Thursday, June 7, 2018


UBS HSC Economics Day, Sydney, Thursday, June 7, 2018

I want to talk to you about the budget last month and fiscal policy, but do so in the broader context of the use of economic policies to manage the economy and deal in particular with the economic issues of growth, unemployment and inflation.

Right now we’re experiencing below trend growth, inflation is below the Reserve Bank’s target range of 2 – 3 pc, and though unemployment, at 5½ pc, isn’t far above the NAIRU – the non-accelerating-inflation rate of unemployment – estimated by the RBA and Treasury to be about 5 pc, it’s falling only very slowly, despite last calendar year’s record growth in total employment of 400 thousand – about double what we usually get, with about three-quarters of those extra jobs being full-time.

So despite the below-trend growth – just 2½ pc – compared with our estimated trend (or “potential”) growth rate of 2¾ pc – we’ve had very strong growth in employment, but very slow improvement in unemployment. Why has jobs growth been surprisingly strong? Mainly because the accelerated roll-out of the national disability scheme created many more jobs in the health and community care sector, and because increased state government spending on infrastructure increased employment in the construction sector. So, it seems to be explained mainly by increased government spending. Why have all those extra jobs done so little to reduce unemployment? Because the growth in employment has largely been matched by growth in the size of the labour force, for two main reasons. First, our high rate of population growth through increased skilled immigration. And second, because of a big increase in the rate of participation in the labour force, particularly by women.

What’s the biggest problem in the economy right now? What’s the biggest reason economic growth has been below-trend for the past four years? Weak growth in wages.  Wages have been growing only fast enough to match the low rate of increase in prices – about 2 pc a year. So, for about the past four years, we’ve had no real growth in wages. This does much to explain the below-tend growth in consumer spending and in real GDP, since consumer spending accounts for more than half the growth in GDP.

Budget forecasts for the economy

But if we can believe the economic forecasts contained in the budget, all that is coming to an end. They say wage growth has already begun to accelerate and will reach the previous normal rate of 3½ pc a year within three years, 2020-21. Largely as a consequence of this, the economy is expected to accelerate to its medium-term “trend” (“potential”) growth rate of 2¾ pc in the financial year just ending, then reach an above-trend 3 pc in the coming year, 2018-19, and stay there for at least another three years. This will bring unemployment down very slowly to reach the NAIRU of 5 pc by June 2022. The inflation rate will soon return to 2½ pc, the centre of the target. Let’s hope this optimism proves justified, but I wouldn’t count on it.

Now let’s look at the secondary arm of macroeconomic management – fiscal policy. But, since the main policy arm - monetary policy – is the main arm used to achieve internal balance (ie low inflation and low unemployment), we need to say a little about monetary policy, since it’s been the main arm responding to this story of so-far disappointingly weak growth in wages and GDP.

Recent developments in monetary policy

Because of the five consecutive years of below-trend growth since 2011-12, the Reserve Bank had cut its cash rate 1.5 pc by August 2016. In the 21 months since then, it has left the rate unchanged – a record period of stability. It’s not hard to see why it has left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy has yet to accelerate and has plenty of unused production capacity, and the rate of unemployment shows no sign of falling below its estimated NAIRU of 5 pc. The RBA governor, Dr Philip Lowe, has said that, though the next move in the cash rate, when it comes, is likely to up, with the economy in its present weak state the Reserve is in no hurry to make that move.

Fiscal policy “framework”

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 course of the economic cycle”. 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.

Recent developments in fiscal policy

Until the financial year just ending, the Coalition government (and the Labor government before it) has seen the growth in the economy being repeatedly less than forecast, meaning the government has made slow progress in returning the budget to surplus and halting the rise in its net debt. Even so, it has focused on the medium-term objective of fiscal sustainability, not the secondary objective of helping monetary policy to get the economy growing faster. The long period of policy stimulus has come almost wholly from lower official interest rates.

In the year to June 30, 2018, however, the underlying cash budget deficit is now expected to be lower than expected this time last year – $18.2 billion, rather than $29.4 billion - thanks mainly to the strong growth in employment (more people earning wages and paying taxes), an improvement in export commodity prices and higher company tax collections for other reasons. Combined with the forecast that the economy will now return to above-trend growth, this means the deficit for the coming year will be $14.5 billion (0.8 pc of GDP), $7 billion less than expected a year ago. In the following year, 2019-20, a tiny surplus is expected, with ever-larger surpluses in the following two years to 2021-22.

This forecast improvement in the budget balance means that, when expressed as a proportion of GDP, the federal government’s net debt is now expected to peak at 18.6 pc in June 2018, and then fall back to less than 5 pc by June 2029. Again, it will be a great thing if it happens. It also means the budget balance is expect to continue improving despite the budget’s centrepiece, a plan for tax cuts in three stages (July 2018, July 2022 and July 2024) over seven years, with a cumulative cost to the budget of $144 billion over 10 years. This is possible because of plan’s slow start, with its cumulative cost in the first four years being just $14 billion.

Whichever way you measure it, the “stance of fiscal policy” adopted in the budget is too small to be either expansionary or contractionary, and so is neutral. This is true even though the immediate tax cuts could be expected to increase consumer spending.