TheKouk – Opening remarks to the Senate Committee on the Commission of Audit


Check against delivery.


 Stephen Koukoulas, Market Economics


Australia does not have a government debt or deficit problem.

According to Treasury numbers published by Treasurer Mr Hockey in the Mid-Year Economic and Fiscal Outlook in December, over the last 43 years of budget outcomes (the full data set), there have been 19 budget surpluses and 24 budget deficits.

Up until 2007-08, just prior to the collapse of the global financial system and the onset of the deepest recession in the industrialised world since the 1930s Great Depression, surpluses were a little ahead of deficits, 19 to 18. This suggests that the recent move to budget deficit is almost certainly nothing more than the long-run business cycle impacting on government finances.

With the financial crisis slowly but surely passing and the global economy now on a track to record a sustained expansion, there seems little doubt that the mix between surpluses and deficits in Australia will again equal out as we participate in this expansion phase and revenue starts to flow back to the government.

And this is how it should be.

Reinforcing the strength of public finances in Australia at the moment, Treasury data published in MYEFO shows that the level of net government debt stands at 10.0 per cent of GDP, a miniscule level. For the OECD, the average is around 100 per cent of GDP.

By way of background, net government debt was a little below zero before the collapse of the global financial system hit Australia, but those same Treasury documents presented by Mr Hockey show that since the early 1970s, the level of net government debt has never been above 18.1 per cent of GDP and the average level of debt over that long time frame is approximately 7 per cent of GDP, a little below the level now.

This is remarkable and shows just how prudently government finances have, on average, been managed for over 40 years.

For Australia, with the economy clearly entering a phase of stronger growth, it is prudent to move the budget back to surplus. This is a relatively straight-forward task given the solid pace of economic growth unfolding and what we are likely to see in terms of some moderate tightening in fiscal policy in this year’s budget.

An unwinding of the government’s shifting of payments, in particular the outlay of $8.8 billion to the Reserve Bank of Australia, will also help to see the budget return to surplus in the next few years.

It is somewhat alarming to see the increasingly popular view that budget deficits are bad and surpluses are good. Alarming because it may encourage policy makers to take the wrong decisions when managing fiscal settings without paying attention to the business cycle. There was a risk of this with the previous government with its commitment to return to budget surplus in 2012-13. It was a worthy objective but thankfully it did not stick to that strategy when it became apparent that the decline in the terms of trade and high value for the Australian dollar had impacted negatively on national income growth and therefore government revenue.

Had it cut spending to meet its surplus goal, the economy would have weakened appreciably and the unemployment rate would inevitably be higher than it is now.

The government and the economics profession needs to work hard to change the misconception that surpluses are always good and deficits always bad.

There should be no value judgement that suggests budget deficits are good or bad without context being placed around the economic and fiscal position.

I have used the analogy elsewhere, but I think it makes the point – is a warm and sunny day good or bad?

Most obviously, it depends.

For a holiday maker at the beach, a warm sunny day is clearly good.  But for a farmer on marginal land in the midst of a drought, another warm and sunny day is clearly bad.

A similar judgment should be applied to budget deficits and surpluses.

It would be an economic policy failure, in the extreme, for any government to be aiming to run a budget surplus if the economy was in recession and the unemployment rate was rising. Here a budget surplus is unquestionably bad, while a deficit would be good, even if it was merely the result of the government allowing the automatic stabilisers on revenue and expenditure to kick in.

Similarly, if the economy was in a well established period of above trend growth, with very low unemployment and inflation pressures evident, a budget surplus would be good and a deficit bad.

When I look at the business cycle in Australia over the last four decades, I see quite clearly that this approach has been in place, more or less, from both sides of politics. I note the Howard government running a budget deficit in 2001-02 as the economy slowed markedly, if only temporarily, in the wake of the ‘tech wreck’ in the US and aftermath of the terrorist attacks on the US in September 2001.

This was appropriate.

Perhaps the best assessment of the state of public finances in Australia is given from the international credit rating agencies.

All three major agencies, Standard & Poors, Moodys and Fitch assess Australia as a triple-A risk with a stable outlook. They held this assessment even after seeing the seemingly pessimistic view presented in MYEFO. Indeed, Fitch upgraded the rating of Australia to triple-A late in 2011 after it observed the prudent use of fiscal deficits to maintain economic growth and to cap the unemployment rate.

In closing, I also note that Australia is in its 23rd year of continuous economic growth, a quite remarkable achievement. In addition, it has been more than 10 years since Australia’s unemployment rate was above 6 per cent and over the past 20 years, inflation has averaged 2.5 per cent.

These are stunning economic achievements.

While there are many reasons for this remarkable trifecta of economic achievement, sound fiscal policy settings would rank highly among them.

Going into budget deficit when needed, staying in deficit when needed, returning to surplus when needed and holding on to surpluses when needed are all part of the policy framework that has helped make Australia one of the richest countries in the world.

Only the economically ignorant would hanker for a budget surplus on all occasions. No credible economist I am aware of would advocate unending surpluses and no government debt in perpetuity. Nor would they argue for a budget deficit on all occasions with forever rising level of debt.

It is not that complex, even though, as we have seen, surpluses or deficits can persist for many years.

These economic achievements over many years have helped propel Australia to the fifth richest nation in per capita GDP terms, according to the International Monetary Fund, behind only Luxembourg, Qatar, Norway and Switzerland.

While the role of government is to prioritise spending and revenue raising measures, and here the Commission of Audit will have some valuable input into the government’s deliberations, account of the business cycle is fundamental when considering how much needs to be cut or which taxes need to be raised.

If the pace of economic growth were to remain below trend into 2014 and 2015, perhaps as the terms of trade decline and mining investment falls, an austere budget that returns to surplus in a hurry would be inappropriate policy. It would unambiguously add to unemployment and compound the economic downturn.

Based on the current Treasury projections, the scope for a significant fiscal tightening is limited.

If, as appears more likely, the economy is stronger than the MYEFO forecasts, the scope to trim a little more and lock in the return to surplus would be prudent.

Thank you.


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The building approval boom


It is staggering that some who should know better reckon that the building approvals data for December were weak.

OK, the number of building approvals fell 2.9% in December in seasonally adjusted terms, but this must be viewed in the context of earlier readings.

Those readings show that the number of building approvals in the December quarter as a whole was the highest since 1994 and the second highest quarterly result ever recorded. Sound weak to you?

The ABS measure of the trend series has increased every month, including December, for two years to be at the highest level since 1994.

Dwelling construction is in a boom.

Making the outlook for the construction sector all the more positive is that non-residential building is explosive with quite phenomenal double digit growth over the second half of 2013.

As mining investment falls away, it looks like construction of hotels, office blocks and shopping centres are taking off.


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SPC: One and a half cheers for Joe Hockey


The Government has made the right decision not to give SPC $25 million so that it can continue to produce expensive canned fruit that most Australians don’t want to buy or eat. There are parallels with the decision to hold back funding on Holden and the car industry in general. Tick.

What is disconcerting about the decision of the Government is what it intends to do with the obvious fallout from the likely closure of SPC.

Work for the dole? That pathetic idea may as well have the former SPC workers, well, getting the dole for making tinned fruit.

What the government must do, but so far it seems to be running away from this idea, is to have a decent, well funded retraining, skill enhancing and education framework for people working at SPC and other businesses past their use by date. A comprehensive policy setting would have the government providing such retraining services for the workers losing their jobs so that they are able to be more flexible in the job opportunities that will present themselves as the economy continues to grow.

What is worrying is that there appear to be cuts, not increases, in funding in these vital areas that have previously helped to enhance the skill set of the Australian workforce as the structure of the economy changed. This is where the government should be held to account – what does it plan to do for those losing their SPC jobs.

The end point is that it is the right decision on SPC, but it is only half right. If the government is serious about limiting the fall out from the likely closure of SPC, it should have the decency and vision to think about the skills and future work possibilities for those about to become unemployed and do its bit to make sure they don’t end up painting rocks white in the loopy work for the dole plan.



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Goldman Sachs versus The Kouk


The Bloomberg interest rate survey conducted after the thumping December quarter inflation data was enlighting.

The team at Goldman Sachs are forecasting an interest rate cut in March… which no doubt is well considered, but I remain firmly of the view that the RBA will be hiking interest rates soon, probably as soon as March.

The March IBs (effectively the interest rate futures for the RBA cash rate), is pricing in an 8% chance (2 basis points) of an interest rate cut in March.

If Goldman Sachs is correct and there is a rate cut, they will make approximately 22 basis points. If there is no change in rates, they will lose 2 basis points and if there is a hike, they will lose approximately 26 basis points (note these do not add to 25 basis points due to the fact the RBA decision is on the 4th of the month).

If I am correct and there is a hike, I will make approximately 26 basis points, if rates are on hold, I still make 2 basis points but if there is a cut I lose approximately 22 basis points.

So even if there is no change, I make money, such are the joys of trading.

TheKouk versus Goldman Sachs.

An RBA rate hike (The Kouk) versus a rate cut (Goldman Sachs) at the March meeting of the RBA.

I would also note that the year-end (2014) forecast for the cash rate is The Kouk at 3.5% versus 2.25% at Goldman Sachs. Let’s see who it nearest the pin in 11 months.

The December 2014 IBs are trading about 5 basis points above the current cash rate – i.e., 2.56% so there is a lot more to be made and lost on making a call 11 months out.




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RBA inflation forecasts hit for six


Some extra inflation news:

It its November 2013 Statement on Monetary Policy, the RBA forecast was for the annual CPI to end 2013 at 2 ½ % with underlying inflation running at 2 ¼ %.

The outcomes were 2.7% and 2.6% respectively.

With this fresh information (and other news), the base for the RBA updated forecasts for inflation for the next couple of years must be higher when the next SOMP is released on 7 February.

In November 2013, the RBA assumed the Aussie dollar to be 95 cents and 72 on the trade weighted index. It is now below 90 cents and around 68 on the TWI, a good 5% lower, notwithstanding broadly steady commodity prices.

The RBA noted in November that “the quarterly rate of inflation picked up in the September quarter, by a bit more than expected” and it must now do the same for the December quarter data. Nought from two for the RBA inflation forecasting team.

Looking at Graph 6.4 from the RBA SOMP, it looks like inflation is now outside its 70% confidence band. http://www.rba.gov.au/publications/smp/2013/nov/pdf/eco-outlook.pdf

Australia does not have an inflation problem and will not have one if the RBA does its work and adjusts interest rates according to this new information. A rate hike in March, with more through 2014, looks the best policy approach.


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All pumped up about inflation


There is no doubt the RBA needs to hike interest rates soon as the momentum on inflation is building rapidly. Not only was the December quarter CPI a shocker, rising 0.8%, but it followed a stonking 1.2% rise in the September quarter.  Anyone with a pocket calculator can see this means that annualised inflation was around 4% over the second half of 2013.

And this is with the cash rate at a record low 2.5%, fiscal policy moving from tight to neutral, the Australian dollar going from fair value to undervalued and house prices rising at a pace that must be playing on RBA Governor Glenn Stevens’ mind.

Recall – the RBA is an inflation targeting central bank, with an objective to keep inflation between 2 and 3% over the cycle. With house construction set to boom, with consumer spending accelerating, with business expectations rising, exports surging and now inflation looking to exceed the top end of the target during 2014, it needs to move monetary policy to neutral. It might be useful to also note that the world economy is looking better by the week, at least in terms of GDP growth.

This means the RBA needs to get the cash rate back to 4% or so over time (neutral), starting with a hike in the next month or two with follow up moves at reasonably regular intervals over the next year or 18 months.

Making matters more disconcerting today was the lift in the underlying CPI, which jumped 0.9% in the quarter lifting after a 0.7% rise in the previous quarter. Another couple of high-ish inflation results will see underlying inflation test the upper bound of the RBA target band.

This is where we take stock. Pretend for a moment you are a member of the RBA Board and the following facts are presented to you:

  • Annual inflation has accelerated from 1.2% two years ago to 2.7% now with the momentum suggesting a break above 3% is now all but certain.
  • House prices are rising at an annual rate of 10% and show few if any signs of cooling.
  • The Australian dollar is more than 15% lower than a year ago and export volumes are rising strongly.
  • Fiscal policy is roughly neutral now, having been massively contractionary over the past two years.
  • The global economy is strengthening.
  • Housing construction is on a surge.
  • Retail and other consumer spending are accelerating with retail sales rising at an annualised pace of 7% in the last 4 months.
  • Commodity prices in Australian dollar terms are rising.

Would you really be doing your job if you left the cash rate at a record low 2.5% for too much longer?


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Here’s why Italian bond yields are lower than Australia


There remains a major misunderstanding of government bond markets, which is now showing up in talk along the lines that Ireland is a better credit risk than the US because its government bond yields are lower, or similarly, that because the 10 year government bond yield is lower in Italy than in Australia, there is something wrong with Australia’s financial security.

A quick lesson on bond pricing.

There are basically two components that make up the yield of a government bond:

  • inflation and
  • risk.

High inflation eats away at the capital value of the bond (the amount of money the government pays you back when the bond matures), so higher inflation means investors needs a high yield.

In Australia, inflation is about 2.5% and likely to rise; in Italy, inflation is 1.2% and falling. This inflation differential alone suggests Australian yields should be 150 to 200 basis points higher than in Italy.

In terms of the risk component of a bond yield, clearly Italy is massively retarded fiscally versus the rolled gold fiscal settings in Australia. Italy looks like never getting the budget to surplus and has net government debt of 103%, while Australia will record a surplus in a couple of years and has net debt of 13% of GDP. This means Australian yields should be lower than in Italy, by a significant amount. That is, at least, until you look at a third possible factor which is normally not relevant but now is and that is the role of government and central bank intervention.

In Australia, government bonds are issued without the central bank intervening (quantitative easing) and the market determines the yield. In Italy, investors buy Italian bonds knowing the European Central Bank will “do whatever it takes” to maintain the integrity of the bond markets of all member countries. This distortion to bond pricing is worth a lot, in terms of lower yields in Italy.

In the case of Japan, which has had lower bond yields than Australia for at least 30 years (as far as I can easily check), it is not because of better credit risk. Clearly. Deflation and government intervention account for this fact.

So now you know.



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Wanna buy your first house? Here are some!


I am devoting this article to some real estate search for first home buyers, many lamenting the fact that where they want to live is really expensive, even $900,000. They seem unaware that there are perfectly decent places not too far from the city (if that what is needed) at OK prices.

I note in making this suggestion that average annual full-time earnings in NSW are approximately $77,000 a year. In Sydney, it would be markedly higher, according to a quick search, perhaps 40% higher than the average for the state as a whole.

Of course many are earning incomes below that (by definition) but assuming two incomes, (most properties below are 2 bedrooms or you may wish to sleep with the person you are buying the house with – your call) a couple each earning 90% of average full-time NSW earnings has an annual income of about $137,000 a year. The properties below are roughly 4 times that.

So here we go:

Lane Cove $575,000


Greenwich: $570,000


Waterloo:  $500,000


Cammeray $420,000 (renovate it on weekends for some tax free gains! It beats going to the gym)


Neutral Bay $525,000


Pyrmont $595,000


Come on, not every one has to have a $900,000 house for their first one.

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Housing affordability, lattes and great expectations


Given it seems I have stirred up The Guardians Bridie Jabour to write an article titled “giving up lattes won’t help me buy a house”, I thought it constructive to consider a few of her points.

Her article is here:  http://www.theguardian.com/commentisfree/2014/jan/16/not-buying-lattes-wont-help-me-buy-a-house

Ms Jabour laments that a house in the street she lives sold for over $900,000 a few months ago. In disclosing this, Ms Jabour is telling readers she lives in an area where house prices are around 15 to 20% above the median for Sydney. For a first home buyer, that seems very ambitious.

It is difficult to imagine there being a first home buyer than would not want to have their first home well above average, but they are competing with people who have the benefit of age, savings, job promotions and the like to have the ability to buy above average property.

Picking a house 15 to 20% below the median would mean a price some $275,000 cheaper than one 15 to 20% above median. The financial issues associated with buying a $900,000 property versus one of $625,000 should be obvious.

Ms Jabour makes an error when she notes “Owning a home in a city like mine is as remote to me as getting a seat next to Lady Gaga on the first commercial space flight”. She should have said that owning a house in that ‘street or suburb’, rather than ‘city’ was the issue.

Ms Jobour then outlines some of her spending and savings patterns and she calculates that she could save $58,400 over five years if she gave up going out and taking holidays. This amount possibly overstates her savings, as she notes, given the substitution of meals at home, for example, which is correct. I would simply note that the pool of savings would attract some interest to offset that.

Ms Jabour then very rightly notes the downside to renting. The dreaded inspections, risk of being kicked out on the landlords whim and not having the piece of mind of where she will be living when retiring. All these issue have some validity, and she could have added not being able to have a pet (usually) or nailing in hooks for pictures or changing the garden and the like.

But ignored are the onerous costs for home owners (including landlords) of council rates, insurance, and depreciation which covers things like the hot water system blowing up, fixing a leaking roof, a new carpet, painting and kitchen every 20 years or so. The sum of these on an average house are around $7,500 to $10,000 a year.

This is where Ms Jabour notes “I could maybe afford a house in the outer suburbs of Sydney”.


Because Ms Jabour says “maybe”, I get the impression she hasn’t looked closely at the prices out there, many of which are around half the price of those in her street and probably without a leaking roof and crappy wardrobes.

I think, unintentionally, Ms Jabour has found the answer to her problems, but it is an answer she doesn’t like. Moving to the outer suburbs means for Ms Jabour, that she would “want to give up everything that makes my life fun for five years”. Been there, done that.

Again, in a revelation about the problems, not joys, of owning a house, Ms Jabour highlights the burden of stamp duty, pest tests, surveying costs and body corporate fees if it is a unit. It is indeed costly to buy a house which lessens its attractiveness.

It is here there is Ms Jabour makes an unsubstantiated claim that “housing affordability is not a Generation Y issue, it’s not even a Generation X issue. It’s an issue for every single one of us not born rich “. It is unclear why Ms Jabour associates the 68% of the population in Australia who own a house as being “born rich”. I would like to see any background to that claim, but I suspect it is an error and that many people who own a house are on very modest incomes and were not born rich.

Ms Jabour remains off the mark by blaming “people with ridiculous amounts of cash who see a sellers’ market and buy up investment properties” as a reason for her perception of housing. I assume she includes her landlord in this statement? While investors can and have driven house prices higher and there is an excellent case for the abolition of negative gearing, it is a little too cute to blame those who provide rental property for the non-home owners for their inability to buy a house. Indeed, it is clear that Ms Jabour is enjoying the returns of renting an above average property without being able to afford to buy it.

And then, the final few paragraphs, Ms Jabour hits a couple of nails on their heads.

Land release, negative gearing and capital gains tax on the family house – critical issues that have had an impact on house prices. Land release is the easy one, and this is something that must be addressed and all efforts to in-fill and provide decent infrastructure in new suburbs is to be encouraged. Negative gearing is another poor policy that should be abolished and soon.

All up, Ms Jabour raises a range of valid issues that reiterate the decent point that affordable housing is a critical issue on decency and equity grounds. That said, it is an issue that requires people to avoid turning up their nose if the affordable house is in a good location of less than average quality or in a less desirable area but of a better standard.



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Crappy jobs data, but it is a lagging indicator


There is no denying that the December labour force data were weak, soft, disappointing. Insert your own word for crappy.

Employment fell by 22,600, the participation rate eased back to 64.6% while the unemployment rate was 5.8%. It would, of course, have been nice to have seen a stronger result.

That said, the labour force data are always the last thing to turn in an economic cycle. Remember talk of the jobless recovery at various stages in the past? That was a phrase that encapsulated the misunderstanding of the lags involved between a change in the economic cycle and the corresponding change in the labour market. There is no such thing as a jobless recovery, just a lag.

The RBA research have noted a one or two quarter lag between changes in a range of labour market indicator changes and the state of the labour market.


The RBA have also noted lags (in 2005) when it was hiking interest rates in a climate of soft GDP growth, yet strong employment data (the lag was in the other direction).


These are a couple of references among many to this well understood phenomenon.

Today’s weak jobs data do not mean that the leading and coincident indicators of the economy such as house prices, building approvals, retail sales, business expectations, exports share market prices, global growth are not strong. They are. Some of them are very strong.

So say it 10 times:

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

Employment is a lagging indicator.

It may also pay to recall that the economy was soft up to the middle of 2013 with annual GDP growth around 2.25 to 2.5%. This below trend growth is showing up in today’s jobs data.

The leading indicators suggest, at the moment, that GDP is on track for annual growth of at least 3% in the  first half of 2014 and 3.75% or so in the second half of the year. Jobs growth will accelerate as these trends are locked in.

So stay calm. The economy is in good shape and with virtually all signs pointing to a strong 2014, it wont be too many more months before job creation picks up at to a stellar pace. The RBA knows this and while it needs a hook, the next move in interest rates will be up.



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