The RBA and most conventional market economists see 2011 as the year in which our biggest challenge will be “managing prosperity”. The mining boom will keep the money flowing, and the economy will just have to cope with the structural change that results.
There’s no doubt that China’s demand for our minerals has generated enormous revenue for the country, by giving us the best terms of trade in the last half century, and turning our trade balance into surplus.
If these were the only forces determining our future, then the expectation that our major economic problem in the future will be inflation driven by supply constraints (mainly labour shortages leading to a wages breakout) could well be correct.
But there are also the forces of credit.
The “managing prosperity” crowd failed to consider these prior to the Global Financial Crisis, which is why they didn’t see it coming while a handful of non-orthodox economists did—including yours truly (Bezemer 2009; Bezemer 2010; Fullbrook 2010).
If these forces had been tamed, then good times could well lie ahead. Equally, if they had turned decidedly positive again—so that credit growth was boosting the economy rather than slowing it down—then boom times could be in the offing, though with an inevitable day or reckoning still in the future as our debt to GDP level mounted.
When I predicted the GFC, I was relying on the ratio of private debt to GDP and its growth rate as indicators of a looming economic crisis. In both Australia and most of the OECD, debt to GDP levels had been rising exponentially, turbo-charging aggregate demand; it was to me (and many other non-neoclassical economists) all too evident that, at some stage, this growth of private debt would have to cease. When it did the mere fact that its rate of growth had slowed would cause a major recession.
That turnaround in the private debt to GDP ratio that I first predicted in 2006 commenced in 2008, and the slowdown in the rate of growth of debt that preceded the peak was the key force behind the financial crisis that began in late 2007.
The economic crisis that ensued was as big as I expected, though its severity has been attenuated by the largest government stimulus programs in human history. However the Australian economy performed far better than I expected, and it could be argued—and has been argued to my face—that I got it wrong about Australia.
I certainly got the empirical predictions wrong. I expected that unemployment would hit double digits here, as it has elsewhere in the OECD (the US figure of below 10 percent reflects its peculiar unemployment scheme plus undercounting of discouraged workers). Instead, it peaked at 5.8% and has since fallen to 5.2%.
It would appear that there are two possible interpretations of this: either Australia really was different, and economic principles that apply to the rest of the globe don’t apply here, or my underlying model of how a market economy works was wrong.
Option 2 was unlikely since the credit-driven, Hyman Minsky grounded approach I’ve always taken to economics did predict the crisis, and in the rest of the OECD it remains a deep and seemingly intractable crisis. So was Australia just the exception that proves the rule?
No. In fact, the data supports a third option: that Australia’s position as a minerals exporter to China does make it somewhat different, but the fundamental model of a credit-driven economic cycle applies here too. It’s just that a peculiarly Australian government policy—the First Home Vendors Scheme—turned the credit engine to our favour during the GFC. Whereas the rest of the developed world became mired in deleveraging, we leveraged our way back towards prosperity.
Private debt has gone from rising by US$4.5 trillion in the USA—thus adding $4.5 trillion to aggregate demand—to falling by $2.5 trillion, and thus subtracting from aggregate demand there. This was the factor that drove the US from boom to near-Depression.
But though Australia began the deleveraging process, it stalled it just as the change in debt approached zero. The increase in debt since then has been a major factor in why our unemployment rate stopped increasing, and has since fallen.
The common factors driving the two economies (and therefore the difference in their economic outcomes to date) is starkly evident when one considers the “credit impulse”—or the rate of acceleration of debt. The turnaround from accelerating debt propelling the change in aggregate demand to decelerating—falling—debt subtracting from the change in aggregate demand was the greatest the US has ever experienced, since and including the Great Depression.
The reversal of this debt deceleration is also evident in that chart of course—and the commensurate slowdown in the rate of the increase in unemployment. Government policy clearly played a large role in this—the private sector was hell-bent on deleveraging before the US’s massive fiscal stimulus and QE1.
Now check out Australia’s story over the same time period—and at the same scale. We got out of the crisis before we really got into it by reversing the private sector’s trend to deleveraging, and encouraging borrowing once more.
Can we keep on borrowing our way to prosperity? Here’s where I turn cynic once more: we could, if we didn’t already have an unprecedented level of private debt, with both households and businesses carrying more debt than they’ve ever sustainably carried in the past.
This implies a limit to the credit impulse (both in Australia and overseas). For the credit impulse to remain positive, then ultimately the debt to GDP ratio must start rising, and keep rising. But with the economy so heavily indebted already, the credit impulse is likely to peter out and give way to decelerating debt once more—with a negative impact upon aggregate demand.
This is already starting to turn up in the data. The credit impulse graphs so far consider the change in the change in debt over a year; this next graph considers the acceleration in debt on a month by month basis as well. Though the monthly data is very volatile, only 3 of the last ten months’ credit impulses have been positive.
This indicator tends to lead changes unemployment by about three months. A sustained run of negatives could be enough to generate yet another “unexpected” increase in unemployment next year.
This returns me to the bottom line of my credit-oriented analysis. Sustained recoveries from recessions in Australia and the whole OECD in the last 40 years have all been accompanied by rising levels of private debt to GDP. I simply don’t believe that’s possible now.
When the Australian economy has hit the skids in the past, the recoveries that ensued – in 1975, 1983 and 1993 – were all accompanied by increases in borrowing. Credit growth boosts investment and job creation, and everyone’s happy. Happiness of the debt-financed kind will be short-lived in 2011, because we’re already past the peak level of debt that we’ve ever had, or are likely to have.
So I expect Australia to resume deleveraging during 2011, leading to recession-like conditions in sectors that are not major beneficiaries of the China Boom. We are already seeing the first casualty – retailers are discounting well before Christmas, rather than after it, and the “unexpected” drop in retail sales last month is something I expected to see when the First Home Vendors Boost wore off. Retailers’ pain will only increase through 2011.
My advice to the optimists is to take their eyes of China for a few minutes and take a good hard look at the direction credit aggregate data is moving – it’s down, and unfortunately that’s where two thirds of the Australia’s “three-speed economy” could well move next year.
Lastly, let’s also take a slightly longer term look at the relationship between our exports and imports. We are certainly benefiting from positive net exports right now. But history’s lesson is that that boost can disappear very quickly.
Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.
Bezemer, D. J. (2010). “Understanding financial crisis through accounting models.” Accounting, Organizations and Society
Fullbrook, E. (2010). Keen, Roubini and Baker win Revere Award for Economics. Real World Economics Review Blog. E. Fullbrook. New York, Real World Economics Review. 2010.