7

Neo-liberalism comes full circle

In democracies, the quality of political leadership has two main components: the quality of the policy platforms endorsed by the electorate when it elects a national government, and the personal characteristics of the leadership group elected to national government, such as their competence, experience, and capacity for rational and competent judgement when negotiating trade-offs and deciding complex policy issues. Above all, it is important for the government to avoid corruption and to have the capacity and the willingness to act in the national interest, as distinct from the interests of those who contribute to its political funding, whether by way of bribes or party contributions.

In this chapter, we address the first component. In particular, we consider the party platforms put before the American electorate in November 2016, and argue that the Washington Consensus, which was implemented in the 1980s in both the United States and the United Kingdom, has now generated political dysfunction as true believers in the neo-liberal faith face an unco-ordinated array of critics.

More than three decades have passed since Washington Consensus policies were implemented with great elan in the United States by Ronald Reagan, a Republican president, and in the United Kingdom by Margaret Thatcher, a Conservative prime minister. Over the following three decades, disposable incomes at the top end of the income scale surged upwards, but the incomes of the majority of the population stagnated. As a Republican, the new United States president, Donald Trump, finds himself suspended between a party establishment that has greatly benefited from the Washington Consensus and a public that has not.

There is a cynicism abroad, related to the increase in economic inequality, or at least to the gulf between promises of economic growth and the actual experience of people of average income. Three decades of neo-liberalism have generated a social malaise that is not yet fully understood. Is it simply disappointed economic expectations — underemployment, unaffordable housing? Or does it go deeper, to the loss of egalitarianism as the economic elite retreat behind their sense of superior entitlement and condescend to all the rest? Is it the loss of trust as people realise that their bank manager has become a salesman? Or is it, maybe, a loss of identity as traditional social institutions such as churches, general stores, and country pubs close, each in their own way losing out to market competition?

The end-result has been the creation of divisions between segments of society so deep that compromise cannot be reached on what policies are necessary to achieve more acceptable economic outcomes — hence political dysfunction. The United States provides a prime example; the United Kingdom, another.

The 2016 United States presidential election

The election of an American president who repudiates important elements in the Washington Consensus was not a surprise to anybody with a rudimentary knowledge of United States income-distribution statistics. The real surprise was why it had taken so long for the political tensions arising from increased inequality to have electoral effects.

The key to Trump’s election was the changed voting pattern of non-college-educated white voters. While the share of this demographic in the total electorate fell from 83 per cent in 1960 to 34 per cent in 2016, it is still a strong voting bloc. When 67 per cent of this bloc voted for the Republican candidate, up from 61 per cent in 2012, they delivered the electoral-college votes of three previously Democrat-majority states (Pennsylvania, Michigan, and Wisconsin) to the Republican candidate.1 This made the difference between winning and losing in a close-fought election. The winning margin across the three states was small — less than 1 per cent — indicating the importance of the shift in the white, less-than-college-educated vote. Over the last three decades, these three ‘rust belt’ states have lost substantial industrial capacity as the combined result of technological change and increased imports, especially imports from China and Mexico. The result of the 2016 US election seems to reflect the rejection of globalisation, particularly of unfettered imports and immigration, by middle-income citizens.

The increase in income inequality that took place during the Washington Consensus era helps to explain the current political dysfunctionality of the United States. During the post-war period from 1950 to 1979, the top 1 per cent of households ranked by income received 10 per cent of household income (including capital gains, and before taxes and transfers), and households in the top 0.1 per cent received a little over 3 per cent. By 2012, the respective income shares were 21 per cent and a little over 10 per cent. Wealth has always been more concentrated than income, and by 2012 the richest 1 per cent of households held 42 per cent of all wealth, and the top 0.1 per cent held 22 per cent. More graphically, during the Washington Consensus era from 1980 to 2012, markets awarded the whole of the increase in the national income to the richest 10 per cent of households. Even among these top incomes, the rewards went mainly to the rich. The highest-income 1 per cent of households claimed 70 per cent of the increase in national income, and the top 0.1 per cent cornered 43 per cent.2

The diversion of income to the rich explains why, in the 37 years between 1979 and the beginning of 2016, median inflation-adjusted weekly earnings derived from full-time employment for those aged 16 and over rose by a total of just 3 per cent — an increase too small to be noticeable. In an associated change, the share of gross domestic income represented by employees’ earnings fell from 47.7 per cent in 1980 to 42.9 per cent in 2015.3 Taken together, these statistics mean that all the gains from the growth in American productivity over those 37 years accrued either to wealth owners or to salary-package employees in the top decile of income earners, such as senior management and finance-sector workers. The last time the United States experienced inequalities of this order was during the 1920s, in the lead-up to the Great Depression.

Radical changes would be needed to restructure the American economy to spread income increases across nearly all social groups, as happened in the golden era from 1945 to 1974. The changes would have to include increases in both taxes and the minimum wage, a rapid expansion of government services directed at low-income and medium-income households, and the adoption of an aggressive infrastructure-investment program and complementary education initiatives to raise the productivity of American workers so that they can compete with those located overseas. Restructuring would also require a reversion to balanced budgets, relying on the balanced-budget multiplier to generate full employment. To avoid excessive reliance on taxes and social-welfare transfers, the share of pre-tax income accruing to the top 1 per cent of households would have to drop from 80 per cent or more to just over 20 per cent.

These radical changes would sacrifice the small-government, tax-cutting element of the Washington Consensus while retaining its free-trade elements. However, such changes are contrary to the perceived interests of the small coterie of billionaires who are major donors to American media, academia, and political parties — especially to the Republicans.4 It comes as no surprise, therefore, that Trump is committed to the small-government side of the Consensus (at least as far as it provides tax cuts for the rich), and has instead appealed to middle-income voters by resiling from the free-trade aspects. A move to raise tariffs and restrict immigration is attractive to an electorate that blames its poor employment prospects on competition from immigrants and imports. This move is of concern to the executives and shareholders of American globalised companies, whose prosperity is built on their capacity to move production to low-cost countries and to evade taxes via tax havens, but is acceptable to those of the American rich whose fortunes derive from domestic sources such as oil or real estate.

It is salutary to remember that the last time the United States experienced high inequality, during The Roaring Twenties, major negative shocks to the political system from the Depression and the Second World War were required to trigger the institutional changes on which the golden era of post-war prosperity was founded. In particular, the war allowed massive government intervention in the labour market to engineer a substantial redistribution of income from high-paid to low-paid employees without inflationary consequences. The war also justified large increases in tax rates.

Given the current dysfunctionality of American politics, it is almost impossible to see how changes of this magnitude can occur unless they are precipitated by external shocks of the same magnitude as the Second World War. The American electorate is ideologically conditioned by partisan media and an untamed blogosphere to abhor big government and taxes. It is bedevilled by the centuries-old unresolved issues of race. It is additionally polarised by differences in socio-economic status between electorates and states. The scope for change is limited by the enforcement of party discipline, which ensures that elected representatives do not diverge from the values of their ‘base’. All this is already apparent and will continue to intensify political tensions, increasing the likelihood that the United States will adopt policies that damage not only its own interests but those of its trading and military partners. We consider these risks from an Australian point of view after the following update on that other bastion of neo-liberal policy, the United Kingdom.

The United Kingdom Brexit vote

In 2016, the United Kingdom also produced political changes that will have long-term adverse economic consequences and that, as in the United States, can be directly linked to the increase in inequality over the three decades of neo-liberal policies, exacerbated by relatively poor economic performance over the last decade. This was the outcome of the so-called Brexit plebiscite as to whether or not the United Kingdom should remain in the European Union.

As in the United States, the proponents of Brexit argued that the re-establishment of national control over immigration and trade would re-invigorate domestic industry while reserving jobs for the native-born. Again, as in the United States, these policy objectives were particularly attractive to lower socio-economic groups. In local government areas (LGAs) with median wages around £300 a week, the average percentage vote for Brexit was 60 per cent. It averaged 50 per cent in LGAs with median weekly wages around £450, and 25 to 30 per cent in LGAs with median weekly incomes approaching £900, such as the City of London.5 The greater the fall in real wages or the lower the rate of wages growth since 1997, the higher was the vote for Brexit. This vote was clearly the revenge of the losers from the United Kingdom’s sustained commitment to Washington Consensus policies, despite the most likely outcome being that Brexit will result in an additional decline in their absolute economic circumstances, if not in their relative position.

The decision of the government to abide by the plebiscite and in 2017 to trigger notice of withdrawal from the European Union will inflict considerable damage on the British economy. With various general elections due in 2017 and 2018, continental European governments have strong incentives to generate income for their voters by transferring as much as they can of local demand currently satisfied by British exports to local producers. They will be keen to attract industrial capacity that would otherwise have been located in the United Kingdom. The transfer of a significant proportion of the City of London’s financial services activities to EU cities will also be rigorously pursued, if only to enhance internal support for the European Union and to demonstrate the costs of leaving.

Theresa May, the new British prime minister, installed after the Brexit vote signalled the end of the Washington Consensus policies introduced by Thatcher. Government interventions, if only moderate, were promised to promote equality of opportunity. For Britain, this shift is far too late. Given the negative headwinds from Brexit, a low currency with price increases squeezing real incomes, and an already high current-account deficit, there will simply be too few resources available to finance the necessary interventions in such fields as education, housing, and employment development. If a hard Brexit does eventually occur by the 2020s, the United Kingdom economy is likely to stagnate, and political divisions will intensify, with a return to the political dysfunctionality of the 1960s and 1970s, and perhaps the 1930s. Thatcherism will have come full circle.

Despite historic ties, the United Kingdom is no longer important for Australian trade and investment, either directly or indirectly via its influence on world trade. Brexit is unlikely to affect Australia’s economic prospects; indeed, the effect could be mildly positive if it hastens necessary fiscal reforms within the EU. It is otherwise with the United States — not so much because of high levels of mutual trade and investment, but because American policies still have strong effects on world trade. It also matters that Australia is a military ally of the United States, while the United States is a rival of Australia’s chief trade partner (China), and that swathes of the Australian political, media, and academic elite are under strong American influence. We therefore return to the risks posed for Australia by the incoming Republican administration.

American risks for Australia

In Chapter 6, we concluded that Australia has a breathing space of a few years before our indicators of vulnerability to economic catastrophe turn to Code Red. We expect that the advent of the American Republican administration will shorten this breathing space. We leave to one side the risks that would arise were Australian politicians to speed the process by copying the Republicans’ policies; we concentrate instead on the effects of the policies’ implementation on Australia, allowing that the policies implemented are likely to fall well short of those espoused in the election platform.

From an overseas point of view, a first concern with American policy is whether it will accelerate or retard the rate of income growth in the United States, and therefore the level of imports it takes from the rest of the world. This is important to Australia, not so much because of direct Australian exports to the United States, but because of the importance of the American market to China, Japan, and other important Australian trading partners. Our assessment is mildly positive as to American income growth, but this growth is likely to generate increases in world interest rates that will definitely not benefit Australia.

The Republicans ardently desire re-election in 2020, and calculate that economic growth of at least 4 per cent in each of 2019 and 2020 would maximise their chances. They face a major constraint in that they do not have the numbers in Congress to pass economic-stimulus measures that will add to the deficit ten years hence. Given this constraint, it is likely that they will resort to temporary tax cuts and expenditure increases.

An important element in the Republican platform was its proposed cuts to income-tax rates, especially to taxes imposed on high incomes. Though these tax cuts will be partially offset by the withdrawal of deductions and the closing of tax loopholes, it has been estimated that the net impact of the proposed changes will be to give a tax cut of 14 per cent of average taxable income to the top 0.1 per cent of income recipients (an average of US$1.1 million each), compared to an average cut of US$110 or 0.8 per cent to people in the lowest income quintile6 — a skewed distribution of benefits that has implications for the effectiveness of the policy as a stimulus to demand.

The draft tax changes presented to Congress in April 2017 broadly followed the election platform, and included a reduction in the corporate tax rate to 15 per cent. Depending on the accompanying changes in deductions, the cost of this was estimated at between US$300 billion and $700 billion a year. Given the political difficulty of eliminating deductions, a realistic cost would be towards the upper end of this range, enough to double the federal government deficit unless expenditure is cut to match.7

There are likely to be savings from cuts to the so-called Obamacare and other social-welfare programs, though these could be offset by increased incarceration costs — the United States has the very expensive habit of using its prison system to provide income support of last resort for many of its poorest citizens. Increased expenditure is also promised on infrastructure, but this is likely to be limited to tax credits to encourage private investment in transport facilities. By their nature, these will target investments that can be financed from user charges, and neglect those with benefits that cannot be so captured — a process that will further increase the inequality of distribution of real income.

In sharp contrast to the promises of cutbacks in social benefits, the fiscal promises include a rapid build-up in defence expenditures, including an upward revision of the current target of a 308-ship navy in the late 2020s to one with 350 ships. This raises an old spectre — that of a national leader seeking to unite his country against a foreign enemy. Even if the build-up is purely defensive, it well-nigh guarantees that the tax cuts will outrun the expenditure cuts, so that the fiscal deficit will increase.

Aside from the proposed increase in defence expenditure, the fiscal policy proposals of the Republican administration will generate very little economic stimulus relative to the size of the likely budget deficit — whether this is financed by adding to government debt held by the public or by adding to the excess reserves in the banking system (as will happen if the budget deficit is funded by the Federal Reserve Bank). The GDP-multiplier benefit accruing from the increased incomes of high-income households is small, because these households have high levels of savings. In response to the windfall of a large increase in their after-tax income, they will no doubt apply even higher marginal-savings ratios. These are the ratios that matter when tax cuts are intended as an economic stimulus.

The company tax cuts will likewise have weak stimulatory effects. In times of high business confidence, corporate tax cuts can be relied on to result in increased purchases of equipment, buildings, and new technologies. But these are not such times. Instead, in the context of relatively weak economic fundamentals, including low expectations of future long-run demand growth, and given that the corporate sector is already flush with funds, the extra corporate cash flows from tax reductions will either be paid out to shareholders — thus adding to the incomes of high-wealth households — or will be spent on investments undertaken largely for financial-engineering reasons (which will include investments under the infrastructure-policy initiative). Such investments may be profitable for the investor, but will not raise total output very much.

Given that they are likely to raise — indeed double — the budget deficit, the Republican policies continue and intensify the Democrats’ recent policy of injecting monetary stimulus into the American economy. This policy has produced much smaller increments to growth than would have been possible with well-designed fiscal-expansion initiatives at a similar budgetary cost, and the Republican version is likely to be even less effective. Even so, the resulting short-term increase in the American economic growth rate will give a temporary stimulus to world trade and to the Australian economy. However, as the United States’ public-sector borrowing requirement rises towards 6 or even 8 per cent of GDP, both financial market volatility and interest rates can be expected to increase above the levels assumed in Chapter 6. This represents a serious risk to the Australian economy, given its current vulnerability.

The other side of Mr Trump’s platform, that involving trade restrictions, is a departure from the Washington Consensus, and the big-business base of the Republican Party will be reluctant to support it. However, the administration will find it difficult to backtrack on it, given its contribution to its electoral success, particularly in the so-called rust-belt states, and the limited benefits these states will receive from the fiscal policy changes. To backtrack would risk loss of control of Congress in the 2018 mid-term elections. This makes it highly likely that, even if it stops short of generating a general trade war, the Republican administration will implement wide-ranging managed-trade initiatives, such as anti-dumping rules and the erection of other short-term trade barriers to assist specific industries, and will try to transfer demand for imports, particularly imports from China, to manufacturers in the rust-belt states. The Republicans are unlikely to be deterred if China and other countries disadvantaged by their policies retaliate against American exports, since these come mainly from the so-called knowledge-industry states on the north-east and west coasts — states that are Democratic Party strongholds.

Even within the new-found Republican strongholds, the new trade-barrier policies are likely to be ineffective if hastily implemented, shorn of long-term support programs. Channelling demand to rust-belt states, where capacity has been permanently closed, will do little to raise output or employment there. If businesses believe that the additional demand is permanent, they will begin to construct new capacity, but it will not necessarily be located in the rust-belt states. Again, even if spare capacity exists in the newly protected industries, production will only increase if the necessary skilled labour is still around and able to work. There is no suggestion that the diversion of demand will be accompanied by the large-scale training programs required to reskill the long-term unemployed and underemployed.

Accordingly, in conjunction with the compulsory deportation of undocumented workers, the trade-barrier policies run the risk of creating inflationary bottlenecks. It is likely that the demand-diversion policies will not only prove to be weak in terms of direct stimulatory impact, but that they will stimulate inflation, and therefore enhance the rise in interest rates over and above the increase required to control the excess liquidity injected into the economy from the higher fiscal deficits. We have already identified increased interest rates as a hazard for Australia.

It gets worse. If, by their protectionism, the Republicans start trade wars and succeed in reducing the level of world trade, and particularly if they curtail Chinese exports, Australia can look forward to additional vulnerability over and above that caused by the increase in world interest rates. Australian exports to China will suffer if the United States succeeds in reducing the Chinese rate of economic growth, and may suffer doubly if the Chinese government takes the opportunity to discriminate against Australia — whether directly, as punishment for Australia’s alliance with America, or indirectly, through a decision to discriminate in favour of emerging market economies as part of China’s cultivation of the leadership of a new ‘silk road’ economic bloc.

China could also respond to increased protectionism by intensifying the role of import replacement in driving its economic growth. If in the process it substituted domestic iron ore and coal for imports, there would be a further significant reduction in Australia’s terms of trade.

Interest rate increases aside, the most serious long-run negative impact of the Republican program is that it will further accentuate the inequality of the distribution of income. The OECD has calculated that the existing high level of inequality significantly reduces American productivity growth. The Republican policies can only make matters worse.8

We conclude that the greater the short-term lift to GDP growth in the United States that results from Trump administration policies over 2017 and 2018, the greater the probability of adverse effects on Australia. These adverse effects will increase the probability that Australia will move to Code Red status in or before 2020, and will also intensify the catastrophe when it occurs.

Crisis-risk parameter adjustments

In Chapter 6, we considered a range of strategic risks that threaten our ‘business as usual’ baseline economic projection for Australia. We found that two of these strategic risks were sufficiently serious to justify modification of the business-as-usual scenario. We specified probability distributions for these two strategic risks — the risk of world financial instability (a second GFC), and the risk that, for whatever reason, Australian exports to China will be less than expected — and generated a revised scenario based on the balance of the probabilities. We now apply the same methodology to the risks raised by the Republican Party platform as it unfolded in early 2017, and re-assess Australia’s crisis vulnerability as augmented by the American election.

As explained above, we expect the Republican policies to increase the probability of world financial instability. In Chapter 6, we identified this as a threat to our baseline projection. To adjust the macroeconomic-crisis indicator for the Republican platform, we kept the range of possible values of the VIX index constant, but adjusted the probability of each value. We reduced the probability of stability in the index to zero, retained the probability of moderate instability at 0.1, increased the probability of a moderate GFC from 0.2 to 0.3, increased the probability that the GFC would be replicated from 0.2 to 0.3, and increased the probability of a more severe GFC from 0.1 to 0.3. The resulting mean expectation is that the GFC will be duplicated sometime over the next five years.

The second threat to the baseline projection identified in Chapter 6 was the possibility that the assumed level of exports to China will not be achieved. The Republican platform contains indirect threats to these exports. We now estimate that the chance that baseline exports to China will be achieved is reduced to 20 per cent, with an 80 per cent chance that there will be varying levels of shortfall. The mean expectation is a most likely shortfall in exports of 6 per cent by 2021.

In addition to its effects on world financial stability and on Australia’s exports to China, the advent of the Republican administration is likely to affect Australia adversely by raising interest rates and reducing trade opportunities.

We now expect that the increase in the United States’ fiscal deficit (or public-sector borrowing requirement) to between 3 and 5 per cent of GDP will generate more rapid increases in interest rates than are required by world GDP growth, inflation, and financial instability. In the event of a full implementation of the Republican fiscal program, we assess a 20 per cent probability of an increase of 0.5 percentage points in United States interest rates; a 30 per cent probability of a 0.8 percentage point increase; a 40 per cent probability of a 1.2 percentage point increase, and a 10 per cent probability of a 1.5 percentage point increase. The mean probability is an increase of approximately 1 percentage point; however, we scale this back by an estimation that no more than half of the fiscal program will be implemented.

Revised United States trade policies are also expected to directly reduce the growth of world trade and hence to depress world economic growth, in addition to their impact on interest rates and financial instability. We assess there is a 20 per cent chance that revised Republican trade policies will have no impact on world growth; a 30 per cent chance that they will reduce world average annual GDP growth over the next five years by 0.1 per cent per annum; a 20 per cent chance that the reduction will be 0.2 per cent per annum; and a 10 per cent chance of reductions of each of 0.3, 0.4, or 0.5 per cent per annum. The mean expectation is a reduction of 0.2 per cent per annum.

A shift to greater reliance on managed trade by the United States, China, and other countries following their lead will have a direct impact on Australia’s terms of trade, over and above the impact of reduced world growth. This will be because of the reduced role of global demand and supply in determining world prices. The mean expectation is that this will result in a reduction of 9 per cent in Australia’s terms of trade compared to the original case without the political disruption of 2016.

Increased financial instability will also have its effect on the year-ahead foreign-exchange-cover ratio. As international investors perceive increased risks in exposure to Australian dollars, they will become less willing to make loans in domestic currency. Our probability settings are for a 10 per cent chance that the share of foreign debt denominated in domestic currency will decline by 20 per cent; a 30 per cent chance that it will decline by one-third; a 30 per cent chance that it will decline by 40 per cent; and a 20 per cent chance the decline will be between 60 and 75 per cent. Our mean expectation is a decline of 50 per cent, which means that that the share of foreign debt denominated in domestic currency would fall to 15 per cent.

The final parameter requiring adjustment is the share of Australian capital outflow as a percentage of GDP. Our probability settings are a 10 per cent chance of no increase; a 20 per cent chance of an increase of 1 percentage point; a 30 per cent chance of a 2 percentage-point increase; and a 40 per cent chance that the increase will be between 2.5 and 3.5 percentage points, with a mean expectation of a 2 percentage-point increase. This will also cover the case where American capital flows back to the United States as a result of one-off tax measures to encourage the repatriation of the foreign-held financial assets of American corporations.

It is important to note that the combined impact of these changes would not be dramatic if the Australian economy were to maintain the relatively strong position it held at the beginning of 2016. For example, even after adjustment for the economic consequences of Trump, the average world growth-rate over 2016 to 2021 would be 2.9 per cent per annum, similar to average world growth from 2014 to 2016, and quite manageable for a strong economy.

However, as we showed in Chapter 6, the underlying trends are adverse, and the various downward adjustments we are making apply to a weakening economy. The mean expectation for the terms of trade, for example, is that import prices will rise more rapidly than export prices, reducing the purchasing power of Australian exports, so that in 2021 a constant quantity of exports will buy only 70 per cent of the imports that it would have financed at the peak of the mining boom in 2012. (The overseas purchasing power of the Australian dollar had already fallen 80 per cent of its peak value by the end of 2015.) Importantly, United States short-term market interest rates are now expected to double from 2.2 per cent at the end of 2015 to 4.2 per cent by 2021. Against the background of high and increasing indebtedness and generally increasing Australian vulnerability, this will have serious implications for the Australian economy.

Our adjustments to the drivers of the vulnerability indicators due to the expected revisions to American economic policies are all unfavourable to Australia, and generate a 60 per cent probability that the macroeconomic crisis indicator will flash Code Red for at least four quarters in 2020–21. The year-ahead foreign-exchange-cover ratio also deteriorates, falling to 0.12, likewise a Code Red value. Australia’s position could easily worsen more rapidly than this, with 20 per cent probability that Code Red status will arise by the end of 2018. In other words, economic breakdown will be more likely than not within a few years. The projections imply the following 2021 values for key economic indicators: a fall in the Australian dollar to 53 US cents; a current-account deficit of 8 or 9 per cent of GDP; and a gross foreign debt-to-GDP ratio of just under 200 per cent. One does not need an economic model to acknowledge that catastrophe would then be imminent.

These dire projections depend on an important assumption, which is that the Australian policy authorities try to maintain an average annual growth rate of 2.2 per cent per annum over the five-year period to 2021 by a combination of expansionary monetary and fiscal policies, and so attempt to maintain the growth trajectory set out in the 2016 budget, ignoring the risks that prevailed before the 2016 United States election, and similarly ignoring the new risks arising from the election. Whether these dire predictions for Australia come to pass will depend chiefly on whether the overseas drivers we have outlined are realised, but also on the discernment and agility of the Australian body politic.

The events of 2016 have increased the risks to the Australian economy to the extent that attempts to maintain a trend GDP growth rate of around 2.2 per cent a year while retaining the neo-liberal reforms of the past thirty years will raise the probability of economic catastrophe to at least 50 per cent. Even if by some miracle Australia manages to escape an economic catastrophe, or the alternative of a severe recession in the five years 2017–2022, it is likely to come to grief later in the 2020s.

In its 2017 budget, the government edged in the right direction by financing increased redistributive expenditures from increased tax revenue, and by directing borrowing into infrastructure investment. However, it failed to increase household saving and curb imports of consumption goods. Australia’s slide towards Code Red continues.

The political responsibility for crisis vulnerability

If an economic catastrophe occurs within the next five to seven years, it will have been decades in the making, with contributions by a succession of Commonwealth administrations. Since Australia’s vulnerability to crisis derives from its accumulation of foreign debt, a simple measure of the contribution of successive administrations to the risk of crisis is the annual average increase in net new foreign debt that took place under their aegis. The net change is calculated after adjusting for the impact of exchange-rate changes, and is best expressed as a percentage of nominal GDP for the period.

The highest average annual increase occurred under the Coalition administration, led by John Howard and Peter Costello, that was in power from June 1996 to March 2007. This administration has been regarded as one of the most economically successful of recent times, but this is because its performance has been evaluated on the basis of only one criterion — the reduction in net national government financial obligations. Net national general government liabilities declined from 20.5 per cent of GDP in the June quarter of 1996 to -1.5 per cent in the June quarter of 2007. However, this achievement was more than counterbalanced by the increase in the household stock of equity-withdrawal borrowing, which rose from 15.4 per cent to 57.8 per cent of GDP by the June quarter of 2007. Between 1996 and 2007, the rate of equity withdrawal averaged just under 10 per cent of net household disposable income a year, peaking at 16 per cent in the December quarter of 2004. The average net discretionary savings ratio was -6.7 per cent over the period.

The Coalition administration succeeded in reducing public-sector liabilities by allowing the banking sector to expand lending rapidly, increasing house prices and driving down net household savings rates as a mirror image of the increase in public-sector savings. Debt did not fall; it merely switched sectors. From this broader perspective, far from being a successful period of economic policy, the Coalition under Howard will be judged to have made a disproportionate contribution to Australian economic vulnerability.

Although overseas debt accumulated most rapidly under the Coalition, the build-up towards Code Red over the last thirty years has been a general government responsibility rather than that of a particular party. It was the Labor administration of the mid-1980s that unleashed financial deregulation, admittedly on a bipartisan basis. Similarly, had a Labor administration been in office from 1996 to 2007, it likely that it would have exhibited similar complacency towards household equity withdrawal, since the trend was well under way between 1992 and 1996, and continued between 2007 and 2013.

What were the factors underlying this bipartisan responsibility? The play of vested interests would doubtless have contributed, along with short-term political strategies, but underlying all other influences is the current mode of thought. The world is complicated, and people inevitably simplify it in their attempts to gain understanding. During the era of imprudent accumulation of overseas debt, neo-liberal theories were fashionable in Australia, the United Kingdom, and the United States. Though intellectually rigorous within their own closed system, and useful as an intellectual weapon in the Cold War, these theories were so abstract that they assumed away the possibility of economic catastrophe brought about by excessive overseas borrowing.

We have argued that neo-liberal policies have stored up trouble for the Australian economy as a whole. In concentrating on these risks, we have not drawn up a comprehensive table of the winners and losers from such policies — when catastrophe occurs, all Australians will lose. The current position is that the Labor Party is showing some signs of repudiating its neo-liberal past, while the Liberal/National parties are reconfirming their allegiance. However, as with the Republican support base in the United States, important groups of Liberal/National supporters are beginning to perceive themselves as disadvantaged by aspects of Washington Consensus policies. Just as both sides of politics repudiated neo-liberalism during the Second World War, and both returned to neo-liberalism in the early 1980s, the time has come for both to move on.

Table B: Annual average change in new foreign debt (per cent of GDP)

		Administration
	Number of quarters	Labor	Coalition
September 1988 to March 1996	30	3.4(a)
June 1996 to March 2007	44		6.7
June 2007 to September 2013	26	4.5
December 2013 to December 2015	9		3.1

Note: (a) At this stage, because of the lack of direct data consistency, the period from March 1983 to June 1988 has been excluded.

Conclusion: the risk rating of current Australian economic policy

In indebted economies such as Australia’s, the major risk of economic catastrophe arises from over-borrowing. We have concluded that, by its heavy reliance on overseas finance, Australia is courting such risks. We have introduced the idea of crisis alerts, and developed two main indicators on which to base such alerts — the crisis risk-indicator for macroeconomic trends, and the year-ahead foreign-exchange-cover ratio for the capacity of the authorities to respond to an incipient crisis. The current values of these indicators are not seriously alarming, but the trends are. To assess these trends, we developed a baseline projection similar to that included in the Commonwealth budget for 2016–17, and concluded that the trends are indeed adverse, such that there is a strong likelihood that Australia has no more than a few years to take action to defend itself against an economic catastrophe. We then reviewed the baseline projection and found a couple of risk factors that, when included in the projection, underlined our conclusion that it would be, to say the least, prudent to take prompt action to reduce the nation’s reliance on overseas borrowing. These and other risks have been enhanced by the 2016 US election result.

At present, the evidence is that the government intends to let things slide. One indication is the absence from the most recent budget papers of any projections of foreign debt and available foreign-exchange reserves. A second worrying indication is the use of interest rates to encourage household borrowing, so as to boost dwelling prices and nominal wealth, and so justify yet more equity withdrawal. Consumption thus financed results in ever-increasing household debt-to-GDP ratios and additional foreign borrowings. Again, the government has shown little concern for the survival of import-competing industries damaged by the high exchange rates of the recent past. In the following chapter, we consider the steps the Australian government could take to restructure the economy so it acquires greater resilience. There is so far no sign that such policies are under consideration, or even any recognition that there is a need for them.

Our conclusion must be, regretfully, that current policies can have no other outcome than economic catastrophe, or, at best, a severe crisis-avoiding recession. Current policy accordingly merits a Code Red alert.