Party politics lost in unemployment

Compiled from: RBA Table H5 Labour Force; online, June 2014

The moral problem is concerned with conflict between individual interest and the interest of society - Joan Robinson

In western societies, economic morality should lie at the heart of economic policy. That was the case until post 1971 when economic theories from the eighteenth/nineteenth century replaced post War economics of Keynes. The loss of post World War II policy values is encapsulated in the current furore over the Abbot Governments announcement that unemployed people must seek a specified number of interviews per day. The best Labor can do is argue that the number of job applications is too onerous. Since 1971, all major political parties lost their way with respect to the moral question in economics. Individual interest has triumphed over the interests of society.

Post World War II

Governments should accept the responsibility for stimulating spending on goods and services to the extent necessary to sustain full employment

White Paper on Full Employment 1945

Australia was a signatory to the 1944 international monetary system negotiated and signed at Bretton Woods. Policy objectives of the Bretton Woods agreement were balanced trade, full employment, and high levels of real income. Prime Minister Curtain's White Paper on Full Employment formally committed post War Australian politicians to pursue policies consistent with international obligations which were designed to prevent a return to unemployment levels that had characterised the Great Depression years. In effect the White Paper became a "transition program" to move the Australian economy from war time production to peace time production.

The 1945 White Paper defined full employment as "employment for all those capable and willing to work". In 1965, the Vernon Report defined full employment as a range of unemployment lying between 1% and 1.5%. Whilst Curtin initiated the White paper, Sir Robert Menzies' 1951 election speech boasted to the electorate that the Australian economy enjoyed over full employment. Full employment was a value important to all major political parties.

Bretton Woods collapsed in 1971; and, combined with two oil crises of 1974 and 1978 created immense difficulties for national governments to maintain full employment. In 1976, Article IV of the IMF Charter was altered to place emphasis on domestic price stability. Australia and other signatories to the IMF, effectively accepted full employment as a second order policy objective.

Bretton Woods Collapse

Dislocation of the 1970's initiated an international search for an alternative economic philosophy to that of J.M. Keynes. This led to a growing "reliance upon monetarism and neoclassical economics of the market". The final form of the alternative became crystallized in a policy direction adopted by Margaret Thatcher and Ronald Reagan known as supply side economics.

Supply side economics was "a renaissance of the classical economics of Adam Smith and Jean Baptiste Say". David Ricardo's Comparative Advantage Theory also features in supply side economics. The policy direction was developed during the 1970's with input from four Nobel Prize winning economists: Robert Mundell, Milton Friedman, James Buchanan, and Friedrich Hayek. Mundell and Friedman were Chicago School monetarists. Hayek came from the Austrian School of thought whilst Buchanan was sympathetic to Austrian economics. Another Chicago School economist involved was Arthur Laffer of the famous Laffer Curve phenomena.

By assuming full employment, nineteenth century theories excluded unemployment from consideration. Consequently, any deviation from full employment was temporary or frictional unemployment caused by workers moving between jobs. Amongst leading twentieth century classical/neoclassical theorists was Professor Pigou of Cambridge University. Pigou believed that the business cycle was a smoothly functioning system that experienced temporary dislocation. He asserted that flexible wage rates would adjust the system and return it to full employment. This view of the business cycle is recognized in economic literature as a restatement of Says Law of Markets in terms of the demand for labour.

Say's Law of Markets applied to a modern economy leads to an economic policy direction characterised by:

• no-industry policy and removal of government intervention in market behaviour
• minimum government involvement in wage determination
• curbing trade union power and minimizing unemployment support

Enter Friedman's Natural Rate of Unemployment

...that simple Keynesian world in which some reduction in unemployment could, apparently, always be at the cost of some more inflation. More inflation simply leads to more unemployment. Bill Hayden

The quotation from Bill Hayden's 1975 Budget is amongst the first made by an Australian public figure that enunciates the concept of Friedman's natural rate of unemployment. It signifies a major shift in Australian economic thinking from the economics of Keynes to monetarism. Implicitly, this rejects Curtain's White Paper on Full Employment and returns to the alternative Say's Law of Markets.

The natural rate of unemployment describes the equilibrium point of an economy beyond which economic expansion to increase employment will produce inflationary pressures. Conversely, an employment rate below natural rate of unemployment produces deflationary pressures. Full employment becomes defined as the natural rate of unemployment consistent with the equilibrium level of real wages. Economic expansion beyond the natural rate of unemployment requires supply side structural change

Monetarism Institutionalized

By 1974-75 both major political parties were converts to monetarism. By 1975, the Federal Treasury had accepted the concept of a natural rate of unemployment. In its 1975 Annual Report, the Reserve Board of Australia accepted the link between increased inflation and unemployment. Political, institutional, and professional acceptance of the Friedman/Phelps natural rate of unemployment inevitably meant economic reform policies directed to supply side phenomena.

Role of the RBA

In 1993 the RBA attempted to define the natural rate of unemployment in a presentation to the Committee on Employment Opportunities. Historic unemployment levels were blamed on structural unemployment. Consequently, "policies aimed at stimulating demand cannot do much about".

Acceptance that demand management could not solve structural unemployment meant acceptance of a "natural rate of unemployment". For Australia, this lay between 6%-8%. Friedman's natural rate of unemployment had become institutionalized in RBA thinking.

Structural unemployment occurs when displaced workers in declining industries do not possess the necessary skills to transition to expanding industries. Education and training become important policy instruments to make workers "job ready". The second policy response is to ensure flexibility in wage determination.

Theoretically, education and training transforms structural unemployment to frictional unemployment. Say's Law of Markets is re-established and the assumption of full employment reinstated.

Labor and natural rate of Unemployment

By the time the Hawke administration had been elected to government, Friedman's theories had been blended into supply side economics. Margaret Thatcher and Ronald Reagan had adopted this policy direction which combined modern monetarism with nineteenth century Adam Smith, David Ricardo and Jeane Baptiste Say. Hawke is credited with introducing Thatcher and Reagan's supply side economics to Australia.

The Liberal Party

In a 1975 policy document of the Liberal Party, monetarist theory of money supply control was advocated

...a target rate of growth of the money supply should take into account the particular definition of the money supply used, the degree to which it is anticipated inflation and price expectations can be reduced, as well as forecasts of productivity, real growth and changes in the velocity of money

The Howard Government elected in 1996 granted independence to the Reserve Bank. Both the Government and the RBA were in agreement over the importance of striving for low inflation and low inflationary expectations. The RBA 1993 unofficial internal inflation target of 2%-3% became the official policy target along with the natural rate of unemployment defining full employment.

Conclusion

Post 1971, the moral question in economics has been abandoned. Individual interest has been the driver of economic policy to achieve growth, income and employment. With an underutilization rate of 14%, under employment around 7.5%, and unemployment 6.4% and rising, it would seem that self interest policies have not delivered for the social interest. It is time for a national debate on economic philosophy. All major political parties appear to be wandering in a wilderness of nineteenth century theories.