Treasury Secretary Dr Steven Kennedy observed this week that there’s been “a fundamental shift in the macro-economic underpinnings of the global and domestic economies, the cause of which is still not fully understood”. He’s right. And he’s the first of our top econocrats to say it. But he didn’t elaborate.
This week we got further evidence of that fundamental shift. The Australian Bureau of Statistics’ consumer price index for the September quarter showed an annual “headline” inflation rate of 0.7 per cent and an “underlying” (that is, more reliable) rate of 1.2 per cent.
This is exceptionally low and is clearly affected by the coronacession, as you’d expect. But there’s more going on than just a recession. Since 1993, our inflation target has been for annual inflation to average 2 to 3 per cent. For the six years before the virus, however, it averaged 1.6 per cent. And most other rich countries have also been undershooting their targets.
So, part of the “fundamental shift” in the factors underpinning the global economy is that inflation has gone away as a significant problem. But why? As Kennedy says, these things are “still not fully understood”. Some economists are advancing explanatory theories, which the other economists are debating.
Former Reserve Bank governor Ian Macfarlane, who has form for being the first to spot what’s happening, offered his own explanation of the rise and fall of inflation in a recent Jolly Swagman podcast.
Macfarlane says that, though every developed economy’s experience is different, they’re all quite similar. If you stand well back and look at the rich countries’ experience over the past 60 years, he says it’s not too great a simplification to say that two phases stand out: inflation rose in the first phase to reach a peak in the mid-1970s to early 1980s, but then fell almost continuously until we reached the present situation where it’s below the targets set by central banks.
In our case, we had double-digit inflation in the ’70s and rates of 5 to 7 per cent in the ’80s, then a long period within the target range until about six years ago. Since then it’s been below the target “despite the most expansionary monetary policy [the lowest interest rates] anyone can remember”.
So how is this experience of roughly 30 years of rising inflation, then 30 years of falling inflation explained? Macfarlane thinks there are about half a dozen reasons for the worsening of inflation in Australia.
For a start, the growth of production and employment during the 30-year post-war Golden Age was stronger than any period before or since. We had high levels of protection against imports, with little or no competition from developing countries.
We had a strong union movement, confident that in pushing for higher wages it wasn’t jeopardising workers’ job prospects. We had a centralised system for setting wages, with widespread indexation of wages to the consumer price index.
Our businesses took a “cost-plus” approach to their prices. If wages or the cost of imported components rose, this could be passed on to customers, confident your competitors would be doing the same. That is, firms had “pricing power”.
Finally, businesses’, unions’ and consumers’ expectations about how fast prices would rise in future were quite low at the start of the period, but they picked up and, by the end, had become entrenched at a high rate.
“This macro-economic environment was clearly conducive to rising inflation, and it took one policy error to push it over the limit,” Macfarlane says.
Under the McMahon government – predecessor of the Whitlam government – fiscal policy was made expansionary even though the inflation rate was already 7 per cent. Monetary policy was eased, with interest rates remaining below the inflation rate. And the centralised wage-fixing system awarded 6 or 9 per cent pay rises.
So, that’s how we acquired an inflation problem. What changed in the second 30-year period of declining inflation? Macfarlane thinks “the defining feature of the later period was that, in the long struggle between capital and labour, the interests of capital took precedence over those of labour”.
That is, the bargaining power of labour collapsed. In most countries the labour share of gross domestic product has declined, with the profits share increasing. Wage growth has been restrained, union membership has shrunk and the inequality of income and wealth has increased.
‘This macro-economic environment was clearly conducive to rising inflation, and it took one policy error to push it over the limit.’Former Reserve Bank governor Ian Macfarlane
“These features have been most pronounced in the US, but many other countries, including Australia, have shown most of the same signs,” he says.
Two main developments account for this change. First, globalisation. The rapid growth of manufactured exports from China and the developing world pushed down consumer prices. More importantly, businesses and workers in the rich world realised that firms or whole industries could be shifted to countries where wages were lower.
Businesses had lost pricing power and sought to maintain profits by cutting costs and reducing staff levels. Union members became more concerned with saving their jobs than pushing for higher wages.
Second, labour-saving technological advance. In manufacturing, sophisticated machines started replacing workers. In the much bigger services sector, advances in information and communications meant that armies of state managers, regional managers and other middle management were no longer needed. Clerical processes were automated. Call centres were cheaper than a network of offices. Customers could buy on the internet, without the need for shop assistants.
As the period of high inflation passed into distant memory, Macfarlane says, inflationary expectations fell. Inflation expectations – whose importance comes because they tend to be self-fulfilling – change very slowly. It took decades for them to rise in the earlier period and, now, after nearly three decades of moderate and low inflation, it will take a long time before higher inflationary expectations are rekindled.
I see much truth in Macfarlane’s explanation. But it certainly means there’s been a “fundamental shift” in the factors bearing down on the economy – the implications of which we’re yet to fully realise, let alone fix.
Ross Gittins is the Herald’s economics editor.
Source: Thanks smh.com