Recession calls are ringing hollow

The recession call has gone out again, for something like the fifth time in as many years, which I have to confess I am a little mystified by.

A high-profile economist, Ross Garnaut, is the latest to express some concern and there was some media coverage about it over the weekend and today. I believe a couple of market economists are concerned as well. Regular readers will know that I’m optimistic on growth, and I’ve outlined why in my pieces of March 4 - Preparing for a capex spree and December 10 Geared for growth. But people still seem to be spooked.

Chart 1 captures everyone’s concerns. Mining investment has surged 854% since March 2005, for an annual average gain of about 100%. In the 10 years prior to that, average annual gains were closer to 5%.

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What, the economists ask, will fill the void when this mining boom ends – as it must. The Reserve Bank says the peak is pretty much now. And it is this idea that something must rise to fill the void that consumes people. Because, if nothing does, then recession could be the result. Now, as I’ve outlined in past notes, I’m confident that the ‘void will be filled’. Even if I’m wrong on that though, the recession call is a stretch.

The reason is simple . The impact of the boom on growth is grossly exaggerated, notwithstanding the above chart. Don’t get me wrong; it’s important, it’s helping, but it’s not the difference between growth and recession as some people suggest. There isn’t going to be some massive void to fill in its absence. You’re probably shaking your head at this stage given it’s the common misperception, often backed by high-profile economists. But hear me out with some basic facts. Don’t forget there has been a litany of market misperceptions over the years, monumental ones, all with the backing of high-profile economists. These have all led investors seriously astray and cost people some serious money in the end.

Anyway, even with that extraordinary growth, mining investment is still only about 6% of GDP. Usually its impact is barely noticeable. As a result of this, it’s actually very difficult to assume recession in its absence, simply because it’s such a small component of our economy. Check out chart 2.

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The chart shows GDP growth with the mining boom (blue line) and GDP in the absence of the mining boom (red line). It’s rudimentary, only to illustrate a point, but I derived the red line by replacing the mining investment boom with something more ‘trend’ like. I then stripped out the lift in imports that has occurred as a result of this. You’re left with growth of 2%. This is lower than what we’ve got now (3%), and lower than trend. Yet, that’s not a recession and, as you’ll see below, this is a worst-case scenario.

So we know that there is no recession in the absence of the mining boom. Knowing that we did actually have a mining boom though, the argument is that as it unwinds, we will effectively have negative mining investment (as we come down from the peak) and this will detract from GDP. It is argued that the magnitude of the falls will cause a recession, because there is ‘nothing to fill the void’. Again take a look at chart 3 below.

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In the above chart I’ve assumed a very aggressive collapse in mining investment over the next few years, falling in that time to only one-quarter of what it is today. That’s unprecedented. That is, the trough settling at the same point from where the boom started in March 2005. In past episodes, when busts have come, investment usually settled at some point above where it started. One reason for that is obsolescence – the greater the stock of investment, the more new investment required to offset depreciation.

Why over three years? It’s a guestimate, sure, but an aggressive one given that we know not all the large mining investment projects finish at the same time. There are some big projects that don’t finish until 2014-15, assuming no delays, and we know projects are being delayed due to costs. That argues strongly against a cliff scenario this year or next. The reality is, any slump would probably be spread over four years or more given delays and the like, but I want to give a worst-case type scenario to rule out any doubt.

So, on the basis of the above, and assuming no change to growth rates elsewhere (that is, ongoing housing recession, trendish consumer spending, soft public spending, no lift to exports) Australia’s GDP growth profile would look a little like chart 4 below.

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The chart shows that even under the extremely aggressive and completely unrealistic assumptions I’ve used, we do not get a recession (dashed red line). Growth certainly does slow substantially to about 1.5-2% annually. But there is no recession in there, and this is a fairly dire scenario. It assumes over the next three years:

• An ongoing housing recession,
• An ongoing non-mining investment recession (worse than the slump in the 1990s recession),
• Trend consumer spending,
• Below trend public spending,
• And no pick-up in exports.

All of these are why GDP growth in chart 2 (the absence of the boom) is only at 2%. If those sectors were healthier, GDP growth could very well be 4-5% now, and 3-4% without the mining boom. And those kind of growth rates are actually much more likely. Why? Because of the reasons I’ve noted in previous pieces (housing and non-mining investment will pick-up).

Don’t forget that the mining investment boom is probably crowding out growth elsewhere. Think infrastructure projects in other sectors, delayed or shelved because of the rising costs. Then think that the Australian dollar would be lower, lifting export values, maybe making manufacturers more competitive, and boosting domestic tourism. No one can give you a good estimate of how that would all interact. But it does argue against the recession call.

In the above chart I’ve shown three other scenarios – a mining slump, and no mining slump with or without a pick-up in growth in other sectors. Most people expect who are pessimistic are looking for a plateau or a peak in mining investment - not a slump as I have outlined in my aggressive scenario. It is entirely plausible, and likely then, that a growth rate of 4-5% won’t be uncommon over the next four to five years – assuming a modest fall in mining investment and a modest pick-up in growth elsewhere. An end to the housing and non-mining investment recession is all it would take.

Note that the International Monetary Fund expects trend growth over the next couple of years to be around 3-3.25%. Note also, in chart 4, that we actually would get better growth outcomes with a mining slump, and a modest pick-up elsewhere, than no slump and the status quo in other areas.

All of this highlights a simple fact. The structure of the Australian economy is now 80% or so service based, which makes it very difficult for one sector – especially one that is about 6% of GDP – to cause a recession. It’s not impossible, nothing is, but it’s very, very unlikely. To get a recession, a mining investment slump won’t suffice – we are going to need a fairly serious deterioration elsewhere as well.

My question is, where is that going to come from exactly? Housing is already in recession, non-mining investment now is actually doing worse than the 1990s recession. See what I mean? Of the two recessions we’ve had in the last three decades – the early 1980s and again in the first-half of 1991 – both were policy induced. Specifically, tight monetary policy to deal with inflation (the almost recession in 2000 isn’t included as numbers were distorted by the Olympics and the GST introduction). This is why recessions in the modern era have been policy induced. Without policy smashing things on a broad-based basis, you’re not likely to get that recession.

Comparisons prior that to that aren’t really useful. So when people talk about past commodity busts or investment busts that have caused recession in the past, they are making disingenuous comparisons. Don’t forget that up to 1950, primary production was about 20-25% of the economy and wool was between 50-70% of our export cheque – a drought could and did cripple us.

The bottom line is that any talk of a severe downturn or recession over the next few years is alarmism at its worst at this stage, regardless of who it is coming from.

In any case, if it were looking like we were going into recession, you shouldn’t doubt that fiscal policy will come to the rescue. Monetary policy has been foolishly spent, but there is still ample capacity fiscally – and it would be used. But I’ll talk more about that another time.