March 1st 2008

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Articles from this issue:

COVER STORY: The Australian economy a 'house of cards'

EDITORIAL: Timor troubles: the way ahead

CANBERRA OBSERVED: What remains to be done after saying sorry?

NATIONAL AFFAIRS: Brian Burke and Kevin Rudd cross paths again

ECONOMIC AFFAIRS: Economic policy-making in conflict

STRAWS IN THE WIND: Hysteria in the House / US election campaign / "Say sorry" segment / The economy

ISLAM: Uproar over Archbishop of Canterbury's Islam gaffe

AUSTRALIAN HISTORY: Why Australia's Christian heritage matters

HUMAN RIGHTS: The 2008 Olympics and China's Communist regime

TAIWAN: Chen: Almost over, but not out

INTERNATIONAL AFFAIRS: Australia and Japan set to draw closer together

AS THE WORLD TURNS: Global warming? It's the coldest winter in decades / Capitalism's enemies within

Reality gap between words and action (letter)

Wentworth's vision for Australian railways (letter)

Thuggery at Brisbane pro-life rally (letter)

The struggling Rudds (letter)

BOOKS: IT'S YOUR TIME YOU'RE WASTING: A teacher's tales of classroom hell, by Frank Chalk


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Economic policy-making in conflict

by Colin Teese

News Weekly, March 1, 2008
Which is the greater danger confronting the Australian economy - a surge in inflation or an economic downturn? The Reserve Bank of Australia believes it is inflation, and has been raising interest rates to combat it. The Rudd Government, however, is pledged to cut taxes. Colin Teese analyses to what degree this might contradict the Reserve Bank's anti-inflationary strategy.

The media of late has been full of the whys and wherefores of the Reserve Bank of Australia's attitude to interest rate rises - understandable enough, one supposes. Much more remarkable was the RBA's media release effectively putting the government on notice that more rate rises were in the pipeline. It was almost as if the bank were telling the government to back off on its tax cuts. Ken Davidson, senior business columnist in the Melbourne Age, has said as much.

The bank's present governor Glenn Stevens, perhaps more than his predecessor, seems steamed up about inflation - not necessarily the reality, he tells us, but the threat. The doctrine of the pre-emptive strike first gained currency in the foreign policy lexicon of US President George W. Bush. But Governor Stevens may be the first central banker to introduce it into the management of monetary policy.


All kinds of nonsense about inflation - and how to deal with it - appears in the serious press from time to time, not least a rambling and confused article by former federal Labor leader Mark Latham ("Shock the only therapy left", Australian Financial Review, February 12, 2008).

As for the RBA, in terms of the policy framework it has created for itself, what Governor Stevens has foreshadowed for the future made sense. Any other policy stance would have obliged the bank to deny its own working hypothesis. But whether it is the right policy framework is another question.

What might certainly be called into question is the RBA's obsession with small surges in inflation. In recent public announcements, the bank's present governor holds to the conviction that inflation should never be permitted to move outside the 2-3 per cent range.

In fact, that is not, strictly speaking, the position the bank is required to defend. Mr Latham has made this point, and, on that much at least, we can agree with him. The RBA's remit is to contain inflation within the 2-3 per cent boundaries over the business cycle. Presumably, under this policy, there could be times, during the cycle, when, for perfectly good reasons, the inflation might for a time be permitted to nudge ahead of the 2-3 per cent figure.

There are good reasons for building in this kind of flexibility. For a start, it is not always easy to explain what precisely is happening to inflation and why. Sometimes the economy might need time to settle before exposing its true intentions.

It is, however, fundamentally more important to ask how we came to have such faith in the capacity of small upward movements in interest rates to contain inflationary pressures. Certain central banks, including our own RBA, presumably inherited that particular mantra from the practitioners of current economic orthodoxy. Whether it has more than a superficial connection with either economic theory or practice is another matter.

There is, of course, a general proposition about interest rate movements on which we can all agree. Starving business and consumers of cheap money in an overheated economy will certainly cool it down, if the policy is pursued aggressively enough.

In practice, however, using interest rates to cool an overheated economy is riddled with problems. Mr Keating, when he was Prime Minister, found to his disadvantage that using interest rates to tame an overheated economy isn't really effective unless rates are lifted to levels which plunge the economy into recession. Keating did this and famously labelled the outcome as "the recession we had to have". The result for him and his party was enduring political harm.

The corollary is that if interest rate rises are too small, they don't work. Recent experience seems to have underlined this point. After 11 successive rises, according to Governor Stevens, the monster is still not tamed.

Governor Stevens's American counterpart, Ben Bernanke, chairman of the US Federal Reserve, has a more flexible attitude to his obligations. Perhaps confronting one or the other possibility, he has decided he likes recessions less than he likes inflation, and is actually cutting rates to help the US ride out its present difficulties. Interestingly, much of the more deliberative US economic and political opinion seems to agree with him.

Perhaps also, the US Federal Reserve chairman has made a better fist of analysing the problem of inflation than has Governor Stevens, and has uncovered the fundamental difficulties in trying to manage it with interest rate movements.

The first lies in trying to calculate the level of inflation. This is done by reference to the measure of monthly price rises as they apply to a so-called basket of goods. We label this basket the consumer price index (CPI).

The problem is that any selection of the basket of goods is necessarily arbitrary: it may or may not accurately measure what has been the impact of price rises on consumers and business. It is necessarily a construct of statisticians. With the best will in the world, these persons, or anyone else, have no objective basis of determining what should or should not be in the basket - and, no less important, what weight should be given to one item over another.

How do we choose between petrol prices rises over meat and bread increases? As to housing costs, should we measure, for CPI purposes, only movements in house rents? If so, should all rents be included, or only some? And, having decided, what does the outcome actually tell us?

There are many other product categories to be considered for inclusion or exclusion, and the decision taken one way or another will always be arbitrary. Given all this, can the Reserve Bank truly measure how price rises feed into the affordability of life for the average person (whoever that might be)?

Much less is it possible to judge what might be the impact on the wider economy. Can we, for example, combat inflation generated by food and housing price increases by containing wage increases?

If food prices are caused by circumstance beyond the control of food-buyers, cutting wages will surely mean people will have less to spend on essential food. Is the RBA concerned about this, or does it not care? Is it only concerned to contain the consequences of increased food prices for the wider economy without regard for the impact on ordinary Australians?

Surely what the RBA governor can, and should, do is to adopt the example of the US Federal Reserve chairman and put inflation into context. In the context of the present US financial crisis, Chairman Bernanke has made what seems to have been a perfectly reasonable risk analysis and decided to lower interest rates. Obviously, he much prefers to allow the risk of at least a mild bout of inflation, rather than raise interest rates and risk pushing the economy into recession.

Some will say that Bernanke, in making this judgement, is taking a political as much as an economic decision. Perhaps, he would readily agree. Yet there are those in Australia today who continue to pretend that, when our Reserve Bank takes a decision which balances the risk of inflation against the risk of recession, it is making an objective decision divorced from politics.

But, of course, politics is mixed up in it. Whether or not justified, right now, there seems to be agreement between our Reserve Bank and the Rudd Government that inflation rather than recession is the true enemy. By act of government policy, the RBA has long been given independent control over the fixing of interest rates at the level it deems appropriate to manage inflation.

However, other aspects of economic management which inevitably impact upon inflation are outside the RBA's control - most notably, budgetary and taxation policy. These, in particular, are and will remain in the hands of the government; indeed, no government could or would wish to surrender control over them.

The contradictions in this dichotomy are only just beginning to emerge. Sooner or later, the government will almost certainly have to decide - as have the Americans - whether they prefer inflation over recession.

Meanwhile. less important conflicts have already emerged. During the election campaign the government promised to cut taxes. If implemented, this policy would stimulate demand and increase economic activity in an economy the bank believes is already overheated.

By keeping its promise to the electorate and going ahead with tax cuts, the government will be applying the accelerator to the economy at the same time as the Reserve Bank applies the brakes (through putting up interest rates). How all of this contradiction plays out in the real world is not clear - especially as the government's stated intention is to wage war against inflation.

The RBA's position embraces the virtue of consistency. The government's does not. It tries to tell us that any inflationary pressures triggered by its tax cuts will be offset by bringing in a tighter budget - which logically must mean cutting back on services.

All of this is somewhat discomforting. Saving money on budget outlays means cutting back on services. The main burden of this will fall on middle and lower-income households. Services which the government would have provided they will now have to pay for themselves. As a result, they are, in effect, being asked to pay not merely for their own tax cuts, but for those applying to the higher incomes as well.

Election pledge

Has the Prime Minister found a new and ingenious way of wriggling out of his election pledge to cut taxes? Or is it that (more likely) his government has taken hold of a set of less than perfect tools for managing the economy in the current difficult circumstances?

Either way, ordinary Australians have every right to feel concerned about what is happening.

- Colin Teese is a former deputy secretary of the Department of Trade.

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