Economy now in a full-capacity straitjacketRoss Gittins February...

Economy now in a full-capacity straitjacket
Ross Gittins
February 25, 2008

EVERYONE'S heard the economy is operating at near full production capacity, but many don't yet understand the unpleasant implications. It's bad now and may well resolve itself by getting a lot worse.

Full capacity means our factories, mines and service businesses have little scope to produce more than they're producing already, that shortages of skilled labour are widespread and we're close to the bottom of the barrel of idle unskilled labour.

When our real resources reach the point of being fully employed, the economy (gross domestic product; aggregate demand) simply can't grow faster than aggregate supply is growing - which these days the econocrats estimate to be 3.5 per cent a year at most, and probably nearer 3 per cent.

When we attempt to grow faster than that we don't succeed, we just generate imports and inflation.

If, for instance, the state governments decide it's time to start making inroads into the infrastructure backlog, their extra spending is more likely to bid up wages in the construction sector than cause more roads and schools to be built.

And since the latest indicators suggest demand is growing a lot faster than 3 per cent, you can understand why the Reserve Bank is so twitchy about inflation, and willing to keep raising interest rates until it's sure it's done enough to slow growth down to 3 per cent or so.

That's stage one. In theory, anyway, if you can ensure demand is growing no faster than supply you've reached a sort of steady state devoid of inflation pressure. Does that sound ideal? It ain't.

It means the economy becomes a zero-sum game. There'll always be some part of the economy that's growing faster than the average growth rate. But, as a matter of arithmetic, this can happen only if other parts of the economy are suffering below average growth.

And those other parts are growing slowly - maybe even contracting - because the real resources they need to permit faster growth are being filched from them by the faster growing parts.

In other words, in a steady-state economy, for every winner there's an equal and opposite loser. That's hardly a pleasant state of affairs for the losing

industries or regions, nor is it fun for the politicians to preside over.

But that, of course, is just the uneven position we find ourselves in with the present resource-fuelled boom and with resource prices set to go even higher in the coming year.

With all that increasing income from abroad, nothing can stop the affected industries and regions - mining and construction; Western Australia and Queensland - attempting to grow very much faster than all the other industries and regions.

And this means that, as a matter of arithmetic, the authorities' attempts to slow the economy's growth rate overall will require the other industries and regions to grow very much slower than the newly lowered average. Not fun.

It also means a need for considerable real resources - but particularly, workers and their families - to migrate from the low-growth to the high-growth industries and states.

Market forces should bring this about by causing wages and other prices to be higher in the winning parts of the economy than the losing parts.

But the more trouble market forces have bringing it about - the more inflexible the economy - the more you end up with excessive price rises without sufficient shifting of resources.

See what that means? It means that, in practice, your steady-state economy - where aggregate demand and supply are growing in lock step, thus eliminating inflation - is impossible to pull off.

So an inflation-free, full-capacity economy is probably unattainable and is certainly unstainable. It's life on a perpetual knife-edge.

What you really need is to return to a situation where a degree of spare capacity provides some margin for error, where the economy can speed up a bit without moving us to inflation red alert.

In the jargon, we need to get back an "output gap" where the economy's "potential" growth rate (determined by the supply side) exceeds its actual growth rate (determined by the demand side).

Question is, how do we achieve that more desirable state? In principle it can be achieved by the only-moderately unpleasant means of limiting actual growth to well below potential growth (equivalent to the long-term trend rate of growth) for a run of years.

Were we to run the economy at 2 per cent or so for three or four years, that would do the trick at the price of slow growth in real incomes and slowly rising unemployment.

Trouble is, I can't think of a time when we - or anyone else - have pulled off that textbook solution. Though the authorities always aim for such a "soft landing" - what in the old days was called a "growth recession" - they rarely achieve it.

Almost invariably we end up solving the full-capacity problem and restoring a large output gap in the most brutal, painful way possible: we step too hard on the brakes and accidentally precipitate a recession.

Factories and service providers cut back their production levels. They lay off existing staff and cease hiring new staff, causing unemployment to rocket.

Such an outcome has to be given a quite high probability of coming to pass this year or next.

So how do we reduce the likelihood of such an unhappy event? By reducing the need for the Reserve Bank to rely as heavily on the blunt instrument of further interest-rate rises by making more use of the budget's braking power.

And that means Kevin Rudd not being so stupid as to keep his ill-considered promise to cut taxes in July.

Ross Gittins is the Herald's Economics Editor.