Covid spending makes bread and circuses too costly for Andrews

These days it’s not unusual for cities to realise they prefer not to host major sporting events such as the Commonwealth Games and Olympic Games. What is unusual is that it’s taken so long for Premier Daniel Andrews to pull the plug.

The later the decision, the greater the disappointment and the ire of organisers, athletes and sport fans. And, no doubt, the greater the wasted spending.

Even so, it does take great political courage – and maybe overconfidence – to make such a decision, especially based on an undocumented claim of such a massive cost overrun – from $2.6 billion to as much as $7 billion.

If there isn’t a political price to be paid at the next Victorian election, it really will prove Andrews’ invincibility – with able assistance from a hopelessly divided opposition.

It isn’t hard to believe that the now-expected cost is far higher than the initial estimate. But the latest estimate of up to $7 billion does stretch credulity.

Overruns are a virtual inevitability in games hosting. This is shown by a table of overruns for the summer and winter Olympics, prepared by researchers at Oxford University.

It shows that Sydney’s stated overrun of 90 per cent in 2000 was on the high side, but nothing to compare with Atlanta in 1996, Barcelona in 1992 and the all-time winner, Montreal in 1976.

Even so, the table does suggest that the size of overruns has fallen in recent times as, presumably, host cities wise up. Perhaps now it’s cities with more experience – and good existing sporting facilities – that are more likely to seek and win the games, or perhaps these days cities know to take more care with their budgeting.

Initially understating the likely cost seems standard political practice for all public projects, let alone major sports events. “It’ll be great fun, bring us the international recognition we deserve, not to mention huge tourist dollars – and it won’t cost all that much.”

But it’s not just the pollies who mislead us. We’re all so keen to enjoy the games at home that we’re easily convinced they won’t cost much and will bring great benefits.

What gives hosting international games such a great risk of blowouts is partly the international sporting body’s demand for many new venues, but mainly the need for them to be completed by a specific, immovable date.

This leaves the games organisers hostage to greedy unions and private contractors.

But there’s rarely a shortage of “independent” consultants willing to take a highly optimistic view of what it all will cost, and what the (always greater) monetary benefits the games will bring in. Even to the extent of putting a dollar value on the supposed “social” benefits they will bring.

It’s all too easy to overestimate the benefit that all the spending by sport fans – local and visiting – will bring. Economists have put much thought into what they call “the economics of special events”, remembering, as most people don’t, to allow for the greatest insight of economics, “opportunity cost” – what your decision to do X means you now won’t be able to do.

Another pertinent concept is “intertemporal substitution” – decisions to move spending between time periods. Remember, too, that the amount of benefit varies with the perspective from which you view it.

Holding the Commonwealth Games in Melbourne, for instance, would attract many visitors from other states, spending on tickets, travel, accommodation, meals and so forth.

From the perspective of the Victorian economy, that’s a benefit. From the perspective of the Australian economy, however, the extra spending in Victoria is cancelled out by the reduced spending in other states.

From a national perspective, the only benefit is from overseas visitors, spending money in Oz that they otherwise wouldn’t have.

Most of the spending would come from Victorians themselves. But it’s likely most of this is money they otherwise would have spent in Victoria on other things, at other times in the year. So, little net benefit to the state’s economy, except for spending by overseas and interstate visitors.

It’s a different matter, however, for the mayors of the five regional cities that were planned to share the hosting of the games. Their cities would have benefited greatly from the spending by visitors from the rest of Victoria, other states and overseas.

Andrews’ decision to regionalise the games was intended to be their special feature, a new model for how the games could be run. But this dispersion seems to have added greatly to the games’ cost. Even at $2.6 billion, Victoria would have been spending much more than other state hosts of Commonwealth Games.

Andrews has promised that the regional cities will still get their planned new sporting venues, but it’s hard to see how this squares with his new view that the state has more pressing spending priorities.

So, just why has Andrews cancelled at this embarrassingly late stage?

He hasn’t said so, but it’s obvious. Because he spent so much coping with the pandemic, and the great debt this has left him with. He has no room left for spending on bread and circuses.

It’s now become common for cities to think twice about their plans to host Commonwealth or Olympic games – though not for them to leave it this late.

It’s noteworthy that Melbourne had no rivals in its bid for these games. And that no other Australia state is interested in filling the vacuum.

Why has hosting become less attractive? Because it’s finally dawning on cities that building so many new sporting venues – which will be little used after the games’ fortnight – is a waste of money that could have been spent on far more lasting and useful things.

But I doubt this means the days of these funfairs are numbered. The international controlling bodies will have to trim their demands for new facilities, and rotate the games between a few cities that have maintained adequate existing venues.

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Perrottet's bold re-election bid: the world's first teal budget

A budget can tell you a lot about the government that produced it, especially a pre-election budget.

This one reveals a reformist Premier anxious to persuade us his government has reformed itself. It’s your classic, all-singing, all-dancing pre-election affair, offering increased government spending on 101 different things.

In his effort to get re-elected, Dominic Perrottet has left no dollar unturned. Enjoy, enjoy.

But recent lamentations in Canberra remind me to remind you: whoever wins the state election in March, next year’s budget won’t be nearly so jolly. If there’s bad news in the offing, that’s when we’ll get it.

For a government going on 12 years old and up to its fourth premier, this budget should be the Coalition’s swansong. But Perrottet wants us to see him as new, young, energetic and reforming.

On the face of it, proof of his reforming zeal is his controversial plan to press on with replacing conveyancing duty with an annual property tax, despite Canberra’s lack of enthusiasm for helping to fund the loss of revenue during the transition.

Most economists would loudly applaud such reform. On close examination, however, the budget’s first stage doesn’t add up to much.

Even so, let’s not forget that the desire to make their people’s lives radically better has become almost non-existent among today’s self-interested politicians.

Perrottet wants a return to co-operative federalism, and will happily work with a Labor Victorian premier and Labor prime minister to achieve it.

And the reform doesn’t stop there. This pre-election budget is also the first post-election budget following the crushing defeat of the Morrison federal government. The NSW Liberal Party, with the least to learn from Scott Morrison’s many failings, is also the one that’s learnt most.

Genuine action on climate change, measures to improve the treatment of women in the workplace and the home, promoting co-operation rather than conflict and division, increased spending on early education, childcare and hospitals, the educated talking to the educated, Perrottet’s rejection of the pork barrelling condoned by his predecessor – this budget has everything.

I give you ... Australia’s first teal budget.

Much of the credit needs to be shared with the new Treasurer, Matt Kean. He is a reforming Treasurer – with many of his predecessors’ mistakes needing reform. This budget is mercifully free of the funny-money deals that blighted so many previous efforts.

The spirit of positivity that pervades the Treasurer’s fiscal rhetoric also infects his confidence that the budget will be back to surplus in a year or three, and the debt will one day stop growing. Should this optimism prove misplaced, there’s always scope for adjustment after the election.

The government is rightly proud of all it’s done building new metros, light rail and expressways. But the Coalition’s original desire to get on with a hugely expensive transport infrastructure program while limiting the state’s debt and preserving its triple-A credit rating, led it into crazy arrangements to hide much of the debt by, for example, paying businesses such as Transurban over-the-odds to do the borrowing for it.

Now Sydney, much more than any other city, is girdled by a maze of private tollways, most with a licence to whack up the tolls quarterly or annually by a minimum of 4 per cent a year. What was that about fighting inflation and the cost of living?

This was always a way of keeping official debt down by shifting the cost onto the motorists of present and future decades.

This ill-considered mess has proved so costly to people in outer-suburban electorates that the latest “reform” is for taxpayers to subsidise the worst-affected motorists – and thereby the excessive profits granted to the tollway companies.

Another false economy was to fatten the sale price of privatised ports and electricity companies by attaching to them the right for the new owner to increase prices and profitability. This has played a small part in all the trouble we’re having now making the National Electricity Market work for the benefit of users rather than big business.

In my home town, a formerly secret deal to enhance the sale price of Port Botany is effectively preventing the Port of Newcastle from responding to the looming decline of the coal export trade by setting up a container terminal.

And all that’s before you get to the creative accounting madness of transferring the state’s railways to the still-government owned Transport Asset Holding Entity.

Perrottet, who was up to his neck in that trickery, seems to be making a better fist of Premier than treasurer. And Kean seems a better Treasurer than his many Coalition predecessors. But will that be enough to cover all the missteps of the past?

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Blaming the states for national policy failures won't wash

It seems everywhere you look you see governments failing to lead, failing to take charge, failing to be prepared for problems they should have seen coming.

Last week it was the flooding, before that, the distribution of rapid COVID testing kits and vaccines, before that, the Black Summer bushfires, and before that, soaring prices in the National Electricity Market along with the federal Coalition’s inability to agree on action to reduce greenhouse gas emissions.

The items on this seemingly disparate list have a few things in common. Most arise from the effects of climate change. All of them involve shared responsibility by the federal and state governments, with the all too familiar squabbling, duck-shoving and cost-shifting.

We’re learning hard lessons about what’s needed to get a better-functioning federation. One is that when ordinary Australians are facing dire emergencies of flood or fire or cyclone, they demand that both levels of government be on-the-job doing what needs doing.

Another lesson is that when you’ve got one federal, two territory and six state governments, one of them has to take the lead, and the one that should do so is obvious: the feds.

On climate change, it’s not just that the Morrison government has failed to do anything much to “mitigate” (reduce) our greenhouse gas emissions beyond belatedly accepting the target of somehow achieving net zero emissions by 2050.

It’s also that it has failed to lead the states in adapting to the climate change we already have and, even if we do make it to net zero on time, will get more of: worse and more frequent extreme weather events.

Why does Scott Morrison seem so bad at working on problems we can see coming, until they’ve actually arrived, and we’re in crisis? Then, when we are in crisis, he makes the excuse that it’s a “state responsibility”, which so infuriates the people left stranded by fire or flood.

I think part of the reason is his deliberate downgrading of public service advice on policy. Until recent years, it’s been a prime responsibility of department heads and their senior people to advise the minister of looming problems in their area of responsibility and to develop detailed options on how the feds – often in partnership with the states – could go about fixing the problem.

But when you tell the public servants that you want their diligent obedience, not their advice – as Morrison did – all you’re left with is advice from the growing number of ambitious young Liberal apparatchiks that populate ministers’ offices.

Plus, of course, the occasional expensive report from one of the big four accounting-turned-consulting firms, whose business model is to produce lovely reports with lots of glossy pictures, that tell the paying customer what you think they want to hear.

What they don’t want to be told is that they should get started on a response to this potential problem or that one, just in case they come to a head some time in the future. “That’s the boring stuff public servants are always banging on about, and it’s a real pain.”

“Do you know they’ve been harping on for years about being prepared for some possible pandemic? Yeah, sure. What other long-shot bet do you want me to waste money on? Talk about useless.”

The beauty of getting your advice from the young would-be-pollies in your office is that, like their masters, they’re always focused on the politics of the now. “How can we draw attention away from the latest stuff-up? How can we look like we’re responding decisively? Why don’t we rush through a law making illegal something that already is? The punters would love it.”

As soon as the election is called officially, the public service goes into “caretaker mode” and begins preparing extensive policy recommendations for the incoming government. They prepare a Blue Book to give the Coalition should it win, and a Red Book should Labor win.

The Grattan Institute, our leading independent think tank, has a tradition of preparing its own Orange Book, proposing policy priorities for whichever side wins. It includes a section on energy and climate change, one of the most important areas of shared, federal and state responsibility.

Grattan’s Tony Wood says that, one of the three things that should be done to ensure electricity plays its major role in achieving “net zero” is to “better co-ordinate state and federal government objectives in the National Electricity Market.

“Frustrated at a decade of federal ‘climate wars’, state governments are increasingly going their own way on electricity and gas [and electric vehicles],” Wood says.

That’s another lesson we need to learn: whenever the feds leave a policy vacuum, the states fill it – badly. Only leadership by the Federal government can make our ramshackle federation work.

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More to running the state than keeping a lid on wages and debt

You’d think that, when it came to assessing the performance of a government in power for 10 years, its handling of economic issues would be central. But, in truth, not as central as you’d think. Much that state governments say about their “state economy” is mere boosterism – or another word starting with b.

The present NSW Treasurer, Dominic Perrottet, is no slouch in telling us how well the state’s doing economically. Before the arrival of the coronacession changed his tune, he used to say we had the “fastest-growing state economy over the past five years” and were “leading the nation” in this or that.

He told us about the Coalition’s “strong financial management” which kept the government’s triple-A credit rating secure, had produced a string of budget surpluses and a “negative net debt”.

“The greatest threat to our future prosperity,” he told us, “would be a return to the budget deficits ... of the past”. Ask him about the present huge deficit and the return to positive net debt and he’ll tell you we’d be crazy not to be borrowing when interest rates are at rock bottom.

Several of the big banks regularly rank the eight states and territories according to their economic performance. This is like calling a horse race. At any point in the race, some horses will be ahead and some behind. At a different point in the race, the order will be different. What does this prove? Not much.

Time for some sense. The fact is, many silly claims are made about the “state economy” because there’s no such animal. The lack of hard economic borders between the states means there’s one, national economy, with eight corners.

The national economy is managed nationally from Canberra and Martin Place, not Macquarie Street (the Reserve Bank, not the NSW Parliament). Interest rates don’t vary by state, nor the rates of income tax, company tax or the GST.

With a few exceptions – mining and financial and professional services – the industry composition of the states is very similar. The feds carefully divide the proceeds from the GST between the states in a way intended to minimise difference in the quality of public services provided by them. The wealthier states subsidise the poorer ones.

The states have responsibility for public health and hospitals, schools, law and order, roads and transport, planning and local government. But they each deal with them in much the same way.

And, in any case, because NSW accounts for about a third of the nation’s population and economic activity, its performance is rarely far from the national average.

All this explains why talk that purports to be about the management of the state’s economy ends up being about the government’s management of its own finances, as shown by its budget and annual capital works program.

Perrottet and his predecessors are terribly proud of their success in limiting the growth in government spending but, since the wages of state government employees account for well over half that spending, they’ve achieved this mainly by keeping a tight 2.5 per cent cap on annual wage rises and using the excuse of the coronacession to freeze state workers’ wages.

Trouble is, this is a two-edged sword. Every dollar the government doesn’t pay its workers is pretty much a dollar they don’t spend on the products of the state’s businesses. What’s more, there’s evidence that keeping the lid on public sector wages encourages private sector employers to give smaller increases. Screwing down wages is the way to grow the economy?

The Coalition boasts it’s spending a lot more on infrastructure – particularly motorways and railways – than its penny-pinching predecessors. True. Much more. Labor allowed a bunch of discredited American rating agencies to dictate how much it could spend on infrastructure, for fear of what its political opponents would say if it lost its triple-A rating.

This government is no braver, but got the bright idea of “asset recycling”. You privatise government businesses – the electricity companies, ports, buses, ferries, the lottery office, whatever – then use the proceeds to build new stuff without upsetting the Yanks.

Trouble is, the government decided to “fatten the pig for market”. To maximise the sale price of the electricity businesses, it created arrangements that allowed the new owners to put up their prices. When it sold Port Botany and the Port of Newcastle, it did what was intended to be a secret deal where, if the new Newcastle owner decided to build a container terminal in competition with the new owners of Botany, it would have to pay compensation.

So the government got great sale prices at the expense of the state’s electricity users, people who hate all the container trucks rumbling through Sydney streets on their way north, and Novocastrians (including me) who worry about where the jobs will come from as the world stops buying our coal.

Sorry, I can’t say I’m wildly impressed by the Coalition’s decade of financial dealings. Too many bankers, not enough economists.

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Perrottet uses no-probs rhetoric to hide fiscal stimulus

If you’ve ever got a dodgy proposition you want spruiked, see if you can get NSW Treasurer Dominic Perrottet to do it.

His budget offers the most optimistic view of the next four years, leading our state to a new Golden Century (and here was me thinking the Golden Century was where Sussex Street Labor went for a Chinese meal).

Behind all Perrottet’s bravado, however, he has taken his lumps, using his budget to absorb some of the economic pain and keep stimulating the state’s slowing economy.

Which makes him much less in denial than his federal counterpart, Josh Frydenberg, who despite all the bad news we’ve had about the national economy since his budget in April, says he’s pressing on with returning the federal budget to surplus.

The stark truth, from which Perrottet was trying to distract attention, is that the NSW economy is well past its peak. It will be many years before yet another housing boom brings back such good times.

The real question is just how far the economy will deteriorate before it levels out. Perrottet sees it slowing only to annual growth of 2.25 per cent in the financial year just ending and going no slower in the coming year, before bouncing back to its average rate of 2.5 per cent in the following years.

In other words, the present sharp slowdown will prove to be just a blip in our inevitable progress onward and upward. Like Frydenberg, Perrottet is a member of the “back-to-normal-in-no-time” party.

Let’s hope their optimism is right. I doubt we’re that lucky.

Perrottet makes much of the unusually strong growth in employment – and unusually low rate of unemployment – we’ve seen in recent years, with NSW performing better than most other states.

What he doesn’t mention is that, according to his own forecasts, those days are past. Employment may have grown by 3.25 per cent in the financial year just ending, but in the coming year growth will slow to 1.5 per cent, and a fraction less in subsequent years.

On the other hand, while the labour market is weakening, we’re told, wage growth will be strengthening, growing 0.75 percentage points faster than consumer prices in the year just ending and pretty much for the next three or four years.

Why so confident of stronger wage growth? Because, if it doesn’t happen, consumer spending will fall in a heap and so will the economy overall.

It’s when you come to his budget that Perrottet’s actions speak louder than his happy words. Having achieved years of huge budget operating surpluses when the housing market was booming and collections of conveyancing duty were overflowing, he’s now repeatedly revised down his expected surpluses as the extent of the housing bust has become apparent.

Had he been as obsessed with budget surpluses as his federal colleagues, he could have sought to limit the fall by cutting expenses but, even in this post-election budget, cuts in government spending are minor.

And, unlike other state governments, he has resisted the temptation to lower the 2.5 per cent government-imposed cap on public sector wage rises. Rather, the government will press on with its election promises to hire more than 14,000 extra teachers, nurses, health professionals and police over the next four years.

State governments regularly run operating surpluses to help fund their annual investment in infrastructure and other capital works. Perrottet increased infrastructure spending by 47 per cent in the financial year just ending and plans to increase it by a further 25 per cent in the coming year. This will increase the state’s expected overall (not just operating) budget deficit (repeat, deficit) to $14.5 billion in 2019-20, up from $2.8 billion two years earlier.

Perrottet estimates that this investment spending will account for about 0.5 percentage points of the state’s expected economic growth of 2.25 per cent in each of this and the coming financial years.

He may talk the same see-no-evil talk as the federal treasurer, but he seems to know a lot more about how you keep the economy growing in tough times.

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Budget Office finds the bigger picture is looking OK

There’s a weakness in the way we think about the government and its effects on the economy that economists and politicians usually don’t see. We draw macro conclusions from micro data because we forget the need for what accountants call “consolidation”.

The problem arises because we keep forgetting that the responsibility for governing Australia is divided between the federal government and eight state and territory governments – not to mention any amount of local councils.

Yet most of us focus only on the federal government’s budget when we want to know what’s happening at the “macro” (national or economy-wide) level, and on our own state government’s budget when we when want to know what’s happening at the “micro” (individual component) level.

Because we think – correctly – that responsibility for managing the macro economy rests with the federal government, and also that the feds’ budget is one of their main instruments for influencing the economy, we study the federal budget in great detail and forget that the eight state budgets also have big economic effects.

It’s when you remember this that you realise the federal budget is micro (part of the total picture) not macro (the whole picture).

We’re bamboozled by the existence of different legal entities, each producing their own accounting statements, even though the economy – a common market between eight states and territories – recognises no legal barriers between its components.

Sometimes this causes us to mislead ourselves, other times it gives the politicians from each level of government much scope for misleading us.

For instance, a federal treasurer bent on showing that our public debt isn’t high by international standards, shows us a graph which compares our federal public debt with other countries’ total public debt.

Similarly, a premier whose state is growing faster than others will claim all the credit. If it’s growing more slowly than the national average, they’ll find some reason to blame it on the feds.

Although it’s true that each state has a different combination of industries, and some states are a bit better governed than others, because Australia is a common market the greatest influence on the economic performance of any state is usually the performance of all the other states.

And, at any point in time, the government whose policies are having the greatest influence on a particular “state economy” is usually the federal government.

It’s partly because we focus on bits of the national economy rather than the whole that politicians – federal and state – put so much effort into shifting costs to the other level of government. (The bigger reason, of course, is that it saves them money.)

Or appears to. A less-remarked flaw in Tony Abbott’s reviled first budget in 2014 was that much of its cost savings involved shifting unchanged costs to other budgets: massive cuts in grants to the states for public schools and hospitals. Abbott’s successors have been backpedalling on those supposed savings ever since.

By contrast, most big listed companies consist of a group of many (mainly wholly-owned) separate legal entities. This is why company law has long required them to publish their financial statements on a “consolidated” basis.


When you combine the accounts of, say, 20 companies into one, you have to eliminate the overlap between them, ensuring nothing’s counted more than once. Money transferred between subsidiaries “washes out”.

The closest we come to a consolidated financial statement for our nine governments – showing us the full picture - is the federal Parliamentary Budget Office’s recent innovation of an annual “national fiscal outlook” using the nine governments’ latest budgets. The report for 2018-19 was published last week.

It’s not a full consolidation because it doesn’t show us total government spending by function. So it doesn’t correct the misperception that spending is dominated by social security payments.

Combine federal and state spending and you see the big ones are health and education.

Because the states use accrual accounting, whereas the feds keep the focus on cash accounting, a federal budget balance can’t be compared with a state budget balance.

Putting them on the same accrual basis (but taking government projections at face value), the consolidated budget balance (the "net operating balance") reached zero last financial year and over this and the next four years is projected to reach a surplus of $46 billion.

Consolidated annual net capital investment is projected to peak at $32 billion this financial year and fall to $28 billion by 2021-22 (though this misses the feds' creative accounting on new airports and inland railways).

Consolidated net public debt is projected to grow by $51 billion to $414 billion in June 2022.

Even so, by then our consolidated net public debt should be about 20 per cent of gross domestic product, compared with Britain’s 75 per cent and America’s 80 per cent.

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How micro reform of electricity has failed

The soaring price of electricity is testament to the disastrous failure of a major item on the 1990s agenda of micro-economic reform – establishing a national electricity market.

In practice, nothing worked out the way the reformers' economic textbooks told them it would.

The failure occurred because the people charged with implementing the reforms – governments and their bureaucrats – did so in ways that defeated the object of the exercise.

They either had ulterior motives, or people charged with regulating the national market in the interests of consumers were "captured" by the big businesses they were regulating.

These are the conclusions I draw from the exposition of the market's many problems given by Rod Sims, chairman of the Australian Competition and Consumer Commission, in a speech this week.

Before reform began, the electricity industry consisted of separate state government-owned monopolies, each generating, distributing and selling electricity, with little trading of power between them.

The reformers' idea was to get a competitive market going, with individual power stations across the eastern states competing to sell electricity into a national grid, and competing electricity retailers at the other end buying the power and selling it to households and businesses.

There was no reason the power stations had to be government owned, so they could be privatised, as could the retailers. New retail firms could be allowed to compete with the big privatised retailers.

The transmission and distribution networks remained natural monopolies, of course, but there was no reason they too couldn't be privatised – provided there was regulation of the prices they could charge.

Victoria's Kennett government was the first to sell off everything in 1994, joined much later and more hesitantly by South Australia, NSW and Queensland.

The consumer price index shows retail electricity prices have doubled in real terms over the past decade, whereas the competition commission's calculations show the average retail consumer's bill has increased by "only" about 50 per cent in real terms.

Three main factors explain the difference. First, the price index is based on the retailers' "standing offer" price, whereas some households have taken advantage of cheaper offers.

Second, many households have responded to price increases by finding ways to reduce the amount of electricity they use, thus reducing the increase in their quarterly bills.

Third, many households with solar panels buy a lot less power from the grid and many get unrealistically high credits for the power they put into the grid.

Sims' people estimate that, of the total increase in household power bills, 41 per cent is explained by increased charges for the distribution network, 19 per cent by increased "wholesale" prices for power generation, 24 per cent by increased retail costs and profit margin, and 16 per cent by the increased cost of the renewable energy target and household solar power incentive schemes.

The excessive increases in charges by the natural monopoly distribution networks of poles and wires occurred because, about a decade ago, the state governments – which owned most of the network businesses and greatly profited from them – succeeded in weakening the rules for regulating their prices.

Some states also lifted their standards for avoiding blackouts to unrealistic levels, thus allowing their networks to increase the cost base on which they get a set rate of return.

When a regulator tried to stop the networks charging for "inefficient costs", the NSW and ACT governments took her to court and got her stopped. Although the NSW government was in the process of privatising its networks, it wanted to preserve their profitability so as to maximise their sale price.

For most of the past decade, the highly sophisticated wholesale market designed by the reformers worked well, keeping prices low while generating capacity exceeded demand.

But now that's changed as ageing coal-fired generators are closed and aren't sufficiently replaced by new generators because of the "regulatory uncertainty" created by the present federal government and its climate-change deniers.

Apart from the contribution the misregulation of the gas market is making to higher wholesale electricity prices, prices are also rising because two or three big companies – Origin, AGL and Energy Australia – have been allowed to dominate both the wholesale and retail ends of the market.

Reformers' models always envisage a market composed of a large number of firms competing vigorously on price, but it hasn't worked out that way. It's taken less than a decade for the national electricity market to become oligopolised, giving the few big firms greater pricing power and ability to induce regulators to "see it my way".

State governments have been happy to sell businesses to the aggrandising oligopolists because they offered higher prices than other buyers. The competition commission's efforts to block these takeovers were unsuccessful.

Meanwhile, the oligopolists were figuring out ways to game the wholesale bidding system.

Retail electricity prices were regulated for many years, but the reformers persuaded state governments to deregulate them since competition between the many electricity retailers could be relied on to keep prices in check.

It hasn't worked out that way. Oligopolistic firms are adept at non-price competition, and so it's proved.

The commission's estimate that 24 percentage points of the overall increase in real power costs have come from the retail level breaks up into 7 points for higher profit margins and a remarkable 17 points for higher costs – mainly, I presume, the costs of marketing, advertising and sales people to flog an essential service. Remarkable.

Being entirely a creation of government policy, the national electricity market is heavily regulated by at least three agencies.

But the regulators have been surprisingly slow to recognise that the market is falling far short of what the reformers promised, and also slow to implement their corrective actions.

They've been far more conscious of the need to avoid annoying the oligopolists than the need to stop consumers having to pay more than they should.

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Baird's budget is the model of conservatism, not reform

If, in these strange times, you have ever wondered what a genuinely conservative government would look like, consider the Baird government as revealed by its budget.

Premier Mike Baird and his Treasurer, Gladys Berejiklian, are cautious and responsible to a fault, putting retention of the government's AAA credit rating above all other objectives.

But, almost by definition, this makes them complacent, unimaginative and lacking in initiative. They are also claiming far too much of credit for the NSW economy's strong performance in recent years, especially relative to the other states.

It's true the state economy has been performing much better. But though the Coalition government has done more to help than to hinder, most of what happens in the economy is outside its puny control.

It's swings and roundabouts. Sometimes other states are growing more strongly than we are; at others - like now - it's our turn to lead the pack. In this our tendency to recurring property booms is a great help (though not to first home buyers).

Berejiklian tells us that "since coming to office in 2011, the NSW government has created 338,600 jobs". Really? Private enterprise played no part in it, eh?

Over the past year, we're told, NSW has created more jobs than any other state and now has the nation's lowest unemployment rate.

True. But what's equally true is that NSW has the lowest proportion of its population in employment - 60.7 per cent, against a national average of 61.1 per cent.

The economy's strong, property-fuelled growth, combined with the effects of privatising various government businesses, has led to rapidly rising budget revenue.

By maintaining fairly tight controls on government spending - particularly on the wages of government employees - Berejiklian has achieve ever-growing budget surpluses.

These surpluses have allowed a big increase in spending on infrastructure without much increase in government debt, thereby preserving our top credit rating.

With so much expansion and renewal of infrastructure needed, a government so well-placed financially and politically could afford to defy the strictures of the discredited American ratings agencies, but that's not the conservative way.

A truly conservative government is largely content with the world as it is and leaves "reform" to the radicals on the other side.

That's certainly been this government's approach. This budget only now honours an eight-year-old commitment to abolish three minor taxes on business transactions.

The government has done so because it has belatedly realised it could make up most of the lost revenue by imposing extra conveyancing duty and land tax on foreign purchasers of real estate.

Is this economically efficient? Does it fit with all the Coalition's talk about the need to encourage foreign investment?

Who cares? The government knows the impost on foreigners will be popular with voters, and is (rightly) confident it will do little to discourage investment - meaning, however, it will do little to make homes more affordable to locals.

Where did this bright idea come from? Although Berejiklian claims NSW is "leading the way in innovation" it came - as did other tax reforms adopted - from those hopeless Victorians. And Queenslanders.

This budget will keep us well away from financial bother. But it could have been much better.

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Two-speed economy has gone away

Remember the two-speed economy we used to hear so much about? Well, no one in the media has thought it worth mentioning, but it's gone away.

It's remarkable how the media can get so excited about some "problem" but then never mention it again.

The two-speed economy was caused by the first two stages of the resources boom, of course, with the high commodity prices and mining investment boom causing the resource-rich states to grow much faster than the other states. The others were held back partly by the boom-caused high dollar making life much harder for trade-exposed industries such as manufacturing and tourism.

According to an article by Sam Nicholls and Tom Rosewall in the latest Reserve Bank Bulletin, Western Australia's real gross state product grew at an average rate of almost 5 per cent a year after 2003-04, and Queensland's grew at 3.5 per cent, compared with 2.5 per cent or less in the other states.

But with commodity prices coming down (and state governments' mineral royalties falling) and construction projects winding up, the mining states' economies are now growing more slowly.

The boom is now in its increased production phase, but this is much less labour-intensive than building new mines and natural gas facilities, meaning less money stays in the state economy rather than going to foreign owners.

Meanwhile on the other side of the fence, the Reserve Bank's bargain-basement level of interest rates has helped consumption spending and home building to grow a bit more strongly in the other states, particularly NSW and Victoria.

With their tax receipts boosted by much higher conveyancing duty from their housing booms, the NSW and Victorian governments won't keep such a tight rein on budget spending.

The dollar has now fallen a long way (though its decline has been inhibited by the "quantitative easing" – money creation – in most of the major advanced economies) and this is starting to revive manufacturing and tourism.

Differences in each state's industrial composition, as well as differences in their rates of population growth, mean the states never grow in lock-step. Barring commodity booms, the nationwide growth rate is rarely far from the growth rates in NSW and Victoria, simply because these two states constitute more than half of national gross domestic product.

We're returning to that more usual state. Nicholls and Rosewall examine the "standard deviation" in GSP growth rates as a summary measure of the degree of variation in growth across the states. They find it has declined recently to be only a little above its long-run average.

Another way to compare the states' economic performance is to look at differences in their rates of employment growth and levels of unemployment, though you have to remember to allow for differing rates of population growth.

Doing this shows that "the variation in state unemployment rates has declined recently, to be well below its average level since 2000", the authors say.

Of course, although the states may now be growing at more similar rates, a decade of disparate growth can't help having a big effect on each state's share of the total Australian economy.

Are you sitting down? Over the 10 years to 2013-14, WA's share has increased from 11 per cent to 17 per cent. Amazing. And get this: WA now has by far the widest gap between its share of the economy and its share of the nation's population, just 11 per cent.

Queensland's economic share has increased by 1 percentage point to 19 per cent. (Mining accounts for a much smaller share of Queensland's economy than of WA's, and the Sunshine State is also more dependent on tourism, which was hard hit by the high dollar.)

The Northern Territory also benefited greatly from the mining boom, with its share of the national economy increasing by about a quarter. In absolute terms, however, it remains tiny.

But if the mining states' share has grown, the other states' shares must have shrunk. In round figures, NSW's share is down 4 points to 31 per cent and Victoria's is down 2 points to 22 per cent. South Australia's and Tasmania's shares are down a combined 1 point to 6 per cent and 2 per cent.

Now let's look at differences in the states' industrial structure. Although most industries' share of each state's economy is similar, there are some big differences, particularly in primary industry.

Mining accounts for a remarkable 30 per cent of WA's economy and 9 per cent of Queensland's, compared with about 2 per cent in the other states.

Agriculture accounts for 8 per cent of Tasmania's economy and 5 per cent of SA's, compared with a national average of 2 per cent.

Victorians see their state as heavily dependent on manufacturing but in truth it accounts for 7 per cent of their economy, the same as for NSW and not far from the national average of 6 per cent.

With NSW fancying itself as the nation's financial capital, it shouldn't surprise that "business services" – financial and insurance services; professional, scientific and technical services; media and telecommunications – make up 30 per cent of its economy.

What may surprise manufacturing-mesmerised Victorians is that they're not far behind at 27 per cent. This compares with shares ranging from 19 per cent down to 14 per cent in the other states.

A last startling statistic. Because our exports are dominated by minerals and energy, and because WA has such a large share of the nation's mining industry, the authors estimate that with just 17 per cent of the economy, WA supplies a stunning 43 per cent of our exports.

No wonder the Sandgropers like to imagine the rest of us are bludging off them.

But it's a mercantilist fallacy that nations make their living by selling things to other nations (and importing as little as possible). Selling goods and services to other Aussies is no less virtuous.

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State governments don't greatly affect the economy

With the election over, Sunday is the first day of the rest of the life of the NSW economy under the new Baird government. So how much has changed?

A lot less than the rhetoric of the election campaign may have led you to expect.

State elections are times when governments claim the credit for all the good things happening in the economy and get blamed by oppositions for all the bad things.

In truth, they should get only some of the credit or blame. That's because there is really no such animal as the NSW economy.

There are no barriers between NSW and the other states and territories, meaning it's just the NSW corner of the national economy.

So the government agencies with the most influence over our corner are the Reserve Bank and the federal government.

It is true the NSW economy has grown relatively strongly since the O'Farrell-Baird government took over four years ago. We were performing poorly compared with other states, but now we are doing best in various categories.

But that's mainly because market economies are cyclical: what goes up must come down, and what is down will go back up soon enough.

What came down was Western Australia and Queensland as the mining construction boom came to an end. What went back up was NSW and Victoria as things got back to normal.

Because NSW is by far the largest of the states, it is rarely far from the national average, and often a bit above it.

But the Coalition's economic policies have been good and it can take some of the credit for our improved performance.

Historically, NSW has had trouble building enough new housing to accommodate the state's growing population, a problem that does much to explain Sydney's exceptionally high house prices – and one the state government can do much to improve.

The undue regulation and high charges on developers have limited the supply of new homes on the outskirts of the city, and planning restrictions have permitted too little of the medium and high-density in-fill home buyers are demanding so as to be closer to jobs.

But a lot more homes are now being built, for which Mike Baird should get credit. This higher level of building is likely to continue.

State governments have no control over immigration and national population growth, but are responsible for solving the growing social and economic problem of traffic congestion and long commute times.

Both sides of politics have neglected the development of public transport. And road projects such as WestConnex are likely to offer only temporary relief.

The state's performance on employment has improved relative to the other states, but worsened with the national performance in recent years.

It will continue slowly worsening until the national economy picks up speed. Schemes offering payroll tax incentives to encourage businesses to increase employment are gimmicks to impress voters at election times.

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A rational analysis of Hockey's 'asset recycling'

I'm never sure who annoy me more, the business types who are certain every business is better run if privately owned, or the lefties who oppose every sale of government-owned businesses on principle.

On the question of privatisation, mindless prejudice is no substitute for rational analysis of the pros and cons. On the tricky question of the "asset recycling" being promoted by Joe Hockey to all state governments with businesses left to sell, careful analysis is essential.

Premier Mike Baird's hugely controversial proposal to sell most of NSW's electricity transmission and distribution network businesses – the "poles and wires" – and use the proceeds to finance $20 billion worth of public transport, road and other infrastructure is a classic example of asset recycling.

It offers a good case study in thinking through the issues, even to people who won't be voting in Saturday's state election.

You must cover all the relevant major considerations for and against, ignoring considerations that aren't relevant (or are common to both alternatives). You have to remember to take account of opportunity costs as well as actual costs and to avoid any double counting.

It will avoid confusion if we consider the two sides of the proposition separately. First, is it a good idea to sell the poles-and-wires businesses to private owners? Second, assuming the planned infrastructure projects are worthwhile, is privatising businesses the only way available to finance them?

The obvious starting point for consumers is: would selling the businesses lead to electricity prices being higher than they would be under continued public ownership? Or would there be a decline in the quality of service, such as blackouts?

In this particular case, the answers are more certain than usual: no and no. That's because, the networks being natural monopolies, the prices they charge are controlled by the Australian Energy Regulator, which believes they're already too high. Service quality is also tightly regulated.

The regulator's determination to get efficiency up and prices down suggests there will be job losses – in other states as well as NSW – whether or not the businesses are privatised.

This being so, the main issues of contention concern state government finances. The critics of privatisation stress that it's no magic pudding: sell these profitable businesses and you lose the dividends they were paying the government, along with the equivalent of the company tax they were paying to the state (because state-owned businesses don't pay tax to the federal government).

That's obviously true. But remember that, according to economic theory, the sale price of any business should be the "present value" of the stream of income it's expected to earn in coming years.

If so, the seller is perfectly compensated in the sale price for the loss of future dividends. Why else would they sell?

But does the theory work in practice? Not perfectly. For one thing, who can be sure what income will be earned in the future? The seller ought to have a better idea than the buyer, but if there aren't many potential buyers and the seller is anxious to sell, they may settle for less than they should.

Alternatively, if there are a lot of potential buyers, the seller may get more than the business is worth. Almost all buyers of established businesses are confident they can run it more profitably than the present owner.

Point is, provided the sale price is adequate, there's no financial reason to regret the loss of dividends. A complication is that a fair price would not compensate the state government for its loss of tax equivalent payments.

That's because a new private owner would be liable to pay real company tax to the federal government. This is part of the rationale for Hockey's scheme to give federal grants – $2 billion, in this case – to states that take part in his asset-recycling incentive scheme.

A factor having a bigger (downward) influence on the amount of the fair sale price is that the flow of annual profits from the network business in coming years is likely to be much lower than the recent $1.7 billion a year that Labor's Luke Foley keeps quoting.

That's partly because the regulator has signalled its intention to crack down on the excessive profits being earned by the nation's electricity network businesses, but also because the demand for electricity from the grid is falling and will fall further as people move to solar and the introduction of smart meters helps homes and businesses limit their demand for power.

(This demonstrates the economic truth that natural monopolies are a product of the existing technology. The network businesses' monopoly is being eroded by climate-change-driven technological advance.)

Some critics argue that selling profit-making assets and replacing them with roads and loss-making public transport reduces the state government's "net worth" and weakens its balance sheet.

This is true arithmetically, but is a strange argument. Governments aren't profit-seeking businesses. Their job is to meet the social and economic needs of their community by, among other things, ensuring the provision of adequate infrastructure – directly profitable or otherwise.

Turning to the predicated link between the sale of network businesses and the spending on needed infrastructure, it rests on an assumption it would be unthinkable for the state government to lose its AAA credit rating, which would happen if it simply borrowed another $20 billion.

For decades, federal and state treasuries have used credit ratings to beat off unworthy proposals for vote-buying capital works. But I think we have little to lose by causing the discredited rating agencies to lower our rating by a notch or two.

But though their limit on our debt level may be too low, there does have to be some safe limit. And the doctrine that state governments may acquire assets but, once acquired, they may never ever be sold off, strikes me as weird.

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Why manufacturing in Australia has a future

Few things about the economy are worrying people - particularly older people and those from Victoria and South Australia - more than the decline in manufacturing. But many of our worries are misplaced, or based on out-of-date information.

For instance, many worry that, at the rate it's declining, we'll pretty soon end up with no manufacturing at all. And everyone knows that, unlike other states, Victoria's economy is particularly dependent on manufacturing.

But Professor Jeff Borland, a labour economist at the University of Melbourne, has written a little paper that sheds much light on these concerns.

It's true that manufacturing's share of total employment in Australia is declining. But this is hardly a new phenomenon, which suggests the end may not be nigh. Half a century ago, manufacturing accounted for a quarter of all employment. Today it's 8 per cent.

And almost none of that dramatic decline is explained by a fall in our production of manufactured goods. The great majority of the fall in manufacturing's share is explained simply by the faster growth of other parts of the economy, particularly the service industries.

It's true, however, there's been a (much less dramatic) decline in employment in the industry over the years. Employment in manufacturing reached a peak of 1.35 million in the early 1970s. Today, it's about 950,000. Of the overall loss of 400,000 jobs, about 200,000 occurred during the '70s, about 100,000 in the recession of the early '90s and the rest since the global financial crisis in 2008.

Many people would explain this decline in terms of the removal of protection against imports in the '80s and the very high dollar since the start of the resources boom in 2003. But, in fact, the great majority of it is explained by nothing more than automation.

How do I know? Because if you look at the quantity (or real value) of manufactured goods we produce, it reached a peak as recently as 2008, and has since fallen just 6 per cent. Nowhere have the machines of the computer age replaced more men (and I do mean mainly men) than in manufacturing. Is this a bad thing? It would be a brave Luddite who said so.

The consequence is a change in the mix of occupations within manufacturing, the proportion of machine operators, drivers and labourers falling by 10 percentage points since 1984, with the proportion of managerial and professional workers increasing by about the same extent. The proportion of technicians and tradespeople is little changed.

But there's also been a change in the types of things we manufacture, with the share of total manufacturing employment accounted for by textiles, clothing and footwear falling from 11 per cent to 4 per cent since 1984, while the share accounted for by food products has risen from less than 15 per cent to more than 20 per cent.

The share of transport equipment (cars and car parts) is down, but the share of other machinery and equipment is up by much the same extent.

The next thing that's changed a lot since 1984 is the location of manufacturing in Australia. Then, almost 70 per cent of manufacturing employment was located in NSW and Victoria; today it's down to 58 per cent. Then, NSW had more manufacturing workers than Victoria; today they have 29 per cent each. (Bet you didn't know that.)

But if the big two states now have smaller shares, which states' shares have grown? The two we these days think of as "the mining states". Western Australia's share has risen to 10 per cent, while Queensland's share has almost doubled to 21 per cent. (Bet you didn't know that.)

So far, South Australia's share of national manufacturing employment has fallen only a little to 8 per cent.

This tendency for manufacturing's distribution between the states to become more even over time, plus the much faster growth of other industries, has made all states less dependent on manufacturing for employment, as well as narrowing the gap between the most dependent (SA on 10 per cent of its total employment) and the least (WA on 7 per cent).

Whereas in 1984 Victoria depended on manufacturing for 21 per cent of its jobs, today it's 9 per cent. (See what I mean about out-of-date information?) Victoria's more dependent on the health industry (12 per cent) and retailing (11 per cent), with almost as many jobs in professional services as in manufacturing.

The wider conclusion is that, though the faster growth of other industries has made all states less dependent on manufacturing for jobs, this doesn't mean manufacturing's dying. Its actual output hasn't fallen much, though it's using fewer workers to produce that output.

The unwritten story is there've been big changes in what Australia's manufacturers produce: less stuff that relies on protection against imports and more stuff that fits with Australia's comparative advantage. You see that with food products - including things such as wine-making - now being the biggest category within manufacturing, employing 20 per cent of all manufacturing workers.

You see it also in the growth of manufacturing employment in the mining states - a spillover from the resources boom.

Manufacturing is undoubtedly suffering from the high dollar. But, apart from that, it's in good shape. It has shed some fat and is fitter and wirier than it has ever been, better able to survive in a harsh world.

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How six states became one economy

It's been a year of anniversaries: 50 years since The Australian Financial Review became a daily, 30 years since the floating of the dollar, 21 years since the Council of Australian Governments replaced the special premiers' conference and 15 years since the start of the national electricity market.

In the Fin Review's self-congratulatory anniversary edition - apparently, the paper brought about micro-economic reform single-handedly - one of my old bosses, Vic Carroll, made a point most of us have forgotten, if we ever knew.

Before Paul Keating began opening Australia to the world in the 1980s, we first needed to break down the barriers between the six states to get one national market. In theory we've had a common market since Federation; in practice it didn't start until the 1960s.

We had separate stock exchanges and even big companies tended to stick to their own state. Coles and Woolworths didn't start to invade each other's home states until the 1960s. The big banks were concentrated in their home states until eight merged to become four in the early 1980s.

For many years the brewers defined much of the Riverina as part of Victoria and thus out of bounds to Sydney-based Tooth and Co. It took the Trade Practices Act of 1974 to make agreements on competition-reducing territorial carve-ups illegal.

A main role of COAG has been to gain agreement between the states to align their regulation of markets and in other ways facilitate cross-border trade. Progress has been painfully slow and at Friday's meeting it gave up trying to introduce a national occupational licensing scheme.

But that makes COAG's initiative of establishing a national electricity market (covering all states bar WA) in 1998 the more remarkable. Before then, we had six separate, state-owned vertically integrated monopolies.

The Australian Energy Market Commission has celebrated the national market's 15th anniversary by commissioning KPMG consultants to prepare "a case study in successful micro-economic reform". The idea was to record the insights of key players before they were carted off to retirement homes.

It took eight years of preparation before the market began. Step one was for each state to break its monopoly electricity commission into separately owned power generators and separately owned electricity retailers, leaving the transmission and distribution network ("poles and wires") as the irreducible natural monopoly.

The generators could be made to compete with each other (and probably privatised) and the retailers made to compete with each other (and privatised) by giving them equal access to the network.

The hard part was setting up the continuously trading wholesale auction market in which competing generators supply power to competing retailers. Once the state networks had been physically connected to a single grid, this was made possible by the "fungibility" of electricity. If one unit of power is identical to any other, I don't have to actually generate the power I end up selling you.

That's handy, but it makes the market, with all its derivative contracts, horrendously complex. Its smooth operation is a notable tribute to the economist's art: it's a quite artificial, geek-designed, government initiated and regulated market. T. Abbott and other sceptics please note.

The case study should prove a useful guide to would-be reformers. One tip is that this radical change was achieved through many small steps. Each state set up its own market before they merged into one after many trial simulations.

Though the federal government had no responsibility for electricity, it was deeply committed to micro reform and, since it would benefit from higher tax collections, transferred these to the states as incentive payments for reforms achieved.

No business people or economists need telling that many people find money highly motivating. Premiers more than most. But the study warns "there are risks that the incentive becomes payment maximisation rather than policy optimisation".

Likewise, establishing a competitive industry structure must take precedence over doing things to maximise the proceeds from privatisation. "Incentive payments are not a substitute for mutual commitment to policy outcomes," we're told.

Careful planning, widespread consultation and good processes are all necessary, but the study emphasises the key role of committed leaders. At the political level, reform was pushed by Bob Hawke and Nick Greiner, by Paul Keating and Jeff Kennett, then by John Howard.

But the person who deserves greatest approbation was the chairman of the National Grid Management Council, John Landels, formerly of Caltex. His strengths were he was beholden to no one, kept the board focused while letting the technocrats get on with the details, and he had pull with prime ministers and premiers. And I doubt he was doing it for the money.

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The two speeds not as far apart as claimed

Some people spent much of this year worrying about how the two-speed economy was affecting the south-eastern states. There was concern Victoria was on the brink of recession and South Australia and Tasmania were already in one.

So when, a week or two back, the Bureau of Statistics finally published the figures for the real growth in the various states' gross state product last financial year, 2011-12, there would have been great interest from the media, right?

Wrong. The only definitive figures we've had for economic growth by state for the past 12 months went virtually unreported.

Why? Because they were a bit dated? No. More likely because they showed no sign of recession. They also showed the gap between the fast and slow states to be narrower than we'd been led to believe.

Turns out we did a lot of worrying for nothing, misled by figures we should have known are always misleading.

The unreported figures show Victoria's gross state product grew by 2.3 per cent for 2011-12 as a whole, just a fraction less than NSW's 2.4 per cent. South Australia grew by 2.1 per cent and even Tasmania pushed ahead by 0.5 per cent.

By contrast, Queensland grew by 4 per cent and Western Australia by 6.7 per cent. Overall, gross domestic product (the national measure) grew by a respectable 3.4 per cent.

A point to remember, however, is that the populations of the states are growing at quite different rates and this accounts for part of the difference in the rates at which their economies are growing. Only to the extent a state's gross state product per person is increasing is it better off materially.

Nationally, economic growth of 3.4 per cent in 2011-12 drops to 1.8 per cent per person. Queensland's growth drops from 4 per cent to 2.2 per cent, while WA's drops from 6.7 per cent to 3.7 per cent.

Not quite so much cause for envy.

If you recollect reading during the year figures a lot more dramatic than these, you're right, you did. As I say, definitive figures for gross state product are published only once a year, on an annual basis. The figures the bureau publishes each quarter as part of the national accounts are for something quite different: state final demand.

These figures are always widely reported by the media, with journalists happily assuming SFD and GSP must surely be pretty much the same thing. Trouble is, they're not. And the media's insistence on reporting these largely meaningless figures means the public is regularly misled about the extent of differences between the state economies.

State final demand and gross state product would be pretty much the same thing if the states' shares of Australia's exports and imports never changed and, more to the point, if there was no trade between the states.

It shouldn't surprise you there's a lot of trade between the states. Nor should it surprise you the mining states import a lot more from the other states than they export to them. The other side of the coin is the other states - particularly NSW and Victoria - export more to the mining states than they import.

This trade between the states spreads the benefits of the resources boom around the continent. In consequence, the much-quoted state final demand figures tend to overstate how well the mining states are doing and understate how well the other states are doing.

That's how the recession furphy got started.

Consider this. According to the latest figures for 2011-12, WA state final demand of 13.5 per cent turned into gross state product of 6.7 per cent, while Queensland's final demand of 8.6 per cent was more than halved to 4 per cent.

By contrast, Victoria's final demand of 2.2 per cent was increased a fraction to gross product of 2.3 per cent, while NSW's final demand of 2 per cent was increased to 2.4 per cent.

SA's final demand and gross product were the same at 2.1 per cent (meaning it neither wins nor loses from the inclusion of international and interstate exports and imports), while Tasmania's final demand growth of zero was increased to gross product growth of 0.5 per cent.

You see how misleading those quarterly state final demand figures are. They exaggerate the true extent of the differences between the states.

So why do the media make so much of them? Because, at a time when the resources boom is doing so much to change the industry structure of our economy, there's much interest in what this is doing to the respective sizes of the state economies.

The quarterly state final demand figures don't give reliable answers to this question, but they're the best that regularly come our way.

But also because the ever-intensifying competition between the news media has prompted them to select their news on the basis of all care but no responsibility. If some information is interesting or controversial it will be published, even if the journalists know or suspect it's dodgy. After all, if I don't do it, my competitors will.

The relative sizes of the six state economies have been changing since federation, partly - but not solely - because of their differing rates of population growth. But, though it's possible to exaggerate the extent to which the resources boom is causing the mining and non-mining states to grow at different rates, the states' relative sizes have been changing particularly rapidly in recent years.

Those recent figures no one bothered to report, known as the State Accounts, showed how the states' shares of overall gross domestic product have changed over the eight years to 2011-12.

In that time, NSW's share has dropped 3.8 percentage points to 30.9 per cent. Victoria's share has dropped 2.6 points to 22.3 per cent.

By contrast, Queensland's share has increased 1.7 points to 19.3 per cent, while WA - which long ago overtook SA in the pecking order - had its share increase a remarkable 5.4 points to 16.2 per cent of overall GDP.

That leaves SA's share falling 0.8 points to 6.2 per cent and Tassie's falling 0.3 points to 1.6 per cent. Its share is now less than the ACT's (2.2 per cent) and only a fraction greater than the Northern Territory's (1.3 per cent).

Whether we like it or not, the shape of our economy is changing.

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Why the economy isn't splitting in two

The news from last week's national accounts seemed very clear and very worrying: the economy was splitting in two, with the mining-boom states of Queensland and Western Australia roaring off into the future, leaving the rest of Australia going nowhere fast.

Over the year to December, state final demand grew by more than 11 per cent in WA and by 10 per cent in Queensland, but by about 1.5 per cent in the rest of Australia.

Fortunately, the true position isn't nearly as bad as that, as Kathryn Davis, Kevin Lane and David Orsmond explain in an article in the March quarter Reserve Bank Bulletin, issued this week.

The trick was that label "state final demand". When we talk about "growth" in the context of the national accounts we're talking about growth in (real) gross domestic product - the value of all the goods and services produced by the market during a period.

We focus on production because it's production that creates jobs and generates income. The equivalent of GDP at state level is gross state product.

So if you want to compare how the states are travelling you compare the growth in their GSP.

Trouble is, the Bureau of Statistics doesn't publish GSP quarterly, only annually. What it does publish quarterly is state final demand, the national equivalent of which is "domestic final demand".

Because these are the only figures available, the media (and some economists who should know better) have fallen into the habit of assuming state final demand and GSP are much the same thing.

Wrong. State final demand differs from GSP in one minor respect and one major respect: it takes no account of exports and imports. And that's not just overseas exports and imports, it's also exports and imports between the states.

In other words, when you make state final demand a substitute for GSP you're implicitly assuming each state has no trade with either the rest of the world or even the other states. Or that its trade is always in balance.

Guess what? Make such unrealistic assumptions and you get misleading results.

The authors point out that growth in spending on home building and non-mining investment over the year to December didn't vary much between the states. There were two main differences. One was that whereas consumer spending grew by about 3.5 per cent in NSW, Victoria and Queensland, it grew by 6 per cent in WA.

The other difference was the huge growth in mining investment spending in WA and Queensland. This was what did most to explain why their growth in final demand was in double figures whereas NSW and Victoria's demand growth was so modest.

But here's the point: the Reserve estimates that roughly half the spending on mining investment goes on imported equipment. Take this into account and the gap between the mining and non-mining states gets a lot smaller.

Another factor narrowing the gap is that part of the miners' spending on investment (and their ordinary operations) goes on goods and services, such as accounting and consulting services, produced in other states. And some of the workers who fly-in/fly-out take their income home to other states.

To give you an idea of how the shift from state final demand to GSP narrows the gap between the states, let's look at the most recent figures, for 2010-11 as a whole. The final demand figures show spending growth ranging from 1.4 per cent in SA to 6.5 per cent in WA - a spread of 5.1 percentage points.

But the GSP figures show production growth ranging from 0.2 per cent in Queensland (get that) to 3.5 per cent in WA - a spread of 3.3 percentage points. After WA came Victoria on 2.5 per cent, SA on 2.4 per cent, NSW on 2.2 per cent and Tasmania on 0.8 per cent.

In other words, state final demand provided a quite misleading guide to the states' ranking. Queensland does so well on spending but so badly on production because, though it gains from having a fair bit of mining, it loses from being so dependent on tourism (hard-hit by the high dollar).

In the absence of more up-to-date figures for GSP, the trick is to examine independently estimated direct and indirect measures of state activity. If the mining states really were growing five or six times faster than the other states, you'd expect that to mean they had much lower rates of unemployment and much higher rates of inflation than the others.

It's true WA's trend unemployment rate was a very low 4.1 per cent in February, but the other mainland states were all tightly bunched around the national average rate of 5.2 per cent. As for inflation, over the year to December the mining states had the lowest rates rather than the highest.

If the gap between the mining states and the rest turns out to be narrower than you expected it's because you've been misled by all the talk of a two-speed economy: mining in the fast lane, manufacturing in the slow.

In truth, and as the distinguished economist Max Corden, of the University of Melbourne, reminded us this week, it's actually a three-speed economy, with mining in the fast lane and manufacturing (plus other export and import-competing industries) in the slow lane, but with almost all other industries - the non-tradable sector - in the middle lane.

This matters because the non-tradable sector benefits from the mining boom and the high dollar in two ways: from the increase in national income brought about by the high commodity prices, and from the lower prices of imports brought about by the high dollar.

Guess what? This non-tradable sector accounts for the great majority of production and employment in all states bar WA (where mining accounts for an amazing 33 per cent of GSP).

The people of Victoria see their state as weak on mining (true) and heavily dependent on manufacturing. Not true: manufacturing accounts for 8 or 9 per cent of GSP in all states bar WA (5 per cent). Where Victoria and NSW stick out is in their dependence on the business services sector (particularly financial and insurance services), which accounts for 28 per cent and 30 per cent of GSP, respectively, compared with about 17 per cent in the other states.

It's because business services are mainly in the not-hard-hit non-tradable sector that Victoria and NSW aren't travelling too badly compared with the mining states.

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