I want to show you something. It has to do with our economy and it’s probably been invisible to you. The majority of journalists have no idea about it and few politicians would, either. But it affects everyoneand it shouldn’t be something only economists know about.

Who controls the levers?

In this era ofcoronavirus lockdowns, we’ve learned a lot about our economic policy settings.

For example, we’ve learned widespread poverty is a policy choice in Australia.

Governments have the power to lift hundreds of thousands of households out of povertyif they want to.

The federal government did it last year, when it increased unemployment payments during the initial lockdowns.

That situation lasted a few months.

But then it let those families fall back into poverty by taking those specialpayments away again, as the graph below shows.

We’ve also learned our policymakers have been miscalculating something significant.

Give me 30 seconds to explain this one.

In recent decades, it’sbeen a policy choice in this country to have a national unemployment rate of somewhere between 4 and5 per cent no lower.

That’s because, since the 1980s, econocrats have asserted there’s a level of unemployment that’s “natural” for prevailing conditions.

They’vecalled that natural level of unemployment the “NAIRU” the non-accelerating inflation rate of unemployment.

According to their theory, if the unemployment rate is allowed to falltoo far below that “natural” level, wages and inflation will start growingtoo quickly.

Sothey’ve been using interest rates as a policy lever to try to keep the unemployment rate onthat natural level, or slightly above it.

How have they done that?

Aim for full employment

Eminent economist Professor Ross Garnaut criticises Australia’s policymakers for allowing hundreds of thousands of people to remain unemployed in recent years.

Read more

Well, if the unemployment rate startsdeclining, and their model’s telling them it’s very close to, or has fallen below, the presumed “natural” level, they’ll lift interest rates to “take some heat out” of the economy.

That’s a euphemism for pushing the unemployment rate higher,or slowing the economy down.

It’s often the same thing.

But there’s been a real-world cost to that policy.

By preventing the unemployment rate from falling below its presumed “natural” level, they’ve been usinghundreds of thousands of unemployed Australians as shock absorbers.

Those unemployed people have been assigned to Team Inflation Controlwithout their knowledge. And for their patriotism, they’ve been ridiculedfor being unemployed.

At the same time, successive governments have tightenedthe screws on unemployment benefits to “incentivise” those unemployed people to look for jobs in an economy where there haven’t been enough jobs to go around by design.

To top it off,in the last two decadesthey’ve also beenimporting hundreds of thousands of workers from overseas, which has helpedto suppress wages and weaken workers’ bargaining power,as the Reserve Bankgovernor explainedrecently.

So how correct have they been, about that"natural" level of unemployment?

Unfortunately, in the last six months,Treasury and RBA officialshave publicly admitted they’ve beenmiscalculating the level of that “natural” rate for years.

Apparently, it was probably lower than they thought.

What does that mean?

It means the economy could have handled a lower unemployment rate without inflation or wages picking up, so the economy was further away from its potential than they suspected, according to their own model.

And that means policymakers could have been working harder to drive the unemployment rate down.

Sorry about that.

Here’s the next thing

But let’s go a step further. Because it gets worse.

This policy framework has never been accepted by economistsacross the board.

There are plenty who criticise the reigningmodel. They say it makes little difference ifTreasury and RBA officials now admit their model has been slightly wrongbecause they’re just tinkering around the edges of a model that should be thoroughly overhauled, or abandoned altogether.

And here’s one reason why.

Australia’s policymakers have been spending a lot of brainpowersince the 1980strying to calculate the difference between theactual unemployment rate and thesupposed"natural" unemployment rate.

They call thedifference between the two the “unemployment gap.”

However, they alsoadmit that they don’t actually know what the “natural” rate of unemployment is, because it’s unobservable.

And that means they can’t say with certainty how big the unemployment gap is either.

But no matter.

The “unemployment gap” has been a veryimportant input into their forecasts for wage growth and inflation.

See any problemhere?

If yourely on an unobservable"unemployment gap" to forecast wagegrowth, it might lead you to publish wage and inflation forecasts that are repeatedly wrong (as the RBA has been doing for years, see below).

Unfortunately,those forecasts are used as part ofsetting interest rates and Treasury’s similarly incorrect forecastsfeed into thefederal government’s budgetnumbers.

It’s the same thing with the economy

Now let’s go one final step.

Here’s the thing I really wanted to talk to you about.

The supposed “natural” rate of unemploymentand the “unemployment gap” (remember: both unobservable)are elements of a larger analytical framework thathas similarproblems.

Let me explain.

Since the birth of economics as a social science hundreds of years ago, economists have been obsessed with trying to figure out where economic growth comes from.

In its earliest texts, you can see them talking about how growth seems to come from three things land, labour, and capital when you use them a particular way.

But as economicsevolved as a discipline, you can see them getting more sophisticated.

They start to wonder what an economy’s “potential” output could be.

Introducing the ‘output gap’

And here’s what they mean.

Let’s say you know what youreconomy is currentlyproducing. What’s the highest level of output your economy could potentially produce without creating destabilising inflation?

If you think your economy’s level of output could be higher(because inflation’s too low), or should be lower (because inflation’s too high)**,**that means there’s a difference between its actual level of output and its potential output.

They call that differencethe “output gap”.

But if there’s an output gap, it leaves us with this question: How do you get the actual level of output to get back to itspotential level?

Thankfully, you now know how to visualise thatproblem.

It’s similar to the wayyou visualised the relationship between the unemployment rate and the presumed"natural" unemployment rate.

If you believe the economy is performing below its potential, you cut interest rates (or boost spending) to stimulate economic activity.

If you think it’s performing above its potential, you lift interest rates(or cut spending) to dampen activity.

But here’s the problem.

How do you know whatdetermines your economy’s potential growth rate over time?

Well, according to the theory that’s been dominant since the 1980s, the potential growth rate is determined exclusively by “supply” sources.

And Australia’seconocrats put it this way.

Theysay the potential growth rate is determined by three things:population, participation, and productivity.

They snazz it up by calling it the “Three Ps.”

According to their framework, the potential growth rate will increase if the population grows faster, or if more people start participating in the labour force, or if the productivity rate increases.

But the Three Ps theory is just that a theory.

There are plenty of economists who criticise it, who sayit neglects the role “demand” plays in an economy’s potential growth.

For instance, if you have an economy with a deliberately high level ofunemployment, with workers with little bargaining power, where wagegrowth is anaemic,millions of households have little disposable incomeand wealth inequality is increasing, wouldn’t you thinkdemand might beweaker than itotherwise would beif millions of workerswere in a better financial situation?

They saystructural weaknesses in demand can become self-perpetuating,permanently reducingthe rate of potential growth over time.

Anyway,I’ll leave you with an excerpt from this year’s federal budget.

Hopefully you’ll see how econocrats have been talking over your head all these years.

Notice how they’reexplaining how the numbers in thebudget were conjured, and how they simply assumethat the “output gap” and the “unemployment gap” will both shrink to nothing, over the horizon, as the economy grows.

It’s an assumption they’ve been making for years.

It’s theirtheory about unobservables disappearing, or something:

By business reporterGareth Hutchens

Republished from the ABC.