My great hope for the future of the Reserve Bank of Australia is fading away. Deputy Governor Phil Lowe showed great promise in the early century as he led from below the bank’s push against the Greenspan doctrine of the time. Alas, the independence of thought that characterised that young man appears to have been molded by the bank’s awesome powers of group think into just another broken record pushing Australia further and further into structural imbalances.
Last night, vice-Capt’ Lowe described Australia’s houses and holes economy beautifully while completely overlooking its internal contradictions. That is, that so long as high immigration drives the services economy via rising house prices, Australian competitiveness can’t improve because it inherently relies upon input cost inflation for growth. It can’t therefore prosper in a era when international competition will only intensify on a demand deficit.
To see the resulting hollowing out of goods production and over-reliance upon resource extraction as strong foundations is to completely mistake cause for effect, as well as endeavor for good fortune.
If you’re wondering why Australians don’t invest in production, Mr Lowe, this is it.
Building on Strong Foundations
Philip Lowe*
Deputy GovernorAddress to the Australian Business Economists (ABE) Annual Dinner
Sydney – 25 November 2014Thank you for inviting me back to the Australian Business Economists’ annual dinner. It is an honour for me to be able to speak again in front of so many of Australia’s leading business economists.
Before I turn to my main topic this evening, I would like to pay tribute to one of my predecessors who passed away earlier this month – and that, of course, is John Phillips. John served the Reserve Bank of Australia (RBA) (and before that the Commonwealth Bank) for more than four decades, and between 1987 and 1992 sat in the office that I now occupy. John epitomised the first of the RBA’s core values – that of serving the public interest. He did this with great dedication during his time at the RBA and in his highly distinguished subsequent career. At the RBA, John worked tirelessly to modernise Australia’s financial and monetary system, and to modernise the RBA itself. The institution that I now serve, as well as the broader Australian community, owe him a considerable debt. John will be sorely missed.
When I last spoke at this dinner, two years ago, the title of my remarks was ‘What is Normal?’.[1] My thesis was that as a country, we were going through a difficult adjustment in expectations. Over the decade or so to the late 2000s we had got used to consumption growing more quickly than income. We had also got used to asset prices, credit and fiscal revenues growing more quickly than income. We had got used to employment increasing more rapidly than the working-age population. And we had got used to growth in our real incomes outpacing the rate at which we were improving our productivity.
We started to think that this was normal. Retailers thought it natural that their sales grew more quickly than people’s incomes. Many investors thought that earning capital gains on their existing assets was the key to wealth creation. Banks got used to very fast growth in their balance sheets. And we all got used to the annual tax cuts that came from strong revenue growth.
But these trends were not normal. And so two years ago, my thesis was that the dawning realisation of this was affecting the national psyche.
Two years on, I think we better appreciate the uniqueness of the earlier episode and there has been some realignment in expectations. But I suspect that this realignment is not yet over and it is one of the things that continues to weigh on the national economic mood. Also weighing on this mood is the prospect of the so-called ‘end’ of the mining boom. As a result, I sense a degree of nervousness about our future among some commentators who sometimes ask: what happens to Australia after this boom is over?; how can Australian businesses compete internationally given our high costs?; and, where will the jobs come from in the future?
These are all good questions. But if I return to another theme from two years ago, it is that uncertainty is also normal. Given this, it is important that we guard against the possibility that this uncertainty mutates into chronic pessimism – that is, for it to become normal for us to think that our prospects are limited. If this were to become our normal mindset, then we would be well on the way to finding ourselves in the very world that we feared.
So this evening, I would like to turn my eyes to the future and talk a little about how the economy might look someway down the track. My central thesis tonight is twofold. First, the Australian economy does have the foundations for a successful and prosperous future. And second, how well we take advantage of those foundations depends increasingly on investment not in physical capital, but in human capital.
An Aspiration
So looking forward, what type of economy should we be aspiring to?
One could answer this in many different ways. But I think a reasonable answer would be a highly productive, globally competitive economy that is operating close to, or at, full employment.
Such an economy would be characterised by: a national currency with sustainably high purchasing power; sustainably high real wages; and sustainably high real returns on capital. High purchasing power and high wages mean that for each hour that we work we are able to buy more goods and services. And high returns mean that savers get rewarded when they take a risk or defer their spending and save for the future.
If we are to meet this aspiration then we need to be an economy where value added is high.
We need to be able to produce a range of goods and services very efficiently and/or be able to sell goods and services at a premium price because of their quality, their uniqueness or some other favourable attribute. This is true right across the industry spectrum. It is true in advanced manufacturing. It is true in the tourism industry. It is true in agriculture. And, it is true in the technology sector and in business and household services. In the end, it is unlikely that we can achieve this aspiration by simply selling standardised, homogeneous, mass-produced goods and services on the world market. We need to be at the high value-added end in much of what we do.
And this is why investment in human capital is so important. It is through human capital that we can create the goods and services that can deliver on this aspiration. The quality of our human capital is critical to our ability: to solve complex problems; to develop and use technology; to deliver premium quality goods and services; and to respond quickly and well to an ever-changing world.
So one of the challenges that lies ahead is to create the environment that encourages the investment in human capital that is ultimately required to sustain the high living standards and high returns to savers that we should be aspiring to. I want to return to this challenge in a few moments.
Cyclical Considerations
Before I do, though, it is important to recognise that the exchange rate, wages and the return to saving each also play a key role in how the economy is performing at any point in time.
In terms of the exchange rate, the RBA has been saying for a while now that a lower value of the Australian dollar would be helpful from an overall macroeconomic perspective. If the exchange rate is to play its important stabilising role, it needs to go down when the terms of trade and investment are declining, just as it went up when the terms of trade and investment were rising. To date, as we expected, we have seen some adjustment, but if our assessment of the fundamentals is correct we would expect to see more in time.
In terms of wages, there is sometimes commentary bemoaning their high level in Australia. There are, no doubt, certain areas where wages are very high and working conditions are highly favourable and some adjustment is likely to be required. But it is also useful to recall that over the past two decades or so, aggregate wage outcomes have been consistent with the inflation target and with a trend decline in the unemployment rate. They have also been associated with a fairly low share of wages in national income. While we need to pay close attention to overall labour costs, these observations point to the conclusion that concerns about the overall level of wages in Australia are, to some extent, really concerns about the exchange rate, with the high exchange rate leading to high wages expressed in foreign currency terms. A lower exchange rate would obviously make a difference to these comparisons.
In terms of the return to saving, it is currently very low. As I spoke about last month, this largely reflects global factors.[2] A lack of investment around the world, relative to people’s desire to save, means that savers everywhere are being offered low returns on their savings in bank accounts. This is causing them to look elsewhere, which, in turn, is pushing up the price of existing assets.
So from a cyclical perspective – and largely as a result of global factors – our exchange rate is unusually high and, at the same time, savers are being offered unusually low returns. Of course, Australia is not unique in being in this position. And this particular configuration is causing complications for macroeconomic management here as well as in a number of other countries.
But as we deal with these complications we should not lose sight of the longer-term challenge of building a highly productive, globally competitive economy.
We should have some confidence that we are able to do this. We certainly have a number of strong foundations that provide the basis for this optimism. The question is how well we can use those foundations over the years ahead.
Some Strong Foundations
Rather than go through all of these strong foundations, I would like to draw your attention to just three.
The first is our linkages with the fastest growing part of the world economy – namely Asia.
I am sure you all know the facts about the trade relationship. Exports to Asia are up by around 30 per cent over the past five years. Our three largest export destinations – China, Japan and South Korea – are all in the Asian region and free trade agreements have been concluded with each of them recently.
But the aspect of the relationship that I would like to focus on is the people-to-people relationship.
Currently, around 8 per cent of the Australian population was born in east and south-east Asia or India (Graph 1). This is up from less than 1 per cent of the population around the time that I was born. In comparison, in the United States, only around 3½ per cent of the population was born in Asia and for most European countries the figure is below2 per cent.
Graph 1