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Henry Thornton - Economics: A discussion of economic, social and political issues Reserve to move but danger looms Date 02/02/2010
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'Australia coped well during the global downturn. We could afford a large dose of fiscal stimulus – although not the waste and debt that were its inevitable by-products. Our flexible labor market helped limit increases to unemployment though, as in other ‘developed’ nations, one can add large numbers to the official estimates for discouraged workers and the underemployed.

'But now the labor market is far less flexible, and recovery is occurring from a still inflationary economy. This fact alone will keep the Reserve Bank’s leaders’ minds on the need briskly to withdraw ‘emergency’ monetary policy ease'.
By Henry Thornton Email / Print

 The reality facing the Reserve Bank is that inflation is too high for comfort as economic recovery gathers strength.


This is why we should see another 25 basis point hike today.


But, there are plenty of reasons for caution. Some facts reinforce the case for rate hikes, while other developments if realised would make further rate hikes damaging.


The global economy is now clearly divided into fast and slow lanes. The developed nations are in the slow lane, undergoing tepid recoveries.  The latest news from the USA shows fast growth of GDP and signs of stabilisation in the jobs market, but unemployment is still officially measured at 10 % of the workforce.  With many ‘discouraged workers’ having left the workforce and even larger numbers working less hours than they wish, the amount of wasted labor market resource is dramatically higher – at least 20 per cent of the US workforce in Henry’s estimation.


This is a story repeated to varying degrees in Eurozone economies.  The US Fed has said it will soon begin to remove ‘quantitative easing’ but leave official cash rates close to zero for some time yet. Alan Greenspan’s near zero cash rates fed asset bubbles in the USA and other parts of the world economy. Very easy US monetary policy will again feed global asset inflation.


It would be hard for Ben Bernanke to begin raising rates while 20 per cent of US workers are unemployed or underemployed, but failure to do this will recreate the asset bubbles of 2003 – 2007.  Bubbles create busts, and the next bust will come from a far higher base of wasted labor market resource. Ben Bernanke presumably spent any holiday break pondering this major dilemma.


The US banks are roaring back, and Wall Street’s enormous profits and bonuses have fuelled unhappiness, even rage, on Main Street. This is President Obama’s dilemma, and he has returned from holiday full of resolve to fix the economy and bring the bankers to heel.  The global banking crisis is far from over.  New rules have been formulated, but The Economist has said: ‘If the banking system resembles a line of climbers roped together, then regulators are busy making the clothes warmer, the maps more accurate, the rations more filling and the whistles louder. Unfortunately none of that is any good if someone falls over the edge, as a handful of banks are wont to do in financial crises'.


In any case, new rules will not be implemented quickly, requiring as they must far higher capital ratios and major changes to banking practice.


There is potential trouble with banks from Paris to Timbuctoo.  US and UK banks have been bailed out (at great cost) by their governments, but so far in Europe there has been remarkable stability in the banking system. Yet Western Europe has lent vast sums to Eastern European nations and businesses.  There is a shaky row of dominos waiting to stand or fall and, if the latter, one doubts the ability of the Eurozone governments to stand them up again.


A major study in 2008 showed that sovereign debt was at a cyclical low during the boom from 2003 – 2007.  Yet four times since the year 1800, low points in sovereign debt default were followed by sharp increases.  This study effectively dismissed the comforting ‘this time is different’ hypothesis so beloved by those who never learned economic history.


Bankers everywhere are inclined to be a bit short on the lessons of history.  China’s bankers have been lending like there is no tomorrow. Added to the Chinese government’s massive fiscal stimulus, the bankers’ largesse has fostered revival with immense rapidity, and the economy is headed for double digit growth in 2010. The world, and especially Australians and other resource exporters, have cheered.  China’s leaders are now trying to rein in their bankers, but like bankers everywhere they also feel the hot wind of economic forces.


There is a direct but badly understood link between America’s monetary policy and China’s banking system. The essential linkage point is created by China’s relatively fixed exchange rate.  The liquidity pumped out by the US Fed spreads globally, and China’s strong economy attracts a large share of the Fed’s easy money. China’s banks find themselves able to fund greatly expanded economic activity, including property and share purchases that drive up prices in those asset markets.


Australia went through this damaging cycle of frustration and policy impotence in the late 1960s and early 1970s.  More than forty years on, China is grappling with this problem and will learn there are no easy answers. Instructions to the banks may work better in a strong, centrally governed nation like China than they did in Australia, but one should not bet too much on this outcome.


How China adjusts to its rising status as a global economic powerhouse, and how the rest of the world responds, will be one of the great stories of this century.  The fallout will be vital for Australia, and this will be one of the RBA Chief, Glenn Stevens’, major concerns in coming months and years.


Australia is caught between its developed nation status and structure and its ‘developing nation’ heritage as a major producer of gold, food and other raw materials.  Like the world economy, Australia is a two speed economy. Resource producing areas and companies are already growing rapidly again, with renewed demands for skilled labor. These demands will quickly run up against renewed union power and constraints of the Labor government’s Fair work legislation.


Filled with optimism, in stark contrast to the deep pessimism experienced for much of the past two years, Treasury officers and senior ministers are speaking of the challenges of a much larger population and the need for greater productivity.


Australia coped well during the global downturn. We could afford a large dose of fiscal stimulus – although not the waste and debt that were its inevitable by-products. Our flexible labor market helped limit increases to unemployment though, as in other ‘developed’ nations, one can add large numbers to the official estimates for discouraged workers and the underemployed.


But now the labor market is far less flexible, and recovery is occurring from a still inflationary economy.  This fact alone will keep the Reserve Bank’s leaders’ minds on the need briskly to withdraw ‘emergency’ monetary policy ease.


Published today in The Australian.

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