Reserve Bank of Australia Annual Report – 1975 Problems of Economic Management

Over the final months of 1973/74 inflation was the main preoccupation of economic policy in Australia. Unemployment was low; pressures on resources had been at unsustainably high levels and widespread shortages had been reported. This situation had its origins in an earlier boom in commodity prices; some large balance of payment surpluses; a budgetary policy primarily concerned with increasing the public sector's command over resources; very fast growth in the money supply; and a build-up of excess demand, wage demands, and inflation. Formidable measures had been taken to counter inflationary tendencies, including revaluation of the Australian dollar, tariff cuts, controls on capital inflow, the creation of the Prices Justification Tribunal, and a tightening of the domestic monetary policy instruments. These powerful policy measures were at work in the first half of 1974, but the full impact they were to have was not then generally apparent. The volume and value of imports were growing apace, and the external accounts had moved into deficit; in these circumstances, and with monetary policy restrictive, the rate of growth in money supply was declining. But expectations of further price rises had become widespread, there were strong demands by labour for a larger share of national income and, salary and wage claims and settlements in the first half of 1974 reached unusually high levels.

Around the middle of 1974, the policy measures taken earlier produced swift and dramatic changes. A substantial deficit in the balance of payments emerged, reinforcing the lagged effects of restrictive monetary policy, and, in the September quarter 1974, money supply declined. Despite ameliorating action by the authorities, financial conditions became excessively tight. The juxtaposition of this situation and the wage explosion produced an especially difficult period. Demand and output fell sharply and unemployment rose at a pace much more rapid than most had expected. At the same time, the rise in wages gave inflation a new impetus. Australia experienced both a rapidly rising level of unemployment and continued acceleration in inflation.

With this rapid deterioration in the employment situation and, by late September, the emergence of clear signs that the intended monetary tightness was developing in the direction of substantial financial disturbances, there came a marked shift in the priorities of economic policy. Although the Bank had acted earlier to reduce the severity of the liquidity squeeze by releasing funds from Statutory Reserve Deposit Accounts and by some buying of commercial bills, monetary policy had been kept very tight and, in particular, a strong rein was kept on bank lending. Early in October, however, with some disturbances apparent in financial markets, quick and substantial action was taken to ease liquidity; the SRD ratio was further reduced, bill purchases were expanded, a special facility was established for banks (see page 21), and yields on short-dated government securities were reduced. With these actions, banks were encouraged to step up sharply their rate of new lending, although it was not intended that all demands arising out of inflation would be met.

External, budgetary, and wage policies also changed course. The Australian dollar was devalued, controls on capital inflow were modified, government spending was expanded at an even faster pace, income tax rates were reduced, and the Budget deficit moved up to an historically very high level. Mostly as a result of the size of the Budget deficit, the money supply began rising at a very rapid pace. Proposals for wage indexation were advanced in the hope that assurances about future real wages would reduce other claims for increases. Employees were urged by the Government to accept the November tax cut in lieu of wage rises.

While the abatement of demand pressures around the middle of 1974 led to much of the rise in unemployment, the position was greatly exacerbated because the rise in wages was a good deal sharper than the increase in selling prices; in other words, there was a fast rise in real wages. In some circumstances, increased wages might have been passed into prices fairly easily but this process was severely hampered in mid 1974 because of competition from imports, tight financial conditions and a tough attitude by the Prices Justification Tribunal. The large rises in money wages were, however, partly passed on, and in this way contributed to inflation. Profits nevertheless fell, even in nominal terms, and there was, therefore, a contraction of firms' activities and a decline in the demand for labour simultaneously with a worsening in inflation.

The tendency for high rates of inflation to be associated with high levels of unemployment was not entirely a new development during 1974/75. Rapid structural adjustments occurring in the economy as a result of government policies were tending to raise the amount of unemployment associated with a particular level of demand. Also, higher levels of unemployment benefits and an easing in eligibility requirements for these benefits, together with the increased incidence of multiple-income households, would have tended to ease the hardships of being out of work and to lengthen time between jobs. In addition, increases in effective tax rates almost certainly led wage earners to increase their wage demands in an attempt to maintain after-tax income, and this would have contributed to inflation. Most important though, there had earlier been indications that the strengthening of expectations of further rapid increases in prices, together with an attempt to increase the share of wages in total income, was tending to worsen the inflation/unemployment trade-off. Early in 1974 price expectations seemed to have become stronger and more widely entrenched. Such expectations induce the raising of claims in wage negotiations in an attempt to ensure that real wages are increased or at least maintained. If, where monetary and fiscal policies are seen to be accommodating, these higher wage claims are granted and at least partly passed into prices, the expectations become self-fulfilling and inflation, once established, will tend to feed on itself.

The dilemma in Australia of the emergence of high levels both of inflation and of unemployment has also been experienced overseas, in some cases more acutely. Some major countries, especially the United States, West Germany and Japan, have recently had lower inflation rates following earlier restrictive policies but at heavy cost in terms of activity and employment; on the other hand, the United Kingdom, where there have been determined attempts to maintain employment, has experienced increases in both inflation and unemployment. The response of the Australian authorities, after the early months of the year, was to stimulate demand and to allow the monetary growth necessary to accommodate it, the main policy focus being the early reduction of unemployment. Without losing sight of the desirability of an early reduction in unemployment, however, the Bank became increasingly apprehensive as the year developed that continued strong stimulus could eventually cause the already very high level of inflation to become a jumping-off point to another, and higher, level with a new round of large wage increases giving a further twist to the inflationary spiral.

There are strengthening grounds for believing that continued rapid inflation in an economy such as Australia's will reduce living standards. The tendency for rapid inflation to disrupt long-term capital markets, especially fixed-interest markets, is fairly well known. At the same time, increased uncertainty for businesses about future costs and returns makes the planning of new long-term projects difficult and the result tends to be a contraction of business activity. In the long run, the consequent lower level of investment will reduce both productivity and employment opportunities. Perversely, in inflationary situations, policies aimed at quickly stimulating demand and reducing unemployment can thus lead not only to higher levels of inflation but also to a breakdown in capital markets and other economic institutions and still higher levels of unemployment.

Continued high inflation creates particular problems for financial intermediaries; not only is the assessment of propositions put to them made more difficult, but they must also guard against large swings in and divergences between their own earning rates and costs of borrowing. In addition, they may face problems in maintaining adequate capital gearing. The reduced efficiency on this account in financing the economy, as well as the heightened risk of financial instability, are further, and not inconsiderable, costs of inflation.

Reasons such as these made it increasingly urgent that policy, in the second half of 1974/75, did not stimulate a new, higher, bout of inflation. The Bank made some movement in the direction of restraint in March 1975 by informing the trading banks that its lending policy did not envisage further expansion in the aggregate provision of new finance beyond levels recently recorded. In early July 1975 monetary policy instruments were tightened further; the SRD ratio was increased and yields on medium and long-term government securities rose. However, the Budget deficit was the main force behind a continuing rapid expansion of money supply and its size was such that monetary policy alone could not, in practical terms, correct the situation. With interest rates having fallen overseas, a widening of interest rate differentials with Australia would, in the absence of changes in external policy, work towards encouraging an inflow of private capital, which would offset restraint in monetary policy. More importantly, although there are heavy costs (mainly associated with accelerating inflation) in allowing monetary policy to become too easy, there are also severe costs in an extremely restrictive monetary policy. Such a policy can lead to severe dislocation in the financial system and place a disproportionate part of the burden of adjustment on activities particularly sensitive to the supply and cost of credit, such as the building industry. Enterprises otherwise viable could fail through lack of finance, and unemployment could go much higher, before any improvement was effected through the fiscal expansion; the experiences of early 1974/75 are instructive in this regard. Reliance on tight monetary policies would tend to have detrimental effects on private investment and productive capacity. In general, economic policies are most efficiently used when a careful balance is kept between them, and when over-reliance on any one set of instruments is avoided.

Towards the end of 1974/75 a report on inflation and taxation, prepared by a committee of enquiry set up by the Australian Government (the Mathews Committee), was tabled. Proposals to reduce tax collections, through tax indexation or otherwise, involve, of course, a relinquishing of command over resources by the public sector in favour of taxpayers. Unless accompanied by rises in interest rates (with the possible deleterious consequences alluded to above) such action is not compatible with policies to substitute, without inflation, goods and services provided by the government for goods and services provided by the private sector. In other words, if there is a rise in the relative importance of the public sector, private spending must necessarily be cut from the level it would otherwise attain.

Entering 1975/76, the economic situation remains poor, despite some signs of a recovery in demand and an end to the deterioration of labour market conditions. Inflationary expectations are firmly entrenched, and a return to stability requires that they be dissipated. There are hopes for a moderation in the rate of growth of wages and prices arising out of recent decisions of the Arbitration Commission, though the robustness of the new framework for wage determination remains to be fully tested. These hopes, and those for a reduction soon in the rate of growth of monetary aggregates, hinge heavily on budgetary policy. The complex relationships emerging between levels of unemployment and the rate of growth in prices make it exceedingly difficult to choose the most appropriate policies; nevertheless, there are strong grounds for belief that, in current circumstances, over-reliance on simple expansionary policies may do more in the medium to longer run to fuel both inflation and unemployment than to cure either of them. Firmer policies would perhaps be associated with lower levels of activity in the short term, but seem to offer the best chances for sustained reductions in both inflation and unemployment over the longer run.