Saturday, June 1, 2013


Economic growth: the economy’s production of goods and services (real GDP) grew by a below-trend 2.5 pc over the year to March. Non-mining business investment spending is weak, home-building and public spending are flat, but consumption is growing at below trend and net exports (exports minus imports) are growing strongly. Mining investment may have peaked. Production is forecast to grow slightly below its trend rate at 2.75 pc in 2013-14.

Inflation: he underlying inflation rate was 2.4 pc in the year to March, down from a peak of 5 pc in the year to September 2008, immediately before the GFC. It’s been back in the target range of 2 to 3 pc for three years and in the bottom half of the range for one year, suggesting no threat from inflation.

Unemployment: using trend estimates, the unemployment rate was 5.5 pc in April, having crept up from 5.1 pc over the previous year, though with the participation rate unchanged at 65.3 pc. Thus the economy has not been growing quite fast enough to hold unemployment steady. And with its growth forecast to stay a little below trend in 2013-14, the unemployment rate is forecast to continue creeping up to 5.75 pc by June 2014. But note that this unemployment rate is not much above the NAIRU, our lowest sustainable rate.

Current account deficit: CAD was $9 billion for the March quarter, or 2.2 pc of GDP. For the year to March, the CAD totalled $49 billion, made up of a trade deficit of $13 billion and a net income deficit of $36 billion. As a consequence of the high CADs in earlier years, the foreign debt has risen. At the end of March the net foreign debt was $764 billion, or 51 pc of GDP. The CAD is below its trend level of about 4.5 pc of GDP because although national investment (mining construction spending) has been stronger than usual, national saving (households and companies) has risen by more, while still being less than national investment.

Now let’s take a closer look at the state of the economy. This is a particularly interesting time to be studying the Australian economy because we have spent the past decade coping with the biggest commodity boom in our history since the gold rush, with the global financial crisis and its aftermath thrown in just to make things interesting. The boom has had big implications for the exchange rate, for change in the structure of the economy and, of course, for macro management.

Resources boom: The boom started in 2003, but was briefly interrupted by the GFC. It arises from the rapid economic development of China and India, which has hugely increased the world demand for energy and the main components of steel. This demand may stay elevated for several decades until the two most populous countries complete their economic development. The boom has involved three overlapping stages:

First, hugely increased prices for our exports of coal and iron. These caused Australia’s terms of trade to reach their most advantageous level in 200 years by June 2011, but they have since fallen back by 17 pc. Even so, we are still receiving significantly higher prices for our exports of coal and iron ore. Prices shot up as demand outstripped supply, but as Australia and other commodity exporters increase their production capacity prices are falling back.

Second, an unprecedented boom in investment in new mines and natural gas facilities as miners take advantage of the great global demand for minerals and energy. This investment spending has been a major contributor to growth for the past few years, but it is now expected to reach a peak in 2013 and, thereafter, begin subtracting from growth as it falls back. Note that, even though spending will decline from one quarter to the next, there is still considerable spending to come.

Third, significant growth in the volume of our exports of minerals and energy as new investment projects come on line. This volume growth will make a positive contribution to GDP growth and also to the trade balance and the CAD, even as falling export prices act to worsen the CAD.   

Exchange rate: As a commodity-exporting country, Australia’s exchange rate always tends to rise or fall in line with world commodity prices and our terms of trade. So our exceptionally favourable terms of trade left us with our strongest exchange rate for 30 years. The dollar is also being kept high by foreign purchases of Australian government bonds and the indirect effect of the developed countries’ use of ‘quantitative easing’ to stimulate their economies.

The higher dollar has reduced the international price competitiveness of our export and import-competing industries. Exporters are earning fewer $As from their overseas sales in $USs, while domestic industries are losing market share to now-cheaper imports. This adversely affects all industries in our tradeables sector (including the miners and the farmers), but particularly disadvantages our manufacturers and key services exporters, tourism and education (international students). These industries’ profits and their production are reduced.

Structural change: Economists argue that the long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports 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. Mining production now accounts for about 10 pc of GDP (though only about 2 pc of total employment).

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.

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, on average, 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 the 2013 budget the government focused on finding offsetting savings (including an increase in the Medicare levy) to cover the cost of phasing in two big new spending programs: the national disability insurance scheme and the Gonski reforms to education funding. On top of this, Mr Swan announced further savings intended to reduce the structural budget deficit by about $12 billion a year by 2015-16. It’s important to note, however, that the government’s net savings won’t start reducing the overall budget deficit until the year following the budget year, 2014-15. Mr Swan says this is to ensure the budget doesn’t contribute to any weakness in demand while the economy makes its transition from mining-based to broad-based growth. In other words, the ‘stance’ of fiscal policy adopted in the budget is neutral - neither contractionary or expansionary.

The government failed to achieve its promised return to budget surplus in 2012-13 because the terms of trade fell by more than had been expected and because there was no accompanying fall in the exchange rate, thus leaving many industries’ prices and profits under pressure. If you take the budget figures literally, Mr Swan now expects to get the budget back to balance in 2015-16 and to surplus the following year. But we should have learnt by now not to take budget projections literally.

Monetary policy: - the manipulation of interest rates to influence the strength of demand - 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.

Over the year to late 2010 the RBA reversed the emergency cut in the cash rate it made at the time of the GFC, lifting the rate to 4.75 pc. By late 2011, however, it realise the inflationary threat had passed, and the greater risk was inadequate growth in the face of such a high exchange rate. So between November 2011 and May this year it cut the cash rate by 2 percentage points to 2.75 pc - its lowest level since the RBA was established in 1960. The ‘stance’ of monetary policy is now highly expansionary. Many people have assumed the RBA is cutting the cash rate in the hope of bringing about a fall in the dollar, but this is not correct. It doesn’t expect a lower cash rate to have much effect on the exchange rate. Rather, it’s objective is to offset the contractionary effect of the continuing high dollar by stimulating the most interest-sensitive areas of domestic demand: housing, consumer spending on durables and non-mining business investment.

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.