Adrienne Hosek
Kate Pomper
The Debt: Australia’s New Ball and Chain?
Over the 1990s, Australia grew faster than any other large developed economy.1 Today, growth
continues to be strong, and major economic indicators are positive. High debt, a housing bubble,
and a steadily growing current account deficit, however, leave Australia vulnerable. To this end,
we recommend tax incentives to encourage consumer saving, and otherwise, staying the course.
I.
Recent Macroeconomic Performance
Australia’s economy is currently in its thirteenth year of expansion. This remarkable growth
period can largely be attributed to low interest rates and inflation targeting, which have created a
favorable climate for investment. Throughout expansion, unemployment has steadily declined.
Gross Domestic Product
Since 1992, Australia’s real gross domestic product has increased from 470.1 billion Australian
dollars (2000) to 739.4 billion Australian dollars (2000).2 It has grown at nearly 4 percent on
average and only grown at less than 3 percent in 2001, when the United States, Japan, Europe,
and Australia’s partners in East Asia were in recession. The growth rate measured on a per
capita basis is slightly lower, averaging 2.5 percent from 1992 to 2003, but trends consistently
with the percentage change in real GDP.
Interest Rates
Between 1989 and 1992, two successive fiscal contractions and modestly expansionary monetary
policy led interest rates to fall from 15.7 percent to 6.1 percent (Figures 1 and 2). Where interest
rates averaged 12.4 percent in the decade preceding the contractions, they averaged 4.4 percent
in the decade following.
Inflation
In 1993, the Reserve Bank of Australia introduced an inflation target with the objective of
keeping monetary policy in check and preventing distortions in economic decisions.3 Since
2003, it has defined the target as 2-3 percent on average over the business cycle, as opposed to
hard-edged band.4 This allows the Reserve Bank to employ monetary policy to soften
fluctuations in the business cycle.5
1
“Down wonder; The Australian Economy,” The Economist, April 6, 2002.
All statistics in this paper are from IMF International Financial Statistics, unless otherwise noted.
3
About Monetary Policy, Reserve Bank of Australia, available at
http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.htm.
4
Ibid.
5
Ibid.
2
Since the target was implemented, inflation has averaged 2.5 percent per year. The Reserve
Bank has not abstained from monetary policy, but rather, has managed it carefully. Between
1993 and 2004, the Reserve Bank substantially expanded the money supply only twice: it
appears once to mitigate the effect of the Asian crisis and once to mitigate the effect of the
international recession at the beginning of this decade (Figure 3). Each time, it carefully limited
growth in the money supply the subsequent year to below GDP growth. In 1997, after the larger
of the two expansions (32.4 percent) the Reserve Bank actually contracted the money supply. It
additionally contracted the money supply in 1999.
Investment and GDP Growth
The combination of low interest rates and low inflation has led investment to grow rapidly.
Excepting the Asian crisis and the international economic slowdown in 2000-2001, real
investment has risen at a rate of 10 percent on average. Consistent with the IS-LM model, this
has resulted in rising output. Importantly, monetary policy aimed at tracking GDP growth in the
mid-1990s and buffering against recession later kept interest rates low with growth.
Low interest rates and inflation targeting thus appear to explain much of Australia’s sustained
economic expansion. Investment is the only component of GDP that surpassed the growth in
real GDP consistently and substantially over the past thirteen years (Figure 4, net exports not
shown). Significantly, consumption, the only component of GDP that exceeds investment,
bolstered the economy in 1997 and 2001 when investment faltered because of recessions among
Australia’s trading partners—the United States, Europe, and East Asia (Figures 4 and 5).
Unemployment
As GDP has grown, unemployment has fallen, illustrating Okun’s Law well (Figure 6). In
1992, the unemployment rate was 10.5 percent. By 2004, unemployment was 5.5 percent.
While unemployment has decreased, labor force participation has risen slightly to 64 percent.6
This statistic, however, masks a decline in men’s labor force participation and a rise in women’s
labor force participation. Women are more than twice as likely to work part-time.7
Consequently, 27 percent of employees in Australia in 2002 were part-time workers, as
compared to 13 percent in the United States.8
II. Vulnerabilities in the Australian Economy
Consumption
As discussed above, consumption buoyed the Australian economy as recession threatened.
Consumers continued to spend, encouraged to borrow by low interest rates and feeling “wealthy”
6
“Labor force participation: international comparison,” Australian Bureau of Statistics, available at
http://www.abs.gov.au/ausstats/abs@.nsf/Lookup/4408BF5064F2EA02CA256E15007513BC.
7
Ibid.
8
Ibid.
as housing prices skyrocketed.9 These very factors that allowed Australia to escape recession in
the 1990s, however, may be the cause of recession this decade.
Consumer borrowing increased so much over the 1990s that the ratio of per capita consumer debt
to per capita income doubled, rising from 24.5 percent in 1992 to 52.7 percent in 2003.10 A hike
in interest rates making debt more expensive could easily lead consumption to dive. A fall in
housing prices could also cause a severe consumption shock. Housing prices are estimated to be
overvalued by as much as 30 percent, and currently, over 60 percent of Australians are
homeowners.11
The Debt
At more than fifty percent of GDP, Australia’s total debt is one the largest of any industrialized
country. Low interest rates and inflation, combined with a robust economy have allowed
Australia to finance its growing debt through net borrowing from abroad. Since 1990, total debt
has increased at an average rate greater than real GDP, though its movement has been volatile
relative to that of GDP.12 The only way to sustain such debt is if the real growth rate of output is
greater than the real interest rate.
Up until this point, low interest rates have supported consumer and corporate spending habits.
For the moment interest rates and GDP are moving in tandem, but interest rates could rise in the
future (Figure 7). Slowing net foreign investment within the past two years indicates that
foreigners are less confident output will continue to outpace interest rates in the future. This
hesitance is support by evidence that foreign investors are beginning to favor more liquid
investment instruments and have recently shied away from long-term interests.
Current Account Deficit
The changing investor environment is most aparent in the market for foreign goods and services.
The current account deficit ballooned to $95 billion at the end last year, a 400% increase since
2002 (Figure 8). The deficit was largely driven by the favorable exchange rate, which made
foreign goods relatively less expensive. As a result, Australian demand for foreign goods
accelerated over these past two years, outpacing growth in demand for exports. An influx in
foreign financial investment has financed the growing current account deficit. Starting in the
first quarter of 2004, however, the financial account surplus narrowed considerably to half of
what it was in 2003 and the overall balance of payments went into a $44 billion deficit, the
second largest ever recorded. The largest balance of payment deficit occurred in 2000, in
response to the global economic recession.
9
“House of Cards,” The Economist, May 29, 2003 [hereinafter House of Cards].
Reserve Bank of Australia Statistics, Table D05: Bank Lending Classified by Sector, available at
http://www.rba.gov.au/Statistics/Bulletin/D05hist.xls.
11
See House of Cards.
12
Reserve Bank of Australia Statistics, Table H05: Australia’s Net Foreign Liabilities; IMF International Financial
Statistics.
10
A closer look at the drop in total foreign investment reveals an interesting trend in the financial
account that has significant consequences for Australia’s ability to sustain a trade deficit into the
future (Figure 9). The financial account is divided into three main types of foreign investment:
net direct foreign investment, net portfolio investment, and net other investment.13 Direct
foreign investment generally signals long-term foreign interest in domestic enterprise, while
portfolio investment includes shorter-term investments in Australian financial markets by
foreigners. Other investments include transactions in currency and deposits, loans, and trade
credits. Portfolio investment reacts more to short-term fluctuations in the economy making it
highly volatile. Investors often prefer portfolio investment to direct foreign investment, because
they can quickly pull-out in response to unfavorable changes in the exchange rate, interest rate
and inflation.
The financial account surplus in recent years has been solely supported by foreign portfolio
investment. Two significant drops in net foreign and other investment, however, cut the
financial account surplus in half in 2003. This narrowing combined with the expanding current
account deficit led to the dramatic drop in the balance of payment curve during this time period.
The last major balance of payment deficit occurred in 2000, and like the most recent event it
followed a period of surplus fuelled by robust financial foreign investment. The earlier slump
coincided with the global economic recession, which saw worldwide investment fall. Australia’s
strong economic growth, however, quickly enticed foreign investors to reinvest in the Australian
markets. In the period that followed, net portfolio, foreign, and other investment tended to be
positive. At the same time, the current account deficit was smaller than in past years.
The present situation is much different. Australia’s current account deficit has steadily grown,
reaching historic proportions. This growth has been largely offset by foreign investment up until
recently. Since 2003, however, the flow of funds from abroad has slowed as investors
abandoned long-term interests in favor of short-term investment instruments. While net portfolio
investment remains strong, net direct foreign and other investment has weakened; a signal that
investors may believe Australia’s phenomenal growth is coming to and end. As the current
account deficit grows, it will place increasing strain on the Australian economy, dampening
expected GDP growth in upcoming years.
III.
Policy Recommendations
▪
Encourage consumer saving through the provision of tax incentives
Increasing consumer saving would leave the economy less vulnerable to a consumption shock by
decreasing consumers’ exposure to a hike in interest rates. More importantly, according to the
Solow growth model, it would promote higher steady-state per capita GDP. Higher savings
rotates the savings function outward leading to higher steady-state per capita capital (Figure 10).
Though it is unlikely that Australia’s economy presents increasing returns to scale, it is important
to note that if an endogenous growth model did provide a better fit, increasing savings would be
13
We do not mention foreign derivatives, as it did not appear to a significant impact on the financial account.
less important. Given Australia’s expansion, it would already be on the portion of savings
function where per capita capital and output are continually increasing (Figure 11).
▪
Do Nothing
Australia has minimized the pressures of a growing debt by engaging in conservative fiscal and
monetary policy. President John Howard is committed to reducing the government debt, and
together with the parliament has avoided deficit spending in recent years. Monetary policy is
constrained by inflation-targeting laws that require the Reserve Bank of Australia to keep
inflation around two percent a year.
The government should stay the course and avoid taking drastic measures even if it means
Australia falls into recession. A more interventionist policy is unpredictable and may potentially
lead to a worse outcome in the long-run. It is possible that Australia’s economy will continue to
grow at a rate that can sustain its debt. Otherwise, a recession would allow Australia’s economy
to naturally readjust to a point where it is in equilibrium and can resume growth under more
stable conditions.
Figure 1. Changes in Real GDP, Real Investment, the Money Base, and the Deposit Rate: 1985-1995
20.0%
15.0%
10.0%
5.0%
0.0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
-5.0%
-10.0%
-15.0%
-20.0%
Changes in Real GDP
Changes in Real Investment
Changes in Money Base
Deposit Rate
Source: IMF International Financial Statistics
Figure 2: IS-LM 1990-1992
r
LM1
LM2
LM3
r1
r2
IS1
IS2
IS3
r3
Y1 Y3 Y2
Y
Figure 3. Changes in Real GDP and the Money Base: 1989-2004
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-5.0%
-10.0%
-15.0%
Changes in Real GDP
Changes in Money Base
Source: IMF International Financial Statistics
Figure 4. Changes in Real GDP, Consumption, Investment and Government Spending: 1992-2004
20.0
15.0
10.0
5.0
0.0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-5.0
Changes in Real GDP
Changes in Real Consumption
Changes in Real Investment
Changes in Real Government Spending
Source: IMF International Financial Statistics
Figure 5. Components of GDP, 2004
Real Net Exports (-), 3%
Real Government Spending,
18%
Real Consumption, 60%
Real Investment, 25%
Source: IMF International Financial Statistics
Figure 6. Australia and Okun's Law: 1992-2004
Percentage Change
in Real GDP
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.5
-1.0
-0.5
0.0
Change in Unemployment Rate
0.5
1.0
1.5
Source: IMF International Financial Statistics
Figure 7. Interest v s Real Growth (GDP) Rate
Millions
Figure 8. Australian Balance of Payments: 1990-2004
15000
10000
U.S. Dollars
5000
0
-5000
-10000
-15000
Q1 1990
Q1 1991
Q1 1992
Q1 1993
Q1 1994
Q1 1995
Q1 1996
Current Account
Q1 1997
Q1 1998
Financial Account
Q1 1999
Q1 2000
Q1 2001
Overall Balance
Source: IMF International Financial Statistics
Q1 2002
Q1 2003
Q1 2004
Millions
Figure 9. Financial Account (1990-2004)
20000
15000
U.S. dollars
10000
5000
0
-5000
-10000
-15000
Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004
Financial Account
Net Foreign Investment
Net Portfolio Investment
Net Other Investment
Source: IMF International Financial Statistics
Figure 10: Solow Growth Model
y
δ+n+g
f(k)
y*2
s(f(k))2
s(f(k))1
y*1
k*1
k*2
k
y
Figure 11: Endogenous Growth Model
f(k)
y1
s(f(k))2
s(f(k)1
y2
δ+n+g
k2
k1
k