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Turning down the economic turbo boost

By Corin McCarthy - posted Wednesday, 9 September 2009

On February 18 last year Malcolm Turnbull asked Wayne Swan a simple question. He wanted to know what the Treasurer thought the current non-accelerating inflation rate of unemployment was.

At the time Samantha Maiden reported “Swan clueless on NAIRU” in the Australian when he could not answer.

Swan is still clueless on the NAIRU - or more precisely - what his policies are doing to lift it.


Simplified, the NAIRU is the lowest point that the unemployment rate can go to without elevated inflation accelerating. It's a critical “capacity constraint” that a modern economy faces when it grows rapidly.

Importantly, Rudd Labor can maintain historically high labour utilisation rates by locking in hard won gains from microeconomic and labour market reform.

And yet, Rudd Labor with its anti-market policies is undermining the reform legacy of the last two Labor and Liberal governments and ultimately reducing the productive capacity of the economy.

Over-regulation through over-zealous labour market rollback, car industry welfare and the 20 per cent renewable energy target, are among their most dangerous measures.

To provide an idea of what is at stake, throughout the 1980s when unemployment dropped below about 7 per cent, inflation would rise and fiscal and monetary policy had to tighten and constrict economic growth.

But, the NAIRU fell to multi-decade lows during the Howard years and the RBA didn't begin significantly tightening monetary policy until the unemployment rate fell below 5 per cent.


So what had changed, and how much is Rudd Labor changing it back?

Treasury Secretary Ken Henry has argued repeatedly that the “miracle” of low unemployment and inflation in recent times, resulted from three crucial factors.

First, there was macroeconomic stability under Costello. With perfect 20/20 hindsight Henry might have considered fiscal policy stable but profligate during what has turned out to be a temporary commodity boom.

Second, Keating floated the exchange rate, deregulated the financial sector and reduced tariff rates to near zero, allowing markets to more effectively allocate resources in the economy.

Third, labour and product market liberalisation, started by Keating and extended by Howard and Costello, contributed enormously to our economic “miracle” as well.

Indeed as recently as May 2007, Henry called labour market reform Australia's “shock absorber”, a pivotal policy for achieving full employment and low wage inflation together.

These policies pursued by the last two governments turbocharged the economy by raising labour utilisation and productivity.

According to Treasury figures, labour utilisation rates rose nearly nine per cent from 1978 to 2006 with most of the dividend achieved through higher participation and more hours being worked, as the unemployment rate in 1978 was similar to that in 2006.

This participation dividend was combined with productivity growth nearly one percentage point above trend in the 1990s largely due to labour market reforms, lower tariffs and other deregulatory policies.

This is why Australians are much richer and better positioned today than when we have previously entered recessions.

And yet, the three crucial labour market reforms for achieving this “miracle” are all under partial threat from Rudd Labor.

The first crucial labour market reform is the workplace level reform of enterprise bargaining and then the introduction of AWAs. Both of these instruments received wholesale endorsement by the OECD as recently as last month for improving the operation of the labour market.

Yet, worryingly, the OECD has placed the more regulatory and less flexible Forward with Fairness under a watching brief for its effects on youth unemployment.

And while the Employment Minister Julia Gillard has achieved some efficiency gains by proposing a national industrial relations system, along with simplifying awards, the majority of this gain was achieved through WorkChoices using Federal laws to override state systems in regulating companies.

Any efficiency gains from a national system are also more than offset by the regulatory and wage burdens from increasing the scope of the safety net.

The second crucial reform was to minimum wage setting that forced the Fair Pay Commission to consider an optimal minimum wage rise for generating work.

This is under threat in Rudd Labor's new low-paid bargaining stream and the revised wage setting powers given to Fair Work Australia. This greatly undermines the flexibility of wages at the low-end and will lead to more unemployment than would otherwise be the case.

History tells us it is better to keep people employed through falling real wages in a downturn than for marginal workers to lose work and social skills on the dole.

Nobel laureate, economist James Heckman wrote in 1993: “A major lesson of the last 20 years is that the strongest empirical effects of wages and non-labour income on labour supply are to be found at … the margin of entry and exit.”

Heckman’s advice should ring in the ears of wage setting bodies as they consider setting minimum and award wage floors.

For these reasons we should applaud loudly the decision of the Fair Pay Commission to freeze minimum and award wages for 2009-10.

While the stimulus packages were welcome to generate more demand in a depressed economy, this decision by the Fair Pay Commission is also crucial for keeping the dole queue lower than it would have been otherwise.

The third crucial reform was increasing incentives for people to re-enter the workforce, both through mutual obligation “sticks” and tax reform “carrots”. This is also under threat as Rudd Labor has relaxed activity tests and there is talk that single-parent pension rules may be relaxed.

So, when Rudd talks of labour participation and productivity growth, and dealing with capacity constraints, he is probably trying to cover up that his labour market policies are neither promoting work nor productivity.

Ceasing such over-regulation should be Rudd's capacity constraint for dealing with unemployment.

For, while it has been possible for ministers Tanner and Emerson to partially offset the Commonwealth's regulation burden through COAG regulatory reforms, the total effect of Rudd's policies through more regulation and picking industry winners will reduce Australia's growth prospects.

The Productivity Commission has already found that for every job saved in the auto industry it costs the community some $300,000 and the Green Car Innovation Fund would be unlikely to yield significant innovation and greenhouse benefits.

And the PC found Rudd's 20 per cent renewable energy target (RET) will not achieve any further carbon abatement above the emissions trading scheme but would impose further costs borne by consumers through higher electricity prices.

This combination of policies will lead to a higher NAIRU. This is a sub-optimal result of more inflation, higher interest rates and lower labour utilisation than should be the case.

We are already seeing evidence for the raising of interest rates by the RBA amid a period of continued labour under-utilisation by business.

This is equivalent to turning down our economic turbo boost on medium-term growth.

Treasurer Swan should take note before nearly three decades of hard won gains are lost!

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This is an extended version of an article first printed in The Australian on July 3, 2009.

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About the Author

Corin McCarthy was an adviser in opposition and government to Craig Emerson MP. He also advised Labor’s 2007 election campaign on small business issues. He has written widely on these issues in The Australian and On Line Opinion. He currently works as a lawyer in London advising on major infrastructure projects. These views are his own.

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