In Economics Explored episode 142, Michael Knox, Chief Economist of Morgans Financial, explains how he predicted high US inflation based on the magnitude of the federal deficit compared with the GDP/output gap. He gives his view on whether a US recession is likely anytime soon, based on his analysis of some key indicators. Michael isn’t concerned about a US recession in the next year or so, and it’s worth noting that hours after this episode was published the latest US employment figures were much better than expected, with 390k new jobs in May 2022 (see the CNBC report Payrolls rose 390,000 in May, better than expected as companies keep hiring).
Also, in this episode, recorded on 2 June 2022, Michael successfully predicted the 50 basis points increase in the Australian cash rate by the Reserve Bank of Australia the following Tuesday. As Michael predicted, the RBA followed the US Federal Reserve and moved the cash rate up so it was close to the US Effective Federal Funds Rate (see chart below). Other issues discussed in the episode between Michael and show host Gene Tunny included the economic outlook for Australia, whether global stagflation is a possibility, and the risk of a Chinese invasion of Taiwan.
You can listen to the episode using the embedded player below or via Google Podcasts, Apple Podcasts, Spotify, and Stitcher, among other podcast apps. A transcript and relevant links are also available below.
About this episode’s guest – Michael Knox
Michael Knox is Chief Economist and Director of Strategy at Morgans. Michael was an Australian Trade Commissioner serving in Saudi Arabia and Indonesia. He joined Morgans in Sydney in 1988.
He was Chief Institutional Options Dealer until moving to Brisbane in 1990 as Economist and Strategist. Michael joined the Board of Morgan Stockbroking in 1996. He became Director of Strategy and Chief Economist in 1998. Michael remained on the Board of Morgans until 2011.
Michael has served on many Queensland Government advisory committees. He was Chairman of the Queensland Food Industry Strategy Committee in 1992, a Member of the Consultative Committee of the Ipswich Development Board in 1993, a Member of the Queensland Tourism Strategy Committee in 1994 and a Member of the Ministerial Advisory Committee on Economic Development in 1997.
From 2003 to 2012, he was Chairman of the Advisory Committee of School of Economics and Finance at the Queensland University of Technology. He has been a Governor of the American Chamber of Commerce from 1997 to 2007.
In 2008, Michael joined the Board of The City of Brisbane Investment Corporation Pty Ltd. Michael remained on the Board until 2016. Michael was the President of the Economic Society of Australia (Qld) Inc from 2009 to 2013.
Links relevant to the conversation
Robert Heller’s paper on International Reserves and Global Inflation (from p. 28)
Is the US heading for recession? | Michael Knox, Morgans Chief Economist
How to see a US Recession??? | Michael Knox, Morgans Chief Economist
How Budget Deficits Caused US Inflation: Michael Knox, Morgans Chief Economist
Michael Knox’s note: Watch the RBA copy the FED
Michael Knox’s note: Is the US heading for recession
Michael Knox’s note: How the budget deficits caused US inflation
Michael Knox’s note: Will the commodities boom ever rest
Where you can find the indicators Michael mentions:
Chicago Fed National Activity Index (CFNAI)
Transcript of EP142: Is a US recession imminent? w/ Michael Knox, Chief Economist, Morgans Financial
N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.
Gene Tunny 00:00
Coming up on Economics Explored.
Michael Knox 00:01
That measure says that there won’t be any near term US recession because the yield curve is still positive but difference between the 90 days and the in the 10 year is still positive.
Gene Tunny 00:18
Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional economist based in Brisbane, Australia and I’m a former Australian Treasury official.
This is episode 142. On the US and Australian economic outlooks. My guest is one of my favorite market economists; Michael Knox, Chief Economist of Morgans – a leading Australian stock broking and wealth management firm. We recorded this episode on the second of June 2022, at the head office of Morgan’s in the Riverside Centre in Brisbane.
Michael gives us some great insights into how he predicted the currently high US inflation rate based on the size of the federal budget deficit and the GDP gap. He also explains why he doesn’t see a US recession anytime soon, based on two important indicators that he watches. So, stay tuned to find out what they are.
In the show notes, you can find relevant links, including To Michael’s Notes in his podcast. And you’ll also find details of how you can get in touch with any comments or suggestions.
Right on, now for my conversation with Michael Knox, Chief Economist of Morgan’s. Thanks to my audio engineer, Josh Krotz for his assistance in producing this episode. I hope you enjoy it.
Gene Tunny
Michael Knox, welcome back onto the show.
Michael Knox 01:40
Good to see you again.
Gene Tunny 01:41
Excellent. Yeah, it’s good to see you, Michael, I’ve been enjoying your notes as they come out. And you’ve written a couple that I’d like to chat with you about today. The first one is how the budget deficits caused US inflation. So, we’ve got inflation over 8% in the US at the moment. And you’ve written this really great note that I think, sets it out quite clearly. So, if you could begin, please, could you tell us what your basic theory there is? How did those budget deficits cause US inflation please, Michael?
Michael Knox 02:20
What we saw in the US in 2020, was because of the shutdown, which we saw an enormous drop in. In US GDP, it fell by around about 11%; 10.7%. That fall was relative to where production was before. And that difference between where output is and where production could be, that’s what’s called the GDP gap. Now, in order to make sure that that gap wasn’t permanent, there was a whole lot of transfer payments, which were provided to the US public income support payments and, and other such things. And that was passed under the Trump administration. And it was passed by a legislature which was; the lower house had a Democratic majority, but the upper house; the Senate, had Republican. But this was passed in; the title man of stimulus that was passed in 2020, added up to a budget deficit, or which was the largest since World War Two. The previous peak since World War Two had been reached back in after the financial crisis and was reached in about 2010. And that was 12 and a half percent of GDP. But in 2020, the budget deficit that was provided to reboot the economy and restart it after the shutdown was 15% of US GDP.
So, my argument was that deficit stimulus will go at the zero bound, if you’re at the zero bound, but this is true. It’s not when you’re above the zero bound. When you’re above the zero bound, what happens is that interest rates go up, and they absorb a lot of the budget stimulus.
Yeah. Crowding out. For example, in the great recession or the financial crisis in Australia, the Australian Federal Government provided stimulus when the Australian cash rate was 3%. So, what actually happened to us in response to that was at least 30% or 40%, of the effect of that budget stimulus was lost, because it just forced interest rates, domestic interest rates in Australia, they go from 3% up to four and a half percent, and that absorbed a whole chunk of the stimulus. So, a lot of the budget deficit was wasted.
But if you were in there at the zero bound, all of that increase in the budget deficit goes through to stimulus directly the GDP. Yeah. And that was what was happening in 2020. There was no increase in interest rates to absorb that budget stimulus. And that was also the case in 2021, when there was another budget stimulus, right? Yeah, when we look at the situation in 2020, that GDP gap, the difference between output, and potential GDP was 10.77%, according to the Fed website, and the budget stimulus was 15% of GDP. So, you can only provide as much increase in growth, whatever the stimulus is, you can only provide as much increasing growth as there is available resources in the economy, and which is the GDP gap. So therefore, the amount that goes to the increase in output in that circumstance and expected to 10.7% of GDP, the difference between the two, and that and the 15% deficit, that’s four and a quarter percent, just goes to pushing up nominal GDP. That is to say it, it goes directly to inflation.
But the great thing about 2020 in the US budget deficit in 2020, is that most of that stimulus went directly to the recovery in the US economy, and wasn’t wasted and it was well used.
The problem really doesn’t happen until the next year, when the person in the White House changes. And there’s an election, and Biden is elected. And Biden is elected with; well, let’s say Biden is really a creature of the Democratic Party machine. That’s how he secured the nomination. You know, he wasn’t actually leading in the primaries at the time. But there was an agreement that he would get the nomination that he agreed to a whole bunch of spending programs, which were part of Bernie Sanders platform. And so that was a compromise that the Democratic party went with, to the election, Biden got elected. So then he had the job of honoring his commitment to the party machine of introducing all of those deficit funded spending programs. Yeah, that were part of this, the science platform. And so that was happened in early 2021, in the American rescue plan. Oh, yes. Yeah. Which was introduced by the Biden administration.
And the problem was, though, in the second quarter of 2021, that when the American rescue plan was introduced, the GDP gap, the previous stimulus package, it worked really, really well. Yeah.
And the Fed tells us that the GDP gap had fallen to only 1.7% of GDP. So, the amount of excess resources in the US economy that could benefit from the additional stimulus had been dramatically reduced. And that meant that if you provided stimulus in excess of that GDP gap, all of that additional deficit in excess of that GDP gap, would go directly in; would increase nominal GDP, but only 1.7% of it would be an increase in real GDP, and all of the rest of it will be in increasing dollar GDP. That is to sy that all of the rest of it would go directly, increasing inflation.
But in the great tradition of American politics, the Biden administration didn’t want to let a good disaster gather waste. And so they provided; and I had people I had to pay back for supporting them in the presidential election, particularly the teachers union and other unions. All their workers unions and other unions, and other public unions and various state governments and governors and such. And so the Biden administration in the American rescue plan provide an additional budget deficit of 12% of GDP. Now 12% of GDP was well in excess of the GDP cap of 1.7% of GDP. Yeah, so what then happens is the total amount the increased a nominal GDP is 12% of GDP deficit minus the 1.7% minus the smart smaller GDP gap. It’s not the amount of stimulus that went directly to; of increasing the GDP price level was 10.3%. So that was the surge in inflation and at the time, I think it was Larry Summers, a lifetime Democrat, you know, a previous treasurer, who pointed out that he thought that what had actually happened was inflationary. And I think he used logic very similar to this. And it’s from that excess size of the American rescue plan over the GDP gap when it was introduced in 2021, which is the cause of US inflation. Right? US inflation just took off with a lag to the introduction of that budget deficit. Yeah. So it’s US inflation is directly caused by the second budget deficit. So, the American rescue plan is what bury the US economy inflation.
Gene Tunny 10:45
So, what’s the outlook? I mean, have you looked at what the predicted deficits are over the next few years? And I mean, it sounds like they must still be larger than that. That output gap. Is that right? So those still be contributing to inflation?
Michael Knox 10:59
Yes, I think the budget deficit this year is about 5% of GDP. And next year, it’s about 3% of GDP. And after that, it’s around 3% of GDP. That’s, what I understand.
Gene Tunny 11:10
Yeah. Yeah. I should have should have had a look before I came. But I was just thinking about it. I mean, we’ve got a similar issue in Australia. I mean, we’ve got this large structural budget deficit in Australia. And so arguably, the federal government here is contributing to inflation here by letting the economy run too hot, or contributing to that.
Michael Knox 11:33
I think the situation both in Europe and in Australia is actually quite different, because as opposed to a budget deficit of 15%, of GDP in 2020, our budget deficit was only 7% of GDP. Yeah. And I think in the Euro area, it was about 7 ½ % of GDP, right. And in fact, our economy had fallen around about 7%, not close to 11%, as in the US.
So, it was kind of, because the size of the slump in Australia, because of things like job keeper, which seem to be far more effective, a way of keeping people in employment in Australia, than what was done in the US. The size of the deficit that was required, both here and in anywhere, also in Europe was much, much smaller. So, I think the budget deficit now, obviously, is only about 3% of GDP. So, our budget deficit in the second year is much, much smaller than the US budget deficit, which in the second year was 12% of GDP. So, I think next year, our budget deficit is 3% of GDP, which is in the US, it’s 5, and after that, our GDP begins to fall.
So, the amount of over stimulus of the economy by the budget deficit in Australia, and in the Euro area is much, much more than was the case in the US. So, and I think that’s why inflation in Australia is significantly lower than in the US. I mean, I think that our core inflation now is about 3.7%, something like that. Yeah, which is, for the very first time, it’s the very first time in five years…the budget, the core inflation, the trimmed mean was 2.7%. And it was the very first time in five years. Mr. Philip Lowe, PhD. He doesn’t like to be called Dr. Phil because that’s somebody’s else.
Gene Tunny 13:32
Is his PhD from MIT?
Michael Knox 13:35
I think it might be. He is not Dr. Phil, Dr. Phil is from Texas.
Gene Tunny 13:41
talking about inflation of 5.1% lately in Australia, and then Philip Lowe.
Michael Knox 13:47
What Philip said, for the December result, that when the trimmed mean came in at 2.7. That was the first time in five years of trying that the RBA has actually hit the inflation target. Yes. And in the March quarter, I think it was 3.7%. And as expected, I think, it got to 4.3 by the end of the year. And at least, that was the estimate that was in the quarterly statement on monetary policy released by the RBA. And that was the very first time in at least six years that inflation had been higher than the RBA target.
So, it’s very similar circumstance. The European Central Bank did nothing with inflation at the same level and actually higher than in Australia. The European Central Bank did nothing. They stopped buying; European Central Bank, in the same circumstance, stopped buying government bonds but kept buying business credit and kept their business credit expansion program going until they said September.
Although the president of the Christine Lagarde as a of the European Central Bank, as I said in her blog, you know, in which she provides her forward guidance in her blog says; that she sees European Central Bank interest rates beginning to normalize before the end of the year is so quiet. Okay? Yeah.
So, she’ll be increasing rates. But in the Euro area, interest rates are minus 50 basis points is the Euro area deposit.
Well, we’re well ahead of that. We seem to be increasing rates in Australia about a month behind the Fed and we seem to be following the effect of Fed funds rate. Instead of setting our rates slide 25 basis points and 50 basis points and, and 75 basis points, what seems to be happening is that instead of sitting right at the zero bound in Australia, on the zero bound in the US, actually resulted in an effective Fed funds rate in the US. You can see this on the Federal Reserve economic database, these numbers have eight basis points. So, we match that in Australia by moving the Australian cash rate to 10 basis points. 25, or 0, as might be the case.
And then, when they moved up their range by 25 basis points, they in fact, set the effective Fed funds rate of point 258 was where the effective Fed funds rate. So, we moved to 0.26. And then they added, in the next move, they moved at a 50 basis points to that, which is not 75 basis points for that year 3. So, we think that next week, the RBA will put up rates to 85 basis points; 50 basis points on top of where we are with 35 basis points plus 50 goes to 85 basis points.
So, we’ll keep going; matching, not 25 basis point target of 50 basis point target but where the US effective Fed funds rate is. And that’s what we seem to be doing.
And the Fed’s various members who were on the Open Market Committee, the Federal Reserve, have said that, particularly Mary Daly to begin with, said that, in the summary of economic projections by the Federal Reserve, that they had thought that was released at the beginning of the year, I think it was the February meeting. They suggested that the long-term equilibrium level of the Fed funds rate was 250 basis points. So, before the last Fed meeting, Mary Daly said that what the Fed needed to do was get to 250 basis points as rapidly as possible. Yeah. And at the meeting, Jay Powell, the chair of the Fed, said that he thought the next couple of rate hikes would be 50 basis points, and then something similar to that in the minutes that had been released.
Since then, I think what’s going to happen is that the Fed is going to keep putting up 50 basis points. So, I think that takes it from the next; it’s sort of by 3 basis points or 85 basis points for us. And then, it’ll be 50 basis points on top of that, and 50 basis points on top of that each meeting, till we get to; well actually by the end of the year, it’s 258 basis points for the effective funds, right. And we think the Australian cash rate will go up to 260 basis points to match that, that is why we think this is all ending by the end of the year.
Gene Tunny 18:47
Okay. Very interesting. I mean, I think there are a lot of economists and market watchers who think that it just looks weird having a cash rate of point three, five, where it is at the moment, and they seem to think that the;
19:02
It has to be 40 basis points to target the 75.
Gene Tunny
Yes, that’s what people are thinking.
Michael Knox
That’s what they’re thinking, but that’s not what Mr. Philip Lowe PhD is thinking. He’s thinking, he’s matching the effect of Fed funds rate.
Gene Tunny 19:14
Yeah, look, there’s no reason to that it should be at you know, in the increments of one quarter or it should be at say, a point 5 or point 75 or 1%. And you shouldn’t have any other rates. So, there’s nothing to stop you from doing that.
Michael Knox 19:29
When I when I looked at it, there was this long period when the effective Fed funds rate was eight basis points in the US and we were at 25 I think or something and then we cut it to 10. And it stayed there for a long period of time and I looked at this for like, this happened went on for months and months. You know…I thought about it and I thought the reason that the RBA would have done this is otherwise you have these…If the assumption is that rates will never change, you can have these capital flow distortions, pushing your exchange rate for one direction or the other for reasons that have nothing to do with the policy of the RBA, it’s just an attempt to arbitrage a distortion.
And so I think that the reason for following the Australian cash route is following the effective Fed funds rate is just to remove those foreign exchange distortions. Yeah. Which really have nothing to do with policy. And there’s no reason you can’t do that. If I mean, having caught a point, right? Labels is an aesthetic, arbitrary; might be aesthetically pleasing. But there’s no actual, practical or theoretical economic reason why you need to do it.
Gene Tunny 20:48
Exactly, exactly.
Okay, we’ll take a short break here for a word from our sponsor.
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Gene Tunny 21:27
Now back to the show.
Now, can I ask you about the US GDP, the US economy, and we could also talk about Australia too. Jay Powell is trying to engineer a soft landing. Is that right? For the US economy?
Michael Knox
Absolutely.
Gene Tunny
US GDP; there was a fall in first quarter. But that was a bit of a quirky thing, wasn’t it? No one really thinks that US;
Michael Knox 21:52
[unclear] private industries because of the supply chain problem.
Gene Tunny 21:56
Yeah. So, no one thinks that’s a sign of an oncoming recession. But there is talk about possibly a recession in the future. And there’s this debate about whether there can be a soft landing. What are your thoughts on whether J Powell can pull this off?
Michael Knox 22:11
My view, that I’ve put forward in my newsletter, is that there will be a soft landing. What is a soft landing? A soft landing is where the economy slows down, unemployment rises but GDP is not negative. That’s what it is. I used to call this a great recession, rather than a recession. And that’s my froze or froze for. Lifestyle planning we had like this was in the middle of the 1990s. And that was caused; what’s actually happening now is that you’ve got a selloff in US Treasury bonds. So, which means these long-term interest rates are rising, and that’s causing a correction and significant correction in the stock market. But the US stock market larger correction than here, because we’ve got a resource stock, which are making a whole bunch of money. Yeah. And profits are fantastic and dividends are fantastic in Australia, and that seems to have stabilized their markets or markets going sideways.
But there’s a lot of technology stocks and growth stocks in the US. And that’s a Night fallen; something like 30% between the peak at the end of last year and now. And that’s because of the increase in bond yields. Now it’s very similar to what happened in ’94 – ’95. But if I look at; for the indicators of the US economy, there’s two that I’ve spoken about in my newsletter. One is the shape of the yield curve which shows up best in fed research, the most effective one forecasting is the difference between the 90 day treasury yield and the US 10 year bond. And what happens is, as the economy comes off the bottom and you get full employment, the only way you can generate growth in that economy is by adding more capital; increasing the ratio of capital relative to labor, and that means you have a lot more investment.
And as you have a lot more investment, you have an increase in the real demand for capital and that tends to force up long term interest rates. And so long-term interest rates rise relative to short term interest rates. Okay. And you have a positive yield curve, which tells you that you’ve got growth in the US economy now. That is actually the situation right now. Right. Okay. Yeah, that indicates that investment is going to keep the US economy growing. Okay. But what happens over the full cycle is that the Fed thinks that because unemployment is too low or wage inflation is too high, that it has to increase short term interest rates. And as increases the Fed funds rate, it forces up the 90 day treasury yield relative to the yield of the 10- year bond. And as it does that the yield curve first flatten, and then inverts turns upside down. And that means that the Fed has increased short term interest rates high enough to choke off that flow of investment, which is keeping the economy growing. That’s how the yield curve works.
But when we look at the shape of the yield curve right now; and I did a newsletter in which I showed my readers how to find the right shape of the yield curve on the Federal Reserve website.
Gene Tunny
This is FRED, is it?
Michael Knox
Yes, FRED was one of the economic databases. You go to Google, which is everywhere, it knows everything. And what’s the yield curve, FRED, capital F-R-E-D. And that starts you on the 23 choices that you have of the yield curve that you can pick, and then you pick the 10 years, one is the 90 days, and then it shows you a short term version. But when you go to that chart, and it shows you the five years of the yield curve. And you could see that the yield curve is upward sloping, which indicates no recession. But then you if you click on max, on that first chart, then you get 40 years of data, and it shows as grey areas, all of the recessions over the previous 40 years, and how they lagged the inversion of the yield curve, and it’s a really, really interesting chart. Yeah.
The reason I did this, in my newsletter and in my podcast was that people could access it themselves, you know, instead of reading all the yield curve says there’s gonna be US recession that can actually go to the data themselves. And they could make that decision themselves on the US recession.
Gene Tunny 26:45
So, how accurate is it as a predictor? Because I know that there have been times when the yield curve has inverted, but it hasn’t necessarily signalled the recession. Is that right? I mean.
Michael Knox 26:56
This particular measure of the yield curve, the 90-day versus the 10-years is actually pretty accurate over a 40-year period, when you look at that long term slope.
The one that has been inaccurate, is the one that’s been referred to by the media, the 2- year and the 10-year.
In spite of that, actually, it’s much more bearish at the moment, which is why the media wants you to look at that one rather than the one that works. Well, the one that the Fed says works, okay.
So, I’ve gone through; there is actually a paper associated with this page of yield curves done by the Fed, which shows that the 90-day versus the 10-year is the right one to use, historically, it was the best predictor. So, that measures says that there won’t be any near term, US recession, because the yield curve is still positive. The difference between the 90 days and the in the 10 year is still positive. I think it’s around about 200 basis points positive.
But the other one that I talked about this week, in my podcast this week is the Chicago fed national activity indicator. And that’s been published by the Chicago fed for a couple of decades now. And in the US, it’s the National Bureau of Economic Research, not the government that tells you when there was a recession. Their data says; they’ve got 166 years of data and then, that time has been 34 recessions, which means the average period of a recession is 4.9 years, and the slump, the latest slump, that we call the recession was the shutdown for COVID. Interestingly enough, that was the longest expansion in the history of the 166 years of data. And so, a recession was gonna happen anyway. Just that we made it happened.
That an extremely reliable indicator of the Chicago fed national activity in the corner. It’s got 85 components to it. And it’s when it falls below marked in standard error. So, point 7 numbers, standard error below 0; 0 was the long-term trend. It’s point 7% below; zero would be a recession. Point 2 above trend is strong growth. And the most recent measure published in April was point 48, for the three month moving average of the School of CFNI3, on the Chicago fed website, which is found at Chicagofed.org. And it was point 48. So, that indicator shows that the US is the near term outlook is for strong growth in the US economy, essentially at all.
So, there’re two fed based indicators; the shape of the yield curve properly found as the 90 days ones as the 10 years and also the Chicago fed national activity indicator and both of them indicate that there is no US recession anywhere in sight. So therefore, there is no US recession about to happen.
And the logic of this is that; there are two bits of logic to this is if there really was a recession in sight, the Fed wouldn’t be putting up interest rates. That’s the first thing, that’s the obvious thing. But the second thing is I’ve noticed that when I do podcasts with US recession in the title twice as many people watch the podcast. So, I think maybe the predictions of US podcasts have a lot to do with the increase in the circulation of podcasters, rather than what’s actually happening in the US economy.
Gene Tunny 30:39
Well, everyone’s trying to get ahead of the curve. I think they try to call it first. So that’s, that’s possibly why the there’s such interested in what I mean, we have to chat about stagflation later. I mean, that’s one thing that people are starting to talk about, too. But I might ask you about Australia first, do you think there’s Is there a risk that the RBA could put up, or maybe they’ve acted too late to start addressing the inflationary situation. And therefore, what they have to do now is really increase interest rates, to a large extent, much more than may be desirable, given that we have all of these people who borrowed money, lots of Housing Credit, and there could be people who are at risk of defaulting. So, all the all the higher interest rates will mean that they have to spend less; there’s less discretionary spending. Is this something that is of concern to you?
Michael Knox 31:34
Well, I think it’s real. But what we are told is that the regulator, told the banks that in making housing loans to people, there’s a period of very, very low interest rates that they had to allow for a 3% increase in interest rates, that people could still pay for that, based on their incomes, not on their savings, but on their incomes. And we had a presentation here in his office by one of the major banks yesterday, we do network to 65 offices around the country. And he was saying exactly the same thing that because of the request of the regulator in granting these loans.
Actually, what they’ve done is they assumed, but even though people had fixed term rates for the initial part of the loan, that the rates would then rise to 3%. When that term ended, yeah. And so, what they then said that, if they couldn’t, on the current income, make the payments at that rate, when that fixed rate expired, the higher market rate, then they didn’t get the loan. So, the banks have already allowed for a 3% increase in interest rates. And like I said, we think that rates will be turning at 60 basis points by the end of the year. So, the regulator, this is one occasion where the regulator moment might have got it exactly right.
So, I think the market can absorb that. But also, what’s happening is we’ve got terrific growth in jobs. Yes, yeah. And we’ve got fantastic labor market, labor force participation. The proportion of women in the workforce is the is the highest this century. And proportion of the total workforce employed is equal to the highest this century. So terrific. labor market participation. Everybody who has had a job before he’s got one again now. And that’s the best; the best insurance against poverty is having a job. And that also helps enormously reducing the size of the budget deficit, because the biggest thing in the budget deficit providing benefits for the unemployed, unemployment transfer payments, plus healthcare for the unemployed, and social welfare payments and a medical expense. So, if everybody’s got a job that he earned, they pay more personal income tax themselves, then that enormously improves the budget deficit.
But I think what actually; we come back to the fact that there is actually a significant difference between the Australian growth model and what you might call the European growth model. In European growth model, countries in Europe and in; we might also say the US but it hasn’t really been such a problem in the US. The problem that growth in the Euro area is that they population growth has been stagnant in the Euro area for some time. You know, there’s a demographic problem. Clearly, people aren’t having as much fun as they were.
Gene Tunny 34:58
I couldn’t believe it when I saw the Italian fertility rate is what is it, 1.4 or something children
Michael Knox 35:04
And the population in Spain, of all places, you know; the great Spanish lovers. The population in Spain looks like it’s set for a significant decline by the end of the century. Because there isn’t the demand, there was strong demand in the Euro area after World War 2 because of the population growth rate; replacing the losses of World War 2. And that generated strong demand in the economy that generated strong growth in Europe in a period after World War 2; 25 years after World War 2 was the fastest growing market in the world. Yeah, amazingly enough. But now there’s very, very little growth in that market. And one of the reasons for Brexit, I think why Brexit is logical is that the market for British goods outside since the beginning of this century, the market for British goods outside the Euro area is growing significantly faster, around about twice as fast as the market for British goods within the Euro area.
And hence, it makes enormous sense to move out of the European Union into a whole of world trading system where you can make your own trade agreements with much more rapidly growing economies like the United Arab Emirates or India, or West. And in that situation, when you’ve got low population growth, you need to run continuous budget deficits to generate enough growth in domestic demand to grow the economy. Well, that’s the European problem.
In Australia, we’ve been able to run much lower budget deficits and even budget surpluses, because we can generate that structural demand, population growth because of high immigration. Yeah, and that might give us a significantly different model, which means it’s easier to generate demand and growth in Australia by adding more skilled immigration. And we have a list; one of the great achievements, I think, of Australian Governments is this bipartisan skilled immigration system that we have in Australia, which is far and away better than the immigration system they have in the US; constantly fight over and can’t make logical conclusions over. But the system the way in the Canadians have, which is bipartisan, in both places, is really, really good because we can fill those gaps in skilled migration, we can grow the economy faster.
Those skilled immigrants, when they come to Australia, firstly, they’ve come here for employment. And that means they can borrow money; they qualify for mortgages, and the house, if they’re living in Sydney or Melbourne, then the house they’re going to buy is worth a million bucks. So immediately, they turn, they’ve got a job, and they have a million bucks to domestic demand. Without that stimulus having to come from the budget deficit. And they pay that down over. You know, we borrow money offshore or reduce our surpluses to finance that, but they pay that back over, you know, over 20 years for life and the workforce.
So. the secret for Australia, I think, is that the outgoing government increased migration level to 160,000 for the coming financial year. And I think that I would be extremely surprised if the Labor government, in order to grow the economy, but keep a handle on the budget deficit, won’t be further increasing that immigration increase in skilled migration. Well, from the current level of 160,000, probably, I would think that I would probably decide to move that up. I think they think it would be good politics for them. And I think it would be good for structural demand and the Australian economy.
Gene Tunny 39:02
Okay. So do you have any thoughts on China at all, Michael? We’ve been looking at China, I see that Shanghai has just reopened, so that’s obviously good news for the global economy?
Michael Knox 39:13
I know that; to paraphrase John Cleese, I should not win, don’t mention the war. But I think as far as China is concerned, I think the war in Ukraine is really important as a harbinger of what might happen in the Pacific. I had Xi Jinping and said that he wants to reunite Taiwan with China. Some esteemed historians at Stanford University in the Hoover Institution, have suggested that China might invade Taiwan as early as next year. I think the Defense Secretary speaking in the US Senate, US Defense Secretary speaking in the US Senate has said that the position of Taiwan relative to China was that extreme risks between now and the end of this decade.
So, I think that we could get I think there’s a real possibility of confrontation. Well, an invasion really by China of Taiwan based on you know, what the Hoover Institution said and what; Niall Ferguson was actually the historian at the Hoover Institution, has suggested that there could be an invasion of by China of Taiwan as early as next year. So that thread hangs over slack. And just the way that we thought an invasion of Ukraine was impossible last Christmas. We should have learned from that experience. And following that, yes, something like this could happen in Taiwan, if not next year, then within very few years. And so that, I think, is the major destabilization that we have in the Pacific, which, I’m sorry, I have no solution for.
Gene Tunny 41:06
No, no, no. It’s a sort of event that; I mean, you realize is it would have a huge disruption of the global economy. And I mean, we’ve seen massive movements in prices in recent years. And, you know, things we just never saw, we thought we would see again, with the pandemic and what, and also war in Ukraine, and what that’s done to commodity prices. I mean, what could that sort of thing mean for the global economy?
Michael Knox 41:33
Well, the importance of Taiwan is that in World War 2, and the limits, actually, you had as his strategic objective of taking control of the Pacific was not invading the Philippines but invading Taiwan. And the reason for that is, Taiwan controls the entire northern entrance to the South China Sea and controls the sea lines to Japan, once you’ve occupied Taiwan, you are absolutely in control of the sea lines to what is now our close ally of Japan in the quad. Okay.
Douglas MacArthur, who was located right here in River City, in World War 2 argued in favor of the Philippines which was also part of the Philippines or Northern choke points of the South China Sea. And he argued for that instead. And then that was Nimitz gave into MacArthur in terms of their strategic plan to, to invade the Philippines. So, both of them are important, but Taiwan is more important. So, when China occupies, and I say when, when China occupies Taiwan, then that chokes us off from attacks off the sidelines to Japan and puts the defense of the quad in a difficult position. So strategically, it’s extremely important. And I think, as the Americans realize that that’s why they’ve definitely said that. But I think that Biden was criticized, or has been criticized by various people, including Western sympathetic Russians, for not definitively saying that; It’s been said, if the US had definitively said that it would stay in behind the Ukraine, in the event of invasion, the Russia would never have invaded the Ukraine. Okay. So now, Biden has said that he will definitively stand behind Taiwan in the event that is invaded with the hope that that stops has been invaded. But there is for those, as I was referring to Neil Ferguson, Neil Ferguson says that all of the studies that have been done in China on the invasion makes us think that the Chinese believe that it’s easy victory to invade Taiwan, that they’ll be able to do it before the Americans can intervene. And I think that was the problem in the Ukraine is that the Russians thought that they could take control of the Ukraine without, before anybody had actually noticed and could respond. That proved to be absolutely not true. Yeah. And they’d start allusion to the easy victory, which could lead China into the same kind of mistakes that the Russians made in Ukraine. And that’s the real problem. And again, I was like, sorry, I have absolutely no solutions for those.
Gene Tunny 44:36
So I’ll have to come back to it on the show, just to look at it in more depth, but Yeah, certainly a big risk. Michael, I’ll probably have to start wrapping up because I’ve picked your brain for nearly an hour, so far.
I wanted to talk about stagflation, but I think I know; well, you’ve basically said that you’re not seeing a recession in the US and so we probably won’t see that, or at least in the near future. So, we won’t see that coincidence of high unemployment and high inflation because there’s a lot of talk and you see columns in the FT every now and then about stagflation could come back. And if you didn’t have any thoughts on that, then yeah.
Michael Knox 45:16
Sure. In the 1970s, there was no collusion. And there was a series of studies done by the International Monetary Fund. Then, cheap research of the International Monetary Fund, was Robert Heller, and he occupied the position for the longest that has been held by anybody in the last 60 years. He did a series of studies, the first of which was total international reserves and worldwide inflation. And he said definitively that it was really the; when Nixon abandoned the the gold standard, which was after the US dollar became noncompetitive in real terms against the Deutsche Mark and the French Franc and the Japanese Yen, which were then part of a fixed exchange rate system. And all those countries dramatically spend their economies after the war, and became infinitely more competitive. And what needed they needed to be was a major realignment, because there wasn’t a major realignment, there was a run on the gold reserves, which are held by the US. And then the US abandoned its gold reserves, and then currency started to freely float for the very first time. And the result of that was a boat tried to flight and just move quickly, the result of that there was a dramatic outflow flow of US dollars into the central banks all around the world, there was a dramatic explosion of central bank reserves. And there was an explosion of central bank reserves, which I think, in 1974, were growing at an annual rate of 88% per annum, right, as against the long term average growth rate of 7.7% per annum since 1948. And, and it was that dramatic acceleration, which caused the post to the 70s inflation in general and moved over to stagflation. Okay, so that’s, that was the event now nothing like that has happened so far.
In matter of fact, the US dollars, very surprisingly, to me, has got stronger over the last year, and the rate of growth of international reserves according to the most recently published numbers, which are the numbers to the end of last year are not growing at 8%. They’re growing at 2%. incredibly low. Yeah, sorry, there was; so that basis of international reserve inflation, which caused stagflation just doesn’t exist right now.
So, I think what will happen is, unless there’s a major collapse in the US dollar over the next couple of years, which could happen, but based on the facts on the ground right now, you simply can’t; the basic elements which caused stagflation do not exist.
Gene Tunny 48:10
Okay. Okay. I think I’ve dug up that study or a paper by Heller, or someone at the IMF, because we chatted about this in a previous podcast, I’ll put a link in the show notes, to that paper, right. Oh, yeah, I think we’ll probably have to wrap up but there were other things I did want to check out but I’ll put links to your recent articles because I really enjoyed that one about the budget; well, I didn’t enjoy the fact that there are the budget deficits and US inflation, but I did enjoy reading the note and how clearly it set it out. And there was another good one on how World War 2 says US budget deficits lead to commodity by; was it in April 2022?
Michael Knox 48:58
Yeah, well, that’s the case. It’s just like, during World War 2, there was really big budget deficits. And then after World War 2, there was astounding boom in Australia, which we think of as the world boom, but really, there was an enormous boom in in wheat prices, and the development of wheat land in Australia, and there was an enormous boom in mining. And in fact, in the immediate period after World War 2, tiny Australia, which had only had 7 million people was the fifth largest exporter of goods in the world. And we had this huge trade surplus and because we were still pegged to Sterling, we have enormous inflation that followed, but because we didn’t allow our currency to float up against the US dollar, as we as we should have at the time, but nobody knew about those kinds of ideas back then. And so, we had big inflation instead, we had this staggering boom in agricultural land and people in living in central Queensland were rich enough to buy hotels in the CBD in Brisbane and all those things.
I used to stay in one of those hotels when I was about 10 years old. So, I remember all of that. But yeah, so just now these huge budget deficits, think it’s in World War 2, have generated a commodity boom like after World War 2; not as big, but the biggest we’ve seen this century. The commodities boom, the increase in the Australian export commodity price as measured by the RBA in the RBA’s index, which is published every month, is higher now, the increase is greater now than it was in what we call the resources boom, that happened after that budget deficits of the previous period. Because back then, of course, as I’d said, the budget deficit was 12 ½% of GDP, whereas the budget deficit this time 15% of GDP, so therefore, the full body prices are even higher now than last time. But what’s amazing, was it last time, we had the big formal US dollar and that simply hasn’t happened this time. And that’s the thing that fascinates me about markets, which may be yet to play out.
Gene Tunny 51:09
Okay. Michael Knox from Morgan’s, thanks so much for your time today. It’s been great. Look to catch up again soon because there’s so much more I’d like to chat with you about the global economy, but I better let you get to lunch.
Michael Knox
Okay, thanks very much Gene.
Gene Tunny
That’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com. And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.
Credits
Big thanks to EP142 guest Michael Knox and to the show’s audio engineer Josh Crotts for his assistance in producing the episode and to Peter Oke for editing the transcript.
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