Is the Australian economy “diseased?”

Sorry people time for something bearish. A phenomenon in Australia normally associated with low income developing countries is becoming more and more obvious. “Dutch disease” refers to the de-industrialisation of an economy that tends to happen when natural resources are found. In the late nineteen fifties in the Netherlands large deposits of natural gas were found and exploited, and the ensuing decay of its manufacturing sector resulted in the term “Dutch disease”. Here’s how the story goes.

When a resource is found the demand for it raises the real exchange rate as overseas countries scramble to buy the gold; silver; iron ore; coal; oil; you name it, we’ve got it. To do so they must first use their currency to “buy” (exchange for) ours, and then they use this Australian currency they’ve bought to buy our resources from us (well actually, most of these commodities are traded in US dollars, so they buy US dollars, give us those in exchange for the resources, and then we exchange them for Australian dollars, but the result is the same). Just like most goods, as the demand for Australian currency skyrockets, its price soon does too. This increase in the price of the Australian dollar has the familiar effect of making overseas goods cheaper. As overseas countries begin to offer more and more of their currency for each Australian dollar (as they clamber to get at our resources) you can jump in and get some overseas dollars at favourable rates making overseas shopping cheaper. However just as other countries goods become cheaper for us; our goods become more expensive for other countries.

All else being equal Australian exporters are hurting from the high Aussie dollar. Companies like National Australia Bank, QBE Insurance (I’m sure I’m not drumming up a whole lot of sympathy here, but come on people; CSL, Billabong!?) suffer as their products either become more expensive or their margins suffer (see How will high Aussie dollar hit retailers). These sorts of companies shed workers, reduce production and investment, and in the worst case scenario fail. Meanwhile mining companies spend up big playing in the dirt, and an economy’s investment funds and labour (think of that mate who quit his high skilled job as a carpenter or manager to go to the mines to watch rocks go by on a conveyor belt) are diverted towards pulling rocks out of the ground and away from other businesses who survive by innovating, adding value, cutting costs, and producing goods and services. It is in this manner that innovation (and all these other desirable qualities in an economy) is stifled and the economy is said to deindustrialise, doing less of the aforementioned innovating and value adding, and more of the simple digging up of dirt out of the ground.

However the model also talks about a third sector, the so called “non tradable” sector. This is the part of the economy that isn’t mining, and isn’t exporting overseas. This sector supposably booms because the influx of spending in the mining sector trickles down through to the rest of the economy. It does this through the same process described in paragraph three of Is gold a good hedge against inflation except this time the initial increase in spending comes not from the government printing money, but from the mining investment.

This boom in the “non tradable” sector is likely to be tepid however, because mining is a very capital intensive business and employs few workers, and a lot of the "non tradable" sector like JB Hi Fi and Woolworths are having problems of their own (the internet is making these guys more tradable by the day) as described in How will high Aussie dollar hit retailers. And the model acknowledges this! Unfortunately the RBA doesn’t, at least not until the last monetary policy meeting.  The RBA has been, as described by some analysts, trying to “make room” for the mining boom by crushing growth in other industries. Higher interest rates in Australia certainly doesn’t decrease the Chinese (and others’) demand for Australia’s resources, but it does decrease Australian residents’ demand for other products like computers, cars, televisions etc. It does raise the real exchange rate and make our exporters products even more expensive. In this way demand is driven away from retailers, car dealers and pharmaceutical companies (basically anything that isn’t a resource company) and towards resource companies. Many argue the RBA has in effect been doing everything it can to exacerbate the Dutch disease!

The other reason the spending affect is mitigated is the trend towards foreign ownership of Australian mining investors. The profits of the mining companies are increasingly going overseas to foreign investors to be spent there instead of here. But this in itself is not bad; it simply reflects the decisions made by people about how much to save. Ironically, the fact that the miners are owned by overseas investors can alleviate the Dutch disease in a small way, because as the Australia dollar profits are sent back overseas to foreigners, they convert the Aussie dollars back to their home currency, which alleviates some of the upward pressure on the aussie dollar (they’re effectively doing the opposite of what pushed the Aussie higher in the first place. However because of the capital intensive nature of mining, a large proportion of the profits are kept in Australia and reinvested in the company to build and maintain the assets required to carry out their business.

On its own it’s hard to argue that this type of process is even bad. Australia has a comparative advantage in natural resources and it benefits us to specialise in this industry. This comparative advantage is amplified by the well developed infrastucture in Australia (minerals like coal and iron ore are so abundant that having a profitable mine is not about finding minerals, but about getting them to a port cheaply). However the deadweight loss comes in the drying up of innovation. This innovation isn’t completely lost; as Australia has become one of the preeminent mining services providers to the world, but one day the minerals will be gone, or at least the insatiable demand for them will be. Currently about fifty percent of China’s GDP is investment. As china transforms to an economy more consumer driven this demand for our minerals will fall (consumers don’t have much use for iron ore). Mind you this could take a while, we’ve been waiting for the Japanese to do it for about thirty years, and large portions of Africa are yet to industrialise. This one day will provide significant headwinds as we end up with lower mining exports and uncompetitive export industries.