Tuesday, June 5, 2012


Talk to UBS Economics Lecture Day, Sydney, Tuesday, June 5, 2012

When you’re a manager of the Australian economy - when you’re the governor of the Reserve Bank in charge of monetary policy, or the federal Treasurer, in charge of fiscal policy - there’s always some problem you’re having to cope with. When the economy’s in recession, or growing only weakly, you probably don’t have a problem with inflation, but you are very worried about high unemployment and how you can get it down. When the economy’s growing strongly, you probably don’t have a problem with high unemployment, but you are worried about a build up in inflation pressure and what you have to do to keep inflation under control.

Economic report card

So what’s the big problem for the economic managers at present? Well, as you’ve been hearing, if you look overseas at the world economy, you find plenty. But I’m going to focus on our economy, and if you’d just arrived here from Mars and took a quick look, you might think it all looks pretty good. In last month’s budget, Wayne Swan forecast growth in real GDP in the coming financial year, 2012-13, of 3.25 per cent - which is right on the economy’s ‘trend’ rate of growth (its longer-term average rate, which is also its ideal cruising speed, so to speak). The latest figures say underlying inflation is running at 2.2 pc - almost down to the bottom of the RBA’s 2 to 3 pc inflation target. The latest figures say unemployment is running at about 5 pc - which economists say is down very close to our NAIRU - the non-accelerating-inflation rate of unemployment, which is the lowest point to which unemployment can fall before labour shortages start causing wage and price inflation. That is, unemployment is very close to its lowest sustainable rate. Even if you look at the latest figures for the current account deficit, you find it’s down at 2.3 pc of GDP, compared with its trend rate of about 4.5 pc.

The resources boom and its high dollar

So our Martian concludes everything in the Australian economy is going surprisingly well, and the economic managers don’t have any kind of problem at present. But they - and you and I - know better. The economic managers have, in fact, got plenty to worry about. Why? Because our economy is being hit by two major, but conflicting economic shocks: the expansionary effect of our exceptionally favourable terms of trade and the mining construction boom, and the contractionary effect of the accompanying high exchange rate.

The problem facing the economic managers at present is to ensure the net effect of those two conflicting forces continues to leave the economy growing at trend, with inflation within the target zone and unemployment neither much lower nor much higher than is now. For most of last year, the RBA’s biggest worry was that the economy would grow too strongly and inflation pressure would start to build. But that didn’t happen - partly because worries about what’s happening in the rest of the world dampened the confidence of consumers and businesses - and the economy didn’t grow as fast as forecast. Inflation is actually lower than expected, so now the RBA is focused on ensuring growth is fast enough to prevent much rise in unemployment.

The three-speed economy

Another way of saying the economy is not as problem-free as a Martian might think is to say, as so many people do, we have a two-speed economy: the part linked with mining is growing very strongly, while the part hit by the high dollar is growing only slowly. Similarly, the main mining states, Queensland and Western Australia, are in the fast lane, but the other states are in the slow lane. Actually, economic theory tells us it’s more accurate to think of the resources boom and the high dollar causing a three-speed economy. The third and middle lane is for the ‘non-tradeables sector’ - those mainly service industries that don’t export their product or compete against imports, so aren’t directly affected by the high dollar, but do benefit from their (and their customers’) access to cheaper imports. Industries and states in this middle lane won’t be growing as fast as the mining-related industries, but nor will they be as hard-hit as manufacturing and tourism.

The big problem: structural change

But perhaps the best way to think of it is that the problem facing the economy at present isn’t the usual cyclical problem - is the economy growing too fast or too slow? - but is more structural in nature. Economists argue that the exceptionally high prices we’re getting for our coal and iron ore exports and the huge investment we’re seeing in building new mines and liquid-gas facilities represents a long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports. This necessitates change in the structure of our industries, with relatively more resources of labour and capital going to mining, and relatively fewer resources going to all other industries, but particularly manufacturing and service exports. Economists further argue that the high exchange rate is the market’s painful way of helping to bring about this structural change. They say that using government subsidies or other forms of protection to help our industries resist change reduces the efficiency with which the nation’s resources are allocated.

Retailing is another industry facing structural change as consumers shift their preferences from goods to services, and as the internet gives consumers access to overseas markets where retail prices are lower. This change is not related to the resources boom, but is related to the end of a long period when consumption grew faster than household income.

So the economic managers are having to manage the economy at a time when it is being hit by a lot of painful structural change. Let’s look at what they’re doing with the main economic instruments - or arms of policy - they use, starting with monetary policy, then moving to fiscal policy.

Monetary policy

Monetary policy is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Aware the unemployment rate was only a little above the NAIRU and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as the RBA had forecast. Instead, the outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by a further 0.5 point to 3.75 pc, more than offsetting the banks’ efforts to preserve their profit margins and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.

Macro bottom line

Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.

Microeconomic policy

The objective of microeconomic policy is to achieve faster economic growth and make the economy more flexible in its response to economic shocks. Whereas macroeconomic policy seeks to stabilise demand over the short term, microeconomic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. It does this mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 90s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.