Paying the Price of Economic Stupidity Cover Story The economy

Sunday, 01 April 2001


    The latest Australian economic figures are not encouraging. There was negative growth in the last quarter. If this continues this quarter, Australia is in a technical recession. So what happened? Only a few months ago the predictions were for continuing growth. As Dr Peter Brain explains, excessive consumer spending is not a solid foundation for growth.

    Australia is undergoing a significant contraction in its economic growth rate. This unexpected decline is in parallel with a similar slowdown in the United States economy. Given the readings of the Australian leading indicators a technical recession (of two successive quarters of negative growth) cannot be ruled out over the next nine months. However, the direct impact of the US economic slowdown on Australia's economy via trade, interest rate changes and exchange rate changes lies well into the future. That is, the current slowdown here is solely due to the internal dynamics of the Australian economy. The local slowdown is not, of course, entirely unexpected. National Economics (NIEIR) has been forecasting in its baseline projection a sharp slowdown post-Olympics. This has been a standard feature of our projections since 1995. Moreover, in these projections, the growth slowdown is projected to extend over at least two years. The inference was that a sharp post-Olympics recession was possible. In projections, NIEIR explained why its models predicted such a slowdown. Therefore, what follows is a summary of this explanation.

    The current situation is the cumulative effect of past economic shocks and events in the Australian economy over past decades. Perhaps the best place to begin is just before the last recession. The 1991 recession was largely the result of Australia experiencing a balance of payments constraint to growth over the late 1980 decade. In order to force the economy to live within a current account deficit of no more than 6 percent of GDP, interest rates were increased to very high levels. In the middle of 1989, the 90-day bill rate was over 18 percent. The effect of this upon the household sector can be seen in Figure 1. From this graph, it can be seen that the household debt service ratio in 1989 reached 26 percent. In order to stop the household debt service ratio from increasing above this unprecedented high level, the household sector had to cut back on consumption and dwelling investment expenditure, which of course, directly led to the recession. The ratio presented in Figure 1 is the ratio of household interest payments and the payments of principal to households' discretionary income. Household discretionary income equals the National Accounts household gross disposable income less imputed income and those segments of income which the households cannot use in the current period, such as superannuation payments and interest on superannuation fund investments.

    High interest rate costs and excessive investment in construction led the private corporate sector to be in as much difficulty as the household sector at the end of the 1980s. From Figure 2 it can be seen that the combined household and private non-financial corporate sector financial balance at the end of the 1980s had reached a deficit of 5 percent of GDP. The financial balance of these two sectors is from the Australian National Accounts and represents the net lending of private corporate non-financial enterprises and households. Until the early 1980s, the private sector financial balance for Australia was 2-4 percent as was also the case for the United States. Clearly at the end of the 1980s, the level of financial imbalance could not be maintained. Corporate enterprises along with households had to cut expenditure, reduce employment and cut costs which of course reinforced the recessionary forces in the early 1990s. The early 1990s recession had the effect of breaking the inflationary problem in Australia. The rise in unemployment reduced nominal wages growth and the severity of the recession reduced long-run inflation expectations. This outcome, in conjunction with institutional and technological change, which weakened the power of collective bargaining, produced the low inflation 1990s. This allowed normal interest rates to fall to low levels which, from Figure 1, led to a decline in the household debt service ratio and improved the Australian private sector financial balances as a percent of GDP. By 1993, this balance was marginally in surplus. Since 1993 the core driver of Australian economic growth has been one where the household sector has exploited the low interest rate environment to build up debt until the household debt service ratio was restored to the high levels that prevailed at the end of the 1980s. This allowed the household savings ratio to fall to negligible levels, consumption growth to be in excess of household disposable income growth, and for the recovery in equity and housing prices to produce a reinforcing positive wealth effect on economic growth. The cost of all this from Figure 2 was a steady deterioration of private sector financial balances over the second half of the 1990s which by 1998 produced the outcome where the private sector financial deficit represented an unprecedented 6 percent of GDP.

    This level has been held ever since. The 1998-2000 level of financial disequilibrium in the Australian financial sector was unsustainable. The turning point would be when the household debt service ratio reached the level that prevailed in the late 1980s. As can be seen from Figure 1, this is currently the situation. Thus, by 2000, the private sector in general and the household sector in particular has no option but to start cutting back in expenditures on consumption and housing expenditures in order to reduce the financial deficit, hence the current weakening in household expenditures both for consumption and growing investment. If the recovery in the private sector financial balance is rapid, as history suggests, then Australia will be plunged into a very severe recession. If it is more gradual, then at the very least Australia will face a number of years of low economic growth. The situation currently in Australia is not unlike that in the United Kingdom just before that country's recession in the early 1990s.

    The next thing to explain is why the Australian economy is on a parallel course with the US economy. The answer is readily seen from Figure 2 where the US economy has allowed an equal deterioration since the middle of the 1990-decade in its private financial sector balance. Until the middle of the 1990-decade, the US economy maintained its long-term historical private sector financial balance outcome of around 2-3 percent of GDP. Since then, the private sector financial balance has been negative with a deficit steadily increasing to just under 6 percent of GDP by 2000. This decline was the result of loose monetary policies and associated equity price boom, which induced and allowed the private sector to increase borrowings for consumption and investment despite deterioration in domestic savings. Again, like Australia, the current sharp deterioration in US growth simply reflects the fact the private sector financial deficit cannot be maintained. The financial sector deficit and its twin, the sharp build-up in private sector debt to GDP ratio is now forcing a cutback in consumption expenditure, investment expenditures, employment and dividend payouts. A healthy long-run growth outlook for both countries requires this process to continue until the private sector financial balance is pushed back into positive territory. A sharp recession or at the very least a lengthy period of slow growth is the only mechanism to achieve this outcome.

    Large-scale reductions in interest rates are no alternative to forcing the private sector back into financial surplus. Large scale reductions in interest rates, to the extent that they allow financial deficits to be maintained, will simply lead to further build-up in debt and lead to the situation where both the US and Australia will be faced with the Japanese scenario. The Japanese scenario is one where the level of debt reaches a point where it simply suffocates any positive growth stimulus to the economy no matter what the level of nominal interest rates might be. As a result of this type of debt trap, the Japanese economy has failed to grow over the 1990s. The final aspect that needs to be explained is why the Australian economy did not suffer a balance of payments constraint to growth in 1998 as a result of the Asian meltdown. The Asian meltdown as a result of a fall in export growth pushed the current account deficit over the critical 6 percent of GDP mark. That is why in 1998 and 1999 Australia was able to continue with high current account deficits, a relatively high exchange rate and low nominal interest rates. The reason is shown in Chart 3 where the build-up in NIEIR estimates of household borrowing for consumption neatly matched the increase in net foreign debt holdings of financial enterprises over the 1990-decade.

    Up until 1994, the household sector borrowed little to finance consumption expenditure. Since then, the explosion in debt financing of consumption expenditure has meant that by the end of the 1990s, total debt held by the household sector for consumption was over $100 billion. Over the 1990s, the holdings of financial enterprise net foreign debt increased by just under $120 billion dollars. Thus, a virtual cycle was set up where the current account debit was financed by household sector borrowings for consumption expenditure and the banks and other financial institutions acting as intermediaries in this process. This also explains the current weakness in the Australian dollar. The dollar was always going to weaken when the household sector was no longer willing to borrow for consumption expenditure. In the second half of 2000 the household sector started to significantly reduce its new borrowings for consumption. In the main, Australian economic policy over the 1990-decade has been reckless and incompetent. Policy was directed at short-term high growth objectives at the cost of an unsustainable build-up in household debt for consumption being been matched by a similar build-up in foreign debt.

    The costs of this economic stupidity are going to remain with the Australian economy for years to come. Moreover this policy has increased the vulnerability of the economy to shocks yet to be felt from the US slowdown and has aggravated the short-term difficulties associated with the introduction of the GST.



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