Saturday, November 28, 2015

GDP slows as population slows

When is slower economic growth not such a bad thing? When it's caused by lower growth in the population.

If that puzzles you, you're a victim of the economists' practice of focusing on growth in gross domestic product rather than GDP per person.

Nigel Ray, a deputy secretary of Treasury, acknowledged in a speech to the Australian Business Economists this week that last financial year, 2014-15, the economy recorded its third straight year of below-trend growth.

"This means Australia is now in a prolonged period of below-par growth, the likes of which we have rarely seen outside of a recession," he said.

We'll be seeing the national accounts for the September quarter on Wednesday, but they're unlikely to show much improvement.

Reserve Bank heavies have been hinting at it for months, but this week Ray made it official: the economy's trend rate of growth is actually lower than the econocrats had been assuming in recent years.

But what exactly is "trend" growth? Good question because there are actually two versions of it (or three if you include the Bureau of Statistics' practice of referring to its smoothed seasonally adjusted estimates as "trend" estimates).

The backward-looking version of trend is the economy's average actual rate of growth over past 10 years or more. Since 1976-77, for instance, real GDP has grown at an average rate of 3.1 per cent a year.

If nothing in the economy ever changed, the backward-looking version of trend would be the same as the forward-looking version, but things do change.

The future trend rate of growth is also known as the economy's "potential" rate of growth, the maximum rate at which it can grow over the medium-term – periods of five or 10 years or so – without causing a big problem with inflation.

The economy's potential rate of growth is the rate at which its ability to produce goods and services is growing.

This, therefore, refers to the supply side of the economy. The supply side involves combining the economy's three "factors of production" – land, labour and capital – to produce goods and services.

Here, "land" includes natural resources and "capital" means man-made, physical capital, such as buildings and equipment, but also roads and other public infrastructure.

But the economists' custom is to view the economy's supply side – its capacity to produce goods and services – through the perspective of just one factor, labour.

So the economy's potential output is seen as being determined by "the three Ps": population, participation and productivity. Potential growth in production is determine by growth in the population of working age (everyone 15 and over) plus change in the rate at which people of working age choose to participate in the labour force by working or seeking work, plus growth in the productivity of labour (average output per hour worked).

Of course, the economy's potential to supply goods and services is only half the story. How much is actually produced in any period will be determined by the demand for goods and services at the time.

Demand can't exceed supply (when it tries, the excess demand that can't be satisfied from imports just forces prices up), but it can fall short of potential supply. When it does, labour is unemployed or underemployed (people not working as many hours as they want to) and factories and offices have idle capacity.

That's the position we've been in for the past three years: the growth in our demand for goods and services has been falling short of the growth in our potential to supply them. So when the econocrats say growth has been "below trend", that's what they mean.

And every year that actual output falls short of our potential output we get a widening in what economists call "the output gap", which will be manifest in rising unemployment or underemployment as well as unused production capacity in factories and offices.

Whereas we usually think of potential output as an annual rate of growth, the output gap is measured as the difference between the absolute levels of potential and actual output.

The size of the output gap is an indicator of the failure of the managers of the macro economy to achieve their goal of keeping its actual growth in line with its potential growth – that is, to keep it growing at full capacity or "full employment" (of all the factors of production, not just labour).

The continued existence of the business cycle means they can never achieve this goal, of course, but it's still their job to try.

The size of the output gap is also a measure of the extent to which a recovering economy can for a few years grow faster than its trend (potential) rate without that causing any inflation problem. A period of above-trend growth is actually the only way to eliminate the output gap and get the economy back to growing at its full-employment rate.

For some years the econocrats' estimate has been that the economy's potential or (forward-looking) trend rate of growth is 3 per cent a year, compared with its actual growth over the year to June of 2.3 per cent.

Ray said this includes an assumption that the working-age population grows by 1.75 per cent a year, its actual rate over the past 10 years. But now actual growth has slowed to 1.5 per cent because of a decline in holders of temporary visas and lower net migration from New Zealand.

So Treasury has cut its estimate of trend (potential) growth to 2.75 per cent, thereby reducing its estimate of the size of the output gap.

Why is this not such a bad thing? Because, although the growth in workers helping to produce goods and services is likely to be lower than we thought, there'll also be fewer people we have to share those goods and services with. GDP per person shouldn't be much affected.