Driving forces

Business investment has been the primary driver of growth this decade. Strong investment in Australia will cushion the economy from the current setback to private consumption expenditure. It will last for a while, but not forever.

Why is investment so strong? We are still living through the consequences of the 1980s boom and subsequent recession.

The 1980s was an investment-driven boom and it was over-investment that led to the subsequent recession. That left the economy of the 1990s with substantial excess capacity and, having blown out employment from 6 per cent to 11 per cent during the recession, significant excess labour.

The prevailing logic of the 1990s was cost cutting and under-investment. Investment fell well below long-term averages required to maintain capital stock. And that was sensible. It allowed absorption of the excess capacity created during the preceding investment boom. It was not just the private sector that wasn’t investing; it was also the public sector which, locality by locality, state by state and Commonwealth, was focused on being “good corporate citizens” and reducing the budget deficit.

The under-investment persisted through the 1990s and into this decade until, around 2003 or 2004, we ran into capacity constraints at the same time as we, after a long attrition of excess labour, ran into skilled labour shortages. That effectively put a speed limit on GDP growth of around 3 to 3.5 per cent (the RBA thinks it’s 3 per cent) and employment growth of around 2 per cent.

The logic of business changed from cost cutting to servicing demand, underwriting a phase of renewed generalised business investment. That was augmented when the minerals boom underwrote an extraordinary surge in minerals investment. And then the under-investment in the government sector started to result in infrastructure constraints, not just for minerals exports, but also in roads, education, health, et cetera. So now strong government investment is making up for the under-investment of the 1990s.

You can understand the private sector logic. But I have real difficulty understanding what happened in the public sector. It seems to me that in the 1990s governments forgot what they were there for. They had this overarching logic to cut their (current plus capital) budget deficits, to maintain their Moody’s ratings, to privatise, to corporatise and behave as closely as possible to what they perceived as the private sector. They forgot public goods and the need to provide infrastructure and services to make their locality, their state or Australia a better place to live and work.

But the private sector separates capital and current accounts, understanding that investment is required for the ongoing operation and growth of the business. And that may mean taking on debt. That’s lost in the overriding logic of cutting the budget deficit.

It is now apparent that governments around Australia were significantly under-investing throughout the whole of the 1990s and into this decade. For me, the sensible way to operate government investment is to identify the long-term investment requirement to underwrite infrastructure, services and growth and to work out the best time to do it. The cheapest way is to invest counter-cyclically, when construction and investment costs are lower. But now there is little choice. Infrastructure bottlenecks mean that investment cannot be delayed and must be undertaken when costs are high and the drain on resources is crowding out activity in the private sector.

So now the business investment is being boosted by both minerals investment and government investment.

Only residential missed the surge in investment. Rising interest rates and the RBA determination to burst the housing price bubble caused the downturn in the residential market in late 2003. Now, we are significantly under-building housing, with the period of interest rate rises suppressing an upswing in residential construction and the escalating deficiency of residential stock causing strong rises in rents. Perhaps the current interest rate decline will operate as a trigger to begin recovery in the residential market.

The 1980s were a period of over-investment, the 1990s a period of under-investment and we are now again over-investing in relation to long-term needs. The saving grace is that we haven’t seen a synchronisation of investment cycles. Rather, we’ve seen rolling investment cycles. Even so, investment is currently at unprecedented levels, particularly because of the strength of non-building construction, leading to strong rises in construction costs. Our forecast is that, with residential waiting in the wings, total construction will be higher in five years’ time. Pressure on construction costs will remain.

The current financial crisis, with pressure on listed entities to reduce expenditure/gearing plus tightening of risk criteria and increased interest margins charged by banks, is delaying some projects. Had the non-residential building cycle been allowed to run its course, it would have peaked in around two years’ time. The current setback to property markets will turn out to be temporary, with a rebound once the crisis dissipates. There will be a downturn – but this ain’t it. There’s another leg to this cycle. But most (not all) sectors will have turned down within five years’ time.

In the short term, the strength of investment will cushion the Australian economy against the impact of rising interest rates on confidence, precautionary saving and the recent setback to consumer spending. Weakening personal consumer expenditure (PCE) growth will be offset by solid investment, strengthening exports and a rebound in agriculture this year. That means that household disposable income will remain reasonably strong.

The RBA just wanted to slow growth below the speed limit. Now that interest rates have finally impacted on consumers, the RBA won’t have to raise interest rates any more. Indeed, the recent decline was intended to restore confidence. Don’t worry about the doom and gloom opinions currently being promulgated in the press. It looks as though there will be a soft landing. The problem of inflation is still lurking in the background. And the fall in the dollar won’t help. So don’t expect too many interest rate declines.

Getting back to the current topic, investment will remain solid for some time yet, though growth will slow. Investment has been a primary driver of the strength of the Australian economy this decade. And it will continue to be so for the next three to five years. Already, capacity constraints in the construction and mining sectors are leading to cost blowouts, slippages and delayed commencement of projects. But growth in investment can’t be sustained indefinitely.

What will replace investment as the driver of Australian economic growth next decade?

Business investment has been the primary driver of growth this decade. Strong investment in Australia will cushion the economy from the current setback to private consumption expenditure. It will last for a while, but not forever.

Why is investment so strong? We are still living through the consequences of the 1980s boom and subsequent recession.

The 1980s was an investment-driven boom and it was over-investment that led to the subsequent recession. That left the economy of the 1990s with substantial excess capacity and, having blown out employment from 6 per cent to 11 per cent during the recession, significant excess labour.

The prevailing logic of the 1990s was cost cutting and under-investment. Investment fell well below long-term averages required to maintain capital stock. And that was sensible. It allowed absorption of the excess capacity created during the preceding investment boom. It was not just the private sector that wasn’t investing; it was also the public sector which, locality by locality, state by state and Commonwealth, was focused on being “good corporate citizens” and reducing the budget deficit.

The under-investment persisted through the 1990s and into this decade until, around 2003 or 2004, we ran into capacity constraints at the same time as we, after a long attrition of excess labour, ran into skilled labour shortages. That effectively put a speed limit on GDP growth of around 3 to 3.5 per cent (the RBA thinks it’s 3 per cent) and employment growth of around 2 per cent.

The logic of business changed from cost cutting to servicing demand, underwriting a phase of renewed generalised business investment. That was augmented when the minerals boom underwrote an extraordinary surge in minerals investment. And then the under-investment in the government sector started to result in infrastructure constraints, not just for minerals exports, but also in roads, education, health, et cetera. So now strong government investment is making up for the under-investment of the 1990s.

You can understand the private sector logic. But I have real difficulty understanding what happened in the public sector. It seems to me that in the 1990s governments forgot what they were there for. They had this overarching logic to cut their (current plus capital) budget deficits, to maintain their Moody’s ratings, to privatise, to corporatise and behave as closely as possible to what they perceived as the private sector. They forgot public goods and the need to provide infrastructure and services to make their locality, their state or Australia a better place to live and work.

But the private sector separates capital and current accounts, understanding that investment is required for the ongoing operation and growth of the business. And that may mean taking on debt. That’s lost in the overriding logic of cutting the budget deficit.

It is now apparent that governments around Australia were significantly under-investing throughout the whole of the 1990s and into this decade. For me, the sensible way to operate government investment is to identify the long-term investment requirement to underwrite infrastructure, services and growth and to work out the best time to do it. The cheapest way is to invest counter-cyclically, when construction and investment costs are lower. But now there is little choice. Infrastructure bottlenecks mean that investment cannot be delayed and must be undertaken when costs are high and the drain on resources is crowding out activity in the private sector.

So now the business investment is being boosted by both minerals investment and government investment.

Only residential missed the surge in investment. Rising interest rates and the RBA determination to burst the housing price bubble caused the downturn in the residential market in late 2003. Now, we are significantly under-building housing, with the period of interest rate rises suppressing an upswing in residential construction and the escalating deficiency of residential stock causing strong rises in rents. Perhaps the current interest rate decline will operate as a trigger to begin recovery in the residential market.

The 1980s were a period of over-investment, the 1990s a period of under-investment and we are now again over-investing in relation to long-term needs. The saving grace is that we haven’t seen a synchronisation of investment cycles. Rather, we’ve seen rolling investment cycles. Even so, investment is currently at unprecedented levels, particularly because of the strength of non-building construction, leading to strong rises in construction costs. Our forecast is that, with residential waiting in the wings, total construction will be higher in five years’ time. Pressure on construction costs will remain.

The current financial crisis, with pressure on listed entities to reduce expenditure/gearing plus tightening of risk criteria and increased interest margins charged by banks, is delaying some projects. Had the non-residential building cycle been allowed to run its course, it would have peaked in around two years’ time. The current setback to property markets will turn out to be temporary, with a rebound once the crisis dissipates. There will be a downturn – but this ain’t it. There’s another leg to this cycle. But most (not all) sectors will have turned down within five years’ time.

In the short term, the strength of investment will cushion the Australian economy against the impact of rising interest rates on confidence, precautionary saving and the recent setback to consumer spending. Weakening personal consumer expenditure (PCE) growth will be offset by solid investment, strengthening exports and a rebound in agriculture this year. That means that household disposable income will remain reasonably strong.

The RBA just wanted to slow growth below the speed limit. Now that interest rates have finally impacted on consumers, the RBA won’t have to raise interest rates any more. Indeed, the recent decline was intended to restore confidence. Don’t worry about the doom and gloom opinions currently being promulgated in the press. It looks as though there will be a soft landing. The problem of inflation is still lurking in the background. And the fall in the dollar won’t help. So don’t expect too many interest rate declines.

Getting back to the current topic, investment will remain solid for some time yet, though growth will slow. Investment has been a primary driver of the strength of the Australian economy this decade. And it will continue to be so for the next three to five years. Already, capacity constraints in the construction and mining sectors are leading to cost blowouts, slippages and delayed commencement of projects. But growth in investment can’t be sustained indefinitely.

What will replace investment as the driver of Australian economic growth next decade?