An overview of the challenges facing the Australian economy today and over the horizon, presented by Ai Group's Director of Research and Economics Dr Jeffrey Wilson at the 2022 PIR (Policy-Influence-Reform) Conference.
Good morning everyone, and welcome back. It's my privilege to be able to begin the proceedings of day two of our program, which we would like to start with an overview of the challenges facing the Australian economy today and over-the-horizon.
Normally, giving the economic outlook speech to a gathering like this is a fairly straightforward affair. There is a standard set of economic topics – GDP, unemployment, inflation, wages, consumer sentiment, wages – that the presenting economist can run through almost by rote. They end the presentation with a couple of forecasts, and the audience is supposed to walk away with one of two simple messages: things are looking up for my policy area, or things are looking down.
But try as I might, I simply can’t give that speech to you today. And the reason is the Australian economy in a complex, contradictory and highly uncertain situation, which the stock ‘economic rundown’ talk simply doesn’t do justice to.
Over the last two and a half years, the Australian economy has been struck by a continuous set of external economic shocks. The COVID pandemic and public health measures to curb it. Disruptions to global supply chains. The closure of our borders and collapse of migration. Inflation like we haven’t seen for fifty years. Geopolitical tensions and war throwing global trade into chaos.
The confluence of these economic shocks is nothing short of historic. None of these shocks have happened before during the professional lifetimes of anyone in this room today, let alone all at once, in the same narrow two year window.
“Unprecedented” may have become the most over-used word in the English language, but there’s no synonym that captures our economic context better.
And in an unprecedented situation like this, we need to find new ways to talk about Australia’s economic context and trajectory.
We are no longer dealing with a smoothly-functioning machine, where indicators gently inch upwards or downwards year by year, and the machine adjusts accordingly. We’re asking the economic machine to do something it was never designed to do – adjust to multiple, sudden and dramatic global shocks.
So in this presentation today, I am going to talk to you about shocks.
What are the shocks that have jolted the Australian economic machine out of its normal mode over the last two years? What are the short-term impacts of these shocks on the Australian economy that demand the most immediate policy responses? And then over the horizon, how will these shocks play out across the rest of the 2020s? And what reform paths do we need to start along now to position ourselves for future success?
Economic shocks are by their nature uncertain events. This means it is easier to ask questions about shocks than provide definitive answers. But asking the right questions is essential if we are to properly frame an economic reform agenda for Australian for the next decade.
By way of prologue, we need to remember that Australia has only just emerged from a recession – the COVID recession of 2020. This recession was historically remarkable, given its depth and length.
As public health restrictions clamped into place in early 2020, the economy began contracting at an unprecedented rate. But aggressive stimulus policies floored the collapse, and our closed border policy avoided the horrific COVID experience of most other countries.
The economy snapped back almost as fast as it fell, almost making the losses back in just a year. A shallower dip-and-return cycle occurred with the Delta outbreak of winter 2021, and since then the economy has roared back to life.
Indeed, its this “roaring” that poses Australia’s major economic challenges today.
The first shock is Australia’s labour market, which is currently as tight as a drum.
The proximate cause is a unique COVID experiment with closed international borders. Australia normally takes around 200,000 net migrants a year who largely go straight into the labour market. But with the international borders closed between March 2020 and February 2022, our migration inflow was temporarily severed. Australia effectively lost two years of new migrants.
And the consequence, when the economy suddenly roared back to life, has been a shortage of labour. Unemployment currently sits at 3.5%, and under-employment at 6.1%. As the chart on the left shows, we haven’t seen employment figures this strong in a generation.
And we’re clearly now running up against the limits of the national supply. The chart on the right shows participation and employment-to-population indicators, which are both at all time highs.
You have to go back to the 1960s – when the White Australia Policy was in force, and women were subject to formal exclusions from the labour market – to get unemployment so low and participation so high.
While a strong labour market is normally an indicator of economic health, in our era of shocks it is also a symptom of malaise.
We see this malaise in businesses facing chronic staff shortages. The chart on the left shows that one third of small businesses, and two thirds of medium and large businesses, report being unable to secure enough staff. This is almost double the labour shortages of a year ago, and reflects the missing migrant cohort that didn’t arrive last year.
And if we look at the reasons why, the explanation is simple: there’s not enough aggregate labour supply. 79% of business who can’t recruit report it is for basic lack of applicants, while another 59% report skills mismatch – which always gets worse when te labour market is tight.
There are today as many advertised vacancies in Australia as unemployed people. Anyone who has attempted to get childcare, hire a trade or take air travel in the last six months will have experienced the consequences.
Our second shock has been supply chain disruptions. The whole world has suffered these during COVID of course. But Australia is especially exposed. We are an island, so more subject to logistics interruptions than almost all other counties. And we are a highly specialised economy, so more broadly reliant on imports.
Business surveys show that supply chains disruptions rank alongside labour as a major constraint on business activity. Across the economy, 41% of businesses are currently affected – they either cannot get the goods they need at all, or those goods are prohibitively priced. For retail and manufacturing, two-thirds are materially affected.
Indeed, the supply chain problem continues to grow. According to Ai Group data, our PMI input prices indicator – the best national proxy measure for supply chain stress – currently sits at an all time high of 89. For context, 50 for this indicator means neutral, and it has never exceeded the low-70s over the three decades Ai Group has produced it. Unprecedented indeed.
Our third shock is inflation, another global problem that is coming home to roost in Australia.
We’ve had steadily building supply chain pressures for two years, then a dramatic spike in energy and food prices earlier as a result of the Russian invasion of Ukraine. As a result, Australia’s inflation took off, and in the June quarter now sits at an historic 6.1%.
This has forced the central bank to raise rates – from 0.1% to 1.85% in just four months – and it will be forced to keep fighting until inflation eases back towards the 2-3% target band.
While these rate rises are necessary, they are putting additional demand side strain on the economy. On the supply side, we’ve already got huge labour and supply chain pressures. And rising interest rates now hurt the demand side with reduced consumer confidence and spending.
Of course, Australian inflation needs to be put in its global context. Compared to the OECD, Australian inflation is only two-thirds that in our peers. This is because Australia is a massive producer of energy and food – the two categories driving the bulk of the inflation – and so our energy and farm sectors are insulating us from the full force of the tide.
Taming inflation will be a rough landing for Australia, but less rough than in most other developed economies.
And this is where we find ourselves in mid-2022: An economy that roared back to life after a COVID recession, but had its normal trade and migration links to the world disrupted, now struggles under supply chain and labour shortages, while the spectre of a global inflationary crisis slowly approaches.
If our policy horizon is to simply grapple with the economic challenges of 2022, that’s where I would conclude my remarks. But the Covidian-era shocks facing the Australian economy will be far more transformative than just these issues of the day.
Looking over the horizon, it is clear that Australia will need to rethink many of our foundational economic assumptions for the post-COVID era. Five new structural challenges are likely to determine our success or failure over the next decade.
The first are our migration settings. Since White Settlement, Australia has been a migration driven economy. Successive cultural waves of migrants have provided the foundation upon which our growth has been built.
Over the last two decades, Australia has averaged 191,000 net new migrants per year. With a median age of 26, and policy strongly biased towards skilled labour, we depend on these migrants to refresh the skilled labour pool.
But our closed border COVID experiment turned off the tap. Migration turned net negative in 2021 for the first time since 1947 – the chart here illustrates the scale of the collapse is historical comparison.
And it cannot be assumed Australia will suddenly ‘snaps back’ to strong skilled migrant flows.
Which raises questions for migration after the “COVID reset”. We need it back, and have a unique chance to redesign the system. But what do we need in terms of both its quantitative (labour) and qualitative (skills) features in the future?
Australia has had an unbelievably lucky run with commodity booms. After our last two recessions – the GFC in 2009 and COVID in 2020 – global commodity markets exploded, giving an extremely well-timed boost to recovery efforts.
However, our commodities lifeboat is “deep but narrow”. Just three commodities – iron ore, coal and gas – account for the lion’s share: $276 billion of exports last year, or 58% of the national export total.
And while prices for the ‘big 3’ commodities may have saved us again, its unlikely they will continue to do so forever:
Australia’s next generation is going to need new commodities industries to replace the big-3. And fortunately, we are extraordinarily well endowed in new ‘climate proofed’ resource exports, including:
But these new resource industries will not spring fully formed from the head of Zeus. Like the effort that went into creating the iron ore and coal export sectors in the 1960s, and gas in the 1990s, there needs to be clear policy strategy and effort to do so. Our efforts today will determine whether these industries exist tomorrow.
Which leads to our next challenge, foreign investment. FDI is extremely important to Australia, as it brings a three part package of services: the capital itself, the technologies of the investor, and marketing channels to unlock exports. Our transition to climate-proofed commodities will be impossible without this three-part package.
Unsurprisingly, global FDI flows collapsed in 2020. But they immediately rebounded for almost all countries in 2021 – except Australia. Last year, our FDI inflows tracked 42% under pre-pandemic levels, compared to recovery or better everywhere else.
Our closed border was the obvious cause – investors were naturally cautious about committing to a country they could not visit.
However, whether the reopened border sees FDI snap back this year remains an unknown:
Australia is about to find itself in a much tougher environment for attracting investment than we’ve seen for a decade. If our climate transition depends on it, we need to reappraise what being investment competitive means in the post COVID-era.
Which means we need to talk about productivity. Ultimately, there are only two sources of economic growth – extensive growth (more people using more thing) or intensive growth (doing things more productively). And the productivity side of the ledger lags terribly at the moment.
Australia’s productivity has gone through two three-decade long cycles: a sudden spurt following economic change (in the 60s and the 90s), followed by a steady tapering off. At the moment, we’re at the low end of the taper that was unleashed by the reforms of the 1980s.
So its clearly time to start the productivity cycle anew. Indeed, we are arguably a decade late to the party! Rebooting it will require policy reforms which:
Productivity isn’t a standalone topic, but touches every area of economic policymaking. If we want to be serious about rebooting the cycle, it needs to be front and centre in every policy discussion – from the big ticket items like industrial relations and workplace, through to the small but important domains of government service delivery.
Finally, we have supply chain resilience. Its underappreciated how big a problem it is for the Australian economy. ABS surveys consistently report supply chain disruptions as the top challenge facing businesses – worse than labour shortages or financial difficulties. And the problem continues to grow, even as we have moved past our heavy COVID restrictions of 2020.
This is because the supply chain problem is now an international one. Its no long driven by logistics connections being severed by COVID, but major global political challenges, such as:
While connectivity will slowly improve, protectionism, geopolitics and China’s zero-COVID are here to stay. This means supply chain disruptions will be a structural feature for the medium term.
Supply chain security has never before been an economic problem demanding policy responses. But as it is likely to remain – and if the geopolitical environment deteriorates, get worse – this needs to change. Our industry and technology policies need to be updated to make risks and opportunities from fractured supply chains their central objective.
It is customary to end economics presentations with a forecast or outlook statement. But I’m not going to do that today. In a shock-afflicted global economy, our ability to offer credible quantitative forecasts of the future simply isn't what it was.
But what we do know is these shocks aren’t going away. Inflation won’t disappear overnight, supply chains won’t suddenly spring back to normal, and volatility will be the order of the day.
We’ve also already seen one major geopolitical black swan this year – Russia’s invasion of Ukraine. Worrying developments regarding Taiwan over the weekend should disabuse us of any notion that there won’t be more.
Controlling these political and economic shocks is not within Australia’s gift. But we can put our house in order to make sure we are in the best position to weather shocks that have already arrived, and the more that ar over the horizon.
We need to use the COVID reset to revisit some fundamental questions about our economy. What role for migration? What kind of commodities? How to attract investment and technology? What does a productivity agenda look like in the 2020? What does supply chain security mean for industry?
The answers remain a work in progress. But it is these questions that provide the frame for adapting the Australian economy to a shock-afflicted world. Our task now is to work towards the answers that will ensure Australia’s next generation enjoy the prosperity and economic security of the last.