Australia reaps the benefits of perfect policy

What would a perfect economy look like? How would the various parts of it fit together if ever economic perfection were ever to be achieved?

First the theory and the economics 101 background. From a macroeconomic perspective, a perfect economy is one that is growing at a sustainable pace, where job creation matches demographic trends in the context of the unemployment rate remaining as low as practicable while inflation is anchored at a low rate.

Now let's put some numbers into this indisputable picture of economic perfection for Australia. Everyone, it is certain, would agree that a perfect economic performance would reflect something like GDP growth at 3 per cent or perhaps a touch more, an unemployment rate at 5 per cent or a touch less and annual inflation running at 2 to 3 per cent over the cycle.

Have a guess at the average for these variables over the last 10 years?

For GDP growth, the average is 3.0 per cent, for the unemployment rate it's an average of 5.1 per cent, for inflation, it's an annual rate of 2.8 per cent.

For the last 5 years, the numbers are similar. Annual GDP growth since the middle of 2007 has averaged 2.6 per cent, the unemployment rate has averaged 5.0 per cent and annual inflation 2.8 per cent.

These numbers, of course, encompass the global financial crisis, which arguably is still having an impact on the economy today, but the most recent numbers for GDP are 3.7 per cent growth, 1.2 per cent inflation and 5.1 per cent for unemployment (with a data update later today).

The facts show that it is not a stretch at all to say the Australian economy is close to perfection.

That said, there will always be an unexpected tilting in the business cycle. Sometimes the economy will be a little too warm, sometimes a little too cold, due to the impact of a global economic or market shock or because of a change in domestic conditions including things like weather (droughts and floods) or behavioural shifts (for example, household savings).

This is where good policy-making comes in. When these shocks or influences occur, policymakers should show flexibility and adjust interest rates, spending and tax. Implicitly, policymakers have been changing policy settings with a broad aim of maintaining these near-perfect economic conditions.

That policy flexibility can perhaps best be shown in the fact that in the last 10 years, the official cash rate has been as high as 7.25 per cent and as low as 3.0 per cent. The federal budget balance has seen a surplus of 1.7 per cent of GDP and a deficit of 4.2 per cent of GDP. This 6 per cent shift in the budget equals around $90 billion a year in today's dollar terms.

In the last decade, the volatility has been in policy settings and not so much the economic fundamentals.

All of which makes a lot of the chatter about the appropriate level of RBA interest rates and the return to budget surplus shrill -- policymakers know what they are doing.

Steady policy is not an end in itself – steady interest rates or perpetual budget surpluses are not and should not be objectives. Economic growth, jobs and inflation are the targets of policy. A budget surplus is not always good, nor is it wrong for the RBA to hike or cut interest rates aggressively when the business cycle swings.

What we have seen is near policy perfection as well as near economic perfection.

We should hope, in fact insist, that the policymakers keep acting without fear or favour to lock in the terrific news on the economy.

Like now. Fiscal policy is being tightened with the economy expected to grow around trend. It is entirely appropriate to quickly move to surplus after the aggressive spending pick-up and implementation of counter cyclical fiscal policy during the GFC.

Fiscal policy is pulling money from the economy which is making room for the private sector to expand, invest and employ. It is also seeing the RBA have few fears in easing monetary policy because it knows that government demand is slicing around 1.5 percentage points from GDP. In other words, monetary policy needs to be set to encourage the private sector to expand at a 5 per cent pace to keep overall GDP growth around 3 per cent or a little more.

As the fiscal tightening bites on the economy between now and the end of 2013, the RBA can look to inflation pressures when deciding what to do with official interest rates. The market is now pricing in an official cash rate at a record low of 2.5 per cent during 2013 to counteract the biggest cut in government spending ever recorded.

All of which sounds a bit too good to be true. There are risks for sure. But the beauty of policy right now is that if we see some horrendous negative shock to the economy, the RBA can keep cutting rates, the Australian dollar has heaps of scope to fall and government finances can rapidly move to stimulus without any risk of the triple-A credit rating being lost.

Near economic perfection. I reckon we'll see it continue for at least a few more years.