Not called the lucky country for nothing or why Australia missed the Great Atlantic Recession

Nigel Stapledon, at the University of New South Wales explains why Australia missed out on the recession recently experienced by the USA and Europe.

While the Australian cricket team may have lost the ashes, in the (less important?) economic stakes, some solace has been taken in the Australian economy’s performance in effectively missing the ‘Great Recession’ (GR) experienced by the US and Europe. Looking at a broad measure (Figure 1), unemployment rose from just over 4% in mid 2008 to a peak of 5¾% in mid 2009 and then back down to its current 5%. Since, on some estimates 5% is full employment, the economy is clearly doing well.

The question is why did Australia miss the Global Recession? Is it because of the better institutions and greater astuteness of our policymakers? There has been a degree of good management involved. However, by far the bigger factor at play has been Australia’s good fortune to be a major source of resources in the Asia-Pacific at a time when China and other major developing economies have a large and growing appetite for resources.

The China story is not new - it has been growing at close to 10% per annum for over 30 years but, despite that, it still lags behind in living standards which leaves ample room for further rapid growth in the next decade. From an Australian perspective, much of China’s growth in the 1980s and 1990s was satisfied from its own resources but by the early 2000s, it needed to look elsewhere and Australia has been ready to oblige. Add in India’s accelerated growth and the demand for resources took off in the 2000s.

Specific to the Global Recession, China and India did feel the effects of diminished demand for their exports in markets in the US and Europe in 2008/early 2009. These economies are just as vulnerable to boom and bust. But on this occasion, these countries did not experience banking crises, had ample room to stimulate their economies and did so, and with their growth potential, by mid 2009 they had resumed normal (fast) growth.

Turning to Australia, in the period 2003-11 it has experienced its biggest resources boom since the gold rush days of the 1850s. One way to gauge the magnitude of the resources boom is the rise in the terms of trade as export prices have surged (Figure 2). The terms of trade is running about 65% above its long-term average. Note that the 1960s/early 1970s boom in response to Japan’s rise as an industrial power pales by comparison, as does the late 1970s/early 1980s energy boom triggered by the second oil shock. The terms of trade spiked in the early 1950s due to the Korean War-driven demand for wool but that was short-lived. On this occasion, the terms of trade high has been more sustained.

Another useful gauge is to look at investment. In the 1990s and early 2000s, resource prices were low and Australia as a resource exporter was out of favour with both domestic and foreign investors. The lack of investment in new capacity in the lead up to the boom meant limited capacity to respond with increased export volumes and that the initial impact of the surge in demand has been to drive up prices. With a lag, high prices have then led to the investment boom which has been the most significant direct effect of the resources boom on growth in aggregate demand in the period 2003-11. A useful way to look at this is in terms of investment as a share of overall activity, with non-residential construction investment (chiefly reflecting mining) at levels which make the property boom of the 1980s seem very modest although this investment is likely to prove more productive than the 1980s property boom (Figure 3).

Now in 2008 when the mortgage meltdown in the US started spreading, there were fears that this investment boom would collapse and lead to a serious recession. In the event, China and India came through this period in good shape and despite the problems experienced in the US and Europe, resource prices dipped sharply but only briefly before heading back to highly profitable levels. Thus while there was a brief pause in investment, it was just that, a pause before the mining companies pressed the go button with renewed vigour.

Central to the Great Recession in the US and Europe has been housing, with most economies experiencing sharp price falls and recession-inducing contractions in housing activity. Like the US and UK, the period from the mid 1990s to the mid 2000s saw substantial rise in house prices in Australia – indeed larger rises – but the end game has been very different. The institutional weaknesses in the US mortgage market were a major factor in the US but the UK shares similar institutional banking structures to Australia, so what explains or distinguishes Australia’s housing story?

The authorities claim some credit for this. In 2003, when the US, UK and European central banks were still reducing interest rates, the RBA started lifted its cash rate (from 4.25% to 5.25%). At the same time, it did some jaw-boning or what it terms ‘open-mouth’ operations – specifically, senior RBA officials making a few headline-catching warnings that house prices were overblown and that borrowers should expect more rate rises. The banks – the major source of lending to housing - were also directly cautioned on the risks and the need to maintain or tighten their lending standards. Their argument is that these actions caused the housing market to peak in late 2003, while other markets mostly continued to rise.

Maybe. But I suspect the good outcome indirectly owes more to the resources boom. When house prices in Sydney and Melbourne peaked in 2003, they were at levels which were over-valued to a about the same degree to that of the US housing market when it peaked later in 2006. The market was over-supplied (vacancy rates high, rents declining) and it was primed for a sizeable fall. But the resources boom was just taking off at this time, which led to solid income and employment gains and an upsurge in immigration. These factors boosted demand for housing which relatively quickly absorbed that excess supply. Those demand factors were partially offset by the Reserve Bank‘s action in lifting interest rates in the period 2004-08 (from 5.25% to 7.25%) in response to emerging inflation pressures in the economy. While causing prices to decline slightly the rate rises chiefly served to constrain new house-building activity.
By 2008 when the GR hit, the net result was that Australia was experiencing a housing shortage and significant upward pressure on rents which, in conjunction with subdued prices, had lifted yields closer (but still below) long-term equilibrium. In short, courtesy of the resources boom, the housing fundamentals in Australia were very different to those in the US and, at the extreme, Ireland for example. The Reserve Bank responded to the GR almost as aggressively as the Bank of England, cutting the cash rate by 4% to 3.25% between August 2000 – February 2009. The result was that house prices surged by 15%! That, together with other positive signs such as resurgent commodity prices, had the Reserve Bank changing tack and lifting rates in the second half of 2009.

On the fiscal front, when a resources boom delivers a river of company tax revenues, the life of fiscal managers is not hard. Governments in the period 2003-10 delivered an unprecedented succession of income tax cuts for households, the last three being the product of a bidding war in the 2007 election. It was also, for a growth phase in the economy, a period of relatively strong growth in government spending. Despite the largesse, at least until the GR came along, governments were able to ‘miraculously’ keep the budget in surplus. In short, courtesy of the resources boom, the Government was in a strong position in 2008 to respond decisively to the perceived threat from the GR.

The Treasury, mindful of its tardiness in advising the Government to respond to the early 1990s recession, recommended a policy of ‘go hard, go early’ this time. The Government accepted the advice and, while GDP contracted by 0.9% in the December quarter 2008, the first tranche of the fiscal stimulus was no doubt an important contributing factor to positive growth in the March and June quarters of 2009 and getting the economy through the hiatus before the resource boom resumed.

The major component of the first tranche involved fairly immediate cash payments to about low/middle income households - it was timely, targeted and temporary (three Ts) and boosted consumer confidence and spending in this period. (The Australian fiscal stimulus package has been applauded by the OECD as “highly effective” and by Joe Stiglitz as the best designed amongst the OECD economies.) There is some debate about the merits of the second tranche of the fiscal stimulus which was predicated on Australia experiencing a much deeper and more prolonged recession. It was targeted at the construction sector which was forecast to be badly hit but in the event was not. There were also a few ‘implementation’ issues which provide valuable lessons for the future on what not to do.

How long will this resources boom last? Lots of predictions but in truth no one knows. On the demand side, it can be argued there is still ample room for demand for resources from China, etc to grow. However, on the supply side, the investment boom will start lifting output significantly in the next few years – e.g., Australia’s output of iron ore is expected to double in the next five years and other producers are also investing in new capacity– so there is potential for supply to start catching demand and take prices down at least a few notches.

So, there is an inevitability that the resources boom will end and that is when (inevitably with hindsight) the astuteness of Australian policy-makers, this time in the good times, will be better judged.

From issue no. 153, April 2011, pp.12-14.

Page Options