It's not just a drop in GDP that should worry us

It seems like we haven’t had much good economic news lately. This was neatly summarised in the drop in national output (GDP) of 0.5% due to weak investment, both private and public.

Private investment is unexpectedly weak across most categories. New building investment fell by 11.5%, construction investment fell by 3.6%, while mining investment fell for the 12th consecutive quarter.

This was all reflected in a drop in business confidence and business conditions in the September quarter.

This is not what’s meant to happen when you have interest rates at record lows. Last week the RBA held the cash rate at the lowest ever rate of 1.5%.

The cash rate has been falling steadily from 4.75% since October 2011 – it has not risen once during this time. Falling interest rates are supposed to stimulate business investment and also consumer spending, yet this is weak too, growing at below trend.

Mining and non-mining investment

The puzzle can be explained. When interest rates get very low they start to have the opposite to their intended effect on both households and businesses.

Households that are either in or approaching retirement have to save more to achieve their target nest egg of savings. This depresses consumption spending. No other than the RBA governor at the time, Glenn Stevens, acknowledged in a speech in April that low interest rates were a big problem for savers.

The arithmetic is simple. If you as a couple want to generate a comfortable income of $60,000 in retirement, you will need about $900,000 at an annual net return of 5% (after fees), if you are willing to run your capital down to zero after 25 years. You would obviously need more than that if you want to leave some capital at the end.

But 5% annual return is now looking very unlikely on a sustainable basis, given a low-risk asset allocation and a world of ultra low interest rates. About 3% (net) is more likely. In that case you will need roughly $1.1 million even if you are prepared to run your capital down to zero in 25 years. This isn’t even including any extras like a short overseas holiday once a year.

People understand this and are saving more to build a bigger nest egg, given such low returns. Other households that are building their wealth are tending to use lower interest rates to borrow in order to buy property.

Their consumption spending is more in the form of interest payments on their debts, rather than purchases of goods and services. The ratio of housing debt to household income has increased over the past three years from 166% to 186%.

And lower interest rates keep the Australian dollar lower than it would otherwise be. That makes overseas purchases more expensive, such as holidays and cars.

New building investment

As for businesses, why should they feel more confident about future sales revenue when the RBA thinks the economy needs stimulating, and when they see weak household consumption and other businesses reluctant to invest?

The apparently good news to come from the September quarter national accounts is actually dangerous. Australia’s terms of trade rose by 4.5%, due to mineral price rises such as iron ore. This feeds into export income and in turn eventually into company profits and tax revenue. Therein lies the danger.

The last terms-of-trade boom, from 2000 to 2010, released rivers of tax revenue. This is not what Australia needs right now because it will not last. It will only allow our politicians to postpone the necessary long-term cuts in government spending. Even worse, it might encourage them to hardbake new spending programs that we can’t afford in the long run.

Instead, we need to remember what Nobel-prize-winning economist Paul Krugman famously said:

“Productivity isn’t everything, but in the long run it is almost everything.”

Sustained improvements in average living standards can only come from improvements in productivity. We know how to improve productivity, we just can’t muster the political will to do it.

We have become far too concerned with how to share a national economic pie that is in danger of shrinking, particularly in per capita terms, than in growing the pie.