RDP 2011-07: Australia's Prosperous 2000s: Housing and the Mining Boom 7. Making the Best of the Terms of Trade Boom and Managing the Risks

As discussed above, the Australian economy has performed strongly over the past two decades and has avoided a severe downturn. From some perspectives though, the economy looks to have moved out along the risk-return frontier, particularly over the latter part of this period. Australia's abundant supply of natural resources and its strong links with Asia have significantly boosted real incomes and have substantially improved the expected outcomes over the next decade. But along with the new opportunities and higher expected returns have come new risks.

During the 2000s, Australia's international trade became more concentrated, both in terms of the goods exported and export destinations, potentially exposing the Australian economy to larger shocks. Over the past year, for example, exports of metal ores and coal have accounted for around 40 per cent of Australia's total export receipts, and exports to Asia now constitute more than 60 per cent of Australia's total exports, with Japan and China accounting for two-thirds of that. Further, an increasing share of exports is to emerging economies, which historically have had more volatile economic growth.

Looking forward, the challenge is to ensure that Australia makes the best of the new global economic landscape while at the same time managing the risks that come with this landscape.

In taking advantage of the new opportunities, the economy is inevitably undergoing significant structural change. The return on capital is high in the resources and related sectors, and labour and capital are flowing to these sectors. At the same time, other sectors are contracting in relative importance. These adjustments can be very difficult for those involved, including the owners of the existing capital in the industries not growing strongly and those working in these industries. But the economy made similar adjustments in previous decades, and if these adjustments do not occur then Australia is likely to forego some of the expected benefits that the strong growth in Asia offers.

In addition, for these benefits to be fully realised, productivity growth will need to pick up. In the 1990s, strong growth in living standards was underpinned by strong growth in output per hour worked. However, productivity growth slowed significantly in the 2000s, with output growth being boosted by faster growth in capital and labour, and income growth being boosted by the rise in the terms of trade (Figure 14).

In the decade ahead, it is highly unlikely that the rise in the terms of trade witnessed in the 2000s will be repeated. This means that if living standards are to continue to rise at the rate we have become accustomed to, productivity growth will need to pick up significantly. For Australia to fully capitalise on the new possibilities, both businesses and government need to be focused on improving how things are done and addressing inefficiencies in regulation and business practices. If this does not occur and complacency bred by good economic times was to set in, then some of the benefits that now seem possible would fail to materialise.

A related set of challenges is how to ensure that the Australian workforce has the appropriate set of skills to take advantage of the new opportunities. There also needs to be sufficient and appropriate infrastructure, with a suitable balance found between financing public-sector infrastructure and retaining sound public-sector balance sheets. In the period ahead, the economy will also need to continue its adjustment to more traditional savings patterns by the household sector after a protracted period in which growth in consumption exceeded that in income. In addition, as an economy with a comparative advantage in the production of carbon-based energy, Australia faces a challenge as the world looks to less carbon-intensive forms of energy.

In terms of the risks, there is little that Australia can do to reduce the probability of economic volatility elsewhere in the world. But the choices that are made domestically can have a significant effect on how such volatility affects the Australian economy.

The floating exchange rate remains a key stabilising influence. Over the past three decades, movements in the value of the Australian dollar have played an important role in offsetting some of the effects of large shocks from the global economy (Debelle and Plumb 2006). While these movements can have significant implications for individual businesses, for the overall economy they have been a source of stability.

Retaining flexibility in other areas is also a significant form of risk mitigation. One area that is important is the labour market. During the 2008–2009 downturn, flexibility in working arrangements and hours meant that the downturn in labour demand was spread more evenly across the workforce than would have occurred with less flexible arrangements. This spread the burden of adjustment and, arguably, helped avoid a more serious downturn in the economy.

The ability to respond quickly and decisively with macroeconomic policy is also important from a risk management perspective. Ensuring that the monetary policy framework remains credible is obviously important here. And in terms of fiscal policy, there is a need to ensure that public debt levels remain relatively low and that the medium-term fiscal outlook is seen as credible, and that fiscal policy is sufficiently flexible to be able to respond and be adjusted quickly.

More broadly, one form of possible risk mitigation is for the nation to save a significant share of the benefits of the resources boom, and then to only gradually increase spending if the outcomes are as positive as expected. Whether this is desirable though depends, in part, on society's tolerance of bearing risk. The benefit of higher savings is that if things do not work out as expected, costly adjustments might be avoided, or at least mitigated. Of course, the downside is that if things do work out well, current levels of national consumption are lower than desirable, with future consumption increasing strongly not only because of the favourable economic outcomes, but also because of the saving that is done now.

Another way in which risk is moderated is through foreign ownership in the mining sector. With a larger mining sector, growth in output and employment, and tax revenue, are more correlated with resource prices and demand than they have been in the past. Foreign ownership of the mining sector, however, means domestic investors hold more non-mining assets, including foreign assets, and so their investment income is less correlated with resources and the associated spillovers to the economy. Indeed, foreign ownership of this sector is estimated to be much higher than for the corporate sector as a whole. While this reduces the already substantial benefits to domestic residents of a mining boom, it also reduces the domestic costs of a mining downturn.

Overall, the 2000s were another prosperous decade for Australia. Strong employment growth contributed to a sustained fall in the unemployment rate and, along with a substantial increase in the capital stock, to faster growth in output than in most other developed economies. Over the latter part of the decade, the unprecedented increase in the terms of trade significantly boosted domestic income growth. To a considerable extent, the ability of the economy to prosper in this environment and avoid the overheating seen in previous booms in the terms of trade reflects the benefits of the flexible economic framework put in place over the past few decades and sound macroeconomic management over this period. The slowdown in productivity growth, after the pick-up in the 1990s, however, raises some troubling questions. While it is far from certain why productivity growth declined, what is clear is that for standards of living to continue to increase as they have in recent decades, faster productivity growth will be needed. Overall though, there remains much to be optimistic about. The Australian economy has demonstrated resilience and adaptability over the 2000s, and no doubt these characteristics will need to be on display once again over the coming decade.