Facing a global economic slowdown, the Labor government will need a new strategy to rise to the economic challenges aheadDec 6, 2022
The Albanese Labor Government has had a very good first six months, however the challenges that lie ahead will be much more demanding. The Government needs to articulate its vision of how our social cohesion depends upon creating an Australian society that is caring and with reasonable equality of opportunity as the foundation for why public expenditure and additional tax revenue is necessary.
At the end of six months in government, and with the Parliament having now risen for this year, the Albanese Labor Government can look back on considerable success.
- All the Government’s election promises introduced and at no net cost to the Budget,
- Australia’s international relations re-established on a firmer footing, and most importantly with the Pacific nations, China, and Southeast Asia,
- Major legislation enacted covering climate change, workplace relations and the establishment of an integrity commission,
- A careful and trusted style of government which is prepared to consult.
But as I said of the Budget (see, Pearls & Irritations October 28, 2022), so far so good. The reality is that for the economy in particular, major challenges lie ahead.
The economic outlook
First, the global economy is slowing dramatically. The Russian invasion of Ukraine has resulted in the biggest energy crisis since the 1970s. In addition, China’s Covid lockdowns have substantially impacted this major driver of global economic growth, and the Chinese economy is forecast to slow even further next year.
In the developed OECD countries, inflation is proving persistent. The necessary response of tighter financial conditions means that on average OECD growth will be much lower next year, with OECD GDP forecast to increase by 0.8 per cent in 2023, compared to 2.8 per cent in 2022.
While that means that the OECD as a whole is expected to avoid a recession, that is not true of many member countries, and Britain is probably already in a recession.
Naturally, this downturn in the economic outlook is impacting Australia. The latest Reserve Bank (RBA) forecast is for GDP growth to be 3 per cent over 2022 and then 1½ per cent over 2023 and 2024.
Although the Australian economy is generally performing better than most other developed economies which are members of the OECD, looking ahead the Albanese Government does face three major economic policy challenges:
- Living standards
- The prospective Budget deficit
The Government is expected to introduce a cap on energy prices which have been a prime source of the surge in inflation. The principal responsibility, however, for bringing inflation back down lies with the Reserve Bank.
The Reserve Bank has increased its cash rate from 0.1 per cent at the beginning of May to 2.85 per cent in November, and probably 3.1 per cent at the end of the year. Market expectations seem to be that the increase in the RBA cash rate will top out at around 3.6 per cent in the first few months of next year.
By then inflation in Australia is expected to be coming down after peaking at around 8 per cent at the end of this year. Indeed, the latest monthly figure for October shows annual inflation of only 6.9 per cent, down from 7.3 per cent for the year ending in September, giving some hope that inflation may be a little more constrained than expected.
A crucial factor in first constraining and then getting the inflation rate back down to the RBA target of 2-3 per cent is future wage increases.
Despite the employers’ campaign against the Government’s new legislation supporting multi-employer bargaining this is unlikely to lead to a wage breakout. Rather the main impact of this legislation will largely be confined to a relatively small group of low-paid workers, mostly women.
Aggregate wage growth will continue to be muted by the multi-year duration of many wage agreements in both the public and private sectors. And most importantly, expectations about future price and wage increases do not seem to have risen much, if at all.
After allowing for these various factors, the RBA is forecasting that the rate of wage increase will pick up to around 3¾ per cent by mid-2023 and 4 per cent by mid-2024. According to the RBA, that would be consistent with an annual household inflation rate of 6¼ per cent in mid-2023, and 4¼ per cent in mid-2024, falling to 3¼ per cent by the end of 2024.
As people will remember, Labor campaigned heavily on living standards during the last election campaign. But what will also be obvious is that the above forecasts for prices and wages mean that living standards will continue to fall before stabilising in the second half of 2024 – thus a wait of another two years before real wages start to rise and living standards begin to recover.
Furthermore, it is difficult to see what Labor can do to change this further fall in livings standards. The Government can reduce the impact of energy prices by capping them, but beyond that there is not much more that the Government can do.
Encouraging faster wage growth would jeopardise the critical goal of bringing inflation back down to its target range. Equally, subsidising households’ expenditure is likely to add to demand and increase inflation. At most any subsidies would need to be limited to the most needy, such as an increase in the rate of assistance to people who are unemployed or renting their homes.
A critical policy constraint is that additional inflation would put more upward pressure on interest rates, and the average home mortgage rate has already jumped from 2 per cent to about 5.5 to 6 per cent, with probably more to come.
The impact of these interest rate rises on living standards was modelled in October by the RBA which estimated indebted households’ remaining spare cash flows after they have met their loan repayments and essential living expenses. The key conclusion is that just over half of these borrowers would see their spare cash flows decline by more than 20 per cent over the next couple of years, including around 15 per cent whose spare cash flows would turn negative.
This of course represents a major decline in many household living standards, although some will be able to maintain their spending on essentials by drawing down their savings and/or reducing their non-essential expenditure. However, new first homeowners with a high mortgage are typically younger households and have only limited discretionary non-essential expenditure and other savings to draw down. While for those who cannot afford to buy a home, their rents are currently increasing by 10 per cent a year, again much faster than their incomes.
The prospective Budget deficit
The Government is projecting continuing Budget deficits of around 2 per cent of GDP every year over the next decade. At the same time, these forecasts presume that unemployment will remain very low.
In other words, the economic strategy presumes that the economy will remain at full employment with little or no spare capacity. Skill shortages will likely continue despite the Government’s increases in training and migration, although both will help.
In these circumstances the Budget should be at least balanced and likely running a small surplus, rather than continuing deficits. Indeed, as long as these deficits continue there will be tension with the RBA’s monetary policy which is attempting to bring inflation back down. Thus, interest rates will be higher than otherwise necessary with consequently lower living standards for new home buyers with large mortgages.
In the next Budget the Government should address this continuing fiscal problem. And basically, there are two ways – reductions in expenditure or increases in taxation.
I have written extensively about this choice in the past (see Pearls and Irritations, October, 22, 28 and November 8), but in brief, cutting expenditures by the 2 per cent of GDP required to restore the budget balance is not realistic. It would damage too many necessary government services and assistance. Indeed, it will be difficult to resist spending more on some forms of assistance and services, such as health and education, if they can be paid for.
That means that the Government really needs to get public acceptance of the need for higher taxation. Australia’s rates of taxation are almost the lowest of any liberal democracy and an increase can certainly be afforded without damage to the economy. Rather the economy would be assisted if additional revenue is spent on supporting innovation and education.
But this means that the Government needs to get out there and start changing the debate. The longer the Government leaves this important discussion, the more difficult it will be to fix the budget and advance overall well-being.
The Government may well feel that it has been well served by its so-called “small target” political strategy. But given the major challenges that lie ahead that strategy will no longer suffice.
The Government needs to articulate its vision of how our social cohesion depends upon creating an Australian society that is caring and with reasonable equality of opportunity. This vision is the foundation for explaining why public expenditure is critical and why additional tax revenue is therefore necessary so the government can play its part in bringing inflation down, while gradually lifting living standards and providing the services that the people and the economy require.