Supply, demand and the employment balancing act

THE INCREASE in the unemployment rate to 10 per cent in June from 9.8 per cent in the previous month served as a reminder that unemployment reflects changes in the willingness of people to work as well as changes in those actually employed.  Thus, while employment rose by 19,000 in June, those actively looking for work increased by nearly 45,000 -- supply increased by more than demand.

The Employment Minister, Simon Crean, treated both the increase in demand and the increase in supply as good news even though the net effect was to push the unemployment rate back to a double-digit figure.  From one perspective he was right.  It is important to have an economy that provides both increased employment and encourages more people to join the workforce.  In the past year or so the Australian economy has been performing quite well in that regard.  In the recent June quarter, employment was three per cent higher and the labor force two per cent higher than in the June quarter of last year, resulting in a fall in unemployment from 10.9 per cent to 9.9 per cent.

However, if this fall in unemployment is to be sustained then the demand for labor has to continue to increase faster than the supply over an extended period.  The Government's stated objective is an unemployment rate of about five per cent by the turn of the century and it claims that this can be reached through a growth rate in the economy of between 4.5 and five per cent per annum.  Such a sustained period of high growth has, however, only been attained in the '50s and '60s and few believe that it can be achieved in the '90s.  It would certainly require the sustained maintenance of at least the three per cent employment growth in the past 12 months, which is indeed the growth rate forecast in the next 12 months in the recent Budget.

Unfortunately, there are already signs of a slowing in the demand for labor.  In the June quarter itself employment increased by only 0.5 per cent, following increases in the previous two quarters of 0.7 per cent and 1.1 per cent respectively.  If the June quarter trend were to continue, the increase in employment during 1994-95 would be closer to two and three per cent and, around this time next year, we could well find the rate of unemployment stuck at about present levels or even higher.

The causes of this recent slowing are unclear and it is possibly only a temporary phenomenon.  However, we may already be starting to see some effects from the sluggish recovery in business investment.  Thus, while businesses have been taking on extra employees and using excess productive capacity, that process can only go a certain distance without additional investment being undertaken.  Yet businesses continue to be reluctant to expand investment and last week's ABS survey of business expectations suggested a very much smaller increase (only 2.8 per cent) over the year to the June quarter of 1995 than the Budget forecast of more than 20 per cent.

Without knowledge of that ABS survey, I pointed out last week that, contrary to the picture being portrayed by the Prime Minister, business profitability may not yet be high enough to provide sufficient incentive for the investment needed to generate the jobs growth that will reduce unemployment on a sustained basis.  Increasing investment is so important to the prospects for employment that, in view of the ABS survey, I am highlighting in the graph on this page that profitability is still below levels which in the past brought forward strong investment growth.

One way of improving profitability (and hence investment) would be to give businesses greater freedom to determine wages and other conditions of employment.  Unless this happens, Mr Crean could find that the demand for labor continues to be insufficient to absorb the growing supply.  The cost of employing labor is being held at too high a level as a result of government-enforced regulations and, most notably, the system of wage awards governing the conditions under which some 80 per cent of the workforce is employed.

Indeed, it is remarkable that even though unemployment was as high as 10.5-11 per cent in 1991-92 and 1992-93, average real wages increased by more than two per cent in each of those years.  A more flexible labor market would have allowed real wages to fall, encouraging businesses to "invest" in more employees and more equipment.  There is also an important issue of equity here, and that is how can we as a society continue to justify regulations which deprive the opportunity of employment, not only to those officially classified as unemployed, but to the additional large number of people who would take a job if offered one but who do not meet the exact criteria necessary to be classified as unemployed?

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Business awaits the incentive to begin spending

THE PRIME Minister, Mr Paul Keating, recently claimed:  "In the national accounts today profits are now without historical precedent, ever, I mean it is the highest profit share in the country's history."

He also rejected any suggestion that uncertainty about the future course of interest rates could delay business investment.  "I don't think business investment has got anything to do with interest rates at this stage of the cycle.  It is just to do with profits."

Since then, a debate has raged about the reasons for continued sluggishness in business investment, given that the recovery has now been running for about three years.  Many possible causes have been advanced, including the likelihood that, with the economy recovering at a much slower pace than in previous recoveries, businesses still have on average a fair amount of excess capacity.  Improvements in workplace arrangements may also have allowed existing capital to be used more intensively, thereby postponing the need for new investment.

Other possible factors inhibiting investment include the uncertain overseas economic outlook (particularly for commodities) and the additional uncertainties created on the domestic scene by developments such as Mabo and (notwithstanding Mr Keating's comment) the recent increase in longer-term interest rates.

Surprisingly, nobody appears to have taken the trouble to examine closely the Prime Minister's claim about the record share of GDP going to profits.  If they had done so, a rather different picture would have been revealed.

For one thing, the profit share of the private company sector did not reach its highest point ever in the March quarter of 1994; it was higher in the September quarter of 1985.  More importantly, while the real rate of return (that is, profits as a proportion of capital) has improved in the past couple of years, it is still below what it was in the mid and late 1980s, and well below levels reached in the 1960s.

There is also considerable doubt about the usefulness of this particular profit share as an indicator of the profitability of the private sector as a whole.  For one thing, private trading enterprises include both incorporated and unincorporated enterprises, and, if the profit share of the trading enterprise sector as a whole is examined, we find that the present level is still lower than it was in any of the seven years 1983-84 to 1989-90.  What seems to have been happening is that, while the profit share of incorporated enterprises has been increasing, this has been more than offset by a decline in the profit share of unincorporated enterprises.  The most likely explanation of this development is that an increasing proportion of trading enterprises have become incorporated.  To the extent that the increase in the profit share of the corporate sector is due to this factor it does not, of course, necessarily reflect an increase in profitability.

Also relevant is the fact that, while the share of GDP going to wage and salary earners has fallen from the high levels to which it jumped in the 1970s and early 1980s as a result of two wages "explosions" generated by the trade union movement (which were in turn the major cause of the large increase in unemployment), it is only in the past year that it has fallen to the levels which we sustained for an extended period in the early 1950s and early 1960s.  This suggests that, if we are to get the investment needed to reduce unemployment to rates even approaching those of the 1950s and 1960s (about 2.5 per cent), wage and salary earners need to continue to exercise restraint for a further extended period.

Between 1989-90 and 1992-93 the share of GDP going to wages and salaries actually rose slightly while the profit share fell.  If Australia did not have such a constipated industrial relations system, the share of wages and salaries would have dropped quite sharply over this period -- but unemployment would not have risen to anywhere near the same extent and business investment would not have dropped to the same extent either.

In sum, while the profitability of Australian businesses has increased in the past year or so, real rates of return are not yet providing sufficient incentive to bring forth the business investment needed to generate the jobs that will reduce unemployment to more acceptable levels.  There would be a better understanding of the reasons for relatively sluggish investment and what to do about it if, instead of making exaggerated claims based on a partial analysis, senior ministers gave an accurate and comprehensive assessment of the situation.

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Signals show it's time for action on the fiscal front

WITH unemployment still running close to 10 per cent and underlying inlfation at about two per cent, many are astonished at suggestions that "the authorities" should soon start to lift short-term interest rates.  One recent proposal is even for a "quick pre-emptive strike", involving a one to two per cent increase, to signal that they are serious about controlling inflation.

Many are even more amazed that long bond rates (which unlike short rates are determined by "the market") have already risen so sharply -- and by more than in overseas counrties.  At nearly 10 per cent, long bond rates now stand more than 2.25 per cent higher than they were a year ago (and about 3.5 per cent higher than the pre-Budget low in February), while the official short-term rate for "cash" (4.75 per cent) is still about 0.5 per cent lower than a year ago.

There are two main reasons why the "real" bond rate is now at an historically high level of seven to eight per cent.

First, the authorities do not have a good track record in keeping inflation under control:  indeed Australia has a worse record than most OECD countries.  Moreover, unlike New Zealand, there have been no changes in institutional arrangements to depoliticise the operation of monetary policy and the Prime Minister's rejection of any need to tighten monetary policy has reinforced his boast that he has the Reserve Bank in his pocket.  Little wonder that our long-term bond rate is now more than two per cent higher than New Zealand's.

Of course, the Prime Minister and the Reserve Bank governor keep on declaring that the bond market has got it wrong.  They assert that there are no indications of any revival of inflation and that the market should accept their statements that inflation will be kept below three per cent per annum and that the one per cent Budget deficit target will be achieved.

Politically, it is scarcely surprising that the authorities are not accepting any early timetable for monetary policy tightening.  That would be an admission that the Budget strategy was wrong.  The Government's theory is that, even with the strong growth forecast in domestic spending, there is sufficient excess capacity to avoid inflationary pressures for a considerable period.

Indeed, Treasury secretary Ted Evans recently asserted that we could continue growing quite rapidly for some years without such pressures arising.  However, Mr Evans also revealed that, without the further supply side reforms this statement was based upon, Treasury modelling suggests that the long-term growth potential of the economy would be only 2.25 per cent per annum once the slack in the economy is taken up.

This implies that, without measures to quickly lift the underlying historical productivity growth of around 1.25 per cent per annum, capacity constraints could emerge within a year or so.  Given the time lag of 12 months or more before a tightening in monetary policy takes effect, this suggests the need for early action.

This leads to the second reason for high bond rates, which is the widespread concern both here and overseas that governments will continue as large net borrowers even as businesses are also now increasing their call on savings.  Notwithstanding projected reductions in existing large structural budget deficits, is little confidence that governments will fulfil promises to wind back their borrowings sufficiently to make room for expanded private-sector demands.

This raises the prospect that the growing calls on a world of low savings will clash and force interest rates up right across the spectrum.

Markets do not always get it right and it may be that the surge in bond yields will prove excessive:  it certainly would be if governments (particularly the United States Government) responded by tightening policies.  As there is no pressing external constraint here at present the authorities can sit it out for the immediate future and avoid lifting short-term rates.

The costs in doing so are that higher longer-term interest rates than are necessary inhibit business investment and that delay reinforces doubts about the inflation objectives of monetary policy.  Also, once the Federal Reserve moves from its present (almost) neutral stance into a serious tightening mode, markets may re-assess the outlook for further commodity price rises and the Australian dollar could then come under pressure.  But a tightening by the Fed could then be the trigger for one here.

Whenever the first tightening comes the same question will arise as in the '80s -- if the public sector had reduced its call on resources faster and by more, wouldn't there have been greater scope for the private sector -- and the external part of that sector in particular -- to expand without having to tighten monetary policy?  In the '80s, the Government did eventually move to a Budget surplus, which it is not proposing to do now.  (It is ironical that Victorian Labor promises a current account surplus while its federal counterpart will likely have a current account deficit even when the economy is operating at full capacity!).  But that was not nearly enough to accommodate the growth in the private sector, with the result that we ended with the recession we didn't have to have.

There is surely a lesson here that this time the Government needs to do more -- and sooner -- on both monetary and fiscal policy.  In the '80s, Mr Keating produced several mini-budgets and he could do a lot worse than foreshadow one now for August.

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