Wollongong
I’m sure you’ve heard people talking about “the new normal”. It means that things have changed from the way they used to work, and the change isn’t temporary, it’s permanent. What’s normal has changed. Often it’s implied that the new normal isn’t as good as the old normal. If you translate that from the way ordinary people talk to the way economists speak, it’s saying that the way the economy is working at present isn’t a passing period of “disequilibrium”, it’s the new and lasting “equilibrium”. The change we’ve seen isn’t “cyclical” (temporary) it’s “structural” (lasting).
In the 10 years since the global financial crisis of 2008, which precipitated the Great Recession – the worse recession since the Great Depression of the 1930s – the economies of the developed world, including ours, have been behaving very differently to the way they behaved in earlier decades. The question is: is the world economy still recovering from the financial crisis and the deep recession - is the problem essentially cyclical - so it’s just a matter of waiting until the old normal is restored, or have deeper, longer-lasting, changes in the structure of the economy been at work, meaning the economy will stay the way it is and won’t be returning to the way it used to work?
Now, get this: No one knows the answer to that question. Economists are still arguing about it because it’s too soon to tell. My guess, for what it’s worth, is that it will turn out to have been a bit of both. Some of what we’re seeing at present will turn out to have been temporary – just the recovery from the Great Recession taking a lot longer than we expected – but also that the world we get back to will, to some extent, be different from what we were used to.
But what are these changes we’re seeing in all the developed economies? The first is slower rates of growth in the economy. Part of this slowdown is explained by slower rates of improvement in productivity – the annual improvement in the economy’s efficiency that allows output to grow faster than inputs. Then there’s less inflation pressure, meaning lower rates of inflation, lower nominal interest rates (because the nominal interest rate reflects the real interest rate plus the expected inflation rate) and lower nominal wage increases (because of lower inflation).
The story for Australia is similar to, but somewhat different from, the stories for the US, Canada, Britain, Europe and Japan. So it’s likely that what’s happening in Australia is explained partly by local factors and partly by international factors.
Australia’s story is that, unlike almost all the other developed economies, we escaped a severe recession after the GFC. Not, as many people believe, because of the resources boom, but because of the immediate and liberal application of fiscal and monetary stimulus by the Rudd government and the Reserve Bank. But though we escaped a recession, it remains true that, in only one financial year (2011-12) of the 10 since then has our rate of growth exceeded our long-term average rate of 3.25 pc. All the others have been well below that – most recently about 2.5 pc.
Like the other rich countries, Australia has also experienced a protracted period of low inflation, with the inflation rate being below the Reserve Bank’s inflation target of 2 to 3 pc since the end of 2014. For the past year it’s been just below 2 pc.
The wage price index has been slowing since the end of 2014 and has been about the same as the inflation rate for most of that time. So wages have been keeping up with inflation, but there’s been little or no growth in real wages for about four years. This is so, even though Australia’s rate of improvement in the productivity of labour has been reasonably healthy during the period. Wages used to grow by between 3 and 4 pc a year. There’s no precedent for such a long period of weak wage growth. The consequence of this absence of growth in real wages is, of course, weak growth in household income, and therefor weak growth in consumer spending, which accounts for more than half of GDP. This is true even though households have been reducing their rate of saving, so as to keep their consumption growing.
In recent years, total employment (full-time plus part-time) has been growing by about 200,000 workers a year, but in the last calendar year, 2017, it grew by almost 400,000, or 3.3 pc, with about three-quarters of those jobs being full-time. This is a wonderful performance, which has given a boost to household income and to the budget’s collections of income tax. But how did it happen, when the economy’s growth has been below par?
And there’s another question: this rate of jobs growth is a record for calendar years, so why did it cause the unemployment rate to fall only from 5.7 pc to 5.5 pc? Mainly because the participation rate rose by 0.8 to 65.5 pc – a near record rate – as many of the new jobs were taken by people (“discouraged workers”) re-joining the labour force. But the size of the labour force grew strongly also because of a high rate of immigration. So a big increase in the supply of labour was met by a big increase in the demand for labour, meaning only a small fall in unemployment.
But where did that strong demand come from if the growth in the economy wasn’t particularly strong? More than half the growth in jobs came from just two industries: “health and social assistance” in particular, but also construction. This suggests that a lot of the growth may have come from public sector spending, particularly the continuing roll-out of the national disability insurance scheme and from state government spending on infrastructure. A disproportionate share of the jobs went to women, which fits with the disability roll-out.
But how can the weak wage growth be explained? This is one area where we need to remember wages are weak across the developed world, though they are at last strengthening in the US. Another thing to remember is that lower nominal wage growth isn’t a problem to the extent that it’s a product of lower inflation. That is, what matters is the growth rate of real wages. But it’s here that Australian economists have divided between those seeing the weakness as cyclical and temporary and those seeing it as structural and lasting.
The econocrats in the Reserve Bank and Treasury see the problem as temporary; it’s taking a long time, but be patient and wage growth will get back to normal. They note that while our economy escaped the worst of the global financial crisis, the resources boom was a huge shock to the economy (even if a favourable one), so it’s not surprising we – and particularly the WA and Queensland economies – are taking a long time to recover from its ending and the sharp and protracted fall in mining construction activity. The officials say it’s clear that the demand for labour is strengthening, so it can’t be long before this higher demand starts pushing up the price (wages).
On the other side of the debate, some economists argue that globalisation (the greater freedom with which firms can move their businesses to countries were labour in cheaper), digitisation (which is reducing the need for semi-skilled workers) and the deregulation of wage-fixing arrangements have weakened the ability of workers to bargain collectively with employers (via unions) and allowed employers to pay wages lower than otherwise and make higher profits than otherwise.
Budget forecasts for the economy
Although the debate about the causes of the weakness in wage growth is unresolved, the economic forecasts contained in the 2018 budget brought down by Scott Morrison on May 8 make the optimistic assumption that wage growth has already begun to accelerate and will reach the “old normal” of 3.5 pc a year with in three years, 2020-21. Largely as a consequence of this, the economy is expected to accelerate to its medium-term “trend” (“potential”) growth rate of 2.75 pc in last financial year, 2017-18, then reach an above-trend 3 pc this year, 2018-19, and stay there for at least another three years. This will bring unemployment down very slowly to reach the NAIRU (non-accelerating-inflation rate of unemployment) of 5 pc by June 2022. The inflation rate will soon return to 2.5 pc, the centre of the target. Let’s hope this optimism proves justified, but I wouldn’t count on it.
Now let’s turn to how the two arms of macroeconomic management – monetary policy and fiscal policy - have been responding to this story of so-far disappointingly weak growth in wages and GDP.
The monetary policy “framework”
Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.
Recent developments in monetary policy
Because of the five consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. In the two years since then, it has left the rate unchanged – a record period of stability. It’s not hard to see why it has left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy has yet to accelerate and has plenty of unused production capacity, and the rate of unemployment shows no sign of falling below its estimated NAIRU of 5 pc. The RBA governor, Dr Philip Lowe, has said that, though the next move in the cash rate, when it comes, is likely to up, with the economy in its present weak state the Reserve is in no hurry to make that move.
Fiscal policy “framework”
Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Turnbull government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. This means the primary role of discretionary fiscal policy is to achieve “fiscal sustainability” - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.
Recent developments in fiscal policy
Until last financial year, 2017-18, the Coalition government (and the Labor government before it) has seen the growth in the economy being repeatedly less than forecast, meaning the government has made slow progress in returning the budget to surplus and halting the rise in its net debt. Even so, it has focused on the medium-term objective of fiscal sustainability, not the secondary objective of helping monetary policy to get the economy growing faster. The long period of policy stimulus has come almost wholly from lower official interest rates.
In the year to June 30, 2018, however, the underlying cash budget deficit is now expected to be lower than expected this time last year – $18.2 billion, rather than $29.4 billion - thanks mainly to the strong growth in employment (more people earning wages and paying taxes), an improvement in export commodity prices and higher company tax collections for other reasons. Combined with the forecast that the economy will now return to above-trend growth, this means the deficit for this year will be $14.5 billion (0.8 pc of GDP), $7 billion less than expected a year ago. In the following year, 2019-20, a tiny surplus is expected, with ever-larger surpluses in the following two years to 2021-22.
This forecast improvement in the budget balance means that, when expressed as a proportion of GDP, the federal government’s net debt is now expected to peak at 18.6 pc in June 2018, and then fall back to less than 5 pc by June 2029. Again, it will be a great thing if it happens. It also means the budget balance is expect to continue improving despite the budget’s centrepiece, a plan for tax cuts in three stages (July 2018, July 2022 and July 2024) over seven years, with a cumulative cost to the budget of $144 billion over 10 years. This is possible because of plan’s slow start, with its cumulative cost in the first four years being just $14 billion.
Whichever way you measure it, the “stance of fiscal policy” adopted in the budget is too small to be either expansionary or contractionary, and so is neutral. This is true even though the immediate tax cuts could be expected to increase consumer spending.
