Memo to RBA: If wages growth isn't the problem, what is?

 I can’t help wondering if the Reserve Bank isn’t misreading the economy. And it seems I’m not alone.

When you’re seeking to manage the economy through its ups and downs, it’s critically important to diagnose its problems correctly. If you’ve misread the symptoms, you can make things worse rather than better. Or, for instance, you can single out citizens who had the temerity to borrow heavily to buy their home and subject them to needless punishment.

Last week, several things made me start wondering if the Reserve needs a rethink. The first was a paper by America’s highly regarded Brookings Institution, that I should have got onto in August.

The world’s central banks – including ours – have concluded that this unexpected burst of inflation is explained partly by temporary disruption to the supply of goods caused by the pandemic (and Russia’s attack on Ukraine), and partly by excessive demand following the authorities’ excessive economic stimulus to counter the lockdowns.

Sorry, not true says the Brookings study, which looked at new data.

“The vast majority of the COVID-19 inflation surge is accounted for by supply-linked factors, especially a rise in company [profit] margins that followed severe delivery delays at the height of the pandemic. Demand-linked factors, notably indicators of labour market overheating, play almost no role.

“As a result, the argument that policy stimulus was excessive is weak,” the study says. And, since company profit margins have yet to return to their previous level, this suggests the inflation rate has yet to fall as the effects of the pandemic continue to unwind. If so, the US Federal Reserve may have overtightened.

Now, all that refers to the US economy and may not apply to ours. May not, but I doubt it.

Despite four successive quarters in which the economy’s rate of growth in “aggregate demand” has been very weak, our Reserve is delaying a reduction in interest rates because, it says, the level of demand is still higher than the level of supply. If so, the rate of inflation may not keep falling, or may even start rising.

How does the Reserve know the level of supply is too low? Mainly by looking at the measure of idle capacity in the jobs market – aka the rate of unemployment.

So, when we saw the figures for October last week, and they showed unemployment still stuck at an exceptionally low 4.1 per cent, no higher than it was in January, it wasn’t surprising that many concluded the Reserve wasn’t likely to start cutting the official interest rate until May next year.

But hang on. One good measure of the job market’s ability to supply more labour as required is the “participation rate” – the proportion of the working-age population willing to participate in the paid labour force by either having a job or actively seeking one.

Now, the econocrats have been predicting that the ageing of the population would cause the “part rate” to start falling for at least the past 20 years. But in that time, it has kept going up rather than down, and is now higher than ever. Last week’s figures show it’s risen by a strong 0.5 percentage points to 67.2 per cent over just the past year.

So where’s the evidence the economy’s reached the end of its capacity to supply more workers?

My guess is that all the Reserve’s unaccustomed talk about the level of supply being too low relative to demand is just a way for it to avoid admitting that its judgment about when to start cutting interest rates is still – as it has been for all macroeconomists for the past 40 years – heavily reliant on its calculation of the present NAIRU: the “non-accelerating-inflation rate of unemployment”, which is the lowest the unemployment rate can fall before shortages of labour cause wage inflation to start going back up.

I think the Reserve’s reluctance to cut is driven by its (undisclosed) calculation that the NAIRU is well above 4.1 per cent. But earlier this month, Treasury secretary Dr Steven Kennedy told a parliamentary committee that, though such calculations are “uncertain”, Treasury estimates that the NAIRU is “around 4.25 per cent, close to the current rate of unemployment”.

Another thing we learnt last week was that a key measure of the rate at which wages are rising, the wage price index, rose by 0.8 per cent during the September quarter, causing the annual rate to fall from 4.1 per cent to 3.5 per cent.

According to Adam Boyton and other economists at the ANZ Bank, this caused the six-month annualised rate of wages growth to be unchanged at 3.2 per cent. “Wages growth has slowed across awards, enterprise bargaining agreements and individual agreements, pointing to a broad-based slowdown,” they said.

This – combined with the lack of increase in the rate of unemployment over the past year, and allowing for the delay before what’s happening to unemployment affects wage rates – has led these economists to conclude the NAIRU is closer to 3.75 per cent.

Finally, Westpac chief economist Dr Luci Ellis noted last week that another measure of wages pressure, the cost of labour per unit (which takes account of changes in the productivity of workers), has fallen from an annualised rate of 7 per cent to 3.5 per cent in just the six months to September.

She said that even if the annual improvement in the productivity of labour averages a touch below 1 per cent, which would be worse than our recent performance, annual wages growth averaging 3.2 per cent – as it has for the past three quarters – is “well and truly consistent with inflation averaging 2.5 per cent or below”.

Get what all this says? Ever since the Reserve began raising interest rates in May 2022, it has worried about the possibility of excessive growth in wages keeping inflation above the Reserve’s target zone. In all that time, and particularly now, it’s shown absolutely no sign of doing so. Neither shortages of labour nor the (much reduced) power of the unions has caused a problem.

The Reserve needs to lose its hang-up about wages and think harder about the need to ease the pain on innocent bystanders.

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Why our standard of living will be rising more slowly

You could call it gloom, or call it realism, but the likelihood is the economy will be growing more slowly from now on.

And we’re talking not just the next year or two – where the Reserve Bank’s rapid rise in interest rates means if we don’t go backwards, we’ll have been let off lightly – but the next maybe 40 years.

No one – not even economists – knows what the future holds, of course. But this long-term slowing is the considered guess of the secretary to the Treasury, Dr Steven Kennedy, who this week gave us his summation of the Treasury’s recent intergenerational report, which makes largely mechanical projections – not hard-and-fast forecasts – for the economy over the 40 years to 2063.

 Kennedy says the projections are “illustrative”. A key assumption on which they’re based, that present government policies don’t change, means the projections demonstrate “the longer-term implications of our current path”.

The report’s “aim is to avoid the risks projected … through ongoing improvement and reform of policy settings”.

Even so, I think we’re justified in concluding that the slower growth the report projects is more likely to eventuate than either unchanged or faster growth. That’s because so many of the factors likely to affect our future growth are beyond the government’s control.

The report projects that real gross domestic product – the nation’s total production of goods and services – having grown by an average of 3.1 per cent a year over the past 40 years, will slow to growth of 2.2 per cent a year over the coming 40 years.

How would this slowdown be explained? The Treasury’s standard way of analysing economic growth is to break it up into the three main drivers of growth – known as “the three Ps”: growth in the population, growth in the population’s participation in the labour force, and growth in the productivity of the workforce.

Notice how people-centred this way of chopping up economic growth is?

First. Population. Whereas our population grew at an average rate of 1.4 per cent a year over the past 40 years, it’s projected to grow by just 1.1 per cent over the coming 40.

These days, “natural increase” – births minus deaths – accounts for only about 40 per cent of the growth in our population, with “net overseas migration” accounting for the remaining 60 per cent.

The Treasury projects a further slow decline in our “fertility rate” – the number of births per woman – which has long been well below the 2.1 children “replacement rate” needed to hold the population steady over the years.

So we’ve long used high immigration to keep the population growing. Net migration fell sharply when we closed our borders during the pandemic. It has surged since the borders were reopened, but the Treasury expects it to fall back to 235,000 people a year once the surge has passed.

This level is what the Treasury projects for the rest of the years to 2063 – meaning that fixed number would fall as a percentage of the growing population. Even so, the population is expected to exceed 40 million in the early 2060s.

It’s just a projection, but I don’t have trouble believing immigration levels will decline rather than increase in the coming years. With all the rich countries – and China - having fertility rates well below the replacement rate, I can see far more competition for immigrants than there has been, especially since we only want skilled immigrants.

This expected slowdown in immigration means the overall size of the economy wouldn’t be growing as fast as it has been, but that doesn’t necessarily mean those of us who are already here will be worse off. That depends less on the economy’s overall growth and more in what’s happening to growth in GDP per person.

The report projects that, whereas real GDP per person grew by 1.8 per cent a year on average over the past 40 years, it will slow to 1.1 per cent a year over the coming 40.

Ahh. So, not just slower growth in the economy, but a much slower rate of improvement in our material standard of living. We’d still be getting more prosperous, but at a rate so small that it would be hard to notice.

And the problem must be coming from the other two Ps – participation and productivity improvement.

At present, the “participation rate” – the proportion of the working-age population that’s either in work or actively seeking it – is the highest it’s ever been, at 66.6 per cent, but the Treasury projects it will have fallen to 63.8 per cent by 2063.

Why? Because the proportion of the population aged 65 and over is projected to rise from 17 per cent to 23 per cent. So population ageing means more people will be too old to work.

But this will be countered to an unknown extent by more women of working age taking paid employment, and a healthier post-65 population choosing to keep working, even if only a few days a week.

However, most of the slowdown in GDP growth per person is explained by the expectation that the rate of improvement in the productivity of labour will be slower.

Whereas productivity improved at an average rate of 1.5 per cent a year over the past 30 years, it’s improved by only 1.2 per cent a year over the past 20 years – and that’s the rate the Treasury has projected over the coming 40 years.

There are plenty of reasons to expect productivity improvement will become harder to achieve. Just one is the greater share of GDP coming from the provision of labour-intensive services and the lesser share from the capital-intensive production of goods. It’s a lot easier to make machines more productive than do the same for people.

Finally, another reason for expecting population, participation and productivity to be weaker in coming decades is that various other rich countries’ experience is leading them to expect the same.

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Workforce participation a key for Turnbull's new plan

Now it's likely the Turnbull government will scrape back to office, what's next? What will it do to improve our economic prospects?

Malcolm Turnbull went to the election offering a "national plan for jobs and growth" that was supposed to secure our future.

Trouble is, it now looks unlikely he'll be able to implement the centrepiece of that plan, the phased reduction over 10 years of the rate of company tax, from 30 per cent to 25 per cent.

Unsurprisingly, the proposed cut in company tax did not impress the voters, who think companies are paying too little tax, not too much.

Labor opposed the cut, save for the immediate reduction to 27.5 per cent for genuinely small business.

With the government now facing an even more hostile Senate, it's unlikely Turnbull will get any more than that.

This would be no great loss in the quest for jobs and growth. The government's own modelling suggested the tax cut would do virtually nothing to create jobs, and the boost to growth in Australians' incomes would be tiny and come only after a decade or three.

But what about the other parts of Turnbull's "five-point plan"? It's a muddle of things that will be done, things already done and a point saying what the plan will achieve.

Point one is "an innovation and science program bringing Australian ideas to market". Already done; benefits likely to be modest.

Point two is "a new defence industry plan that will secure an advanced defence manufacturing industry in Australia". Or a highly protectionist and costly way of buying votes in South Australia, of debatable defence value.

Point three is "export trade deals that will generate more than 19,000 export opportunities". This refers to preferential trade deals already made with Japan, Korea and China.

As my colleague Peter Martin has demonstrated, this is one of the big lies of the campaign. Such trade deals usually add more to our imports than our exports (which, of itself, is no bad thing).

Point four is the company tax cut and point five is "a strong new economy with more than 200,000 jobs to be created in 2016-17". This is just Treasury's budget forecast for growth in employment. Few of those extra jobs would have been "created" by anything the government did.

Get it? The "plan for jobs and growth" is a (now-thwarted) plan to cut company tax, plus a lot of packaging. That is, Malcolm Turnbull has no plan.

And, as we've been reminded by noises coming from one of the credit rating agencies, nor does he have a plan to get the government's budget back to surplus anytime soon.

His projection of that happening in 2020-21 relies heavily on a host of forecasts and assumptions.

Many people conflate the need for action to get the budget back to surplus with the need for "reform" to hasten our rate of productivity improvement and economic growth.

The two are related, of course, but they're not the same thing and we should consider them separately.

Remember that whereas productivity improvement is what you could call a "positive" objective, leaving us clearly better off materially, fixing the budget is a "negative" objective – it would just reduce the risk of problems down the track.

Obviously the longer we take to get back to balance, the more our interest bill grows. If this arises from borrowing to cover recurrent spending at a time when the economy is back to growing at about its trend rate, this is a bad thing.

However, if the borrowing is needed to cover spending on infrastructure (as you discover is largely the case when you study the information buried on page 6.17 of the budget papers) this is no cause for concern – provided the money hasn't been spent wastefully.

The cost of any credit rating downgrade is overrated, but it is true that, if we've got the budget back to surplus by the time we're hit by the next recession, we'll feel freer to respond as we should: allowing the downturn to push us back into deficit and adding temporary stimulus spending on the top.

Getting the budget back to surplus will do nothing to create "jobs and growth". Indeed, if you go about it the wrong way, it could come at the expense of jobs and growth.

A lesser-known point is that improvements in our productivity performance do little to improve the budget balance.

That's because it does about as much to increase government spending (directly and indirectly) on public sector wages and wage-indexed welfare payments, as it does to increase economy-wide wages and profits and, hence, tax collections.

As he casts about for a real plan to implement in the coming term, Turnbull should remember the thing that does help both the budget and Jobson Grothe: increased participation in the workforce.

This truth was lost when Turnbull was led astray by the rent-seeking of the Liberals' generous big business supporters and their obsession with cutting their own taxes in the name of "reform".

So one obvious place for Turnbull to start is with women. The Abbott government made a good start with the reform of childcare subsidies, but this has been blocked in the Senate because of the insistence on linking it with a crazy attempt to save money on paid parental leave in a way that would discourage employers from offering paid leave at their own expense.

The government should ensure that lack of available childcare isn't limiting young mothers' participation and continuing progress in their careers.

It could do much more to reduce the amazingly high effective marginal tax rates that discourage "secondary earners" (aka married mothers) from moving from part-time to full-time.

And then it could take a more careful run at winning public support for raising the age pension age to 70. We can get on with a slow phase-in, or wait until it's unavoidable.

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