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Snapping the inflation stick

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When I last sat around this table four months ago Chris Higgins was sitting beside me. I worked with Chris in Treasury from the time he returned to us from the OECD in Paris to his sudden death last December, and I know all of you here who worked with him over the years will feel with me when I say we lost a great Australian as well as a friend and


Chris died in the midst of his career but he was already a veteran of the economic policy struggles of our times. He was in Treasury here during the world stagflation of the seventies, which demonstrated to us in Australia that the

easy post war years had ended. He had later seen the second oil shock and the second great inflation of the early eighties. If there was one single lesson of those years upon which Chris insisted it was that we should never underestimate the social and economic costs of persistent high inflation, or the benefits of switching to a low

inflation path. For him it was not just a matter of growth but also a matter of equity. And it was not just a superficial if chronic problem, but one that hurt Australians

in substantial ways and which we could do something about. Its a sad irony that he died when the Australian economy had for the first time in two decades come within reach of fulfilling his great hope that we could rank with other advanced OECD countries not only in the openness of our economy and in our common belief in the vitality of markets, but also in the stability of prices. That is something I want to say more about a little later.


Today Tony Cole is with me for the first time. Tony too is a well trained economist with a strong policy background. He returns to us fresh from a sterling performance as head of the Industry Commission. You do not have the opportunity to make many friends as head of the Industry Commission. It's a

testimony to Tony's straightforwardness and integrity that he leaves it with so much good will. I know from observation that his new job is one of the most complex in the country and I ask you to join with me in welcoming him to this table as Secretary to the Treasury.


Since I addressed EPAC in November last year we have continued to experience difficult times in the Australian economy. The downturn in activity has continued and it is still too early to say we have touched bottom. To my great

regret in the last six months we have lost jobs. But we are now beginning to see some of the rewards of a consistent policy in dealing with our current account and inflation problems of the late eighties.

The current account deficit for the six months to December was around 30 per cent down on the current account deficit for the same period of a year before. Despite the fact that commodity prices and the terms of trade have been weaker than

expected, the current account outcome for 1990-91 is likely to be close to the Budget-time estimate.

Nothwithstanding dramatic oil price increases, import price increases flowing from a lower exchange rate, and increases in State charges, we have made significant progress in reducing our inflation rate. The consumer price index rose 3.4 per cent through the six months ending December, compared to 4.2 for the same period a year before. As the petrol price increases unwind in the next two quarters we expect to come within the budget forecast of 6.0 per cent over the year to the June quarter 1991.

More important than the measured CPI is the underlying rate, which excludes transitory influences on consumer prices. The underlying inflation rate over the six months to December was only 2.1 per cent. Over the year to the December quarter the

increase slowed to 5.4 per cent.

Compared to Budget-time forecasts GDP growth has been slower than we expected. Growth will be flat at best over the year, though I believe we are approaching the bottom of the growth trough.

The comparison with our Budget time forecasts gets to the heart of what has become an intellectually lazy debate about the whys and wherefores of recession. I think it's time I pointed out a few of the salient facts. The first is that I


readily concede - not for the first time and no doubt not for the last time - that the downturn in output is steeper than expected. There is no secret about that. You only have to look to my Budget-time forecast for GDP to see what the best

judgment was in August.

But the second point I'd make is a lot tougher. It underlines the difficult choices we must make in economic policy. It's a point the critics don't make. Despite the recession, inflation and the current account are still too

high. If growth had been higher - if it had been in line with Budget forecasts - then inflation and the current account deficit would in all probability be a good deal higher than they are. We would have had the pain of high

interest rates and a growth slowdown. We would have had lost output and lost jobs. But we would not have had the gain on the current account and inflation.

The price we are paying to fix inflation and the current account is high. But let me say this: having paid it, let's not blow it.

Before I leave this subject let me add a word about the choice of instruments of policy. From time to time I read that we have recession now because we chose to use monetary policy rather than wages policy or budget policy to slow the boom. Well, I want to ask those critics to reflect with me on the Australian experience of the eighties.

From the time I became Treasurer in 1983 to the end of 1987 we had sharply falling real unit labor costs. The result, which we wanted and foresaw, was higher profits and then

higher investment. Beginning two years after I became Treasurer we had sharply increased government saving, and the result - which again we wanted and foresaw - was a crowding in of private investment. Both policies were so successful

that when a terms of trade surge tipped the scales we found ourselves in the second half of the eighties with an investment boom and its automatic result, a rapidly expanding current account deficit. So great was the boom that it also

threatened our wages policy and our inflation performance. So heady was the atmosphere it created that there were clearly speculative elements driving its expansion.

Now, how do you deal with an investment boom based on increased public saving and falling real unit labor costs? Our critics thoughtfully tell us we should have cut unit labour costs more, and increased public saving more! We

should have slashed real wages and increased the budget surplus. No advice could be more unfair or more dangerous. Instead we did the right thing and the only thing - we increased the cost of investment and broke this speculative bubble directly by raising interest rates.


Comparing this downturn to 1982-83 we see some important differences. We have lost jobs in this downturn. We may lose more. But the loss is very much smaller than 1982-83 because wages and gross profits are in much better balance. Ομτ unemployment rate may rise further, but it has an

entirely different meaning. In 1982-83 the measured unemployment rate was cushioned by a falling participation rate - by discouraged workers leaving the workforce. Taking hidden unemployment into account, the figures in 1983 were much worse than they appeared.

I don't make this point merely to defend our record. I make it to draw an important conclusion about the path of our coming recovery. As the economy took off after Labor's election in 1983 we needed to expand employment enough to recover the backlog of joblessness we inherited. We needed to create more than one job for every unemployed worker, because whenever one unemployed Australian found a job, others were encouraged to rejoin the pool of those seeking employment. And we not only had to grow to recover jobs. We also had to simultaneously correct a low profit share, a structural budget deficit, and an overvalued currency.

But in this downswing we have seen little evidence of a significant change in the participation rate. It follows that in the upswing, employment won't need to grow as rapidly to have an equivalent impact on measured unemployment. Unemployment will fall with quite moderate rates of growth of GDP. That will reduce the pressure on prices and of course on the current account. For the first time in decades it becomes possible for us to have a low inflation recovery path

and reduce unemployment. And where in the last expansion, cuts in real unit labour costs encouraged employment growth so rapid that there was little room left for increases in productivity; in the next expansion we expect to see a

return to our historical trend rate of productivity increase, or perhaps better. That in itself will make a great deal of difference to our ability to sustain a low inflation path, and increase living standards.

Policy Stance

Policy is now set to achieve a low inflation upswing which can set us on a path of sustained low inflation output and employment growth.

In November 1990 I renegotiated our accord with the ACTU. It will deliver a nominal wage increase of no more than 6.25 per cent in 1990-91. We are now moving further toward a decentralised wage fixation system based on enterprise


The fiscal balance has of course changed as the automatic stabilisers of falling tax receipts and increasing unemployment benefits have altered the numbers forecast in August. The Budget is therefore performing its normal role


of cushioning the impact of the recession. The estimated surplus at Budget time was $8.1 billion. The estimate is now much lower - $1.7 billion. The overwhelming reason for the lower surplus is the recession. We estimate that the downswing will slice $2800 million off estimated revenue. Additional unemployment benefits add $400 million to

outlays. On top of that, the Opposition's rejection of the sale of the pipeline authority and assets tests for family allowances will add $750 million to outlays.

Revisions to receipts involving PAYE and PPS refunds have cut revenue by $640 million. Tax cuts associated with the new wage agreement have reduced receipts by $430 million.

The Gulf War has added $280 million to outlays in wheat default payments and increased defence spending while wool industry assistance has added $275 million. Other minor outlay decisions have amounted to $130 million.

It's important to note that the change in the surplus is coming from the downturn. As activity recovers the surplus will rebound. For this reason we will not be taking action to offset the impact of the cycle on the surplus. To do so would only worsen the recession.

Let's remember too that for the first time in post war history this year we will have a Commonwealth Budget surplus in a recession year. That is how tight a ship we have been running.

The Budget will remain in surplus in 1990-91 and the Commonwealth remains a net saver, but the surplus will no longer be sufficiently large to cover all maturing Commonwealth bonds this year. For this reason, the Treasury will today be announcing a bond tender scheduled for April.

This will not add to the stock of Commonwealth bonds on issue.

With $5 1/2 billion of bonds maturing in 1991-92 regular tenders will continue to be held to refinance maturing bonds.

Monetary policy has eased considerably over the past year Short term nominal rates are not very different to those prevailing before we began tightening in early 1988. Yields on long terms bonds are now at their lowest level for about a decade. Given the 600 basis points fall in short term rates over the last year, the direction of monetary policy is compatible with steady expansion and there clearly remains

room for banks and other financial intermediaries to lower their margins. We will continue to closely monitor monetary policy so that it is consistent with our growth, inflation and current account objectives.



We cannot yet be certain that we have reached the bottom of the trough. Nor can we say with confidence when we will have the first clear evidence that the upswing has begun. But I am certain that like all cycles the recession will end, that the upswing will commence, and that we will begin to see evidence of it before very long. Monetary policy has been eased quite sharply over the past year. As well as the automatic Budget stabilizers I mentioned, tax cuts with an annual value of $3.5 billion were paid beginning January 1

1991. The Accord has secured a favourable wage outcome. Inflationary expectations are declining. Although there is much uncertainty, the world economy is continuing to expand,

we have already seen a reversal of the oil price increases caused by the Gulf war and we may soon see a successful end to the war itself. There is every reason to expect a return to growth in the housing sector, stronger consumption, and

rebuilding of stocks, ahead of a general economic expansion.

There is no question in my mind that the upswing is coming. What concerns me far more is what kind of upswing we want to have, and what kind of long term expansion path it will lead to. The fact that we entered the recession with a more

competitive economy, with a structural Budget surplus, and with the profit share restored gives us the makings of a expansion path quite different from those we have experienced before in the Australian economy. The fact that we will

emerge from recession without the huge backlog of discouraged workers we found when we took office in 1983 gives us more control over the pace and characteristics of our expansion. We now have the option to choose a different expansion for

the Australian economy. The issue is whether we now have the confidence in ourselves, the faith in our maturity as a nation, to do it.

A Low Inflation Recovery and Expansion Path for Australia.

This brings me to the issue on which I wish to dwell this morning. Despite the temporary influences bunching in the December quarter inflation result, we are now within reach of a historic transition in Australia. For the first time in

nearly two decades we have within our grasp the chance to move to a low inflation growth path.

On a casual inspection the December quarter rise of 2.7 per cent might imply we should postpone a discussion about what a low inflation path might mean for Australia. We are told it is premature to claim victory. But we should not proceed as we sometimes do in Australia, with the well known actors

repeating their well known lines from a script that is no longer relevant, refusing to recognise that change is occurring until it suddenly dawns on us that the world no longer resembles the one to which we have become accustomed.


Now I know some of you are worried that we might have low inflation numbers for the next couple of quarters, but they will then begin to rise as output and employment rise over the coming year. In 1985, we saw a major cut in inflation

before it resumed a rate of around 7 per cent. But the circumstances today are quite different. In the mid eighties we had to correct the squeeze on profits, which constrained investment. Today the gross profit share is well above the

level of the early eighties, despite the pressure on profits which inevitably accompanies an economic slowdown. Until the mid eighties we still had an overvalued exchange rate and an economy that was only beginning to become competitive

internationally. Today real unit labour costs are more than 10 per cent below the peak reached in the September quarter of 1982. Compared to our major trading partners our real exchange rate today is more than one fifth below - or our competitiveness one fifth above -its level in 1982. And finally in the mid-eighties we were reaching the limits of output capacity. Today we are benefitting from the late eighties investment boom, which added substantial new capacity - in office space perhaps a tad too much.

The average inflation in the 1980s was much less than the seventies. Our inflation performance was much better than our critics predicted. We went right through the late eighties boom - and this was an unprecedented achievement - with no acceleration in the inflation rate. But nonetheless

simple arithmetic tells us we could not have a sustained low inflation rate and at the same time a rapid increase in the profit share, unless wages fell in nominal as well as real terms. We could not have a sustained low inflation rate and

at the same time a major correction of an overvalued exchange rate and the inevitable accompaniment of steep increases in the prices of imports. We could not have a sustained low inflation rate and at the same time counterbalanced the terms of trade hit to our exporters in 1986 with another round of depreciation.

In those respects the recovery from the recession of 1982 and 1983, the experience of the mid eighties, is no guide to our Today those imbalances have been corrected, and we have a real chance to recover on a low inflation path.

So I think we need to begin thinking now about what the change to a low inflation path might mean. We need to think about how it will affect our competitiveness, investment decisions, borrowing and lending, and the perceptions of overseas markets. For those who doubt that the change can be made, or that it will be important, I have only to point to

the grave consequences for those companies which failed to predict the end of the rapid asset price inflation of the late eighties. These transitions matter and they can be upon us before we have thought out what they mean. Some of the

implications of a low inflation path are technically detailed


issues on which many economists are now doing some useful work. Today I will only have time to briefly mention this work. I hope as these investigations, when completed, can come into the public arena to widen the discussion.

We also need to think about the requirements for sustaining a low inflation environment. One thing I am quite certain of is that we cannot have a sustainable low inflation environment until Australians want one, and are prepared to be convinced that we can do it. We won't have it until we believe in it - until inflationary expectations are altered

and our decisions alter accordingly. We cannot sustain a low inflation path if the profit share of national output increases at the dizzy rate of the mid eighties. We cannot

sustain a low inflation path through a wages spike like 1974 or 1981. We cannot sustain it if State Governments recover in taxes and charges losses they have made in business enterprises. We can't sustain it if business executives claim credit for falling unit wages and reward themselves with mighty salary increases. We have to begin with the

assumption that the inequities of the early eighties have been corrected. But I am also convinced that Australians welcome the gains on inflation we have already made, are prepared to stick with the current economic strategy until

inflation is substantially lowered, and will support arrangements to keep us on a low inflation path. It is of the most telling significance that the Westpac-Melbourne Institute Survey of Inflationary Expectations - the only

reliable measure we have of what Australians really think will happen to prices - is now recording a fall in expectations of inflation to the lowest level in the 19 years the survey has been taken. And the line on the graph is

heading south. It's significant too that long term interest rates have been falling, suggesting the professionals in financial markets share these changing expectations about inflation.

We need a new consensus around a low inflation recovery path, but we won't get one if that path simply means stagnation, persistent high unemployment and falling living standards. If it means elected governments surrendering control over the economic policy for which they are responsible and instead giving a supposedly independent central bank a direction to choke the economy until there is no sign of life. But a low

inflation path need not and must not mean permanently low growth of real output. On the contrary, we should expect to have a faster rate of growth of living standards in a low inflation environment than a high inflation environment, for

reasons I will come to in a moment. A low inflation path does not mean falling wages, or falling profits, or economic stagnation. We can recover from recession and we can keep to

a low inflation growth path.


So, what are these big benefits of a low inflation expansion path? In essence they are the reverse of the costs of a high inflation path.

. A high inflation path undermines our competitiveness by invisibly appreciating the exchange rate. If our inflation is faster than our trading partners then unless there is a depreciation of our exchange rate

foreign currencies will buy fewer and fewer Australian goods. When the depreciation comes, as it inevitably must, it adds to inflation. That is the vicious circle. But if we keep to the low inflation path we

are now on, we can put ourselves in a virtuous circle. So long as our inflation is lower than our trading partners we are invisibly depreciating the Australian dollar. This increases our competitiveness and

increases the purchasing power of our exporters. If and when there is a nominal appreciation, it will lower import prices and push inflation further down.

. High inflation may at times give us a higher nominal exchange rate than we need. The higher nominal interest rates resulting from inflation are extremely attractive to foreign lenders since their exchange

losses are often tax deductible. This demand for Australian debt may lead to an appreciation of our currency. To the extent this effect is important, it will be minimised as the Australian economy moves onto

a sustained low inflation path.

. A high inflation path favours appreciating assets over depreciating assets. In the context of the mid eighties that meant property, homes and offices over equipment, factories and research. If we can move to a

low inflation path we can remove that distortion.

. A high inflation path raises nominal interest rates, because the interest rate will contain expected inflation as well as real returns.

. A high inflation path can also raise real interest rates which along with higher nominal rates can therefore inhibit investment.

. A high inflation path probably adds to uncertainty, and in that way also discourages investment.

At bottom a current account deficit must reflect the difference between national savings and national investment, and if investment increases when savings are stable a rising current account deficit is not in itself undesirable. But

short of a textbook economy, the Government cannot ignore the nature of investment or the sustainability of a current account deficit. At the minimum we must maintain an environment in which those investment decisions are soundly based. Otherwise they will not generate the income necessary

to service the debt we acquire. To the extent we achieve and


maintain a low inflation path we can diminish, to an extent, our concern with the current account deficit because we will have more confidence that investment and savings decisions are rational and efficient.

In my eight years as Treasurer - in my 23 years in Parliament - there has never been a time when I have been about my work with more gravity. It is an awesome responsibility to take actions which could put men and women out of work - however

few, however good the safety net, and however short the period of unemployment will be. But having taken those decisions, having accepted that responsibility to do what I believed had to be done, I want to ensure that none of it has been in vain. I want to entrench a permanent benefit for the

future working lives of Australians and their children's. In eight years we have deregulated the financial system. We have floated the dollar. We have maintained the most successful incomes policy of any nation. We have turned the Commonwealth Budget around so successfully that in the midst of recession we still remain in surplus, and government

spending remains low in relation to the size of the economy. Now I want to put at the head of our agenda another great task in reforming the Australian economy. I don't want to just bend inflation a little and then see it spring back. I want to snap the inflation stick and. bring Australian back to

the community of its OECD partners-

CANBERRA 22 February 1991