It’s the Foreign Debt Stupid

Today’s Column from the Fin:

In a stand-up routine, Woody Allen is about to be lynched by the Ku Klux Klan. His life passes before his eyes. The childhood in Kansas, swimming, fishing, eating cat-fish with gingham clad sister Mary-Lou. Does this sound like Woodys childhood to you? As he explains, They’re gonna hang me in two minutes, the wrong life is passing before my eyes.

Were having a Woody Allen economic crisis. Our debt is passing before our eyes. But its the wrong debt.

Both economists and politicians are focusing on government debt. But our government is free of net debt thanks to twenty five years of responsible fiscal management, umpteen privatisations and the revenue dividend, first from micro-economic reform and then from the minerals boom (remember that?).

Two thirds of the recent stimulus will fund small scale rapid fire investments. Theyll leave us with a tad more government debt, (less than three percent of GDP). But we’ll own more assets. Given that their construction will employ otherwise unemployed labour, the projects only need to be of reasonable quality which they are to render the exercise a no-brainer. Its like doing renovations on your house during a work layoff.

While were waiting for the renovation rescue, the last two stimulus packages have doled out around $20 billion to Australias low and middle income households. The evidence from similar exercises elsewhere suggests that around two thirds of the money will be spent within about six months. The annual interest on both cash splashes and the investments amounts to around $100 for each Australian. Is that so scary?

Compare this with the foreign debt the debt which featured on the Liberals debt truck as they took power in 1996. But once the Liberals took office and exposed their predecessors cover-up of the deteriorating budget, and the difficulty of reducing foreign debt, they had a Woody Allen moment. They decided that theyd been passing the wrong debt before our eyes and switched their critique to government debt. Insert dark mutterings about Beazleys black hole here.

Meanwhile ANU Professor John Pitchford had shown economists why the previous policy preoccupation with external deficits looked like an anachronism with a floating exchange rate allowing markets to equilibrate our foreign debt. If Australian consenting adults borrow overseas, why worry? Its a good question, but as Pitchford himself said, its not the last word. Especially when crises threaten, some consenting adults financial transactions can unleash systemic shocks.

But the political and intellectual landscape is changing. Fast. A decade of bipartisan fiscal populism anathematising government debt even for the obviously sensible purpose of building assets has evaporated as the worlds governments scramble to rescue their economies.

The next casualty might be might have to be our complacency about net foreign debt, which was 38 percent of GDP or just under $200 billion on the debt truck in 1996. Last sighted at $658 billion or around 60 percent of GDP, it will surge as we prime the economy while demand for our exports falters. Our current account deficit (CAD) already smacking gobs at six percent, will soon be gasting flabbers at nine percent of GDP.

Will it end in tears? The good news is that New Zealands going guinea pig (sound familiar?). Having overwhelmingly rejected compulsory super, its CAD tops eight percent even amid domestic recession. With net foreign debt already around 90 percent of GDP, Standard and Poors have it on watch for a credit downgrade. The bad news is that if New Zealand is dumped by international markets, the contagion could spread here as screen jockeys genteelly poke through their goat entrails pondering which nearby economies are sufficiently similar to deserve similar treatment.

So our growth path from recession should be focused on investment, particularly in traded goods and services. Thats why Id like to have seen faster interest rate cuts (and a correspondingly lower exchange rate) and continued vigorous rate cuts. And we could ramp up the recent investment allowances further and include R&D. But to minimise windfalls for existing plans Id focus it on firms that were substantially increasing investment. We might be able to bring forward large foreign direct investments by allowing major projects to cash out their shareholders imputation credits as lower company tax as a prelude to doing it more generally.

Now converting investment into strong net export growth also requires higher saving which can be delivered with further increases in compulsory super. Doing so now would worsen the downturn. But committing now to doing it in two years would help address a question foreign lenders on whom were increasingly reliant must already be asking themselves.

Whats Australias plan to get out of this mess?

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32 Responses to It’s the Foreign Debt Stupid

  1. NPOV says:

    Is it also a fair statement that a problem with the “consenting adults” position is that we know that once private citizens allow themselves to get up to a certain level of debt, when conditions turn sour, they are all likely to attempt to simultaneously deleverage, with inevitably paradox-of-thrift type consequences? In other words, everyone would be now better off if some sort of attempt had been made to limit the level of private debt, to prevent panic debt reduction that ultimately effects everyone – including those who were sensible about their debt in the first place.

  2. NPOV,

    That’s certainly the kind of argument that I’m seeking to imply, though I don’t think there should be some arbitrary limit on private debt – after all, I’m suggesting we get in more of it (admittedly a risk) but with a very definite plan to get out of it again. One of our big problems was expanding foreign borrowing (partly) for consumption (it was also for investment, but we should have been paying for more of the investment ourselves).

  3. NPOV says:

    I can’t see an arbritary limit working either, but there were surely lots of way government (and RBA) policy could have helped in keeping private debt from ballooning unproductively during boom times.

  4. Fred Argy says:

    A thoughtful piece but a little ambiguous.

    Are you envisaging a credit downgrade (“the contagion could spread to us”)? Apart from the fact that Standard and Poor’s have got little credibility left at all, there is the question of whether their advice would be right.

    Are they going to say to us that in a period of declining private debt, we need to also reduce public debt levels? That would be a certain recipe for declining GDP, which you clearly don’t want to see. So if they threaten our credit rating, so what?

    You prefer instead to look at an alternative strategy. I do like your idea of more investment-related incentives and less consumption (although you do need both in present circumstances and the cost of an upheaval in the overall package would further delay implementation). If we could do this, it would amount to more “public saving” overall to match the public outlays.

    Your superannuation proposal (more compulsory saving) only makes sense only if (a) you can make the system fairer and (b) you can be sure that there is a net increase in overall national savings.

  5. Patrick says:

    I have to say the contagion point seems very weak to me.

    But the rest of it seems pretty sound.

    Fred is right about super. I think the only reasonable thing would be to tax fund payments above eg $100k a year. Maybe there could also be a law that where surplus exceeded 1% of GDP there was automatic pro-rated topping up of low-income earners’ super.

    But none of that would address the immediate issues, on which I largely agree with you. A GST holiday would seem like one way to do it (as well as easing cash burden on companies, which cannot be overstated).

  6. AMcCredie says:

    A great start to an important debate on how we can tilt the balance more towards investment in productive assets.

    It is interesting to note that while Australia has FIRB controls to prevent foreigners making speculative equity investment in Australian real estate (which was unlikely to amount to much more than a few $10s of billions), there are no controls on the use of foreign debt by Australians to make speculative investment in real estate($100s of billions).

    In particular no restrictions/public warnings were made about home lenders whose business model was based totally on access to (then cheap) short-term foreign borrowings, when any reasonable risk assessment would raise the possibilty that foreign loans might become so unavailable/expensive as to make this model unviable. In the event, the Government decision for AOFM to invest upto $8 billion in stablising Australia’s Residential Mortage-Backed Securities market seems the only viable option, and if it works we may have a lucky escape.

  7. Fred,

    fair enough to repeat your call for equitable concessions on super – I agree. But I can’t stuff everything into an op ed as you know. However I don’t agree with the proposition that increasing compulsory super could reduce national savings. It could in the short term, but the pressure on pollies to produce balanced budgets is sufficiently strong in this country that, if increasing compulsory super put a drain on the public budget, it would be made up elsewhere (with deferred tax cuts or spending cuts). Of course you might object to this too (though I wouldn’t), but I think that, for the reason specified, in ‘political equilibrium’ compulsory super would not have as much negative effect on the budget as the simple numbers might suggest.

    Re S&P’s were you meaning to take a cheap shot – in which case it’s more than deserved by your victim – or were you seeking to comment that really, when the market learns of a downgrade that it will reject it on the grounds that S&Ps have trashed their reputation. If it’s the latter, please explain why S&P downgrades routinely produce sharp market reactions.


    With respect, you may find the contagion argument unpersuasive, but it only need appeal to some in the markets, with others seeking to second guess them and we’re on our way. If you don’t think foreign investors will look askance on a country running a 9% CAD with a foreign debt over 70% of GDP, then you’re a brave man. The world is a dangerous place. Here’s an extract from Krugman’s Return of Depression Economics.

    After all, Indonesias current account deficits had been nowhere near as large . . . as its neighbours at less than 4 percent of GDP, Indonesias . . . deficit was actually smaller than, say, Australias.

  8. conrad says:

    “in keeping private debt from ballooning unproductively during boom times”
    People always say this, but it never seems quite satisfying. I mean, compared to debt accumulated at other times, how unproductive was it? A lot of it went into things like housing, which, given the growing population, probably isn’t such a bad thing. Thus what I’d like to know is how much more poorly was the money used in, say, the last 5 years, compared to the 10 before it. Are what we are seeing now (in Australia at least) really due to the last few years, or is it also due to long-term accumulation?

  9. NPOV says:

    That’s assuming it went into building new housing, conrad. A lot of it simply went into pushing up the price of existing housing, with minimal if any improvements in quality. But I’d also think the high levels of credit card debt reached are now having a big impact on spending patterns – suddenly we all feel uncomfortable with having 3 or 4 close-to-maxed-out credit cards and cut back our spending accordingly. It seems to me there’s a case for perhaps raising government fees on many credit/store cards during boom times, which can be cut back during contractionary phrases.

  10. Yes, taxing credit cards wouldn’t be all bad – but pretty unfair – a bit like taxing the casino takings. Hits the worst off.

    I recall back in the 1980s John Dawkins telling me the Govt was going to do this – but they didn’t for some reason. I think they just jacked up FID – though that may have been the Fraser Govt. Can’t remember.

  11. Patrick says:

    Krugman is not a currency trader. Maybe JC would have some insight here. But my sister also trades currencies and they (currency traders) really are sophisticated enough to look beyond physical proximity. Your own example of Indonesia highlights this, even if it isn’t excruciatingly obvious to Krugman why Australia should be ‘allowed’ to have a higher CAD than Indonesia it is to everyone else.

    For further illustration consider the spreads on Euro-denominated national public debt of various EU governments. These are countries which are not only immediate neighbours but actually part of the same monetary zone and yet currency traders have no problem making 40 basis point distinctions between them.

  12. Patrick says:

    Sorry, I forgot a digit. I meant 240 basis point differences.

  13. Patrick,

    I’m pleased to see you’re so confident.

    Krugman is aware of the distinctions between the economies – as am I.

    But have a read of the Krugman book – I’ll lend it to you if you like. It certainly brings out the way in which countries that are managing pretty well can suddenly be subjected to some almighty squeeze of one kind or another. Hong Kong is a good example. You can say that that was their dollar peg, and we don’t have one. That’s true – and in fact they staved off the run. But when your time comes and the hedge funds are pursuing some ‘theme’, going after some weakness or perceived weakness with a vengeance, nasty things happen, and feedback loops get amplified and turn very nasty.

    The unpreparedness of international capital not to flee from countries that borrow to invest is one of the ingredients behind the imbalances we have now. After the Asian Crisis the Asians swung massively towards funding their development from their own savings (and then some) rather than taking the risk of using international capital. We shouldn’t be so confident that we’ll be treated so differently. Or to put it more carefully, why push your luck?

  14. Patrick says:

    I guess I can’t really disagree with any of that. All I disagree with is that there is a serious risk of contagion from Australia to NZ. My sister disagrees with that and she works at one of those thematically-influenced hedge funds.

    So I don’t disagree with being careful etc. I am not confident of the direction of our currency either let alone the magnitude of the movements. However I am fairly confident that the risk of contagion from NZ is very low.

    Maybe I am just silly. In any case this is really just nit-picking on what seemed like the kind of silly argument that undermines the conclusion it is supposed to support.

  15. NPOV says:

    Nicholas, would it make sense at the point that the economy is obviously starting to recover to introduce, say, a new fee for credit cards that kicks in only once new purchases are made? The fee could be based on a percentage of what’s owing, so it’s not excessively regressive, but given that nobody is forced to use credit cards, I’d suggest that a regressive tax on credit cards is reasonably justifiable.

  16. Patrick says:

    Why do you keep hating poor and lower-middle class people NPOV?

    We use our credit card(s) for everything, literally. Interest bill to date – about $10 (one of our cards which we only use when all the others are maxed out does charge interest immediately).

    It’s called cashflow management. Why would you want to tax us for that?

  17. Patrick,

    Can you get your sister to elaborate her claim. I suspect we may be talking at cross purposes. Because when the markets get skittish any number of contagions become possible. For instance we now behave as if there was not much chance of us ‘catching’ the crisis from Indonesia. You’ve implied as much above. Well, you may recall that wasn’t what people were saying at the time. We were damn worried we might catch the contagion (and we did, but only in the small measure of the hit to our exchange rate which turned out to be good, rather than bad news. But the RBA was dead worried at the time.

    So one doesn’t even have to be very similar to get a contagion. These things can leap tall buildings at a single bound. But similarity helps. And NZ is similar to us. It undersaves – only more than us – it’s had a property boom, it’s part of a profligate anglosphere which has been operating as the borrower of last resort for a while now. Its got very deregulated financial markets and its own floating exchange rate. It has a similar institutional structure and history.

    The US would have its national currency down around its ankles if it wasn’t for its unique status as international reserve currency and so somewhere you can ‘fly to quality’ (cough cough!).

    Not only that but New Zealand has a better national anthem than us and its more violent sporting teams do the Haka – what chance does that give us?

  18. pedro says:

    “So our growth path from recession should be focused on investment, particularly in traded goods and services.”

    Indeed, let’s hope so.

    It strikes me that an increase in compulsory saving would be more palatable if the uses could be sensibly widened beyond retirement. Perhaps at least part of the money could be allocated for home purchasing (using off-set accounts), home ownership being a boon in retirement, and also hard-times cushions. It would be awful to lose your house in a recession while keeping your super locked up. I wonder also whether the average person might not like having the option of simply putting their compulsory savings into a bank account with similar restrictions to super fund accounts.

  19. Yes, agreed Pedro, and things that were picked up in the open letter to the PM signed by me and a bunch of economists.

  20. Tel_ says:

    If Australian consenting adults borrow overseas, why worry? Its a good question, but as Pitchford himself said, its not the last word. Especially when crises threaten, some consenting adults financial transactions can unleash systemic shocks.

    I would see that as a sign of the system being broken, not the debt itself. Having government step in to fill in the gap only makes the system more broken, the house of cards gets built even taller and people who did the right thing learn the stupidity of trying to be economically sensible when politics is the game.

    With net foreign debt already around 90 percent of GDP, Standard and Poors have it on watch for a credit downgrade. The bad news is that if New Zealand is dumped by international markets, the contagion could spread here as screen jockeys genteelly poke through their goat entrails pondering which nearby economies are sufficiently similar to deserve similar treatment.

    S&P demonstrated soundly that they had no particular crystal ball seeing the downturn any more than anyone else did. This convinces me that they have no real idea, and that their customers have even less idea. The concept that a single credit rating describes a whole nation of individual borrowers is so incredibly far fetched, it doesn’t even make sense.

    I believe in the free market system enough to also believe that players with no idea of what they are doing will eventually come unstuck. If I didn’t believe that much then might as well sign up for the Red Army because there would be absolutely no point having a free market system (and yeah, an increasing number of people are coming to that decision from various angles).

    Now converting investment into strong net export growth also requires higher saving which can be delivered with further increases in compulsory super. Doing so now would worsen the downturn. But committing now to doing it in two years would help address a question foreign lenders on whom were increasingly reliant must already be asking themselves.

    Compulsory super is all about taking responsibility for investment selections away from the person who actually will reap the results and handing the decision to someone who just couldn’t care what happens. You make this sound like a question of investment versus no investment, but actually it is a question of who should decide what we invest in. I’ve yet to see even the slightest hint that the super funds have any particular skill when it comes to investment selections.

  21. NPOV says:

    Patrick, we use our credit cards for most things too – and for quite a substantial period we maintained the discipline to keep our interest payments zero to very low (unfortunately things didn’t entirely stay that way, but I’m not blaming anyone other than ourselves for that).
    If your interest payments are regularly so low, I doubt you’d be paying much in the way of fees at all. At any rate, there’s plenty of ways to structure fees/taxes on credit cards so that those who use credit cards simply to manage cash flow and on average pay very little interest pay virtually no extra taxes.
    (I’ll point out that fees on interest-free store cards always exist, so it’s hardly a radical suggestion).

    As for “hating” lower-middle class families, if it were up to me such a fee on credit cards would be combined with a significant rejig of the current tax scales to make them considerably more progressive, from which lower-middle-class families would be considerably better off overall. Even allowing for the fact that there won’t be any jobs for them once my new tax scales will cause all Australia’s top executives to leave for Singapore.

  22. Tel,

    Yes, it’s true that super funds aren’t the greatest. But if you don’t like it you can at least manage your own super fund – which should be simpler and cheaper as I’ve suggested elsewhere. Super’s not perfect as an investment vehicle, but it’s a good, fair way of raising the savings rate. The alternative is improving ‘incentives to save’ which is, by definition highly regressive.

  23. Patrick says:

    Nope, we pay no fees and almost never any interest. Please don’t underestimate the Singapore threat.

  24. NPOV says:

    Fine, name 3 top executives who have moved from Australia to Singapore because our top marginal tax rates are too high.

  25. NPOV says:

    (FWIW, I can easily name more than 3 top executives that have moved here from other countries despite having to pay more tax here).

  26. NPOV says:

    Alright, here’s my list…

    Cameron Clyne, who moved here from New Zealand as head of Bank of NZ where he was paying 39c in the dollar for most of his salary, to take up the role of CEO of NAB, now paying over 45c in the dollar for most of his salary.

    Sol Trujillo, who would have been paying around 35c in the dollar for most of his income back in the U.S.

    John Stewart, who would have been paying about 40c in the dollar back in Scotland before moving here.

    So almost certainly these three sacrificed some amount of cash in the pocket for the opportunity to work in Australia. Do you really think any of them *wouldn’t* have made the move if there was a 50% top marginal tax rate on any income not linked to performance assessments?

  27. NPOV says:

    (And yes, given the performance of Telstra and the NAB recently, that list is open to the charge that “well if that’s the best we can get, it’s proof our top marginal tax rate is too high!”. Or it could be proof that it’s a waste of money bringing in overseas executives…or it could be proof that their income is insufficiently linked to company performance. But that they are experienced top executives that would surely have been in demand elsewhere is undeniable.)

  28. Patrick says:

    You are assuming Sol was not resident in a State which charged taxes on income.

    You are also not factoring in the increase in Clyne’s salary.

    On Singapore I can’t really name anyone. But if it helps I am talking more about companies moving their entire board there. The actual residence of the directors/execs is another question.

  29. NPOV says:

    But that’s my point – there are many factors that determine where good executives are going to go. I’m not going to pretend income tax rates aren’t an issue at all, but it’s certainly not necessary to have ultra-low tax rates to attract talent.

    As far as whole companies go, I’d be more than happy to see increases on higher-end individual salaries combined with a reduction in corporate tax rates.

  30. conrad says:

    NPOV — in terms of Singapore, I think the more important groups you are likely to lose are those that get reasonable but not ridiculously high pay. Obviously if you are bank, you have far more flexibility in what you pay than other organizations, so if tax rates are high, you can simply pay more.

    On this note, when I worked in HK, I was surprised by how many Australians I met — many (almost all in fact, excluding bankers) which worked in shortage occupations in Australia — these included all manner of medical staff, hard to find teachers (e.g., male primary school teachers), academics in shortage fields (e.g., engineering), etc. I imagine many of these people are very valuable if you consider the amount invested in them in terms of their education and so on. This is particularly so for those that got “star picked” from Australia — something which Singapore does with scientists I believe.

  31. NPOV says:

    Well I wouldn’t have any problem with ensuring that medical staff, teachers and academics enjoyed net incomes here that were at least as high as Singapore’s. In fact I’m curious what the difference is even now.

  32. conrad says:

    “In fact Im curious what the difference is even now.”
    I know at least for academics, the difference is huge (perhaps +30% before even before worrying about tax — although working conditions are only somewhat better than the rather woeful conditions in Australia in terms of teaching loads. You also get the fun of signing a say-nothing-against-the-government contract, which makes working in some areas such as politics, education etc. rather difficult since all your work needs to be vetted first). I imagine, possibly incorrectly, the same is true of teachers.

    There are other factors which are rather specific to the individual. If you happen to have, say, two children, then rent is going to be brutally expensive (which is no doubt true of Sydney too unless you want to live in trash-ville), and education isn’t cheap if your kids want to go to schools for white people/rich Chinese. Alternatively, you won’t need a car unless you want to show off, food is reasonable, and you can probably get cheap child care thanks to third-world domestic helpers.

    So basically, it’s a a super deal if you are single and don’t mind living somewhere small, but it isn’t so good if you have kids and would have sent them to a public school in Aus even if you had to pay more to live in a decent neighborhood where such schools occasionally exist in Australia.

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