By Alan Mitchell, Economics Editor

Peter Costello wants to cut unemployment to 5 per cent. But what do ordinary Australians want?

That's what really matters.

Because we can have any unemployment rate we choose.

The economy has been growing for an uninterrupted 7 years at an average rate of 3.6 per cent a year. Why after all that growth is 7.5 per cent of the labour force still unemployed?

Why have we done so poorly when the US has managed to reduce its unemployment rate to 4.3 per cent?

It is because we have chosen not to reform our labour market to the extent necessary to get unemployment down to US levels.

And it is because we, the 90 per cent-plus of the labour force who are employed, have chosen to take the benefits of economic growth in the form of higher real wages for ourselves rather than as extra jobs for the unemployed.

And yet, on the most recent research by economists at the Reserve Bank, the sacrifice needed to make additional inroads into unemployment is not huge. According to that research, a 2 per cent cut in the growth of real wages, for one year, could lead to a permanent reduction of unemployment of about 1 percentage point.

Unless there is a consensus in favour of change, the unemployment outcomes will remain the same. Labour market reform will die in the Senate.

If we want the unemployment rate cut to 5 per cent, we have to stop pretending that our unemployment problem will melt away if only the Government and the Reserve Bank have the sense to stoke up the economy with more public spending and lower interest rates.

Growth is crucial, but growth alone can't be relied on to reduce unemployment to 5 per cent in the next few years.

To see why, look at the growth in unemployment in the past two decades. Nearly all the growth occurred in the two recessions of 1982-83 and 1990-91.

In the periods of economic growth after each recession, unemployment was wound down slowly, although it never got much below 6 per cent.

The first lesson of that history is that it is sustained growth that matters. The real damage is done in the recessions.

Pumping up the economic growth rate is counter productive if it leads to overheating and inflation and the Reserve Bank is forced to jam on the brakes.

Moreover, the damage caused by recessions is greater than suggested by the blowout in the headline unemployment rate.

The recessions have also resulted in an increase in the incidence of long-term unemployment, as the people who lose their jobs find themselves pushed further and further back in the unemployment queue.

That's why it takes so long to wind the unemployment rate back down again after the recession.

Once people are pushed into long-term unemployment, it is very hard for them to get out.

Why? People become demoralised, lose their self-confidence, their work skills decay, and the efficiency of their job search declines.

In addition, employers use the duration of unemployment as a screening device. Employing a dud can be a costly mistake. The short-term unemployed are simply a better bet.

So, the moral of the story is: avoid recessions. But that's easier said than done. For one thing, Australian recessions are often the result of external economic shocks -- like the one we are trying to deal with now. This is a crucial issue in the current debate. With inflation at just 1.6 per cent, it has been argued that the Reserve Bank should now cut interest rates in pursuit of its other objective of reducing unemployment.

However, such a strategy would entail a high degree of risk. Australia is already growing much faster than the rest of the world, and its current account deficit is blowing out to banana-republic proportions as a result.

Do we try to push our luck a bit further? What happens if the market dumps the $A? If the Reserve Bank were forced to jack up interest rates to defend the $A, the result could be a disaster for the long-term unemployed.

Our last small taste of currency trouble was back in the middle of last year, when the Reserve Bank spent $3 billion to support the $A. Suppose the attack on the dollar had been more sustained, and the bank had been forced to put up interest rates: what would that have done to business and consumer confidence?

If there were a really serious shift of sentiment against the $A, it is not clear that one or two genteel 25 basis point rate increases would be enough to win the day.

The monetary authorities typically have to show the market that they will go to any length to defend the exchange rate. Interest rate rises of several hundred basis points can be required.

Several hundred basis points . . . and another disastrous blowout in the number of long-term unemployed!

But there is more to getting unemployment down than just avoiding recessions.

As the incidence of long-term unemployment has been ratcheted up, so has the "natural" rate of unemployment.

There is nothing natural or God-given about the "natural" rate of unemployment. But it is a level of unemployment at which wage demands pick up and inflation starts to accelerate.

It therefore represents a constraint on demand management.

If governments want to push unemployment permanently below that level, they have to go beyond demand management and do something to reduce the natural unemployment rate.

Like what?

Labour market reform, to allow low-productivity workers to compete for jobs, and to make the labour market in general less inflation-prone; product market reform, to make the labour market even less inflation-prone; welfare reform to remove poverty traps; wage-tax trade-offs to lighten the burden of wage restraint; training programs to make the long-term unemployed more "job ready"; wage subsidies to make them cheaper to employ.

More of what we have been doing, in other words.

The crucial but, until recently, almost unmentionable issue in all this labour market reform is that the cost of labour matters. Labour competes with capital. When labour becomes relatively expensive, employers invest in labour-saving technology. Production workers are replaced by automated assembly lines, bank tellers are replaced by teller machines, ticket collectors are replaced by automatic turnstiles, and so on.

The cost of labour is particularly important for the unemployed, who are mostly unskilled and are in competition with more skilled workers.

Basically, unskilled workers compete with skilled workers and their machines.

Both sides of the debate understand this, although Labor politicians and union officials rarely can afford to admit it publicly.

In public, they quote a US study by two Princeton economists, David Card and Alan Kreuger, which purports to show that high minimum wages have no negative effect on employment.

In practice, their actions demonstrate a clear understanding of the need to make labour competitive. The Hawke Government's Accord cut real wages; the Keating Government's Working Nation initiative subsidised the wages of the previously long-term unemployed.

The reluctance of the labour movement to acknowledge the negative relationship between the cost of labour and the level of employment is understandable.

Nevertheless, it is one of the reasons Australia has not been able to build a political consensus in favour of the measures necessary to cut unemployment.

The legitimate concern, of course, is equity. One of the attractive features of Australian society is its relative equality of income.

Equity has long been a central objective of Australian labour market regulation.

However, while that system fitted easily into the world of the 1950s and '60s -- when the world was experiencing uninterrupted growth, and Australian producers had relatively little competition and Australian workers had a much less generous welfare alternative -- it has been much less successful in the past 25 years.

As the economic environment has become more competitive and less stable, the tension between equity and efficiency has become apparent.

Overpaying unskilled workers in the name of equity reduces their ability to compete against more skilled workers and machines.

The result is another kind of inequity. The majority of employed unskilled workers benefit from being overpaid. They are the insiders.

A minority of unskilled workers, however, become long-term unemployed. They become the outsiders.

The insiders pay their union officials to protect them against the outsiders. Award minimum rates, last-on, first-off rules, restrictions on the use of part-time labour -- these are all time-honoured defences by the insiders against the outsiders.

The challenge for reformers is to preserve or improve the equity of the labour market while improving the efficiency with which it generates jobs for all who want them.

The answer, almost certainly, will be for government to promote equity via taxes and subsidies, while leaving the labour market free to more efficiently allocate resources and generate jobs.

An example of just such a reform is the recent proposal by five prominent economists -- a proposal described by the Governor of the Reserve Bank as "about the most constructive thing that's come along in this area for years".

Their idea is to freeze the award wages safety net for four years, while subsidising low-income earners through cash subsidies or tax credits.

The decline in wage costs over four years, the economists calculate, would be enough to cut the unemployment rate by 1.5 to two percentage points. That is, if economic growth stayed on its present track, unemployment could be cut to 5 per cent.

At the same time, equity would be improved because unemployment would be reduced and because carefully targeted tax credits are a better way of helping the poor than are artificially inflated award wages.

"Recent research by Sue Richardson and Ann Harding has highlighted how those people receiving low wage rates are well spread throughout the distribution of family incomes," the economists pointed out in their original letter to Prime Minister John Howard.

"This makes Living Wage adjustments a very blunt equity device. Indeed, the proposed tax credits would be more valuable to many such low-income families than 'Living Wage adjustments'."

But that is just one of the measures the Government should take.

The Howard Government, to its credit, has widened the opportunity for enterprise bargaining with its Workplace Relations Act. And that extra flexibility is already proving its worth. The coal industry, for example, has been able to weather the Asian crisis better because it has been able to achieve an increase in labour productivity of around 20 per cent.

In the very short term, that has cost jobs in the mining industry. But it has also kept mines open and it will ultimately mean more export income, more investment and more jobs across the wider Australian economy.

However, the Howard Government's reforms were not sufficient to make a long overdue clean sweep of the waterfront.

And while it has taken the industrial relations law further in the right direction than the Keating Government would ever have dared, the Howard Government has also made at least one serious wrong turn.

It cut the Keating Government's labour market programs -- the good ones as well as the not so good -- leaving the long-term unemployed with inadequate training and support.

Some would say that is just further evidence of the need for a new consensus on the issue of unemployment.

The Focus on Jobs series continues for five days. Tomorrow: Stephen Koukoulas looks at the debate on our natural rate of unemployment. How do we compare internationally?

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