Glenn Stevens has added his credibility to the view that, faced with an income shock that might occur once or twice in a century, the federal government ought to consider a “stabilisation fund” to smooth future volatility in economic conditions.

The Reserve Bank governor’s starting point for that part of his speech to the Committee for Economic Development of Australia last night was that Australia’s terms of trade are as high as anything experienced since Federation. It was, however, not possible to know whether that increase in the terms of trade was permanent or temporary. Past episodes tended not to be permanent but they sometimes lasted for several years and for long enough to be “very disruptive”.

If the rise in income was only temporary, Stevens said, it would make sense to allow the income gain to flow into a higher stock of savings which would then be available to fund future consumption, including during periods of temporarily weak terms of trade.

Stevens talked about the implications of a permanent or persistent change for the structure of the economy, but said the most prudent assumption might be that the terms of trade will be persistently higher than they used to be by enough that there would be a need to accommodate structural change in the economy but not by so much that we shouldn’t seek to save the surge in national income occurring in the “next year or two”.

In the longer term the economy’s increased exposure to larger emerging economies like China and India raised the prospect that they might continue to grow strongly but, as with all economies, still have business cycles. The result may be that Australia experiences faster average growth in income but with more variability.

If that were the case we could seek to smooth consumption through changes in spending and fluctuations in saving and, “in then most ambitious version of this approach” seek to hold those savings in assets that provided some sort of natural hedge against or weren’t correlated with the variability of trading partners. He subsequently referred to a stabilisation fund.

Economist and Reserve Bank board member Warwick McKibbin and others (The Grattan Institute’s Saul Eslake and BHP Billiton’s Marius Kloppers are among those who share McKibbin’s views) have argued that we should use the windfall of the terms of resources-inspired trade boom to establish a new Norwegian-style sovereign wealth fund.

McKibbin says the fund should hold its assets offshore to dampen the effects of excess demand on the domestic economy and spreading the income shock from the resources boom over a longer period. The income from the fund could be repatriated as the boom deflated or — as Stevens indicated — during the down periods in what could by a volatile cycle.

As McKibbin noted in a Business Spectator interview in July, the sort of recycling of the resources windfall that the government envisages is to impose a mining resource rent tax but use it for recurrent spending, which just stimulates near term domestic demand.

In any downturn in resources, of course, that would magnify the negative shock to the economy.

Stevens referred to the “next year or two” — a period during which, because it refused to wind back its stimulus program, the Gillard government will still be presiding over a budget deficit.

The sensible policy would be to dedicate the proceeds of the MRRT to establishing a new fund, creating a relief valve to ease the pressure on the domestic economy and taking out an insurance policy against a either a subsidence in the terms of trade or increased volatility in them and in our economic settings.

Whether one can get sensible policy given the awkward balance of federal parliament is debatable, but at least Stevens has, in the RBA’s usual subtle way, lent his support to the concept that for a variety of reasons the windfall from the once-in-several-generations resources boom should be saved rather than frittered away.

*This article was originally published on Business Spectator

Peter Fray

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