MICHAEL KEATING. Continuing economic stagnation

Mar 6, 2020

Wednesday’s release of the national accounts for the December quarter reported better economic growth than many of the pundits feared. But there is no cause for celebration.

The economy is stuck in a rut, the impact of the bushfires and coronavirus are still to come, and the Government has no real idea about how to restore the economy’s long-term health.

The key economic aggregates

The Treasurer Josh Frydenberg welcomed the December quarter’s national accounts as representing further proof of the strength of the Australian economy. Frankly I wonder who does he think he is kidding?

The (unadorned) reality is that in the last December quarter, real GDP grew by 0.5 per cent, and by 2.2 per cent over the course of 2019. This was a bit of an improvement on the 1.8 per cent rate of economic growth recorded over the previous 12 months ending in September, but way below the average annual rates of economic growth recorded in the past. By comparison, real GDP used to grow much faster: at an average annual rate of 3.9 per cent in the 1990s, and by 3.0 per cent from 2001 to 2016, but over the last three years economic growth has slipped and only averaged an annual rate of 2.3 per cent (Table 1).

Instead, the only area of economic strength is job growth, which as the Government never ceases to remind us, has been reasonably strong. However, much of that job growth has been part-time, and labour underutilisation has risen.

As I discussed in a previous article, “How good is the labour market” (P&I, 27 February, 2020), over the life of the Coalition Government, total employment has increased at an average annual rate of 2.0 per cent, but the total hours worked increased at not much more than half that rate, at an average annual rate of only 1.1 per cent. In the last three years, however, the increase in hours worked has been stronger – averaging 2.2 per cent between the December quarter 2016 and the December quarter 2019.

Unfortunately, the counterpart of this stronger growth in labour inputs and weak growth in GDP is that productivity growth has declined. Indeed, over the three years from the December quarter 2016 to the December quarter 2019, there was no net increase in labour productivity, as measured by GDP per hour worked (Table 1).

 How to lift productivity growth

A critical issue for economic policy is therefore why is productivity growth so weak, and what can be done about it? Many of the pundits respond by calling for more microeconomic or structural reforms. Others, including the Governor of the Reserve Bank, have pressed for more infrastructure investment.

Frankly I am a sceptic. It is not that I am against sensible microeconomic reforms nor sensible infrastructure investment, but I think their impact on productivity is likely to be much more limited than is often supposed.

Thus, in the last comprehensive report by the Productivity Commission, Shifting the Dial, which discusses how to improve national productivity, I note many worthwhile proposals for reform. However, I don’t think the Productivity Commission has come anywhere near showing how these proposals to improve the effectiveness of education and health expenditures, or to improve the efficiency of our cities and such like, would lift national labour productivity by half a percentage point a year on a sustained basis over time. Even in the heyday of microeconomic reform in the late 1980s and 1990s, the productivity gains were almost entirely one-off gains, and even then they didn’t add up to anything like the present shortfall in the continuing rate of productivity growth.

Equally, the infrastructure lobby is adept at over-promising and over-demanding. As the Grattan Institute has shown, the vast majority of projects approved have never had a proper cost-benefit study, and I think this is almost always because they wouldn’t be supported if subjected to proper evaluation in advance. Thus, in short, assuming present approval processes are maintained, then I think additional infrastructure investment is more likely to lower the productivity of the nation’s capital investment than to improve it.

Instead, the key to increasing labour productivity through history has been private investment by businesses. First, this business investment usually leads to increased capital per worker, and thus directly lifts their productivity. Second, and most importantly, new business investment is the main vehicle for introducing new technologies, and it is the adoption and adaptation to new technologies that has been the principal driver of productivity increases through time.

Business investment

So what has been happening to business investment? The answer is not much. In the last year the volume of business investment actually fell by 1.4 per cent, and it has been relatively weak over the last three years increasing at an annual rate of only 2.5 per cent. Previously when the economy was more buoyant, real business investment used to increase at an annual rate of 5.1 per cent (Table 1).

Furthermore, I would contend that this faster rate of increase in business investment – faster than the growth of GDP – was largely the reason why productivity growth used to be higher.

The weak structure of aggregate demand

The next obvious question is why is business investment so weak? And the answer is essentially because consumer demand has also been weak. Business will not invest in new capacity if they cannot fully utilise their existing capacity – and no matter how low interest rates go.

However, household consumption only grew by 1.2 per cent over the last year; significantly less than the rate of increase in GDP, and much lower than in the past (see Table 1).

As I have argued in numerous articles, the reason why aggregate demand is weak, and especially consumer demand is weak, is because wage growth has been weak. Over the last year, nominal wages only increased by 2.2 per cent – the same rate as averaged over the life of the present Coalition Government since 2012-13.

With consumer prices increasing at an annual average rate of 1.6 per cent over the last six years, and the same over 2019, this means that the annual rate of increase in real wages has only been around half a percent in recent times.

Essentially, household consumption is being propped up by a falling household savings rate. This was as high as 8.1 per cent, back in March 2013, and has steadily fallen ever since to be only 3.6 per cent in the December quarter 2019.

Although households did increase their savings initially in response to the tax cut in the September quarter, the savings rate is back down again, and it is hard to see it falling much further.

In addition, households are not investing either in new dwelling construction. Indeed, the volume of expenditure on new dwelling construction actually fell at an average annual rate of 3.7 per cent between the December quarter 2016 and the same quarter in 2019. Furthermore, this rate of decline is still deteriorating, as over the last four quarters, household expenditure on dwelling construction declined by as much as 9.7 per cent.

Essentially, the Australian economy is being propped up by government spending– State and Commonwealth – and a bit by net exports. But private domestic demand has been very stagnant, and that is before the impact of the bushfires and the coronavirus.

Over the last three years from December 2016 to December 2019, the volume of general government consumption expenditure increased at an average annual rate of 4,6 per cent and their capital expenditure increased at an annual average rate of 9.2 per cent. In both cases, this rate of expenditure increase is much faster than the growth of GDP and is thus helping significantly to prop up aggregate demand.

In addition, the contribution of net exports to aggregate demand is useful, but it remains problematic about how far it can be relied upon in the future. Exports have been aided by the 9.3 per cent fall in the trade-weighted exchange rate over the course of 2019, while imports are being restrained by the weak domestic demand referred to above. But imports will likely grow faster if the economy recovers its past momentum, and we don’t want to rely on further falls in the exchange rate to maintain export growth.

Implications for policy

Given the continuing economic stagnation, and the structural weaknesses in the Australian economy, the advent of the coronavirus must represent a welcome distraction for the Morrison Government.

Instead of addressing the real problems affecting the Australian economy – and most especially the weak wage growth – public discussion has been seized by how economic policy should respond to the impact of the coronavirus.

For the most part, the Morrison Government seems to be handling this immediate, and hopefully short-term, challenge well. We cannot know with any certainty just how long and severe the impact of the coronavirus will be, and therefore its economic impact is at least equally uncertain, and the policy response can be expected to evolve over time.

Already the Reserve Bank has responded with another interest rate cut. Given the public expectations they could hardly have done otherwise, but it is doubtful with interest rates already very low, whether this latest cut will achieve anything much. Asset prices will respond and increase even more, but consumers and businesses are most unlikely to increase their debt. Businesses will not increase their investment until consumer demand improves, and most households with mortgages will maintain their present repayments and thus lower their debt faster, rather than spend their small savings from lower interest rates.

Thankfully, the Government has recognised that fiscal policy must play the main role in responding to the cashflow problems that will emanate from the downturn in business from both the bushfires and the coronavirus. Given the inevitable uncertainty, as I said, this fiscal response should be flexible and evolve in response to circumstances as they emerge.

But my real concern about this Government remains: they continue to kid themselves that the economy is performing well, and they have no real plan to revive it from its present stagnation. As shadow Treasurer Jim Chalmers said: “The government should stop pretending that weakness in the economy only just arrived with the outbreak of the coronavirus”.

In addition, it is no good assuming, as the Treasury and the Reserve Bank are wont to, that this stagnation is primarily cyclical. The debate about whether economic recovery will be V- or U-shaped is essentially a second-order issue, as the economy is suffering from severe structural weaknesses as well.

Fundamentally, the Government needs a plan to achieve a sustained improvement in the rate of increase in household incomes, and that means wages in particular. Without such policies, we can expect economic stagnation to continue, and long after the coronavirus has disappeared.

Michael Keating is a former Head of the Departments of Prime Minister & Cabinet, Finance, and Employment & Industrial Relations. He is presently a Visiting Fellow at the Australian National University.

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