Australia | Jul 27 2009
By Greg Peel
Prime Minister Kevin Rudd has taken the rare step of writing an essay for the benefit of the electorate on just how tough times may yet become in Australia. While one cannot criticise a PM who makes a point of speaking directly and candidly to his people, one must also be cognisant of the politics involved.
From the point at which the GFC really hit in earnest last year, the government has issued forecasts of a rather grim nature. Indeed, private sector economist consensus at the time was not quite as dire, and gradually in 2009 that consensus has improved. The government, on the other hand, has mostly stuck to its numbers. As any Treasury Department official will tell you, economists plug parameters into a model which then arrives at economic forecasts. Governments, however, start with the forecasts they want and ask their bureaucrats to work backwards towards the various parameters.
It thus made sense earlier this year for the government’s outlook to be pessimistic given it was forced to bring down a budget that swung Australia abruptly into fiscal deficit after a decade of surpluses. The size of the budget naturally came under criticism, particulalrly from a blindly adversarial Opposition, but in reality it was small beer compared to budgets being fashioned in the rest of the developed world. Nevertheless, the electorate needed to feel drastic measures were necessary for drastic times.
If it turns out that the government’s forecasts were too bearish after all, then rather than blame poor forecasting the government will take credit for acting decisively and successfully. The government has then forecast for relatively strong economic growth in 2011, which will work out nicely in an election year. But we have to get there first, following a likely dour 2010. Global “green shoots” and an apparent return to strong economic growth in China have fuelled a big surge in confidence measures in Australia, initially sparked by having so far avoided a “technical” recession. The US, for example, will this week issue its first estimate of second quarter GDP movement, which is tipped to be the fourth consecutive quarterly contraction.
The most important point to note about Australia’s slightly positive March quarter GDP result, however, is that the surprising result was impacted by a surge in Chinese iron ore buying at last year’s prices. This year’s prices are at least 33% less (albeit yet to be settled with China) and already economists have been caught out by big drops in subsequent monthly trade balances. There is every possibility the June quarter could see a return to negative GDP. Such a result may yet be avoided given the effect of the government cash stimulus and housing grants, but it could be a close run thing. By the September quarter nevertheless, the cash handouts will be a memory, and by the December quarter the housing grants are downgraded. This leaves only a ramp up in infrastructure stimulus to carry the can.
None of this will be lost on Kevin Rudd. Saturday’s treatise was largely setting Australians up for a period of dreaded stagflation – negative economic growth combined with rising inflation. Or even if the GDP manages to stay above the flat line, the lagging rise in unemployment will make it “feel” like a recession. The apparent rapid turnaround in Asian growth – thanks again to stimulus – will indeed put upward pressure on commodity prices, particularly if the US dollar continues to slide on money over-supply (huge fiscal deficit) fears. So Rudd is not barking up the wrong tree.
Unemployment has long been expected to rise in Australia, as that’s what always happens in recessions, technical or otherwise. Businesses look to cut what costs they can first, run down inventories and so forth, before finally having to make that unpleasant decision to let employees go. When recovery is apparent, businesses wait to be sure before rushing to restaff. That’s why unemployment is a lagging factor, and that’s why Rudd has issued his warning.
Yet the government’s ultimate forecast is for 8.5% unemployment, which even at the time seemed pretty grim. Now such a figure is looking almost unattainable, given the unemployment rate to date is only a stoic 5.6%. Before the boom times took the unemployment rate into the fours, five percent was considered “full employment” (given a healthy economy needs a constant reserves bench of labour to help avoid wage inflation). Thus 5.6% seems hardly the stuff of recessions. Is there just a very serious lag, or are there other factors at work?
The data, and anecdotal evidence, tell the tale. Businesses are cutting back working hours rather than cutting actual jobs, where possible. Having struggled to find staff at the right price during the boom times, businesses are reluctant to now let them go only to face the same problem again in a recovery, and particularly if that recovery comes about sooner than first expected. Sacking employees can also mean costly redundancy pay-outs, meaning actual cost savings may not be felt before the economy turns around, in which case they would be wasteful. So what we are seeing instead is a small rise in the unemployment number, but a noticeable drop in hours worked. Staff are being asked to work shorter hours, four-day weeks in some cases, and to take unpaid leave where possible. This seems like an unfortunate but necessary trade-off against losing one’s job outright, and also means bosses can portray a “we’re all in this together” stance.
What it also means, however, is that the unemployment number is not offering a traditional pointer to a subsequent fall in consumer spending. Resilient employment should suggest a buffer to a consumer spending collapse, but less hours means less wages, and that has the same effect. Furthermore, one must remember that the official unemployment number measures the number of people on the dole, not the number of people actually out of work. Given the high level of “professional” lay-offs, such as in the financial industry, there clearly would be a significant number of people looking for work but not yet stooping to the demeaning process of applying for the dole. In other words, the unemployment number may never get to 8.5%, but a lesser number could be misleading.
So Kevin Rudd is possibly still being pessimistic in his unemployment consideration, but not unrealistic in the greater scheme of things.
Turning to inflation, Rudd is very right in suggesting inflationary pressures are possible. The Reserve Bank has held its cash rate unchanged at 3% now for three months given that “sticky” core inflation measure of 3.9%. Yet the RBA is not about to raise the interest rate again given the extent of disinflationary pressure from excess production capacity (idle factories) and excess labour (rising unemployment), and from still falling business investment. Such deflationary pressure is apparent across the globe at present, and is the excuse governments have used to justify their massive fiscal deficits. Monetary stimulus is serving to reduce deflation rather than spark inflation – so far.
Now that it appears China may well lead the global drive out of economic weakness, thus directly benefiting Australia, economists have decided that perhaps 3% will be as low as the cash rate will go. Thereafter, and just as Rudd suggests, price inflation may reappear. The headline CPI has now fallen under 2%, but that reflects a period of lower food and petrol prices and extensive discounting from retailers stuck with excess inventory. Commodity prices in general are now back in an upswing, and inventory restocking is expected around the corner. If Australian consumers back their own newfound confidence, there is a good chance price inflation will start to swing back up. And that will mean (although probably not until 2010) that the RBA will need to raise its cash rate.
So again Kevin Rudd is not talking rubbish. However, there is one area where he can certainly be questioned. As part of his treatise, Rudd suggested further “severe” budget cuts would be needed to avoid a spiralling fiscal deficit. Again this smacks of political consideration. Deliver a tough budget in 2010 which the excuse again of economic hardship, and then deliver a sweeter budget in 2011 – the election year. Because realistically, the budget is tracking pretty well.
The economists at UBS note that the FY09 budget is already tracking at around a $16bn lower deficit than the numbers suggested in May. This is comprised of an $11.49bn reduction in expenses, and a $4.65bn better revenue result than the May budget forecast. UBS believes a good $10-15bn of this figure simply reflects economic conditions being better than the May budget numbers had forecast. Lower than expected unemployment, for example, is resulting in smaller transfer payments, while stronger than expected retail sales are providing more GST revenue. The government projected a $32.9bn FY09 deficit in its May budget. In May the deficit had only reached $12.3bn, or $20.6bn better than forecast. Throw in a seasonal $3-5bn loss in June, and you arrive at UBS’ $16bn “better” number.
The government’s GDP forecast for FY09 is for 0% growth. This implies, suggests UBS, an “implausibly weak” June quarter of negative 3.2% growth. UBS is forecasting 0.7% positive growth in FY09, as well as 0.4% in FY10 to the government’s negative 0.5% forecast. Most Australian economists have been revising up their earlier forecasts to a less drastic result.
There is a lot of pressure on the US Federal Reserve at present to provide news of its intended “exit strategy” from its monetary stimulus (being zero cash rate and quantitative easing). America fears a sudden burst of excessive inflation if economic recovery eventuates because of the sheer extent of money supply being created by both the Fed and the Obama Administration’s enormous budget deficit. In the latter case, Obama’s universal healthcare policy is wavering given doubt from even the Democrats.
Australia would also be at risk of monetary inflation were its budget to remain excessive. Inflation is driven from both the demand side – price inflation of goods – and by the supply side – money being pumped into the system. According to the UBS research, the latter is already apparently under control.
This is thus good news for those with mortgages, given the RBA takes fiscal measures very much into account in its own monetary policy decisions. Thus while Rudd is right to warn of potentially higher petrol prices, for example, there will yet potentially be an offsetting influence on the money supply side. This means bond yields will not be under so much inflationary upward pressure, and thus the RBA has a bit of leeway on its eventual need to raise its cash rate.
When all said and done one might take Rudd’s letter to be leaning to the negative in order to look positive down the track. At the end of the day Australia would rather a quick return to economic growth, but there will be a lingering hangover. Perhaps the November budget update might bring a less cautionary tale, provided nothing untoward happens in the meantime.