POLICY RESPONSE by

BARRY HUGHES*

I have been asked to talk about alternative policy responses to the present sorry economic state. We are very much back in that grim posi- tion, perhaps worse, that we last confronted in 1978. It is the 1978 show all over again. The mood is pessimistic, a fact also reflected in the defen- sive nature of my remarks to come. It is also very uncertain, particularly in regard to our major constraint-the balance of payments.

Rather than rehash old ground about why we are still stuck in the swamp, I will address myself to the question of what the present Govern- ment might do next. In order to get a handle on possible responses, I have outlined one position that I see as eminently defensible, save, I guess, for a total external disaster scenario. In putting this forward I do not mean to imply that other positions cannot be adopted.' These, however, will have to be subjected to the same range of difficult choices that confront the position adopted here, so that we can get some idea of the terrain by look- ing at just one policy.

I begin with the observation that, unless strong reasons to the contrary can be demonstrated, the Australian economy needs a policy response from government that would deflate further an already sagging demand like it needs a hole in the head. Precisely that hammer blow, of course, would result from an attempt to wind back further the budget deficit in times when that magnitude is sharply increasing as a passive reaction to recession. * Dr. Hughes is Reader in Economics, the Flinders University of South Australia. 1. As Peter Sheehan pointed out at the Winter School, the alternatives are conditioned

somewhat by the nature of the government in power. This is not a matter of party politics. In two respects the nature of the present Government sharply restricts the available range of options. As regards incomes policy, the gross variability of its past positions [support and then attack on wage indexation in 1975 and 1976; threat of rigid monetary targets to discipline wages in the 1978 budget, which were then not made good; advocacy of only indirect monetary pressure on wage settlements in 1981 and early 1982 superseded by renewed pressure for direct wage limits in August 1982) leaves a yawning credibility gap. which is scarcely an ideal basis for success in a difficult area. As regards fiscal policy, the Government's well-rehearsed rhetoric on deficits and government spending locks away another set of options, even allowing for political flexibility. To ignore these matters while that Government remains in power would be otherworldly. In other words, contrary to what Ross Gittins says below, there is no incongruence between what is said here and what might have been said with a different government, even a Liberal one (Hughes, 1980).

35

The plan of my response is to consider first the minimum policy steps that can be taken by government so as not to aggravate the demand downturn, and then to inquire whether there exist any good reasons, singular or plural, why such a minimum should not be put into effect? We can consider also, if we like, whether something more than the minimum is advisable.

I consider the first question within the framework of the simple Keynesian model. As I argued some eighteen months or more ago, that model is perfectly capable of explaining the activity variations of the 1970s [Hughes, 1980).

There is first a level of government outlays [strictly speaking, being split consistently between transfers and expenditures on goods and ser- vices) that would achieve a real growth equal to that in the underlying capacity of the economy.z Since we a re dealing now in minimum positions, under which labour productivity is unlikely to improve by much if a t all, that means a real growth equal to slightly greater than the underlying growth in the population of working age, or a little more than 2% per year. With the commonly assumed inflation rate of about lo%, that would mean an increase in outlays of around 13% [to allow, also, for the public sector deflator rising a little bit faster than average).

On the personal taxation side, the minimum position calls for restraint on real tax levels, in other words indexation of the brackets. By this I mean a real level of personal tax rates no higher than that in 1981/82, or full indexation of the structure operating for the full financial year rather than such shorter period a s can be contrived by the imagination of the economists in PM & C. In this, a s in some other areas, I am a t the mercy of the detailed figures. But I take it that such a policy would slice something less than about $1,300 million off revenue collections that would other- wise be made-something less because I do not want to advocate the absurd position that the marginal propensity to consume is zero for a period a s long a s a year.3

2. The minimum position is thus not one which seeks to maintain a constant net fiscal con- tribution to aggregate demand, but one which seeks to keep that contribution steady in relation to capacity output. In other contexts, and with other governments, one could envisage positions that sought to keep overall demand in this relation. But we live in a very conservative country.

3. The position one adopts on reactions to taxation is critical to the assessment. Thus no account is taken here of government revenue losses due to the well-known stickiness of some indirect tax rates under inflation [as opposed to losses caused by variations in activity levels), because real wage incomes are assumed to remain unchanged through real wage resistance (Sheehan, 1974). On the other hand, income taxation is assumed un- affected by such a mechanism. In practice, of course, such polar extremes are unlikely to be faithful representations of actual economic processes. Some effect on private demand

36

With some real growth in government outlays, and with fiscal drag being abolished, fiscal policy would not crack down further.‘ In these circumstances the gloom can lift a bit. Consumer and government spend- ing can go forward a little, while everything else is going backward or marking time, We might get a small growth in non-farm GDP, but not one large enough to stop unemployment rising. The minimum position is one to moderate the growth in unemployment.

The minimum position for monetary policy is to permit the fiscal policy to take effect. An inflation rate of 10% and little growth a re consistent with an M3 target of around 10%. On present indications I would not be unhappy to see last year’s target fulfilled this coming year.

What are the objections to this minimum position? The first is the notion that we need extra unemployment to combat inflation. Well, extra unemployment is already likely to be contained in the minimum position, so that the objection boils down to a demand for sharply rising unemploy- ment. For what purpose? There is nothing in inflationary expectations theory that suggests that we have not already got sufficient unemploy- ment to start the concertina of the short-run Phillips curves, unless the natural rate is believed to have risen yet again. On the other hand, the de- mand may be being made without benefit from a theoretical position, com- ing instead from a purely empirical belief in the efficacy of slugging one’s way out of inflationary troubles.

The difficulty with this position, as Bob Gregory (1982) has recently observed, is that its effect seems to wear off quickly. The empirics here and overseas in our sort of economy show that the policy works while unemployment is increasing, but not persuasively that any control remains when unemployment stabilises. If, as is usually the case, advocacy of the sharp slug is combined with a belief that expansion inevitably leads to an acceleration in inflation, it is a simple matter of deduction to conclude that the policy is a recipe for an upward ratchet in unemployment, which may or may not do anything worthwhile to the medium-term rate of inflation. Either way, natural or unnatural, unemployment moves permanently higher.

The second objection is that such a minimum policy cannot be put together. Ignoring the fairy stories about counter-productive demand

out of non-wage incomes would occur from indirect tax changes, and some tax-push recovery of extra income taxation would modify the conclusion there. What this means is that fiscal impact is complex. The point is particularly relevant to the deficit figures presented below, which ought to be treated with a fairly liberal dose of salt. This is a Ross Gittins memorial footnote.

4. Of course, any number of combinations of government spending and taxation could give this no-change fiscal result.

37

policy, the usual cry is that the implied increased deficit is inconsistent with the monetary target. I know that Milton Friedman would be amused by such an objection, but let us give it the respect that is warranted by its following among some of my fellow economists, the financial writers, and the money people.

The implied deficit for 1982/83 on the minimum policy seems, on the broad outlines of likely events, to be around $1.8 to $2.2 billion, allowing for a clawback from tax indexation over what otherwise would have happened of around $200 to $300 million during this financial year. Obviously this figure is at the mercy of detailed information, but it is at least consistent with the inspired leak to Business Review Weekly a fort- night ago. Such a deficit implies a domestic addition to the money supply of between nothing and about $300 million, or at most about half of 1% of M3.5

We know, of course, that this addition to the monetary base will be multiplied. But we also know that the budgetary contribution is not by itself vital to the M3 outcome-the actual correlation in recent years is the reverse of that supposed. Indeed, in a sense we may be returning to the 1978 show, a performance interrupted by the antics of the sheiks. We cannot really make sense of the domestic deficit figure until we also know something about private sector foreign exchange movements and non- bank take-up of Commonwealth securities.

Much has been made of the difficulties of capital inflow for monetary management in 1981/82. But the retrospective figures indicate that it was an extremely poor securities performance that caused the troubles. To the end of May there had been a net outflow from Commonwealth securities of $146 million, heavily conditioned by a dismal performance from uncompetitive ASBs. By contrast, in the three previous financial years there had been a positive non-bank take-up of between $534 and $740 million. This turnaround alone went a long way to wiping out the effect on money formation of the domestic surplus. While the constituent amounts were higher than had been expected, net private sector foreign exchange movements in 1981/82 were probably marginally lower than had been expected in the August 1981 Budget.

5. These numbers, which were formulated in advance of budget day, must be regarded as very approximate, because of a lack of uptwdate detailed information, the uhcertainty of outcomes, and because of varying reactions to taxation canvassed in footnote 3. They are slightly lower than those given to the Winter School audience on account of incorporation of public service pay day effects. [That my initial reaction on budget day to a deficit of $1,600 million should be that it is mildly expansionary is due to compositional and distribu- tional effects within the document and to the credibility and impact of some $870 million extra taxation of "funny money".)

38

As recent experience has taught us, this international area is even more clouded with uncertainty than the previous one. A big current account deficit is again clearly in prospect, but views conflict on the likely size of the capital inflow. If international financiers become upset by a higher deficit-the Stone line, which seems a peculiarly Australian crea- tion-we would have a private sector drain, and there would clearly be a balance of payments problem. But we would not need to worry about overshooting M3. You cannot have it both ways. Indeed, we may well be returning to the 1978 show, when a very much larger domestic deficit than that contemplated here did not prevent a need for the monetary managers to rush in with buckets full of liquidity. Uncertainty on the external front is a double-edged weapon for monetary management. Under the prospects prevailing for 1982183 we may need to be as wary of substantially undershooting my M3 target as exceeding it.

But if there is a net private sector inflow, the slack would have to be taken up by monetary operations. These, of course, will succeed to the extent that the interest rate structure is judged right. While it would be a brave person who forecast interest rates with confidence, there a re some signs that we are in better adjustment now than earlier in the year. ASB rates are now more competitive, both because of their higher rate and because of the decline in the major sources of competition recently. There is thus very much less likelihood of last year's drain sabotaging overall sales this year. The other securities, too, seem to be better placed. That means that a normal selling year (even including amongst these the con- ditions prevailing between 1978 and 1981) would more than wipe out the domestic deficit contemplated by the minimum position. Some private sec- tor inflow would thus still be needed. If it is bigger than that, the authorities are better placed than ever, given their recently improved freedom. If things go wrong, they have nobody to blame but themselves.

The final and most important objection is in the international sphere. Can the balance of payments afford the minimum position? Again we operate in an uncertain environment under which firm forecasts are unreliable. I suppose the most worrisome outcome in this particular context would be a very large slump in capital inflow ahead of a fall in the current account deficit. To some extent we can cover by using up our present large reserves and by borrowing, not a great amount of which has been done in recent years. That strategy, of course, depends ultimately upon a judgment of the duration of the world recession. If the judgment goes the wrong way, so that a bridging strategy is considered unwise, we are faced with the nasty adjustment choices of devaluation, further defla- tion of the economy, and a tight monetary policy to maintain interest differentials and so to prop up the capital account. Under these circum-

39

stances, which, as I have said, I am by no means sure are present, devaluation seems the least of the evils. Further and substantial deflation amounts to running for cover until something turns up somewhere in the world economy-like another 1979 bonanza. It is not as if our activity levels are totally out of step with the rest of the world. We have nothing to crow about, nor would we with the minimum position. Tight monetary policy is partly a variation on the same theme, and partly a mechanism for inflicting additional injury on top of recession.

Devaluation, starting from a point where we are still above the exchange rates prevailing two years ago with all our major trading part- ners save the United States, always was the preferred option if the economy was in fundamental disequilibrium. It is feared mainly because of inflation. (It is idle to fear it on international beggar-my-neighbour grounds when one considers that is common to all the alternatives). That, it is true, is a clear disadvantage. But as 1977, another dismal year, showed, fears of a devaluation-inflation spiral can be much exaggerated.6 The effect will come through in bits and pieces in a distributed lag.

So I conclude that, given a modicum of management ability, the mini- mum position ought to be achievable. I repeat that this minimum position is not an expansionary policy: it is merely what is required to prevent government policy, which already provides substantially less support for demand than in 1975176, aggravating an already dismal demand position. The fact that the deficit would grow substantially is merely a reflection of recession. It is not an indicator of expansion, a proposition which used to be stressed in large headlines by the old Treasury before new Treasury began to extol the virtues of whatever ports it could find in recent stormy years.

If we want an expansionary policy, and that is something I do not expect to see next month, it obviously follows that we need more than the minimum position, and an initial higher deficit than that contemplated here. The chief difficulty would likely be the balance of payments con- straint, with a possible return to the circumstances of 1978 when Max Corden warned that a big expansion would require a big devaluation, over and above that which is already occurring. While these circum- stances clearly would remove any money management worries, expan- sionists need to face up to the possibility of an external problem while the world economy remains recessed, and while Australia’s main export items are under pressure.

Finally, I come to the wages area. What role is there for a specific

6. On this see Norman (1981) cautioning against mechanical application of the “law of one price”.

40

incomes policy, operating independently of demand management? For the current Government the answer seems to be none. During its term of office its views have changed, so that recently it has seemed to accept that it does not want to operate a wages policy, but in earlier times its wages policy asked for the impossible and consequently got nothing.’

That we lack a government wages policy is perhaps no bad thing. The evidence is pretty clear that government-operated incomes policiesa have been failures, largely, I suspect, because they have been creations foisted on (sometimes unwilling) unions and employers. They are not creations of the main parties, and thus neither feels particularly responsible or locked in to them. Where they have worked (including the British social contract until that was taken over by the UK Treasury), it has been because the non-government parties wanted them to work and, indeed, very largely created them because they were in their respective self interests.

The role of government is to observe carefully what is happening in the wages arena, to support (if it can] what is happening (remembering that it is probably powerless in the short term to change events), and, most im- portantly of all, to make sure that its policies are consistent with the likely settlements. This latter point, in a sense, takes the place of the question of what wages policy ought to be. That is the wrong question. What we ought to be considering is how governments should react to what is being deter- mined outside their orbit of power.

So that I am not misunderstood, let me state straight away that I do not rule out governments shaping the bargaining environment by demand management (which is clearly happening this year) or by such persuasive leadership on our general economic problems as they can muster.

What I do mean can be illustrated in concrete fashion by possible developments this year. The $25 round is virtually through, the $14 round is going through slowly and attention is shifting to what the metals or the building industry or somebody else will negotiate from September onwards. Whatever labels are attached, there is an extremely high chance that the collective bargain will be centralised by flow-on, whether or not the Arbitration Commission is involved. The dismal economic state of the country has taken its toll so that, coming on top of recent gains, what the unions will be sticking for is something like preservation of the real wage, though there may also be claims for further reductions in stan- dard hours.

7. After this paper was delivered, yet another somersault occurred. The Government now

8. By which I mean policies concocted in Treasury departments. seems to favour wage limits and jawboning after all.

41

In this environment it would be clear folly to announce in August that indirect taxes have been increased sharply. That will simply feed into cost-of-living indexes, prospective or retrospective, and add to the wage settlement. Nobody, not even the Government, will have benefited. The action will not have facilitated industrial relations: it will have thrown a spanner in its works. The folly is only compounded when the argument for indirect tax increases is spurious, namely that a small increase in sales and other indirect taxes (which in any case are open to dodging) can facilitate a marginal reduction in income taxation and so a lessening of avoidance and evasion. This is cloud cuckoo land. In any case there is good reason to believe that avoidance is a one-way game. Once learned, it is not easily forgotten. It is nice that a tripartite meeting is being held on budget day; it is a pity that by then journalists will almost have evidence of decisions that may be in conflict with sensible industrial relations. Australia cannot afford such compartmentalised thinking.

REFERENCES

Gregory, R.G. (1982). “Work and Welfare in the Years Ahead”, Australian Economic Papers

Hughes, B., Exit Full Employment (Angus and Robertson, 1980). Norman, N., in K. Hancock (ed.), Incomes Policy in Australia (Harcourt Brace Jovanovitch,

Sheehan, P.. “Wage Indexation: Solution or Stimulus to Inflation”. Australian Bulletin of

(forthcoming).

1981).

Labour, December 1974.

42