THE DISTILLERY: Debt delusion

Karl Marx described it. Economic theory defines it. The ACCC is supposed to fight it and anyone calling themselves a businessperson should oppose it. It's the desire by big business to consolidate competition and attract monopoly pricing power.

Today a senior commentator wakes up and declares victory for this column over Australia's most destructive example of it. According to Terry McCrann of the Herald Sun, "... there's now not a hope in Hades of [the BHP and Rio] Pilbara iron ore merger getting up. Indeed arguably it shouldn't anyway. It poses arguably too big a competition risk – and it's probably against our national interest.”

McCrann reckons that "...Now Rio and BHP have also, and I would suggest quite honestly, argued that the merger was only a production union to maximise efficiencies. They estimated synergies would top $10 billion – I'd suggest another big underestimate. Once produced, each would then take their ore and market it as before. Unfortunately for the duo, maybe with perfect timing for everyone else, this year's negotiations have demonstrated that it's not that simple. Production, especially when you are producing nearly two-thirds of the world's traded iron ore, can be a powerful anti-competitive tool. Indeed, you don't even have to suggest potential deliberate manipulation of supply to see there 'is a problem'. The simple reality of adjusting production to market conditions could have 'unintended' competitive consequences.”

This column will be a little blunter. Serial attempts by BHP to merge with Rio businesses demonstrate a simplistic desire on the part of the Big Australian to get fat on rent seeking. The first time around it cost shareholders $500 million. How much on this second attempt? Moreover, if we look at the Big Australian's long-term strategy, we find much greater waste. The Financial Times recently estimated that new short-term iron ore contracts will deliver roughly $10 billion in new revenue to the companies. These revenue gains are offset to a degree by the unachieved cost-reductions resulting from the failing JV. Worse, the higher iron ore price will greatly encourage global competition. And all of this was achieved at the cost of infuriating the major buyer: China. When surplus production arrives and prices soften, China will remember its enemies.

For the nation, we have traded a cosy duopoly with strong reliable revenue and a sustainable rules-based frame of strategic engagement with the rising regional power for an economic and diplomatic boom/bust cycle. This column humbly suggests that what is needed is an informal but official two-pillar policy for the two big miners – along the lines of that faced by the banks – to prevent them attempting to gouge again and repair some of the diplomatic damage.

Needless to say, this renders moot columns by Matthew Stevens of The Australian and Stephen Bartholomeusz of Business Spectator on whether or not Rio shareholders should seek higher equalisation payments for the JV. This column will observe wryly that at least the two companies have a face-saving excuse to walk away when (or before) the deal gets spiked by regulators.

This future makes two economic pieces by Alan Kohler and Stephen Bartholomeusz of Business Spectator on the likely commodity windfall this year all the more pressing. Kohler argues that "... RBA board member Warwick McKibbin suggests that Australia follows Norway's lead and sets up sovereign wealth fund that goes beyond the narrow ambition of the Future Fund to finance public service pensions. Norway's 4 million souls now own a fund worth more than $US400 billion, throwing off a big contribution to national income every year.” Michael Stutchbury of The Australian has made similar suggestions on this line and more debate from all quarters would be good. On the other hand, Bartholomeusz argues that "...the government could absorb that shock and return the budget to surplus years ahead of schedule”. This column endorses the call, not least because the wholesale bank guarantee sitting off the government balance sheet, now totalling $155 billion, must be prevented from any possibility of a debt deflation spiral via sovereign downgrade when the cycle turns.

Either way, the government must prevent the income surge from entering the real economy. The reason for this is simple. Contrary to arguments by Alan Kohler, Adam Carr and Christopher Joye at Business Spectator, Australia does indeed have gigantic credit bubble. It may not yet be apparent in the flow of credit in this cycle – with solid mortgage growth in the 8 per cent range. But it is screamingly obvious in the debt stock, where we find mortgage credit alone in excess of GDP.

The propensity of equilibrium economic models to ignore stock was recently identified by William White, former head of the BIS, as the number one cause of the GFC. This column agrees. Australia has an enormous debt-stock overhang from the offshore borrowing of the last cycle. That is our credit bubble. If addressing it means property spruikers and retailers must suffer, so be it. It is no longer prudent for externally funded economies to use leverage to live beyond their means.

As Alan Jury of The Australian Financial Review argues, this will not be easy. "Now, amid growing wage pressures and tight labour markets, rising forward orders and capacity utilisation, an equities market that is being swelled by surging takeover activity, and mixed economic signals at best from many of our traditional trading partners, the task seems to have become one of reining in confidence and keeping a lid on expectations, lest it get out of hand.”

This column will add that this was always going to be the challenge of this cycle. The easy days of macro management are when a population's expectations of living standards are lower than the economies' productive capacity. The difficult days are when expectations are higher. The RBA looks to be on to this. It needs greater support from government and commentators.