Reinhart and Rogoff Continue to Cast a Shadow

A number of years ago, Carmen Reinhart and Kenneth Rogoff wrote the best seller, This Time Is Different: Eight Centuries of Financial Folly, which showed that highly indebted governments were associated with prolonged slow economic growth.  The book’s main theme resonated around the world due to the then unfolding European sovereign debt crisis in 2011.  Since then, governments worldwide have been reluctant to use fiscal policy to stimulate their economies which has put the onus on monetary policy to help overcome the global shortfall of aggregate demand.

The Government’s Mid-Year Economic and Fiscal Outlook (MYEFO) is a timely reminder that Australia, like most other advanced economies, is suffering from deficient demand and as a result, remains stuck in a nominal recession.  The Commonwealth Treasury has slashed its forecast for nominal GDP growth in 2014/15 to 1.5% (from the Budget estimate of 3%), and marginally downgraded the growth forecast for 2015/16 to 4.5% (from 4.75%).

If the estimate for 2014/15 comes to pass, it would be the fourth consecutive year of sub-4% growth, effectively dragging the economy into another year of a nominal recession, the longest such stretch since the economy shifted to a low inflation regime from the early 1990s (see chart).

The Treasury has consistently over-estimated the outlook for nominal GDP for over three years now, and obviously been surprised by the extent of the slide in prices for Australia’s key commodity exports (see chart).  The terms of trade – the ratio of export to import prices, which represents a measure of a country’s purchasing power – has declined by one quarter from its 2011 peak, which in a mechanical sense, has slowed growth of nominal GDP.

The Reserve Bank has clearly been frustrated by the persistently strong currency.  In the face of the 25% decline in the terms of trade, the Trade Weighted Index has fallen by only 15%.  So the currency hasn’t performed its shock absorbing role in response to the negative terms of trade shock as well as in the past.

A number of factors have underpinned the currency’s resilience: the safe haven status that the $A offers at a time when global investors have had an insatiable appetite for safe assets, and Australia’s still large interest rate differential; Australia continues to have among the highest policy rates across the developed world at a time when world’s major central banks have maintained a zero interest rate policy.

The Reserve Bank has little power over the prices of the country’s commodity exports, but should have used monetary policy more proactively to boost growth in nominal GDP, by reviving animal spirits in the corporate, household and even the public sectors.

The economy’s nominal recession has suppressed growth in the key nominal variables, notably tax receipts, company revenues and employee compensation.  Per capita tax receipts collected at the Commonwealth level has grown at an annualised rate of 4.3% since 2010, well below the 6% compound annual growth over the preceding two decades.  Given that the cyclical environment is unlikely to be supportive, the Treasury’s forecast of a lift in compound annual growth of tax receipts to 5% over the next four years looks a touch too optimistic (see chart).

The two charts below confirm the extent of slowing in per capita company revenues and employee compensation in recent years.  No wonder then that consumer and business confidence have remained fragile for an extended period.

If the economy is going to pull out of its long nominal recession, the Reserve Bank should no longer under-estimate the power of monetary policy to revive animal spirits in the corporate, household and public sectors.  Because its timid approach to ameliorating the effects of the negative terms of trade shock  – stemming from concerns over house prices and rapid growth in lending for investor-housing – has imposed a significant cost to the broader community in terms of lower growth in tax receipts, company revenues and employee compensation

The Reinhart/Rogoff thesis still casts a shadow over the pro-active use of fiscal policy and the ability for governments to lift debt to finance capital spending.  This has encouraged governments in Australia to undertake privatisations to raise funds and retain their credit ratings.

The Federal government faces a delicate task between not further undermining already fragile consumer and business confidence in the short-term, but putting their financial positions on a sustainable footing over the longer run.  Further rate cuts accompanied by more aggressive rhetoric from the Reserve Bank would offer the government more wiggle room by lifting growth in nominal GDP and tax revenues.

Looking through the prospect of any cyclical recovery in tax receipts, a lift in the corporate tax burden is probably inevitable to assist in the government's medium term strategy of fiscal consolidation, particularly at a time when the growing political influence of retirees will limit the ability to reform healthcare entitlement spending.  

Portfolio managers should therefore be cautious about stocks and sectors that are exposed to greater tax regulatory risk.  To that end, Evidente will examine those stocks with low effective tax rates in a forthcoming blog post.