Glenn Stevens: The challenge of prosperity
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the
Committee for Economic Development of Australia (CEDA) annual dinner, Melbourne,
29 November 2010.
* * *
Thank you for the invitation to play a part in marking the 50th anniversary of CEDA. It is
particularly significant for me to be here because 2010 also marks 50 years since the
commencement of central banking operations by the Reserve Bank of Australia. There were
in fact a number of significant beginnings in 1960.
It was a time of rising prosperity after a long period of difficulty. Between the depression of
the 1890s and the end of World War II, real GDP per capita in Australia had risen by about
35 per cent - or around half a percentage point per year. But in the 15-year period from the
end of the war to 1960, it expanded by about 25 per cent - or about 11⁄2 per cent a year.
The long post war boom would eventually see growing excesses from the late 1960s, which
ended in the disastrous instability of the 1970s. But in 1960, the boom still had a long way to
run.1
So 1960 was a time of optimism. There have been many ups and downs for the Australian
economy since then. CEDA has played its role in informing discussion and debate along the
way.
Two years ago, when I last addressed this group, optimism was anything but the order of the
day.2 The global financial system was in serious disarray and the global economy was
heading into recession. It was obvious Australia would be affected but I suggested that there
were good reasons for quiet confidence then about the long run future of Australia. There still
are, two years later.
But we have to turn that confidence into lasting prosperity. So I would like to offer a few
observations about some of the things we need to be thinking about. I do not have definitive
solutions, but offer these observations as a modest contribution to the discussion.
In so doing, I am not trying to convey anything about recent or prospective monetary policy
decisions. Tonight, at an event marking the 50th anniversary of a body devoted to Australia's
economic development, it is more useful to lift our gaze beyond the next interest rate
decision to look at a broader canvas.
I have one picture to show.
This is a very long-run chart of Australia's terms of trade. You may have noticed the Reserve
Bank saying a lot about the terms of trade in the past few years. Before I describe the chart,
why is it important?
Our terms of trade have a big bearing on national income. In economic commentary, there is
typically a very strong focus on GDP - the value of production - as a summary of national
material progress. There is also quite rightly an emphasis on lifting productivity - real GDP
per hour worked - as the source of our growth of material living standards.
For open economies, though, our standard of living is affected not just by the physical output
we can obtain from our resources of labour and capital, but also by the purchasing power of
that output over things we want to have from the rest of the world. This is what the terms of
trade is measuring. It is the relative price of our export basket in terms of imports. At the
extreme, if the economy were open to the extent that we exported all our production and
imported all our consumption, then the price of exports relative to imports would determine
our living standards entirely, for any given level of productivity per hour worked. As it is,
that
Australia is not open, and not as open as many smaller economies, but it is considerably
more open than the really large economies like the United States, the euro area or Japan. So
the terms of trade matter.
When the terms of trade are high, the international purchasing power of our exports is high.
To put it in very (over-) simplified terms, five years ago, a ship load of iron ore was worth
about the same as about 2,200 flat screen television sets. Today it is worth about 22,000
flatscreen TV sets - partly due to TV prices falling but more due to the price of iron ore rising by
a factor of six. This is of course a trivialised example - we do not want to use the proceeds of
exports entirely to purchase TV sets. But the general point is that high terms of trade, all
other things equal, will raise living standards, while low terms of trade will reduce them.
Returning to the chart, to my eye there are three key features.
The first is the degree of variability in the terms of trade through the middle parts of the 20th
century, from about World War I to the aftermath of the Korean War. This was, of course, a
period of considerable instability in the global economy, with the attempt to return to the Gold
Standard after the "Great War", followed by the 1930s depression, the Second World War,
the post war expansion and then the Korean War. I might add that, in those days, with the
attempt to maintain a fixed exchange rate, these swings were very disruptive to the
economy. Typically, a rise in export incomes would result in a rise in money and credit, a
boom in economic activity and a rise in inflation. Then the terms of trade would fall back and
the whole process would go into a rather painful reverse. The advent of the flexible exchange
rate in the early 1980s made a great difference in managing these episodes.
The second feature is the downward trend in the terms of trade, particularly noticeable from
the early 1950s to about the mid 1980s.3 This was the period of resource price pessimism,
the "Prebisch Singer hypothesis" and so on, which held that primary products would tend to
decline in price relative to manufactured products.4 The latter part of this period was the one
in which the realisation became widespread that the (apparently) easy gains in living
standards of the post-war boom were gone, and in which pessimism about Australia's
economic future was probably at its most intense. It was also the period when, under strong
political leadership backed by a highly capable bureaucracy and an economically literate
media, our determination to press on with various productivity-increasing reforms was
greatest. That these two phenomena occurred together was probably not entirely a
coincidence.
The third feature is the current level of the terms of trade relative to everything but the
alltime peaks over the past century. Measured on a five-year moving average basis, and
assuming (as we do) some decline in the terms of trade over the next few years from this
year's forecast peak, the terms of trade are as high as anything we have seen since
Federation.
To give some perspective on how important this is, let me offer one back-of-the-envelope
calculation. The export sector is about one-fifth of the economy. The terms of trade are at
present about 60 per cent higher than their average level for the 20th century, and about
80 per cent higher than the outcome would have been had they been on the 100-year trend
line. This means that about 12-15 per cent of GDP in additional income is available to this
country's producers and/or consumers, each year, compared with what would have occurred
under the average or trend set of relative prices over the preceding 100 years (all other
things equal). That will continue each year, while the terms of trade remain at this level.
Of course, part of this income accrues to those foreign investors who own substantial stakes
in the mineral sector. In this sense, the current boom is a little different from the early-1950s
one where most of the income went first to Australian farmers. Nonetheless, a good
proportion accrues to local shareholders and employees, and to governments via various
taxes. A non-trivial part of it is available to consumers as higher purchasing power over
imports, as a result of the high exchange rate.
It does not take much imagination to see that an event of this magnitude is expansionary.
Incomes are higher - in some cases a lot higher - and, absent some offsetting force, some
of that will be spent. So it has always proved in the past. Moreover, if, as seems very likely,
these prices prompt a build-up in investment to supply more of the commodities concerned,
there are further expansionary effects. Even applying significant discounts to stated
investment intentions, as the Reserve Bank staff have done in their forecasts, there is likely
to be a further significant rise in business investment over the next few years, from a level
that is already reasonably high as a share of GDP. On all the indications available, we are
living through an event that occurs maybe once or twice in a century.
So a very important question for us is: how do we handle all this?
We obviously have to be wary of overheating. The Bank has given its views on this point
before and I will say no more about that tonight.
But in fact the issues are broader than that. They extend to how we use the additional
income, and how soon, and to questions of structural adjustment.
One difficulty is that it matters a great deal whether the rise in the terms of trade is likely to
be permanent or only temporary. Unfortunately, we cannot really answer that question. It is
obvious from my chart that past episodes tended not to be permanent, but they sometimes
lasted several years and certainly long enough to be very disruptive.
If the rise in income is only temporary, it would be desirable not to raise national consumption
by very much. Instead, it would make sense to allow the income gain to flow into a higher
stock of saving, which would then be available to fund future consumption (including through
periods of temporarily weak terms of trade, which undoubtedly will occur in the future).
Moreover, it would probably not make sense for there to be a big increase in investment in
resource extraction if that investment could be profitable only at temporarily very high prices
(and which could come at the cost of reduced investment in other areas).
If the change is likely to be persistent, then income is likely to be seen as permanently
higher. Households and most likely governments will probably see their way clear to lift their
consumption permanently, both of traded and non-traded goods and services. Structural
economic adjustment will also occur as the sectors whose output prices have risen, now
being more profitable, will seek to expand, in the process attracting productive resources -
labour and capital - away from other sectors whose output will decline as a share of GDP.
Australia's floating exchange rate, which tends to rise in line with the increase in the terms of
trade, helps the reallocation of labour and capital by giving price signals to the production
sector. The higher exchange rate also speeds the spread of the income gains from the terms
of trade rise to sectors other than the resources sector, by directly increasing their
purchasing power over imports. The resulting rise in imports spills demand for tradable
goods and services abroad, which helps to reduce domestic inflation.
So the shift in the terms of trade will, unless clearly quite temporary, drive shifts in the
structure of the economy. It is easy, of course, to speak in the abstract of "reallocation of
productive resources", but this means that some businesses and incomes become relatively
smaller; jobs growth in some areas slows even as in others it picks up. Some regions
struggle more than others. Some sources of government revenue are adversely affected
even as other sources see an improvement. This process will be seen, not unreasonably, as
costly by those adversely affected, even though the overall outcome is that the country as a
whole is considerably better off. (It is also obvious that, if the terms of trade change really is
only temporary, it may not be worth paying these adjustment costs from the perspective of
the overall economy.) The policy challenge for governments will be whether to help these
sectors resist change, or to help them adapt to it.
We can carry out the thought experiment of imagining that, as a society, we wanted to resist
these changes completely and seek to preserve the existing structure of the economy. Let
me be clear I do not advocate this. But consider what would be involved. We would need,
inter
alia, to prevent the resources sector from responding to changed prices (preventing any
increase in its size). That would probably involve taxing away completely any additional
national income resulting from higher prices, and maybe also preventing any additional
exploration or capacity expansion to take advantage of strong demand that could be met
profitably even at after-tax prices. We would probably need to re-cycle any funds raised
overseas, in the process holding down the exchange rate. It is important to note, by the way,
that such funds could not be spent at home without adding to aggregate demand and hence
risking the inflation we would still be seeking to avoid in this scenario. In the scenario where
we want as much as possible to be unchanged, the additional income handed to us by the
change in global relative prices all has to be used offshore, one way or another.
If all the above could be achieved - a very big if, when one considers the logistics of what
would be required - then the economy's structure could, perhaps, remain as it was. This
course would mean forgoing the potential for higher export income by investing more in
resource extraction; either those gains would go instead to other resource-supplying
countries or, in commodities where Australia is a major producer, our lack of supply response
would result in further upward pressure on prices. So we would avoid the disruption of
structural change, but overall would be poorer than otherwise would have been the case, as
would, perhaps, our trading partners. It is hard to believe such an outcome could be
achieved and no less difficult to imagine it being thought desirable.
Realistically, we won't be able to hold the economic structure static in that fashion if there is
a major, persistent change in relative prices. Nor, I would argue, should we try. Had we had
that approach through our history, we would still be trying to employ 25 per cent of our labour
in agriculture and still be trying to ride "on the sheep's back" in chase of a world economy
that had moved on to place a much higher value on many things other than wool. We would
not have the highly developed services sector that we have today, nor the standard of living
we currently enjoy. So if the terms of trade do remain fairly high for a lengthy period, the task
is going to be to facilitate structural adjustment so as to make it occur in as low cost a way as
possible. But that ought to be feasible given that overall income is considerably higher.
Of course we cannot know whether the terms of trade will be high for a long period. History
certainly would counsel caution in this respect. We do know that supply of various resources
is set to increase significantly over the years ahead and not just from Australian sources. It is
for this reason that we assume some fall in commodity prices over the next several years.
The assumption underlying the Bank's forecasts published a few weeks ago is that iron ore
prices fall by up to about 30 per cent over the next several years. Even if they do, the terms
of trade will remain quite high by the standards of the past 100 years in the near term, as the
chart showed.
Is that assumed fall realistic? There is no way of knowing. Larger falls have happened
before. In fact they have been the norm. On the other hand, experienced people seem to be
saying that something very important - unprecedented even - is occurring in the emergence
of very large countries like China and India. If the steel intensity of China's GDP stays where
it is already, and China's growth rate remains at 7 or 8 per cent for some years to come,
which appears to be the intention of Chinese policy-makers, then the demand for iron ore
and metallurgical coal will rise a long way over the next couple of decades. If India's steel
intensity goes the same way as most other countries have, that will add further. Even with
allowance for supply responses by other producers and considerably lower prices than we
see today, that seems to point to a prominent role for the resources sector, broadly defined,
over a longish horizon.
So the most prudent assumption to make might be that the terms of trade will be persistently
higher than they used to be, by enough that we will need to accommodate structural change
in the economy, but not by so much that we shouldn't seek to save the bulk of the surge in
national income occurring in the next year or two, at least until it becomes clearer what the
long run prospects for national income might be.
As it happens, there does seem to be a good deal of saving going on, thus far, in the private
sector. A little-noticed recent statistical release was the annual national income accounts for
the year 2009/10. In that release, the Australian Statistician has made some major revisions
to the estimates for household saving (which of course is a residual arising from other major
aggregates). The revision lifted estimated household saving by $45 billion, or about 5
percentage points of income, from the previous estimates. The net saving rate is now seen at
some 9-10 per cent of income over the past year or two, up from about -1 per cent five
years ago.
In all the circumstances, considering what has happened around the world in recent years,
more cautious behaviour by households is not surprising. Nor, I would argue, is it
unwelcome. With the stimulus from the terms of trade and the likely investment build-up, the
economy can cope with more saving by households for a time. On the other hand, to expect
it to absorb a major surge in consumption at the same time as an historic increase in
investment is also occurring would be rather ambitious. In fact, we probably need private
saving to remain on a higher trajectory, and we will also need public saving to rise, as
scheduled.
In the longer term, the economy's increased exposure to large emerging economies like
China and India (these two now accounting for over a quarter of exports) - assuming that
continues - may also pose important questions. If these and other emerging economies
continue to grow strongly on average, but also, as with every other country, still have
business cycles, the result may be the Australian export sector, and therefore the Australian
economy, having a potential path of expansion characterised by faster average growth in
income, but with more variability. That possibility has been noted by some observers. It is
worth recording that such concentration would hardly be unprecedented - think about the
dominance of Japan in Australia's trade in the 1970s and 1980s, or the dominance of the
United Kingdom in an earlier era. Nonetheless, the degree of concentration could be higher
than we have seen in the past decade or more, which was a time of considerable stability for
the Australian economy overall.
We can't know whether this scenario of higher but more variable income growth will come to
pass. But if it did, how should we respond?
We could simply accept higher variability, if that comes, as the price of higher average
income growth. That would see higher variability in demand in the economy, which would
have its own implications, not least that it could make it harder for macroeconomic policies to
foster stability.
Another approach would be to reflect the higher income variability in our saving and portfolio
behaviour rather than our spending behaviour. We could seek to smooth our consumption -
responding less to rises or falls in income with changes in spending and allowing the effects
to be reflected in fluctuations in saving. In the most ambitious version of this approach, we
could seek to hold those savings in assets that provided some sort of natural hedge against
the variability of trading partners, or whose returns were at least were uncorrelated with
them. Of course, such assets might be hard to find - the international choice of quality assets
with reasonable returns these days is a good deal more limited than it used to be.
It is possible that this behaviour might be managed through the decisions of private savers.
There might also be a case for some of it occurring through the public finances. That would
mean accepting considerably larger cyclical variation in the budget position, and especially
considerably larger surpluses in the upswings of future cycles, than those to which we have
been accustomed in the past. There would also be issues of governance and management
of any net asset positions accumulated by the government as part of such an approach,
including whether it should be, as some have suggested, in a stabilisation fund of some sort.
These are pretty big questions and addressing them would not be straightforward, so I am
not going to attempt that tonight. The point simply is that, in the face of what appears to be a
very big event in our terms of trade, these issues are deserving of consideration - perhaps
by CEDA, among others, as you enter your sixth decade.
Conclusion
As I said at the outset, we have grounds for confidence in the future of our country, just as at
CEDA's beginning 50 years ago. Recent performance, not to mention the economic
opportunities in our time zone, has helped to strengthen our confidence.
But it would be a mistake to rest on recent achievements, as significant as they have been,
and to fail to press on in our efforts to do better. Past periods of apparently easy affluence,
conferred by favourable international conditions, probably lessened the sharpness of our
focus on the other element of raising living standards, namely productivity. It was
subsequently a long and difficult grind when we realised that international conditions had
become less favourable. So while I have not talked about productivity this evening, I do not
wish my focus on the terms of trade to be interpreted as implying that lifting productivity is
unimportant. On the contrary, while our terms of trade are handed to us, for better or worse,
by international relative prices, the efficiency with which we work is a variable we can actually
do something about.
A prudent approach might be to use the current period of exceptionally favourable
international prices to raise our saving, while maintaining a disciplined approach to ensuring
there are no impediments to lifting productivity. Consumption deferred - private or public -
can easily be enjoyed in future; consumption we get used to today is harder to wind back in
the future if circumstances change. These issues, and the associated structural adjustment
issues, no doubt will pose a challenge. But that's the challenge of prosperity - and not a bad
challenge to have.
It is sometimes said that Australia manages adversity well but prosperity badly. There will
never be a better opportunity than now to show otherwise.
References
Bowen I (1960), "The Australian Economy, July 1960", The Economic Record, 36 (75),
pp 307-355.
Prebisch R (1950), The Economic Development of Latin America and Its Principal Problems,
United Nations, New York.
Singer H (1950), "The Distribution of Gains between Investing and Borrowing Countries",
American Economic Review, 40, pp 473-485.