Inflation and the Making of Australian Macroeconomic Policy, 1945–85

Michael Beggs

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137265975
• Topic: Economics
• Subtopic: Economic Policy
• Index: Economics

In the decades after World War II, inflation undermined the aspiration for full employment in Australia. This book tells the story of how the Australian state was shaped by the confrontation with monetary instability: a pre-history of neoliberalism.

1

Inflation, the State and Economic Policy

1.1 Fighting inflation first

This book traces the development of counter-inflation policy in Australia between the end of World War II and the 1980s. A focus on this specific aspect of policy sheds light on the historical evolution of the role of the state in capitalist society much more broadly. Furthermore, although I focus on Australia, and the particulars of this history are unique to that country, the broad shape of the evolution and the tensions that drove it have much in common with the rest of the advanced capitalist world. Some aspects set Australia apart in important ways – such as the centralised wage bargaining system – but many others are shared – the experience of a long postwar boom followed by stagflation, the profit squeeze of the 1970s, successive waves of financial innovation and the monetarist experiment. The peculiarity of the centralised bargaining system is in itself a variation of interest to the rest of the world, because such an institution was sometimes held up elsewhere as a potential solution to macroeconomic dilemmas: by looking at the Australian experience we can get a sense of how it affected policy options – and how it did not.

The control of inflation is of central importance to the structural role of the state within contemporary capitalism. It is in some sense more important than it seems to be for its own sake: it is not only because inflation is inconvenient, distorts relative prices, adds to uncertainty, erodes nominally-fixed incomes and so on that it is policy enemy number one. These are all reasons why price stability would be a policy concern among others, but inflation has become an overriding concern which trumps the rest. The independent, inflation-targeting central bank has become the queen of economic policy, its job so important that this branch of the state has been deliberately isolated from democratic control. It sits in tacit judgement on the macroeconomic policy of the government of the day, ready to take away with interest rates whatever may be given with fiscal policy, should it seem inflationary. Governments have generally not wanted to push the envelope anyway, because fighting inflation first is the common sense of responsible politics.¹ The apparent importance of inflation as a policy concern above others is no accident, but arises because it is the focal point of other structural political- economic tensions. Investigation of inflation quickly leads into, and links, a range of economic spheres: money and the financial system, wage bargaining and the labour market, fiscal policy and the relative value of currencies. Inflation connects distributional conflict and macroeconomic instability. For these reasons, understanding why counter-inflation policy is so important to the contemporary capitalist state is a way into understanding the structure of contemporary capitalism.

I believe that tracing the origins of this counter-inflationary consensus helps us to understand why it now has this key position in the policy strategy of modern capitalist states. This is not obvious or uncontroversial, because to trace the origins of something is not necessarily to explain why it persists today, stably or otherwise. French economist Pierre Berger once argued that ‘an excessive concentration on research into the past can be a source of confusion in analysing the present, at least as far as money and credit are concerned’ (Quoted in Vilar, 1976, p. 7). He had a point: money has taken so many forms and performed a number of functions within systems of quite different character. It is a mistake, for example, to draw conclusions about the nature of money from its historical origins in ancient Mesopotamia – the genetic fallacy. But historical comparisons, and the tracing of patterns of change and stability, do help us to understand money as a component of broader economic and social systems (Schumpeter, 1991, pp. 524–43; Melitz, 1974). When Berger complained, econometric studies of the money-demand function were coming into vogue, and would run into a different problem of historical inference: financial innovation, inflation and policy shifts were destabilising the structural background against which parameter estimates had been made on the basis of historical data (Goodhart, 1989, 95–103). History was no longer a guide to the present – and yet, it was still fruitful to recognise this and try to explain why. The historical comparison was necessary not because it helped to predict present and future very accurately, but to explore the nature of structural change, and therefore understand the present, which is still, after all, subject to further structural change.

This book presents an origin story for the ‘new macroeconomic consensus’ in Australia. But I hope that it is of more than historical interest, because in tracing that history it throws light on the strategic position of macroeconomic policymakers within capitalist societies more generally. We can learn from the history about how and why policy evolves. I also hope it might be of practical use. Certain older policy goals do not fit the ‘new consensus’, but still might be worthwhile aspirations: most importantly, full employment and a dampening of income inequality. In this book I focus in particular on the fate of full employment, bound up as it is with inflation.

Full employment – in the everyday sense that everyone who wants a job can find one reasonably quickly – is good not only because unemployment is costly in terms of lost output. It gives people – the vast majority of people depending on employment for their standard of life – security in their livelihood, and a certain degree of power in the workplace. After World War II, Australian macroeconomic policy was committed to full employment. Many were sceptical that it would be sustainable (see Chapter 3). But sub-two-per cent unemployment was the norm until the 1970s. Then, in 1974, it jumped above four per cent and never came back down. In the recessions of the early 1980s and early 1990s, it topped ten per cent, a level not seen since the 1930s. Today, five per cent unemployment is widely considered a good outcome, and indeed, is often described loosely as ‘full employment’.²

It is fear of inflation that seems to set the limit on expansionary macroeconomic policy. Since the central bank is committed to an inflation target (‘2–3 per cent, on average, over the cycle’) it starts to raise interest rates as soon as policymakers see signs that prices are set to head out of bounds. The central bank does not officially target a level of unemployment (though the Reserve Bank Act still commits it to ‘the maintenance of full employment in Australia’), but its pursuit of the inflation target means it inevitably acts to slow expansion at the first signs of tightness in the labour market. This happens well before unemployment gets anywhere close to what would have been considered ‘full employment’ in the postwar era. The lowest it has reached since 1974 is 4.0 per cent, for a few months in 2008, and after an exceptionally long expansion, which had lasted since 1991.³ The average over the 2000s to the end of 2014 is 5.5 per cent (Reserve Bank of Australia Statistical Table ‘Labour force – H5’). The reason this can be considered ‘full employment’ is that standard macroeconomics suggests that the minimum sustainable level of unemployment is that which is compatible with a stable rate of inflation: the ‘natural rate’, or, more awkwardly, the ‘non-accelerating inflation rate’ of unemployment (NAIRU).

How did we get here? First, let us take a look at two common answers to that question, both of which I find wanting. Then I outline the framework on which my own answer is based.

1.1.1 The origin myth of the ‘new macroeconomic consensus’

The first is the origin myth of the ‘new macroeconomic consensus’ of the 1990s and 2000s. It projects its understanding of the economic system back over the whole period, denying that there was a systematic transition, but instead only a change in the behaviour of one element in the system: bad policy was replaced by good policy. Its narrative of change thus centres on the intellectual history of the working out of good theory to inform the good policy, amid breakdowns resulting from the policy application of bad theory.

By the ‘new macroeconomic consensus’ I mean both the policy convergence towards a regime based on a central bank targeting inflation (formally or de facto) with a variable interest rate, and the body of theory supporting it, centred on a conception of the ‘output gap’ between potential and actual output, defined in terms of a non- accelerating rate of inflation.⁴ The state is deeply implicated in the management of money, to the extent that it is common for inflation to be explained as a result of what the authorities failed to do. The projection of this worldview backwards generated a crop of research in the 2000s into the stagflationary episode of the 1970s, and thus the consensus’ own origins. Despite significant debate on the details among this recent literature, Cecchetti et al. (2007, p. 8) note that ‘[a]ll of these accounts view the Great Inflation as a result of monetary policy error and the Inflation Stabilisation as a restoration of more effective monetary policy’. For example, Nelson (2005) puts forward the ‘monetary policy neglect hypothesis’, while from a different perspective, Cecchetti et al. themselves explain ‘the Great Inflation’ in terms of policy deviations from a Taylor rule, which means that a central bank should set interest rates according to a formula linking them to the output gap and the distance between actual and target inflation:

Summing up the international comparisons, three of the four countries exhibit a qualitatively similar pattern in which deviations from a simple policy rule in the 1970s and early 1980s are consistent with the timing of the increases and declines in trend inflation (and its volatility). The peak in the inflation trend and the undershooting of interest rates relative to those implied by a Taylor rule generally occurred around the mid-1970s. There also is some evidence that increases in deviations from policy rules (in an accommodative direction) accompanied increases in trend inflation in the early 1970s. (Cecchetti et al., 2007, p. 42)

Yet the Taylor rule (after Taylor (1993)) was not formulated until the 1990s. Such confidence in the current macroeconomic consensus is tied to an implicit belief that the economic system has remained essentially the same over time. This leads to a certain teleology in historical narratives, as the errors and instability of the past are explained as a failure to be more like the stable present, and the emergence of that present appears as the inevitable triumph of correctness over error.⁵ The stories can be more or less complex: for example, Romer and Romer (2002) present the zigs and zags of US policy history as truth forgotten but eventually regained with sharper vision: ‘the evidence reveals an evolution from a fairly crude but basically sound worldview in the 1950s, to a more sophisticated but deeply flawed model in the 1960s, to uncertainty and fluctuating beliefs in the 1970s, and finally to the modern worldview of the 1980s and 1990s’. Alternatively, politics can play a role alongside the evolution of theory: economists and policymakers knew what they should do but were prevented by the irrationalities of politics. Or political choices were rational but preferences changed: the public once preferred low unemployment to low inflation, and later changed its collective mind (Meltzer, 2005).

But all these accounts share a conception of policy history as driven primarily by changes in policy conception and action, while the political and economic environment in which policy operates remains stable – in the sense that given some policy action, other elements will react in a stable way. In fact, much of this wave of research largely dismisses or downgrades the importance of once-common, supply-side explanations for stagflation: such as supply shocks from oil and commodity prices and/or structural effects from the labour market (Cecchetti et al., 2007, pp. 26–31).

This notion that ‘the mystery element in monetary policy’ (Coombs, 1971a, p. 22) has finally been cleared up has been a recurring theme in economic thought. Time and again, paradigms have been knocked over and pre-Enlightenment history rewritten as a tragicomedy of grievous, incomprehensible error. Since World War II, there have been three such Enlightenments: the postwar Keynesian-neoclassical synthesis, the monetarist moment of the 1970s and early 1980s and the ‘new macroeconomic consensus’ solidifying in the late 1990s. They are incapable of understanding the basis of pre-Enlightenment theory as anything other than misguided because they fail to conceive of the political-economic system itself as capable of evolution. They do not register that the closure imposed by theory can lead to a valid and useful generalised model of real structures and yet be broken down because the systems are not closed in reality – they can be broken down by exogenous shifts in their supporting structures, or by their own internal tensions. Finally, they do not give much explanation for why policy ideas evolved towards the good taste of the 1990s and 2000s, other than to imply that good ideas ultimately won out.

A simpler, older and still widely believed version of this story is the Milton Friedman – or Phillips curve – myth (Forder, 2010; 2014). This is the idea that policymakers in the postwar period attempted to exploit a trade-off between unemployment and inflation that they mistakenly believed to be stable. They prioritised full employment over price stability. But Friedman (1968) explained their error: if people expected inflation, they would adjust their behaviour accordingly. Only if people are generally surprised by inflation could unemployment be lowered below its ‘natural rate’ – a rate determined by the real wage and demand for labour at that wage. Policy can hold unemployment below this rate only as long as inflation keeps surprising; that is, only if the rate of inflation continually rises. Eventually people would come to expect rising inflation, and then the game would truly be up. Thus did Friedman predict the stagflation of the 1970s, and it was ended only once policymakers accepted his message and stopped trying to hold inflation below the natural rate.

I discuss the problems with this myth in later chapters: in Chapter 3, I show that Australian economists and policymakers in the postwar period always took inflation seriously, and did not believe in or try to exploit a stable trade-off between it and unemployment; and in Chapter 6, I argue that the Friedman story does not explain stagflation. The basic problem is quite simple. Actual unemployment averaged less than two per cent over more than 30 years from the start of World War II, without any upward trend in the rate of inflation. If we accept the idea of a natural rate of unemployment or NAIRU, it must itself have been much lower over that period than it was after the early 1970s. Indeed, estimates of the NAIRU have persistently found it to jump discontinuously around 1973–74 (Borland and Kennedy, 1998, pp. 70–71; Gruen et al., 1999). The ideas of the NAIRU and the expectations-augmented Phillips curve do not in itself explain this jump. Nor does the idea that the path to a reduced NAIRU involves labour market deregulation sit easily with the experience of the postwar period, with its highly centralised wage bargaining system.

1.1.2 From ‘Keynesianism’ to ‘neoliberalism’

A second problematic approach to the transition sees it simply as ideologically-driven policy regime change. It implies a total rupture between the so-called Keynesian postwar system of capitalism, and the present ‘neoliberal’ system. It tends to present each regime as a coherent whole, though perhaps plagued by its own particular contradictions, and each as an expression of the policy choices of governments, which are in turn explained by their guiding ideologies. Narratives of the transition focus on the rise of ‘neoliberalism’ as an ideology, possibly promoted by the deliberate strategy of capital (e.g., Harvey, 2005).

A typical instance of this very well-known trope in left/liberal discourse is George’s (1999) ‘short history of neoliberalism’. She traces its success as ‘the major world religion’ to a promotional network beginning from a ‘tiny embryo at the University of Chicago with the philosopher-economist Friedrich von Hayek and his students like Milton Friedman at its nucleus’:

They have built this highly efficient ideological cadre because they understand what the Italian Marxist thinker Antonio Gramsci was talking about when he developed the concept of cultural hegemony. If you can occupy people’s heads, their hearts and their hands will follow ... [T]his vast neo-liberal experiment we are all being forced to live under has been created by people with a purpose. Once you grasp this, once you understand that neo-liberalism is not a force like gravity but a totally artificial construct, you can also understand that what some people have created, other people can change. But they cannot change it without recognising the importance of ideas. (George, 1999)

In Australia, detailed histories of the rise to ideological dominance of ‘economic rationalism’ (a local synonym for ‘neoliberalism’) have been written from both a critical liberal (Pusey, 1991) and a more sanguine conservative perspective (Kelly, 1994) – both sharing a vision of change as a result of ideolog...

Table of contents

• Cover
• Title
• 1  Inflation, the State and Economic Policy
• Part I  The Long s
• Part II  The Long s
• Notes
• Bibliography
• Index