The good thing about digging holes is that you can fill them back up again. You get two bursts of economic activity from the one project. Heck, you could employ two people to do the job instead of just one. A hole digger and a hole filler. That would solve our economic ills in a flash. We’d double GDP and halve unemployment in one fell swoop. Best of all, we’ll have lots of filled up holes when we’re done.
Can you spot the error in this way of thinking? The famed economist John Maynard Keynes couldn’t. To be fair, he couldn’t see the problem with eugenics or anti-Semitism either. Nobody’s perfect…
In fact, there are a whole bunch of problems with the idea of creating pointless economic activity. Debt, misallocation of capital, crowding out and a waste of resources, to name a few. But the really concerning one for Australians right now is called ‘the Curse of Once-Off Economic Growth‘. At least that’s what we call it…
You see, starting a business that does something creates recurring economic activity. Buying a machine that produces something creates recurring economic activity. Planting a grape vine creates recurring economic activity. But pointless hole digging does no such thing. Unless you’re a treasure hunter with a reasonable success rate, digging a hole creates a single burst of useless economic activity. Once you’re done, it’s over.
Why is recurring economic activity important? Well GDP is a measure of flow, not stock. That’s an economist’s way of saying it measures something that is happening, not something that you have. Economic activity this year is counted in this year’s GDP only, no matter what effect it has on the future. The key to recurring economic activity is that it doesn’t just disappear suddenly next year. It continues on. A business will do what it did last year. But economic activity of a once-off kind will have to be re-initiated each year. You’ll have to dig a new hole each year just to maintain the same level of GDP.
If you want to increase GDP using once-off economic growth type projects, you’ll have to repeat not just the same amount of projects, but even more of them. If you want to engineer an annual GDP growth rate of 8%, you’ve got to spend 8% more each year on once-off projects (assuming the rest of the economy keeps pace). That’s a 50% increase over 5 years, which isn’t necessarily a problem. We need some types of economic activity that are once-off. The problem arises when this kind of activity is generated for the wrong reasons. Like, say, generating GDP for appearance’s sake. When GDP is generated for the sake of it, that GDP tends to be of a certain kind – the unproductive kind.
A machine financed with debt will pay off the debt by growing revenue year after year. A filled up hole financed with debt will leave the hole diggers in debt with nothing to show for it. This shows that economic activity which pays off its cost is much better than economic activity which doesn’t. Only productive economic activity pays for its cost. Profit is what defines economic activity as productive, after all.
Recurring economic activity is much more likely to be profitable. Otherwise it wouldn’t recur. The problem with once-off economic activity is that there isn’t as obvious a feedback loop as to what is and what isn’t productive. You get the same GDP impact from both productive and unproductive once-off activity. Only much later do you find out if the economic activity was productive or not.
How is all this relevant to Australia? Well, the world has been engaging in a lot of once-off economic growth creation. Unfortunately, it’s the hole digging kind, not the productive kind. And so soon it will incur the wrath of the curse of once-off economic growth. Australia is caught like a deer in the headlights of the curse’s oncoming dump truck.
Before we explain the curse, one last tangent. Mining, believe it or not, does not come under the once-off economic growth banner. That’s because what the miner digs up pays for the mine. Think of it like this. We didn’t run out of stone in the stone age. We didn’t run out of bronze in the bronze age, iron in the iron age or gold in the golden age. We simply moved on to coal, oil, uranium, thorium and so on. Mining remains a productive enterprise throughout all that. No hole dug for the sake of digging ever generated the same kind of economic effect.
Anyway, back to the curse of once-off economic growth. One of the biggest sources of Australia’s economic activity comes from exporting iron ore to fuel China’s growth. Much of the demand comes from the construction in China. The interesting thing is that construction belongs firmly in the ‘once-off economic growth’ category. You build something, and then you have it. It only shows up in GDP once.
That’s not to say construction is a waste. Just know that there is the potential of a sudden fall in GDP if construction stops. Why would that happen? Well, if houses stop paying enough rent to pay off the debt you need to fund their construction, it’s tough to finance building more houses. The same goes for bridges, toll roads, and so on. In other words, when people realise building is unproductive, construction will stop. All that GDP will suddenly cease to exist.
When will that happen? As we just mentioned, it’s difficult to judge whether once-off economic growth projects are productive or not. Does the house pay for itself in the form of rent and capital gains? You don’t know until it’s built. In China, there are some fairly obvious signs that the housing being built is not productive. But back to that in a moment.
Here’s the twist. If people are convinced that construction is a productive form of economic activity, they will build things. Or, put it another way, if you can convince people that building houses is a productive form of economic activity, that will spruce up GDP and employment, which will make politicians and central bankers look like geniuses. For a while, that is.
In the US early last decade, central bankers did such a good job of managing the economy and interest rates that people become convinced that houses always rise in price. Anytime things looked dicey, the central bankers just lowered interest rates to get things going again. This misleading signal triggered huge amounts of housing construction, investment and capital gains. Vast once-off economic activity was created, and everything looked rosy.
But at some point, that doesn’t work anymore. The unproductive nature of all those houses begins to emerge. In the US in 2007, people began selling houses and defaulting on mortgages. Construction stalled and huge amounts of GDP evaporated. The rest, as they say, is history. But not for Australia. For us, a slightly different sequence of events is going to trigger our own, similar disaster.
In China, rather than relying on self interest and interest rates to fuel the housing boom, the government has done the job much more directly. It built vast ghost cities to make GDP look good and give many people jobs. You’ll guess from the fact that they’re called ‘ghost cities’ that these are unproductive once-off economic growth projects. As soon as construction stops, that economic activity won’t show up in GDP figures any more. And if nobody’s paying the rent in these buildings, then nobody is going to be able to repay the debt or generate further economic activity out of the buildings.
Just how bad this issue is in China is difficult to comprehend. Al Jazeera interviewed Victor Shih of Northwestern University on these issues. Here are some quotes on how unproductive Chinese economic activity has been and how bad the debt burden has become:
‘China is among the most inefficient in the use of capital. They need to invest $4 for every $1 in economic growth.‘The problem in China is gigantic… They have a governmental debt to GDP ratio of over 100% and if you count contingent liabilities of the Chinese government, which includes debt of the state owned enterprises, is well over 150% of GDP, and that’s among the highest in the world…’
Once China’s unproductive economic activity is exposed and its once-off economic growth generating efforts can no longer be funded, a huge portion of its GDP will suddenly cease to exist. Remember, that’s because GDP is a measure of activity, not a measure of what you have. The buildings they’ve built might not disappear, but construction activity can suddenly stop. The portion of Chinese GDP most at risk of this is precisely the portion what creates the demand for key Australian resources like iron ore. In other words, the speedy part of Australia’s two speed economy will be in for a sudden shock.
In digging seemingly productive holes for China, Australia has dug a hole for itself. The curse of once-off economic growth has been cast. At some point, all that once-off growth will be pulled out from under the mining industry’s feet.
By the way, GDP is an abysmal measure of economic activity. Here’s a quick quote from African Development expert Morten Jerven which will make your realise just how flawed the measure is: ‘…in Ghana, when they re-did their GDP estimates, they recently found out that their economy was almost double the size of what they previously thought and previously published.’ Despite the complete uselessness of GDP, the point we’re making remains the same. GDP is just a measure for economic activity. The measure might be flawed, but economic reality remains. Australia is hugely over-exposed to the curse of once-off economic growth.
We’ll have to come up with a better name for it…
In the meantime, why not take a look at what you can do about all this? Greg Canavan is a man with a plan. You can find out what it is here.
Markets and Money Weekend Edition
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