Friday Economics - implications of the changing Australian labour market

  

Useful piece by Leith van Onselen in Macro Business, Australian unemployment in detail. Triggered by the latest  Australian labour force data, it looks at changes in employment over the last few years.

As an aside, I find the free Macro Business daily economic email briefings very helpful.

This first chart shows total Australian employment. You can see the rise in total employment, its peak, plateau and then slight decline.

The Australian population has continued to increase. Unemployment has been edging up, but not by as much as you might expect.

The reason for this shown in the next chart, the changing workforce participation rate. 

From 2000, the participation rate rose steadily, quite remarkably in fact for such a relatively short period. More people working helped drive Government tax revenues, as did increasing company tax collections.

The participation rate then dipped sharply. The decline began before the full global financial crisis hit, but was connected to it. The rate then rose, if to a lower peak, before declining significantly.

This was the period of the two speed Australian economy. As the mining sector boomed, the high value of the Australian dollar slowed growth or even forced contraction elsewhere. This, combined with progressive public sector cuts, led to people dropping out of the workforce. Economists call this the discouraged worker effect. After a certain period of unemployment, people give up and stop looking for work.

Note, however, that the labour force participation rate is still well above the 2000 level. It's helpful to remember that because some economists are now suggesting that declining workforce participation rates have created a choke point limiting Australia's return to trend growth. There may be a choke point, I don't think that there is, but it's more the participation rate is still high by historic standards. This means that there are proportionately fewer workers to draw back into the workforce.

Other factors come into play as well.

The next  graph compares growth in full time as compared to part time worker since 1991.

Growth rates for both categories display wild swings. The start of the period is Mr Keating's recession. This was the period of restructuring and process re-engineering as firms shed full time long term employees. These were, in part, replaced by part time workers. Then came a period of sustained growth in full time employment as business improved and firms corrected previous employment errors. Growth in part time employment dived, then rose sharply as new workers were added to meet immediate needs.

Over the whole period, growth in part time workers generally fluctuated more than full time workers. Part time workers are generally easier to add or get rid of. They are economic buffers. However, over the whole period, part time work on average grew father than full time work. The effect of this is illustrated in the next graph.

The fourth chart  shows the decline of full time employment as a proportion of total employment. The tile is actually a little misleading. Not all part time workers are casual, nor full time workers permanent or long term.

What is true, I think, is that an increasing proportion of full time workers are on often shorter term term contacts, while part time workers are, on the whole, more likely to be in casual work. I commented on the impact of this trend in an earlier post here, Friday Economics- economic outlook 2014:

While workforce flexibility does aid business activity, the growing proportion of the Australian workforce working in contract or casual roles has affected consumer behaviour. Greater work uncertainty requires people to hold larger cash reserves, as do the periodic employment gaps often associated with such work. It also depresses Christmas sales, since a not insignificant proportion of the workforce is now only paid when they work. Christmas is actually a low income period for many people. 

A few weeks back, I assisted in interviewing for a short term contract position. It was a relatively low level project officer role. All the applicants were over-qualified for the role, some had been out of work for twelve months. Every candidate we interviewed was considered as suitable for the position.

This was not a job in a high prestige area. In the past, it has struggled to get suitable applicants. Now, looking at the applicants from my own experience, I thought that if I could put them together in a single unit, I would have a very powerful multi-skilled team.

The point here is that, unlike some of my economist colleagues,I do not think that the present state of the Australian labour market creates a significant short term constraint on growth at trend or above. There are specific choke points, but there is also plenty of immediate scope for increasing hours worked or to bring skilled people back into jobs.

Friday Economics- economic outlook 2014

  At the start of November, I prepared an economic outlook for 2014 for publication in a business magazine. The piece is not on-line, so it seemed sensible to run it again here with an update, thus testing my assessment in light of the some what topsy turvy changes over two months since I wrote.

The piece begins 

Twenty thirteen has been a funny old year in economic terms. Globally, the year began with expectations of somewhat greater economic growth, continuing the slow recovery from the great global recession. Pessimism re-emerged as growth was slower than expected, turning again to optimism as growth began to pick up. At the 1 October Monetary Policy Meeting of the Reserve Bank Board, members observed that, on balance, the “data for the global economy had been a bit more positive of late and broadly consistent with growth of Australia’s major trading partners remaining around its long term average.”

How quickly things change! At the time the Board met, the US fiscal and debt crises were looming, but there was still an expectation that they would be resolved. Then came the partial US government shutdown, followed by brinksmanship over the debt ceiling. Debt default was avoided and the US Government re-opened, but with new deadline dates; January 15 2014 for government activity, 7 February for Government borrowings.

The immediate direct effects on the US economy were relatively small, with Standard and Poors estimating that the shutdown had shaved at least 0.6 per cent of the US economy’s annualised growth rate in the December quarter. The impact on confidence and business certainty is likely to have been much greater.

You can get a feel for this from the increasingly concerned comments made by central bankers as the crisis proceeded. “We felt helpless”, the SMH’s Glen Hutchens reports Reserve Bank Governor Glen Stevens as saying. “The Bank could neither predict nor properly prepare for the way the drama might play out”. It wasn’t just the impact on global financial markets that had to be considered, but also a possible forced contraction in US Government spend equivalent to 4 to 5 per cent of US gross domestic product.

Doubts linger, casting a continuing cloud as we move towards 2014. Uncertainty over the ending of quantitative easing and the impact that this might have on markets adds to doubt, as do continuing uncertainties over the Chinese economy. Despite these doubts, I think that 2014 is likely to be a better year in economic terms, far better than some analysts allow.

Comment

The US sorted its fiscal and debt limit problems, at least for immediate purposes. Quantitative easing has begun to end, although in a very tapered way. Both are positive for the economic outlook. 

The Importance of Business Confidence

One of the unusual features of the last two years has been the general lack of confidence displayed by Australian business. I say unusual, because the Australian economy has actually performed quite well in global terms. Many international economic commentators have been bemused by this Australian economic gloom, pointing to the divergence between it and the actual performance of the Australian economy.

This first graph prepared by the Reserve Bank illustrates the confidence problem. Business confidence plunged with the onset of the global financial crisis to levels lower than those holding in the recession of the early 1990s. Business confidence then rebounded sharply as the crisis eased and Australia’s mining boom picked up pace, peaking slightly above the levels holding over the previous decade. Business confidence then began an inexorable decline.

Confidence is important, for without it business will neither invest nor employ new people. The progressive decline in business confidence dragged on economic activity, effectively feeding itself. Political uncertainty fed the lack of business confidence, especially in the last period. You can see this in the sudden rebound in business confidence following the election. If sustained, this will encourage increased economic activity, providing a first building block for economic expansion.

Comment

At the time I wrote these words, I did not forsee the instability in Australian Government policy, nor the nature of the debate that would take place in the lead-up to the release of the Mid Year Economic and Fiscal Outlook with its somewhat lower Treasury economic projections, nor the almost forced announcement of Holden's intention to cease manufacturing. This will probably have minimum real economic impact  over 2014, but it has damaged confidence.

The swing in economic commentary was quite remarkable. Over a four week period marked by selective leaks on the budget position, the central tone in commentary went from neutral/slightly positive to negative/neutral. It was really quite a remarkable swing that must affect confidence. For the moment, call this one a negative.     

Consumers on Strike

Retail sales have been relatively stagnant over the last two years. Effectively, consumers have been on strike. There have been good practical reasons for this. In Australia, as in may other countries, personal debt levels rose during the long period of economic growth, supported in part by rising asset values. Savings rates dropped to very low levels.

This process went into reverse following the global financial crisis and subsequent global recession. People sought to save more, to spend less, to de-leverage, adding to downward economic pressure. The effects were muted in Australia by the mining boom, but persisted nevertheless.

Structural change in the Australian workforce reinforced the process. While workforce flexibility does aid business activity, the growing proportion of the Australian workforce working in contract or casual roles has affected consumer behaviour. Greater work uncertainty requires people to hold larger cash reserves, as do the periodic employment gaps often associated with such work. It also depresses Christmas sales, since a not insignificant proportion of the workforce is now only paid when they work. Christmas is actually a low income period for many people.

Further downward pressure has been added by public sector cuts backs and then, more recently, by cut backs in mining employment as mining companies seek to curtail costs. The combined effect can be illustrated by the second graph drawn from the Australian Bureau of Statistics showing the employment to population ratio from April 2012 to September 2013. This shows clearly the decline in the proportion of Australians actually employed over the last eighteen months. This decline has been significantly greater than the increase in the unemployment rate because many Australians have dropped out of the workforce.

In simple terms, there are fewer Australians working, and those who are working are less prepared to spend money.

This is likely to turn round over 2014. The increase in savings and consequent decline in willingness to spend associated with financial de-leveraging, structural change in the workforce and uncertainty about the future has probably peaked, although the effects will linger. Further, the labour force data suggests that there is considerable scope to increase employment without creating new wages pressures. The combination provides the second building block for better economic conditions in 2014.

Comment

I think that consumer confidence was hit by the discussion associated with the Commonwealth Government's budget position and the Holden decision, and all this just before Christmas with retailers dependent on Christmas sales. Talk about timing.

There have been signs of some of weakening in the labour market too, although this is more anecdotal than anything else. This would not be surprising given the changed business mood. However, at this stage my position remains the same. 

The Exchange Rate

The Australian dollar is likely to provide the third building block for faster growth. By all measures, the Australian dollar is over-valued, although there is dispute about the exact scale of over-valuation. This has depressed economic activity through lower Australian dollar returns on exports, combined with higher import competition.

So long as quantitative easing remains in force in key countries and especially the US, the dollar is likely to remain over-valued. However, as quantitative easing ends with consequent rises in international interest rates, the Australian dollar will fall. We have already seen how the merest hint of an end to US quantitative easing shifted the value of the dollar down. Quantitative easing will end, although the timing is uncertain and the process likely to be messy.

Australian interest rates will rise over 2014, in part because of the need to avoid or at least minimise an emerging property bubble. However, what is relevant from an exchange rate perspective is the differentials between real interest rates. So long as Australian rates rise less in real terms than interest rates in other key countries, the value of the Australian dollar will fall. This is likely, given that real interest rates in major developed countries are now so low or even negative.

A lower Australian dollar brings benefits, but also costs. We saw this in the September quarter, when the Australian import price index rose by 6.1 per cent, the export price index by 4.2 per cent. Both increases were directly associated with a fall in the value of the Australian currency. The increase in export prices benefits exporters, the rise in import prices aids domestic production but also feeds directly into inflation.

Inflation will rise as the dollar falls. For the present, Australian inflation is quite low, well within the Reserve Bank’s target range. However, it is likely to kick up noticeable over 2014, adding somewhat to interest rate pressures.

Comment

Action in the US to end quantitative easing has begun and the Australian dollar has fallen. The taper actually helps us by minimising the immediate currency flows that might have adversely affected emerging markets. The fall in the value of the Australian dollar has already begun to feed through, including an unexpected but helpful lift in Western Australian Government revenues.

The Reserve Bank has the capacity to cut rates if that is necessary to counter domestic economic weakness, thus further reducing the value of the Australian dollar. However, for the present I hold to my analysis for 2014.    

Investment

In October, Reserve Bank Deputy Governor Phillip Lowe noted in a speech that the developed economies have been in an investment drought since 2008. Investment has also been very low for the world as a whole.

Graph three illustrates this.

Note the longer term downward trend, as well as the sharp fall since 2008. Note, too, the widening gap between investment in major developed countries and total world investment, a sign of the economic shifts that have been taking place within the global economy.

By contrast, Australian investment has a proportion of GDP has risen quite sharply since 1993.

Graph four presents the dramatic change that has taken place. Australian private business investment peaked at levels not seen since the gold rush and post gold rush periods.

This growth has been almost entirely due to the mining investment boom. Outside mining, private business investment has been quite low, mirroring international patterns. As a consequence, Australians started talking about a two speed or even patchwork quilt economy.

In many ways these were accurate descriptions, but also missed an important point. Unlike past booms, the cost pressures associated with the mining investment boom were effectively quarantined to mining, leaving the remainder of the economy in a better position to grow.

With the end of the mining investment boom, investment as a proportion of GDP has started to fall, placing downward pressure on economic activity. This has led some analysts including Deloitte Access Economics to talk about investment in quite gloomy terms. I don’t share that view. Indeed, investment is my fourth building block for better economic conditions in 2014. I am not saying that investment will boom, simply that it will be better than expected.

In balance sheet terms, Australian business is well placed to expand investment if conditions suit. Corporate debt levels have been reduced, while liquid assets have risen. Banks, too, are in a position to expand business lending. But will conditions suit? I think that they are likely too.

In October, the Australian Bureau of Statistics released some quite remarkable numbers. The trend estimate for total dwellings approved rose 2.5 per cent in September, up 15.1 per cent from the same month last year, and has been rising for twenty one months. The increase was driven particularly by dwelling units, up 20.9 per cent in trend terms, but private sector houses also rose by a substantial 10.6 per cent.

These statistics are supported by a variety of anecdotal evidence. The property sections in Australian newspapers including the Financial Review are expanding, an expansion not limited to housing. Investment in retailing, office building and industrial estates and rural land are all displaying signs of increased activity.

This expansion is not limited to building. Rising share prices and increased confidence has led to a resurgence of initial public offerings. The markets are moving. Indeed, if you ignored the official economic statistics and the sometimes gloomy commentary based on those statistics and relied only on newspaper reporting, you might be forgiven for concluding that a new boom was well underway! Herein lies a problem, for the Reserve Bank may in fact be forced to move earlier on interest rates than would otherwise be the case in order to control investor exuberance.

Comment 

My glasses may have been too rosy here, but for the moment I hold to my position.

The Global Economy

As a trade exposed economy, Australia is affected by economic conditions elsewhere in the world. Here, too, I am more positive than many commentators. Yes, there are some problems. As I have written in my column, China remains a question mark because of the need to rebalance the economy, a process likely to prove messy. The US fiscal cliff and debt ceiling debates still cast a shadow. However, Australia does not need the rest of the world to boom in order to grow. All the country needs at this point is continued global economic growth even if at moderate level. Here the signs are reasonably positive.

The Europeans are slowly dragging themselves out of a recession that, in statistical terms, bears a striking resemblance to the Great Depression. The results have been absolutely awful from a European perspective in human and economic terms, but the immediate likelihood is for slow growth that has the potential to accelerate once properly underway. The US too has been growing despite the best endeavours of US politicians.

My best judgement in all this is that while I see few signs of a rapid acceleration in global economic growth, there will be growth. And that’s all Australia needs at this point.

Comment

Global economic growth and especially US growth has been stronger than expected even two months ago. This building block remains positive.

Conclusion

In writing, I have consciously tried to break from the gloom that sometimes dominates current economic analysis, to set out the reasons why I think that 2014 is likely to be better in economic terms than 2013 so far as Australia is concerned. In so doing, I focused on four building blocks.

The first is business confidence. Low business confidence has been a drag on the Australian economy, but has now resurged. I think it likely that business confidence will remain positive.

The second is consumption. Australian consumers have been on strike, again dragging down the economy, because of both uncertainty and the effects of fundamental strategic change in the workforce. That strike is coming to an end.

The third building block is the exchange rate. The Australian dollar has been overvalued. Over 2014, I expect the value of the Australian dollar to fall. This will have adverse price effects, but the overall impact will be support for domestic economic activity.

My final building block is investment. Yes, the end of the mining investment boom will exert downward economic pressure. However, I do not share the gloom and doom view of some commentators. There is increasing evidence of an investment boom in non-mining areas, a boom that will encourage economic activity in non-mining areas of the Australian economy. In fact, the big economic challenge of 2014 may be to find the best way of managing that boom without depressing the overall economy.

In all, I think that 2014 will be an interesting and potentially profitable year.

Comment

Pollyanna may be speaking, but for the moment, I am prepared to hold my overall assessment, 

March employment data suggests continuing weakness in the Australian economy

 

The latest Australian employment statistics suggest continuing weakness in the Australian economy.

The graph from the Australian Bureau statistics on the left shows employed persons. You can see how the seasonally adjusted numbers shot up then down. These stats are very volatile, but its quite a big fall.

A better feel is given by the numbers. In summary:

• Employment decreased 36,100 (0.3%) to 11,592,700. Full-time employment decreased 7,400 to 8,111,300 and part-time employment decreased 28,700 to 3,481,500.
• Unemployment increased 25,900 (3.9%) to 686,900. The number of persons looking for full-time work increased 30,900 to 501,900 and the number of persons looking for part-time work decreased 5,000 to 185,000.
• The participation rate decreased 0.2 pts to 65.1%.
• Aggregate monthly hours worked decreased 5.0 million hours to 1,627.3 million hours.

The graph on the right hand side from unemployment. You can see the kick-up in the seasonally adjusted rate. The unemployment rate increased 0.2 pts to 5.6%.

ABS normally prefers to use trend estimates, because these flatten things out. But both seasonally adjusted and trend show an upwards drift in unemployment.

During the week the Australian currency measured by the trade weighted index reached a new high. So long as quantitative easing continues in certain advanced countries, the dollar is likely to remain high with consequent pressure on domestic economic activity.

With so many Australian workers now on contract work, the fear of unemployment also exercises a downwards effect on spending and on economic activity.

Australia in the Pacific century

Interesting short piece by Robert Gottliebsen (Obama spearheads an Asian coup) in Business Spectator on the implications for Australia of the US's re-engagement with Asia. The key point is that Australia risks being sidelined. 

I'm not sure that's right, but it is a risk. Over on my personal blog I have been musing from time to time about the changes taking place globally and the implications for Australia. It's a sort of check and update thinking series. We all have to do this from time to time.

This morning (Art, pop music & a dash of fracking) I mused in part about the implications of the US's growing energy self-sufficiency. The US is a very big economy. I know that seems self-evident, but we tend to forget it in all the discussion on the rise of China. As the US changes direction, it has a lot of economic levers to attract Asian interest.

How this might affect Australia is unclear. Here Mr Gottliebsen's point is worth considering. Australia may be a member of the G20 and may have passed Spain to become the world's twelfth largest economy, but it's still a small economy. 

Focus not on Asia, but on the Pacific. Where might Australia fit in a world where the economic centre of the Pacific gravity shifts to the US?  Should Australia be talking about a Pacific rather than Asian century?   Just a thought.

The future for the Australian economy

Note to readers: This column appeared in the June/July edition of Australian Business Solutions magazine. It was written just before the budget. It's not on-line, so I have re-published it here.

In my last column I spoke of the economic forecasting mess. Since then, the International Monetary Fund has released its latest forecasts on global growth. This was greeted by some in the Australian media with glee - “Australian economy leads the world” screamed one headline.

The reality is a little different, for the IMF is actually a good example of what I have been taking about. In recent years, its forecasts have been all over the place like a dog’s breakfast! So what did the IMF actually say? Well, not quite what the headline would suggest.

To begin with, the IMF suggested that there was some strengthening in the global economy, although this was heavily qualified in some ways with recognition of the various risk factors. But what did the IMF think of Australia? The IMF actually projected some further weakening in the Australian economy. We are still forecast to do relatively well by the standards of other developed nations, but hardly well enough to suggest that the Australian economy leads the world!

But in all this confusion what can we actually say about the Australian economy? The first and most important point is that world commodity prices will continue to weaken, reducing returns on our major exports. Why do I say this? It’s simple. The structural imbalances that developed in the global economy over the long boom are still there. They will take time to unwind. So long as they continue, global economic growth will continue to be weak. In turn, this means weakened demand for commodities.

Yet despite the fall in commodity prices, the Australian mining investment boom will continue, if at a lower level than previously forecast. Work already under way guarantees that. This means, in turn, that pressures on the non-resource sectors will continue. However, it’s not all doom and gloom.

A very significant proportion of the inputs required for all those new mines and supporting infrastructure, over 40 per cent, will be imported. With lower export prices, the current account deficit will grow. This will place downward pressure on the Australian dollar.

The Australian dollar may not go lower than now, but it will go lower might otherwise have been the case. Both export and import competing industries will be better off as a consequence. There will be more time to adjust.

But the story doesn’t end here. World growth may be slow, but it is still positive. This means that the total marketplace for Australia’s non-resource exports will grow. Importantly, the fastest growing marketplaces will continue to be in our immediate region, which gives us an advantage. The decline in commodity prices will also increase the relative return on non-mining investments, encouraging investment outside mining.

Taken together, we are likely to see a smaller resource sector than would otherwise have been the case, a larger non-resource sector.

For the present, the Australian economy should continue to grow if below the trend rate - and the biggest immediate economic risk? It’s actually the budget!

By the time you read this, we will know what Treasurer Swan has in mind. Looking at the numbers, the size of the apparent spending cuts required to return the budget to surplus will place considerable downward pressure on economic activity. That pressure will be felt most by the non-resource sectors of the economy, just those sectors adversely affected by the mining boom. That would be a pity.

Australian budget day

A post on my personal blog, Australian budget day - what will I examine?, briefly looks at tonight's Australian budget. I will bring the follow up post here tomorrow.

Navigating the economic forecasting mess

It is extremely difficult to keep a level head in the face of current economic forecasting and reporting. One minute it’s all doom and gloom, the next things suddenly seem better.

The gyrations have been quite remarkable, beyond anything in my own experience. They have also continued for some time now - since the onset of the global financial crisis, in fact. Measures of consumer and business sentiment have followed the gyrations.

From a practical business perspective, both economic forecasting and reporting have become a burden. They affect, but do not inform.

So how do you navigate your way through this mess? The first thing to remember is that forecasts are just that - forecasts. In all cases, they rely on past data and incorporate assumptions about the structure of the economy and of the relations between different types of economic activity.

But there is a further problem. Most prominent business economists work for financial institutions. Because their primary internal role is to provide advice on what might happen in financial markets, the economic reporting that follows from their public utterances is also markets’ focused. This means that both forecasts and reporting often do not provide the type of longer term information most businesses require.

Business wants answers to questions like: What’s happening to my market place or to my costs? By contrast, many forecasters and reporters are concerned with the immediate market impacts of changes in longer term expectations. How will it affect the dollar or shares, or the financial markets in general?

Perhaps the best course may just be to ignore the whole lot unless there is something there that seems directly relevant to your business! If this sounds extreme, consider all the reporting of interest rates over the last twelve months. How much of that has actually been in any way useful to the majority of Australian businesses?

I am not saying that you should ignore economic conditions or all economic reporting. I am saying that you should be selective and focus on information relevant to your needs.

Say that you an engineering business that provides components to certain firms in certain sectors. It is safe to say that you have a direct interest in developments in those sectors and especially in your own customer base. This includes the likely demand for your own products or services, as well as payment patterns. It is critical that you know if your customers paying more slowly and, if so, why?

If, like most businesses, you have borrowings, then you are interested in interest rates. But, more importantly, you are also likely to interested in the availability of credit.

Each business needs to define the economic information that is directly relevant to their needs. A lot of people in business do not focus properly on the economic and industry conditions that are relevant to their businesses. They will tell you how awful the economy is when, in fact, their business is doing just fine. These perceptions about the economy can affect actions, and the results can be quite damaging.

Note to readers: This column appeared in the April/May edition of Australian Business Solutions magazine. It's not on-line, so I have pre-published it here.

How do we break free from the ratings entanglement?

 

A number of people have asked to see my Australian Business Solutions January column. It's not on-line, so  is repeated below.

In December, Treasury Secretary Dr Martin Parkinson took a swipe at the global ratings agencies.

They were, he is reported to have said, “becoming mechanistic and excessively simplistic, running the risk of moving from excessive optimism to excessive pessimism every time they look at a country or firm.”

It’s worse than that. The global credit rating agencies have become a cancer eating away at the global economy, one that affects every business.

In the lead-up to the global financial crisis, they gave triple A credit ratings to institutions and securities that were clearly not. That helped fuel a global financial bubble.

As the crisis unfolded, the variations the agencies made to country and institutional rankings added to market instability.

We saw the same thing in the unfolding crisis with the Euro.

The credit rating agencies provide no new information to the market. The standard of their economic and financial analysis is clearly suspect. Yet despite all this, a shift or threat of a shift in a county’s credit rating can have damaging or even catastrophic market effects even though it tells us nothing that we didn’t already know.

It’s actually our own fault, yours and mine. Let me explain.

Our problem, and it is our problem because it affects us all, lies in the way that we awarded the ratings agencies authority without responsibility. We created the cancerous monster.

Back in a now dim and distant past when I was working in the Commonwealth Treasury, I remember discussions on the possibility that Australia might get a triple a credit rating for the first time. We did, lost it in 1986, then finally got it back in 2003.

Australia’s original concern with its credit rating at state and Federal level made a lot of sense.

In those days, both State and Federal Governments borrowed to fund infrastructure. We needed access to global capital for both private and public purposes. A high credit rating made it easier for a small relatively remote country like Australia to access funds and at a lower cost.

Sadly, from being a means to an end, the maintenance of a triple A credit rating became an end in itself. All Australian Governments preached this as a badge of honour.

Those in the business community nodded their heads and made approving noises, even though it was obvious even to Blind Freddy that much of the ratings shifts actually didn’t matter very much.

Governments throughout the world then did something worse. They built the ratings into policy, procedures and regulation. Business and especially the finance sector followed.

This institutionalisation of agency ratings, their incorporation into so many regulations and arrangements, meant that variations in credit ratings had direct flow on market effects in ways that no-one had foreseen. The ratings system itself had become a direct cause of market instability and on a large scale.

You would think that we would learn, but no! Even as Treasury Secretary Parkinson is complaining about the agencies, we see Federal Treasurer Swan, NSW Treasurer Baird, quoting rating changes approvingly as evidence of their good economic management.

Politicians respond to their electorates, that’s part of their job. But surely it’s time for the Australian business community as a whole to say enough is enough, that Australia and the world must break free from the ratings entanglement that we have created?

Why Chinese over-investment is important

For some time now, Michael Pettis has been arguing that China has been over-investing and that this over-investment is unsustainable. His most  recent piece, How do we know that China is overinvesting?, provides a useful introduction to his arguments. In essence, there is a growing gap between real borrowing costs and the real economic returns on the investment. 

Along with exports, heavy Chinese domestic investment has been a key driver in that country's growth. To the degree that Michael Pettis is right, and I think that he is, then the investment and industrial demand that has underpinned Australian mineral exports is likely to slacken.

I must say that's been my feeling all along, but its interesting to see another perspective.

Australia's continued economic disconnection

Note to readers: While short, this post took a little while to complete. I am bringing it up at the original scheduled publication date.

Interesting piece from Lorenzo, A misbegotten Union – Guest post by Lorenzo, on some current problems in the EU with a specific focus on the Euro.

From a purely management perspective, it illustrates the difficulties created for all of us when Governments' stuff up.

I don't think that any of us would argue that the creation of the EU and even the Euro has not made some aspects of doing business in Europe easier. It is easier to operate in a more harmonised environment. Yet, and this is something Australian business groups pushing for national uniformity should consider, common rules can come at a price.

I intend to do an update post on the latest developments in the Australian economy. The headline point is that Australia remains to some degree disconnected from developments expressed in terms of global or large regional unit data.

Today's Sydney Morning Herald story Indian coal rush heads Australia's way illustrates part of the reason, Australia's resource base. Demand will continue. The only issue really is price. However, there is a little more to it than that.

One of the wisest Australian Government decisions in recent decades was that taken in December 1983 to float the currency, allowing market demand to determine its value.  As I have discussed here before, the highly traded nature of the Australian currency creates its own problems since, as happened recently, the value of the currency can move in ways not directly connected to local economic conditions. However, the floating currency actually provides a very useful buffer, one that Greece would now find valuable.

In the lead up to the global financial crisis, the US dollar value of the Aussie declined sharply, providing one measure of protection to local demand. If, and on worst case scenarios, demand would continue if at a lower price for Australia's agricultural and resource exports. In this event, the currency would be likely to decline in value. However, this would of itself have some domestic stimulating effects.

A floating exchange rate combines with a good budgetary position and low Government debt.

To my mind, Government debt is too low. It is actually quite hard to deny that Australia has been under investing in public infrastructure. Further, the obsession with public-private partnerships has actually skewed public investment in a way that doesn't make a great deal of sense. Yet all this said, I cannot deny that Australia's budget and public debt position gives the country a great degree of flexibility in current circumstances.

National planning for global downturn

I concluded my last post, Global economic gloom, with the comment:

Like many, I have been mulling over what all this means (for Australia). I thought that it might be helpful, at least to me, if I did some of the same type of very basic economic analysis that I did during the GFC. You know, the simple stuff based on first principles. That's a better guide than the more complex analysis at a time of change.

As I write, the stock exchange and financial markets have been all over the place, with some of the type of breathless reporting that I have commented on before. One minute we are all ruined, the second everybody seems to breath a sigh of relief!

From a practical business perspective, what is important first is changes in the marketplace in which the business operates, rather than overall trends. I make this point simply because the two are not the same, but may diverge quite widely. Then there are the effects on funding of changing conditions in financial markets. This raises a different set of issues independent of individual market conditions. I make these points because there is a tendency to focus on general trends when some businesses may in fact be doing very well.

There is no doubt in my mind that the Australia economy has weakened, although the pattern is variable across the country. The latest Westpac-ACCI survey of Australian industry shows this quite clearly.

We have a number of effects working in combination here. One is the rise in the value of the Australian dollar relative to some other currencies. This has affected certain trade exposed industries in particular. Then, and as has happened before, anecdotal evidence suggests that business is cutting back on discretionary spend, creating flow on effects in related areas including legal services. Then, too, housing has been weak, as has retail spending,

Australia operates in a global marketplace and is affected by changes in that market. These flow through to Australia along four dimensions:

• Direct changes in demand for exports
• Financial affects associated with exchange rate movements and in the availability of funds to the banking system
• Psychological affects as people respond to global changes
• The impact on superannuation funds of global changes in an environment where a significant proportion of funds are invested in equity and off-shore. This one is insufficiently discussed for with compulsory superannuation it actually has major impacts on domestic behaviour.

Australia may be exposed to international conditions, but that exposure is more limited I think than most realise:

• Our main exports, minerals and primary products, have something of a natural buffer in that there is a stable base demand. Prices may fall - I have argued that present commodity prices are unsustainable -  but demand will continue
• Our floating exchange rate means that falling export income would (should) translate to a lower Australian dollar, with domestic stimulus effects. Quite a bit of Australian industry wouldn't mind in the slightest if all the hype about the mining boom #2 proved false!
• We are exposed to international financial markets, but the proportion of bank borrowings funded domestically has increased as local savings have increased
• We have strong institutional structures and relatively low Government debts, giving plenty of capacity to expand spending.

In the aftermath of the global financial crisis, one of the problems that I pointed too was the way in which many countries had lost their public infrastructure investment pipelines. This linked to changing approaches to public administration in many countries. I suggested that one practical result was that Government plans to expand infrastructure spending could not be realised in the proposed time limits.

Putting aside special pleading, there appears to be general agreement in this country that Australia has been under investing in public infrastructure for many years. We have also been under investing in housing, given population growth. Managed properly, there is scope for considerable expansion of public or even public private investment that is likely to yield considerable paybacks in economic terms.

The problem with the previous Rudd Government stimulus measures in this area is that, in the absence of a real investment pipeline and with a need for urgency, we arguably didn't get a long term return for our dollars.

This need not be the case if proper planning is put in place now.

If you accept conventional wisdom about mining boom mark two, then the place for such spend is limited. But who, now, would argue with certainty that that boom will occur? We really do need to have a fall-back position in the event that it doesn't.       

Global economic gloom

The release of the latest IMF global economic projections makes for gloomy reading.

In Australia, the latest minutes of the Reserve Bank's Monetary Policy Committee provides a useful summary of the overall domestic and global economic position as seen by the Bank.

It seems pretty clear that the IMF and others face considerable forecasting difficulties. That should not come as a surprise, for all the econometric models they use actually rely on a degree of stability that is presently lacking.

As it was during the GFC, Australia continues to be a lucky country. This is reflected in the Euromoney nomination of Treasurer Wayne Swan as the world's best finance minister. However, the country is still vulnerable at two levels.

The first is simply its reliance on certain markets and especially China and Japan. If they sneeze, Australia may catch a cold. The second is the high level of domestic household debt. This is manageable in a growing economy, but will become an increasing drag should economic conditions worse.

Like many, I have been mulling over what all this means. I thought that it might be helpful, at least to me, if I did some of the same type of very basic economic analysis that I did during the GFC. You know, the simple stuff based on first principles. That's a better guide than the more complex analysis at a time of change.     

Sustainability vs short term managerialism

As a professional adviser, I try to help firms improve business performance and to resolve problems. More and more, I have found a conflict between reality and aspirations. Reconciliation of that conflict comes back to one word, sustainability.

At a macro level, if the total business objectives set by all firms exceeds the possible growth rate in the economy, then some firms must fail to achieve objectives. If the gap between total firm targets and what is possible becomes large, then the shortfall between objectives and performance for most firms will also be large.

Since remuneration often depends upon achievement of immediate financial objectives, the incentive for managers to do whatever is required to get to immediate target is great. This leads to short termism. Cut now, with the costs coming later. In aggregate, this results in increasing economic instability.

Obviously, the position varies between firms.

If I am advising a start-up or a firm in a rapidly growing market place, then I provide one set of advice. If I am advising a firm that wants to increase market share and is prepared to pay the price, I provide a second type of advice. If the business is unprofitable, then that's another set of advice.

But what do I do if I am providing advice to an existing profitable business in a mature market that wants to improve performance to achieve new growth targets dictated by what is really managerial hubris? How do I say that you are doing the wrong thing? How do I say keep on going as you are, just improve at the margin?

If the reality is as it is that most businesses cannot achieve their targets, then shouldn't we be adopting a new approach? Isn't sustainability combined with incremental growth better?

Say you are a reasonably profitable law firm. What do your partners, your owners, really want?

They want to be able to get on with their professional work. They want a stable income with prospects of reasonable increase. Most don't want the prospect of big increases that risk the business.

Think how nice it would be as an adviser if your client said we want to improve what we do over time. Our focus is on business sustainability, not big targets. We want you to help make things better for clients, for partners and for our staff. We want you to give us practical suggestions to achieve this.

It would be nice, wouldn't it! 

Why do we underestimate the value of broad based skills?

I followed up China's foreign reserves - what they mean, what might happen with a post on my personal blog, Australia's economic fragmentation. Since then we have had the ending of the US debt crisis, new troubles in Europe, bad US economic data and something of a stock market crash. In the first minutes of trading this morning, falls slashed $A56 billion of the value of Australian stocks. There is a smell of panic in the air.

All this took my thoughts in a different direction, one that may seem a bit odd. One problem now is that many of those involved whether as commentators or traders, those trying to decide how to respond, actually lack the broad based experience required to respond sensibly. Further, they live in a wired twenty four hour world where initial responses feed on each other, where reporting heightens nervous excitement.

My original qualifications were in history and economics. Then I worked for twenty years as a professional economist and economic adviser before moving into the private sector as a strategic consultant and manager of professional services firms. I no longer claim to be a professional economist - the profession has moved on. In a way, the economics of finance has replaced the economics of economics, financial modelling has replaced a focus on economic principles.

I was in Shanghai when the Global Financial crisis struck. I watched it unfold on the television screens. Upon my return to Australia, I was struck by the fevered nature of reporting. Australian reactions just did not seem to match what I understood of the fundamentals affecting the Australian economic performance. I was actually drawn back into my past world as an economist.

The analysis that I did then suggested that, so far as Australia was concerned, the GFC was highly unlikely to have the type of catastrophic results forecast. It just wasn't going to happen. I said so, and I was right.

One thing that I have learned from my experience is the importance of time. There is a fundamental disconnect between most current analysis on the economy and the actual lengths of time involved in economic processes. For example, just as it takes time for economic imbalances to emerge, so it takes time for them to unwind. In similar vein, it takes time for new policy initiatives to work, especially where capital investment is involved.

In 1929, the effective closure of the London capital markets to Australian borrowings plunged Australian Governments into effective depression. In similar vein, the GFC had very real world affects. Yet it pays to stand back and look. You do not need complicated models to understand what is happening, nor do ideological positions help.

Economics is about relationships. If you are going to understand what is happening, you have to look at the relationships in general and as they affect your sector. One of the reasons why I have such a high opinion of Australia's Reserve Bank lies in the standard of their analysis of relationships. I may not agree with their analysis, but I can understand it and therefore respond to it. That is not true for a lot of the other analysis I have seen.

I am not sure why we have come to so distrust general skills and broad based experience, why we now place so much weight on narrow specialisation and very task specific requirements. You see, the problem is that narrow specialisations with task specific requirements are very good at getting things done within defined parameters, but hopeless at coping if those parameters change. Then everybody is at sea, lost without a paddle or, sometimes, even the boat.

I know that I sound jaundiced, but today we have managers who have never managed, economists who know a lot about a little but very little about a lot, lawyers whose knowledge is largely limited to a narrow specialisation, policy advisers who see their key roles in terms of narrowly defined statistical outputs. It's all very odd.

While I have been writing this post, share prices have continued to decline. Time, I think, to stand back and look at what is really going on.   

China's foreign reserves - what they mean, what might happen

A post on my personal blog, Saturday Morning Musings - fall of the US dollar, pointed to the growing mismatch between the pattern of currencies traded and the evolving structures of the world economy. There I said in part

All I am saying is that I feel that, in the longer term, traded currencies are likely to better reflect real patterns of economic activity. In the past, the reserve currencies (gold, sterling, the US dollar) facilitated global transactions by providing a measurable store of value in circumstances where other currencies were either not traded or were of uncertain value. The position today is different. Who can really say that the US dollar is a secure currency?    

The types of changes that I am talking about will take time. However, that time may be less than we all expect.

This led a colleague (Denis Wright, an historian) to ask if I could write a simple non-technical explanation of the significance of China's foreign exchange reserves. It's actually quite an important topic, so here goes.

Important identities

In the comments that follow, there are just two economic identities that you need to bear in mind.

The first is that if one country has a surplus on its balance of payments, another country or countries must be running an equivalent deficit or deficits. The reason for this is that one country's exports are other countries' imports. Globally, imports and exports must balance. If one country is selling more than it is buying, it acquires foreign exchange reserves. However, since imports and exports must balance in total, that means that other countries are buying more than they are selling. They must be running deficits that exactly match others' surpluses.

The second is that if you are going to buy more than you sell, then you have to fund the gap through borrowings or capital flows of some type. Otherwise, you can't buy.

Growth in China's foreign reserves

Initially China's foreign exchange reserves were relatively small, then they started to accelerate. The following gives an indication of scale:

Year	Reserves $US billion
1980	2.5
1990	29.6
2000	165.6
2010	2,847.3
today	c3,200

The increase has obviously been quite dramatic, an increase of over $US 3 trillion in 20 years. To put this in perspective, Australia's total GDP is something over $US1,200 billion! 

Why did China's foreign reserves increase?

There is a lot of argument on this one, but I think that we can simplify.

On the Chinese side:

• The country had a high domestic savings rate meaning that local cash was available for investment.
• The country had a large industrious underemployed workforce, meaning that low cost labour was available for new activities.
• The Chinese currency, the yuan or renminbi, was largely non-traded. The Government was able to keep the value of the currency low, facilitating export growth.

It takes two to tango. Elsewhere:

• Reducing trade barriers facilitated China's export growth.
• Savings rates in many developed countries dropped. With rising asset prices, consumers felt able to increase consumption by more than income, thus providing a growing base for Chinese exports. This was aided by tax cuts, placing more income in individual hands.

Increasing Chinese reserves necessarily flowed back into into developed countries. In a very real way, the Chinese themselves were funding their own exports.

China's reserve conundrum

The accumulation of large quantities of investable funds by a country is not unique. The British Empire, the economic superpower of the nineteenth century, accumulated such investment wealth that it took the rise of the US, a great depression and two world wars to wipe it out. However, China is in a different position.

One difference lies in the then power of the City of London. This marshaled surplus funds and channeled them round the world from mining companies to railroad investments, from the Russian Empire to Argentina. China has no domestic equivalent.

A second and critical difference is simply time. China's accumulation has happened very quickly. China has looked for ways of redeploying reserves via things such as a $US 300 billion sovereign wealth fund and direct overseas investment, but all these take time to build up. In the meantime, China has to put its money in deposits or some form of financial investment. Here it faces a problem

To illustrate this, have a look at the attached graph. This was included in my original posts and comes from one of my favourite bloggers, Stubborn Mule.

The graph simply shows the most important currencies in the world in trading terms. The Chinese authorities simply cannot invest their reserves willy nilly, but have to put them where they can be realised as required. This means they have very few short term choices.

To illustrate their problem further, consider the Australian dollar, the world's fifth largest traded currency.

According to newspaper reports (I don't have the links), China has decide to place 1.6% of its foreign reserves in Ozzie dollars or Ozzie dollar denominated securities.  That sounds a tiny proportion, but it actually amounts to over $US51 billion. That's quite a large amount relative to the size of the Australian economy. You see their problem?

The immediate practical effect is that China is locked into holding US and especially US Treasury securities, something like $US2,000 billion. This makes what happens in the US kind of important to China in financial terms.  

The longer term

In both the short and longer term, economic changes in China and its trading partners will affect the equation. I will discuss these in another post. For the moment, I just want to focus on what might happen to the Chinese reserves on the assumption that they continue to be significant. This links to the point that I made in my original post, about likely changes so that traded currencies better reflects the pattern of trade.

Here I want to point to just three things:

1. As China globalises, its capacity to invest effectively in other countries will increase , thus shifting Chinese assets from financial to real investments.
2. As more trade and investment is written in Chinese currency, the Chinese will be able to invest more in assets denominated in their own currency.
3. The number of significant traded currencies will rise, making it easier for China to invest in a bundle of currencies, not just the US dollar.

If I'm right, these changes will have quite profound influences on the distribution of economic power and activity.        

Australian Reserve Bank views on the economy

I really wanted to record this one for later use.

Measured by the official statistics, the Australian economy has been all over the place. We still have a looming boom, yet many aspects of the local economy are soft. Australia may not be in as bad a position as some other countries, but it's still confusing!

The Australian Reserve Bank has released two relevant papers that set out its views.

The first is the Minutes of the July 2011 Monetary Policy Meeting of the Reserve Bank Board released on 19 July. The second is The Cautious Consumer, a speech given by the Reserve Bank Governor.

I mention them now because I thought that it might be of interest to do a review of the bank's official thinking.  

Australian March 11 capex figures surprise

The Australian Bureau of Statistics capital expenditure figures for March were higher than some expected. You can clearly see the upwards trend.

The expectations data  on future capital expenditure also continues strong.

The multiple speed nature of the Australian economy continues, with some data very soft indeed.   

Postscript

In this morning's Australian (27 May), Sarah-Jane Tasker reports that the Australian Bureau of Agricultural & Resource Economics & Sciences planned investment in Australia's resources sector has hit a record $173.5 billion.

Some care must be exercised in interpreting these major project figures. I know from my own experience, my then area was responsible for similar monitoring back in the early 1980s, that the numbers can bounce around. If prices fall, projects can be deferred or re-scheduled.   

Australian annual CPI increase reaches 3.3%

The Australian dollar has soured through the US 108 cents mark, while the Australian CPI figures are up. The two have been connected in some commentary, as though the markets have interpreted the CPI increase as a reason for buying the Ozzie. I must say that this strikes me as a bit odd.

I will comment on the currency in a later post. Looking at the trade figures, I am cautious about the sustainability of the increase, accepting that the market does as the market does. In this post, I want to look at the CPI numbers. Those who are interested can find the Australian Bureau of Statistics release here.

The headline number was a CPI increase in the March quarter of 1.6% bringing the annual inflation rate to 3.3%. The largest group increases for the quarter were education (5.7%), health (3.9%), food (2.9%) and transportation (2.7%). Food was influenced by the floods, transportation by global oil price increases.

  The rising Australian dollar is keeping downward price pressure on imports of fuel and final goods. However, because Australia imports so many intermediate goods, the high dollar is also increasing producer prices, increases that feed through into final goods prices.

At the moment, the concept of a patchwork economy is popular in this country, reflecting the fact that the combination of mining boom and consequent high dollar is having differential effects across the country. Some parts of the economy are effectively in recession, others booming. The on-ground impacts vary greatly depending on the locale economic mix.      

Australian law firms retrench

The economic downturn in Australia is clearly biting the legal sector.

A story in today's (28 November) Australian Financial Review - I cannot give you the link because it is behind the pay wall - records that Corrs Chambers Westgarth has retrenched fourteen lawyers to try to fit its business to the new economic landscape. This brings the total number of retrenchments including support staff to something approaching fifty staff.

Last week DLA Phillips Fox confirmed that it had retrenched twenty staff including twelve lawwers at its Sydney and Auckland offices.

Economics of professional services - surviving recession 5: expanding the business 1

In my third post in the surviving recession series I emphasised the need not to simply freeze all new spending since this was likely to cripple your chances of doing the new things that might be required to survive a downturn. This is especially important if you want to grow the business despite the recession.

Just because the economy has gone into downturn does not mean that you cannot increase billings in your existing practice areas, nor expand into new areas. However, you also need to be aware of the problems involved.

The starting point is to understand your marketplace.

How bad is the contraction in your key areas? If the market is down by a third, and this happened in a number of professional services areas in the Australian economic downturn over 1990 and 1991, then you have to increase your market share by just over fifty per cent to maintain constant fees.

If you are already the market leader, this may in fact be impossible. In this case, you will need to consider new areas if you are to maintain or increase billings.

The next point is to understand your competition. They will be facing the same problems, and may respond quite aggressively. You need to be able to understand this and take it into account.

An example to illustrate.

The 1990 crash meant that all the big shops suddenly started looking for new work to try to cover their fixed costs, in so doing bidding for jobs that they would not have considered before. In the case in question, the firm (the consulting arm of a big consulting firm) had a survey centre whose work had dropped very sharply.

The Australian Department of Defence wanted a capability census carried out of a small but important local sector. This involved identifying and then contacting every industry participant, writing the results up in a standardised way to allow the Department to make judgements about both existing capabilities and capability gaps.

Defence industry was one of our core areas. We really wanted this job, cut our costs as much as we could while putting forward a very detailed methodology. The Defence area in question wanted us to do the job because they thought we would give the best result. However, without giving away information, they indicated that the big shop had come in with a much lower offer, making it very difficult to reject them even though their methodology was not as good. We and the big shop were invited to put in revised offers.

We really agonised over this one, Finally, we told Defence that we could not lower the price further because this would almost certainly risk a cash loss on the job. The assignment went to the big shop.

Later when we found out the tender price (tender results of this type are on the public record) we discovered that our opposition's price was 60 per cent of ours. We knew our costs very well. It seemed clear that they had no idea of the real costs involved. And so it proved. The job took twice as long as expected at a cash out cost on our estimate more than twice the tender amount.

The third point is to understand your clients. In a sense, the starting point in surviving recession is to try to keep what you have.

Now this one may seem self evident. Of course you need to understand your clients. You do, don't you?

The problem is that understanding clients is quite complicated and is actually not well done because it involves interactions at a number of different levels. Many firms are really quite bad at it.

I will look at the detail here in my next post in this series.

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