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 ⅓ 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 per cent for a sustained period of time and that the overall under-utilisation rate (which allows for under-employment and discouraged workers) will grow to 8 to 8.5 per cent. 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 2.5 to 3 per cent per annum for several quarters. With the potential workforce growing by 1.5 per cent and labour productivity by 1.5 per cent, the increase in demand for labour will (under this scenario) fail to match supply.

If this happens, it will be seen by many 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 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 per cent in mid 2007 was below the equilibrium rate consistent with stable and low inflation, that Costello should have recognised 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 stabilised at or around 4.5 per cent. Instead fiscal policy helped create a dangerous inflation problem, making it inevitable that unemployment will now rise to 5.5 per cent.

This argument has more than a little 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 today’s 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 must at some point produce sharp price adjustments elsewhere in the economy and the price falls can offset the uptrend in energy and food. But the cost of such a monetary stance is 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 per cent “on average over the business cycle” (i.e. over the next two or three 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.