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If unemployment turns sour, who should we blame?

By Fred Argy - posted Friday, 16 May 2008


Australia may be lucky and sail through the boisterous economic seas without any significant impact on unemployment. However, while we may have seen the worst of the credit crisis, I would rate this outcome as only a ⅓ probability.

Allowing for the delayed impact of earlier interest rate increases, a more likely outcome over the next couple of years is that official unemployment will rise above 5 per cent for a sustained period of time and that the overall under-utilisation rate (which allows for under-employment and discouraged workers) will grow to 8 to 8.5 per cent. This is effectively what the economic forecasts of the Reserve Bank and (to a lesser extent) Treasury imply. They envisage a sharp slowing in real non-farm GDP growth - down to 2.5 to 3 per cent per annum for several quarters. With the potential workforce growing by 1.5 per cent and labour productivity by 1.5 per cent, the increase in demand for labour will (under this scenario) fail to match supply.

If this happens, it will be seen by many as a failure of economic policy. Who will the economists blame? Some will attribute it to “the rest of the world” but that begs a lot of questions. For the most part, economists will point to a number of home-grown suspects.

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Suspect 1: Failure of monetary policy in 2006 and 2007

It can be argued that the Bank misread the signs of inflation in 2006 and 2007 and should have tightened much earlier. It did act bravely during the campaign but by then the horse had bolted.

It is a legitimate criticism but it should be seen as a small hiccup in an otherwise impeccable performance by the Bank over the decade and a half to end-2007.

Suspect 2: Fiscal policy in 2006 and 2007

One view is that the prevailing unemployment rate of close to 4 per cent in mid 2007 was below the equilibrium rate consistent with stable and low inflation, that Costello should have recognised it was unsustainable and deliberately sought to slow the economy in 2007 (i.e. hoarded more of the fiscal surpluses). Instead the Howard Government adopted a “neutral” fiscal policy. Had it cut back spending in 2007, unemployment might have stabilised at or around 4.5 per cent. Instead fiscal policy helped create a dangerous inflation problem, making it inevitable that unemployment will now rise to 5.5 per cent.

This argument has more than a little validity. And not just in retrospect: many economists (including myself) warned in 2007 that fiscal policy was contributing to inflation.

But some perspective is needed here. The inflation take-off during 2007 was due in good part to factors in the energy and food markets which are insensitive to domestic demand. I frankly doubt that a tougher fiscal policy in 2006 and 2007, while helpful, would have made a huge difference to the inflation outcome.

Suspect 3: Excessive RBA zeal in 2008

Having been slow to act in 2006 and 2007, the Bank may well have over-reacted in 2008.

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As noted above, the bulk of today’s underlying inflation is directly or indirectly the result of higher energy and food prices which are relatively insensitive to restrictive domestic monetary policy. Sure, interest rate rises must at some point produce sharp price adjustments elsewhere in the economy and the price falls can offset the uptrend in energy and food. But the cost of such a monetary stance is higher unemployment.

The Bank knows this - yet is prepared to go down that road. I believe it should have stayed its hand in 2008 and managed inflationary expectations with a mix of warnings, threats and education and forcefully explained why current inflation rates were temporary and should not be built into wage demands or price settings.

This is not to argue, as some have, that we should abandon inflation targeting or move the target range upwards. I believe the existing inflation target is perfectly achievable as intended - i.e. 2 to 3 per cent “on average over the business cycle” (i.e. over the next two or three years or so) - without the need for the strong pre-emptive action on interest rates of the last four months. All it required was a cool head and patience.

Suspect 4: The failure of the Rudd Government to support WorkChoices

If unemployment rises to 5 per cent plus over the next 12 months and remains stubbornly high even when economic conditions improve, many economists will see the retreat from WorkChoices as a significant culprit.

In many ways this will be an academic debate, given the resounding rejection of WorkChoices by the electorate in November and more recently by Opposition Leader Nelson. Still, the issue is important for the future direction of labour market policy.

I believe that the Gillard reforms will prove unfriendly to trade unions. This is the view of most analysts, including the right wing Institute of Public Affairs. It is also the view of the unions themselves. Note this comment from Dean Mighell, Victorian Secretary of the Electrical Trades Union: “There are all these great fears about wages breakouts. I would like to know how it’s going to happen when Howard’s laws, which are now Rudd and Gillard’s laws, still apply and give workers no bargaining rights in this country” (cited in The Australian May 10, 2008).

We will have to wait and see.

Suspect 5: Swan’s excessive fiscal zeal

This is the line the Treasury Opposition spokesperson, Malcolm Turnbull, was running a week or so ago (although he is now taking a bet each way).

Swan’s budget is certainly deflationary in that it sharply slows down the rate of growth in government spending (from 2.9 to 1.1 per cent per annum) and increases the cash surplus. To do this when the RBA and Treasury are forecasting a big slow down in consumption and housing is “brave”.

But, as with Costello’s over-expansionary fiscal stance in 2006 and 2007, the risks that Swan’s stance will do much damage to the employment market are small. First, Swan is withdrawing about ¼ to ½ a percentage point from domestic demand- not a big deal. Second, he has put his surpluses in easily accessible Funds which could be drawn on quickly if economic circumstances change. The Rudd Government could also quickly implement some active labour market programs to better match job vacancies and job seekers (regionally and occupationally). So the fiscal strategy can be quickly reversed if the unemployment figures turned ugly (started to rise towards 5.5 or 6 per cent).

Some economists are saying Swan should have been tougher (surprise, surprise) so the arguments will run both ways.

Summing up

If there is a rise in unemployment above 5 per cent over the next two years - and there is a good chance this may not happen - some of the blame will be attributed to the above factors but in my view the RBA’s over-reaction in 2008 will have to take the lion’s share of responsibility.

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First published in Club Troppo on May 14, 2008.



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About the Author

Fred Argy, a former high level policy adviser to several Federal governments, has written extensively on the interaction between social and economic issues. His three most recent papers are Equality of Opportunity in Australia (Australia Institute Discussion Paper no. 85, 2006); Employment Policy and Values (Public Policy volume 1, no. 2, 2006); and Distribution Effects of Labour Deregulation (AGENDA, volume 14, no. 2, 2007). He is currently a Visiting Fellow, ANU.

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