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.

IMF World Economic Outlook, October 2017

Poor wage growth and the hangover from the Great Depression.

Melbourne was very lucky to host this event – it usually only passes through Sydney and Canberra. The presentation was made by Dr Petia Topalova, a very accomplished economist and a great presenter. Dr Topalova was born in the former Yugoslavia, studied at Cambridge, and is now a published writer for the IMF in their Washington, DC. headquarters. Like I said, accomplished.

And this week she was in Australia delivering the IMF’s October 2017 World Economic Outlook. Clearly she’d made this presentation a few times, so it was largely committed to memory. But more importantly, she didn’t miss a single step during the Q&A. Every question was answered clearly and concisely, with no hesitation or uncertainty. The Doctor knew her stuff.

The focus of this presentation was the recent disconnect in advanced economies between economic growth and wage growth. We are starting to see, especially in the US but also in Australia and other advanced economies, economic growth pick up and unemployment rates fall. Economic theory would suggest that as this ‘slack’ is picked up, wages should start to recover also. But they aren’t. In fact, wage growth is still below pre-GFC rates. For the economists amongst us, this means the Phillips Curve is flattening. Why?

Well this recent phenomenon, largely occurring in advanced economies, is supposedly because of the modern proliferation of ‘involuntary part-time work’ – workers (particularly low to medium skill) who would like to work more hours but are restricted to part-time work. Not technically unemployed, but definitely underemployed.

Increasing use of temporary contracts is also part of this trend.

As to be expected, this results in workers have less bargaining power to demand greater wage growth – hence this modern disconnect between economic and wage recovery[1].

An important implication of this is for social safety nets. Modern social safety nets were largely designed after the Great Depression and WWII, when most workers were either full-time employed, or unemployed. And if you were unemployed, you qualified for these social safety nets.

Today, social safety nets need to adapt to increasing part-time work – workers who, while not technically unemployed, are underemployed and therefore, likely in need of greater support than a full-time employed worker, and greater support than current social safety nets are designed to provide.

A side note on Japan:

'Abenomics' (Prime Minister Shinzo Abe's strategy of monetary easing, fiscal stimulus and structural reform) seems to have provided a little boost in terms of some indicators. But inflation rates are still well below target. And their ageing demographic will continue to weigh on activity.

Japan really is a cautionary tale for the rest of the world. During a crisis, Central Banks and governments need to react quickly and strongly, lest inflationary expectations become so ingrained that, three decades later, active policy has virtually no discernible impact on the economy.

Greater openness to skilled immigration would also help.

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[1] Note in commodity countries such as Australia, Canada and Norway, recent declines in commodity prices have also weighed on wage growth.

Interestingly, increasing automation was not a very significant force behind tepid wage growth – not since the early 2000s.

Globalisation requires cooperation

Especially during crises.

Economic multipliers are shrinking

Economists often use input-output modelling to measure the broader economic impacts of a single event. If, for example, a major $100 million construction project is announced, we can insert that $100m into the model, and it tells us how the effect of that construction activity would spread to the rest of the economy.

The difference between this broader impact and the initial construction injection is called the ‘multiplier’.

But in recent years, the assumed multiplier in input-output modelling has been falling, meaning that individual investments by industry and/or government are having smaller and smaller knock-on effects on the broader economy. Why?

Well one explanation lies within globalisation – specifically the globalisation of supply chains. Businesses no longer source all their inputs locally. They can buy machinery from Germany, parts from Bangladesh, technical expertise from the US, even one’s workforce can be sourced from interstate or overseas (just look at Australia’s mining and resources boom, where most of WA’s labour shortfalls were met with international labour, not labour from other states).

Consequently, even when money is invested in one area, it ‘leaks’, resulting in smaller and smaller general impacts in the location in which the investment was initially made.

Example – Geraldton

Western Australian regional city, Greater Geraldton, for example, suffers from significant economic ‘leakage’. A project Geografia undertook last year calculated total business ‘leakage’ alone of $1.24b, much of which was from the Manufacturing sector, but also Construction, Mining, Transport, postal and warehousing, and Rental, hiring and real estate services (Figure 1). Returning to our construction project above, $100m here would result in only a $31m direct economic impact and a $65m flow-on impact ($96m total – still smaller than the initial injection). Many of the benefits would be felt elsewhere. Consequently, the broader economic impact was only larger than the initial injection when you include the positive impacts outside Greater Geraldton.

Figure 1: Expenditure Leakage by Source, Greater Geraldton

Source: Geografia, 2016

Not surprisingly, Greater Geraldton residents spend a lot of money outside of Greater Geraldton. A small regional city (Greater Geraldton’s population was less than 40,000 at the 2016 Census) just does not have the goods and services available to meet local need.

Example – Casey

Outer metropolitan municipalities offer a variation on this theme. They are notorious for highly mobile labour forces and therefore, out-commuting. And as residents leave every day to work closer to the city centre, they spend a considerable proportion of their income outside of their home municipality.

Let’s take Casey in outer metropolitan Melbourne. With a population of 300,000 at the 2016 Census, Geografia used bank transaction data in their Spendmapp product to see they spent upwards of $250 million outside their own municipality just in the month of December 2016 (Figure 2). In addition to out-commuting, this may also be due to a lack of appropriate offerings within Casey. As per our construction example above, just $84m in total would be captured locally if the $100m project occurred in Casey.

Figure 2: Resident Expenditure Leakage, Casey

Source: Spendmapp, 2017

More leakage means smaller multipliers and less local impact

This kind of leakage has significant implications for the economic viability of investment projects. A local government is going to have a harder time justifying a project if they can’t demonstrate through input-output modelling that a large proportion of the benefits from such a project will remain in the local area.

There are also implications for economic recovery after crises. The standard Keynesian approach says that during a recession, fiscal multipliers are especially high and therefore, particularly effective at reviving a lagging economy. In the US, those multipliers have indeed been strong in recent years, justifying a stronger fiscal policy response to an economy that was, until recently, underperforming. But the US is an enormous economy, so their domestic supply chains are well-established and diverse, resulting in minimal economic ‘leakage’ and strong fiscal multipliers. But for smaller, internationally open economies such as Australia, fiscal policy may be less and less effective at kick-starting a slumping economy.

And this brings me to the solution – self-sustainability vs. cooperation.

Self-sustainability

In the case of Greater Geraldton, a significant amount of their ‘leakage’ could actually be clawed back (Geografia estimated about $259m of the $1.24b in business leakage). This can be done by identifying industries where the volume of leakage is so high, it demonstrates a large local market that could be used to entice (and support) a new business to invest locally. ‘Buy local’ policies could be used to support these businesses. Equally, population growth will help meet more of the local workforce needs. This increased self-sufficiency would help contain a much larger share of any investment directed at Greater Geraldton. Leakage would be minimised, and multipliers would be higher.

Entire nations have even greater potential to contain leakage by diversifying into more industries along their supply chains, thereby reducing reliance on imported inputs. Investment in education and training can also reduce reliance on foreign skilled labour.

Of course, this kind of self-sustainability is not always possible or advisable. Capital City CBDs for example, are major financial and business hubs – and should remain so. Trying to stimulate their economies by increasing the local resident population, thereby reducing the need to import labour from the rest of the city, will likely detract from its commercial advantages. Yes, it may retain more of its local resident expenditure, but this will reduce floorspace available for commercial use.

And even nationally, it is often not advisable for an economy to try to specialise in everything. Firstly, in a developed country such as Australia, where the private sector hasn’t already developed such activity, this would require the government to ‘pick winners’ – this ‘infant industry argument’ has been successful in the past (sometimes), but it’s a risky option.

Furthermore, often it is just better to import things that other countries are better at doing (like labour-intensive manufacturing from Bangladesh), rather than dedicating resources to an industry in which we will probably never reclaim our competitive advantage (and potentially taking resources away from our real advantages).

Cooperation

Consequently, if self-sufficiency is not possible or advisable, cooperation is needed. If Greater Geraldton needs an economic boost but ‘leakage’ is a concern, fiscal support from the State government is justified. This way, Geraldton benefits from added assistance, Perth will benefit, given many of Geraldton’s inputs would be sourced from Perth, and, in a lovely positive feedback loop, Perth would potentially buy more goods and services from Geraldton. So when a small area is susceptible to leakage, the broader area that benefits from this leakage should also assist.

Nationally, this requires global cooperation. During the post-GFC slump in the developed world, efforts by individual countries to stimulate their economies fiscally (if they existed) would have leaked somewhat, having less impact locally. But through international cooperation, nations could have coordinated their fiscal policy programs, with all nations benefitting from the leakage of other nations, via the modern world’s globalised supply chains.

The verdict

The solution, as is often the case, will require a balance. Places, big and small, should not become so overly specialised that they are vulnerable to external shocks, and virtually unaffected by local fiscal stimulus. But at the same time, the benefits of globalisation should not be unwound by attempting to become completely self-sufficient in areas of competitive/comparative disadvantage.

A global economy requires global cooperation.

Immigration and Identity: The Economics of a Globalised World.

I went to an Economic Society of Australia event a few weeks ago - Immigration and Identity: The Economics of a Globalised World. The panel included Dr John Edwards (CEDA), Denise Ryan Costello (The Age), Professor John Langmore (formerly UN Division for Social Policy) and Dr. Jim Minifie (Grattan Institute). They encouraged live audience tweeting during the panel discussion. So here were a few of my thoughts:

What impact will global insular movements (Brexit, Trump) have on international immigration? Will underlying trends continue?

Could better public infrastructure investment also help better address Australia's two speed economy?

How could a universal basic income help, generally, but also in alleviating populist hostility towards immigration/globalisation?

How can Australia - a high cost country with only 24m people - justify its own car industry?

Did Australia avoiding the GFC help us avoid the subsequent populism unlike the US and Europe?

How will automation affect immigration? Less jobs required so less immigration?

As Keynes said, trade can turn an enemy into a business partner.

If WA taught us anything, save your big productive infrastructure investments for the downturn!

National identity should come from shared values - free speech, separation of church and state, equality for women and minorities.

Universal basic income vs. addiction.

Fascinating article about addiction. It's not the drug that people are addicted to - it's the bond.

So by giving addicts the financial means to create other bonds, it doesn't finance their addiction - it actually helps them escape it.

https://medium.com/age-of-awareness/universal-basic-income-vs-addiction-9be994f6acc5

Keynes the Enigma.

Left or right?

I never thought of John Maynard Keynes as particularly right-wing. He was, after all, one of the most prominent voices calling for MORE government action during the Great Depression, not less.

But given his general support of free trade and a more market-based exchange rate system (he called the Gold Standard a ‘barbarous relic’), as well as his criticism of Russian Communism, I never saw him as particularly left wing either.

However, I did more recently stumble upon one of his papers ("National Self-Sufficiency", June 1933) that, in my opinion, does push him dramatically to the left. While he does not abandon his free-market sympathies, and does clearly qualify his opposition to unfettered globalisation, he does appear to be advocating government support to the extent of (though not in name) a universal basic income/ government services.

And in this transition, he appears more like Adam Smith – less so an economist and more so a philosopher.

The whole paper is worth a read. But here is one section in particular. It’s a fairly long read, but an interesting insight into the man’s enigmatic perspectives.

“The decadent international but individualistic capitalism, in the hands of which we found ourselves after the war, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous – and it doesn't deliver the goods. In short, we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.

…

There is one … explanation, I think, of the re-orientation of our minds. The nineteenth century carried to extravagant lengths the criterion of what one can call for short "the financial results," as a test of the advisability of any course of action sponsored by private or by collective action. The whole conduct of life was made into a sort of parody of an accountant's nightmare. Instead of using their vastly increased material and technical resources to build a wonder city, the men of the nineteenth century built slums; and they thought it right and advisable to build slums because slums, on the test of private enterprise, "paid," whereas the wonder city would, they thought, have been an act of foolish extravagance, which would, in the imbecile idiom of the financial fashion, have "mortgaged the future" – though how the construction today of great and glorious works can impoverish the future, no man can see until his mind is beset by false analogies from an irrelevant accountancy. Even today I spend my time – half vainly, but also, I must admit, half successfully – in trying to persuade my countrymen that the nation as a whole will assuredly be richer if unemployed men and machines are used to build much needed houses than if they are supported in idleness. For the minds of this generation are still so beclouded by bogus calculations that they distrust conclusions which should be obvious, out of a reliance on a system of financial accounting which casts doubt on whether such an operation will "pay". We have to remain poor because it does not "pay" to be rich. We have to live in hovels, not because we cannot build palaces but because we cannot "afford" them.

The same rule of self-destructive financial calculation governs every walk of life. We destroy the beauty of the countryside because the unappropriated splendours of nature have no economic value. We are capable of shutting off the sun and the stars because they do not pay a dividend. London is one of the richest cities in the history of civilization, but it cannot "afford" the highest standards of achievement of which its own living citizens are capable, because they do not "pay."

If I had the power today, I should most deliberately set out to endow our capital cities with all the appurtenances of art and civilization on the highest standards of which the citizens of each were individually capable, convinced that what I could create, I could afford – and believing that money thus spent not only would be better than any dole but would make unnecessary any dole. For with what we have spent on the dole in England since the war we could have made our cities the greatest works of man in the world.

...

Today we suffer disillusion, not because we are poorer than we were--on the contrary, even today we enjoy, in Great Britain at least, a higher standard of life than at any previous period – but because other values seem to have been sacrificed and because they seem to have been sacrificed unnecessarily, inasmuch as our economic system is not, in fact, enabling us to exploit to the utmost the possibilities for economic wealth afforded by the progress of our technique, but falls far short of this, leading us to feel that we might as well have used up the margin in more satisfying ways.

But once we allow ourselves to be disobedient to the test of an accountant's profit, we have begun to change our civilization.

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I bring my criticisms to bear, as one whose heart is friendly and sympathetic to the desperate experiments of the contemporary world, who wishes them well and would like them to succeed, who has his own experiments in view, and who in the last resort prefers anything on earth to what the financial reports are wont to call "the best opinion in Wall Street." ”

Is it excessively leftist? Or does it simply reinforce the nature of economics as the pursuit of value beyond mere financial gains, to include culture, society and environment. Otherwise, what is economics good for?

Congratulations Australia!

World record 26 consecutive years without recession. Take that, Netherlands!