A REPORT CARD ON THE AUSTRALIAN ECONOMY June 2011 Ross Gittins, Economics Editor, The Sydney Morning Herald

Website: rossgittins.com When I went to school in the olden days, teachers didnt believe, as they do now, that children should always be patted on the head and told how wonderful they are, for fear of damaging their self-esteem. What teachers believed then was that what every kid needed was a good kick in the pants, to get them working. So my report cards always said, could be better. Right now, we could say that about the Australian economy. But that wouldnt adequately describe its situation and prospects. A better summation would be: will do much better. Temporary weakness Despite all the talk of the return of the resources boom, the economy at present seems surprisingly weak, with real GDP actually contracting by 1.2 per cent in the March quarter. Much of the problem is the short-term effect of the natural disasters in Queensland (and also New Zealand and Japan). In particular, its taken the Queensland coal mines a long time to get all the water out and resume production. But this negative for GDP will soon become a positive as firms work overtime to catch up on lost production and as much money is spent rebuilding houses, roads and other infrastructure. Another reason for the economys present weakness is the slowdown in home building, which seems to have been caused by the gradual tightening in monetary policy. Although mortgage interest rates at present arent particularly high by past standards, the high level of house prices means mortgages are big and monthly mortgage payments represent a high proportion of household income. A third reason for the apparent weakness is the weakness of retail sales as households save a higher proportion of their incomes. But though were always hearing complaints about the economys weakness, there are other signs that its anything but weak. Over the year to April, total employment grew by 280,000 (2.4 per cent), with more than 90 per cent of those jobs full-time. Over the same period the unemployment rate fell by 0.4 percentage points to 4.9 per cent and the participation rate rose by 0.4 points to a near-record 65.7 per cent (all trend figures). And then we have all the effects of the resources boom starting to flow through. This is why, though the government is expecting year-average growth of just 2.25 per cent in the financial year just ending (2010-11), its forecasting growth of a rapid 4 per cent in the new financial year (2011-12), with growth almost as fast the year after. Higher saving and lower CAD One interesting development in the economy is the increase in the rate of household saving, which has gone from negative levels in the early noughties to

about 10 per cent of household disposable income today. This is the highest the household saving rate has been since the 1980s, though even higher rates were normal until then. The saving rate has been recovering since well before the global financial crisis, which suggests there may be more to it than just a shortterm reaction to the crisis and a desire to seek the safety of lower levels of debt. Though some of the rise may be just temporary caution on the part of households, its looking increasingly likely that much of it is structural - a return to more normal attitudes towards saving following a protracted period of reduced saving as households made a one-off adjustment to financial deregulation and the return to low inflation. Its likely much of the saving has been done by people paying higher monthly mortgage payments than their contracts require. You know that another way of looking at the current account deficit is that it represents the amount by which national investment exceeds national saving, thus requiring us to call on the savings of foreigners to make up the difference (the capital account surplus). Household saving is only one of the components of national saving (the others being company saving and government saving), but its clear the increase in household saving has led to an increase in national saving relative to national investment spending. The result is a significant fall in the CAD as a proportion of GDP. For the March quarter it was just 3 per cent (compared with 5 or 6 per cent in recent years). External stimulus from the terms of trade One reason economists are convinced the economys present weakness cant last is their knowledge that, thanks to the return of the resources boom and the extraordinarily high prices China and India are paying for our coal and iron ore, Australias terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - improved by 19 per cent in the year to June 2011 to reach their best level in 140 years. An improvement in our terms of trade represents an increase in the nations real income because the same quantity of exports now buys an increased quantity of imports. In other words, an improvement in the terms of trade is a source of stimulus - external stimulus - to the economy. As this extra income is spent and thus circulates around the economy it adds to domestic demand and creates jobs. An investment-led expansion But the resources boom is adding to demand in a second way: by prompting a huge surged in investment in the construction of new mines and natural gas facilities. The government expects that, after growing by 4.5 per cent in 201011, new business investment will grow by 16 per cent in 2011-12 and by a further 14.5 per cent in 2012-13. Often, the recovery from downturns is led by strong growth in consumer spending. But this time its business investment thats leading the expansion, thanks to the resources boom. This is why the Reserve Bank is pleased rather than worried by the weakness in consumption. To have consumption booming at a time when investment is booming would double the risk of excessive inflation. Much better to have consumption take a breather while investment booms.

Its not a two-speed economy, its three-speed or more Next time you hear someone talking about our two-speed economy, ask yourself how much economics they know. Probably not much. This notion comes from the fact that the improvement in the terms of trade has led to a sharp appreciation of our exchange rate. The exceptionally high exchange rate has reduced the international price competitiveness of our export and import-competing industries, particularly manufacturing, tourism and education. The mining industry is also adversely affected by the appreciation, but this has been more than offset by the higher prices its getting. Its a similar story for agriculture, which has also been enjoying high prices of late. So the two-speed economy argument is saying that mining is growing rapidly, but manufacturing and other export and import competing industries are doing it tough and so are growing only slowly. Its undoubtedly true that manufacturing, tourism and education are doing it tough. So whats wrong with the twospeed/fast and slow economy notion? Just that it ignores about three-quarters of the economy. It focuses on the tradeables sector (the part of the economy producing goods or services capable of being traded internationally) and ignores the non-tradeables sector (the part of the economy producing goods and services that arent capable of being traded internationally) which includes most of the services sector and accounts for about three-quarters of the economy. How are these industries affected by the resources boom and the high dollar? They arent affected directly, but they do benefit indirectly because some of the income from the improved terms of trade comes to them via the circular flow and also because the imported capital equipment and intermediate goods they buy are cheaper. So the non-tradeables sector should grow at a speed somewhere between the fast growing miners and the slow growing manufacturers and services exporters. Limited spare capacity All this may sound like pretty good news for the economy, but the macro managers have one big worry: with the unemployment rate already below 5 per cent the economy is close to full employment, as determined by the nonaccelerating-inflation rate of unemployment (NAIRU), which macro economists lies between 4 and 5 per cent. That is, they fear that should unemployment go much lower, shortages of labour could lead to excessive wage growth and rising inflation pressure. To minimise this risk, the macro managers have been trying to slow the prospective growth in demand somewhat by tightening the stances of both monetary policy and fiscal policy. Monetary policy Monetary policy is the primary policy arm used to achieve internal balance - low inflation and low unemployment - which implies a relatively stable rate of economic growth. It is conducted by the Reserve Bank independent of the elected government and in accordance with its inflation target, to hold the inflation rate between 2 and 3 per cent, on average over the cycle. The primary

instrument of monetary policy is the overnight cash rate - also known as the official interest rate - which is manipulated by means of open market operations. The Reserve Bank slashed the cash rate to 3 per cent when it feared the global financial crisis would cause Australia to go into recession. But once it realised how mild the recession was going to be it quickly returned the cash rate to more normal levels. Between October 2009 and May 2010 it increased the cash rate to 4.5 per cent in six steps of 0.25 percentage points, thus returning the stance of policy to neutral. In November last year it raised the rate to 4.75 per cent a level which, combined with the banks extra increase in mortgage interest rates, it now describes as mildly contractionary. The Reserve has made it clear it expects to have to raise interest rates a fair bit further to ensure inflation stays within its target zone. The next rise could come soon. Fiscal policy Fiscal policy - the manipulation of taxation and government spending to influence the economy - serves as a backup to monetary policy in the pursuit of internal balance. The Gillard Governments medium-term fiscal strategy is to achieve budget surpluses, on average, over the medium term. This years budget included a large number of savings measures intended to ensure the budget balance is returned to surplus by 2012-13, as Julia Gillard promised in the election campaign. Wayne Swan is expecting an underlying cash budget deficit of $49.4 billion (equivalent to minus 3.6 per cent of GDP) in the financial year just ending, falling to a deficit of $22.6 billion (minus 1.5 per cent) in the coming financial year and turning into a surplus of $3.5 billion (plus 0.2 per cent) in the following year, 2012-13. So this means an expected improvement in the budget balance of 2.1 per cent of GDP in the coming financial year and a further improvement of 1.7 per cent the following year. This leaves no doubt that the intended stance of fiscal policy is highly contractionary. In the macro managers efforts to reduce inflation pressure, the tighter they make fiscal policy, the less the need to tighten monetary policy, raising interest rates and adding to the upward pressure on the exchange rate. This is unlikely to eliminate the need for further rises in rates, but it should mean fewer rises than there would otherwise have been.