The higher the world’s central banks lift interest rates, and the more they risk pushing us into recession, the more our smarter economists are thinking there has to be a better way to control inflation.
Unsurprisingly, one of the first Australian economists to start thinking this way is our most visionary economist, Professor Ross Garnaut. He expressed his concerns in his book Reset, published in early 2021.
Then, just before last year’s job summit, he gave a little-noticed lecture, “The Economic Consequences of Mr Lowe” – a play on a famous essay by Keynes, “The Economic Consequences of Mr Churchill”.
Academic economists are rewarded by their peers for thinking orthodox thoughts, and have trouble getting unorthodox thoughts published. Trick is, it’s the people who successfully challenge the old orthodoxy who establish the new orthodoxy and become famous. John Maynard Keynes, for instance.
In his lecture, Garnaut praised the Australian econocrats who, in the late 1940s, supervised the “postwar reconstruction”. They articulated “an inclusive vision of a prosperous and fair society, in which equitable distribution [of income] was a centrally important objective”.
The then econocrats’ vision “was based on sound economic analysis, prepared to break the boundaries of orthodoxy if an alternative path was shown to be better”.
It culminated in the then-radical White Paper on full employment, of 1945, under which policy the rate of unemployment stayed below 2 per cent until the early 1970s.
Garnaut’s earlier criticism of the Reserve was its unwillingness to keep the economy growing strongly to see how far unemployment could fall before this led to rising inflation. “We haven’t reached full employment [because] the Reserve Bank gave up on full employment before we got there.”
Now, Garnaut’s worry is that “monetary orthodoxy could lead us to rising unemployment without good purpose”.
“Monetary orthodoxy as it has developed in the 21st century leads to a knee-jerk tendency towards increased interest rates when the rate of inflation... rises.
“I have been worried about the rigidity of the new monetary orthodoxy since the early days of the China resources boom.” He had “expressed concern that an inflation standard was replacing the gold standard as a source of rigidity in monetary policy”.
Ah. That’s where his allusion to Churchill comes in. In 1925, when he was Britain’s chancellor of the exchequer, Churchill made “the worst-ever error of British monetary policy” by following conventional advice to suppress the inflationary consequences of Britain’s massive spending on World War I by returning sterling to the “gold standard” (Google it) at its prewar parity.
The consequence was to plunge Britain into deep depression years before the Great Depression arrived.
“If we continue to tighten monetary policy – raise interest rates – because inflation is higher that the target range, then we will diminish demand... in ways that seriously disrupt the economy.
“High inflation is undesirable, and it is important to avoid entrenched high inflation. But not all inflation is entrenched at high levels. And inflation is not the only undesirable economic condition.
“There is a danger that we will replace continuing improvement to full employment with rising unemployment – perhaps sustained unnecessarily high unemployment.
“That would be a dreadful mistake. A mistake to be avoided with thoughtful policy.”
Such as? Garnaut has two big alternative ways of reducing inflation.
First, whereas in the early 1990s there was a case for independence of the Reserve Bank because, with high inflation entrenched, it needed to do some very hard things, he said, “what we now need is an independent authority looking at overall demand, and not just monetary policy.
“We need an independent body playing a role in both fiscal and monetary policy... It would be able to raise or lower overall tax rates in response to the macroeconomic situation.”
Second, we shouldn’t be using higher interest rates to respond to the surge in electricity and gas prices caused by the invasion of Ukraine.
Because of the way we’ve set up our energy markets, the increases in international prices came directly back into Australian prices. This put us in the paradoxical position of being the world’s biggest exporter of liquified natural gas and coal, taken together, but most Australians became poorer when gas and coal prices increased.
“Many Australians find this difficult to understand. If they understand it, they find it difficult to accept.
“Actually, it’s reasonable for them to find it unacceptable,” he said.
So, what to do? We must “insulate the Australian standard of living from those very large increases in coal, gas and therefore electricity”.
How? One way is to cause domestic energy prices to be lower than world prices. The other is to leave prices as they are, but tax the “windfall profits” to Australian producers caused by the war, then use those profits to make payments to Australian households – and, where appropriate, businesses – to insulate them from this price increase.
By causing actual prices to be lower, the first way leaves the Reserve less tempted to keep raising interest rates. Which, in turn, should avoid some unnecessary increase in unemployment.
There are two ways to keep domestic prices lower than world (and export) prices. One is to limit exports of gas and coal to the extent needed to stop domestic prices rising above what they were before the invasion.
The other way is to put an export levy (tax) on coal and gas, set to absorb the war-cause price increase.
Either of these methods could work, Garnaut said. Western Australia’s “domestic reservation requirement” specifying the amount of gas exporters must supply to the local WA market, has worked well – but this would be hard to do for coal.
This week Treasury secretary Dr Steven Kennedy said the measures the government actually decided on could reduce the inflation rate by three-quarters of a percentage point over this year.
Garnaut’s point is that we’ll end up with less unemployment if we don’t continue leaving the whole responsibility for inflation to an institution whose only tool is to wack up interest rates.