Pearls and Irritations

Today I address (i) how best to support aggregate demand, and (ii) how quickly to restore budget balance. In Part 1 of this article yesterday I concluded that these are the two key issues for future economic policy.

As we emerge from the Covid-19 pandemic policy is now starting to consider future economic policy settings. As I reported in yesterday’s  MICHAEL KEATING. Economic Policy post Covid-19. Part 1. ,the Prime Minister has already conceded that new policy settings will be needed, but he seems to interpret this as requiring a more business-friendly policy agenda going forward.

Instead, I argued that the reason for the poor economic performance of the Australian economy (and most other advanced economies) was the slow growth in aggregate demand, caused by increasing inequality and low household income growth.

Accordingly, in Part 2 of this article, today, I will discuss the two key issues for future economic policy, which are:

· how best to support aggregate demand in future, and

· how quickly to restore budget balance.

Aggregate Demand

As discussed in Part 1 yesterday, the weakness in aggregate demand that the Australian economy has been experiencing for several years is primarily driven by the stagnation of household disposable incomes. And this stagnation in household incomes primarily reflects the low rate of wage growth and rising inequality.

Accordingly, the key to better economic performance is to accelerate the rate of increase in household incomes. Of course, the tax-transfer system can play a role here, especially for those who cannot support themselves.

Indeed, it is inconceivable that income support for unemployed people will be halved again when the JobSeeker allowance terminates in a few months’ time. In addition, low-income households who rent their accommodation are much worse off than homeowners, and there is a very good case on equity grounds for increasing the rental allowance and building more social housing.

However, wages account for nearly three quarters of gross household incomes, and therefore it will not be possible to achieve the necessary acceleration in household incomes without a faster rate of average wage growth.

Instinctively, most people when they think of faster wage growth, think in terms of increases in rates of pay. In my view, there is some scope to increase minimum wages, but the risk is that too great an increase would damage employment prospects and thus prove counterproductive.

Instead, we need to address the reasons why wages have stagnated and inequality of earnings has also risen over the last few decades. The studies of the empirical evidence over-whelmingly find that the main cause has been technological change. This is because the automation associated with technological change has mainly impacted middle-level jobs, and the loss of these jobs has automatically changed the distribution of earnings, even without any change to relative rates of pay.

In addition, technological change has often been skill-biased in favour of the more highly skilled and highly paid jobs and that has contributed to changes in pay relativities in some countries, and especially in the US, but less so in Australia. But in Australia, the middle-level jobs that have been lost were historically often the most strongly unionised jobs, spear-heading the unions’ demands for pay increases, and the power of unions to gain wage increases has consequently been reduced across the board.

Of course, globalisation and a cultural shift, associated with financialisation, in favour of much higher remuneration for the most senior executives have also impacted the distribution of earnings. However, the empirical evidence shows that neither of these phenomena are nearly as significant as technological change in their impact on earnings.

This evidence therefore leads to the conclusion that a significant and lasting increase in the rate of wage increase and the distribution of earnings will require a better adaption to technological change, so that we maximise its advantages and minimise its disruptive effects.

We also know that this better adaption to technological change is most dependent on more and better investment in education and training, and especially life-long learning. Thus, as Piketty concluded in his monumental study of inequality:

‘the poor catch up with the rich to the extent that they achieve the same level of technological know-how, skill and education, not by becoming the property of the wealthy. The diffusion of knowledge is not like manna from heaven: it is often hastened by international openness and trade.’ (2014:71)

‘To sum up: the best way to increase wages and reduce inequalities in the long run is to invest in education and skills.’ (2014:313).

Furthermore, it is technological change that has driven the increase in productivity ever since the industrial revolution. Therefore, improving the ability of people to adopt and adapt to new technologies not only represents the best way to increase aggregate demand, it is also the best way to increase productivity.

However, the funding for vocational education and training (VET) has been cut, and universities also are going to need a new funding model now that they can no longer depend upon overseas students.

In sum, the demands on the budget will have to increase if the government is to adequately support the future growth of household incomes and achieve the growth in aggregate demand required to restore and sustain Australia’s future rate of economic growth. This will of course require more revenue over time, and how that might best be raised will be a major part of the future reform agenda, with the plugging of tax loopholes being the best place to start in my opinion.

However, the speed with which extra revenue is needed depends significantly on how quickly the looming budget deficit is reduced, and that is the other key reform issue to be discussed below.

A balanced or surplus budget – how fast?

Until Covid-19 the Morrison government had a slogan, not a policy, and that slogan was ‘debt and deficits’. It is to the credit of the government that it has dropped this fetish about the budget deficit when it most counted after the advent of Covid-19, and adopt Keynesian fiscal policies to stimulate aggregate demand.

But as I argued in my post  on 14 April MICHAEL KEATING. Covid-19 and Future Fiscal Policy the government should be very cautious and not rush back to achieve a balanced budget for the following reasons:

· The economy is likely to remain weak for some years, as households try to restore their budgets, and some businesses will not come back while others will take some time

· Monetary policy can help support the bond market, but with interest rates at rock bottom, monetary policy cannot play much of a role in restoring economic growth – indeed, the RBA now relies heavily on quantitative easing and its main impact is on asset prices, not economic activity.

· Inflation is not likely to be a problem in the foreseeable future, instead Australia has been undershooting the RBA’s inflation target for some years, and that will continue.

· Australia, which is starting from a relatively good position, will not have a problem in financing the likely increase in public debt. Australia’s debt will still be lower than in just about all other countries.

· Accordingly, the extent to which the budget is tightened over time should be based on an assessment of when investment has picked up sufficiently to outpace domestic savings, and aggregate demand risks exceeding aggregate supply.

· Indeed, premature tightening of the budget risks lower economic growth and would thus prove counterproductive.

Conclusion

The Prime Minister is right, the restoration of the Australian economy will require changes to the past economic policy settings. But that should not result in a business-oriented policy agenda.

Instead, future economic growth depends most importantly on increased aggregate demand, and that requires faster growth in household incomes. This in turn will best be achieved by investing in human capital so that Australia can foster technological change and adopt and adapt to new technologies, although increased income support for those who cannot work would also help.

This strategy will require greater government intervention and revenue, and how best to obtain the necessary increase in revenue should be the prime focus of tax reform. In addition, with monetary policy reduced to a supporting role, the government does not need to nor should it reduce the budget deficit any faster than is consistent with maintaining a proper balance between supply and demand.

Reference

Piketty, T., 2014, Capital in the Twenty-First Century, Harvard University Press, Cambridge, MA.

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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