Why fixing negative gearing would be a positive for our kids

Life wasn’t meant to be easy for our politicians – which is as it should be. Poor old Anthony Albanese. No sooner has he got away with breaking his promise on the stage 3 tax cuts than he’s besieged by people demanding more tax reform.

Trouble is, they all want different things, and every one of them could cost him votes as fat cats who stand to lose some tax break join forces with the opposition to run a great scare campaign, claiming it’s ordinary voters who’d be hit.

Despite the many things wrong with our tax system, the two big parties have wedged themselves into a corner on reform. Neither side’s game to do anything for fear of what the other side would say.

But when, unsurprisingly, polling showed that most people approved of Albanese’s decision to switch about $7 billion a year of the tax cuts away from those at the top and give them to those in the middle and bottom, the would-be reformers swarmed out of the woodwork.

First out was the (Big) Business Council, terribly worried about the lack of investment and the need for greater productivity. I’ll check their claims another day.

Then came two of our best economists, Professors Ross Garnaut and Rod Sims, proposing to bring back the carbon tax, only bigger and better. As I wrote last week, it’s a good idea.

But the one to watch, another old favourite, is the talk of finally doing something to curb the negative gearing of investment properties, which really took off 20 years ago after John Howard decided that the capital gain on property and other investments should be taxed at only half the rate applying to income from actual work.

A rental property is negatively geared when so much of the cost of buying it is covered by a loan rather than your own savings that the interest bill and other expenses exceed the rent you earn.

Why would anyone deliberately set up a business to run at a loss? Because the loss is deductible against your income from work. On a small investment of your own money, you sell the property a few years later at a big capital gain, only half of which is taxed. Not bad, eh?

Former Treasury secretary Dr Ken Henry reminds us that the rental property sector’s deductions are now so huge they exceed the rental income, making it not a net taxpayer. Taken together, all those landlords contribute nothing but are being subsidised by the mug workers.

What should worry Albanese is that the Greens are now pushing negative-gearing reform as part of their efforts to rebrand themselves as the party that cares about renters and first-home buyers.

If Labor doesn’t start showing it wants to improve the daunting prospects facing the younger generation, it risks losing its share of the youth vote to the Greens. The Libs needn’t worry, they’ve lost most of their share already.

Some years ago, the Grattan Institute proposed allowing landlords’ rental losses to be deducted only from other “passive” income, not wage income. There must be some recognition that capital gains shouldn’t be taxed at their full, inflated amount, so the 50 per cent discount should be cut to 25 per cent.

Another approach would be to allow losses to be deducted against wage income only if the investment property was newly built. This would overcome the objection that investors usually buy established homes, thus adding to the demand for homes without adding to their supply, and so pushing prices up out of reach of first-home buyers.

Now, the business people who see themselves as losing from the restriction of negative gearing – the real estate agents and home building companies – always claim it would do great damage to renters and home buyers alike. Don’t believe it. When economists try to estimate the likely effects, they find them to be small. Average house prices would fall by just 1 or 2 per cent, they say. So much for the death and destruction.

But these sums underestimate the likely benefit to young buyers. While the fall in the average price of all houses and units may be small, that’s because most house prices would be unaffected. Entry-level homes, the kind bought by mum-and-dad investors and first-home buyers, would become more affordable because those prices would fall by a lot more.

What’s more, a recent study finds that the share of households who own their home rather than renting it would increase by a huge 4.7 percentage points. Nor would it surprise me if, in practice, the effect was greater than the economists’ figuring suggests.

Even so, fixing negative gearing is no magic answer to housing affordability, and the Albanese government’s efforts to increase the supply of housing, particularly in the parts of cities where people prefer to live, is another part of the answer.

Albanese and Treasurer Jim Chalmers say they have no plans to change negative gearing, but that’s what they said about changing the stage 3 tax cuts – until they were ready to move.

And with the Greens using negative gearing as a bargaining chip in the Senate, progress is far from impossible.

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A home of one's own: So good only the rich need apply

Slowly – but sooner than you may think – this country, so proud to be a nation of home owners, is turning into a nation of renters.

Perversely, it’s happening because we value home ownership so highly. And we’ve never much worried about what happens to those who don’t make it onto the home owners’ merry-go-round.

Historically, the reason we want so much to own the home we live in is security of tenure. We don’t want to be beholden to a landlord deciding whether we stay or must go.

We don’t want to live in a place where someone else decides if we can have a pet, whether we can knock a nail into a wall, whether the place needs a coat of paint, or when they’ll get around to fixing the leaky toilet.

That’s always been the chief reason for wanting to own the place you live in. What’s changed is that a second motivation has become more prominent in our minds: homes turn out to be a good investment, a good place to put your savings and watch them grow.

Whereas the value of shares goes up and down with the vagaries of the sharemarket, the price of homes just keeps going up and up. (As we’re seeing now, that’s not quite true, but we still believe it.)

And because home ownership is such a national priority, it comes with many exemptions. When we decided to start taxing capital gains in the mid-1980s, we exempted the family home. And, unlike other assets, the home you own is largely ignored when assessing your eligibility for the age pension.

Any savings I invest in making my principal residence bigger and better won’t be subject to gains tax, as most other investments would.

Actually, homes are such a good investment, why don’t I invest in more than one? I’ll have to pay gains tax when I sell, but this time I’ll get a tax deduction on the mortgage interest I pay.

And naturally, being a home owner with a big investment, I’ll make sure the local council knows how opposed I am to people building those terrible high-rises anywhere near my place.

See what happens? The more benefits we attach to home ownership and the more people want to own a house or three, the more they bid up the price of houses. That makes being on the home owners’ merry-go-round an ever-better investment, but that much harder for others to climb aboard.

The more we favour home owners, the more we disadvantage renters. The more we encourage multiple home owning by those who can afford it – which most rich countries stopped doing long ago – the more unaffordable buying your first home becomes.

But not to worry. I’ll just give my kids a leg up in putting a deposit together. Of course, this just keeps home prices high and makes those kids without well-off parents worse off. Tough.

The other thing it does is more sharply divide Australia by making home ownership something only the well-off can afford.

Why don’t the politicians do something about it? Because that would involve reducing the privileges of existing home owners, who’d fight it all the way, led by real estate agents and developers.

There’s always been a minority of life-long renters but, home ownership being the national obsession it is, we’ve never worried about them. Renters have much greater legal rights in other rich countries than they do here, but that’s never bothered us. Renters, we happily assume, are just youngsters on their way to their first home.

This was never true, but it becomes more untrue as each census passes. In a major speech last week, the Grattan Institute’s Brendan Coates said “home ownership rates are falling fast, especially among the young and poor”.

Over the 40 years to 2021, home ownership rates among 25- to 34-year-olds fell from more than 60 per cent to 40 per cent. Among the lowest-paid 40 per cent of that age group, it has more than halved, from 67 per cent to 28 per cent, Coates said.

Last year’s census shows we’ve started seeing accelerating declines among middle-income households too, with noticeable falls in home ownership at all age levels, including older middle-income households.

The proportion of people who reach retirement never having been able to afford a home is increasing, as is the proportion of home owners retiring with unpaid home loans.

I wouldn’t like to be in the shoes of the 70-year-old pensioner living in a small town, who told Tenants Victoria she had to work two days a week to afford the ever-increasing rent on a granny flat in an old house.

We can keep ignoring the poor treatment of renters because they’ll soon get a place of their own, or we can take the controversial measures needed to stop housing from becoming ever-more unaffordable.

But even if we put through all the necessary changes tomorrow, we’d still end up with many more people spending most of their life as a tenant. Time we cared about renters.

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Next election will offer voters more genuine, wider choice

Even if we don't end up having a federal election this year, rest assured, it will feel like a year-long campaign. But whenever it occurs, it's likely to determine the fate of neo-liberalism, aka "bizonomics".

Though the two sides like to paint every election as a clear choice between good (us) and evil (them), many voters have concluded all politicians are the same – liars and cheats.

But that's truer of the way they behave than of the policies they espouse on some key issues.

The plain fact that neither side has enough committed supporters to guarantee it election means victory goes to the party that attracts more of the uncommitted voters in the middle.

This has long been a factor encouraging both sides away from extremes of left or right and towards the more moderate, "sensible centre". They've retained only enough pro-business or pro-worker positions to keep their voting, donating and polling-booth-staffing "base" motivated, as well as to provide some product differentiation.

The standard approach of recent decades has been for each side to seek to neutralise those issues where the other side is perceived by voters to have the advantage, by saying "me too", while trying to highlight those issues where it has the perceived advantage over its opponents.

Polling released last week by Essential, shows the Liberals' great perceived strengths are national security and terrorism, and management of the economy, whereas Labor's strengths are (in ascending order) education, health, housing affordability, the environment, industrial relations and climate change.

Note that almost all the contentious issues are economic, broadly defined. Voters see little to distinguish the two sides on population growth and asylum seekers. The government's already pushing hard on national security and terrorism, but Labor will run from any argument over these issues, where it starts well behind in voters' estimations.

Of late, however, the parties have departed from the standard script. Realising he lacked the charisma to get away with mimicking Tony Abbott's virtuoso performance of total negativity against the death-wish Rudd-Gillard-Rudd Labor, Bill Shorten thought he had little to lose by abandoning the small-target strategy of most oppositions, and went to the 2016 election with some relatively daring proposals on tax increases, particularly on restricting negative gearing and the capital gains tax discount.

Despite the conventional wisdom that touching negative gearing would be political suicide, Shorten's bravery was rewarded. Now look at the speeches Shorten and Malcolm Turnbull gave last week, and you see both sides planning to widen, rather than narrow, the policy distance between them.

Abbott was someone with conservative social values and hard-right economic views that fitted well with a party base that's be drifting to the right for many years. But he knew better than to highlight such views when seeking enough middle-ground votes to win the 2013 election.

Which leaves Turnbull with a big problem. His oft-stated position as a small-l liberal means much of his parliamentary party neither likes nor trusts him. To keep them behind him, he's had to loudly espouse policy positions – on big business tax cuts, weekend penalty rates and saving coal mines, for instance – that are far to the right of majority, middle-ground opinion.

The further Turnbull's party base has forced him away from the centre, the more Shorten has been emboldened to move his own policies further leftward from the centre than his predecessors would ever have dared.

It's clear Turnbull will go to the election offering no real plan to achieve Australia's Paris climate change commitments and making no more than sympathetic noises about the supposedly soaring cost of living, while claiming that big business tax cuts would trickle down and allow big pay rises.

In the meantime, the ever-continuing budget deficit won't stop the government also promising a tax cut for ordinary workers.

In echoes of Labor's winning policies at the 2007 election, Shorten will promise concrete action on climate change and on winding back the parts of Work Choices' attack on collective bargaining that Kevin Rudd and Julia Gillard weren't game to.

A rhetorical challenge for Shorten will be to shift the punters from their misconceived concern with the soaring cost of living, to the real problem: weak wage growth.

Despite that weak growth, I doubt many voters will be greatly tempted by the promise of modest tax cuts. A test of Shorten's leadership credentials will whether he has the courage to avoid matching Turnbull's promise.

But with Turnbull sticking to his plan for big-business tax cuts, and his resistance to reform of negative gearing and wage-fixing, this election may well determine the fate of the era of bizonomics.

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An independent assessment on negative gearing

Labor claims its "reforms" to "negative gearing" would do wonders to make home ownership more affordable for our kids. But Malcolm Turnbull says vote for high-taxing Labor and the value of your home will crash, while rents soar.

Many voters have strong views for or against negative gearing. But when rival politicians fall to arguing about their policies, most of us find we don't know enough to decide who's right.

We need someone we can trust to act as a kind of umpire, pronouncing on who has the better case. So we're fortunate to have John Daley and Danielle Wood, of the independent Grattan Institute, issuing a report on the topic.

For defenders of negative gearing, it's bad news. The pair explain that there's a good case for acting against the practice, dismissing alarmist claims it would disrupt the property market.

For opponents of negative gearing, however, the news isn't as good as it seems. Since the resulting reduction in house prices isn't likely to be great, acting against the practice wouldn't do much to make home ownership more affordable.

Investment in a rental property is negatively geared when so much of the cost of the property has been borrowed that the interest bill and other expenses exceed the earnings from rent.

Why would anyone deliberately structure an investment to run at a loss? Partly because they can deduct that loss from their income from other sources, thus reducing their tax.

But that means they're still out of pocket for the remaining half or more of the loss. Why do that? Because they're hoping eventually to sell the place at a big capital gain, which should more than make up for the after-tax losses they've incurred.

That's been more likely since 1999, when the Howard government introduced a 50 per cent discount on the rate of tax on capital gains.

Daley and Wood disprove the dishonest claims that negative gearing is used by many people on modest incomes to get ahead. There may be a few of them, but the statistics show high income earners claim the lion's share of the benefits.

The authors say there's no point of principle that supports our longstanding practice of allowing losses on property investments to be charged against wage income for tax purposes.

Very few other countries do this. It makes the housing market more volatile and reduces home ownership. It diverts capital from more productive investments while doing little to increase the supply of homes.

They propose allowing losses on property investments to be deducted only against income from other investments, not against wages. This would save the budget $2 billion a year in the short term, falling to $1.6 billion a year as behaviour changes.

But much of the attraction of negative gearing comes from its connection with the 50 per cent discount on the taxing of capital gains.

They say there is a case for taxing capital gains more lightly than other income – mainly because much of the seeming gain comes just from the effect of inflation, which makes it illusory – but this doesn't justify a discount as great as 50 per cent.

Allowing such a high discount (as well as allowing rental losses to be deducted against wage income) greatly reduces the government's tax collections, meaning it has to rely more heavily on other taxes. Those other taxes often do more to distort economic behaviour than taxing saving does.

In any case, empirical evidence shows people on high incomes save almost as much regardless of the tax rate. Measures intended to encourage saving mainly influence the vehicle through which wealthy people save – superannuation or property or a bank account, for instance.

As well, the high discount on capital gains tax creates opportunities for artificial transactions to reduce tax and encourages investors to focus too much on speculative investment – sit back and wait for capital gains to accrue – rather than investment that earns annual income by producing goods and services.

Daley and Wood propose halving the capital gains discount to 25 per cent. This would save the budget about $3.7 billion a year.

These policy proposals may sound the same as Labor's, but there are important differences. Labor promises that, for new investments undertaken from July 1 next year, deduction of losses against wage income will be permitted only for investments in newly built homes.

Investments made before then will be unaffected, while losses on new investments in shares or existing properties may still be deducted against other investment income.

Labor promises to cut the capital gains discount to 25 per cent for all assets bought after July 1, 2017. All investments made before then will be unaffected.

Daley and Wood criticise both proposals. Retaining existing negative gearing rules for prospective investments in newly built homes adds a new distortion that would, they believe, do little to increase the supply of homes.

And they criticise Labor's plan to "grandfather" existing investments – for both negative gearing and the capital gains discount – leaving them unaffected by the change.

A better way to minimise disruption to the market and to the expectations of existing investors would be to apply the changes to everyone, but phase them in equally over 10 years.

If only making up our mind on the other election issues we'll face could be so easy.

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Tax reformers forget budget repair

Don't say no one warned you. As finally the nation focuses on tax reform, something is quietly slipping out of our grasp: the return to a balanced budget.

How so? Short answer: an annoying little thing called opportunity cost. Long answer: tax reform and budget repair are, to a significant extent, in conflict. The more we get of one, the less we get of the other.

So which does the government, its big business urgers and most economists want more? The choice will be most excruciating for Treasury.

The first reason for doubting we'll ever see a return to structural budget balance starts with simple arithmetic. For tax reform to have no direct effect on repair of the budget, the total reform package needs to be "budget neutral": its net changes on the revenue side should exactly offset its net changes on the spending side.

But major, potentially unpopular tax reform doesn't work that way. In practice, governments need to minimise the number of net losers by giving away more than they take.

John Howard's package introducing the goods and services tax in 2000, for instance, was heavily budget negative. He'd taken the precaution of saving up, so to speak, to pay for disproportionate tax cuts by amassing huge bracket creep, having avoided tax cuts for five or six years.

Of course, he had the budget well back into surplus by then and could take the hit without causing concern.

Nothing about Malcolm Turnbull's rhetoric suggests he's headed for a budget neutral package. He's been assuring his right wing that the package won't involve any net increase in the overall tax take.

But if it's revenue neutral rather than revenue positive, that means it has to be budget negative.

Why? Because the package will need to compensate low-income earners via increased spending on pensions, the dole and family allowances.

And if the premiers aren't to oppose the reform package, the feds will need to pay a fair proportion of the GST proceeds to the states. This would represent a decrease in Tony Abbott's $80 billion in prospective budget savings from cuts to the states' grants for schools and hospitals, already in the budget's forward estimates.

The second reason for doubting the budget will ever be repaired is that much of the present deficit is structural rather than cyclical. Turnbull has been saying the budget will return to surplus once the economy gets back to trend growth.

Sorry, Malcolm, not right. By definition, to say we have a structural deficit – as Treasury does in each year's budget papers – is to say the budget will still be in deficit even when we've returned to the normal part of the business cycle.

Structural deficits are the cumulative effect of past unfunded decisions to cut taxes or increase spending. This may not have been obvious at the time if the economy happened to be booming, giving you a big cyclical surplus to hide your transgressions.

This is why so much of our present structural deficit is owed to the decisions made by the Howard government during the first stage of the resources boom, including the eight successive tax cuts and, notably, Peter Costello's unsustainably generous increase in superannuation tax concessions in 2007. Also, Howard's halving of capital gains tax in 1999 (which has done so much to fuel negative gearing).

Labor's unfunded spending on the national disability insurance scheme and the Gonski school funding reforms have added to the structural problem laid by the Coalition, though much of this spending is to come.

Apart from allowing bracket creep, the only way to eliminate a structural deficit is via explicit cuts in spending and "tax expenditures" (special tax breaks), and explicit tax increases.

With tax cuts and tax expenditures playing such a big part in creating the structural problem, to resolve to fix it solely via spending cuts is a recipe for failure. That's the lesson of last year's disastrous budget.

The obvious way to begin eliminating the structural deficit is to reverse at least some of the irresponsible tax expenditures that gave rise to it. However, if Turnbull summons the courage to act on super and capital gains, it's likely he'll use the proceeds to make his tax package look fairer, not to cut the deficit.

The third reason for doubting we'll ever see budget repair also concerns opportunity cost. Even a leader as popular as Turnbull has a limited supply of political credit to draw on.

The more points he uses on the unpopular elements of his tax reform package, the fewer are left to cover the unpopular measures needed to get the budget back to balance.

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Tax reform push doesn’t add up

For once the Business Council has said something those who don't champion the interests of big business can agree with. We have indeed reached a new low in the nation's political leadership.

The council's president, Catherine Livingstone, said last week that "at a time of great economic uncertainty, Australia needs and deserves strong leadership, and the opportunity to discuss reform options as a community".

"Our political representatives are elected and paid by the community to implement policies that will best serve the country. Their leadership responsibility is to ensure that there is a constructive, well-informed debate, leading to implementable outcomes; it is not to undermine the debate in the cause of party political positioning."

Livingstone's rebuke was rightly aimed at both sides of politics and both levels of government. But it must be said that Tony Abbott is the worst offender. Clearly, a government has greater responsibility to lead than an opposition.

The federal opposition's responsibility is not to descend to the level of destabilisation and automatic obstruction resorted to by the previous occupant of the position. Abbott is forging new lows on both sides of the Speaker's chair.

It was Abbott who, not long after Joe Hockey made his first call for a "sensible, mature debate about tax reform", summarily ruled out reform of negative gearing and superannuation tax concessions.

Why? Because Labor signalled its intention to propose such reforms and Abbott saw a chance to wedge Labor by portraying it as high taxing and the Coalition (with all its bracket creep) as low taxing.

Hence Livingstone's reference to "party political positioning". The sad truth is, these days governments rarely propose any "reform" without using it to attempt to wedge the other side. Kevin Rudd tried it with his failed carbon pollution reduction scheme, and Julia Gillard tried it with the Gonski education reforms and the national disability insurance scheme.

There's nothing Bill Shorten would like more than to wedge the Coalition on changes to the goods and services tax (apart from being given an excuse to proclaim the return of Work Choices), but Abbott lost no time in wriggling out of promising any serious change to the GST by imposing a condition he knew would not be fulfilled: every premier must first agree to the change before he endorsed it.

Those calling for greater bipartisanship on tax reform need to remember that, of all the areas of reform, taxation is the one where it's been least evident in the past. The Coalition (and the Business Council) opposed Paul Keating's introduction of capital gains tax and fringe benefits tax.

Labor opposed John Howard's introduction of the GST; the Coalition opposed Labor's introduction of the carbon tax and the mining tax. The only instance of bipartisanship I remember is Simon Crean (foolishly) waving through Howard's halving of the capital gains tax.

The parties divide on tax because there's no issue where the two sides' continuation of class warfare is more apparent. The Coalition seeks to favour the interests of business and high-income earners; Labor tends to favour middle and lower-income earners.

While in opposition, Abbott promised his big-business backers he'd take proposals for major changes in taxation and industrial relations to the 2016 election. But the public's rejection of his first budget as grossly unfair, and his subsequent poor showing the in polls means the government is fighting for survival, with no stomach for unpopular "reforms" of taxation or anything else.

Last week we had Hockey giving a speech that pretended the tax reform white-paper process was alive and well, even though we all know it's going nowhere.

He repeated his call for a mature debate about tax reform, while ruling out various reforms – changes to super tax concessions, negative gearing, the half tax rates on capital gains, the GST – and listing the changes he favoured (at some wonderful time in the future): a lower company tax rate, cutting the top personal tax rate and doing something about bracket creep.

The government's professed goal is lower taxes and no new taxes but, apart from the rise in GST we're not having, Hockey mentioned no tax he'd be prepared to increase to pay for all those he'd like to cut.

The only way to square that circle is another attempt at sweeping cuts in government spending, or to let budget deficits and debt go up rather than down. But who'd believe that?

The tax changes he fancies are from the Business Council wish-list​, shifting the tax burden from higher earners to lower earners. They'd be just as unfair as last year's budget.

Memo big business: no fairness, no deal. You should have learnt that last year.

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How cutting interest rates affects demand and inflation

Although many people have their doubts, the Reserve Bank cut interest rates last week believing it would help the economy grow faster and reduce unemployment. But how exactly is this meant to work?

Monetary economists believe interest rates affect the strength of demand (spending) in the economy via several "channels" or mechanisms. Eventually the effect on demand affects the degree of pressure for higher prices.

As we work through these channels we'll see why some people didn't want interest rates to be cut further, why some believe monetary policy (the manipulation of interest rates) is at a point where it's less effective and why others (such as me) believe the further cut risks fuelling a house-price bubble.

The first channel goes by the fancy name of the "inter-temporal substitution" effect. Inter-temporal means "between time periods" and it's making the point that the rate of interest is the opportunity cost of choosing to spend now rather than later.

If you want to buy a car but don't have the money to pay for it, the cost of buying it now rather than waiting until you've saved the money is the interest you pay on the loan. But even if you already have the money in the bank to buy the car, the opportunity cost of buying it now rather than later is the bank interest you forgo by taking your money out.

So when the Reserve brings about a fall in interest rates it's hoping the lower cost of borrowing (or the lower opportunity cost of reducing the money in your bank account) will encourage households and businesses to bring forward their spending on consumer durables and assets from a future period to the present period. This is inter-temporal substitution.

The next channel is the cash flow effect. In principle, cutting interest rates reduces monthly mortgage payments, leaving people with more cash to spend on other things. Equally, the lower repayments make it easier for would-be home buyers to go ahead.

Remember, however, that although almost all businesses have debts, only about a third of households have mortgages. Roughly a third have paid off their homes, leaving about a third renting.

This suggests that about two-thirds of households are "net lenders" (they have more money in bank accounts and the like than they owe on credit cards and personal loans), leaving only a third of households as "net borrowers".

But as any retiree will unhappily remind you, a fall in interest rates might be good news for borrowers, but it's bad news for lenders. So about two-thirds of households (including oldies and young people saving for a house deposit) will be left with less cash to spend on goods and services.

It's true, however, that the remaining third of households gain more overall than the two-thirds lose, because the amount they owe exceeds the amount the two-thirds have in bank accounts and securities.

This is why you'd expect the cash flow channel to be a further mechanism that, in net terms, was encouraging spending and growth. Trouble is, a high proportion of people with home loans leave their monthly mortgage payments unchanged despite the fall in rates. That is, they don't spend their saving in interest, they save it.

A third channel by which a cut in interest rates should hasten economic growth is the exchange rate effect. When our interest rates fall relative to other countries' rates - thus reducing our "interest rate differential" - this should make bringing foreign funds into Australia less attractive and so reduce the demand for Aussie dollars, causing it to fall relative to other currencies.

A lower dollar makes Australian businesses more price competitive by making our exports cheaper to foreigners and imports dearer to Australians. This should encourage greater Australian production of goods and services, increasing employment.

It's a nice, neat chain of logic but, as the Reserve notes in its description of the monetary channels on its website, they are "far from mechanical in their operation". Lots of other factors affect our exchange rate beside the interest differential.

There's a strong, but far from automatic, correlation between our dollar and the prices we get for our commodity exports. Our exchange rate is also affected by the things our trading partners do in their economies, such as manipulating their exchange rate by engaging in "quantitative easing".

Don't forget, our dollar was falling during the 18 months that our interest rates were unchanged.

Even so, my guess is that trying to keep the Aussie's recent downward momentum going was a big part of the Reserve's reason for cutting rates last week. It knows forex markets are affected by speculation and bandwagon effects that don't get much coverage in textbooks.

Another part of the channels story is that cutting the return on safe financial investments such as bank accounts has the effect of encouraging individuals and businesses to seek higher returns by buying riskier assets. Retirees move from bank term deposits to shares, while some households respond to lower interest rates by buying negatively geared investment properties.

Lower rates lead to more borrowing to buy houses, which pushes up house prices. Rising house prices encourage more people to buy, particularly investors seeking capital gain. If you're not careful this becomes a house price bubble that inevitably ends in tears.

Left out of the standard story about the channels through which lower interest rates cause faster growth is that the era of greater reliance on monetary policy has also been the era of credit-fuelled asset price booms and busts. As witness, the global financial crisis.

Why did the Reserve wait 18 months before cutting interest rates to a new low? Because it knows it's running a high risk of sparking a housing boom and bust. But with the economy now so weak, it felt it had no choice.

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Top 10 economic reforms that transformed Australia

1. Floating the dollar
Letting the market set the value of the Aussie dollar after December 1983 allowed it to fluctuate between US48c and $US1.10 so far, making it an absorber of shocks from the rest of the world. This has made the economy more stable and stopped the resources boom causing an inflation blowout.

2. Deregulating the banks
Introducing foreign banks and allowing banks to set their own interest rates made it much easier to get a loan and increased competition between banks and other lenders, but led to excessive lending to businesses and caused the deep recession of the early 1990s.

3. New taxes on capital gains and fringe benefits
In October 1985 Paul Keating announced new taxes but cut the top income-tax rate from 60 per cent to 49 per cent. He also abolished negative gearing, but reversed this under pressure from estate agents.

4. Removing import protection
In May 1988 Keating announced the virtual phasing out of the import duties and quotas imposed on most manufactured goods. Predicted demise of manufacturing industry did not materialise.

5. Privatising government businesses
Sale of the Commonwealth Bank began in 1991 and Qantas in 1992. The Howard government sold Telstra in three tranches from 1997. State governments sold their banks, insurance companies and some power producers and distributors.

6. Enterprise bargaining
In 1993 the Keating government ended centralised wage-fixing through a "national wage case" and introduced collective bargaining at the enterprise level. In 2005, Work Choices sought to promote individual contracts by reducing worker protections, further encumber unions and end reliance on industrial rewards. The Rudd government reversed the most extreme parts of Work Choices, but left much of it in force.

7. National competition policy
In 1995 Keating sought to encourage deregulation and privatisation by state governments and tighten the Trade Practices Act's restrictions on anti-competitive behaviour. Premiers tended to drag their feet.

8. Central Bank independence
In 1996 Peter Costello allowed the Reserve Bank to make its decisions independent of the elected government, endorsing its target of holding inflation between 2 per cent and 3 per cent, on average. The Reserve has raised interest rates more than a politician would - including during the 2007 election campaign - but this has kept inflation under tighter control than when politicians were in charge.

9. Goods and services tax
The start of the GST in 2000 came 25 years after it had been proposed by a major inquiry. It replaced wholesale sales tax and various unconstitutional or inefficient state taxes. Much death and destruction were predicted; little eventuated. But now GST is showing signs of wear and needs renovation.

10. Taxes on mining and carbon
Wayne Swan planned to raise huge sums from taxing miners' high profits and use the proceeds to give tax cuts and concessions to business and individual savers. He also used a tax to impose a price on carbon dioxide emissions. Both reforms were badly mishandled and Tony Abbott has pledged to reverse these reforms.

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Baby boomers' wealth effect hits the retailers

Back in the early Noughties, when the property market was booming, a lot of baby boomers began contemplating their future and realised they hadn't saved nearly enough to allow them to continue in retirement the privileged lives they'd always enjoyed. They decided they'd have to start saving big time.

So what did they do? Went out and bought a negatively geared investment property, of course. Their notion of saving was to borrow to the hilt, then sit back and wait for the lightly taxed capital gains to roll in.

If you're wondering why the retailers are doing it tough at present, don't blame it all on the mug punters' conviction that Armageddon starts next July 1 with the carbon tax. Part of the explanation rests with the baby boomers learning the hard way that saving actually requires discipline.

Glenn Stevens, governor of the Reserve Bank, has reminded us of the way real consumer spending per person grew significantly faster than household disposable income for the decade to 2005. Over the period our rate of household saving steadily declined until we were actually dis-saving.

And this from a nation that hitherto had saved quite a high proportion of income. Why the change? Well, Stevens is no doubt right to explain it primarily in terms of our return to low inflation and low nominal interest rates, combined with a deregulated banking system now more than eager to lend for housing.

But there has to be more to it. For most of the decade in question we fought each other for the best house in the block, forcing house prices up and up. At much the same time, the sharemarket was rising strongly as we and the rest of the developed world enjoyed the last phase of the over-confident Great Moderation that ended so abruptly with the coming of the global financial crisis.

Over the 35 years to 1995, the nation's real private wealth per person grew at the rate of 2.6 per cent a year, pretty much in line with the growth in real gross domestic product per person.

Over 10 years to 2005, however, real household financial assets (including our superannuation and direct shareholdings) grew by 5.3 per cent a year per person. The corresponding growth in non-financial assets (most of which is the value of our homes) was 7.5 per cent.

Put the two together and our total assets grew by 6.7 per cent a year. (Our debts grew, too, of course. The ratio of debt to total assets rose from 11 per cent in 1995 to 17.5 per cent in 2005.)

So what was it that gave us the confidence during this period to let our consumer spending rip and stop saving any of our household income? One almighty ''wealth effect''. Capital gain was king.

Everywhere we turned we could see ourselves getting wealthier, year after year. The value of our homes rising inexorably, the value of our super swelling nicely. With all that going for us, who needed to save the old-fashioned way? No wonder negative gearing - of share portfolios as well as residential property - was so popular.

As Stevens says, that period of debt-fuelled wealth accumulation had to end sometime. We would come to terms with the new world of lower nominal interest rates and readily available credit, loading ourselves up with as much debt as we needed (or a bit more) and calling it a day.

The recovery in household saving began well before the global financial crisis. Even so, there's no reason to doubt the crisis did much to accelerate our return to rates of household saving - 11.5 per cent at last count - not seen since the 1980s. For one thing, it reversed the wealth effect.

In principle, the behaviour of people of all ages should be affected by the knowledge of what's happening to the market value of their wealth. In practice, however, you'd expect it to have the greatest effect on those approaching retirement - the baby boomers - or even the already retired.

Consider it from their perspective. In the months leading up to and during the global financial crisis of late 2008, they observed it smash the sharemarket and take a huge bite out of their super savings. The market has recovered a fair bit since then but it hasn't regained its earlier peak and could hardly be said to be booming.

As for house prices, the boom is long gone and prices are, in market parlance, ''flat to down''. There's no reason to believe they'll be taking off again any time soon.

Many boomers have responded to this marked change in their prospects by postponing their retirement. A government-funded survey regularly asks workers over 45 when they expect to retire. In 2009, almost 60 per cent were expecting to retire at 65 or later, up from 50 per cent two years earlier.

With little prospect of much in the way of capital gains, it's a safe bet the baby boomers are leading the way in the nation's return to a higher rate of saving.

But that doesn't spell the death of retailing. As a matter of arithmetic, it's only when households are increasing their rate of saving - as they are now - that consumer spending has to grow very much more slowly than household income is growing.

Once households have reached a rate of saving they're happy with - no matter how high that rate - consumption can resume growing at the same rate as income.

But who knows? It may not be until the second half of next year that the punters - including the baby boomers - realise how much Tony Abbott & Co conned them about the depredations of the carbon tax.

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