We must thank the unemployed for their service. They were used to control inflation.
I want to show you something.
It has to do with our economy and it has probably been invisible to you.
Most journalists have no idea and few politicians either.
But it affects everyone and it shouldn’t be something only economists know about.
Who controls the levers?
In this era of coronavirus lockdown, we have learned a lot about our economic policy settings.
For example, we learned that widespread poverty is a political choice in Australia.
Governments have the power to lift hundreds of thousands of households out of poverty if they so choose.
The federal government did it last year, when it increased unemployment benefits during the initial lockdowns.
This situation lasted for a few months.
But then he let those families fall back into poverty by cutting back on those special payments, as the chart below shows.
We also learned that our decision makers miscalculated something important.
Give me 30 seconds to explain this one.
Over the past decades, this country’s political choice has been to have a national unemployment rate of between 4 and 5 percent, no less.
This is because, since the 1980s, econocrats have asserted that there is a level of unemployment that is “natural” for current conditions.
They called this natural level of unemployment the “NAIRU” – the rate of inflation without accelerating unemployment.
According to their theory, if the unemployment rate falls too far below this “natural” level, wages and inflation will start to grow too quickly.
So they used interest rates as a political lever to try to keep the unemployment rate at, or slightly above, this natural level.
How did they do it?
Well, if the unemployment rate starts to drop and their model tells them it’s very close or has fallen below the presumed ‘natural’ level, they’ll raise interest rates to ‘relieve’ l ‘economy.
It is a euphemism for increasing the unemployment rate or slowing the economy.
It is often the same.
But this policy has come at a real cost.
By preventing the unemployment rate from falling below its assumed “natural” level, they have used hundreds of thousands of unemployed Australians as shock absorbers.
These unemployed people were assigned to the inflation control team without their knowledge. And for their patriotism, they have been ridiculed for being unemployed.
At the same time, successive governments have tightened the screws on unemployment benefits to “incent” these unemployed people to seek work in an economy where there have not been enough jobs for everyone on purpose.
To top it off, over the past two decades, they have also imported hundreds of thousands of workers from overseas, which has helped suppress wages and weaken workers’ bargaining power, as explained. recently the Governor of the Reserve Bank.
So to what extent have they got the better of this “natural” level of unemployment?
Unfortunately, over the past six months, Treasury and RBA officials have publicly admitted that they have miscalculated the level of this “natural” rate for years.
Apparently it was probably lower than they thought.
What does it mean?
This means that the economy could have managed a lower unemployment rate without inflation or wages accelerating, so that the economy was further from its potential than they suspected, according to their own. model.
And that means policymakers could have worked harder to bring down the unemployment rate.
Sorry about that.
Here is the next thing
But let’s take it a step further. Because it’s getting worse.
This strategic framework has never been accepted by all economists.
There are many who criticize the model in place. They say it makes little difference if Treasury and RBA officials now admit their model was slightly flawed because they are only tinkering around the edges of a model that should be completely overhauled or completely scrapped.
And here’s one of the reasons why.
Australian policymakers have spent a lot of brainpower since the 1980s trying to calculate the difference between the real unemployment rate and the supposedly “natural” unemployment rate.
They call the difference between the two “the unemployment gap”.
However, they also admit that they don’t really know what the “natural” unemployment rate is because it is unobservable.
And that means they can’t say for sure how big the unemployment gap is, either.
The “unemployment gap” played a very important role in their forecasts of wage growth and inflation.
Do you see a problem here?
If you rely on an unobservable “unemployment gap” to forecast wage growth, it could lead you to publish wage and inflation forecasts that are repeatedly wrong (as the RBA has been doing for years, see below. below).
Unfortunately, these forecasts are used for federal government budget numbers.
It’s the same with the economy
Now let’s move on to a final step.
Here’s the thing I really wanted to tell you about.
The assumed “natural” unemployment rate and the “unemployment gap” (remember: both unobservable) are parts of a larger analytical framework that has similar problems.
Let me explain.
Since the birth of economics as a social science hundreds of years ago, economists have been obsessed with figuring out where economic growth comes from.
In his early texts, you can see them talking about how growth seems to come from three things – land, labor, and capital – when you use them in a particular way.
But as economics has evolved as a discipline, you can see them become more sophisticated.
They begin to wonder what could be the “potential” output of an economy.
Presentation of the “production gap”
And this is what they mean.
Let’s say you know what your economy is producing right now. What is the highest level of output that your economy could potentially produce without creating destabilizing inflation?
If you think your economy’s output level could be higher (because inflation is too low) or should be lower (because inflation is too high), this means that there is a difference between its actual level of output and its potential output.
They call this difference “the output gap“.
But if there is a production gap, that leaves us with this question: how to bring the real level of production back to its potential level?
Fortunately, you now know how to view this problem.
It’s similar to how you visualized the relationship between the unemployment rate and the assumed “natural” unemployment rate.
If you think the economy is performing below its potential, you are cutting interest rates (or increasing spending) to stimulate economic activity.
If you think it is performing above its potential, you are raising interest rates (or cutting spending) to dampen activity.
But here is the problem.
How do you know what determines the potential growth rate of your economy over time?
Well, according to the theory that has dominated since the 1980s, the potential growth rate is determined exclusively by “supply” sources.
And Australian econocrats express it this way.
They say that the potential growth rate is determined by three things: population, participation and productivity.
They highlight it by calling it the “Three Ps”.
According to their framework, the potential growth rate will increase if the population grows faster, or if more people begin to participate in the labor force, or if the productivity rate increases.
But the Three Ps theory is just that – a theory.
There are many economists who criticize him, who say that he neglects the role that “demand” plays in the potential growth of an economy.
For example, if you have an economy with a deliberately high unemployment rate, with workers with little bargaining power, where wage growth is anemic, millions of households have little disposable income, and wealth inequalities are increasing, don’t you think the demand could be lower than it would be if millions of workers were in a better financial situation?
They say structural weaknesses in demand can be self-sustaining, permanently reducing the rate of potential growth over time.
Anyway, I’ll leave you with an excerpt from this year’s federal budget.
I hope you will see how the econocrats have spoken over your head all these years.
Notice how they explain how the budget figures have been spoken of and how they simply assume that the “output gap” and “the unemployment gap” will come to naught on the horizon as the economy shrinks. will develop.
It’s an assumption they’ve been making for years.
This is their theory on the disappearance of the unobservables, or something like that: