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If Joe’s right, living standards will fall

Dec 18, 2014
Joe Hockey announcing the MYEFO this week.

Joe Hockey announcing the MYEFO this week.

If Joe Hockey’s predictions about the terms of trade are correct, then living standards are set to fall, argues Janine Dixon.

Australia is now in an income recession. A fortnight ago, when the National Accounts revealed a second quarter of negative growth in seasonally adjusted real gross domestic income, treasurer Joe Hockey assured us that “2015 will be better”.

This week, Mr Hockey’s Mid-Year Economic and Fiscal Outlook (MYEFO) foreshadows the biggest fall in the terms of trade in more than half a century.

Over the year to September 2014, real gross domestic income grew by less than 1%, while real gross domestic product grew by 2.6%. The difference between gross domestic “income” and “product” is based on prices. “Product” measures the volume of things produced in Australia, while the concept of “income” converts this into purchasing power. In a closed economy, they would be the same.

The all-important “terms of trade”, the ratio of export prices to import prices, indicates the terms on which we exchange our “product” – of which around 20% is exported – for the things we consume.

The story of the terms of trade and the mining boom is familiar – after climbing through most of the early 2000s the terms of trade peaked in 2011, by which time iron ore was fetching over US$150 a tonne, up to eight times the price it had been in 2003. As supply in Australia and other parts of the world has expanded, the price of iron ore and other commodities has fallen. In the three years since September 2011, the terms of trade have dropped by a massive 25%.

Modelling at Victoria University’s Centre of Policy Studies (CoPS), based on forecasts of the terms of trade in last year’s MYEFO, found that the in the medium term, the “break even” point for per capita real incomes was a GDP growth rate of 2.5%. That is, in the face of falling terms of trade as forecast in last year’s MYEFO, GDP would need to grow at 2.5% per annum just to maintain the living standards of 2014. The modelling also found that on recent performance, productivity growth would need to improve to achieve this.

This year’s MYEFO increases the fall in the terms of trade forecast for 2015 to 13.5%, compared to the 5% forecast in last year’s MYEFO. GDP is still forecast to grow at 2.5%. Based on this new information, preliminary updates to the Centre of Policy Studies modelling show that the income recession will deepen.

Reducing the terms of trade by a further 8.5% effectively reduces the value of exports, worth 20 per cent of GDP. The CoPS result for purchasing power, or “income”, is revised downwards by almost 2 percent, that is, 20% of 8.5%.

The increase in the unemployment rate of .5% forecast in MYEFO is small given the weakening terms of trade. To contain unemployment, real wages will need to fall by as much as 3% in 2015. In headline terms, this is a fall in the nominal wage of close to 1%, assuming normal inflation of 2 to 2.5%. If wages do not fall, the increase in unemployment could be much larger than the MYEFO forecast.

With prices acting to diminish purchasing power, GDP needs to grow strongly to compensate for the fall in real incomes. The MYEFO forecast for GDP, at 2.5%, was sufficient to maintain living standards under what now appears to be a relatively small fall in the terms of trade.

To compensate for the larger fall in the terms of trade, GDP growth would need to be in excess of 4 per cent to maintain living standards. And to achieve this, multi-factor productivity would need to grow at an unprecedented 2.3%.

In this MYEFO, it is difficult to see how “2015 will be better”. If MYEFO has got the terms of trade right, living standards are heading lower.

But every cloud has a silver lining. Reserve Bank Governor Glenn Stevens has called for the dollar to fall to US75c. Incorporating the new MYEFO forecasts into our modelling suggests that this could be achieved by mid-2015, with positive implications for the trade-exposed agriculture, manufacturing, education and tourism sectors.

Janine Dixon is a senior research fellow at Victoria University.

This article was first published at The Conversation.

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