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Tuesday, August 10, 2010

Who’s right on rates?

Today I am going to try and resolve two skirmishes around interest rates and whether we should cultivate population growth or productivity.

Yesterday’s debate between Wayne Swan and Joe Hockey resulted in the standard dispute about interest rates and inflation under the last two governments.

The good news is that there should be no uncertainty here. The Reserve Bank of Australia (RBA) provides us with a wealth of objective interest rate and inflation data.

The Treasurer, Wayne Swan, was correct in claiming that the RBA’s ‘target cash rate’ has been lower under the current government. The exact differential is 0.6 per cent per annum. This is largely explained by the fact that the RBA cut its target rate to an all-time low of just 3 per cent to help offset the worst effects of the GFC.

His opponent, Joe Hockey, was also correct in responding that businesses and households do not borrow at the RBA’s cash rate. They get their loans at rates set by banks. On this score, small business, residential mortgage, personal, and credit card interest rates were lower under the previous government. The annual difference in rates ranged from -0.5 per cent to -1.3 per cent for small business, -0.14 to -0.42 per cent for home owners, and -2.2 to -2.6 per cent per annum for personal loans and credit cards (see table below).

At the end of the day, the RBA focuses on these real-world lending rates, and the target cash rate is the tool it uses to influence them. A related point that was raised in this context is who ultimately controls rates. The short answer is that the spread between the RBA’s target cash rate and the effective rates paid by borrowers is determined by the banks. However, actual interest rate levels will ultimately be set by the RBA.

This inevitably leads one to the question of what motivates the RBA to change rates. The simple answer is so-called ‘core’ inflation, which measures changes in the cost of consumer goods and services over time. Between March 1996 and December 2007, core inflation averaged 2.5 per cent per annum, which was smack-bang in the middle of the RBA’s target band. Since December 2007, core inflation has averaged 3.8 per cent per annum. The 1.3 per cent per annum higher inflation experienced during the last three years can been attributed to Australia’s unprecedented terms of trade boom, and our extraordinary population growth, which has placed upward pressure on the price of essential services such as utilities. These were high-quality problems to have during a global downturn.

A separate skirmish has been the claim by some economists, politicians and commentators that our future prosperity rests not on immigration and population growth, but on a rather abstract notion known as 'productivity'. On these grounds, the population debate is a nonsense, they exclaim. But is this just another example of lazy thinking? Surely one cannot separate long-term productivity from population policy? And has anyone ever made this point before? There is certainly empirical evidence at a micro-level that there are very strong relationships between productivity and age.

Astute observers will have seen more and more demographic data slipping into the RBA's output of late. Why? Because I am guessing that long-term (ie, over the next 40 years) the RBA is worried about deflation, not inflation. The secular trend the RBA is now regularly drawing attention to is one of extraordinary increases in ‘dependency ratios’ across the developed world (including Australia, if we don't do something about it), interminable fiscal deficits, deteriorating public balance-sheets (read much more government debt), reduced effective demand, and downward pressure on prices. Think long-term deflation. Think Japan. Indeed, the future that many countries face is unfolding before our eyes in Japan today. Expect, therefore, to hear much more about ‘lost decades’.

The following chart derives from the RBA's latest Statement on Monetary Policy. Have a look at the amazing demographic changes in countries like Spain, Italy and Germany.

Today the number of people aged 65 and over as a share of the working-age (ie, productive) population is less than 30 per cent (actually, 20 per cent in Spain's instance). Thus these nations currently have more than 3.3 functional workers for every semi-non-functional person over 65 who likely does not work, or, if they do, works very little.

By 2050, the number of folks aged over 65 as a share of the working population will rise to 60 per cent or more (ie, more than double present-day levels). And so there will be just 1.7 productive workers to support every aged person, or around half the number they have today. Think much lower national income growth and hence effective demand. Think a relatively much smaller tax revenue base to support far larger public pension and health liabilities. Think fiscal crises.

This is why our own Treasury's intergenerational report warns us that Australia will run perpetual fiscal deficits between 2030 and 2050, which only stops because it is the end of their forecast horizon.

The much more complex issue here is whether there is a relationship between the share of the population that works and the economy’s productivity. You would have to think so. This is why the arguments made by Ross Gittins, Warwick McKibbin and Mark Crosby trying to distinguish population policy from productivity seem a bit silly—at least to me.

Productivity is just economic efficiency. And you improve efficiency by technological progress. And technological progress is made by your human capital. And your human capital innovates during its working life. I am afraid there ain't much innovation, technological progress, and efficiency that happens post 65.

Sure, I am a big believer in longevity risks due to genetic engineering, which will only exacerbate our long-term population problems (ie, elongating life spans means that we are cruising towards 40 million plus persons by 2050). But to think that a 70 year old is going to be as productive as a 40 year old during our lifetimes is stretching credulity.

On the basis of this logic, it is not hard to see that as our population ages, productivity growth will not improve and may, in fact, atrophy. This could be the combined result of less output per unit of labour input due to, frankly, older and less energetic (!) labour, and, of greater consequence, (relatively) less research and development, innovation and technological progress occurring over time due to, again, a fewer number of 'productive' people (or functional human capital) as a share of the overall population.

If you think this is mere speculation, a very quick search shows that there is a great deal of academic evidence that demonstrates that productivity declines once a worker hits, say, 50 years of age. So as the share of 50 year olds in the labour force rises, we can be relatively confident that productivity will also fall, all things being equal. This may be why Japanese labour productivity is 30 per cent less than US estimates, according to the OECD.

Ipso facto, there must be credible relationships between fertility and immigration policies, and national productivity outcomes. Trying to treat them as mutually exclusive policy areas is asinine. At the very least, it would be instructive to see more research on these dependencies.