The missing recession

While the Australian and American economies have moved in virtual lockstep for the past three decades, recent commentary suggests a sudden break. The Economist magazine rhapsodises about the merits of an economy they now call "Down Wonder", while gloom about the US economy reached a crescendo when the events of September 11 further deflated an economy suffering from the bursting of the dot-com bubble. Should the United States now be looking to Australia for lessons on how to run a successful economy?

In a stark reversal of national traditions, Australian hubris about our economic prospects is in contrast with American hand wringing. Why this sudden divergence in the economic outlook?

One likely explanation is that while our economic rhetoric may be out of step with the Americans, our economic reality is not. American pessimism over the recession is overwrought, while closer to home complacency threatens.

Indeed, the similarities between the Australian and United States economies are more striking than the differences. Both economies have had a similar record of mild inflation over recent years. Both have also seen unemployment rise sharply. In the US unemployment has risen 1-3/4 percentage points since its trough, while local unemployment appears to have peaked 1 percentage point above earlier levels.

What then is the source of Australian hubris? Federal Treasurer Peter Costello boasts triumphantly that our current output growth of four per cent is the highest among the world’s leading economies. But this compares us with a pretty miserable lot: Europe remains sluggish, and Japan is fighting a decade-long depression. (After a decade of outperforming the Kiwis, comparison with New Zealand is barely even worth noting.) Perhaps a better marker is our own history, and on this scorecard, current growth rates are barely above our long-run average of 3.75 per cent.

But despite this, it is our performance relative to the United States that has drawn the most attention. Even on this score Australian triumphalism appears premature; an increasingly influential view suggests that the US economy is not doing too badly after all.

The National Bureau of Economic Research, the semi-official scorekeeper of the business cycle, declared that the United States entered recession in March 2001. Their determination on when or if the recession has ended will not be made for several months. However many are prepared to pre-empt their decision. At its most recent meeting the Federal Open Market Committee of the Federal Reserve Board declared the US economy to be "expanding at a significant pace".

Recent numbers provide support for this view. While the US economy took a backward step in the third quarter of 2001, it appears to have resumed a healthy forward momentum, growing at an annual rate of 1.7 per cent in the final quarter of 2001, despite the sharp shock to consumer confidence following the terrorist attacks. Latest numbers suggest that it is probably growing even faster today.

US Treasury Secretary Paul O’Neill is prepared to go a step further, arguing that "it seems quite clear now that our economy never suffered a recession". In support of this attempt to define away the recession, Dr Randy Krozner, a member of Bush’s Council of Economic Advisors, noted, "some people use two quarters of negative growth. We haven't had that".

Latest forecasts suggest that US real output will grow by around 2.5 per cent in 2002, and 3.5 per cent in 2003.

Yet if it is business as usual in the United States, someone forgot to tell the employers. John Sweeney, head of the AFL-CIO, the peak union body in the US, captured the mood of his members nicely, noting, "the much anticipated economic upturn continues to elude millions of workers." While output growth is continuing at a healthy pace, the US economy has shed over 400,000 jobs over the past year, and several pundits suggest that the unemployment queues will keep growing.

Taking these numbers together, it appears that the US has suffered a fairly unusual type of recession. Why has this downturn been so short, and why does the labour market look so ill, while the output numbers look reasonably healthy?

Some clues may be found in research presented at a meeting of leading US economists held last week by the National Bureau of Economic Research, where academic pundits pondered the future of the US business cycle. Several research findings are of particular relevance to our current situation.

Professors Jim Stock and Mark Watson, of Harvard and Princeton, respectively, argued that the US economy has become fundamentally more stable. They find that year-to-year shifts in output growth have declined substantially. Recessions have not only become less common, they have become milder. And the latest business cycle – the longest boom on record followed by arguably the mildest recession – fits their story perfectly.

The applicability of this finding to Australia is confirmed in recent research from RBA economist Dr John Simon. Dr Simon suggests that the Australian business cycle also seems to have stabilised, and that "continued low output volatility should enhance the prospects that the business cycle will be milder than in earlier periods." Indeed, the slumps that have plagued us may be replaced by a milder form of "growth recession".

Focussing on the current downturn, prominent Stanford economist Professor Bob Hall suggested that the while the bursting of the dot-com bubble was bad news for the United States, this particular cloud had a silver lining: a large and positive productivity shock associated with ongoing innovations in information technology. Thus, output has continued to grow even as employment has declined.

Rather than simply considering economic conditions as good or bad, Hall urged analysts to consider the various shocks to the economy separately, listing the negative shocks attributable to both September 11, the wealth effects from a declining stock market, and the positive productivity shock due to advances in information technology.

The implications for Australia are immediate. Each of these shocks is affecting the Australian economy, but in each case, they are having a more subdued effect.

September 11 undermined consumer confidence on both sides of the Pacific, but it seems to have had only a minor impact in Australia. According to Tim Harcourt, Chief Economist at Austrade, much of this reflects the fact that the main "concern for Australian exporters has been the impact of the US downturn on East Asia rather than the US-Australia direct impact".

The fallout from the bursting dot-com bubble has been less important for Australia than the United States because the wealth effects are much smaller. (Information technology stocks only ever made up 15 per cent of the market capitalization of the Australian stock market; at the peak they were 45 per cent of the US market.) Furthermore, Harcourt argues that the effect on our exports "has not been as bad as expected by many analysts mainly because we are not large producers of information technology."

Yet in a provocative paper titled "Productivity Growth in the 2000s", University of California, Berkeley Professor Brad de Long argued that information technology holds the key to a rosier, more productive future. A fearless prognosticator, de Long argued that the productivity boom catalysed by improvements in information technology in the mid-1990s is likely to continue for at least the next decade or two.

His argument is simple: Moore’s Law has proved itself in each and every year since Intel co-founder, Gordon Moore famously claimed in 1965 that computing power would double every eighteen months. But while the implications of Moore’s Law for the aggregate economy were fairly small back when computers were only a small part of all spending, this is no longer the case.

With both the power of computers increasing, and the number of computers in our homes and our workplaces growing rapidly, de Long calculates that there has been "a four-billion-fold increase in the world’s automated computational power in forty years." This computing power has enabled "revolutions in data processing and data communications," that will continue for some time.

Fortunately for Australia, while we are only small producer of information technology, the key to de Long’s optimism lies in the thoughtful deployment of computers in industry, not in the production of computers themselves. On this score, Australia does pretty well, with RBA researcher Dr Simon (this time working with co-author Sharon Wardrop) finding that our "use of computer technology is amongst the highest in the world" and still growing rapidly.

All of this yields a somewhat nuanced explanation of our current situation. Current hubris appears misplaced: that we have weathered the US recession probably says more about the peculiarities of this particular slowdown than it does about the Australian economy. Yet the longer run forces shaping both the US and Australian economies show cause for real optimism. Productivity growth will be strong, and the business cycle will be somewhat milder. Surprisingly then, the dismal science finally has some good news.