Monday, June 1, 2015


June 2015

This year’s budget papers remind us that the Australian economy is entering its 25th consecutive year of growth since the severe recession of the early 1990s. This is the second longest continuous period of growth of any advanced economy in the world. What’s more, the government tells us, we are “one of the fastest growing economies in the advanced world”.

All this is true, but the fact remains that, though we escaped the global financial crisis and the Great Recession it precipitated, we’re making heavy weather of the transition from the resources boom to more broadly-based economic growth. We did get through the boom’s upswing - the huge surge in the prices of our exports of coal and iron ore and the equally huge surge in investment in new mines and natural gas facilities - without the great outbreak of inflation that had accompanied previous commodity booms. This was mainly because of the major appreciation in the dollar prompted by the big improvement in our terms of trade, and permitted by our floating exchange rate. This cut the price of imports and thereby encouraged greater “leakage” from the circular flow of income, as well as reducing the output of our other export and import-competing industries - particularly manufacturing and tourism - by making them less internationally price competitive. But we’re making heavy weather of the downswing as export prices fall and the boom in mining investment construction activity falls away sharply.

The economy’s medium-term average (or “trend”) rate of growth in real GDP is about 3 pc a year. This is also its “potential” rate of growth - that is, the average rate at which aggregate supply - the economy’s potential capacity to produce goods and services - grows each year. But the economy has grown by less than its trend rate for five of the past six years, and is now forecast to grow by only 2.5 pc in the financial year just ending, and by 2.75 pc in the coming financial year. Since our growing labour force means the economy needs to grow at its trend rate just to prevent the rate of unemployment from rising, unemployment has been creeping up since early 2011 from 4.9 pc to 6.2 pc, with the participation rate falling by 0.8 percentage points to 64.8 (with only part of that fall explained by the ageing of the population).

So what policies have the managers of the macro economy been pursuing to try to stimulate the economy to counter the slowdown in economic growth and prevent the rise in unemployment? Well, as has long been the usual policy mix, they have relied primarily on monetary policy, though fiscal policy has been playing a supportive role. Let’s look first at monetary policy, then at fiscal policy.

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.

After the GFC reach its height in late 2008, the RBA feared we would be caught up in the Great Recession that hit other economies, so it quickly slashed the cash rate from 7.25 pc to 3 pc. By October 2009, however, it realised we would escape the recession, so began lifting the cash rate from its emergency level, reaching 4.75 pc in November 2010.

In November 2011, the RBA decided the resources boom was easing and would not push up inflation. It realised growth in the non-mining sector of the economy was weak - held down particularly by the dollar’s failure to fall back in line with the fall in export prices – at a time when mining-driven growth was about to weaken. So it began cutting the cash rate, getting it down to a historic low of 2.5 pc by August 2013.

For the next 18 months the Reserve sat back and waited for this very low interest rate work through the economy and have its effect. Not all that much happened, with the economy continuing to grow at a below-trend rate. The dollar did start falling in the first half of 2013, and by June 2015 it had dropped to about US77 cents (from its peak of US1.10 in mid-2011), but this would have been explained much more by the continuing fall in coal and iron ore export prices than by our lower interest rates relative those in the major advanced economies. The Reserve continued to note that the exchange rate hadn’t fallen by as much as the fall in commodity prices implied it should have, explaining this as a consequence of the major advanced economies’ resort to “quantitative easing” (money creation), whose main stimulatory effect on their economies came by forcing their exchange rates lower (thus causing ours to be higher than otherwise).

So in February 2015, after a gap of 18 months, the Reserve began cutting rates, dropping the official rate another notch, and again in May, to reach a new low of just 2 pc. Will it cut rates any further? It will if it has to, but won’t cut again if it can avoid it. The Reserve is desperate to get the economy moving and growing at a rate sufficient to get unemployment falling rather than continuing to creep up. And the only instrument it has to influence the speed at which the economy is growing is interest rates. It would like to see its low interest rates encourage greater spending on new housing (which is happening) and, particularly, see them encourage greater investment spending by non-mining businesses to counter the marked fall in investment by the mining companies. So far, this is not happening.

But the extraordinarily low rates have encouraged a boom in the buying and selling of established houses, particularly by investors, which is pushing up house prices rapidly in Sydney and Melbourne, but less so in other capital cities. At the RBA’s urging, APRA - the Australian Prudential Regulation Authority - is trying to discourage excessive lending for investment housing by use of “macro-prudential” guidance of the banks, but it is too soon to say how effective this will be. The RBA is highly conscious of the danger of a house-price boom leading to a bust, which could damage individuals, hit confidence and even trigger a recession. Its problem is that interest rates are its only instrument for fostering demand.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Abbott 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.

Mr Hockey’s first budget included many cuts in government spending, big increases in user charges for GP visits, pharmaceuticals and university education, a shift from indexing payments and benefits to wages to indexing them to prices, a return to indexing the fuel excise and a temporary deficit levy on high income-earners.

From a fiscal-policy perspective the first budget had two key features: 1) A slow pace of fiscal consolidation. Its new measures and revisions to forecasts were expected to do little to improve the budget balance in the first three years, but really cut in in the fourth year, 2017-18. This slow start was intended to avoid the budget having a dampening effect on growth while the economy was expected to be growing at a below-trend rate.

2) A switch in the composition of government spending. While spending on transfer payments leading to consumption was to be reduced, spending on infrastructure investment was to increase by $12 bil. About half this was to be spent on an ‘asset recycling initiative’ intended to encourage the states to increase their own infrastructure spending. The goal was to help fill the vacuum left by the fall in mining investment.

However, many of the proposed spending cuts proved highly unpopular with voters and many were voted down by the Senate. The government withdrew or modified many of them. The asset recycling initiative has not been taken up by most states.

Mr Hockey’s second budget, for 2015-16, seems aimed more at restoring the government’s political fortunes than at either advancing its efforts to return the budget to surplus or at using fiscal stimulus to supplement the efforts of monetary policy in getting the economy out of the doldrums. The budget has been packaged to make it look stimulatory - with increases in childcare allowances and, for small business, tax cuts and immediate full tax deductions for new business equipment costing less than $20,000 each. But, in truth, the budgetary cost of these measures was offset by savings from the decisions not to proceed with a more generous paid parental leave scheme or with a cut in the rate of company tax paid by big business. So the net effect of the discretionary measures announced in the budget will be neither expansionary nor contractionary.

That’s the strict Keynesian way to measure the “stance” of fiscal policy adopted in a budget. But the RBA assesses the budget’s implications for monetary policy using a simpler test which doesn’t distinguish between the cyclical and structural (discretionary) components of the budget balance. It just looks at the direction and size of the expected change in the budget balance. The budget deficit is expected to fall from $41 bil in the old financial year, 2014-15, to $35 bil in 2015-16, then to $26 bil, $14 bil and $7 bil in subsequent years.

Expressed as a percentage of nominal GDP, the government expects the budget deficit to fall by about 0.5 pc between the old financial year and 2015-16, and by about the same amount in each of the following three years. A change of 0.5 pc is considered to be right on the border between insignificant and significant in its effect on the economy. I therefor judge the policy stance adopted in the budget to be, at most, mildly contractionary.

New thoughts on the policy mix

Around the developed economies, it has been observed that monetary policy has become less effective in influencing demand as interest rates have got down to “the zero lower bound” and so many of them have had to resort to “quantitative easing” (creating money by having the central bank buy bonds from the trading banks and pay for them merely by crediting those banks’ accounts with central bank). Massive amounts of QE have pushed down those countries’ exchange rates relative to other non-QE countries, and pushed up prices in the markets for shares and bonds, but done little to stimulate demand. There is thus gathering support among economists for policy makers to make greater use of fiscal policy to get their economies moving, particularly by increased spending on public infrastructure.

Though Australia’s circumstances are very different to those in the major advanced economies, there are some obvious similarities. It’s clear that cutting the official interest rate from 4.75 pc to 2.5 pc between November 2011 and August 2013 did little to stimulate activity, apart from home building and house prices. And on several occasions Reserve Bank speakers have hinted that they’d appreciate more help from fiscal policy, presumably by increased spending on worthwhile infrastructure projects to fill the void left by mining projects.