Transcript of Finance News Network Interview with Australian National University Economics Professor, Warwick McKibbin.Lelde Smits: Hello I’m Lelde Smits and joining us today at the Finance News Network to discuss the European debt situation, its effect on confidence and solutions is Australian National University (ANU) Economics Professor, former Reserve Bank of Australia (RBA) Board Member and Senior Fellow at the Lowy Institute, Professor Warwick McKibbin. Warwick welcome to FNN.
Prof Warwick McKibbin: Hello Lelde.
Lelde Smits: First up, could we start by getting your opinion on what you believe the root of the problems are in Europe?
Prof Warwick McKibbin: So I think there are two problems in Europe. One is that countries are technically bankrupt, they’ve over borrowed, they’ve got very high government debt. The second problem is these same countries in southern Europe, are very uncompetitive relative to Germany and France, but they are locked into a single Euro currency. So there is no mechanism to improve their competitiveness except major structural reform. Normally a country would devalue but they don’t have that option, so they’re stuck in a growth trap.
Lelde Smits: What do you believe needs to be done to fix the debt and confidence crisis?
Prof Warwick McKibbin: Well effectively I think the problem is the Eurozone itself. It was a single currency that was designed without the appropriate mechanisms in place to force countries to adjust. What is needed now is either countries pulling out of the Euro which would be very disruptive, or a very systematic adjustment where a group of countries are separated into a second Eurozone and you have the dual currency within Europe.
Lelde Smits: So is what you’re saying here, a major restructure needs to occur?
Prof Warwick McKibbin: I think that’s right. Either the countries change their economies which they’ve had the opportunity and failed, or they have to move out of the single currency to become competitive, and to be able to grow their economies out of their debt crisis.
Lelde Smits: We’re hearing a lot of talk of action out of Europe but not a lot of detail. One option has been to recapitalise Europe’s banks.
How viable do you think this is?
Prof Warwick McKibbin: Well if you just recapitalise the banks but don’t solve either of the other problems, which is the sovereign problem and the fixed exchange rate, you’re postponing the inevitable. Countries’ banks are requiring recapitalisation because many of their assets are sovereign risk assets and they’ve lost value. And until you fix the economies, you’re not going to fix the debt problem.
Lelde Smits: Another suggestion has been to write-down Greek debt by up to 50%. Would this avert default?
Prof Warwick McKibbin: That is a default actually, but Greece has to default. But even if they defaulted, if you wrote-off all the Greek debt because their exchange rate is fixed, because they’re non-competitive, prices in Greece have to fall by 30% or 40% to be consistent with the German economy. This is a massive economic and social shock to the Greek economy which I don’t think they can survive.
Lelde Smits: Markets really seem to be calling for signs of reassurance and investors are jumping on any signs of hope of a resolution. Do you think Europe’s leaders are on track and when are we going to see some action?
Prof Warwick McKibbin: No I don’t think they are because they’re, in my opinion, not understanding the fundamental competitiveness problems that Greece and other southern European countries face. That’s the core problem, that’s what has led to the debt crisis, there’s a lot that needs to be done. Yes, there needs to be probably trillions of dollars now put into a pool or fund, either the EFSF (European Financial Stability Facility) or via the ECB (European Central Bank), to try and put out the fire that’s occurring. But that doesn’t solve the problem. That’s not really addressing the problem, it’s addressing the symptom.
Lelde Smits: So what really needs to be done to address investor confidence?
Prof Warwick McKibbin: I would have actually done the Greek bailout, I would have written-off the Greek debt a long time ago and I would have worked out an adjustment to remove Greece from the Eurozone. That’s easy to say now that hasn’t been done. The longer you wait, the more sovereign risks rise, the more the costs of servicing the debts in Italy and France and Spain become unsustainable. And then eventually this falls into a full-scale crisis. It can be avoided, it should’ve been avoided. I just don’t think there’s the political understanding or the political will in Europe to come up with a real genuine solution.
Lelde Smits: It really seems they’re just ripping off a bandaid very slowly, which as we know is very painful. Why don’t they rip it off faster?
Prof Warwick McKibbin: Well I can understand, so there’s a very interesting political dynamic in Germany because exporters for example, have done very well out of the Eurozone. Because there are weak countries in the Eurozone, it means the Euro has been undervalued. That means the productive exporters in Germany have been able to do very well in the global market. So their competitiveness on the input side has been real, their exchange rate under valuation has been real and they’ve done very well. So if the Euro was to split, the German currency would appreciate - from our research, would appreciate quite substantially and could cause a recession in Germany. That’s the balance that Germany, German officials are balancing up against - the economic costs of staying in the Eurozone and bailing out the south, and the economic benefits of not doing that. And it’s a very finely drawn calculation. It’s not clear which way, from a German perspective, they would want to go.
Lelde Smits: Well there seem to be a percentage of people that are losing patience. Over the past fortnight we’ve seen protesters hit the headlines demonstrating against financial excess. The “Occupy Wall Street” movement in the US has now even spread to Australia with rallies in Sydney and Melbourne. Do you think the protests are justified?
Prof Warwick McKibbin: Well I understand these protests; they’re driven by frustration that the financial system and governments in general are not performing in the way that they should perform. Underlying all this is a fairly large swing in income distribution in many economies. So the rich are becoming very rich and the poor are becoming wealthier, but by nowhere near as quickly. So the relativities within countries is changing quite a lot and this is all part of the globalisation process, governments need to understand this. The best way to solve this problem, I think, is to focus on freeing up global trade and allowing countries to develop comparative advantage in areas in which previously, they may not have had. But also the bailouts that we’ve seen of major corporations, particularly banks, have been rather skewed. And I think a lot of people are being led to believe that they’ll be made better off, and in fact not have found that they have.
Lelde Smits: Now as a former Reserve Bank Board member, do you think policy members are addressing the concerns of the people?
Prof Warwick McKibbin: Well I don’t think they are in many countries, because the problem is that you can’t grow an economy by having the government continuously issuing debt and creating schemes. What grows the economy is the private sector. So governments are there to look after property rights, manage the rule of law to give incentives. But really to assume that the government should be the driver of growth is
misunderstanding the way that progress is achieved. It comes from innovation by individuals and corporates.
Lelde Smits: Thanks Warwick, now you were just in the US. How are Americans feeling about the state of their economy?
Prof Warwick McKibbin: Well they’re very pessimistic; they’ve got unemployment hit 10 and is now around 9%. Again the Obama administration tried to use fiscal stimulus as a way of growing the economy, when the problem they faced wasn’t just a temporary loss of demand. It was a fundamental misallocation of capital, particularly into housing, but also into other investments which had to be written off. And that was something that the consumers and the industries in the US should have worn and then moved on. Instead the government has tried to postpone the adjustment. In doing so, they’ve increased the Government debt to well over 100% of GDP in gross terms by the end of 2012. That’s not going to stimulate the economy. What’s interesting is that the Americans at the moment, or the Americans I spoke to, are blaming the Europeans for their problems because there’s someone out there that’s actually worse. And doing worse and causing more uncertainty in the global economy. But fundamentally the problem lies in the US economy and it’s a needed fiscal adjustment, of cutting budget deficits and bringing down the Government debt, so that people are more confident about what future taxes might be. So if they invest today they know they get to keep the return in the future. That’s what’s slowing down the consumption, that’s what’s slowing down investment, is this uncertainty about where future taxes and future growth are going to be.
Lelde Smits: So what’s your outlook for US growth in the short to medium term?
Prof Warwick McKibbin: Well I think the US economy won’t go into recession now, I think they’ll grow slowly. I think the unemployment rate is unlikely to come down very quickly. This spills across into the housing market, people don’t borrow for houses when the risk of losing your job is reasonably high. The global uncertainty is on top of that, so consumers aren’t spending, firms aren’t investing. So I expect the US will keep growing, but I don’t expect it will grow fast enough to substantially reduce the unemployment rate.
Lelde Smits: Now to our own growth prospects. How well is Australia positioned to weather the uncertainty arising from Europe and the US?
Prof Warwick McKibbin: I think we’re in a very good position. We’ve got growing Asia, we’ve got Latin American growth, we’ve got pockets of the developing countries performing quite well. Highly vulnerable of course to uncertain shocks coming out of Europe and the US, but I’m fairly confident.
Our problem in Australia is not just the uncertainty coming from Europe; it’s the fact that our political system is currently locked in a battle and generating enormous uncertainty. Nobody knows where climate policy is going, nobody knows what the next big policy change will be driven by, minorities rather than by policy evaluation exercises. So there’s a great deal of uncertainty, consumers have slowed down their spending, firms have slowed down their investment except in the mining industries. So it’s both domestic political uncertainty and the uncertainty coming from the US and Europe are a drain on our growth, but we are sailing pretty well through the high seas at the moment.
Lelde Smits: Domestically we do have a lot riding on the commodities boom, but is there a chance we’ve put our faith in a risky basket?
Prof Warwick McKibbin: Well strong commodity growth has been very good for us and should always welcome high income, more income is better. The issue that we face is how uncertain that is and I think it’s highly uncertain. Not just because we’re relying on growth continuing in China, which is important, but also we’re relying on the fact that other major commodity exporters are not going to be flooding the world with production.
Now we’re observing that’s beginning to happen now. In some of the price negotiations in China, we’re seeing very competitive bids coming in from countries like Brazil. I just think that the supply of commodities will probably at some point, outstrip even Chinese growth demands and that’s going to cause a softening of commodity prices.
Lelde Smits: So when do you think we are likely to see commodities softening?
Prof Warwick McKibbin: Well I think it’s happening now. I mean growth is slowing and that’s driving down some commodity prices. I think prices could either level out or fall. And then other prices around the world, non commodity prices, will start rising quite quickly, because we have a massive inflationary shock coming from the central bank policies in the US and Europe. And the fixed exchange rates in China and other countries which is flooding the world with liquidity, so all prices will start rising quickly. So the relative commodity prices then will start to come down from that effect as well.
Lelde Smits: Thanks Warwick. Now you are a well-known expert on climate change, but you haven’t held back from criticising the proposed tax that just passed in the House of Representatives. Why do you believe this tax is flawed and what is your proposed model?
Prof Warwick McKibbin: So Peter Wilcoxen and I have been working on this carbon policy for at least twenty years and we have very clearly laid out an approach. The Government has adopted a fair bit of what we’ve advocated, what’s missing and what’s essential is a long term carbon price. What you need to drive technology and innovation is not a carbon price today, which is an input cost, but it’s a future’s carbon price which lets you drive and innovate, so that you can avoid those future costs and benefit from being able to reduce carbon emissions. The future’s carbon price is critical - it’s missing. The second thing is we need a system which increases the amount of certainty. It doesn’t matter it’s not completely certain, but it reduces uncertainty. We have a proposal of a fixed price which is higher than the world price at the moment, which in 2015 will switch to a carbon trading system with the floor and a ceiling. We don’t know what the world will look like, so if the price collapsed from say $28 a tonne to $15 a tonne overnight, that’ll destroy value in many assets that have been invested in. Or it could actually hit the ceiling, which would be a very high carbon price. That volatility is unnecessary and creates greater uncertainty. The third issue is fiscal uncertainty. The compensation is being done in dollars or tax cuts which are fixed, whereas the revenue firstly comes in the short term from the carbon tax but in the future, could actually go to foreigners who provide emission permits. So we’ve increased the amount of fiscal risk within the budget and that was unnecessary.
Lelde Smits: Finally Warwick, we have spoken a lot about confidence. Why did the Government choose now to introduce this tax?
Prof Warwick McKibbin: Well this is absolutely clearly political compromise with The Greens. That is what keeps this government in place. It’s
the minority parties and the minority parties have particular agendas and those agendas are finding their way into government policy. That is very bad for the Australian economy in my view. We should have open debate on issues; we should have evidence based policy formulation. We shouldn’t have just special interests being paid off to continue political power. It’s a very dangerous situation and many historical examples in Latin America and parts of Europe have shown that that really does lead you down a slippery slope.
Lelde Smits: And what do you believe leaders should be doing now to boost confidence?
Prof Warwick McKibbin: Well firstly I think most policies when we have a key innovation like the carbon policy, needs to be bipartisan. If you haven’t got a bipartisan approach, then it’s very dangerous to put a policy on the table and then have it obliterated. If we’d gone ahead in 2007 with the John Howard/Kevin Rudd type of policy at the time, we would have been much better off. Now we’ve destroyed carbon policy and the debate in this country, and that is unfortunate. The same thing has happened in the United States by the way. And so I think what you need is a government that’s willing to get a group of experts together to give five options which are credible within a community of experts. And then use the political process to choose between those policies based on political compromise. You don’t create a policy starting with political compromise because then you’ll end up with a mess.
Lelde Smits: And do you think we are likely to see those sorts of solutions in Australia anytime soon?
Prof Warwick McKibbin: No, I doubt it. What will happen over the next couple of years regarding the political situation here, will really determine whether Australia is going backwards or forwards.
Lelde Smits: Warwick McKibbin thank you so much for your insights today.
Prof Warwick McKibbin: It’s my pleasure.
ENDS
