Return the favour.

Lessons from Europe.

Southern Europe had an investment and inflation boom from 2000-2007 that helped Germany’s economy recover from their late 1990s slump.
Germany should have returned the favour during the Euro debt crisis. But they didn’t.
And the eastern states have just done the same thing to WA.

GERMANY VS. SOUTHERN EUROPE

An idea came to me recently during the research and writing of my trade blogs (see here). One of Trump’s arguments for protectionism was against Germany’s significant trade surplus. As a justification for tariffs, it is highly illogical (see above blog). But the concern is based on a bit of truth.

From 2000 to 2007, on the back of ‘Europhoria’, supposedly-safe countries in Southern Europe enjoyed a significant investment boom. Money was flowing into their countries. And, if they had their own exchange rates, it would have driven those up too. But being pegged to the Euro currency – which had to take into account their slower-growing neighbours – the investment boom put additional pressure on their internal inflation rates. Consequently, Germany – with its relatively lower inflation rates – enjoyed a boost to its competitiveness relative to Southern Europe. And this actually helped bring Germany out of its late 1990s slump. Thank you, Southern Europe!

But when the debt crisis struck Southern Europe, this was the moment for Germany to repay the favour. Germany should have boosted its own internal inflation rates with fiscal stimulus to help Southern Europe’s competitiveness. But they didn’t. Along with criticising the ECB’s attempts to reflate the Euro economy, Germany also underwent unnecessary and unforced fiscal austerity (in the face of negative interest rates and the fact that Germany is a big lender, not borrower!). This slowed Germany’s inflation rates, thereby worsening and prolonging the deflation in Southern Europe needed to rebalance the Euro internally. This allowed Germany to maintain an exchange rate that is too low for their individual circumstances, extending their internal competitiveness and trade advantage, and their ‘unfair’ trade surplus.

Southern Europe's recovery has been underway since about 2013. Their relative competitiveness started being gradually re-established through drastic internal deflation. This will presumably reduce Germany’s ‘unfair’ trade surplus. But this process has taken far longer, and was far more painful than it needed to be. Germany did not return the favour of Southern Europe’s inflation ‘boom’ years earlier. So Southern Europe had to endure devastating deflation, hardship and permanent losses of economic output. The fact that this internal deflation eventually had the same result as would have been achieved by a more cooperative Germany, does not justify the pain and hardship of adjustment imposed on Southern Europe. The end does not justify the means.

EAST VS. WEST AUSTRALIA

So my idea that I wanted to test was “could this apply to smaller areas?”. Could, for example, we see a similar phenomenon in Australia between the States and Territories?

Like Southern Europe (though not to the same devastating extent), WA enjoyed a (mining and resources) investment boom followed by a downturn. Now, the eastern states of Australia are enjoying stronger economic performance with an exchange rate that is largely lower than their individual economic circumstances would dictate (because it is being partially dragged down by slower states like WA).

So like Germany and Southern Europe, are the eastern states of Australia limiting their internal inflation rates (whether deliberately or not), thereby prolonging and worsening the disflation required in WA to bring back their competitiveness?

If so, we would expect to see inflation rates at or below target in the eastern states (reflecting the fact that they are not inflating as fast as they could/should to help WA recover), and inflation rates in WA that are well below target, perhaps even in dreaded self-fulfilling deflationary territory.

And whaddaya know, that’s exactly what we see…

From 2004-2007, inflation in Perth was greater than the eastern capitals – consistent with the beginning of the mining boom. This would have helped the competitiveness of eastern states goods and services. And from 2007, the rest of Australia caught up (Brisbane even took back some ground), and inflation rates (and price levels) remained broadly similar between Perth and the other capitals.

But by around 2014, the mining investment boom had well and truly ended and Australia was entering a downturn. WA’s inflation rates drop furthest. Like Germany should have returned the favour to Southern Europe, the eastern states should have returned the favour of WA’s earlier higher inflation rates (and the east’s consequent improvement in competitiveness). The eastern states should have driven their own (inflation) boom to help WA regain some price competitiveness without having to have a drastic downturn and potential deflation.

But while Perth inflation trod dangerously close to deflationary territory, and still struggles to reach even 1%, eastern states inflation is barely sustaining 2%.

There was only so much the Reserve Bank could do. You can see below that Perth residential property prices were over 20% higher than the weighted average of Australia’s capital cities just before the GFC, thanks to the early years of the mining boom. Prices then tended towards equality until about 2014, before the slump in WA and the property market boom in Sydney, Melbourne and Brisbane (which frustratingly didn’t drive inflation in the real economy). Now, Perth property prices are just 71% of the weighted average of capital cities.

But the RBA has already dropped interest rates substantially (at 1.5% since August 2016). And they wanted to go further but feared overheating the eastern states property markets. APRA has had some success in cooling these markets using their macro-prudential powers (tighter lending standards, higher capital reserve requirements). But in terms of lowering interest rates to further support WA, their hands were pretty much tied.

 

 

Rather, a sizeable chunk of the blame resides with the Federal Government’s fiscal policy. This downturn was the optimal moment to invest in infrastructure. Inflation needed a boost, and the RBA had facilitated some beautifully low interest rates at which the Federal Government could borrow. To be fair, they have enacted some nice infrastructure spending recently (though their project choice is subject to debate). But it was about two years later than it should have been.

And the greatest betrayal for WA is that this fiscal boost didn't even need to go directly to WA (although that would have been nice). Given Sydney’s, Melbourne’s and Brisbane’s inflation rates too were barely sustaining 2%, an inflationary boost in the east would also have worked. It wouldn't endanger the eastern economies. It would have improved WA’s cost competitiveness without WA’s inflation rate having to dip so close to self-fulfilling deflation. It would have imposed less hardship and a smaller cost to human welfare that comes from high unemployment. And it could have cost less in the way of forgone economic output that is now lost forever. This was the favour the eastern states should have returned to WA (and itself!) as thanks for WA’s inflationary boom ten years earlier.

RETURN THE FAVOUR

No doubt people have tried to justify WA’s suffering by using the tired old morality card – that they got themselves into this problem by being fiscally irresponsible, and now must pay the price. This is not an issue of morality. It is an issue of economics. And macroeconomic downturns should not be used to punish people. They should be addressed immediately, and the problems that led to them addressed after the economy has recovered. There is no guarantee that those responsible for the downturn will be the ones punished by it. But you can all but guarantee that innocent people and families will be hurt by it. That’s why the economic problem must be addressed first, and the moral problem second (see my financial crisis blog here).

This is the price of Federation. Asymmetric economic shocks to areas that share a common currency and common monetary policy must be balanced out with appropriate fiscal policy, not mass unemployment and a deflationary spiral. A failure to do so breeds not just hardship and forgone potential, but resentment and threats to the union itself.

Don’t believe me? Just ask Europe.