James Arvanitakis & Alex Surace | The Disease that Ate the Budget

Wayne Swan’s fourth budget can be commended for beginning to address upper-class welfare and ending unnecessary tax cuts. However, Australia once again finds itself riding the resource boom and China’s continuing expansion with little consideration of the broader consequences for the nation in the medium to long term. In the short term this mining boom will continue to compound Australia’s multi-speed economy. Just how cognisant the Treasurer is of this fact was evident in the first few paragraphs of his speech when he used the phrase ‘patchwork economy’ multiple times and described the coming years as the Asian century.

It is concerning that the plan to return the budget to surplus in 2012-13 is dependent on rising commodity prices and the ongoing expansion of the resource sector – an industry whose benefits are often exaggerated. Is there a Plan B if record demand or prices level out? This budget unfortunately continues to aggravate the multi-speed economy by putting all of our economic eggs in the one basket.

Can we continue to do this or will the multi-speed economy cause a real headache for Australia? Can we afford to continue to rely heavily on mining at the expense of our manufacturing, tourism and education sectors?

Each of these sectors are an important part of the Australian economy. Manufacturing, for example, accounts for just over 10 per cent of employment and almost 20 per cent of exports. Manufacturing employs 1.1 million people with almost half of these people working for firms with fewer than 100 employees. Despite significant global pressures, this industry has remained dynamic and relevant by restructuring to focus up the value chain.

Like manufacturing, tourism and education are also important contributors to the economy [PDF] with tourism employing around 4.5% of the total workforce and contributing 8.3% to exports. Education further adds to the mosaic of the economy by contributing 6.5% of total exports.

Unfortunately, the mining boom both creates pressures and diverts our attention from the various risks that these sectors confront. To begin with, the economic activity around the mining boom creates inflationary pressures. The Reserve Bank has previously responded to such pressures caused by the mining sector by increasing interest rates – something that they are likely to do again. Higher rates will increase the cost of funds to industries that are not benefiting from the record terms of trade experienced by the resources industry.

While the Treasurer has attempted to address inflation by increasing the skilled migration levels and improving vocational training, it is unlikely this measure alone will ease these pressures.

Additionally, the ongoing focus on the mining industry will continue the process of crowding out investment in other sectors of the economy. This occurs as investors take note of the government’s ongoing support and reliance on mining profits. Consequently, capital continues to flow to this sector to the detriment of others. After all, if the government is focusing on mining to return the budget to surplus, it makes sense to expect the government to maintain support for the industry even if prices or demand fall. The fact that the budget restricted assistance of $34 million to manufacturers directly servicing the resource sector is an example of this.

A third important downside of the mining boom is the consequences that follow a rising currency. Driven by record terms of trade and high interest rate differentials, the appreciating Australian dollar has resulted in record high exchange rates that are making export industries including manufacturing, tourism and education, much less competitive. While mining can survive the high dollar thanks to its healthy profits, other export sectors are simply being punished by it.

What appears to be unfolding is a classic case of ‘Dutch Disease’ (a term coined from the experience of the Netherlands’ initial economic boom from North Sea oil). The basic idea is that an increasing reliance on natural resource exploitation ultimately leads to a decline in the manufacturing sector.

This occurs as the value and volume of natural resources being extracted increases, an appreciation of the nation’s currency follows that makes other exports more expensive. This means that other sectors of the economy like manufacturing suffer as it becomes increasingly difficult to compete internationally.

An associated risk is the deskilling of the workforce. The high dollar means that it is more attractive to domestic consumers to import high value foreign goods than those made locally. Over time this decreases the demand for skilled labour as production of high value goods moves overseas. This does not necessarily result in large unemployment, but a fall in the demand for skilled labour. This process even has the potential to lead to a process of de-industrialisation is the local industry eventually collapses – something that we have seen occur in certain Canadian provinces.

This is aggravated as both the government and private sector respond to the increasing economic activity surrounding natural resource extraction by allocating more resources in support of continued expansion. This is exactly the type of crowding out we noted above as other sectors lose out.

In addition to these developments is the emerging risk of dumping. Dumping generally refers to international trade where a manufacturer in one country exports goods to another country at below market prices to protect their own markets from fluctuating prices. Heather Ridout, from the Australian Industry Group, noted that the high Australian dollar is making Australia more vulnerable to such a process as imported goods become cheaper compared to locally manufactured alternatives.

The irony then, is that the fortunes of these other sectors are becoming inversely linked to the mining industry. That is, in the process of producing low value-added resource outputs, other sectors of the economy become less internationally competitive. Clearly this has negative implications for the long-term prosperity of Australia.

The problem is that this budget seems to support rather than treat the symptoms of ‘Dutch Disease’ as it missed an opportunity to address the two-speed economy, the issue of the rising Australian dollar and the vulnerabilities being experienced by the rest of the economy.

Now that we know we are showing all the symptoms of the ‘bug’, how should the Treasurer have responded?

The first thing that needs to be done is to reduce the value of the Australian dollar to a more sustainable level that does not compound our multi-speed economy. One way of doing this is to impose a super-profit tax on miners as proposed by the Henry Tax Review. The tax would take some of the heat out of the mining sector as well as generate revenue that could be used to create a sovereign wealth fund. This fund could invest in international markets, putting downward pressure on the value of our currency as we sell Australian dollars.

Another strategy which the government is currently working on, but has failed to adequately link to industry policy, is to create a price on carbon. Pricing carbon is not simply about addressing climate change, but establishing a sustainable economy that meets the future demands of a carbon constrained world. This is achieved by ensuring that the polluter pays and we send a signal to the market to invest in clean technologies helping us to diversify our energy related and manufacturing sectors and economy. Similarly, current fossil fuel subsidies amounting to several billion dollars that are afforded to the mining companies should be stopped and redirected to support other parts of the economy that are not in the mining ‘fast lane’.

The mining boom and close links to China were key reasons why Australia was able to traverse the recent volatility in the global economy. We cannot, however, continue to put all our economic eggs in one basket. We are unlikely to be so luck next time.