We owe more than we realise to our best econocrats

If you believe, as all of us do, that governments need to be accountable to the voters who elect them, then someone has to care about the way those governments account for all the money they raise in taxes and charges, plus all the money they borrow. Governments spend this money on myriad services they provide and the huge array of infrastructure they build for us, ranging from police stations to grand spaghetti junctions.

Our politicians are meant to care about how – and how well – money is raised and spent, but the control of all that money and the recording of where it comes from and goes to is the responsibility of bureaucrats in federal and state treasuries and finance departments, not forgetting the central bank.

The budgets and financial statements they produce are intended to account publicly for all the money that passes through the governments’ hands, but the econocrats know that the system of accounting must also help ensure that governments and their departments and agencies are well managed. That the money they spend actually achieves its intended objectives, with little waste.

Whereas political journalists spend much of their time talking to the politicians we read about, as an economic journalist, I spend most time talking to the technocrats standing in the shadows behind them.

The pollies are never keen for the econocrats to take much of the media limelight, and that usually suits the bureaucrats fine. But while they all work hard in the voters’ interests, some of them do an outstanding job in protecting and advancing those interests.

One such person was Percy Allan, who died at 78 last month. He was secretary of the NSW Treasury for about 12 years under three premiers – Labor’s Neville Wran, the Liberals’ Nick Greiner and Labor’s Bob Carr. Allan was a contact of mine who later became a friend.

You may think of economists and accountants as being as boring as the work they do. But that’s not the way they think of themselves, and no one who knew Allan ever thought of him as dull.

As we were reminded during the pandemic, whereas the federal government raises most of the taxation, it’s the state governments that are responsible for delivering most of the government services we rely on.

The six states and two territories have much autonomy. They compete against and copy each other. But usually, it’s the biggest states, NSW and Victoria, that initiate change.

If you want boring, try this: Allan led the way in getting federal and state governments to adopt the accounting profession’s general accounting principles and also the public sector’s budget reporting and financial statistics standards.

It helps make governments’ budgets and financial statements more accountable and transparent if all governments follow the same set of rules, rather than them each doing things their own way. And for the rules to make sense.

Governments provide many figures for publication by the Australian Bureau of Statistics. It helps if those figures are calculated on the same, consistent basis, and if government figures fit with all the statistics provided to the bureau by the private sector.

Similarly, it helps if all the world’s governments use the same internationally agreed standards laid down by the International Monetary Fund and the United Nations Statistical Commission.

Private businesses have long been required to report their annual profit or loss, and their balance sheet of assets and liabilities on the last day of the year, on an “accrual” basis. That is, to make a great effort to ensure that the income reported for a particular period was earned during that period.

Likewise, to ensure the expenses reported for the period didn’t relate to other periods. Accountants call this making sure the income and expenses reported for a period actually “match”.

If that sounds obvious, it wasn’t the way federal and state government budgets and financial statements were prepared until Allan and others led the way in conforming to private sector and international accounting and statistical standards.

Until then, federal and state budgets and financial statements were calculated on a “cash” rather than accrual basis. Revenue was any money that hit the government’s bank account during the period, even if some of the money was people paying last year’s tax late or others paying next year’s early. Similarly, all money that left the government’s bank account during the year was counted regardless of the year to which it applied.

Has the penny dropped yet? Compared to the cash basis, the accrual basis makes it much harder for the company or the government to fudge their annual figures by switching incomings and outgoings between years.

Now get this. The federal government has used accrual accounting since the start of this century. But to this day, federal budget documents are written in a confusing mixture of the two accounting languages – cash and accrual. The budget deficit or surplus the treasurer tells us about is always the “underlying cash” balance.

Treasury will tell you cash is the more appropriate basis from a macroeconomic perspective. That is, when you want to judge the budget’s effect on the economy, or the economy’s effect on the budget.

Maybe. But what’s undeniably true is that, unlike the states, the feds’ retention of the cash basis makes it a lot easier for the government of the day to engage in creative accounting – which it often does.

Another reform Allan was proud of was the “corporatisation” of various businesses the state government owns: the railways, the buses, water and sewerage, electricity generation and distribution, the ports and so forth.

Allan wanted all government-owned businesses to run, and be accounted for, as though they were commercial undertakings. When so many of them are natural monopolies, this has its dangers.

But when state-owned businesses aren’t run like businesses, they’ll tend to be run for the convenience of employees rather than customers, with overstaffing and other wastefulness.

So, better to have transparent accounting, leading to greater efficiency and higher profits going back to the government, to be spent on additional services without the need for higher taxes.

Linked to this was Allan’s role, during the term of the reforming Greiner government, in setting up the NSW Independent Pricing and Regulatory Tribunal to ensure the prices charged by government-owned businesses rose by no more than could be justified.

But one of Allan’s greatest achievements was achieved long after he’d left NSW Treasury. He founded and ran the Evidence Based Policy Research Project, in which a right-leaning and a left-leaning think tank have been commissioned to examine more than 100 federal or state bills to assess whether they stack up.

Most have been found not to. Allan had a big win when the NSW upper house passed a standing order that all government bills answer a public interest questionnaire. The project has been taken over by the Susan McKinnon Foundation.

My mate Percy Allan devoted his life to trying to make the world work better. We all owe him thanks.

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Let's stop using interest rates to throttle people with mortgages

What this country needs at a time like this is economists who can be objective, who’re willing to think outside the box, and who are disinterested – who think like they don’t have a dog in this fight.

On Friday, Reserve Bank governor Michele Bullock, with her lieutenants, made her first appearance as governor before the House of Reps economics committee.

See if you can find the logical flaw in this statement she made: “The [Reserve’s] board understands that the rise in interest rates has put additional pressure on the households that have mortgages. But the alternative of lower interest rates and high inflation for a prolonged period would be even worse for these households, as well as all the households without mortgages.”

Sorry, that’s just Bullock doing her Maggie TINA Thatcher impression, mindlessly repeating the assertion that “There Is No Alternative”. Nonsense. There are various alternatives, and if economists were doing their duty by the country, they’d be talking about them, evaluating them and proposing them.

What’s true is that the Reserve has no alternative to using interest rates to slow demand. Some economists can be forgiven for being too young to know that we didn’t always rely mainly on interest rates to fight inflation, just as we didn’t always allow the central bank to dominate the management of the economy.

These were policy changes we – and the rest of the rich world – made in the early 1980s because we thought they’d be an improvement. In principle, now we’re more aware of the drawbacks of giving the central bank dominion over macroeconomic management, there’s no reason we can’t decide to do something else.

In practice, however, don’t hold your breath waiting for the Reserve to advocate making it share its power with another authority. Nor expect the reform push to be led by economists working in industries such as banking and the financial markets, which benefit from their close relations with the central bank.

What those with eyes should have seen in recent years is that relying so heavily on an instrument as blunt as interest rates is both inequitable and inefficient. It squeezes the third of households with mortgages – or the even smaller proportion with big mortgages – while hitting the remaining two-thirds or more only indirectly.

It’s largely by chance that the Reserve’s need to jam on the demand brakes has coincided with the worst shortage of rental accommodation in ages, thereby spreading the squeeze to another third of households. Had this not happened, the Reserve would have needed to bash up home buyers even more brutally than it has.

Clearly, it would be both fairer – and thus more politically palatable – and more effective to use an instrument that directly affected a much higher proportion of households. This should mean the screws wouldn’t have to be tightened so much, another advantage.

One obvious alternative tool would be to temporarily move the rate of the goods and services tax up (or, at other times, down) a percentage point or two.

Another alternative, one I like, is to divide compulsory employer superannuation contributions into a part permanently set at 11 per cent, and a part that could be varied temporarily between plus several percentage points and minus several points.

This would leave workers less able to keep spending (or more able to spend), as the managers of demand required to stabilise both inflation and unemployment.

Its great attraction is that it involves the government temporarily fiddling with people’s ability to spend, without actually taking any money from them. Surely, this would be the least politically painful way to manage demand.

Experience with central-bank dominance has shown us one big advantage: the economic car has been driven markedly better when the brake and the accelerator are controlled by econocrats independent of the elected government.

But this simply means we’d have to set up an independent authority to control all the instruments of macro management, whether monetary or fiscal.

Not all our economists have been too stuck in the mud of orthodoxy to think these new thoughts. They were canvased by professors Ross Garnaut and David Vines in their submission to the Reserve Bank inquiry – which, predictably, was brushed aside by a panel of economists anxious to stay inside the box.

A century ago, Australians were proud of the way we showed the world better ways of doing things, such as the secret ballot and votes for women. These days, our economists are dedicated followers of international fashion.

This means the country that should be leading the way to better tools to manage demand will wait until it becomes fashionable overseas. Why should we be first? Because our unusual practice of having mainly variable-rate home loans means our use of the interest-rate tool bites a lot harder and faster, thus making our monetary policy a lot blunter than theirs.

Economists may not fret much about how badly some punters are hurting as the economic managers rapidly correct the consequences of their gross miscalculations – the Reserve played a big part in the excessive stimulus during the COVID lockdowns – but one day the politicians who carry the can politically for these miscalculations will revolt against the arrogance of their economic gurus.

Reserve Bank governors – and, in earlier times, Treasury secretaries – privately congratulate themselves for being the last backstop protecting the nation against inflation. When no one else cares, they do. When no one else will impose a cost of living crisis on spendthrift consumers, they will.

Don’t you believe it. If they cared as much as they think they do, they’d care a lot more about effective competition policy. But when the economists leading the Australian Competition and Consumer Commission – Allan Fels and later, Rod Sims – were battling to get more power to reject anticompetitive mergers, they got precious little support from their fellow economists.

While the (Big) Business Council was lobbying privately to retain the laxity, backed up on the other side by a few Labor-Party-powerful unions that had done sweetheart deals with their big employers, the Reserve and Treasury were missing in action.

The people at the bottom of the inflation cliff boast about the diligence of their ambulance service, while doing nothing to help the people at the top of the cliff trying to erect a better safety fence.

If you were looking for examples of oligopolies with pricing power, you could start with the big four banks. If you were looking for examples of “regulatory capture” – where the bureaucrats supposed to be regulating an industry in the public interest get sweet-talked into going easy – you could start with the Reserve and banking (with Treasury not far behind).

In the natural conflict between the goals of financial stability and effective competition, the Reserve long ago decided we’d worry about competition later.

But the more concentrated we allow our industries to become, the more often the Reserve will have to struggle to control inflation surges, and the harder it will need to bash home-buyers on the head.

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Bullock the safe choice as RBA governor, but is that what we need?

In Treasurer Jim Chalmers’ decision to accept the internal candidate as successor to Philip Lowe as Reserve Bank governor, we see what may become the ultimate judgment about the Albanese government: it wanted change, but not radical change. Not change that rocked the boat too much. Certainly, not change that got big business offside.

The choice of deputy governor Michele Bullock to move up one chair will delight the Reserve’s higher ranks (though the put-upon lower ranks may have been hoping for a newer new broom to sweep out the old order).

As with most institutions, the Reserve’s insiders want the internally determined pecking order to be preserved. The governor persuades the Canberra politicians to appoint the next-most able person as deputy and, when the time comes, they move up, as do those in the queue behind them.

The Reserve insiders’ great fear is that the pollies will impose one of their trusties on them, or – next worse – that someone from their eternal bureaucratic rival, Treasury, will be appointed to sort them out. Either way, the pecking order is disrupted.

Over the years, the Reserve has had much success in persuading governments to let it choose its own governor. This has been the safe choice for pollies of both colours.

Only once has the internal order been disrupted in (my) living memory, which was when, in 1989, treasurer Paul Keating decided to move his Treasury secretary, Bernie Fraser, from Treasury to the Reserve.

Although I was disapproving at the time, it turned out to be a very healthy development. Fraser brought a breath of fresh air to a fusty institution. He was one of our better governors, a lot more reforming than his predecessors.

Fraser came to fear that one day he’d wake up to find himself reporting to a new Liberal treasurer, Dr John Hewson, a former economics professor, who’d immediately impose on him the latest international fashion, a central bank with operational independence from the elected government, whose decisions on monetary policy (interest rates) would be guided by an inflation target.

That never happened, of course. But Fraser decided that, if this was the way the world was turning, he’d get in first and design his own inflation target, ensuring it was a sensible one.

The Kiwis, who were the first to introduce such a target, set it at zero to 2 per cent, which became the international standard. But, with help from the Reserve’s best people, Fraser decided on something more flexible: to hold the inflation rate between 2 per cent and 3 per cent “on average” over the cycle.

So, it wasn’t just higher than the others. While they had a target with sharp corners, our “on average” would free the Reserve from having to jam on the monetary brakes every time the consumer price index popped its head above 2 per cent.

Foreign officials kept telling the Reserve it should get a proper target like the Kiwis. But in the end, it was they who had to accept their target was too inflexible.

Fraser announced the new target in 1994, by casually dropping it into a speech to business economists. It wasn’t until the next Liberal treasurer, Peter Costello, arrived in 1996, that the target, and the Reserve’s operational independence, were formalised in an agreement between Costello and the new governor, Ian Macfarlane.

Opposition leader Peter Dutton has said that neither present Treasury Secretary Dr Steven Kennedy, nor Finance Secretary Jenny Wilkinson should be appointed to succeed Lowe because they would be “tainted” by their work with the Labor government.

This was ignorant nonsense. He failed to note that both those people were equally “tainted” by their close work with that last Liberal treasurer, Josh Frydenberg, throughout the pandemic.

So it’s worth remembering that, because of Fraser’s close connection to (by then) prime minister Keating, the money market smarties were convinced Fraser wouldn’t be raising interest rates before the 1996 election.

Wrong. He did. Indeed, he raised them before a crucial byelection, which Keating lost in the run-up to losing the election. Since then, governor Glenn Stevens raised rates during the 2007 election campaign, and Lowe during the 2022 campaign.

Getting back to the point, I’d have been happy to see someone from Canberra put in to implement the (more sensible of the) reforms proposed by the recent review of the Reserve’s performance. Such an insular, self-perpetuating institution needs a regular injection of new blood.

With the benefit of hindsight, it’s almost as though Lowe’s speech last week outlining the Reserve’s plans to implement the review’s recommendations – with Bullock having done most of the work on those proposals – constituted her application for the top job.

Or maybe it was the Reserve’s written undertaking to the Treasurer that, should he agree to preserve the order of succession, it would nonetheless faithfully implement the changes needed.

That so many of those changes – which would be of little interest to any but Reserve insiders and the small army of Reserve-watching outsiders – can be described as major reform says much about what a stick-in-the-mud outfit successive governments have allowed it to become.

The number of meetings of the Reserve Bank board will be cut from 11 a year to eight. Really. Wow.

In making that change, the Reserve will continue its practice of having four of its meetings timed to come soon after publication of the quarterly CPI. But it will use the opportunity to have the remaining four meetings come soon after publication of the quarterly national accounts.

The present practice of meeting on the first Tuesday of the month meant it was meeting the day before it found out how fast the economy had been growing.

Get it? The Reserve could have fixed this problem any time in the past several decades by moving its board meetings to fit. But no, it took a full-scale independent review to make it change its practice. We like doing things the way they’ve always been done. (The good news? No more meetings on Melbourne Cup Day.)

The only significant administrative change will be to have decisions about interest rates made by a board better able to argue the toss with the governor. In particular, what they need (and is already in the pipeline) is someone with expertise in real-world wage-fixing.

The real world keeps changing under the feet of economists, and we need central bankers capable of changing their views in an economy where the cause of inflation is changing from excessive wage growth to excessive profit growth.

That requires more debate within the Reserve, and more opportunity for the newly recruited bright young economics graduates to debate matters with the old blokes at the top.

The Reserve’s problem is too much deference to the views and wishes of the governor. It’s long been a one-man band. Bullock’s appointment as the first female governor ends that problem at a stroke. Let’s hope she does better than turn it into a one-woman band.

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Debt and deficit fixed in just Labor's second budget. Really?

Small things amuse small minds. Too many people have allowed their excitement over an expected budget surplus of a tiny $4 billion this financial year to distract them from noticing a much bigger deal.

Remember that mountain of government debt we ticked up fighting the pandemic? Now Treasurer Jim Chalmers tells us it’s more like a big hill. Remember the frightening spectre of the “structural” budget deficit? Not to worry, it’ll have disappeared in a decade – if you can believe it.

Assuming it happens, achieving an infinitesimally small, and one-off, surplus of $4 billion may be significant politically, but from an economic perspective, it’s not worth popping the champagne cork. In a budget worth $630 billion a year, in an economy worth $2600 billion a year, it’s no more than a rounding error.

No, what’s genuinely significant is not that magic word “surplus”; it’s that this time last year we were expecting a deficit of $78 billion. It’s the absence of another big deficit that’s the big deal. It represents the passage of a year in which we didn’t add to the existing public debt. And, as a consequence, didn’t add to the size of our annual interest bill every year until we’re all dead.

What’s more, the absence of a deficit this year suggests the expected deficits for the next few years will also be smaller than we thought. So next year will see not just a smaller than expected annual interest bill, but a smaller than expected addition to the debt, and thus an even smaller than expected addition to the following year’s interest bill, and so on and on forever.

Well, in principle, anyway. What this news also shows is how hopeless Treasury (and all economists) are at predicting the future.

Next, note that this year’s expected deficit disappeared not thanks to Chalmer’s superior management, but thanks to Treasury’s failure to realise how strong the economy would be. More people are in jobs and paying tax (and not needing to be paid the dole).

Company profits are up, as is the tax they pay. Export commodity prices have stayed higher than Treasury was expecting, so mining companies’ taxes are well up. And remember this: inflation causes taxes to rise faster than government spending does.

But though nothing Chalmers did caused the big improvement, he’d like a round of applause for not spending much of the extra dosh.

And he’s got some very impressive news he’d love me to tell you about. Treasury hasn’t just produced revised forecasts for the financial year just ending and for the budget year 2023-34, it’s done “projections” for a further three years. It’s also made “medium-term” projections right out to 2033-34.

What they show is truly amazing. Unbelievable, even. The budget papers say the absence of the formerly expected $78 billion deficit this financial year, and consequent improvement in forecasts for the following few years, “will avoid $83 billion in interest payments over the 12 years to 2033-34. It also means [the government’s] gross [public] debt, as a share of gross domestic product, will be 7.1 percentage points lower in 2033-34.”

That bit you can believe. It’s just compound interest – which, of course, works in reverse for a borrower rather than a saver.

Now it gets hairy. The Albanese government’s various decisions to limit the growth in government spending mean real spending growth is now “expected to average 0.6 per cent a year over the five years [to] 2026-27”.

This compares with average real (inflation-adjusted) spending growth of about 4 per cent in the eight years before the global financial crisis of 2008, and 2.2 per cent a year over the eight years to 2018-19, before the pandemic.

Really? That’s a truly Herculean achievement. And with so little blood on the floor.

What used to be a mountain of debt is now just a big hill. Phew. And we thought it was only Scott Morrison who could call forth miracles.

Except, of course, that it hasn’t been achieved. It’s just “projected” to happen. All those other averages are “actuals” whereas, the unbelievable 0.6 per cent is simply a projection.

Projections are based on assumptions, which are then mechanically multiplied out, year after year. One assumption is that the economy, and the budget, will just move in a straight line over the next five years, with nothing unexpected – say, a pandemic or a recession – blowing us off course.

The five-year projection says the gross public debt is now expected to peak at 36.5 per cent of GDP in June 2026. Now, get this: this would be 10.4 percentage points lower, and five years earlier, than projected just seven months ago in Labor’s first budget.

And if you keep cranking the projection handle, the public debt “will” (their word) be down to 32.3 per cent of GDP by June 2034.

Next, remember all the economists wringing their hands over the “structural” budget deficit? This is the part of the budget balance that’s left when you take out the part that’s just the product of where the economy happens to be in the business cycle at the time.

The balance will look good when you’re at the top of the boom (as we are now) and bad when you’re at the bottom of a recession (as we may be in a year or two). The structural deficit or surplus is a calculation of what the balance would be if we were in the dead middle of the cycle, neither up nor down.

In Chalmers’ first budget, last October, Treasury took its projection of the budget balance out 10 years, and estimated the structural component to be steady at a deficit of about 2 per cent of GDP.

That’s $50 billion a year in today’s dollars. A medium-size economy with a big debt can’t live with that. We have to get it down, so we’re well placed to borrow heavily in the next recession or pandemic.

Well, has Chalmers got good news for those economist worrywarts. Seven months later, the projection (budget paper No. 1, page 131) shows the structural deficit steadily withering away until it reaches almost nothing in 2033-34.

So, how did Chalmers magic it away? Assumptions, dear boy, assumptions. For years, the biggest single program driving the growth in government spending has been the explosive growth in the National Disability Insurance Scheme.

But the government has decided to take steps to limit its growth to a mere 8 per cent a year. The projections are based on mechanically projecting “existing policy”, so the 8 per cent target – which may or may not be achieved – is baked in.

Take that monumentally optimistic assumption, add further optimism about restraint in other spending areas, allow them to magnify the believable bit (that a disappeared deficit right at the beginning of the projection significantly reduces our formerly expected interest payments over a decade) and you’ve eliminated the problem.

If only reality was as easy.

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Treasury's advice now back in favour with the government

The Coalition’s practice of sacking a bunch of government department heads whenever it gets back to office is clearly calculated to discourage bureaucrats from giving frank advice. Fortunately for us, the Albanese government is not as arrogant.

In my experience, weak managers surround themselves with yes-persons, so their brains – and, as they see it, their authority – aren’t challenged.

Strong managers want frank advice from their experts, so they’re less likely to stuff up. They’re confident of their ability to sift through conflicting advice and pick the best way forward.

This Liberal policy of frightening bureaucrats into keeping their opinions to themselves began when they returned to power in 1996 under John Howard. It was repeated when Tony Abbott got back in 2013, sacking then Treasury secretary Dr Martin Parkinson and various other Treasury-related department heads (narrowly missing Treasury’s incumbent, Dr Steven Kennedy).

Their crime, it seemed, was that they actually believed in the Rudd-Gillard government’s policy of using an emissions trading scheme to limit carbon emissions. Guilty as charged. Like almost all economists, Treasury accepted the scientists’ advice on the science, and believed the best tools for fighting climate change were economic instruments such as “putting a price on carbon”. Labor’s Department of Climate Change was staffed manly by Treasury people.

But the Libs’ peak disdain for the public service came under Scott Morrison who, upon attaining the top job, told the bureaucrats he wanted no advice from them, just diligent implementation of the policy decisions made by Cabinet.

What gave this bunch of not-so-super men (and the odd woman) the arrogance to believe they could govern wisely without the bureaucrats’ policy advice? Mainly, their ability to fall back on the small army of taxpayer-funded, but unaccountable ministerial staffers, mainly youngsters with political ambitions and the willingness to interpose themselves between the minister and the department.

These young punks, who think they outrank the most senior public servants, are generally big on politics, but weak on policy. Which, you’d have to say, was the Coalition cabinet’s “revealed preference”.

The apotheosis of this decadence was revealed in evidence to the robo-debt royal commission last week. Advice sought from an outside law firm, which found that the government’s cost-cutting scheme was unlawful, was paid for but not passed up the line to the minister – presumably because the bureaucrats judged it would not be welcome.

But in a little-noticed part of a recent speech by Treasurer Jim Chalmers, he left no doubt that, under Labor, Treasury’s advice would be sought, and used to improve the government’s decisions. What’s more, Treasury’s ability to convey its views to the public would be enhanced.

Chalmers noted that, even after the government had dealt with the inflation challenge, “we will have to manage a budget weighed down by persistent structural spending pressures”. Doing this required new thinking and deeper thinking, he said.

“It requires us rebuilding the evidence base for policymaking. Because, to get better, more-forward-looking economic policies, we need better, more-forward-looking policy foundations.”

Chalmers revealed six ways in which he will be “rebuilding the evidence base for policymaking”. One was “putting Treasury back at the centre of climate modelling again”, to build on “the new approach to climate risks, costs and opportunities” revealed in last month’s budget papers.

Second, Treasury’s annual statement on “tax expenditures” would be made “more accessible, more useful analysis of what tax concessions are costing the budget” and their effect on the distribution of income between high and low earners.

Economists have long believed that such “tax expenditures” are equivalent to actual government spending in their effect on the budget balance, and should be subject to just as much critical reassessment as actual spending.

But the Libs didn’t agree. Since taxes are evil, anything you do to reduce them must be a good thing, even if the concessions go to some (usually higher-earning) taxpayers and not others. They sought to play down the tax expenditure statement – which hugely annoys the interest groups receiving concessions on such things as superannuation savings, and the 50 per cent discount on taxing capital gains – by renaming it the “tax benchmark and variations statement”. Not anymore.

The third, even more significant change will be the appointment of an “evaluator-general” to regularly and publicly examine the effectiveness of government spending programs. Many programs don’t do much to achieve their stated objectives, but ministers and their department heads are notoriously reluctant to have them rigorously examined, for fear of embarrassment.

But, as first proposed by economist Dr Nicholas Gruen, such a person and their agency would have similar powers and independence to those of the much-feared Auditor-General. This should work, provided governments couldn’t do what Morrison did to the Auditor-General: cut his funding.

The appointment of an evaluator-general is official Labor policy, and has been championed by the assistant assistant treasurer, Dr Andrew Leigh, whose outstanding economic expertise is negated by his failure to align with any Labor faction.

No doubt Leigh will be keen for the evaluator to make use of the latest in evidence-based decision-making, randomised controlled trials.

The point is that one thing Treasury (and the Finance department) should be hugely knowledgeable about – but aren’t – is what policies work, and what policies don’t. An evaluator-general will fill this vacuum.

Fourth, Treasury will work with Finance Minister and Minister for Women Katy Gallagher to “ensure gender considerations are at the core of our work”, building on last month’s “gender-responsive budgeting”.

Fifth, Treasury will produce Australia’s first “national wellbeing statement” next year, which will be “a hard-headed way to gauge progress by recognising that a robust and resilient economy relies on robust and resilient people and communities”.

And finally, Chalmers will step up production of the Intergenerational Report from five-yearly to three-yearly, in the middle year of each parliamentary term. He promises the document will be “depoliticised”.

It’s true that former treasurer Joe Hockey trashed this exercise by turning it into a blatant attack on his Labor predecessors. It was hard to take subsequent reports seriously, especially when they imposed an artificial cap on tax collections over the next 40 years, while letting government spending run wild.

We need the report to be a much more balanced assessment of future budgetary challenges, not just a Treasury tract on the supposed evils of runaway government spending. We need more acknowledgement of the possible effects of climate change on the budget over the next 40 years – a start to which was made in last month’s budget.

And it would be nice if the report lived up to its name by having much more to say about intergenerational equity issues and trends, such as the effect of ever-rising house prices, and the longer-term consequences of the way the Howard government kept stacking the odds in favour of the old at the expense of the young, particularly favouring the self-proclaimed “self-funded retirees” (who never mention the huge superannuation tax concessions they’ve been given, nor that many of them also get a part-pension).

So, well done, Jim. With better advice and a better “evidence base”, now all Labor needs is the courage to stand up to a few powerful interest groups, including those industries that get the relevant union to plead their case in the new-look Canberra.

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Don't expect great productivity if we give business an easy ride

An unwritten rule in the economic debate is that you can say whatever you like about the failures of governments – Labor or Liberal; federal or state – but you must never, ever criticise the performance of business. Maybe that’s one reason we’re getting so little productivity improvement these days.

One reason it’s unwise to criticise big business is that it’s got a lot of power and money. It can well defend itself but, in any case, but there’s never any shortage of experts happy to fly to its defence, in hope of a reward.

But the other reason is the pro-business bias built into the standard demand-and-supply, “neoclassical” model burnt into the brains of economists. It rests on the assumption that market economies are self-correcting – “equilibrating” - and so work best when you follow the maxim “laissez-faire” – leave things alone.

So if markets don’t seem to be going well, the likeliest explanation is that intervention by governments has stuffed them up. Business people always respond rationally to the incentives that governments create, so if what business is doing isn’t helpful, it must be the government’s fault.

In theory, economists know about the possibility of “market failure”, but many believe that, in practice, such failures are rare, or of little consequence.

All this explains why almost all discussion of our poor productivity performance assumes it must be something the government’s doing wrong, which needs “reforming”. You’ll see this mentality on display at next week’s jobs and skills summit.

Which is surprising when you remember that, for the most part, productivity improvement – producing more outputs of goods and services from the same or fewer inputs of raw materials, labour and physical capital – occurs inside the premises of businesses, big or small.

Fortunately, one person who understands this is the new assistant treasurer, Dr Andrew Leigh, a former economics professor, who this week used the Fred Gruen lecture at the Australian National University to outline recent Treasury research on the “dynamism” of Australian businesses – how good they are at improving their performance over time.

The news is not encouraging. One indicator of dynamism is job mobility. When workers switch from low-productivity to high-productivity firms, they earn a higher wage and make the economy more efficient.

The proportion of workers who started a new job in the past quarter fell from 8.7 per cent in the early 2000s to 7.3 per cent in the decade to the end of 2019.

Another indicator of dynamism is the “start-up rate” – the number of new companies being set up each year. It’s gone from 13 per cent in 2006 to 11 per cent in 2019.

Over the same period, the number of old companies closing fell from 10 per cent to 8 per cent. So our firms are living longer and getting older.

The neoclassical model assumes a high degree of competition between firms. It’s the pressure from competition that encourages firms to improve the quality of their products and offer an attractive price. It spurs firms to develop new products.

Competition encourages firms to think of new ways to produce their products, run their businesses and use their staff more effectively, Leigh says.

“In competitive industries, companies are forced to ask themselves what they need to do to win market share from their rivals. That might lead to more research and development, the importation of good ideas from overseas, or adopting clever approaches from other industries.

“Customers benefit from this, but so too does the whole economy. Competition creates the incentive for companies to boost productivity,” he says.

As Leigh notes, the opposite to competition, monopoly, is far less attractive. “Monopolists tend to charge higher prices and offer worse products and services. They might opt to cut back on research, preferring to invest in ‘moats’ to keep the competition out.

“If they have plenty of cash on hand, they might figure that, if a rival does emerge, they can simply buy them out and maintain their market dominance. Monopoly [economic] rents lead to higher profits – and higher prices.”

Taken literally, “monopoly” means just one seller, but economists use the word more broadly to refer to just a few big firms - “duopoly” or, more commonly, “oligopoly”.

One indicator of the degree of “market power” – aka pricing power – is how much of a market is controlled by a few big firms. At the start of this century, the market share of the largest four firms in an industry averaged 41 per cent. By 2018-19, it had risen to 43 per cent. So across the economy, from baby food to beer, the top four firms hold a high and growing share of the market.

And the problem’s even greater when you remember that the rival firms often have large shareholders in common. For instance, the largest shareholders of the Commonwealth Bank are Vanguard and Blackrock, which are also the largest shareholders of the three other big banks.

But the strongest sign of lack of competition is the size of a company’s “mark-up” – the price it charges for its product, relative to its marginal cost of production. In the textbook, these mark-ups are wafer thin.

Treasury estimates that the average mark-up increased by about 6 per cent over the 13 years to 2016-17. This fits with the trend in other rich economies. And the increase in mark-ups has occurred across entire industries, not just the market leaders.

It seems that rising market power has reduced the rate at which labour flows to its most productive use, which in turn has lowered the rate of growth in the productivity of labour by 0.1 percentage points a year, according to Leigh’s rough calculations.

If so, this would explain about a fifth of the slowdown in productivity improvement since 2012. Lax regulation of mergers and takeovers has allowed too many of our big businesses to get fat and lazy, even while raising their prices and profits. But don’t tell anyone I said so.

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Treasury boss’s message: higher taxes the cure for debt and deficit

Anthony Albanese and his Treasurer, Dr Jim Chalmers, have inherited many problems that won’t be solved quickly or easily. Nor will they be solved without the new government being willing to persuade voters to accept the sort of tax changes no pollie wants to talk about in an election campaign.

That’s the conclusion I draw from Treasury secretary Dr Steven Kennedy’s belated annual speech to the Australian Business Economists this week.

Election campaigns are times when we hear about all the wonderful things the politicians want to do to improve the public services we get and reduce the taxes we pay. It’s after the election that pollies present the bill.

Especially when the election has changed the government. This wasn’t Chalmers bringing us the bill, it was the waiter reminding us we’d eaten quite a lot and the bill was getting pretty long.

The economic story had “shifted significantly”, Kennedy said. Inflation pressures had emerged faster and more strongly than most people expected. These were likely to persist into next year “at the very least”.

This, of course, is why the Reserve Bank has been raising the official interest rate – to eventually bring inflation back to acceptable levels.

“Interest rates are at near-record low levels and therefore highly accommodative and should normalise”, Kennedy said. In other words, they need to be increased until they’re back to more-normal levels. If so, they have a lot further to go.

But, Kennedy says that “just as fiscal [budgetary] and monetary [interest-rate] policy worked together to respond to the pandemic, they will need to work together in managing the risks to inflation and the economy more broadly”.

Ah yes, the dreaded duo, Debt and Deficit. Not a subject to be dwelt on during election campaigns, but one to return to afterwards. Presenting the bill, remember?

Chalmers is, understandably, anxious to remind us that our trillion-dollar public debt is inherited from his predecessors. What Kennedy does is implicitly confirm that the previous government’s “medium-term fiscal strategy” - to “focus on growing the economy in order to stabilise and reduce debt” - is still the go.

With an important, after-the-election qualification: “a more prudent course would be for the budget to assist more over time”.

How? We’ll get to that. But first, he gave the best explanation I’ve seen of how a government can get on top of a big debt simply by ensuring the economy grows at a faster annual rate than the rate of interest on the debt.

To “get” the explanation you have to accept one proposition that many otherwise sensible people and media commentators can’t get their head around: that the government of a nation is in a radically different position to an individual household.

Households have to repay any money they borrow sooner or later, but governments don’t. That’s because every family gets old and dies, whereas nations are a collection of many millions of households that, though the faces change, goes on forever.

For a nation, what matters is not its ability to repay the debt, but just its ability to afford the interest payments on it. As long as the nation continues to exist, it can re-borrow by issuing a new government bond to replace an old government bond as it falls due for repayment.

Kennedy explained that strong economic growth and interest rates that are low compared with what’s been normal for the past 50 years are likely to ease the burden of the debt. This is by reducing its size not in dollar terms, but relative to the size of the economy, measured by the dollar value of all the goods and services the economy produces annually (nominal gross domestic product) in coming years.

Interest payments add to the amount of debt the nation owes, but growth in the economy (nominal GDP) increases the economy’s capacity to “service” (pay the interest on) that debt. “When the economy grows quicker than the interest payments add to the debt, the debt burden will decrease,” he said.

That’s the basic mechanism all governments in all the rich countries have relied on since World War II to get on top of their debt. It’s what the Morrison government was relying on, and it will be what the Albanese government continues relying on.

But – with Treasury there has to be a but – there was a weakness in the previous government’s strategy: their projections showed the budget remaining in deficit for the next decade and, indeed, the next 40 years.

That means it wasn’t just the interest bill that was adding to the debt each year, it was also the continuing deficits.

“The current projected reduction in the debt [relative] to GDP is unusual in that it is relying solely on favourable growth and interest-rate dynamics [that the average rate of interest on the debt will rise more slowly than the rising rate of interest on the new borrowing because the average government bond takes about seven years to fall due] to reduce the ratio [of debt to GDP],” Kennedy said.

So here’s the post-election But (which, since it’s the same Treasury, would probably have happened even without a change of government): “A more prudent course would be for the budget to assist more, over time,” Kennedy said.

How? By getting the budget deficit down a lot faster than the Liberals were planning to. Maybe even by running budget surpluses for a while – which would involve repaying a bit of the debt.

Sure, but how do you get the deficit down? The government will be reviewing all the spending programs left by the Coalition, looking for savings. But what savings it finds will mainly be used to pay for Labor’s promised new spending.

So the main way to improve the budget balance will be by “raising additional tax revenues”. Kennedy implied that this would be done by reducing businesses’ and households’ tax concessions.

The next three years will be interesting.

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Unlike the media, econocrats in no great hurry to raise interest rates

The financial markets and financial press may have convinced themselves we have a serious inflation problem and must hit the interest-rate brakes early and often, but the clear message from our top econocrats is that they aren’t in such a hurry. Their eyes haven’t moved from the prize: seizing this chance to achieve genuine full employment.

Nothing in Treasury secretary Dr Steven Kennedy’s remarks to a Senate committee this week suggested he was anxious about our recent rise in prices, nor hinted that a rise in the official interest rate was imminent.

Indeed, “interest rates are still close to zero and expected to remain historically low for some time,” he said.

What little he said about inflation was that “the effects of COVID on inflation, often characterised as a combination of increased demand for goods [at the expense of demand for services] and supply-side shocks, are still passing through the economy.

“Fortunately, these impacts have been much less pronounced in Australia than in other countries. Nevertheless, the impacts have been felt and headline inflation is currently at an 11-year high.” (Not hard when inflation has been so low for so long.)

It’s true Kennedy also said that “it will not be until we see interest rates rise back to more usual levels that the risks associated with very low interest rates abate”.

But it’s clear he meant it would take years before the Reserve had rates back up to “more usual levels” - such as an official rate of 3, 4 or 5 per cent – not to give a big hint that Commonwealth Bank economists were right in predicting this week that the Reserve would start whacking up the official rate at its first board meeting after the May election.

And he was also making a quite different point. Settle back. Usually, he said, monetary policy (the manipulation of interest rates) is the primary tool with which to manage economic cycles, with fiscal policy (the manipulation of government spending and taxes in the budget) focusing on economic growth and budget stability.

Of course, in this conventional approach fiscal was complementary to monetary policy primarily through the workings of the budget’s “automatic stabilisers” (which cut tax collections and increase the number of dole payments when private sector demand is weak, but do the reverse when private demand is strong).

However, when major shocks to the economy come along, fiscal policy plays a more active role. And shocks to the economy don’t come bigger than the pandemic.

In any case, lockdowns cut the supply of goods and services, whereas monetary policy works to encourage demand – provided there’s plenty of scope to cut interest rates, which there wasn’t because rates were already close to zero.

So fiscal became the dominant policy instrument, with huge increases in government spending – including on the JobKeeper wage subsidy scheme – leading to huge increases in the budget deficit and public debt.

Got that? Now for Kennedy’s big announcement: “This unusual episode of macro-economic policy is now coming to an end.”

From here on, the dominant role will revert to monetary policy, with fiscal policy taking a step back.

Why? Well, partly because monetary policy will be busy for years getting interest rates back to “more usual levels”.

In which case, Kennedy says, “it is important that the withdrawal of fiscal policy support is tapered, as it currently is, to ensure that monetary policy has an opportunity to normalise”. (In the lingo of econocrats, “tapered” means something reduces slowly and steadily, not sharply and suddenly.)

As Kennedy says, the tapered withdrawal of fiscal policy support has already been arranged. That’s because all the government’s stimulus measures were designed to be temporary. So, as those programs wind up, the level of government spending – and the size of the budget deficit – will fall noticeably over the next few financial years.

Which means that what he’s really saying is there should be no additional, discretionary moves to hasten the return to a lower budget deficit. Why not? So monetary policy has an opportunity to “normalise”.

Get it? Over coming years, the Reserve will have to move interest rates up a long way to get them back where they should be – that is, to a level where borrowers have to compensate savers both for the loss of their money’s purchasing-power (that is, for inflation) and for being given the (temporary) use of the savers’ money.

But the Reserve’s scope to do this will be constrained if, while it’s trying to tighten monetary policy, the government’s rapidly tightening fiscal policy.

And Kennedy says there’s “an even more compelling reason” for fiscal policy support for demand not to be withdrawn too abruptly. Which is? “The opportunity to achieve full employment”. The “important opportunity to achieve and sustain full employment.”

No one knows how far unemployment can fall before shortages of labour cause wages to grow at rates that worsen inflation. Which, Kennedy says, suggests we need to exercise “a degree of caution” in tightening both fiscal policy and monetary policy.

All this fits with the remarks Reserve Bank governor Dr Philip Lowe made to a House of Reps committee the week before.

Lowe made it clear most of our inflation problem was temporary, not lasting. Although underlying inflation was 2.6 per cent, for the first time in years, “it is too early to conclude that inflation is sustainably in the target range”.

The Reserve has “scope to wait and see how the data develop and how some of the uncertainties are resolved” – one of which is whether “the stronger labour market [is] going to translate to higher wages”.

“I think it’s worth taking the time to have the uncertainties resolved and trying to secure this low rate of unemployment, which we have not had for 50 years.”

The financial types may be in panic mode over inflation, but it doesn’t sound to me like our top econocrats are in any mood to join them.

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Blame the lockdown on business urgers trying to wish the virus away

I’ve yet to see any of the perpetrators – Liberal tribal mythmakers, industry lobby groups and business’ media cheer squad – admit to their part in the humbling of that “gold standard” virus fighter, NSW premier Gladys Berejiklian (a woman I quite like).

All those business people feeling the pain of NSW’s protracted lockdown – which seems not to be getting anywhere, with no end in sight – have no one to blame but the short-sighted, self-centred urgers on their own side.

The great “learning” from our earlier struggles to control the coronavirus – particularly Victorian premier Daniel Andrews’ struggles this time last year – was the wisdom of the medicos’ advice that the exponential nature of pandemics meant the best strategy was to go early, go hard.

The economic modelling Treasury did to accompany the Doherty Institute’s epidemiological modelling confirmed this wisdom. “Continuing to minimise the number of COVID-19 cases, by taking early and strong action in response to outbreaks of the Delta variant, is consistently more [economically] cost-effective than allowing higher levels of community transmission, which ultimately requires longer and more costly lockdowns,” Treasury concluded.

Another relevant “learning” – drawn by Treasury from economic studies overseas – is that, should governments not impose lockdowns, many anxious people will significantly curtail their economic activity of their own accord. The assumption that it’s the government’s lockdown, not the virus’s threat to people’s health, that does all the economic damage is fallacious.

Yet going early and strong is just what Berejiklian failed to do. Why? Because of all the pressure she was under from her own side to be a true Liberal and control the problem without resorting to lockdowns or border closures.

That pressure started at the top with Scott Morrison and his ministers, but was eagerly pursued by the business lobbies and business’ media cheer squad. In his efforts to score points off Andrews, no one worked harder than Treasurer Josh Frydenberg to propagate the mythology that only Labor premiers were so dictatorial and disregarding of business wellbeing as to lockdown and close state borders at the first sneeze, whereas Liberal premiers knew how to get results with superior testing and contact tracing.

To be fair, it’s clear Labor’s Mark McGowan in Western Australia and Annastacia Palaszczuk in Queensland, both with state elections coming up, were well aware of the votes to be reaped by gratifying their locals’ xenophobic tendencies towards possibly plague-ridden people from “over East” or “down South”.

But the fact remains that with Sydney and Melbourne being the country’s two main international gateways, it’s been eminently sensible for the other premiers to protect their states from infection by closing their borders. Yet they’ve been subject to continuing abuse from the national press.

And in view of the medical experts’ consistent advice, the pressure to which all the premiers have been subjected over lockdowns and borders amounts to trying to wish the virus away. “Don’t worry about contagion, just keep business open and making money.”

This is hardly enlightened self-interest. It’s short-termism at its worst. It’s wilfully disregarding the greater good. “Ignore the interests of other ‘stakeholders’ – even the consumers I hope will still be able to buy my product in the months ahead – I’m just gunna keep pushing my own self-interest.”

The nation’s business people don’t need me to tell them our politicians – including those purporting to represent the business side - can be trusted to favour their own survival at the next election over the prospects for businesses long beyond the election.

But I do wonder whether business people understand the potential for conflict between their interests and those of others anxious to take up the cudgels on their behalf – for the small fee.

The industry lobby groups work in the national capital representing the interests of member businesses around the country. No doubt much of what they do isn’t highly visible and doesn’t lead to spectacular results.

Much of their communication with members would be via the media, where they need to be seen as tireless champions of their members’ interests, shouting louder than rival interest groups. Just to be noticed by the media they’d need to be hardline.

An ability to see the other side’s viewpoint – or the government’s difficulty in balancing conflicting objectives - wouldn’t be career-enhancing. Like the pollies themselves, they’d worry more about appearances and impressions than about making all things work together for the ultimate good of their members.

The self-appointed media business cheer squad is operating on a business model that sees telling people what they want to hear as more rewarding than telling them what they need to know. Commercially, they may be right. But, as you may have gathered, it’s not the way I do business.

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The economy doesn’t work well without good public servants

You’d hope that one of the big things Scott Morrison learnt in 2020 was to have more respect and trust in his public servants. After all, they must get much of the credit for helping him – and the premiers – respond to the pandemic far more successfully than most other rich countries. What Morrison did right was take their advice.

Morrison began his time as Prime Minister by making his disrespect and distrust of public servants crystal clear. He was blunt in telling them he didn’t need their advice on policy matters, just their full cooperation in faithfully implementing the decisions he and the Cabinet made.

The Coalition has continued its Labor predecessor’s practice of imposing annual “efficiency dividends” – fixed percentage cuts in the money allocated to pay public servants’ wages and admin costs – which by now amount to annual rounds of redundancies, with those more senior public servants with policy experience being the ones most likely to get the heave-ho.

This has robbed the public service – and its political masters – of much benefit from its institutional memory of what works and what doesn’t. The government prefers to get its advice from the young people with political ambitions employed to help in ministers’ offices.

These young punks act as intermediaries between the minister and his department. Their great attraction is their loyalty to the party. They tend to be a lot stronger on political tactics than policy detail.

In a quite wasteful way, when the government has felt the need for advice on tricky policy matters it now pays top dollar for a report from one of the big four accounting firms busy turning themselves into management consultants (which is more lucrative).

Where does a bunch of auditors and tax agents find the expertise to advise on quite specialised issues of public policy? They hire – at much higher salaries - some of the redundant public servants who know all there is to know on particular topics.

Despite the expense to taxpayers, one reason the government likes to pay outsiders for advice is that, like all profit-making businesses, the consultants make sure they tell their paying customers what they want to hear, not necessarily what they need to be told.

By now, most big businesses have learnt it’s smarter to keep their core functions and expertise in-house, but the Liberals prefer to pay outsiders because they neither trust public servants nor like them. They don’t like them because they see them as members of the Labor “public” tribe, not their own Liberal “private” tribe. Private good; public bad.

The Libs don’t trust public servants for same reason: how could supporters of their rival tribe give them honest, helpful advice? Plus a bit of paranoia. Whenever Labor’s in office, the Libs sit fuming in opposition, watching the public servants working hard to help the government pursue its policy preferences and keep it out of trouble, and conclude the shiny-bums are doing it because of their partisan sympathies.

The Libs’ paranoid tribalism blinds them to the plain truth that the public service takes professional pride in wholeheartedly supporting the government of the day, while suppressing their personal political preferences.

In recent times, much of the Libs’ hostility towards public servants stems from John Howard. It was Howard – aped by Tony Abbott – who instituted the practice of beginning their term in office by sacking a bunch of department heads considered to be Labor-sympathisers (or in Abbott’s case, to be so hopeless they actually believed all that Labor bulldust about climate change).

This was retaliation, but also a knowing attempt to “encourage the others”. And it’s worked well in discouraging senior bureaucrats from giving ministers advice they don’t want to hear. But in a leader, surrounding yourself with yes-persons is a sign of weakness. If such a minister stuffs up, don’t be surprised.

You couldn’t have picked a crisis more likely to bust the Libs out of their I-don’t-need-any-advice hang-up than the pandemic. There’s no recent precedent and it’s full of technicalities. Anyway, who thinks they’re smart enough to tell a doctor they’re wrong?

By contrast, every Liberal pollie thinks they know at least as much, and probably more, about the economy as any economist. Economics is much more mixed up with politics than are the principles of human health.

But get this: Morrison wouldn’t have dared to accept the medicos’ advice to lock down the economy without Treasury’s assurance that it could throw together the measures – particularly JobKeeper and the JobSeeker supplement – that would hold most of the show together until the economy could be unlocked. As has happened. Treasury is back in the good books.

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Treasury chief warns big changes are on the way

When finally the pandemic has become just a bad memory, we’ll see it has left big changes in the way the macro economy is managed and the way we work and spend. Whether that leaves us better or worse off we’ve yet to discover.

That’s the conclusion I draw from Treasury Secretary Dr Steven Kennedy’s (online) post-budget speech to the Australian Business Economists on Thursday, the restoration of a tradition going back to the 1990s.

Kennedy observes that, although “fiscal policy” (changes in government spending and taxing) has always responded to large shocks such as recessions, for the past 30 years the accepted wisdom in advanced economies has been that the preferred tool for stabilising the ups and downs in demand is “monetary policy” (changes in interest rates by the central bank), leaving fiscal policy to focus on structural and sustainability (levels of public debt) issues.

This mix of policy roles was preferred because central banks could make timely decisions, using an appropriately nimble instrument – the official interest rate. Interest rates, it was considered, could help manage demand without having much effect on the allocation of resources (the shape of the economy) in the long-run, Kennedy says.

In previous downturns, monetary policy played a major part in helping to get the economy moving. In response to the 1990s recession, Kennedy reminds us, the Reserve Bank cut the official interest rate by more than 10 percentage points. In response to the global financial crisis of 2008-09, it cut rates by more than 4 percentage points.

By now, however, the Reserve has run out of room. In its response to the coronacession, it cut the rate by 0.5 percentage points to 0.25 per cent. This week it squeezed out another cut of 0.15 percentage points and went further in “unconventional” monetary policy measures. That is, printing money.

Why so little room? Interest rates are down to unprecedented lows partly because, as I wrote last week, the rate of inflation has been falling for the past 30 years.

But Kennedy explains the other reason: the “natural” or “neutral” interest rate has been “steadily falling globally over the past 40 years”. The neutral interest rate is the real official rate when monetary policy is neither expansionary nor contractionary.

(Note that word “real”. Conceptually, nominal interest rates have two parts: the bit that’s just the lenders’ compensation for expected inflation, and the “real” bit that’s the lenders’ reward for giving borrowers the temporary use of their money.)

“The declining neutral rate is due to [global] structural developments that drive up savings relative to the willingness of households and firms to borrow and invest,” Kennedy says.

“While the academic research is not settled on the relative importance of different structural drivers, it is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.

Because this is a “structural” (long-term) rather than “cyclical” (short-term) development, “a number of central banks have suggested that interest rates will not rise for many years”.

Kennedy says the size and speed of the shock from the pandemic necessitated a large fiscal (budgetary) response. This would have been true even if a large response from conventional monetary policy had been available – which it no longer was.

Monetary policy is a one-trick pony. It can make it cheaper or dearer to borrow, and that’s it. As we saw with the early measures – particularly the JobKeeper wage subsidy and the temporary supplement to the JobSeeker dole payment – fiscal policy can be targeted to problem areas. “Monetary policy cannot replace incomes or tie workers to jobs,” he says.

So the move from monetary policy to the primacy of fiscal policy is not only unavoidable, it has advantages.

Since the onset of the pandemic, the federal government has provided $257 billion in direct economic support over several years, which is equivalent to 13 per cent of last financial year’s nominal gross domestic product. That compares with the $72 billion the feds provided in economic stimulus during the global financial crisis, or 6 per cent of GDP in 2008-09.

Kennedy notes that fiscal policy is about stabilising the economy’s rate of growth over the short term; it can’t increase economic growth over the medium to long-term. According to neo-classical theory, that’s determined by the Three Ps – growth in population, participation in the labour force, and productivity.

But whereas over the 10 years to 2004-05 our rate of improvement in “multi-factor” productivity averaged 1.4 per cent a year, over the five years prior to the pandemic it averaged half that, 0.7 per cent.

There are many suggested causes for this slowdown (which can also be observed in the rest of the rich world). Treasury research has highlighted signs of reduced “dynamism” (ability to change over time), such as low rates of new firms starting up, fewer workers switching jobs, slower adoption of the latest technology, and fewer workers moving from low-productivity to high-productivity firms.

Kennedy says it’s not clear how the pandemic will affect Australia’s long-run rate of improvement in productivity. But it has the potential to cause some large structural changes in the economy. We’ve seen the way it has forced businesses to innovate.

“Necessity is a great ramrod for breaking down the barriers to technological adoption,” he says.

Remote working is one example. In September, almost a third of workers worked from home most days. If this continues it could have “significant implications for transport infrastructure planning and for the functioning of CBDs”.

An official survey in September found that 36 per cent of businesses had changed the way products or services were provided to customers. The ability to pivot displayed by many firms indicates potential for innovation and adaptation.

On the other hand, there’s a risk that closures among smaller firms will lead to even more market concentration and slower productivity growth. Let’s hope not.

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Why the government's forecasts are always way off

Just to warm you up for the mid-year budget update on Monday, let me ask you: why do you think Treasury and the Reserve Bank have gone for a least the past eight years forecasting more growth in the economy than ever transpired?

Kieran Davies, a respected economist from National Australia Bank, has been checking. He says their mistake has been failing to allow for the decline in our “potential” growth rate since the global financial crisis in 2008.

Actually, Davies has checked only the Reserve’s forecasting record, not Treasury’s. But the two outfits use similar forecasting methods and use a Joint Economic Forecasting Group to ensure their forecasts are never very different.

An economy’s “potential” growth rate is the average rate at which its capacity to produce goods and services is growing each year. This is determined by the average rate at which the Three Ps are growing – population, participation (in the labour force) and productivity (output per unit of input).

Sometimes (as now) the economy’s annual demand for goods and services doesn’t grow as fast as its potential to supply those goods and services is growing. This creates an “output gap” of idle production capacity, including unemployed and under-employed workers.

When demand picks up, the economy can grow faster than its potential growth rate for a few years until the idle capacity is fully taken up and the output gap has disappeared. Once that’s happened, the potential growth rate sets the speed limit for how fast the economy can grow. If demand’s allowed to grow faster than supply, all you get is inflation.

We know from the fine print in the budget papers that Treasury’s estimate of our present potential growth rate is 2.75 per cent a year. You can be sure the Reserve’s estimate is the same. This is often referred to as the economy’s forward-looking “trend” (medium-term average) rate of growth.

Treasury’s projections of growth over the rest of the next 10 years are based on the assumption that, once the economy has returned to its trend rate of 2.75 per cent, it will then grow by 3 per cent a year for several years until the idle capacity is used up, when it will revert to 2.75 per cent. (This projection of perfection is what allows the budget papers to include an incredible graph showing the budget surplus going on forever and the government’s net public debt plunging to zero by June 2030.)

Now, here’s the trick. Because the Treasury and Reserve forecasters have no more knowledge of what the future holds than you or I do, they rely heavily on a long-established statistical regularity called “reversion to the mean”. That is, if at present the variable you’re forecasting is above its average performance, the greatest likelihood is that it will move down towards the average. If it’s below average, it’s likely to move up towards the average.

So now you know why, for at least the past eight years, Treasury has forecast that, though growth in the economy is weak at present, within a year or two it will return to trend, and then go higher. When it turns out that didn’t come to pass this time, it’s still the best bet for next year. Fail and repeat. Although the Reserve revises its forecasts every quarter, it follows the same method.

Davies’ examination of the Reserve’s forecasting record found that, since the financial crisis, it had persistently overestimated growth in real gross domestic product in the year ahead, and had nearly always overestimated growth over the next two years.

Why? Because it failed to take account of the decline in the potential growth rate since the crisis. It’s a safe bet the Reserve has stuck with 2.75 per cent. But Davies says the Reserve’s own econometric model of the economy, MARTIN, finds that potential growth has declined from 3.1 per cent in 2000 to 2.7 per cent in 2010 and 2.4 per cent in 2019.

In other words, when your forecasting method relies so heavily on reversion to the mean, if your estimate of potential growth is too high, it’s hardly surprising you’ll forecast more growth than you ever get.

But what’s wrong with the econocrats’ estimate of the potential growth? It could be in one or more of their estimates of growth in its three P components, but Davies’ checking shows it’s not population or participation, but productivity.

Davies says the MARTIN model shows that trend growth in productivity has slowed from 2 per cent a year in 2000, to 1.3 per cent in 2010 and to 1.1 per cent in 2019. This slowdown is not peculiar to Australia, but has occurred across the advanced economies.

Taking the median rate for those other economies, he estimates that the annual improvement in their productivity of labour per hour worked has slowed from 1.9 per cent in the 10 years before the crisis, to 0.8 per cent in the years since the crisis.

Davies’ equivalent estimates for us are similar: from 2.1 per cent to 1.2 per cent.

Okay, so why has productivity improvement slowed? Labour productivity has two components: “capital deepening”, where investment in more capital equipment per worker makes workers more productive, and “multi-factor productivity”, which is the improvement that can’t be explained by anything but technological progress (not more equipment so much as better equipment, plus improvements in the way factories and offices are organised) and reforms to the structure of the economy (“micro-economic reform”).

Davies finds the overall decline is mainly explained by the weakest rate of improvement in multi-factor productivity in decades – that is, little technological progress, here or overseas – but also by investment in the stock of non-mining physical capital that’s only just keeping up with the growth in the supply of labour (which, I imagine, hasn’t been helped by our need for “capital widening” to provide equipment to all the extra migrant workers).

What Davies’ digging has really exposed, of course, is the econocrats’ refusal to accept that our economy’s caught in former Bank of England governor Mervyn King’s “low-growth trap”.

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Please, no more Pollyanna impressions in the budget update

The mid-year budget update we’ll see next Monday presents the government and its econocrats with a threshold question: can their battered credibility withstand one more set of economic forecasts based on little more than naive optimism?

Or won’t it matter if first the industry experts, and then the Quiet Australians in voterland, get the message that budgets are largely works of fiction - based on political spin, with forecasts crafted to fit - and so are not to be believed?

Last week’s national accounts confirmed five successive quarters of weak growth in the economy and left Reserve Bank governor Dr Philip Lowe’s lovely thought of the economy reaching a “gentle turning-point” looking pretty ragged.

Maybe if you squint you could see a pattern of improvement, with the economy’s weakness concentrated in the last two quarters of 2018 (growth in real GDP of 0.3 per cent and 0.2 per cent), and strength returning in the first three quarters of this year: 0.5 per cent, 0.6 per cent and now 0.4 per cent.

Trouble is, that ain’t economics, it’s numerology: looking at a pattern of numbers without troubling your head with the varying factors that are driving them. Look at what’s driving those numbers and the illusion is dispelled.

Every part of the private sector is weak: consumer spending, home building and business investment, so much so that, as a whole, it’s actually contracting. That consumer spending is weak and getting weaker – despite the tax cut and three cuts in interest rates – is hardly surprising when you remember how weak the growth in wages has been.

It’s a great thing that public sector spending is providing most of what little growth we’re getting while the private sector goes backwards, but it doesn’t count as a sign the economy’s getting back on its feet.

As for the contribution from net exports, it would be more encouraging if it weren’t for the knowledge that a fair bit of it comes from the fall in imports you’d expect to see when domestic demand is “flat to down”.

But for a disillusioning summary statistic, try this: real household disposable income per person – a good measure of average material living standards - has essentially been flat since the end of 2011. So the Quiet Australians have nothing to show for eight years of toil. The rest is a conjuring trick where high population growth is passed off as growing prosperity.

Three quarters into our run of five weak quarters, Scott Morrison fought the election on a claim to have delivered a Strong Economy. The two subsequent sets of national accounts have destroyed that masterpiece of the marketer’s art.

But Morrison’s misrepresentations came bolstered by Treasury forecasts and projections showing the economy would quickly recover from weakness to strength, whereupon it would enter a five-year period of above-trend (3 per cent) annual growth before reverting to trend for the rest of a decade.

This flight of back-of-an-envelope fancy not only appeared to be Treasury’s endorsement of Morrison’s unfounded claims about strong growth, they supported the government’s claim that the budget could easily afford to double the tax cuts announced in the previous year’s budget – taking the cumulative cost to revenue to $300 billion over a decade – and still achieve healthy annual surpluses, eliminating the government’s net public debt by June 2030.

Just eight months later, these fearless forecasts aren’t looking too flash. They had the economy returning to trend growth of 2.75 per cent this financial year and inflation returning to 2.5 per cent by June 2021.

Most wonderful of all, they had annual wage growth accelerating to 2.5 per cent by June (actual: 2.3 per cent, falling to 2.2 per cent following quarter), to 2.75 per cent by June next year, then to 3.25 per cent by June 2021 and 3.5 per cent by June 2022 and in all subsequent years.

Wages are such a central driver of the economy, this triumph of hope over experience was essential to any forecast recovery in consumer spending and economic growth, not to mention any return to (bracket-creep-fuelled) budget surpluses despite tax cuts.

See the problem Treasurer Josh Frydenberg and his troops face in preparing next Monday’s mid-year budget update? Do they keep playing the budgetary version of the with-one-bound-our-hero-broke-free game and leave themselves open to growing derision, or do they stop pretending, offer plausible forecasts and adopt a more defensible projection methodology, and start on the long road back to being respected and authoritative?

But if the days of Treasury being game to give the boss (Morrison) forecasts he won’t like are long gone, that raises a courage question for the Reserve heavies: when will they stop ensuring their forecasts tick-tack with Treasury’s and start telling us what they really think?

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Treasury explains why we shouldn't worry about the economy

There’s a lesson for Scott Morrison in new Treasury secretary Dr Steven Kennedy’s first public speech this week: put the right person at the top of Treasury and they’ll defend the government’s position far more eloquently and persuasively than any politician could. The econocrat’s greater credibility demands they be taken seriously.

I fear that time will show it's been a costly mistake by the government not to respond to Reserve Bank governor Dr Philip Lowe’s unceasing requests for budgetary stimulus to supplement the diminishing effectiveness of interest rate cuts. Costly in terms of lost jobs – perhaps even including the Prime Minister’s.

But that Kennedy’s opening statement at Treasury’s appearance before Senate Estimates is a robust defence of official policy should surprise no one (except politicians, who are prone to paranoia). In my experience, senior Treasury officers never gainsay the government of the day, in public or private. If it’s an independent view you’re after, try the Reserve.

However, since this is the most ably argued exposition of the government’s case for sitting tight, it deserves to be reported in detail.

Kennedy is clearly worried about the threat to us from events in the rest of the world, but is
"cautiously optimistic" that the domestic economy will pick up. According to the government’s long-established "frameworks" for the respective roles of the two policy arms used to manage the macro economy – monetary policy (interest rates) and fiscal policy (the budget) – the heavy lifting is done by monetary policy, with fiscal policy being used only during a crisis. As yet, there’s no crisis.

Over the past year, Kennedy says, global growth has slowed. As a result, the International Monetary Fund and the Organisation for Economic Co-operation and Development now expect world growth this calendar year to be the slowest since the global financial crisis in 2008. Even so, they expect growth next year to improve to about 3 to 3.4 per cent – "which is still reasonable".

Chief among the factors involved are the ongoing and still evolving "trade tensions" between the United States and China. "There is no doubt that trade tensions are having real effects on the global economy, which you see in trade data from the US and China," he says.

Combined with other problems – Brexit, Hong Kong, and concerns about the financial stability of some countries – trade tensions are leading to an increased level of uncertainty around the outlook for the world economy.

Many central banks have responded to slowing global growth by supporting their economies. And South Korea and Thailand have also provided more supportive fiscal policy.

Turning to the domestic economy, it slowed in the second half of last year, then grew more strongly in the first half of this year. This amounted to growth of just 1.4 per cent over the year to June.

Household consumption, the largest part of the economy, grew by 1.4 per cent, held down mainly by weak growth in wages. Linked to this is a fall in home building over the past three quarters, which is likely to continue in the present financial year.

Moving to business investment spending, mining investment fell by almost 12 per cent over the year to June, and non-mining investment was weaker than expected.

But, Kennedy argues, these problems are temporary and "there are reasons to be optimistic about the outlook". Recent figures have shown early signs of recovery in the market for established housing. Overall, capital city house prices have risen for the past three months. Auction clearance rates have picked up and more homes are changing hands.

Consumer spending will be supported by the government’s tax cuts and the Reserve’s three cuts in interest rates.

The substantial investment in mining capacity of past years is boosting exports, and mining investment spending is expected to grow this year rather than contract, as it had been since 2012.

Despite modest growth in the economy, employment has continued to be strong, increasing by more than 300,000 over the past year. The rate of unemployment has been "broadly flat" rather than falling because near-record rates of new people are joining the labour force and getting jobs.

The rate of improvement in the productivity of labour – output per hour worked – has averaged 1.5 per cent a year over the past 30 years, but slowed to just 0.7 per cent a year over the past five. This isn’t as bad as it looks because it’s exactly what arithmetic would lead you to expect when employment is growing faster than output. And even 0.7 per cent is higher than the G7 economies can manage.

Now to the question of whether the government should be applying fiscal stimulus to guard against a recession.

Kennedy says that, in an open economy such as ours, having a medium-term "framework" (set of rules) for the way fiscal policy should be conducted, in concert with a medium-term framework for the way monetary policy should be conducted, "has long been held to be the most effective way to manage the economy through cycles".

Under this view, fiscal policy’s medium-term objective is to deliver sustainable patterns of taxation and government spending [and thus a sustainable level of public debt].  A further objective is usually to minimise the need for taxation, as is the case in Australia.

This approach reflects an assessment that apparent short-term economic weakness or, alternatively, unsustainably strong growth, is best responded to by monetary policy, not fiscal policy.

Within this framework, however, the budget’s in-built "automatic stabilisers" will assist monetary policy in stabilising the economy. For instance, revenue will weaken, and payments will strengthen, when an economy experiences weakness.

The other exception to the rule that fiscal policy should be focused exclusively on achieving sustainable public debt is that there’s a case for "temporary [note that word] fiscal actions" in periods of crisis.

But "the circumstances or crisis that would warrant temporary fiscal responses are uncommon".

So, sorry, Phil. Application denied.

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We’re relying on a government that spurns economic advice

I’m starting to wonder if the trouble with our politicians is that they’ve evolved to do politics but not economics, making them unfit to cope with the economic threats we now face.

On the one hand, they’ve been able to leave the management of the economy to the independent Reserve Bank, whose tinkering with interest rates – up a bit, down a bit – has successfully kept the economy growing for 28 years.

On the other hand, the pollies have been locked in a decade of unprecedented political instability where, since the demise of the Howard government in 2007, no prime minister has been safe from attack – from their own side.

In such an environment, with monetary policy (interest rates) so successfully managing the economy, the budget ceases to be “fiscal policy” and becomes just an instrument of politics.

Because you’re eternally looking over your shoulder trying to spot the next colleague holding a dagger behind his back, you use the budget primarily to shore up your support within the party, rewarding the base and punishing its designated enemies.

Be slavish in feeding the 24-hour news cycle. Keep up the pressure for ministers and their departments to provide a continuous flow of minor “announceables”. Remember, any vacuum you leave will be filled by your enemies (external or internal). If you run out announceables, just slag off your (official) opponents.

Of course, if the punters understood what you were up to, they wouldn’t be impressed. So when you’re trying to shore up the support of big business by cutting the rate of company tax, you keep claiming it’s a “plan for jobs and growth”.

When you’re using an income tax tax cut to buy some popularity at the election, you pretend that economic growth is driven by lower taxes.

The worst of it is, since the things your side really cares about – cutting taxes, preserving tax breaks favouring high income-earners, cracking down on the leaners and loafers on social welfare – are economic measures, you convince yourself you’re really into economics.

And running a budget surplus – that’s economic isn’t it? (No, not when your forecasts of a strong economy have proved way too optimistic and you’re counting on a freak improvement in iron ore prices to get you over the line. Then, it becomes an indulgent stretch for political kudos.)

You don’t actually know enough economics to realise economics is about rolling back rent-seeking and increasing the efficiency with which resources are allocated, at the micro level, and managing the economy through the ups and downs of the business cycle, at the macro level. All the rest is politics.

We’ve come to expect that if the person taking the treasurer’s job doesn’t know much about economics, Treasury will give them a crash course and get ’em up to speed. But former senior Treasury officer Paul Tilley’s new book, Changing Fortunes, leads me to think this no longer happens.

These days, treasurers are so preoccupied by the daily battle for political survival they have little time or interest in economics tutorials. Treasury has got out of the habit of giving the treasurer any advice his staff doubts he’d want to hear. Treasury’s job is largely to supply facts and figures when demanded by the treasurer’s staff.

In which case, you have to worry about how much professional rigour goes into producing the budget forecasts. How much they’re designed to avoid giving the treasurer news he doesn’t want to hear.

The Reserve Bank’s latest forecasts for wage growth are laughing at the optimistic forecasts of the budget in April. Where the budget has wages growing by 3.25 per cent a year by June 2021, the Reserve has the growth rate rising only a fraction to 2.4 per cent.

But here’s the surprising thing. Despite the central importance of wages in driving consumer spending and overall economic growth, the Reserve’s year-average forecasts for real GDP differ little from those in the budget.

I find this suspicious. And worrying. If the central bank feels constrained by the forecasts of a Treasury anxious to avoid displeasing its political masters, we’ve got a problem.

Last week, while worries about how much damage Trump’s trade war might do to the world economy were causing share markets to plunge, Treasurer Josh Frydenberg – who was 20 at the time of our last big recession – emerged from his bunker to assure us the government would “take the necessary actions to ensure our economy continues to grow”.

Great. But who’ll be advising him on which actions are necessary? The young punks in his office?

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How politics came to trump economics in Canberra

How does the federal government really work? Is it as we were told in Yes, Minister, with the bureaucrats actually in charge, quietly manipulating the politicians? Or are public servants actually the servants of their political masters, as the pollies focus more on getting re-elected than running the country well?

Does Treasury dominate the other departments and the economic advice going to government? Do bureaucrats still give ministers "frank and fearless" advice, or has their role been usurped by the ever-growing army of ministerial staffers, politically aligned think tanks and lobby groups?

In truth, it’s hard for outsiders to be sure. But a new book by a former 30-year senior Treasury officer, Paul Tilley, Changing Fortunes, is surprisingly frank and fearless in spelling out how things work, and how Treasury’s relationship with the elected government has "changed dramatically in recent times".

Last month Scott Morrison said he saw the bureaucrats’ role as implementing the government’s policies. Their advisory role was limited to advising the government of any problems that might arise during that implementation.

Tilley makes it clear this isn’t just what Morrison would like, it’s pretty much what he and his recent predecessors have long had. Treasury gives much information to the treasurer, but avoids giving written policy advice it believes would be unwelcome. What little frank advice is given comes verbally, as part of the private discussion between the treasurer and Treasury secretary.

Tilley says the art of policy advising involves understanding the true nature of the problem, predicting the consequences of policy options and framing effective policy advice.

To be influential, however, policy advisers need to find a balance between having sufficient separation from the raw politics of government to maintain a strong policy framework, on one hand, and having sufficient responsiveness to ministers to be listened to, on the other.

"Treasury’s influence spectrum had ‘frank and fearless advice’ at one end and full ‘responsiveness to government’ at the other," he writes. The trick was the find the right spot in the middle.

But by 2014, under Tony Abbott, "Treasury was now at the full responsiveness-to-government extreme," he writes.

His book is a history of Treasury from its establishment in 1901. "Treasury has long considered itself to be the best economic policy advising agency in Australia.

"Its favoured economic policy framework has for the most part been grounded in neoclassical economics - a belief in the power of markets, and the inherent tendency of supply and demand forces to move towards equilibrium.

"Non-achievement of equilibrium must be caused then, by some market impediment or government interference, and Treasury has seen it as its job to tackle those impediments or that interference.

"If there has been one enduring belief within Treasury – its light on the hill – this is it," he writes.

This is what Tilley means by Treasury’s possession – unlike so many other departments - of a "strong policy framework".

"If there has been a central defining culture in Treasury, it has been around analytical excellence – having the strongest policy framework and the best ideas. If there has been one recurring constraint on Treasury’s policy effectiveness, it has been too narrow in its focus and closed to alternative perspectives," he says.

Tilley’s title, Changing Fortunes, recognises that, over its 118-year life, Treasury’s influence has waxed and waned.

For its first 30 years it was the government’s bookkeeper. It evolved into an economic policy agency only after the Great Depression revealed its inability to provide authoritative advice on economic policy.

The economists arrived from the 1930s, with the advent of Keynesianism. The "golden years" for the economy in the 1950s and ‘60s were also golden for Treasury, which grew in size and status, leading the debate about economic ideas and allowing its influence and strength to give it "a level of arrogance".

This did not sit comfortably with the increasingly assertive governments of the post-Menzies era. Treasury was pushed out into the cold by Gough Whitlam, and kept there by Malcolm Fraser. Treasury’s advice remained frank and fearless, but was considered dogmatic, and often wasn’t listened to. I think this was when our Yes, Minister era ended.

Relations became more constructive when Bob Hawke and Paul Keating arrived, and continued so under John Howard and Peter Costello. "There was a sense of partnership in the Treasury-government relationships, and with the advancement of economic reforms that Treasury advocated it again influenced the policy agenda."

But for the past decade, first under the Rudd-Gillard-Rudd government, then under Abbott-Turnbull-Morrison, the "political chaos" has robbed governments of the sustained political capital needed to pursue difficult reforms. Governments fighting for their political survival have maintained a "relentless push for message over substance".

"In the daily political and media battles of the last decade, Treasury policy advice has not been sought, and at times not very effectively given. In those battles, it has been economic and budget facts and figures, not policy advice, that have been demanded," we’re told.

"The habit has developed of not providing policy advice that ministers don’t agree with. Policy advice on contentious issues now is discussed with ministers’ offices in its preparation and if the office indicates that the minister would not be comfortable with the proposed advice an information brief goes instead.

"The office’s (politically attuned) policy advice can then be provided over the top of the Treasury information brief."

The balance of policy influence has shifted to the political offices and external stakeholder groups, with the public service becoming more information providers and implementers of government decisions, he says.

"The government, therefore, is left without a strong source of genuine policy advice. The consequent lack of a consistent economic narrative over the last decade is plain for all to see."

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