RBA review attacks the groupthink of others, but not its own

With more time to think about it, it’s clear the review of the Reserve Bank is not the sweeping blockbuster shake-up overhaul we were told it was. Even if all its recommendations are accepted, ordinary borrowers and savers won’t discern any difference in the way interest rates go up and down. But to those who work at the Reserve, and the small army of people who make a lucrative living second-guessing its decisions, the proposed “modest improvements” are a big deal.

Ostensibly, they’re aimed at getting the Reserve up to “world best practice”. But that’s just a spin doctor’s term for doing things the same way everyone else does them. Where’s the evidence that the conventional wisdom is sure to be “best practice”?

It’s also a way of concealing the colonial cringe. Because the rich world’s financial markets are now so highly integrated, with the biggest rich country’s Wall Street setting the lead, most people in our financial market think that if we’re not doing it the way the US Federal Reserve does it, we’re obviously doing it wrong.

This inferiority complex is reinforced because, for the past 30 years, most other central banks have conformed to the US Fed’s ways – even the world’s best colony-conscious country, Britain, has switched to the Fed’s way.

So, what is the Fed’s way? To have interest rates set by a special committee of outside experts, meeting eight times a year not monthly, with each member employed part-time and getting lots of research assistance.

The monetary policy committee should hold a press conference after every meeting and each member should give at least one speech a year on the topic.

To be fair, the Reserve’s Americanisation was pre-ordained by Treasurer Jim Chalmers’ terms of reference and his decision to have the inquiry led by Carolyn Wilkins, a former Bank of Canada heavy and now Bank of England heavy.

Of course, just because we do things differently to the others doesn’t guarantee we’re doing it better, any more than it means we’ve been doing it worse. I’d say our performance over the past 30 years – since the introduction of inflation targeting – has seen a few missteps, but been at least as good as any of the others.

And if the American way is “best practice”, how come the Fed’s been so heavily criticised for being slow to respond to the inflation surge?

But let’s be frank. The review’s big criticism of the Reserve is that it’s too insular, too inward looking and inbred. Except when one Treasury man got the job, governors are always promoted internally. The present governor joined the bank from high school. External appointments to senior economic jobs are rare.

As the review’s critique implies, the Reserve is a one-man band. The governor’s word is law, with limited tolerance for debate. He runs as much of the show as he chooses to, leaving the boring bits to his deputy.

It suits the governor to have a board stacked with business people because, not being economists, their doubts are easily dismissed. Employees would never disagree with the boss in front of the board, and any reservations the Treasury secretary may have would be raised in private.

There always used to be a union leader on the board, but he was let go as part of John Howard’s efforts to delegitimise the union movement which, in his eyes, was in league with his Labor opponents.

This does much to explain the present governor’s ignorance of labour-market realities. Dr Philip Lowe bangs on unceasingly about wages, but excludes unions from the Reserve’s extensive consultations with business and even welfare groups. I don’t remember hearing that swearword “union” ever pass his lips.

There’s always been an academic economist on the board, but they’re in no position seriously to take on the establishment. The board rarely if ever votes on anything. Rather, the chairman-governor “sums up the feeling of the meeting”.

Note, the Reserve has worked this way for the four decades I’ve been watching it. But it does seem to have become more insular and, as the review charges, more subject to “groupthink”, under Lowe.

The inquiry heard from young ex-Reserve economists saying they’d been warned that expressing doubt about the house line would harm their promotion prospects. I’ve been hearing that lately, too.

It’s madness for the Reserve to recruit the cream of each year’s graduating economists, then tell ’em not to speak unless spoken to. And what a way to train the next governor but three.

So, bring an end to groupthink inside the Reserve? Of course. Get a more vigorous debate around the board table before deciding on rates? Sure.

But here’s the joke. While rightly criticising the Reserve for encouraging groupthink, the report is itself a giant case of groupthink. It accepts unquestioningly the conventional wisdom of recent decades that there’s really only one way you could possibly manage the economy through the ups and downs of the business cycle, and that’s by manipulating interest rates.

Any role for “fiscal policy” – changing taxes and government spending? Didn’t think of that but, no, not really. Just make sure it doesn’t get in the way of the central bank.

We’ve fiddled with interest rates so much we’ve got them down to zero. Should we stop? Gosh no. Just think of some way to keep going. The review accepts that the central banks’ misadventure into “unconventional monetary policy” – UMP – which it sanctifies as “additional monetary policy tools”, is now part of “best practice”.

Really? Competitive currency devaluations are the way to fix the global economy’s ills? Can you hear yourselves?

Apparently, slowing the growth in spending by directly punishing the small proportion of households young and foolish enough to load themselves up with mortgage debt is “best practice”.

No, it’s not. It’s just a sign that the review committee is so caught up by global groupthink that it has never thought there might be a better way.

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Why we're stuck with low interest rates for a long time

When it comes to interest rates, we’re living in the strangest of times, with rates lower than ever.

Savers are getting next to no reward for lending their money. Does this make sense? Not really. But we’re moving through uncharted waters and aren’t sure how we’ll get out of them, nor what happens next.

When Reserve Bank governor Dr Philip Lowe appeared before Parliament’s economics committee last Friday, he was asked whether we get the interest rates the world forces on us, or whether our authorities are free to set the rates they want.

Lowe’s answer was “we have the freedom, but we don’t”. Huh? “It’s complicated,” he explained.

Sure is. What he could have said is that we have some freedom, but not much. Were we to set our interest rates at a very different level to those in the rest of the world, there’d be a price for us to pay.

His own explanation was as clear as mud: we don’t have freedom in a structural sense, but we still have freedom in a cyclical sense.

Let me have a go. Remember that, as part of the process of globalisation over the past 40 years, the rich countries’ national financial markets are now so closely integrated with each other that each country exists in what’s pretty much a single global market, producing a single long-term real interest rate.

Purely by virtue of its big share of the global market, the things an economy as big as the US does can influence the level of the global interest rate. But nothing a middle-size economy like ours does is big enough to move the world rate. We are, as economists say, a “price taker”. We’re free only to take it or leave it.

The market price of something (including the price of borrowing money – the rate of interest) is set by the interaction of demand and supply: how much of it the buyers want to buy, relative to how much the sellers want to sell.

Lowe explained that the reason the “world equilibrium interest rate” has fallen so close to zero since the global financial crisis of 2008 is that, around the world, there’s been an increased desire by people to save, but a reduced desire to invest. That is, savers want to lend a lot more money than investors want to borrow, so interest rates have fallen sharply.

I think by now most economists accept this as the best explanation for the amazing low to which interest rates have fallen. It’s what Lowe means by “structural”. Just why saving is so much greater and investment so much smaller are questions economists are still debating.

Note that this explanation laughs at the standard view in neo-classical economics that saving increases when interest rates are higher, while investment increases when interest rates are lower.

Nor does it fit with the view that the “natural” rate of interest should reflect the rate of business profitability. Although the profits of some businesses have been hard hit by the pandemic, before it arrived – and even since, for most businesses – profitability has been high.

An alternative, minority view – pushed by economists at the Bank for International Settlements in Basel, the central bankers’ central bank – is that world interest rates have fallen so low because of the Americans’ excessive use of “quantitative easing” (central banks buying second-hand bonds and paying for them with money they’ve just created) after the global financial crisis and then, once the US economy had recovered, their failure to sell those bonds back to the market and so push interest rates back up.

An economy where households are saving too much of their incomes, and businesses don’t want to invest in expansion, is an economy that’s growing too slowly and not creating many new jobs. The solution, Lowe said, was to give people confidence to spend (and so get their rate of saving down) and give firms the confidence to invest.

How is he doing this? By cutting the official interest rate as close to zero as possible, and using quantitative easing to lower longer-term government and private sector interest rates. Really? Sounds to me like hoping to recover from a hangover by having another drink.

But back to the point. If interest rates ought to be higher to give savers a decent reward on the money they lend, why can’t our central bank set our interest rates higher than those being paid in other parts of the world?

Well, it can. We do retain that freedom. But because our financial markets are just part of the global market, what that would do is push up our exchange rate.

Why? Because financial institutions around the world would shift money into Australian dollars so as to get into our market and take advantage of our higher interest rates. When the demand for “the Aussie” exceeds the supply, the price goes up.

Such a rise in our currency’s rate of exchange against other currencies would reduce the international price competitiveness of our export and import-competing industries, thus reducing our economy’s growth and job opportunities.

That’s the price we’d pay for stepping out of line.

Lowe told the committee that the two main factors that drive the value of our dollar are world commodity prices and relative interest rates – that is, the level of our interest rates relative to other countries’ rates.

The prices we receive for the commodities we export (particularly iron ore) are up but, he said, the Aussie hadn’t appreciated (risen) by as much as you’d expect from past relationships. Why not? Because our lower official interest rates and quantitative easing have narrowed the interest rate “differential” between our rates and the rest of the world.

So, although rising commodity prices have caused our exchange rate to go higher, our quantitative easing has nevertheless caused the dollar to be “lower than it otherwise would be”. Ah. That’s the game he’s playing.

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Morrison is taking the recovery too cheaply

In theory, recovery from the coronacession will be easier than recoveries usually are. In practice, however, it’s likely to be much harder than usual – something Scott Morrison’s evident reluctance to provide sufficient budgetary stimulus suggests he’s still to realise.

The reasons for hope arise from this recession’s unique cause: it was brought about not by a bust in assets markets (as was the global financial crisis and our recession of the early 1990s) nor by the more usual real-wage explosion and sky-high interest rates (our recessions of the early 1980s and mid-1970s), but by government decree in response to a pandemic.

This makes it an artificial recession, one that happened almost overnight with a non-economic cause. Get the virus under control, dismantle the lockdown and maybe everything soon returns almost to normal.

It was the temporary nature of the lockdown that justified the $70 billion cost of the unprecedented JobKeeper wage subsidy scheme. Preserve the link between employers and their workers for the few months of the lockdown, and maybe most of them eventually return to work as normal.

Note that, even if this doesn’t work out as well as hoped, the money spent still helps to prop up demand. Had we not experimented with JobKeeper, we’d have needed to spend a similar amount on other things.

Because this recession has been so short and (not) sweet, it’s reasonable to expect an early and significant bounce-back in the September quarter. Just how big it is, we shall see. But, in any case, there’s more to a recovery than the size of the bounce-back in the first quarter after the end of the contraction.

And there are at least five reasons why this recovery will face stronger headwinds than most. The first is the absence of further help from the Reserve Bank cutting rates. People forget that our avoidance of the Great Recession in 2009 involved cutting the official interest rate by 4.25
percentage points.

Second, Australia, much more than other advanced economies, has been reliant for much of its economic growth on population growth. But, thanks to the travel bans, Morrison is expecting net overseas migration to fall by a third in the financial year just ending, and by 85 per cent in 2020-21.

Now, unlike most economists, I’m yet to be convinced immigration does anything much to lift our standard of living. And I’m not a believer in growth for growth’s sake. It remains true, however, that our housing industry remains heavily reliant on building new houses to accommodate our growing population. And if Morrison’s HomeBuilder package is supposed to be the answer to the industry’s problem, it’s been dudded.

Third, we’re used to our floating exchange rate acting as an effective shock absorber, floating down when our stressed industries could use more international price competitiveness, and floating up when we need help constraining inflation pressures – as happened during most of the resources boom.

But this time, not so much. With the disruption to our rival Brazilian iron ore producer’s output, world prices are a lot higher than you’d expect at a time of global recession. And with world foreign exchange markets thinking of the Aussie dollar as very much a commodity currency, our exchange rate looks like being higher than otherwise – and higher than would do most to boost our industries’ price competitiveness.

Fourth, the long boom in house prices has left our households heavily indebted, and in no mood to take advantage of record-low interest rates by lashing out with borrowing and spending. The “precautionary motive” always leaves households more inclined to save rather than spend during recessions, but the knowledge of their towering housing debt will probably make them even more cautious than usual.

The idea that bringing forward the government’s remaining two legislated tax cuts could do wonders for demand is delusional. If you wanted the cuts spent rather than saved, you’d aim them at the bottom, not the top.

Finally, although our politicians and econocrats refuse to admit it, our economy – like all the advanced economies – has for most of the past decade been caught in a structural low-growth trap. We can’t get strong growth in consumer spending until we get strong growth in real wages. We can’t get strong growth in business investment until we get strong consumer spending. And we can’t get a strong improvement in the productivity of labour until we get strong business investment.

Meanwhile, the nation’s employers – including even public sector employers - will do what they always do and use the recession, and the fear it engenders in workers, to engineer a fall in real wages. Which will get us even deeper in the low-growth trap.

I fear, however, that Morrison and his loyal lieutenant, Josh Frydenberg, will learn all this the hard way.

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We should get a fair share of foreign investors' profits

Australia has been a recipient of foreign investment in almost every year since the arrival of the First Fleet in 1788. Yet for much of that time the idea of foreigners being allowed to own so much of our businesses, mines, farms and land is one many ordinary Australians have found hard to accept.

For older Australians, the thought of “selling off the farm” to foreigners makes them distinctly uncomfortable. Why can’t we do it ourselves and own it ourselves?

The short answer is, we could. But had we chosen that path we wouldn’t be nearly as prosperous today as we are. As the Productivity Commission reminds us in a paper published this week, you need money to set up a business, let alone a whole industry.

That money has to be saved by spending less than all your income on consumption. And had we been relying solely on our own saving, we’d have been able to develop much less of this vast continent than we have done. So, from the days when we were a British colony and had no say in the matter, we’ve invited foreigners to bring their savings to Australia and join us in exploiting the golden soil and other of nature’s gifts with which our land abounds.

Total foreign direct investment – that is, where the foreigner owns enough of the shares in a company to have some control over its management – is now worth about $1 trillion. The largest sources of direct investment are, in order, the United States, Japan and Britain. In recent years, of course, most of the action – and the angst – comes from China.

The less poetic way to put it is that Australia has been a “net importer of capital” for more than two centuries. It’s thus not so surprising that, despite whatever reservations ordinary Australians may have, the dominant view among our politicians, business people and economists has been that we must keep doing whatever it takes to attract the foreign investment we need to keep the economy expanding strongly.

For many years it was felt that we always run a deficit on our balance of trade in goods and services with the rest of the world, so we always need to attract sufficient net inflow of foreign capital to be sure of financing that trade deficit – as well as covering all the regular payments of dividends and interest we need to make to the foreigners who have invested in local businesses or have lent us money.

This mentality made sense in the days when we had a “fixed exchange rate” – when the government, via the Reserve Bank, set the value of our country’s currency relative to other countries’ currencies – particularly the British pound and, later, the US dollar – and changed that value only very rarely in situations where it couldn’t be maintained.

The point is that when you choose to fix the price of your currency, you do have to worry about getting sufficient net inflow of foreign capital to cover the deficit on the “current account” of the “balance of payments”. Should you fail to attract sufficient inflow, you’re forced into the ignominy of cutting the price you’ve fixed.

Now, this problem went away a long time ago. In 1983, after we’d been having a lot of trouble keeping our exchange rate fixed and our balance of payments in balance, we decided to join most of the other advanced economies in allowing the value (or price) of our currency to float up and down according to the strength of the rest of the world’s demand for the Australian dollar (the Aussie, as it’s called in the foreign exchange market) relative to the supply of it.

From that day, the two sides of our balance of payments – the current account and the capital account – were in balance, the deficit on one matched exactly by the surplus on the other, at all times. How? Because the price of the Aussie adjusted continuously to ensure they were.

The “balance of payments constraint”, which had worried the managers of our economy for so long, just evaporated. But here’s the point: the attitude that we must always be doing as much as we can to attract as much foreign investment as possible continued unabated.

There’s this notion that, in the now highly competitive, globalised financial markets, if poor little Australia doesn’t try really, really hard, we’ll miss out.

This, of course, is the reasoning behind the unending push by big business for us to cut the rate of our company tax. Our system of “dividend imputation” means Australian shareholders have nothing to gain from a lower company tax rate. The only beneficiaries would be foreign shareholders because they aren’t eligible for “franking credits”.

We’re asked to believe that how well the level of the nominal rate of our company tax compares with other countries’ rates is the main factor determining whether we get all the foreign investment we need. Not even how the tax breaks we offer compare matters much, apparently.

I don’t believe it. It’s a try-on. As the Productivity Commission’s paper reminds us: “Foreigners invest in Australia because of our fast-growing and well-educated population, rich natural resource base, and stable cultural and legal environment.”

Just so. Mining companies flock to Australia because we have the high-quality, easily-won minerals and energy they need. The idea that global companies such as Google or Amazon would give Australia a miss because our company tax rate’s too high is laughable. Especially when they’re so adept at minimising the tax they pay in advanced countries.

We should take a more hard-nosed, business-like attitude towards foreign investors such as the miners, which make huge profits but employ very few workers. When state governments fall over themselves building infrastructure for them and offering royalty holidays and other inducements, it matters greatly how much company tax they pay before they ship their profits back home.

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Weakening dollar looks a lot worse than it is

Oh dear. While the pollies have been playing their games, the dollar has been falling and there’s even talk in the market of it going below US70¢. Is this a worry? Short answer: naah.

At the local close on Friday the Aussie was at US72.8¢. That’s down from a recent peak in January of almost US81¢. Is that a bad thing?

Depends who you ask. You can find plenty of people who’ll tell you a low dollar is bad and a high dollar is good. But most manufacturers, farmers and miners will tell you the opposite. The lower the better, they say.

Truth is, a fall in the dollar has some advantages and some disadvantages; a rise in the dollar has the opposite set.

A lower dollar has the disadvantage of making imported goods – and overseas holidays – more expensive. It will add to inflation. But it has the advantage of making our export and import-competing industries more internationally competitive on price.

An Australian item priced in Aussie dollars will be cheaper for foreigners to buy; an Australian item priced in US dollars will now bring more Aussie dollars to an Australian exporter. And overseas-produced goods and services will be more pricey relative to locally produced.

Since our inflation rate is unusually low, and our economy should be growing faster, that doesn’t sound like a bad deal to me.

But that’s just the first part of the story. Because a fall sounds bad and a rise sounds good, many people assume a falling dollar must be happening because we’ve stuffed up.

As we’ve seen, wrong on the first count. And most likely wrong on the second. The exchange rate is a relative price – the value of our currency relative to the value of another country’s currency. In this instance, the Yankee dollar.

Any change in that rate of exchange could be explained by happenings on either side of the Pacific – or a bit of both.

At present, however, all the action’s on the American side. The US economy is growing strongly, with President Trump stimulating an economy already close to full employment by cutting company and personal taxes.

So higher inflation is a significant risk. The US Federal Reserve has already raised the US official interest rate from about zero to about 2 per cent (significantly, higher than our 1.5 per cent), and may well raise it further if it gets more concerned about inflation.

A strongly growing economy, with rising interest rates attracting more capital inflow, is an economy with an appreciating currency. In recent times the greenback has been rising in value not just against the Aussie but almost all currencies.

A fact too few people realise is that, though the Aussie has fallen against the greenback (and the currencies of a few developing countries that shadow the greenback), it hasn’t changed much against most other currencies.

We don’t realise that because we’ve long had the bad habit of regarding the Aussie’s value against the greenback as the exchange rate rather than just one of many.

Economists, however – and particularly those at the Reserve Bank – know not to take such short-cuts. They focus on our “effective” exchange rate – the rate against a basket of our trading partners’ currencies, with each country’s currency weighted according to its share of our two-way trade (exports plus imports).

This is the trade-weighted index, or TWI (pronounced “twy”). Since our trade with the US is less than most people assume, the US dollar’s direct weight in the basket is just a bit over 10 per cent.

So whereas since January the Aussie has fallen by almost 10 per cent against the greenback, it’s fall against the TWI has been a more modest 4.4 per cent.

Which is why the country’s economic managers are neither greatly worried nor greatly excited by the dollar’s movements in recent times.

They see the TWI as simply as being around the bottom of the band in which it’s been moving for the past few years. No biggie.

For someone planning an overseas holiday, it’s not good news if you’re off to the States. But doesn’t make much difference if you’re going to Britain, Europe, N’Zillund or Bali.

But could the Aussie fall a lot further against the greenback? It could, and that’s what economic theory would lead you to expect. But I don’t recommend making currency bets on the basis of economic theory.

As a Reserve Bank assistant governor admitted recently, if she knew how to forecast the exchange rate with any accuracy she wouldn’t be here, she’d be on her private island.

Even so, should the dollar end up falling below US70¢ in coming months, I can’t see the Reserve getting too worried. As I say, a bit more inflation would do little harm and a boost to our export industries would be handy.

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Economic case for cutting company tax rate is weak

Most people don't realise it, but we're on the verge of letting foreign multinationals pay less tax on the profits they earn in Australia because we locals don't mind paying higher tax to make up the difference.

Our almost unique system of "imputing" to Australian shareholders the company tax already paid on their dividends means they have little to gain from Malcolm Turnbull's pressure on the Senate to phase the rate of company tax down from 30 per cent to 25 per cent, over about 10 years, at a cumulative cost to the budget of $65 billion.

So what can we hope to obtain in return for our generosity to foreign businesses? Economic theory (which may or may not prove realistic) assumes it would induce them to increase their investment in Australia which, in turn, would increase the demand for Australian workers relative to their supply, thus bidding up their price (otherwise known as wages).

Note that, contrary to all Turnbull's said about his "plan for jobs and growth", the theory does not promise a significant increase in employment – mainly because the theory assumes the economy is already at full employment before the company tax rate is cut.

As my colleague Peter Martin has written, Treasury's updating of its modelling of the theory finds that, after 10 to 20 years, consumer welfare (arising mainly from higher wages) would be $150 per person higher than it otherwise would be.

Doesn't seem a lot.

Apart from the initial benefits of the company tax cut going pretty much only to foreigners, another reason Treasury's modelling has always shown the ultimate benefits to us as being surprisingly small is Treasury's further assumption that the budgetary cost of the cut would have to be covered by some means.

Treasury's consultant modelled several possibilities: by cutting government spending (don't hold your breath), imposing a lump-sum tax (a textbook fav), increasing the goods and services tax, or by letting bracket creep quietly increase income tax (the most likely).

Trouble is, the model's assumption that increased taxes would harm the economy's performance diminishes the good the lower company tax is assumed to do. As Milton Friedman liked to say, there are no free lunches (you'll end up having to pay, one way or another).

So the impression the government and big business are trying to give us (and naive crossbench senators), that only an economic wrecker would oppose a lower company tax rate, is just spin.

As always, every possible economic policy change has costs as well as benefits, which should be debated. I think the case for cutting company tax is weak.

With the government taking such a propagandist line, the most dispassionate advice we've received has come from evidence Reserve Bank governor Dr Philip Lowe, and an assistant governor, Dr Luci Ellis, gave to a parliamentary committee last year.

Lowe pointed out something no other official has mentioned: the main countries are engaged in a bidding war, in which each moves to a lower company tax rate than the others, hoping to pick up a bigger share of the world's foreign investment - before some other country cuts to an even lower rate.

You can imagine how much the world's chief executives love this game and are urging their own government to put in the lowest, supposedly winning, bid.

But the longer everyone keeps playing, the closer we'll come to the point where no country has any company tax to speak of – and no country has any competitive advantage over the others. All we'll be left with is a distorted tax system.

Lowe's point was that we should think twice before we join this mutually destructive game. Why would a tax war be good, whereas a trade war would be terrible?

The proponents' latest argument is that, now the US is cutting its company tax rate to 21 per cent, we'll get little foreign investment if we don't cut our rate from 30 per cent.

What no one seems to have noticed is that the case for a company tax cut has now turned from positive to negative. It's not that we'll gain anything by cutting, but just that we'll avoid losing if we don't.

But you don't have to accept that argument if you don't want to. Behavioural economics reminds us that the proponents have "framed" our choices in a way that favours their case.

They want us to accept without thinking that foreign companies make their decisions about whether or not to invest in Oz solely by comparing the rate of our company tax with other countries' rates.

That is, foreigners take no account of how our special tax breaks compare with other countries' tax breaks, nor any non-tax factors that make investing in Oz attractive (say, we've got better iron ore than everyone else) nor even that they don't have to worry about our taxes because their lawyers know how to avoid paying them.

As Lowe and Ellis explained to the parliamentary committee, the notion that multinationals focus solely on the rate of our tax is highly implausible.

I think all those other factors mean we're unlikely to attract insufficient foreign investment, even though the US has cut to 21 per cent.

But Treasury's been a great worrier about us attracting enough foreign investment for as long as I've been in the game, without there ever being much sign of a problem.

So, what's eating Treasury? My theory is that it hasn't adjusted its thinking since we moved from a fixed to a floating exchange rate in 1983.

What the proponents of a lower company tax rate don't tell you is that, with a floating dollar (and all else remaining equal), the more successful we are in attracting foreign investment – as we were in the resources boom - the higher our exchange rate will be. Is that what we want?

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Why we needn't worry about our massive foreign debt

When you consider how many people worry about the federal government's debt, it's surprising how rarely we hear about the nation's much bigger foreign debt. When it reached $1 trillion more than a year ago, no one noticed.

That's equivalent to 60 per cent of the nation's annual income (gross domestic product), whereas the federal net public debt is headed for less than a third of that – about $320 billion – by June.

Similarly, when you consider how much people worry about the future of the Chinese economy, American interest rates and all the rest, it's surprising how little interest we take in our "balance of payments" – a quarterly summary of all our economic transactions with the rest of the world.

Note, I'm not saying we should be worried about our foreign debt. We already do more worrying about the federal government's debt than we need to.

No, I'm just saying it's funny. Why do we worry about some things and not others?

Short answer: the politicians don't want to talk our "external sector" because it sounds bad. The economists don't want to talk about it because they know it isn't bad.

But since we're on the subject – and since Reserve Bank deputy governor Dr Guy Debelle gave a speech about it this week – let's see what's been happening while our attention's been elsewhere.

If you're unsure of the difference between the two debts, it's simple. The federal net public debt is all the money owed by the federal government to people, less all the money people owe it (hence that little word "net").

According to Debelle, about 60 per cent of all bonds issued by the feds is owed to foreigners and 40 per cent to Australian banks and investors. About a quarter of all bonds issued by the state governments is held by foreigners.

In contrast, the nation's net foreign debt is all the money Australian businesses and governments (and any other Aussies) owe to foreigners, less what they owe us. (For every $1 we owe them, they owe us 52¢.)

But how did we rack up so much debt?

Long story. Let's start with the balance of payments, which is divided into two accounts. The "current" account shows the money we earn from all our exports of goods and services, less the money we pay for all our imports, giving our "balance on trade".

Our imports usually exceed our exports, giving us a trade deficit. This deficit has to be funded (paid for) either by borrowing from foreigners or by having them make "equity" (ownership) investments in Australian businesses or properties.

Of course, when we borrow from foreigners, we have to pay interest on our debts. And when foreigners own Australian businesses, they're entitled to receive dividends.

The interest and dividends we pay to foreigners, less the interest and dividends they pay us (actually, our superannuation funds and Australian multinationals), is the "net income deficit".

We've been running trade deficits for so long, and racking up so much net debt to foreigners, that the net income deficit each quarter is much bigger than our trade deficit.

But add the trade deficit and the net income deficit (plus some odds and ends) and you get the deficit on the current account of the balance of payments.

The money that comes in from various foreign lenders and investors to cover the current account deficit is shown in its opposite number, the "capital and financial account".

Because the price of our dollar (our exchange rate) is allowed to float up and down until the number of Aussie dollars being bought and sold is equal, the deficit on the current account is at all times exactly matched by a surplus on the capital account, representing our "net [financial] capital inflow" for the quarter.

It turns out that, in the years since the global financial crisis of 2008-09, the current account deficit has narrowed.

In the 14 years to then, it averaged 4.8 per cent of GDP. In the years since then it's averaged 3.5 per cent. And in calendar 2016 it was just 2.6 per cent.

Why has it narrowed? Well, Debelle explains it's mainly a reduction in the net income deficit component of the overall deficit, which is at its lowest as a percentage of GDP since the dollar was floated in 1983.

The rates of interest we're paying on our foreign debt are lower because Australian – and world – interest rates are a lot lower since the crisis. And our dividend payments to foreign owners of Australian companies fell as the fall in coal and iron ore prices hit mining company profits.

That's nice. But while ever we have any deficit on the current account, our foreign debt will grow, and it already exceeds $1 trillion. Isn't that a worry?

Not really. It's not growing faster than our economy (GDP) is growing, and thus our ability to afford the interest payments.

More to the point, the current account deficit is just the counterpart to all the foreign capital flowing into Australia and helping us develop our economy faster than we could without foreign help.

The proof that such a massive debt doesn't mean we're "living beyond our means" is, first, that the nation – households, businesses and governments combined – saves a high proportion of its income rather than spending it on consumption.

Everything the nation saves each year is used to fund new investment in houses, business structures and equipment, and infrastructure. This investment is further proof we're not living beyond our means.

In fact, the nation invests more each year than we save. Huh? Well, the extra funding is borrowed from foreigners.

You can call it the surplus on the capital account of the balance of payments, or the "net foreign capital inflow" or – get this – the current account deficit.

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Our other problem: xenophilia towards foreign investment

There are few topics on which there's more irrational thinking than foreign investment. Trouble is, the illogic comes as much from economists and policy makers as it does from uncomprehending punters.

Sometimes I think the wonky thinking by the economic literates is an overreaction to the crazy prejudices of the economic illiterates.

The punters think we can decide not to sell off the farm – not to allow foreigners to buy Australian businesses – without that having any economic consequences. Without the decline in foreign capital inflow leading to slower economic growth and a slower-rising material standard of living.

Of course, there's no reason the electorate shouldn't decide to trade off less foreign ownership for a standard of living that's lower than it could be, provided people understand the price they're paying.

The econocrats go the other way, exaggerating our dependence on foreign investment and other capital inflow.

Econocrats have the knowledge that we're a "capital-importing country" burnt into their brains. They live in eternal fear that one wrong move could reduce the inflow to a trickle, stuffing us completely.

They preach the need for us to attract more foreign investment even while they worry that the dollar's too high – another example of how long it's taking economists to adjust their "priors" (long-held beliefs) to a world of floating exchange rates.

I can't think of a time when we've had too little foreign investment. Even when the dollar briefly fell below US50¢ in 2000 there was no obvious problem.

Another silliness about the econocrats' conviction that we can never have enough foreign investment is their assumption that prices – specifically, the rates at which various taxes are set – will be the overwhelming factor determining how much we get.

Treasury continually lectures us on how globalisation has made it easier to move financial capital between tax jurisdictions, thus making the quest for foreign investment far more "competitive".

This, we're assured, makes it imperative we have tax rates that are competitive with far less attractive investment destinations, including developing countries a fraction of our size, where cronyism and corruption are rife, and you can't be sure of getting fair treatment in the courts.

Only economists, mesmerised by their model – which ignores all factors that can't be measured in dollars – would be silly enough to imagine that decisions about where in the world to set up business would be made without reference to non-quantifiable factors.

That global companies such as Google or Apple would refuse to do business in Australia because our company tax rate is higher than Singapore's.

Yet the need to be more price-competitive in the quest for foreign investment is advanced as almost the only argument needed to justify a cut in company tax. That there'd be nothing in it for domestic shareholders is treated as beside the point.

John Howard's decision in 1999 to discount by half the rate of tax on capital gains was justified on the grounds that it would attract lots of investment by foreign fund managers. Never mentioned again.

In their revulsion against the public's "economic nationalism", the econocrats have gone to the opposite extreme of assuming all foreign investment is good and we can never get enough.

When it suited the world's big mining companies to come to Oz and engage in a decade-long frenzy to build more mines before China went off the boil, it never occurred to our policy makers to make the miners form an orderly queue.

Rather, we let them turn our economy upside down. We saw our job as ensuring the miners' frenzy didn't cause an inflation surge, using high interest rates and tolerating a hugely overvalued exchange rate to suppress the non-mining economy and allow the miners to get all the resources they wanted.

We did lasting damage to our manufacturing and tourism industries to allow the miners to have their rowdy party.

We're left with a huge, capital-intensive, 80 per cent foreign-owned mining industry that employs just a handful of Australians.

Its foreign ownership wouldn't matter so much if it was paying its fair whack of tax. But we let the miners con us out of imposing a sensible resource rent tax, and now we discover they're turning legal somersaults to minimise the company tax they pay.

The econocrats have become so defensive towards foreign investment they've forgotten the most basic reason for having and managing an economy: self-interest.

Foreign investment is a means, not an end. It's not our job to make our economy a playground for foreign companies.

We should welcome them and tolerate their self-interested, rent-seeking behaviour only to the extent that it leaves us better off.

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Lower dollar boosts services exports

Did you know that when the value of our dollar falls, imports become dearer? When the Business Bible learnt this last week, it got so excited it led the paper with the news.

Every smarty knows that the economic turmoil in Greece and China must spell bad news for us, so when the turmoil caused the Aussie dollar to fall below US75¢, this was obviously the start of the badness.

Apparently, it means the "global purchasing power" of Australian households has fallen. Who knew?

Immediately, our ever-vigilant media sprang into action to determine which purchases were likely to be more expensive. Don't you love the way the media can find the downside in any piece of economic news?

The fact that for months the nation's macro-economists and many of our business people have had their tongues hanging out, thirsting after a lower exchange rate, was something no one considered worth mentioning.

Nor that Reserve Bank governor Glenn Stevens' wish to see the dollar fall to US75¢ had finally come true.

It's true that if you view the position solely from the perspective of consumers, a higher dollar is good news and a lower dollar is bad.

However, from the perspective of Australia's trade-exposed industries and their employees, it's the other way around.

A high dollar means you get fewer Aussie dollars for anything you export, whereas the imports you compete against in the local market are now cheaper than they were.

So a higher dollar means Australian tradeable industries suffer a loss of international price competitiveness, which almost always leads to them reducing their production and their job opportunities.

In other words, a higher dollar has a contractionary effect on economic activity (which at least has the advantage of reducing inflation pressure). And that's been our story since the mining boom caused the Aussie to appreciate so strongly.

However, with mineral commodity prices having been falling since mid-2011 and mining construction projects winding up since the end of 2012, the dollar finally began falling back; though, thanks to the advanced economies' resort to "quantitative easing" (creating money), not by as much as the fall in commodity prices implied should happen.

It follows that a lower dollar has an expansionary effect on economic activity. Since our exporters now get more Aussie cents for each US dollar they earn, they're able to export more. And, since imports are now more expensive to their domestic customers, they're able to recapture a larger share of the local market.

The consequence is that our tradeable industries increase their production and the job opportunities they provide.

In our attempts to explain why relatively strong growth in employment – particularly since the start of this year – has caused the official unemployment rate to stay steady at 6 per cent, you'd have to give the lower dollar a fair bit of the credit.

That's particularly evident in the strong growth in employment in the services sector and in exports of services. Historically, services were regarded as non-tradeable, but globalisation and advances in transportation, telecommunications and digitisation are making that less true every year.

The tradeable services sector's improved price competitiveness comes at a time when Asia's middle-class is growing in size and income, with its consumption preferences shifting towards Western goods, services and destinations.

No service industry better demonstrates the lower dollar's beneficial effect on production and jobs than tourism: an industry where import replacement is just as important as exporting. The lower dollar not only attracts more foreigner visitors, it encourages Australians to holiday at home rather than abroad.

Estimates from Paul Bloxham, of HSBC bank, show spending on tourism accounts for about 3 per cent of gross domestic product, with about a third of this coming from foreign tourists.
The industry employs more than 500,000 people.

Overall, the value of tourism exports reached $14 billion in 2014, up 8 per cent. Tourist arrivals from China over the year to May were up 21 per cent on the previous year, Bloxham says. Chinese visits to Oz have increased to 920,000 over the past year, up from 370,000 five years ago.

Turning to education exports, Bloxham says international student enrolments reached a new high of almost 147,000 at the start of this year. Last year, the value of education exports reached $17 billion, surpassing the previous record in 2009.

And Joe Hockey has reminded us that the value of all services exports over the year to March was up 8 per cent, their fastest growth since 2007.

So if the fallout from the present international turmoil involves further falls in the Aussie, don't let anyone tell you it's a bad thing.

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The economy: old dog shows signs of life

With bad news this week from the March quarter survey of business capital expenditure, we need cheering up. Fortunately, budget statement No. 2 shows Treasury has been looking under every rock to find some good news.

It kicks off its annual assessment of the economic outlook by reminding all us worriers that the economy is entering its 25th consecutive year of growth, which is the second longest continuous period of growth of any advanced economy in the world.

And, we're reminded, though the economy has grown by less than its medium-term average ("trend") rate of 3 per cent-odd for five of the past six financial years, and is now forecast to grow by just 2.5 per cent in the financial year soon to end and 2.75 per cent in the coming year, this still leaves us as "one of the fastest growing economies in the advanced world".

Treasury gives us an update on the story we've become so familiar with in the past few years: the boom in investment in new mines and natural gas facilities is fast subsiding, leaving a big vacuum in economic activity that needs to be filled by faster growth in the rest of the economy.

To encourage such growth, the Reserve Bank has resumed cutting the official interest rate, such that it's now fallen 2.75 percentage points since its peak in late 2011, to a record low of 2 per cent. And, despite all the complaints about spending cuts, Joe Hockey has ensured his budget is only a minor drag on economic activity.

In response, we're now getting quite strong growth in new home building, and consumer spending is stronger than it was.

Fine. But that brings us to the crux of our continuing sub-par performance: business investment spending. Treasury expects mining investment to fall by more than 15 per cent this financial year, then by 25 per cent in the coming year and a further 30 per cent in 2016-17.

Yipes that's precipitous. And Treasury fears non-mining investment will show only modest growth until 2016-17 when it should increase by 7.5 per cent.

Put mining and non-mining together and you see business investment spending is the economy's continuing weak spot. After falling by 5 per cent last financial year, total business investment is expected to fall by another 5 per cent in the year just ending, then by 7 per cent in the coming year and even by a further 3.5 per cent in 2016-17.

Now you see why this week's figures for business "cap-ex" were such a downer. They really confirmed Treasury's dismal outlook. They showed a weak outcome for the March quarter and an unexpected deterioration in how much non-mining businesses expect they'll be spending in the coming financial year.

Moving right along, Treasury reminds us the economy does have a couple of things going for it apart from rock-bottom interest rates: one is lower petrol and oil prices and another is lower electricity prices (with more falls to come in some states).

And then, of course, there's the lower dollar, down mainly because the prices of our mineral exports are down, but perhaps also because our interest rates are lower than they were relative to those of other countries.

Our "real" exchange rate – that is, after adjusting the nominal exchange rate for our inflation rate relative to those of our trading partners – appreciated by about 30 per cent during the mining prices boom, but since September 2011 it has depreciated by about 13 per cent.

That's bad news for businesses and households buying imports, of course, but good news for Australian firms competing against imports in the domestic market. It's also good news for Australian exporters, who now get more Aussie cents for every US dollar they earn.

Treasury is forecasting strong growth of 5 or 6 per cent a year in the volume (quantity) of our exports over the next few years. Most of that is increased exports of minerals and energy as new mines come on line, but some of it comes from faster growth in non-mining exports.

On the other side, Treasury's expecting the volume of our imports to fall by 3 per cent in the year just ending and by a further 1.5 per cent in the coming year, before growing moderately by 2.5 per cent in 2016-17.

Why? Mainly because of fewer imports of heavy mining equipment, but also because the lower dollar will allow local firms to recapture market share from imports.

Such as? A classic exporting and import-competing industry is tourism. Real travel spending by international visitors to Oz has grown by 11 per cent since the start of 2012, whereas real travel spending by Aussies travelling abroad has decreased by 11 per cent.

The combined effect has been to turn our balance of trade in tourism services from a small deficit to a much bigger surplus. The increased inflow of tourists has been shared by all states.

Remember how much our leaders bang on about the big bucks to be made from China's rapidly growing middle class? Tourists from China accounted for more than a quarter of the growth in tourist spending in Oz last financial year.

The more than three-quarters of a million Chinese visitors that year spent an average of $8600 per person with our businesses.

Now get this: the volume of our exports of medium-skilled and technology-intensive manufactures has grown almost continuously over the past 30 years, as have our exports of high-skilled and technology-intensive manufactures, with the latter now bigger than the former.

It's really only the low-skilled and labour-intensive manufactures that have fallen back. The starring industries make goods such as pharmaceuticals, professional and scientific equipment, and machinery and transport equipment.

Strikes me we're not dead yet.

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Worried officials opt for risky strategy

My guess is the Reserve Bank is a lot more worried about the weak state of the economy than it's prepared to admit in its soothing words and the small downgrade to its growth forecast.

That's the only explanation I can think of for its decision to cut the official cash rate by 0.25 percentage points last week, despite governor Glenn Stevens' most recent "forward guidance" that "the most prudent course is likely to be a period of stability in interest rates".

The Reserve  could have preserved the credibility of its formal signalling regime by delaying such a tiny rate cut by just four weeks and using last week's statement to change its guidance, but such was its impatience that it reverted to its formerly forsworn practice of briefing selected journalists.

The financial markets got the message - thus giving the Reserve the self-generated justification that it had to act because the market was expecting it to - but most business economists didn't. In their naivety, most economists regard the word of the governor as more reliable than media speculation.

Despite the rate cut - and the assumption of at least one further cut - on Friday the Reserve shaved its forecast for real growth this year by 0.25 percentage points to 2.75 per cent, but left its forecast for next year unchanged at a midpoint of 3.5 per cent.

So what was so worrying that the Reserve, having sat on its hands for 18 months, couldn't wait another four weeks so as to protect its reputation?

The old story. This year has long been expected to be when mining investment spending falls hardest, leaving a huge hole in activity, to be filled by the resurgence of the non-mining economy, particularly ordinary business investment.

The Reserve worries that business investment isn't recovering fast enough. So, despite having already cut the official interest rate from its peak of 4.75 per cent in late 2011, it decided to take off another click or two.

It might make all the difference, but I doubt the high cost of borrowing is what's holding businesses back from expanding. More likely, they don't see any great scope for making a bigger buck, and they're not in any mood to try their luck.

As central banks in other developed economies have discovered, when "animal spirits" aren't helping, you can get to a point where even exceptionally low rates do little to encourage borrowing and spending, when cutting rates to encourage growth is like "pushing on a string".

There's one exception, however: borrowing for homes. The main reason the Reserve has waited so long to cut rates further is its fear this would do more to encourage musical chairs in the housing market - the buying and selling of existing homes - including yet more negative gearing.

This doesn't do much to increase economic activity, but does bid up house prices and so add to the risk of a price bubble developing, particularly in Sydney and Melbourne.

It also leads to faster growth in household debt. Saul Eslake, of Bank of America Merrill Lynch, notes that after stabilising for some years, the ratio of household debt to annual household income has been rising to more than 150 per cent and will now go higher.

With their official interest rates down virtually to zero, the Americans, Europeans and Japanese have already got close to the limits of monetary policy. They've had to resort to "quantitative easing" (creating money out of thin air), but this has done a lot more to distort exchange rates and inflate prices in asset markets than it has to encourage real economic activity.

At 2.25 per cent, our official rate is still well above zero but, even so, we're close to the point where the costs and risks of a rate cut threaten to exceed the benefits.

The upshot of the great battle between Keynesians and monetarists in the 1970s was agreement that monetary policy was the most effective way to fight the opposing evils of inflation and unemployment.

By the 1990s, some concluded that manipulation of interest rates by independent central banks had conquered the problem of keeping economies on an even keel. Yeah, sure.

We discovered a fatal weakness in the new macro management: monetary policy was great at controlling ordinary inflation, but when used to stimulate weak demand it was prone to encouraging excessive borrowing and asset-price bubbles which, when inevitably they burst, caused deep and protracted "balance-sheet" recessions.

From our perspective, the answer to our present problem isn't more risky rate cuts, it's greatly increased federal spending on infrastructure to fill the hole created by the fall in mining investment.

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Treasury boss's parting advice is daunting

One of Tony Abbott's first acts on becoming Prime Minister was to sack the secretary to the Treasury, Dr Martin Parkinson. Parkinson's crime was to believe - as did the government he had been serving - that we need to take effective action against climate change.

Abbott also sacked Parkinson's obvious successor at Treasury, Blair Comley, for the same crime. It was a disgraceful, vindictive way to treat loyal and proficient public servants.

But Parko's departure from Treasury was delayed, first so he could help the new government prepare its first budget and then because his experience was sorely needed to help Abbott and Joe Hockey prepare to chair the G20 meeting this month.

But the time for his departure has finally arrived and this week he gave one of the last of many speeches during his distinguished career. It was a tour of the short-term and longer-term challenges and opportunities that lie ahead. He professed to be very optimistic about our prospects, but I found his remarks pretty daunting.

Starting with the rest of the world, Parkinson observed that, even this far on, the big, developed economies' recovery from the global financial crisis was slow and uneven. Forecasts for global growth next year had been downgraded again, to 3.75 per cent, following a pattern that had become familiar over the past few years, he said.

"We now have a situation where 200 million people around the world are looking for work. As the International Monetary Fund's Christine Lagarde noted, if the unemployed formed their own country, it would be the fifth-largest in the world."

The financial crisis led to rapid accumulation of public debt, and governments in many countries had neither the political support nor market tolerance to use deficit spending to stimulate their economies, he said.

In normal times, countries might use monetary policy to offset fiscal tightening, supporting demand by cutting interest rates and boosting economic activity by having their exchange rates fall. But many countries already had their interest rates at zero.

So their efforts to cut spending and raise taxes while their economies are still so weak - known as a policy of austerity - ran the risk of weakening demand further and making the budget deficit bigger.

Many countries had resorted to "quantitative easing" - metaphorically, printing money - to offset the budgetary tightening. Trouble was, we are yet to see the massive increase in funding this has generated translate into growth-inducing investment, he said. It was leading to too much financial risk-taking (buying high-priced shares and bonds) but not much economic risk-taking (increasing production capacity).

This was why our move to get each of the G20 members to agree to take measures that would cause their growth over the next five years to end up 2 per cent higher than otherwise, particularly by increased investment in infrastructure, made so much sense.

In the short-term construction phase, it adds to aggregate demand. If it's done well, it adds to the economy's supply capacity and boosts productivity for the long term. And if you price access to the infrastructure properly, it might even help the budget in the medium term.

Turning to our economy, the short-term outlook was dominated by our transition from resources investment-led growth and risks associated with continued weakness in the global economy and the potential for renewed financial instability, he said.

But our transition to broader sources of growth was occurring more slowly than we might have expected. In particular, the dollar hadn't fallen as much as expected, considering how far commodity prices had fallen, so the boost to the non-mining economy hadn't been as great as hoped.

The limited fall in the dollar was explained by the big countries' quantitative easing, which was pushing their currencies down relative to ours.

Our consumers were also cautious in their spending and businesses seemed unwilling to invest until they saw consumer spending picking up. It was looking likely the economy would have grown below trend for seven of the eight years to 2015-16.

The long-delayed return to healthy growth created a risk that cyclical (temporary) unemployment turns into structural (lasting) unemployment. However, working the other way was our moderate growth in wages, which was a sign that the labour market was adjusting flexibly, even though it was also likely to be limiting consumer spending.

Turning to our longer-term challenges and opportunities, our big opportunity arose from the shift in the centre of global economic growth to Asia. By 2050, four of the five largest economies in the world would be in our region: China, India, Japan and Indonesia.

In this decade, the number of Asian middle-class consumers would equal the number in Europe and North America. These people would increase their demand for a wide range of goods and services that we could help supply.

But if we were to grasp these opportunities, we would need to work for them, and work hard, Parkinson said. There were no grounds for complacency.

We must use the opportunity provided by all the present reviews - of the tax system, the workplace relations system, the financial markets, competition policy and the functioning of our federation - to make decisions that improve our productivity growth and position ourselves to reap the most from our prospects.

Our other big problem was achieving a more sustainable fiscal position - getting the budget back to surplus. Australia had a "structural" budget problem - that is, one that wouldn't disappear once the economy had returned to normal growth - requiring a sustained and measured response, involving people giving up benefits.

It was important we start the process of repairing the budget now, he said. We had recorded 23 years of consecutive growth and the budget projections were based on an assumption that this would continue for another decade.

Such an outcome - 33 years of uninterrupted growth - would be without precedent. Get it? We're unlikely to be that lucky.

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No 'reform' could increase jobs in the short term

What do we need to do to get the economy growing properly again? Wait ... for at least a year.

The most recent figures from the Bureau of Statistics confirm the economy has grown at an average annual rate of only 2.5 per cent over the past two financial years. Since it needs to grow at its medium-term trend rate of about 3 per cent just to hold unemployment steady, the jobless rate has been rising slowly over that time.

With the authorities holding out little hope of much improvement before 2016, it is not surprising people are wondering what more we could be doing to get things moving. Some have noted the impending loss of jobs in car making and elsewhere, and are wondering where the new jobs will come from.

At such times there is never a shortage of people peddling solutions. A perennial favourite is "industry policy" - which usually starts as a plan to kick-start some wonderful new industry, but too often ends up using subsidies to prop up industries from which the market has moved away.

Business lobbies perpetually tell us tax reform that lightens the burden on business and high-income earners would do wonders for the economy. But though it is true the tax system could be made more efficient, it is unlikely such reform could make more than a small addition to growth, spread over many years.

While it is true the economy's growth is weak because it is taking us a few years to get things back to normal following the major change in the structure of our economy that left us with a much-expanded mining sector, our growth problem is cyclical - that is, temporary - rather than structural.

Abstracting from the ups and downs of the business cycle, there is nothing fundamentally wrong with the functioning of our economy. While, as always, there are plenty of bits whose efficiency could be improved, there is no reform that could make a big difference in a short time.

Some people imagine the economy grows only to the extent the government is doing things to push it along. It ain't true. What propels the economy, keeping the number of jobs increasing virtually every year, is the material aspirations of business people and households.

All the macro managers do is hold the economy back a bit when it's going too fast, or give it a bit of a shove when it is going too slow. In normal times, the main instrument they use to slow things down or speed 'em up is interest rates.

That is just what is being done now, as an assistant governor of the Reserve Bank, Dr Chris Kent, explained in a speech this week reviewing the state of the economy and its prospects.

He warned that "GDP growth is expected to be below trend for a time before gradually picking up to an above-trend rate by 2016", meaning "the unemployment rate is likely to remain elevated for some time".

Many people devote a lot of time to following the chequered fortunes of the big economies - the United States, Europe, Japan, China - and probably conclude their slow growth will weigh heavily on our own.

If that's you, Kent has news: if you take our major trading partners' growth and weight it according to their share of our exports, it turns out our customers' economies have been growing since 2010 at the relatively stable rate of about 4 per cent a year, close to the long-term average.

The Reserve expects them to continue growing at that rate over this year and next. How is this possible? Simple: over the 13 years to last year, the advanced economies' share of our exports has fallen from 40 per cent to 25 per cent, with the much faster-growing developing Asian economies taking their place.

So the main adverse effects on us from the rest of the world are our still-too-high exchange rate, which is harming the price competitiveness of our export and import-competing industries, and continuing falls in the prices we get for our commodity exports, which reduce our real income.

The other big factor we will have working to keep our growth inadequate is mining investment spending, which "is set to decline more rapidly in the coming year or so than it has since it peaked in mid-2012".

Most of the factors pushing the other way arise from the stimulus provided by our exceptionally low interest rates. These have already led to growth in home building and some uptick in related spending on consumer durables, particularly in NSW and Victoria.

Growth in consumer spending is being constrained by weak growth in household income because growth in employment is so slow and wages are rising so modestly.

Even so, the Reserve is expecting consumer spending to be boosted by a continuation of the modest fall in the rate of household saving we've already seen. If so, this would represent households seeking to smooth the growth in their consumption despite weak income growth, as well as the effect of the rise in share and, particularly, house prices making them feel wealthier.

A separate source of stimulus Kent expects to see is a further fall in our exchange rate. With the American economy's recovery now entrenched, US authorities have ended their "quantitative easing" (creating money) and are expected to start raising their official interest rate in the middle of next year.

Once financial markets are convinced that tightening is on the way, the greenback should appreciate and our dollar depreciate. This would reduce the pressure on our tradeables industries and eventually help produce the long-awaited lift in investment spending by the non-mining sector.

As far as the Reserve is concerned, it has already done what needs to be done to get the economy back to normal. It's sitting tight, waiting for its sweet medicine to work, and thinks we should, too.

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We've handled the resources boom surprisingly well

Are we in for big trouble in the aftermath of a misspent resources boom, or has the boom been over-hyped, leaving us in good shape to face the future?

This is a matter of debate among some of Australia's most prominent economists. Professor Ross Garnaut, of the University of Melbourne, advanced the former argument last year in his book Dog Days: Australia After the Boom, and Dr John Edwards, a fellow of the Lowy Institute and member of the Reserve Bank board, makes the counter-argument in his new book, Beyond the Boom.

This week Dr David Gruen, of Treasury, weighed into the argument in a speech written with help from Rhett Wilcox. Gruen took a middle position, agreeing with each man on some points and disagreeing on others. Appropriately, he was speaking at the annual conference of economists in Hobart. They enjoy that kind of thing.

Gruen strongly disagrees with Edwards' claim that the resources boom "hasn't been as important for Australian prosperity as widely believed", saying the boom was "one of the largest changes in the structure of our economy in modern times" which "generated the largest sustained rise of Australia's terms of trade ever seen".

"The result was that resources investment increased from less than 2 per cent of gross domestic product pre-boom to around 7.5 per cent in 2012-13, an increase, in dollar terms, from around $14 billion to more than $100 billion a year," he says. "This has seen an additional 180,000 workers employed in the resources sector since the boom began and will see the capital stock in the resources sector almost quadruple by 2015-16."

But Gruen disagrees with Garnaut's implication that the economy was not well managed during the boom. He notes that all previous commodity booms - including the rural commodity boom of the early 1970s - led to blowouts in wages and inflation, followed by recessions after the boom busted.

This time, however, wages have been well controlled and the rise in prices has rarely strayed far from the Reserve Bank's 2 per cent to 3 per cent target range. The boom in the resources sector has not led to excessive growth in the economy overall. Real GDP growth averaged 3 per cent a year over the decade to 2012.

Edwards supported his claim that the resources boom has not been as important for our prosperity as commonly believed by comparing this 3 per cent growth rate unfavourably with the 3.8 per cent annual rate achieved over the decade to 2002.

But Gruen counters by noting the earlier decade "saw above-trend growth as the economy recovered from the deep early-1990s recession, with unemployment falling from above 10.5 per cent to below 6 per cent over the course of that decade".

So why has the upside of the resources boom been handled so much better than in earlier commodity booms? Gruen gives much of the credit to three micro-economic reforms: the floating of the dollar in 1983, the move to letting the Reserve Bank set monetary policy (interest rates) independent of the elected government, formalised by Peter Costello in 1996, and the decentralisation of wage-fixing, largely completed by the Keating government before 1996.

(This to me is a point worth noting: the greatest continuing benefit from the era of micro reform - but also from the move to set formal "frameworks" for conducting the two arms of macro-economic policy - is a much more flexible economy, one that is less inflation-prone and less unemployment-prone. By the way, Garnaut and Edwards can take their share of credit for these reforms.)

Next Gruen rebuts Garnaut's argument that the income the nation earned from the boom was misspent.

Garnaut might have in mind the Howard government's decision to respond to the temporary increase in collections from company tax and capital gains by cutting income tax for eight years in a row, a move that does much to explain the trouble we are having getting the budget back into surplus.

But there is more to the economy than what the feds do with their budget. And Gruen points out that, over the decade to March 2014, national consumption spending (by households and governments) actually declined from about 76 per cent of GDP to 73 per cent. If so, the nation's saving must have increased by 3 percentage points of its income (remember: income equals consumption plus saving).

Against that, over the same period bar the last few quarters, national investment has been high and rising, relative to income. "Rather than the income gains from the boom having been consumed, it would be more accurate to conclude that they were invested," Gruen says - a point Edwards also made.

(Had the nation been "living beyond its means", that would show up as a widening in the current account deficit. Instead, the deficit has been narrower in recent years.)

But what about the downside of the boom? Will the bust result in a period of contraction for the economy as a whole? Gruen's answer is "so far, so good", but he concedes that, over the next three or four years, investment spending by the miners is expected to fall from about 7 per cent of GDP to about 2 per cent or 3 per cent, a subtraction from growth of about 2 per cent to 2.5 percentage points (remembering that about half of mining investment is in imported equipment).

Remember, too, that mining production and export volumes will be growing strongly. Even so, avoiding recession will require a further significant fall in the dollar.

Gruen agrees with Garnaut that for the economy to benefit from such a "nominal" depreciation in the currency, it will need to be translated into a "real" depreciation by only moderate wage growth. But this could be achieved provided real wages grow by less than the growth in labour productivity.

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We need a wage problem, so let's imagine one

It's been two decades since we had reason to worry about excessive wage growth. This remains true despite cabinet ministers and some economists saying we have a problem.

The structural reason we don't have to worry is the continuing effect of the Hawke-Keating government's micro-economic reforms - particularly the floating of the dollar, the removal of protection against imports, deregulation of many industries and the move from central wage-fixing to bargaining at the enterprise level - in making the economy far less inflation prone, as well as more flexible in responding to economic shocks.

Micro reform failed to deliver the expected lasting rise in the rate of productivity improvement, but it did deliver the unheralded benefit of making the macro-economy much easier to manage. You would expect people who profess to care so much about reform to know this.

Starting with the cabinet ministers, it's understandable that a conservative government that made a solemn promise to make no significant changes to industrial relations law in its first term would want to camouflage its lack of pro-employer militancy by turning up the volume on its anti-union rhetoric.

That the union movement is a shadow of its former self is no impediment to the gratification it gives the Liberals (and the national dailies) to portray the unions as the economy's great bogeyman.

Trouble is, the ministers don't seem to have looked at the stats lately. As the Reserve Bank summarised the story on Friday: "Various measures of wage growth are now around the lowest they have been over the past decade or longer."

Since the economy has been growing at below trend, with slowly rising unemployment, for quite a few quarters, this is hardly surprising.

More worthy of serious discussion is the argument of Professor Ross Garnaut and others that, if the economy is to gain lasting stimulus from the belated fall in the dollar, it will need to be accompanied by a fall in real wages.

It is true that a fall in the dollar leads to a rise in the prices of internationally tradeable goods and services.
It is also true that the fall in the nominal exchange rate has to be accompanied by a fall in the real exchange rate (the nominal rate adjusted for our inflation rate relative to those of our trading partners) if it is to cause a lasting improvement in the price competitiveness of our trade-exposed industries.

What doesn't follow is that the real exchange rate can fall only if real wages fall. For a start, it doesn't require wages to grow no faster than the inflation rate for that rate to be unchanged.

All that's need is for wages to grow no faster than the inflation rate plus the trend rate of improvement in the productivity of labour (often taken to be 1.5 per cent a year).

Thus are the benefits of productivity improvement spread around the economy in the form of rising real wages (and, thanks to indexation, rising real pensions) without adding to inflation. As it loved reminding us, this is just what happened throughout the Howard government's term.

It follows that real wages would need to fall only to the extent that the increase in inflation caused by the fall in the dollar exceeded the trend rate of productivity improvement. (Of course, the need for slower wage growth would also be reduced to the extent that our trading partners' inflation rate happened to be higher than ours.)

Let's do some figuring. The Reserve's rule of thumb is that a 10 per cent fall in the dollar adds between 0.25 and 0.5 percentage points to the annual inflation rate over each of the following two years or so.

Since its peak last April, the Aussie has fallen by about 15 per cent against the US dollar. But it's misleading to focus on temporary peaks, so a more representative fall would be less than 14 per cent. And we really should use the fall against the more economy-wide trade-weighted index, which reduces the depreciation to about 11 per cent.

There may be a fair bit more to come, of course, but so far we don't have a lot to worry about. There's no sign we need a fall in real wages, just lower-than-normal real growth.

And if you take the danger level of economy-wide nominal wage growth to be 4 per cent (that is, the inflation-target mid-point of 2.5 per cent plus trend labour productivity improvement of 1.5 per cent), we're looking very restrained.

The wage-price index never got out of hand even at the height of the resources boom, and by September its annual rate of increase had slowed to a terrifying 2.7 per cent. Not.

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Outlook for us and the world is sombre

Australia and the world are experiencing a Micawber moment. The economic prospects aren't reassuring, but there's not a lot we can do except hope something will turn up. Wherever you turn, the outlook is for continuing sub-par growth.

According to Dr Min Zhu, a deputy managing director of the International Monetary Fund, in Australia this week, the post-global crisis growth cycle may be coming to an end. At the peak of the crisis in late 2008, most countries gave their economies enormous injections of fiscal (budgetary) and monetary (interest rate and liquidity) stimulus to get them moving.

It worked. After an unprecedented contraction of 0.4 per cent in 2009, gross world product grew by 5.2 per cent the follow year, by 3.9 per cent the year after, then 3.2 per cent last year. Notice it running out of steam? At this late stage it's expected to slow further to 2.9 per cent this year.

If 2.9 per cent doesn't sound too bad, remember the world economy's long-term average rate of grow is 3.5 per cent a year.

In last month's world economic outlook document, the fund warns that "the major economies must urgently adopt policies that improve their prospects; otherwise the global economy may well settle into a subdued medium-term growth trajectory".

Trouble is, Zhu says most countries - rich and poor - have little "space" left for further fiscal or monetary stimulus. Indeed, the policy action the fund is calling for is more structural than cyclical: "strong plans with concrete measures for medium-term fiscal adjustment and entitlement reform" in the case of the United States and Japan, while the euro area "must develop a stronger currency union and clean up its financial systems".

As for the emerging market economies, many of them "need a new round of structural reforms". China, for instance, "should provide a permanent boost to private consumption to rebalance the growth of demand away from exports and investment".

Well that's fine and dandy. But though structural reforms that improve the functioning of the economy may ultimately have a big payoff, it usually takes ages to come through. And often there are costs up-front.

In the meantime the world's left, like Mr Micawber, hoping we turn out to be luckier than the forecasters expect. And the outlook for our economy isn't all that different.

Reading from a graph in the presentation to the Australian Business Economists' annual conference this week by Dr David Gruen, at the time of the pre-election economic update Treasury was expecting growth of 2.6 per cent this year, improving to 2.7 per cent next year.

That compares with the economy's "potential" growth rate of about 3 per cent - the rate needed to hold unemployment steady. So we can expect a continuing rise in joblessness. And the boss of Treasury, Dr Martin Parkinson, said this week that the prospects for the economy had deteriorated a little since the election.

The pundits seem agreed that the economy could return 3 per cent growth in 2016. But that's just the nice way of saying we look like having to endure three years of sub-par growth. Beaudy.

In theory, we do retain "space" to further stimulate demand with either lower interest rates or increased government spending. But rates have already been cut a long way, and the Reserve Bank seems likely to avoid another cut while we see what difference those earlier cuts make.

As for the budget, it has been in deficit for four years already, so no one is keen to go any deeper. At this stage the Abbott government is following the Labor government's policy of avoiding taking measures to hasten the budget's return to surplus - which would, in any case, be counterproductive to some extent at a time when the economy's weak.

But some of the noises Joe Hockey has been making suggest he's preparing to step in with big spending on infrastructure should the end of the mining investment boom cause a much bigger hole in overall demand than we're expecting. Replacing heavy investment in mining with heavy investment in infrastructure would make a lot of sense.

The main thing we are hoping will "turn up" is a turn down in the dollar. Even the fund said this week it believed the dollar was overvalued by about 10 per cent. An exchange rate with the US dollar in the mid-80s would do a lot to stimulate our trade-exposed industries.

Gruen reminds us that, whereas through most of the noughties exports of resources made a contribution to annual growth in real gross domestic product of about 0.4 percentage points, over this year and the next two or three they will contribute well over 1 percentage point.

The decline in mining investment - which itself will make a big subtraction from growth - will also lead to a decline in imports, since mining investment involves a lot of spending on imported capital equipment. That's a saver.

And for those who worry we may be blowing up a housing bubble, Gruen advises that the median capital-city house price has been roughly steady at four times average household disposable income for the past decade and at present is a fraction below four.

If you look at the graph you don't find the ratio has been steadily climbing over the years. Rather, it was a bit less than three times during the 1990s, but then jumped to four times in the early noughties and has stabilised there.

What happened in the early noughties to bring about this change? The return to low inflation and, with it, low nominal interest rates for home loans. This fall greatly increased the amount banks were prepared to lend people on an unchanged income. Australians used this increase in borrowing power to bid up the prices of our housing.

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What's driving our dollar

The clouds over our economy got a bit darker this week with the news that the US Federal Reserve was in no hurry to begin "tapering" its quantitative easing.

This underlined the reality now dawning on the new Abbott government that the outlook for the economy is quite uncertain and, unless we're lucky, quite weak. It's certainly not a time when you should shift to a contractionary stance of fiscal policy because of some misguided desire to force the pace in getting the budget back to surplus.

But let's start with the Americans and their quantitative easing. "QE" is a form of economic stimulus - the sort you resort to when you can't stimulate the economy the conventional way by cutting the official interest rate because it's already close to zero.

It involves the central bank buying government bonds or other securities in the marketplace and paying for them by just crediting money to the sellers' bank accounts (a trick only central banks, the creators of money, can do).

The intention is that increasing the money in circulation encourages demand (spending) at a time when aggregate (economy-wide) supply exceeds aggregate demand, with workers lying idle and firms operating well below full capacity.

Some people, remembering stuff their heard in the 1970s and '80s, worry that "printing money" causes inflation. It does if it causes demand to exceed supply - as would have been the case back then - but it doesn't when demand is a lot weaker than supply, as has been the case in the North Atlantic economies since the global financial crisis.

Even so, the Fed has been warning it will start cutting back (tapering) the amount of its continuing monthly purchases of bonds as it sees the economy strengthening, just to be on the safe side.

What happened this week was the Fed's decision that the economy wasn't yet strong enough to start the tapering. It was worried that recent figures for employment weren't as strong as expected.

It was also aware that the congressional deadlock over the budget was bringing about cuts in government spending and increases in taxes that exerted significant contractionary pressure on the economy. And another confidence-sapping battle between the President and Congress was brewing.

So how do our interests fit into this? Well, this is where it gets tricky. It's not bad news that, in the face of a weaker-than-expected economy, the Fed decided not to start withdrawing monetary stimulus. It's in our interests for the US economy to be as strong as possible.

What is bad news is that the US economy isn't strong enough for the tapering to begin. That's because one of the ways quantitative easing stimulates demand is by putting downward pressure on the country's exchange rate.

And anything that puts downward pressure on an important currency like the US dollar puts upward pressure on our dollar. What's stimulatory for them is thus contractionary for us.

As we've been reminded only too well in recent years, a high dollar reduces the international price competitiveness of our export and import-competing industries, causing us to produce less than we otherwise would.

From our perspective, our dollar has been high because of the resources boom: the high prices we were getting for our exports of mineral and energy and because of the foreign capital flowing in to finance all the investment in new mines and natural gas facilities.

With export prices having fallen a fair bit over the past two years, we expected to see our dollar come down and stimulate production in manufacturing and tourism.

For a long time nothing happened. It started falling in mid-April, but still hasn't fallen as far as it probably should given the size of the fall in export prices.

It took us too long to realise what the problem was: quantitative easing in other countries, particularly the US. Our dollar couldn't come down because it was being held up by the weak greenback.

This is a reminder that the exchange rate is a relative price: the value of our currency relative to the value of some other country's currency. So it's affected both by developments in our economy and developments in theirs.

It was when the Fed started making noises about tapering its quantitative easing that the currency market began anticipating this occurrence, pushing the greenback up and allowing our dollar to fall. Between mid-April and the end of July the Aussie had fallen about 14 per cent.

But this week's surprise announcement from the Fed saw the greenback drop against most currencies, including ours. Last time I checked, the fall since mid-April had narrowed to 10 per cent.

It's always dangerous to assume some change of direction that's just happened in financial markets will continue or even just not be reversed. But this week's events do suggest that the further fall in the Aussie dollar we've been hoping for is now less likely because the phasing out of America's quantitative easing is now further away.

Our present problem is familiar to you: with the resources boom's net contribution to growth now turning negative, we need the rest of the economy - particularly investment in new housing, and non-mining business investment - to take up the running. A decent fall in the dollar would do a lot to help stimulate the non-mining economy.

The other hope is for a turnaround in business and consumer confidence following the change of government.

The main indicators of confidence have improved since the election, with the Westpac-Melbourne Institute index of consumer sentiment jumping 4.7 per cent this month as Coalition voters' confidence leapt 19 per cent and Labor voters' fell 10 per cent.

But it's far too soon to say whether this improvement in the indicators of business and consumer confidence will translate into a significant improvement in actual economic activity and employment.

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Economic problems the pollies don't notice

Whoever wins the looming election will inherit a quite uncertain outlook, in which the economy may well slow further and unemployment rise faster over the next few years.

If so, all the politicians' wrangling over "debt and deficit" will be of little relevance and no help. That's the conclusion I drew from Reserve Bank governor Glenn Stevens' surprisingly sombre speech this week, in which he switched from glass half-full to glass half-empty.

If you didn't get that message, it's probably because it was missed in the financial markets' usual obsession with looking for hints about the next move in interest rates and the media's obsession with searching for criticism of the politicians - real or imagined.

Stevens warned that, in our efforts to get economic growth back to its trend rate of about 3 per cent a year - which is necessary to stop unemployment continuing to worsen - "the challenges ahead are substantial". What's more, those challenges will continue for "the next few years".

His speech explained those challenges. You know the basic problem: ensuring the rest of the economy takes up the slack as the stimulus from the mining investment boom tails off.

The first uncertainty is the future path of mining investment spending, which "rose from an average of about 2 per cent of gross domestic product, where it had spent most of the previous 50 years, to peak at about 8 per cent".

Presumably, that means it could eventually fall by a massive 6 per cent of GDP. But over what period? We don't know. All Stevens knows is that "that big rise is now over, and a fall is in prospect, with uncertain timing. It could be quite a big fall in due course."

Spending on the construction of new mines and facilities could stay on a plateau for a while, or it could just keep falling. If it plateaus, it makes no contribution to growth; when it falls, it subtracts from growth.

Meanwhile, what have we got going for us on the upside? Stevens advises that, "at this stage, global growth is sub-par". So, not much help from the rest of the world.

The much awaited fall in the dollar has improved the price competitiveness of our trade-exposed industries, which should allow them to produce more. "It would not be a major surprise if a further decline occurred over time," he says, "though, of course, events elsewhere in the world will also have a bearing on that particular price".

In particular, how soon and how far the Aussie falls will be influenced by how much more "quantitative easing" (creation of money) we see in the developed economies, particularly the US.

And then, of course, there's the stimulus to the non-mining economy from the easing in monetary policy. Since late 2011, the Reserve has cut the official interest rate by 2 percentage points to 2.75 per cent (with another click likely on Tuesday).

So monetary policy is "very accommodative," Stevens tells us, "by historical metrics, at least".

Huh? It turns out that, in our present circumstances, low interest rates don't pack the punch they used to, so we're not going to get as much increase in activity as usual.

Why not? Because, Stevens reminds us, we're not just coping with the aftermath of one boom, but two. The other is the end of the "credit boom".

You'd expect unusually low interest rates to encourage increased spending, particularly on those things that are usually bought on credit: consumer durables, homes and (non-mining) business investment.

But Stevens warns that while "some strengthening in consumption from recent rather subdued growth rates is a reasonable expectation ... we should not expect a return to the sorts of growth seen in the 1995 to 2007 period".

Why not? Because that period, in which consumer spending grew much faster than household income, was a product of the housing credit boom that largely preceded the resources boom. Households borrowed heavily to buy homes, thereby pushing up household debt levels and the prices of homes.

Ever-rising house prices (but also rising share prices) left households feeling ever wealthier, encouraging them to reduce their rate of saving and thus to allow their consumption to grow faster than their income.

In the aftermath of the credit boom - when share prices fell a lot and house prices fell a bit - households felt poorer and became more concerned about their high levels of debt. They thus began increasing their saving and trying to reduce their debts.

The household saving rate has now been steady at about 10 per cent of household disposable income for several years, meaning consumer spending has grown (and, as a matter of arithmetic, could only grow) at the same rate as household income.

Some people think the rate of household saving is unusually high and is the product of low consumer confidence, meaning it should fall when consumers cheer up, causing - again as a matter of arithmetic (because income equals consumption plus saving) - consumption to grow faster than income.

But Stevens says consumer confidence is neither weak nor strong and warns that the present saving rate isn't high, it's just back to normal. As well, "it would seem unlikely that we could bank on a resumption of sustained growth in assets [prices]", thus causing rising wealth to lead people to save less.

The household sector's apparent conclusion that its level of debt should go no higher makes it unlikely low interest rates will touch off another housing boom, although this "does not preclude prudent levels of borrowing by new entrants to the housing market, or by investors" (as existing borrowers continue paying down their mortgages).

As for non-mining business investment, its healthy growth is "by no means a certainty" and "looks like it is a while off yet".

Doesn't sound to me like a prospect where the highest priority of whoever wins the election should be getting the budget back to surplus.

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