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How did we get here?

-Donal Curtin

Wednesday 10th October 2007

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In my day job I give a lot of speeches on the economy and I get asked a lot of questions. And there's one question above all that's bothering people at the moment: how come we have ended up with a crippling exchange rate and the developed world's highest interest rates?

It's an issue that bothers people at all levels. Some folks question whether we really had an inflation issue in the first place to justify such a hardline response. Others wonder if keeping inflation under control is worth it, if it means costs like these. Others ask what it is about us, or our policies, that seems to have us going from one extreme to another - ultra-low exchange rates and interest rates one year, ultra-high a few years later. Some people wonder if there weren't better routes we could have taken, that wouldn't have involved more expensive mortgages and knackered exporters. And it has sparked myriad responses, from the suggestion we could tell the Reserve Bank to take a break from controlling inflation for a while, to a full-blown select committee inquiry into how monetary policy has or has not been working.

A lot of well-intentioned people, in short, are either confused, dismayed, or angry. So here's an attempt to explain what's happened.

We know there's a finite limit at any time to what the economy can produce: it's set by the size of the labour force, the amount of gear they've got to work with, and the level of expertise and know-how. The Reserve Bank actually calculates what that maximum level is (called 'potential output') and can tell whether we're below it, at it, or (and you can manage this for a while by running overtime and the like) above it.

The key to the hole we're in is our economy has effectively been working beyond full capacity for six years in a row. Why does that matter? Because above that full capacity level, you get inflation picking up. If everyone's fully employed, the only way you're going to get someone working for you is to bid them away from the other fellow - for higher pay. If your factory's already flat tack and someone wants a quote, you price the order on the high side and figure out how to fit it in afterwards, if you get it at the fancy price. And so it goes throughout the economy.

This isn't some mad macroeconomic theory: it actually describes what's been happening. We've had domestic inflation running at around 4% a year for the last four years. That's a serious issue: 4% a year halves the buying power of your money in 18 years.

And it also leads to the reason we stick out with our high exchange and interest rates. It isn't because the Reserve Bank has lost the plot, or hasn't got the tools it needs. It's because we are one of the few economies that has been bumping up against its capacity limit for so long. In that position there are no easy fixes: the only thing you can do, in the short term, is have monetary policy slow the economy till it pops back under that full capacity level.

A more palatable solution in the longer term is to increase the maximum output capability of the economy so we can grow faster without inflation issues. That means a bigger labour force, so a liberal immigration policy ought to be high on your agenda. It means more investment, by businesses in capital equipment and by government in infrastructure, so you ought to favour policies that make those easier. And it means increasing commercial expertise and know-how, which is the last leg of the 'poten-tial output' trifecta, and leads to policies around good education and commercialisation of research.

So I wouldn't be too keen on some of the gimcrack nostrums being peddled at the moment as 'solutions' to a system that is, supposedly, broken. It isn't: all that's happened is we, compared with most OECD countries, have been pushing the boundaries hardest and have the corresponding inflation pressures. We've had to deal to them harder than most, because we've got more than most to deal with.

And it's no time to be thinking of junking our anti-inflation policies. There is (I'd never heard of it before Dr Cullen drew attention to it) a section 12 of the Reserve Bank Act, which allows the finance minister to tell the Reserve Bank to do something other than keep inflation under control.

If I were that minister I'd be wary because I would risk shooting myself in both feet. For one, allowing inflation to stay high doesn't lead to lower interest rates: it leads to higher interest rates. And for another, it risks jettisoning the most potent weapon in any Reserve Bank's armoury, namely its credibility. In an ideal world, a high-credibility central bank, known as a proven inflation fighter, would only need to raise an eyebrow and financial markets would jump. But nobody would pay attention to the bank that's known to cut and run. To get its bidding done, it would need to do even more than a more-respected bank would - leading once again to higher interest rates than otherwise.

So let's stay with the programme. Sure, it's tough, but the alternatives look worse. This would be a high-risk time to start experimenting with magic bullets.

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