Where to from here?

Media commentary is dominated by "experts" pontificating over climate change, cost of living, homelessness, gender politics, and the RBA. Politicians look seriously at cameras; but, have no answers to declining living standards confronting low to middle income groups saddled with rising food prices, mortgages, and rental costs. Meanwhile, Federal Parliament has launched the traditional "Inquiries" that will take months to complete. Recommendations from these Inquiries will then be subject to the political process that adopts some recommendations whilst ignoring others. In the meantime, the disadvantaged continue to survive as best they can whilst those advantaged capitalise upon income inequalities and political positioning.

In short, the contemporary policy debate has become confused and, in most instances, ill-informed. Contemporary debate concentrates upon social policy and monetary policy managed by the independent RBA. Distribution of income and effectiveness of Australia's industrial system are not on political or industry agendas. Whilst fiscal policy is focused upon government expenditure; it has become bogged down in political ideologies embedded in nineteenth century economics. The 1945 Full Employment White Paper introduced by the Curtin Labor Government and supported by the Menzies era Coalition has been long forgotten.

The major issue facing not only Australia, but also, most western economies, is the suitability of prevailing international monetary system that replaced the post World War II fixed exchange rate regime in 1971. Despite the development of elegant econometric modelling post the 1970's, dislocation following the outbreak of Covid, and international hostilities appears to have confounded the economic philosophies that underwrite the modern supply side global monetarist synthesis which now underwrites the international monetary system.

This short essay attempts to throw some light upon questions that have emerged post the GFC and Covid which questions policy reliant upon mathematical models. Meanwhile, as political utterances by politicians, industry leaders, and economic commentators have no answers to contemporary economic dislocation, this discussion looks at the development of underlying economic philosophy in an effort to shed some light on the way forward from problems confronting most western economies today.

Economic philosophy 1950's-1990's

Over the 1950's and 1960's a modern incarnation of global monetarism emerged. Leading proponents of global monetarism were Robert Mundell and Arthur Laffer who in the 1970's combined with Milton Friedman, Friedrich Hayek, and James Buchanan in development of supply side economics. Global monetarism believes that macroeconomic phenomena is best analysed in terms of the relationship between the demand for and supply of money within a world market considered a single integrated closed economy.

In 1958, Bill Phillips produced a negative statistical relationship between money wages and unemployment. Within the economics profession this relationship became known as the Phillips Curve. Economic researchers found supporting evidence over the post World War II era in major economies thereby embedding the Phillips Curve in serious economic literature. However, in 1960, eminent American economists Paul Samuelson and Robert Solow noted that no American study had confirmed a link between unemployment and inflation. They proceeded to undertake such a study. Samuelson and Solow concluded that for the US to enjoy zero inflation, unemployment would have to lie between 5% and 6%. For the USA to have unemployment at the then popular 3% rate, inflation would need to be between 4%-5%. Paul Ormerod asserts that Similar models could be constructed for most major western economies.

However, by the end of the 1960's, the original Phillips Curve relationship between unemployment and inflation appeared to break down. Milton Friedman and others wishing to reassert micro economic theory of competitive equilibrium over macroeconomics seized upon the breakdown of the Phillips Curve to discredit Keynesian economics. The key to their attack was a view that rational people learned from experience which taught them that as unemployment fell inflation rose. Consequently, there emerged the hypothesis of rational expectations which allowed free market orthodoxy to explain the breakdown of the Phillips Curve. The rational expectations Phillips Curve followed which asserts that at any point in time there is a unique level of unemployment at which inflation will neither accelerate nor decelerate It is believed that this level of unemployment is determined by supply side factors rather than Keynesian demand management policies. As Keynes had died in 1946, he was unable to defend his theories and philosophy.

This new view of economics passed from economic debate into the world of politics. In 1976, the then Labor Prime Minister of England told an annual party conference that whilst it was commonly believed that governments could spend their way out of a recession, that was no longer the case. On election of Margaret Thatcher in 1979 as British Prime Minister, supply side economics emerged in Britain and became known as Thatcherism. Supply side economics emerged as serious economics in the US as Reaganomics over the early 1980's.

In an online article, one early US advocate of supply side economics, Bruce Bartlett, states that the aim of supply side economics was to reaffirm the truth of Jean Baptiste Say's Law of Markets. Say argued back in 1803 that production of commodities is ultimately paid for with other commodities or supply creates demand. In 1927, Professor Pigou modernised Say's Law in terms of the labour market. Pigou argued that under perfect competition, wage rate adjustment would ensure that the demand for labour would always ensure full employment. It was this belief in Say's Law that underwrote the post War attack on Keynesian economics. Contemporary restatement of Say's Law can be observed in modern economic models that assume "all markets clear"; and in production functions that assume constant returns to scale.

Economic philosophy in Australia

The 1975 Australian Treasurers Budget speech reflected the inflationary expectations model developed by Friedman and Phelps over the late 1960's. According to this theory, sustained unemployment below the "natural rate" would simply lead to accelerating inflation. This view of an economy became known as the inflation augmented Phillips Curve underwritten by rational expectations.

Theoretically, the inflation augmented Phillips Curve implies that for an economy at any point in time there is a unique level of unemployment at which inflation will neither accelerate nor decelerate. Any deviations from this unique rate of unemployment are thought to be temporary. The phrase "Non-Accelerating Inflation Rate of Unemployment" or NAIRU was coined to describe this unique rate of unemployment. When the RBA assumed unofficial independence in 1993, NAIRU became the basis of their inflation targeting monetary policy. The difference between the actual rate of unemployment and NAIRU became the determinant of RBA monetary policy stance.

The Friedman Phelps model offered a two-pronged policy strategy. Firstly, inflation had to be expunged from the system by creating a bleak market environment. Under a bleak market environment, behaviour of unions and business would moderate to an acceptable level. For example, whilst unions would not push for large real wage increases, business would be concerned about their ability to pass on rising input costs. Under austerity policies, so long as unemployment remained high, business profit margins accommodate unwinding inflation.

The second policy strategy becomes available when inflation has been driven down to an acceptable level. At this level of inflation, the full employment objective is replaced with the "natural rate of unemployment, or in modern parlance NAIRU. Friedman supported the concept of the "natural rate" of unemployment at which market conditions would not encourage any group to pursue excessive demands. The Australian Treasury in its 1975 Budget discussion papers displayed enthusiasm for this monetarist approach to macroeconomic policy.

Labor had embraced Friedman Phelps inflation expectations augmented theoryas early as 1974.Australia officially joined the monetarist club when Prime Minister Malcolm Fraser's Treasurer adopted monetary growth targets for M_3. over the second half of 1975-76. The political view of that period thought that Friedmans monetarism could be used to argue a connection between government spending, deficits, money supply, economic growth, and inflation. The contemporary political agenda that government spending is responsible for inflation can be dated back to the failed economics of Friedman's monetarist era of the 1960's.

Treasury supported the Friedman idea of inflationary expectations believing that unemployment could not be reduced until inflation was brought under control. Controlling the deficit therefore became central to recovery policy which would allow lowering of deficit induced interest rates.

Monetarism arrived in the Reserve Bank of Australia with its RBA 's 76 model. In the RBA 76 economic model, monetary disequilibrium is assumed a proxy for expectations. From the 1980's onwards economic modelling came to dominate macroeconomic policy. Econometrics became a world of mystery and intrigue for commentators. However, all is not well in the field of economic modelling despite the first general equilibrium model of the Australian economy being developed by Evans in 1970-71. Economic models are only as good as their underlying assumptions reflect the real world. Rational expectations which underwrites inflationary expectation economic models cannot claim accurate representation of real-world behaviour.

On election to Government in 1983, the Hawke Administration set about implementing the competitive equilibrium component of the new monetarist neoclassical synthesis. A first move was to deregulate the financial sector by allowing the Australian currency to float and be market determined. In the 1988 Budget, the Hawke Government began withdrawing historic industry support. Withdrawal of industry protectionism gathered momentum in the 1991 Industry Statement. In 1993, the Keating Administration used Section 51 (xx) of the Australian constitution to introduce enterprise bargaining and establish the ILO minimum wage as the basis of industry policy.

The Howard Administration simply completed the transition of the post-World War II Keynesian mixed economy to a "modern" supply driven internationally competitive economy. In other words, the Howard Administration linked Australia to the international community in adopting the "Third Way". However, the GFC in 2007 and Covid 2019-2020 have generated doubts about the wisdom of acceptance of the neoclassical/monetarist synthesis supply side reforms. Hence today's confused economic debate maintains belief in the supply side monetarist model from the 1970s despite having no answers to today's economic dislocation.

Conclusions

Dislocation from Covid and international hostilities have shown little respect for elegant mathematical economic models. Political parties that supported Thatcherism and Reaganomics are in electoral decline. Informed debate is now needed to develop alternative economic theory and philosophies.