THE ECONOMY AND THE POLICY MIX

June 2012

If you’re not quite sure what’s happening in the economy at present, don’t feel bad. Some people are saying the economy’s in bad shape; others are saying it’s doing pretty well. The reason for the confusion is that the economy’s being hit by three different factors, at present: one expansionary, one contractionary and one that sounds worse than it actually is - so far, at least. These conflicting factors are affecting different industries differently and different states differently. This is because they’re bringing about a change in the structure of our economy, and structural change is often painful. The three factors are: first, the resources boom; second, the high exchange rate the resources boom has brought about and, third, the problems in the developed economies of the North Atlantic, particularly the Europeans’ debt crisis and worries about the survival of the euro. Let’s start with the troubles in the North Atlantic, then move to the boom then on to the high exchange rate.

Problems in America and Europe

The mighty US economy is recovering only very slowly from the Great Recession of 2008-09. But the problems are much more severe in continental Europe, as well as Britain. Europe’s basic problem of excessive levels of public debt is greatly complicated by the now-exposed structural weaknesses in the euro currency union. Most governments have resorted to the policy of ‘austerity’ - attempting to reduce budget deficits by slashing government spending and raising taxes at a time when their economic recoveries were still very weak. Unsurprisingly, this policy has proved counter-productive and has pushed various economies back into recession.

The media have given great publicity to Europe’s troubles and its tribulations have caused weakness in global sharemarkets, including ours. But the real question is the extent to which Europe’s problems affect our economy. They could do so via three main channels. First, the financial channel: they could cause certain global lending markets to seize up for a time, or increase the risk premiums paid by Australian banks or businesses borrowing in those markets. Second, the confidence channel: media reports of problems in Europe could damage the confidence of Australian consumers and business people. Third, the trade channel: weak growth or contraction in Europe could reduce our exports.

So what damage have we suffered so far? Europe’s tribulations have added a little to our banks’ costs of borrowing overseas. They do seem to have added to the uncertainty of our business people, helping to explain the weakness of non-mining business investment spending. But it’s hard to be sure Europe has had much effect on consumers because the household saving rate has been steady for more than a year and consumer spending has been growing at its trend rate. Europe accounts for less than 10 pc of our exports, so its weakness has had little direct effect on our export income.

However, Europe is a significant customer of our biggest export customer, China. So any adverse effect from Europe’s weakness could come to us via China - unless China were to offset the fall in its export income from Europe by stimulating its domestic demand, as it seems willing and able to do.

Bottom line: Europe’s problems have had some negative effect on us, but so far, not much. This could change, however, if the euro arrangement collapsed. Were something really bad to happen in Europe, the RBA would react quickly with big cuts in the official interest rate.

Resources boom

The big expansionary shock to the economy is coming from the resources boom, the biggest we have experienced since the gold rush. The rapid industrialisation of China and India has pushed prices for our exports of coal and iron ore to extraordinary heights, with our terms of trade only now starting to fall from their best level in 200 years. The improvement in the terms of trade represents a significant increase in the nation’s real income which, when spent, adds to demand. The boom has also added to demand by sparking a huge surge of investment spending on the construction of new mines and liquid-gas facilities. The emerging economies’ demand for the main components of steel is likely to stay strong for a decade or two. So, though the price of our exports of coal and iron ore is likely to fall back to less extreme levels, the volume of our exports is likely to continue growing for many years.

High exchange rate

The big contractionary shock to the economy is coming from the still very high exchange rate caused by the resources boom. An improvement in our terms of trade almost always leads to a rise in our exchange rate. Our dollar is likely to stay unusually high for some years, even as commodity prices fall back, because of the significant net inflow of foreign capital needed to finance the expansion of our mining sector. The high exchange rate helps to prevent the resources boom from leading to inflation by, first, directly reducing the price of imports and, second, reducing the international price competitiveness of our export and import-competing industries, thus reducing their production and so working in the direction of diminishing demand.

Structural change

The public is used to thinking about the economy in cyclical terms: it’s either booming or turning down. At present, however, because these two big shocks to the economy - the resources boom and the high dollar - are working on opposite directions, the economy is neither booming nor busting. It’s easier to understand what’s going on in the economy if you think of it in structural terms: the interplay of the two conflicting forces bearing on the economy is causing some industries to expand while others contract. The mining industry and mining-related parts of the construction industry and the manufacturing industry - accounting in total for up to 20 per cent of GDP - is expanding rapidly, whereas most of the other trade-exposed industries (manufacturing and service export industries such as tourism and education) are likely to get relatively smaller. The other industry that’s suffering from structural change is retailing. The pressures it’s facing have little to do with the high dollar, however. It’s being affected by the digital revolution and the rise of e-commerce.

Outlook for the economy

Over the year to March, the economy grew by an exceptional 4.3 pc, lead by strong consumer spending and the boom in mining investment. But now the economic managers are expecting growth to return to its trend rate of 3.25 pc for the coming financial year, 2012-13, as a whole. But this is expected to involve quite disparate growth in the components of GDP: another very big increase in mining investment spending and trend growth in consumer spending, but no growth in new home building and a small contraction in public sector spending as federal and state governments seek to return to operating surplus.

And note that the other economic indicators are looking pretty good at present. The latest figures say underlying inflation is running at 2.2 pc - almost down to the bottom of the RBA’s 2 to 3 pc inflation target. The latest figures say unemployment is running at about 5 pc - which economists say is down very close to our NAIRU - the non-accelerating-inflation rate of unemployment, which is the lowest point to which unemployment can fall before labour shortages start causing wage and price inflation. That is, unemployment is very close to its lowest sustainable rate.

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.

Aware the unemployment rate was only a little above the NAIRU and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as the RBA had forecast. Instead, the outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by 0.5 points in June by a further 0.25 points, taking the cash rate down to 3.5 pc, more than offsetting the banks’ efforts to preserve their profit margins, and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.

Fiscal policy

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

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.

Conclusion

Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.

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Is economic reform worsening productivity?

The North Atlantic economies have pressing problems to grapple with, but here at home the biggest thing we have to worry about is our weak rate of productivity improvement. And we won't get far if we stick to the received wisdom it's all the fault of excessive government intervention.

If our econocrats want to preserve their monopoly over the advice their political masters seek, they need to be less model-bound in their thinking. Since it doesn't take much thought to realise ''more micro reform'' is unlikely to make a big difference, we need more lateral thinking.

Rather than merely assuming market failure wouldn't be a material part of the problem - or assuming nothing could be done to correct market failure that wouldn't make things worse rather than better - perhaps we should look harder to see if market failure is part of the story.

After all, it's the market that's failing to generate as much productivity improvement as it has in the past.

Then we could start looking for cleverer forms of intervention that don't end up being counterproductive. Here we could put a lot more effort into evaluating interventions, so as to build up our understanding of what works and what doesn't.

The acute government debt problems in the United States and Europe are a reminder of how much more fiscally disciplined our governments have been, going right back to the Hawke-Keating government with its various budget limits and targets.

It's a great temptation to give the public the ever-increasing government spending it demands, but then fail to summon the courage to make people pay the extra taxation needed to cover that higher spending.

For all their failings, however, our politicians have achieved balanced budgets on average over the cycle and have kept government debt levels - federal and state - quite low and manageable.

But could it be we've paid for our fiscal responsibility with lower productivity improvement? It seems clear we've been underspending on public infrastructure as part of our efforts to keep debt levels low, but adequate public infrastructure is needed to permit the private sector to raise its own productivity.

As well as physical capital there's human capital. As part of our abstemiousness, we've gone for several decades underspending on all levels of education and training: early childhood development, schools, vocational training and universities. Particularly universities.

If we've gone for so long underspending on human capital, is it any wonder our productivity performance has worsened? It's true the Rudd-Gillard government has loosened the purse strings in recent years, but there's safe to be a delay before that leads to an improvement.

Another possibility worth exploring is whether the microeconomic reforms of the past have had unintended consequences that damaged our productivity.

Micro reform is almost always aimed at increasing firms' efficiency by subjecting them to great competitive pressure - whether from rivals in the domestic market or from imports.

But the human animal has achieved the great things it has not only as a result of competition between us but also as a result of our heightened ability to co-operate in the achievement of common objectives. The economists' conventional model is big on competition, but sets little store by co-operation, since it assumes we're all rugged individualists. Could it be that, by greatly increasing the competition most firms face in their markets, micro reform has reduced the amount of productivity enhancing co-operation?

A further possibility is that, in turning up the heat of competition in so many markets, and in spreading market forces into areas formerly outside the market, micro reform has diminished our ''social capital'' in ways that adversely affect economic performance.

There's no place for trust, feelings of reciprocity or norms of socially acceptable behaviour in the economists' model, so they tend to under-recognise their importance. But you only have to observe a loss of trust within the community to realise the high cost that loss imposes on the economy as well as society.

The less we feel we can trust each other, the more avoidable costs we impose on the economy in spending on supervision and monitoring, security devices and security people.

Micro reform seeks to increase the community's income without paying any attention to the equitable distribution of that extra income. If higher earners end up with more than their fair share, the disaffection of those who lose out may detract from their productivity.

It seems clear the increased competitive pressure on firms has led many to take a more ruthless attitude towards their employees.

Firms are more anti-collective bargaining, more prone to laying off staff as soon as business turns down, more willing to award huge pay rises to executives without a thought as to how this might make other employees feel, more inclined to pay some workers more than their peers, more inclined to expect people to work split shifts or on weekends and public holidays without extra pay and more likely to demand unpaid overtime (which last does increase measured productivity, however).

Is it so hard to credit that all this might have made workers less co-operative and productive rather than more?

In the Treasury Secretary's recent speech on our poor productivity performance, Dr Martin Parkinson nominated health and education as the next candidates for major micro reform. He's right, there's plenty of scope for improvement.

But these are service-delivery sectors where it's the performance of professionals that's crucial. And economists' notions about what motivates people and how you encourage excellence are so blinkered - they assume money is the only incentive and key performance indicators work a treat - that you'd have little confidence their ''reforms'' would make things better.

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The real action is in the developing world

If the US, the world's biggest economy, starts to contract again and the Europeans' government debt problems prompt more austerity, the world economy will be plunged back into recession. Is that what you think? If so, your picture of the world economy is about 20 years out of date.

There are cultural, historical, family and language reasons why we focus our attention on Europe and the US. The media keeps us well informed about what's happening in their economies. And since, between them, they account for a big chunk of the world economy, it's easy to assume that where they go the rest of the world follows.

Indeed, that used to be true. When I first got into this game, the Organisation for Economic Co-operation and Development used to make forecasts for its 24 rich-member countries, add them up and call it the world economy.

But consider these figures from the Reserve Bank's latest statement on monetary policy. Over the four-and-a-bit years since the March quarter of 2007, the world economy has grown by about 10 per cent in real terms.

The contribution of the North Atlantic economies (the US, Canada, Britain and the euro area) to that growth was near enough to zero. So all the net growth the world's seen in that time has come from the remaining, mainly developing, economies.

Between them, the Chinese and Indian economies have grown by nearly 50 per cent, while east Asia (excluding China and Japan) grew by almost 20 per cent.

The faster the developing countries grow relative to the rich countries, the larger their share of the world economy becomes. An article in The Economist points to the many respects in which the world economy is coming to be dominated by the "emerging economies", as they're increasingly called.

As many as 11 of these economies have emerged to the point where they've been reclassified as developed rather than developing. But when you do that, you understate the extent to which the developing countries are taking over the running. So the figures that follow classify as developing all those countries that hadn't made it to developed status before 1997.

The developed countries account for only about 15 per cent of the world's population, but in 1990 they accounted for 80 per cent of gross world product. By last year that share had dropped to 60 per cent. It is projected to fall to less than half within the next seven years.

But that calculation is based on converting each country's gross domestic product into US dollars at market rates. This understates the developing countries' share of gross world product (GDP) because one US dollar buys a lot more in poor countries than in rich countries.

When you adjust for "purchasing-power parity" you find the developing countries' share of gross world product reached 50 per cent three years ago and is expected to reach 54 per cent this year. Their share of world exports has reached half, which is almost double what it was in 1990.

Much of these exports would be produced by multinational companies operating in developing countries, so it's no surprise the developing countries attract more than half of all the inflows of foreign direct investment.

So far, this conforms to the popular perception of developing countries as economies that make their living selling cheap exports to rich countries. But The Economist observes that "foreign firms are increasingly lured by these countries' fast-growing domestic markets as much as [by] lower wages".

That's the point: developing countries are increasingly standing on their own feet, generating their growth internally.

The mainstays of "domestic demand" are capital (investment) spending and consumer spending. The developing countries now account for more than half the world's capital spending, compared with a quarter 10 years ago.

Last year the US's capital spending was just 16 per cent of its GDP compared with 49 per cent in China. (Ours was 28 per cent.)

The developing countries' share of world consumer spending is only 34 per cent, though this is up from 24 per cent 10 years ago (and would be higher if you allowed for the lower prices they pay for housing and services).

Even so, their shares are: 46 per cent of world retail sales; 52 per cent of all new car sales (up from 22 per cent in 2000) and 82 per cent of all mobile phone subscriptions.

You can see from this how rapidly living standards are rising in poor countries. And when the locals start spending, some of that spending is on imports. Last year the developing countries' share of world imports rose to 47 per cent.

So whereas we're accustomed to thinking of developing countries as dependent on rich countries, it's becoming more the case that the rich countries depend on the developing countries.

Even so, because the developing countries are still at the early stages of developing their economies, their demand for basic commodities - whether locally produced or imported - exceeds their demand for sophisticated goods and services.

They account for 60 per cent of the world's annual energy consumption, 65 per cent of all copper consumption and 75 per cent of all steel use. Yet, as The Economist remarks, there's plenty of room for growth: they use 55 per cent of the world's oil but their consumption per person is still less than a fifth of that in the rich world. (Always assuming we don't run out of oil, of course.)

And here's a pertinent reason the developing countries are likely to continue growing faster than the North Atlantic economies: they're responsible for only 17 per cent of the world's government debt.

No prize for having guessed the punchline: the rich countries likely to do best over the rest of this troubled decade are those most closely plugged into the developing world.

Heard of a poor, cautious, sorry-for-itself country called Australia? It sells less than 10 per cent of its exports to Europe and only 5 per cent to the US, but about two-thirds to developing countries.

Most of those countries are in Asia, of course, the most dynamic part of the world economy. In just the past 10 years, China's share of our exports of goods and services has gone from 5 per cent to 23 per cent, and India's has risen from 2 per cent to 7 per cent.

As Wayne Swan keeps saying, Australia is in the right place at the right time.

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Are we talking ourselves into a recession?

Is it possible for a country that is the envy of the developed world to talk itself into recession? I don't know. But it seems we're about to find out. It won't be easy, of course. It's a question of whether our increasingly negative perceptions can overwhelm the reality that our economy has a mighty lot going for it. Let's start with reality, then move to perceptions.

The Europeans, and now the Americans, are rightly worried about their yawning budget deficits and huge levels of government debt. Their problem is, the more they do to reduce deficits the more they weaken their economies, at a time when they're already pretty weak. By contrast, our budget deficit isn't particularly big and our level of government debt is laughably small.

Part of their problem is the money they spent bailing out their banks - many of which still aren't back in full working order. By contrast, we've had no problem with our banks.

Despite their weak economies, the Europeans and Americans have been worried about the rising cost of rural and mineral raw materials. But what's a problem for them is income for us. The prices we're getting for our exports have rarely been higher.

As a consequence of this boom, the mining companies are spending mind-boggling amounts building mines and natural gas facilities. Were we in our right minds we'd have no trouble accepting that, since you and I live in the same economy as the miners, a lot of this income and spending rubs off on us. Instead, the incessant talk about the alleged "two-speed economy" has allowed us to imagine that, while the miners are doing well, the rest of us are stuffed. Retail sales are flat? See, I told you I was doing it tough.

Trouble is, there's little hard evidence to support this impression. Unemployment in the North Atlantic economies is about 9 per cent; here it's below 5 per cent. And this holds around the country. Using trend figures, it ranges from 4.2 per cent in Western Australia to 5.6 per cent in Tasmania, with 5.1 per cent in sorry-for-itself NSW and 4.7 per cent in Victoria. Nationally, employment grew by 2 per cent over the year to June, with WA and NSW right on the average, resource-poor Victoria topping the comp with 3.1 per cent and resource-rich Queensland achieving just 1.1 per cent. Pay rises are few and far between in the US and Europe but in poor little Oz the wage price index rose by a too-generous 4 per cent over the year to March. Again, the growth was remarkably similar around the country. Wages in WA grew by 4.1 per cent and in Tassie by 3.5 per cent. NSW and Victoria were right on the national average.

Admittedly, mining wages grew by 4.6 per cent, but workers in the (genuinely) hard-pressed manufacturing sector got 4.1 per cent and even in retailing workers averaged rises of 3.3 per cent.

Conduct a focus group and punters will tell you they're suffering mightily under the rapidly rising cost of living - which is why politicians on both sides are always encouraging the punters to feel sorry for themselves.

But when you combine healthy growth in employment with too-high wage rises you get household incomes growing faster than consumer prices. So if retail sales are weak, it's not because we can't afford to spend, it's because we choose not to - whether out of prudence or fear for the future.

There's no doubt the retailers - along with manufacturing and tourism - are doing it tough. But there's nothing in the capitalist contract that guarantees businesses an easy life. And, as an indicator of the overall health of the economy, the weakness in retail sales is misleading.

Did you (or any of the journalists carrying on this week) know retail sales account for only about 40 per cent of consumer spending? They cover mainly goods bought in shops, particularly department stores. They don't include sales of cars, nor the growing proportion of our incomes we spend on services.

New car sales have been weak in recent months, partly because of the lack of supply from Japan since the tsunami, but (though no one thought it worth telling you) this week we learnt car sales jumped by 12 per cent in July.

And that's not the only sign we're more willing to spend than many imagine. This week we also learnt that plenty of people are spending big on overseas travel. Short-term departures of Australian residents rose by 1.4 per cent in June to be up almost 11 per cent on a year earlier.

In real terms, retail sales grew by 0.3 per cent in the June quarter and just 0.5 per cent over the year to June. But total consumer spending is expected to grow by 0.5 per cent in the quarter and 2.5 per cent over the year. That's not brilliant, but it's a far cry from death's door.

So if the underlying reality of the economy is enviably good, why are we so dissatisfied and anxious? Why are we so ready to think the worst about the prospects in America and Europe and to conclude - contrary to all the evidence - that tough times for them spell tough times for us? Well, not because the media are revelling in the bad news and forgetting to mention the good. They always do that. It's just that, when we're in an optimistic frame of mind we ignore the gloom mongering, whereas when we're in a pessimistic mood we lap it up.

Alternating waves of optimism and pessimism - "animal spirits" - do much more to explain the swings in the business cycle than it suits most economists to admit. And because we're such herd animals, we tend to contract these moods from one another - even from our cousins on the other side of the globe.

Will our increasingly negative perceptions overwhelm our strong reality? If they do, they'll have a fight on their hands: thanks to the mining construction boom, business investment spending is expected to grow by 15 per cent this year and another 15 per cent next year. For your own sake, pray reality wins.


AUSTRALIAN ASX 200

OPENED THURSDAY

4332.8

CLOSED THURSDAY

4276.5

OPENED YESTERDAY

4222.9

CLOSED YESTERDAY

4105.4

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