Australia must prepare for the mother of all hangovers

Partied too hard? Julian Smith/AAP

You know Australia’s in trouble when the Reserve Bank cuts interest rates.

Last week, the central bank did precisely that, in belated recognition of the income recession that has struck. Gross domestic income (GDI) fell by 0.3% in the June quarter of 2014, followed by a further 0.4% slump in the September quarter.

The RBA has cut its 2015 GDP growth estimate as well, by 0.25%, predicting a 1.75%–2.75% range.

In 2012, I predicted an Australian recession, albeit as a “delayed tsunami” effect of the global financial crisis of 2008–12. However, some bank economists since late last year have declared there is a recession in the making in 2015.

Welcome to the post-industrial economy. Fortress Australia is long gone; the automotive industry is evanescing before our eyes; while textiles, footwear and clothing barely exist on these shores.

Steel, once the linchpin of Australia’s heavy industries, is a shadow of its former self. Battered by fierce competition from China and India, Australian steel tonnage output didn’t even crack the top 20 world rankings in 2013.

As everyone knows, the main game in Western Australia and Queensland is mining, mining and mining. Meanwhile, the sucker-fish, located predominantly in Sydney and Melbourne, comprising the finance, insurance and real estate (FIRE) industries, gorge themselves on the vast swathes of export dollars produced by coal and iron ore.

But for how long?

From hero to zero?

Throughout the last 12 years, Australia has produced world-beating results. Australia’s GDP doubled between 2007 and 2013. It is the world’s 12th-ranked economy, a remarkable feat for a population comprising a mere 24 million people (and 20.7 million cats, apparently). Nationally, unemployment is low. In 2013 and 2014, Australians were the world’s richest, thanks to the property boom, with every man, woman and child worth an average of $A258,000.

And oil prices are so low that they’re better than any tax cut any miserly government could ever give you in its wildest dreams.

Everything’s going swimmingly, isn’t it? Where’s the party?

But Australia is also facing an income recession. Real household disposable income is falling, exacerbated by the tumbling Australian dollar. Ominously, the world may be about to experience a Great Deflation.

Agriculture and manufacturing – the mainstays of Australian employment from federation until the 1990s – have been displaced by service sector industries. These largely feed off the revenues of a resources sector whose exports dwarf all others. But even iron ore export prices have halved in the past year, and there could be worse to come. There is not much point in Australia boosting its iron ore output if no one wants to buy it. Just ask the Soviets what they did with their surplus steel. Komrade (they dumped it in the west, to save you looking it up).

Unfortunately for us, we like to party hard and we didn’t invest all the enormous benefits of the boom in the terms of trade during the 2000s. We spent it on tax breaks. Which we then spent. On property. And Chinese consumer goods.

And speaking of being dwarfed, Australia’s Future Fund – designed to fund public service pensions and the odd politician – is paltry by comparison with Norway’s, which ranks third in the world with almost $US1 trillion in assets.

By contrast, Australia ranks 13th globally (as it does in most things, except cricket), with a mere $A109 billion at its disposal. Or about 2.1 years of Commonwealth deficits, roughly.

The Great Deflation

This week, China reported its inflation figures and the numbers are troubling. Year-on-year domestic demand has weakened considerably. Moreover, in January, the US economy saw its consumer-price index (CPI) fall to its lowest level since bottoming out during the Great Recession of 2009.

Deflation means prices are down. One type of deflation can be positive, as it emerges from gains in technology, efficiency and scale, coupled with cheaper labour and energy.

But too much of the wrong kind of deflation – where inflation is negative – leads to long-term unemployment, reduced demand and low, zero or negative growth. Exhibit A: Japan. Two decades of deflation.

The main reason price deflation is occurring is due to weak demand. This is due partly to a reduction in the gross money supply, and partly as a by-product of lower wages.

Money supply evaporated – temporarily – as credit markets froze in 2008. As governments poured liquidity back into financial markets in 2008–09, credit cautiously returned, but growth was non-existent or hesitant throughout most of the developed world. Millions of jobs vanished during the Great Recession, and the jobs that eventually returned paid much less than they had just a few years earlier.

In fact, the US has reportedly regained all the jobs it lost during the recession. With one hitch: these jobs pay 23% less.

Now, this scenario has some resonance in Australia. The 2007–13 period saw Australian wages rise much faster than their OECD counterparts. But in 2014, wages hit a brick wall, barely matching inflation. Yes, even miners saw lower wage growth. And, judging by their trade magazines, neither white-collar nor blue-collar resources industry workers are too optimistic about the future.

Oh Eurozone crisis: we’ve missed you most of all

If you thought the IMF and European Central Bank (ECB) had muddled successfully through the 2011–12 eurozone crisis, think again. Exhibit B: The ECB’s January 2015 quantitative easing program, injecting €60 billion per month into the eurozone economy.

Sounds impressive. But it isn’t. What it will do is simply refinance the banking sector, which is now beginning to pay back the three-year Longer-Term Refinancing Operation (LTRO) funds it borrowed during the crisis. Over 500 eurozone banks accepted more than €1 trillion during the crisis.

Now the ECB’s LTROs are maturing. As of January 2015, banks were due to repay up to €196 billion on LTROs by the end of February. But they still owe nearly €900 billion.

Consequently, the ECB’s QE program will only keep liquidity flowing back to the banking sector, as it replaces old LTROs with new QE.

The elephant in the room is not Greece. It’s inflation – or lack of it, to be precise. Eurozone inflation is running at -0.2%, a far cry from its 2% target. Not to put too fine a point on it, but -0.2% is not inflation. I’ve met inflation. And that’s not inflation.

The clear objective of the ECB’s €1.2 trillion QE program is to reflate the eurozone economies and ensure sufficient bank liquidity. But it also has a secondary objective: currency manipulation. 18 months of the Federal Reserve’s QE 3, which concluded in late 2014, injected $US85 billion per month into the American economy, pumping up its GDP growth figures, manipulating its currency and, coincidentally, depreciating China’s massive stash of US bonds.

How has the ECB responded to this? By engaging in its own currency manipulation scheme. This has sent the euro below $US1.15, a far cry from its $US1.45 rate of mid-2011. With the euro closer to parity with the US dollar, eurozone global exports can at least remain competitive.

Why does any of this matter to Australia? First, the EU is Australia’s largest source of foreign direct investment. Second, the currency power-play between New York, Tokyo and Frankfurt has hurt Australian productivity and exports, even as the Reserve Bank tries to play this poker game as well. Although the dizzy heights of an above-parity Australian dollar are a long-forgotten dream, currency depreciation in Europe, North America and Asia has contributed to the loss of Australian industries, such as the automotive sector. Equally, the Australian dollar, even at $US0.70, is not competitive enough to substitute for a lack of productivity.

The ducks are all lined up. A perfect storm approaches.

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