It’s quite clear that the Australian economy’s strength has taken most commentators and economists by surprise. Indeed it’s an alarming fact that through most of the post-GFC world, analysts appear to have largely missed the underlying dynamism of the economy. It consistently manages to outperform.
So why the ongoing drama? Surely if the downturn call has proven to be wrong in each and every year for the last six years, people would learn from that, right? Wrong.
Instead we find that people can’t believe the GDP figures, or the employment figures or the inflation figures, or company earnings or even the fact that house prices are rising. Instead, house prices are falling and, even if they’re not, only a fool thinks they go up! This is despite the fact they have only ever gone up, and notwithstanding the very strong fundamental support for future growth.
What could drive such an emotionally charged dystopian view of the economy? The main culprit is the mistaken view that national income is falling, driven by the slump in the terms of trade. It lies at the heart of this doomsday cult that seems to be running Australia and it stands behind the constant call to slash wages and cut the exchange rate. Presumably because the only way to lift national income is by cutting it!
Some of the confusion has arisen because of a debate that has been raging for many years about how we actually measure national income.
Many economists were rightly critical of the standard approach, GDP, because it fails to capture movements in the terms of trade. So they augmented it with another, real gross disposable income RGDI, which simply adjusts GDP according to movements in the terms of trade.
By this measure, real incomes fell by about 0.33 per cent in the June quarter -- and are only a little over 1 per cent higher for the year. This well below average and, on the face of it, cause for great alarm.
Now this call is very intuitive. If the price of what we sell goes up , then we must be better off. If it goes down, then we must be worse off. Except that this doesn’t necessarily have to be the case. The best way to think of this measure is as some kind of counterfactual -- a theoretical construct which really only tells us that we could have bought more stuff from overseas, given a fixed quantity of exports, if the price of those exports was higher (or imports lower). That is, the purchasing power of our exports is higher.
That doesn’t necessarily mean that when it falls that incomes or our standard of living is declining. And this is where I think economists are getting it wrong. The terms of trade is only a relative price index and the effect on income from a fall in the terms of trade depends on what is driving the fall.
A fall in the terms of trade doesn’t capture volumes or new sources of income, such as the upcoming LNG boom. More broadly, traded goods are only one subset of the economy and relying solely on the prices of those traded goods as a measure of income attributes a weight to export prices that simply does not exist in the real economy. National income is so much more than the terms of trade -- indeed roughly 90 per cent of our national income is household salaries and non-mining corporate profits. Moreover, the mining sector is a comparatively small employer -- 1-2 per cent of the labour force only.
This is why other measures of the country’s real income, GDP for instance, show quite solid growth. This concept measures what companies and household actually earn: profits, wages, returns to investment and the like. On this basis, real incomes were up 3.5 per cent over the last year -- a rate well above trend and markedly higher than the terms-of-trade adjusted figure.
So which is right?
Naturally, those who want to push the case for alarm -- seemingly most of the nation’s policymakers and commentators -- rely on the first. Yet how does that explain the recent jobs surge we’ve seen?
Even if you don’t believe the 121,000 figure, jobs growth has been undeniably strong this year. How does it explain solid corporate earnings growth or elevated inflation at the top of the band? The idea that national income is falling is clearly inconsistent with all of these developments.
Traditional measures of income like GDP have their flaws. Yet that doesn’t mean economists should go to the other extreme and assume national income is plummeting and that a downturn is coming, simply because the terms of trade fall.
This is a flawed approach, and gives weight, or attributes an importance to the terms of trade, that it simply doesn’t have. To do so implies that the growth and welfare of the nation rely solely on illusory price changes. This is wrong. Capital, population growth and productivity are the ultimate determinants of income growth and national welfare, not the terms of trade.