The resources boom and economic policy in the long run

15 Sep 2012

A major economic impact on Australia of the rise of Asia has been through the resources sector. Australia is experiencing the biggest and most sustained resources boom in its history, and over the past decade has sustained economic growth well in advance of its developed country comparators. The mining boom is yet to run its full course, but at this stage the lift in Australian income levels, compared to Australian OECD Europe and US relativities of a decade ago, is probably of the order of 25 per cent.

We think of this extraordinary mining boom as moving through three stages: the increase in the terms of trade, an induced mining investment response and finally a significant increase in mining exports. This paper explores the implications and policy issues arising as the mining boom passes through these three phases.  The emphasis is firmly placed on the medium term and the analysis is stripped back to what we regard as the essential elements of economic outcomes and needed policy responses as the mining boom runs its course.  

We put forward four propositions about the economic impact of moving through these stages.

First, the direct impact of the large increase of the terms of trade, considered in isolation (the trading gain), has been massive, and of the order of 10‐12% as a ratio of GDP since 2002.  The trading gain income effects of the terms of trade increases are not included in real GDP, but they do impact on real GDP. The general flow‐on effects of the terms into real GDP have been very positive and this net direct impact contributes an additional large stimulatory effect.  These flow‐on effects, measured by changes in real GDP, have lifted Australian incomes by a further 10‐12 per cent relative to our European and North American comparator nations.  Over the next five years, however, we conjecture that the terms of trade will fall substantially and this fall will be a substantial deflationary force acting on the Australian economy to remove some of the trading gains and slowing the rate of growth of real GDP.  

Second, in the near future this deflationary shock from the decline in the terms of trade will be offset to some extent by the large increase in mining investment that has begun and will continue, although scaled back relative to previous projections. While the investment boom lasts it will be a positive force for economic growth.  But this source of stimulus should peak in two years or so.  

Third, the increase in mining export volumes, in response to the large price increases over the last decade, have been very modest to date, but this situation is about to change as mining exports begin to increase rapidly in response to increased supply capacity. We expect exports to increase substantially even though export prices are likely to fall. Increased mineral exports will be a positive force increasing income with the potential to offset some of the deflationary impacts of falling terms of trade and falling mineral investment.

Fourth, when we put together our best conjectures as the future evolution of the terms of trade, mining investment and mineral exports, and attempt to balance the changing pattern of positive and negative influences on growth outcomes. The calculations invariably suggest that the total mining boom experience will become a net deflationary force operating on the Australian economy within a few years. We conjecture that the negative impact on economic growth begins in about eighteen months or so and will become increasingly evident quite quickly. There seems to us to be little doubt as to the direction of change – mining will move from a stimulatory force of a contractionary one – although it is not at all certain how strong the negative forces will be. If there is a major economic downturn two or three years hence, the central challenge facing macroeconomic policy over the medium term is how to address this deflationary shock. What should be done to retain as much as possible of the past income benefits of the resources boom?  

Our first policy point, in addressing these deflationary forces, is that the limits of monetary policy in this environment must be recognised. If interest rates over the next year or so are significantly reduced, the limits of conventional monetary policy could be quickly reached, as has been the case in our comparator countries of Europe and North America. Expansionary monetary policy, to fully offset a major deflationary impact as the mining stimulus to growth is withdrawn, is not a feasible outcome. In the longer term exchange rate devaluations, which could be substantial relative to current exchange rate levels, will help, but we do not see large and quick responses of a sufficient magnitude within the economy over the period needed.

Our second policy point, in response to a deflationary shock, is that the Government should follow a more expansionary fiscal policy, with an acknowledgement of continuing deficits and increasing debt levels. But, in spite of Australia’s strong fiscal position, the extent of this response is likely to be limited by the low level of government revenue as a share of GDP, by slow growth in tax receipts from resource projects and by political concern about deficits and debt. Given these real and political constraints on monetary and fiscal policy, how might we proceed?

Our third policy point addresses this question. We do not see any real alternative to increased government involvement in providing increased expenditure stimulus. We have a particular program of reform in mind to achieve this. We suggest that a new Federal‐State infrastructure investment vehicle be developed, which made use of rising revenue to the States from mining royalties (including to the non‐resource states through the GST redistributive mechanisms) to meet the funding costs of such investment. An important part of the development of this institutional structure will be to use the Australian Government’s strong credit rating position to facilitate low cost financing by the States. We suggest that this development also be used to reform the tax revenue base and suggest that consideration be given to increases in the GST rate. This would be a win‐win situation, providing benefits for both levels of government and the Australian economy. This plan goes to the very nature of Australian federalism and it is important that the policy discussion begin as soon as possible. The economics might be straightforward but the politics may be difficult.

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