There are two ways to lift our living standards. Coasting isn’t one of them

News this week that the iron ore price has fallen to the lowest level in several years has economic commentators worried. Most of the commentary has focused on the impact of the price drop on the federal budget. It is predicted that the fall in price to less than $90 a ton will cost the budget $3 billion across the forward estimates — and may push us into deficit sooner than expected.

It is important to note from a fiscal perspective, all that is really happening is that the underlying structural deficit (i.e., the fact that our governments habitually spend more than they raise) has been exposed by a return to more normal global economic conditions.

In truth, neither Labor nor the previous Coalition government was willing to take the unpopular but necessary steps that would have brought the budget back into a more structurally neutral position.

The previous government focused its efforts on bending down the future path of expenditure, while relying on bracket creep to slowly bring revenue up to the level of expenses. The glacial progress achieved under a softly, slowly approach was always at risk when an economic shock appeared.

In fact, when Covid swept away the guardrails, the government abruptly capitulated and opened the spending taps to maximum.

The current government, critical as it was during the pandemic that the then government wasn’t spending enough, has simply ploughed ahead with its spending agenda. It has shown no more regard for the effect of its spending on the budget than it has for its effect on inflation.

Nevertheless, a return to deficit may stop some Labor partisans from pretending that it was Labor’s superior economic management that produced the recent run of budget surpluses.

However, this is far from guaranteed. Political partisans have never let the facts get in the way of their preferred narrative.

The government itself has largely had the good sense to keep its surplus spruiking to a minimum. One reason was undoubtedly an understanding that the surplus was driven by temporary economic tailwinds.

It is also likely they didn’t want to revive the public perception that a budget surplus is a sine qua non of good economic policy.

Of course, it may be that the drop in iron ore prices is temporary, and the hit on the budget never materialises. Australia has been exceptionally fortunate for decades, in that global economic forces have lined up to our benefit, especially with respect to timing.

There is no better example than our lucky escape from the worst of the GFC.

While any loss in revenue is bad news from a budgetary perspective — especially given our recent accumulation of government debt — it is not in fact the most important part of this story.

The bigger issue is that Australia has effectively been economically coasting for two decades off the back of several booms in mining revenue.

To understand why this is a problem requires us to take a step back. In essence, there are two ways living standards can increase.

One, by far the more reliable path and the most important in the long term, is to boost productivity. Productivity is basically just how much we can make per worker. As that increases, so too do wages.

The other, far less predictable and more erratic, is to hope for an improvement in the terms of trade. Essentially, this means that we can buy more imports compared to our exports, thus making us richer.

Unfortunately, while the terms of trade can go up and make us richer, they can also go down and make us poorer. This is why productivity means almost everything in the long run.

Australia has had favourable luck with its terms of trade now for several decades, at least in part because of the seemingly insatiable desire by Chinese markets for Australian exports.

While, as noted above, this has generated significant revenue for the government, more importantly it has also fed through into continual improvements in our living standards.

Undeniably this has been a good thing. However, it has enabled Australia to largely ignore the need for productivity-enhancing economic reforms for more than two decades. Indeed, the general thrust of economic reform following the GST has been harmful for productivity.

We have re-regulated the labour market on multiple occasions, with the effects of the last round of regulation still yet to be felt throughout the economy. We have fiddled at the very edges of tax settings while many other countries have aggressively courted investment by lowering their corporate tax rates.

We have passed millions of pages of new regulations aimed at policing the behaviour of companies rather than enabling competition. We have bailed out businesses that should have failed. We have imposed dumping duties on countries trying to sell us cheaper goods.

And we have watched on as global free trade has become a dirty word.

It should hardly be a surprise that productivity growth in Australia is low, given how little we have done to improve it.

Yet we have not suffered for our ignorance because of the effects of the reforms of the 80s and 90s and the terms of trade booms of the 2000s and 2010s.

If the tide of good times is flowing out in the mid-2020s, we may be forced to deal with all the junk we dumped in the harbour while imagining it was going to float out to sea.

In truth, regardless of whether this is a temporary blip in iron ore prices or a permanent decline, eventually our terms of trade will normalise.

At that point, our living standards will depend on our productivity performance. That’s not a comforting thought.

Simon Cowan is Research Director at the Centre for Independent Studies.

Photo by Valentin Antonucci.