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Australian economy: Is falling unemployment signalling recession?

Gerard Jackson

Monday 12 June 2006

Paradoxical as this might sound our falling rate of unemployment could be a symptom of an emerging recession. Although this phenomenon directly challenges orthodox economic teachings it does have empirical support and an economic theory to explain it. Let us first look at the evidence. To begin with job

... aggregates hide for a while what is happening. For example, the National Association of Purchasing Management index for November fell from 48.3 to 47.7, though it did peak at 53.1 during the month. I think the most important thing to note is not that anything lower than 50 is considered to be a recession but that rising manufacturing output at points close to consumption can hide the emergence of contraction production in capital goods industries if an index is being used (Economic clouds are turning black for US economy, The New Australian 6 December 2000)

In the same article I stressed:

Even as unemployment rises in manufacturing as the recession begins to make itself felt, the demand for labour in the consumption industries can continue to rise...the demand for labour in building, retailing and other service industries has continued to grow...This growth has offset rising unemployment in manufacturing. A similar situation occurred in 1929. Although industry started to contract in June unemployment still stood at only 3.9 per cent at the end of the year.

In 1999 I was warning that the US had started to exhibit symptoms indicating that a recession was inevitable. I pointed out that

manufacturing is definitely weakening while consumption spending still surges ahead. This is a paradox that the Keynesian and monetarist schools are unable to deal with. (The US economy: not what it seems, The New Australian 14 February 1999).

The response of Michael Prell, chief forecaster for the Fed, to this development was to weakly declare that “we need to be careful about letting the trials of the manufacturing industries colour our sense of the overall picture excessive”. Prell pushed the fallacious line, that also became popular in Australia for a time, that large increases in household wealth generated by the booming stock market has fuelled consumer spending and the demand for housing.

This became known as the “asset price-driven wealth effect”, according to which assets rose in value which then made households wealthier, fuelling their consumption spending. (Terry McCrann also pushed this line in Consumer spending flows from a deep reservoir, Herald Sun, 31 May 2006). What these commentators overlooked is that for the alleged ‘wealth effect’ to operate on a national level there would have to be a monetary expansion. This leads to the conclusion that surging consumer demand and rising asset values were being driven by credit expansion.

The wealth-effect fallacy was followed by the equally fallacious proposition that the American economy had experienced a shift toward investment in less durable equipment resulting in larger amounts of gross investment being required to get the same addition to the capital stock. (I suspect this may have been borrowed from Simon Kuznets’ observation about the problems of durable capital in Europe before the Industrial Revolution).

The Australian economy is now experiencing the same process. Last week official figures revealed that 56,000 net jobs were created, 47,000 of them in New South Wales, driving the jobless rate down from 5.1 to 4.9 per cent even though more people had entered the labour market. Naturally Prime Minister Howard was elated, declaring it to be a “day a wonderful day for the workers of Australia”.

What Howard and Costello’s economic advisors had missed, as they always do, is the simple fact that the devil really is in the details, a simple observation that is easily revealed once we disaggregate the employment figures: The PricewaterhouseCoopers’ PMI (Performance Manufacturing Index) report for April showed that the situation for manufacturing jobs was still deteriorating with the index falling from 50.2 to 44.2 — even as aggregate unemployment fell.

The May report makes for equally grim reading with the PMI falling from 51.3 in May 2006 to 48.9 last May. The same period witnessed national production dropping from 50.9 to 48.0. Employment was down from 50.2 to 44.2. These figures indicate recession, a fact that would be clearly recognized if it were not for the resources boom and consumer spending.

The latter brings me to Terry McCrann of the Herald Sun. He is probably Australia’s most prominent economics and business commentator. As expected, he regurgitated one of the most dangerous economic fallacies that plague us today and that is the mercantilist belief that “consumer spending... is 70 per cent of the economy (Four cylinders and three gears, 8 June 2006).

In fact, business spending greatly exceeds consumer spending. The reason for this was explained in detail by Friedrich von Hayek (Prices and Production, Pub. Augustus M. Kelley 1967. See Lecture II pp.32-68. There is also The Paradox of Saving, Profits, Interest and Investment, Augustus M. Kelley Publishers 1975). Understanding how the net-income approach has misled economists into accepting the egregious fallacy that consumer spending is what basically underpins prosperity will open the door to production structure analysis. (See Prices and Production and Böhm Bawerk’s Capital and Interest, Vol. II, for an introduction to production structure an analysis).

McCrann’s Pollyanna view of Australian investment (Building big for tomorrow, 2 June 2006) reminds me of the inimitable Yoga Berra’s comment that “It’s deja-vu all over again”. Back in 1990 most of the economic commentariat were predicting a soft landing for the Australian economy, with some even arguing that investment in the resource sector would cushion any recession. I was the only one who stressed that the landing would be tough and that the resources sector could not cushion it.

Terry McCrann, and he is not alone, is repeating the error. He reckons that “If business confidence stays strong, [investment] could actually come in above $90 billion [next year]. Let us just assume for a moment that he is right. Now it is estimated that GDP will, at the current rate, be AUS$1 trillion at the end of the year.

Let us be even more generous and put Terry’s cheery investment estimate at $100 billion. This is 10 per cent of a trillion. Taking the neo-classical approach and assume that the ratio our value of capital to the value output is 3:1 at the margin then Terry’s investment will increase national income by something like 2.5 to 3.3. (W. Arthur Lewis, Theory of Economic Growth, ch. V, Unwin University Books, 1965. Paul Samuelson’s Economics 10th edition, ch. 37, McGraw-Hill Book Company 1976).

The fallacy here is to treat capital as homogeneous. (See Ludwig M. Lachman’s fascinating Capital and Its Structure, Sheed Andrews and McMeel Inc 1978. Also Hayek’s Maintenance of Capital in Profits, Interest and Investment). This is clear from McCrann’s lumpen treatment of investment. The contradiction emerges with his admission that “overall investment in manufacturing seems to have plateaued out, but done so at a level some double that of five or six years ago”.

That the level of investment may be higher today than “five or six years ago” is totally irrelevant. What is relevant is that manufacturing is contracting regardless of McCrann’s joyful investment estimates. Allow me to draw his attention to Tony Pensabene of the AIG who only last October confessed to being flummoxed by what is happening to the economy. In his view

… something different is going on in manufacturing. In the 12 months to August [2005], the overall economy added 352,000 jobs. In the same period, manufacturing lost 46,800 jobs.

Pensabene obviously does not realise that this is exactly what happened to the Clinton economy. I think it is about time our economic commentariat seriously reconsidered their approach to economics as well as empirical evidence.

Gerard Jackson is Brookes’ economics editor

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