WA economy in good shape, despite market moves

IN 1929, the Australian share market peaked and subsequently fell 41 per cent, heralding the Great Depression.

At the close of trading on Monday 27 October, the S&P/AS200 closed at 3,809, about 43 per cent down from its record high reached 12-months earlier.

It's an alarming comparison, particularly when juxtaposed with the dramatic government intervention to guarantee bank deposits and the precipitous fall of the Australian dollar, now trading around the US60 cent mark when it threatened parity just a few months back.

So, just how concerned should we be?

It seems difficult to believe, but the outlook for the economy is nowhere near as bad as the fortunes of the share market might lead one to expect.

To be clear, I am not suggesting that it's time to pop any champagne corks; it would be entirely appropriate to tone down the Christmas party this year, perhaps opting for an excellent Australian sparkling wine rather than the vintage Krug the staff might have wrapped themselves around last year.

However, there's little reason to expect the real economy to tank to the same extent as the share market.

Why is this?

There are three reasons. One is, that the fortunes of the share market and the real economy are, in general, not well correlated.

Jay Ritter, an eminent US financial economist, has investigated the relationship between real returns to shares and real per capita gross domestic product for 16 countries (including Australia and the US) over a more than 100-year period, from 1900 to 2002.

He finds, contrary to expectation, that there is a slight negative correlation between share market returns and the real per capital GDP.

A specific illustration of this general trend is the respective performances of the Chinese economy and its share markets over the 12 years to 2005.

Jeremy Siegal, professor of finance at Wharton School of Business, has noted that while the Chinese economy grew the fastest over this 12-year period, its share markets performed abysmally, "turning a $1,000 investment into a little over $300".

In another striking example, Warren Buffet has famously observed that over the 17-year period to 31 December 1981, the Dow Jones Industrial Average index increased by just one-tenth of one percent (sic), even though the US economy increased in size by 373 per cent.

Perhaps the most dramatic illustration, however, is provided by the Japanese economy.

On Monday October 27, Japan's Nikkei index plunged to a level last seen in 1982, i.e. just a few months after Prince Charles and Lady Diana tied the knot.

Since its record high reached in December 1989, the Nikkei has fallen 81 per cent; yet the Japanese economy hasn't plummeted in tandem but rather it has grown through the 1990s and 21st century, albeit at a modest rate.

It is true that in Australia we have been fortunate to experience positive growth in both the real economy and the share market over the past decade (until this year), but the point remains that the share market is not, in general, a reliable indicator to how the real economy will fare.

Notwithstanding the above, one might argue that surely if share prices decline this is due to a fall in expected profitability and such a fall cannot bode well for the economy?

Yes, it's true that falling expected profits spell bad news for share prices; but economic growth consists of growth in labour demand and capital goods as well.

In its December 2007 report, the Labour Economics Office of WA noted that of the $25.6 billion worth of private sector projects approved in the state, almost 90 per cent of projects could be classified as resource-related.

While the recent softening in commodity prices has decreased the expected profitability of these approved projects, the overwhelming majority would still be viable and so demand for labour and capital investment would not fall to the same extent as profitability.

In this context, it is worth noting that the September 2008 edition of the Australian Regional Labour Markets Report from the Department of Education, Employment and Workplace Relations shows that WA enjoys a record low unemployment rate of 2.8 percent, about 40 per cent lower than the 4.6 per cent unemployment rate in New South Wales.

Ten years ago this month, in the "good old days", the unemployment rate in WA was 7.7 per cent.

In short, the unemployment rate would have to be 2.75 times higher than it is today to get back to the level it was in 1998.

So, as suggested, the second reason to be optimistic about the state economy is that the driver of WA's growth, the resources sector, remains largely in robust health, even though exploration companies may beg to differ.

It is this underlying strength in the resource sector that led the WA Chamber of Industry and Commerce to put out a statement earlier this month headlined "WA well placed to ride out international financial uncertainty".

Notwithstanding the above, resources contribute just 8 per cent to Australia's GDP.

What if the rest of the economy fell off a cliff due to the financial crisis?

In this case, what would be required is a Keynesian-style stimulus to aggregate demand.

Here we have the third reason to be optimistic. The federal and state governments are much better placed than they were in the 1930s to provide this stimulus.

My colleague, Dr Michael Mclure, a specialist in economic history, has pointed out in a recent public lecture at UWA that in the period leading to the Great Depression there was very high public debt and the states were in financial distress.

At present, the public sector is a net lender and the governments' credit capacity is rated so there is significant capacity to deliver a fiscal stimulus, if required.

In summary, it may not quite be the season to be jolly.

But, by the same token, there is no cause to contemplate jumping off a tall building either.

The economy is in far better shape than the share market would lead one to believe.

- Professor Raymond da Silva Rosa is director of the WA Centre for Capital Markets Research, University of Western Australia Business School.