MICHAEL KEATING. The True State of the Economy

Apr 1, 2019

As usual the state of the economy and its management are likely to play a central role in the forthcoming election. With the election now only six weeks away and the Budget tomorrow, it is timely to consider the true state of the economy and its management. 

To the extent that Scott Morrison is prepared to depart from a scare campaign in the forthcoming election, it seems that he will rely heavily on his claim that the economy is strong – thanks to his government’s good economic management. Furthermore, the main proof offered in support of this claim will be that the Budget has apparently returned to a surplus.

But as I will show below this Government has ‘form’ when it comes to over-claiming in its economic forecasts and its role in achieving those forecasts.

The reality is that the economy is not performing nearly as well as Morrison would have us believe, nor indeed as well as was projected this time last year in the 2018 Budget. In the first half of this current financial year, the economy only increased in real terms at an annual rate of ¾ of a percentage point; hence the widely publicised decline in per capita GDP. Unless the next six months sees an acceleration, then economic growth for the whole of 2018-19 will not be much more than one percent. This compares with the forecast in the last Budget of 3 per cent and is way below the economy’s potential growth rate which is generally estimated to be around 2½ to 2¾ per cent each year.

Only a very brazen salesman could ever dream of calling this a ‘success’.

In addition, while the Budget will probably show a fiscal surplus for 2018-19 – this time better than projected – that surplus owes nothing to the Government’s economic management. Instead, the improvement in the fiscal position is entirely due to an unexpected and fortuitous surge in government revenue flowing from much stronger mineral and resource prices than expected.

Indeed, as I showed in my review of the Government’s last Mid-Year Economic and Fiscal Outlook Statement (see Pearls & Irritations, 18 December 2018), the Government could have achieved a much bigger surplus more quickly if it had not made so many new policy decisions to spend and cut taxes. Even at that time the total fiscal cost of these new policy decisions added up to an extra $32 billion over the four years ending in 2021-22. So much for careful and responsible fiscal management!

What is of even more concern is that this revenue bonanza cannot be expected to last. The economic outlook for the rest of the world on which Australia depends for its export sales is weakening. Interest rate cuts are now expected in many developed countries, and long-term rates are now lower than short-term rates, which in the past has typically preceded a recession. Trump threatening a trade-war and Brexit are also not helping. While, our most important trading partner, China, is continuing to experience difficulties in adapting to a new and different growth model, that relies more on consumption and less on domestic investment and exports to support aggregate demand.

This soft outlook for the world economy does not augur well for our future exports. The Department of Industry, in its latest Resources and Energy Report forecasts that Australian resource export earnings will rise by 22.1 per cent in 2018-19 to a new record $278 billion. But 2019-20 is forecast to see resource export values drop by 2.2 per cent and to fall a little further over the following four years.

Of course, this drop in resource exports will impact future government revenue, which must therefore be expected to rise much more slowly in future. Indeed, unless the next government tightens its spending or takes positive steps to raise more revenue – as Labor is proposing – it seems most unlikely that the forecast fiscal surplus can continue.

The Government has capped revenue at 23.9 per cent of GDP – a figure that is likely to be reached soon. After that revenue will rise with GDP. On the other hand, the Morrison Government’s budget management over the last three has resulted in Budget outlays increasing at an average annual rate of 4½ per cent. That means that sustained budget surpluses would require more spending restraint than this Government has so far been capable of, or that nominal GDP grows faster than 4½ per cent a year in future.

Frankly that rate of economic growth looks doubtful. It would certainly require faster growth in nominal GDP than Australia has experienced over the last five years when the Coalition has been in government. As already discussed, however, resource exports are likely to stagnate in the next year or so, but this is not the only factor slowing future Australian economic growth. In the last couple of years, the Australian economy has been heavily supported by residential construction and public works, but residential construction is slowing. In addition, falling house prices will probably slow consumption spending. As in other countries our central bank, the RBA, now considers that because of the deteriorating economic outlook, an interest rate cut is as likely as another interest rate hike, while the market is already pricing in one or more cuts this year.

As the RBA has itself made clear, ‘the real crisis is slow wage growth’ and how this is impacting on aggregate demand. The reality is that wages are not just a cost, they are also an income. In particular, low-income earners rely on their wages to support their consumption and in addition, these low-income earners have a high propensity to consume. They thus make an outsize contribution to maintaining aggregate demand.

Until wage growth and aggregate demand improves, investment is likely to stagnate, which will in turn restrain the technological progress that underpins productivity growth.

In fact, in the last six months labour productivity in Australia actually fell, and in the two previous years it only grew very slowly at an average annual rate of ½ per cent. This a pathetic result for a government that the Government actually forecast an increase of 1½ per cent in its last Budget and wants to campaign on its record of economic management. In fairness, however, low productivity growth is not a problem that is unique to Australia – many advanced economies are also experiencing the same problem.

One common response in Australia has been to call for more microeconomic reform, but productivity is mostly driven by technological progress, and it is hard to see why that should have declined. Instead, the obvious answer to why productivity growth is low is that it requires investment to actually realise technological progress, and sufficient investment is unlikely to be forthcoming as long as wages and therefore aggregate demand continue to stagnate.

What is of concern, therefore, is that the latest data available indicate that real wages are only increasing at around an annual rate of 1 per cent. This is in line with the Government’s forecasts in the 2018-19 Budget, but it represents a slower rate of increase than needed if we want to achieve economic growth in line with the economy’s potential.

In short, all the signs point to an economy that is not in great shape, and which is unlikely to reach its potential and sustain that growth rate.

But what is the Government doing about it? The Morrison Government asks us to believe that tax cuts that heavily favour the rich will kick-start the economy, and eventually trickle down to engender a more broad-based economic recovery. Frankly that defies all recent experience.

Finally, against this background of over-optimistic official forecasts and an underperforming economy, there should be more than usual interest in the credibility of the forecasts in the Budget next week. It will also be a test of the Treasury’s mettle. If the Budget forecasts are not deemed realistic, it would support Labor’s decision to give the independent Parliamentary Budget Office this forecasting responsibility in future.

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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