The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, August 23, 2010

What are the economic consequences of a minority Australian government?

Contrary to the current gloomy atmospherics, it is entirely possible that a minority (Coalition?) government could be a positive for both financial markets and the economy more generally in the medium term.

At the outset, it should be acknowledged that hung parliaments are not uncommon overseas, and will not, therefore, be overly worrying to foreign investors. Domestic institutions, on the other hand, have not seen one since 1940 and could, as a result, take more time to adjust.

Perhaps the biggest economic benefit of a minority government is that it will be hard to enact radical legislative change. In financial markets, change represents uncertainty, which feeds into higher volatility (read risk). The last thing anyone wants right now is more risk. In recognition of this, the Australian dollar fell by around one cent in early trade this morning in response to the weekend’s news.

Assuming that the Coalition forms government, which may be a higher probability outcome if one takes at face-value the ostensibly conservative leanings of the three independents, investors will kiss good-bye to the much-derided RSPT and its love-child known as the MRRT. This will be a considerable boon for Australia’s resources sector and should precipitate an uplift in equities valuations and greater long-term business investment.

Another economic win will be the ability to avoid a reasonable amount of the $26-43 billion in taxpayer money that was to be spent on the National Broadband Network (NBN). While there are doubtless many sound arguments for taxpayers to support investments in broadband infrastructure, the NBN suffers from serious financial flaws, which I have previously outlined here. A cheaper and more modular approach that enables the market to at least partly determine what technology solutions are delivered, and which involves more private sector money with appropriate concessions to the three independents in regional Australia, will be a lower risk outcome for the economy and the government’s balance-sheet.

Assuming that an ALP in opposition is reflexively resistant to Coalition-initiated policy changes, which seems a safe bet in view of the highly partisan nature of politics these days, the Greens will be able to block legislation in the Senate. This means that the Coalition will struggle to push through substantive economic reforms in its first term.

Yet as others have already observed, control of the Senate is the exception rather than the rule. Most sitting governments have had to negotiate with a Senate in which the balance of power is held by independents (think Steve Fielding) and minority parties.

And while reform-hungry commentators might conclude that this is an undesirable result, the truth is that stability and continuity are valuable things for an economy that is hesitantly emerging from the GFC and about to embark on a period of above-trend growth. Governments of all political persuasions are capable of throwing sand in the wheels of progress. After so much recent turbulence, and ongoing instability care of deep ructions in the US and Europe, a minimalist and predictable manager might be exactly what Australia’s economy requires for the foreseeable future.

The injection of at least three independents—Tony Windsor, Robert Oakeshott and Bob Katter—into the government of the day’s decision-making process is much like the addition of independent directors to a public company’s board that is controlled by insiders. We will likely see an emphasis on better governance and transparency, as the independents flagged on the ABC’s 730 Report last night. This should bring more rigour to the business of government with the cost being slower decision-making speed and arguably more bureaucracy.

One concern is that taxpayers will have to endure a new phenomenon, which one might term "green-barrelling", in order to facilitate the passage of Coalition policies through the Senate. This could undermine the Coalition’s desire to quickly shrink the fiscal deficit and delay any return to surplus. But considering the state of the government’s balance-sheet, which has little net debt, this is not going to be the end of the world.

A more disturbing outcome would be if such green-barrelling introduces additional inflationary pressures into an economy that is already operating near full capacity, which might compel the RBA to raise rates more quickly than would otherwise be the case. Market economists have already today begun noting that minority governments are not known for their fiscal discipline. This will mean that the market will almost certainly start pricing in higher interest rates in the medium to long-term as manifest in lower 3-year and 10-year government bond prices (as yields go up, bond prices decline). A knock-on effect will be higher fixed-term mortgage rates and a higher cost of debt for the public sector. Naturally all of this depends on what the ‘green-mail’ involves.

One would hope that the Greens’ newfound electoral legitimacy would presage a period of ‘base-broadening’ via the development of more mainstream and sensible policy proposals. For example, Bob Brown has recently been an advocate of sound financial services reform, and there is much fertile territory for him to till in this arena. And if the nation ends up making greater than anticipated investments in technology to mitigate climate change, this will also be a good thing. Nobody knows with certainty what, if any, deleterious effects climate change will have. But it is prudent to prepare for the worst and take out comprehensive insurance.

A final important risk is that a minority government finds it difficult to make urgently-needed investments in the ‘supply-side’ of our economy. In recent communications, the RBA has belaboured its belief that Australia suffers from acute infrastructure bottlenecks that pose major risks to the economy’s productive capacity. Critically, these will not be addressed by cutting population growth, as many politicians would have us believe.

The Treasury’s long-term population projections, which find that Australia’s resident population will rise by 60 per cent from 22m persons today to 36m persons by 2050, already incorporates a dramatic slowdown in overall population growth and net overseas migration. In particular, the Treasury assumes that our population growth rate falls from nearly 2 per cent per annum today to just 0.9 per cent by 2050 (averaging a relatively modest 1.2 per cent per annum between 2010 and 2050). They also fix net overseas migration at a constant 180,000 persons per annum between 2012 and 2050. Even taking these parameters, we are still going to have 7-8 million people living in Sydney and Melbourne within four decades.

Accordingly, the RBA believes that both the public and private sectors should materially boost their spending on infrastructure amenities (think energy utilities, rail and roads, water and housing supply) in order to avoid the higher interest rates that the RBA will have to impose to curb inflationary—and asset price—pressures in the absence of the required capital expenditure.

In this context, the Coalition’s proposal for tax-advantaged infrastructure bonds might be one intelligent solution. I have argued for years that the $1.3 trillion in national savings buried in the superannuation system are subject to flawed asset-allocations that result in excessively high exposures—around 60-70 per cent—to risky shares. Most Australian super funds are materially underweight safer fixed-income investments, such as government bonds, corporate bonds, bank bills, and mortgage-backed securities, which increases, amongst other things, the economy’s reliance on the four major banks.

Offering a tax-break to private sector infrastructure bonds would achieve a number of things. First, it could stimulate a shift in super money away from shares and back into fixed income, which the Future Fund has embraced (it has half the typical super fund’s weight to equities). Second, it would encourage more private investment in public infrastructure, which is important given that many investors in these assets were burnt during the GFC and are now shying away from the area. Third, overlaying market disciplines (eg, rigorous cost-benefit analysis and cash-flow forecasting) on the funding, development and implementation of public infrastructure is surely a superior outcome than leaving these tasks wholly to government.

I would personally like to see government working as a joint-venture partner alongside the market. Even with some tax-subsidies, the private sector will struggle to supply all of the infrastructure funding Australia needs. The Commonwealth also has two major advantages. First, its cost of capital is much lower than any private company care of its AAA-rating. All other things being equal, it is cheaper for the Commonwealth to raise this money than third-party investors. Of course, we know that governments generally have a poor track-record making smart investments, which is why you want the market to control the allocation of the capital and the project-planning. The second advantage the Commonwealth has is its unburdened balance-sheet, which could, in-principle, support larger liabilities.

What about the alternative? ANZ Bank concluded this morning that both offshore and onshore investors would not respond well to a minority government that fuses together the ALP and the Greens, and which potentially controls both houses of parliament. This would constitute an unprecedented leftward shift in contemporary Australian politics and raises the risk of a further deterioration in the government’s fiscal discipline combined with big policy uncertainties, such as an inflationary ETS, a more onerous MRRT (as advocated by the Greens), and an unknown quantum of taxpayer spending on the NBN, to name just a few.