MICHAEL KEATING. Economic Update Part 1

Oct 7, 2019

The recent release of the National Accounts data confirms that the Australian economy is stuck in secular economic stagnation. This article argues that current policies are unlikely to restore economic growth sufficiently to allow Australia to realise its economic potential. The fiscal implications of this outlook for economic growth are further explored in a subsequent article to be posted tomorrow.

This week the Reserve Bank reduced the official cash rate to 0.75 per cent: an all time low, and the third such cut in interest rates since the election. Yet at that election – which was only a tad more than three months ago – the Morrison Government was boasting about how strong the economy was, and how only this Government could be trusted with economic management.

Frankly it was obvious even before the election, that the economy was stagnating (see my post in Pearls & Irritations, 1 April). Now the recently released National Accounts show that GDP only increased by 1.4 per cent over the course of the last financial year from June 2018 to June 2019. While employment continued to increase reasonably strongly, this rate of economic stagnation has resulted in productivity actually declining during the last financial year.

Furthermore, 40 per cent of the increase in Australia’s real GDP in 2018-19 was accounted for by the increase in net exports (i.e. exports minus imports). That is a very high proportion, and especially reflects the huge increase in mineral exports. But these, and other Australian exports, are very dependent on the Chinese market. Even in the best of circumstances we cannot afford to rely so much in the future on our economic growth being sustained by China. In addition, the volume of imports actually fell last year, but that mainly reflects the weakness of Australian demand, and accordingly, we equally don’t want to rely on lower imports for our future economic growth.

In its April Budget the Government forecast that in the current financial year, 2019-20, the economy would grow by 2¾ per cent before returning to an even higher 3 per cent growth rate over time. Frankly that forecast was unbelievable then (see my review of the Budget forecasts in Pearls & Irritations, 8 April) and it looks even more preposterous today. It will be interesting to see how the Government reacts in its mid-year economic and financial review, due in December, to the accumulation of data now clearly showing that the Australian economy is stagnating.

So far, however, the Government seems determined not to recognise that it has a problem. In particular, the Government gives no sign that it will introduce any form of fiscal stimulus. Instead, the Government seems determined to protect its forecast Budget surplus, which it has trumpeted as a “success”. Nevertheless, it might be doubted whether that Budget surplus – if it eventuates – is really sustainable if the economy continues to stagnate (see more in a following article to be posted tomorrow).

For its part the Reserve Bank has clearly called for more fiscal support, with an emphasis on more infrastructure investment. The Bank is keenly aware of the limits to what monetary policy on its own can achieve in a low interest rate environment. A view that has recently received support from the former Liberal Treasurer, Peter Costello, who this week also argued that the effectiveness of monetary policy is diminishing as interest rates fall.

The Reserve Bank is properly concerned that Australia’s underlying problem is a shortage of consumer demand, brought about by low wage growth. I doubt, however, whether more infrastructure investment really represents an effective way to stimulate wage growth. First, almost all of the major transport and irrigation projects currently being undertaken or promised never had a proper business case; probably because the proponents knew that they couldn’t show that these investments were in fact economic, even after making generous allowances for external benefits. Second, the lead-times for new infrastructure projects are quite long, and all previous experience is that it is hard to wind them up quickly.

What concerns me most about the Reserve Bank’s proposals, however, is that the underlying assumption in their economic model is that the low wage growth – which has affected most advanced economies for the best part of a decade – is in fact a cyclical phenomenon and not structural. According to the Reserve Bank as unemployment falls, wage growth will return to past norms.

Stephen Bell and I have criticised this model at some length in our book, Fair Share, as I have in previous posts (see for example, Pearls & Irritations, 12 March), and Bell and I have provided a more theoretical critique in an article that will be published in the Australian Economic Review (and which is already available on-line from the publisher). In brief, until recently the Reserve Bank considered that the rate of unemployment consistent with the target rate of inflation was about 5 per cent. Yet, when unemployment fell to 5 per cent in the last year, and wages continued to stagnate, the Bank revised its estimate of the full-employment rate of unemployment down from 5 per cent to 4½ per cent. However, no evidence to support this revision was offered; instead it flows from the assumption in the Bank’s neo-classical growth model that wage stagnation is entirely due to cyclical slack in the labour market.

But this view of the labour market is contradicted by a host of research that shows that the increase in inequality and low wage growth has been largely driven by structural changes. There are debates about the relative importance of the different causes of these structural changes, including the impact of technological change, globalisation, and the loss of power by trade unions to protect workers’ rights. But given the importance of these various structural changes, it is unlikely that wage growth will rise by enough to maintain adequate demand, unless these structural causes of low wage growth are directly addressed.

In sum, my argument is that present policies are most unlikely to lead to an unemployment rate as low as 4½ per cent: wage growth and demand will not be sufficient. But even if, by some miracle, unemployment did fall to as low as 4½ per cent, I strongly doubt that wage growth would have returned to past norms of around 3-3½ per cent.

This means that while a fiscal stimulus is needed, it should focus on protecting and improving the incomes of ordinary households. Tax relief, focused on these households can help, as can increasing the income support to low-income households by raising the amount of Newstart and rental assistance. In the longer run, however, the best way to ensure reasonable wage growth is to assist workers to adapt to the new technologies as they are introduced. A significant increase in spending on education and training is needed, and it must be broad-based, encompassing all phases of education from pre-schools to better opportunities for mid-career adults to return to education and gain new skills. That investment in human capital will do most to improve both Australia’s economic capacity and its aggregate demand. As Thomas PIcketty concluded in his monumental study of inequality:

Knowledge and skill diffusion is the key to overall productivity growth as well as the reduction of inequality within and between countries… To sum up: the best way to reduce wage inequalities in the long run is to invest in education and skills.

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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