AFR: The Budget's Problem is a Large Surplus of Optimism

Published in the Australian Financial Review on May 20, 2014

Officially the Australian economy is not forecast to return to trend growth for at least two years. Even that turnaround is based on an expectation in the Budget Papers that consumers will spend much more while the job market continues to deteriorate. If the unemployment rate rises from 5.8 per cent to 6.25 per cent and stays there, as forecast, working families are unlikely to celebrate the increasing prospect of being thrown out of work or losing working hours by going out to dinner or slipping up to the Gold Coast for a holiday.

So what makes the authors of the Budget Papers assume increasingly stressed-out workers will spend more and save less?  A house price bubble, it seems. Treasury is forecasting that home owners will spend up big on the back of their perceptions of increased personal wealth from rising house prices, writing that: “further gains in household wealth are expected to support a further modest decline in the savings ratio, enabling consumption to grow faster than income.”

Back in the mid-2000s, when house prices were rising sharply, the household savings ratio plunged from its long-term average of 10 per cent to zero; householders were spending all their income, saving nothing. This didn’t seem sustainable and it wasn’t.  As the Reserve Bank increased interest rates in response to inflationary pressure the savings ratio began rising.  

Then, as the global financial crisis hit home, previously profligate consumers, who had borrowed 100 per cent of the cost of their new McMansions, took the scissors to their second and third credit cards. First-home buyers began saving for a deposit. Even as the Australian economy recovered after averting recession, the Reserve Bank observed that the cautious consumer had become the prudent consumer, and the household savings ratio returned to 10 per cent.

Policy makers would consider this a positive development. Increased consumer spending based on a returning housing bubble is hardly an economic strategy and definitely not a sustainable one. In a weakening labour market, with money wages growing at their slowest pace in at least 17 years, it doesn’t seem plausible.

If the happy, confident consumer story doesn’t pan out, maybe other parts of the economy will come to the rescue? Sure, lots of new houses and apartments are being built to fill a backlog. But that same dwelling construction activity will also be a source of downward pressure on house prices.

Sustainable economic growth requires investment in new productive capacity. Yet as the mining construction boom comes to an abrupt halt with the major gas projects nearing completion, nothing is turning up to take its place. Nothing. Investment in engineering and construction work is forecast to decline by 13 per cent in the coming financial year and by 20 per cent the following year. Australia is entering an investment drought. The economy is not making the transition from a mining investment boom to investment in a more diversified economy. At an exchange rate above US$0.90, management in exporting and import-competing industries is struggling to make a business case for new investment in non-mining projects.

Perhaps the increased export volumes from the mining investment boom will lift economic growth? They will. But as increased mineral export volumes come on stream worldwide, prices will continue to fall. To illustrate, iron ore prices, recently at A$130 per tonne, are officially forecast to fall below $90 per tonne by 2016 and further thereafter. And while mining exports might help boost the growth figures a bit, they won’t do much for jobs or national income. Mine production is about the most capital-intensive activity imaginable, far more so than even the mine construction phase, and the majority of the company income earned will accrue to foreign shareholders.

Ironically, with all the talk about vicious budget cuts, spending by the federal and state governments is projected to prop up the economy in the short term. Policy decisions will improve next year’s Budget bottom line by less than $2 billion. The Budget, however, is unlikely to do much for consumer confidence.

The official economic outlook for the next three years appears overly optimistic. Private investment is falling off a cliff as the expiring mining investment boom is not being replaced by new investment in productive capacity elsewhere. Mineral export values are being hammered by falling prices. Yet, confronted with a deteriorating job market and declining real wages, workers are implausibly assumed to spend much more of their incomes and to save less.