Rising unemployment endangers the recovery

The Great Recession is the more or less inevitable consequence of asset bubbles bursting following realisation of foolish and reckless over-borrowing and over-spending by households, over-lending by banks and over-complication of financial instruments (to the point that the financiers themselves lost touch with the risks they were running).

And, it must be added, lack of diligence by central banks allowing overheated bubble economies to develop with bank regulators allowing unsustainable practices to flourish.

(As just one recent example, it has emerged that US regulators were told more than once about the Bernard Madoff scam, but the fact that their investigations failed surprised even Madoff himself.)

To return to the graph of consumer inflation, note the gradual rise from the mid-1990s, as near to a new trend as the naked eyeball will detect.

Until very recently, it was widely assumed that the Great Recession would take care of inflation. Reserve Bank governor Glenn Stevens has recently showed renewed concern at the risks of inflation, and market participants have swung from the assumption of rate cuts to come to the view that the next move in cash rates will be upward.

This volatility of expectations is itself a sign of instability in the economic fabric.

But there is also the risk of "poverty and civil unrest" as unemployment and underemployment builds.

Australia is officially judged to be a nation where unemployment is likely to peak at about 8 per cent of the workforce. So far, official (ABS) unemployment has risen from a low point of 3.9 per cent to a "mere" 5.7 per cent.

The Reserve Bank has lifted its game under the leadership of Stevens. It responded briskly to the Great Recession with several 100-point cuts to cash rates from October last year.

It is showing signs of recognising the importance of asset inflation and deflation, though so far there is no attempt to tell us how this gets allowed for in operational decisions. And it has explicitly recognised the importance of inflationary expectations.

But people far closer to labour market realities than public officials with firm tenure have been arguing for some time that unemployment and underemployment is far greater than suggested by official ABS statistics.

In fact, the latest figures from Roy Morgan suggest the actual rate of unemployment is 7.6 per cent and there is a further 9 per cent of the workforce who would like to work longer hours if work were available.

This is a structural issue that requires careful analysis leading to policy reform by government.

But the Reserve Bank cannot and should not ignore it in its decisions about interest rates. It creates a third risk to recovery, with bank failure and inflation.

Even without further bank failures, the risk of rising inflation and the certainty of rising unemployment is an inherently destabilising combination.