Reserve Bank of Australia Annual Report – 1976 Problems of Economic Management

At the outset of 1975/6, although fiscal and monetary policies were framed with awareness of the need to promote improvement in the level of real activity, they were, in association with initiatives taken on the wages front, primarily directed to exerting steady pressure to reduce the rate of inflation. The consistent orientation of fiscal and monetary policy throughout the year included maintenance of this firm thrust towards containment of inflation but the succession of events was such that progress was in uneven steps.

A series of difficulties impeded the effectiveness of policies. The curbing of government spending was undertaken in repeated thrusts, later in the year as well as in the Budget; it proved to be very heavy work, and the savings were necessarily slow to appear. In the December quarter, although need was seen to tighten monetary policy further, political constraints for a period precluded action. In the June quarter of 1976, a heavier-than-expected flow of taxation funds to the government, coming on the heels of actions taken in the March quarter to reduce excess liquidity of markets, required monetary management for a time to be directed, not to contracting, but to easing liquidity.

Policies on wage costs were within the year mainly seen in action before the Arbitration Commission, which, through the indexation guidelines, affected the pace of the upward movement in earnings. In the first three quarters of 1975/6, a strong nexus continued between movements in the consumer price index and adjustments in award wage rates. During the latter part of the year, the nexus between prices and wages was less close; the decision in the May indexation case, by means of a “plateau” formula, passed the price movement on into earnings only partially. Notwithstanding the complexities of the institutional framework within which it operates, and the limitations of its direct influence on these matters, the consistent tendency of wages policy was towards a slowing of the up thrust of wage cost pressures.

Despite the various frustrations of financial policy from time to time by the sequence of events during the year, major progress was made with restraint in fiscal and monetary aggregates. Monetary restraint in particular was very firm in the period from December to March. The speculative outflow of funds through the foreign exchanges in December drew down domestic liquidity substantially. An agreement was reached in January with the major trading banks that their minimum LGS ratio would be raised from 18 to 23 per cent, with the higher ratio remaining in force until March 1977. About the same time there was the determined and effective drive to draw small savings directly to the government by the issue of an attractive savings bond. Different in nature as these various contractionary actions were, their considerable size is illustrated by the fact that the combined funds involved in them amounted to some $2.5 billion.

Within the over-riding objective for monetary policy in 1975/6 of re-establishing a financial environment conducive to a moderation in inflation, various exigencies greatly complicated the task. The experience of the year was instructive in a variety of ways. First, the variability of liquidity projections during a period of high inflation was evident in the swings during the year in the prospect for the outcome of the budget and the balance of payments. The uncertainty of the liquidity estimates reinforced the need for flexible use of the instruments of monetary policy. Second, the effectiveness of the drive to sell savings bonds, despite some discomforts which attended it, demonstrated the scope that firm and flexible monetary policy action can have to bring about a rapid transformation in an inflationary liquidity prospect without intolerable disruption. Third, while the year's experience should not be taken as the forerunner of a changed pattern of handling seasonal fluctuations, the existence of a substantial volume of high-grade commercial bills provided an added dimension of flexibility for policy over the June quarter. The need that was felt to take into the central bank such large volumes of private paper reflected an exceptional situation. Holders of private paper should not infer from this that it can be regarded as being as reliable a source of ultimate liquidity as short government paper, through which seasonal swings in liquidity are normally managed. Although market dealings cope adequately with usual seasonal fluctuations, the year's experience points to a need for continuing study of administrative arrangements bearing on the size and evenness of the flow of tax money to the Government.

17 Selected Long Term Indicators

There was considerable effort, beginning with its formulation, to contain the budget deficit in 1975/6 and to curb the growth in government spending. A budget deficit can in many circumstances provide an important short term cushion for activity and employment; when inflation is running high, deliberate stimulus by deficit is more likely to produce a small and probably only temporary growth in activity and employment, and a subsequent large boost to inflation and increase in unemployment. The method of financing the deficit is relevant to the outcome. Inflationary effects can be reduced by financing the deficit through sales of government securities to the non-bank sector. This will usually require higher interest rates, to the detriment of private financing. In practice, there are limits, especially in the short run, to the community's appetite for government securities at rates of interest which do not overstrain existing institutional arrangements, including financial markets. There is need also to avoid having too large a proportion of a government's borrowing liabilities cashable on one month's notice, particularly if rates on competing claims can increase substantially. Thus it is difficult to avoid circumstances where large and persistent budget deficits are likely to give a strong boost to inflationary pressures or require unduly harsh constraints on financing of economic activity in the private sector. Judgments on these and other policy issues are complicated by the changes in traditional economic relationships occurring when there is high inflation and unemployment. Along with the detrimental effects of inflation on the reliability of some economic data, this makes diagnosis, forecast and prescription more difficult.

These problems are not confined to governments. Businesses and households also experience major problems with framing decisions when inflation is high and hard to predict, and when unemployment threatens. Households responded to the recent economic problems by increasing sharply their saving. The extent to which their saving has been directed into particular financial assets rather than into physical assets was also difficult to predict. Experience overseas appears to be that appreciably slower inflation, recovery of activity and a return of business confidence march together. Since the saving ratio in Australia increased more strongly than in most other countries, there may be a more substantial shift to spending as more stable conditions emerge. The complexity of the behaviour of households in recent years further illustrates that when inflation is high, policy-making is much less able to rely on the continuance of traditional economic relationships.

The effect of inflation on the task of economic management is adverse and very general; the problems multiply as the inflation continues over a prolonged period. When it is associated with increasing unemployment and distortions in the economy, specific measures directed at correcting these are increasingly called for by various sectors of the community. Many of these seem to offer short term benefits; in the longer term they are most likely to add to inflation, instability, cause other distortions in the economy, or perhaps all of these. Continuing inflation also builds up vigorous efforts by individuals and groups to protect (or increase) both their level and share of real income in a way that can hinder needed adjustments to economic disturbances. Problems such as these were plainly evident in Australia during 1975/6.

Implications of continued inflation for long term investment are of particular importance. The inflationary process in Australia in recent years has been to the detriment of business profits. Along with lower demand this has contributed to lower business investment. Beyond this, however, uncertainty generated by high inflation discourages investment in longer term projects, with obvious consequences for longer run growth in real incomes. Attempts to stimulate investment from a depressed level while inflation continues are at best a palliative; a return to greater economic stability is required.

Inflation can also have important consequences for the balance of payments. A continuing rate of inflation faster than that of our trading partners would tend, in the absence of booming world prices for our major export commodities, to weaken the balance of payments. The pressure on the balance of payments would be the greater, through higher domestic costs, insofar as the high rate of inflation gave rise to formal or informal arrangements to raise money wages in parallel with movements in prices. The experience of countries which have sought to compensate such developments by heavy use of tariffs, quotas or other direct restraints of imports – which affect competition and efficiency, the more so as time goes by – or by repeated devaluations or a continued “floating” down of the exchange rate provides a sharp warning against use of these devices of adjustment in an attempt to avoid the needed strengthening of wages, fiscal and monetary policies.

The strength of the Australian balance of payments has owed much to a high level of investment in the past decade or so. Major factors in that strength have been the rapid expansion of mineral exports which began in the 1960's, and, on average, higher prices of rural commodities in the first half of the 1970's. Mineral development in particular has contributed much to the growth in total output and incomes, and to strengthening the current account. The growth of the mineral industry both required and encouraged large blocks of foreign investment including risk capital which, even when not necessary to the balance of payments, provided funds which were beyond the capacity of Australian financial markets to mobilise. The foreign capital was frequently accompanied by links to overseas markets and to new technology, although not necessarily in proportion to the size of the investment. The benefits of this international interdependence of course entailed costs to Australia. There has been emphasis more recently on seeking, by careful regulation, greater opportunity for Australians to share the benefits; the continuing need is to reconcile this thrust with maintenance of a climate which accepts, and respects the rights of, those factors of production – including capital and skills – which have been and need to be contributed from abroad.

The prospect for such major investment projects is also affected by inflation in Australia. If this continues to run at a relatively high level, the scope to sustain a rapid expansion in the capital stock generally, not only from domestic sources but also from foreign investment, will be reduced – although official capital inflow can, to an extent, offset at least quantitatively a decline in private capital inflow. But the use of official resources in projects traditionally privately financed does not do away with the burden of inflation on the viability of a project. Moreover, the cost of errors of judgment in committing official resources falls on the whole community rather than private venturers – whose incentive to succeed may be correspondingly the greater.

There is ample recent evidence that unstable economic conditions are very costly in the short run; some factors mentioned above point towards their very heavy costs in the longer run. Failure to maintain price stability jeopardises the restoration and retention of high levels of employment. From the longer-run point of view, poor comparative price performance will erode the structure of our external receipts and payments, on which much of our prosperity depends, and will frustrate the realisation of the advantages provided by our extensive endowment of resources.

The manner of conduct of policy is important. The need is for the main arms of stabilisation policy – wages policy, budgetary policy and monetary policy – to keep moving firmly towards restraint so that the subsidence of inflation in Australia does not lag long after other countries. There are naturally fears of the effects of restraints; there are fears of disruption if restrain, are applied too suddenly and severely, and fears that activity will be held down if policy is firmly restraining. It is widely accepted that suddenness and disruption in policy shifts involve heavy costs and are to be avoided. As regards monetary policy, it seems clear that durable economic growth will not be resumed unless for a time monetary aggregates continue to grow more slowly than prices and wages. Despite the discomforts inherent in such a process, the need is to move steadily and firmly in that direction.