Mr. Macfarlane discusses monetary policy and economic growth in Australia
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the Australian
Institute of Company Directors (Western Australia Division) Winter Dinner held in Perth on
12/8/97.
1. Introduction
It is a pleasure to be in Perth to address the Western Australian Division of the
Institute of Company Directors. It is also fitting that I should be talking about economic growth,
since Western Australia has set an example to the rest of Australia by its high growth rate in the
1990s. Some would say this is inevitable, given its resource base, but we have seen
internationally that the fastest growth does not coincide with the biggest resource endowments.
Enterprise and a willingness to embrace change are also vital ingredients, and here Western
Australia has also distinguished itself.
In the Reserve Bank we are often drawn into a discussion of economic growth
because of claims that we have a "growth ceiling" of 31⁄2 per cent per annum. I do not know
where this perceived ceiling came from, and I have on several occasions denied its existence. I
will do so again tonight.
It has been suggested to me that one of the reasons for this belief is that I have often highlighted
the data contained in Table 1 below, particularly when I have been doing my patriotic duty in
Table 1: OECD GDP Growth Over the Past Six Years
(Average annualised growth)
Real GDP
Ireland 6.4
Australia 3.5
Norway 3.5
New Zealand 3.4
United States 2.7
United Kingdom 2.4
Canada 2.2
Denmark 2.1
Netherlands 2.0
Austria 1.7
Japan 1.6
Spain 1.5
Finland 1.5
Germany 1.4
Belgium 1.3
France 1.3
Italy 0.9
Sweden 0.9
Switzerland -0.1
Source: OECD
front of audiences of overseas investors. It shows that over the past six years, that
is the period of the current expansion, we have grown at an annual average growth rate of
3.5 per cent. This is very good by the standards of the "high income OECD countries". Only
Ireland has done better, and Norway and New Zealand have grown at about the same rate as we
have. These are all much smaller countries than we are (their combined GDP is less than
Australia's). The other thing that stands out from this table is how well the English-speaking
countries have done in the nineties; the six English-speaking countries are in the top seven spots.
The 31⁄2 per cent per annum contained in this table is there for international comparisons, not as a
yardstick for what we can do this year, next year or the year after. For a start, that six-year
average of 31⁄2 per cent contains years like the past 12 months where we have achieved only 2.4
per cent, but there are other periods like the year to September 1994 when we managed 51⁄2 per
cent.
2. Economic growth over the cycle
While we do not have a growth target or growth ceiling, we do have an inflation
target. This says that inflation should average somewhere between 2 and 3 per cent over the
medium term. That is, when we look back, we should see that it has averaged 2 point something
per cent, even if we have been over 3 per cent on some occasions and below 2 per cent on
others.
This approach is not, as some might think, anti-growth. It is, in fact, pro growth
by favouring forward looking management of the business cycle, which will help in achieving a
stable platform for long-run growth. The other way of expressing an inflation target is to say that
the economy should grow as fast as possible consistent with maintaining low inflation, but no
faster. We say no faster because post-war experience in a number of countries has shown us that
allowing inflation to rise too much actually harms growth prospects in the longer term.
Sustained periods of strong growth have always gone hand in hand with low inflation. Weaker
growth occurred in the high inflation era, particularly between the mid-seventies and
mideighties.
We have also emphasised that it is the length of the expansion that is important.
Our last two expansions were cut short by inflationary pressures after about six-and-a-half years.
It would probably be possible on this occasion to engineer a short-lived boom, characterised by
rising output and falling unemployment, but also by increasing inflation, unrealistically high
asset values, inflated paper wealth and financial instability - which is, of course, a recipe for a
slump thereafter. Recessions may come for some other reasons, but there is no reason to run a
high risk of a self-inflicted one. It is important that we take a longer view in order to achieve a
longer expansion. The value of the inflation targeting regime is that it forces us to do precisely
that. That is why I am confident that, under our present arrangements, we will be able to do all
that can be done to foster a long expansion.
What does this mean for the next couple of years? That is really a matter of
forecasting rather than speed limits. With inflation tamed, and with some slack available, we
should be quite capable of growing by 31⁄2 per cent, 4 per cent, 41⁄2 per cent (or possibly even
faster) over the next couple of years without any significant detrimental effect on inflation. None
of these figures is a target; they are simply illustrative of the sorts of numbers we might
reasonably expect to see after a period of sub-par growth such as 1996.
Ideally, as we grow fast enough to take up existing slack, businesses would lift
investment rates further, pushing the capacity constraints further back. If, at the same time, we
found that labour market arrangements were able to bring new employees onto payrolls without
generalised pressure on wages, we would be able to sustain faster growth for longer. In other
words, by having a longer expansion, we would be able to drive unemployment down further.
How likely is that outcome? It is hard to say. We do not have a doctrinaire view
on what can be achieved. We will evaluate the evidence as it comes in. Critical in that evidence
is the course of prices. The main test of what is sustainable on the growth front is the inflation
test: is the rate of growth compatible with achieving the 2-3 per cent average for inflation,
looking forward as best we can over a year or two? If the answer is yes, then that growth is
sustainable, at least at that point in time. To repeat: we do not have a growth ceiling, beyond
which the brakes automatically go on. We have an inflation target, appropriately and flexibly
defined, which tells us to tighten when our forecast of inflation has it exceeding the target for
any sustained period of time, and to ease when the forecast has inflation sustainably below
target. Growth per se does not necessarily trigger this response: it is the inflation outlook which
is important. In thinking about the inflation outlook, of course, we need to ask ourselves whether
the growth which is occurring now and that which is in prospect are likely to put pressure on
capacity to such an extent that inflation might rise noticeably. But that is a judgement based on a
range of factors, not a mechanical response to the breaching of some arbitrary growth threshold.
Another point I would like to make is that at the moment I do not see that
monetary policy is placing any constraint on growth. This is as it should be - one of the
advantages of an inflation target is that it makes sure monetary policy is eased when the inflation
forecast is below the target average. Hence the five easings over the past year. This might help
to reassure those people who think that in order to maintain a low average inflation rate,
monetary policy has to be kept continuously tight. It does not - monetary policy will be eased as
often as it is tightened. Monetary policy has to be no tighter to maintain an average inflation
rate of 21⁄2 per cent, than to maintain an average of 5 or 10 per cent. In fact it probably would
have to be tighter at the higher figures as it would be fighting against rising inflationary
expectations.
Another sign that present monetary policy is not restrictive is to look at the effect
it is having on the cost and availability of credit. If this was too expensive, we would not see
much being used, but that is not the case at present. All forms of credit - business, housing and
personal lending - have been growing at somewhere between 8 and 11 per cent over the past
year. This does not suggest that the economy as a whole is finance-constrained, although there
will always be some individuals or firms that are.
Another manifestation of this that may have escaped many people is that we now
have lower interest rates out to five years than the United States, which is the usual benchmark
for international comparisons. Now this is entirely fit and proper, given the different cyclical
positions of the two economies and given our lower inflation. But even so, it would have been
unthinkable even a few years ago. Financial markets took it for granted that Australia would
always be a high interest country relative to the United States. (International investors put
Australia in with a group of countries called the "high yielders".) I am strongly of the view that
these lower interest rates are a substantial benefit for Australian businesses.
3. Economic growth in the long run
So far, we have been talking about growth over short time horizons such as a
couple of years or so. Over this horizon, growth can vary quite a lot, and monetary policy will
have some influence on the outcome. While monetary policy's major long-term influence will be
on the rate of inflation, over shorter periods it can have a significant influence on economic
activity and employment. If it is too tight, it will unnecessarily constrain them, and if it is too
loose, it could set up the conditions for an inflationary boom. The relationship between
monetary policy and economic growth is thus essentially a short-term or cyclical one.
But this is not what a lot of people are interested in. They want to know what is
Australia's long-term growth potential. Is our potential growth rate relatively low like all the
standard OECD countries in Table 1? Is it a bit higher? Or, alternatively could it be as high, or
nearly as high, as the newly-industrialising countries of Asia? How could it be raised to a higher
figure?
These are all difficult questions to answer, and I shall only attempt a very cursory
one. But before I do that, I want to make an important point - whatever our potential growth rate
is, monetary policy will have little to do with it compared with other factors. Monetary policy
mainly works by affecting aggregate demand in the economy. Fluctuations in demand are the
normal (though not exclusive) source of business cycles. In thinking about long run trends,
however, it is the structure - the economy's capacity to produce and how that can be
supply
increased - that is crucial.
Perhaps I can take the liberty of illustrating this distinction between short and
long run with a stylised diagram. An economy could have an average long-term growth rate as
shown in the straight line Trend A. Its actual growth will never be a straight line because of the
business cycle, so it is likely to look like the wavy line Actual A. If monetary policy was
conducted badly, we could end up with a boom and bust given by the dotted line Actual A
Alternatively, if monetary policy was conducted well, we should expect to have relatively stable1.
conditions, including low inflation; with a bit of luck, we should also get longer lasting
expansions and milder recessions. Because a reasonably stable aggregate price level does not
prompt the distortions in economic decisions seen with high inflation, trend growth should be a
little higher. But while that difference will be worth having, it only adds a little to trend A, and
many people would have trouble noticing the difference.
GDP: : Trend d and d Actual
200
Level l
Trend d B
180
of f
Rea eal l
160
GDP
140
Actual
120
100
80
Trend d A
60
Actual l A
40
Actual l A'
20
0
10 15
5 20
Yea ears
Now, people may be unsatisfied with this outcome and say that they would prefer
to be on the faster trend growth line given by Trend B, which is perhaps two or three per cent
higher than Trend A. This is a reasonable aspiration, but it cannot be achieved by an adjustment
to monetary policy.
What factors then explain long-run growth? In simple terms, it is explained by the
growth of the productive factors in the economy - the growth of the labour force, expansion of
the capital stock and growth in productivity of both labour and capital. This is why there is such
focus on micro-economic policies to raise efficiency, rather than manipulation of the
macroeconomic instruments, when people talk about long run growth potential. Again, all that
monetary policy can do is to minimise the booms and busts around the higher trend. The only
way that the economy can move from Trend A to Trend B is by enacting policies that either
increase the growth of the productive factors or increase their productivity.
I do not intend to say much about the growth of the labour force, which in the
long run is determined by population growth and participation in the workforce. Note, however,
that in the short run the economy can grow faster than the labour force constraint would suggest
because, if there is enough flexibility, we can move people out of unemployment into
employment. The other point that I should register is that I do not think in the long run we will
be able to maintain our current low male participation rate. With life expectancy still increasing,
we will not be able to continue the luxury of having so many people entering the workforce in
their early twenties and leaving in their mid fifties. This is a transitory phase, not a permanent
increase in leisure.
In thinking about how to ensure that the capital side of the production potential is
expanded sufficiently, it is hard to go past the simple idea that investment has to be funded by
saving, and we would probably have more if we increased our domestic saving. Of course it
could be funded by more foreign saving, but that path tends to be a more unstable one. I have no
new ideas on how to increase our savings other than through the familiar methods of making
sure that the government does not reduce national savings through chronic budget deficits and
by enacting measures to make sure that a higher proportion of retirement incomes are funded out
of private savings.
The really big issue for long-run growth is how we raise productivity. In simple
debate, this is often portrayed as producing the same with less people, either by job shedding or
by substituting capital for labour. But any business knows that it is not just manning levels
which are important. The flexibility of the workforce in using the capital equipment, the skills
which they can bring to bear in response to new demands and opportunities, the capacity of the
firm to innovate and improve processes in industrial and service applications, the ability to
develop and exploit new technology - these are actually more important ingredients in the long
run.
Of course, all good firms are trying to do this all the time. In a competitive
marketplace, they have to keep up with their competitors or fall by the wayside. In a global
marketplace, they increasingly have to move towards international best practice, which itself is
always advancing as a result of innovation and adoption of new technology. In the process of
matching their competitors, the best firms drive the development of productivity and the rise in
living standards.
Not all firms nor all industries will succeed in doing this. Some will thrive and
others will fail. Some industries will grow, and some industries that we do not even know about
as yet will emerge. The only thing we know is that there will be continuous change, not just here
but in all countries, under the constant pressure of competition, new technologies and
globalisation. There is no simple secret to success, but part of the answer must be for both firms
and for countries to facilitate change, and to adapt to it, not to resist it. The central issue is that
all productivity gains involve change. By their nature they involve producing goods and services
in different (and better) ways, or in producing different goods and services. Change is a
necessary condition for productivity growth.
These major changes are going to occur in the private sector among both large
and small firms. The adjustment task will be difficult, but they must try to seek out the profitable
and growing areas. While the role of government will be important, the Government will not be
able to do the adjustment for the private sector. I find it hard to believe that the Government
would be better than the private sector at picking the growth areas, so I believe that the
Government's main contribution should be to remove unnecessary obstacles to change, to
provide a high quality infrastructure, to encourage saving and to work at lifting and maintaining
quality of education.
I know this is a difficult message to give to a public which is growing tired of
change (not all of it economic). But the alternative of stopping change is really not viable. It has
always been the case that the firms and societies that have managed to embrace the challenge of
change and seize new opportunities, rather than turning their backs, have been the ones that
prospered.
It may, of course, be harder for the high income societies like Australia than for
the newcomers who feel less attachment to established ideas and who therefore have less to
"lose" in embracing change. But we surely have the capacity to adopt change when we see the
need. We have to be convinced it is worth it.
The advantages of flexibility have been well demonstrated in the nineties by the
superior performance, both in terms of growth and in lower levels of unemployment, of the less
regulated English-speaking countries compared to the corporatist European ones.
I am not suggesting we should remove all regulation and rely totally on laissez
faire. There is clearly a large role for government, but we should always ask whether particular
government initiatives are forward looking, or whether they are protecting an existing industry
or an existing privilege.
The first requirement of government is to provide as stable a macro-economic
environment as it can. The second requirement of government is to provide first class, low cost
infrastructure. This stretches from such items as the legal system and accountancy standards
through to more tangible items like the education system and the utilities, including electricity,
gas, water and telecommunications. The Government, of course, need not be the provider of
each of these, but it will always ultimately set the standards. Inevitably, governments will also
be called upon to enact policies which affect one industry at the expense of others. My only plea
here is that they do it in a way that encourages adjustment, perhaps even compensates losers, but
not to do it in a way which resists change.
4. Conclusion
Australia has recorded quite a respectable growth performance by developed
country standards during the current upswing. Even our low point in the mid-cycle growth
pause - a bit over 2 per cent - is pretty good compared with many countries' average
performances. People are disappointed that more progress has not yet been made on reducing
unemployment, but we have made some, and further real progress will be made if we can sustain
a long running expansion. As I have noted tonight, I think our current monetary policy
framework is serving us well in this regard, by requiring us to take a medium-term view in our
policy deliberations and maximising the chances for a long recovery. I hope I have helped to
explain our thinking.
When we shift our focus to the economy's long run growth prospects, however,
monetary policy should inevitably attract less attention. Price stability is a necessary condition
for faster long-term growth, but there are many other policies which have to be got right. That's
why it is so hard. If there is a simple message, I think it is that the heart of the long-term growth
process is productivity enhancement through innovation, technological change and so on, and
that to reap the benefits of those processes, we have to embrace the forces of competition and
globalisation, with all the changes and discomforts they bring.