The disappointing Philip Lowe

Yesterday’s set of RBA speeches were very disappointing. They confirmed that Australia will plod down the same weary path of financial repression that the rest of the Western world is so enjoying.

But they were disappointing for a second reason. The major speech of the day was delivered by Deputy Governor Philip Lowe, heir apparent to Glenn Stevens, who is considered a smart operator and capable of thinking outside of the box. Yet his speech more than any other I can remember entrenched the orthodox thinking and denial of Australia’s current elite that our economic model is balanced and without risks. This was very disappointing indeed. From the speech:

I would like to begin this morning by briefly summarising the broad economic outcomes in Australia since I first spoke at this Forum in March 2010.

Since that time, output in the Australian economy has increased by 9 per cent. The number of people with jobs has risen by over half a million. The unemployment rate today, at 5.4 per cent, is exactly the same as it was three years ago. And underlying inflation has averaged 2½ per cent over this period, which is the midpoint of the medium-term inflation target.

So over these three years we have seen growth close to trend, a stable and relatively low unemployment rate and inflation at target.

By the standards of most other countries, this represents a very good outcome and a high degree of internal balance. Remarkably, we have achieved this balance despite experiencing the biggest boom in business investment and the largest rise in the terms of trade for over a hundred years (Graph 1). In the past, much smaller investment and terms of trade booms caused outbreaks of inflation and the emergence of other imbalances in the economy. On this occasion this has not happened. The investment boom has not led to a large increase in the current account deficit. There has not been an explosion in credit. Increases in asset prices have generally been contained. And the average level of interest rates has been below the long-term average, despite the very significant additional demand generated by the record levels of investment and the terms of trade.

Graph 1

Graph 1: Business Investment and the Terms of Trade 

Click to view larger

There are a number of factors that are important to understanding how domestic or internal balance has been maintained, with generally low interest rates, despite the very large shocks experienced by the Australian economy. This morning, I would like to focus on just two of these.

The first is the flexible exchange rate.

The high levels of investment and commodity prices have been associated with a high value of the Australian dollar. This has clearly caused some difficulties for parts of our economy, including the manufacturing, tourism and education sectors. But from an overall macroeconomic perspective, the appreciation of the exchange rate has played an important stabilising role.

Had we not experienced the sizeable appreciation over recent years, it is highly likely that the economy would have overheated and that we would have had substantially higher inflation and substantially higher interest rates. This would not have been in the interests of the community at large or, I might add, in the interests of the sectors currently being adversely affected by the high exchange rate. It is also worth adding that, in any case, it is unlikely that we would have avoided a substantial real exchange rate appreciation, with it coming through the more costly route of higher inflation.

I accept that the RBA can only operate with the tools it is given but that does not mean it cannot discuss alternatives. There are any number of macro settings that could have achieved a superior internal balance than the one Phil Lowe admires. For instance, had macroprudential tools been used then the RBA would never have had to fear a blowoff in credit associated with the boom, rates wold have been much lower and the dollar too. We would not have had to embrace Dutch disease as a way of managing surging mining investment. This is only one example. Others might have been used.

Lowe’s internal balance (note it is not “external” balance leaving him an out later on) of course did have its casualties. The major ones being Australia’s non-mining tradable goods sectors: tourism, education, services generally and manufacturing especially. As we know, the last ABS private capex report showed manufacturing investment in outright collapse, running at 1989 levels before inflation adjustment:

This can be viewed as “balanced” so long as you are of the view that China will grow at outsized rates forever and, moreover, that it will do so consuming more and more commodities.  It’s never happened in history and goes against economic theory but you never know.

The truth is it’s a punt and in this context it is hardly fair to describe Australia’s growth as  enjoying “internal balance”. If China does revert to mean, we’ll have nothing but under priced dirt to sell overseas. Balance should surely include some factor of risk and offsetting industrial diversity, no?

So what did Phil Lowe do with the inconvenient truth that the higher dollar is producing a balanced economy? Sadly, he cherry-picked a few rosy statistics about manufacturing successes:

This adjustment in business processes and models is often painful. But the fact that it is occurring is one reason why the Reserve Bank has been tentatively optimistic for some time that productivity growth would pick-up from the low rates experienced over much of the previous decade. We are now seeing some tentative evidence of this in the aggregate productivity data (Graph 2). While these data tend to be volatile from year to year and subject to sizeable revisions, productivity growth in 2012 was better than it has been for quite some time. Of course, we cannot be sure that this will continue, but the structural changes that are now occurring mean that there are reasonable prospects for a sustained lift in productivity growth.

Graph 2

Graph 2: All Industries Labour Productivity Growth 

Click to view larger

We can also see evidence of adjustment in the detailed industry data, including in the manufacturing sector. While there has been little net growth in either aggregate output or exports from the manufacturing sector for some years, some parts of the industry have done quite well. Output of machinery and equipment and of metals have both trended higher over recent years, and exports of specialised mining-related and other machinery have increased, as have exports in some other categories (Graph 3). Many of these are areas where Australia does have a comparative advantage and where value added is high. It is by focusing on these comparative advantages that we can best build a strong and successful manufacturing sector, while at the same time living with a high exchange rate.

Graph 3

Graph 3: Manufacturing Production and Exports 

Click to view larger

I don’t disagree that the high dollar will be making some manufacturing, and tradables broadly, more competitive. But there is plenty of research floating around that illustrates that Australia’s productivity issues stem much more from services and other non-tradable sectors as well as the flaccid mud slide of mining capital operating in fringe projects. The collapse in manufacturing investment is, in fact, a gigantic thumb in the eye for prattle about rebounding manufacturing productivity. Capital investment drives the vast majority of productivity gains in business and especially in manufacturing so if its collapsing then where can the rebound be coming from?

The corollary of the orthodox view is, of course, that because China will build stuff forever, there is no need to worry about tradables diversity nor, for that matter, savings and consumption. If the windfall gains from Chinese uber-growth are permanent then, hey, let’s leverage it up and party, which Lowe also endorsed yesterday:

The one notable exception to the expected responses following a substantial easing of monetary policy is that there has been little movement in the exchange rate. However, this reflects the global factors that I talked about earlier, and the Reserve Bank has attempted to calibrate the setting of monetary policy to take account of this.

Now, if the monetary transmission mechanism works broadly as it has in the past, then an improvement in consumer sentiment and higher asset prices should feed through, in time, to higher spending by households. There are some signs, albeit still tentative, that this is beginning to occur. ABS data and the Bank’s liaison suggest slightly firmer retail spending over recent months than over the second part of last year, though conditions remain mixed across the industry. There are also signs of a pick-up in the forward indicators for new dwelling construction across many areas of the country. In addition, a number of labour market indicators, after having softened last year, have had a slightly firmer tone of late.

Another critical element in the monetary transmission process is a pick-up in private business investment. This is often the last link in the chain, and typically follows increased confidence and higher spending. Given the nature of the investment boom we are currently experiencing, it is non-mining investment where we are looking for this pick-up to occur. As mining investment inevitably peaks and then gradually declines, a critical question for the outlook is the strength of this expected pick-up in non-mining investment.

It is ironic is it not that the RBA is cutting interest rates because the mining boom is ending much sooner than it expected, not because it got it right? This is happening  because China has begun to transform towards a new model of growth that is less commodity intensive. Yet Phil Lowe’s speech is busy praising a macroeconomic course that embraces dirt exports, asset inflation and consumption over export diversity and saving.

Th next Governor earned his reputation in part by ignoring orthodoxy when he wrote seminal papers on asset bubbles well in advance of the GFC. Mr Lowe should go back to the future.

David Llewellyn-Smith
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Comments

  1. Perhaps if Phil Lowe wants the Top Job, rocking the boat at this stage isn’t the ting to do? It’s what he does, after, that counts….

  2. It is interesting that the wealthy bankers with their guaranteed public incomes never never address the issue that this cheap money has shocking side-effects for the rest of the community as it flows down the path of least resistance and into the river of poorly regulated residential property speculation.

    The very factor that brought the global economy to its knees last time (and may well do so again http://www.acting-man.com/?p=22209 on the rise of a new variant of residential property securitisation) doesn’t seem to get a mention.

    This can only be about status quo – about a banking system that owns our political system and doesn’t give two sh*ts about the carnage they cause.

    I’m more and more inclined to the view that these are dangerous and greedy men.

    • It has really good side effects for about 65% of Australian families by giving them a good return on equity, particularly those young, highly geared owners.

      With 10% equity a 20% rise in house prices is a 200% return on equity.
      Older people with less debt get a smaller return on equity as there equity might be 50%. For the retired, it really gives them only the 20% return as they likely have no debt, and in any event they have to live somewhere. It might give them a bit more free cash when they downsize.

      It has been the same way for about 80 of the last hundred years.

  3. Maybe the humbling truth is that all this country has are houses and holes, and nothing will ever change that. So when one horse flags, flog the other harder. 😯

  4. This is an excellent summation of Australian economic policy:

    The corollary of the orthodox view is, of course, that because China will build stuff forever, there is no need to worry about tradables diversity nor, for that matter, savings and consumption. If the windfall gains from Chinese uber-growth are permanent then, hey, let’s leverage it up and party

    The mud-slide bit was good too. Well done!

    BTW, I saw a snippet from the Q&A last night on the ABC where some poor manufacturer asked “After listening to you I’m wondering if we’re living in the same country?”

  5. Excellent work.

    It is very disappointing reading speeches like that but it tends to highlight the problem of having the RBA running economic policy and trying to do so with a rusty pair of multi- grips.

    An independent RBA is critical as a handbrake on reckless governments who drive up inflation with too much pork.

    But if inflation is under control it has NO role beyond making sure the currency is not being printed by crooks and the ATMs spit out cash on Friday nights.

    Economic management is the responsibility of the elected representatives of the people.

    The RBA still has a veneer of respectability but its days are numbered as more and more people clue on to the fact that if it running the economy it is responsible when the economy heads south.

    Re-write the RBA charter NOW.

  6. +100 for THIS, H&H:

    “…..there is plenty of research floating around that illustrates that Australia’s productivity issues stem much more from services and other non-tradable sectors as well as the flaccid mud slide of mining capital operating in fringe projects. The collapse in manufacturing investment is, in fact, a gigantic thumb in the eye for prattle about rebounding manufacturing productivity. Capital investment drives the vast majority of productivity gains in business and especially in manufacturing so if its collapsing then where can the rebound be coming from?….”

    As I keep saying, urban planning and inflated urban land prices strangle the sectors of the urban economy that tend to need more land. These are usually the ones that “add value to resources”, while the “economic rent” associated with the land price inflation makes the “services” and non-tradables sector look good…….

    The UK is the leading example.

    Note that big bailouts etc can continue to make the “services” sector look artificially good for a long time even as the REAL economy is crushed to total death.

    And it is the REAL economy that is needed, ONE DAY, to dig our way back out of the debt hole…..won’t do it any other way. I guess becoming even more of a low wage economy supplying our Chinese creditors with the products of our slave labour to rebalance the external accounts might “help”. I suggest that everyone wakes up to the inverse relationship between urban land prices and the wage rates that will need to apply one day to the REAL economy’s workforces.

  7. I think the RBA is being run on the “not on my watch” principle at present, at least until the transition to Captain Glen’s successor.

  8. Great article HnH. Thank you for the effort!

    “The corollary of the orthodox view is, of course, that because China will build stuff forever, there is no need to worry about tradables diversity nor, for that matter, savings and consumption. If the windfall gains from Chinese uber-growth are permanent then, hey, let’s leverage it up and party, which Lowe also endorsed yesterday:”

    Well said…Mind you we WILL get consumption either way..It depends on whether you think increased consumption in a society already living beyond its means is a good thing

    From Lowe
    “This has clearly caused some difficulties for parts of our economy, including the manufacturing, tourism and education sectors.”

    That’s bloody classic! Who gives a s..t about rural communities anyway eh Phil(Lowe)?

  9. Note re inflation (Again!!! 🙂 )

    We have inflation. Our ‘core’ inflation in the non-tradables is offset by the high exchange rate causing negative to zero inflation in tradables despite widespread increases in FOB prices.
    So we need a higher and ever higher exchange rate just to keep this whole scheme going.
    Can’t see anything wrong with that!

  10. This little quote was a pearler (picture recalcitrant child with fingers in ears denying hard realities):

    “The investment boom has not led to a large increase in the current account deficit. There has not been an explosion in credit. Increases in asset prices have generally been contained.”

    I think lucky Phil has taken a page from the Bubble Boy’s sermon:

    https://www.youtube.com/watch?v=mor10bQYiB8

    • They really don’t live on the same planet these guys. How on earth can you take residential property out of the ‘asset prices have been contained’ analysis.

  11. The RBA didn’t create Chinese demand for resources, it didn’t approve lots of new mines and it didn’t create the US housing bust or the European sovereign debt and housing and banking crises.

    Having been presented with the scenario of the above, totally outside its control, the RBA has done a reasonable job in managing the macro economy it has been handed.

    The sectoral problems of the manufacturing and other import competing or exporting (including tourism and education) sectors are not within the remit of the RBA.

    Employment and inflation are their mandate and they have done quite well in that regard.

    Changing the mandate or balancing sectoral interests is for the federal and state (after all it is they who approve the mines and set the royalties which make a mine viable or not) governments in most cases).

  12. Just thinking about MB’s position on all this (and here I’m referring generally to MB’s discussion on RBA policy and to how this relates to the broader economic picture). There actually doesn’t seem to be too much difference between what the RBA is doing and what MB advocates. The main difference seems to be introducing macroprudential (MPR) tools versus not introducing them*. And even then I’m not actually sure that MPRs are really the crux of the issue – the housing supply issues raised by Leith may well be a really big macroeconomic factor in terms of how they influence house prices, credit expansion and thus the volatility in business cycles. Note I’m not saying that MPRs are a bad idea or that they don’t matter. There is definitely merit to them. But it seems to me there is still quite a bit of grey area in these issues – including the issue of monetary policy and the exchange rate. I’m a massive fan of MB and think their raising of these issues was much needed. But going hard in your criticism will only put interests like the RBA on the defensive, and therefore less likely to be open to the ideas. Given MB’s thesis is far from being obviously correct, wouldn’t it be better to be a little more circumspect?

    I know most MB commenters are in agreement with MB, so I expect some people getting defensive on this. All I propose is that we take a breath and have another think.

    *Other differences seem to include: effectively picking winners to diversify the economy, which may cause higher domestic inflation; allowing RBA experts to make decisions on the economy instead of people with skin in the game. These examples are not clearly correct, and while I worry that we are excessively leveraged to China, and have been complacent with economic reform, the policy options on how to handle these issues are complex and far from clear cut.