The porridge is too hot, Goldilocks

All's well with the economy.

The US is heading for recession but the China boom will keep global activity strong.

Australia's terms of trade will remain high. Indeed, the current round of price negotiations will produce further increases.

Inflation is up, likely to reach an annual rate of 4 per cent or so, but should be down again by 2010.

Aggregate demand has been growing far too fast, but consumers have lower expectations and growth of private demand will be reduced.

Government demand will be reduced as the Rudd Government tightens fiscal policy.

Productivity has slumped but this is partly due to the drought and partly due to mining investment to expand capacity. A more important reason is waning effects of past economic reform. A new, reformist Labor Government is, however, poised to reintroduce productivity growth.

Australia's CEOs think all is well, just so long as interest rates are not raised further.

This is the Goldilocks view of the economy. It is now admitted by the commentariat that it has been too hot for comfort but now it is just right.

Like all good fairy stories it is just believable, especially if the listener or reader believes in bears that talk and fairies at the bottom of the garden.

There are two clear indications of an over-stretched economy - inflation and the current account deficit (CAD).

This column has focused on inflation for some years now, with little support from others. Last week, the Prime Minister's climate change guru and leading economist, Professor Ross Garnaut (a rare supporter of Henry's views), pointed out that: "Inflationary pressures that have been building in the economy since 2005 are now deeply entrenched and will be difficult to remove."

Amen to that, and if wage claims and settlements continue to escalate - and there are many pressures from the mining boom as well as degraded public services - it will trouble inflation fighters in the Reserve Bank and elsewhere.

The current account deficit is another powerful indicator of pressure on demand in an economy. Technically, it measures the excess of aggregate demand over domestic supply for goods and services. Australia is a growing economy and as such this excess is acceptable, up to a point.

The point at which markets (or policy makers) cry "enough is enough" is impossible to predict but our graph of almost 50 years of history is suggestive.

The red line on the graph shows the CAD as a ratio to GDP. The blue line shows net foreign liabilities, also as a ratio to GDP.

The vertical lines show the timing of peaks and troughs in the business cycles - as measured by the Melbourne Institute based on the pioneering work of Dr Ernst Boehm many years ago.

There is a clear message - a CAD of about 6 per cent of GDP signals danger for the economy.

Every cyclical downturn - except those in the troubled 1970s - has been accompanied by a CAD to GDP ratio of 6 per cent.

Let us briefly discuss the episodes involved. The 1950s experienced a long boom with both inflation and the CAD building gradually. In 1960 the Menzies government hit the brakes and produced a short, sharp recession that fixed both for a decade.

The 1970s CAD was lower as much of the initial cyclical impetus was from the global commodities boom. Inflation was imported in part through the effects of a strong CAD but when the Whitlam government added to domestic demand, inflation soared to peak around 16 per cent.

During the 1970s the CAD was building, leading finally to another 6 per cent cyclical peak in 1981-82. During the resulting downturn the Reserve Bank began to publish estimates of Australia's international debt.

The next 6 per cent peak in the CAD was in the mid-1980s, when a vigilant central bank warned Treasurer Paul Keating of the expanding CAD and associated blowout of Australia's international debt. Keating declared the nation was in danger of becoming a banana republic and persuaded the cabinet to cut government spending. Political leaders in turn persuaded the ACTU to cop a necessary cut in real wages. Keating was persuaded to authorise hikes in interest rates.

Helped by a drop in the value of the floating Australian dollar, crisis was averted, or at least postponed, in what Henry regards as Australia's finest set of pre-emptive economic policy actions.

By 1989, however, the CAD was again blowing out, and this time pre-emptive action was not undertaken. Monetary tightening was too little, too late and when it came was greatly overdone. The benefit was that the CAD was cut to safe levels and inflation was killed.

Throughout the 1990s there were benefits of Labor's economic reforms keeping the lid on inflation. Global inflation hit a post-World War II low. The CAD remained in deficit and international debt rose inexorably.

The CAD reached 6 per cent of GDP three times, in each case to pull back before a crisis erupted. Australians have come to regard the CAD as a friend and debt as sensible "gearing up" of relatively ungeared balance sheets.

Does the graph ring warning bells, gentle readers? The CAD was around 7 per cent in the December quarter of 2007.

Henry asserts that the peak to the long boom of the 1990s and 2000s was then. We are in the midst of an economic slowdown. Crisis and a severe recession can be prevented if Keating's banana republic policies are repeated on a bigger scale. Are the relevant decision-makers and advisers as focused as they were when Bob Hawke was prime minister?

The budget must be tightened substantially, wage increases must lag behind inflation and interest rates must rise until there are clear signs of overall restraint.

Henry expects the Reserve Bank to stay its hand today.

But further rate hikes will occur if fiscal policy fails to deliver, if inflation again surprises on the upside or if wages begin to blow.