Conference – 1990 Introduction Stephen Grenville

The Bank commissioned the five papers in this volume, giving the authors the brief to review what had happened in the 1980s – the events, the developments in policy and the changes in academic thinking. Taken together with the conference discussion, the papers provide a comprehensive picture of the Australian macro-economy in the 1980s, in the tradition of the Bank's 1979 Conference in Applied Economic Research. This introductory chapter provides a background to the papers and discussion, rather than a summary of them.[1]

1. Legacy of the 1970s

By the end of the 1970s, some of the important “stylised facts” were:[2]

  • the break-down of the Phillips curve trade-off between unemployment and inflation, not only in Australia, but in most OECD countries. Partly in response to this, there was a focus on money as the key to inflation control;
  • the widespread (but not universal) acceptance of the central role of labour costs in the rising unemployment of the 1970s;
  • a concern that the sharp rise in Government expenditure had adversely changed economic relationships; and
  • the vulnerability of the economy to external shocks: “imported” inflation in the early 1970s, and slow world growth in the second half of the decade.

2. Macro-Economic Performance in the 1980s

The 1982 recession marks a watershed dividing the decade into two periods. The early years of the decade were in many ways a continuation of the policies and problems of the 1970s. The 1980s began with the optimism of the OPEC-II-induced “resources boom”, which temporarily raised investment and (more importantly) led to excessive optimism on future national income growth. As a result, by the end of 1981, the “real wage overhang” had become worse. The recession of 1982 was a result of the combination of an adverse external shock, an internal “wages shock” (i.e. excessive wage claims) and policy response in the form of a monetary tightening. This sharp recession pushed the unemployment rate from 6 per cent to well over 10 per cent. The budget deficit expanded, both cyclically and structurally, taking the PSBR to around 7 per cent of GDP. The subsequent years of the decade showed substantial growth – 4 per cent per year. Employment grew by over 3 per cent per year so that by the end of the decade the unemployment rate was around the same level as at the beginning.

The current account deficit, which had been out of the spot-light in the 1970s,[3] widened early in the 1980s, and remained atypically-large for the whole of the decade. Inflation during the 1980s was lower than during the 1970s, although Australia made less progress than other OECD countries.

3. Issues of the 1980s

The macro-economic paradigm changed substantially during the 1980s, in response both to theoretical developments and (more importantly) to the inability of previously accepted explanations to fit the emerging facts. As the intellectual underpinning of policy changed, some old debates were resolved but new ones began.

One of the continuing issues was whether discretionary policies served any purpose. At the heart of this debate was a difference of opinion about the strength of the self-equilibrating forces in the economy. If these were powerful and quick to operate, and policy lags (recognition, reaction and implementation lags) were long, then active macro policies could be counter-productive. Often associated with this argument was the view that the inter-relationships of the economy were so complex that there was no sound base for intervention. These arguments may have made policy-makers more cautious, but have not led them to abandon discretionary policies, either in Australia or overseas. It was, however, one motivation in assigning fiscal policy to a longer-term role (see below).

One recurring theme extolled the virtues of deregulation and greater reliance on markets for resource allocation. The most thorough-going application of this was, of course, the deregulation of the financial sector, but this was not the only example. One important general thrust was to open the economy up to greater international competition.

A number of important changes in the theoretical framework had already begun during the 1970s. The importance of expectations was recognised, particularly in the widely held view that the long-run Phillips curve was vertical. Expectations were seen as important, too, in financial decisions such as exchange rate determination. The theoretically attractive idea of “rational expectations” was developed more fully in the 1980s: this, too, had implications for the effectiveness of discretionary policy.

There was increasing attention on the supply side of the economy. This not only took the form of a reappraisal of taxation (particularly concentrating on the reduction of marginal tax rates) but also put the spotlight on distortions and the need for micro-economic reform. The emphasis here was on pushing the production frontier outwards rather than ensuring that the economy operates continuously near the frontier.

4. Specific Issues

(a) External

Perhaps the most radical changes in thinking took place in the external sector. The central focus of earlier policy had been the dichotomy between internal and external balance,[4] with the former to be achieved by a judicious mixture of monetary and fiscal policy, and the latter to be achieved through changing the real exchange rate. This framework was outmoded by the floating of the exchange rate in December 1983. Even before this, the authorities had progressively diminishing control over the exchange rate as a result of the greater integration of Australia with international financial markets during the 1970s. What had been seen as an exogenous policy instrument became an endogenous variable, reflecting the stance of other policy variables and market sentiment.

There was a widely held belief that the floating exchange rate would relieve the chronic preoccupation with external balance: the foreign exchange market would keep demand and supply for foreign exchange continuously in balance. Some slipped into thinking that this would automatically ensure a satisfactory current account result. In practice the external sector dominated policy thinking for much of the decade – most notably when policy was adjusted sharply in response to the terms of trade weakness and associated exchange rate depreciation in 1985 and 1986. Even with this episode over, there was widespread concern about the persistence of a large current account deficit. The importance of interest- and exchange-rate-sensitive capital flows in the balance of payments now meant that the exchange rate and the current account were “uncoupled”, with exchange rate movements which were often perverse when viewed from the old perspective of current account imbalance. During the decade, many observers came to question how effectively markets were setting the exchange rate: whether speculative capital flows were always stabilising and whether the market had a well-based longer-term view of where the exchange rate would be.

The floating of the exchange rate removed one of the earlier important potential transmission channels of external shocks – “imported” inflation. Australia could now insulate itself from overseas inflation if it chose to do so. At the same time, it lost the “anchor” which a fixed exchange rate gave to the domestic price level. A floating rate did not, of course, insulate Australia from real external shocks, such as changes in the terms of trade. There was a greater interest in the way terms of trade shocks impinged on Australia, and in refining the proper policy response (including the role of the exchange rate as a “shock absorber” for the commodity sector).

(b) The Labour Market

One issue was clearly resolved in the 1980s: reductions in real unit labour costs did allow employment to increase. Between 1983 and 1989, real unit labour costs fell by around 15 per cent and employment increased by over 3 per cent per year. Any lingering concerns that wage restraint might result in inadequate aggregate demand were removed by this employment response. Household disposable income rose rapidly in the second half of the 1980s, despite wage restraint.

A sharp departure from earlier policies was the move away from restrictionist policies as a means of controlling wages and inflation, towards an incomes policy based on the Accord. If Australia ended the 1970s with a fair degree of agreement that reducing the “real wage overhang” was important to restoring macro-economic balance, the 1980s showed how this could be done through an incomes policy. This left, at the end of the decade, the unresolved question of whether such policies introduced too much inflexibility, extracting a high cost in terms of low productivity. There were concerns that the macro-level consultative approach may have hindered the development of a new institutional environment for employer/employee relations. Others thought that the Accord could evolve to provide flexibility.

(c) Money

The late 1970s and early 1980s represented, worldwide, the high tide of monetarist influence.[5] Australia shared this enthusiasm: the early years of the decade corresponded with a continuing belief that monetary targeting would reduce inflation. At the same time, the old monetary control techniques (through credit ceilings, reserve ratios and balance sheet limitations) were breaking down in the face of competition from non-bank financial institutions. What was needed was:

  • an operating procedure by which the central bank could influence the whole spectrum of financial intermediation; and
  • a guide for policy – in the form of an intermediate target – which would overcome Friedman's “long and variable lags” in providing a medium-term objective for monetary operations.

By the middle of the decade, the apparent simplicity of the monetarist prescription was looking less attractive to many. The reappraisal reflected:

  • the recognition that the relationship between monetary aggregates and nominal income was not as stable or as close as earlier thought;
  • growing doubts that there was a clear causal relationship from monetary aggregates to nominal income. The relationship observed between the two showed no leading role for money and was equally consistent with the reverse relationship, whereby monetary aggregates respond to nominal income.

Even with this loss of faith in targeting, important elements of this approach remained. Price expectations were seen as a critical element in inflation and credibility was recognised as the crucial factor in influencing expectations. However, credibility was “difficult to acquire, easy to lose and never to be taken for granted”.[6]

The unresolved issue was what could be put in the place of targets. For some, this was a medium-term focus for monetary policy, based on indicators of future inflation but not relying on rigid predetermined rules. For others, there was no prospect that monetary policy could serve a counter-cyclical role because of the long and variable lags and the lack of knowledge about the relationships; rigid rules were necessary to halt inflation.

(d) Fiscal

The decade saw the Public Sector Borrowing Requirement reduced from 7 per cent of GDP to a surplus. This was done through both expenditure cuts and revenue increases. Just as important, fiscal policy was removed from the armoury of short-term counter-cyclical instruments and given longer-term objectives; on the expenditure side, outlays would be confined to those items which are best provided by governments (with no place for Keynesian “pump priming”), while on the receipt side, there was an increasing awareness of the disincentives of high marginal tax rates and the importance of removing distortions.

The reining-in of the deficit left two unresolved issues:

  • if private-sector saving was deficient, should public saving be increased further to compensate for the shortfall;
  • whether the squeeze on public expenditure had been so great as to affect productive government expenditure, with adverse effects on private-sector productivity;

At the same time, there was a greater understanding that changes in public expenditure would also cause changes in private expenditure. This did not mean an acceptance of “Ricardian equivalence” (i.e. that private saving would change to exactly offset changes in government saving), but it accounted for the failure of the “twin deficits” view to explain the behaviour of the current account in response to reduced government expenditure. As government saving increased, private sector investment also increased, leaving the overall saving/investment balance largely unchanged.

What were the fiscal-multiplier responses to budgetary restraint? This is an uncertain area; but it does seem clear that overall economic activity has not been very sensitive to changes in fiscal position.

(e) Inflation

The floating of the exchange rate in 1983 seemed to remove a constraint on external balance and on monetary policy (see above). But whereas the external linkage had probably worsened Australia's inflation in the 1970s (“imported inflation”), the severing of this linkage in 1983 cut us off from the reductions in inflation which occurred in most OECD countries in the mid 1980s. An important difference, of course, was that the terms of trade movements at that time assisted their inflation control, while making Australia's problems more severe. As noted above, the float removed an “anchor” for price expectations. The suspension of monetary targeting at the beginning of 1985 exacerbated the potential problem, but these fears proved largely groundless: one of the side-effects of the Accord was to provide some stability (some would argue, rigidity) to inflation.

The 1980s combination of significantly lower unemployment and steady inflation put paid to any simple version of the expectations-augmented Phillips curve. The need was to sort out the precise roles of wage increases, economic activity, and money aggregates in driving inflation. To the extent that inflation-control was a costly process in terms of foregone output, these costs had to be weighed against the benefits of lower inflation.

5. An Assessment

The legacies of the 1970s were:

  • the “wage overhang” and the resultant high unemployment:
  • high government expenditure and a substantial structural government deficit;
  • high and persistent inflation.

By the middle of the 1980s, the first two of these adverse legacies had been overcome and some progress had been made in reducing inflation. But the current account deficit was uncomfortably large, our performance in slowing inflation was significantly worse than other OECD countries, our productivity performance was mediocre, and the benign international climate of the 1980s could not be relied on to persist. In short, Australia was on a high-growth path, despite its relatively rigid internal structure and its vulnerability to external shocks.

By the end of the 1980s, many saw a need for further policy development. On inflation, the search was for a formula which would bear down on price increases without running the economy continuously below capacity. The 1960s demonstrated that rapid growth could be compatible with low inflation, but once the inflationary “cat was out of the bag”, the speed limits on the economy might be more binding. There was a belief, too, that the main benefits of the Accord in reducing real unit labour costs had already been reaped, and that significant changes to wage-setting institutions would be needed if Australia's productivity performance was to be improved. One reflection of the higher growth (and the change in the nature of the external constraint) was the growing external debt and the vulnerability it brought. To tackle this at its fundamental level – the saving/investment balance – would require wide-ranging measures going well beyond the scope of macro-economic policy.

Footnotes

This chapter draws on some material presented by Ian Macfarlane and Fred Gruen at the final session of the conference. [1]

For a more complete listing, see Jonson, P.D., “The Economy in the 1970s: Information and its Interpretation” in Norton, W.E. (ed.), Conference in Applied Economic Research, RBA 1979. [2]

The current account was not included in the “top ten facts” from the summary of the 1979 Conference – see Jonson, P.D., op cit. [3]

Embodied in the Swan/Salter framework (see, e.g., Swan, T.W., “The Longer-run Problems of the Balance of Payments” in Arndt, H.W. and Corden, W.M. (eds.), The Australian Economy, Cheshire, 1963). [4]

See Goodhart, C.A.E., “The Conduct of Monetary Policy”, Economic Journal, 99, June 1989. [5]

OECD, “Why Economic Policies Change Course”, p.19, Paris, 1988. [6]