Section One on “ The future of the Australian economy” starts with the following preamble:

“The Australian Government is committed to modernising our economy so that we can compete with the leading nations in a world economy that is being transformed by globalisation, new technologies, and the rise of China and India. While we take full advantage of the mining boom, we must also build long term competitive strengths in the global industries of tomorrow – industries that will provide the high-paying jobs of the future.

The Australia 2020 Summit will examine:

  • After a long period of sustained economic growth and with the added benefits of the global mining boom, how do we best invest the proceeds of this prosperity to lay the foundations for future economic growth?
  • How we best prepare for a global economy that will increasingly be based upon advanced skills, advanced technology, low carbon energy sources and integration with global supply chains?
  • How we take advantage of Australia’s proximity to the fast growing economies in the world?
  • How we boost public and private investment in economic infrastructure?
  • Foster innovation in the workplace; encouraging the transfer of ideas across businesses and economies? “

My submission

I add a 6th point: “Cope with a financially fragile economic system”.Fragility is indicated by the proportion of GDP needed to service debt; the higher this proportion is, the less there is available to both consume and invest. Economists habitually excuse any private borrowing on the assumption that it will lead to increased output, and thus finance itself. But 90% of the debt incurred in the past 3 decades has financed speculation rather than investment. Productive capacity has risen far less than debt, so that the debt ratio has grown exponentially.

All major OECD nations (except France) have experienced rising private debt to GDP ratios over the past 3 decades. Australia’s debt ratio rose 4.2% faster than GDP for the past 44 years—taking our ratio from 24% in 1964 (and 43% in 1977) to 165% now. The UK’s private non-financial debt ratio was 96% in 1977, versus 243% now; the USA’s was 93% excluding finance, and 108% including, in 1977; today it is 170% excluding finance, and 282% including.

These levels are unprecedented. The US private non-financial debt to GDP ratio was 150% in 1929—20% below today’s level (it peaked at 215% in 1932, due to Great Depression deflation of 10% p.a., and falling output of 13% p.a.).

Lower interest rates do not explain this growth in debt: interest rates were lower in the 1970s than they are now, when the debt ratio was 1/6th of what it is today.

The debt has caused a leveraged increase in asset prices, which are also at unprecedented levels when compared with consumer prices. Though US asset prices have begun falling recently, if anything resembling reversion to the mean occurs, they have a lot further to go. Shiller’s “Irrational Exuberance” indices show US house prices rose from 115 in 1997 to 228 in mid-2006 (versus the 1890-1995 average of 103), before falling to 190 now. His real Dow Jones index peaked at 1240 last year, against the 1915-1995 average of 255.

Australia is no better placed. Nigel Stapledon’s long term price index implies Australian house prices are even more overvalued than the USA’s.

Recoveries from other financial crises in the post-WWII period have worked because they have re-ignited the growth in private borrowing. I doubt that there is any further capacity to do this: there are no sub-subprime borrowers to whom to lend. The growth in debt levels and asset prices will reverse, and the change in private debt will therefore subtract from demand rather than augmenting it.

This prospective deflationary scenario reverses accepted wisdom on economic policy. Sustaining budget surpluses and suppressing commodity price inflation in this environment would worsen the outcome, by reducing the capacity of private borrowers to reduce their debt, and by maintaining the real burden of debt.

Graphs and web links to substantiate the above are available at my Debwatch Blog: www.debtdeflation.com/blogs.