Showing posts with label SPEECHES. Show all posts
Showing posts with label SPEECHES. Show all posts

Tuesday, July 21, 2020

THE AUSTRALIAN GOVERNMENT’S ECONOMIC RESPONSE TO THE CORONAVIRUS

UBS HSC Online Economics Day, Tuesday, July 21, 2020

Australia is in the grip of a recession that’s its deepest since the Great Depression of the 1930, but also it’s most unusual, being the consequence not of problems in the economy, but of the effects of the coronavirus pandemic and the government’s response to it. After the government realised the virus had spread to Australia, it banned foreign arrivals from China at the start of February and progressively widened the ban to include all foreign nationals, with all returning Australians required to enter 14-day quarantine. In concert with the state governments, it then moved to limit the spread of the virus within Australia by ordering many industries, schools and universities to close. It required people to work from home where possible, and leave their homes as little as possible. During this “lockdown”, hand-washing and “social distancing” were encouraged, and large gatherings and unnecessary travel were banned.

This hugely reduced economic activity, prompting many businesses with little revenue coming in to lay off workers or reduce the hours of part-time workers. So from mid-March, the government introduced a series of measures intended to assist firms facing financial pressures, helping them retain their staff until the crisis had passed, to help people who had lost their jobs, maintain the training of apprentices and trainees, help firms and households having difficulty paying their rent, and assist industries with particular problems, such as housing and airlines. Taken together, these measures would provide fiscal (budgetary) support to the economy in general, at a time when private sector demand was weak. All these measures were designed to be targeted to easing particular problems and to be temporary, running for about six months to the end of September 2020.

The government’s two most important measures were the $70-billion JobKeeper wage subsidy scheme, which paid those employers whose revenue had fallen significantly subsidies of $1500 per fortnight for each worker they retained. This unprecedented and hugely generous scheme – adapted from similar schemes introduced in Britain and the US – was intended to maintain the link between an employer and its workers until the crisis had passed and normal business could resume. For those workers unable to benefit from the JobKeeper scheme, the JobSeeker coronavirus supplement effectively doubled unemployment benefits by adding a supplement of $1100 a fortnight for six months.

In mid-March the Reserve Bank made the last contribution it was able to make toward stimulating demand. First, it cut the official cash rate by 0.25 percentage points to its effective lower bound of 0.25 per cent, and promised the rate would not be raised until the rate of unemployment was falling towards its full employment level (about 4.5 per cent) and the inflation rate was in the target band of 2 to 3 per cent. It made a move to “quantitative easing” by setting at target of 0.25 per cent for the yield on Australian government bonds. That is, it promised to buy as many second-hand bonds as was necessary to get the yield down to 0.25 per cent. So far, this has involved it creating credit (or “printing money”) only to the extent of about $50 billion. Third, to encourage the banks to ease their repayment requirements on hard-pressed small businesses, the RBA offered to lend them up to $90 billion at the concessional rate of 0.25 per cent. This too would involve the RBA creating credit. So far, however, there has been little demand for this relief.

The crisis caused the annual federal budget to be postponed from May until Tuesday, October 6 (just a few weeks before the HSC Economics paper on Friday, October 23). In the meantime, however, Treasurer Josh Frydenberg will deliver an economic statement this Thursday, July 23, in which he will announce changes to the JobKeeper and JobSeeker schemes after they are due to expire at the end of September. He will also announce new forecasts for the economy and the budget deficit.

Definition of recession

Don’t be misled by media assertions that the economy is in recession when real GDP falls in two successive quarters. This mere rule of thumb has no status in economics and can be misleading. It puts all the emphasis on production and none on the real reason people fear recessions: rapidly rising unemployment. A former senior Treasury official has defined recession as: “a sustained period of either weak growth or falling real GDP, accompanied by a significant rise in the unemployment rate.” In February 2020, before the virus struck, the unemployment rate was 5.1. By June, just four months later, it had leapt to 7.4 per cent. Over the same period, the rate of under-employment jumped from 8.7 per cent to 11.7 per cent. That’s all you need to know to be certain we’re in a deep recession. But the effect of the lockdown and the JobKeeper subsidy (which involves many people being counted as employed although they are doing no work) means the “effective” rate of unemployment is about 13 per cent [graph 2].

How this recession differs from past recessions

This recession is different partly because it’s much worse than the previous recessions in the mid-1970s, early 1980s and early 1990s – which was almost 30 years ago. Whereas in the early ‘80s unemployment peaked at 10 per cent, and in the early ‘90s at 11 per cent, this time we are already up to 13 per cent and counting [graph1]. The contraction in GDP is also likely to be a lot bigger this time than in those earlier episodes.

But this recession is different – even unique - because its cause is non-economic. To stop the spread of the virus, the government ordered a large part of the economy to cease trading. And even if it hadn’t, many people would have cut their economic activity and kept to their homes to protect themselves from the virus. Normally, recessions occur because a boom has got out of hand and has prompted the authorities to push interest rates too high in an effort to control inflation. They often end up overdoing it and accidentally causing a downturn.

The unique cause of this recession means that, whereas previously the brunt of the downturn has been borne by workers in manufacturing and construction, this time it’s workers in the services sector. The hardest hit have been in accommodation, restaurants and cafes; retail; and arts and recreation. This change in the industrial composition of the recession means that whereas it’s usually men who bear the brunt, this time it’s women. It’s always the young – particularly education-leavers - who are hit hardest by a recession and, I’m sorry to tell you, this time is no exception.

The budget, debt and deficit

All recessions involve the government using the two main instruments of macroeconomic management to cushion the economy from the contraction in private sector demand and, more positively, stimulate an expansion in private demand, by cutting interest rates, increasing government spending, or cutting taxes. This time, however, monetary policy has pretty much done its dash and all the work falls to fiscal policy – the budget.

Whereas the government had managed finally to return the budget to balance in 2018-19 and was proudly looking forward to a surplus in the financial year just ended and many further surpluses in the years ahead, all that has been turned on its head by the response to the virus. The mini-budget on July 23 will give us the latest official figures, but unofficial estimates from Dr Shane Oliver suggest a deficit of about $95 billion (or almost 5 per cent of GDP) in the financial year to June this year, rising to a deficit of more than $220 billion (or 11 per cent of GDP) in 2020-21. Note that this likely enormous blowout in the budget deficit is explained not just by increased stimulus spending, but also by the effect of the recession in causing tax collections to fall. The stimulus is an increase in the “structural” component of the deficit, whereas the fall in tax collections is an increase in the “cyclical” component. In Oliver’s estimates, the two effects are of roughly equal size.

How the budget deficit will be funded

There are various ways the budget deficit could be funded but, at least since the early 1980s, it has always been funded by the government borrowing from the public rather than from the RBA (which would constitute printing money). The bonds are sold by regular auctions conducted by a branch of the Treasury. There is never any shortage of banks, superannuation funds, other fund managers and other countries’ central banks wanting to buy the bonds. This can be seen in the government’s ability in recent months to sell 10-year bonds paying an effective interest rate of less than 1 per cent. It is true, however, that when the RBA buys second-hand government bonds previously sold to financial institutions by Treasury, and pays for those bonds merely by crediting those institutions’ bank account with the RBA, it is doing the modern equivalent of printing money.


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Sunday, December 1, 2019

SECULAR STAGNATION COMES TO AUSTRALIA

Talk to Comview conference, Melbourne, Tuesday, December 3, 2019

You’ve probably seen me writing a lot lately about “secular stagnation”, how it applies to all the advanced economies – the US, Europe, Britain and Japan – and how, particularly since the marked slowing in our economy since the September quarter of 2018, it’s now clearer that Australia, too, has long been caught in the same long-lasting period of stagnation. This is true even though none of our political leaders or econocrats have used the term, and they persist in forecasting that, within the next year or two, the economy will return to trend growth or better. It’s true, however, that Reserve Bank governor Philip Lowe has on several occasions acknowledged the phenomenon of a savings glut which is at the heart of secular stagnation, and is evident from the fall in world interest rates to unprecedented lows.

What I’ll do today is give you a bit more of the context and background to the secular stagnation hypothesis – more than it’s possible to include in a newspaper column and, probably, more than you’ll feel needs to be passed on to your students. I’ve always believed that teachers need to be equipped with more understanding of a concept than they see fit to pass on to their students. I often write that the world’s economists are still debating the causes of secular stagnation and, hence, the main things governments should be doing to get our economies moving again. Today I’ll outline some of the main issues they are debating - without, let me warn you, offering any resolution of that debate.

Meaning and origins of the term

Secular stagnation means a prolonged period of weak economic growth caused by change in the underlying structure of the economy. “Secular” is the old word for “structural” – as opposed to short-term weakness caused by the business cycle. “Stagnation” could mean no growth at all, but usually refers to growth persistently weaker than an economy’s “potential” growth rate, as estimated in the conventional way.

The term was first re-introduced to the debate in 2013 by the leading American economist, Laurence Summers, of Harvard, a former US Treasury Secretary in the Obama Administration. Summers was reviving a term first used by the famous American economist, Alvin Hansen, who argued in 1938, after the end of the Great Depression, that the US economy had entered a period of protracted weak growth. Since the advanced economies grew strongly in the 1940s and the post-war period, most economists believe Hansen’s theory was wrong. Summers’ retort is that, since it took another world war to lift the US economy out of the doldrums, that just shows Hansen was right. A point worth remembering is that, once the war was over, many economists feared the economy would lapse back into weak growth. Instead, it enjoyed a 30-year-long post-war “golden age” of technological advance, strong growth, full employment and rapidly rising material living standards. So accepting the reality of secular stagnation at present doesn’t necessarily imply accepting that nothing could occur that returns us to more healthy rates of growth.

In a recent speech to the IMF, the former governor of the Bank of England, Mervyn King, essentially accepted the reality of secular stagnation, but preferred to say that, since the Great Recession of 2008-09, we’ve entered the Great Stagnation and are "stuck in a low-growth trap".

This looks like another macro paradigm shift

The fact that we’re in a period of confusion and furious debate between economists about the causes of the “low-growth trap” we’re caught in, and what we need to do to escape it, may be disturbing to you, but I feel like I’ve seen this movie before – and know it will end satisfactorily . . .  eventually. Why? Because I became an economic journalist in 1974, immediately after the first OPEC oil shock and just before the world recession it precipitated, which saw the advanced economies caught in “stagflation” – the combination of high unemployment and high inflation that Keynesian economics and the Phillips curve said couldn’t happen. The world’s economists fell into furious debate between Keynesians and monetarists, which took about a decade to be resolved into the new macro management policy orthodoxy that today we find under challenge: the main instrument used to manage demand should be monetary policy, not fiscal policy. The conventional wisdom among the economic managers abandoned Keynesian demand management and reverted to a neo-classical macro-economics which gave primacy to the supply (production) side of the economy.

Which side is the bigger problem: demand or supply?

This is where I advance my own theory. The concept of a macro economy that needs to be managed by the authorities goes back only as far as the Great Depression of the 1930s and the utter confusion among economists about why it had happened and what should be done about it. At the time, neo-classical economics, which was preoccupied with micro, used Say’s Law – supply creates its own demand – to assume the overall economy was always at full employment and so needed no meddling by governments. That is, it said depressions couldn’t happen. Keynes wrote the General Theory to explain why it had happened – deficient demand – and, since what today we call monetary policy was caught in a liquidity trap, why the answer was for government to create demand by its own spending. Hence the post-war orthodoxy that the big problem in achieving full employment was recurring deficiency of demand – growth in the economy’s supply side, potential production capacity, could be left to its own devices – and the best instrument to use to ensure adequate demand was the budget.

After the arrival of stagflation in the mid-1970s, economists eventually decided that, with so much inflation, demand could hardly be said to be deficient, and the big problem was on the supply side: getting productive capacity to grow faster and keep up with demand. The reversion to a form of neo-classical macro-economics fitted with this analysis. Over the medium term, the rate at which the economy could grow was determined by the supply side – the growth in potential output – which, in turn, was determined by the growth in the three Ps: population, participation and productivity. If we wanted faster growth in supply, the answer was micro-economic reform to reduce the government interventions that were inhibiting growth in participation and productivity. Macro management of demand could do nothing to hasten supply-determined growth over the medium term. Over the short term, however, monetary policy was the best instrument to use to dampen the impact of either inadequate or excessive demand which can cause fluctuations around the growth path as determined by supply. Otherwise these fluctuations would result in the new problem of excessive inflation (which was assumed to be purely “demand-pull” inflation) or, alternatively, a temporary rise in unemployment.

Which brings us to the present era of secular stagnation. Inflation is almost non-existent and interest rates are hovering above the “zero lower bound” but, though employment growth is strong and unemployment isn’t particularly high, economic growth is weak, real wage growth is weak and living standards have stopped improving. Advocates of the secular stagnation hypothesis say the problem is deficient demand and that the answer is for governments to generate some demand, particularly via government spending on such things as infrastructure. This is especially so since monetary policy now has no room to move. It’s comparative advantage relative to fiscal policy is controlling inflation, not stimulating demand when the economy is again caught in a liquidity trap.

Are you starting to detect a pattern here? In the 30-odd years after World War II, the problem was perceived to be deficient demand not deficient supply, and the right macro instrument was seen to be fiscal policy. In the 30-odd years following the emergence of high inflation, however, the problem was perceived to be deficient supply not deficient demand, and the right macro instrument was seen to be monetary policy. Since the global financial crisis and Great Recession roughly 30 years later, however, the economy has fallen into a “low-growth trap” and the leading thinkers are defining the problem as deficient demand not deficient supply, with the right instrument being fiscal policy. If so, we’re seeing unfold before us the emergence of another paradigm shift in macro management.

Symptoms of secular stagnation

In the decade or more since the Great Recession, the advanced economies’ performance has been characterised by weak growth in consumption and business investment, plus unusually low rates of productivity improvement, adding up to persistently weak economic growth overall. Inflation has been consistently below-target everywhere – itself a sign of weak demand. It’s thus not surprising that nominal wage growth has been low, but real wage growth has also been unusually low. The US economy has been stronger than most other economies, but it’s had a temporary benefit from the “sugar hit” delivered by Donald Trump’s pro-cyclical cuts in corporate and personal income tax.

The bit that doesn’t fit this story of universal weakness is surprisingly strong growth in employment and, in consequence, falling unemployment. We know that’s happened in Australia, but it’s also happened in most other economies. The strong growth in employment at a time of continuing weakness in real wage growth has prompted many of the advanced economies to revise downward their estimates of their NAIRU – non-accelerating-inflation rate of unemployment – that is, full employment. The Reserve has cut ours from “about 5 per cent” to “about 4.5 per cent”, but it’s probably lower and, in truth, no one can be sure how low.

With the sharp slowdown in Australia’s economic growth in the quarters following the June quarter of 2018, it’s become much easier to see that we, too, have been caught up in the stagnation affecting the other advanced economies. Using the three Ps, Treasury and the Reserve Bank estimate the economy’s forward-looking “trend” or potential rate of growth to be 2.75 per cent. Over the seven financial years to June 2019, that figure has been touched just twice, the economy achieving a simple average growth rate of 2.5 per cent. It’s important to note that this below-trend growth has happened despite unusually strong growth in the population – much higher population growth than in the other advanced economies. So whereas over the seven years to June 2019 real GDP grew by 19 per cent, real GDP per person grew by a pathetic 6.4 per cent. This doesn’t mean the economy is on the edge of recession. Rather it means that mere population growth accounted for two-thirds of the overall growth, leaving the other two Ps – participation and productivity – accounting for just a third.

Treasury and the Reserve have gone year after year forecasting an early return to above-trend growth, only to fall short of their forecasts, particularly for nominal wage growth. By now, it’s hard not to believe that they are merely cracking hardy, refusing to accept that something fundamental in the economy has changed.

But at the heart of the secular stagnation hypothesis is the remarkable decline in world interest rates. It’s not surprising that, with the advanced-economy-wide fall in inflation rates, nominal interest rates have also fallen. But Summers and others have demonstrated that the world real interest rate – on long-term government bonds – has been falling since long before the GFC and now is at record lows. As Phil Lowe has noted several times, this fall in interest rates can be explained only by the supply of “loanable funds” made available by savers exceeding the demand for funds from real and financial investors. Obviously, the interest rate is the price that equilibrates the supply of funds with the demand for funds. Note that this process happens on the financial side of the economy, not the real side.

Rival explanations of secular stagnation

Globalisation and the digital revolution. We know that the digital revolution is working its way through the economy, industry by industry – the entertainment and news media, retailing, accommodation, taxis, motor vehicles and many others – destroying traditional business models and leading to much uncertainty. This usually benefits consumers, bringing lower prices and new or improved services, but doing so at the expense of industry incumbents and their workers. In Australia, our retailers in particular are being put through the wringer, and it may be that this is a big factor in holding down inflation and making firms reluctant to invest. If so, this would be more in the nature of a once-only adjustment spread over a number of years, rather than permanent source of weak demand.

Mismeasurement. Many economists find it hard to believe that productivity growth, as measured, could be so weak at a time when the digital revolution is indeed revolutionising our lives and delivering so many benefits to producers and consumers. It’s probable that many of these benefits occur in our private lives and so aren’t measured by the national accounts. But Professor John Quiggin makes the broader point that the national accounting framework, which was developed about 80 years ago, was designed to measure an economy very different to the one we have today. It was designed to measure an economy dominated by the production of goods – farming, mining and manufacturing – whereas today’s economy is dominated by services, which are much harder to measure. If so, this suggest the economy is doing better in reality than the figures are telling us.

Demographic change. It’s widely believed that the ageing of the population – and, specifically, the greater proportion of workers getting close to retirement – helps explain why households are saving a higher proportion of their incomes (and thus devoting a lower proportion to consumer spending), on one hand, while the slow growing or even declining populations of most advanced economies have reduced the incentive for firms to invest in expansion. The retirement of the baby-boomer bulge has been expected to reduce the participation rate and thus make a negative contribution to the growth in potential production, though many older workers, particularly women, are staying in the workforce longer than expected. Just because people stop working doesn’t stop them consuming, of course.

Inequality. There is much evidence that globalisation and, more particularly, technological change, are “skill-biased”, favouring the growth of high-skilled occupations (eg managers and professionals), leaving some scope for growth in unskilled service occupations, but greatly reducing the demand for semi-skilled, routine jobs that are easily done by machines. Thus the middle of the workforce has been “hollowed out”. This implies that a much higher proportion of the growth in total wages is going to highly skilled and already highly paid workers. If so, a much higher proportion to wage growth is being saved rather than spent on consumption. It’s a demonstration of how increased income inequality is inhibiting economic growth. This is the reason former top econocrat Dr Mike Keating believes the best medium-term response to secular stagnation is a much great effort to ensure every level of our education and training system is helping our workforce adapt to employers’ changing demand for skills.

Debt. Phil Lowe argues that much of the weak growth in investment spending by households, companies and governments is explained by, variously, those sectors’ high levels of existing debt. In Australia, the inhibitor is much more housing debt than company debt or even government debt.

Market concentration. Some American economists believe weak growth in real wages, consumer spending, business investment and productivity can be explained partly by increasing “market concentration” as a few firms account for an ever-greater share of particular markets. The pricing power they acquire allows them to keep consumer prices higher than otherwise, limit wage increases, buy up new competitors and even limit productivity-enhancing investment. In other words, economic growth has been slowed by decades of successful rent-seeking by a small number of dominant firms – where rent-seeking means not just seeking favours from governments but also seeking out market situations when firms are able to charge prices that greatly exceed production costs (including “normal” profit). The big tech firms – Microsoft, Google, Facebook, Amazon and Apple – are classic examples of firms dominating their markets by early innovation, then buying out start-ups.

Arguments about real wages. Economists offer rival explanations for weak growth in real wages. Neo-classically inclined economists argue that real wage growth is weak purely because improvement in the productivity of labour is weak. Their solution is more micro-economic reform. But it’s by no means clear that the reforms they favour – eg lower company tax rates and further weakening of union bargaining power – would lead to higher labour productivity. Nor, at this point, is it as sure as we used to assume it was that the market economy contains some property which pretty much ensures all improvement in labour productivity is reflected in real wage growth. What if the mechanism through which that occurred was the industrial relations law’s previous balance of bargaining power between employers and unions, which IR “reform” – with its efforts to reduce collective bargaining and increase individual bargaining - has now shifted in favour of employers? Certainly, this is the union movement’s explanation for weak real wage growth. An alternative explanation is that technological change has most affected those jobs that been most unionised.

Arguments about business investment. There are various explanations for the weakness in business investment spending (or, in our case, non-mining business investment). Remember that business investment spending adds to demand in the short term and to supply – production capacity – in the medium term. One explanation is that the digital revolution has lowered the cost of capital equipment. If so, the weakness in spending isn’t as bad as it looks. Linked to this is the argument that the digital revolution has changed the nature of things firms want to invest in from expensive machinery and structures to less-expensive computer hardware and software. And linked to that is the argument that with services share of the economy ever-expanding at the expense of the goods share, meaning a shift from capital-intensive to labour-intensive production, the typical firm’s investment needs have been reduced. All these arguments imply that the weakness in business investment spending isn’t as bad as it seems, and thus not as damaging to continued expansion of potential production.

Conclusion: Although some of these explanations are mutually exclusive, it’s possible than many of them explain part of the slowdown. I’ll meet you back here in five or 10 years and tell you what economists have finally decided are the main causes, and the new conventional wisdom on how we should respond to secular stagnation. I’m pretty sure it will involve a return to worrying most about deficient demand and relying mainly on fiscal policy.

 

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Thursday, May 30, 2019

FISCAL POLICY AND THE BUDGET

UBS HSC Economics Day, Sydney, Thursday, May 30, 2019

I want to start by congratulating you – you’ve picked a really interesting year to be studying economics. Strange things are happening in the economy – it’s not working the way it used to before the global financial crisis. The managers of the macro economy have gone for years predicting things will soon be back to normal, but it hasn’t happened yet and, just last week, the governor of the Reserve Bank, Dr Philip Lowe, made it clear the RBA would begin cutting interest rates next Tuesday. So, though I will be talking about the budget last month and fiscal policy, I’ll 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.

Our economy – and, as it happened, the global economy – slowed sharply in the second half of last year, growing by just 2.3 pc over the course of 2018, a lot slower than our estimated “potential” (or “trend”) rate of growth of 2¾ pc. So we’ve had seven years of weak growth in real GDP, in productivity improvement and in real wages, with inflation stuck below the target range of 2 to 3 pc on average. And although employment has grown a lot more strongly than all that would lead you to expect, the unemployment rate was stuck at 5 pc for six months, and now may be starting to rise, and under-employment with it.

Trouble is, the government and Treasury don’t seem to have got the message. When the Treasurer, Josh Frydenberg, unveiled his first budget on April 2, effectively the start of the election campaign, he repeated essentially the same forecast Treasury had been making for the previous seven years, that the economy, wages and inflation would soon return to the old normal: 2¾ pc economic growth, 2½ pc inflation, wage growth of 3¼ pc and unemployment of 5 pc. This optimistic forecast – particularly of an early return to strong growth in real wages – is hard to reconcile with recent deterioration in economic indicators I’ve just mentioned, and the RBA’s sharp downward revisions to its own forecasts and its decision that it must start cutting interest rates again to stop the economy slowing even further.

Now let’s look at the secondary arm of macroeconomic management – fiscal policy. But, since the main policy arm - monetary policy – has so far been 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 six consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. For more than 2½ years after that, it left the rate unchanged – a record period of stability. It’s not hard to see why it 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 little sign of falling below its estimated NAIRU of 5 pc. But now, after many months of saying the next move in interest rates would be up, the recent bad results on growth and inflation – a fall in the inflation rate to just 1.3 pc – the RBA is starting to cut the cash rate, so as to increase the monetary stimulus being applied to the economy.

Fiscal policy “framework”

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

Recent developments in fiscal policy

Until recently, 2017-18, the Coalition government (and the Labor government before it) had 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 proved a lot smaller than expected - thanks mainly to an improvement in export commodity prices and higher company tax collections for other reasons. The improvement in export prices continued in bolster company tax collections in the financial year just ending, 2018-19, producing another big fall in the budget deficit. How can the budget be improving rapidly when economic growth has been weak? Because of the unexpected improvement in the terms of trade and thus mining company profits and tax payments.

In this year’s budget Mr Frydenberg is forecasting a return to a modest budget surplus of $7 billion (0.4 pc of GDP) in 2019-20, with the surplus continuing to grow in future years.

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 19 pc in June 2019, and then fall back to zero by June 2030. Again, it will be a great thing if it happens. It also means the budget balance is expected to continue improving despite the budget’s centrepiece, a doubling of last year’s 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 a remarkable $300 billion over 10 years. This is possible because of plan’s slow start.

Judged the RBA’s way, by its “fiscal impact” (the expected direction and size of the change in the overall budget balance), the “stance of fiscal policy” adopted in the budget is mildly contractionary. However, judged the Keynesian way (which focuses on the expected direction and size of the change in just the structural or discretionary component of the budget balance) the stance is mildly stimulatory, thanks to the doubled immediate first stage of the tax cuts.


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Wednesday, May 1, 2019

THE HEALTH OF THE AUSTRALIAN ECONOMY

May 2019

In Josh Frydenberg’s recent budget speech, he referred to our “strong economy” no less than 14 times. Turns out the Morrison government is using the claim that it has delivered a strong economy as its main argument that it should be re-elected at the federal election on May 18. Unfortunately for Scott Morrison, the release of recent key economic indicators of the health of the economy have caused many economists to abandon their view that the economy is reasonably strong and about to get stronger.

The first upset came in early March, with the national accounts for the December quarter of last year showing a second successive quarter of surprisingly weak growth, which lowered the growth in real GDP over 2018 to just 2.3 per cent. The second data upset came in late April, with the CPI showing no overall change in prices in the March quarter of this year, thus causing the annual rate of inflation to fall to 1.3 per cent – way down from 1.8 per cent the previous quarter and way below the bottom of the Reserve Bank’s inflation target of 2 to 3 per cent on average. This news of weak economic growth and an inflation rate moving further below the target range has greatly increased the pressure on the RBA to add to the monetary stimulus acting on the economy by cutting the overnight cash rate, after having held it steady for more than two and a half years.

To see how disappointing this recent news is, consider this. In Morrison’s own budget this time last year, he forecast that the economy’s growth (real GDP) in the financial year just ending would have accelerated to 3 per cent. In this year’s budget Mr Frydenberg cut this forecast to 2¼ per cent. Last year Morrison forecast an inflation rate of 2¼ per cent in the financial year just ending; now Frydenberg has cut it to 1½ per cent. Morrison forecast wages growth of 2¾ per cent; Frydenberg cut it to 2½ per cent.

The fact is that, for most of the time since the global financial crisis, Treasury and the RBA have been forecasting that the economy would soon return to growing at its “trend” or “potential” rate - which they calculate to be 2¾ per cent a year – and even a bit faster while the economy uses up idle production capacity, know as the “output gap”, before reaching full employment of labour and other resources. Full employment is estimated to be growth of 2¾ per cent and a NAIRU – non-accelerating-inflation rate of unemployment - of about 5 per cent. This would involve inflation returning to the centre of the RBA’s target range, 2½ per cent, and wage growth increasing to 3½ per cent.

Budget forecasts: Treasury has forecast that this acceleration would begin each year for the past seven years. And each year, when it has failed to happen, Treasury has repeated the forecast of an early return to the “old normal”, just moving it forward a year. Surprisingly, despite the recent evidence of a sharp slowing in the economy in the financial year just ending, in this year Treasury persisted with forecasting that the economy will soon return to the “old normal”. Indeed, it sees the economy speeding up in the coming financial year, 2019-20, returning to potential growth of 2¾ per cent, staying at the NAIRU of 5 per cent, inflation back in the target range at 2¼ per cent and wage growth strengthening to 2¾ per cent, implying real wage growth of about ½ per cent. And things get even better in the following year, 2020-21, with real wage growth increasing to ¾ per cent, then 1 per cent in each of the following years. It would be wonderful to see these forecasts come to pass, but they are increasingly hard to believe.

Why the economy’s weakness hasn’t been evident until now: There are four main reasons why the economy’s continuing weakness hasn’t been evident until now. First, we’ve been preoccupied with the ups and downs of the decade-long resources boom: the rise and then fall in mineral export prices and our terms of trade, and then the rise and fall of mining investment spending.

Second, our rates of growth have compared well with other advanced economies because we have had much higher rates of population growth than they have. Over the 6½ years since mid-2012, real GDP has grown by 17 per cent, whereas GDP per person grew by less than 6 per cent. In other words, most of our growth was explained by a fast-growing population, not by higher productivity and growing prosperity. The economy was bigger, but not a lot better. Measured by GDP per person, our growth has not been a lot faster than the other rich countries.

Third, in 2017, our growth in employment was about twice as fast as usual, and since then it has been faster than usual. Over the past 2¼ years the unemployment rate has fallen from 5.8 per cent to 5 per cent – which is impressive. Even so, it’s now only a fraction lower than it was in mid-2012. Similarly, the under-employment rate has fallen over the past 2¼ years, but is still quite a lot higher than it was in mid-2012.

Fourth, much of what growth we’ve had in the economy, and in employment, has come from the public sector, not the private sector. Of the 2.3 per cent growth in GDP over 2018, increased government consumption and investment spending accounted for more than half. Similarly, most of the growth in employment has come from the rollout of the National Disability Insurance Scheme and from increased spending on infrastructure by the states, as well as in health and education. The point here is not that there is something bad about government spending, but just that, when you take it away, you find the private sector economy – the biggest part of the economy - isn’t strong.

The key role of wages: Much of the economy’s weak growth and weak prospects of faster growth can be explained by weak growth in real wages. It’s not surprising that nominal wage growth has been low when consumer price inflation has also been low, but there has been almost no real wage growth for the past five years. In the past, a healthy economy has seen real wages growing by a per cent or more each year, roughly in line with growth in the productivity of labour. An economy with no growth in real wages is an economy in which real economic growth is likely to be weak. This is because wages are the main source of growth in household disposable income, household disposable income is the main source of growth in consumer spending, and consumer spending accounts for about 60 per cent of GDP. What’s more, firms are unlikely to invest much in expanding their business if demand for their products isn’t strong. And it’s firms replacing their equipment with the latest model than does most to increased productivity by spread new technology through the economy. Treasury and the RBA have been forecasting a recovery in real wage growth for five years or more, but it still hasn’t happened. The union movement and some labour economists have argued that the decentralisation of wage fixing has shifted the balance of bargaining power in favour of employers and robbed workers of their ability to ensure their real wages keep rising. Whatever the true cause of weak wage growth, it’s certainly hard to see the economy returning to strong growth until real wages are growing strongly.

Now let’s turn to how the two arms of macroeconomic management – monetary policy and fiscal policy - have been responding to this story of disappointingly weak growth in wages and GDP.

The monetary policy “framework”

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. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Recent developments in monetary policy

Because of the six consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. For more than 2½ years after that, it left the rate unchanged – a record period of stability. It’s not hard to see why it 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 little sign of falling below its estimated NAIRU of 5 pc. For many months, the RBA governor, Dr Philip Lowe, kept saying that, though the next move in the cash rate, when it came, was likely to up, a rise was some way off. Earlier this year, however, he switched to saying that the next move was just as likely to be down as up. And now, with the recent bad results on growth and inflation, he is under pressure to start cutting the cash rate.

Fiscal policy “framework”

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Morrison 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 recently, 2017-18, the Coalition government (and the Labor government before it) had 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 proved a lot lower than expected - thanks mainly to an improvement in export commodity prices and higher company tax collections for other reasons. The improvement in export prices continued in bolster company tax collections in the financial year just ending, 2018-19, producing another big fall in the budget deficit. How can the budget be improving rapidly when economic growth has been weak? Because of the unexpected improvement in the terms of trade and thus mining company profits and tax payments.

Since this year’s budget rests on Treasury’s continued assumption that the economy is about to return to the strong growth of old, Mr Frydenberg is forecasting a return to a modest budget surplus of $7 billion (0.4 pc of GDP) in 2019-20, with the surplus continuing to grow in future years.

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 19 pc in June 2019, and then fall back to zero by June 2030. 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 doubling of last year’s 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 a remarkable $300 billion over 10 years. This is possible because of plan’s slow start.

Judged the RBA’s way, by its “fiscal impact” (the expected direction and size of the change in the overall budget balance), the “stance of fiscal policy” adopted in the budget is mildly contractionary. However, judged the Keynesian way (which focuses on the expected direction and size of the change in just the structural or discretionary component of the budget balance) the stance is mildly stimulatory, thanks to the doubled immediate first stage of the tax cuts.


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Wednesday, March 6, 2019

AN ECONOMY FIT FOR HUMANS

Balmoral Lectures, Queenwood school, Wednesday, March 6, 2019

Some of you may remember Jill Tuffley, who was for many years in charge of economics teaching at Abbotsleigh. In 1988, Jill wrote a textbook to go with the new syllabus in HSC economics, which she asked me to launch. I complimented her on her choice of title, Our Economy, though I noted that, had I written the book, I’d have called it My Economy.

But Jill was right, of course. It is our economy, it belongs to all of us because we are the economy. It disturbs me to find people who feel alienated from The Economy, as though it belongs to other people – the rich and powerful, I suppose – who impose their will on us without us having any influence over what it does to us. In truth, though there may well be powerful people who have more influence than we do as individuals, it is our economy for two reasons. The first is that if, as they say, the Church of England is the Tory party at prayer, the economy is all of us at work and play. Or, as the first great economics textbook writer, Alfred Marshall, famously put it, economics is the study of humankind in “the ordinary business of life”. The second reason it’s our economy is that we live in a democracy, we each have a vote, and governments know that, if we get too dissatisfied with how the economy is working, we’re perfectly capable of tossing them out of office – as we’ve done many times before.

This is the point of my title, An Economy Fit for Humans. Ordinary people in the economy far outnumber the “1 per cent” of rich and powerful people, so it’s the job of governments to ensure the economy is run for the benefit of the ordinary people. The needs and preferences of the business class can’t be disregarded – it is a market economy, after all, which leaves most of us reliant on the private sector for our employment and our consumption – but business should be seen as just a means to an end. Its needs and wishes should be catered to only to the extent necessary to ensure the economy satisfies the public’s needs and wishes.

That’s what I mean by saying we should be fashioning an economy that’s fit for humans – for the people who make up the economy, and for whom it exists to serve. To that end, I think we’ve got a fair way to go. Many of us aren’t getting as much satisfaction as we should be. I don’t have any magic answers to all our discontents to offer tonight. Rather, I hope to offer some clarifying observations, drawn from some of the conclusions I’ve reach in more than 40 years of observing, thinking and writing about the economy.

That experience has made me aware there are fashions in economic thinking, and left me a strong believer in the pendulum theory of history. After World War II there was a strong view in Britain that the economy wasn’t working well and that the answer was to nationalise the key industries so governments could ensure good decision-making in the public interest. Even in Australia we nationalised the utilities – electricity and water with, in NSW, a privately-owned gas monopoly whose prices were so tightly regulated that it might as well have been publicly owned.

By the time of Margaret Thatcher in the late 1970s and Ronald Reagan in the early 1980s, the post-war pendulum had begun swinging back the opposite way. There was a strong view that the economy wasn’t working well and the answer was to privatise government-owned businesses, deregulate industries and outsource the provision of government services so market forces could bring about greater competition and efficiency in the economy’s functioning.

Today, with all the dissatisfaction over the way people have been mistreated and over-charged by the deregulated banks, the privatised electricity market, as well as the way “contestability” for vocational education and training was rorted, young people and those on temporary visas have been paid less than their legal entitlements, and much else, I think it’s now clear that, after about 35 years of what its critics now call “neo-liberalism”, the pendulum is now swinging back the other way, towards re-regulation of industries, more government intervention in markets and more vigorous policing of the laws applying to businesses.

Why does the pendulum keep swinging from over-regulation to under-regulation and now back the other way? I think it’s because “the truth is somewhere in the middle”. Trouble is, that’s not an emotionally satisfying position to espouse. It’s too vague and offers little illusion of certainty. We find it much easier and more attractive to gravitate to one extreme or the other. I don’t want to live in a heavily regulated economy and deal with government-owned businesses run like take-it-or-leave-it, get-back-in-the-queue monopolies. But nor do I want to live in an economy so lightly regulated that big businesses feel entitled to mistreat or overcharge their customers and think obeying the law is optional. We learnt from the GFC that market economies can’t be left to their own devices and do need to operate within a set of rules laid down by government. But setting rules that actually achieve their intended objectives without unintended consequences is much harder than many people realise. The truth may be somewhere in the middle, but putting your finger on it – finding the sweet spot - is devilishly hard.

Economics focuses on the material aspects of our lives – the production of goods and services and the consumption of those goods and services; the getting of money and the spending of it. It’s idle to deny the importance of the material aspect of our lives. I’m never impressed by people who claim to have a soul above money and the material. The great danger of our age, however, is falling into the habit of thinking the material is the only aspect of our lives that matters. Of attaching too little importance to all the other aspects: to our family lives, our relationships and social interactions, to the importance of leisure, re-creation, music, culture and spirituality. Over-emphasising the material is an occupational hazard for economists, because it’s their special area of expertise. It’s a great temptation for business people because how much money you make is the great metric of success, the objective measure of how well you’re doing in the comp. And it’s a pitfall for politicians because they mistakenly conclude it’s the main thing we want from them. This means it’s up to us to keep economics in context and stand up to people who want to make us richer at the expense of our relationships and cultural interests.

I think we’ve put too much emphasis on achieving economic growth. It’s stated aim is to raise our material standard of living at a faster rate, but usually offers no guarantee that the proceeds of that growth – the extra income – is distributed reasonably fairly between the bottom, the middle and the top. The business people who urge growth most strongly are probably hoping their income will grow a lot faster than yours. I think we’d do well to put more emphasis on better quality than greater quantity. There’s a tendency for those keenest to see faster growth to ignore the non-monetary costs it brings – the congestion, stress, anxiety and sometimes depression people suffer. If our material standard of living rises at the expense of our quality of life, why is that a good deal?

Politicians on both sides strive for economic growth because they believe a higher material standard of living will make us happier. I think that assumption’s far too narrow as a summary of what we want from governments. Sometimes I think the politicians would do more to increase “aggregate happiness” by trying to reduce un-happiness. The national disability insurance scheme is costing a lot of money, and it’s still got a lot of bugs in it, but it must surely be doing a lot to make the disabled and their families happier than they were. Unemployment – especially among the young – causes a lot of unhappiness and we ought to care more about it. We could be doing better on helping people with mental health problems. And, of course, doing better on eliminating domestic violence.

Before we leave the question of economic growth, however, I do have to remind you that, if we choose to have a growing population then, with a growing number of people needing jobs, we do need growth in the size of the economy to accommodate them.

We do need to accept that, economic activity can do damage to the natural environment – the ecosystem, if you like – especially if we do that activity the way we’ve long been doing it. It would be extremely short-sighted for us to continue practices that are damaging the environment we all live in and depend on. To use a word we use so often it’s lost its punch, such foolhardiness is unsustainable. If we keep doing what we’ve been doing, the time will come when the natural environment is so degraded it stops functioning. Then it will be too late to reverse the damage. I’m thinking of climate change, but much more than that. If we continue taking too much irrigation water out of the Murray-Darling because there are farmers and towns whose present existence depends on that water, eventually the river will dry up and there will be no more water to over-use. So I see our environmental arguments as being about short-sightedness. Our reluctance to pay short-term costs in return for the avoidance of much higher costs at some indeterminate point in the future. People worry about leaving government debt to their grandchildren, but not about leaving them a natural environment that’s stopped working.

If we became less gung-ho about economic growth, one of the potential benefits could be fewer bosses cracking the whip at work. I don’t see why being pressured and mistreated at work is a cheap price to pay for having our real wages grow by 2 per cent a year rather than 1 per cent. Actually, I don’t see that treating your staff unreasonably is the way to get the best out of them. One of the biggest things I care about – though you don’t see me writing about as often as I’d like to – is the need for us to get more satisfaction from our working lives. We spend so much of our lives at work that a big pay packet is poor recompense for doing a job you hate or for putting up with always being given a hard time. As individuals, it’s worth us moving around until we find a job we enjoy and a company we like working for, even if that does involve less pay. There’s much more I could say, but organisational psychologists have long understood the way to structure job responsibilities so as to make them more satisfying. There is some evidence that happy, fulfilled workers lead to higher profits. But, even if that weren’t true, I don’t understand bosses who don’t much care how unhappy their workers are.

But having said all that about governments doing more to reduce unhappiness and bosses doing more to ensure their troops get more satisfaction at work, I don’t want to leave you with the impression I think the economy can be like a Sunday school run by loving and infinitely forgiving mums, where nothing unpleasant ever happens and all is sweetness and light. The main source of pain and unhappiness is change. But we can’t have – and wouldn’t want – an economy where nothing changed. Change is inevitable because we’re affected by changes coming from overseas, which are beyond our control. We can’t build a wall that protects us from all external influences on us. But the greatest source of change is advances in technology, which bring us many benefits but, as we’re seeing with the digital revolution, often involve upending industries, my own among them. Generally speaking, consumers get better products, while producers get turned upside down. Some change is social - for instance, the long campaign to reduce discrimination on the basis of race, ethnicity, religion, sexual preference and, of course, discrimination against women, which has come a long way during my lifetime and has further to go. Yet another important source of change stems from our growing understanding of the damage we’re doing to the natural environment by the fossil fuels we burn, our farming practices, our disposable society and much else. So, while just about all change is disruptive, that doesn’t mean all of it is bad. Much of it is for the best. Similarly with change initiated by governments – invariably labelled “reform” – which often is necessary, but may not always be wise or well done. Certainly, it’s government-initiated change we feel freest to resist. Too often we resist change for selfish, short-sighted, NIMBI reasons. We can’t hope to live in an economy where the industry structure never changes, where old industries decline and new industries expand, where people lose their jobs and suffer a lot until they find new ones. We ought to be giving those people more help than we are to make the transition, but we shouldn’t be attempting to stop progress in its tracks.

However, that’s not to say some change shouldn’t be resisted. It should. Take, for instance, the notion that the rise of the “gig economy” means the end of stable, full-time jobs for our children. I think that notion is wrong and defeatist and must be resisted. It’s wrong because it’s not what most employers would ever want and, in any case, it wouldn’t happen because, under pressure from the electorate, governments won’t allow it to happen. It should be resisted because it would lead us to an economy that wasn’t fit for humans.


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