Why Australia may need a recession

Australia may need a recession to force through structural reform and address growing imbalances in the economy. Major reform has fallen by the way side, from housing policy and competition reform to climate change and tax, as households and businesses become complacent and our politicians increasingly lazy, ideological and incompetent.

The Australian economy has enjoyed an unprecedented period of success over the past quarter century but, more recently, our success has led to rising imbalances throughout the financial sector and poor political judgment.

The housing sector is but one key example. We have one of the most overpriced property sectors in the world. Our tax system encourages property speculation over productive investment, while our banks are bloated and over-leveraged.

But we also have a manufacturing sector that is uncompetitive and headed for extinction, a victim of high wages, elevated land prices and an elevated real exchange rate.

Our tax system is misguided and in desperate need of reform. At the federal level, we continue to rely on income and company taxes, while our state governments actively discourage labour mobility via stamp duties. We also have arguably the least functional GST among advanced economies.

If that wasn’t enough, Australia’s Prime Minister doesn’t understand the housing market, our Treasurer doesn’t understand the marginal tax system and the federal opposition is mainly interested in pursuing a populist narrative -- sensible policy be damned.

It wasn’t always like this. There was a time during the 1980s and 1990s when our federal and state politicians made difficult choices. They pursued ambitious reform programs in areas such as financial services and public utilities. A combination of financial deregulation and competition reform drove economic growth through the 1990s and early 2000s.

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The common thread joining those two reform episodes was that they were prompted by recessions between 1981 and 1983 and during the early 1990s. It would be folly to suggest that a recession was the sole cause of these reforms, far from it, but a recession provides a key signal to both the market and our politicians that the existing system is flawed and in need of a tweak.

Part of the problem with the economic debate in Australia is that it is dominated by the fact that we have had almost a quarter century of uninterrupted economic growth. It assumes we live in a binary world in which a recession is bad and growth is unambiguously good. It makes no distinction between strong growth or weak or even whether the growth itself is built on sustainable foundations.

The truth, though, is that the Australian economy has been exceptionally weak over the past decade, despite remarkable growth in China and the mining boom, and is set to ease further now that our terms of trade is falling and the baby boomers enter retirement.

Over the past decade, real GDP per capita -- an estimate of living standards -- has increased by 1.1 per cent a year on average, its slowest pace in three decades. By comparison, over the decade to 2005, real GDP per capita rose by 2.5 per cent a year.

That might not seem like much but it becomes a big deal due to the compounding nature of economic growth. Even small changes in the rate of growth, if maintained, can have a profound impact on living standards.

This is the prism through which we should view Australia’s economic performance and assess whether it is on a path that is worth maintaining.

The following graph should illustrate this concept more clearly. It shows how many years it will take real GDP per capita and real GDI per capita to double based on Australia’s 10-year average growth rate.

The data provide a sobering assessment of Australia’s economic performance and helps to highlight how damaging sub-par growth can be over a sufficient time frame.

Based on economic activity between 1996 and 2005, real GDP per capita was scheduled to double every 27 years. By comparison, based on the past decade, real GDP per capita will double every 66 years.

Due to compounding, the economy in the first scenario would be more than twice as large as that in the second scenario over the course of a half century.

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With the Australian economy facing numerous headwinds, including unfavourable demographics, more moderate growth in China and a sharp decline in our terms of trade, we now have a choice to make.

We can continue along our current path of rapidly rising debt and unproductive investment until it becomes unsustainable, prompting a more severe downturn, or we can embrace a new generation of structural reforms that could put us back on the path of rapid economic growth.

A recession, though obviously painful for some households and businesses, may be the impetus needed to force our politicians to take stock of the current situation, identify our failings and sell the public on the need for a wide-reaching reform program.

It could force businesses to trim their fat and run a leaner more efficient operation in the same way that lower commodity prices have encouraged greater efficiencies within the mining sector.

It would force our politicians to recognise and deal with the massive misallocation of capital caused by a combination of negative gearing and the capital gains deduction. It may lead to the Federal Government undertaking the policy recommendations contained in the Murray inquiry.

And it could force the Federal Government to admit that our budget problems are primarily due to revenue rather than excessive spending. Genuine tax reform could follow including the recognition that superannuation tax concessions are counterproductive to a sustainable retirement system.

This might seem overly optimistic, except that this is precisely what happened in the previous reform episodes. Structural reforms that were once unthinkable became reality.

Former Treasury Secretary Martin Parkinson summed it up last year when he noted, “unless we tackle structural reform, including fixing our fundamental budget problem, we will not be able to guarantee rising income and living standards for Australians.”

The reality is that when we think about economic growth we need to think more long term. A 0.5 percentage point change doesn't matter a great deal from year to year but over 10 or 20 years it matters a great deal.

If structural reform can lift productivity by 0.5 percentage points a year or boost real GDP per capita towards 2 per cent annually, then a brief recession would be a small price to pay for those gains. The longer it takes to begin these structural reforms the greater the existing imbalances, which points to weaker long-term growth.

In an ideal world, our leaders would see structural reform as a key component to creating a vibrant and sustainable growth model. They would compete for our votes with innovative ideas and a vision for a better Australia. Unfortunately, that isn’t the case.

Rather than recognising and addressing our structural deficiencies, our political leaders would prefer to stick their heads in the sand and maintain the status quo. Unfortunately, this means that our economic framework must fail before they realise what is readily apparent in the data: the Australian economy has underperformed for years.