Friday, June 08, 2007

Don’t trial L-platers but discard discredited 'natural rate' theories

In the midst of a catastrophic drought the Australian economy has grown at 3.8% over the past year, its fastest rate for 3 years. The non-farm sector in the March quarter grew at the phenomenal rate of 4.6%. As the drought ends growth rates will improve further.

Australia is in the longest expansion in its history with record low unemployment of 4.2% (the lowest in 33 years) and low inflation. The number of part-time jobs has fallen, the number of full-time jobs has risen strongly and the participation rate has continued to rise to 65%. An extra 10,000 workers are getting jobs each week. Moreover the boom is not restricted to the ‘resource’ states alone as Labor Party would suggest – the biggest reduction in the jobless occurred in NSW.

If anyone doubts the value of unemployed people getting a job, or of part-timers getting a full-time job, read this heart rendering account. The story touched me.

Peter Costello’s views on the situation are here. The RBA’s graphs of recent developments in the Australian economy are here. The ABS figures are here.

Labor argues that what Australia really needs now is a change of government that will end a decade of economic mismanagement. It argues we urgently need to reestablish ‘fairness’ in labour markets. Only if we assign a more substantial role to Australia’s trade unions can economic prosperity be sustained and unemployment kept low. As Mr. Swan warned us yesterday our productivity growth is woeful and the employment growth we have enjoyed is due to Labor’s economic reforms more than a decade ago. Paul Keating attributes the gains to the Labor reforms of the 1980s. Good grief - I'll settle for this state of misery thanks!

One thing we should do is to reassess lame duck theories of natural rates of unemployment and non-accelerating inflation rates. With inflation less than 3% and unemployment about to fall below 4% these theories should be consigned to the rubbish bin – inflation creates unemployment and the way to keep unemployment low is to allow the RBA to do its job and to keep inflation low. I have never believed natural rate theories. If they were valid why were exceedingly low rates of inflation and unemployment possible in Australia for 20 years after the Second World War? Why are we enjoying record low unemployment and inflation simultaneously now?

The natural rate apologists say that the natural rate is falling due to structural changes in the economy (such as the abolition of pattern wage agreements) so that the economy can exist with a comparatively lower level of unemployment with a given inflation rates. Every time both inflation and unemployment unexpectedly fall they say a structural shift has occurred. This is unhelpful.

These ‘natural rate’ theories have a dangerous impact on policy thinking – this morning’s Age, reverts to true form when it complains that the recent surge in employment will have the harmful effect of requiring an interest rate rise. But why given that there are no prospects of inflation?

Macroeconomists should find better things to do with their time. Fostering growth, allowing the RBA to do its job, allowing labour markets to operate as freely as possible and getting the disguised unemployed among the ranks of the macroeconomics profession to study microeconomics.


Damien Eldridge said...

Harry, is this current period of expansion really the longest in Australian history? I seem to recall that there was a long period of expansion post WW2 that was known as the long boom.

According to Wikipaedia, the long boom lasted from 1939 until 1974. That is a period of 25 years, which is much longer than the current period of expansion. The relevant Wikipedia entry can be found at: .

Damien Eldridge said...

Actually, according to the dates listed in the Wikipedia entry, the long boom lasted for 35 years. The Wikipedia entry suggests that the long boom started at the beginning of WW2.

Anonymous said...

The NAIRU is falling because the entry of China and India into the global economy is driving down wage bargaining power.

This is allowing central banks to run monetary policy looser than they would otherwise do. The consequence is asset price inflation - in equities, bonds, property and now alternative assets such as private equity.

Howard and Costello are surfing on the wave of this boom, a boom that is underpinning demand in most major world economies and is increasing pressure for interest rates in many of them.

This is why the Dow fell 200 points last night. And it is why interest rates will rise in Australia, perhaps in July but most likely in August.

But the major point, for anyone who knows anything about economics, is that Costello's claim to be driving the economy and that no-one else, particularly Labor can be risked behind the wheel, is sheer nonsense.

Our economic fortunes are largely being determined elsewhere. But we are lucky to have an independent inflation-fighting central bank and a floating currency (both legacies of Labor men Hawke and Keating) to ensure the boom is preserved.

Costello is a lazy treasurer who piles up surpluses from company tax windfalls and then shovels them out to marginal seats every three years. You call this sound economic management?

hc said...

Damien, I think 16 years is the longest expansion without a recession. We had troughs at the end of 1952, the start of 58, a nasty recession in 1961 and a moderate recession at start 1968, 1972, 1975, 1977, 1983, 1987.

OK I am no economic historian but think the statement that 16 years provides the longest period of economic expansion is correct.

anonymous, I agree China and India might have improved the tradeofff but they were not there for the two decades following WW2.

If China and India are driving a resource boom was is employment growth also strong in non-resource states such as Victoria and NSW.

The one strong feature of Costello's rule as Treasurer is that he has not overreacted and not stuffed things up. That cannot be said of previous Treasurers with sky high interest rates and recessions we had to have.

Give me a plodder who doesn't damage the economy to an imaginative, Mahler-loving dill who stuffs things up any day.

jan said...

Harry, I think your interpretion of the natural rate hypothesis is wrong and hence your criticism unwarranted. What Friedman was stressing is not the static side of things (the level) but the dynamics.

Specifically, it was the fact that the Macro market tends to go back to some equilibrium level that is determined by a number of factors (labour market etc that change significantly over time).

So your approch is like criticising the CONCEPT of equilibrium since you never really get there (due to constant change). It is about the direction of the adjustment mechanism and as such the natural rate is very useful (the fact that we may not be able to estimate it ex ante is a different matter).

derrida derider said...

The one strong feature of Costello's rule as Treasurer is that he has not overreacted and not stuffed things up ... give me a plodder who doesn't damage the economy to an imaginative, Mahler-loving dill who stuffs things up any day.

Fair enough, Harry, tastes differ. But I don't think Kevin Rudd likes Mahler.

That you prefer Costello to Keating is irrelevant - it's Costello vs Rudd we have to look at in a few months. And no-one could accuse Rudd of being either immaginative or a dill; he's the archetypal technocrat. That's why this sort of scare campaign just is not credible. In fact it's the sign of a rattled government.

Anonymous said...

Harry, the benefits of the China-India driven boom do not just flow to the resource industry. There are multiplier effects across the entire economy.

You mention job growth in NSW and Victoria. Much of that is related to the financial services sector, where the boom is fed by the super guarantee levy (another Keating/Hawke initiative).

I think Keating put it well on Lateline last night. Costello really has done nothing to structurally improve the economy. The best thing you can say about him is that he hasn't stuffed up.

And before anyone here raises "the recession we had to have", keep in mind this would have happened whoever was in power at the time.

The recession of 1990-91 was not unique to Australia. The US, the UK and Japan were also in recession at that time.

The downturn was a legacy of the excess of the '80s, in particular irresponsible bank lending and unsustainable property booms.

The structural improvements underpinning our economy now (floating dollar, independent central bank, tariff reform, super, decentralised wage fixing) were all put into place by Keating.

The bigger question regarding Costello and Howard is whether they have properly used the global windfall we have received to improve productivity and protect us during the next bust.

I would say the answer to that question is a big fat NO.

observa said...

"I have never believed natural rate theories. If they were valid why were exceedingly low rates of inflation and unemployment possible in Australia for 20 years after the Second World War? Why are we enjoying record low unemployment and inflation simultaneously now?"

Simply demographics. By the 70s the young adult baby boomers were all trying to squueeze into the workforce, particularly women and at the same time creating insatiable demand. Hence creating more money would directly fuel inflation, whereas nowadays, with that same demographic, it will go straight into assett price inflation for retirement. That will become very apparent when they try to cash in that investment. I the meantime the economy has soaked up the baby boomer labour overhang.

robert merkel said...

Harry, to follow up observa's point about demographics, isn't there reason to suggest that the high rates of unemployment through the 1970s and 80s were at least partly caused by the mass entry of women into the workforce?

Furthermore, how much impact is the impending (and already happening with early retirement) boomer exodus from the workforce having?

davidp said...

There are two problems with many of these comments about the NRU
(1) Many of them seem to be ex poste rationalizations.
(2) The NRU is something like a reduced form equation it being hard to generate an equation for it based on the (micro) primitive parameters for the economy

Ideally we need some sort of natural experiment to examine the NRU - maybe using local labor markets over time (if it is meaningful to talk about local inflation).

ilanit said...

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