PART II: ECONOMIC FRAMEWORK

Economic policy is being framed against a backdrop of six years of economic growth and low inflation which has delivered episodes of strong employment growth but nevertheless has left unemployment at high levels. The economic outlook continues to be favourable, supported by sound economic fundamentals and a positive international environment. This provides a sound framework but leaves many challenges.

The overriding aim of the Government's economic strategy is to achieve the maximum sustainable rate of reduction in unemployment by lifting the pace at which economic growth can be maintained without running into inflationary and external pressures. Higher inflation and current account deficit pressures, and the need for corrective policy action, have previously cut short periods of economic expansion in Australia, with adverse effects on growth and unemployment. Policy therefore needs to be directed at alleviating these constraints by keeping inflation low, promoting an adequate level of saving to finance investment and improving the supply capacity and flexibility of the economy. These objectives require a full range of macroeconomic and microeconomic policies.

Australia's recent inflation performance is a welcome improvement on the record of the previous twenty years. In order to sustain the progress made to date, the Government has taken steps, through the Statement on the Conduct of Monetary Policy released by the Treasurer and the Governor of the RBA in August last year, to strengthen the policy framework. In particular, the Government has endorsed the RBA's inflation target (underlying inflation of 2-3 per cent on average over the cycle) and enhanced policy credibility by clearly recognising the RBA's independent role in setting interest rates. The inflation outlook reflected in the economic forecasts in Statement 2 points to a continuation of the current low inflation environment in the period ahead.

The maintenance of low inflation is important in avoiding spending and savings distortions and maintaining confidence in the economic outlook by reducing risk and uncertainty - including the risk of policy tightening.

A central plank of the Government's economic strategy is to put in place policies to lift national saving to a level adequate to finance national investment without having to rely excessively on foreign saving. As explained in detail in last year's Budget papers, excessive reliance on foreign saving is likely to result in higher borrowing costs and exposes Australia to sudden and disruptive shifts in market confidence.

Policy priorities in this area encompass fiscal consolidation measures to increase public saving at the Commonwealth level and measures to encourage private saving. Of particular importance is the need to correct the structural weakness in the Commonwealth's fiscal position evident in the past twenty years which has underpinned the structural deterioration in the current account deficit. Full details of the fiscal policy strategy and measures to promote private saving are set out later in this Statement and in accompanying Statements.

While sound monetary and fiscal policies are fundamental to longer-term economic prospects, there is a limit to their influence on structural unemployment. In essence, that is the role of microeconomic policies: policies to improve the supply potential of the economy, to improve the operation of markets, and to enhance worker skill levels.

The Government's microeconomic reform priorities include labour market reform, competition policy, education and training, transport, small business deregulation and financial system reform.

Particular attention has been given to reforming the labour market. The Workplace Relations Act 1996 will boost labour market flexibility by increasing the focus on workplace bargaining and limiting the role of the award system to a genuine safety net, providing more choice in, and streamlining the process for, making agreements and preventing excessive use of bargaining power by employers and employees. The reforms have only come into effect very recently and will take some time to be utilised, but experience in other countries (eg the United States, the United Kingdom and New Zealand) suggests that a flexible labour market and policy reform working in that direction are crucial in reducing structural unemployment.

The Government has a comprehensive economic strategy, covering both macroeconomic and microeconomic policies, which will be effective in reducing unemployment over time. As discussed in Statement 3, pursuing a wide-ranging approach to reform is consistent with the results of cross-country analysis by the Organisation for Economic Cooperation and Development (OECD), which indicate that the best outcomes have been obtained in member countries following such an approach. This reflects in part the synergies and interaction between macroeconomic and microeconomic policies.

The constraints to growth faced by Australia, and indeed by most industrial countries, are deep-seated and do not lend themselves to an easy or immediate turnaround. International experience indicates that the benefits of reform take time to become fully apparent, but that the most effective results are obtained by the persistent application of a broad and consistent policy approach. There is no experience to the contrary.