60% of the world's wealth can't be explained.

I recently attended the Freebairn Public Lecture in Melbourne. The topic was “what has really driven the growth of wealth and material wellbeing since the Industrial Revolution?” And the answer wasn’t simple.

Wealth is not just a matter of plant, equipment and infrastructure used to produce goods and services. These are just a matter of, well, matter. They are fixed in the universe. So the continual expansion of these forms of capital will only ever deliver diminishing returns. Specifically, only 15-20% of global wealth can be accounted for by these forms of capital – 40% once we include varying levels of human skill. Which leaves 60% of our world’s wealth unexplained. Where does it come from?

Well, as Francis Bacon said:

“People do not create material things, only ideas.”

“Knowledge is the only truly original factor of production” and therefore is the only factor that can drive a continual growth in output per worker. And the speaker at this event, Professor Beth Webster, provided three examples of exactly how knowledge drives wealth.

First, investor confidence – the notion that no brilliant idea can really take off unless someone is willing to finance it. Once upon a time, if a business needed finance, they generally had to be in the same industry with which their own banks were familiar. Banks didn’t generally become familiar with other country’s industrial specialties, so they generally didn’t invest in them at home. Today though, thanks to instantaneous communications and global finance, an Australian chemical manufacturer can obtain finance from a German bank, a German robotics manufacturer can obtain finance from a Japanese bank, and a Japanese miner can obtain finance from an Australian bank. Domestic specialties are no longer a limitation on good ideas.

Second, knowing about knowing – essentially a cultural openness to learning new ideas and guarding against your core competencies becoming your core rigidities. Examples here include Nokia failing to keep up with the smartphone, and Kodak inventing the digital camera but not capitalising on it because it would cannibalise their traditional camera division. These companies couldn’t distinguish between transient fashions and discontinuities.

But the really interesting factor that drives growth in the world was the notion of complementary inputs – that certain ideas, as revolutionary as they may have been, were not able to progress because a key input didn’t exist yet.

For example, the wheel. As revolutionary as it was, wooden wheels fell apart quite easily. It wasn’t until the invention of metallurgy that the wheel really came into its own.

Another example, in the mid-19^th century, Charles Babbage originated the concept of a digital programmable computer! But it wasn’t able to really take off because the invention of ‘standardised electricity’ hadn’t occurred yet. The same applied to the invention of the vacuum cleaner, dishwasher and washing machine, which also required yet-to-be-invented standardised electricity and a reliable water supply.

And penicillin was invented in 1928 but wasn’t rolled out at an industrial scale until after WWII, thanks to the contributions of 30 different pharmaceutical companies in the US.

But the best example was Erasmus Darwin, Charles Darwin’s grandfather, who was actually remarkably close to discovering the theory of evolution for himself. Unfortunately, Frederick William Herschel hadn’t yet theorised that the universe was billions of years old, and Thomas Robert Malthus hadn’t yet theorised that the population of a species can temporarily outstrip its food supply. Thus, Erasmus didn’t have access to two of the most important factors behind evolution – life old enough, and a species able to survive hardship long enough, for evolution to take place.

As it was, his grandson was the one to discover it. Imagine the implications if it had been discovered two generations sooner! For one, I doubt we’d still be teaching Creationism in schools.

The US economy probably is nearing full employment. But the Fed should behave as though it isn’t.

Even though an economy approaching full employment (and it really does seem like the US is) means inflation is probably just around the corner, the Federal Reserve should hold back on preemptively increasing interest rates any further. The risks are asymmetric.

If the Fed holds back on increasing interest rates, and wages and inflation accelerate faster than anticipated, it won’t be a disaster. Worst case, inflation may temporarily reach 4% before the Fed gets it under control again. It certainly won’t be like the rampant inflation of the 1970s and 80s that many current policymakers still remember (and about which may be overly paranoid).

Alternatively, if the Fed continues to raise interest rates on the assumption that full employment and inflation are near, and it turns out that there is still a lot of labour market slack remaining, the US economy could be sent back into the dreaded liquidity trap. This means low economic growth, low wage growth, worsening of the debt situation, and – with monetary policy’s effectiveness severely limited in a liquidity trap – no easy way to get out.

In the US’s current situation, inflation is easier to beat than a liquidity trap.

Try to keep calm - it's the Federal Budget!

Is Australia really another four years from proper wage growth?

Economists (myself included) have been claiming for a while now that the US must be approaching full employment. The official unemployment rate in the US is now 3.9% – the lowest this century. But while wages growth and voluntary quit rates have experienced recent surges, they are still not overly impressive. The UK and Japan too have seen unemployment fall steeply without any meaningful increase in wages.

Australia’s new Federal Budget has assumed that over the forward estimates (four years), our economy too should be knocking on full employment’s door. Does this mean, if we’re using the US as a comparison, we have another four years before our wages start properly rising too?

Four years is plenty of time for a material disruption to occur. A property market correction, an international trade war, or just the continued rise of global interest rates, could significantly damage household financial security. And given their level of indebtedness already, that could be the tipping point for a crash that some have argued is long overdue in Australia.

Australia does have one advantage though, that the US didn’t when it was in our position. Our government is enacting a significant public infrastructure program (albeit a couple of years late) which could accelerate wage growth sooner. We also don’t have the memory of 10% unemployment levels that the US had during the GFC. So our employers may be more willing to offer (and employees more willing to demand) wage rises with less paranoia that another significant downturn will make those rises suddenly unaffordable.

But the RBA is not overly confident about the government’s wage growth projections either. They could still drop our interest rates further (from currently 1.5%) if rising overseas rates put too much pressure on household budgets. We certainly wouldn’t be the first developed economy in recent years to tempt the zero-lower bound – or even negative interest rates. But APRA has only recently started making progress in reigning in bank lending and cooling eastern states property markets. The RBA wouldn’t want to upset that by stoking the fire all over again.

So, unfortunately, there is still plenty that could go wrong before we are well and truly out of the woods.

Sorry.

Return the favour.

Lessons from Europe.

Southern Europe had an investment and inflation boom from 2000-2007 that helped Germany’s economy recover from their late 1990s slump.
Germany should have returned the favour during the Euro debt crisis. But they didn’t.
And the eastern states have just done the same thing to WA.

GERMANY VS. SOUTHERN EUROPE

An idea came to me recently during the research and writing of my trade blogs (see here). One of Trump’s arguments for protectionism was against Germany’s significant trade surplus. As a justification for tariffs, it is highly illogical (see above blog). But the concern is based on a bit of truth.

From 2000 to 2007, on the back of ‘Europhoria’, supposedly-safe countries in Southern Europe enjoyed a significant investment boom. Money was flowing into their countries. And, if they had their own exchange rates, it would have driven those up too. But being pegged to the Euro currency – which had to take into account their slower-growing neighbours – the investment boom put additional pressure on their internal inflation rates. Consequently, Germany – with its relatively lower inflation rates – enjoyed a boost to its competitiveness relative to Southern Europe. And this actually helped bring Germany out of its late 1990s slump. Thank you, Southern Europe!

But when the debt crisis struck Southern Europe, this was the moment for Germany to repay the favour. Germany should have boosted its own internal inflation rates with fiscal stimulus to help Southern Europe’s competitiveness. But they didn’t. Along with criticising the ECB’s attempts to reflate the Euro economy, Germany also underwent unnecessary and unforced fiscal austerity (in the face of negative interest rates and the fact that Germany is a big lender, not borrower!). This slowed Germany’s inflation rates, thereby worsening and prolonging the deflation in Southern Europe needed to rebalance the Euro internally. This allowed Germany to maintain an exchange rate that is too low for their individual circumstances, extending their internal competitiveness and trade advantage, and their ‘unfair’ trade surplus.

Southern Europe's recovery has been underway since about 2013. Their relative competitiveness started being gradually re-established through drastic internal deflation. This will presumably reduce Germany’s ‘unfair’ trade surplus. But this process has taken far longer, and was far more painful than it needed to be. Germany did not return the favour of Southern Europe’s inflation ‘boom’ years earlier. So Southern Europe had to endure devastating deflation, hardship and permanent losses of economic output. The fact that this internal deflation eventually had the same result as would have been achieved by a more cooperative Germany, does not justify the pain and hardship of adjustment imposed on Southern Europe. The end does not justify the means.

EAST VS. WEST AUSTRALIA

So my idea that I wanted to test was “could this apply to smaller areas?”. Could, for example, we see a similar phenomenon in Australia between the States and Territories?

Like Southern Europe (though not to the same devastating extent), WA enjoyed a (mining and resources) investment boom followed by a downturn. Now, the eastern states of Australia are enjoying stronger economic performance with an exchange rate that is largely lower than their individual economic circumstances would dictate (because it is being partially dragged down by slower states like WA).

So like Germany and Southern Europe, are the eastern states of Australia limiting their internal inflation rates (whether deliberately or not), thereby prolonging and worsening the disflation required in WA to bring back their competitiveness?

If so, we would expect to see inflation rates at or below target in the eastern states (reflecting the fact that they are not inflating as fast as they could/should to help WA recover), and inflation rates in WA that are well below target, perhaps even in dreaded self-fulfilling deflationary territory.

And whaddaya know, that’s exactly what we see…

From 2004-2007, inflation in Perth was greater than the eastern capitals – consistent with the beginning of the mining boom. This would have helped the competitiveness of eastern states goods and services. And from 2007, the rest of Australia caught up (Brisbane even took back some ground), and inflation rates (and price levels) remained broadly similar between Perth and the other capitals.

But by around 2014, the mining investment boom had well and truly ended and Australia was entering a downturn. WA’s inflation rates drop furthest. Like Germany should have returned the favour to Southern Europe, the eastern states should have returned the favour of WA’s earlier higher inflation rates (and the east’s consequent improvement in competitiveness). The eastern states should have driven their own (inflation) boom to help WA regain some price competitiveness without having to have a drastic downturn and potential deflation.

But while Perth inflation trod dangerously close to deflationary territory, and still struggles to reach even 1%, eastern states inflation is barely sustaining 2%.

There was only so much the Reserve Bank could do. You can see below that Perth residential property prices were over 20% higher than the weighted average of Australia’s capital cities just before the GFC, thanks to the early years of the mining boom. Prices then tended towards equality until about 2014, before the slump in WA and the property market boom in Sydney, Melbourne and Brisbane (which frustratingly didn’t drive inflation in the real economy). Now, Perth property prices are just 71% of the weighted average of capital cities.

But the RBA has already dropped interest rates substantially (at 1.5% since August 2016). And they wanted to go further but feared overheating the eastern states property markets. APRA has had some success in cooling these markets using their macro-prudential powers (tighter lending standards, higher capital reserve requirements). But in terms of lowering interest rates to further support WA, their hands were pretty much tied.

 

 

Rather, a sizeable chunk of the blame resides with the Federal Government’s fiscal policy. This downturn was the optimal moment to invest in infrastructure. Inflation needed a boost, and the RBA had facilitated some beautifully low interest rates at which the Federal Government could borrow. To be fair, they have enacted some nice infrastructure spending recently (though their project choice is subject to debate). But it was about two years later than it should have been.

And the greatest betrayal for WA is that this fiscal boost didn't even need to go directly to WA (although that would have been nice). Given Sydney’s, Melbourne’s and Brisbane’s inflation rates too were barely sustaining 2%, an inflationary boost in the east would also have worked. It wouldn't endanger the eastern economies. It would have improved WA’s cost competitiveness without WA’s inflation rate having to dip so close to self-fulfilling deflation. It would have imposed less hardship and a smaller cost to human welfare that comes from high unemployment. And it could have cost less in the way of forgone economic output that is now lost forever. This was the favour the eastern states should have returned to WA (and itself!) as thanks for WA’s inflationary boom ten years earlier.

RETURN THE FAVOUR

No doubt people have tried to justify WA’s suffering by using the tired old morality card – that they got themselves into this problem by being fiscally irresponsible, and now must pay the price. This is not an issue of morality. It is an issue of economics. And macroeconomic downturns should not be used to punish people. They should be addressed immediately, and the problems that led to them addressed after the economy has recovered. There is no guarantee that those responsible for the downturn will be the ones punished by it. But you can all but guarantee that innocent people and families will be hurt by it. That’s why the economic problem must be addressed first, and the moral problem second (see my financial crisis blog here).

This is the price of Federation. Asymmetric economic shocks to areas that share a common currency and common monetary policy must be balanced out with appropriate fiscal policy, not mass unemployment and a deflationary spiral. A failure to do so breeds not just hardship and forgone potential, but resentment and threats to the union itself.

Don’t believe me? Just ask Europe.

“A tariff war does not furnish good soil for the growth of world peace.”

Here is the exact letter, written and signed by 1,028 economists, sent to President Hoover in 1930 to try to convince him not to pass the Smoot-Hawley Tariff Act in the wake of the Great Depression.

“Economic faculties that within a few years were to be split wide open on monetary policy, deficit finance, and the problem of big business, were practically at one in their belief that the Hawley-Smoot bill was an iniquitous piece of legislation.”

The letter failed. A trade war ensued that worsened and prolonged the Depression, and Western democracies fell apart. But the letter did make it subsequently easier for Congress to eventually pass the reciprocal-trade bill that helped reverse these tariffs.

And recently, a group of dozens of prominent economists (including some Nobel laureates) literally forwarded this very letter virtually word-for-word to President Trump, warning him against actions that may result in a similar outcome. I have highlighted a few of the more pertinent points in my mind – how Hoover’s (and Trump’s) tariffs would:

·        Increase costs to consumers via more expensive imports and more expensive domestic goods that use imported inputs that would now be subject to tariffs;

·        Increase costs of production to domestic businesses that use imported inputs that would now be subject to tariffs;

·        Foster inefficient use of national resources by encouraging/requiring us to produce goods and services to which we are not as suited as our trading partners, leaving the country as a whole worse off;

·        Force global supply chains once again into disruptive and destructive upheaval – this time in reverse so without the efficiency gains; and

·        Perhaps most importantly, invite retaliation from other countries, hurting our exporters, souring our international relations, and sowing the seeds of war (no, not an exaggeration).

But even beyond these points, it is remarkable how relevant the content of this letter is almost 90 years later.

THE TARIFF AND AMERICAN ECONOMISTS

[from Congressional Record-Senate, May 5, 1930]

As in legislative session,

Mr. Harrison. Mr. President, I ask unanimous consent to have printed in the record and to lie on the table, with the names, a statement signed by 1,028 economists who are known throughout the Nation protesting against the tariff bill.

The Vice President. Without objection, the statement will lie on the table and be printed in the record.

The statement is as follows:

The undersigned American economists and teachers of economics strongly urge that any measure which provides for a general upward revision of tariff rates be denied passage by Congress, or if passed, be vetoed by the President.

We are convinced that increased protective duties would be a mistake. They would operate, in general, to increase the prices which domestic consumers would have to pay. By raising prices they would encourage concerns with higher costs to undertake production, thus compelling the consumer to subsidize waste and inefficiency in industry. At the same time they would force him to pay higher rates of profit to established firms which enjoyed lower production costs. A higher level of protection, such as is contemplated by both the House and Senate bills, would therefore raise the cost of living and injure the great majority of our citizens.

Few people could hope to gain from such a change. Miners, construction, transportation and public utility workers, professional people and those employed in banks, hotels, newspaper offices, in the wholesale and retail trades, and scores of other occupations would clearly lose, since they produce no products which could be protected by tariff barriers.

The vast majority of farmers, also, would lose. Their cotton, corn, lard, and wheat are export crops and are sold in the world market. They have no important competition in the home market. They can not benefit, therefore, from any tariff which is imposed upon the basic commodities which they produce. They would lose through the increased duties on manufactured goods, however, and in a double fashion. First, as consumers they would have to pay still higher prices for the products, made of textiles, chemicals, iron, and steel, which they buy. Second, as producers, their ability to sell their products would be further restricted by the barriers placed in the way of foreigners who wished to sell manufactured goods to us.

Our export trade, in general, would suffer. Countries can not permanently buy from us unless they are permitted to sell to us, and the more we restrict the importation of goods from them by means of ever higher tariffs the more we reduce the possibility of our exporting to them. This applies to such exporting industries as copper, automobiles, agricultural machinery, typewriters, and the like fully as much as it does to farming. The difficulties of these industries are likely to be increased still further if we pass a higher tariff. There are already many evidences that such action would inevitably provoke other countries to pay us back in kind by levying retaliatory duties against our goods. There are few more ironical spectacles than that of the American Government as it seeks, on the one hand, to promote exports through the activity of the Bureau of Foreign and Domestic Commerce, while, on the other hand, by increasing tariffs it makes exportation ever more difficult. President Hoover has well said, in his message to Congress on April 16, 1929, “It is obviously unwise protection which sacrifices a greater amount of employment in exports to gain a less amount of employment from imports.”

We do not believe that American manufacturers, in general, need higher tariffs. The report of the President’s committee on recent economics changes has shown that industrial efficiency has increased, that costs have fallen, that profits have grown with amazing rapidity since the end of the war. Already our factories supply our people with over 96 percent of the manufactured goods which they consume, and our producers look to foreign markets to absorb the increasing output of their machines. Further barriers to trade will serve them not well, but ill.

Many of our citizens have invested their money in foreign enterprises. The Department of Commerce has estimated that such investments, entirely aside from the war debts, amounted to between $12,555,000,000 and $14,555,000,000 on January 1, 1929. These investors, too, would suffer if protective duties were to be increased, since such action would make it still more difficult for their foreign creditors to pay them the interest due them.

America is now facing the problem of unemployment. Her labor can find work only if her factories can sell their products. Higher tariffs would not promote such sales. We can not increase employment by restricting trade. American industry, in the present crisis, might well be spared the burden of adjusting itself to new schedules of protective duties.

Finally, we would urge our Government to consider the bitterness which a policy of higher tariffs would inevitably inject into our international relations. The United States was ably represented at the World Economic Conference which was held under the auspices of the League of Nations in 1927. This conference adopted a resolution announcing that “the time has come to put an end to the increase in tariffs and move in the opposite direction.” The higher duties proposed in our pending legislation violate the spirit of this agreement and plainly invite other nations to compete with us in raising further barriers to trade. A tariff war does not furnish good soil for the growth of world peace.