Economic adjustments loom as magic pudding disappears

While many Australians are busy discussing how to carve up our magic-pudding economy, the realisation that it is already depleted seems a distant prospect.

While many Australians are busy discussing how to carve up our magic-pudding economy, the realisation that it is already depleted seems a distant prospect.

But Woodside's decision to shelve the Browse liquefied natural gas project last week has ended the mining boom and we must now find new ways to develop investment if we are to grow. To do so, we must become more competitive, and we will, one way or another. There are two models to achieve it.

When an economy's standard of living surpasses its productive capacity, it tends to run large current account deficits as it borrows overseas and invests in unproductive stuff like property to support its inflated living standards. But this eventually runs out of gas when that nation's external position deteriorates enough to spook markets about the risk of not being repaid - such as what happened to Britain in the global financial crisis.

At this point a country has limited choices. It can continue to borrow via the public sector, as Britain has done, to support growth, as well as drop interest rates very low to ease the repayment burden on the private sector. This also devalues the currency, which makes the nation even more competitive.

The lower currency might spark inflation, which also serves to devalue the debts that are burdening public and private sectors and the real price of labour. Britain has also done this and wage growth since the GFC has been modest and below inflation.

Britain was succeeding in growing through external demand until Europe descended into crisis.

Which brings us to our second model. Europe's fringe states are being forced to pursue an exclusively internal devaluation. The big differences to the British approach are that government spending is cut, not expanded, and because of the common currency, there is no boost to competitiveness via a falling external price.

In Greece, for example, this has meant that wages are taking the brunt of the price adjustment, which has worked well to boost the external demand for its goods but has also meant that unemployment is through the roof.

In this scenario, growth is also so low that real debt burdens increase despite cutting spending.

Australia is better placed because it has a built-in increase of exports under construction already in the LNG boom. Some might argue that the same is going to happen in volumes for the bulk commodities, but they are wrong. The expansion in iron ore and coal is in trouble, with supply set to leapfrog demand later this year and then leave it far behind.The LNG boom will substitute for this deflating boom, not build on it.

That presents a pricing problem. We have enjoyed the high wage and income growth rates of the mining boom largely because China paid more for our goods, not because we earned it with better efficiency. As that income falls, so will capacity for wage growth and, if the falls are large enough, the nation will need to deflate to repair its competitiveness and boost investment.

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