Dutch Disease, Hollowing Out and Picking Survivors

Courtesy of the RBA

In my first year of university, in one of the earliest classes, we were shown a graph Australia’s terms of trade in the 1950s. This is something I doubt would happen in economics education in most of the world, but Australia is different. The Korean war had required thousands of soldiers to be clad in uniforms woven from wool, the price of which soared along with the fortunes of the remanants of the old squatocracy. Then the war ended and things fell apart. The importance of international volatility and commodity prices was laid especially bare. This led to a great deal of study on similar topics by Australian economics, as well as giving the local profession a readyness for demand shocks in a way that their North Atlantic counterparts have tragically been shown to be lacking. It also created a deep insecurity and pessimism about Australia’s prospects, notably in The Lucky Country, that has helped ease the way of reforms. These inclinations are now being awakened again by the current resource boom.

The hardest bit is the problem of Dutch Disease or the “Two speed economy” as it gets called now (I guess punditry enjoys renaming familiar phenomena to make the discussion seem novel). This occurs high priced resource exports lead to an highly valued currency and tighter monetary policy. The first acts to the detriment of other trade exposed sectors and the latter acts to the detriment of all of them. This raises the prospect of higher unemployment and lower incomes for those not blessed by the resources.

There is the short term problem of differing fortunes. The idea of an Optimal Currency Area seeks to discover a situation where a single currency (and thus interest and exchange rate) will not cause too much distress. An element is fiscal unity so transfers from the booming  sector or region to the others can take place easily. This is absent in the Euro but fortunately not in Australia. In fact long before the Optimal Currency Area literature Australia implemented the Commonwealth Redistribution Scheme. Transfers to Western Australia were the price to keep it from seceding. Decades later, with WA blessed with an attic of iron ore, the money flows, at least temporarily, the other way. The issue of how such funds are raised is neatly addressed by a rent tax on resources. As the flood of money is comes from a price boom rather that anyone’s sweat or ingenuity, taxing it does not distort incentives and prices like a tax could normally be expected to. These have already been pursued, at least to the extent that public debate and the media favours reason over spivery. We could also target second order effects on the currency, such as extra appreciation due to the carry trade. Mark Crosby suggests a mild capital control in this vein.

Far more interesting are longer term effects. One is the notion that the Australian economy will be “hollowed out” – a fear heightened by news such as Bluescope Steel’s layoffs. Great rhetoric, but we should clarify what “hollowing out” means before we think about policy presciptions.

Lets consider an industry that, at least for low and medium levels of production, have increasing returns to scale. That is to say the marginal costs (and thus average costs) of each extra unit of output falls. Firms in this industry are operating profitably against foreign competitors at an output large enough to keep costs are low. But then a mining boom comes and the industry is rendered unprofitable by an exchange rate that lowers their competitiveness and high interest rates. They go bankrupt and disappear. Then the boom turns to bust and the exchange rate and monetary policy return to normal. If the firms were still operating they would be profitable once again, but they’re not. Furthermore, firms that start in that industry would be beginning at lower levels of production. Without economies of scale their marginal and average costs will be higher and they will be unprofitable. I think this is a clearer idea of what “hollowing out” would look like. Formerly viable industries are wiped out by a transitory resource boom but they cannot be easily reestablished. It’s not just the economies of scale and institutional structure  in individual firms that has been lost. The human capital of the workforce has deteriorated as workers have been unemployed or in other work and no replacements have been trained for those who have been retired and the positive externalities of industry clusters have also gone. The boom leaves the economy less productive than it was before.

With the problem better defined, how does this apply to Australia and the current boom?

Firstly, is the current boom going to turn to bust? There’s an argument that it won’t. Current demand owes a great deal to Chinese and Indian growth and both of these countries remain quite poor by per capita standards – there’s still a great deal of catch up growth possible – and unlike the wool boom there’s no discrete event like a peace treaty that can brings things crashing down. In this case we’d best work on structurally adjusting to a permanently higher dollar and high interest rates. On the other hand, every other resource boom in history has gone sour and there are many potential financial or political crises that could turn the Chindia story sour. There’s even the chance of massive technological advances that make coal and iron ore worthless. In truth we can’t make any confident forecasts at all. In this case we’d best in principal be wary of “hollowing out” merely as an insurance policy. The costs of acting needlessly should the boom be a structural change likely pale against the downsides if it does go bust with nothing to replace it.

So what insurance policies would be taken? The most obvious course would be to provide government support to affected industries to tide them over until they’re viable again. The basic logic is similar to the old infant industry argument for tariff protection and like the infant industry argument it has innumerable difficulties. The world is awash with kidult industries (including many national car industries) that never grew up and left the family home. If it was hard to pick winners, how would we pick survivors – industries who are unviable only due to the boom and not due to any other factors such as competition, technology or simple failure? When guarding against hollowing out we might end up with dead industries on life support (like most of the remainder of the world’s national car industries).

There are some differences though. On the downside, industries that are already established also already have spivs on retainer to produce sophistry arguing for government help. Were we to try and find which industries to support, anyone who could pay a PR man or lobbyist would miraculously produce evidence that the mining boom is needlessly hurting them (and this would probably include the Minerals Council). On the upside though there’s a great deal less uncertainty. Unlike infant industries we’ve already seen these industries in operation and can get a better idea of their problems.

Lets look at a few candidates.

The retail industry is not looking great as consumers use a high dollar to shop around on the Internet. But this is clearly not the whole issue. The Internet also reflects a structural change that provides greater variety with lower overheads. Anecdotally wholesale prices are higher than retail online prices for imported goods so anti competitive problems in the wholesale sector may also be to blame. High retail rents might be the result of a planning process that favours politically connected developers like Westfield. Furthermore, are there large economies of scale in retail that need to be maintained? I’m not sure that reestablishment would be difficult. [fn1]

The education sector is another candidate. But the part sector with high establishment costs (esp universities) will always be subsidised because of the desire to educate Australians. Additionally Stephen King contrasts the Australian sector with similarly resource booming Canada and fingers visa laws as the culprit.

The woes of tourism are more easily slated to the exchange rate [fn2]. Earlier this year we went on a 10 day holiday through NSW and Victoria and it cost over twice as much as our holiday to Vietnam the year before, and much more than our trips to Japan. That said what will be lost that is hard to reestablish? Hotels closed can be reopened – many open today have had stints as office buildings. Tour groups have fewer overheads etc.

I guess most successful candidates would be in manufacturing, such as Bluescope [fn3], and they would require more analysis than I am capable of giving. Perhaps more than we can genuinely hope for from experts. The sexy young things of New Trade Theory may have justified infant industry arguments in theory, but never found a way to make it a viable policy in practice. The same may be true in the hollowing out thesis.

If it’s too difficult to identify who, if anyone, we can directly support, what other options are there? Harry Clarke describes an idea from Ronald Findlay to tax resource exports, thus providing an effective cross subsidy to domestic manufacturing firms that use the commodity. Here Bluescope is a natural beneficiary of cheap iron ore. HC is skeptical for good reasons, and I would add the concern that it only works for industries that use the booming export. There’s no good reason why this would coincide with industries suffering solely from the currency and monetary policy.

But it is a start, and we could use the ideas.

[fn1] All of this likely to be little comfort to anyone who loses their job, but hollowing out, as opposed to the short term pain, is a long term problem.

[fn2] By way of disclosure, half my household income derives from this sector.

[fn3] Perhaps Port Kembla might hope their experience parallels Newcastle’s. The closure of the steel works is the best thing that ever happened to us.

 

 

 

 

 

About Richard Tsukamasa Green

Richard Tsukamasa Green is an economist. Public employment means he can't post on policy much anymore. Also found at @RHTGreen on twitter.
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20 Responses to Dutch Disease, Hollowing Out and Picking Survivors

  1. rog says:

    The closure of BHP in Newcastle was offset by the rise in the price of coal and the sudden shift to mining as a source of employment. There are other attractions but coal mining is the big earner. The south coast may have a different fate as much of the development around places like Shellharbour appear to be driven by factors unrelated to BHP.

  2. Richard Tsukamasa Green says:

    That’s a fairly easy hypothesis to refute if we look at the 2006 census data. This comes early in the mining boom, but by 2006 the observation that Newcastle was far better off was already common, and the persistent gap in unemployment between the city and the rest of the state was already rapidly closing (in fact was effectively gone). In the Newcastle urban area [fn1]

    [fn1] The unemployment graph is of the Newcastle LGA, the urban area also includes the Northern suburbs of Lake Macquarie. 1.39% of the employed population (or 1733 people) were employed in the mining industry, as opposed to 1.17% nationally. Compare to the difference between Education and the national percentage, or how mining is dwarfed by effectively everything else. BHP shed 2500 direct employees in 1999 (with up to 2000 in direct supporting firms). Even if every single mining job was created post 1999, it would only have reduced a rise in unemployment. As it turned out the loss of massive externalities like pollution massively outweighed the loss of jobs. Port Kembla is cursed with the steelworks remaining but jobs leaving.

    The mining as saviour story is an easy one to tell, but evidence shows it as implausible in Newcastle as it is nationally.

  3. JohnG says:

    Peter Martin has also posted on this issue and is concerned about the long-term skill losses:
    http://www.petermartin.com.au/2011/08/mining-it-hurts-us-more-than-you-think.html

  4. Paul Frijters says:

    I dont worry so much about the skills losses: Australia is such a great place that we can simply invite skilled foreigners to come in stead of educating them ourselves.
    The main worry I have regarding the Dutch disease (Gregory Thesis) is its long-term effect on Australian politics. Last-year’s mining tax saga was a real eye-opener in that regard.

  5. derrida derider says:

    A very clear analysis, Richard – this is an excellent post. Though I do reckon that if you want to have influence with People Who Matter you need to be much more dogmatic about the policy prescriptions. This economist’s “on the other hand …” shtick will get you nowhere against the PR spivs who will all find it very easy to “identify who .. we can directly support”.

    Paul, I’ve always worried about that argument for skilled immigration, at least as a longer-term strategy:

    (1) If the ToT collapses then you wont be able to pay the money to attract those skilled people. But then if the ToT stays high a lot of the skills will be for areas which, precisely because there’s a boom in the things you trade, face worldwide shortages of specialised skills – as the mining companies will already tell you.

    (2) There’s the wider question of why the country of origin would spend its resources on human capital investment if the products with the biggest investment just piss off overseas – an effect that has long been part of the poverty trap for some developing countries (eg India).

    (3) There’s the politics of it. You’re giving opportunities to foreigners that you’ve deliberately denied to your own kids. The argument that it is eventually in your kids’ own interests exists, but that’s going to be a bloody hard sell given instinctive human tendencies to xenophobia.

  6. Patrick says:

    You’re giving opportunities to foreigners that you’ve deliberately denied to your own kids.

    DD, what do you actually mean by this?

  7. Richard Tsukamasa Green says:

    Paul – Likewise, although I am less effusive about Australia – you have the enthusiasm of a convert. In many ways the capacity of mining rents to derail good policy was more disturbing to me than the Tampa was. Bigotry and Xenophobia comes and goes, with a long term trend towards the latter. The Bunyip aristocracy was something I thought was buried in the 19th century.

    DD – I decided a while ago that I’d rather be intellectually honest to myself as well as others than to fight spivery with spivery. That’s actually a reason why I chose to use my real name on blogs, as a hedge against any future cynicism that might possess me. This way, if I change my mind, I’ll have to explain why.

  8. JC says:

    The main worry I have regarding the Dutch disease (Gregory Thesis) is its long-term effect on Australian politics. Last-year’s mining tax saga was a real eye-opener in that regard.

    Paul, how exactly would imposing a tax on the mining industry improve Harvey Norman’s sales? Let’s leave aside the fact that this form of taxation was always meant to be a state based issue.

    Hollowing out is a serious problem. However there are numerous ways of offering permanent assistance to other industries that doesn’t mean tariffs and subsidies, or smacking down the very profitable industry.

    I see this too-much-focus thing as another example of the managerial class seeing a problem and thinking THEY must/can fix it.

    Sometimes you just leave things alone as you can’t really fix them. In pure macro terms, 40% of humanity is seeing rising living standards and this obviously places demand on scarce resources. There is nothing the Australian government can or should do to meddle in this.

  9. Paul Frijters says:

    DD,

    on (1), this is mainly a question of avoiding a low-income trap (let’s call it a Kiwi-trap to focus the argument since the Kiwis cant hold on to high skilled people who prefer to come here). As long as you manage to avoid really sliding a lot down the pecking order, the good people you managed to attract will themselves move into other industries if the ones they came for become les attractive. Australia’s long-term comparative advantage remains its land abundance and pleasant culture/weather, but the medium-term economic comparative advantage shifts.

    on (2) you are right that our gain is their loss, but it is not our concern. Countries like India, China, and the EU have no alternative but to educate their kids. From an ex ante point of view furthermore, they are investing in the well-being of their citizens, even if those citizens go on to be happy somewhere else. It aint bad from a world point of view either so no reason to feel guilty.

    on (3) I have noted that few know about this nor do they care as long their kids get jobs requiring no more than a passing affinity with the local language and customs. Amazingly, there are plenty of such jobs around.

  10. rog says:

    Richard, you may need to revise your earlier statements;

    In 1999, the steelworks closed after 84 years operation and had employed about 50,000 in its existence, many for decades.[22] The closure of the BHP steelworks occurred at a time of strong economic expansion in Australia. At the time of the closure and since the closure Newcastle experienced a significant amount of economic diversification which has strengthened the local economy.[23] Despite this, the closure caused a deterioration of the employment situation in Newcastle where the unemployment rate rose rapidly to almost 12% from under 9% at the previous trough just prior to the closure.
    Newcastle was hit particularly hard by recessions in the early 80s and early 90s. As of 2010 however, the region has experienced particular economic strength through increased diversification and high commodity prices.

    Since 2003, Australia experienced the effects of the 2000s commodities boom as commodities prices for major export good such as coal and iron ore rose significantly. This provided a large incentive for investment in the Newcastle and Hunter region due to its status as a major coal mining and export hub to Asian markets. Large projects related to the coal industry helped to propel the Newcastle unemployment rate to 20 year lows and allow the Newcastle region to weather the effects of the late 2000s recession better than NSW as a whole.[24]

  11. observa says:

    There is another glaring disparity with online shopping and that’s the asymmetric postage costs and China in particular dumping postage costs on Auspost and to the extent they do that it raises average costs for local onliners. An example should suffice. I purchased a Cat5 cable connector from China via ebay and it arrived supplied, packed labelled and posted for $1 AUD all up. You cant post a domestic letter for less than 60c and it costs $8.60 minm to post a parcel from Oz to China. Essentially original mutual post obligations(ie pay post only in country of origin) were set up for MDC to MDC but Asia is effectively postage dumping and stretching the friendship now. Or more accurately Auspost and domestic couriers are very much an import competing sector for online retailing now.

  12. Richard Tsukamasa Green says:

    By all means Rog, I revise as follows.

    The mining as saviour story is an easy one to tell, including by the editors of Wikipedia,but evidence shows it as implausible in Newcastle as it is nationally.

    If a lazy analysis is exposed with reference to data, you can’t just cite the same lazy analysis from another source. Doubling down on the facile isn’t very convincing. Data is.

  13. rog says:

    I am still unconvinced Richard, given that your own data sources are from Wikipedia it would seem that your argumentis without substance.

  14. rog says:

    Lets put it this way, if you want to base your analysis on what you can Google you have already lost.

    When BHP closed down it was very dark for Newcastle, the whole area was stunned. I remember reading in the Newcastle paper the numbers of real estate transactions, single digits and always negative – like “4 people sold and moved out and 2 moved in.”

    What really changed Newcastle (and I dont mean the LGA, I mean the Hunter) was the emergence of China which busted the stranglehold that Japan had on coal prices.

  15. Patrick says:

    I wonder if this is not a bit misconceived. Isn’t it arguable that developed countries generally are hollowing out, with perhaps the major exception being Germany?

  16. Patrick says:

    Premature posting syndrome.

    Also, how does one get to assume that skilled emigration is bad for the source countries? Doesn’t it:
    a) provide remittances?
    b) increase the returns to education and thus investment and participation in education, including for those who don’t actually migrate?
    c) provide a diaspora who can return as well as source non-remittance investment?

    On balance, I would have thought there was a lot to be said for skilled emigration.

  17. Mike Pepperday says:

    Avoiding the hollowing out seems straightforward – just tax the export of raw materials. Today’s NYT tells us China is doing pretty much what I suggested the other day:

    http://www.nytimes.com/2011/08/25/business/global/chasing-rare-earths-foreign-companies-expand-in-china.html?nl=todaysheadlines&emc=tha25

    “Companies that continue making their products outside the country must contend with tighter supplies and much higher prices for the materials because of steep taxes and other export controls imposed by China over the last two years.”

    Turns out the Prime Minister, Wen Jiabao, is a geologist. A politician with a real profession.

    The article also says:
    “China’s tactics on rare earths probably violate global trade rules, according to governments and business groups around the world.”

    More specifically:
    “For the last two years, China has imposed quotas to limit exports of rare earths to about 30,000 tons a year. Before that, factories outside the country consumed nearly 60,000 tons a year.
    “China has also raised export taxes on rare earths to as much as 25 percent, on top of value-added taxes of 17 percent.”

    And then, naturally:
    “For most industrial products that are manufactured in China using rare earths and then exported, China imposes no quotas or export taxes, and frequently no value-added taxes, either.
    “Companies do that math, and many decide it is more cost-effective to move to China to get cheaper access to the metals.”

    And it goes on to give some examples.

    “China’s timing is excellent, said Dudley J. Kingsnorth, a longtime rare earth industry executive and consultant in Australia. Mines being developed in the United States, Australia and elsewhere will start producing sizable quantities of rare earths in the next few years, so China seems to be using its leverage now to force companies to move.”

    We will, presumably, simply export ours raw.

  18. JC says:

    Mike:

    Rare earths are being “taxed” because China thinks it screw around with other users through two ways.

    It thinks it can control the price, but it can’t because rare earths actually aren’t so rare, as we’ve found out.

    The other, dirty little secret with his stuff is that the processing is absolutely toxic leaving poison lakes of sludge that will kill you if you’re within a few miles of the stuff. Few countries were able to process it for environmental reasons. The US became an importer for that reason alone.

    Those people that think Solar and Wind power are wonderful goldly creations ought to go look at what is left behind in China, as those elements are pretty important in contraction of those things.

    Now guess what happened when China tried to play footsie with supplies and the price.

    It started a rare earth boom around the world and also helped in people figuring out ways to process it with less damaging environmental residual. See Lynas plan to process in Malaysia.

    Take a look at Lynas price last year and how it ran up. Also look at some of the US prospects and the stock price for Molley Corp.

    This attempt didn’t work and China will lose its status. Japan refuses to deal with them longer term as they are too unreliable. And japan isn’t alone.

    We have actually done something long lasting and helpful to ourselves.. BHP started the ball rolling by refusing to quote much of their produce in long-term contracts and now the market mostly deals in the spot market rather than long-term contracts. This is a good change in the market as Iron ore and coal have fairly pronounced negative yield curves.

    I would welcome anyone being able to obtain a processing licensee here in the same way the Chinese process rare earths. But don’t hang around the lake filled with that toxic sludge.

    We will, presumably, simply export ours raw.

    We closing steel plants.

  19. Mike Pepperday says:

    JC- Thanks for the info. It is evident from the NYT article that China seeks to exploit its monopoly position. But it’s not the whole story. Alone by levying an export tax, they are encouraging domestic processing.

    Pollution is a separate matter. Secondary industry tends to be polluting and we are always hearing of industrial countries pushing dirty work onto less developed countries. And of course China is slack in this regard. Actually, it’s another argument in favour of our levying export tax: the domestic/foreign price difference would pay for proper environmental measures.

    Observa – I never heard of the Swiss choosing between govt or private enterprise on the basis of accountability. Not implausible. For example, though it is a very capitalist, zero tariff, free enterprise country, they did vote for a national health scheme. The 26 cantons vary in the extent of their direct democracy and I do know there is a lot of research showing that the more direct, the lower the taxes.

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