House price boom could be our biggest economic problem

A surging Australian dollar to near three-month highs overnight will help to bring a big dose of realism to all this talk of expectations and confidence driving a weak Australian economy higher.

As US economist Paul Krugman said, the “fairies of confidence” and the “imps of expectations” are nothing but ephemera in the greater scheme of things, there to wave their wands when all else fails. We saw this yesterday when the sharp rise in business confidence in the National Australia Bank’s August business survey, but little or no impact on weak trading conditions.

Today it was a big rise, to a three-year high, in the Westpac/Melbourne Institute Consumer Sentiment survey for September, the highest level since late 2010 (when which government was in power? Why the Gillard government).

All agree the economy is waiting for the confidence fairy to emerge and convince consumers to spend, business to invest and jobs to be created. Just a sprinkle of confidence dust and the economy will be surging. If you were in the UK in 1992 after John Major unexpectedly won, you would have seen Rupert’s papers pushing this line?—?“Cash Happy Shoppers Celebrate Tory Win” was one Sun headline. Before, of course, Black Wednesday arrived in September that year. Before the bad times.

Much of this “confidence” stuff is economic gobbledygook?—?like Tony Abbott’s line that Australia is now “open for business”. Improving expectations and confidence among business and consumers is imprecise and hard to formalise, and has minimal correlation with real-world outcomes.

And since the poll there has been a surge in the value of the Australian dollar?—?not because of the Coalition win, but because of more evidence that the Chinese economy has stopped weakening and is now probably just starting to grow again. It underlines what Abbott, new treasurer Joe Hockey and Andrew Robb (temporary finance minister until Arthur Sinodinos has his Senate spot confirmed) ignored for the past two years: the fact that offshore investors view Australia and the dollar as proxies for the Chinese economy.

Australia is now the most exposed of all major economies to the health of the Chinese economy and, with the fifth most traded currency in the world, it’s been easy for investors offshore to bet against China (go short) or go long and believe the China story. There’s been a battle between the shorts and the longs, and from May onwards the shorts won. The combination of both, plus the August interest rate cut from the Reserve Bank, saw the Aussie dollar hit a low of 88.48 US.

But with Chinese economic data for July and economic better than expected, there is now a growing belief that China is recovering. Demand for the dollar is up and the currency is over 93 US cents, the highest since late June. Should China continue to recover, the Aussie dollar will rise, even if the Fed reveals next week a timetable to end its $US85 billion a month in spending.

If that happens, Abbott and Hockey will only be able to sit and watch with the same sense of frustration as Julia Gillard and Wayne Swan as a strengthening Aussie dollar starts to put a stranglehold on the economy and the budget’s revenue base. Helping this is the virtuous circle of good economic management by successive governments and the RBA; we have low inflation, reasonable growth, rising labour productivity and low interest rates that have resulted from the high dollar/ high credit rating and good economic management by the federal government, and especially the Reserve Bank.

This is a positive feedback loop. Like the Gillard government, Abbott will be an unwilling bystander to the fallout from years of solid, successful management of the economy and creative policy measures during the GFC.

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