Friday, December 2, 2016


Talk to Economics Teachers Association of WA, Perth, Friday, December 2, 2016

The theme for your conference, Economic Cycles - Riding the Waves, is particularly well chosen. At a time when Western Australia is well and truly in the downswing of its cycle, the national economy is celebrating have completed 25 years of continuous growth, a record for our economy and something no other developed economy has achieved in the same period. I’ll leave it to Nicky Cusworth to look closely at the ups and downs of the WA economy, but how can we say the national economy is sailing along while WA is making such heavy weather of it? Because, as the RBA’s chief economist, Dr Chris Kent, reminded us last week in a speech that’s well worth West Australians looking up,

the national economy is just the weighted average of the six state and two territory economies. And whereas a few years back the mining states, WA and Queensland, were riding high and NSW and Victoria were doing it tough, the end of the boom has seen those roles reversed.

Why we’ve gone 25 years without a severe recession

I’ll say no more about that, but switch the focus back to the national economy and the question of how we’ve been able to keep the economy growing for so long. A lot of people think the answer is obvious: China has kept us going. But that’s wrong. For one thing, the resources boom didn’t start till about 2003, roughly half way through the 25 year period. More fundamentally, giving all the credit to China reveals an ignorance of the way economies move in cycles. You can say that China’s resources boom added greatly to the amount of economic growth over the period, but it’s a strange argument to say that introducing a huge boom and bust - first, in coal and iron ore prices and then in mining and natural gas construction activity - explains why the economy has never contracted in 25 years, even though, before that - and still in other developed economies - recessions are usually about seven years apart. To put it another way, economies rarely drop into recession just because they’ve run out of puff. They usually do it because someone jammed on the brakes too hard. And they usually jam on the brakes because they’re reacting to a boom they’ve let run away and become too inflationary.

As the RBA governor, Dr Phil Lowe, remarked in one of his recent speeches, our 25-year expansion is the more remarkable when you remember the major “economic shocks” that hit our economy during the period and could have knocked us off track the way they did many other countries: the Asian financial crisis of 1997-98, the US Tech Wreck of 2001 and the global financial crisis of 2008.

So why didn’t they? More because of our good management than our good luck. The microeconomic reforms of the 1980s and 1990s made the economy more flexible - better able to roll with the punches from economic shocks - and thus less inflation-prone and unemployment-prone. The reduction of protection and the floating of the dollar made our industries more open to competition from imports, while deregulation heightened competition between domestic players. Increased competition - including in the provision of utilities - also reduced cost-push inflation pressure by reducing the pricing power of some industries and their unions. The move from centralised wage-fixing to collective bargaining at the enterprise level reduced the risk of excessive wage increases and, as we saw in the wake of the GFC, reduced the tendency of employers to respond to downturns with mass layoffs.

A more flexible, less-inflation prone economy is one that’s easier for the macro managers to keep stable. But we’ve see reforms also at the macro-economic level with the establishment of formal “frameworks” for the way fiscal policy and, more notably, monetary policy should be conducted. Monetary policy decisions are now made by the RBA independent of the elected government, and in accordance with the medium-term inflation target.

You can see how the macro stabilisation task benefits both from the greater flexibility arising from micro reforms and from the more deft use of the macro policy arms arising from the introduction of “frameworks” in the way we handled the biggest economic shock to hit our economy since the Gold Rush, the resources boom. Previous commodity price booms to hit our economy have led to inflation surges, followed by belated corrective action, followed by busts and recessions. Knowing this, the econocrats went to great lengths to ensure it didn’t happen this time. In this they were greatly assisted by the move to a floating exchange rate. Rather than having to wait too long while the government accepted the need for revaluation, the floating rate appreciated immediately and significantly in response to the increase in export prices. One effect of this was to shift some of the benefit of the improvement in our terms of trade away from the mining companies to all those businesses and consumers who bought imports. But another effect of the high dollar was to reduce the demand for tradable goods and services - such as manufactures, tourism and international education - thus making it easier for resources to shift from the contracting sectors to the expanding mining sector without great inflation pressure. Decentralised wage fixing, plus the use of temporary 457 visas, kept the rise in mining sector wages from spreading to wages everywhere. The result of all this was that the resources boom’s potential inflation pressure was contained, but at the expense of weaker growth in the non-mining states.

By now, as you well know, the price and construction phases of the resources boom have come to an end and, although the increased-production phase has further to run, the economy has been making a transition from mining-led growth to growth led by other parts of the economy. Growth in the non-mining economy is being stimulated by a very expansionary stance of monetary policy and by a large fall in the dollar (in belated response to the fall in export prices and deterioration in the terms of trade), although we’re not getting much help from slowing growth in China, moderate growth in the United States and weak growth in Japan and Europe.

Recent record and outlook for the economy

We’ll get another reading from the national accounts next week, but previous quarters show real GDP growing at the rate of 3 per cent - which, as we’ll see, is just a fraction faster than our “potential” growth rate. The RBA’s most recent forecasts show the economy continuing to grow at about 3 per cent next year, strengthening to about 3.5 per cent by the end of 2018. This would involve inflation gradually returning to the 2 to 3 per cent target range. The unemployment rate should improve only marginally, with the labour market weaker than it seems from looking just at the level of the official unemployment rate.

If you find that hard to believe, the explanation is simple: most of the growth is coming from NSW and Victoria (which account for 55 per cent of the national economy), with most of the weakness coming from WA (accounting for less than 15 per cent) and mixed performances in Queensland, SA and Tasmania. The NSW economy is growing so strongly it even has strong growth in non-mining business investment; which is going backwards in WA. The RBA estimates we are about 80 per cent of the way through the decline in mining investment as the pipeline empties out.

Australia’s lower potential growth rate

Australia’s present and prospective rate of economic growth is lower than we experienced in earlier years. This is partly for cyclical reasons - the continuing transition from the resources boom, especially in WA - but also for longer-lasting 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 - our potential growth rate 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 a level, 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 - non-accelerating-inflation rate of unemployment) 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 medium term. 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 this 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.