Thoughts of depression fade to long white clouds

I haven't been posting as trying to prepare for my teaching year - research and golf had high priorities this summer and the procrastination finally caught up with me. Also I am heading off to New Zealand tomorrow for a few days for the annual Economic Theory Workshop at Massey University in Auckland. 

To two things that stood out economically this week for me were (i) the apparent disasterous decline in the Japanese economy - it is entering a depression* and (ii) the worsening economic/financial situation in the UK with growth likely to fall to its lowest level since 1931.   It is interesting that the worst economic responses are being experienced outside the US. In Europe investors fear a Zimbabwean response to economic problems - inflate them away via comnpetitive devaluations - and are dring gold prices to record highs.  It is  frightening.

I am fearful of Australia's economic future particularly irrespective of who is in power.  Desparate times can lead to panicky, foolish policies that reduce long-term living standards without helping those who will cop it in the neck (in the main those already disadvantaged) short-term.  Eventually the tide will turn,both economically and politically, but my feeling is that this recessed state will take several years at least to correct itself.

* As The Australian points out it is Japan not China which has been the major source of Australian export growth in recent years.

Pointless fiscal expansions that swamp us with debt but don't reduce unemployment

I liked this article by Henry Ergas on the likely ineffectiveness of the $42 billion fiscal package introduced by the Rudd Government as it accords with my own macroeconomic priors. For a small open economy like Australia fiscal actions make sense in a standard Mundell-Fleming macroeconomic context if the exchange rate is fixed.  Monetary policy then does not work in this setting since, with international capital mobility, a monetary expansion to drive down interest rates is simply offset by an outflow of capital seeking higher international interest rates abroad.  This was one reason for seeking exchange rate flexibility - to give local monetary policy more bite. Monetary policy effects were then 'bottled up' in an economy and had a real impact.

With flexible exchange rates however, while monetary policy has bite, fiscal actions do not. The only effect of fiscal expansion is to drive up local interest rates attracting capital from abroad and hence appreciating the exchange rate.  This reduces our exports and nullifies the effects of the fiscal expansion.  The standard theory result is that fiscal actions have zero effect if exchange rates care flexible.  Monetary policy is a preferred means of expanding an economy.

As Ergas states:

"Australia is a small, open economy with a flexible exchange rate. There is consequently a real possibility that any increase in demand caused by fiscal easing will merely raise interest rates, induce capital inflow from abroad, appreciate the currency and reduce net exports.

With growth in China and Japan slowing significantly, why implement measures that could exacerbate Australia's expected export downturn?

 In the Keynesian framework, monetary policy, on the other hand, is actually more effective in an open economy. A monetary policy-induced reduction in interest rates boosts aggregate demand and induces capital outflow, leading to a depreciation of the exchange rate and a reduction imports.

As a result, even if we take the Keynesian approach seriously, fiscal stimulus may not only be ineffective, but by impeding or slowing further reductions in interest rates may stand in the way of a more effective response. As Treasury concluded in 2002, "higher budget deficits (or lower surpluses) can have a significant effect on interest rates in Australia", with the result that the "automatic stabilisers are likely to be relatively more effective than discretionary changes in policy". The federal Government must explain why those findings no longer apply".

Of course the Mundell-Fleming approach is only a simplified model - macroeconomists have a range of Ripley-Believe-It-or-Not macroeconomic models that justify any sort of policy action - but I would like to know why the effects the MF model stresses are not appropriate here. The argument that we might be in a liquidity trap where monetary policy is ineffective does not improve the case for expansionary fiscal actions. IMoreover if monetary expansions are taken to keep the exchange rate low then it is these expansions not the debt-incurring fiscal actions that are providing the stimulus. If the fiscal actions are funded using debt as they will be then although huge debts will be imposed on future generations there will be no immediate stimulus now as would be the case were they money-financed.

The standard objection to the Mundell-Fleming model that it is designed for settings where inflation and inflationary expectations don't have a role is not relevant. We have close to zero inflation.  Another objection might be that capital mobility is low because of the financial crisis itself.  That might be true right now but not so if and when the international economy recovers - and the effects of these fiscal measures will operate with long lags.

Those on the left seem to me to support the Rudd fiscal expansion because they support Rudd not because they understanding Keynesian macroeconomics in an open economy. I wish to know why expenditures of $42 billion by Rudd and his mates - which look likely to leave Australia with a huge eventual debt - were so self-evidently correct. Debate itself - and even quibbling about the size of the package - was portrayed by Rudd as something unpatriotic and unreasonable.  Was it that the $42 billion package was primarily designed to threatrically demonstrate that the government was 'doing something'? Indeed to save one job - Kevin Rudd's? The handouts of course appealed to those who simply like handouts.

We will live with the consequences of ineffective fiscal actions which raise debt, but which do not stimulate economic activity, for decades. If the current measures fail there will be inevitable calls by the Keynesian slobs for more and more and our debts will mount.  I am pessimistic.

The Treasury critique of Turnbull

The Treasury isn't adding much by saying that it supports Kevin Rudd's package and rejects that of Malcolm Turnbull. It would have designed the Rudd package and so, in essence, is saying that it stands by its design. In essence this means supporting a large package rather than a smaller one. The claim by Ken Henry that a dollar spent directly by government has bigger stimulatory power than a dollar in tax cuts given to households is correct - it reflects the balanced budget multiplier idea - because households will save some of the dollar. But this only again relates to a defence of a larger package - tax cuts will just have a smaller expansionary effect.

Ken Henry's claim that the smaller package runs the risk that the economy might fall into recession is also correct. But it is also the case that, since the Australian economy is operating in unchartered waters with an especially uncertain international economic environment, that the larger stimulus will have its own risks. It will certainly add more to debt and it will reduce the ability of policy makers to make further expansionary moves in the future if this crisis is prolonged. Fiscal actions are available options now basically because public debt was reduced under the Howard Government. Deficits and debt are difficult to control particularly when a populist social democratic party holds the reins of power and when a gaping public deficit adds to the constraints imposed on an economy by an already weak current account. The AFR this morning has it right:

"Right now the government's financing task looks manageable. But if the worst comes to the worst, it wikll be years before the deficit is brought under control, adding to the burden. If foreign demand for Australian goverrnment debt remains scarce, the government will have to pay higher yields or face a currency depreciation. It - and we - need everything to go right from here".

Moreover, I am completely unclear on how Henry derives the case for his $42 billion package. Econometric modelling will be useless in the current environment because the economy has deviated significantly from its past sample path. That the Labor Party were hedging a month ago on the issue of whether Australia would run a budget deficit and still hedges on the issue of whether a recession is imminent - views that would be motivated by background briefings from Treasury - suggests policy-maker uncertainty is huge.

Under these circumstances the case for moderation and for avoiding a strident policy defense is clear. Certainly the Turnbull proposals should be put on the table and debated intelligently. The hysterics of Kevin Rudd and his inept Treasurer Swan over the past couple of days have been a disgrace. Rudd's earlier talk about the case for greater civility in public life is revealled to be hypocrisy given his insistence on uncritical support for this massive package and for the unreasonable dishonest abuse about ripping up school programs and denying handouts to millions with which he has effectively threatened the Coalition without meeting its points.

Rudd banalities & handout disease

Rudd’s critique of neo-liberalism of course goes too far. His plan is probably to convert the global crisis into a historic failure of Liberal Party philosophy and its allegedly pro-market ideas. That’s a useful output for Rudd from a few hastily drawn-together conclusions that are vague enough to be reversed tomorrow and, even if this seems a bit dishonest, Rudd is a banal politician at heart, who confuses verbiage for honesty. But more importantly his half-baked theories on the failures of capitalism do not in themselves imply what should be done in terms of current policy in relation to the financial crisis. My fear is that that the theory he believes underlies his views will be used as a jargon-driven excuse for a big, mindless ‘Labor Party spend’.

LOL: The Labor Party will fix the economy! Car dealers, the car industry, child care, commercial property, banks have all received bailouts and now the dairy industry wants one. The Labor Party is heavily infected with the bailout disease as well as its inevitably confused social romanticism.

Rudd’s view of ‘government to the rescue’ is already producing dreadful outcomes. Rudd’s $30 billion package - $2 billion from government, $26 billion in government loans and $2 billion from the banks - supporting the property sector seems to have been rushed through following tearful representations from National Australia Bank*. Two days before Rudd made his January 24 statement Lindsay Tanner told the 7-30 Report that the government was only considering options. Two days later Rudd had decided on his course of action without apparently involving the RBA. Recall that Rudd disregarded the RBA in providing the unlimited guarantee for bank deposits - a case study in unintended consequences.

Rudd reminds me of one of my former bosses who arrived in his new job reading a book on how to make decisions in two minutes. I thought he was joking at the time in endorsing this treatise but this excuse for an educated human being made everyone's life a nightmare because he believed his own two minute judgements and invariably got it wrong.

Rudd claims the property move will save the jobs of 50,000 tradespeople. But with this ‘plucked-out-of-the-air’ figure that’s a hefty $600,000 per job as Brian Toohey points out in the Weekend AFR (firewall protected). Moreover, it is not clear that it will save any jobs – as Malcolm Turnbull has pointed out these jobs hardly depend on who has borrowed to buy the real estate that the loans finance. It is the use of that real estate not who owns it that will determine the complementary employment. The move by Rudd is about protecting the assets of banks and transferring valuation risk onto Joe Citizen. Government – particularly Labor - constantly needs to be reminded that it produces no wealth and only transfers privately created wealth to its coffers through taxes and charges.

Falling property prices are to be expected in the current situation and the last thing anyone should want is a government-induced expansion of this sector. The property sector should contract and the shareholders of the big banks deserve a kick in the guts not non-shareholders for backing boards who got it wrong.

Recall too that Rudd crumpled completely in the face of whining from Woodside concerning the exclusion of natural gas from compensation under the emissions trading scheme. Woodside won 100% and nothing was left to fund low emission technologies.

Toohey crisply sums up the Rudd problem:

“There’s a legitimate role for argy-bargy in public policy formation. But when a prime minister is a complete pushover, cabinet should supply constant adult supervision’.

I’d go further than this but I have decided to conceal my bitterness that we have elected poultry for a PM. His existence is like the capital bailout – we all pay the costs.

*It of course helps that property developers are major Labor Party funders.

Keep wages high to increase misery

As unemployment in Australia looks ominously set to soar the mindless are at it again endorsing preservation of real wages in the face of the most serious threat to employment Australia has faced since the Whitlam and Keating years. The reason they claim – keeping wages high will stimulate aggregate demand and the role of wages as a cost of production is exaggerated. It is also, they claim, socially just. Employers can deal with reduced demand for their output by means other than shedding labour – for example by investing in skills. Of course if this argument is valid then why not increase wages when the demand for labour falls – this will really get unemployment increasing at a time of falling Labor demand! Indeed that is the ‘strategy’ (to stretch a term) of the ACTU that I have recently discussed.

Of course, the reason this is so daft is that firms employ workers in terms of the value of their additional contribution to output the workers generate so that when this value falls employment will fall. The extra demand from higher incomes will only reflect extra spending from the diminished pool of those who hang onto jobs. Not from that pathetic lot forced to join the dole queues whose diminished incomes are paid for by transfers from those lucky enough to retain their jobs.

The notion that keeping wages high is 'socially just' is economic illiteracy. It is behind the nonsensical notion that whatever happens the real wage should only ever remain fixed or increase. A social wage can be sometimes preserved by means of government transfers but, in market economies - all economies other than North Korea and Cuba - privately paid wage signals determine employment decisions. The notion that wages themselves should reflect what dreaming lefties believe are appropriate living standards essentially denies the existence of labour markets.

Trade union policies for increasing unemployment

The Whitlam-inspired wage breakout in the 1980s drove unemployment to 10.4%. Another Labor-driven wage breakout in the 1990s exacerbated the recession we 'had to have'. This was Labor's economic legacy. I remember my left-wing mates at the time telling me that 30% wage increases given to metal workers would boost purchasing power and stimulate the economy! They didn't - these sorts of decisions created high unemployment and high inflation - stagflation.

But from December 1995-December 2005 the Howard Government created 1.7 million jobs. In the 18 months to September 2007 another 500,000 jobs were created in an astonishing burst. Inflation was almost eliminated. Howard's reward was to be voted out of office.

Now the Labor Party is at the helm again and, in the face of a looming recession, the real contribution John Howard made to reducing human misery in Australia by driving unemployment to a 33 year low faces the prospect of being destroyed not, in the main, by economic circumstances as much as by idiot trade unions.

According to The Age:

"The union movement is pushing ahead with wage claims despite the Rudd government calling for restraint in difficult times.
The slowing economy will suffer further if the real incomes of workers are not protected, the ACTU says.
Unions are under pressure to moderate their positions during bargaining negotiations with employers after it was reported the CFMEU will ask aluminium giant Alcoa to strike a new deal giving power plant workers at its West Australian operations an immediate pay rise of up to 33%.
ACTU president Sharan Burrow defended the union saying the claim amounted to annual pay rises of between 5-10% over several years.
It was important real incomes were maintained because the economy would suffer if workers could not pay their bills.
"If you don't protect incomes, then that's a negative for the economy as well," she said.
"If working people can't pay their bills, if in fact their mortgage is threatened ... then that's not going to help the economy survive, nor indeed recover."

Apparently Burrows sees the role of wages as a source of aggregate demand but does not want to understand that they constitute a cost for firms and will influence employment because they are a cost. The Burrows policy position is that in times of emerging unemployment wages should be prevented from falling. Her claim is that wage reductions to reflect reduced demands for such things as our mineral exports will damage Australia! This is precisely analogous to the remarks of my friends in the 1980s on the metal worker wage claims.

If anything real wages need to fall in industries experiencing hard times and reduced demand just as they rose during the good times. This flexibility is the best guarantee we have against another emerging unemployment catastrophe. 5-10% wage claims in a time of depressed demands when productivity growth is less than 2% is a recipe for disaster.

The contrary suggestion that higher wages act only to boost aggregate demand is really too stupid to warrant serious analysis but it does show the forces that our intellectually-challenged Treasurer Swan is up against in trying to manage the economy. It is not just a few CFMEU ratbags but the ACTU - those dinosaurs whose contributions funded the current mob of nitwits into Federal power and whio are now baying for payback - who endorse this sad idiocy.

Watch the left of politics duck this issue! Silence will prevail! They cannot challenge this stupidity even though they recognise its craziness because of their blinkered ideological priors and hypocrisy. Their integrity is close to zero in these areas.

Richard Posner recently made the following remarks about US trade unions – they are appropriate to Australian unions as well:

"The goal of unions is to redistribute wealth from the owners and managers of firms, and from workers willing to work for very low wages, to the unionized workers and the union's officers. Unions do this by organizing (or threatening) strikes that impose costs on employers. ... Because the added cost to the employer of a unionized work force is a marginal cost (a cost that varies with the output of the firm), unionization results in reduced output by the unionized firm and, in consequence, benefits nonunionized competitors. Unless those competitors are too few or too small to be able to expand output at a cost no higher than the cost to the unionized firms, unionization will gradually drive the unionized firms out of business.
Unions, in other words, are worker cartels. Workers threaten to withhold their labor unless paid more than a competitive wage (including benefits and work rules), but unless their union is able to organize all the major competitors in a market, the cartel will be eroded by the entry of nonunionized firms, which by virtue of not being unionized will have lower labor costs. The parallel to producer cartels is exact--workers are producers.....
I don't think there's much to be said on behalf of unions, at least under current economic conditions. The redistribution of wealth that they bring about is not only fragile, for the reason just suggested, but also capricious, as it is an accident whether conditions in a particular industry are favorable or unfavorable to unionization. By driving up employers' costs, unions cause prices to increase, which harms consumers, who are not on average any better off than unionized workers are. Unions push hard for minimum wage laws and for tariffs, both being devices for reducing competition from workers, here or abroad, willing to work for lower wages.....And by raising labor costs, unions accelerate the substitution of capital for labor, further depressing the demand for labor and hence average wages. Union workers, in effect, exploit nonunion workers, as well as reducing the overall efficiency of the economy".

Indeed this describes what happens in normal economic times not in the current severe economic situation. Alcoa, the firm subject to the above-mentioned 33% pay claim, is already planning to cut 15,000 jobs. The union stance is madness. Unemployment will be much higher than it would otherwise be because of union and complicit Labor Party stupidity. Without wage restraint now we will have an appalling recession with hundreds of thousands of additional people on the dole.

And chardonnay socialists will declare Kevin Rudd a Great Leader because he has apologised to aboriginees on behalf of us all for claimed sins we had no part of and ratified the impotent Kyoto Protocol but done little to address climate change. November 2007 was an eventful moment in Australian history.

RBA backflip

In hindsight the RBA overreacted to inflation in making interest rate hikes up to March 5 this year when rates peaked at 7.25%. After being cut by 100 basis points last month they were cut by another 75 points today to be 5.25%. Global deflationary forces have removed the risk of inflation and the clear, substantial risk is a severe recession in Australia accompanied by our own mini debt crisis if house prices really crash.  Official interest rates are at their lowest level since December 2003 but still remain high relative to those abroad.

Financial crisis, Australia & unknown unknowns

One of the refreshing incidental features of the current financial crisis is that many economists are displaying uncharacteristic humility. They don't know what is happening and they know that they don't know. Humble pie is also being eaten by supporters of theories that our real savings performance has been boosted by capital gains on the stock market and in house prices. I have even gone a bit quiet myself on the irrelevancy of current account deficits - I am a long-term supporter of the Corden/Pitchford thesis - although still thinking about this one.

A few strident Keenly-alert alarmists are 'predicting' a doomsday as a consequence of the financial collapses but this seems to be media-tartism as much as 'prediction'. A few have predicted a deep U or even L-shaped rather than V-shaped recession in the Australian economy with median estimated duration of about two years. When pressed to back up their judgements these 'experts' appeal to past recession characteristics (which seem irrelevant now) or to the need to make an educated guess - in other words they are guessing but giving their naked guesses a modest cloak.

We can easily gawk and gasp at the startling financial shocks that are occurring around the world but no-one really understands how these shocks will feed into the real economy. How will employment and incomes change? Of course these are the substantive issues.

What are my guesses? I think it is likely Australia will experience a sharp contraction in economic activity over the next few years that is a recession. The share price collapses of the mining giants Rio Tinto and BHP-Billiton - along with a collapse of the Australian dollar - jointly don't make a lot of sense in themselves since the falling dollar should largely offset lower resource prices. But the implication is that more than 50% of Australia's exports are destined to be severely impacted on by the recession. The market is implicitly forecasting much more bad news not less. The 'big end' of town is forecasting a quite severe slowdown. Unfavourable movements in the terms-of-trade and reduced investment activity will end or severely slow down the mineral boom and reduce our living standards just as the boom enhanced them.

The destruction by about 40% of stock market wealth savings - more if you value assets in US dollars - and the fear that the housing market is subject to a threat of near collapse will put a dampener on private sector spending and encourage community-wide efforts at deleveraging. While these are individually rational for households (I have already done it!) and firms these moves will put a dampener on demand and economic activity.

Much of the growth in borrowing in recent years has been in business investment and this will inevitably slow, even if interest rates fall dramatically, as retail sales and other indices fall off.

Could we have a dramatic recession that leaves more than say 10% unemployment? I would not rule out this possibility partly because of the high probability that further adverse financial shocks will occur in response to real shocks engendered by the first round financial shocks.

More specifically however Australian real estate prices have not tumbled as they have in Europe and the US and Australian private debt levels remain high. The claim that there is a housing shortage due to high immigration is fine but a deteriorating economy, and rising unemployment, will raise severe solvency issues among those who took on huge mortgages on the assumption that the economy and their incomes would grow at a rapid rates forever. It is a substantial threat that could ultimately threaten thebanks and lending institutions and call into play the Government's deposit guarantee.

Rudd's fiscal stimulus

Kevin Rudd's $10 billion fiscal expansion package makes some degree of sense as a preemptive way of offsetting the impending effects of a (likely) impending international recession on the Australian economy. This move will complement the recent interest rate cut and the dramatic decline of the Australian dollar as a means of stimulating the economy.

Under flexible exchange rates the main tool for stabilising the economy is monetary policy not fiscal policy.  Part of the effect of a fiscal expansion will be to drive up local interest rates which will to some extent undo the welcome monetary relaxation.

The major effect of fiscal policy, in general, is to determine the allocation of resources across the public and private sectors of the economy. But the current expansion is mainly to increase spending by pensioners and families with children which will primarily drive demand which is probably welcome.  The doubling of the first home buyer's grant will mainly drive up real estate prices and have a negligble effect benefitting new home buyers.

The search by Labor Party yokels for viable infrastructure projects is deeply troubling. It is partly a search by disgruntled socialists for an alternative to to private enterprise. It is also partly a search by third-rate Labor politicians for opportunities to grand-stand. Governments around Australia are retreating from a past commitment towards thinking rationally about public investments. The $1 billion the Victorian Government is wasting on the Northern Dog - the central Victorian attempt to resolve water resource problems by promoting dubious 'water efficiency improvements' - is an early instance of fiscal stupidity.  My fear is that many more stupid projects are in the pipeline.

A comment on Aussie equity markets

Equity markets around the world have fallen dramatically over the past week as fear of the next financial disaster or just fear of the pure unknown has taken hold.  I have no idea what will happen or how long the current crisis will prevail - indeed I am unconvinced anyone does - but I have a few tentative ideas about the current situation at least with respect to equity markets.

The collapse of the Australian dollar and the collapse of Australian export-oriented resource stocks do not make a lot of sense taken together.  The Australian economy seems in much better shape than most other developed economies and, at the present time, our financial system seems sound.  It is difficult to believe that the main sources of demand for our coal, iron ore and food exports will dry up and there has been some relief from the drought.

Consider a stock like BHP-Billion which at $27-74 is now priced at 9.7 times earnings.  Its share price high for the year was just on $50.  It is true that its export prospects have dimmed somewhat with the likely future global recession but the destination of most of its exports remains in the high growth parts of Asia where recession is unlikely.  The price in US dollars of these exports would need to decline by a little less than 1/3 to match the improvement in returns in Aussie dollars that will result from the vastly devalued Australian dollar which has fallen from 98 to about 65 cents US.  And if this reduction in 1/3 did occur that would restore the Australian dollar earnings of this exporter. There would be no further implied need for a fall in the Australian dollar price of the stock of the type that has occurred. I cannot help thinking that (further financial disasters excluded) this stock is massively oversold.

Indeed, looking through the industrial and mining stocks I see a fair bit of apparent value in many places.  Rio Tinto is selling at 8 times earnings and looks even cheaper than BHP-Billiton - an additional bonus is that, if BHP-Billiton's takeover of Rio Tinto does go ahead, it is a cheap way of getting into BHP-Billiton since the target is currently trading at a discount to the takeover offer.

Much the same sorts of observations can be made about the prospects of listed beef and food exporters. They look very cheap at current prices and would seem to have tremendous medium to long-term prospects.

Boring though hopefully safe income yielding stocks like Telstra (13X earnings) at $3-90 and AMP (12X earnings) at $5-89 are yielding around 8% when interest rates look like falling to around 5% over the next few months.  There are plenty of other stocks in similar situations.  Again very cheap.

I am not suggesting anyone hops in and starts buying - I'd definitely at least wait until the market heads out of its current nosedive before doing this.  But I wonder if because I can see real value emerging in the market at present that others might be doing the same. Barring further financial shocks and disasters - OK these do seem reasonably prospective - greed and self-interest should start to drive a recovery in what seem to be very undervalued Australian stocks.

Swan implements Turnbull's policy after misrepresenting & attacking it

Swan implements Turnbulls's policy. Yes, the Australian government will buy home mortgages - an amazing backflip involving $4b. OK, so no-one really knows what they are doing in the current volatile situation but sometimes the low-brows in the government's benches might consider opposition suggestions.

Anyway imitation is the sincerest form of flattery. After criticising Turnbull's pronouncements Swan is doing exactly what Turnbull suggested - to buy mortgages in order to increase competition in the mortgage market.

Federal Budget 2008

I've been busy and found it difficult to assign time to assessing the budget. Clearly the Labor Party has inherited a fabulously prosperous economy - that the terms of trade is due to increase by so much over the next year is astounding and should dominate our impressions of where the Australian economy is going.

The bugdet response has been to award miserly tax cuts to lower income groups and to defer them for higher income groups and to run a massive budget surplus. Much of the surplus is to end up in investment funds to be spent on infrastructure, health and education.

This budget is therefore a beginning not an outcome. The main issues are how these funds will be allocated and how they will be spent when the economy is close to full employment. Project costs will be high so there is the prospect that returns on these investments will be under pressure. There is the possibility Labor will use them to pork-barrell in 2010 but they may surprise and spend the money wisely. It is a beginning.

Longer term these surpluses belong to the citizens of Australia not to the Labor Party. It is unsatisafactory for tax rates to be set so high that the government runs massive surpluses.

The funds can only be spent with a continued commitment to Labor market reform that prevents cost push inflation from emerging. The economy should be able to reduce unemployment still further and guarantee longer term better wages if the link between wages and prices can be broken.

I was less-than-impressed by the response of the Coalition to the budget. Malcolm Turnbull's responses on alcopops taxation added a bit of comic relief however. His claim was that the tax could not seriously target youth drinking because revenue to the government was forecast to increase with the tax! This is incorrect since the demand for alcopos clearly will slope downwards. The tax can still yield additional revenue if the price-elasticity of demand for alcopos is low enough. If the price elasticity is high then the tax will substantially reduce consumption but (contrary to the expectations of Treasury) yield less tax.

Update: John Quiggin makes a scathing attack on Brendon Nelson who has apparently followed Malcolm Turnull in criticising the alcopops tax. As I publicly supported the Government in increasing this tax two weeks ago I've got to agree with John that the criticism of the increased tax is foolish politics that suggests foolish policy sense. Taxes on alcohol in Australia are approximately volumetric which makes sense if you believe (as I do) that alcohol is a neurotoxin - they are not quite right however as the alcohol in beer is taxed less heavily than that in spirits. I favour a hefty tax on alcopos because these drinks are directed at youth and at ensuring an ongoing dependence on booze.

Health tourism

I posted recently on the booming market in Thai exports of health services. Americans and Europeans are travelling in droves to Thailand to take advantage of lower costs of health services there. I sent a copy of the post to a well-known Australian trade theorist and his immediate response was – why doesn’t Australia get in on this act?

I agree and so too does the Managing Director of the Australian Tourism Export Council. His argument – having a sound international reputation for health services would encourage heath tourism and regular tourism among those with health concerns. It would also lead to having improved health facilities available for Australian residents. We would have to pay more for our health services - unless discriminatory pricing was enforced via, for example, a tax on health exports - but economically Australia would enjoy gains from trade.

The impending wages explosion

I posted last week on the teachers’ pay decision in Victoria and the dangerous potential for flow on effects that will drive high inflation and create a much larger pool of unemployed. I indicated that I hoped to be wrong on this issue - I lived through the misery of high cost-push inflation and high unemployment during the 1970s and 1980s. It is no joke.

Rudd is trying to suppress release of the Treasury critique of Labor’s foolish IR policies. These will add to inflation and unemployment. But the trade unions can do much more damage than this. They have already made their views clear. The following passage from The Australian is worth studying. Australia faces an impending wages explosion unless Kevin Rudd gets serious about dealing with these trade union fools who evidently seek to damage the interests of labour in Australia:

‘….unions in Victoria vowed to chase annual pay rises of up to 6% for the next 3 years to compensate for the 4.2% inflation rate and suppressed pay under John Howard.

Victorian Trades Hall Council secretary Brian Boyd told The Australian a deal struck by teachers in Victoria endorsing pay rises of up to 15.2% exemplified the catch-up increases unions wanted under the Prime Minister.

"I am quite aware that a number of key private sector unions and groups of workers are arguing for 5% (a year) to get ahead of that 4%" he said.

"There are agreements already being looked at around 15% over three years, and some will even go to 18-19%.

"(It's) not only to compensate for inflation but also to compensate for the restriction on the ability you had for decent wages under the previous government."

The Australian understands the pay push includes unions in the construction, manufacturing, transport, electrical and plumbing sectors. The Victorian teachers' deal has also buoyed public servants across several states - including teachers and nurses - on the verge of pay negotiations.

The wage push came as Brendan Nelson demanded Mr Rudd release Treasury advice prepared in February showing whether his industrial relations reforms would drive up inflation.

….Mr Boyd said the Victorian teachers' deal was a "good case in point" of unions playing catch-up after wages were suppressed under the Howard government.

"There has been a lot of wages curtailed in the last 3 or 4 of the Howard government and people are trying to catch up," he said.

Ordinary working people were not responsible for rising inflation, but were entitled to receive compensation for higher petrol and grocery prices, he said.

"The union movement is an independent voice for trying to find a fair market price for workers they represent in the capitalist market place," he said.

"We have put up with 11 years of IR laws that have been aimed at restricting our ability to find a fair price for labour.

"Just because (John) Howard got elected for a decade doesn't mean we accept that these harsh IR laws were justified in restricting our ability to find a fair price for labour.

"So I have no qualms in saying if we want to play the catch-up game for wages and conditions, we'll do it."

Mr Boyd said he did not accept the wage push would exacerbate game for wages and conditions, we'll do it."

Mr Boyd said he did not accept that the wage push would exacerbate inflationary pressures. "Ordinary working people didn't cause the inflation situation," he said. "Other factors caused that. The oil price internationally is one of them, and grocery prices going up has nothing to do with what workers do.

"They're entitled to get compensation for that. That's why I'm calling it a catch-up process, not a breakout process."

Mr Boyd denied the pay push could lead to a wages breakout. "It's not really a wages explosion, in my view. It's a catch-up that is currently going on because of what happened over the last few years of Howard," he said.

"It's making up lost ground. I think there should be an understanding that a lot of the workforce across the country, not only in Victoria, are viewing their situation in terms of inflation and (consumer price index) rises, in terms of the cost of living, in terms of petrol prices and power prices, and so on".

If Boyd and his crony economic-illiterates can't achieve these objectives then well-and-good. The difficulty is if they can and unions in Australia start playing 'wage catch-up'. Once-and-for-all price hikes will then translate into inflation and eventually the need for a major monetary contraction.

But the key task for Kevin Rudd is not budgetary. It is to talk down the demands for an instant wage nirvana in Australia. It is to put the trade unions in their place and to reinitiate the processes of labour market reform that Rudd has so foolishly quashed.

Treasury effectively denounced Labor's IR policies

All my long held criticisms of Labor's IR reforms - that they will trigger job losses, worsen inflation and increase interest rates have been supported by the Commonwealth Treasury in its analysis of the plan to abolish WorkChoices. According to The Australian:

"...the secret Treasury advice, the department, under Treasury secretary Ken Henry, concluded that the abolition of AWAs and the return of guaranteed penalty rates would cut jobs, put "upward pressure on prices", create more "flow-on" wage claims from sectors such as mining to less productive sectors and allow unions to "bid wages up above their market level".

"The shift to a more centralised wage system might reduce employment and increase inflation. For example, higher unit costs, either through higher real labour costs, lower productivity, or a combination of both, will place upward pressures on prices, which effectively lowers real disposable incomes, consumer spending and thus employment. The rate of flow-on of wage increases from high-productivity firms and sectors to low-productivity ones may increase. Reinstalling union power will raise the ability of unions to bid wages up above their market level."

In addition abolishing unfair dismissal laws will cut jobs, increase red tape for small business and make it more difficult for people to move from welfare to work.

Treasury said WorkChoices was "expected to allow a more expansionary monetary policy setting and result in higher rates of employment".

Where's Labor's cheer squad on this one?

This document was written before the last election but despite Julia Gillard's denials it is definitely applicable to Labor IR policies. The unemployed of Australia and those facing higher mortgage repayments and higher inflation can attribute part of these problems to inept Labor IR policies and to those sections of the leftwing intelligensia who, against all reason, supported these particularly inept and foolish proposals to reregulate the Labor market.

Brumby's cave-in to the militant teacher union

Victoria’s 43,000 teachers secure wage increases of up to 15.2% as Premier Brumby caves in. Victoria’s teachers become the highest paid in the country with starting salaries for graduate teachers being $51,184 – an increase of $5000. Mr Brumby declared that the $2 billion budgetary cost would be offset by productivity improvements – teachers will work an extra 10 minutes per day.

I suppose at least he didn't award their ambit claim of 30%!

One teacher a Jason Pietzner said he ‘was still coming to grips with what the deal would mean over time. It says we will be the highest paid teachers but I wonder if that will be the case in three years' time after the other states have struck new deals’.

The Victorian taxpayer clearly has more to look forward to.

Melbourne’s Pravda called the deal a 'win-win' outcome. The teachers get more money and the government will get greater teacher productivity. I agree with the first part of this claim.

Last September the Victorian Government awarded police salary increases of 14%. Public service unions around the country are lined up for their next round of wage negotiations and will undoubtedly insist on parity. Wages have been galloping away for state public servants around Australia in recent years. Sharon Burrow has told workers they are not responsible for inflation and deserve to be compensated for foreign fuel price increases and food cost rises.

Federal Workplace Relations Minister Gillard urged ‘restraint across the economy’. Should I laugh or cry?

My expectations are that, with Labor holding a monopoly on political power in Australia, there will be a dramatic economy-wide surge in wages over the next year or so followed by rapidly rising inflation, huge rises in interest rates followed by a severe contractionary monetary policy needed to get things ‘back on track’ that will lead to hundreds of thousands of low income Australians being unemployed. The Coalition will be returned to power both Federally and at the State level around Australia but another generation of Australians will have their lives devastated by the latest batch of incompetent Labor yahoos.

I really do hope I am wrong on this one.

Don Harding on RBA policy

My colleague Don Harding has a forceful piece on monetary policy in today's Australian. He argues that the RBA has not tightened monetary policy since the real rate of interest has fallen slightly. True Don but those nominal increases in interest rates do impact on consumers faced with assets not appreciating at the rate of inflation so that borrowers can take out loans to cover their higher nominal costs without any real impact.

I agree with Don that the RBA have shown flexibility in not mechanically responding to external price shocks via a Taylor rule. It makes sense not to do so if these shocks are price increases that are not necessarily the start of an inflationary process.

Don argues that the danger with the RBA's 'softly, softly' policy is that inflation may emerge unchecked. I agree but see the problem here mainly as an issue of preventing wage increases to match cost-of-living increases that are exogenously imposed on us. Its the reason I* worry about Labor's political debts to the trade union movement. RBA policy itseklf seems to me quite sound.

Australia's emerging debt crisis

Over the past few years I have repeatedly referred to the effects of rising debt in the Australian economy – most recently here. Australia has been on a huge borrowing binge that follows closely - if not so severely - what has happened in the US and the UK. Our solid, persistent economic growth and our avoidance of recession for 17 years has sharpened the community appetite for risk and led to a situation where we hold too much debt.

It annoys me intensely that the RBA and many economists – some doubtless drawing lucrative financial consultancies from the banks – have been telling us that debt is not too high given the growth in the share-market and in asset values, in terms of the ratio of interest payments to incomes and so on. These explanations work only if incomes continue to rise, if interest rates remain low and if asset markets continue to grow in value at unsustainable rates.

The human and practical dimensions of Australia’s forthcoming debt crises (plural) were well portrayed on Four Corners this evening. If you didn’t see it you should. We need to consider at least partial reregulation of the financial system so that we do not rely mainly on the self-regulation of lending practices by the inept and immoral major banks.

From the blurb for ‘Debtland’:

Mortgages doled out to people on disability support pensions; loans to refugees with no English and no jobs that leave their families with next to nothing to live on; home loans so large they push borrowers below the poverty line…

This isn’t America’s sub-prime meltdown – it’s Australia’s debt debacle, the legacy of a credit binge that’s sent household debt through the roof and lending standards through the floor. Now the hangover is kicking in.

As many as 300,000 Australian households may be at risk of losing their homes. It mightn’t take much – another rate rise or two, a family illness or maybe just the car breaking down – to send people under. And for thousands more who are better off but feeling the pressure, this credit crisis is getting too close to home.

Dianne and her family are frontline casualties. Their home is being repossessed after constant refinancing landed them with two mortgages, one at 10% and another – on terms they didn’t understand - at 20%.

Four Corners meets them as they despairingly pack their belongings and give up the keys. Why did they take out loan after loan? "Because they keep giving them to us," is Dianne’s blunt reply.

It’s not just fringe lenders but also big banks which have pushed unaffordable credit. "We lent to whoever we could and as much money as they wanted," admits a former bank credit salesman.

Four Corners reveals how one major bank dished out unsustainable loans to numerous refugee families in one area. Some had no English and no job. In one such transaction a nine-year-old girl acted as interpreter. Elsewhere a disabled pensioner tells how her welfare cheque and small part time wage were enough for another bank to lend her $200,000. She is now in penury.

These cases exemplify how lending standards have slackened. Not long ago the rule of thumb was that mortgage payments should not exceed 30% of gross household income. Now lenders leave borrowers teetering on the poverty line.

Mortgage stress is compounded by plastic debt. "The banks are just handing out money on credit cards like there’s no tomorrow… It’s quite terrifying to think that the average household… now has three months of their disposable income on a credit card balance," says one analyst.

All the rage now are store-branded cards offering in-house credit with zero to pay for several years – then, typically, punishing interest takes effect. More than 10,000 stores offer these cards and many shoppers have several of them - but behind nearly all of them is one global financial colossus. [General Electric].

Many Australians have gone deep into the red to fund a newfound love affair with the stock market. The amount they have borrowed to buy shares now equals the total they have racked up in credit card debt. And as Four Corners discovers, when the market plunges and a margin call comes, some people are just reaching for the plastic…

Reporter Stephen Long surveys the human wreckage of the household debt crunch and looks at the key players and tactics behind recent aggressive lending. Long’s disturbing report also throws doubt over the data that banks rely on to make crucial lending decisions.

Three monetary pessimists

As I argued in a recent post it is important for Australia to anticipate the likely success of US Federal Reserve moves to avoid a long and severe US recession. These three monetary economists are pessimistic and believe recession is a sure thing and that it will be long and severe. This suggests that commodity price pressures currently driving Australia’s terms of trade as well as local inflation will moderate the US economy weakens. To state the obvious it also means that Australia’s RBA must exert caution with respect to future interest rate hikes lest it induce a local recession here. Indeed the need to be flexible about possibilities for reversing interest rate movements might become apparent over the past year.

Thus although I have argued that the RBA are correct in placing heavy weight on limiting inflation and on maintain credibility for doing so (see here) I take the following pessimistic views seriously.

1. Nobel Prize winning economist Edmund S. Phelps takes a pessimistic view of control possibilities in a modern economy. He rejects the possibility of fine-tuning using monetary ‘financial engineering’ based on standard risk analysis as conceit. He foresees higher US interest rates and higher unemployment for wealth effect reasons – current monetary policies will only have short-term effectiveness. I agree completely – I am disgusted with the way contemporary macroeconomists trot out ‘natural rates of unemployment’ as guides as to whether the economy should be expanded or contracted. As Phelps notes the US natural rate will be higher now than in the past because of financially-induced long-term job destruction in the US residential investment sector. The natural rate idea is so volatile that it is not a useful guide to thinking about macroeconomic policy. Australia’s RBA said last year they don’t use the idea in their policy analyses and that seems sensible to me.

2. Gloomy Paul Krugman also believes that US monetary policy will fail and anticipates a long and deep US recession. It is not that the increasingly ‘desperate’ (Krugman’s word) Federal Reserve is not doing a lot – it is just that the scale of the US woes is so vast. The Fed is buying $400 billion worth of insecure bonds backed by mortgages – this is half of its available funds. To Krugman the current US difficulties look like becoming one of history’s great financial crises with the Fed bailing out the banks but the banks still being unwilling to lend. He seems these monetary woes as the major task of the next US administration. Ugly economics will create ugly politics.

3. David Roche completes the triumvirate of monetary pessimists. Hedge funds and other NDFI (non-deposit taking financial institutions) are now being hit by the credit-crunch. Roche says some strong things:

‘Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline’.

‘Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.

We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.

Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time’.

Meanwhile there is value in trying to shut the gate even if the horse has bolted.

Macroeconomic issues at Blogocracy

I joined with John Quiggin in responding to the following macroeconomic questions over at Tim Dunlop's Blogocracy.

• Has the Reserve got its policy settings about right? In other words, have they overplayed the interest rate card, or do you think we are in for more rises in the next six months or so?
• The Rudd Government is making much play of its so-called five-point plan to tackle inflation long-term. Do you share their diagnosis about what needs to be done? They say the keys are (1) fiscal constraint—cutting back government spending (2) measures to encourage savings (3) measures to increase the skilled workforce (training investment etc) (4) identify and fund (probably via public-private programs) major infrastructure projects (ports, for eg) (5) lift workforce participation. Is this more or less how you would approach the matter?
• Can the government really achieve the sort of spending cuts they claim to want without getting rid of so-called “middle-class welfare” policies such as family allowances and negative gearing?
• What is different about the US economy—where they are lowering interest rates—and the Australian economy, where we are raising ours?
• The proposed tax cuts I suggest are a political necessity - a promise the new government can’t afford to break. That aside, what do you think of them from a economic viewpoint? Stay or go? Good or bad?

I'll wait to see how the discussion pans out at Blogocracy before I think about posting an update here.