Thursday, September 1, 2016


September 2016

We are living through times when there’s a fair bit of bad economic news, but most of that news is coming from abroad. America’s economy is not growing strongly enough for the Federal Reserve to risk getting on with its intention to raise the official interest rate from its present level not far from zero. Britain’s decision to leave the European Union means it economy is likely to slump, which won’t help the rest of Europe, whose growth is weak as it struggles to hold the euro currency area together. Japan is continuing many years of weak growth. And China’s economy has slowed as it makes the transition from investment-led to consumption-led growth.

All this bad news is well publicised in Australia, so many Aussies assume our economy must be quite weak, too. Or, if it's been going OK to date, it must be slowing. It’s true that we can’t be unaffected by the weaker growth of our trading partners, but it’s also true that our economy is affected mainly by purely domestic factors. And the effects of those domestic factors mean it’s not true that our growth is weak, nor that our economy is slowing. Recent quarterly national accounts show the economy is growing at the annual rate of 3 per cent, and the Reserve Bank’s forecast is for it to stay growing at 3 per cent for the next few years. This a much better rate than most other developed economies are achieving.

As we’ll see in a moment, growth of 3 per cent is actually a fraction faster than our “potential” growth rate, which should be sufficient to at least hold the rate of unemployment steady, even allow it to fall a little. And, indeed, over the year to July, the trend rate of unemployment has fallen from 6.1 per cent to 5.6 per cent, where it seems to have stabilised.

But since 5.6 per cent is still above our NAIRU - our non-accelerating-inflation rate of unemployment - as demonstrated by our high rate of under-employment, but also by our exceptionally low rates of inflation and wages growth, it’s clear the labour market and the rest of the economy still has a fair bit of idle capacity. In other words at present we have a negative “output gap”. Earlier years of below-potential growth mean the economy could grow for a few years at a rate well above our medium-term potential growth rate as we return to full capacity - full employment - without any risk of excessive inflation. This is why, though our present growth rate is OK, it would be good to see it a bit higher.

The new era of slower growth

It’s tempting to think the slower rate of growth in the world economy is essentially “cyclical” - that is, many economies are still in the process of recovering from the global financial crisis of 2008 and the Great Recession it precipitated. There is truth to this, but many economists have concluded that part of the slowdown is “structural” - it has deeper, longer-lasting causes. In other words, the world economy - but particularly the developed economies - seem to have entered an era of slower growth. Remembering that the causes of economic growth can be decomposed into the Three Ps - population, participation and productivity - the developed countries have slower rates of population growth and growth in the population of working age (15 to 64). Population ageing as the baby boomers retire is lowering the overall rate of participation in the labour force. And the rate of productivity improvement (output per unit of input) has slowed and seems likely to stay slow, for reasons economists are still debating. One factor is that a slower-growing and ageing population has less reason to increase investment in business equipment and infrastructure.

Australia’s lower potential growth rate

Australia is no exception to this move to permanently slower growth for structural reasons. You can see this in the way the econocrats have been revising down their estimate of our “potential” growth rate. Our potential growth rate is determined by the supply-side of the economy, rather than the demand side. It is the average rate of growth in the economy’s capacity to produce goods and services over the medium term. It can be raised by growth in the labour force, growth in investment in business equipment and infrastructure and improvement in productivity. Once the economy is operating at full capacity utilisation - full employment - it sets the speed limit at which the economy can grow without excessive inflation. But while the economy is operating with spare production capacity - that is, while it has a negative “output gap” - it can grow at rates exceeding the potential rate without worsening inflation.

An economy’s output gap is a measure of the extent of its spare production capacity. Where its actual rate of growth is lower than its potential growth rate, the difference contributes to a negative output gap. Where the actual rate of growth is higher than the potential rate of growth, and economy is at full employment, the difference is a positive output gap, which will be causing inflation pressure to build. Note that, because the economy’s ability to produce goods and services gets a bit bigger almost every year, potential is a rate of growth.  By contrast, the output gap is an absolute amount - the deference between one level of GDP and another level.

It’s hard to calculate an economy’s potential growth rate (or, for that matter, its NAIRU) with any degree of certainty. And the rate will change over time as the factors affecting it change. For a long time Australia’s potential rate - often referred to as our (forward-looking) “trend” rate of growth -was taken to be 3.25 per cent a year. But then this was lowered to 3 per cent and last year it was cut further to 2.75 per cent. Why? Because of slower population growth since the end of the resources investment boom, because the retirement of the baby boomers is lowering the labour force participation rate (only partly offset by the trend to later retirement) and because, as is true for all the developed economies, Australia’s rate of productivity growth is lower than it used to be.

It’s roughly estimated that, because of many years of weak growth until the past year or so, our negative output gap is equivalent to about 1.5 per cent of GDP. That is, actual growth could be a cumulative 1.5 percentage points higher than the potential rate before we reached full capacity and had to slow down to the potential rate to avoid excessive inflation. But each year that we grow by more than 2.75 per cent will take up spare capacity and reduce the output gap.

Now let’s turn to recent developments in the management of the macro economy using monetary policy and fiscal policy, starting with monetary.

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.

The RBA cut the official interest rate hard in response to the GFC in 2008, but then put rates back up once it became clear a serious recession had been averted.

In November 2011, the Reserve 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 per cent 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 resumed cutting rates, dropping the official rate another notch, and again in May, to reach a new low of just 2 pc. It resumed cutting a year later, in May 2016, and then by another notch in August, taking the cash rate to a new record low of 1.5 per cent. There is little reason to doubt that the total fall of 3.75 percentage points since November 2011 has helped to hasten growth the non-mining sector of the economy. In particular, it prompted the boom in the housing market, causing big increases in house prices and new home building, particularly in Sydney and Melbourne. How much the lower rates contributed to the fall in the exchange rate is debatable.

The further rate cuts in 2016 were made possible by the weakness in inflation and wages growth, with the inflation rate falling short of the target range. It’s doubtful whether the Reserve expects the recent cuts to do much to encourage borrowing and spending. More likely it is hoping that lowering our rates - which are still high relative to rates in the major economies - will exert some downward pressure on our exchange rate, thus improving the international price competitiveness of our export and import-competing industries. In his final speech, retiring Reserve governor Glenn Stevens acknowledged that the effectiveness of monetary has been reduced by the already-high debt level of Australian households, which has limited their willingness to borrow more so as to spend more - the main mechanism by which lower interests stimulate demand. Mr Stevens noted that Australia’s households are far more heavily indebted than our government, arguing that, if further policy stimulus is needed, it should come from fiscal policy: increased public borrowing and spending, provided that spending is on useful infrastructure rather than recurrent expenses.

Fiscal policy

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

The Abbott government’s first budget, in 2014, set out a program of largely delayed measures to return the budget to surplus over a number of years. The measures focused heavily on cutting spending programs of benefit to low and middle-income families, ignoring the many overly generous tax concessions on superannuation, negative gearing and capital gains tax, whose benefits go predominantly to high income-earners. Because many of the spending cuts were contrary to Mr Abbott’s election promises, and many were judged to be unfair, the budget caused a plunge in the Abbott government’s popularity, from which it never recovered. Many of its cuts were blocked in the Senate.

The Abbott government’s second budget, in 2015, made little further attempt to reduce the budget deficit and seemed to focus mainly on measures intended to restore the government’s standing in the opinion polls. The deficit in 2015-16 was twice the size of the deficit in 2012-13.

The Turnbull government’s first budget, in 2016, attempted to do no more than hold the line on the deficit while it introduced a package of tax reform measures. It propose a minor cut in income tax, but its centrepiece was a plan to cut the rate of company tax from 30 to 25 per cent, phased in over 10 years. To help cover the cost of this cut, the budget sought to increase taxes in three main ways: by big increases in the tax on tobacco, a very worthwhile reduction in superannuation tax concessions and a serious crackdown on tax avoidance by multinational companies. The government is likely to have more success in getting these tax increases through the Senate than its cuts in company tax for big business. If so, its budget may end up making a useful contribution to reducing the budget deficit.