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.
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.
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.
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.