OECD wants growth rather than austerity

THE Organisation for Economic Co-operation and Development has urged Europe to shift its economic tack by adopting a growth compact , including interest rate cuts, infrastructure investment, and ultimately, the issuance of eurobonds.

In its half-yearly Economic Outlook, released overnight, the OECD cautiously throws its weight behind the snowballing demands for the European Union to reweight its economic policies to give more priority to growth rather than austerity and low inflation.

Its economic forecasts are heavily qualified, as they rest on the assumption that policy actions will be sufficient to prevent destabilising euro developments, that there will be no major disturbances affecting oil prices, and that disruptive US fiscal consolidation will be avoided .

If those assumptions are right, the OECD estimates GDP growth in 2012 will be 3.1 per cent in Australia, 2.4 per cent in the US, 2 per cent in Japan, 1.6 per cent in the rich world as a whole and -0.1 per cent in the eurozone, ranging from 1.2 per cent in Germany to -5.3 per cent in Greece.

The OECD does not challenge the EU s fiscal compact, which requires EU members to slash their bloated budget deficits to below 3 per cent of GDP by next year, other than to urge that if growth slumps, countries should abandon the targets rather than try to meet them at all costs.

But while noting that prospects for the global economy are somewhat brighter than six months ago , when markets were paralysed with fear of government debt defaults and bank failures, it warns that the risks facing the world are extensive, and primarily on the downside .

The OECD warns that the eurozone crisis is the biggest risk to the global economy and urges the EU to try radical new measures to restore confidence and growth.

In particular, it urges new issues of jointly guaranteed government bonds to refinance Europe s troubled banks, and allow them to write off bad loans. It suggests this could be a step towards the future issuance of eurobonds, which would allow Greece, Ireland, Spain, Italy and other troubled countries to borrow from global markets without prohibitive costs.

France s new President, Francois Hollande, will propose eurobonds tonight at an informal summit of EU leaders called to debate Europe s recession and the crisis of confidence surrounding its banks and government debt.

German Chancellor Angela Merkel firmly opposes any move to centralise debt issuance. Germany s 10-year bond yields have fallen to record lows, just below 1.5 per cent, with widening spreads to other EU members. Yields for French bonds are almost 3 per cent, Italy and Spain close to 6 per cent, and Greece in the 20s. For Germany, a move to eurobonds could be expensive.

An economic think tank based in Paris and financed by its 35 rich and middle-income member governments, including Australia, the OECD is a fringe player in the policy contest now being fought out all over Europe, from national leaders at summit meetings to the voters at the polling booths.

But its endorsement counts for something when new economic policies are in the wind.

Its new report does that, in suggesting that the EU s proposed growth compact includes increased mutualisation of risk by:

Issuing jointly guaranteed government bonds to help recapitalise Europe s banks and encourage them to write off bad loans.

Increasing the resources of the European Investment Bank so it can step up financing new projects in transport, energy and communications infrastructure.

Growth-friendly structural reforms, agreed jointly by a range of countries, to liberalise labour markets and product markets, particularly opening new opportunities for service industries.

An easing of monetary policy by the European Central Bank, in view of the minimal risk of an inflation breakout.

The risk of disruptive policy changes has probably increased, the OECD observes. Against the backdrop of fiscal consolidation, increased inequality, and high and rising unemployment, a sense may be spreading that the burden of the crisis has not been shared fairly.

This risks giving rise to policy upheavals with adverse long-term, and possibly near-term, effects on growth prospects.

Read more >>

Flaw found in joint plans to cut deficits

IN A finding with dismal implications for the world economy, the International Monetary Fund has found that the new wave of simultaneous deficit reductions in key Western economies is likely to be far more painful than their governments assume.

A major new IMF study tackles the hottest topic in global economics whether it is more important for the United States, Britain and other countries with high unemployment and high deficits to spend up to stimulate jobs, or cut spending to bring their budgets back under control.

The IMF research, published as an early chapter from next week's World Economic Outlook, concludes that cutting spending is the right path in the long term. But it warns that the costs will be far higher and longer lasting than some have estimated.

It tears apart two influential studies by American-Italian economists Alberto Alesina and Silvia Ardagna, which found that fiscal consolidation rarely does much short-term damage to the economy, and can even bring immediate gains. The Cameron government in Britain, and others, have cited this research to justify heavy spending cuts.

But the IMF study apart from accusing Alesina and Ardagna of choosing their examples selectively found this was true only when isolated countries carried out fiscal consolidation, when interest rates were free to fall, and a slump in domestic demand was offset by rising exports.

None of those conditions was true now, the IMF warned. It endorsed arguments by columnists Paul Krugman of The New York Times and Martin Wolf of the Financial Times that Western countries cannot collectively export their way out of a domestic slump, since most of their exports go to each other.

When isolated countries cut spending sharply, as Australia did in the late 1980s, the study found, a budget cut of 1 percentage point of GDP created a similar cut in domestic demand. But an expansion of net exports halved the GDP cost, while interest rate cuts cushioned demand.

By contrast, the costs to GDP are doubled when the rest of the world is also cutting spending, and doubled again when interest rates are already too low to allow further cuts.

Over the long term, however, the study found that fiscal consolidation more than pays for itself, by increasing investor confidence, allowing lower interest rates, and allowing governments room to cut income tax.

It found that spending cuts deliver more long-term gain than tax rises, mostly because central banks are more likely to cut interest rates to offset the impact.

Read more >>

Treasury backflip: Deficit no impact on rates

A TREASURY paper has endorsed the federal government's stance that Australia's debt and deficits have no significant impact on interest rates either short-term or long-term.

In a stunning backflip from Treasury's earlier views, a new paper by two economists finds no causal link between movements in Australia's budget balance or government debt levels and the margin between Australian and US interest rates.

An earlier Treasury paper was quoted by the opposition during the election campaign to support its argument that the government's deficits were responsible for the Reserve Bank's six interest rate hikes in the past year.

But incongruously, the new paper concludes that the variables that really decide Australia's interest rates are all born in the USA.

It found not only are US Treasuries the global benchmark for interest rates, but the margin between them and Australian rates is determined primarily by shifts in US core inflation and the US current account deficit.

"All else equal, the results suggest that, in the long run, the real interest margin rises by around 3 basis points in response to a 1 percentage point (100 basis points) of GDP increase in the stock of Australian general government net debt", the paper reports.

The margin also rises by 10 basis points if the US government net debt falls by a percentage point something that, at this point, appears unlikely to happen any time soon.

"In the short run, Australian fiscal variables do not have a statistically significant impact on the interest margin," it concludes.

The paper, by Yong Hong Yan and Shane Brittle from Treasury's macroeconomic group, carries the usual disclaimer that its views are not necessarily those of Treasury. But they do match those of Treasury secretary Ken Henry, who has consistently played down any link between the budget deficits and rising interest rates.

Reserve Bank governor Glenn Stevens has also played down any link, arguing that it is the trends developing in the economy that influence setting short-term interest rates, and fiscal policy changes are rarely big enough to have an impact.

But the Treasury paper challenges a large body of work by other economists that find a strong link between fiscal policy and interest rates. A review published last year by the OECD suggested a strong, if highly variable, relationship, with long-term rates forecast to rise by between 10 and 60 basis points if the budget balance declines by 1 per cent of GDP.

Treasury Working Paper 2010-04: Reconsidering The Link Between Fiscal Policy And Interest Rates In Australia, Friday, 17 September 2010

Read more >>

A deficit of difference

THIS election has two economic issues. Does Labor's record in office warrant re-election? And which side offers better leadership, better policies, and a safer pair of hands for the future?

There are no easy answers. The Coalition was out of office when the global financial crisis hit: had it been in government, it would have taken a different position. The political theatre would have been reversed: the Coalition running up deficits, Labor attacking them.

The budget papers imply that in the four years of expected deficits, from 2008-09 to 2011-12, half the budget blowout was due to the financial crisis and half to the stimulus measures. Whenever pressed, the Liberals concede that deficits and debt in some measure were unavoidable.

Economists argue over what would have happened had there been a smaller stimulus, or none at all. Treasury estimates it added 2 per cent to GDP in 2009, and saved 200,000 jobs. Some others estimate a smaller bang for buck. What is clear is that without the stimulus and the bank guarantees that headed off a financial collapse Australia would have suffered a far worse downturn.

The $21 billion of handouts to households allowed many to pay down debt and others to keep retail demand rising and shops are big employers. Even the $16 billion for school buildings delivered only after Australia had begun to emerge from the crisis has played a key role in the recovery of growth and jobs since work began a year ago.

Why? Because private sector activity collapsed. In the non-residential sector excluding education approvals halved from $28 billion in 2007-08 to $14 billion in 2009-10. Bank lending to business has shrunk by $87 billion, or 11 per cent and for many companies there are no other lending sources.

Think about that. Even now, there are 150,000 more Australians out of work and 180,000 more working shorter time than before the crisis. Growth is sluggish, and GDP per head remains less than two years ago. Ask yourself: what would Australia be like now had the government not pumped all that money into new construction?

Construction is usually the epicentre of any slump: not this time. The stimulus kept the industry going. In the March quarter, 38 per cent of work on non-residential buildings was on schools and the like, up from 5 per cent before the crisis. Work also began on 4259 public housing units, more than they normally build in a year.

Without the stimulus, construction would have collapsed in 2009-10 as it did in 1990-91 when 15 per cent of construction workers lost their jobs. That's another 150,000 people unemployed, with flow-ons throughout the economy costing who knows how many more jobs.

Yes, a lot of money was wasted, and Labor has to answer for that. Brad Orgill's taskforce concluded that $1 billion was wasted from middlemen and contractors overcharging for school buildings. Probably more than that was wasted from the Rudd government's refusal to halt its foil insulation program. Even so, they saved us a much worse cost.

We will have to pay later for what we borrowed to avert a crisis. But, as Reserve Bank governor Glenn Stevens has argued, Australia's public debt is a non-issue by global standards. Our debt will peak at 6 per cent of GDP, Japan's at 154 per cent, the US at 86 per cent and even Germany 75 per cent.

By its actions, if not its rhetoric, the Coalition concedes that. It now plans to deliver a surplus in the same year as Labor, and of roughly the same size. We now have a bipartisan fiscal policy. Whoever wins, we'll get the same deficits and debt.

We'll also get the same lectures on how bold economic reforms in the 1980s and '90s laid the foundations for Australia's economic success along with a refusal by either side to risk any of its skin to take similar bold decisions today.

The classic example is the failure to tackle climate change. Tony Abbott and Julia Gillard once supported emissions trading. Then, when the going got tough, they cut and ran. The difference now is that Abbott says he'll never have one, whereas Gillard at least has left the door open.

Yet depending on which British or US monitoring agency you believe, the past year has been the hottest or second hottest since records began. Even to meet both parties' common target of reducing emissions in 2020 to 5 per cent below 2000 levels would require us to cut per capita emissions by more than a third over the coming decade.

You cannot get there without putting a price on carbon. And you cannot do that unless you have leaders and ministers who are prepared to take on public opposition and put their political skins at risk to argue, persuade, and ultimately drive the legislation through. That is how Bob Hawke, Paul Keating and John Howard achieved their reforms.

But, as Ross Garnaut argued in his recent Hamer Oration, that period ended with the introduction of the GST, and there have been no big economic reforms since.

Key reforms proposed by the Henry report have been ruled out by both sides. There has been little put forward to end the waste in which 10 per cent of men (and even more women) of prime working age are not even looking for work and that hundreds of thousands of our young are heading down that path.

Nor has there been any new policy to tackle the single biggest issue for many other young Australians: housing affordability.

In 2003, then Reserve Bank governor Ian Macfarlane warned against complacency, publicly urging the government to give "priority to tomorrow's working age population, rather than satisfying the demands of yesterday's".

At this election, neither side is voting for the future.

Read more >>

Tackle the debt - IMF tells US

THE International Monetary Fund has called on the US to take "decisive policy action" to bring its government debt under control, warning that it is on track to be almost 100 per cent of GDP by 2020.

In its annual report on the US, released last night, the IMF said the Obama administration and Congress needed to go further to tackle the budget deficit which IMF staff estimate will be between 5 and 8 per cent every year over the next decade.

The IMF's board of directors made it clear that both tax rises a taboo for Republicans and spending cuts would be needed to bring the US budget back anywhere near balance, let alone into surplus.

"A larger than budgeted adjustment would be required to stabilise debt to GDP under the staff's economic assumption, requiring revenue and expenditure measures," it said.

It urged reform of entitlements, such as farm subsidies, pensions and benefits. It also urged the US to aim to cut its debt-to-GDP ratio over the longer term. The US has run just one budget surplus in the past 50 years.

A separate report by IMF staff estimates the deficit this year will be 11 per cent of GDP (compared with 3 to 4 per cent in Australia). That is forecast to halve by 2012, but then rise as the ageing population and soaring health and debt costs inflate spending.

The report tips the 10-year bond rate to average 3.6 per cent this year, but then jump to 5.9 per cent by 2012, and to 6.5 per cent thereafter.

The staff estimate that gross government debt will be larger than the US GDP by 2012.

"The mission saw a key macro-economic challenge as ensuring that public debt is put and is seen to be put on a sustainable path, without jeopardising the recovery," the staff report said.

"Under current policies, federal debt held by the public could rise from 64 per cent to 95 per cent of GDP by 2020."

It suggests most of this will need to be bought by domestic investors, with foreign investors likely to unwind their holdings.

"Over the medium term, higher real interest rates will be needed to encourage the implied portfolio shifts," the report said.

The report lays bare clear disagreements between the IMF team and the US authorities over prospects for the US economy, and hence for returning the budget to some form of sustainability.

In Melbourne yesterday, Harvard historian Niall Ferguson warned that competition between a rising China and a fiscally weakened US could lead to conflict.

Read more >>

Coalition might increase deficit, debt

THIS election campaign is changing colour more rapidly than Julia Gillards hair. Last week, both parties pledged, hand on heart, this would not be an election spendathon. But if its not that, what do you call it?

On Monday in Queensland, both party leaders pledged roughly $1 billion of new spending, in one day: both pledged about $750 million to build a rail bridge in Brisbane without a benefit/cost analysis, and Abbott pledged another $240 million to build a bypass of Mackay.

Yesterday, Labor took a break owing to certain problems with cabinet leaks, but the Liberals ploughed on.

The spend-of-the-day award indeed, the big spend of the campaign so far went clearly to Tony Abbott, as he pledged to cut the company tax rate from 30 per cent to 28.5 per cent from mid-2013.

This one-upped Labors pledge to cut it to 29 per cent, and neutralised Labors campaign against Abbotts impromptu decision in April to make employers, not taxpayers, pay to lift maternity leave to six months.

That decision, made without reference to shadow cabinet, could now be reversed. Shadow Treasurer Joe Hockey said yesterday the Coalition would have more to say on the issue later in the campaign clearly implying that it would be different to what it has said since April.

Fine, but if so, well be paying for it. And who would pay for his cut in company tax?

Well, we would. Under Labors plan, the cut in company tax would be financed by the mining tax. The Coalitions cut would come out of general revenue.

And its not cheap. The Coalition estimates it at $2.5 billion in year one, settling down then to $2.1 billion a year. On the four-year basis we usually use, thats $8 billion plus easily the most expensive campaign promise yet.

But isnt it financed by their plans to cut spending in other areas?

In theory, yes. In practice, the cuts are far smaller than the Coalition claims, and now run the risk of being overwhelmed by its spending promises.

The Coalition claims $24 billion of spending cuts. But $9 billion of that is pledging not to spend money it wont raise by not having a mining tax. How can you save money you dont receive? Thats phoney.

Are you sure Labor will receive it?

No! It depends entirely on mineral prices, and who knows what they will be?

Analysts Wood Mackenzie forecast that the coal half of Labors tax could raise as little as $7.4 billion over the next five years. If so, the revenue will be well short of the $6.5 billion a year target.

But Labors numbers include some safety buffer. The Coalition has none. Take out that $9 billion, and its claimed savings shrink to $15 billion. But $5.6 billion of that is savings from programs it plans to replace with new spending, so you cant book gains from that.

That leaves roughly $9 billion of real savings over the next four years mostly $4.4 billion from not replacing public servants who leave, and $2.3 billion from cutting climate change programs.

The Coalition tells us it will reduce the deficits and debt. But this way, its in danger of increasing them.

Read more >>

The big projects go where the people and the votes are

YOU cant accuse Auditor-General Ian McPhee of going soft on the government. Two reports issued by his team show the government playing fast and loose with its own rules in allocating money for infrastructure projects.

Report 1, on major infrastructure projects, found the government ignored the criteria set by Infrastructure Australia, and funded projects that failed to meet its benefit/cost criteria, while ignoring others that did including the top project in bang for buck.

Report 2, on the stimulus program to fund shovel-ready local projects, found that by June, when the program was intended to end, only a quarter of the money had been spent. Instead, most was sitting in councils bank accounts.

That might be overlooked in the brawl over the distribution of funding between electorates. The auditors found that while Labor and Coalition seats as groups got roughly their fair share of funding (with a small bias towards Labor), only 18 per cent of applications from councils in Coalition-held seats were funded, as against 42 per cent of applications from councils in Labor-held seats.

The Coalition is screaming unfair, and it has a point. The audit team points out that Infrastructure Minister Anthony Albanese gave no explanation about why he chose 131 of the shortlisted applications, rejected 57 others, and waived the rules to fund six others. You can bet politics played a part.

But the reality is most applications failed, not because of the minister, but because they failed to make the departments shortlist. And a state breakdown hints at why: Victorian councils had twice the success rate of councils in South Australia, Western Australia and Tasmania, where there are many rural councils with few people. Size counts.

The real scandal uncovered by the audit team is that while the projects selected were meant to be shovel ready to provide immediate work in the 2009 downturn, few of them were. By June 30, when the program was to end, $550 million had been allocated, $438.5 million paid to councils, but only $142 million actually spent.

Why? The audit team finds many projects in fact were not shovel ready. Others were planned for a longer time period. And many involved high delivery risks, which have been realised. Most of the money is now planned to be spent in 2010-11.

The audit of Infrastructure Australia highlights a different problem. On one hand, the government pledged that project selection would be based on rigorous analysis of the costs and benefits. But on the other . . . well, infrastructure programs help to buy votes.

Infrastructure Australia found the biggest bang for buck would be delivered by Canberras eastern bypass, the Majura Parkway.

But there are no marginal seats in Canberra. So the government instead allocated $91 million towards Sydneys metro project, which had no cost-benefit analysis. Fortunately, no money was handed over before the metro died in February.

The noble intentions are being trampled in the dust. Yesterday both parties pledged $750 million or so to build Brisbanes Moreton Bay rail link another project yet to pass the benefit/cost test. Tony Abbott also pledged to build a ring road around Mackay, a winnable Labor seat. Your taxes at work, for the politicians.

Read more >>

Loss of stimulus hits home

THE Reserve Bank has blamed the strange behaviour of Australia's housing market in recent months partly on the end of federal government stimulus for first home buyers.

Trying to explain the housing market in 2010 when housing prices have soared yet home lending has plunged an article in the Reserve's quarterly bulletin says at least part is due simply to the sharp fall in sales to first home buyers.

The article, by researchers Paul Bloxham, Daisy McGregor and Ewan Rankin, does not explore the role of foreign investors, who have been widely blamed for driving house prices upwards, especially in Melbourne, when finance to local buyers was shrinking.

But they point to a different explanation.

The big change in the market this year, they say, was the fall in purchases by first home buyers once the boost to the federal first home buyers grant ended on December 31.

In 2009, when federal grants for buying existing homes temporarily doubled to $14,000, first home buyers borrowed as much as 25 per cent of all money lent for home purchases. That shrank to just 12 per cent in March and April.

The researchers say 90 per cent of first home buyers take out a mortgage, whereas only 65 per cent of existing home owners moving home do so.

As first home buyers retreat from the market, that explains much of the fall in lending.

Moreover, they say, first home buyers tend to buy cheaper houses. That means that when their share of the market shrinks, the median price of homes rises even if the underlying trend is flat.

"As the composition of housing turnover normalises, the more typical relationship between housing price growth, loan approvals and auction clearance rates is likely to be re-established."

This explanation ignores the central role of housing investors, who on average borrow 40 per cent of all finance for home purchases.

Investors tend to be even more heavily geared than first home buyers.

Read more >>