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.