crises, This Time is Different, C M Reinhart and K S Rogoff distinguish several main types of crisis. The first type is an inflation crisis, for which they set a threshold of general prices rising by 40 per cent a year or more, usually as a result of mismanagement of the public finances. (Inflation is a time-honoured way of defaulting on public debt.) Closely related are currency crashes, where a country’s currency depreciates against the currency of its trading partners by 25 per cent a year or more.
Mismanagement in the private sector more often results in a banking crisis, a crisis in which banks and other financial institutions encounter difficulty in meeting their obligations. The primary source of such difficulties generally lies on the asset side of bank balance sheets, in the form of bad debts to the banks (sometimes glossed over as ‘non-performing loans’), but a bank can also run into trouble on the liability side of its balance sheet when the cost of one particular liability (typically ‘loans raised overseas’) rises so much that the bank is unable to meet its obligations for other liabilities (say, ‘domestic deposits’). Banking crises do not always reach the stage of outright default, since this is often averted by the reconstruction of major parts of the financial system, usually with government involvement.
The public-sector counterpart of a banking crisis is a government debt crisis. It has been claimed that governments do not default on debts contracted in their own currency, since they can always print money and so relieve themselves of debt by causing inflation, but Reinhart and Rogoff instance episodes in which governments have preferred default to printing. More commonly, governments in financial crisis may default on debts incurred in external currencies. These might be debts incurred through government overseas borrowing, but may have been originally incurred through private borrowing and transferred to the government in its capacity as manager of a country’s foreign-exchange reserves.
Armed with these definitions, Reinhart and Rogoff find that, over the long haul since the early nineteenth century, Australia has been reasonably free of inflation (only during the 1850s gold rush did the rate breach their 40 per cent threshold), and Australian governments have honoured their debts, both external and domestic. (When New South Wales attempted to default in the early 1930s, it was brought to heel by the Commonwealth.) However, Australia (or at least its eastern states) underwent a major banking crisis in 1893, involving bank closures, the severe curtailment of credit, and a Depression with soaring unemployment. Like many of his fellow Victorians, one of our grandfathers weathered the Depression on the goldfields at Kalgoorlie in Western Australia.
It is notable that Australia survived the Great Depression of the 1930s without a banking crisis. The economic breakdown of those years was transmitted from abroad — a major contrast to the Depression of the 1890s, which occurred despite reasonably buoyant world trading conditions.
Thus summarised, Australia’s largely forgotten history of economic breakdown has much in common with that of other countries: severe costs during the World Wars and the Great Depression, plus a home-made Depression in the late nineteenth century. The Second World War was followed by six decades during which Australia shared in the post-war economic recovery and then in the general prosperity and economic growth of the wealthy countries.
The post-war intention on both sides of the Iron Curtain was to eliminate economic crises and the associated Depressions. So long as the policy agencies in each country concentrated on this aim there was a degree of success, and few countries experienced economic crisis in the two decades following 1945. However, as the 1930s receded into history, the various national policy agencies faced new challenges, such as the change in the distribution of world wealth that followed from increased oil prices. All the wealthy countries, Australia included, shared in the 1970s combination of stagnation and inflation, which they muddled through without any of them incurring the feared hyper-inflation or serious Depression.
However, the decade of stagflation prompted fundamental revisions to economic policy, based on the revival of neo-liberal economics. We describe this revival in more detail in Chapter 2; here, it is sufficient to note that it originated in the United States, and was adopted with some enthusiasm in other Anglophone countries, although with less enthusiasm by countries subject to the ministrations of the International Monetary Fund (IMF). Here, we stick to the background story of the international incidence of banking crises.
Economic breakdowns from the 1970s onwards
As the post-war period receded into history, crises involving serious falls in GDP became more common. Starting in the economically less robust countries, particularly in Latin America, in 1998 the trail of crisis moved to the ‘Tiger Economies’ of East Asia, and finally in 2008 reached the core of the global economy in the United States and Europe. Economic crises had not, after all, been consigned to history.
An economic crisis is worse than the recessions of the kind that, from time to time, arrested economic growth during the post-war period. It is catastrophic; a conflagration that leaves no citizen unaffected, no element in the capital stock untouched, and which so devastates the foundations of the economy that a complete restructure is required.
Across the world, the years since 1980 have seen economic catastrophes from both war and hyper-inflation, but these have been confined to low-income or, at the most, middle-income countries. The high-income countries have been affected but not thrown into crisis by the costs of war, and they have experienced inflation, but again not so badly as to suffer catastrophe. Neither war nor hyper-inflation are current threats in the high-income countries, but unfortunately this does not preclude banking crises that, uncontrolled, snowball into economic catastrophes.
As Reinhart and Rogoff emphasise, banking crises arise out of bad debts; more specifically, from defaults on financial contracts. Banking crises arise fundamentally out of failed attempts to take the risk out of lending by the issue of supposedly risk-free debt, rather than by equity instruments in which the lender shares the risk. The genius of capitalism is that it is able to raise funds for risky investments by equity financing — this underlies its record of innovation. But let the investor beware: the investment prospectus may be shonky; the risks may be under-stated, and even if they are correctly perceived, the uncertainties of innovation are such that much of the equity invested in innovation will go bad.
The precise purpose of equity markets is to deal with this, and because they deal in uncertainty they are inherently unstable and prone to cycles of optimism and pessimism, boom and bust. It is important that equity markets are able to rise and fall without seriously affecting the ordinary flow of production — as, for example, the dot.com bubble of 1995–2001 inflated and burst without causing serious economic breakdown. The bursting of such an equity bubble creates financial losses, but they are not likely to be unmanageable unless they have been converted into bad-debt losses by investors who are not in a position to bear uncertainty.
In theory, the same story should apply in property markets, since property is an equity investment. However, equity in property is usually leveraged with debt, which means that property bubbles are a dangerous source of bad debts.
The historical experience is that fixed-interest lending can deal with a certain level of bad debts. Banks have historically been major sources of finance for businesses too small to have access to equity markets. Though the risky nature of small business provides a strong argument for equity rather than debt support, banks are an established source of funds, especially to businesses that can provide collateral and accept basic management advice as a condition of the loan. However, fixed-interest lending becomes dangerous when it finances propositions more suited to equity lending — if indeed they are suited to lending at all. The old golden rule was that a lender who finances consumption is taking on a high risk of default.
No matter what the country, the government and finance sectors both have the potential to generate a banking crisis that ends in economic catastrophe by incurring more debts than they can handle. Governments are constantly caught between the Scylla of expenditure demands and the Charybdis of tax resistance; they are tempted to the insidious accumulation of debt that turns bad when it fails to generate additional tax revenues. Similarly, financial institutions are under constant temptation to seek high returns by accepting high levels of risk. When they succumb to this temptation they also may find themselves lumbered with unmanageable bad debts. The temptation to engage in excessive borrowing tends to be strongest in times of euphoria, when uncertainty is downplayed — hence the association of excess debt with booms, particularly consumption booms.
As is often the case with temptations, behaviour that is desirable or at least tolerable in moderation becomes disastrous when carried to excess. Current rhetoric would have it that government deficits — government borrowing — are always and everywhere undesirable. But the truth is that, in moderation, they can help to accumulate public capital that pays for itself through increased tax revenues. Deficits can also be appropriate when they finance the utilisation of resources that would otherwise be unemployed — once again yielding revenue that would not otherwise be received. Conversely, current rhetoric would have it that bank borrowing to finance credit for home-buyers is generally desirable; but when such lending ends up financing rising urban land prices, rather than actual construction, the loans have a nasty propensity to turn bad.
The risks inherent in overseas borrowing
Moderation is a particularly important central principle for countries that borrow overseas. Borrowing overseas must not only generate cash flow to service the loan; it must do so in the context of a balance of payments sufficiently robust to generate that flow in foreign exchange acceptable to the lender. The United States is in a special position in this regard — despite its persistent balance-of-payments deficits, its dollars and Treasury Bills are still widely acceptable internationally, and frequently comprise the greater part of the foreign-exchange reserves of other countries. No other country is in a position to borrow overseas so readily and so completely in its own currency. Despite the overhang of overseas debt accumulated during decades of heavy overseas borrowing, the great American recession of 2008 did not result from problems in financing overseas borrowing, but from bad debts contracted by an excessively clever finance sector. In this, the United States is a special case; no other country has such ready access to overseas credit, and countries that ape American insouciance regarding overseas borrowing are courting disaster.
Australia has a long history of overseas borrowing, much of which has been win-win in nature — it accelerated economic development to the benefit of domestic consumers and overseas investors alike. However, in the nineteenth century the Australian colonists discovered how easy it was to borrow in London, and the country has been tempted ever since to borrow overseas more than its balance of payments can bear.
Of the forty or fifty economic catastrophes that have occurred over the past three decades in countries with developed financial systems, thirty or forty have taken place in countries that have significant overseas debt. These crises were generated when the country’s creditors came to fear that they might not be repaid on time and in an acceptable currency. Once afflicted by such fears, creditors want their money back quickly. Each crisis has followed its own course, as determined by the economic structure of the borrowing country and the decisions of its policy authorities and its creditors. However, the number of heavily indebted countries that have experienced catastrophe, in the form of a rapid and significant decline in GDP and rise in unemployment, now exceeds the number that have not, and they have provided sufficient combined experience for researchers to generalise from them. The researchers have concluded that excessive overseas borrowing has been a major source of economic breakdown. The second is that, once a crisis begins, it feeds on itself and becomes very hard to arrest.
There are different forms of overseas borrowing, each with its costs and benefits, including direct equity investment, portfolio investment in equities, property investment, interest-bearing loans to private businesses, and fixed-interest loans to financial intermediaries and governments.
The form of overseas borrowing that is least likely, dollar for dollar, to generate economic breakdown is direct equity investment by overseas businesses, usually in the form of subsidiary companies. From the recipient country’s point of view, such equity investment is a form of overseas borrowing, but the equity arrangements take uncertainty into account. The owners monitor the performance of these businesses, and may withdraw their funds if business prospects dim. This is most commonly accomplished by subtle means, such as over-invoicing for inputs from the parent firm of a multinational business, a slow process that may underlie a crisis but is unlikely to be the precipitating factor. Even if disinvestment involves an outright sell-out, the effects are likely to be at the industry or at most regional level, and not a cause of general crisis. Many overseas fixed-interest loans direct to non-financial businesses have similar characteristics, though some are more akin to portfolio investments.
Overseas portfolio investors in equities participate in the alternating capital gains and losses of the share market. Overseas loss of confidence in the market is most likely to occur when a speculative bubble bursts, and can precipitate a crisis as overseas investors sell off and seek to repatriate their money immediately. However, overseas portfolio investors may also have steadier nerves than domestic investors, in which case they may ameliorate the effects of a burst bubble. On the whole, overseas portfolio investment can accentuate crises, but is not particularly likely to precipitate one.
Overseas equity investment differs from portfolio investment in that it is location-specific; it can exacerbate booms and busts in the property market in particular locations. It also interacts with domestic investment in property, much of which is financed from mortgage loans. As with portfolio investment in equities, it can accentuate or dampen domestic price trends; but, unlike portfolio investment in equities, these movements will be multiplied by resulting trends in domestic debt. If overseas property investors lose confidence and decide to exit the market, prices will fall and there will be a multiplier effect as domestic mortgages go bad, with regional and probably national effects.
Overseas fixed-interest loans to governments and financial intermediaries are under constant re-appraisal, not only by individual lenders (whose lending position may be affected by developments in their home market), but by ratings agencies — not that the agencies have proved at all prescient as to impending crisis.3 Reviews of the quality of debt — its probability of repayment on time and in full — are affected by the balance-sheet and cash-flow position of the banks and governments issuing the debt, and also by the balance-sheet and cash-flow position of the country as a whole, particularly by any fall in export revenue (whether due to falling export prices or falling quantities). Falls in export revenue reduce the flow of foreign exchange available for servicing overseas borrowing. Even in the absence of trade shocks, debt may be downgraded simply because the country’s creditors begin to think that it has borrowed too much, or maybe because they perceive similarities to countries that have borrowed too much. There is a long history of countries that have seen their debt downgraded because the hotshots of New York made false comparisons, as when Wall Street downgraded Norway because of defaults in Iceland.
As regards exposure to economic breakdown, the most dangerous form of overseas borrowing is borrowing by the finance sector, in particular by banks. This is because changes in the terms and conditions of overseas borrowing by banks translate directly into the terms and conditions of their domestic lending. Government borrowing is also dangerous in that changes in the interest rates that governments are obliged to pay on their overseas borrowing are likely to translate directly into domestic interest rates.
Whatever the cause of the change in a borrowing country’s credit rating, a banking crisis will ensue if a significant number of foreign investors come to the conclusion that their money is seriously at risk. When the creditors thus change their minds, they demand that their loans be repaid as they fall due. Banks that have borrowed overseas will scramble for foreign exchange with which to repay their debts, an obvious step being to offer higher interest rates to reward overseas lenders for rolling over their loans. This requires an increase in the interest rates charged to the banks’ domestic borrowers, which can have the mild effect of reducing domestic demand for new borrowing and the salutary effect of increasing the proportion of bad debts in the banks’ domestic-lending portfolio.
This, in turn, can generate a vicious cycle. The rise in interest rates plunges the economy into recession. Slack demand increases the default rate on business loans, and rising unemployment increases the default rate on household loans, further weakening bank balance sheets and so worsening the recession by curtailing the supply of credit. The outwards rush of funds also triggers an exchange-rate crisis (that is, a rapid fall in the currency), which feeds on itself by undermining the confidence of other foreign and domestic investors. This not only reinforces the falling exchange rate; it can unleash intense inflationary pressures as capital and labour fight to retain their share of a diminished national income. This fight has the potential to convert recession into Depression.
At the point where the outflow of overseas currency exhausts the country’s reserves of foreign exchange, it is no longer possible to pay for imports. The country will then suffer further economic disruption, not only because consumers can no longer buy imported goods and services, but because domestic producers are unable to buy the imports that are necessary to their operations. Further, if the banking sector had been active as a transmission mechanism for foreign loans, and has significant foreign liabilities on its balance sheets, the sector’s problems due to bad debts will be greatly exacerbated by the rising domestic-currency value of its overseas borrowings, leading most likely to a banking collapse with further dire consequences for economic activity.
In recent crises in various countries, official reactions to the fall in the exchange rate have included the imposition of international capital controls, sometimes combined with attempts to fix the exchange rate at low levels. Quotas have been imposed on imports by rationing foreign exchange, sometimes with multiple exchange rates for different categories of goods and services. There are precedents for the policy authorities moving to augment the resources available to repay overseas lenders by the compulsory acquisition of residents’ foreign assets, and by large-scale government borrowings from the IMF and/or from consortia of ‘friendly’ countries. The last resort is full or partial default on foreign debts, perhaps including ‘haircuts’ imposed on foreign lenders, with a consequent fall in the country’s credit rating and a reduced access to overseas borrowing.
In recent crises in countries similar in size to Australia, the conditions imposed by creditors have included minimum government surpluses; fixed repayment schedules for foreign debt (especially debts to foreign governments or their agencies incurred during the crisis); imposed structural-reform measures; limits on nominal wage increases; limits on particular types of expenditures, including social security and other safety-net expenditures; and minimum net tax rates on household incomes. All of these measures curtail the power of the government of the indebted country and commit it to prioritising the expectations of its creditors over the needs of its citizens. Since the Global Financial Crisis (known in the United States as the Great Recession), the effectiveness of these measures has been debated, but they remain a risk that indebted countries should take into account.
Financial crises originating in excess overseas borrowing vary in severity. The Asian financial crisis of 1998, though sharp, turned out to be relatively mild. The cessation of borrowing coupled with measures to reduce imports (which diverted foreign-exchange earnings to loan servicing) and fresh international loans (or, in the Malaysian case, a mild rescheduling of repayments) proved sufficient to restore confidence. The regional fall in GDP was limited to 5 to 10 per cent, followed by a quite rapid recovery. Elsewhere, crises have included serious foreign-debt defaults and have generated peak-to-trough falls in GDP in the 20-to-30 per cent range. In recent times, the most extreme example of a country experiencing a severe crisis was Greece, with a 50 per cent fall in its GDP. However, the Greek case was atypical, because Greece is a member of the Eurozone, and its exchange rate is fixed. It is possible that the fall in GDP would have been less had it had its own currency to devalue.
Can economic breakdowns be avoided?
These costs are very large indeed, much greater than the cost of a typical recession. A major, if negative, goal of economic policy must therefore be the avoidance of such economic catastrophes. However, this goal has to be placed in context. In a medium-sized, open economy such as Australia, the threat of catastrophe is inherent in the country’s principal source of prosperity: trading and investment relationships with the rest of the world. The risk of this type of catastrophe can only be completely removed by eliminating overseas borrowing. A more workable choice is to accept that the threat of catastrophe lurks amid the opportunities opened up by international trade and investment, and to try to manage the threat. The need is for moderation in borrowing, and the adoption of a prudent approach to international economic relationships, as indeed there is a need for prudence in domestic economic relationships.
In the light of recent experience, many observers would write off calls for moderation and prudence as no more than pious hopes. Both optimism and pessimism are contagious, and what hope has moderation when faced with a fearlessly buoyant finance sector, or equally when trying to entice the sector out of a blue funk? Who is to keep a level head when all around are losing theirs? Since it is noticeable that busts generally follow booms, pessimism follows optimism, and funk follows elation, the calls for moderation concentrate on restraining over-optimistic behaviour. Once an economic breakdown threatens, and even more when it is under way, the actions required to limit the damage and reconstruct the economy are very challenging indeed. Hence the importance of avoiding crises, if at all possible.
As always, the pursuit of moderation itself requires moderation. It is too much to expect any human person or institution to observe continuous moderation in all things; too much moderation is not only inhuman, but may also suppress the restless spirit of innovation that is an important element in capitalism. However, it may not be too hard to invent institutions that identify and counterbalance threats of serious economic crisis — government and financial institutions that provide shelter from the excitements of everyday market action, and cultural institutions that can stand back from the excitements of the day. The particular challenge is to put in place institutions that can stand their ground, not only when memories of disaster are fresh, but during the following periods of complacency. The post-war experience is relevant: was the increased global incidence of banking crises after 1980 due to fading memories, or was it due to a failure to maintain defensive institutions?
Some of the concerned institutions will be internal to the sectors that are most at risk. As a matter of internal culture, it is important for governments and banks to value moderation and prudence, leaving the response to emerging opportunities to those with a real appetite for risk, and ensuring that these entrepreneurs have access to equity and venture finance. As regards institutions, within government it is the duty of Treasuries to counsel moderation, particularly as regards overseas borrowing. They should oppose borrowing that is unlikely to generate foreign exchange for loan-servicing; they should champion borrowing with good prospects of repayment plus a surplus. Within banks, it is the duty of treasuries to act in the long-term interests of the bank and to identify and oppose risky lending, no matter how juicy the apparent short-term profits.
We will argue that individual bank treasuries cannot do this unaided, particularly as regards loans financed from overseas borrowing. This requires the imposition of a second line of defence — national authorities charged to ensure that risky financial activity is confined to people who know that they are taking a gamble, and is not foisted off, unknown, onto a trusting public. Such prudential authorities, as well as the national Treasury, should be the custodians of the lessons of history and have the power to act, if not to maintain their economy on a precisely even keel, at least to head off catastrophe. They will therefore be attentive to the signs of economic breakdown and be ready with strategies to avoid it, if possible, or at least to minimise its impact. In this task of watching for danger signals, the prudential authorities (and, more broadly, economic analysts and the media) can take advantage of recent experience in countries that have experienced an economic breakdown. In particular, the European Union (EU), has made a concerted effort to learn from recent experiences both within and outside the union.
The European Commission indicators of macroeconomic imbalance
In recent years, much has been written about the dysfunctionality of the European Union, and, as we note in Chapter 8, the British public has voted that they would be better off out of it. This dysfunctionality is highly political, and is not helped by poor institutional design. To its credit, the European Commission (EC) has recognised the need for governments to coordinate economic policy, and is seeking to control the incidence of bad debts internationally by discouraging both over-lending and over-borrowing. To this end, it has persuaded its members to participate in a ‘macroeconomic imbalance procedure’. Though, in theory, the procedure aims to identify which countries are over-lending as well as those that are over-borrowing, in practice the emphasis has been on the excessive accumulation of debt that results in financial crisis.
In 2011, the commission identified ten statistical indicators that, it argued, provided an early warning of macroeconomic imbalance sufficiently reliable to warrant corrective action being embarked upon, and also gave sufficient warning time to allow such action to be taken.4 The ten indicators are used to identify countries that are at enough risk of crisis to warrant a detailed investigation — following which, use would be made of ‘auxiliary indicators’ to allow a more nuanced assessment of the position. A year later, the commission promoted one of the auxiliary indicators to scoreboard status,5 and three years later it raised the status of three more.6
In the interests of ease of interpretation and statistical accuracy, the number of indicators was initially restricted to ten, with an emphasis on the competitiveness of each economy and on weaknesses that had in the recent past led up to economic catastrophe. The list emphasises indicators of structural weakness in trade and international investment, and that provide warnings of potential catastrophe for the information of the policy authorities in each country and also for each country’s partners in trade and investment. Within the EU, the indicators underpin policy discussions; outside the EU, they have no such formal status, but are still valid as warnings based on recent experience. It remains uncertain whether the indicators will give sufficient early warning to permit corrective action, and even less certain what that corrective action might be, or whether corrective action is politically possible. However, an early warning is at least a beginning.
The EC has specified a threshold for each indicator (for some, two thresholds, upper and lower), defined as the value of the indicator that, if exceeded for a period of time, has the potential to push the country into crisis. If several of the threshold levels are exceeded simultaneously, and if further investigation of other aspects of the economic position corroborates the indicator findings, an alert may be issued that a crisis threatens and that it would be prudent for the authorities to make whatever policy changes might be possible to avert the danger.
Rated by the EC indicators, Australia’s performance ranges from exemplary to atrocious.7
Australia assessed by the EC indicators
Indicators of satisfactory performance
The EC indicator for which Australian performance has been most exemplary is government debt. The EC threshold for this indicator is set at 60 per cent of GDP. Above this level, the EC considers that current and future economic-growth prospects may be diminished by expenditure reductions and/or tax increases required to keep faith with government creditors. At 28 per cent, Australia’s current level of national, state, and local government borrowing is at less than half the level that would ring alarm bells at the EC. Australian governments have been less addicted to borrowing to finance tax cuts and expenditure increases than their equivalents in Europe, not to speak of the United States. This is not to argue that all is well: the tax cuts that accompanied the early phase of the mining boom are now widely regretted as imprudent, while the expenditure constraints have seriously curtailed government infrastructure investment. Again, the trend is unfavourable, and the current level of 28 per cent is the highest recorded over the years since 1992.
This said, the media rarely congratulate Australian governments on their exceptionally low deficits, nor do they point to the scope for government borrowing to finance infrastructure investment. Indeed, analysts either directly or indirectly associated with the finance sector have been allowed to dominate public discourse on economic policy, and spend their time harping on the dangers of government-sector debt, so diverting attention from the accumulating debt of the private banks.
A second area where Australian performance has been reasonably good compared to the EC threshold is the labour market. The EC sets a threshold for the unemployment rate of 10 per cent, with higher levels indicating a lack of adjustment capacity in the economy. Australia, as a whole, has not recorded this level of unemployment since 1992.
A related indicator is the three-year percentage increase in unit labour costs, where the EC threshold is set at 12 per cent. Above this rate, the EC fears that inflation will rise to the point where profits and investment are compressed, and economic growth is curtailed. Once again, Australian performance over the past quarter-century has been good, with the indicator rising above the threshold level in only three years: 2006, 2008, and 2011.
A further indicator measures the competitiveness of a country’s exports by the change in its share of the market in the countries to which it exports. Australian performance on the basis of this indicator has again been satisfactory, but the indicator does not take into account the fact that, as a commodity and particularly a minerals exporter, Australia is subject to wild fluctuations in the prices it receives for its exports.
By contrast with government debt, labour-market flexibility, and, with caveats, export competitiveness, Australia’s performance has been less than satisfactory when measured by two groups of indicators, both closely associated with the generation of financial crisis via bad debts: its financial relationships with the rest of the world, and the level of household debt.
Indicators of unsatisfactory performance: international trade
The EC scoreboard includes three indicators of a country’s economic relationships with the rest of the world. The first relates to the volatility of its exchange rate, as measured by the three-year percentage change in its real effective exchange rate against the currencies of other countries. Two thresholds apply. If the exchange rate rises by more than 11 per cent over three years, there are likely to be unmanageable price pressures on domestic producers, resulting in long-run loss of competitiveness. In the other direction, if the exchange rate falls by more than 11 per cent over three years, there are likely to be unmanageable inflationary pressures. Australia has suffered both these evils. In six of the past 25 years, the exchange rate has been more than 11 per cent below the rate applying three years previously, and in nine of the past 25 years it has been more than 11 per cent above. An exchange rate that gyrates like this is a severe handicap to long-term planning in trade-exposed industries, so it is no wonder that Australia’s trade performance has been less than satisfactory and has resulted in a dangerously high level of overseas debt.
Second, the EC measures the flow of overseas borrowings by the three-year backward moving average of the current-account balance, taken as a percentage of GDP. (The current account offsets foreign exchange received from export earnings, income earned overseas, and gifts from overseas against foreign exchange spent on imports, income payable to overseas investors, and gifts to overseas.) When seriously negative, this is an indirect indicator of unsustainable overseas borrowing or, at best, an indicator that international investment in Australia is growing too rapidly for comfort. The threshold here is set at -4 per cent. There is also an upper threshold, of less relevance to Australia: if the current-account balance rises above +6 per cent, the EC argues that the country is engaged in unsustainable lending. Between 1992 and 2010, the Australian economy more often than not exceeded the 4 per cent current-account-deficit threshold. At the end of 2016, commodity prices rallied to produce a relatively low current-account deficit for 2016–17. However, the rally was due to temporary factors that are expected to fade, including the unfortunate combination of waning demand for commodities as world growth falters and increases in their supply as capacity-enhancing investments come on stream.
The third of the group of three indicators covering relationships with the rest of the world is the net international investment position (excluding equity investment) as a percentage of GDP. The EC threshold is 35 per cent; above this level of debt, a country is likely to have difficulty managing any crisis in international banking that may come its way. As a consequence of its persistent current-account deficits, Australian performance on this indicator has been consistently woeful, with the threshold value exceeded by at least 14 percentage points in all of the past 25 years. Currently, the indicator value is 57 per cent compared to the threshold value of 35 per cent. Australia has elected to live with the high-level risk that its external borrowing will prove to be unmanageable.
Indicators of unsatisfactory performance: debt
The obvious question is, why has Australia borrowed so much? Thanks to the imprudent behaviour of governments in the United States and Europe, the international literature comes close to making it axiomatic that excessive overseas borrowing arises from government deficits. Australian governments have, relatively speaking, controlled their deficits, so why is the level of overseas borrowing so dangerously high? The answer lies with the private sector, which the EC scoreboard covers with a further three indicators.
The first of these indicators of private-sector debt accumulation is private-sector credit flow as a percentage of GDP. The EC threshold for this indicator is 14 per cent, above which level there must be grave doubts as to the quality of the loans being made. Australia has exceeded the EC threshold for ten of the past 25 years, chiefly in the late 1990s, the mid-2000s, and in 2013, 2014, and 2015.
The EC scoreboard also includes gross private financial liabilities (excluding equity) as a percentage of GDP. Excessive private debt constrains both business investment and household expenditures, and hence constrains economic activity. The EC threshold is 160 per cent of GDP, a level that Australia reached in 1998. The level has since risen to 245 per cent, providing a counterpart to the high level of overseas borrowing. Most of the increase has been due to borrowing by the household sector that, having in 1992 accounted for one-third of private-sector debt, was responsible for 55 per cent of such debt by the eve of the Global Financial Crisis. This proportion has been maintained since.
One of the major influences on household borrowing is the level of house prices. The EC scoreboard includes the annual change in real house prices (that is, the excess of house price increases over the consumer price index). Increases in real house prices encourage households to borrow: households aspiring to ownership borrow more to cover the enhanced prices, while households that are already owners are encouraged to borrow because of their increased wealth. Mild increases in relative house prices are manageable, but rapid increases are associated with destabilising bubbles. Reinhart and Rogoff list real housing prices along with changes in the real exchange rate as the best available warnings of an imminent banking crisis.8 The EC has set its threshold of manageability at 6 per cent a year. Taking house prices nationally (and so disregarding the differences between its many geographically separate house markets), Australia exceeded this threshold in eight of the past 25 years — the early 2000s and, of more concern, every year from 2013 to 2015.
Currently, five of the 10 original EC scoreboard indicators for Australia are flashing red. That is, they exceed their threshold values. The EC has found that, typically, in the European Union countries that had recently fallen into crisis — namely Greece, Spain, and Ireland — the thresholds of five or six indicators had been exceeded on the eve of their crises. There has been little improvement since: in 2014, Ireland was in breach of six indicators; Spain, five; and Greece, four.
The European Commission’s macroeconomic-imbalance scoreboard accordingly identifies Australia as a candidate for economic breakdown. The next step in the EC procedure would be to conduct an in-depth review that takes auxiliary indicators and trends into account, to judge whether Australia suffers excessive imbalances warranting the implementation of a corrective-action plan. These EC processes are highly political and far from perfect — corrective-action plans have not been imposed on the three countries that are running excessive current-account surpluses — but they at least serve to put EU member countries on notice that they, and the union more broadly, need to take action to avert crises.
Australia is not a member of the EU, and therefore will not be subject to an in-depth review. However, the EC indicators serve as an alert, not only to borrowers in Australia but to lenders overseas, that the time has come to think deeply about Australia’s financial structure. Such a re-think cannot undo history, but requires an assessment of the path by which Australia has acquired its current unenviable EC indicator values. We resume the discussion of the EC indicators in Chapters 3 and 4. Before then, we need to look at how Australian economic institutions evolved after the end of the Second World War.