The RBA can keep waiting, but our economic problem won’t go away

If the weakness is structural, waiting a bit longer won’t see the problem go away. The world’s economists will need to do a lot more researching and thinking to determine the main causes of the change in the structure of the economy and the way it works, and what we should be doing about it.

Apart from dividing problems between cyclical and structural, economists analyse them by viewing them from the viewpoint of demand and then the viewpoint of supply.

Weak demand is holding back our economy, but is it mainly cyclical or mainly structural? Credit:Kate Geraghty

Obviously, what you’d like is demand and supply pretty much in balance, meaning low inflation and unemployment, with economies growing at a good pace and lifting our material standard of living. In practice, however, it’s not that simple and demand and supply don’t always line up the way we’d like.

For about the first 30 years after World War II, the dominant view among economists was that the big problem was keeping demand strong enough to take up the economy’s ever-growing potential supply – its capacity to produce goods and services – and keep workers and factories in “full employment”. Keynesian economics was developed to use the budget (“fiscal policy”) to ensure demand was always up to the mark.

From about the mid-1970s, however, the advanced economies developed a big problem with inflation. After years of uncertainty and debate, the dominant view emerged that the main problem wasn’t “deficient” demand, it was excessive demand, always threatening to run ahead of the economy’s capacity to produce and thus cause inflation.


The answer was to get supply – potential production – growing faster. Most economists abandoned Keynesian economics and reverted to the former, “neo-classical” macro-economics, in which the central contention was that, over the medium-term, the rate at which an economy grew was determined on the supply side, by the three key determinants of production capacity, “the three Ps” – population, participation (by people in the labour force), and productivity – the rate at which investment in more and better machines and structures allowed workers to produce more per hour than they did before.

If so, the managers of the macro economy could do nothing to change the rate at which the economy grew over the medium term. Their role was simply to ensure that, in the short term, demand neither grew faster than the growth in the economy’s production potential (thus casing inflation) nor slower than potential (thus causing unemployment).

And the best instrument to use to achieve this balancing act was, as Treasury secretary Dr Steven Kennedy explained recently, monetary policy (moving interest rates up and down).

Everyone agrees that the problem with the advanced economies at present – including ours – is weak demand. The question is whether that weakness is mainly cyclical or mainly structural. If it’s cyclical, all we have to do is be patient, and the old conventional wisdom – that, fundamentally, growth is supply-determined – doesn’t need changing.

But the conclusion that fits our circumstances better is that the demand problem has structural causes. Consider this: we’ve had plenty of episodes of weak demand in the past, but never has demand been so weak that inflation is negligible. Nominal interest rates are way down in consequence, but even real global interest rates have been falling since even before the financial crisis.

Reserve Bank governor Philip Lowe sees Australia's wage problem as cyclical.

Reserve Bank governor Philip Lowe sees Australia’s wage problem as cyclical.Credit:Bloomberg

That’s why monetary policy has almost done its dash. It doesn’t do well at a time of negligible inflation, and fiscal policy is back to being the more effective instrument. But if the demand problem is mainly structural, then a burst of stimulus from the budget may help a bit, but won’t get to the heart of the problem.

As former top econocrat Dr Mike Keating has argued consistently, weak growth in real wages seems the main cause of weak growth in consumer spending and, hence, business investment, productivity improvement and overall growth – both in Australia and the other advanced economies.

Reserve Bank governor Dr Philip Lowe would agree. But he tends to see the wage problem as mainly cyclical: wait until we get more growth in employment, then the labour market will tighten, skill shortages will emerge and real wages will be pushed up.


Other economists stick to the supply-side, neo-classical approach: if real wages aren’t growing fast enough it can only be because the productivity of labour isn’t improving fast enough, so the answer is more micro-economic reform. Not a big help, guys.

The unions say the root cause is that deregulation has robbed organised labour of its bargaining power – and there may be something in that. But Keating’s argument has been that skill-biased technological change has hollowed out the semi-skilled middle of the workforce, with wage increases going disproportionately to the high-skilled, who save more of their income than lower-paid workers.

So Keating wants any budget stimulus to be directed towards the lower-paid, and a lot more spending on all levels of education and training, to help workers adopt and adapt to the digital workplace.

Ross Gittins is the Herald’s economics editor.

Twitter: @1RossGittins

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