This article first appeared in the Adelaide Review on 18 December 2014 at this link: 

The Australian economy is in need of some medicine

In terms of some hard numbers, Australia should ideally be recording real economic growth a little above three percent, on average, over the course of the business cycle. This would translate to employment growth sufficiently strong to lock in an unemployment rate that is consistent with the Reserve Bank of Australia’s inflation target of two to three percent.

Depending on other economic drivers, such as the terms of trade and productivity, household income should also be growing steadily, delivering improving living standards for the community.

As 2014 draws to a close, the Australian economy is some way from this ideal. Recent data show annual real GDP growth at 2.7 percent that, based on the criteria above, does not sound too bad. But the current growth rate is sub-optimal is because GDP growth has been mired at or below three percent for two straight years. GDP growth has averaged around 2.5 percent over that time, which means the economy has been underperforming and, as a result, the unemployment rate has been increasing.

The most recent labour force data confirm the unemployment rate hovering around 6.25 percent, a 10-year high. It is up around one percentage point from the rate two years ago and well above the four percent low in 2008. The current period of sluggish economic activity has fed into falling national income over the last two quarters.
It has also meant that wages growth has slumped to a record low, which is undermining household incomes, spending and, therefore, wellbeing.
In simple terms, the economy is far from ideal.

Notice that I have not mentioned the level of interest rates or the stance of the budget in an assessment of the health of the economy. This is quite deliberate as these are not performance benchmarks on how the economy is travelling. It would be a bit like judging the success of medicine by how much of it was administered rather than by analysing whether or not the medicine – in whatever quantity – worked. For the patient, it matters little whether the path to full fitness required 10 or 100 tablets.

In other words, the level of interest rates and stance of the budget are the policy levers or instruments that are adjusted to ensure the economy is performing as well as it can, whether that means interest rates are one percent or 10 percent or whether the budget is in surplus or deficit.

The policy prescription to a sick economy should be clear. Needed now in Australia is easier policy in the form of either stimulatory levels of interest rates or a relaxation of fiscal policy, or some mix of the two. If ever there was an example of how policy can and should react to a major economic threat, it was the slashing of interest rates and move to substantial budget deficit when the global financial crisis was inflicting damage on the Australian economy. These policy changes worked.

Here and now, while we are a million miles from the dark days of the GFC, the economy is crying out for a bit of extra support from the policy makers.

For the RBA , is now seems likely that there will be lower interest rates in 2015 as it plays its part in shoring up economic activity. On fiscal policy, the story is complicated by politics. It is not clear where the priorities are for the Abbott government with the quest for a budget surplus still high on its list, even though the economy has been undershooting its potential.

The true test will come when Treasurer Joe Hockey delivers what will be his second budget in May 2015. By then there should be a much clearer picture of the degree to which the economy has continued to under-perform, including whether the unemployment rate has reached or even exceeded 6.75 per cent.

If the economy remains soft or indeed, has weakened further, we may see what would be a remarkable turn in government policy if itdrops its budget surplus fetish and embarks of a strategy of fiscal stimulus.