Saturday, February 1, 2014

Outlook for the economy: short-term and long

A lot of people believe Tony Abbott and Joe Hockey begin their first full year in office facing a daunting economic challenge, even a crisis. But what is the nature of the challenge? How daunting is it, and how pressing?

Well, let's analyse it - and do so using some of the standard distinctions economists use to get their heads around a problem.

People see the government as having a problem with the economy and with its budget. To the casual observer, the economy and the budget seem pretty much the same thing. But, though the two are obviously interrelated, economists draw a clear distinction between them.

The government's budget (its spending and revenue-raising) has an effect on the economy (the whole nation's production and consumption of goods and services, income-earning and spending) and, equally important, the much-bigger economy has an effect on the government's budget.

But we'll get a clearer picture of what's happening if we deal with the two separately. Let's focus on the economy and leave the budget for another day. (Don't worry, you'll hear a lot more about the budget in coming weeks.)

And in thinking about the economy, let's use the economists' trick of distinguishing between cyclical and structural factors. Cyclical factors are those temporary influences that are causing the economy to speed up or slow down at present and over the coming year or two.

Structural factors are those that operate underneath the cyclical factors, affecting the economy less dramatically at any particular moment, but having a much longer-lasting and hence more important influence in changing its shape.

Starting with the cyclical outlook, it isn't too hot. The economy's production of goods and services (real gross domestic product) grows at an average rate of about 3 per cent a year, sufficient to keep the rate of unemployment steady and inflation within the Reserve Bank's 2 per cent to 3 per cent target range.

But we've been growing more slowly than 3 per cent for the past few years, and Treasury's expecting growth to slow to just 2.5 per cent this financial year and next, 2014-15. The recent slow growth explains why unemployment has been creeping up - to 5.8 per cent on the latest reading - but inflation hasn't been a worry.
The forecast of continued weak growth implies unemployment will continue creeping up - to 6.25 per cent by June next year - but inflation will stay controlled.

The reasons for the past and coming slow growth are well known: the end of the resources boom's investment phase and the high dollar the boom brought with it. Most growth was coming from mining construction, with the rest of the economy pretty subdued, but now mining construction is expected to fall off rapidly, with the rest of the economy only slowly getting back on its feet to take up the slack.

We've already done what we need to get the economy growing faster: the Reserve Bank has cut interest rates to historic lows, and the dollar has fallen by about 16 per cent (partly because the Reserve has been talking it down). Now we're waiting to see how long it will take for the medicine to work.

Remember that primary responsibility for managing the macro-economy rests with the Reserve Bank, not the elected government. Hockey's main job is to make sure the budget doesn't add to the present weakness, but also stand ready to apply emergency fiscal stimulus should mining construction spending unexpectedly collapse at some point.

So the economy's short-term, cyclical position isn't wonderful, but there's isn't a lot more we can or need to do. Leaving aside the inevitability that one day our record period of expansion since the last severe recession will have to end, the economy's longer-term, structural position is vaguely similar: it's not as dire as some imagine but, as usual, there's plenty of room for improvement.

While Labor was in power, it suited some business lobby groups to claim our rate of improvement in productivity (output per unit of input) had stalled. Surprisingly, the answer was always for the government to give them the rent-seeking privileges they wanted.

The truth is less apocalyptic. It's true we had an uncharacteristically strong burst of productivity improvement in the second half of the 1990s, but then weak to non-existent improvement through much of the noughties. Since then, however, productivity has been improving at a rate that's OK but hardly wonderful. Analysis of our formerly weak performance suggests much of it was explained by one-off factors and measurement problems.

But in Treasury's periodic intergenerational reports, it has consistently projected slowing in our long-term rate of growth in real GDP. Most recently, in 2010, it projected that the annual rate of growth in GDP per person would slow from 1.9 per cent over the previous 40 years to 1.5 per cent over the coming 40.

This may not sound disastrous - and to me it isn't - but to our deeply materialist economists and business people it is. So note that half the decline is explained by a fall in the proportion of the population participating in the labour force as the baby boomers retire and the population ages.

This can be predicted reasonably confidently, but the other half is explained merely by Treasury's assumption that our 40-year average rate of improvement in the productivity of labour will fall from 1.8 per cent to 1.6 per cent a year.

Plenty of economists around the world share Treasury's fear that productivity improvement will be slower in coming years. And this probably wouldn't take anything like 40 years to become apparent.

So for the Abbott government and those who share its professed commitment to maintaining strongly rising material affluence (and don't worry about little annoyances such as the survival of the planet), there is a reason to pursue reforms that improve labour force participation and labour productivity.