Once again Australia’s economic debate has gone off the rails with a number of economic issues being conflated. The received wisdom, following a speech from Reserve Bank of Australia Governor Glenn Stevens last week, is that we might need to settle for a lower rate of economic growth going forward – and if we want to raise living standards (i.e. growth in GDP per capita) we need more structural reforms to boost productivity.
I can’t argue with the need for more economic reforms that boost productivity. That’s always on an economist’s wish list and Governor Stevens is no different from other past and present econocrats in pushing the reform bandwagon.
Sadly, it seems to be falling on deaf ears in Canberra these days as Prime Minister Abbott’s near-death experience after last year’s unpopular Budget has made him gun-shy over any controversial reforms. The Abbott Government seems content to fight the next election over border protection and the Labor’s renewed commitment to a carbon emissions trading scheme. At this stage I don’t think Labor can effectively counter the Government’s likely devastating scare campaign – which is giving our Prime Minister (hard to hide) confidence.
The unemployment rate and growth
But let’s get back to the economy. The big issue at present is that despite allegedly “below trend” economic growth of late, the unemployment rate has surprised on the downside. Indeed, so far this year the unemployment rate has trended slightly down. In June, the unemployment rate was 6%, compared with the May Budget time estimate of 6.25%. Yet in the year to March, non-farm GDP grew by only 2.4% - below what we consider “trend” growth of around 3.25%.
Has the economy really changed? To my mind, it’s still far too early to tell given the likely statistical noise within short-term indicators and the loose lagged relationship between economic growth and unemployment.
Economists have a term for the relationship between unemployment and economic growth – it’s called the “Okun” curve after the famed US economist that invented the concept.
Australia’s Okun curve – which I’ve estimated since 1978 – is shown in the chart below. I’ve also used trend non-farm GDP and the trend (quarterly average) unemployment rate to reduce noise. I have also lagged economic growth by two quarters – which produces the best fit over time.
As evident, there is a good negative relationship between the two – when economic growth is particular strong, the unemployment rate tends to fall and visa-versa.
More specifically, the above relationship suggests that annual growth needs to be around 3.25% before it places downward pressure on the unemployment rate. And for every one percentage point of non-farm GDP growth above 3.25% over a given year, the unemployment rate tends to fall by around 0.44 percentage points over a year (with a two quarter lag). As should also be evident, this relationship is not precise – there is a fair degree of slippage, but overall the fit is still not that bad as far as macroeconomic relationships go.
Not so bad
So where are we today? Trend non-farm GDP growth was 2.6% in the year ending December quarter 2014. That would suggest the trend (quarterly average) unemployment rate in the June quarter this year would be around 0.3 percentage points higher than in the June quarter 2014 – or around 6.3%.
Instead, the trend unemployment rate last quarter only averaged 6.1%. So unemployment is a bit lower than we might have expected, but not by that much. The differences are certainly within the margins of error associated with our “Okun” curve as estimated since 1978.
What’s important to realise is that while economic growth has been “below trend” of late – the gap has not been shockingly large, and certainly far from recession levels. At growth of around 2.5%, the above relationship suggests the unemployment rate would only rise by around 0.3 percentage points over a year – or just only 0.1 percentage points a quarter. Given such a gentle rise over time, and the margins of error involved, it’s not inconceivable that the rate could bounce up a little for a quarter or two.
It’s also important to realise that - assuming the above relationship still holds - then continued below-trend economic growth should continue to place upward pressure on the unemployment rate over time. Annual growth in trend non-farm GDP slowed to 2.3% in the March quarter, which suggests the trend unemployment rate should average around 0.4 percentage points higher this quarter than the 6.2% averaged in the September quarter last year – or 6.6%. A lurch higher in the unemployment rate that far that fast seems unlikely, but it’s premature to suggest the pressure on the unemployment rate at current growth rates is anything other than upward.
Of course, there are been much talk of population ageing slowing the rate of labour force growth – and the fact that immigration levels have slowed due to weak economic growth. Population ageing will slow our potential rate of economic growth, but this is a long-term issue – and need not be the case if work-force participation among the elderly also increases.
As for immigration, this has always been cyclically sensitive, and recent trends seem little different from that observed in the past. That said, to the extent that immigration has become more cyclically sensitive (due to more flexible visa requirements) it also means it’s likely to bounce back much quicker when economic growth picks up – limiting the downward pressure on the unemployment rate we would otherwise enjoy.
In our power
The final point to note is that apart from productivity, Australia can also dictate the level of “trend” economic growth it wants by setting its immigration levels accordingly. This is something Governor Stevens never mentioned.
If we feel there’s an advantage in more growth and a higher population – which is certainly what corporate Australia would want to see – it is in our powers to make it happen. Australia is a great place to live and we could take our pick of the best workers in the world if we wanted to.
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