Australia’s G20 growth challenge: protecting our standard of living

Australia’s standard of living is under threat. Scott Woodman/Flickr, CC BY-NC-ND

When the G20 finance ministers agreed in February to significantly raise global growth, they locked in a goal of lifting collective GDP by more than 2%. This was a cumulative goal - that is a total of 2% above the trajectory implied by current policies over a period of five years.

The ministers argued this would equate to US$2 trillion more in GDP in real terms, leading to significant additional jobs.

The IMF’s latest forecasts for medium-term annual growth in GDP in Australia are between 2.8% and 3.0%. With the addition of the G20 goal, Australia will be looking for annual GDP growth well in excess of 3%.

According to forecasts by the Centre of Policy Studies at Victoria University, annual GDP growth of almost 2.5% will be required just to prevent Australia’s standard of living (proxied by per capita real income) from falling from its present level for the rest of the decade.

One might wonder how a respectable level of GDP growth translates into such a poor result for per capita real incomes. Usually, growth in GDP per worker, a measure of individual economic output, is a pretty good proxy for individual incomes, but this is not always the case.

During the boom period – we’ll call it 2004 to 2011, during which the price of iron ore increased eight-fold – GDP grew at an average of 2.8% per year, equivalent to annual growth of just under 1% in output per hour worked. Over the same period, individual incomes rose at an average of 2.2% per year, easily outpacing growth in output. In other words, we were able to consume and save more than we had to produce. What is going to be different now?

Firstly, the purchasing power of domestic income will be weakened by depreciation of the Australian dollar. This is the opposite of what happened in the boom years. By 2011, we could exchange one tonne of iron ore for a bundle of imported goods that would have cost us eight tonnes back in 2004. To the extent that we did this, the commodity price boom made us richer. The undoing of this effect has begun, and will continue for several more years.

The average price of household consumption, a fifth of which is imported, is set to increase annually by half a percent faster than producer prices for the remainder of the decade. As we exchange the goods we produce for the goods we consume, we are coming out worse off.

Mining might be good for GDP, but not incomes

Secondly, foreign ownership plays an important role. Much of the growth in GDP will be driven by mining exports. The mining industry operates with relatively few employees, and enormous capital stocks, of which four fifths are foreign owned. An increase in mining production, which feeds into GDP, will be good for the foreign recipients of mining profits, but less good for domestic incomes.

Thirdly, as the baby boomers move into retirement, population growth will outstrip employment growth. When we translate the nation’s aggregate income into per capita income, we find there is less to go around.

This is not the only challenge. It is not clear that the annual GDP growth of 2.5%, sufficient to maintain our standard of living, can even be achieved. In the absence of a stronger increase in employment (via increased participation, hours worked, or a lower unemployment rate) the key requirement here is growth in productivity. Growth in productivity enables output to increase by more than inputs. Its contribution varies widely over time, but the average over the last 40 years is a contribution of a little below three quarters of a percentage point to annual GDP growth.

Over the next five years, if we were to achieve the annual GDP growth of 2.5% required to maintain our incomes, we would require annual productivity growth of half a percent. (This is similar to that of the 1980s, and much less than that experienced in the 1990s.) More than 1% would be required to achieve the much higher target espoused by the G20.

However, over the last decade, non-mining productivity growth has contributed just one quarter of a percentage point to annual GDP growth (the contribution of mining has been negative). Our incomes grew without much help from productivity growth, buoyed instead by high commodity prices during the boom years. If this low rate of productivity growth continues, it will not be enough to maintain the present standard of living for the remainder of the decade, let alone the G20 goal.

The productivity challenge

Productivity growth is the mantra of economists, but sources of productivity are not always easy to find. Regulatory reform and innovation are the “silver bullets”, but take time to implement, and the effectiveness of the Abbott government’s proposed reforms in the health and education sectors is as yet unproven. Pressing our noses ever harder to the grindstone may increase measured productivity, but drawing a connection between an increase in incomes achieved by this method and an increase in “living standards” is dubious indeed.

If, in keeping with recent history, productivity growth is less than half a percent for the remainder of the decade, the circumstances – falling terms of trade, falling investment in mining, the concentration of growth in the largely foreign-owned mining sector, and a growing and ageing population – present a challenge for the nation. Living standards will fall.

Why wages are stagnating

An important element of an orderly adjustment to these circumstances will be to limit wage growth. Over the last decade, annual growth in wages adjusted for inflation in consumer prices averaged 0.9%. This was possible because good times enabled employers to pay high wages, while consumer inflation was low because the strong currency made imports cheap.

As growth in producer prices starts to lag behind growth in consumer prices, there will be no reason to expect an increase in wages commensurate with consumer prices. Wages adjusted for inflation will need to fall if unemployment is to decrease or even remain at its present level. The latest wage and inflation figures from the ABS indicate that in the year to June 2014, for the first time this century, the inflation adjusted wage fell. It will need to fall further, undoing most of the growth of the last decade, to prevent further increases in the unemployment rate.

Although the wage statistics show promising signs of good adjustment in the labour market, unemployment has increased throughout the year. Households are stuck between a rock and a hard place. A reduced wage relative to the cost of living is undoubtedly bad for household income, but unemployment is worse.

With modest productivity growth and no further increase in unemployment, real wages will fall to around 5% less than their current level by 2020 and living standards will fall. The G20 growth target might not be achievable, but if it inspires productivity-enhancing reform, we might just manage to retain our present living standards.