Economists do not make good psychologists, so when i hear my colleagues talk about ‘confidence’ my skin crawls.
If you feel the same way, and have that roller-coaster desire to make yourself (nearly-)barf, read this collection of ‘confidence’ abuse that Macrobusiness has collected.
This sort of talk is always around, but i blame the RBA Governor for feeding the frenzy with his ‘after the booms’ speech.
As economists, we are taught a framework — it’s a cost-benefit framework … let’s use it!
An axiom is that folks do things when the (expected) benefits exceed the (expected) costs. This framework has everything we need to speak meaningfully about why investment is depressed (expected returns are low relative to the cost of capital) or why consumption is low (expected future spending power has declined).
So what are the folks (Stevens included) saying when they talk about low confidence being the problem?
Are they saying that expected returns are unreasonably low? How could they know that? They couldn’t — no one can say that for sure. No one is any good at forecasting returns over the horizons that matter.
We can talk about the extent to which generally expected returns differ from our own — but would that tell us anything? There’s no information in this about confidence as an economic force. Perhaps it just says our forecasts are too high (or that we are over-confident).
A clue would be if there was nothing we could point to that explained pessimism … But that is not the case.
We are in the midst of a large terms of trade shock. It’s been big so far, and we are probably only at the start of a multi-year event. The mining investment drop off hasn’t even really started … That will happen in 2014.
Every terms of trade boom has ended with the terms of trade over-shooting to the downside. The terms of trade remain wayyyy above the long run average — so the pain isn’t nearly over.
What does theory say will happen as this nominal income shock spreads out across the economy?
The textbooks suggest we will see the return on capital in the mining sector fall, as the AUD is unlikely to fall by enough to offset the drop in export prices. As this sector retrenches, the normal input-output relationships mean that all sectors will experience weak demand and profitability.
There are two obvious consequences of this: a weak labour market and depressed government finances.
In the first case, sectors will shed labour and shutter output (or at least slow additional capacity) as demand from the mining sector falls back and they wait for interest rate sensitive sectors and the external sector to pick up the slack (via a weaker AUD). This will show up as a period of depressed investment, slow GDP growth, and higher unemployment — pretty much what we see just now.
In the second case, weaker company profits and a soft labour market (slower growth in both wages and hours worked) mean less government revenue and larger deficits.
This may feed back via fiscal policy — and is currently doing so. The government is responding by raising taxes and cutting spending, so firms are seeing less demand as both consumers (who are paying the taxes) and governments spend less.
So what’s the ‘circuit-breaker’? A lower AUD. The lower AUD will boost other sectors, and they will eventually pick up the slack.
Why should consumers be happy about this? A weaker AUD is a real wage cut for Australian households and consumers.
I think the weakening AUD will have a larger depressing impact on consumer confidence than usual, as an increasing number of Australians are exposed to a weaker AUD via purchases of online goods.
Ask a 25 year old about the AUD, and they’ll sound like they work in finance … at least they’ll know how much it’s gone down, over what period, and might even supply a quote as to what it’s done to their toy and clothing expenses …
… for the rest of us, there remains the price of the fuel we put into our cars — these complaints have picked up following the AUD’s ~15% decline over such a short period.
So there reasons to think that the returns on investment will be low in the future. If you think this terms of trade boom will end just like every other terms of trade boom, you would hunker down.
If the terms of trade just goes back to the pre boom average, investments will be less likely to pay off handsomely (although some will), jobs will be less secure, taxes will be higher, government services will be reduced, nominal wage growth will be slower, and real wages will fall (via the lower AUD).
We do not need myths about bad government (though we do have one), nor appeals to things that cannot be measured to understand what’s is going on.
So let’s leave the confidence fairies behind — we ought to talk about the real shocks that are hitting the Australian economy (and are likely to continue to do so).
Given these real shocks it is reasonable for folks to have lower expected returns. The RBA cam offset this with lower policy rates. Better regulation — both more predictable governance and more permissive regimes — would also help …
But let’s be clear that the terms of trade drop is a real shock and it is this real shock that is very reasonably lowering expected returns.