Managing the Growth Shock Warwick J. McKibbin Director, ANU Research School of Economics Presentation to the 2011 Economic & Social Outlook Conference, Melbourne 30 June, 2011

Focus What are the sources of Australia’s terms of trade boom? Is this boom likely to continue? What Policies should be followed?

Overview Global Drivers of Growth China and India Loose global monetary policy Risks –Fiscal Risks –Euro Crisis –Global Inflation and policy response Implications for relative prices of commodities Appropriate Policy Responses

The Beginning of the Great Convergence? Source: Angus Maddison, The world economy: historical statistics, 2003 and IMF World Economic Outlook database (September 2006) – Mark Thirlwelll, The Lowy Institute

Summary Global growth will be dominated by long term trends from – The emergence of the BRICS into the global economy – Large demographic changes – Productivity and technical innovation – Impact and response to environmental problems BUT short term risks

The Risks: Fiscal Adjustment A slow motion train wreck

Government Debt to GDP Source OECD Economic Outlook 88 Database (November 2010)

Required change in underlying primary balance to stabilise debt by 2025 in per cent of potential GDP Source OECD Economic Outlook 88 Database (November 2010)

The Risks: A Euro Crisis

The Risks: Global Inflation

Commodity prices Rising because of – Real growth in emerging economies (Chindia) – Loose monetary policies raising nominal demand

Australia’s Terms of Trade Likely to fall from current highs because – Global supply response – Withdrawal of loose global monetary policy – Rise in non commodity price inflation Other factors – Global climate response will tax our comparative advantage

Policy Responses Key is whether the boom in the terms of trade is permanent or temporary Optimal response should not be based on our ability to forecast but should manage the risks of alternative futures

Policy Responses Need not need to be a contracting sector – Expand effective labour supply – Allow foreign capital and labour to flow in Create a Sovereign Wealth Fund – Reduce excess demand which is increasing Dutch Disease problems Less relative price adjustment in the short run – Creates a pool of foreign currency assets that can be used when the cycle turns

Conclusion Difficult but important to distinguish between relative price changes and global inflation – the 1970s is an important lesson Even though the terms of trade of commodity exporters is likely to decline, the overall income gains will be positive for the world as developing countries becomes wealthier