Predicting the future course for the Aussie economy isn’t hard. I often find myself looking towards Canada, Russia or Brazil for guidance.
Like Australia, all three nations are major commodity exporters. Each one has a larger economy than Australia in real terms. Yet when I look at them today, I feel dread for Australia.
All the reasons for this dread start with one thing: commodities.
Commodity exporters have suffered from major slumps in price over the past year. Low oil prices weigh down on the Canadian and Russian economies.
Australia and Brazil are hurting from weak iron ore prices. Iron ore makes up 15% of all Brazilian exports. That’s less than Australia’s share of 22%. Both economies live and die by incomes generated from iron ore sales.
Iron ore has shed two thirds of its price since last year. The future outlook suggests prices are heading lower. And they may not recover for years.
Because of this, both countries face uncomfortable futures. Every commodity nation must find an answer for growth amid weaker prices.
That’s what makes Canada, Russia and Brazil so key to Australia. They show us what happens to economies when commodity prices tank. Usually it goes as follows:
- Governments first extend, and then rein in budgets.
- Deficits and debts grow. Economies slide towards recession.
- There’s a scramble to prevent things slipping further. Often to no avail…
Brazil, Russia and Canada have all entered recession in recent months. All three are struggling with growing budget deficits. And all three are responding to this in similar ways. As a major iron ore and coal exporter, Australia finds itself in a similar position.
To spend or to cut?
Governments have two options when the economy turns for the worse. Spending is the first option. Spending cuts is the second.
When the first doesn’t work, the latter follows. Spending your way to growth never works. Not unless you’re exporting sector is thriving.
That leaves spending cuts and taxes as the only solutions.
But the Aussie government still believes the economy can improve. Even amid low commodity prices. Hoping it can grow its way out of trouble by spending.
Growing your way out of trouble isn’t possible. Growth rarely occurs unless you can sell something to the world. Something which it’ll pay generously for.
You can ramp up spending, but only at a cost of a growing debt pile.
What option does that leave for the Aussie government?
As I look towards Canada, Brazil, and Russia, I reach the same conclusions. Austerity is the only solution for the economy in the long term. The government won’t dare admit this heading into an election next year. But I believe it knows that’s where we’re heading.
Australia can’t help but follow in the footsteps of other commodity exporters. That’s where Brazil comes in.
Brazilian government introduces tough austerity measures
Brazil, like Australia, struggles with a sizeable budget deficit. Brazil’s deficit stands at almost $125 billion. That’s higher than Australia’s estimated $40 billion deficit.
In response to its deficit, Standard and Poor (S&P) downgraded Brazil’s credit rating. It lowered Brazil’s rating to BB+, or junk status. Investors use credit ratings in determining whether to invest in countries. Simply put, S&P is telling investors to stay out.
Yet as the Brazilian economy slows, it needs all the investment it can get. The government is now scrambling to get ratings agencies back on its side. It responded to the downgrade by announcing a fresh round of austerity measures.
‘Finance Minister Joaquim Levy proposed a new round of spending cuts and tax increases that are designed to close the budget gap and protect Brazil from further credit downgrades.
The government will reduce 26 billion reais ($6.8 billion) in expenditures from next year’s budget in large part by capping salaries of civil servants and suspending exams for new entrants, Levy said Monday. Brazil also plans to raise 28 billion reais in revenue by boosting taxes, including a levy on financial transactions’.
The Brazilian government hopes to achieve two things.
Fixing the budget deficit is the first priority. The second is preventing any further credit downgrades.
Achieving this requires both spending cuts and tax hikes.
The government is cutting back spending to the tune of $10 billion. These spending cuts involve salary freezes for public sector jobs.
Raising revenues will slug voters with $10 billion in new tax hikes. A levy on financial transactions is among the measures proposed.
It hopes this is enough to create a budget surplus at 0.7% of GDP by 2016.
This is a bold move from the Brazilian government, one which calls itself the Workers’ Party (WP). With strong links to labour unions, the WP is risking its reputation.
Worse still, the WP knows that austerity measures can only go so far. These measures delay decline, but don’t prevent it. Its economy will struggle without a rebound in export revenues. But the WP doesn’t have much choice.
Austerity coming to Australia?
Looking at Brazil, one wonders what this might mean for Australia. If Brazil is slashing spending and hiking taxes, why are we any different? I don’t believe we are, but our austerity won’t be as obvious as Brazil’s.
First, let’s address the similarities.
The government may think we’re special, but we’re not.
It thinks it can bring the budget to surplus by early next decade. But it won’t achieve this without major spending cuts and tax hikes. The only route available then is the one Brazil is going down: austerity.
Austerity isn’t a new concept for the Aussie government. It set out a plan for tacking the budget deficit last year.
It announced spending cuts of 1.1% of national income by 2025. And it promised to lower spending below a 30 year average.
But spending cuts alone aren’t enough. For it to work, our trading partners must be expanding quickly. Fast growth among emerging economies ensures high private sector investment in Australia. Only that would offset cuts to government spending. Anything else just damages the economy in the long run. And creates a deflationary spiral where no one is spending.
That’s not an option. What’s the solution then? More cuts, and more taxes… and higher spending.
And this is the difference between the two nations.
Arguing for more spending runs contrary to what I’ve been saying. But it’s the only way the government will mask the situation from getting worse. I see it playing out like this:
The government will introduce new taxes and spending cuts. But it will end up spending more too. Just not as much as it cuts through spending or raises through taxes.
It can do this because Australia’s debt to GDP ratio is 27%. That’s lower than Brazil’s debt to GDP of 48%. And it’s much lower than the US ratio of 80%. In other words, the government has some leeway to rack up debt and spend.
Yet it knows Australia can’t spend its way to growth in the long term. That’s why austerity measures (cuts and taxes) must outweigh spending. Because of this, we might see an imbalance in government spending. Sectors like defence could receive a larger share of funding. Whereas health or education might see cuts.
Either way this spending will be used as proof that austerity measures are working. It will mask the fact that GDP growth and living standards are both falling.
That will give the government enough political clout to introduce new taxes. Government plans to raise the GST tax to 15% is only the tipping point here. Yet I suspect that any tax revisions will take place after the election in 2016.
Australia isn’t faring as badly as Brazil. But we’re not far behind. The lesson it provides us is simple. Australia’s austerity may not look like Brazil’s. Our government has enough space to grow its debt pile. Unlike the Brazilian government, Australia can use this to trick voters into thinking that austerity is working well.
However the government cuts it, living standards will drop as spending cuts and new taxes take hold.
Contributor, The Daily Reckoning
Like Brazil, Australia is entering a new era of austerity. It’s another sign that the economy is inching towards a recession.
The Daily Reckoning’s Greg Canavan says Australia is on course for its first recession in 23 years.
In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals why our economy finds itself in the hole it’s in. He’ll show how debt levels have spiralled out of control. And he’ll prove why that means a recession is almost inevitable.
But there are actions you can take right now to lessen the blows of the recession.
Download your free copy today to learn how to protect your wealth from the fallout of the crash. To find out how to download his free report right now, click here.