OBSERVATIONS ON MACRO MANAGEMENT

Talk to Economic Society, Victorian branch, Wednesday, September 9, 2015

I want to draw on a few themes from my new book, Gittins: A life among budgets, bulldust and bastardry, particularly some observations about macro management, recessions and, what I consider to be my special subject, the politics of economics.

Don Stammer, the veteran business economist, says you need to have seen four recessions before you’re fully qualified. I thought the global financial crisis of 2008-09 would bring my fourth, but if you don’t count that---l count it as a potentially severe recession turned into a mild one by remarkably skilful management---I’ve seen three big ones. The recession of 1974-75 would by itself have caused the Whitlam government’s defeat had there not been more than enough other reasons. The severe recession of the early 1980s brought the Fraser government’s reign to an end after just seven years and the severe recession we didn’t have to have in the early 1990s---in the sense that all recessions happen by accident rather than design---finally did for the perpetrator of that bravado in 1996, although his execution was delayed three years by the political inexperience of a former economics professor, John Hewson.

I soon formed the view that recessions occurred roughly every seven years. I know from the three recessions that have occurred so far ‘on my watch’---each of them accurately branded ‘the worst recession since the Great Depression’---how terrible recessions are: the fear and pain they cause to small business people, workers who lose their jobs and young people who have the misfortune to be leaving school or university at the time. Whitlam’s recession saw the rate of unemployment shoot up from 2 per cent to 6 per cent, Fraser’s recession saw it peak at 10 per cent and Keating’s at 11 per cent. I know how thoroughly depressed people get for years on end, convinced things will never pick up again. I also know how bitter are the public’s recriminations against economists. Recessions may be a ‘good story’---in the sense they give people like me plenty to write about---but I hate them.

My notion that recessions occur about every seven years remains pretty true for all the developed economies bar Australia. Even if you count the mild recession of the GFC---which I do---it remains true we haven’t had a recession bad enough for ordinary people to notice for 24 years. There are two things to say about this.

First, in one sense only it’s a pity you have to be so old to know how terrible a severe recession is and hence to be hugely relieved, even grateful, we managed to avoid one in the aftermath of the GFC. About seven years later the North Atlantic economies are still embroiled in the Great Recession we escaped.

Second, that we’ve avoided severe recession for an unprecedented period is thanks more to good management than good luck. Even if you’re so ill-informed as to imagine our escape from the Great Recession is due purely to China and the resources boom, you still have to explain 17 years of uninterrupted growth since the recession of the early 90s, including our exemption from the world recession of the early noughties. We should have been brought low by the Asian crisis of 1997-98, but weren’t.

I decided very early in that 17-year period that the ultimate test of good economic management was to keep the recessions as far apart as possible, mainly because recessions put a lot of people out of work for long periods, and the longer you’re jobless the harder it gets for you to regain a berth. I could have decided the ultimate test was to keep the inevitable recessions as mild as possible. Either way, our economic managers pass with flying colours. I know Australians find it hard to believe Aussies could be world-class at anything but sport, but it happens to be true of our econocrats.

I know because I watched at close quarters as it happened and I know how they did it. It’s certainly true that our economic management was pretty bad for at least the first decade of my time as an observer. But between the late 80s and the early 90s the econocrats started getting their act together. Although most of the seeds were sown under the Hawke-Keating government, the Howard government was the first to enjoy the fruits. The Rudd-Gillard government also enjoyed them---as witness, its avoidance of the Great Recession---though it lacked the whit and internal cohesion to reap the harvest.

The econocrats did it by persuading their successive political masters to subject the conduct of day-to-day economic management to ‘frameworks’ of rules and targets intended to limit the scope for politically motivated short-termism. The obvious example is the decision---formalised by Peter Costello---to use an inflation target to guide decisions about changes in the official interest rate and to hand control over interest rates to an independent central bank.

The many acts of ‘micro-economic reform’---including floating the dollar, deregulating the banks and various other industries, phasing out protection against imports and shifting the locus of wage-fixing to the level of the individual enterprise---also helped. Micro reform failed in its stated objective of permanently lifting the rate at which the economy could grow, but it had an unexpected benefit: by intensifying the competition within industries it made the economy far less inflation-prone and unemployment-prone, thus greatly simplifying the macro-managers’ task in keeping the economy on an even keel.

What they do in Canberra

The theory of public choice holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever its original motivations, all government regulation of industry ends up being ‘captured’ by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs. The regulated have a huge incentive to get to the regulators so as to modify the regulation in ways the industry finds more congenial, or to advantage the existing players against new entrants or rival industries.

I don’t accept for a moment the accusation that all regulation of industry is subverted. But I do believe there’s more than a grain of truth to the accusation: there is considerable scope for regulatory capture. And I’ve long suspected that the way our bureaucracy is organised---where the department of agriculture looks after the farmers, the industry department looks after the manufacturers, the environment department looks after the greenies, the resources and energy department looks after the miners and the tourism department looks after the tourist industry---could have been purpose-built for regulatory capture.

In the various industries’ battle for their share of industry assistance, in the inter-departmental battle for influence and resources, each industry has its own special champion, those whose true role is supposed to be to keep the industry acting within the bounds of the wider public interest. Is the bureaucracy divided up this way just to gain the benefits of specialisation, or is each department’s real role to keep their particular industry happy and not making trouble for the elected government?

Of course, the two government agencies whose motivations and behaviour I’ve watched most closely are Treasury and the Reserve Bank. Being---like Prime Minister & Cabinet and the Finance department---‘co-ordinating departments’---Treasury and the Reserve have no particular industries they regard as ‘clients’. For instance, though the Reserve has daily dealings with the banks and the financial markets, I’ve never suspected its decisions about the level of interest rates were influenced by anything other than what it believed to be in the best interests of the wider economy over the medium term.

In other words, Treasury and the Reserve are on about macro management or ‘stabilisation policy’. But since they each wield different macro instruments, there is some specialisation between them. The question I ask is: what would they die in a ditch over? They care about lots of things, but what do they care about most?

In the Reserve’s case, the answer is inflation. Its attitude is, if we don’t accept ultimate responsibility for keeping inflation under control, who will? It also regards its instrument---monetary policy, or the manipulation of interest rates---as the best one to use to keep inflation in check. All this is implicit in its single target of keeping the rate of inflation between 2 and 3 per cent on average over the medium term. When it first adopted that solitary target 20 years ago, some took this to mean achieving low unemployment was not something it cared much about. Fortunately, our experience since then has dispelled such fears. The best way to think of its objective is ‘non-inflationary growth’. Even so, it does mean that, when forced to choose, fighting inflation will always come first.

So what does Treasury care most deeply about? What does it see as its ultimate responsibility, the responsibility others are less likely to care so much about? This took me longer to realise, but treasuries---state as much as federal---care most about the budget and getting it back to surplus just as soon as the state of the business cycle permits. As the recent troubles of governments in America and Europe attest, left to their own devices politicians are capable of running budget deficits year after year, in bad times and good, for decades until finally their lack of self control gets them into serious difficulties, invariably at the most inopportune times.

That our governments’ records have been so much more disciplined is testimony to our treasuries’ obsession with keeping budgets in balance ‘over the cycle’ and thereby avoiding the build-up of excessive levels of public debt. It’s testimony also to our treasuries’ greater success in persuading their political masters to curb their natural instinct to spend more than they raise in taxes.

Bearing in mind the wide discrepancy between the politicians’ willingness to increase taxes to cover their increased spending, much of Treasury’s effort goes into urging politicians to restrain their spending and into developing devices to help the co-ordinating, ‘purse-string’ ministers keep the other, ‘spending ministers’ in line. In this, Fraser’s attempt in the mid-1970s to punish Treasury by splitting a Finance department off from it---with Treasury responsible for revenue and Finance responsible for spending---had the unexpected effect of doubling Treasury’s influence at the cabinet table. It could have meant Treasury lost interest in the spending side of the budget, but it certainly hasn’t.

When Costello introduced the reforming Charter of Budget Honesty early in the Howard government’s term, he included---no doubt at Treasury’s suggestion---a requirement for Treasury to produce an ‘intergenerational report’ every five years to assess the fiscal sustainability of present government policies over the next 40 years. The first of these reports in 2002 found that (given a quite restrictive assumption about the growth in tax revenue) the present comfortable budget surpluses would soon give way to ever-growing budget deficits thanks to the ageing of the population and, more particularly, the public’s ever-growing demand for access to medical science’s ever-more-expensive advances in health care.

The following three reports have used the same assumptions to tell essentially the same story. From the first report it became clear to this (not unsympathetic) Treasury watcher that the report was being used by the treasurer as a kind of waddy to wave over the heads of the spending ministers. See the problems we face down the track? See how much worse it would be if I were to stop beating off your grandiose schemes? It was such a handy implement the state treasuries lost little time in producing their own intergenerational reports, each telling a story remarkably similar to federal Treasury’s.

But the state treasuries’ favourite disciplinary device is the state governments’ triple-A credit rating, ratings that emerged early in the Hawke-Keating government’s budgetary reforms when it ceased the practice of borrowing on the states’ behalf. No innovation could have been more effective in disciplining the states’ propensity to borrow, probably to the extent that it helps explain those governments’ inadequate spending on infrastructure.

State governments of both colours live in fear of the political censure that might follow a downgrading of their credit rating, not the modest increase in their borrowing costs it would also bring. And state treasurers exploit this fear indefatigably. When occasionally state governments do suffer a downgrading, they work untiringly to get their top rating restored.

I half agree with the academic economists who think too much attention is paid to credit ratings and that state governments could borrow for infrastructure investment a lot more heavily than they do without this creating an economic (as opposed to political) problem. I also suspect the rating agencies draw their lines in the sand more conservatively for governments than they do for businesses.

When you remember the big American rating agencies’ disgraceful contribution to the sub-prime debt debacle---where they sold paying customers triple-A ratings for the mortgage-backed securities they were issuing, only to have those securities ultimately revealed as ‘toxic assets’---you wonder why they give governments such a hard time. I finally decided they do it because they viewed the state treasuries as their clients, and know full well the treasuries want them to take a hard line.

But having conceded all that, I don’t criticise treasuries and their treasurers for the way they use credit ratings to beat back spending ministers’ insatiable demands for more spending on this worthy cause and that. What the academic critics forget is that their theories provide no clear dividing line between what level of borrowing is safe and what isn’t. In the real world of government, treasurers have to draw an unavoidably arbitrary line and then enforce it. If they use the bogeyman of credit ratings to keep their governments out of trouble, I’ve been loath to criticise.

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Depressed economists lose faith in capitalism

The nation's practicing economists are working themselves into a state over the future of the economy, convincing themselves the prospects for growth are dismal and the only answer is more "reform".

They're being rallied by former Treasury secretary Dr Martin Parkinson.

He told the National Reform Summit that Australia risked sacrificing as much as 5 percentage points of economic growth over the next 10 years, the equivalent of the production and income lost during a recession.

"Unless we grab this challenge by the horns and really get concrete about what are the priority issues, we are actually going to find ourselves sleepwalking into a real mess," he said.

There's a host of dubious assumptions hidden behind this stirring call to economic arms. For a start, how do we know we've got a problem? How do we know we're heading for a decade of slow growth unless the government acts?

We don't. We look at the below-trend growth in six of the past seven years and, as any economic illiterate would, simply extrapolate it for 10 years. But why stop at 10? Why not make it 40?

One of the shafts of enlightenment at the summit, we're told, came when a modeller from Victoria University challenged the inter-generational report's modelling that the productivity of labour would improve at an average annual rate of 1.4 per cent over the next 40 years. The rival modeller's modelling put it at less than 1 per cent.

Really? Talk about the biter bit. Rather than using their models to bamboozle the punters, economists are bamboozling themselves, mistaking an "exogenous" variable for an "endogenous" one.

Putting that in English, both the 1.4 per cent and the 1 per cent are merely assumptions, not a finding of the models. No economist knows what will happen to productivity over the next two years, let alone the next 40. And no model can tell them.

All the economists are doing is what any mug punter would do: relying on gut feel rather than science. You may be optimistic about the future, but I'm pessimistic.

They're making the economic illiterate's assumption that our recent weak growth is structural rather than cyclical. Sure, falling commodity prices are reducing our real income, but one day they'll stop falling.

Sure, we're making heavy weather of the transition from the resources boom, but one day it will have been made. Simple statistical theory should be telling economists that a protracted period of below-average growth is most likely to be followed by a period of above-average growth.

The next weird thing about the economists' bout of depression is their assumption that the economy will go nowhere without government intervention. It's as though they've lost their faith in capitalism.

The economy isn't a living organism whose growth and striving is driven by consumers' self-interest and producers' profit-seeking; it's more like a marionette whose animation depends on the Public Puppeteer continually jerking its strings.

Economic growth, it seems, is exogenous not endogenous. Really? What textbook did you read that in?

When you convince yourself, as many economists have, that the only way we'll see faster growth and further productivity improvement is for governments to engage in extensive reform, you've convinced yourself our economy is deeply dysfunctional.

Hugely inflexible and uncompetitive, highly protected, rife with cartels and lazy government-owned monopolies.

You're saying all the (unrepeatable) reform of the 1980s and '90s – floating the dollar, deregulating the financial system and a dozen industries, removing import protection, decentralising wage-fixing and privatising or corporatising public utilities – delivered a once-only productivity improvement but no lasting gain in efficiency, flexibility or dynamism.

There's nothing about those reforms that will help the economy grow in the future, you imply. Somehow in the intervening decade or so all those reforms have disappeared under a jungle of inefficiency; the jungle that's preventing us from ever returning to our former average growth rate.

So now you're threatening to slash your wrists unless the government trawls through all the second-string reforms not yet made and gets on with them.

Naturally, your best advice on how we can get productivity improving faster relies on the things economists think matter most: prices (including tax rates and the wage-fixing system) and intensifying competition (much of which would appal the Business Council and other industry lobbies).

And what do we get if we follow your advice? Another fleeting productivity improvement or something of continuing benefit?

Sorry, guys, but the propositions you're advancing are more like a high-pressure sales job than a rational analysis of our future opportunities and threats. Why don't you take a break and cheer up?

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Contrary to reports, economy battles on

Joe Hockey is right. The economic news is hardly wonderful, but the media's attempt this week to convince us the economy was perilously close to recession was sensationalist nonsense.

What set them off was news from the Australian Bureau of Statistics' national accounts that real gross domestic product grew by just 0.2 per cent in the June quarter. What they forgot to mention was that in the previous quarter it had grown by 0.9 per cent.

As Hockey says, the figures "bounce from quarter to quarter". But why let that small fact get in the way of a good scare story?

The less excitable Dr Chris Caton, of BT Investment Management, put it another way: "The weak growth for the June quarter was in part payback for the strong growth in the March quarter."

Just so. We were told, for example, that spending on home building fell by 1.1 per cent in the latest quarter, but not reminded that the previous quarter it had grown by a remarkable 5.6 per cent. There is no reason to believe the housing construction boom has ended.

We were told that the volume of exports fell by 3.3 per cent in the latest quarter, but not reminded that in the previous quarter it had grown by 3.7 per cent. Turns out the weather was unusually favourable around bulk-commodity ports in the first quarter, but unusually bad in the second.

We weren't told about these one-off negatives for growth in the June quarter, but much was made of a one-off positive: a sudden surge in defence spending, we were told, fully accounted for the quarter's 0.2 per cent growth.

(Actually, it was worse than that. Whereas total public sector spending made no contribution to overall growth in the March quarter, it contributed 0.6 percentage points in the June quarter.)

All this is why searchers after truth rather than headlines don't take quarterly changes in GDP too literally. Combine the two quarters and you get average quarterly growth of 0.55 per cent, or annualised growth of 2.2 per cent - which is probably closer to the truth.

It also fits better with a fact we were told only in passing, that the economy grew by 2 per cent over the year to June and by 2.4 per cent on average over the financial year, meaning Treasury's forecast of 2½ per cent was near enough to right - a point Hockey kept making and the media kept ignoring.

Examine the figures for the year to June and you don't find much evidence of an economy likely to collapse in a heap. Consumer spending grew by 2.5 per cent, home building by 10.4 per cent, public sector spending by 3.3 per cent.

Export volumes grew by 4.5 per cent, while import volumes fell by 0.7 per cent. In fact, apart from a small fall in the level of inventories, the only major negative contribution to growth came from business investment spending, which fell by 4.1 per cent.

That fall comes from the end of the mining construction boom, of course. It's a reminder of the truth of our position - that our transition from mining-led growth to more normal sources of growth has been far from smooth and isn't achieved yet - a truth too prosaic for the headline chasers. Growth in the low 2s is clearly well below average.

But if you dig a bit deeper you do find signs that the transition is proceeding, with help from record low interest rates and an ever-lower dollar.

For a start, there is evidence of recovery in non-mining investment. According to rough figuring by Kieran Davies, of Barclays bank, it's up by 4 per cent over the year to June, led by investment in the services sector.

Exports of services - including tourism and education - are also growing. Though little changed in the June quarter, their volume was up 7 per cent over the year, Davies says.

"With imports of services down 8 per cent over the past year as the falling exchange rate has made it more expensive to take an overseas holiday, trade in services [exports minus imports] added 0.1 percentage points to GDP in the June quarter and 0.6 percentage points over the past year."

Much has been made of the 1.2 per cent fall in "real net national disposable income per person", rightly described as the best measure of material living standards the national accounts provide. It's fallen for five quarters in a row.

Why? Because of the deterioration in our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - as coal and iron ore prices have fallen.

But it's important to see this in context. Why do so many people care so much about economic growth? I (and Joe and his boss) think it's mainly because they want to see more jobs created.

If so, real GDP - the quantity of goods and services workers are employed to produce - is a more relevant indicator than the various measures of "real income".

And the growth in GDP we've had has been sufficient to create 240,000 jobs over the year to July (including 68,000 during the supposedly knackered June quarter) and to stabilise the unemployment rate at just over 6 per cent.

It's true that the size of our real income has an effect on our spending on goods and services, and the demand for goods and services affects employers' demand for workers.

But much of the loss of income caused by lower coal and iron ore prices is borne by the mining companies (which are about 80 per cent foreign owned) and by state and federal governments (which collect lower mining royalties and company tax), rather than by the rest of us.

Times aren't easy, but we're not in bundle-dropping territory.

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The game pollies play rather than governing

It came to me while I was lying awake the other night: the business, union and community worthies at last week's National Reform Summit thought the way to make progress was to hammer out a compromise proposal most people could agree to. You hand it to the government, the opposition agrees, they whack it through parliament and problem solved.

But that's not the game Tony Abbott is playing.

He doesn't want agreement, he wants disagreement, but with the government on the majority side and its opponents on the minority side. That way, you get re-elected and maybe, as a bonus, there's some benefit to the country.

Pretty bad? Here's the worst part of my early-hours revelation: the other side's no better.

This is the way both sides have been playing the political game for years. It's just more obvious now because Abbott doesn't play it with as much finesse as his predecessors.

In Canberra, the game is known as "wedging", but is better described as "wedge and block". Whoever's in government thinks of issues acceptable to their side – and popular with voters – but inconsistent with the other side's values and thus likely to divide it. Ideally, the others oppose you and so get themselves offside with most voters.

Failing that, the pragmatists on the other side – who see perfectly what you're up to – reluctantly go along with you, but a more principled minority don't, so you've sown dissent among your opponents. Always a bad look to the electorate.

If the practitioners of expedience get their way without noticeable demur from the keepers of party principle, the wedge has been successfully blocked and you have to go away and think up another one.

How do you come up with a good wedge issue? You consult those polls that regularly ask voters which party is better at handling particular issues. Study these results and you find voters have highly stereotypical views about the parties' strengths and weaknesses.

The Liberals are better at what you'd expect a penny-pinching bosses' party to be better at: managing the economy, fighting inflation, keeping taxes and interest rates low and controlling the budget. And, of course, keeping the country safe from threats to our security.

Labor, on the other hand, is better at what you'd expect a big-spending workers' party to be better at: unemployment, social security, health, education, the environment and industrial relations.

In the months leading up to an election, each side manoeuvres to establish as key election issues problems the voters regard them as better at dealing with. They try to neutralise – block – those issues the other side is pushing that would leave them at a disadvantage.

The sainted Julia Gillard wasn't too saintly to use her two most popular (and expensive) measures to try to wedge Abbott at the 2013 election.

She proposed a 0.5 percentage point increase in the Medicare levy to help pay for the national disability insurance scheme, hoping Abbott would object and so could be accused of opposing greater assistance to the disabled.

She delayed the Gonski reforms to school finding, hoping Abbott would defend private schools and she could make it a key election issue.

Abbott blocked both wedges. He quietly agreed to the tax increase which, becoming uncontentious, was never mentioned again. On the Gonski reforms he belatedly professed to be on a "unity ticket" with Labor. But the delay meant many Liberal state governments declined to sign up to the scheme so close to an election.

Abbott's efforts to wedge Labor have come thick and fast in recent days. He asked President Obama to ask us to join in the US bombing of Syria because he was hoping Labor would object to such an ill-judged move. It didn't.

In another effort to increase public concerns about national security, he propose stripping certain Australians of their citizenship, hoping Labor would object and so allow him to accuse it of being "soft on terrorists". It didn't.

Abbott is anxious to portray his government as big on "jobs and growth". He cooked up a story about greenies using the law to block a new coal mine in Queensland and proposed amending the federal environment protection act to counter "green sabotage", hoping Labor would object and he could accuse it of putting the environment ahead of jobs.

As became clear at last week's reform summit, there's now widespread agreement that superannuation tax concessions to high-income earners are too generous and need to be cut back, with big savings to the budget.

Earlier this year, Joe Hockey had Treasury working on super changes when Labor announced it would take such a policy to the election. Abbott immediately embarrassed Hockey by insisting the government would countenance no changes to super or any other tax concessions.

Labor may stand for higher taxes, he told us, but the Libs stood for lower taxes. He made it clear last week that, come hell or high water, the government would go into next year's election promising tax cuts.

Great wedge. One small problem: all Labor has to do to block it is promise to match it – just as it did when John Howard tried the same thing at the 2007 election.

Bad policy, but what of it?

If you wonder why our politicians don't seem interested in good government, their addiction to playing the wedge-and-block game explains a lot.

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