WHEN I spoke in April about the ‘road to recovery’, the issue was how to get onto that road.
WHEN I spoke in April about the ‘road to recovery’, the issue was how to get onto that road. As it turns out, in April we were pretty much at the nadir of sentiment about the Australian economy.
Six or seven months later, even most of the optimists are a little surprised, I suspect, at the economy’s performance.
So the title of this conference is particularly apt. But the issue before us now is not, in fact, how to get onto the road to recovery: we are already on it. The question, rather, is how to make sure that the road to recovery will connect to the road to prosperity.
The first lesson is that the business cycle still exists and that financial behaviour matters, sometimes a lot, to how that cycle unfolds. We need to have a broad definition of the term ‘business cycle’ in mind. There is more than just the cycle in the ‘real’ economy of GDP, employment, consumer price inflation and so on. These remain important, but it is just as important to recognise the cycles in risk-taking behaviour and finance. Failing to do that is precisely what has got some countries into trouble this time.
It’s an old lesson, but worth re-stating. No country has managed to eliminate the business cycle. No country ever will, because the cycle is driven by human psychology, which finds expression in financial behaviour as well as ‘real’ behaviour.
We are seemingly just made – ‘hardwired’, as some would put it – in a way that makes us prone to bouts of optimism and pessimism. Occasionally, we are prone to periods of myopic disregard for risk followed, in short order, by an almost complete unwillingness to accept risk.
But the second lesson we ought to draw from recent experience is that while downturns will inevitably occur, we are not helpless to do anything about their severity. We can make a difference.
Now, the relative resilience of the Australian economy in this cycle warrants some discussion. Unless we are prepared to accept it has all been an incredible coincidence, we have to ask why things turned out that way.
It wasn’t just that China returned quickly to growth. That certainly was important in sustaining export volumes, and in re-establishing confidence in the outlook for the resources sector, which did wobble for a few months. But China’s importance may be greater for future outcomes than recent past ones.
Equally important recently were other factors, including the relative strength of the financial sector, the economy’s flexibility and the willingness and scope to change macroeconomic policy.
Applying the lessons
The task before us now is to manage a new expansion. Of course, we are still in that period when we cannot be absolutely certain that the expansion will gain full momentum.
Even so, it is not too early to think about issues of a medium-term nature. The key question is: having had a fairly shallow downturn, how do we make the upswing long and stable, and relatively free of serious imbalances?
Let me offer three observations.
First, we start this upswing with less spare capacity than some previous ones. After a big recession, it usually takes some years for well-above-trend growth in demand to use up the spare capacity created by the recession. This time that process will not take as long.
Most measures of capacity utilisation, unemployment and underemployment are much more like what we saw after the slowdown in 2001, than what we saw after the recession in the early 1990s.
This is not a problem. In fact, it is good. It is a goal of macroeconomic policy to try to keep the economy not too far from full employment. And some spare capacity does exist, and will do so for a little while, which is why we think underlying inflation will probably come down a little more in the period ahead. But it does underline the importance of adding to supply, not just to demand, over the medium term, and of maximising the productivity of the factors of production that we have, if we are to have the sort of growth that genuinely brings prosperity.
Second, and following on the theme of potential supply, others have noted that the rate of population growth at present is the highest since the 1960s. On one hand, this may help alleviate capacity constraints, insofar as certain types of labour are concerned. On the other hand, immigrants need to house themselves and need access to various goods and services as well. That is, they add to demand as well as to supply.
It follows that the demand for additional dwellings, among other things, is likely to remain strong. Corresponding effects will flow on to urban infrastructure requirements and so on. So the question of whether enough is being done to make the supply side of the housing sector more responsive to these demands will remain on the agenda.
Adequate financial resources will of course also be needed. In that regard, the current issue is not the cost of borrowing for end buyers, which remains low, but the availability and terms of credit for developers. Perceptions by lenders of the riskiness of development in some cases are probably overdone just at the moment, given the strength of the underlying fundamentals on the demand side for accommodation.
That will probably not be a permanent problem though; the more persistent difficulties look like they may be in the areas of land supply, zoning and approval.
Third, the likely build-up in resources sector investment over the years ahead carries significant implications for the medium-term performance and structure of the economy. Even if a number of the proposed projects do not go ahead, the ratio of mining investment to GDP for Australia, which is already very high, will probably go higher still over the next several years. A sizeable share of the physical input will be sourced from abroad (through imported equipment) but the domestic spend will still be significant. So, other things being equal, the investments will be expansionary for the economy.
The financial capital to fund this build-up will mostly come from abroad. This may well be optimal, because it would mean that a good deal of the risk of the projects was being shared with foreign investors, and that makes sense.
Why would Australians alone take on all the risk of these massive projects? It is probably more sensible to share the risks with global capital markets and global companies.
Over time, if the resources sector is to grow as a share of the economy, as seems likely, other areas will by definition shrink. This does not necessarily mean that they will shrink in absolute terms, particularly given the population is growing quickly, but certainly their growth prospects would be weaker than in an alternative state of the world in which the resources sector was to remain at its historical size.
It follows that adjustment challenges will arise, with industrial and geographical implications.
The ‘two-speed economy’ debate of a few years ago was really only a preview of what we could see if the resources sector build-up goes ahead.
A further implication is that the economy’s trade patterns could end up becoming less diversified than they have been in recent years. Such concentration would not be unprecedented and may well be worth accepting if the returns from doing so were high enough, as it appears they might be.
But we might also think about how to manage the risks associated with any concentration. The emergence of China and India is a benefit to Australia, but we stand to have a heightened exposure to anything going seriously wrong in those countries.
n This is an edited extract from Reserve Bank governor Glenn Stevens’ speech to the 2009 Economic and Social Outlook Conference in Melbourne on November 5