The longest period of below-trend growth for 50 years
The announcement today that the Australian economy grew 2.3% over the last year has been reported as a "positive surprise". But if growth of nearly a full percentage point below trend is "positive", then Australia's economy is in serious trouble.
It's worth panning back from the hype around today's result to consider the broader perspective. Australian annual economic growth has now been below-trend for 11 consecutive quarters .... and all but 3 of the last 27 quarters! The evidence is now inescapable: Australia is stuck in the longest period of below-trend growth for more than 50 years.*
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Figure: Australian Real GDP growth
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... and no recovery in sight
Less than a month ago, the Budget predicted an imminent economic recovery. Growth was forecast to bounce back to trend of 3.25% by 2017 and then skip along at 3.5% for the subsequent five years.
Already these forecasts are looking optimistic. Last week's investment data was diabolical. Australian firms reported forward capex expectations 24.6% lower than last year, which implies we're headed into the biggest investment slump since the 1970s. And wages growth hit its lowest level since the series began in 1997. As leading indicators go, these don't point to a recovery, they warn of a train wreck.
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Why is the Australian economy not recovering?
Optimistic growth forecasts are becoming a recurring feature of Budgets from both sides of politics. As the chart below shows, the federal Budget has predicted an economic recovery every year since the global financial crisis; but every year the timing is pushed out.
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Figure: Budget forecasts vs actual GDP growth
Real GDP growth, % p.a. Source:Treasury
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The most important question in Australian economics is: Why is the Australian economy experiencing such sustained weakness?
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The official view: Recovery is coming ... eventually
The official view from the Treasury and Reserve Bank is that the current economic weakness is temporary and the economy will return to trend growth “soon”.
The RBA is confident they have correctly diagnosed the problem ailing the Australian economy. And they believe they have prescribed the right medicine: ultra-low interest rates to encourage consumers to spend and businesses to invest.
Unfortunately the interest rate treatment hasn’t yet worked. Unemployment keeps rising and economic growth is stuck below trend. Finally, in a wonderful example of central bank understatement, the RBA admitted “the transition that is taking place is not exactly seamless" and conceded that “GDP growth is forecast to remain below trend for a bit longer than had been anticipated.”
But instead of reconsidering their prescription, the RBA doubled the dosage. Interest rates were cut in February and May to an unprecedented low of 2.0%. Yet still no recovery.
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The alternative view: This might be as good as it gets?
After 24 quarters of weak growth, the official diagnosis of the Australian economy is losing credibility and it's time to consider alternatives.
Perhaps instead of transitioning back to historic growth rates, the Australian economy has simply reset to a lower growth trajectory. Maybe this is as good as it gets.
The rationale for this view is that the fundamental drivers of long term growth might be weaker in the future than they have been in the past. That means we might have to get used to lower 'trend growth'.
The three fundamental drivers of long term national income growth are:
- Workforce growth: Which grew rapidly over the 20 years before the GFC thanks to more women entering the workforce, but will slow over the next 20 years as the population ages.
- Productivity growth: Which grew rapidly over the 20 years before the GFC thanks to the economic reforms of the 1980s & 1990s, but has slowed recently.
- Terms of trade: Which boomed thanks to China's infrastructure binge, but are now falling as commodity prices normalise.
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Looking forward, each of these three drivers may make a smaller contribution to growth in the future than in the past.
Using plausible forecasts from the ABS & Treasury's Intergenerational Report, Australia's trend Gross Domestic Product (GDP) growth may be around half a percent lower in the future than it was in the past. And Australia's future trend Gross Domestic Income growth (GDI is a measure of economic growth that accounts for the impact of the terms of trade) could fall by as much as 1.6%.
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What does this mean for government and business?
So who is right? How much of our current growth disease is a temporary illness and how much is permanent impairment?
Currently the RBA and Treasury are betting that this is a passing illness. On that basis they are injecting unprecedented monetary and fiscal medicine into the economy. Interest rates are at their lowest ever levels and budget deficits extend beyond the forward estimates.
But if much of the slowdown in growth is permanent, then these policy settings are very dangerous. Medicine has unwanted side effects. Very low interest rates are creating ominous financial bubbles in real estate and stock markets. And unchecked budget deficits can lead to spiralling debt burdens.
If the official diagnosis is right, and the growth slump is temporary, then current policy settings are entirely appropriate. If not, we may be over-medicating the patient.
The correct diagnosis is also critical for business. If the slowdown is temporary, then the RBA is right to blame weak investment on lack of confidence in the business community. But if growth is permanently weaker, then lower business investment may partly be an appropriate response to lower expected returns.
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