March 5th, 2008

Talk about blunt instruments…

Before I get on to the question of how effective the Reserve Bank’s actions are, it’s worthwhile to pause and consider the deeply compassionate thinking of the priests of the temple of economic orthodoxy. Here’s Alan Wood:

A complaint from ordinary Australians is that they are not the ones causing inflation, but with domestic demand running at more than 5 per cent, and a lot of it consumption spending, it doesn’t wash.

That’s after he’s explained that interest rates will not trouble those with high incomes as much as those who are “struggling”, although there’s a fair bit of obfuscation along the way. That also raises the question of the genuineness of this sort of claim:

The obvious but important point is that inflation is a national problem, and unless the pain of bringing it back under control is widespread, monetary policy won’t work.

As I argued in New Matilda the other day, singling out wages inflation as a primary cause doesn’t appear to have led to shared pain. And there’s at least an implication that “those who have taken on the highest risk” are somehow morally at fault - a spectre that often lies behind the apparently impersonal language of market choices. But, of course, all this pain will be in vain if the assumptions that underlie monetary policy are wrong. Peter Martin in his column in the Canberra Times interviews a couple of economists who think they may be.

Martin is discussing the question of the NAIRU - the “non-accelerating inflation rate of unemployment”, which Malcolm Turnbull made famous when he tried to play cute in Question Time with Wayne Swan. The idea is that if unemployment falls below a certain level, inflation rises. So, if you accept this argument, according to Martin, you try to slow the economy and induce more unemployment to restrain inflation. Here’s what his interviewees had to say:

By the way, a senior Treasury economist confirmed in a speech last
year that he thought the answer was “currently around 4.7 per cent,
although there is a considerable band of uncertainty.”

If the NAIRU is 4.7 per cent then around 66,500 jobs will need to be
sacrificed to achieve it. 4.1 per cent will have been as good as our
rate of unemployment got.

Swan dodged the question in parliament, but two days ago on the Sunday
program confirmed that the fight against inflation would cost jobs,
saying that “the economy may slow a lot but I have no advice from the
Treasury that suggests that unemployment will increase substantially”.
Note the use of the word “substantially”. Swan accepted the premise
that unemployment was about to stop falling and begin to climb.

If Turnbull, Swan and the harbour full of economists are right, our
dole queues are about to grow again after shrinking more or less
continuously for 15 years.

But not everyone agrees.

Dr Barry Hughes is the doyen of Australian labour market
specialists. A former professor of economics and an advisor to Paul
Keating and several state premiers he knows his way around the
employment stats better than anyone else.

In a study released this week by the Australian Industry Group he
has dared to challenge the conventional wisdom by asking “how natural
is the Australian natural rate?

He has a number of problems with the idea. One is that Australia
appears to have two rates of unemployment at the moment – a low one in
the mining-rich states “where wage and price inflation has been
increasing and is almost completely outside the control of the
authorities” and a higher one in the rest of the country where “the
natural rate of unemployment seems to have gone missing in action”.

NAIRU turns out to be elusive. Like the Loch Ness Monster, whenever it
is sited, it moves.

Back at the start of the decade NAIRU was believed to be 6 per cent.
If unemployment fell lower than that, it was thought that inflation
would rise. Unemployment did fall lower, inflation didn’t rise and so
the estimate of NAIRU was cut. It’s a continually moving constant.

Dr Hughes has dared to suggest that the conventional view about NAIRU
“might be incomplete, if not wrong”.

Professor Ian McDonald of the University of Melbourne has calculated
an alternative lower-bound to sustainable unemployment using a
different method popular in Europe.

It abandons the traditional assumption that a low rate of unemployment
will automatically spark inflation by pointing out that that depends
on a number of things including trade union power. Australia’s trade
unions are weaker than they used to be, partly as a result of
WorkChoices. As a result it might now be possible for unemployment to
fall very low without sparking wage-price inflation.

His estimate of the lowest sustainable rate of unemployment in
Australia right now is 2.5 per cent - a rate that seems low only to
Australians with short memories. It is where the rate was in the late
1960s and early 1970s.

Professor McDonald says only at that level should wages now pose a
threat to inflation. Only at an unemployment rate of 2.5 per cent
would it be literally true to say that Australians were fully
employed.

But surely the Reserve Bank needs to push up interest rates when its
board meets today in order to contain the inflation we’ve got right
now, I asked him on the phone last night.

It doesn’t, because interest rate hikes are designed to tackle wage
inflation, which we don’t have in most of the country, he replied.

The inflation we do have right now is fueled by climate change (higher
energy and water prices), a worldwide food shortage (higher grocery
prices), higher oil prices, higher rents and the mining boom.

Higher interest rates will dent none of these.

But they will crunch the economy and push people out of work.

For no reason, in Professor McDonald’s view.

We will have abandoned the quest for a 2.5 per cent national rate of
unemployment just when it was within our reach.

As it happens the ACT’s unemployment rate has already fallen to 2.5
per cent. Inflation here is no worse than it is in Melbourne where
the unemployment rate is 4.5 per cent.

Professor McDonald might be right.

If he is, our Reserve Bank is about to make a tragic mistake.