Christopher Kent: Australian economic growth - the how, what and
where
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of
Australia, to the National RSL Clubs Conference, Hobart, 11 March 2015.
* * *
I thank Kathryn Davis, David Jacobs and James Wang for excellent assistance in preparing these remarks.
Accompanying graphs and the table can be found at the end of the speech.
Introduction
I'd like to thank the Board and members of the RSL & Services Clubs Association for their
invitation to speak here.
I want to consider three closely related questions I am often asked:
1. How can the Australian economy become more productive?
2. What will help generate additional growth (in demand) needed to boost
employment?
3. Where is that growth going to come from? In particular, which industries will have
the profitable opportunities that will lead to more employment and drive investment?
It is hardly surprising that Australians are interested in these questions given the rise in the
unemployment rate and sub-trend growth of the economy over the past couple of years.
How to be more productive?
From the middle of the previous decade, Australia enjoyed a sharp run-up in the prices of our
key commodity exports. This led to an unprecedented boom in mining investment. The
benefits were spread beyond the narrow confines of the mining industry in numerous ways,
with strong growth in employment and wages across a range of industries around the
country.1
But now that commodity prices and mining investment have turned down, it is natural to ask:
how are we going to sustain and build on our standard of living over the longer term? This
boils down to two essential elements. We can work more (i.e. raise our labour force
participation). We can also work more efficiently. In other words, we can boost our (labour)
productivity, which is the source of sustainable gains in wages and profits (in the absence of
a resurgence in commodity prices).2 I've spoken elsewhere about participation, so let me
focus here on productivity.3
There are a number of sources of growth in labour productivity (i.e. output per hour worked):
• technological progress, which supports new business processes and new
production techniques as well as more efficient use of productive resources. In other
words, an expansion of the technological, or productive frontier
• additional physical capital, both private and public, some of which may embody new
technologies
• more human capital (via education and training).
These things have a somewhat formulaic air to them. They suggest that we just need the
right combination of inputs so as to produce goods and services as efficiently as possible.
But for that to lead to sustainable growth of incomes - of wages and profits - we need to
make sure that the goods and services produced are those that people want at a price they
are willing to pay. Also, we need to fund investment from domestic or foreign sources of
savings, which are provided with the expectation of a reasonable return.
A market-based economy can achieve these things with the help of competitive and flexible
labour and product markets.4 These provide the price and wage signals that encourage
labour and capital to move into profitable opportunities and out of unprofitable ones.
Competitive markets also encourage companies to seek out efficiency gains and pursue
innovations. Developing new products or processes and taking advantage of scientific
progress are key drivers of long-term growth.
It helps too for those markets to be supported by a robust institutional framework, such as:
the rule of law; effective regulation and oversight of parts of the economy, including to ensure
the soundness of the financial system; and institutions to oversee the efficient provision of
public services and infrastructure, and encourage prudent management of fiscal and
monetary affairs.
Productivity growth was especially strong across many countries, including Australia, over
the decade starting in the mid 1990s (Graph 1). There may have been some common
sources to this strong growth. An obvious candidate is technological progress.5 In the case of
Australia, and a number of other countries, a range of earlier economic reforms may also
have played a role. These included a broad-based deregulation of financial, product and
labour markets, further liberalisation of international trade and a program of corporatisation
and privatisation of public enterprises.6 While these things don't push out the technological
frontier, they provide an environment that encourages and enables us to get closer to that
frontier.
Following this period, there was time from the mid 2000s during which productivity growth
was considerably slower than its longer-term average. This slowdown was also common to a
number of economies.7
However, productivity growth has picked up in Australia over more recent years. Some of this
reflects the move from the investment to the production phase of the mining boom, which has
seen a strong rise in output combined with a reduction in employment in resource-related
activity. But the pick-up in productivity growth is broadly based across other sectors of the
economy. This may, in part, reflect the response of businesses to rising competitive
pressures following the period when the exchange rate had risen to very high levels, growth
of non-mining activity had been relatively weak and wage growth relatively strong.
Responding to those pressures is not easy. A common theme from the Bank's liaison
program in recent years has been the heightened focus on reducing costs and improving
productivity in response to the subdued growth in demand. In more extreme cases, however,
it involves businesses that are not sufficiently productive going out of business and workers
losing their jobs.
What more could be done to secure strong productivity growth? As others have noted before
me, the experts at the Productivity Commission have put together a "list" of what could be
done.8 The list describes how improvements to incentives, capabilities and flexibility could
enhance productivity. Again, the idea is not that these things can push out the technological
frontier, but they can help us get closer to it. Recommendations to improve incentives largely
focus on promoting competition, such as further reducing barriers that inhibit international
trade or new entrants to markets. Policies on capabilities focus on the development of human
capital, improving infrastructure and government services as well as the institutions for
creating and transmitting knowledge (academic institutions and their links with the business
community, for instance). The third part of the list deals with providing a more flexible
regulatory environment and reducing unnecessary "red tape". Any one policy will be helpful
by itself, but it is likely that the combined effect will be greater than the sum of each of the
parts.
This discussion has focused on how economies can support growth over the longer term.
You will note, however, that I haven't said much about the role of monetary policy. While
monetary policy can help to ensure low and stable inflation, and contribute to
macroeconomic stability, it cannot influence the longer-term determinants of growth. Even
so, monetary policy has an important role in influencing economic activity over the course of
the business cycle, which is the subject of the next question.
What will help generate additional growth in demand over the next couple of years?
Since about mid 2012, Australia's GDP growth has been a bit below trend and so the
unemployment rate has been rising gradually (Graph 2).9
The Bank's recent update to its forecasts has pushed out the time at which we see GDP
growth picking up from its current sub-trend pace. It is not that economic growth has
weakened of late. But there is little to suggest that it will increase in the near term.
This implies that the unemployment rate will rise for a bit longer and peak a bit higher than
previously expected. The question then is what is it that will generate an improvement in the
rate of economic growth and lead to a decline in unemployment? What are the triggers for
such a revival?
Part of the answer is that the very low level of interest rates is expected to sustain strong
activity in the housing market and support household wealth. This will provide some support
for consumption, although the response of consumption to low rates may be somewhat less
and work in different ways from previous episodes, in part because of the higher levels of
household indebtedness now.10 Low interest rates also work by raising overall cash flows for
the household sector (since households are borrowers in net terms) and by encouraging
households to bring forward some spending and lower their saving rate a little further.
Looking back over the past year we can see the effect of low interest rates at work. Dwelling
investment has grown strongly and made a contribution to demand across all the states
(Graph 3). Consumption growth has picked up a bit, particularly in New South Wales, but it
remains a bit below average for the nation as a whole. Consumption growth is weakest in
Queensland and Western Australia, which are dealing with the direct effect of the decline in
mining investment. Business investment is making a positive contribution to growth in the
other states. Meanwhile, in line with fiscal consolidation at state and federal levels, public
demand has made no contribution to growth for the country as a whole, but the contribution
is mixed across the different states.
In time, a pick-up in household demand should encourage businesses (outside of the
resources sector) to increase employment and undertake more investment. When that
occurs, businesses will make more use of funding that is currently readily available at low
cost. Also, exports, especially of resources - most notably liquefied natural gas (LNG) - are
expected to continue to contribute significantly to growth, while declining mining investment
and, to a lesser extent, fiscal consolidation are likely to weigh on growth over the next couple
of years.
It's tempting to think that economies are well served by being directed or guided in a way that
will produce better outcomes. There is some truth to that. Monetary policy is certainly playing
an important role, but it guides things rather imprecisely, with the relatively blunt tool of the
overnight cash rate.
Other means of adjustment
Economies are responsive in many other ways that don't require the active input of
policymakers. The so-called "invisible hand" of markets can provide the incentives for
producers and consumers to alter their behaviours via a range of price signals.
The exchange rate provides one such signal. The earlier substantial appreciation of the
Australian dollar in response to very high prices for our commodity exports was a signal for
labour and capital to move into the resources sector.11 But, for a time, the Australian dollar
stayed high even after mining investment and commodity prices began to turn down. That
meant that it was not playing the usual role of helping to rebalance growth towards other
parts of the economy.
However, the Australian dollar has depreciated by nearly 20 per cent (on a trade-weighted
basis) since its peak in mid 2013 and is starting to play a role in helping the economy to
adjust. Australians and foreigners will direct more of their spending to Australian produced
goods and services (such as tourism and education) as they become relatively cheaper
compared with the alternatives available offshore. Along the same lines, the depreciation has
lowered the level of Australian wages when measured in foreign currency terms; since April
2013, they are 30 per cent lower in US dollar terms.
While the depreciation seen to date will be helpful, our assessment is that our exchange rate
remains relatively high given the state of our overall economy.
A change in the growth of wages (in Australian dollar terms) is also an important source of
adjustment. Just as wage growth picked up when conditions in the economy were stronger,
the growth rate of wages has declined substantially since 2012 (Graph 4). The lower growth
of wages works to depress the growth of incomes for those in employment. At the same time,
however, lower wage growth allows for more employment than would otherwise be the case,
which works to support the growth of total labour incomes. In a similar vein, the pick-up in
productivity growth over recent years means that the cost of obtaining the labour required to
produce a unit of output (the unit labour cost) has not changed for three years.
In summary, the economy is currently operating somewhat below its productive capacity. The
forecast is for a gradual increase in the growth of demand and employment, and eventually a
rise in non-mining business investment, supported by the very low level of interest rates. The
lower exchange rate will offer some support to demand for Australian produced goods and
services. Adjustments are also occurring along other dimensions, such as gains in
productivity and slower growth of wages, both of which will help place the economy on a
stronger footing.
So that is what I think can help, in time, to generate some more growth. It is based on a
macroeconomic perspective, and draws on knowledge of the history of business cycles. It's
only natural though to want more tangible evidence regarding the prospects for growth. That
is, where is the growth going to come from more specifically?
Where is the growth going to come from?
In some ways this is the hardest of the three questions. It is difficult to know what new
products and companies will come along, and which products and companies they might
displace. And while no doubt there will be further technological progress and innovation, it is
hard to predict how this will affect specific industries, especially for those not yet in existence!
Nevertheless, we can say a few things about the general forces and trends that are likely to
be with us for a time.
One such trend is the increasing importance of household and business services in the
economy. Over the past 30 years, households have increased the share of their spending
devoted to services, from about 53 to 65 per cent of their total consumption (Table 1). Health
and education account for a large part of that. Households are also spending a larger share
of their growing incomes on recreation and leisure services, as well as communication and
financial services. The shift in spending away from goods reflects, in part, the fall in the
relative prices of goods. In turn, that reflects stronger productivity growth for goods relative to
services as well as the development of lower-cost manufacturers in emerging economies.
That is, the world has become much better at producing goods. Mirroring these trends in
consumption and production, the share of employment in household services has increased
from 25 to 33 per cent over the past 30 years. This includes employment in accommodation
and food, arts and recreation, education and training, and health care and social assistance.
These are all things we want and need more of as our appetites for goods becomes more
easily satisfied.
Business services have increased substantially as a share of output and employment. In part
this is because it has become increasingly cost-effective for businesses to outsource a lot of
their "non-core" functions to other more specialised industries. For example, accountants that
used to work for a manufacturing firm may now be in the "business services industry" helping
out a wide range of different companies.
Resource production and exports are likely to continue to grow strongly for the next few
years as the new LNG facilities ramp-up production. While many people across a wide range
of industries helped to build those facilities, a much smaller workforce is required once they
enter into production. Mining more generally is likely to continue to account for a relatively
small share of total employment.
Manufacturing output has increased over the past few decades as a whole, but not as much
as output from other industries. This is common to most developed economies, reflecting the
increased demand for services and the emergence of lower-cost manufacturers in emerging
economies. The high level of the Australian dollar has also weighed on manufacturing over
recent years.12 Those manufacturers with more exposure to the construction industry
(including in mining) and focused on more complex, highly skilled techniques have tended to
fare better than those exposed more to the pressures of international competition from
emerging markets.
The depreciation of the Australian dollar over the past year or so is expected to support
expansion of industries in the traded sector. This will benefit both goods and service
industries exposed to trade. Exports of services, which include education and tourism as well
as business services, were worth about $60 billion in 2014, and at current prices were a
touch higher than iron ore exports at the end of last year (Graph 5).13 Most of the growth in
services exports is attributable to rapidly growing economies in the Asian region. These
service industries should benefit from further strong growth of demand from that source, with
many more households in Asia gaining a foothold in the middle class. While Australia has
many strengths in these service industries, our comparative advantage here is perhaps not
as obvious as it is in mining and agriculture, which benefit from our substantial endowments
of natural resources. This means that we will need to continue to work hard to maintain
competitiveness in these global markets.
Conclusions
The Australian economy has good prospects for growth over the longer term. Among other
things, we have the advantage of a well-educated workforce, strong population growth and a
robust institutional framework. Also, we are closer to a rapidly developing part of the world
than we are to many slower growing developed economies. We have benefited too from
earlier reforms. Among other things, this has left us with more flexible and competitive
product and labour markets than we had in the past and helped us to get closer to the
technological frontier. However, other countries will continue to pursue reforms and we can't
rest on our laurels.
The Bank's central forecast for economic activity is for growth to gradually pick up over the
course of the next couple of years. Monetary policy has been and will continue to play its part
in this regard. The depreciation of the exchange rate seen to date is helpful. And we
shouldn't forget that there are other sources of adjustment, including the pick-up in
productivity growth over recent years.
However, as we've emphasised regularly, forecasting is difficult, there are many
uncertainties and better growth is not guaranteed. It is also difficult to know exactly where
growth will occur. The very low level of interest rates suggests that the housing market is
likely to remain strong. We will probably see a continuation of trends such as the growing
importance of the services sector in our economy, which is relatively intensive in terms of
employment. Resource production and exports are less employment intensive, but the
significant investment in that sector will continue to bear fruit for a long time. Finally, a lower
exchange rate will provide support for demand for the output of the wide range of firms
operating in the tradable sector.
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