Thursday, February 28, 2013

Innovation - fixing the right problem

This comment first appeared as an op-ed article in the Dominion Post newspaper.

We hear the word innovation a lot lately.  Key multi-lateral economic agencies such as the International Monetary Fund or the OECD are telling policymakers, particularly in the major developed economies, that innovation is the key to solving the woes of weak economic growth in the wake of the global financial crisis (GFC). But any Government intervention in the innovation system must fix the bit that’s broken. The recent launch of the new Crown Entity, Callaghan Innovation is a step in the right direction.

Post GFC, economic growth in developed economies is subdued. In some countries, central banks have done most of the heavy lifting in terms of supporting demand.  But moving to a structurally higher level of growth is not just about monetary policy.  It is about structural reform including the regulatory environment, labour market, goods markets and access to trade.

It’s also about being more innovative.  That’s because in some countries the traditional sources of growth, such as exports in China and consumption in the US, need to change.  In fact they need to reverse:  The US needs to increase its exports and China needs to increase domestic consumption.

Economists will typically talk about a country's national innovation system to describe constituent parts of the system and, just as importantly, the linkages between the parts of that system.  In New Zealand, our national innovation system is made up of our universities, research institutions (including Crown Research Institutions or CRIs), the providers of skills, the stock of skills (or human capital) available in the economy at any given time, firms and entrepreneurs.

Describing it in this ways means we can start to think about where our strengths and weaknesses lie.  It also means that, assuming we agree we need more innovation, it helps us decide what we should do about it, and who should do it.

If the Government is going to invest in innovation, it needs to fix the right problem and contribute to higher economic growth, especially given the higher stakes in these straitened fiscal times.  We also need to ensure the fix better enables us to take advantage of the opportunities that are currently staring us in the face like our burgeoning economic relationship with China.

I think our universities, CRIs and a number of our firms do great research.  Think about biotechnology. New Zealand is a world leader and agriculture has been the driving force of productivity gains within the New Zealand economy.

Outside agriculture I think we have had only limited success in innovation, particularly in the commercialisation of innovation.  We've tended to always think of ourselves as being quite entrepreneurial.  I disagree.  Entrepreneurship goes beyond just simply having a great idea: it means having the capability to take that bright idea to market, thus turning it into a viable commercial enterprise.

To me, the link between research and firms, particularly entrepreneurs who can commercialise that research, is the greatest weakness in our innovation system.  To put it simply, it’s not the Research in R&D that’s the problem, it’s the Development.  That’s why I have always been against R&D tax credits.  They are expensive and aimed at research.  That doesn’t fix the fundamental problem.

The Government’s new Crown Entity, Callaghan Innovation, was launched to little fanfare, yet in my opinion, it could prove to be the most important economic development initiative in New Zealand in many years.  It has three areas of focus: to Motivate, to Connect and to Deliver.  It’s the building of connections between ideas, science and commercialisation that will create the greatest opportunity for a step-change in New Zealand’s economic performance. Should it prove successful, it will also prove that economic development is not just about how much money you spend on it.

The challenge now is for business to get in behind it.  Too often we look for Government to fix the problems of low growth, poor productivity growth and low wages.  The pathway to higher growth and higher wages requires a partnership between individuals with skills, businesses with aspirations and Government which creates the right environment for those aspirations to be fulfilled.  In launching Callaghan Innovation I think the Government has just taken a giant leap forward in creating a stronger environment for the commercialisation of innovation.

This is important because the commercialisation of innovation is critical to achieving higher economic growth. And higher economic growth is important in achieving better social services we expect the Government to provide us and the quality of life we aspire to, including our ability to afford the sorts of houses we want to live in and a comfortable retirement.

Wednesday, February 27, 2013

Italian election

The Italian election has proven to be a timely reminder that there is still considerable work to be done in the Euro zone and that it will be vulnerable to setbacks from time-to-time. 

The election resulted in a narrow margin in Italy’s lower house for Pier Luigi Bersani’s centre-left coalition, but he failed to win a majority in the Senate.  Bersani is still short of a majority in the Senate even if you include Mario Monti’s party, thanks largely to the strong showing of the “anti-establishment” Five Star Movement.  The Five Star Movement’s strong showing highlighted the strong public backlash against austerity.

Since Mario Monti’s technocrat government came to power in November 2011 progress has been made in strengthening public finances and instituting broader economic reform.  The budget deficit now stands at 2.6% which is not bad by Euro zone standards.  The concern is that further work still needs to be done to turn growing financial stability into stronger economic growth to help make Italy's public debt of 127% of GDP less burdensome.

Of course in the period in which Monti has been doing good work in Italy, the European Central Bank has also pledged to do “whatever it takes” for the Euro to survive.  But remember the Outright Monetary Transactions (OMT) program only comes into play if the individual government’s seeking assistance sign up to budget and structural reform conditions.

It remains to be seen just how big a setback Italy’s inconclusive election outcome will turn out to be.  But as we have seen already since the election, financial markets will treat any setback harshly.  That’s a good discipline.

Sunday, February 24, 2013

UK downgrade, Europe PMIs and China housing

There were three developments late last week worthy of note: Moody’s downgraded the United Kingdom, Euro zone PMIs highlighted the growing divergence in economic performance between Germany and France, and China has announced renewed efforts to contain the residential property market.  Sorry I couldn’t think of a more elegant title to tie them all together!
In a move that is no real surprise, Moody’s downgraded the UK one notch to Aa1.  Moody’s cited continuing weakness in the UK’s medium-term growth outlook which they expect to last into the second half of the decade.  That’s a reasonable expectation. 
Moody’s shifted the outlook for the UK rating to stable, reflecting their expectation that “a combination of political will and medium-term fundamental underlying economic strengths will, in time, allow the government to implement its fiscal consolidation plan and reverse the UK’s debt trajectory”.
My concern for the UK is the government seems to have put all his eggs in one basket: fiscal austerity.  They are finding that, unlike in the early 1990’s, “expansionary austerity” isn’t quite so easy in the aftermath of a financial crisis when interest rates are already low and business and consumer confidence are weak.  Furthermore, I’m not convinced the UK has yet done enough structural work to be confident of robust growth in the future.
In the Euro zone, February “flash” PMI data showed that while financial tensions may have reduced in recent months, it is yet to have any meaningful impact on real economic activity.  The composite (manufacturing and services) index for the Euro zone fell from 48.6 in January to 47.3 in February.  That puts downside risk on my expectation of March 2013 quarter Euro zone GDP of zero.
The data again highlighted the divergence in economic performance between Germany and France. The composite index slipped for both countries over the month, but the German index at 52.7 is well ahead of the 42.3 recorded in France.   December quarter GDP data released last week showed Germany contracting -0.6% over the quarter and France contracting -0.3%.  I still think that was the low point in the cycle for Germany but it appears France has further to slow.  Let’s hope France doesn’t become the big story in the Euro zone in 2013.
Finally, the Chinese authorities have asked local authorities to step-up their enforcement of current policies to curb property market speculation.  Property prices rose 0.5% in the January month to be up 0.6% in the year to January, the first annual increase in 11 months. 
This is a prudent and therefore welcome move.  The authorities have been reluctant to ease monetary conditions too aggressively, for fear of reinflating the property bubble that emerged out of the post-GFC stimulus measures.  In taking modest steps now to better enforce existing policies, it reduces the risks of having to take more aggressive steps further down the track that would be more detrimental to overall economic growth.

Friday, February 22, 2013

The Fed

We are at the point in the US economic cycle (inflation currently benign, but economic and financial conditions improving) when the minutes of the FOMC meetings are more interesting than the post-meeting statement.  We saw that in January with the release of the December minutes which spooked bond markets by hinting at the possibility of an earlier than expected end to QE3.

There were no surprises in the January minutes released this week, although the market has interpreted them as biased to the hawkish end of the spectrum.  My reading of them is there was something in there for both the doves and the hawks.  What we are seeing is an FOMC actively engaging in debate about the appropriateness of current policy settings and the risks around that.  The minutes reflect a discussion on the potential costs of quantitative easing including inflation risks, financial stability and the risk of capital losses.  That’s a healthy discussion especially when policy has entered the realm of the unconventional. 

Staff projections for near-term GDP growth were revised up, largely due to fiscal drag not being as restrictive as they had assumed.  That may be reversed in the next meeting depending on the quantum of the fiscal drag from the sequester. 

The minutes also reflect an ongoing discussion on where the growth rate of potential GDP currently sits.  Of course what matters for monetary policy is not so much the absolute level of economic growth but the rate of growth relative to potential GDP.  Our assumption since the GFC recession is that potential GDP growth is lower than it was previously in most developed economies (yes, New Zealand included) which means output gaps may not be as large as currently estimated.  So, that too is a healthy debate to have.

In general there was nothing in the minutes to change my view that the first change in US monetary policy settings will be a gradual phasing out of QE3 (i.e. a reduction in the quantum of QE), but the end of QE is a 2014 story.  The risk to that view is a sharper fall in the unemployment rate than currently anticipated or earlier than expected signs of rising inflationary pressure.  Board staff have also been asked to do more work on the risks of QE.  That being the case, any unfavourable reassessment of the risks of ongoing asset purchases will have implications for current policy settings.

Tuesday, February 19, 2013

Currency wars

I don’t subscribe to the theory that the world’s major economies are engaging in currency wars.  But it is correct to say that in the absence of a broader policy response to the woes of weak growth in output and lacklustre gains in employment, monetary policy is doing all the heavy lifting.  In that environment, central banks are using the only tools available to them, including quantitative easing.

The various central banks around the world have mandates that vary in scope.    In some cases, those mandates are quite broad. The US Federal Reserve, for example is mandated to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.  Some are more narrowly focussed: the Reserve Bank of New Zealand has a goal of “maintaining a stable general level of prices”, defined as being average inflation near the 2% target mid-point of a 1%-3% range.  While its mandate is more directly tied to inflation outcomes than the Fed, the RBNZ is required to “have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate”.

Central banks are currently using the tools at their disposal to achieve their mandates.  In countries facing weak or negative output growth, weak labour markets and the risk of deflation some central banks have resorted to unconventional methods to ease conditions further as interest rates reached the lower bound.  That has involved quantitative easing (i.e. printing money) which has led to depreciating exchange rates in countries undertaking QE and appreciating exchange rates elsewhere, and accusations of competitive devaluations.  In the early days of QE most of the criticism came from emerging countries such as Brazil as the Real appreciated significantly.

The direct and foremost objective of quantitative easing is in expanding the money supply, thereby working against deflationary forces.  It is therefore more than a tad odd that it is Japan, a country that has been and still is mired in deflation that has come in for the most recent criticism for aiding and abetting currency wars.  It is even more peculiar that it was Germany, the primary winner in the “Euro project”, who started the criticism of Japan.

Regular readers will know that I have been somewhat dubious about the benefits of quantitative easing on real economic variables such as growth in output and jobs.  The transmission mechanisms exist, but they’re indirect and we really don’t know how strong they are.  The first is via higher asset prices like the US stock market.  Periods of QE by the Fed have coincided with strong gains in the S&P 500 which has fed through to higher wealth and stronger consumer confidence.  The second is via the debasing of the exchange rate resulting in a weaker currency which obviously supports export growth and makes domestic import competing domestic firms more competitive.

To me the critical issue isn’t so much whether central banks are engaging in competitive devaluations so much as it is whether some central bank mandates are too broad and that those banks are not getting enough support from policy makers.  There is simply too much expected of monetary policy to fix the woes of low growth and lacklustre jobs growth.  In short, building an environment of robust growth in output and jobs requires a broader policy response and policy-makers, particularly in the large developed economies, have been generally lacking in that response.

That has left central banks to do the heavy lifting, and I’m pleased they have.  In the absence of their action it’s possible that no-one would have been doing anything!  That would have most likely led to economic depression and deflation.  That’s a “new normal” that wouldn’t have been a good outcome for anyone.

The answer is (still!) structural reform, a phrase that is often confused with obfuscation and doing nothing.  But this time it matters.  Productivity, innovation, trade access and regulatory reform are all important ingredients for stronger growth.  To that end the most important part of President Obama’s recent “State of the Union” address was plans for the negotiation of a trade agreement with the European Union.  Now that’s the sort of action that matters.

Friday, February 15, 2013

Europe and Japan GDP soft, NZ retail sales a little ripper

A 0.6% contraction in Euro zone GDP in the December quarter of 2012 was a disappointing result.  That took annual growth to -0.9% for calendar 2012.  Annual average growth came in at -0.6%, weaker than our long-held forecast of -0.5%.


The softer than expected result in Germany where GDP also contracted 0.6% in the quarter was especially disappointing.  We don’t have a full breakdown of the result yet (that comes later in the month), but it appears the weakness came through in business investment and net exports.  France was also softer than expected with a q/q result of -0.3%, although it appears much of the weakness was in inventories.  Germany was the only major country in Europe that had a positive annual rate of growth in 2012.

The disappointment in this result is tempered by the fact that the forward look data is improving.  Importantly PMI data and business confidence are improving, although less so in France. Also, with the recent reduction in risk premia in Europe the cost of capital is lower and credit conditions are improving.  We expect that to support economic activity in the period ahead.

However, we don’t expect that to lead to an across the board increase in activity.  We think Germany has passed the low point in the cycle, but the periphery is still bearing the brunt of front-loaded austerity.  And despite the recent weakness in France being due to de-stocking, which should be good for production in the period ahead, PMI data is not indicating a recovery in activity anytime soon.  Recent strength in the Euro will also have a dampening effect on export growth.

I remain happy with the view that Euro zone will remain relatively flat in GDP growth terms for the first half of 2013 before a modest recovery emerges in the second half.

Japan fourth quarter GDP was also released this week and also came in softer than expected.  Activity contracted -0.1% q/q (-0.4% annualised).  Average expectations were for a q/q increase of +0.1%.  The recently announced fiscal stimulus package gives me confidence in my forecast of +1.0% GDP growth in 2013.  The weaker Yen and stronger global growth this year should also support exports.

New Zealand fourth quarter 2012 retail sales were released this morning and showed a whopping 2.1% q/q increase. Core sales (i.e. excluding motor vehicles) were up 1.5%. This result follows a revised -0.2% in the third quarter (previously -0.4%).  All else being equal that result shifts my fourth quarter GDP forecast from +0.7% q/q to +0.9%, but there’s a lot more partial data to come.

Monday, February 11, 2013

China data supports improving outlook

China export, import and lending data all started 2013 stronger, while inflation was softer.  But with the different timing of the Lunar New Year holiday this year (January in 2012, February in 2013), cautious interpretation is required.  In general though, the data support the story of a recovery in growth in 2013.  There is clear upside risk emerging to my 8.0% annual average GDP forecast for 2013, but I will leave it where it is until the New Year holiday data washes through.

Exports surged to annual growth of 25% in January, up from 14% in December.  This data can be volatile so we’re not reading too much into this number.  Our 3-month rolling annual percent change current stands at a more modest 13%, which is closer to where we think 2013 exports will end up.  That still seems strong compared to where U.S. and Europe growth is likely to be this year, but the biggest growth in China exports to other Asian economies.

Imports were up an even more robust 29%, reflecting restocking prior to the New Year holiday and the fact that in China, exports have a high import component.  In that regard, strong imports support the validity of the export data.

Lending was also very strong in January with total new lending more than double that of December, although base effects kept the growth rate subdued.  Social financing was also strong reflecting stronger demand for credit in the economy.

Consumer inflation dropped back to 2.0% in January, down from 2.5% in December.  However, the lower inflation rate in January primarily reflects the higher base in January 2012 when prices increased sharply for the New Year holiday.  We expect a spike higher in prices to come through in February, and for inflation to trend higher in 2013 to around 3.0-3.5%.

With higher inflation ahead, the property market recovering and stronger money supply growth it was no surprise the People’s Bank of China last week flagged their intention to contain inflation risks.  To us that means no further monetary easing this year, although we wouldn’t expect to see any tightening in conditions this year either unless growth is significantly ahead of expectations.

Thursday, February 7, 2013

NZ employment signals still mixed, but HLFS weakness getting harder to ignore

The good news in today’s Household Labour Force Survey (HLFS) was that after three consecutive quarterly increases in the unemployment rate that saw a recent peak of 7.3% in the September quarter of 2012, the unemployment rate declined to 6.9% in December.  The bad news is it declined for all the wrong reasons.  Employment fell 1.0% in the quarter while the participation rate dropped sharply.  Both are signs of a labour market that is not in good health.

Apart from the drop in unemployment the only other mild positive to take out of this result was that the weakness was centred in part-time work while full-time employment rose.

If I was pressed for a reason for the weakness I would conclude that the labour market is a lagging indicator and the weakness in the December quarter reflects the soft patch in the economy in the second and third quarters of 2012.

However, the mixed signals come from the fact that over the last few quarters a significant gap in employment growth has opened up between the HLFS and the Quarterly Employment Survey (QES).  The HLFS shows a 1.4% decline in employment over the 12 months to December, while the QES shows growth of 1.4%. That’s quite a gap.

The HLFS employment data is also inconsistent with other data on the labour market and broader economy.  Increases in wages and unit labour costs are running at just slightly below trend.  Businesses are telling us they intend hiring and are finding it difficult to find skilled labour.  That does not sound to me like a labour market that’s going backwards.

Furthermore, we think GDP expanded 0.7% in the December quarter which puts annual growth at around 2.1% in calendar 2012. If employment really did fall 1.4% over the year, that suggests productivity growth of around 3.5%.  Now that’s a stretch.  Even if it’s true, it’s unlikely to be sustained.

However, the longer the weakness in the HLFS goes on, the harder it is becoming to ignore.  We continue to believe the economy is expanding modestly and that we will see a tick-up in growth this year on the back of construction in Canterbury and Auckland.  That should be consistent with modest jobs growth and a trend decline in the unemployment.  Emphasis on the “should be”....

Sunday, February 3, 2013

Modest growth still the story for America

It was an interesting week for data out of America.  GDP for the fourth quarter of 2012 posted a small decline, the first since the GFC recession, while manufacturing and employment data for January supported the “modest growth” story.

December quarter GDP posted a 0.1% seasonally adjusted annual rate of decline, well below market expectations of a 1.0% increase.  The weakness can be explained by two factors: a sharp contraction in federal defence spending which was probably explained by anticipation of automatic spending cuts (sequestration) kicking in, and inventory investment.  Together those factors knocked 2.6 percentage points off the headline result.

Aside from those factors the result painted a picture of an economy that was expanding at a modest pace at the end of 2012.  Personal consumption spending rose 2.2%, residential construction rose 15.3% (and is becoming a real tailwind), non-residential construction 8.4% and equipment and software rose 12.4%, belying the anecdotal evidence that businesses were delaying capital spending as the fiscal cliff loomed.  In terms of net exports weakness in exports was partly offset by a contraction in imports.

More recent December month construction and durable goods (reflecting a recovery in defence spending) data suggests the December quarter GDP number is likely to be revised up when the second estimate is released in a few weeks.

In general we continue to expect an accelerating profile for US GDP growth this year with the early part of the year bearing the brunt of fiscal cliff tax changes, but the recovering housing market providing greater impetus as the year progresses.   The other factor to watch however is how federal government spending shapes up in the next few weeks as Congress resolves the spending issues in front of it.  Could well be that we have not factored in enough for spending cuts and that the fiscal drag may well end up larger than we currently anticipate.  Watch this space.

US manufacturing and employment data for January supports the modest growth story for 2013.  The January ISM manufacturing index rose to 53.1, its strongest level since April last year.  This follows several months on the trot of the index hovering around the 50 benchmark, reflecting neither strong contraction nor strong expansion. 

I’m being a tad cautious not to read too much into the jump in the overall index this month.  The most significant contribution to the overall index was a sharp increase of 8 points in the inventories index.  This reflects confidence by businesses to start adding to stock piles again once it was clear that the worst of the fiscal cliff had been avoided.  This suggests some upside risk to our pick of 1.6% for March quarter GDP growth.  I would need to see signs of stronger consumption and export growth before I believed this rise in the index suggested a sustained pickup in manufacturing output.  Indeed the export index dropped to only 50.5, reflecting still soft global growth.

The employment index rose to 54.0 from 51.9.  That, combined with the January employment report, suggests the labour market ended 2012 and began 2013 in fine fettle.  That again belies anecdotal evidence of firms holding back in the face of fiscal uncertainty.

There was something for bulls and bears in the January employment data.  The monthly payrolls gain of 157k was slightly below market expectations and the unemployment rate ticked up from 7.8% to 7.9%.  However, the data was revised back to March 2011 with recent average monthly payroll growth rising from around 150k to 180k.  That’s a tad more robust.  Remember our previous musings wondering whether the payrolls data collection was keeping pace with the structural change in the economy?

The participation rate was steady at a depressed 63.6%.  With employment looking to track along at a steady pace in the months ahead, the key number to watch is the unemployment rate, given the Fed’s “target” of 6.5%.  The participation rate will be critical to where the unemployment rate heads in the next few months.  If it stays where it is, unemployment will track steadily (though unspectacularly) lower.  However, if the better economic mood leads to an increase in people re-entering the labour market to seek work, the unemployment rate could head higher.  Fascinating.

Finally, to the Fed, the FOMC made no changes to monetary policy settings last week.  There were some minor tweaks to the language in statement which I’d summarise as being a tad more upbeat about the world.  We are at the stage in the cycle where the minutes of the meeting are actually more interesting than the statement itself and we will get those soon.  However, with the unemployment rate still elevated and the increase in the annualised quarterly core Personal Consumption Expenditure deflator having halved over the course of 2012 (from 2.2% in March 2012 to 0.9% in December 2012), don’t expect the Fed to be changing course anytime soon.