No faith

Did Australia ever really believe in itself?

Stan and Bert Kelly

A couple of weeks ago (I know, falling behind schedule again), I attended the Stan Kelly lecture at the University of Melbourne, presented by Assistant Governor (Economic) of the RBA, Luci Ellis. But on the same day that it was announced Australia, in a moment for the history books, had voted in favour of marriage equality, the lecture’s significance was somewhat overshadowed.

The lecture was named by Bert Kelly, former Member of Parliament and commentator, for his father, Stan. Both men were strong free trade and open economy advocates. Even though Stan actually sat on the Commonwealth Tariff Board, he opposed the broad use of tariffs. Not only did tariffs hinder economic performance, they were inherently unfair, supporting not the most deserving sectors or the sectors that provided the best products or customer service, but the sectors with the loudest lobbyists.

The lecture was quite technical, but Luci linked it all together with a good story about Australia’s journey from a protectionist, inward-looking, low growth, high inflation economy with lagging living standards of the late 1950s (when Bert Kelly first entered Australian Parliament) to the prosperous and internationally open economy of the modern day. And this journey was thanks in no small part to the actions of both Bert and Stan.

What has filled the void left by the mining and resources sector? Housing, public infrastructure, and participation.

Then the lecture turned to the challenges of the modern day, and the topic of the lecture itself – where is growth going to come from? Since the mining and resources boom ended, Australia has searched for a new ‘engine of growth’ – a single sector that will fill the void left by the mining and resources sector and drag the rest of the economy with it.

Initially, it was residential housing construction. But even at its peak, it only contributed to the economy about a third of the growth that the mining and resources boom had at its peak. And with the housing market reaching dangerous heights, APRA and the RBA enacted a series of macro-prudential measures to reign it in, lest it get too overheated and crash, dragging the rest of the economy with it (a downside of having single drivers of growth – they can also be the drivers of recession if they crash). And these measures appear to be working.

Public infrastructure investment (the kind I've been advocating for a while as an economic kick-starter) is now taking on some of the burden, especially transport infrastructure. This would appear a sensible transition sector, being a similar activity – and using similar skills – to the mining and resources construction boom. It also directly drives private sector activity and helps boost productivity broadly across the economy. But this kind of boom, like the mining and resources investment boom, and indeed a housing construction boom, is inherently temporary. Over-investment is a potential risk, so we can’t rely on this as the main engine of growth indefinitely.

Similarly, the rise in labour force participation rates since the GFC (particularly women and older people) that has driven growth is also only a once-off boost – you can’t re-join the labour force more than once without first leaving it.

So where is growth going to come from next? Well according to Luci, in a word, everywhere.

Firstly, remember that the mining and resources investment boom gave way to a subsequent boom in mining and resources exports, which is still growing as more projects come on line.

In fact, as the Australian dollar falls, all export sectors should benefit, not just mining and resources. Manufacturing, tourism and agriculture (sectors that suffered under the high exchange rate of the mining and resources boom) will pick up again. Also services exports like education and health, which Luci argues is not taken seriously enough as a real and sustainable engine of growth. Maybe because it’s not a physical product like iron ore, wheat or wool. Or maybe it’s seen as driven by government activity, and therefore isn’t ‘real’ growth from the ‘real’ economy. Or simply because productivity in services is so much harder to measure, therefore it’s not real. But Luci disagrees.

“There's a hint of the eighteenth century physiocrats in this mindset, but with manufacturing and business investment taking the place of agriculture in the firmament of virtuous activities … Do people genuinely think it’s not really production if you can’t drop it on your foot?” Luci Ellis

Services are a very real, sustainable and potentially prosperous sector. Not only do sectors like health, education and child care generate benefits in their own right, they also foster productivity and innovation in other sectors, and help drive participation rates and workforce longevity (as we've recently seen above).

Then Luci pointed to immigration fostering growth – immigration of generally younger, more highly education individuals driving productivity and living standards, not just the raw size of the economy. And as most of this immigration concentrates in cities, economies of scale will drive activities and efficiencies that could only happen in large cities.

“There are some sorts of industry, even of the lowest kind, which can be carried on nowhere but in a great town. A porter, for example, can find employment and subsistence in no other place. A village is by much too narrow a sphere for him; even an ordinary market town is scarce large enough to afford him constant occupation.” Adam Smith

And so it is with management consultants, medical specialists, and all manner of activity that can only occur in cities.

Luci also highlighted R&D investment and rates of technology adoption – recently at relatively low levels in Australia – as potential drivers of growth in the future.

We still don’t believe in ourselves.

So Luci takes issue with the idea that Australia needs a single engine of growth – an external factor, like a Chinese-driven commodities boom or foreign investment in our housing market, or government infrastructure investment. When in reality, growth can come from everywhere and it can be through our own productivity and innovation, not some external factor beyond our control.

And the key insight I found from her lecture was her conclusion as to why Australia thinks like this – because we still don’t believe in ourselves. Just like the late 1950s and the Kellys’ time when Australia didn’t think its industries could compete against international competition without government tariff and subsidies support, let alone be good enough to actually export, Australia still believes we don’t have the capacity to be universally productive and innovative enough without a single outstanding and exogenously-driven industry to keep us going.

While we have come a long way, liberalising our trade policies since the 1970s, opening up our manufacturing and agricultural sectors to the world, and floating our currency in 1983, consequently discovering – to the surprise of many – that we actually had an incredible ability to compete internationally (manufacturing exports skyrocketed in the 1980s and 90s in response to this), we still seem to hang on to that mid-20^th century insecurity that says we can’t do it ourselves.

There will always be some sectors – for whatever reasons – that grow faster than others, but that doesn’t mean we need them to drive the rest of us.

So to paraphrase Luci herself:

When someone asks you where growth is going to come from, tell them … everywhere.

Economics and quantum physics

A short but very amusing blog post by Paul Krugman, where he compares the current Republican tax plan to Schrodinger's cat.

https://mobile.nytimes.com/blogs/krugman/2017/11/24/schroedingers-tax-hike/?referer=https://www.google.com.au/

Did Donald Trump just make a sensible decision?

Janet Yellen should have been re-confirmed. But the choice of replacement could have been so much worse.

Donald Trump recently announced the new Chair of the Federal Reserve to replace Janet Yellen – Fed Governor Jerome Powell. And the collective economists’ reaction appears to be one of relief. Not because it was the best possible choice, but because the choice could have been so much worse.

To be honest, there doesn’t seem to be any reason why Janet Yellen couldn’t have been confirmed for a second term. In fact, Fed Chairs in recent history have served at least two consecutive terms. And Yellen, by all accounts, has done a great job. She has continued the process of normalising interest rates in the US – faster than some, including Nobel Prize winning economist and New York Times columnist Paul Krugman, would have deemed ideal, but not drastically so. And she has laid the path for the future normalisation of the Fed’s enormous balance sheet.

Yellen was chosen by Obama, and was the first woman to Chair the Fed, but I’m sure these facts had no bearing on Trump’s decision to replace her.

So the choice to replace her at all didn’t seem ideal. But the choice of Jerome Powell was such a relief because of the other candidates that were in the running.

Both former Fed Governor Kevin Warsh and academic economist John Taylor were two such candidates. Taylor you may recognise as the name behind the famous ‘Taylor’s Rule’ of interest rates – a formula he devised in 1993 using data relating to unemployment, inflation and potential output to generate an estimate of the current interest rate that the Fed should be targeting. The Fed didn’t follow this rule explicitly but, during normal times, this formula functioned quite well.

During the GFC however, Taylor’s formula seemed to suggest that Fed Chair at the time Ben Bernanke and Co. had dropped interest rates too far and flooded the market with too much liquidity. Many very influential and supposedly learned people, including John Taylor, all proclaimed in their now infamous 2010 open letter that the Fed’s actions would result in runaway inflation and the debasement of the US currency. Warsh made similar claims. Claims they maintained year upon year, and which never materialised. Bloomberg tracked down all these signatories in 2014 and still none of them conceded that they were wrong – that during a crisis like the GFC, extreme liquidity measures are indeed required, and will not produce runaway inflation or the debasement of the currency.

For the last decade, inflation has, in fact, remained stubbornly below the Fed’s 2% target. This is because, as mentioned in one of my previous blogs, this liquidity was not being spent/absorbed by the system – it was simply acting as a floor through which the system couldn’t keep spiralling. This is the nature of a ‘liquidity trap’, where a Central Bank can create the floor, but not the recovery – that requires fiscal support.

Were either of these two to become the new Fed Chair (or worse, had they become the Chair during the GFC), they very likely could have withdrawn liquidity from the system and raised interest rates in the face of these false prophesies, and in so doing, driven the fragile US economy properly into Depression 2.0. And I do not believe I am exaggerating in this assertion. Nor did I think that the Federal Reserve – perhaps the most powerful economic agency in the world and one of the last (at least quazi-) independent bastions of intellectual rigor and competence in the US – was immune to being, as Paul Krugman put it, “Trumpified”.

Then came the relief – Jerome Powell. Powell has been a faithful supporter of Yellen’s policies on interest rates and financial regulation over the last few years, and is likely to be a steady hand in the future. And while I would have liked to see Yellen for another four years, we can take comfort in the fact that Powell is not likely to normalise interest rates or the Fed balance sheet faster than the economy can handle, and that the Fed is in the hands of an experienced Chair who hasn’t been consistently wrong about monetary policy for the last decade.

Every cloud …

IMF World Economic Outlook - Part 2

As a general interest follow-up to the IMF World Economic Outlook, I decided to test the IMF’s hypothesis in Australia specifically.



PART-TIME EMPLOYMENT IS SLOWING INFLATION

One of the key findings of the IMF was that the modern proliferation of part-time employment is hindering wage growth and making it harder for Central Banks around the advanced world to achieve their inflation targets[1], even a decade after the GFC.

Well, a simple comparison between Australia’s inflation rate over time, and the share of the labour force that is full-time employed, seems to support that notion. Australia’s full-time share of employment has fallen from 85% in 1978 to 68% most recently in September 2017, with the remainder being part-time workers. And correspondingly, Australia’s inflation rate has fallen from commonly over 8% per annum up to 1990, to an average of 2.5% since March 1993.

Over this period, the R-squared between these two variables is 0.63 – a fairly strong relationship, where the increasing proliferation of part-time work does seem to be associated with falling inflation.

So the IMF appears to be on to something.

Note that I’m using headline consumer price index (CPI) inflation above, instead of core CPI inflation. Headline CPI inflation is an estimate of the rate at which the goods and services purchased by the average household are increasing in price. Core CPI inflation excludes items such as food and fuel which, due to the volatility of their prices, distract from the underlying trend. So core CPI inflation is arguably a better measure of inflation, but I used headline CPI inflation above because the data provides a longer time series.

But even when using the shorter core CPI inflation time series (since March 1983), the whole period still returns an R-squared value of 0.59 – fairly strong still. But what using core CPI inflation does reveal – in further support of the IMF’s findings – is that the relationship between inflation and the full-time employment share has become even stronger since the GFC (an R-squared of 0.72 since March 2008).

That is, the modern proliferation of part-time work really does seem to be increasingly associated with lower inflation.



CORRELATION VS. CAUSATION

Now, I’m an economist, so I understand the risks of assuming causation from correlation. As the meme below rather humorously suggests, you could just as easily conclude that there is causation between Nicolas Cage movies and pool drownings.

But even if these Nicolas-Cage-pool-drownings numbers are correct (I admittedly haven’t check), there’s no reason – short of subliminal messaging – that would lead us to conclude that Nicolas Cage movies are causing pool drownings (or the other way around).

But there is logic behind the IMF’s theory. Part-time workers arguably have less bargaining power to demand higher wages than their full-time counterparts – quite simply because an employer risks losing more labour hours if they don’t meet the needs of a full-time worker. Think of it like one person asking for a raise under the implicit threat of quitting, versus two workers asking for a raise. Who’s more likely to get the raise? The two workers because together, they have more labour hours with which to bargain. It’s the same logic behind trade unions improving worker bargaining power by acting on their collective behalf, rather than individually.

So the IMF’s logic does go beyond mere correlation.

But there are a few points to consider.



THE BALANCE BETWEEN HIGH AND LOW INFLATION

First, we don’t want inflation to be as high or as volatile as it was before the 1990s. True, inflation that is too low is a risk because the closer it gets to negative territory, the greater the chances of a self-fulfilling deflation-led Depression where households, businesses and even government indefinitely delay their major expenditures and investments in the expectation that these expenditures and investments will be cheaper in the future, thereby creating a self-fulfilling prophecy and causing the economy to crash. Deflation also increases the real burden of debt, by putting downward pressure on household wages, business revenue, and government tax revenue while the absolute level of debt remains constant. As Keynes observed, high inflation can cause problems, too, but at least it encourages spending, while the expectation of deflation can “inhibit the productive process altogether”. Some Central Banks are even considering increasing their inflation targets to around 4% to provide them with a greater buffer from zero, given how close inflation rates around the advanced world have been/are to the dreaded negative territory.

But we also don’t want inflation to be too high. High inflation isn’t necessarily bad, per se, as long as it’s predictably high. If we know that inflation is going to be 10% (say 9.5-10.5%) with as much confidence as we used to expect it to be between 2% and 3%, then that’s probably okay. Everyone will simply adjust their expectations and behaviour to account for 10% inflation. Theoretically, a million per cent inflation would be fine, as long as it’s consistently a million per cent (even though there’s no reason we’d want it that high). Remember, inflation shouldn’t have any real consequences if its predictable – they’re just numbers[2].

Unfortunately, high inflation can be (and historically has been) also very volatile. And that’s a problem. Wage contracts are harder to negotiate because it’s harder to predict the future cost of living, resulting in either excessive wages, reduced business profits and increased unemployment, or insufficient wages, rising inequality and slower economic growth. Businesses have a harder time justifying major investments in property, machinery, labour, etc. because they don’t know what the price of their goods or services will be in the future. The finance industry also has a harder time lending money if it doesn’t know what interest rate to charge to offset future inflation[3]. Even governments need to do cost-benefit analyses on their investments, which becomes harder when future prices are unpredictable. But even if high inflation weren’t also volatile, we still wouldn’t need it to be too high to be a safe distance from negative territory.

So while we want a little inflation, if worker bargaining power is the key, we may not want to push it too far.



THE RESERVE BANK AND AUSTRALIA’S AGEING DEMOGRAPHIC ALSO AFFECT INFLATION INDEPENDENTLY OF THE FULL-TIME EMPLOYMENT SHARE

Second, there are definitely other factors at play here. From the early 1990s to the GFC, the correlation between inflation and the full-time employment share virtually disappears. As mentioned above, despite some short-term volatility, inflation was relatively flat around a 2.5% average from March 1993, while the full-time employment share continued to decline. And there’s a reason why this correlation could have weakened during this period. In March 1993, the RBA unofficially adopted what would eventually become it’s official and explicit target of 2-3% inflation over the business cycle. The RBA was also given independence from government to achieve this target with all the tools at its disposal[4]. And to their credit, since March 1993, Australian inflation has averaged precisely 2.5% – not bad! So the RBA became much more effective at controlling inflation, apparently regardless of what the full-time employment share was doing – at least for a while.

Thirdly, Australia’s population continues to age and the workforce as a share of that population continues to shrink. This will be an ongoing drag on economic growth and therefore, probably inflation, and could already be partly responsible for recent sluggish inflation, independent of the rise in part-time employment.

Fourthly and finally, (though these four factors are not by any means exhaustive), as Milton Friedman once said, “inflation is always and everywhere a monetary phenomenon”. While we may like to scapegoat “greedy businessmen, grasping trade unions, spendthrift consumers, Arab sheikhs, bad weather, or anything else that seems remotely plausible” as the cause of inflation, none of these entities can affect ongoing inflation because none of them possess a printing press.



THE COMMON ANCESTOR – DEMAND

Personally, I think both the modern proliferation of part-time work and low inflation, rather than driving each other directly, are both driven by insufficient demand. Simply, I think the solution isn’t going to be Central Bank-driven or monetary policy-driven. It’s going to be demand-driven. As I’ve mentioned before, while Central Banks still have only limited scope to further stimulate their economies with interest rates and liquidity, and while global interest rates are still so low, infrastructure spending by governments should be used. Happily, this should drive both inflation and full-time employment.



THE IMF OFFERS VALUABLE INSIGHT BUT WE MUST PROCEED WITH CAUTION

So no doubt the share of full-time employment isn’t the only factor driving the inflation rate, certainly not for Australia. This is not to say the IMF’s findings were wrong – never would I be so bold[5]. Perhaps the attempts of Central Banks to control inflation independently of the full-time employment share only succeeded temporarily, and recent years have simply seen a return to the long term downward trend. But it is an important lesson in the difference between correlation and causation, and in the risk of applying general findings for the advanced world to specific countries without considering their individual (perhaps unique) circumstances.

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[1] The rate at which the goods and services in an economy are increasing in price which, in Australia, the RBA targets at 2-3% per year.

[2] Though it would still be a hard political sale for a Central Bank, which has spent so much time building up its credibility around a 2-3% inflation target, to suddenly announce that they want 10% inflation.

[3] Also, other countries might get annoyed if they have lent money to a country that is now producing higher inflation and paying back their debt in increasingly worthless currency, without them necessarily being able to charge a higher interest rate to compensate. While decreasing the real value of their debt may be beneficial for the country that is in debt, it risks starting a currency/trade war with the lender country.

[4] Their official objectives under the Reserve Bank Act 1959 are: a stable currency; full employment; and the economic prosperity and welfare of the Australian people over the medium term. And it achieves these three objectives partly through maintaining a low and stable inflation rate.

[5] Until I start talking about their role in Europe’s austerity efforts.