Our leaders slowly come to grips with a different economy

The beginning of economic wisdom is to understand that the advanced economies – including ours – have stopped working the way they used to and won’t be returning to the old normal.

Second in the getting of wisdom is to understand that economists are still debating why the economy is behaving so differently – so poorly - and what we can do about it.

Last week Reserve Bank governor Dr Philip Lowe gave a speech to a conference of central bankers in Wyoming revealing his acceptance that, as he put it, the economic managers are having to “navigate when the stars are shifting”.

And Treasurer Josh Frydenberg gave a speech on Australia’s productivity challenge, which offered the Morrison government’s first acknowledgement that maybe not everything in Australia’s economic garden is rosy.

The shifting “stars” to which Lowe alluded were economists' estimates of the rate of full employment and the equilibrium real interest rate – both of which have moved downwards. He said that economists have become very good at developing explanations for why this has happened.

“Even so, the reality is that our understanding is still far from complete about what constitutes full employment in our economies and how the equilibrium interest rate is going to move in the future,” he said.

He offered two likely explanations for why the stars had moved. First, major changes around the world in the appetite to save and to invest. People were saving more despite low interest rates, and were borrowing less to fund physical investment despite low interest rates.

On the saving side, these changes were linked to demographics (the ageing population), the rise of Asia (which saves a lot) and the legacy of too much borrowing in the past.

On the investment side, the links were to slower productivity improvement and “importantly, increased uncertainty and a lack of confidence about the future”.

The second major change was an increased perception of competition as a result of globalisation and advances in technology. “More competition means less pricing power, for both firms and workers,” he said.

In all this he gave the lie to the latest line that our economy is going fine, it’s just the threat from abroad that’s the problem. Nonsense. Our economy is slowing to a crawl because of weak real wage growth. The external threat just makes it worse.

After giving a learned account of our slower rate of productivity improvement (and acknowledging that it’s happening throughout the developed world), Frydenberg admitted that business investment spending was not as strong as it ought to be.

But then he stepped into the lions’ den. Rather than returning capital to shareholders, business needed to back itself – make its own luck – by using its strong balance sheet (and exceptionally low interest rates) to “invest and grow”.

The fury of the righteous descended upon him, with the business media in full cry. It really is amazing the way business people boast about the centrality of the private sector to the economy and its success, but refuse to accept any responsibility for its outcomes.

Any weaknesses in the economy are solely the government’s fault, and feel free to criticise it uphill and down dale – not to mention using problems in the economy as a pretext for rent-seeking. Don’t even think that the performance of business could be less than blameless. Who do you think invented the term “all care but not responsibility”?

Even so, I fear business is right in protesting that the reason it’s not investing is that, with demand so weak, it can’t see how expanding its production capacity could be profitable.

This problem began long before Trump started playing his crazy trade-war games, but there’s little doubt that the uncertainty he has created is adding to firms’ reluctance to commit to major investment projects. And the more people delay their investment plans until the future is clearer, the greater the risk that conditions deteriorate and the investment never gets done.

Dr Mike Keating, a former top econocrat, argues that productivity improvement is weak because business investment spending is weak. It’s when businesses install the latest and best machines and systems that new technology is diffused through the economy, lifting productivity.

So when weak wage growth leads to weak growth in consumption, you don’t get enough business investment and, hence, slower productivity improvement.

Government intervention to improve workers’ bargaining power may help speed up the flow of income through the system, but Keating believes a lasting improvement will come mainly by making education and training more effective in helping workers adapt to and adopt new technologies.

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If you think surpluses are always good, prepare for great news

Don’t look now, but Australians’ economic dealings with the rest of the world have transformed while our attention has been elsewhere. Business economists are predicting that, on Tuesday, we’ll learn that the usual deficit on the current account of the balance of payments has become a surplus.

If so, it will be the first quarterly surplus in 44 years. If not, we’ll come damn close.

You have to be old to appreciate what a remarkable transformation that is. Back in the 1980s we were so worried about the rise in the current account deficit and the foreign debt that it was a regular subject for radio shock jocks’ outrage. They knew nothing about what it meant, but they did know that “deficit” and “debt” were very bad words.

By the 1990s, Professor John Pitchford, of the Australian National University, had convinced the nation’s economists that the rises were a product of the globalisation of financial markets and the move to floating exchange rates, and weren’t a big deal.

By now, economists have become so relaxed about the “balance of payments” that it’s rarely mentioned. So news of the disappearing deficit will be a surprise to many.

To begin at the beginning, the balance of payments is a summary record of all the monetary transactions during a period that have an Australian business, government or individual on one end and a foreign business, government or individual on the other.

The record is divided into two accounts, the current account and the capital and financial account.  The balance on the current account is always exactly offset by the balance on the capital account. If one has a deficit of $X billion, the other must have a surplus of $X billion, so that the balance of (international) payments is in balance at all times.

As a Reserve Bank explainer says, the current account captures the net flow of money resulting from our international trade. The capital account captures the net flows of financial capital needed to make all the exporting, importing and income payments possible. These flows during the period change the amounts of Australia’s stocks of assets and liabilities at the end of the period.

To work out the balance on the current account, first you take the value of all our exports of goods and services and subtract the value of all our imports of goods and services, to get the balance of trade.

Then you take all the interest income and dividends we earnt from our investments in foreign countries and subtract all the interest and dividend payments we make to foreigners who’ve lent us money or invested in our companies.

The result is the “net income deficit” which, after you’ve added it to the trade balance, gives you the balance on the current account. As Michael Blythe, chief economist at the Commonwealth Bank, noted this week, that balance has been a deficit for 133 of the past 159 years.

Why do we almost always run a deficit? Because our land abounds in nature’s gifts, and there’s great opportunity to exploit those gifts and earn wealth for toil. What we’ve always been short of, however, is the financial capital needed to take advantage of all the opportunities.

Moving from poetry to econospeak, for pretty much all of our modern history Australia has been a net importer of (financial) capital, as Reserve deputy Dr Guy Debelle said in a revealing speech this week.

Because we don’t save enough to allow us to fully exploit all our opportunities for economic development, we’ve always drawn on the savings of foreigners – either by borrowing from them or letting them buy into Australian businesses.

Blythe says “the shortfall reflects high investment rather than low saving. By running current account deficits, we have been able to sustain a higher [physical] investment rate than we could fund ourselves. Economic growth rates and living standards have been higher than otherwise as result.”

True. And Debelle agrees, noting that Australia’s rate of saving is on par with many other advanced economies. (So don’t let any silly pollies or shock jocks tell you a current account deficit means we’re “living beyond our means”.)

Be sure you understand this: a current account deficit is fully funded by the corresponding surplus on the capital account, which represents the amount by which we needed to call on the savings of foreigners because the nation’s physical investment in new housing, business plant and structures, and public infrastructure during the period exceeded the nation’s saving (by households, companies and governments) during the period.

But if all that’s true, how come we’re expecting a current account surplus in the June quarter? It’s a combination of long-term changes in the structure of our economy that have been working to reduce the deficit, and temporary factors that may push us over the line.

Debelle says that between the early 1980s and the end of the noughties, the deficit averaged the equivalent of about 4 per cent of gross domestic product. But it’s narrowed since 2015 and is now about 1 per cent of GDP.

Most of this change is explained by the trade balance. It averaged a deficit of about 1.25 per cent of GDP over the three decades to 2015, but since then has moved into surplus. It hit record highs during the three months to June, totalling a surplus of $19.7 billion for the quarter.

The resources boom has hugely increased the quantity of our minerals and energy exports, and there’s been a temporary surge in the price we’re getting for our iron ore. At the same time, the end of the investment phase of the resources boom has greatly reduce our imports of mining and gas equipment.

The rise of China and east Asia also means protracted strong growth in our exports of education and tourism.

At the same time, the net income deficit has widened a little in recent years but, at 3.4 per cent of GDP, is in the middle of its range since the late 1980s.

The marked reduction in the current account deficit overall means that Australia’s stock of net foreign liabilities (debt plus equity in businesses) peaked at 60 per cent of GDP in 2009 and has now declined to 50 per cent. But that’s a story for another day.

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Greater social inclusion makes us wealthier, not just happier

If you like made-up, clunky words you could call it the humanisation of economics. And it’s one of the most exciting developments in a field most people don’t consider very exciting. It’s the product of economists’ search for reasons why the economies of the developed world have stopped working as well as they used to.

This week our Reserve Bank governor, Philip Lowe, gave a short but sobering speech at a conference of central bankers in Wyoming exploring the deeper, structural reasons why economies – including ours - aren’t growing as fast as they did, and admitting this wasn’t likely to change any time soon.

A big part of the reason for weaker growth is a slower rate of improvement in the productivity of labour – the use of improved technology to increase the output of goods and services per worker.

Also this week, Treasurer Josh Frydenberg gave a long, carefully researched and highly informative speech about the deterioration in our productivity performance. His one controversial proposition has been monstered by the business media, but the speech was an encouraging sign that the Morrison government may be moving from happy slogans to careful consideration of the problems besetting our economy.

Now to my new word, humanisation. Until the past couple of decades, it was relatively easy to achieve high annual rates of productivity improvement by using bigger and better machines to increase the efficiency of our farms, mines and factories in their production of goods.

These days, goods are produced by machines, helped by humans. Services, on the other hand, are delivered by humans helped by machines. Goods have come to account for an ever-smaller share of the value of economic activity, with services contributing an ever-bigger share.

But installing more productive goods-producing machines is a lot easier than making the human providers of services (ranging from prime ministers to scientists, doctors and teachers on to waiters and cleaners) better at their jobs. This does a lot to explain the slowdown in productivity improvement.

So economists have had to turn their minds to humans, and how you make them more productive. An obvious response is to ensure they’re well educated and trained, equipped with the right skills to take them onwards in an ever-changing economy.

Equally obvious is making sure our workers are in good health – mental as well as physical. These are things we could be doing better than we are.

Less obvious is economists’ relatively recent discovery of the economic importance of “place” – where people live and work. Particularly at a time when knowledge has become a more critical ingredient, big cities have become incubators, bringing together talented workers to promote experimentation and learning, as well as enabling the transfer of knowledge. (Bit surprising in an age where digital connections are ubiquitous.)

Another less-obvious realisation is that, in the services sector, productivity depends on creativity and imagination, which drive innovation. Increasingly the services sector is the home of start-ups aimed at finding innovative ways to deliver new and existing services to larger numbers of customers.

This is very touchy-feely stuff for hard-nosed economists. One of our leading economists, Professor Ian Harper, dean of Melbourne Business School, says creativity and imagination “are generally stimulated by human interaction, social creatures that we are".

“And the more diverse we are when we gather, the more we stimulate, challenge and goad one another to greater heights of imagination and creativity.

“But for diversity to work its magic, there must also be inclusion. No matter how diverse we are, without inclusion we remain separated by physical, social, cultural and emotional barriers, and the creative spark is quenched by sameness and group think,” Harper says.

Enter the SBS network, which has commissioned Deloitte Access Economics to study the economic benefits of improving social inclusion.

By this is meant affording all people the best opportunities to enjoy life and prosper in society. It includes the Indigenous, and almost 7 million immigrants, from 270 ancestries, since 1945. All the women who should have more senior jobs. Almost 50,000 same-sex couples, and one in five people with a physical or mental disability.

About a third of small businesses in Australia, representing 1.4 million employees, are run by migrants to Australia, the great majority of whom didn’t own a business before coming here. And most migrants feel socially included.

Greater social inclusion means people are less likely to experience discrimination in employment, less likely to experience health issues, especially anxiety and depression. By lifting wages and workforce participation in districts of socioeconomic disadvantage, the benefits of economic growth can be shared more evenly across the community.

All this could save the taxpayers money, as well as making businesses more productive – which, by Deloitte’s modelling, could yield an economic dividend of more than $12 billion a year. And that’s not to mention the small matter of allowing the individuals to lead happier, more satisfying lives.

For many years economists believed economic efficiency and fairness to be in conflict. You could make the economy a fairer place only by making it a less-rich place.

That’s the economists’ exciting discovery in recent years: if you play your cards right, you can make the world fairer and a bit richer.

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Why government-controlled prices are soaring

As if Scott Morrison didn’t have enough problems on his plate, we learnt last week that government-administered prices are rising much faster than prices charged by the private sector.

Last week my colleague Shane Wright dug out figures from the bowels of the consumer price index showing that, over the almost six years since the election of the Abbott government in September 2013, the prices of all the goods and services in the CPI basket have risen by just 10.4 per cent, whereas the government-administered prices in the basket rose by 26 per cent.

Some of those "administered" prices actually fell and others rose by less than prices overall. But let’s do what everyone does and focus on the really big increases.

Behavioural economics tell us that people’s perceptions of the cost of living are exaggerated by a ubiquitous mental shortcut psychologists call "salience". We tend to remember the things that leapt out at us at the time and forget all the things that didn’t.

So, for instance, we vividly remember the shock we got when we opened our electricity bill and saw how huge it was and how much it had increased.

In round figures, the cost of secondary education rose by 30 per cent over the period, childcare by 27 per cent, postal costs by 27 per cent, hospital and medical services by 36 per cent, council rates by 21 per cent, cigarettes by 109 per cent, gas prices by 16 per cent and electricity by 12 per cent (most of the bigger increase came during the term of the previous Labor government).

Not hard to see that the government has a huge salience problem. Plenty of scope there for the punters to convince themselves the cost of living is soaring.

But what should Morrison do? At a glance, the problem's obvious: government prices rising much faster than market prices say governments are hopelessly wasteful and inefficient. So expose the government to competition and the waste will be competed away, to the benefit of all.

Sorry, the true story’s much more complicated. Indeed, part of the problem is the backfiring of governments’ earlier attempts to make the provision of government services "contestable".

Let’s look deeper. For a start, some of the increase in administered "prices" is actually increases in taxation. The doubling in cigarette prices is the result of the phased massive increase in tobacco excise begun by Malcolm Turnbull.

Local council rates work by applying a certain rate of tax to the unimproved land value of properties. State governments usually cap the extent to which the tax rate can be increased, but the base to which it’s applied soars every time there’s a housing boom.

Postal costs rise because we want to continue being able to post letters to anywhere in Australia at a uniform price, even though we're actually doing it less and less, thus sending economies of scale into reverse. Australia Post would have been privatised long ago if any business thought it could make a profit from the business without scrapping the letter service.

The doubling in the retail prices of the now largely privatised (but still heavily regulated) electricity industry over the past decade is the classic demonstration that attempts to introduce competition to monopoly industries are no simple matter and can easily backfire.

The cost of childcare has been rising over the years because governments have been raising quality standards – staff-child ratios, better educated and paid workers. Is that bad? This formerly community-owned sector has long been open to competition from for-profit providers without this showing any sign of helping to limit price increases.

Even so, childcare is heavily subsidised by the federal government. This government’s more generous subsidy scheme caused the net out-of-pocket cost to parents (which is what the CPI measures) to fall a little last financial year.

The modest suggested fees in government schools wouldn't have risen much over the past six years. If private school fees have risen strongly despite the heavy taxpayer subsidies going to Catholic and independent schools, it’s because the number of parents willing to pay them shows little sign of diminishing. Hardly the government’s problem.

Detailed figures show that the out-of-pocket costs for pharmaceuticals rose by less than 6 per cent (thanks to reforms in the pharmaceutical benefits scheme) and for therapeutic goods fell a few per cent, while for dental services they kept pace with the overall CPI, leaving the out-of-pocket costs of hospital and medical services up by a cool 36 per cent.

That tells you private health insurance is falling apart. Add the continuing problems with needs-based funding of schools, and electricity and gas prices, and the scope for further efficiency improvements in healthcare, and you see the Morrison government has plenty to be going on with.

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How strange could money get if the worst came to the worse?

With our official interest rate heading ever closer to zero, there’s much talk that the Reserve Bank may be forced to join other central banks in resorting to “unconventional monetary policy,” including QE – “quantitative easing”. But how likely is this? What might it involve? Are there alternatives? And would it be good or bad?

These questions were debated by Dr Stephen Kirchner, of the United States Studies Centre at Sydney University, Dr Stephen Grenville, a former deputy governor of the Reserve now at the Lowy Institute, and Lyn Cobley, boss of Westpac’s institutional bank, at a meeting of the Australian Business Economists in Sydney this week.

But let’s start with what the Reserve’s governor, Dr Philip Lowe, said on the subject to the House’s economics committee earlier this month.

He said it was possible the official interest rate would end up at zero. Here’s the key quote: “I think it’s unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it.”

The Reserve had been doing a lot of thinking about unconventional policies, so as to be ready if they proved necessary, not because it thought them likely to be needed.

“I hope we can avoid that,” he said. Which I take to mean that, should they prove needed, the economy’s prospects would be much worse than they are now. But also that the Reserve doesn’t fancy having to use unconventional methods.

Conventional monetary policy involves the central bank using its “open market operations” (selling or buying Commonwealth bonds from the banks) to push its official interest rate, and hence the banks’ short-term and variable interest rates, up or down so as to discourage or encourage borrowing and spending (“demand”) in the economy.

Lowe’s list of unconventional measures includes the “negative” interest rates applying in Switzerland, the euro area and Japan (where lenders pay the borrowers tiny interest rates; don’t hold your breath waiting for this one), the central bank lending funds to banks at below-market rates provided they lend them on to businesses, the central bank buying corporate bonds or mortgage-backed securities, or intervening in the foreign exchange market to push the value of its currency down.

But the measure Lowe seemed least uncomfortable with is the central bank buying long-term government securities to try to lower risk-free long-term interest rates. This is similar to conventional policy, just at the long end rather than the short end.

Lowe also said that, if it became necessary to start buying long-term securities, you wouldn’t need to have cut the official interest rate to zero before you started. He implied he might go no lower than 0.5 per cent.

Why stop there? Because by then the banks’ deposit rates would be too low to be cut any further, meaning they couldn’t pass the cut on to their home-loan and business borrowers.

However, he admitted, if things got so bad internationally that all the other central banks had cut their official rates to zero, we might be obliged to follow suit. Another possibility would be if our economic growth slowed even further – say, into the 1 per cent range – though in that case a response would be needed from fiscal policy (the budget) as well as monetary policy.

Turning to this week’s debate, Westpac’s Cobley made it clear the banks would have trouble coping with most of the unconventional measures. Even cutting the official rate any further would hit the banks’ profits (sounds of weeping and breast-beating by the bank customers present).

Kirchner, who is among the minority of economists who believe fiscal policy is ineffective in managing demand, saw no problem with using unconventional measures, which could easily have the same effect as cutting the official rate by a further 2.5 percentage points.

He said the consensus of academic studies was that unconventional measures in the US had been quite effective. Grenville agrees with him that, for the central bank to switch from buying short-term securities to buying long-term securities in no way constitutes “printing money” (even metaphorically).

Grenville disagreed with his claim that unconventional measures don’t promote inequality by helping the rich get richer, however. They lead to higher prices in the markets for shares and property, which help expand the economy through a “wealth effect” – working best for the wealthy.

Except where unconventional measures were used to rescue financial markets that had frozen at the height of the financial crisis, Grenville was unconvinced they achieved much. The academic studies made too little distinction between different episodes.

So he opposes taking interest rates lower and moving on to unconventional measures. Rather, the Reserve should tell the government monetary policy had gone as far as it reasonably could – was already “pedal to the metal” – so now it was over to fiscal policy.

Unconventional measures (I think “quantitative easing” is misleading) would probably achieve lower long-term interest rates, inflate asset prices (particularly shares), encourage financial risk-taking and lower the exchange rate, Grenville said.

None of those things seemed particularly desirable, he said. Lower long-term interest rates wouldn’t help much because, unlike in America, Australian households and businesses borrow at the short end. We’ve had plenty of asset-price inflation already.

A lower dollar helps our exporters, but it’s a “beggar-thy-neighbour” policy (inviting others to do the same to us) and, in any case, the dollar is already low enough to make any viable exporter profitable.

When unconventional measures are discussed, some people think of “helicopter money” – governments distributing cash to ordinary punters, from a metaphorical helicopter. But central bankers insist such a measure is not monetary policy and would have to come from the government as part of fiscal policy.

If the government covered the cost of the cash by borrowing from the public in the usual way, such a stimulus measure would be quite conventional – a la Kevin Rudd’s 2008 “cash splash” into people’s bank accounts.

If the government simply ordered the Reserve to credit people’s bank accounts, that would be “printing money” and highly unconventional. Again, don’t hold your breath.

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