How resilient is the Australian Economy

http://blog.wired.com/wiredscience/images/2007/10/19/mouseboxer.jpgIn 2008 a group of people and organisations coming together under the name of Australia 21 invited both John Quiggin and me to discussions in Sydney to discuss the issue of resilience with them.  Resilience, they suggested was something that we should be concerned about generally regarding all sorts of systems that make up our physical and social world. One idea people were particularly preoccupied with was the idea, familiar to environmental science and politics that one might be wandering up to a ‘tipping point’ without much knowledge of it, and with things looking like they were fine, only to find out that they most assuredly were not fine. 

My reaction – and I think John’s – was that there was some instinctive overplaying of this idea. People were arguing that by stretching our economy to become more and more efficient in the short term, we might be compromising its capacity to adapt to shocks. While that’s definitely worth thinking about, and we developed a version of it in our essay, it wouldn’t be very sensible to go back to old style manufacturing, just because ‘just in time’ production renders you more vulnerable to disruption in the event of certain shocks.  There is often a value in pushing the system and then trying to iron out the resulting bottlenecks that one discovers (preferably before they occur). On the other hand . . . 

The upshot was that John and I penned an essay for them, now published in a larger set of essays on building resilience (pdf), on the resilience of Australia’s economy.  We wrote it as the GFI (the Global Financial Infarction) was getting underway throughout 2008 and before it got really really serious with the bankruptcy of Lehman Brothers.  

When we were called on to publish the essay we’d written a lot of water had flowed under the bridge (IIRC from around Aug 2008 to March 2009).  Was our essay resilient to events? We thought it stood up quite well and popped a postscript on (which naturally enough highlighted the ways we’d been Right All Along – and quietly smoothed over our less clairvoyant moments – the usual kind of thing.)

But seriously folks, I think it did hold up fairly well – at least a bit better than John McCain’s comment that the economy was basically sound.  

It’s set out below the fold for Troppodillian delectation. 

Boiling frogs and black swans:  How resilient is our economy and how could we improve its resilience?

Introduction

The boiling frog has long been the standard cliché referring to the situation in which people particularly groups fail to notice danger because of the smooth small increments with which it creeps up on them. The frogs, we are told (apparently falsely) wont jump out of water as it is heated to boiling point if it is heated slowly enough.

In the context of resilience, the boiling frog metaphor may be seen as a warning that gradual adverse changes may not be noticed until the system in question has passed the point where a shift to a new, adverse state, is irreversible.

The metaphor is of some use in thinking about modern management of risk, as is another that has become popular more recently, that of the black swan. Most formal theory of risk is developed from mathematics which takes as its context certain well defined probability distributions.  The mathematics elegantly investigates the implications of the information we have providing our notion of what kind of population the sample comes from is accurate.  And we can never really know if it is accurate.

Thus every observation of a swan until the discovery of Australia tended to confirm the proposition that all swans are white.  But it turned out they were not!

There is a nasty coalescence of phenomena by which much of the risk management apparatus we have set up, from the theory of risk management to the institutions of the financial market, is well equipped to deal with the risk involved in normal states of the world but fails when unusual events occur. 

Yet things as diverse as limited liability companies, bonuses linked to corporate performance and risk management protocols with undue reliance on mark to market valuations all tend to reward behaviors like excessive leveraging which greatly increase returns in normal times and often increase individual remuneration even more at the cost of catastrophe in the event of some unusual black swan event.

Shouldnt managing for this latter eventuality be at the heart of risk management?

The task of divining the resilience of our economy to adverse shocks in the future whether they come from within or without must begin and end with modesty.  Niels Bohrs observation that prediction is always difficult, especially about the future is a standard of economics conferences and is even taken to heart at the better ones.

To discuss the Australian economys resilience to future shocks sensibly, the kind of shock we have in mind would range from a global economic downturn lasting a year or so of either a relatively modest or severe kind.  It is also sensible to consider something more serious again, perhaps a depression of the magnitude of the 1890s or the 1930s or just the decade long stagnation we saw in Japan in the 1990s.  Our judgement is that the Australian economy is likely substantially more resilient to a mild downturn and that it may be more resilient to a sharper but still short lived downturn.

However the big risk is the extent to which we have increased our foreign borrowing and the huge resulting increases in our foreign indebtedness. In some possible futures it would become evident that such borrowing had been unwise and in the event of a really severe and prolonged global economic downturn our borrowing is likely to see the Australian economy perform very badly not just absolutely as most economies would do in such circumstances, but even relative to the poor performance of other economies.

We begin with a brief consideration of the economic implications of environmental damage.  Without downplaying their environmental significance, we conclude that these threats do not pose a threat to the resilience of our economy, either now or in the future.

Economic resilience and the environment

The economic dimension to ecological degradation is this: Biodiversity loss, salinity, water and depletion of various natural resources reduce the economys productivity. While these problems generate economic costs, theyre not large in the scheme of things. Further, though there may be some local tipping points the macroeconomic implications of all of these phenomena will assert themselves both slowly and in a way that markets are relatively well suited to dealing with and to the extent that they are not, we have developed a range of collective institutions, such as community action groups and governments at all levels which will also assist markets to deal with the problems.

The one exception to this is global warming.  Here, although effects will emerge relatively slowly, there are global tipping points that we are in danger of tripping if we have not already and the economic consequences could be substantial.  Accordingly it is worth expending resources in order to combat global warming for as long as the scientific consensus suggests that not doing so exposes us to the risk of a loss which is greater, possibly much greater.

Even here, in pure economic terms even the costs of global warming will be dwarfed by the growth of knowhow.  This is not an argument against tackling any of our environmental problems and addressing them efficiently will reduce their economic costs.  However it does put the issues in perspective looked at from the perspective of economic resilience.  

Further, one might well want to address any or all of these concerns even at the cost of some diminution of economic consumption because of their intrinsic value.  We should be able to do so without any significant diminution of the resilience of our economy.

Resilience to relatively minor shocks

Australias economy is probably much more resilient to minor economic shocks than it was a generation ago.  The Australia of the 1970s imposed heavy constraints on the flows of goods and capital and set wages centrally.  While central wage setting could conceivably improve the economys capacity to absorb certain kinds of shock as it arguably did in the mid 1980s most of the time central wage setting was dominated not by economic thinking but by the political attitudes embodied in the concept of comparative wage justice.  In these circumstances external shocks such as booms in our terms of trade were liable to set off boom bust cycles in the economy.  This occurred in the mid 1970s and again just a few years later.

In the Australia of the late 1990s, flows of foreign capital and goods had been liberalised, the exchange rate floated, monetary authorities were independently targeting low and stable inflation and wage setting had been decentralised.  Of course we will need several more cycles to be really confident, but theoretical considerations suggest that the economy will handle such shocks much more flexibly and the empirical evidence we have confirms this expectation.

Thus for instance in the Asian financial crisis of the late 1990s, the exchange rate depreciated heavily, yet inflation and wages remained moderate providing Australia with a trajectory through the crisis that would be hard to fault. In macroeconomic terms this trajectory resembles a typical Keynesian response to a downturn, except that it was engineered by the market.  Thus where initially the shock was to the traded sector in the form of reduced demand for our exports and falling import prices, a substantial portion of that shock was passed on to the rest of the economy by the falling dollar.  Likewise external borrowing rose to enable Australians to smooth their consumption through the temporary downturn in external demand.

Likewise in the current difficult economic circumstances, we are far from being out of the woods yet and a recession is quite possible.  But so far the Australian economy appears to be weathering the various storms around it much better than it might be doing with the institutions of the 1970s.  It is notable for instance that our appreciating exchange rate since the early 2000s has moderated the inflationary impact that Australias terms of trade boom would otherwise have had. Likewise decentralised wage bargaining and the credibility of independent monetary policy has prevented the current terms of trade boom from creating a wages boom.  Note also that as a slowdown has approached, exchange rates have suddenly fallen from a Trade Weighted Index of 73 in June 2008 to 64 in mid September at the time of writing.  Markets do not always behave so benignly but all of what we have described here seems straight from the textbook.

Indebtedness domestic and foreign and the current account

Access to a global financial system has the potential to increase Australias resilience to economic shocks whatever their source. By borrowing from overseas lenders, Australian households can smooth their aggregate consumption and firms can finance new investments even when domestic institutions are unwilling or unable to extend credit.  This was in evidence during the Asian financial crisis, improving the resilience of our economy.

On the other hand, by increasing the risk of a foreign debt crisis, excessive reliance on overseas borrowing may reduce the resilience of the economy, particularly to large external shocks. If large debts are incurred under favorable conditions, as has been the case in Australia, there is a risk that foreign creditors will be unwilling to extend additional credit if circumstances deteriorate.

Australias actual experience yields only equivocal evidence on the question. On the one hand, the Australian economy has exhibited a high degree of resilience since the severe recession of 1989-91. The expansion since the recession has been on some measures the longest in our history. But contrary to the expectations of many, even a substantial improvement in our terms of trade has not produced sustained balance of trade surpluses or any significant reduction in the ratio of foreign debt to GDP.  This is partly the result of increased investment, particularly in mining to increase production of increasingly valuable commodities. But this has not been the whole story and to the extent that it has not been (and to some extent even to the extent that it has since changing circumstances could undermine the returns of the investments we are making) we are taking a risk. 

If all goes well, our increased indebtedness will have enabled us to finance increased investment with minimal sacrifices in our own consumption, something that is to be welcomed. On the other hand it is possible to envisage a scenario in which this course of action would look foolish in hindsight.  It is not that difficult to imagine a situation in which the economies of the developing giants of China and India experience a slowdown, particularly as a result of reduced import demand from depressed Western economies and/or some domestic problem such as inflation and/or financial crises as occurred in the case of the Asian financial crisis of 1997.

Financial sector shocks

The Australian economy, like the global economy of which it is a part, has experienced spectacular, growth in the volume and sophistication of financial transactions since the 1970s. A vast range of new financial products collectively referred to as derivatives, has emerged. These products include options, swaps, and securitized obligations. The total volume of derivatives currently outstanding is well over $300 trillion or more than five times the annual value of world output.

Derivative contracts provide households, firms and governments with a range of flexible options to manage the risks they face. Regulators have devised a sophisticated framework to ensure that financial institutions use such options to achieve a sustainable allocation of risk, rather than engaging in dangerous speculation that might create the possibility of bank failure, or worse, a failure of the entire system. Despite the difficulties that have affected a number of institutions in the last year, no such systemic failure has emerged.

By comparison with US and European banks, the core of the Australian banking sector has suffered little damage from the current financial crisis. However, the rapid emergence of the crisis in the US, where only a year ago problems were thought to be contained to the subprime sector of the home mortgage market raises the concern that a similar crisis could emerge here.

Moreover, in the event of a global systemic crisis causing the failure of major US banks, it is unlikely that Australia would emerge unscathed. Such a crisis may already be underway.

A global depression

Before the emergence of stagflation in the 1970s many economists would have believed that we had essentially mastered economic management sufficiently to rule out another Great Depression.  We do know more, and it does seem unlikely that we would make the series of mistakes that led to the Great Depression.  But most economists are no longer as complacent as they were in the 1960s on this point. 

Certainly the financial crisis we are currently experiencing has been easily the most comprehensive since the Great Depression.  And it has taken on global proportions with frightening speed.  Of central importance is the extent to which the financial sector has expanded beyond the structure for which we have developed reasonably comprehensive (though not error proof) prudential supervision.

Further, we are moving away from a world in which there was a dominant economy the United States which was both able and prepared to take a global leadership role in maintaining global aggregate demand and stabilising the global financial system.  The Asian development model as pioneered by Japan and the imitated throughout Asia has emphasised export led development.  But countries seeking to increase net exports must do so with trading partners prepared or able to increase their net imports.  And the importing countries have typically been the English speaking developed counties.  Most have run up sizable foreign debts and so their capacity to continue on this path is likely to moderate.  As Dani Rodrik put it recently, We are moving to a new world economy, and one of the casualties of the transition could well be the East Asian export-led growth model.

It is possible, though not very likely that this could lead to a situation in the developing economies where growth stalls and in such a situation it is also possible that those countries or some of them would encounter financial crises as Asia did in the late 90s.  A coincidence of the kinds of bad news outlined above, could lead to a very severe and prolonged global downturn.

In such a situation Australias position would be unusually bad.  Our terms of trade are amongst the most volatile in the world but unlike commodity importing countries, that volatility tends to amplify the effect of the volatility in global growth rather than dampen it as occurs with commodity importing counties.  This, our stock of foreign liabilities and our ongoing current account deficit would all tend to lead Australias performance through such a difficult time to go from being above the economic performance of its peers to below them.

What could be done to improve our resilience?

One way of improving our economic resilience would be to increase national savings. We might use some of the dividends of the current windfall we are experiencing in our terms of trade to invest for the future.  If we were to do so offshore this would diversify the investments held by Australians and so reduce risk in the future.  The Norwegians have done this via a sovereign wealth fund with their own resources windfall from North Sea petroleum.

In this context we note the benefits of compulsory superannuation. By increasing Australian saving and by channeling it overwhelmingly into professionally managed, relatively high return portfolios of assets (including a substantial portion of offshore investments) this policy has also made us less reliant on foreign capital, something which will stand us in good stead should foreign investors become less favourably disposed to Australia in the future.  The contrast with New Zealand is instructive.  With no compulsory super, New Zealands firms have worse access to capital and have accordingly invested less heavily. Likewise the New Zealand has invested a far less capital per person in foreign assets and runs a higher current account than Australia.  These things makes its economy relatively less resilient to adverse shocks. 

Increasing compulsory superannuation further would probably be sensible in this context, as would facilitating the expansion of superannuation contributions through default mechanisms according to which peoples contributions would rise over time unless they made a conscious decision to opt out of such plans.

But even with compulsory super and various other measures to increase national savings dating back to the Fitzgerald report of the early 1990s, household savings have remained low or negative, and national savings remain inadequate to produce a decline in the current account deficit.

A concern with resilience might, therefore, suggest the adoption of more conservative prudential policies for Australian financial institutions. The aim would be to ensure that aggregate borrowings from overseas were kept sufficiently low to reduce the risk of a systemic failure arising from a credit crisis.  It might also make sense to try to facilitate a situation in which lenders took greater account of the cycle in their decisions about the creditworthiness of borrowers and the security of assets.  One way this might be done would be to calibrate capital adequacy requirements and/or prudential rules on borrowing with greater sensitivity to the economic cycle.

In the age of the internet, governments could provide a simple deposit taking service that would give citizens a low cost and relatively liquid means of placing their savings with government in return for some reasonable interest payments as well as a means of making payments to others in the same system.  This system could compete with the existing banking system.

More generally, it has been accepted since the recovery from the Great Depression that governments have a central role in providing market making facilities of last resort to shore up liquidity in critically important financial markets.  In the wake of a generation of financial innovation, government market making of last resort is playing catch up.  It seems both likely and sensible that the state will expand its operations to protect against illiquidity in financial markets beyond the core banking markets within which current central banks now operate.  The difficulty will be in working out the details and the limits of this transition.

Postscript

We reread the above with some trepidation after a few months which seemed like an eternity in the financial markets.  The piece was written as financial crisis loomed, but it was written before Lehman Brothers a major financial institution was allowed to go into liquidation.  While it seems the caution we expressed about our own ability to predict the path the crisis would take forsook any chances we may have been able to take of demonstrating our clairvoyance, the piece above seems to us to stand up relatively well.

We were right to make the distinction between the navigation of small and large shocks. It seemed quite clear that the great moderation the reduction in volatility from the end of the last major recession in the early 1990s and 2008 should be seen as an improved capacity to deal with minor shocks.  The question was always whether it would assist in the handling of larger shocks.  We expressed our skepticism.  Now we know more.  Indeed as Daron Acemoglu argued recently it looks like the financial systems improved capacity to handle small shocks came at the cost of its ability to handle large shocks.  As he puts it, lesson one from the crisis is this:

The seeds of the crisis were sown in the Great Moderation… Everyone who patted themselves or others on the back during that time was really missing the point… The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.

It is possible to make the case that the Australian economy traded lower vulnerability to small shocks for greater vulnerability to large shocks in an additional way.  In addition to the embrace of a variety of financial innovations to which Acemoglu is referring, the period of the Great Moderation sees Australia using the increased availability of foreign capital to fund increased borrowing during periods of low export demand (following the Asian crisis) and increased investment (during the mining boom). The resulting smoothing of domestic consumption has come at the cost of higher foreign debt which, as the article above makes clear increases our vulnerability to external shocks the kind of shocks we are experiencing now.

References

Acemoglu, Daron, 2009. The Crisis of 2008: Structural Lessons for and from Economics, MIT, January 6, 2009 downloaded from http://econ-www.mit.edu/files/3703 on January 9th 2009.


http://en.wikipedia.org/wiki/Boiling_frog provides some evidence and links

It should be acknowledged that similar predictions of success were made in 1989 at what may prove to be a similar time of the cycle vis-à-vis today.  It would be better to wait before being too confident that we will make it through this cycle with a soft landing, particularly given the collapse of Lehman Brothers announced on the day this piece was due for submission!

On both points see Gruen, D., A Tale Of Two Terms-Of-Trade Booms*, Address to Australian Industry Group, Economy 2006 Forum, Melbourne, available at http://www.treasury.gov.au/contentitem.asp?NavId=016&ContentID=1077

Gruen, N., 2006, Designed defaults: how the backstop society can failsafe Australians’ superannuation, Progressive Essays, available at http://tinyurl.com/omves (pdf).  Nevertheless if this were done, steps should also be taken to reduce the regressiveness of the tax concession on saving within the superannuation system. 

Thus for instance one might allow lenders to lend 75 percent of the value of residential property of a certain quality during booms and 85 percent during downturns before requirements for additional security via mortgage insurance were required.  It would not be possible to fine tune such a policy, as regulators will not know precisely where we are in the current cycle, but they can have a reasonable idea of approximately where we are.

See Gruen, N., Govt could be net banker Australian Financial Review, 29th July 2008.

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