Tuesday, March 04, 2008

Tuesday Column: Are we about to abandon the quest for full employment?

If you are thinking about changing jobs, do it now.

The Reserve Bank is going to push up interest rates and keep pushing them up until it pushes Australians out of work.

Wayne Swan, Malcolm Turnbull, and enough economists to fill the Sydney Harbour agree - our golden days of a 4.1 per cent rate of unemployment are behind us.

Here's the brutal assessment of Australia's most astute Reserve Bank watcher, Rory Robertson of the Macquarie Bank:

"The Reserve Bank's concern about medium-term inflation boils down to a particular worry that unemployment has fallen too far and wages growth is accelerating in an unsustainable way."

"Accordingly, the purpose of any further interest rate hike in March will be to dampen domestic demand and push unemployment back towards 5 per cent"...

That's the way the Opposition's Malcolm Turnbull sees it. He famously
introduced the concept of NAIRU into question time last month. It
isn't a Pacific island, it's the Non-Accelerating Inflation Rate of
Unemployment – the rate below which inflation is said to climb.

It is also called the "natural rate of unemployment", because if
unemployment falls below it, it is said to spark wage claims that will
force up inflation and force the Bank to jack up interest rates to
push unemployment back up.

In parliament Turnbull asked Swan where he thought the NAIRU was, and
if it was higher than 4.1 per cent "how many Australian jobs would
have to be sacrificed in order to achieve it."

By the way, a senior Treasury economist confirmed in a speech last
year that he thought the answer was "currently around 4.7 per cent,
although there is a considerable band of uncertainty."

If the NAIRU is 4.7 per cent then around 66,500 jobs will need to be
sacrificed to achieve it. 4.1 per cent will have been as good as our
rate of unemployment got.

Swan dodged the question in parliament, but two days ago on the Sunday
program confirmed that the fight against inflation would cost jobs,
saying that "the economy may slow a lot but I have no advice from the
Treasury that suggests that unemployment will increase substantially".
Note the use of the word "substantially". Swan accepted the premise
that unemployment was about to stop falling and begin to climb.

If Turnbull, Swan and the harbour full of economists are right, our
dole queues are about to grow again after shrinking more or less
continuously for 15 years.

But not everyone agrees.

Dr Barry Hughes is the doyen of Australian labour market
specialists. A former professor of economics and an advisor to Paul
Keating and several state premiers he knows his way around the
employment stats better than anyone else.

In a study released this week by the Australian Industry Group he
has dared to challenge the conventional wisdom by asking "how natural
is the Australian natural rate?

He has a number of problems with the idea. One is that Australia
appears to have two rates of unemployment at the moment – a low one in
the mining-rich states "where wage and price inflation has been
increasing and is almost completely outside the control of the
authorities" and a higher one in the rest of the country where "the
natural rate of unemployment seems to have gone missing in action".

NAIRU turns out to be elusive. Like the Loch Ness Monster, whenever it
is sited, it moves.

Back at the start of the decade NAIRU was believed to be 6 per cent.
If unemployment fell lower than that, it was thought that inflation
would rise. Unemployment did fall lower, inflation didn't rise and so
the estimate of NAIRU was cut. It's a continually moving constant.

Dr Hughes has dared to suggest that the conventional view about NAIRU
"might be incomplete, if not wrong".

Professor Ian McDonald of the University of Melbourne has calculated
an alternative lower-bound to sustainable unemployment using a
different method popular in Europe.

It abandons the traditional assumption that a low rate of unemployment
will automatically spark inflation by pointing out that that depends
on a number of things including trade union power. Australia's trade
unions are weaker than they used to be, partly as a result of
WorkChoices. As a result it might now be possible for unemployment to
fall very low without sparking wage-price inflation.

His estimate of the lowest sustainable rate of unemployment in
Australia right now is 2.5 per cent - a rate that seems low only to
Australians with short memories. It is where the rate was in the late
1960s and early 1970s.

Professor McDonald says only at that level should wages now pose a
threat to inflation. Only at an unemployment rate of 2.5 per cent
would it be literally true to say that Australians were fully

But surely the Reserve Bank needs to push up interest rates when its
board meets today in order to contain the inflation we've got right
now, I asked him on the phone last night.

It doesn't, because interest rate hikes are designed to tackle wage
inflation, which we don't have in most of the country, he replied.

The inflation we do have right now is fueled by climate change (higher
energy and water prices), a worldwide food shortage (higher grocery
prices), higher oil prices, higher rents and the mining boom.

Higher interest rates will dent none of these.

But they will crunch the economy and push people out of work.

For no reason, in Professor McDonald's view.

We will have abandoned the quest for a 2.5 per cent national rate of
unemployment just when it was within our reach.

As it happens the ACT's unemployment rate has already fallen to 2.5
per cent. Inflation here is no worse than it is in Melbourne where
the unemployment rate is 4.5 per cent.

Professor McDonald might be right.

If he is, our Reserve Bank is about to make a tragic mistake.