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Henry Thornton - Economics: A discussion of economic, social and political issues The Great Complacency Date 31/03/2005
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BREAKING THE AUSTRALIAN GREAT COMPLACENCY OF THE EARLY TWENTY FIRST CENTURY.
Paper presented at the conference, “Sustaining Prosperity, New Reform
Opportunities for Australia”, 2005 Economic and Social Outlook
Conference, Melbourne Institute and The Australian, Melbourne, 31
March, 2005.
By Ross Garnaut Email / Print

I. The Great Complacency


The first Australian-Melbourne Institute conference, three years ago, was to a considerable extent premised on the favourable outcomes of a period of sustained economic reform in Australia. Australia after the 1990-91 recession had experienced stronger growth in output than any other advanced economy after trailing its peers through the preceeding nine decades of the twentieth century. This had established a base from which Australians could reasonably aspire to continued productivity-raising economic reform and strong economic  growth, alongside equitable income distribution. We talked about hard heads and soft hearts, which were concerned with combining economic efficiency with equitable distribution of the fruits of growth. I noted in my opening
address to the conference that Australia through the early twenty first century was likely to experience all three of continued economic reform, equitable distribution and strong economic growth, or none of them.


In March 2005, Australia is in serious danger of getting none of them. Output growth over the year to the December quarter at 1.5% was close to the lowest of the developed countries. One year's data does not make a new trend, but analysis of the data confirms that there are grounds for concern. The slowdown was entirely on the side of supply capacity. Domestic demand, led by consumption on the back of the housing boom, was still rising rapidly. An exceptional proportion of the demand growth was being supplied by imports.

The imbalance between growth in domestic demand and supply capacity was
being reflected in shortages of labour, goods and services that threatened the
re-ignition of inflation. It was being reflected in extraordinarily high current
account deficits and rapidly increasing net external liabilities as a share of
GDP, despite external circumstances that in the past had been associated with
lower external deficits¡ªexceptionally favourable export prices and terms of
trade.


What went wrong? What is the remedy? And what are the prospects if
Australia now takes corrective action?


The deterioration had its origin in a Great Complacency that descended upon
the country after a decade of exceptional economic growth. As a community,
we accepted the excellent economic performance as evidence that we had
changed enough. Our community had never been comfortable with the
application of professional economic analysis to policy choice, so-called
'economic rationalism' but for a while, from 1983 to the turn of the century,
had been persuaded of its necessity. Now Australians had reverted to their
traditional preference for having popular politics in command of resource
allocation and economic policy-making. The links were forgotten between
earlier economic reform and the contemporary prosperity.


Economic analysis was banished to the periphery of many areas of policymaking.
Endorsement by business interests and economists hired to argue a
case for politically preferred policies again became more important than
transparent analysis in trade and industry policy and to some extent in fiscal
policy. The exception was in monetary policy, where the reform era had left a
legacy of independence at the Reserve Bank of Australia, which so far has not
been endangered by an apparent recent re-politicisation of interest rate policy.
The return to traditional approaches to economic policy-making, favouring the
ad hoc and expedient over the economically rational, has had broadly based
support within the Australian polity and across the organised political
spectrum. It is as evident in State as in Federal Government. The return to
populism in economic policy-making has had bipartisan support at Federal
level, with the Labor Party voting in favour of damaging decisions of the
Coalition Government and in at least one area of policy promising to do worse.


Much remains from the reform era, to help in the rebuilding of support for
economic policies that generate strong economic growth alongside equity. The
most important legacy from the reform era is the recent reality, that a farreaching
program of economic reform can make a large difference. This is an
advantage of the present over two decades ago, when leaders promoting
productivity-raising reform had to argue against powerful and longstanding
prejudice without the support of practical examples of benefits.


Most of the transformative policy changes of the reform era have remained
intact, although backsliding in some areas of public finance and trade policy
will turn out to be costly. In most areas of policy, the problem is that the
reforms stalled before they had gone far enough to deliver their full benefit. For
these, the problem of the Great Complacency is that opportunities have been
lost when highly favourable circumstances had been established for them for
example on taxation and social security reform. In a few areas of policy, there
has been continued improvement despite the complacency, strengthening the
opportunity for restoration of strong economic performance. Here the
outstanding example is the large and continuing expansion of the skills
component of the immigration programme.


The first step towards restoration of reform and good national economic
performance is to break the complacency. This must start with realisation of the
extent of the deterioration in our economic outlook. My contributions to the
public debate on macro-economic policy through 2004, culminating in the
Melville Lecture at The Australian National University on December 3, were
meant to help that step. Over recent months the Reserve Bank of Australia and
the Treasury have added their warning messages, and this has contributed to a
significant change in public mood on the economy. The change has been
accelerated by the publication of new data in March 2005 on real output and
the external accounts, and by some monetary tightening by the Reserve Bank.
The second part of this paper updates the Melville Lecture, noting that new
data confirm the cautions embodied in that earlier statement.


The second step towards restoration of reform and good national economic
performance is to build community confidence that a new programme of bold
reform has reasonable prospects of restoring strong economic growth. This
requires a return to bold and comprehensive discussion of reform, of the kind
that laid the basis for policy change in the 1980s. Optimal policies will be
found on territory that is taboo to the professional political advisers to our
major political parties. The political advisers will argue for the incremental
adjustment that has been electorally so successful over the past four years¡ªas
they argued for caution in the early years of reform. The case for major change
will have to be made by independent analysts who derive their authority from
their professional standing. Regrettably, Australia is less well endowed with
authoritative, independent public sources of analysis than it was in the early
stages of the reform era. It is important that the contemporary weakness be
corrected including through the maintenance and development of fora like
this.


The third part of the paper updates some perspectives presented in a paper that
I prepared for the Business Council of Australia in the years before the reform
era was replaced by the Great Complacency. It focusses on one of the two areas
that are potentially most productive in expanding growth opportunities in the
years ahead, in which policy developments over recent years have reduced
incentives to efficient resource allocation, that is, on taxation and social
security reform. The fourth part of the paper focuses on issues in the
relationship between State and Commonwealth Governments. Reform of
taxation and social security is crucial to more effective utilisation of Australia¡¯s
labour including skill resources. Reform of Federal relations is at the heart of
any efforts to raise effectiveness of education and training, and provision of
infrastructure.


The focus on two critical issues is not meant to suggest that other areas of
reform are unimportant. An effective reform program in the early twenty first
century, as in the late twentieth century, will utilise a large range of
opportunities to raise productivity, expand the resource base of the economy,
and raise rates of growth. But tax and welfare and Commonwealth-State
relations would be at the centre of any contemporary reform programme.
The paper concludes with discussion of the timing of reform measures.


Productive reform of tax and welfare, training and education and infrastructure
would be facilitated by utilisation of the large fiscal surpluses expected for the
immediate future, especially as the recent and prospective increases in terms of
trade flow through into Commonwealth and State revenues. This has become
an element in discussion of tax reform in particular. But the current imbalances
in the economy, and concerns about the temporary nature of part of the
improvement in the terms of trade, argue for larger short-term fiscal surpluses.


If effective reform is to proceed alongside the maintenance of economic
stability, itself essential for strong long-term growth, the ground must be
prepared now for fundamental change. But any drawing down of fiscal
surpluses to facilitate structural reform should be delayed until the weakening
of demand eases inflationary pressure over the one or two years ahead.


II. The Imbalances Threatening Economic Stability


The Melville Lecture presented a large amount of data to demonstrate the
similarity of the boom in domestic expenditure in recent years to the debtfunded
expansions of domestic demand that had preceded a number of earlier
recessionary episodes in Australia. The audience and the reader were invited to
note the comparisons between macro-economic developments from the
December quarter of 1998 to the present, with those in the quarters from
December 1984 through to and beyond the onset of recession in 1990.


There are, of course, differences between the two periods. One is the much
stronger financial system in the early twenty first century. The professional
weakness of Australian financial institutions after deregulation in the mideighties
left them vulnerable to shocks, and their responses magnified the large
shock to demand that followed the extreme tightening of monetary policy in the
late eighties. The monetary authorities are unlikely to repeat the error of
excessive contraction that precipitated recession in 1990. The early twenty first
century boom in domestic demand has been concentrated much more intensely
in a single sector, housing, than the earlier debt-funded boom, and had a much
smaller component of general business investment. This raises some special
challenges to demand management.


The following nine charts update the data presented in December. Mostly the
additions confirm the similarities between the two periods covered in the
charts.


Chart 1 allows comparison of real GDP growth in the 25 quarters leading to the
present, with the comparable expansion in the late eighties.


Chart 2, read with other data, reveals that domestic demand contraction led the
decline in GDP in the earlier episode, but not in the early twenty first century.
The recent decline in real growth is entirely the result of the economy running
into capacity constraints.


The capacity constraints in the early twenty first century have caused
continuing strong domestic demand growth to be manifested in a large,
sustained negative contribution of net exports to output (Chart 3). In the late
eighties and early nineties, the period of extreme negative contributions from
net exports was brief, before the reduction in domestic demand and
depreciation of the real exchange rate induced rapid correction.


The trade and current account deficits as a share of GDP in the early twenty
first century have turned more strongly negative for longer than in the late
eighties¡ªindeed, than ever since national accounts have been maintained in a
comparable form (Charts 4 and 5). In the absence of substantial correction
through monetary policy, the deficits continued to grow in the December
quarter. There is debate about the conditions under which deficits on this scale
might be sustainable. What is broadly agreed is that Australia now faces risks
that would be realised suddenly and with recessionary consequences if there
were a significant deterioration in external business conditions while the
external accounts remain in their present states.


One exceptional feature of the current account deficit is that it is so large at a
time when international interest rates remain low by historical standards.
Australia's net external liabilities (Chart 6) and net external debt are far higher
in proportion to GDP than they were when they were the subject of
considerable domestic concern in the late eighties. The size of the current
account deficit ensures that the ratios will grow beyond the levels of December
2004. The burden of servicing the dominant debt component of these external
liabilities will become increasingly burdensome with the movement of
international (and, less dramatically, Australian) interest rates towards more
normal levels. The failure to anticipate the effect of rising global interest rates
on the cost of servicing external debt contributed to the market surprise on the
release of current account data in the September and December quarters of
2004.


A second surprising feature of the current account deficit is that it has reached
the recent depths despite terms of trade that are extraordinarily high (Chart 7).
The high export prices that have been the dominant element in the recent lift in
terms of trade are correctly attributed to the strength of Chinese demand for
energy and metals at a time of reasonably strong global economic growth. They
are vulnerable to correction, either with any setback to Chinese economic
growth (and we would be prudent to expect China, like all market economies,
to have cyclical downturns from time to time), or in other major economies.


One special feature of the recent lift in the terms of trade is its concentration in
the prices of mineral products. The fiscal arrangements for these products taken
together generate for the State and Federal public revenues a high proportion¡ª
approaching one half¡ªof the gross increase in export revenues from high
prices. Thus, high export prices alone, above long-term average levels in real
terms, will soon be contributing more than two percentage points of GDP to the
public revenues. Prudence argues for this windfall to be saved in fiscal
surpluses, at least until there are grounds for presuming the sustainability of the
higher export prices. This makes the recent surpluses in public budgets seem
far too low in the context of the stabilisation requirements, at a time of
booming domestic demand (Chart 8).


Capacity constraints and associated competitiveness problems have contributed
to a sharp deceleration of export growth since 2000 (Chart 9a). Explanations
have been sort for this poor performance in the international slump of 2001-
2002, following the US 'tech-wreck' but this does not acknowledge the
reality of continued buoyant import growth in Australia's major markets in
Asia through this period. Explanations have been sought in the drought that
was at its depths in 2002, and the SARS epidemic (affecting trade in services)
of 2003. But the weakness extends across all categories of exports over the past
four years (Chart 9b), and in time beyond the effects of drought and SARS.


Explanations are sometimes sought in the high exchange rate of recent times
but the real effective rate is currently short of its highs from the time of floating
the dollar, and the weak export performance began when the exchange rate was
exceptionally low.


The weak growth in export volumes since 2000, after 15 years of strong and
diversified growth (Charts 9a and 9b) were early warnings of the emerging
imbalances in the Australian economy. That it took so long for the imbalances
to become a subject of public concern speaks eloquently of the complacency of
recent years.


III. Raising Growth Capacity: Labour Supply


The growth in the productive capacity of the economy depends on the rates of
growth in productivity, the employed labour supply, and the capital stock. Each
of these contributed to the exceptional growth in the Australian economy
through the 1990s to 2003, although the concentration of investment in housing
limited its impact on output growth.


In the absence of a return to far-reaching reform, labour supply and
productivity growth are unlikely to make comparable contributions in the
period ahead.


Real labour productivity has fallen sharply as capacity constraints have
interrupted the supply of a range of necessary inputs to production (Chart 10).
The amount of labour employed has expanded steadily through the period of
strong growth. Unemployment has fallen steadily and participation rates have
increased. But limits on expansion of labour supply are approaching, at a time
when the proportion of the Australian population in employment remains well
below comparable countries.


The recent Australian discussion of labour and skill shortages has focussed
usefully on immigration, training, and incentives to greater labour force
participation by the Australian population.


Higher levels of skilled migration would be helpful to Australian growth and to
the standards of living of established Australians. However, the lead-times to
significant expansion of the immigration programme are considerable, and the
economic effects long-lasting. Attempts at cyclical variation in the migration
levels to mesh with short-term macro-economic conditions are likely to be
destabilising. The economic contributions would be more favourable if skilled
immigration levels were set at higher levels on a long-term basis, and the
programme held steady through the business cycle.


The emigration of young, talented and well-educated Australians; the 'brain
drain' has accelerated in recent years (Fullilove and Flutter, 2004), and is
now a significant contributor to supply constraints within the Australian
economy. High tax rates augmented for recent graduates by HECS
obligations, which are avoided or postponed by residence abroad are one
factor influencing decisions to leave, and, more powerfully, decisions on
whether to return to, Australia.


For a number of years, if favourable incentive structures were established, the
most important source of expanded labour supply could be higher labour force
participation and higher rates of employment from the resident Australian
population.


Charts 11 and 12 indicate the potential for expansion of domestic labour supply
from greater participation of the established population. The ratio of
employment to population in Australia was once much higher than in either the
United States or New Zealand (Chart 11). It is now lower, after 14 years of
strong economic growth unbroken by recession. The United States at the end of
its long boom of the 1990s, in 2000, had much higher employment rates than
Australia after an even stronger boom, although US employment fell in the
2001-2 recession and by 2003 had yet to recover to earlier levels. The New
Zealand ratio had moved decisively ahead of Australia by 2003, although
Australia had a stronger record of economic growth. The share of part-time in
total employment was similar in Australia and the United States in 1980. By
1980, much more than 100 per cent of the growth in the employment to
population ratio in Australia was part-time, whereas in the United States parttime
and full-time employment grew at similar rates (Chart 12).


Why have Australian employment rates fallen so much relative to two
countries which are similar in many ways that affect labour market behaviour?
The answer lies in the different and changing incentive structures for labour
force participation and employment of labour. Australian legal minimum
relative to other wages are much higher than American or New Zealand (Chart
13). And the effective marginal taxation rates created through interaction of the
social security and income taxation systems are much higher in Australia,
diminishing incentives to labour force participation (OECD, 2005).


The other side of the coin is that Australia makes better provision for the needs
of people who are in a weak position to earn high incomes in the market. As
Prime Minister Howard has recently observed, the high minimum wages and
generous provision for social security¡ªboth extended considerably over the
past decade of Coalition Government©¤have deep roots in Australian social
preferences, and will not be diminished lightly.


The most important reform task at present is to improve the trade-off between
generous provision for the disadvantaged and economic efficiency. To fail in
this task will lead to continued economic underperformance as well as poor
outcomes on employment and equitable distribution.


These matters have been discussed at length at this conference on two earlier
occasions. The capacity constraints in the economy and the considerable
extension of the social security system over the past several years make the
issue more important than ever.


The most urgent task is to reduce considerably the effective marginal tax rates
for social security recipients, the high levels of which contribute to relatively
low labour force participation and high levels of part-time employment. High
taxation rates are also significant elements in labour force participation, and
attraction and retention of skilled personnel, at higher levels, and probably at
all but the highest levels, of the incomes range.


At the highest levels of incomes, personal income tax rates tend to be relatively
unimportant in determining levels of taxation. Current taxation treatment of
corporate income and capital gains provide opportunities for high income
earners to convert most of their potential personal income into forms that
attract taxation at rates at or in most cases below 30 percent.


A reform of taxation rates that established a flat 30 percent marginal effective
tax rate for all corporate and personal income, including capital gains, would be
most advantageous for people at the bottom of the income range, and most
disadvantageous for Australians on the highest incomes and with the greatest
wealth. Contrary to popular perception, it would be progressive, as well as
being highly advantageous to incentives for greater labour force participation
within Australia. It would have the additional advantage of removing the gains
from conversion of personal into corporate income, which is at the origin of
much of the complexity and perception of unfairness in the current taxation
system. The raising of the rate of taxation on capital gains (and it would need to
be on real rather than nominal gains), would have the incidental effect of
greatly reducing the distortions in capital allocation that have spurred the
housing and associated consumption boom of recent years.


It would only be possible to establish uniform and moderate effective marginal
tax rates throughout the income tax range within a version of a 'negative
income tax' arrangement, for which individuals would receive payments
related to their objective circumstances and unrelated to income, for
participation in the labour force (subject to 'mutual obligation' tests), age,
participation in formal education and training (independently of age), disability
(calibrated for degree), and responsibility for dependent children. All payments
would be subject to an assets test cutting in at considerable wealth, and would
be withdrawn when income reached some high threshold.


The biggest beneficiaries, proportionately to current after-tax and after-social
security income, would be Australians who were now on social security and
who had some opportunity to work, and those on low incomes who currently
fall outside Australia's extensive social security framework. Losers would
include people who were succeeding in converting large potential income into
capital gains, and non-members of the labour force who were utilising the
current tax-free threshold.


The large benefits to low-income workers would provide the context in which
it would be feasible and reasonable for the Government to ask the Industrial
Relations Commission to take taxation and social security arrangements and
employment considerations into account in setting minimum wages, and to
suggest a freeze on minimum wages for a number of years. Success in this
effort, in combination with the taxation and social security reforms, would be
likely to move Australian employment ratios back to and beyond those in
comparable countries. Over a period of four or five years, this could raise total
employment in terms of hours worked by 5 percent or more, and raise potential
rates of economic growth considerably over this period. The expanded
economic output and incomes would make a significant contribution to the
financing of the taxation and social security reform.


Eight years ago in a paper for the Business Council of Australia I suggested a
reform of the tax and social security systems along these lines. The proposal
was built around reducing to 30 percent the effective marginal tax rate on all
income, while preserving and augmenting incomes for low-income Australians
(Garnaut 1997, reproduced in Garnaut 2001). Two versions of the 'negative
income tax' were discussed; a comprehensive version, where the basic
payment would be made to all adult citizens who were not in receipt of another
benefit; and the constrained version presented here, in which the basic payment
was confined to members of the labour force, and subject to a 'mutual
obligation' test. The analysis at that time suggested that, within the
constrained version of the reform, the top effective marginal tax rate would
have been reduced to 36 percent by mid-2003 and to 30 percent by about mid-
2005.


Some element or other of the Australian polity would find some part of the
proposed reform completely unacceptable. The trade union movement would
find the downward pressure on real minimum wages unacceptable. Parts of the
business community would reject outright the return to taxing capital gains at
the (albeit greatly reduced) income tax rate. No doubt citizens concerned with
perceptions of equity would object to the reduction in notional tax rates on high
incomes. Every Australian will be able to think of an alternative tax reform that
is superior to the one proposed, because it gives more to her or him.


But while each element of the package is unacceptable to some influential
group, it may be that the package as a whole is electorally attractive, because it
removes a major impediment to continued strong economic growth in
Australia, and is recognised as being broadly equitable.


It could be said that the time for introduction of such a system has passed. We
have had our eight years of strong economic growth and extraordinarily rapid
growth in government revenues. We now face less expansive times, and cannot
so readily fund a major tax and social security reform from the fiscal dividends
of growth.


But while it is true that a great opportunity has been lost through the years of
strong growth, the opportunity has not gone away. I return to the funding issue
in the final section of the paper.


IV. Raising Economic Growth: Infrastructure and Other State Services


The second critical and urgent area of reform is Commonwealth-State relations
on fiscal matters and the regulation of economic activity. The recent discussion
on infrastructure and on education and training as constraints on economic
growth, has moved into issues of State responsibilities and Commonwealth-
State relations.


The Australian constitution formally specifies a limited range of
Commonwealth responsibilities, leaving other matters to the States. The High
Court's interpretation of the constitution (most importantly in the second
Uniform Income Taxation Case decision of 1957) has given the
Commonwealth an overwhelmingly dominant role in revenue collection. The
introduction of the GST and its replacement of several minor States taxes
compounded the vertical taxation imbalance within the Federation.


The Commonwealth-State agreement on introduction of the GST has extended
and entrenched a dysfunctional element of Federal fiscal relations¡ª
comprehensive fiscal equalisation through the Commonwealth Grants
Commission.


The combination of Commonwealth domination of taxation powers and the use
of conditional grants in more and more areas in which the States have
constitutional responsibility has over time turned virtually all States powers
into joint responsibilities. The resulting overlapping of responsibilities in the
absence of effective coordination, has exacerbated the dilution of responsibility
of State Governments for economic outcomes.


The dysfunctional Commonwealth-State fiscal relations and overlapping
responsibilities contribute to poor management and funding of a wide range of
services that are essential to continued strong economic growth. First amongst
these are the provision of business infrastructure, and education and training.


The strongest short-term electoral gains for both State and Federal
Governments lie in the deflection of public blame for imperfections in supply
of services onto the other party. To solve the problems rather than deflect
blame, would be more difficult and take time beyond the four or three year
electoral cycle. As a result, in this even more than other areas of policy, it is
essential that a strong base for productivity-raising reform is established in
community opinion.


The Prime Minister has been reported recently as expressing the opinion that an
optimal Australian governance system would not have States in their current
form. He may well be right. He is certainly right in adding that the States are
part of the Australian reality for the foreseeable future. There is no satisfactory
alternative to making the Federal arrangements work efficiently.


An efficient system of Commonwealth-State relations in economic affairs
would require an agreement on reallocation of responsibilities, leaving one or
other level of Government unambiguously responsible for policy decisions
wherever this is feasible. The clear-cut allocation of responsibility is generally
more important for efficiency than the final location of powers between
Commonwealth and State. Where decisions clearly have large national
implications - as for example with regulation and funding of major
infrastructure - it is more efficient for responsibility to lie with the
Commonwealth. However, it is by no means clear that the national interest
would be served by uniform industrial relations and wage regulation: there
would be benefits from differentiated minimum wages, taking into account
regional differences in living costs and supply and demand conditions.
Australia would be more likely to have this differentiation within a
decentralised than a uniform national system. Where responsibilities continue
to be shared, as may be inevitable at least in some areas of education, health
and aboriginal community development, it is important that a clear basis be
agreed for cooperation between the Commonwealth and the States.


It is unlikely that a new definition of responsibilities can be agreed without
revision of the system through which GST revenue is allocated, which is in
itself the source of major deadweight costs (Garnaut and FitzGerald, 2003). It
is likely that the macro-economic adjustment which is required in Australia in
the period ahead will provide both motivation and opportunity for revision of
the fiscal equalisation arrangements.


V. Financing Reform and Economic Stability


The resumption of bold, productivity-raising reform contains large potential for
restoring economic growth to the levels enjoyed through the 13 years to late
2003. Australians in the recent past have demonstrated an ability to embrace
change on the scale that is required.


Part of the challenge of reform is to integrate the timetable of design and
implementation of policy change with the budgetary requirements of stable
economic growth.


Some important reforms, for example in Federal-State financial relations, are in
their essence institutional, and can be commenced without net calls on budget
surpluses.


On the other hand, the budgetary costs of fundamental tax and welfare reform
are considerable. Significant room could be made for commencement of reform
by reducing government expenditure in the many areas where increases in
recent years have contributed relatively little to either equity or to economic
efficiency.


It is tempting to see the substantial current fiscal surpluses - soon to become
larger still as the effects of higher minerals and energy prices flow through into
public revenues - as an opportunity for making additional early progress in
cutting some tax rates. Ultimately the current and prospective fiscal surpluses
can make important contributions to funding the tax reform. But not yet.
The contemporary supply constraints on Australian economic growth are tight.
The Reserve Bank of Australia has emphasised in recent statements that
domestic demand is running well ahead of those constraints. Any delay in
reducing demand to levels within those constraints will be reflected not in
higher growth, but in increased inflationary pressure. The greater the increase
in Government spending or reduction in tax revenue in the period ahead, the
larger the requirement further to tighten monetary policy to contain that
pressure.


It is always difficult to judge how much fiscal and monetary tightening is
required to bring excessive demand expansion back within prudent limits.
However, the extent of excess demand is currently so large that several more
interest rate increases of similar dimension to that of early March may be
required. Further to raise the requirement of monetary tightening through
additional fiscal expansion at this time would increase the risk of recession.
Recession would be damaging for all of long-term reform, long-term growth
and equity.


It is much better to save the growing budget surpluses until the growth in
demand has fallen back below the growth in productive capacity. By then we
will have a clearer view of the extent to which the recent improvements in the
terms of trade can be expected to continue for a long period. By then, there will
be scope for some fiscal stimulus, helping to finance taxation and social
security reform in ways that are beneficial to stable economic growth.


The most likely trajectory of the economy suggests that there will be room for a
decisive step towards fundamental tax and social security reform within the life
of the current Parliament. Or, if this new chance is missed, there will be an
opportunity for an alternative Government to foreshadow reform early in the
life of the next Parliament.


---------------------------------------------


Notes


1.  I am grateful for Sam Hill for assistance in preparation of the charts, and for discussions with Sam,
Warwick McKibbin and other colleagues at The Australian National University, Ian Macfarlane, David
Vines, Max Corden and Don Stammer on the lines of economic analysis.
2.  See Peter Dawkins and Paul Kelly (eds), Hard Heads, Soft Hearts; A New Reform Agenda for
Australia
, Allen and Unwin, 2003 and Ross Garnaut, 'Equity and Australian Development: Lessons
from the First Century', in The Australian Economic Review, pp.227-243, Vol. 35, No. 3 September
2003.


Charts - to be posted later

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