In the end, it was necessary to destroy the city to save it.
A US Army commander’s infamous explanation for the 1968 decision to bomb and bomb a Vietnamese city, regardless of civilian casualties, appeared to be echoed in Treasurer Jim Chalmers’ ministerial statement on the economy.
“It is not,” he told the nation in an address to parliament in its first session a week after the election, “that inflation that is too high for too long undermines living standards . . .”
Chalmers acknowledged then – and acknowledged again after the Reserve Bank raised rates again, by another 0.5 points this month – that the innocent would suffer. But hey, if you want to defeat the Viet Cong, or inflation, these casualties are inevitable.
So the new Labor government, which campaigned strongly before the election against falling living standards, now admits that real wages will fall for at least three years running.
This is what economic orthodoxy dictates: cut inflation, cut demand and cut demand, cut wages.
The problem is that there is nothing orthodox about Australia’s economic situation.
“That’s really what happens when you don’t get the policy right… This whole issue should have been dealt with by the politicians and the tax authorities. But instead it just kept getting pushed down the road.”
The central bank’s usual trigger for raising rates is an overheated economy in which wages and prices are chasing upward. This happens when unemployment is low, meaning employers have to compete by offering a higher wage.
The strange thing is that unemployment has been relatively low for years, except for a brief spike during the pandemic, but there has been negligible growth in wages, as Chalmers himself emphasized in the July 28 statement.
“We don’t have an inflation problem because workers are earning too much or because we’re in some kind of wage-price spiral,” he said.
“Growth in real wages over the past decade has averaged just 0.1% a year. In the year to March, real wages fell by 2.7%, the worst result in more than two decades “.
Unemployment fell below 5% from a year ago, and is currently around 3.5%, the lowest in nearly 50 years. While there is anecdotal evidence of wage pressure in some sectors, there is still nothing to suggest that wage growth is contributing significantly to inflation.
So why are wage earners being told that they face a real reduction in their pay and living standards, as interest rates rise to keep up with inflation?
“Because,” says Peter Tulip, chief economist at the Center for Independent Studies, “the past history of this country and the current evidence from other countries, where wages have soared, suggests that it could happen here.
“I don’t think it’s certain. I mean, these relationships have the nature of being somewhat surprising and changing over time. But the empirical evidence from the past suggests that it’s much more likely than not that wage growth and price growth are ‘accelerate even more.’
In other words, the Reserve Bank has chosen to fire under suspicion of wage inflation.
This worries Nicki Hutley, a leading independent economist focused on social and environmental issues. “Before you think about what the solution is, you have to really define where the problem is,” he says. “This looks like something very different from what we’ve seen before, in terms of economic shock, but the policy response doesn’t seem to differentiate.”
Under normal circumstances, he says, the Reserve Bank would say “let’s raise interest rates, lower demand and that will solve the problem”.
“But that assumes that inflation is driven by demand, but a lot of what we’re seeing now is very specifically a supply problem.”
The root causes of the inflation problem are the supply chain problems caused by the pandemic, especially the Chinese government’s zero-Covid policy, and the flow through energy prices of the Russian invasion of ‘Ukraine.
“These things,” Hutley says, “certainly wouldn’t be addressed by interest rates.”
Professor Jeff Borland, a labor market economist at the University of Melbourne, takes a similar view. “What we have at the moment is a price inflation problem, not a wage inflation problem,” he says. “This problem of price inflation is primarily driven by the supply side of the market.”
In fact, “trying to deal with supply-side inflation with a demand-side instrument” could make things worse, he says, referring to higher interest rates. Hit the monetary brakes too hard and Australia could go into recession.
Rising prices are already having a contractionary effect on the economy, Borland says. Putting the burden of higher interest rates, he says, risks “pushing output down, so you’re going to have this double contractionary effect on the economy.”
So why do it?
One reason is that everyone does it. Interest rates are rising around the world and if Australia didn’t follow suit, says Tulip, the exchange rate for our currency would fall, making imports even more expensive.
Another reason is that even though real wages are falling, Australians still spend a lot, or at least we did until very recently.
Data released this week by the Australian Bureau of Statistics showed total household spending was 10.2% higher in June this year than in the same month last year. It was the 16th consecutive increase over the course of the year.
In some spending categories, this was inevitable. High gasoline prices, for example, contributed to a 22.7% increase in transportation spending. But it also made an upswing in air travel.
Spending rose in all categories, but was much stronger on non-essential items than on essentials: hotels, cafes and restaurants were up 17.1 percent; clothing and footwear increased by 16.3 percent; leisure and culture increased by 15.5%.
The strange thing is that even though we act like the good times are rolling in, other data indicates that we think things are unpleasant. Westpac’s consumer confidence index has fallen for eight consecutive months. In August it stood at 81.2, almost 23 percent less than last November. A reading below 100 indicates pessimism, and collectively we are as pessimistic as we were during the Covid-19 lockdowns.
This dissonance between our behavior and our vision is partly explained by what happened during the pandemic.
We had a couple of years where we couldn’t spend much, on travel, eating out or entertaining. Those of us who had jobs often did them from home, which saved us travel expenses. Those of us who couldn’t do our normal jobs were paid by the government, in some cases more than we would have normally earned. There was even, briefly, free childcare. The money, estimated at $250 billion, piles up in households.
Another factor fueling demand, says Professor Warwick McKibbin of the Australian National University’s Crawford School of Public Policy, was government transfers to prop up companies, fattening their balance sheets for the benefit of owners and shareholders.
Also, there was essentially “free money,” because interest rates were so low.
“And now investment is picking up — private investment,” McKibbin says. “That’s more demand stimulus coming in, which is good from a long-term perspective because it’s going into productive assets, but bad from a short-term perspective.”
So while raising interest rates does nothing for supply-side problems, it is necessary to “respond to demand shocks, i.e. excess monetary stimulus plus fiscal stimulus “.
McKibbin says it remains an open question how high interest rates should go and how quickly. “But my calculation is that this neutral policy at this point, everything else given, [would] probably around 3 percent interest rate. It’s nowhere near the 1.85 we have now.”
There will be financial pain as a result of both inflation and the rate hikes that are supposed to cure it, but it won’t be felt the same, and for some it won’t be felt at all.
Nicki Hutley says the pain of inflation will be felt acutely by job seekers. “In general, they already live below the poverty line. We seem to have forgotten the need to raise the rate [of unemployment benefits]. With inflation over 7% … it’s very, very difficult for these people.”
And there will almost certainly be more unemployed as a result of the fight against inflation, says Tulip: “I don’t think 3.5 percent unemployment is sustainable.”
The Fair Work Commission’s recent 5.2 per cent increase in the minimum wage will ease some of the burden on the lowest paid, says Professor John Quiggin of the University of Queensland’s School of Economics, but others who earn just above minimum wage will struggle. . “It’s really going to be the next to the next level, those who earn low to moderate wages but above the minimum, those who are going to be squeezed.”
People who work in labor-scarce areas can get wage increases to offset rising costs, but very few workers will have enough to fully offset them.
Everyone is feeling the effects of rising energy prices, which affect almost every part of the economy. And while exogenous factors play an important role, so do domestic policy failures. The sharp increases in gas and electricity prices, says McKibbin, are largely a consequence of the long climate wars.
“That’s really what happens when the politics aren’t right,” he says. “You do not correctly understand your energy policy, nor your climate policy. This whole problem should have been dealt with by politicians and tax authorities. But instead, everything just kept getting pushed down the road.”
The pain of higher interest rates will obviously be felt most acutely by people with a lot of debt. In particular, that…