If unemployment turns sour, who should we blame?

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 1/3 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% for a sustained period of time and that the overall under-utilization rate will grow to 8 to 8.5%. 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 well under 3% per annum for several quarters. With the potential workforce growing by 1.5% and labour productivity by 1.5%, the increase in demand for labour will (under this scenario) fail to match supply.

If this happens, it will be rightly seen 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.

Suspect 1: Failure of monetary policy in 2006 and 2007

It can be argued that the Reserve 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% in mid 2007 was below the equilibrium rate consistent with stable and low inflation, that Costello should have recognized 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 stabilized at or around 4.5%. Instead fiscal policy helped create a dangerous inflation problem, making it inevitable that unemployment will now rise to 5.5%.

This argument has some 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.

As noted above, the bulk of todays 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 can produce such sharp price adjustments elsewhere in the economy that they offset the uptrend in energy and food. But if so, the cost must be much 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% on average over the business cycle (i.e. over the next 2 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% 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 suspect that the Gillard reforms will prove very anti-trade union. This is the view of most analysts, including the right wing Institute of Public Affairs. It is also the view of the unions. 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 its going to happen when Howards laws, which are now Rudd and Gillards laws, still apply and give workers no bargaining rights in this country (opinion piece by Ewin Hannan, The Australian 10/5/08).

We will have to wait and see.

Suspect 5: Swans excessive fiscal zeal

This is the line Turnbull was running (but may be retreating from).

Swans budget is certainly deflationary in that it sharply slows down the rate of growth in government spending (from 2.9 to 1.1% p.a.) 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 Costellos over-expansionary fiscal stance in 2006 and 2007, the risks that Swans stance will be too deflationary are small. First, Swan is withdrawing about 1/4 to ½ a percentage point from domestic demand not a big deal. Secondly, 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 any damage should be capable of being quickly reversed if the unemployment figures turned ugly (started to rise towards 5.5 or 6%).

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

Summing up

Who then will we blame if unemployment rises excessively? All five suspects will have a little bit of guilt on their hands but in my view the RBAs over-reaction in 2008 will be the principal culprit. Lets hope we never need to ask this question.

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9 Responses to If unemployment turns sour, who should we blame?

  1. Sinclair Davidson says:

    Nice piece. I think the RBA will pick up the blame (either under or over zealous is open to debate) and, indeed, should pick up the blame.

    Their current forecasts leave little room for error (non-farm GDP growth at 1.75% in the next while). Also (measured) inflation to be back in the 2-3% band just as the emissions trading system is meant to be introduced. We’re looking at a sustained period of time where (measured) inflation will be outside the target band.

    As an aside, I don’t think the IPA is suggesting the IR reforms are ‘anti-trade union’, Ken Phillips suggested that the IR reforms are not a mask to deliver industrial power to unions.

  2. Peter Ferguson says:

    Fred,

    You don’t describe what “excessive unempoyment” is. Is 5% excessive? In the 70’s & 80’s 5% would have been considered a great outcome. With the resources boom would not an unemployment rate of 5 or 6 help to move people to where they are needed now, north & west?

    Smithkid

  3. observa says:

    Sinclair,
    Why should the RBA realistically pick up the blame in the short run when its higher interest rate policy currently, is lagging the market in setting rates? In the longer run (the last decade) I’d argue they’re as guilty as sin, along with other CBs world-wide for throwing money at each economic cough, the inevitable and compounding results of which, the market is holding the mirror up to right now. Firstly there is the preposterous presumption that the RBA can somehow assess and judge what some true interest rate is. The fact that they’re being led around with a ring through their nose by the market at present, puts the immediate lie to that. Even if they were such omniscient souls in being able to guess what rate the market needs to throw up when it actually is(and isn’t that a mouthful), then there is the inevitable upward ratchet effect of money supply, as they see it their binding duty to wipe any and all runny noses, with the only hanky they have. Why then should we be at all surprised that we’re right where we are now I wonder?

  4. JC says:

    Ob

    The yield curve is telling us they’re quite tight as the cash rate to 10 year spread is quite inverted. Recent stats that are quite interest rate sensitive are also pointing in that direction such as building approvals etc.

    I think interest rate targeting is becoming more of an issue than it once was.

  5. Sinclair Davidson says:

    The RBA are insulated in the short run by the terminology ‘on average over the cycle’. That is very vague and people understand that there are shocks to the CPI (intro of GST for example). To have measured CPI outside of its 2 – 3 % for a sustained period of time is the problem.

  6. Fred Argy says:

    Sinclair, touche. I should have said that, on present indications, the IPA seems relaxed about the potential for abuse of union power.

    Peter, I cannot accept that we need a pool of unemployed (and a threat of more) to force people to move. Is it really beyond the wit of governments to devise relocation and retraining incentives which will speed up the movement of people to “where they are needed now”?

  7. NPOV says:

    It’s also worth asking why it is that the big companies desperate for labour out West aren’t prepared to fork out to pay the moving costs of more potential East coast employees. Surely the most valuable thing the government could do at this point is some sort of survey of the unemployed and underemployed to find out what are the biggest hurdles to labour mobility. If it ultimately comes down to, e.g., not wanting to be too far from family and friends, then perhaps there’s nothing realistically that could be done to improve mobility. But it’s hard to imagine the mindset of someone that would prefer to live off employment benefits rather than relocate for a few years of your life.

  8. Patrick says:

    Its also worth asking why it is that the big companies desperate for labour out West arent prepared to fork out to pay the moving costs of more potential East coast employees.

    My understanding is that this is quite common.

    But its hard to imagine the mindset of someone that would prefer to live off employment benefits rather than relocate for a few years of your life.

    Try harder. The classical lefty sequ

  9. NPOV says:

    Well my version of nanny-statism says that the government should decide for such individuals that they’re better off moving than living off the dole.

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