A Year in Retrospect, a Decade in Prospect

Dr Martin Parkinson PSM, is Secretary to the Treasury. As Secretary, he is a member of the Board of the Reserve Bank of Australia, Chair of the Advisory Board of the Australian Office of Financial Management, member of the Board of Taxation, Infrastructure Australia, Council of Financial Regulators and the Centre for International Finance and Regulation. Beginning in 2001, Dr Parkinson spent six years as Deputy Secretary in Treasury with responsibility for domestic and international macroeconomic issues. Taking up an opportunity to review a tough year in global financial experience, Dr Martin Parkinson, addressed The Sydney Institute on 13 December 2011.

A YEAR IN RETROSPECT, A DECADE IN PROSPECT

MARTIN PARKINSON

I would like to acknowledge the assistance of Leigh Soding in preparing this address. Thank you for the opportunity to be here with you tonight.

With 2011 rapidly coming to an end, I thought I might take stock of what has happened over the year, both globally and domestically, and muse a little about what lies in store for the year, and years, ahead. 2011 has been a tumultuous year.

Were I to have been standing here this time last year, I would have said something like:

The Australian economy is in a strong position … real GDP is now growing at around its trend rate … The global economy has recovered from recession faster than expected, but at different speeds across regions … Financial market conditions have improved since the sharp increase in market volatility and stress experienced in mid-2010 when the European sovereign debt crisis reached its peak.¹

In fact, a barrage of events, either unanticipated or occurring more rapidly than expected, has battered both the global and Australian economies. Who would have thought standing here last December that we were shortly to see a series of tremendous and devastating natural disasters. Floods and cyclones in Australia; the triple calamity of an earthquake, tsunami and nuclear accident in Japan; and a second devastating earthquake in New Zealand.

These natural disasters have wreaked immense damage on people and communities in all these regions. And they have also had significant implications for the Australian economy.

The deadly floods in Queensland saw the tragic loss of 35 of our fellow Australians and, along with Cyclone Yasi, disrupted countless other lives, with the loss of houses, jobs and community infrastructure. They disrupted coal exports, while agricultural production was also hit hard, with the resulting supply shortages leading to temporary, but significant, increases in some product prices and to headline inflation.

The events in Japan, a key export market for our commodities, impacted on the closely integrated global supply chains of vehicles and high-end manufactures. Indeed, the loss of production in Japan was a key factor in the 12 per cent plunge in US light vehicle sales over April to June, with similar impacts being seen in Australia — clearly evidence of globalisation at work. Combined these natural disasters subtracted around three quarters of a percentage point from Australia’s economic growth in 2010-11.

These events also meant that the Australian economy, and to some extent the global economy, entered 2011 on a less stable footing than anticipated, although the global and domestic outlooks still seemed broadly positive.

This stability has been questioned a number of times this year, including in part by the major geo-political event of the year – the “Arab Spring”. This reawakening of the Arab peoples has seen the overthrow of governments in Tunisia, Egypt, Libya, a transition of power in Yemen, serious challenges to the authority of others in the region, and what looks to be virtual civil war in Syria. It is too early to tell how this will all turn out, but these are events that I suspect will have long-term geo-political and, possibly, economic implications.

But what of the global recovery?

Well, it was dramatically undermined by a series of events emanating in the North Atlantic. To be frank, Europe spent 2011 lurching between economic catastrophe and mere disaster. The world watched morbidly fascinated as a fundamental mismatch between underlying competiveness and fiscal policies dragged one Euro-zone country after another into crisis, recognising that the integration of global banking systems increasingly risked turning Europe’s slow-motion train wreck into a global problem.

And while we all knew that the US faced considerable medium-term fiscal challenges, how many of us expected a decision around raising the debt cap for the US government would reach the brink of pushing the US into default? Or that this would result in the unprecedented loss of its AAA credit rating?

As a result of these factors, and the inability or unwillingness of political institutions in the affected countries to craft effective responses, at the end of 2012 the Mid Year Economic and Fiscal Outlook (MYEFO) describes the short term global outlook as follows:

International growth prospects have weakened markedly since Budget and the risks to global stability from the European sovereign debt crisis have intensified … The deterioration in global conditions has contributed to a weaker near-term outlook for the Australian economy than at Budget, with forecast gross domestic product (GDP) and employment growth both revised lower. Conditions are also expected to remain uneven, with the weaker global economy, the high Australian dollar and cautious household spending behaviour creating significant challenges for some sectors.²

Despite this, Australia remains among the best placed of all the world’s advanced economies to weather the fallout from these global developments. But we have been significantly affected and we cannot expect to be immune if things deteriorate further.

MYEFO saw our forecasts downgraded from Budget, with economic growth lowered by three quarters of a percentage point in 2011-12 and by half a percentage point in 2012-13. We have seen forecast revenue fall by some $20 billion over the forward estimates, meaning that in 2012-13 alone our revenue forecasts are some $10 billion lower than we anticipated prior to the GFC.

At the same time, our economic growth is still likely to be around trend, underlying inflation is firmly in the middle of the RBA’s target band, and unemployment remains close to the NAIRU.³ Australian banks remain well placed to handle the ongoing funding market pressures emanating from Europe. Our four major banks remain among the most profitable and well capitalised in the world. Indeed, according to Standard and Poor’s, Australia’s four major banks remain amongst the safest in the world, with only one bank globally rated higher.

A decade in prospect

In describing the start of the next decade, most attention is devoted to the continuing fallout from the North Atlantic. So, what does 2012 and beyond hold? Let’s start with Europe.

In early 2011, ongoing concerns about Greece’s debt led to fears of a disorderly Greek debt default and adversely impacted confidence in the region. Coupled with “slippage” in the Greek IMF/EU program in May 2011, this resulted in markets once again becoming highly stressed. These developments weighed on confidence and economic growth in the region.

In Greece, the need to meet agreed targets under the IMF/EU program despite dramatic falls in forecast GDP, led to even more dramatic fiscal tightening. This “vicious cycle” was widely seen as unsustainable without further intervention. And the fate of Ireland and Greece was increasingly being projected onto other Eurozone countries as the year progressed.

In mid-2011, EU leaders agreed to increase the effective size of the region’s emergency bailout fund, the European Financial Stability Facility (EFSF), to combat the crisis. However, delays in its implementation, together with a lack of detail, on top of deteriorating growth prospects and fears of contagion through interlinked banking systems, resulted in significant market scepticism and led to the credit ratings of the sovereigns underwriting the guarantees being threatened – adding to greater uncertainty, and a further escalation in the crisis.

As the year progressed, economic prospects in Europe continued to worsen and market confidence in political institutions’ capacity to develop credible responses continued to decline. This manifested in different ways in different countries. For example the previous Italian government’s perceived “foot dragging” when it came to implementing credible reforms, saw Italian bond yields climb to around 7½ per cent. Given Italy’s sizable debt (gross debt is 120 per cent of GDP) and deteriorating outlook, this led to concerns that it would be difficult for Italy to service its debt, should yields remain at these elevated levels.

The 26 October 2011 Leaders Summit attempted to achieve three key objectives — place Greek sovereign debt on a sustainable footing, minimise contagion to other euro area sovereigns by increasing the firepower of the EFSF, and restore confidence in Europe’s banking sector by increasing banks’ capital requirements. However, markets remained sceptical over the measures. In particular, questions remained over the details, implementation and whether the commitment existed to deal with underlying problems associated with both high sovereign debt and weak growth.

The recent announcement (9 December) of moves towards more fiscal integration is to be welcomed, but repeats the same process, with little detail feeding even more heightened market scepticism. Moreover, while the measures announced may be a good step forward in addressing medium to longer term issues, they are not perceived by markets as dealing with the immediate problems facing the region⁴.

Before leaving Europe, let me return to again to Greece and the vicious circle referred to earlier. Historically what has tended to occur is that in response to the crisis, the troubled sovereign implements even harsher austerity measures. Greece is a case in point.

As this chart shows, each subsequent review of its program has meant even greater fiscal consolidation and corresponding lower rates of economic growth. To achieve agreed targets under the IMF/EU program requires even greater austerity. That is, fiscal policy is pro-cyclical without any other actions to boost growth.

Given the delays in crafting a Euro-wide credible policy response, and the fiscal contractions now underway in many Euro-zone members, Europe will almost certainly return to recession next year, with the potential for it to be deep and drawn out. On a more positive note, let’s now turn to the US.

Compared to only six months ago, the US economic recovery is looking in far better shape. The first half of 2011 saw a US economy hit by a confluence of events that acted to seriously impede the growth of the world’s largest economy. Poor weather in early 2011 depressed tentative growth in the construction sector, which was followed by ongoing supply-chain effects of the Japanese tsunami that seriously affected the US manufacturing sector, and US exports. Together, this culminated in combined GDP growth of only 0.4 per cent in the first half of 2011. In addition, downward revisions to US GDP meant that at even by the June quarter 2011, the US economy had still not completely recovered from the 2008-09 recession.

Confidence in the recovery was not assisted by the Congressional debt ceiling debate, which took the US to the brink of default. Since then, however, the fortunes of the US economy appear to have turned, with consumer confidence rising and domestic demand contributing to a relatively robust September quarter GDP growth of 0.5 per cent. That said, this remains a very unusual recovery, with GDP only now back to pre-GFC levels.

And the US labour market remains anaemic, with employment still nearly five per cent below its peak. The US housing market remains equally depressed, with an estimated excess supply of housing to that would take around eight months to clear, at current sales rates, and with persistently low house prices acting to weigh down new home construction. That said, the US economy is now on the path to a recovery — albeit a slow, and tentative one.

However, the US public balance sheet remains in a work in progress. The failure of the Congressional “Super committee”, tasked with finding US$1.2 trillion in budget savings has now triggered automatic spending cuts. These could reduce GDP growth by up to ¾ of a percentage point in financial year 2013, a potentially significant shock to what is likely to be a still modest recovery.

Back to Australia

Developments in 2011 in the North Atlantic have emphasised the importance of good public finances. They also highlight how critical is a focus on underlying competitiveness to generate sustainable growth — and that this requires credible medium-term macroeconomic policy frameworks and structural flexibility.

As I noted earlier, developments globally have, and will continue to have, impacts on Australia. Perhaps the most marked impact has been on the budget, particularly through the write down in the Commonwealth’s revenue estimates.

In total, revenue over 2008-09 to 2012-13 is expected to be $141 billion less than we expected at the 2008-09 Budget, as a result of the GFC, natural disasters and now the growth effects of the European crisis. While the impact was less than was initially feared, around $110 billion of the revenue downgrade can be directly explained by the GFC.