A deficit of economic good sense

AUSTRALIA land of drought and flooding rains, and many mining booms in the past 150 years is currently in the biggest boom of them all. Commodity prices and mining investment are at record levels and, for the first time, both are at record levels simultaneously.

The mining boom is reshaping Australia, and has made most of us much better off. This is mainly because imports of all types are much cheaper, and also because the value of shares in superannuation portfolios has risen. But the boom also has negative effects, hitting trade-exposed industries such as manufacturing, tourism and education, and the communities that depend on them.

For eight years, leaving aside the brief period of the global financial crisis, the mining boom has delivered increased net benefits each year. The Australian economy and its policymakers have cruised along in the wake of these benefits. But the situation has changed.

Although the boom continues, its net benefits have peaked. Year-on-year it is no longer boosting economic growth, or helping improve Australians' welfare.

The nation must find new sources of growth, and adjust to a new reality of a high exchange rate but without further stimulus from mining. The boom has underwritten the economy for almost a decade. The new challenge is to shape policy in different circumstances for the next decade. In the near term this will mean further interest rate cuts and a shift to a more expansionary fiscal policy.

The once laudable goal of a budget surplus in 2012-13 is now inappropriate. The government should move to a less restrictive fiscal policy rather than pursuing an outdated commitment for political reasons. The underlying change is that the positive effects of the boom have ceased or become more muted, while the negative effects are growing.

First, the rise in the exchange rate has boosted the real incomes of all Australians who use imported goods and services, as we all do to varying degrees. We can buy more imported cars, foodstuffs, electrical and electronic goods and overseas trips, or we can save on our spending on imports and use the money elsewhere.

As a result of these and other factors, real household income per capita increased by 2.8 per cent a year between 2002 and 2011, nearly three times the rate of the previous 20 years. In 2011 it is about 18 per cent higher than it would have been had the earlier trend prevailed. But the sharp rise in the exchange rate has come to an end, as has real income growth from this source.

Second, the mining boom is so huge that even though the sector is now about 80 per cent foreign owned according to a report prepared in August for the Reserve Bank, the rise in mining incomes has flowed through to the value of assets held by many Australians.

Reflecting this and other factors, between 2002 and 2007 the real per capita assets of Australian households increased by 8 per cent a year, about three times the long-run rate.

But this source of benefit has also come to an end. Share prices are well below their earlier peak, real house prices are falling and many of the biggest new mining projects are effectively 100 per cent foreign owned.

Third, mining investment continues to increase, and the Reserve Bank predicts it could reach 7 per cent of gross domestic product by 2013-14. But what matters for the stimulus is the local content of this huge investment, which appears to be falling sharply. The emphasis is shifting to large liquefied natural gas projects, often offshore, and the high Australian dollar is reducing the competitiveness of Australian suppliers.

An extreme case of the shift in composition is the $12 billion Prelude LNG project, being built by Shell for drilling use off Western Australia. This involves the construction in South Korea of a platform three times the size of the MCG, which will contain the drilling rig, the liquefaction plant and docking facilities. It will be towed to the gas location and all aspects of production and export will be undertaken at that location. The local-content implications of such a project are minimal.

Finally, as the Australian dollar stabilises at or above parity with the US dollar, the position of trade-exposed local industries is becoming more difficult. Producers and customers do not respond much to volatility in the exchange rate. But when a major change becomes entrenched, more serious decisions to change the source of supply or spending are taken.

At its meeting on November 1, the Reserve Bank recognised that the economy was slowing and the threat of inflation was easing, and cut interest rates accordingly. Further reductions are likely to prove necessary.

With the mining boom boosting the economy further each year, it made sense for the government to take $50 billion out of the economy, or 3.6 per cent of GDP over two years, to achieve a budget surplus in 2012-13. Without the ongoing boost from mining and with the economy slowing this is no longer appropriate. Fiscal policy needs to be much less restrictive and more supportive of growth.

When heckled in a meeting about his inconsistency over time, the great economist John Maynard Keynes replied: "My good man, when the facts change I change my views. What do you do?" This is the challenge now facing the federal government.