Mr. Macfarlane reviews monetary policy, growth and unemployment in
Australia Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to the
Australia-Israel Chamber of Commerce in Melbourne on 15/5/97.
It is a pleasure to be here in Melbourne, and to be speaking to the Australia-Israel
Chamber of Commerce. I was very pleased to be invited to address this distinguished group so
soon after I was appointed. If at the end of this address, you feel that I have still left some
important questions unanswered, my suggestion is that your next guest be my opposite number
from Israel. Jacob Frenkel, the Governor of the Bank of Israel, is a distinguished economist, but
a very busy man. My invitations to him to visit Australia have so far been unsuccessful - perhaps
this Chamber can swing the balance.
I want to take this opportunity today to talk about the economy, monetary policy,
and some aspects of unemployment. I propose to do this by looking over a longer period than
normal. Most economic commentary concentrates on very current events and focuses on the
latest monthly or quarterly economic statistics. This is an inevitable result of the news-gathering
process and the need for financial markets to reassess after each new piece of information. In
this environment, the outlook for the year ahead is considered a long time. In my view, even that
is too short - for monetary policy purposes, we should be looking at a period as long as an
economic expansion. That may not be a lot of immediate help to most people because they
would be unsure of what time span was encompassed by an economic expansion. As a point of
reference, the last two expansions have lasted for about six-and-a-half years, but I think we can
do a lot better on this occasion.
Lengthening the expansion
The current expansion in Australia has been going on for about 51⁄2 years, which
is similar to the United States, the United Kingdom and New Zealand, and a fair bit longer than
for countries in continental Europe or Japan. Table 1 shows that over that period we have grown
at an annual rate of 31⁄2 per cent and had inflation of 21⁄2 per cent. Our growth rate has been
higher than nearly all OECD countries, although not as strong as for the countries of east Asia.
Our inflation rate is also very good and close to the average for OECD countries.
The results are pretty good by international standards, particularly since there
should be a lot more expansion still to come. The main reason that I think we still have a lot
more to come is that this has been a low-inflation expansion and remains so.
An important reason why inflation has remained low is that monetary policy has
been determined to keep it low this time. The centrepiece of our monetary policy approach is a
medium-term inflation target endorsed both by the Government and the Reserve Bank. It was
also endorsed by the Treasurer in the previous Government and was incorporated into the
Accord Mark VIII agreed in June 1995. It is not just something we dreamt up at the Reserve
Bank; it has enjoyed wide bipartisan support. And recently, the Industrial Relations Commission
made it clear that they felt their own decision had to take note of this framework.
The statement agreed between the Treasurer and myself at the time of my
appointment saw low inflation as a requirement for sustained growth, which is another part of
the Bank's Charter. Containing inflation is not an end in itself; it is one of the pre-conditions for
sustained growth. It is not the only one, but it is obviously the one for which central banks have
to accept most responsibility.
Table 1: GDP Growth and Inflation
a a
GDP Consumer Prices
Ireland 6.1 2.4
Norway 3.8 2.3
Australia 3.6 2.3
New Zealand 3.6 1.7
United States 2.7 3.1
Canada 2.2 1.7
Denmark 2.2 2.0
Netherlands 2.2 2.9
United Kingdom 2.2 3.0
Finland 1.6 1.9
Germany 1.4 3.1
Japan 1.4 0.8
Spain 1.4 4.8
Belgium 1.3 1.9
France 1.3 1.9
Italy 1.0 4.3
Sweden 1.0 2.1
Switzerland -0.1 2.3
(a) Average annual rate since June 1991
Inflation and growth
We do attract criticism, however, from people who think that because we have an
inflation target it means we are not interested in economic growth. This is not true - as I have
pointed out on a number of occasions. In fact, the reverse is true: we are interested in sustaining
a good inflation performance because we are interested in growth. Let me make two points I
have made before:
(a) The other way of looking at an inflation target is to say that the aim is to
grow as fast as possible consistent with maintaining low inflation, but no faster. We say no
faster because post-war history has taught us that allowing inflation to rise actually harms
growth prospects in the longer term. Strong growth and long expansions have always gone
hand-in-hand with low inflation. Weaker growth and short expansions have occurred in the
high-inflation era, particularly the 1970s but also in some parts of the 1980s. This "no
faster" idea does not mean that we will panic at unexpectedly strong growth over a short
period. It does mean we intend to avoid a "full steam ahead and damn the torpedoes"
approach to policy.
(b) As I said at the start of the talk, we want a long expansion this time. We
do not want the expansion to last only six-and-a-half years and be followed by a recession.
The damage, particularly to unemployment, occurs during recessions. The net rise in
unemployment in Australia over the past 25 years has not been due to prolonged periods of
weak economic growth; it has been concentrated into three relatively short periods of
recession (see Diagram 1). The best thing monetary policy can do to improve our
employment prospects is to prolong the expansion and delay and reduce the size of any
subsequent recession. On occasion, that means easing the growth rates back a bit to
counter inflationary pressures early, as an alternative to more vigorous application of the
brakes when inflation has built more momentum.
Diagram 1
Unemployment Rate
% %
9 9 9 9
6 6 6 6
3 3 3 3
0 0 0 0
1973 1977 1981 1985 1989 1993 1997
Ideally, we should try to eliminate the business cycle (and recessions) altogether,
but that would be too utopian an aspiration. The business cycle has been declared dead before,
only to re-assert itself. I do believe, however, that if inflation is kept under control, this
expansion will be a lot longer than its predecessors and any subsequent downturn kept milder
than in the past. Less pressure would be placed on monetary policy in a late-cycle situation if the
aim were only to slow the economy, than if it were necessary both to slow the economy and to
reduce an entrenched inflation, as has been the case in the past.
Speed limits
Some people would characterise our approach to monetary policy as
incorporating "a speed limit". In a very broad sense this is true. We do not want the economy to
grow so fast that it pushes up wage and price inflation to unacceptable rates. I have already
explained the reason for that.
However, the concept of a "speed limit" is unhelpful if we try to use it
mechanistically. It has been claimed that the Reserve Bank has a rule that the economy cannot
be allowed to grow faster than 31⁄2 per cent. I have seen this claim on a number of occasions, but
can assure you that it is not true. I do not know where it came from; perhaps from observing
historical growth rates, or perhaps from some misinterpretation of things that the Bank has said
on occasion. The figure of 31⁄2 per cent is also sometimes regarded as the Government's target.
Again, I do not know where this claim came from, but it is probably derived from the fact that
government projections, such as those underlying the Budget forward estimates, often assume
average growth rates like this, particularly for the out-years of multi-year projections. These
assumptions should be seen as what they are - an attempt to base government planning on
prudent, conservative assumptions rather than wishful thinking - not as iron-clad limits to
growth or short-term "targets".
There are a number of reasons why it does not make sense to specify a particular
number as the "speed limit" for the coming year. Among those reasons are the following:
(a) Even if we have a clear idea of a long-term average rate of growth, an economy
can clearly grow faster than that when it is taking up excess capacity. This would
be the case if it was coming off a year when growth was a bit on the soft side (as
was 1996, for example) and where inflation was very well contained.
It is not possible to "fine-tune" an economy to grow at the rate you want over the
(b)
space of one year. Neither forecasting accuracy, nor the monetary policy process,
permits that degree of accuracy. Even with very good economic policy, the
economy will grow faster than average half the time and slower the other half.
(c) Just because the economy averaged a particular figure in the past, it does not
mean that this average is the one we should project into the future when thinking
about potential growth. There is some evidence, as is shown in our Semi-Annual
Statement on Monetary Policy, that productivity growth has increased, and hence
it is possible that potential growth may have risen. On the other hand, population
and labour force growth may well be slower than in the past and this would work
in the opposite direction.
I hope I have made it clear that we do not regard economic growth as excessive
because it has breached a particular figure - say, 31⁄2 per cent. We would regard it as excessive if
it is pushing up wages and prices in a way which would cause our medium-term target to be
exceeded. Obviously, the faster is growth in any particular period, all other things equal, the
higher the risk of that problem becomes. But we do not have, and it is not sensible to have, a
doctrinaire view of particular growth thresholds which, if breached, are assumed to generate
problems. The policy process is rather more pragmatic than that, and proceeds by the rather
simple technique of examining the evidence for what it says about inflation pressures in the
period ahead.
That, to repeat, is the test: not whether a growth rate matches or exceeds a
particular pre-determined figure, but whether low inflation performance is being maintained
over time. At any point in time we are constantly monitoring wages and prices and making an
assessment of the outlook over the next year or so. If we get good news and our assessment is
for lower growth in wages and prices, we can, other things equal, let the economy run faster.
This may be done by reducing interest rates or, depending on the circumstances, refraining from
raising them. If on the other hand we are getting bad news, we may have to tighten or forego an
easing.
This idea is not all that novel. It is very similar to the way the monetary policy
process is described in the United States. Our newspapers are full of the latest speculation about
what Alan Greenspan - the Chairman of the Federal Reserve Board - is going to do this month,
next month and thereafter. The big story of 1996 in the United States was that nearly everyone
expected monetary policy to be tightened. The US economy was already at full capacity and still
growing strongly, people expected that inflationary pressures would soon emerge, and the Fed
would have to tighten. On three occasions - July, September and December - the markets were
convinced it was going to happen, but on each occasion the Fed was able to sit on its hands.
Why was it possible to delay the tightening for nearly a year? It was not because the economy
weakened; in fact, it grew faster than initially anyone had forecast, expanding by over 3 per cent
in 1996, well above previous forecasts and economists' estimates of its long-run potential
growth rate. It was because the Fed continued to receive constant feedback from the economy
indicating that rises in prices and wages remained moderate. None of this means that the US
economy is somehow entirely freed from all the constraints it has experienced in the past; only
that, to date, inflation performance has been a bit better than they expected. To that extent, the
Fed has been able to allow the growth to run just a little longer.
No-one would be more pleased than the Reserve Bank to see a similar outcome
for the Australian economy over the next 12 or 18 months - that is, continuing good news on
wages and prices, allowing us to grow faster for longer. It was an assessment of improving
prospects for inflation, and the associated scope for additional growth, that lay behind the three
easings in the second half of 1996. We would like to have seen that pattern of news continued,
but the latest data on wages seems to have been a setback to that expectation.
Other views
Of course, not everyone agrees with this approach. There are those who think a
much higher figure for growth is achievable and should be pursued. Their approach would be to
nominate a figure - I have seen 5 per cent mentioned - and expect the Reserve Bank to adjust
monetary policy to achieve it in the long run (not just for one year).
The trouble with this approach is that it amounts to a gamble with rather poor
odds. While we do not wish to take too strong a view on what is "too much" in any particular
short period, we need to keep a reasonably sober perspective on what is likely to be feasible over
the long run. A growth rate of 5 per cent, for example, is so far above our historical performance
that unless you can specify how improvements on the supply side of the economy have lifted the
potential growth rate dramatically, it cannot be taken seriously. Now there may well be some
significant benefits coming through on the supply side as a result of structural changes and
micro-economic reform. For example, reductions in tariffs and increased competition within the
domestic market are two that spring to mind. We may also be getting something out of increased
flexibility in some parts of the workforce, though the jury is still out at present on exactly how
far that process has brought us. But even though there is some tentative evidence of higher
productivity, I think we have still got a lot further to go before we could be confident that
supply-side reforms have significantly lifted our potential growth rate.
More importantly, our current monetary policy procedures, consistently applied,
should guide us to the right answer without having to take such a gamble. If the economy really
is capable of much faster non-inflationary growth than in the past, constant evaluation of the
feedback we receive from the data should enable us to detect this change. If we receive a flow of
information pointing to lower pressures on wages and prices, for example, we can let the
economy run faster than earlier relationships might have suggested, as in the Greenspan
example. This may not satisfy those with a liking for a punt, because the feedback process takes
longer. But it carries less risk of miscalculation.
Longer-term aspects of unemployment
So far, we have been talking about monetary policy in relation to the business
cycle. I have argued that we should try to maintain the economy in a position of growth for as
long a time as possible. This is best achieved by seeking to remain free of major imbalances, and
addressing those which do emerge as quickly as possible.
But there is a bigger dimension to Australia's unemployment problem than
managing the business cycle. It becomes clear from a consideration of the longer-term history
both of our own economy and those of other countries. What I want to suggest is that a common
perception that if we could only grow faster, unemployment would go away, is missing an
important part of the story.
Consider the data in Table 2, which is for the same group of countries as shown
earlier in Table 1. The table sets out the average growth rate per capita in these countries and
their unemployment performance. This latter concept is measured by seeing how much higher
their current unemployment rate is than it was in the first half of the 1960s. There is one country
where the unemployment rate is now lower, namely the United States. At the other end of the
spectrum, we have the large European countries where the unemployment rate is enormously
higher than it was in the 1960s. We are somewhere in the middle - better than the large
Europeans, but not as good as the United States, the United Kingdom or New Zealand.
We can then pose the question: have the Europeans suffered because their growth
rates were inferior to the United States? Is that the reason for their higher unemployment rates?
The answer seems to be no, because column 1 shows that most of the major European countries
had quite respectable growth rates over this period; for example, Germany, France, Italy and
Spain all grew faster than the United States (or the United Kingdom, New Zealand or us). Their
performance on unemployment has been dismal, not because of their growth performance, but
despite it. Diagram 2 shows that, over this relatively long period, there is no systematic
relationship between the growth of the economy and the change in the unemployment rate (if
there was, the dots would be clustered around a downward sloping line).
Table 2: Growth Rate and Change in Unemployment
GDP per capita Unemployment Rate
Average Growth Early 1960s Latest Difference
1960-1996
United States 2.1 5.7 4.9 -0.8
Norway 3.2 1.7 3.5 1.8
Japan 4.5 1.3 3.2 1.9
Canada 2.3 6.0 9.6 3.6
United Kingdom 2.0 1.7 6.1 4.4
Switzerland 1.5 0.0 5.6 5.6
Netherlands 2.3 0.5 6.2 5.7
New Zealand 1.2 0.1 6.4 6.3
Denmark 2.3 1.5 8.0 6.5
Australia 2.2 2.0 8.7 6.7
Ireland 3.7 5.0 11.7 6.7
Sweden 2.0 1.6 8.4 6.8
Italy 3.0 3.5 12.3 8.8
France 2.6 1.4 12.8 11.5
Germany 2.4 0.7 11.2 10.5
Belgium 2.7 2.2 12.9 10.7
Finland 2.7 1.4 15.1 13.7
Spain 3.4 2.3 21.7 19.4
There are, no doubt, many aspects to this story, which I cannot go into here. But it
seems reasonably apparent that while good economic growth is a very important part of reducing
unemployment, growth will not be the whole answer. If it was, Europe's unemployment
alone
rates would be much more like that of the United States. There is something in the European
system which means that growth is not converted into jobs in the same way as it is in the United
States.
People who have spent a great deal of time studying these issues have come to the
conclusion that the highly regulated labour markets that form part of the continental European
world can often work against the interests of job creation. Such labour markets usually have an
institutional framework which promotes job security, imposes relatively strict minimum wages
and conditions, provides easily accessible sickness and unemployment benefits, and increases
trade union involvement in decisions.
Diagram 2
Growth and Unemployment in OECD Countries
%
•
15
•
••
•
10
•
•• •
•
••
•
5
•
•
•
•
0
•
-5
0 1 2 3 4 %
GDP per capita (average annual growth, 1960 to 1996)
As a result, these systems tend to be good at protecting the interests of those in
work - the insiders, but are often not helpful to the longer-term interests of the outsiders - those
looking for work. Employers are less keen to offer new jobs because of the higher costs and the
difficulty of reversing the decision if it becomes necessary. The unemployed, while having a
more generous safety-net than under a US-type system, are less likely to be offered a job and
less likely to look for one. A high proportion of long-term unemployed is a feature of
continental European countries. Ironically, it seems that measures designed to promote security
of employment may well have the effect of limiting the extent of employment.
I think we know that there are elements of this story in our own case too. It is not
as though the Australian economy has suffered particularly bad growth in the last twenty years.
It grew more slowly than in the 1960s, but everyone suffered that slowdown. We have had
several periods of reasonably solid growth by international standards. On each occasion, we
have, unfortunately, found the limits to growth. But we still have high unemployment by the
standards of the United States, New Zealand and the United Kingdom and, more importantly, by
the standards of what we ourselves regard as acceptable.
Why does our unemployment performance have rather more in common with the
continental European countries than we would like? Is it perhaps because our labour market
institutions also have much in common? Our labour market was never as deregulated as the
United States and we have not gone through recent deregulations to the same extent as have the
United Kingdom and New Zealand. Last year the Government enacted some changes to increase
flexibility through the Workplace Relations Act. These changes, simplifying and streamlining
arrangements and making it easier to strike bargains, seem to be a move in the right direction. It
is too early to judge how substantial the beneficial effects of these changes will be (and it will of
course depend on how much use the parties choose to make of the flexibility on offer). On the
surface, these reforms were less ambitious than those in the United Kingdom or New Zealand.
Changes to labour market arrangements are, of course, politically difficult. One
reason is that the insiders have to give something up. Job security is clearly reduced, and some
hard-won entitlements may have to be relinquished. More flexibility in wage setting almost
certainly entails a wider dispersion of wage rates - that is more wage inequality - and reform of
unemployment benefits would place tougher conditions on the unemployed. It is understandable
that many people are unwilling to make these changes and why they foresee such worrying
phenomena as the "working poor".
Most people in our society, in other words, see general fairness as a relevant
criterion in choosing policy outcomes. As a result, we would not want to go completely down
the US route, with such extreme differences in incomes between senior executives of companies
and the shop floor. But we do not have to go as far as the United States - there is a happy
medium in this, as in most things. All I am suggesting is that we should re-examine our labour
market institutions to see whether they are protecting those in jobs at the expense of those
looking for jobs.
At the same time, while income inequality may not seem fair, unemployment is
not very fair either. Some of our labour market regulations, and many of our attitudes towards
labour market outcomes, indeed some of our very ideas about fairness, stem from a time when
the unemployment rate was 2 or 3 per cent. It was inconceivable then that unemployment would
have an upward trend over twenty years, or that labour market regulation would have any
significant role in that process. But the world has changed, and our ideas about what sorts of
labour market arrangements are appropriate need to change too. This is already happening, as
evidenced by recent reforms. My guess, however, is that this will not complete the process.
Conclusion
I began by talking about the need to lengthen the economic expansion. This,
achieved by keeping inflation at bay, is the best contribution monetary policy can make to the
long-term health of the economy. That long-term focus does not mean that we are too cautious,
that we never take a risk; it simply means that we weigh the risks and rewards of policy actions
over longer time horizons than many of the commentators on the economic scene which fill our
newspapers and airwaves each day.
We want an expanding economy, and low inflation. That offers the prospect that
progress can be made in addressing the rate of unemployment, which remains too high by any
standard in Australia. We fear, however, that the debate about whether unemployment will or
will not reach supposed "targets" over the next year is missing the main point. Faster growth
over the next year or two will help reduce unemployment. But it would be a great shame if that
decline obscured the longer-term aspect to unemployment, which endures beyond the business
cycle.