## Why do we need 3% economic growth to keep unemployment stable? – Part 2

This series started yesterday when I started wondering about the exact reason we needed economic growth to keep the unemployment rate down.

I wrote an introductory post then, explaining I was going to do some learning in public.  (The risk of embarrassing myself is real). Now I want to dive into this a bit more.

It’s true we need economic growth to prevent the unemployment rate rising. I checked and important people believe it.

RBA Assistant Governor Chris Kent has specifically linked changes unemployment to trend growth. “Since about mid 2012, Australia’s GDP growth has been a bit below trend and so the unemployment rate has been rising gradually.”

And he has given us this excellent graph:

Phew! That’s one thing I got right.

The link between economic growth and changes in unemployment is real and it has been formalised in a relationship called Okun’s Law.

I put the word out on Twitter for an explanation and I was swamped with awesome economists offering helpful explanations. Thanks to everybody.

This was the main thing I heard.  Basically:

• Because of population growth you need growth in output to have jobs for the new people.
• Because of labour productivity changes (people getting more efficient) you need more output or else you’ll employ fewer people.

This is a nice neat story. If you have 2 per cent labour force growth and 1 per cent productivity gains, you need 3 per cent growth. It’s mathematically sound. I learned something.

So is that it? Are we wrapped up? All silent?

I still find myself with questions. I want to understand things in more than just mathematical terms.

Productivity causes growth. It allows us to produce more, using the same. But we also need growth to compensate for it? This sends me into something of a chicken and egg loop.

I’m aware that chicken/egg scenario is why economics uses maths so much. Supply and demand need to be solved simultaneously. You can’t think through a market equilibrium slowly because you need an answer on both sides at once.

So I could stop here. But I have other questions.

If rising labour productivity is both cause and cure for unemployment, why is it spoken of in exclusively glowing terms? Would we not be as well off, in unemployment terms, without it?

And population growth causes economic growth too. This is what I believe, a belief reflected in articles like these:

Fewer people want to live in Australia in growth risk for RBA

RBA’s Glenn Stevens: Australia may need to rethink growth

If we did not have the population growth, would we still have stable unemployment? This remains my sticking point – my reason for wondering about the deeper reasons and implications of why we need 3 per cent growth.

Seems to me an important part of the existing population is employed creating space for the new population to live in.

While the productivity angle makes sense to me, the population one still gives me pause. Establishing the new capital stock to accommodate the lives of new babies and new migrants is a huge cause of economic activity. More roads, more shops for them to shop in, more buildings for them to live in, more pipes going to their houses, more hospitals for them to be sick in, etc.

New population consumes and works the same as the existing population; but also requires extra spending. I intuitively believe population growth causes a rise in employment so I can’t quite grasp that it’s a wash, unemployment wise.

Whenever I think about this question I think about Japan, where capital is being abandoned as the population shrinks, and (while unemployment is low) secure employment is a problem.

Perhaps I need to think about this differently? Perhaps I need some more empirical evidence? I’ll dive deeper and present what I find tomorrow.

If you have any thoughts on this topic or want to suggest some reading, please feel free to make a comment below.

## Why do we need 3% economic growth to keep unemployment stable? – Part 1

I like to think of myself as not too stupid. When I don’t understand something, I like to dive into that.

• Sometimes I learn new facts that help me make sense of what seemed like disparate and nonsensical data points.
• Sometimes I learn what I thought were facts were not.
• Sometimes I learn new theories of the world.
• Sometimes I decide those theories are nonsense and the reason I didn’t understand the thing in the first place is that it makes no sense.

Searching out areas where I feel confused or uncertain is a useful way to figure out how to move forward. I try to shield from public view when these areas of uncertainty are to do with economics. But no more.

I believe we need high growth to keep unemployment stable. But I’ve never really understood why.

My economics education was a good one. But I never did honours – let alone a PhD – and it was a long time ago. They didn’t teach us everything, and I’ve forgotten plenty.

This is my way of saying I don’t know everything about economics. (Despite how obvious it is this is weirdly hard for me to type.)

What I’m doing here then, is going on a learning expedition. Trekking deep into territory that has been explored, but not by me. Maybe along the way I’ll learn something. Maybe even have some insights that are new to me. Maybe even have some insights that are new!? Most likely I will discover everyone else already knew something I didn’t.

This is part 1. I’m expecting to be able to put together a few more parts over coming days as I learn a bit on this topic. But for now, I’m going to write about a few of the preconceptions I have that give me the idea this is an important question to pursue.

1. My sense is if the Australian economy saw population growth and productivity growth drop to zero it would have growing unemployment. But basic economic equilibrium theories would suggest that doesn’t happen. Why wouldn’t all the firms just produce the same again next year, using the same workers?
2. My guess is that growth has in the past come largely from population growth. Which is weird. It suggests adding new people to the population / labour force creates so much new demand that it props up not only their own job but other people’s jobs too.
3. The global population is growing fast. But it may stop doing so within our lifetimes. At that point, population growth will stop contributing to economic growth. If population growth causes econ growth causes employment, the end of pop growth could be the end of employment.  That’s a nasty scenario. We may have to choose between the limits of the planet or the employment of its workforce.

At the least this will be a quick two part series where I explain the answer in part 2 and am forced to revise the first thing I said in this post. ;)

## A Harvard Professor has two big reasons China will crash (and wreck your personal finances)

China’s economic growth has been very strong for a decade, making Australia one of the richest countries in the world. China has buffered us from the GFC, boosted exports, lifted house prices and invested in our businesses.

Forecasts are for more of the same: At Budget time, Australia predicted growth of about 7 per cent for China until 2017.

But Harvard Professor Lant Pritchett is doubtful about those forecasts. The economic development expert has published a working paper full of reasons why China is far more likely to come to a bust than continuing boom. If he is right, the Australian economy will be stuffed (a technical term) and we’ll probably all lose our jobs.

“History teaches that abnormally rapid growth is rarely persistent.”

This is the unique angle of his story. Pritchett doesn’t purport to analyse China in depth. He looks at economic history, comparing China’s streak of success to other countries’ growth spurts, and predicts reversion to mean.

“regression to the mean is the empirically most salient feature of economic growth. It is far more robust in the data than, say, the much-discussed middle-income trap.”

I’m inclined to think this approach has strengths. The current trope about Chinese policy-makers is that they simply set the level of economic growth that they want.

If this is true they are the only country in the world with that power.

What do we really know about the Chinese economic policy-making apparatus? We know only that it has been very successful, according to its own statistics. And everyone acknowledges those statistics are rubbery.

Pritchett compares betting on China to investing in the best-performing managed fund – past performance is no guarantee of future performance, he cautions us.

“The lack of persistence in country growth rates over medium- to long-run horizons implies current growth has very little predictive power for future growth”

Pritchett, it turns out, really hates extrapolation:

“Paul Samuelson’s textbook predicted in 1961 that there was a substantial chance that the USSR would overtake the United States economically by the 1980s. There was a widespread view right up until the end of the 1980s that Japan would continue to grow and outcompete the world. Or in the opposite direction, consider the pervasive pessimism of even a decade ago regarding Africa. Since then, African countries emerged as a majority of the world’s most rapidly growing nations.”

His paper shows the correlation between growth in one decade, and growth in subsequent decades is low: from 0.3 for adjacent decades, down to around 0.1 for decades separated by 20 years.

“The median duration of a super-rapid growth episode is nine years… China’s experience from 1977 to 2010 already holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid (> 6 ppa) growth for more than 32 years.”

Pritchett instead suggests China will grow at an average of 3.3 per cent a year over the next decade. That means China’s GDP will be about half of what it would have been by 2033 than if it grew at 7 per cent.

Pritchett does make one concession to analysing China itself, and that is to note that growth is, on average, less variable in countries that are more democratic.

“For China, continuing to have rapid economic growth while maintaining its current level of democracy (as proxied by its Polity score) … would make it more and more anomalous.”

So if China crashes, what should you do?

1. Have a job that doesn’t depend on China (BHP bad, Qantas bad, universities bad, milk exporters bad. Doctor and primary school teacher probably safe.)

2. Have a job that can survive in a downturn. (BMW retailing bad, electricity retailing good)

3. Get out of shares. Australia’s corporate profits depend on Australia’s growth, which depends on exports to China. A China collapse and a stock-market collapse would look like that Olympic event where the two divers leap from the platforms at the same time.

4. Sell your property. China props up our house prices directly (by bidding on them) and indirectly (by making us wealthy). When the firecrackers stop popping in Beijing, auctions in Australia are going to be cold and quiet for a few years.

5. Put your money in a government guaranteed deposit account (and get ready to get very little interest indeed, because the RBA will be busy cutting rates to near-zero.)

In summary, let’s all hope Mr Pritchett is really wrong.

## Betting on the Chinese Communist Party, and why that could make us poorer.

China’s economy is showing signs of failure, but people keep betting on it.

For example, last week an index of Chinese manufacturing output showed its fifth consecutive month of falls, and China-linked assets shot up.

The reason?

Financial markets believe the Chinese government will come to the party with extra spending and extra stimulus.

Are they right? The question we are asking here is not merely academic. If we bet on China and lose, the following are likely to fall:

• The Australian dollar.
• Australian economic growth.
• Australian share market.
• Australian house prices.

The Chinese government obviously wants the economy to keep growing. The continued existence of the Communist Party is tied to the performance of the Chinese economy. They have to keep it ticking over. Their motivation is clear and pure and strong. But motivation is not always enough.

Consider this. The only reason markets need to trust the Chinese government to add more stimulus is that previous rounds of stimulus haven’t done enough. Financial markets are betting the guys that got the market into this pickle can safely navigate out again.

“We expect Beijing to launch a series of policy measures to stabilize growth. Likely options include lowering entry barriers for private investment, targeted spending on subways, air-cleaning and public housing, and guiding lending rates lower,” said Hongbin Qu, chief China economist at HSBC.

A few iterations is enough for the human brain to learn a pattern. We’ve seen the Chinese government come to the party during the GFC and during the European debt crisis that followed, keeping China’s growth rate up over 7 per cent, rain hail or shine.

No wonder traders and hedge fund gurus trust their guts on whether the dragon will roar again. But a well established patten hurts the most when it breaks.

This time the problems in China seem to be inside China. They are not dips in demand caused by a failing USA or Europe.

China recently experienced its first debt default and its first bank run. Corporate debt is being reined in.

The big pile of flammable material at the heart of China’s economy is house prices that are too high. China’s property market issues are unique. Everyone agrees prices are in bubble territory and will have to fall. Even the Asia editor of the Economist, who is otherwise totally excited by more China growth.

The question is what will happen when Chinese house prices fall. It’s easy to imagine that it will happen in a controlled way, or simply not be too important. That’s what Ben Bernanke imagined pre-GFC too.

China is enormous and its government freer to act than most, due to the absence of democracy. I suspect any crash would be over sooner than some expect. But even a short dip would be a big problem.

The value of China’s growth has been that it is consistent. It can be counted on. Having to risk-weight China’s future growth will take a lot of shine off Australian asset prices.  House prices would be under attack from all quarters, with receding Chinese purchases, a falling share-market, and a weakening Australian economy. Bank shares, which account for a quarter of our stock market, tend to follow house prices. The Chinese government’s ability to manage its economy has become, it seems, one of the biggest risks to our wealth and well-being.