AustraliaÕs Virtuous Cycle
By Stephen Kirchner 
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Much has been made of the outstanding performance of the US economy in recent years.Ê This has led some to postulate the existence of a Ônew paradigmÕ underpinning the US economy and to pronounce the demise of the conventional business cycle.Ê A lesser known success story has been the Australian economy, which has enjoyed the same combination of strong growth and low inflation, underpinned by significant gains in productivity.Ê What makes the performance of the Australian economy more impressive, however, is that this has been achieved despite a much greater exposure to the world financial and economic crisis that began in mid-1997.

This paper examines the recent performance of the Australian economy.Ê It argues that this performance owes much to the reforms instituted by successive Australian governments since the mid-1980s.Ê These reforms have seen a significant improvement in AustraliaÕs productivity performance and contributed to the sustainability of the current expansion.Ê There is now compelling evidence to suggest that these reform measures have yielded important macroeconomic benefits. These benefits argue against complacency in pursuing further reform.Ê The continuation of strong economic growth will rely on further productivity improvements, which in turn will remain dependent on continued reform efforts.Ê Unfortunately, the very success of the Australian economy may encourage complacency on the part of policymakers.

Recent Economic Performance

The Australian economy has put in an outstanding performance in recent years.Ê Australia is currently enjoying one of its longest uninterrupted periods of growth since the Second World War.Ê The economy has now grown for 29 consecutive quarters, including six consecutive quarters of growth in excess of one percent up until the year ended March quarter 1999.1Ê This is longer than the expansions of the 1970s and 1980s (24 quarters and 23 quarters respectively), although still significantly shorter than the prolonged postwar expansion of the 1960s (nearly 50 quarters).Ê Australia has been able to maintain above trend rates of economic growth amid the worst world financial crisis in 60 years and with many of AustraliaÕs key trading partners in recession.Ê As Chart 1 shows, economic growth is currently well above its 10 year average.Ê Moreover, the volatility of this growth, shown by its standard deviation, has fallen dramatically in recent years.Ê Economic growth is becoming more sustainable and less subject to the boom and bust cycles of the past.

By international standards, this is an impressive performance, outpacing even the US economy.Ê As the Governor of the Reserve Bank of Australia (RBA) Ian Macfarlane has been quick to point out, AustraliaÕs average Gross Domestic Product (GDP) growth over the 1990s exceeds that of the US and most of the countries of the OECD and Asia (Macfarlane 1999: 1-2).Ê What makes this performance more impressive, however, is that Australia is a small, relatively open economy, with a greater direct exposure to the world financial and economic crisis that began in mid-1997 than is the case with the US (see Kirchner 1998: 35).

The Virtuous Cycle: Productivity and Low Inflation

A number of factors have contributed to the sustainability of the current expansion and the resilience of the Australian economy in the face of the world economic downturn.Ê Perhaps one of the most significant factors underpinning economic growth has been the improvement in the productivity performance of the Australian economy over the last decade.Ê This growth in productivity in turn reflects a wide range of structural reforms over the period since the early 1980s that have increased the competitiveness of domestic product and factor markets.Ê According to the RBA, total factor productivity growth has been running at an annual rate of 1.6 per cent in the 1990s, compared to the 0.8 per cent seen in the 1980s (RBA 1997: 20-21).Ê AustraliaÕs productivity performance has also been impressive by international standards.Ê Whereas AustraliaÕs productivity underperformed the weighted OECD average over the periods 1960-75 and 1975-90, Australia significantly outperformed the average in the period 1990-97 (OECD 1999: 64).Ê In previous cycles, productivity growth has slowed as the business cycle matured.Ê However, the March quarter 1999 national accounts showed GDP per hours worked running at an annual rate of 3.4 per cent versus a 10 year annual average of 2.7 per cent, giving no indication of a late-cycle decline in productivity growth.

This improved productivity performance has been an important contributor to vastly improved inflation outcomes compared to previous cycles.Ê Favourable inflation outcomes have also been fostered by the adoption of explicit inflation targeting by the RBA from about 1993 onwards (see Kirchner 1996).Ê The structural break in inflation and inflation expectations that occurred in the wake of the early 1990s recession has enabled monetary policy to maintain a more accommodative stance over the course of the economic cycle.Ê Previous expansions have been characterised by inflation and wage pressures that have forced a tightening in monetary policy and subsequent economic downturn.Ê Monetary tightenings were a significant factor in the last two recessions.Ê While strong growth in the mid-1990s necessitated a brief tightening episode in late 1994, this was small by the standards of past cycles and there have been long periods when official interest rates have been left unchanged.Ê The amplitude of the interest rate cycle in Australia has decreased in recent years, while the periods between peaks and troughs have lengthened (see Lowe and Ellis 1997: 288).Ê Low and stable inflation and interest rates have contributed significantly to the sustainability of the current expansion.

Low inflation has been important in holding down nominal unit labour costs.Ê With productivity growth running ahead of inflation, real unit labour costs have fallen (see Chart 2).Ê

The fall in real unit labour costs has been important in underpinning international competitiveness. Chart 3 shows three measures of competitiveness, based on the ratio of domestic prices to exchange rate-adjusted prices in the US, Japan, UK and Germany.Ê A fall in these indices represents an improvement in competitiveness or a fall in the real exchange rate.Ê On these measures, AustraliaÕs competitiveness is well above the levels of the late 1980s.Ê

Subdued growth in unit labour costs has also ensured that the profits share of the economy has been maintained at record high levels, which in turn has fostered a prolonged expansion in business investment.Ê The boost to profit margins has been an important factor in reducing the pass-through of recent exchange rate weakness to consumer prices, by allowing companies to absorb higher import costs on their margins.Ê The limited control firms can exercise over final selling prices in a competitive environment has seen a much greater focus on controlling costs.

This account of the factors underpinning the Ôvirtuous cycleÕ in Australia is largely the same as for the US, where there has been considerable debate about whether this represents a genuine structural shift in its economy.Ê Skeptics argue that low inflation in the US owes much to a number of favourable, but essentially one-off and coincidental, supply shocks.Ê Specifically, falls in commodity prices, especially oil, and a strong US dollar have exerted downward pressure on domestic inflation.Ê It is argued that once these one-off influences have worked their way through the US economy, we will see a return to the conventional business cycle (see e.g. Brinner 1999: 37-49).Ê Australia has benefited from similar influences, at least in terms of inflation outcomes.Ê But to the extent that some of these influences turn out to be at least partly secular rather than merely cyclical, the current expansions in the US and Australia may prove to be more durable than the skeptics are prepared to concede at this point.

Internationalisation of the Australian Economy

The internationalisation of the Australian economy has also been a factor in underpinning the durability of the current expansion. Chart 4 shows the combined imports and exports share of Gross Domestic Product (GDP).Ê Abstracting from the cyclical behaviour of this series, we find a steady rise in the openness of the Australian economy to trade flows in recent decades.Ê This openness has often been blamed for a number of economic problems, but has been an important contributor to recent economic performance.Ê

The Australian economy has often been thought to suffer from external imbalances which have acted as a constraint on growth.Ê Indeed, the authorities engineered a deliberate slowing of the Australian economy in the late 1980s in an effort to curb the current account deficit.Ê Although these policies were seriously misguided, they reflected a view that current account deficits in excess of six percent of GDP were unsustainable.Ê Australia is currently experiencing a current account deterioration, brought on by the combination of a deterioration in the terms of trade and a fall in export volumes due to the world economic downturn.Ê This is expected to see the current account deficit deteriorate to around 6 per cent of GDP during early 1999.Ê On this occasion, however, the authorities remain remarkably sanguine about the current account deficit and it is certainly not seen as a major constraint on growth (see, for example, Macfarlane 1999: 8).Ê Treasury Secretary Evans has endorsed the Ôconsenting adultsÕ view of the current account deficit (invoking NozickÕs memorable defence of Ôcapitalist actsÕ) (Evans 1999: 4).Ê

For one, the trade balance (the main cyclical driver of the current account balance) is on a steadily improving trend as a percentage of GDP (see Chart 5).Ê The trade balance has yet to deteriorate to the extent seen in the 1980s, although one is unlikely to hear this from the proponents of economic nationalism.

Another reason the authorities can be relaxed about the external deficit is the vastly improved debt servicing ratio compared to previous episodes of current account deterioration.Ê As Chart 6 shows, the debt servicing ratio (net foreign debt to exports of goods and services) has more than halved since the current account was last considered a problem.Ê

This reflects a steady net foreign debt, coupled with a growing exports share of GDP, although it also owes something to the increased use of equity rather than debt to finance AustraliaÕs net international investment position.Ê A deflationary environment makes debt financing more expensive, encouraging a greater use of equity.Ê Regardless of this shift towards equity financing, openness to trade flows has helped to remove what was once considered to be a constraint on economic growth.Ê The lower debt servicing ratio also means a lower risk premium attached to Australian dollar-denominated assets and bond yields.

Good economic fundamentals are usually associated with a strong currency.Ê The Australian dollar, however, has been trending lower since late 1996, at least with respect to the US dollar.Ê On a trade-weighted basis, however, the currency is not far below its 10 year average.Ê The increased openness to trade flows also increases AustraliaÕs exposure to any deterioration in the terms of trade.Ê Weak commodity prices have seen AustraliaÕs terms of trade fall 6.5 per cent over calendar 1998.Ê The burden of adjusting to this fall in national income necessarily falls on the exchange rate.Ê The floating of the Australian dollar in 1983 has enabled Australia to remain competitive in a difficult international trading environment.Ê Although weaker currency poses increased inflation risks, the competitiveness now characteristic of private sector goods markets has seen only very limited pass-through of recent Australian dollar weakness from import to retail prices, thereby protecting inflation outcomes from the exchange rate deterioration.

Fiscal Consolidation and the National Balance Sheet

The main contributor to the current account deficit has been the savings-investment imbalance that has long characterised the Australian economy.Ê This provided the impetus for a major fiscal consolidation on the part of the Commonwealth in its 1996 Budget.Ê The principal rationale behind this consolidation has been to ensure that the public sector does not make a call on national saving (see Kirchner 1997), while seeking to put in place measures to encourage private saving.Ê But these measures have been limited and the household saving ratio has fallen to a record low 0.4 per cent in the March quarter 1999.

This suggests some substitution of private sector dissaving for increased public sector saving, particularly as the Commonwealth cuts back on benefits that would otherwise contribute to household disposable income, although this is somewhat offset by increased saving by the corporate sector.Ê A more important factor in the demise of household saving, however, has been the increase in household wealth in recent years.Ê Net private sector wealth grew 5.1 per cent in real terms for the year ended June 1998, to 4.1 times nominal GDP, a rate considerably faster than the 20 year average (Commonwealth Treasury 1999: 72).Ê Contrary to the popular view that these gains have come from the stock market, most of the contribution has come from growth in the value of dwellings, which constitute 55 per cent of net private sector wealth.

The sustainability of gains in asset prices is one of the main question marks over the continued expansion of both the US and Australian economies.Ê The wealth effects associated with these gains in asset prices have been an important factor underpinning the consumption side of both economies.Ê However, it would take a massive correction in asset prices to unwind the large increases in household wealth seen in both Australia and the United States.Ê

The fiscal consolidation in Australia of recent years owes as much to this period of strong growth as it does to restraint in Federal government spending.Ê This has seen Commonwealth revenues remain broadly steady as a percentage of GDP, while underlying outlays have fallen (see Chart 7).

The government has been quick to claim that the improved budget balance has helped to Ôfire-proofÕ the economy against the regional and world economic downturn.Ê In fact, rather than the improved budget balance supporting growth, it is largely the strength of the current expansion that has served to put public sector finances on a more sustainable footing.Ê At the same time, however, it serves to reduce the pressures on the Commonwealth to reform its vast own-purpose spending, given that this spending is usually tailored to available revenues.Ê The Federal governmentÕs proposed tax reform measures are explicitly designed to alleviate the revenue constraint on government, avoiding the need to take difficult decisions on the expenditure side beyond those taken in the 1996 Budget.

Implications for the Reform Process

The reform process has suffered in recent years from perceptions in some quarters that it has not delivered economic benefits to offset sector-specific costs.Ê This is encouraged while the debate remains focussed on microeconomic issues, where perceptions of costs and benefits tend to be lost in the distributional conflict that inevitably ensues.Ê A focus on the macroeconomic benefits of reform tends to abstract somewhat from these distributional issues to focus on economy-wide benefits.Ê These benefits are increasingly apparent in the case of Australia and have enabled the economy to sustain a long expansion and withstand a significant downturn in the world economy.Ê However, it is also apparent that these benefits have only materialised with a long lag.Ê The reforms of the 1980s are still delivering benefits well into the 1990s, assisted by the improvements made to the conduct of monetary and fiscal policy in the 1990s under the current administration.

These benefits point to the potential costs of complacency.Ê The reform process is widely thought to have lost momentum, largely due to the unwillingness of politicians to push further an allegedly Ôreform-fatiguedÕ electorate.Ê Complacency is also encouraged by the now inevitably favourable comparisons made between Australia and the rest of the world.Ê For example, AustraliaÕs economic performance has recently been compared with that of New Zealand to argue that radical New Zealand-style reform is not necessary to achieve good economic performance.Ê After years of being embarrassed by New ZealandÕs reform efforts, an unwarranted air of self-satisfaction has enteredÊ into public discourse about New Zealand in Australia.2

This ignores the fact that AustraliaÕs economic performance still lags New ZealandÕs in important respects.Ê Much has been made of the fact that New ZealandÕs unemployment rate rose to match that of Australia in the final three months of 1998 at 7.7 per cent.Ê However, New ZealandÕs performance arguably remains superior given that this follows a recession in New Zealand in the first half of 1998, compared to extremely robust growth in Australia over the same period.

New ZealandÕs recession largely reflects its greater exposure to two external shocks, the Asian crisis and a drought.Ê However, the recession has also been attributed by some critics to overly tight monetary policy on the part of the Reserve Bank of New Zealand (RBNZ).Ê While tight monetary policy was certainly a contributor to the recession, this reflects the fact that the RBNZ takes its statutory responsibilities for ensuring price stability very seriously.Ê Unfortunately, other policies pursued by the government in New Zealand were not conducive to price stability, in particular, the fiscal stimulus instituted by the New Zealand Coalition Government following its election in late 1996.Ê Australia has a much less ambitious inflation targeting regime, which has yet to be seriously tested by the sort of inflationary pressures seen in New Zealand in recent years (see Kirchner 1996).Ê The institutional framework for monetary policy in New Zealand arguably remains superior to that in Australia in terms of delivering price stability over the longer term (as a comparison of recent inflation rates would also suggest).

The widespread failure to appreciate these differences between Australia and New Zealand suggests a number of risks.Ê In particular, there is the risk that Australia will rest on its laurels, content to outperform selected other countries, rather than setting its own absolute standards of economic performance.Ê There are also lessons from the Australian experience for the recovering economies of Asia, particularly Japan.Ê The principal lesson is that there is no substitute for structural and real economy solutions to economic problems.Ê Attempts at manipulating the business cycle, such as JapanÕs fiscal policy initiatives or the proposed reflationary monetisation of its government debt, are not able to deliver sustainable growth.Ê Rather, the focus should be on the institutional and structural framework underpinning economic growth.Ê The structural imperative is as important for Asia as it is for Australia.

References

Brinner, Roger 1999, ÔIs Inflation Dead?Õ New England Economic Review, January-February: 37-49.

Commonwealth Treasury 1999, ÔAustralian Net Private Sector Wealth,Õ Economic Round-Up,Õ Summer:Ê 71-81.

Evans, Ted 1999, The Fiscal and Economic Outlook, address to Australian Business Economists, 19 May.

Kirchner, Stephen 1996, ÔÒTwo Point SomethingÓ:The Credibility of Australian Monetary Policy,Õ Policy, Spring:
11-17.

Kirchner, Stephen 1997, ÔNational Saving and Commonwealth Budget Strategy,Õ Policy, Spring: 14-21.

Kirchner, Stephen 1998, ÔWhy interest rates will fall,Õ The Australian Financial Review, 20 March: 35.

Lowe, Philip and Luci Ellis 1997, ÔThe Smoothing of Official Interest Rates,Õ in Monetary Policy and Inflation Targeting, Reserve Bank of Australia, Sydney.

Macfarlane, Ian 1999, Notes for Talk to ABN AMRO Australia Day Seminar, Tokyo, 11 March.

Organisation for Economic Cooperation and Development (OECD) 1999, Australia, OECD, Paris.

Reserve Bank of Australia 1997, Semi-Annual Statement on Monetary Policy, November.

Stephen Kirchner is Director of Economic Research, Standard & PoorÕs MMS, Singapore.

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