Tuesday, June 7, 2011

Reserve Bank risks a bust to stop boom

THE markets think there is only a 16 per cent chance that the board of the Reserve Bank will lift interest rates today. You hope they're right - but it's far from certain.

Our central bank is on a mission. It believes Australia is springing into a new boom that threatens to lift inflation. Its job is to stop inflation getting out of hand, and its one real weapon is interest rates.

And the boom it foresees is not ''five minutes of sunlight'', as John Howard memorably called the post-recession growth bounce in 1994 (of which, more later). The bank believes we have entered a new era in which global supply of minerals will be unable to meet the booming growth in demand, driven by China and India. And that will entrench high minerals prices for years, and possibly decades.

How does that change life for you and me? Well, high minerals prices over time will mean we also get full employment, and more: a high Australian dollar over a long period, making many producers uncompetitive, and the perennial risk of high inflation - which the Reserve will shield us from by high interest rates.

And if you're in debt (as most households are), that could make life uncomfortable. If the minerals boom unfolds on the scale its advocates envisage, life could become very uncomfortable.

Essentially, the Reserve and Treasury believe the other 90 per cent of the economy will have to shrink - in relative terms, and in some parts, in absolute terms - to free up the resources for the minerals sector to fulfil its destiny to dig up Australia's rocks and sell them to the world.

We are not talking about small tweaks here. The Reserve's most uncritical fans among market economists predict that in the next 15 months, it will deliver at least four interest rate rises, and possibly five. If they are right, that would wreak big changes in the Australian economy.

Many companies would shut down, especially in trade-exposed areas such as manufacturing, tourism and higher education. Many workers would lose their jobs. That would not be accidental ''collateral damage''. It is how the policy works.

The Reserve and Treasury believe (in my view, wrongly) that we are close to full employment. The mining companies say they plan to double their investment in 2011-12 from current levels. Even if that is exaggerated, the Reserve sees its role as ensuring that the companies do not bid up wages so high they create a wages breakout that would spread across the nation, and create the inflation it is there to stop.

To be blunt, it sees its role as to create unemployment - or at least, slow employment - in the rest of the economy, so that more of our scarce skilled workers go to build and operate the mines, where their work will bring the greatest return.

As Treasury secretary Martin Parkinson argued last month in a speech in Sydney, this is structural change. The factories and tourist ventures they close will not come back. In their view, the long boom in mineral prices means Australia will not need them. Others are less sure.

These rate rises would have damaging consequences for many, in a wide range of areas. Melbourne, and south-eastern Australia, would take the brunt of the damage, if firms here are shut down by high interest rates and an ever-higher dollar. Ross Garnaut is right: if the Reserve follows this course, then the carbon tax is a minor issue. Firms will be shut down anyway.

We need to talk about this - and before the Reserve jumps the gun by lifting interest rates for the eighth time in less than two years. Is there a better way to handle the problem? If so, what?

The first step for the Reserve is to guard against hubris. It is not enough to convince itself that it knows what lies ahead. It was right in 2009 when it said the recession would be short and shallow. But forecasting the future is fraught with danger and, recently, the Reserve has got more calls wrong than right.

A year ago, its forecasts significantly overestimated both non-farm growth in 2010 (by a full percentage point) and underlying inflation (by half a percentage point). I don't blame the Reserve for not foreseeing things that few if any saw coming, but look back at its forecasts at this time in 2009, or 2008, or 2007, and you can see its crystal ball is all too fallible. It needs to tread warily. In 1994, it ended that ''five minutes of sunshine'' with three big interest rate rises. Some of us warned this was overkill, and we were right. Unemployment stopped falling, and remained stuck around 8.5 per cent until late 1997, after the Reserve had relented. Let's not repeat that mistake.

As Oliver Cromwell put it: ''I beseech you, in the bowels of Christ, think it possible you may be mistaken.''

There are alternatives. If our choice is between giving mining companies a free hand to import the skilled labour they need, or shutting down growth in the rest of the economy in the hope that some of the displaced workers will migrate to the Pilbara, the first is obviously a better solution. With the Immigration Department predicting net overseas migration to be just 170,000 to 180,000 a year from now to 2014, there is room for more.

We seem to have lost the best option: a comprehensive, well-designed tax on mining profits that would keep the mining boom in check. A golden opportunity to do that was blown away: first, by the Henry review, which proposed an excessive, impractical tax that required taxpayers to pay for mining companies' losses - and then by the Gillard government, which backed down so far that it stripped the tax of any bite or universal coverage.

But the Reserve should try a strategy that parents use (within limits): let nature take its course. If mining companies and contractors get into a bidding war over wages, fewer mines will be built. The risk of a wages breakout in the Pilbara triggering breakouts in Melbourne or Sydney is remote. Let them solve their own problems. Don't shut down the rest of the economy to try to solve their problems for them.