Monday, July 1, 2013


The economy isn’t travelling too badly at present, but if you listen to what you hear from much of the media, you could be forgiven for thinking it’s in terrible shape. There are several reasons why the economy’s doing a lot better than many people imagine. A fair bit of it is political: if you don’t like the government it’s easy to conclude it must be making a mess of the economy. The world economy is not growing strongly and a lot of the bad news we get from Europe may be worrying people, even though our strong and growing links with the developing Asian economies mean we are much less affected by problems in the North Atlantic economies than we used to be. Another part of the explanation may be that all the fuss about the Gillard government’s inability to keep its promise to return the budget to surplus in 2012-13 may have been taken wrongly by some as proof it is managing the economy badly. And it remains true that some parts of the economy are under great pressure from the high exchange rate and other factors.

Economy doing better than many imagine

When you stand back from all the argument and complaints you see the economy isn’t doing too badly. Real GDP is expected to have grown at the medium-term trend rate of 3 per cent in the old financial year, 2012-13, as a whole. The budget forecasts growth will slow to a little below trend, 2.75 per cent, in the coming financial year, 2013-14.

This growth has been sufficient to hold the unemployment rate in the low 5s for several years, though it is drifting up slowly and is forecast to reach 5.75 per cent by June next year. Remember that most economists believe the non-accelerating-inflation rate of unemployment (the NAIRU) - the lowest sustainable rate of unemployment - to be about 5 per cent. So the economy is not far from full employment and thus should not be growing faster than its trend or ‘potential’ rate of growth.

Inflation remains low, with underlying inflation at 2.4 per cent over the year to March and the rate having stayed within the 2 to 3 per cent range for three years. The diminishing threat from inflation has allowed the RBA to cut the official cash rate to an exceptionally low 2.75 per cent (it was 7.25 per cent before the GFC), meaning mortgage interest rates are the lowest they’ve been since the time of the GFC.

Resources boom has presented a succession of challenges

Apart from the GFC, the biggest issue confronting the macro managers of our economy has been the resources boom. It began about a decade ago and in that time they’ve had to confront a succession of differing challenges. At first the great problem they foresaw was that the boom would lead to an outburst of inflation, as so many previous commodity booms had done. This explains why the RBA had interest rates so high immediately before the GFC and why, even though it slashed the cash rate when the GFC hit, as soon as it realised the crisis wasn’t going to precipitate a severe recession it began pushing rates up again. For some time, however, it’s been clear inflation is well under control. That’s partly because of the economic managers’ vigilance, but mainly because the appreciation in the exchange rate that accompanied the huge improvement in our terms of trade did much to dampen inflation pressure, both directly by reducing the price of imports and indirectly by worsening the international price competitiveness of our export and import-competing industries and thereby dampening production.

About this time last year, after the inflation challenge had passed, the macro managers began worrying about a second challenge. The economy was being hit by two opposing external shocks: the positive shock of the mining investment construction boom, and the negative shock of the high exchange rate and its adverse effect on our trade-exposed industries’ price competitiveness. It was important for the managers to do what they could to ensure net effect of these two conflicting forces left the economy growing at around its trend rate, thereby keep unemployment not much above 5 per cent. To help bring this about, the government pressed on with tightening fiscal policy and getting the budget back towards surplus, thus giving the RBA more scope to loosen monetary policy. It was hoped the lower cash rate would reduce the upward pressure on the exchange rate. The managers haven’t been completely successful in this - unemployment has been creeping up - but, as we’ve seen, the economy isn’t travelling too badly.

But now the macro managers face a third challenge associated with the resources boom: to manage the tricky transition from mining-led growth to broader-based growth without the economy slowing down too much.

The tricky transition from mining-led growth

Although the economy isn’t travelling badly, it is facing a potentially tricky transition in the coming financial year as the resources boom eases and we move back to relying on broader and more normal drivers of economic growth: consumer spending, housing, non-mining business investment and exports.

The resources boom began in 2003 and was divided into two parts by the global financial crisis of 2008-09. The boom has had three stages: first, much higher prices for our exports of coal and iron ore, causing our terms of trade to reach their best for 200 years. Second, a historic surge of investment spending to greatly expand our capacity to mine coal and iron ore and extract natural gas. And third, a considerable increase in the volume (quantity) of our production and export of minerals and energy.

The first stage is now over, with coal and iron ore prices reaching a peak in mid-2011 and the terms of trade falling 17 per cent since then. Now it’s likely the second stage, the growth in mining investment spending, will reach a peak sometime this financial year and then decline, making a negative contribution to growth. This is likely to be only partly offset by the recent commencement of the third stage of the boom, the rising volume of mineral and energy exports as the newly installed production capacity comes on line.

What makes it uncertain the transition from mining-based to broad-based growth will proceed smoothly - that is, without a period of quite weak growth leading to a sharp rise in unemployment - is the failure of the exchange rate to fall back as the terms of trade have fallen back. This explains why, with inflation well under control, the RBA has cut the cash rate so far since late 2011.

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, 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.

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

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.

As we’ve seen, 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. 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.

Australia’s conflicting macro policy

At the time the macro managers responded to global financial crisis in late 2008 and the threat that our economy would be caught up in the Great Recession, both policy arms were moved to the same setting of ‘extremely stimulatory’. The cash rate was slashed from 7.25 pc to 3 pc. The automatic stabilisers moved the budget from surplus to deficit, to which the Rudd government added significant discretionary stimulus spending.

Once the emergency had passed and it became clear severe recession had been avoided, however, the managers began using the two arms to pursue different objectives. On fiscal policy, the temporary stimulus spending was allowed to finish, the government stuck to its deficit exit strategy and the automatic stabilisers were allowed to push the budget back towards surplus. The RBA quickly returned monetary policy to a neutral stance but, with inflation under control, from November 2011 it began easing policy to counter the high dollar and encourage growth in spending.

At the time of the 2012 budget the stance of fiscal policy was quite restrictive as the government sought to keep its election promise to return the budget to surplus in 2012-13, while the stance of monetary policy was expansionary.

The stance of fiscal policy adopted in the 2013 budget is roughly neutral - that is, neither expansionary nor contractionary - whereas the stance of monetary policy is clearly highly expansionary. Should signs emerge that the economy is faltering in its transition from mining-led to broad-based growth, the RBA retains the scope to cut the cash rate further. Should the long-awaited fall in the dollar materialise, however, the stimulatory effect of such a fall would discourage the RBA from cutting rates further. Were the RBA to conclude the lower dollar was threatening to rekindle inflation pressure, it would start increasing rates. For the moment, however, the greater risk is that growth will be too weak rather than too strong.