If you think getting inflation down is our one big economic worry, you have a cockeyed view of economic success. Unless we can get it under control without returning to the 5 to 6 per cent unemployment rate we lived with in recent decades, we’ll have lost our one great gain from the travails of pandemic: our return to full employment.
And if we do lose it, it will demonstrate the great price Australia paid for its decision in the 1980s to join the international fashion and hand the management of its economy over to the central bankers.
There has always been a tricky trade-off between the twin objectives of low inflation and low unemployment. If our return to full employment proves transitory, it will show what we should have known: that handing the economy over to the central bankers and their urgers in the financial markets was asking for inflation to be given priority at the expense of unemployment.
In his customary post-budget speech to economists last Thursday, Treasury secretary Dr Steven Kennedy began by explaining to academic economists why their claim that the budget was inflationary lacked understanding of the intricacies of economics in the real world.
But his strongest message was to remind economists why full employment is a prize not to be lost.
Whereas early in the pandemic it was feared the rate of unemployment would shoot up to 15 per cent and be difficult to get back down, the massive fiscal (budgetary) stimulus let loose saw it rise only to half that, and the remarkable economic rebound saw it fall to its lowest level in almost 50 years.
“This experience is altering our views on full employment,” Kennedy says. “One of the stories of this budget – one that risks being lost – is the virtue of full employment.”
For one thing, near-record low unemployment and a near-record rate of participation in the labour force are adding to demand and to our capacity to supply goods and services.
This time last year, Treasury was expecting a budget deficit of $78 billion in the financial year ending next month. Now it’s expecting a surplus of $4 billion. Various factors explain that improvement, but the greatest is the continuing strength of the labour market.
As I explained last week, this revision has significantly reduced the projected further increase in the public debt and, in consequence, our projected annual interest bill on the debt every year forever. It has thereby significantly reduced our projected "structural" budget deficit although, Kennedy insists, has not eliminated it.
And getting a higher proportion of the working-age population into jobs – and having more of the jobs full-time – improves our prospects for economic growth and prosperity.
There’s no source of economic inefficiency greater than having many people who want to work sitting around doing nothing. And adding to the supply of labour is not, of itself, inflationary.
But let’s not confuse means with ends. The most important benefit of full employment goes not to the budget or even The Economy, but to those people who find the jobs, or increased hours of work, they’ve long been seeking.
Kennedy reminds us that the greatest benefit goes to those who find it hardest to get jobs. While the nationwide unemployment rate has fallen by 1.6 percentage point since before the pandemic, it has fallen by 3.2 percentage points for youth, and by 2.3 percentage points for those with no post-school education.
This is where we get to Kennedy’s observation that recent experience is altering Treasury’s views on full employment.
The obvious question this experience raises is: why have we been willing to settle for unemployment rates of 5 to 6 per cent for so long when, as he acknowledges, “the low rate of unemployment and high levels of participation [in the labour force] have been sustained without generating significant wage pressures”?
Short answer: because economists have allowed themselves to be bamboozled by modelling results. Specifically, by their calculations of the “non-accelerating-inflation rate of unemployment” – the NAIRU.
As Kennedy says, the unemployment rate consistent with both full employment and low and stable inflation isn’t something that can be seen and directly measured. So, as with so many other economic concepts, economists run decades of inflation and unemployment data through a mathematical model which estimates a figure.
Economists have redefined full employment to be the 5 or 6 per cent unemployment rate their models of the NAIRU spit out. They think using such modelling results makes decisions about interest rates more rigorous.
But that’s not true if you let using a model tempt you to turn off your brain and stop thinking about whether the many assumptions the model relies on are realistic, and whether more recent changes in the structure of the economy make results based on averaging the past 30 years misleading.
It’s now pretty clear that, at least in recent years, NAIRU models have been setting the rate too high, thus leading the managers of the economy to accept higher unemployment than they should have.
There are at least three things likely to make those modelling results questionable. One is that, as a Reserve Bank official has revealed, the models assume inflation is caused by excessive demand, whereas much of the latest inflation surge has been caused by disruptions to supply.
Professor Jeff Borland, of Melbourne University, points out that the increasing prevalence of under-employment in recent decades makes the models’ focus on unemployment potentially misleading, as does the increasing rate of participation in the labour force.
Third, unduly low unemployment and job shortages are supposed to lead, in the first instance, to wage inflation, not price inflation. But this turns to a great extent on the bargaining power of unionised labour, which many structural factors – globalisation, technological advance, labour market deregulation and the decline in union membership – have weakened.
If the NAIRU models adequately reflect these structural shifts I’d be amazed.
What is clear is that the Reserve Bank’s understanding of contemporary wage-fixing is abysmal. As yet, it has no one on its board with wage-fixing expertise, its extensive consultations with business leaders exclude union leaders, and Reserve Bank governor Dr Philip Lowe says little or nothing about wage-fixing arrangements.
And this is despite Lowe’s unceasing worry about the risk of a price-wage spiral and an upward shift in inflation expectations. So far, there’s little evidence of either.
Some increase in unemployment is inevitable as we use the squeeze on households’ disposable income to slow demand and thus the rate at which prices are rising.
But if the Reserve’s undue anxiety about wages and expectations leads it to hit the brakes so hard we drop into recession, and full employment disappears over the horizon, it will be because we handed our economy over to the institution least likely to worry about making sure everyone who wants to work gets a job.
