This budget less dishonest than last year's

When it comes to forecasting the economy - and thereby the budget balance - the econocrats of the Reserve Bank and Treasury are on a hiding to nothing.

When they get it pretty right that's no better than it should be. But when they get it wrong - for whatever reason - they're fools and probably knaves as well.

The obvious truth is no economists are consistently good at forecasting the economy. It's those non-economists who forget this - including Wayne Swan and Julia Gillard - who are the fools, not the economists who cater to humankind's irrational but unquenchable desire to pretend the future can be known.

Budget week is open season for anyone who can find a microphone to claim Treasury's forecasts are wildly optimistic. But though the econocrats' record is pretty bad, I've yet to discover any non-official forecaster whose record is better.

And whereas the budget-time know-alls are rarely held to account, the econocrats are always accountable. Their forecasts are on the record for the whole world to judge after the event.

The proof of their high standard of accountability is that they often conduct systematic reviews of their forecasting accuracy, which they make public so as to keep themselves humble and to warn users of their forecasts' fallibility.

According to my quick squiz, the leading business economists' forecasts for real gross domestic product are only a fraction lower than Treasury's, but their forecasts for nominal GDP are significantly lower, mainly because they expect our terms of trade (export prices, essentially) to fall by a lot more than Treasury does.

If they are right, you'd expect Treasury's revenue forecasts again to prove too high. But to give the business economists their due, they haven't been trumpeting their differences with Treasury, either for cheap publicity or to prove what fools they are in Treasury.

No, this year the vociferous criticism of Treasury's forecasts and assumptions has come from the Opposition (they would say that), partisan economists and shock jocks who wouldn't know the difference between a forecast and a projection if it bit them on the backside.

The irony is, this is a less dishonest budget than the past few that Swan produced as he realised the long-promised return to surplus in 2012-13 would need help from performance-enhancing accounting.

One trick used extensively last year was to take spending planned for the early weeks of 2012-13 and switch it into the later weeks of the old year, thereby overstating spending in the old year and understating the budget year. Every $1 you switch increases the difference by $2.

This year Swan's creative accounting has been limited to bringing forward $1.1 billion in payments to local government - presumably to hide the fact that the budget year's deficit is actually a little higher than the previous year's.

As every accountant knows, the trouble with shifting expenses is that it comes back to bite you the following year. The government's strategy requires it to limit the real growth in its spending to 2 per cent a year, on average.

The games played in last year's budget caused real government spending to grow by 4.8 per cent the previous year, then fall by 3.2 per cent in 2012-13. But that year's fall means, despite this year's restraint, spending is expected to jump by 4.3 per cent. The comparison would be even worse without this year's fiddle.

Another trick last year was to use Swan's fiscal bulldozer to push spending commitments off into the future beyond the forward estimates, where they became invisible.

This year he's done something new, showing how the offsetting savings (including sinful tax increases) are more than sufficient to cover the growing cost of the disability scheme and the Gonski education reforms, not merely over the forward estimates but over the next 10 years.

Those who think politics but never economics saw this move as a cunning attempt to "wedge" Tony Abbott. If so, it didn't work. But I see it as a marked improvement in budget transparency, needed to prove the fiscal bulldozer had been left in its shed.

The transparency has, however, allowed Saul Eslake, of Merrill Lynch - who invariably produces the most penetrating analysis of the budget - to note that, though the disability scheme will cost only $1.9 billion over the four years to 2016-17, the linked increase in the Medicare levy will raise $11.6 billion in that time.

Eslake says about two-thirds of the net improvement in the budget balance attributable to policy decisions over the four years to 2015-16 comes from this discrepancy.

He further notes that, if you switch your focus from the "underlying" to the "headline" cash balance (thus taking account of the off-budget building of the national broadband network), the budget should still be in deficit in the last two years of the forward estimates.

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Worry more about the economy than the budget

Most of those who take a political approach to the budget assume that if it's in deficit, the way you get it back to surplus is to cut government spending or, if you're a really bad person, increase taxes. They forget it's the budget itself that's supposed to do the heavy lifting.

When the severe recession of the early 1990s turned Paul Keating's budget surpluses into big deficits, he told people not to worry: as the economy recovered, the budget would "whirr back to surplus".

He was right, it did. Only trouble was it took a while to happen, and by then the chap in charge of the budget was Peter Costello - who, as any politician would, took all the credit.

When Wayne Swan and Julia Gillard began predicting the budget would be back to surplus this financial year, 2012-13, they were assuming it would happen pretty much automatically. The budget would again whirr back to surplus after all the weakness of the global financial crisis.

It hasn't happened. As we learnt this week, the budget balance for this year is now expected to be a deficit of $19.4 billion rather than a surplus of $1.5 billion.

Why? Not because the government has continued to spend like a drunken sailor, as some would have you believe, but because the budget didn't whirr back as it was expected to. Rather than growing strongly, tax collections grew by a lot less than expected.

Contrary to what most economists were expecting, when the high coal and iron ore prices feeding the resources boom began to fall back, the dollar didn't fall back with them.

So the miners' profits have fallen, but the high dollar has continued to squeeze the profits of our other trade-exposed industries as well. They haven't been able to earn as much from their exports, nor charge as much for the stuff they sell in our domestic market because imported goods and services have stayed cheap.

So far, this hasn't adversely affected economic activity. The quantity of goods and services we produce (real gross domestic product) has continued to grow at a reasonable rate, but the rise in prices has been weak, meaning nominal GDP hasn't grown as fast as real GDP.

This means we haven't had to worry about inflation, but the profits of our miners, manufacturers and tourist operators (and, for different reasons, our wholesalers and retailers) have been squeezed.

For the budget, it means collections from company tax have grown more weakly than expected, as has the tax on capital gains. (Collections from the new mining tax have been a fraction of what was expected, but for a quite different reason: because the tax was new, Treasury overestimated how much it would raise in its early years.)

So the budget hasn't whirred back to surplus as expected because, for quite unusual reasons, the recovery from the GFC hasn't proceeded normally. The spending and taxing decisions of the government have had little to do with this.

Here's the point: if problems in the economy have prevented the budget from returning to surplus, we should worry about those problems, not the delayed return to surplus.

As the budget papers say: "Fiscal [budgetary] objectives are not ends in themselves. They matter because of their implications for employment, incomes and wellbeing. In essence, good fiscal policy entails allowing the fiscal position [the budget balance] to vary in response to economic conditions in the near term, while ensuring fiscal settings are sustainable over the medium-to-long term."

What causes the budget balance to vary in response to economic conditions are the "automatic stabilisers" built into the budget. They're what does the whirring, pushing the budget into deficit when the economy goes down and pushing it back into surplus when the economy comes back up.

The main built-in stabilisers are the progressive income-tax scale and the availability of the dole but, as we've just been reminded, the other taxes also play a part.

So much for the economy's effect on the budget balance. In budget week we need to look also at the budget's effect on the economy; to assess the "stance of policy" adopted in the budget.

The Reserve Bank's way of doing this is simply to look at the expected change in the underlying cash budget balance, from a deficit of $19.4 billion this financial year to a deficit of $18 billion next year, 2013-14.

But Wayne Swan has fiddled this comparison by taking payments to local councils worth $1.1 billion and paying them in the old year when they weren't due until the new year. If you adjust the figures to remove this fiddle, you get a deficit of $18.3 billion in the old year and one of $19.1 billion in the new. This says the budget overall will have a tiny expansionary effect on total demand in the economy.

The Reserve will take this into account - along with many other factors - when it decides whether a further easing in the "stance" of monetary policy (another cut in interest rates) is needed.

However, the strict Keynesian way of assessing the stance of fiscal policy is to ignore the effect of the automatic stabilisers and focus on the net effect of all the discretionary policy changes announced in the budget.

Doing it this way shows that, after correcting for the fiddle, those changes will add $1.2 billion to the deficit for the old year and $1.4 billion to the one for the new year. This says the policy stance is stimulatory, but only to the tiniest extent (remember, nominal GDP will be $1.6 trillion).

It is true, as you've heard, that the effect of all the spending and tax changes announced this week would (if they are implemented by the government that wins the election) improve the budget balance by a net $28.4 billion over five years.

But this discretionary tightening isn't planned to start until the year after next, 2014-15, by which time we can expect the economy (and the budget) to be a lot stronger.

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Swan's last budget: weird in a good way

This is the weirdest budget you or I are ever likely to see. That doesn't make it bad - just very strange.

With just four months until the election, it's the most unlikely pre-election budget you could imagine, with loads of nasties and next to no sweeteners. It is more like a post-election budget, particularly the kind you get after a change of government.

But its strangeness doesn't end there. The Parliament has so few weeks left to sit, it is likely most of its controversial measures won't become law before the election (with the increase in the Medicare levy the main exception).

That makes it less a budget than an election policy speech. Only if Julia Gillard is re-elected can we be sure the budget measures will become a reality.

And since the chances of Labor's re-election seem low, this is more Tony Abbott's budget than Gillard's. It will be he who decides which measures survive and which don't; whether Labor's last budget becomes anything more than its final, impotent gesture.

Do you think Gillard doesn't know that? This is the budget of a government that knows it's a dead duck.

Usually when governments know they are going to lose, they go for broke, offering electoral bribes they know they will never have to find a way to pay for, aiming to minimise their loss of seats.

Not this time. This budget is more likely to cost Labor votes than win it any.

No, the purpose of this budget is not vote-buying - it is reputation-rescuing, a last-ditch attempt to influence what history will say about the Rudd-Gillard government as an economic manager.

History will be impressed by this budget - and a lot more forgiving of Labor's shortcomings than voters are likely to be on September 14.

At this time in 2010, Wayne Swan seized on a Treasury projection three years into the future and boasted about his feat of returning the budget to surplus in 2012-13.

In the following election campaign, Gillard foolishly turned that long-range projection into a solemn promise.

This time last year, Swan boasted of budgeting for four surpluses in a row, as though they were in the bag. His surplus of $1.5 billion for the financial year just ending is now expected to be a deficit of $19.4 billion (but even that isn't yet certain). This year his boast of being able to get the budget back to a surplus of $6.6 billion in 2016-17 (again on the basis of Treasury's long-range projections) will draw understandable cynicism.

But just as Swan and Gillard should have more sense than to attach much weight to economists' forecasts, so should the rest of us. Treasury's crystal ball will be no more reliable after a change of government. Less initial naivety on the part of the media and the public would reduce ultimate cynicism.

The strength of this budget - should it come to pass - is that Swan has found sufficient saving measures (90 per cent of them tax increases) to cover the cost of the painfully slow phase-in of the disability insurance scheme, the Gonski school funding reforms and other new spending measures.

He has found other savings to make a start on reducing the budget's significant "structural" deficit - the product of excessive generosity by successive governments - and eventually getting the budget back to surplus, but without endangering the economy's tricky transition from mining-driven to consumer and business investment-driven growth over the coming year.

These additional, structural deficit reductions build from nothing in the coming financial year to $6 billion in the following year and $12 billion in each of the next two years. Being saving measures, these figures are less dependent on predictions about the state of the economy and so are easier to believe.

By my rough figuring, they will eventually reduce the structural deficit - that is, claw back unfunded handouts - by about 60 per cent.

It has to be said, however, that few of the nasties in the budget will cause voters to lose much sleep. They are aimed mainly at the well-off and foreign multinationals.

Even so, for a government that's been far too timid in tackling unjustified spending programs and tax breaks, this budget is surprisingly brave.

And if, by being the one to propose last night's unpopular measures, Gillard makes it easier for Abbott to agree to them now or to introduce them after the election, Labor will deserve respect for initiating such a heavily disguised form of bipartisanship.

For what it's worth, this is a good budget. But that is the trouble: under these strange circumstances, it ain't worth a lot.

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Budget becomes Canberra's con job on the nation

Tuesday night's budget may have become the central plaything in the dog fight between Labor and Liberal, but its economic importance is a shadow of what it used to be.

It suits no one in Canberra to admit it - not the pollies of either side, the econocrats, the business lobbyists nor the journalists - but these days the budget is not of great significance in the macro management of the economy.

True, it's still of great newsworthiness because the decisions the government makes about changes to spending programs and taxes do affect the pockets of people across Australia.

And these decisions are of micro-economic significance because they affect the efficiency with which the nation's economic resources are allocated. They also affect the fairness with which income is distributed between low, middle and upper-income households.

But with so many people having made up their minds on whom they'll vote for, and so many of the nasties already leaked to the media (or selectively leaked to the morning papers before being announced the same day), I doubt the budget will have much political significance.

And that's even if, following the usual budget media-manipulation script, the government has held back a few nice measures for the media to give exaggerated attention to on the night.

Even so, Canberra's dirty little secret is that the decisions we'll be making so much fuss about on Tuesday night will have surprisingly little effect on how the macro economy performs over the coming financial year.

That's for two reasons. First, politicians' decisions have much less effect on the budget than the daily decisions made by the 98.4 per cent of Australians living outside the ACT.

If, as seems likely, most of the budget deficit we're told about on Tuesday is accounted for by the "structural deficit" - that is, the net cumulative effect of unwise decisions by governments of both colours over many years - this will prove how much tosh the pollies have been spouting about the bad state of the economy.

Even the government has long been crying crocodile tears about how tough people are finding it to keep up with the rising cost of living. Julia Gillard and Wayne Swan keep doing this because their focus groups tell them the cost of living is all the punters can find to complain about.

They make sympathetic noises even though they know the economic indicators say real incomes are rising, not falling.

The second reason the budget's macro-economic significance is exaggerated by the denizens of Canberra is that, as the fine print in the budget papers admits every year, the primary responsibility for the day-to-day management of macro economy rests with monetary policy (the manipulation of interest rates), which is determined by the Reserve Bank in Sydney without reference to the pollies in Canberra.

It's true changes in the budget balance affect the strength of aggregate demand in the economy, but what the Keynesian Rip van Winkles haven't woken up to is that so do a lot of other things - the exchange rate, for openers.

The point is, the budget is just one of various factors the Reserve takes into account when deciding whether to use its interest-rate lever to stimulate or restrict demand. In other words, monetary policy is the "swing instrument".

Sometimes the Reserve chooses to push in the same direction as the budget, sometimes it chooses to counteract the budget by pushing in the opposite direction (as it did in the Howard government's later years when it was using its budget to worsen rather than improve the business cycle).

Much will be made on Tuesday night of the forecasts for the economy contained in the budget papers. We'll be told how fast Treasury expects the economy, inflation and all the rest to grow next financial year, as though this is news of great significance.

It isn't. Why not? Partly because it's the forecasts of the macro managers that matter and, as we've seen, neither Treasury nor its masters manage the economy. It's the Reserve Bank's forecasts that matter.

Actually, Treasury makes sure its forecasts (which it uses primarily to help it estimate budget spending and revenue) are little different from the Reserve's. Why? Because the Reserve's independence of the politicians makes it the more credible forecaster.

And get this: the forecasts we'll be told about with great fanfare on Tuesday will be old news. Why? Because they'll be the same as the forecasts the Reserve announced last Friday. The economy's growth should average 3 per cent in 2012-13 and about 2.5 per cent in 2013-14. The forecasts for inflation will be 2.25 per cent and about 2.5 per cent respectively.

Why does everyone in Canberra have an interest in misleading us about the budget's macro-economic significance? Because, as the ACT's principal export to the rest of Australia, the budget is how they make their living.

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How to worry about the budget deficit

Far too much fuss is being made about this year's budget because politics has overtaken economics. I'm adding to the fuss, of course, but at least I'm trying to help people assess the economic significance of all the political argy-bargy.

When we see the budget on Tuesday night the deficit is likely still to be very big. How worried should we be about that deficit? And how urgent is it for the government to get the budget back to surplus?

For the politically partisan, these are easy questions. If you're a one-eyed Liberal supporter, any deficit is a terrible thing and it should be eliminated ASAP. If you're a one-eyed Labor supporter, budget deficits aren't a great problem and to reduce them while the economy is in its present state could do great damage.

If you're interested in an economic analysis, however, it's not as simple as the political partisans imagine.

To decide how worrying a budget deficit is you have to know about the state of the economy at the time. This is because - although the political types don't know it, or keep forgetting it - the budget balance at any moment is a product of two different forces: the economy's effect on the budget, on one hand, and the government's effect on the budget on the other.

When the economy's in the upswing part of the business cycle the budget's likely to be in or heading towards surplus. That's because people will be earning more income and paying a lot of tax on it, while others will be finding jobs and going off the dole.

When the economy's in the downswing part of the cycle the budget's likely to be in or heading towards deficit. That's because people will be earning less income and paying less tax, while others are losing their jobs and going onto the dole.

But though the economy's effect on the budget balance via the business cycle is usually the bigger effect, we still have to take account of the government's effect on the balance. The economy's effect is known as the ''cyclical component'' of the budget balance and the government's effect is called the ''structural component''.

The structural component should be the cumulative effect of all the policy decisions the government has made - some going back quite a few years - to change taxes and government spending (although it may also include the effect of changes in the underlying structure of the economy).

The point of all this is that if the deficit at a particular time was largely the product of the weak state of the economy, the weak state of the economy would be something to worry about, but the deficit it produced wouldn't be.

So to decide how worried we should be about the budget deficit we see on Tuesday, we need to know how much of it is cyclical and how much is structural. Whatever part of it is cyclical is justified by the state of the economy and something that will fix itself as the economy strengthens.

If a significant part of it is structural, that could be justified only if the economy was so weak the government was adding its own stimulus to that provided automatically by the budget's ''automatic stabilisers''. (These are built-in elements of the budget - particularly the progressive tax scale and the dole - the operation of which is what creates the cyclical component of the budget deficit or surplus.)

The way economists divide the budget balance into its cyclical and structural components is to work out where the budget balance would be if the economy were running at trend levels - on its medium-term average growth path, averaging out all the ups and downs in the cycle. The extent to which the actual budget balance departs from this trend estimate represents the structural component.

As with so many concepts in economics, the idea's easy to grasp but putting a number on it ain't. You have to make a lot of assumptions and estimates, meaning different economists come up with different figures.

This week Chris Richardson, of Deloitte Access Economics, published his estimates that the overall cash budget deficit will be $22.2 billion for the year just finishing, 2012-13, and $20.2 billion for the coming year.

His corresponding estimates for the structural deficit are $22.8 billion (equivalent to 1.5 per cent of gross domestic product) and $20.2 billion (1.3 per cent). In other words, the overall deficit is totally explained by structural factors.

Note that these figures are on a ''no-policy-change basis''. That is, they're estimates of the ''starting-point deficit'' before the government began deciding on all the policy changes to be announced on Tuesday (and which it has been leaking as part of its media manipulation). Richardson says the small improvement in the structural deficit between the years is probably mainly the result of a year's worth of bracket creep.

Does it surprise you that, according to Richardson's figuring, no part of the overall deficit is cyclical? If it does, it shouldn't. You've been listening to politicking, not reading the economic indicators. Reserve Bank governor Glenn Stevens said this week the economy is growing at only ''a bit below trend''.

And this week we learnt the smoothed unemployment rate has been at 5.5 per cent for three months. Remember, economists regard full employment as an unemployment rate of about 5 per cent.

All this says most of the deficit we see on Tuesday will be structural. As we saw in last week's column, however, much of it will be the legacy of unwise decisions made by the Howard government (including, Richardson reminds us, its decision to stop indexing the excise on petrol, which is now costing about $5 billion a year).

To be sustainable, the recurrent budget does need to be in balance on average over the cycle. It would risk damage to the economy to try to eliminate a big structural deficit in one hit. But that will not excuse any failure by the Gillard government to get on with reducing it.

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The economic geography of big cities

If you've seen those ads the mining industry is running you probably realise the entire economy is riding on the miners' backs, and if asked to pay another dollar more in tax they'll up sticks and shift their mines to some better-run country like Peru or Nigeria.

If you've spoken to a farmer any time in the past 50 years you'll know it's actually farming that's propping the economy.

In either case you'll be surprised to know the truth: according to estimates by the Department of Infrastructure and Transport, 80 per cent of Australia's economic activity takes place in Australia's major cities.

That's because the great majority of us live in big cities. We live there because that's where most of the jobs are. Equally, most of the jobs are where the people live because most jobs involve doing things for people (such as bringing them the news).

But it's not by accident that so many of us happen to be piled into a handful of cities (as are people in all developed countries and, increasingly, many developing countries). We pile together because it's more efficient economically, thus making us more prosperous.

For one thing, it saves on transport and other distribution costs. For another, outfits such as hospitals and schools - even shopping centres - gain economies of scale when they have more people to serve.

But that's just the start of the "economies of agglomeration", as Jane-Frances Kelly and Peter Mares point out in their report for the Grattan Institute, Productive Cities.

We're used to dividing up the economy by sector - agriculture, mining, manufacturing and the big one, services - and focusing on how these sectors' shares of the economy are changing. But this blinds us to an important development.

"One of the most significant long-term shifts in advanced economies is towards knowledge-intensive activities. These take place across all sectors of the economy," the authors say. In other words, there are knowledge-intensive jobs in each of the sectors - but almost all of them are located in the cities.

Knowledge-intensive activities tend to involve customised problem solving, which requires significant intellectual effort. So such workers solve problems and generate ideas. Their jobs are clean, safe, well-paid and intellectually satisfying. They're the way for Australia to go if we want a better future than just farming and mining (lucrative though they are).

But here's the point: knowledge-intensive activities grow best in big cities. This is because people and businesses learn from each other, and the closer together they are the more they learn. According to the urban economist Edward Glaeser, the "central paradox of the modern metropolis" is that even as the cost of connecting across distance falls, so the value of being close to other businesses rises.

As well, the more businesses and workers cluster together, the more they each benefit from "deep" labour markets. Firms have more workers to pick from; workers have more firms to pick from. Jobs can become more specialised, and ever-increasing specialisation is one of the main ways economies have become richer over the past 200 years.

When you specialise in something you get better at it. And the individual worker more closely fits the needs of the individual employer (which makes the worker more valuable and able to command a higher salary). But the more specialised you are the more contact you need with others in your specialty to help you keep up.

The report says that, adapting to changing economic circumstances, Australia's largest cities have evolved from compact colonial cities where jobs and houses were close together and most people walked to work, to cities that spread outwards into suburbs.

"This transition was made easier by changing transport technologies: first trams and trains, then buses and cars. The transition further separated the worlds of work and home, an arrangement that was well suited to a 20th-century economy driven largely by manufacturing, when industry could often be a dirty and noisy neighbour."

Initially this led to the "hollowing out" of inner cities as both residents and jobs moved to the suburbs. In the decades since 1980, however, the trend began to turn around, as services began to replace manufacturing as the main source of new jobs.

Combined with factors such as traffic congestion and rising fuel prices, this helped to prompt a resurgence of CBDs and inner suburbs as places to live and work.

The point here is that the economic efficiency of cities - their ability to generate well-paying jobs - turns on where the jobs are, where the homes are and the adequacy of the transport system that allows us to move between the two.

But the report finds that labour markets are shallow in significant parts of Australia's biggest cities. "In many suburbs - particularly outer suburbs - residents can reach fewer than 10 per cent of all metropolitan jobs with a reasonable commuting time," it says.

The answer is not for governments to try (and often fail) to create jobs in outer suburban areas. People want to live closer in, and many of them want units rather than houses. So the answer is to remove the disincentives faced by developers building in established suburbs and stop established suburbs from being "locked down" by restrictive zoning and planning rules.

The way to reduce traffic congestion and increase the capacity of city transport systems is to start charging for the use of roads and use the revenue to expand public transport.

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Pain hits business before it hits the budget

As we approach the budget next week we're hearing a lot about how the strangely weak growth in nominal gross domestic product has hit tax collections, particularly from company tax.

But we're hearing a lot less about what this implies is happening to the "real" economy.

What's causing nominal GDP to be so weak - weaker than real GDP - is that although the prices of our mineral exports have fallen a fair bit, the dollar hasn't also fallen, as it was expected to. This means we're getting the worst of all worlds.

The miners are getting lower prices, but still losing as much from the high dollar. The other export and import-competing industries - farmers, manufacturers, tourist operators and others - who gained little from the resource boom are still being robbed of their international price competitiveness when they could have expected to be getting a bit of relief by now.

If company tax collections aren't growing as strongly as had been expected, this must be because corporate profits are weak.

In fact, the national accounts version of corporate profits ("gross operating surplus") has fallen in nominal terms for five quarters in a row and by 4 per cent over the year to December.

So company profits are being squeezed - which is really only what you'd expect when the dollar's been so high for so long. Even so, it helps explain why businesses are so unhappy and blaming the Labor government for their troubles.

But the consumer price index for the March quarter showed puzzling things are happening to a sector you'd expect to benefit from a high dollar: retailing.

It showed that whereas the retail prices of "non-tradeables" - goods and services not able to be traded internationally - rose by a hefty 1.3 per cent in the quarter and 4.2 per cent over the year to March, the retail prices of "tradeables" fell by 1.2 per cent in the quarter and 0.2 per cent over the year.

This is further evidence manufacturing and tourism are under a lot of pressure.

But it's also a puzzle because it's only when the dollar is rising that you would expect the prices of tradeables to be falling. As Paul Bloxham of HSBC bank has observed, the Australian dollar has been broadly steady for more than two years.

According to the CPI, retail furniture prices fell 6.8 per cent in the quarter and 2.3 per cent over the year.

Household textile prices fell by 6.7 per cent and 4.3 per cent. Appliance prices fell by 2.5 per cent and 4.4 per cent.

Retail prices of audio-visual items fell 4.7 per cent and 13.5 per cent, while overseas holiday prices fell by 5.2 per cent and 0.4 per cent.

Michael Workman of Commonwealth Bank argues the lower prices of imported goods and services are a reflection more of weak global consumer markets for European and Asian producers than the effect of the high dollar.

That is, foreign suppliers are cutting the prices they charge Australian importers so as to keep their sales up. If so, the lower prices our retailers are charging customers aren't coming out of their own hide.

Well, that's one theory. But others aren't so reassuring. Another theory is that weak demand and intense competition between retailers is obliging them to cut their prices at the expense of their profit margins.

They may be starting to feel the heat from customers using the internet to discover the lower prices being charged overseas, or using their smartphones to seek lower prices from other stores while haggling with shop assistants. If so, their profits are being "compressed" as the econocrats put it.

I have a theory retailing is suffering from a lot of excess capacity - too many stores - because it geared itself to a world where the rate of household saving kept falling, so that consumer spending grew consistently faster than household incomes.

Now the saving rate seems to have stabilised at 10 per cent, spending can grow no faster than incomes, meaning stores are competing to see who survives and who doesn't.

If so, this would be squeezing profits - at least until the losers shut up shop, so to speak.

Yet another possibility - which would apply to the manufacturers and tourist operators as well as the retailers - is that several years of heightened competitive pressures have obliged firms to find tough ways of lifting their productivity and then pass the savings through to their customers rather than taking them to the bottom line.

Whatever the truth of the situation - maybe some combination of all the various possibilities - it's not hard to see why the retailers are just as unhappy as the manufacturers. And don't forget a big part of small business is in retailing.

But not to worry, chaps. As soon as Julia's out and Tony's in, he'll fix everything.

Pain under the Libs is much easier to take.

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Ghost of Costello haunts Swan's budget

If you're a rusted-on supporter of the Coalition there can't be a shadow of a doubt that all the budget problems we're hearing about are the product of the Gillard government's incompetence. And if you don't think much about economics, it's perfectly believable.

After all, the budget had been in surplus for eight years straight when the Howard government lost office in late 2007. In that time Peter Costello not only paid back the $96 billion net public debt he inherited from Labor, he clocked up a credit balance of $45 billion.

In marked contrast, Labor's first budget went straight into deficit and has stayed there ever since, despite its solemn promise to get back to surplus this year. Wayne Swan soon chewed up all the money the Libs left him and racked up a net debt of about $140 billion and counting.

What more do you need to know?

Well, a bit of economics would be nice. Failing that, a bit of commonsense. The good guys/bad guys story I've just told rests on two silly assumptions.

First, everything that happens to the federal budget happens because of the actions of the government. Nothing happening in the rest of the economy - or the rest of the world - could possibly affect the budget balance. In other words, nothing happens that's beyond the treasurer's control.

Second, from the day a new treasurer takes over, everything that happens must be in consequence of his actions. Nothing his predecessors had done could still be having an effect on the budget long after they'd been tossed out.

Clearly, life - and budgeting - is a little bit messier than that. Economists well know that things beyond the treasurer's control actually have a bigger effect on the budget than things that are within the government's control.

That's true regardless of whether you're Labor or Liberal and whether what the economy does to your budget is good or bad.

It's equally true that some of the decisions made by a treasurer can still be affecting his (we've never had a female treasurer) successors many years later.

So, as with everything else in work or life, the budgetary performance of a government is some combination of luck and management.

Costello's management was good in many respects but, as we'll see, not as good as many have assumed. Swan's management has been the opposite: far from perfect, but not as bad as it has suited many people to claim. As for luck, there's no contest: Costello's luck was great; Swan's has been lousy.

To a partisan of the right, the trouble Swan is facing in getting the budget back to surplus any time in the foreseeable future is explained solely by Labor's chronic inability to stop spending. All the recent talk of "structural" (that is, long-lasting) problems on the revenue side of the budget is just excuse-making.

It's true Labor has trouble controlling its urge to splurge. But it's also true that the slowness of tax collections to return to their normal healthy rate of growth as the economy grows is partly the result of weaknesses that go back to decisions made by the Howard government.

Increasingly, economists are realising our governments mishandled the revenue windfall from the first phase of the resources boom, spending too much of it and saving too little.

Not only did John Howard allow government spending to grow at Labor-like rates in the noughties, but Costello responded to the temporary boost in collections from company tax by cutting income tax eight years in a row (though, to be sure, the last three of his cuts were actually delivered by Labor).

Usually, income tax is cut only every three years or so, and cut close to an election so voters haven't forgotten it happened. Does it surprise you that cutting income tax so much can reduce its revenue-raising power today and in coming years? It shouldn't.

The Australia Institute has used the well-regarded Stinmod micro-simulation model to estimate that, had the income-tax scale for 2004-05 still been in use last financial year, 2011-12, collections from the tax would have been almost $39 billion higher.

Now, you may object that we couldn't have gone for all that time without any tax cut. Since our tax scales aren't indexed for inflation, we need regular tax cuts just to counter the effect of bracket creep.

Fair point. So next the institute compared the actual tax scale in 2011-12 with the 2004-05 scale with its tax brackets indexed up to allow for all the inflation in between. It found the indexed scale would have raised an additional $25 billion. So Costello's many tax cuts cut the real rate of income tax - on the strength of a surge in company tax collections that proved to be temporary.

Think how much smaller the budget deficit (and the accumulated debt) would be now had he limited himself to offsetting the effect of bracket creep. (Remember too that, particularly in the years before the global financial crisis, his decisions to spend rather than save the tax windfall from the resources boom obliged the Reserve Bank to raise interest rates higher than otherwise, to prevent this recycling from causing inflation.)

It's worth noting that the successive tax cuts were biased in favour of the better-off, with the cut-in point for the top tax rate trebled to $180,000 a year. As a result, the value of tax cuts going to the top 10 per cent of income earners exceeded that of the cuts going to the bottom 80 per cent.

If that doesn't convince you responsibility for the present and future state of the budget has to be shared between Labor and the Coalition, remember the other irresponsible revenue decision Costello made when the government was temporarily flush with funds: making income from superannuation totally tax free for people 60 and over.

Even at the time, economists warned this handout to the better-off was unsustainable - and so it has proved.

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AUSTRALIA’S POLICY MIX

The economy isn’t travelling too badly at present, but if you listen to what you hear from much of the media, you could be forgiven for thinking it’s in terrible shape. There are several reasons why the economy’s doing a lot better than many people imagine. A fair bit of it is political: if you don’t like the government it’s easy to conclude it must be making a mess of the economy. The world economy is not growing strongly and a lot of the bad news we get from Europe may be worrying people, even though our strong and growing links with the developing Asian economies mean we are much less affected by problems in the North Atlantic economies than we used to be. Another part of the explanation may be that all the fuss about the Gillard government’s inability to keep its promise to return the budget to surplus in 2012-13 may have been taken wrongly by some as proof it is managing the economy badly. And it remains true that some parts of the economy are under great pressure from the high exchange rate and other factors.

Economy doing better than many imagine

When you stand back from all the argument and complaints you see the economy isn’t doing too badly. Real GDP is expected to have grown at the medium-term trend rate of 3 per cent in the old financial year, 2012-13, as a whole. The budget forecasts growth will slow to a little below trend, 2.75 per cent, in the coming financial year, 2013-14.

This growth has been sufficient to hold the unemployment rate in the low 5s for several years, though it is drifting up slowly and is forecast to reach 5.75 per cent by June next year. Remember that most economists believe the non-accelerating-inflation rate of unemployment (the NAIRU) - the lowest sustainable rate of unemployment - to be about 5 per cent. So the economy is not far from full employment and thus should not be growing faster than its trend or ‘potential’ rate of growth.

Inflation remains low, with underlying inflation at 2.4 per cent over the year to March and the rate having stayed within the 2 to 3 per cent range for three years. The diminishing threat from inflation has allowed the RBA to cut the official cash rate to an exceptionally low 2.75 per cent (it was 7.25 per cent before the GFC), meaning mortgage interest rates are the lowest they’ve been since the time of the GFC.

Resources boom has presented a succession of challenges

Apart from the GFC, the biggest issue confronting the macro managers of our economy has been the resources boom. It began about a decade ago and in that time they’ve had to confront a succession of differing challenges. At first the great problem they foresaw was that the boom would lead to an outburst of inflation, as so many previous commodity booms had done. This explains why the RBA had interest rates so high immediately before the GFC and why, even though it slashed the cash rate when the GFC hit, as soon as it realised the crisis wasn’t going to precipitate a severe recession it began pushing rates up again. For some time, however, it’s been clear inflation is well under control. That’s partly because of the economic managers’ vigilance, but mainly because the appreciation in the exchange rate that accompanied the huge improvement in our terms of trade did much to dampen inflation pressure, both directly by reducing the price of imports and indirectly by worsening the international price competitiveness of our export and import-competing industries and thereby dampening production.

About this time last year, after the inflation challenge had passed, the macro managers began worrying about a second challenge. The economy was being hit by two opposing external shocks: the positive shock of the mining investment construction boom, and the negative shock of the high exchange rate and its adverse effect on our trade-exposed industries’ price competitiveness. It was important for the managers to do what they could to ensure net effect of these two conflicting forces left the economy growing at around its trend rate, thereby keep unemployment not much above 5 per cent. To help bring this about, the government pressed on with tightening fiscal policy and getting the budget back towards surplus, thus giving the RBA more scope to loosen monetary policy. It was hoped the lower cash rate would reduce the upward pressure on the exchange rate. The managers haven’t been completely successful in this - unemployment has been creeping up - but, as we’ve seen, the economy isn’t travelling too badly.

But now the macro managers face a third challenge associated with the resources boom: to manage the tricky transition from mining-led growth to broader-based growth without the economy slowing down too much.

The tricky transition from mining-led growth

Although the economy isn’t travelling badly, it is facing a potentially tricky transition in the coming financial year as the resources boom eases and we move back to relying on broader and more normal drivers of economic growth: consumer spending, housing, non-mining business investment and exports.

The resources boom began in 2003 and was divided into two parts by the global financial crisis of 2008-09. The boom has had three stages: first, much higher prices for our exports of coal and iron ore, causing our terms of trade to reach their best for 200 years. Second, a historic surge of investment spending to greatly expand our capacity to mine coal and iron ore and extract natural gas. And third, a considerable increase in the volume (quantity) of our production and export of minerals and energy.

The first stage is now over, with coal and iron ore prices reaching a peak in mid-2011 and the terms of trade falling 17 per cent since then. Now it’s likely the second stage, the growth in mining investment spending, will reach a peak sometime this financial year and then decline, making a negative contribution to growth. This is likely to be only partly offset by the recent commencement of the third stage of the boom, the rising volume of mineral and energy exports as the newly installed production capacity comes on line.

What makes it uncertain the transition from mining-based to broad-based growth will proceed smoothly - that is, without a period of quite weak growth leading to a sharp rise in unemployment - is the failure of the exchange rate to fall back as the terms of trade have fallen back. This explains why, with inflation well under control, the RBA has cut the cash rate so far since late 2011.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year, on average, until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In the 2013 budget the government focused on finding offsetting savings (including an increase in the Medicare levy) to cover the cost of phasing in two big new spending programs: the national disability insurance scheme and the Gonski reforms to education funding. On top of this, Mr Swan announced further savings intended to reduce the structural budget deficit by about $12 billion a year by 2015-16. It’s important to note, however, that the government’s net savings won’t start reducing the overall budget deficit until the year following the budget year, 2014-15. Mr Swan says this is to ensure the budget doesn’t contribute to any weakness in demand while the economy makes its transition from mining-based to broad-based growth.

The government failed to achieve its promised return to budget surplus in 2012-13 because the terms of trade fell by more than had been expected and because there was no accompanying fall in the exchange rate, thus leaving many industries’ prices and profits under pressure. If you take the budget figures literally, Mr Swan now expects to get the budget back to balance in 2015-16 and to surplus the following year. But we should have learnt by now not to take budget projections literally.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

As we’ve seen, over the year to late 2010 the RBA reversed the emergency cut in the cash rate it made at the time of the GFC, lifting the rate to 4.75 pc. By late 2011, however, it realise the inflationary threat had passed, and the greater risk was inadequate growth in the face of such a high exchange rate. So between November 2011 and May this year it cut the cash rate by 2 percentage points to 2.75 pc - its lowest level since the RBA was established in 1960. Many people have assumed the RBA is cutting the cash rate in the hope of bringing about a fall in the dollar, but this is not correct. It doesn’t expect a lower cash rate to have much effect on the exchange rate. Rather, it’s objective is to offset the contractionary effect of the continuing high dollar by stimulating the most interest-sensitive areas of domestic demand: housing, consumer spending on durables and non-mining business investment.

Conclusion

The ‘stance’ of fiscal policy adopted in the 2013 budget is roughly neutral - that is, neither expansionary nor contractionary - whereas the stance of monetary policy is clearly quite expansionary. Should signs emerge that the economy is faltering in its transition from mining-led to broad-based growth, the RBA retains the scope to cut the cash rate further. Should the long-awaited fall in the dollar materialise, however, the stimulatory effect of such a fall would discourage the RBA from cutting rates further. Were the RBA to conclude the lower dollar was threatening to rekindle inflation pressure, it would start increasing rates. For the moment, however, the greater risk is that growth will be too weak rather than too strong.

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What it's like to be genuinely poor

Don't be too alarmed by all the talk of budget black holes and everything being on the table in Julia Gillard's search for savings. It's more likely we're being softened up for a lot more budget deficits than for a horror budget in two weeks' time.

Even so, it's clear there will be more cuts in spending and tax concessions. And though they're hardly likely to be draconian, you can be sure they'll draw howls of protest from those affected, egged on by shock jocks and opposition pollies on the make.

What's more, it's a safe bet they'll be aimed mainly at the better-off. So before we're engulfed by another round of upper middle class self-pity, I thought I'd get in early and tell you a little about the lives of people who really do have difficulty making ends meet.

According to a survey conducted by the Bureau of Statistics in 2010, almost one in five Australian adults experienced "financial stress" that year, where this means not being able to pay their bills, rent or mortgage on time or make minimum repayments on their credit cards, or they had to sell or pawn something because they needed cash.

A newly published report by Dr Nicola Brackertz, of Swinburne University, for the Salvation Army (my co-religionists), tells us a lot about the who, how and why of people suffering genuine financial stress. She surveyed 225 of the clients of the Salvos' free financial counselling service, Moneycare, operating for 20 years.

The first thing to note is that a third of respondents were living alone and another 28 per cent were sole parents. Only 14 per cent were couples with dependent children.

Two-thirds were women. Almost 80 per cent had a government pension or benefit as their main source of income. Only 15 per cent had wages as their main income.

Almost 40 per cent of respondents were renting privately and 22 per cent were renting public or community housing. Only 21 per cent were paying a mortgage and just 5 per cent owned their homes outright.

Put all this together and it tells me we're dealing with people right at the bottom of the heap. Most of the respondents would be unemployed, on the disability support pension or sole parents (many of whom have been relegated to the dole by a caring government).

Since the great majority of age pensioners own their homes, we're dealing in the main with only those age pensioners living alone and renting. It all goes to show how close people on the dole live to the poverty line, the more so if they have to rent privately.

With rents as they are, it's no surprise people in privately rented accommodation on a very low income are highly likely to experience financial stress. The surprise is the disproportionate number of respondents living in public housing.

The rent these people pay is generally set at 25 per cent of their income, no matter how low that income is. This sounds pretty generous; the standard measure of housing stress is rent or mortgage payments exceeding 30 per cent of income.

The trouble is the cost of true necessities such as food, clothing and power tends to be a reasonably fixed amount, whatever your income. So if your income is very low, you may not be left with enough for spending 25 per cent of the total on rent to be easily manageable. By the same token, if your income is quite high, a lifestyle choice to devote a lot more than 30 per cent of it to housing doesn't leave you feeling the pinch.

If you're as comfortably off as I am, it's a surprise to discover how small were the total debts that got the respondents into trouble with their creditors. Although a third had debts of more than $20,000, the typical (median) debt level was $5000 to $10,000.

Almost half had three or more sources of debt, with the most common being utility bills, credit cards, phone bills and personal loans. Well over half the respondents had been experiencing financial difficulties for two years or more.

Why did the respondents get into financial trouble? In their own words, "the leading causes were insufficient income caused by retrenchment, unemployment or underemployment and an insufficient level of government allowances and pensions", the report says.

"Health reasons, including disability and mental illness, often prevented respondents from earning sufficient income." It's easy for you and me to tell ourselves these people are just bad money-managers. But American research I've been reading says they're no better or worse managers than the rest of us. Their real problem is that life at the bottom is so much more unforgiving.

When your income's so low you need all of it just to get by, there's no scope to build a buffer of savings to cover you when quarterly utility bills arrive or some unexpected expense arrives. And when you can't afford car insurance or home contents insurance, big unexpected expenses are more likely to arrive.

When some service is cut off because you haven't paid the bill, you can't get it back on until you've paid the arrears and a reconnection fee. When you borrow to tide yourself over, you pay much higher interest rates than the rest of us - including to "payday lenders" and pawnbrokers.

If none of this applies to you, count your blessings (as we used to sing in Sunday school).

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Beware the one-eyed budget brigade

A great journalistic delusion is that politicians and others are always resorting to spin, so what journos do is remove the spin and tell it like it is. But too often they replace the speaker's spin with their own.

Consider the treatment of the Grattan Institute's report on budget pressures facing Australian governments. One paper reported it as concluding that "federal and state budgets will be generating yearly combined deficits of $80 billion within a decade unless welfare, health and education spending is cut".

Another national daily's version was that "Australian governments are facing a budget black hole so large that politically painful cuts to growth in public health and education spending are all but unavoidable if the nation is to avoid a European-style debt quagmire".

What the report actually said was that strong growth in government spending - particularly health spending - combined with weaker-than-expected tax collections could leave us with deficits equivalent to 4 per cent of gross domestic product in the next 10 years.

Its figuring shows this deficiency divides equally between increased spending and weak tax collections. So what solution did it propose? "That means finding savings and tax increases of $60 billion a year."

It also said: "There is no reason why a balanced budget, or more efficient government, necessarily requires smaller government. [However] history suggests that successful budget repair invariably involves both tax increases and expenditure reductions."

See the spin? So what's their motive? Probably a combination of the editors' personal ideology, self-interest (I pay too much tax already, don't ask me to pay more) and a belief that tailoring your reporting to fit your readers' prejudices will sell more papers.

But it is not just the media that take such a one-eyed approach to budgeting. Most business lobby groups do, too, plus a lot of economists. Many economists believe the answer to budget deficits is always to cut spending and never to raise tax collections, because of the libertarian political ideology implicit in their dominant "neoclassical" model.

The model assumes people are rational in all their decisions (implying governments can never know what's in my interest better than I know myself); each of us is a rugged individualist with nothing in the model to acknowledge the benefits we gain from acting collectively; each of us has roughly equal bargaining power in the market place (that's a good one); and wide disparities in the distribution of income and wealth are of no relevance.

Even so, as the Grattan report acknowledges, there is little economic support for the view that smaller government is always better than bigger.

You often hear people noting that a high proportion of the "structural saves" Wayne Swan likes to boast about constitute tax increases rather than spending cuts, as though this was some sort of crime or con trick.

But such people reveal their economic ignorance. Most of the supposed tax increases represent not the introduction of a new tax or an increase in the rate of an existing tax but the reduction or elimination of special concessions.

Economists refer to the latter as "tax expenditures" precisely to remind us they are essentially equivalent to actual expenditure. It often doesn't make a difference whether assistance to people in some category is delivered by a cheque from the government or a reduction in the tax they would otherwise have to pay.

One-eyed economists love to quote studies showing that, on average, every $1 of tax that governments raise generates a "deadweight loss" of about 30? in reduced economic efficiency because of the tax's effect in distorting taxpayers' behaviour. They use this to imply economics teaches us to minimise taxation. But they don't mention the hidden assumptions in the calculation, particularly that $1 of tax buys, at best, $1 of gross benefit to the community. In truth, $1 of spending on public goods may deliver benefits worth another, say, 30?.

In any case, the more legitimate use of such deadweight-loss calculations is to compare the inefficiency of particular taxes, with a view to correcting the features of those taxes that make them more economically distorting than others.

This is where tax expenditures come in. The way to reduce the 30 per cent deadweight loss is to eliminate the special concessions built in to so many taxes and thereby reduce the tax's distortion of people's choices.

The list of tax expenditures whose removal could reduce the budget deficit and make the allocation of resources more efficient at the same time is long, but includes negative gearing, the senior Australians tax offset, the 50 per cent discount on capital gains tax, exemption of super payments to people over 60 and the various exemptions from the GST.

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Why a little inflation isn't such a bad thing

I was in a taxi on Wednesday when we heard on the radio that the consumer price index had risen by just 2.5 per cent over the year to March - smack in the middle of the Reserve Bank's target, leaving it room to cut interest rates further if need be. So, no probs there.

"But why do we have any inflation?" the cab driver asked me. "When I came to Australia I could buy a rock cake for 8? - the other day they wanted $3.50."

It was a simple, sensible question. Unfortunately, the answer isn't at all simple. The short answer, however, is that it's a policy choice. That is, the monetary authorities - the central bank and the government - believe a moderate rate of inflation (moderate meaning between 2 per cent and 3 per cent, on average) is, on balance, a good thing.

Inflation refers to a persistent rise in the general level of prices. It may surprise you that in Britain over many centuries there was no net rise in the level of prices. Prices would rise during wars, but then fall back after the war was over. Governments controlled the price level by tying the amount of money in circulation to the amount of gold, and then controlling the amount of gold.

But this "gold standard" broke down during the Great Depression, and after World War II it was replaced by the Bretton Woods system where each country's currency was fixed to the US dollar, with the US dollar fixed to a gold price of $US35 an ounce.

This system meant all other countries effectively imported their inflation rate from the US economy. The Americans kept inflation pretty low until they began financing the Vietnam War by printing money rather than borrowing from the public.

This caused the fixed exchange-rate system to break down in the early 1970s, with most developed countries allowing their currencies to float. This gave them the ability to control inflation for themselves.

The trick, however, is that they - and we - do so not by controlling the quantity of money in circulation (as the monetarists tried and failed to do in the old days), but by using their ability to control the price of money - interest rates - to keep the demand for goods and services pretty much in line with the supply of goods and services. But if the authorities have the ability - in principle, at least - to use their control of interest rates to control the price level, why don't they keep it completely stable, thus allowing a zero increase in the CPI? Why do they permit inflation averaging a couple of per cent a year, and call this "practical price stability" (as they do).

Short answer: because they care about unemployment as well as inflation. The first reason is their belief that, due to practical limitations, the CPI tends to overstate the rise in the price level. Huh? This is because of the delay in including new products in the CPI basket of goods and services, and also because it treats as inflation price rises actually caused by an improvement in the quality of goods in the basket. For instance, part of the reason for the price of the new model Holden being higher than the price of the previous model is that it's a better car - better under the bonnet or better accessories.

If you accept that the CPI tends to overstate inflation then achieving zero inflation as measured by the CPI would involve keeping money so tight you were actually forcing prices down, which would be quite damaging to the economy and employment.

The second reason the econocrats like a bit of inflation is that there can be times when wages grow too quickly and make employing people too expensive. Wages need to fall back a bit, but workers are hugely resistant to cuts in their wages (and sensible employers don't fancy the idea, either).

The thing is that, if there's a positive rate of inflation it's much easier to cut wages in real terms by raising them less than the inflation rate. This is what happens in every recession.

The third reason the econocrats regard a bit of inflation as helpful is that, in a deep recession, they may judge it necessary to stimulate the economy not just by cutting interest rates but by cutting them so far they're negative in real terms - that is, cutting them until they're actually lower than the inflation rate (as they are right now in the US and Britain).

Think it through: when real rates are negative, lenders are actually paying people to borrow from them (after you allow for the effect of inflation), so this should be highly stimulatory. But, clearly, you can't bring about negative interest rates - something you'd only ever do in an emergency - unless you've got a positive inflation rate to go below.

So those are the three reasons the Reserve Bank is satisfied with an inflation rate averaging 2 to 3 per cent and defines this as practical price stability.

But back to my taxi driver. It's all very well to remember how much less you had to pay for things in the old days and feel cheated, but you shouldn't forget your income is also a lot higher than it was in the old days. In fact, just about everyone's income - whether wages or the pension - grows a bit faster than prices are rising, so there's no cause to feel cheated by the system. That is, almost everyone's income has risen in real terms over the years.

This real income growth is the reason economists are so unimpressed by punters and pollies carrying on about the trouble they're having keeping up with "the cost of living". You can achieve that delusion only by focusing on what's happened to the prices you pay and ignoring what's happened to your income.

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Budget surplus suddenly out of political fashion

Something highly significant has happened in just the past week: it's become clear the tide has turned in our politicians' demonisation of budget deficits and debt. What used to be anathema is so no longer.

Predictably, it's happened not because the pollies have seen the light, but because they've been mugged by reality. In consequence, the Grattan Institute's John Daley may well be right in saying we face a "decade of deficits".

That's not to say we'll hear no more of unpopular cuts in government spending, however. We'll get more of those in Wayne Swan's budget next month, and a lot more should Tony Abbott win the election in September. But these will be about stopping the parties' expensive election promises making the budget deficit even bigger, not about getting back to surplus. In Abbott's case it will involve cutting away Labor's favourite programs and replacing them with his own.

I won't be sorry to see an end to the economically illiterate nonsense the pollies have been spouting for so long about the evils of deficits and debt. That's because there are times when deficits are exactly what governments should be running and when modest levels of debt are nothing to worry about.

But, equally, there are times when surpluses are just what governments should be running. And we'd have to be terribly unlucky for such times not to return well before another 10 years have passed.

Governments have been agonising over the need to restrain budget deficits for almost all of the four decades I've been observing them - usually without much success. But the fashion for outright demonising of deficits began when Peter Costello became treasurer in 1996, claimed to have inherited a "budget black hole" from his Labor predecessors but, after one super-tough, promise-breaking budget, soon found the budget had swung back into surplus, only to stay there for the rest of the Howard government's 11-year term.

The steady stream of surpluses, combined with the proceeds from privatising Telstra, allowed him to eliminate the manageable debt he had also inherited. Costello used this experience to argue incessantly that deficits are always bad and surpluses always good, with the Liberals the party of surpluses and Labor the party of deficits.

When the global financial crisis hit in late 2008 and pushed the budget back into deficit, with Kevin Rudd's stimulus spending adding to that deficit, the immediate effect of the crisis on our economy proved surprisingly modest and it suited both sides to claim we had escaped recession.

Labor claimed this proved what a good economic manager it was, whereas the Libs used it to prove Labor's stimulus spending was unnecessary and wasteful, leaving our children and grandchildren weighed down by horrendous government debt.

The more years have passed with unemployment, inflation and interest rates all staying low during Labor's term, the more the Libs have focused on attacking its economic management by repeating the Costello line that deficits are always bad and by exaggerating the size of its debt.

Rather than patiently explaining the economic ignorance of this deficit demonising, however, Labor capitulated to it, with Julia Gillard promising faithfully in the 2010 election campaign to have the budget back to surplus by this financial year.

Problem is, the budget has not played ball. Much to the amazement of economists (and the consternation of Treasury's forecasters), the recovery in the economy has not been accompanied by a commensurate recovery in tax collections. Among the many reasons for this, the main one seems to be that our dollar has stayed high even though the prices for our mineral exports have fallen back.

This dawning reality is what forced Wayne Swan to concede just before Christmas that the budget would remain in deficit this financial year. Knowing the weakness on the budget's revenue side is likely to continue indefinitely, he's made no new commitment on when it will be returned to surplus.

But he and Penny Wong keep saying they won't be cutting government spending just to get the budget back to surplus, for fear of this costing jobs. Clearly, they've allowed their membership of the Deficits Are Evil Club to lapse.

For years the Libs have condemned Labor's timid explanations as mere excuses and have been promising to return the budget to surplus as soon as they got back to office. But the reality of the budget's revenue weakness has finally dawned on them, too.

Last Thursday, Abbott declared that "all bets are off" on the question of when a Coalition government would achieve a surplus. He's repeated the warning since. And also on Thursday, shadow treasurer Joe Hockey advised that "we are not going to go down the path of austerity simply to bring the budget back to surplus because it would end up being a temporary surplus".

So though we can expect to hear a lot more about Labor's alleged bad budgeting, we'll be hearing nothing more about achieving surplus ASAP. For both sides it's now a mere "aspirational objective".

I fear, however, we're swinging from one extreme to the other, from falsely claiming budget deficits are always evil to complacently accepting them long after it's become prudent to eliminate them and start repaying debt.

To say deficits aren't always evil is not to say they're always OK. So be warned: when budget surpluses fall out of fashion with the politicians, it won't be long before they're back in favour with economists - and commentators such as me.

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GITTINS’ GOSPEL: THE ECONOMICS OF JUST ABOUT EVERYTHING

I read that the Anglican Archbishop of Sydney, Dr Peter Jensen, very much disapproves of playing I Did It My Way at people’s funerals, describing it as ‘vulgar egotism’. This is a pity because, in my own vulgar and egotistical way, I like to think that, in the more than 30 years I’ve been the Herald’s economics editor, I’ve tried to do it my way, not the way other journalists would do it. The besetting sin of journalists is to write to impress other journalists. Failing that, they write to impress their contacts. But I’ve always believed in writing for the benefit of the Herald’s readers, for the intelligent layperson.

Perhaps because I didn’t take enough notice of the economics they tried to teach me at Newcastle Uni, I’ve had to work to understand economics, to understand what’s happening in the economy and understand the rationale behind the economic policy of the government of the day. But once I’ve figured it out, I’ve been keen to pass on that understanding to my readers. I write for the person who, though they lack formal training in economics, knows the topic is important and is keen to learn about it.

In my latest book, Gittins’ Gospel, a selection of my columns, I confess that my father was a preacher and I’ve inherited his sermon-delivering habit. Like his sermons, mine have been less fire-and-brimstone and more about teaching, although since journalists aren’t supposed to teach I prefer to say I’m an exponent of ‘explanatory journalism’. In the first part of my career I acted as a kind of missionary, trying to convert people to the economists’ way of thinking (and, indeed, there is a section of the book devoted to helping people understand how economists think). But as my career has progressed - as I’ve read more about economics and got older and, I hope, wiser - I’ve become more aware of, and critical of, the limitations of economists and conventional economics. So these days I see my role as more like that of the Herald’s theatre critic - I explain economics and the economy, but I also offer my readers a critique of economics and economists, pointing out their weaknesses and helping readers make up their own minds on how much to believe and not believe.

The full title of the book is: Gittins’ Gospel: the economics of just about everything. ‘The economics of just about everything’ is the title for our meeting tonight, and Ross Kerridge has given me a list of just about everything he wants me to talk about. I’ll get on to that in a minute, but first I should say something about why I was so vulgar and egotistical as to call a book, Gittins’ Gospel.

Well, it was partly an allusion to the sermonising habit I inherited from my father - who, by the way, delivered his sermons to tiny congregations in New Lambton (where I was born) and Cessnock, went away for some years but came back to Lambton, Merewether, East Maitland and Shortland. But it was also a reference to the main conclusions I’ve come to in almost 40 years of studying the topic, and the main messages I’ve been trying to get over.

Economics need not be stratospheric or incomprehensible: it’s about the ordinary business of life, about going to work, earning and income, then spending that income on all the things we need. But it’s about the material side of life and, important though that is, it’s not the only dimension of our lives, and we oughtn’t to focus on it to the exclusion of the other important dimensions: the relational, the social and even the spiritual. Similarly, the community and our political leaders need to take their advice from a much wider range of experts than just economists. Nor should we allow economists to advise us on matters outside their field of competence - as they often try to do. In other words, a big part of my gospel is that economics needs to be kept in context.

Another theme of my gospel is that the modern practice of lobby groups, and even governments, commissioning supposedly ‘independent modelling’ to bolster their case for or against some policy change is almost always an attempt to blind the public with science. I see part of my role as to demystify econometric modelling. Economic modelling is at once hugely complicated and surprisingly primitive. It rarely proves what the people who paid for it say it proves. It’s always built on assumptions - which are rarely spelt out by the people waving around its conclusions - and it’s always possible to vary the assumptions to ensure you get the results the outfit paying for the research was hoping for. The media should be a lot more sceptical in its reporting of the results of supposedly independent modelling, and in the book I look at three well-publicised cases and show how the modellers managed to produce the misleading results they did.

I love being a journalist, but the longer I stay in the business the more critical I become of the way the media do their job. A lot of what they do can be misleading, and in the book I devote a section to explaining how not to be misled. Literally, the word ‘gospel’ means ‘good news’ - but the media seem increasingly, almost exclusively, full of bad news - which some readers are finding increasingly off-putting. Well, I’m an optimist and, though I’m not afraid to face up to the problems we encounter - as of course we do - nor am I reluctant to point to the respects in which we’re doing quite well. This book is a book for optimists.

Economics is meant to be about people and for people; take the people out of an economy and you don’t have an economy. But much of the economics you read seems remarkably impersonal. So another theme of my gospel is that we need to get the people back into economics. We need an economics fit for humans. You often see me writing that conventional economics incorporates a misleading model of human behaviour. Its two big weaknesses are its assumptions that we’re all coldly rational calculators of what’s in our interests, and then that we’re all rugged individualists - that our attitudes and behaviour are never influence by the attitudes and behaviour of those around us, and that we never act in groups. In truth, the findings of modern psychology show we’re highly instinctive and emotional animals, and also that we’re highly social, ‘groupish’ animals. So in recent years I’ve been reading a lot more widely than conventional economics so as to get a better picture of how humans actually behave. And when that reading leads me to something interesting and important, I pass it on to my readers. The book contains a section - We’re only human - that brings together 10 of the columns I’ve written about these findings.

For instance, rationality tells us we need to be completely realistic about the state of the world and our place in it. But psychological research tells us that’s bunkum. It turns out to be healthier and more useful to hold a few unrealistic views about ourselves and the world.

People with high self-esteem---which is most of us---believe themselves to be healthier, more intelligent, more ethical, less prejudiced and better able to get along with other people than average. Obviously, a lot of those judgments are unrealistic. But that’s beside the point. The point is that self-esteem makes us both happier and better equipped to deal with the world. The lack of self-esteem is highly debilitating.

People with the freedom to control their own lives, make their own choices and decisions---at work and at home---are happier and even healthier. But it’s a question of perception---how much control you think you have. People with a positive attitude to their boss, for instance, may see themselves as having more freedom of action than those who see their boss as censorious and untrustworthy. (What’s more, in my experience such attitudes tend to be self-fulfilling.)

But nowhere is self-deception more prominent than in the personal characteristic of optimism. Indeed, it’s virtually built into the definition of optimism. Optimists are people who take the credit for their successes but blame their failures on others or on circumstances. They regard setbacks as temporary rather than permanent, and specific (I happened to strike a bad teacher) rather than universal (all teachers are bad).

So optimists tend to overestimate their abilities and their chances of success in dealing with the world, whereas pessimists tend to underestimate their abilities and their chances of success. Fortunately, most of us are optimists, which does much to explain why most of us are reasonably happy most of the time.

So much for the virtues of a little self-deception.  Now let me ask you a personal question: how honest are you? According to the people who study these things, not as much as you think you are. In an experiment in which people were asked to solve puzzles and were paid a set amount for each puzzle they solved, some participants were told to check their answers against an answer sheet, count the number of questions answered correctly, put their answer form through a shredder, report the number of questions they got right to the experimenter and receive the money they had earnt. A second group wasn’t allowed to shred their answers before reporting how many they got right. Those whose claims about how many they got right couldn’t be checked claimed to have got significantly more correct than the second group.

Those who cheated probably counted a problem they would have answered correctly if only they hadn’t made a careless mistake. Or they counted a problem they would have got right if only they’d had another 10 seconds. In other words, they didn’t tell blatant lies, they just gave themselves the benefit of any doubt, bent the rules a little bit in their own favour. And get this: they wouldn’t have thought they were cheating. When subjects are asked to rate how ethical they are compared to other people on a scale of zero to 100, where 50 is average, the average rating is usually about 75. That is, almost all of us consider ourselves to be more ethical than other people. Clearly, that’s not possible.

We’re often unaware of how inconsistent we are. We may think of ourselves as scrupulously honest because we’d never steal and would always return a wallet we found, forgetting that we take home office stationery because this is ‘not the same thing’. That’s why it’s always hypocritical to accuse others of hypocrisy---all of us are hypocrites.

The psychologists who study ‘behavioural ethics’ say our ethical behaviour is often inconsistent and, at times, even hypocritical. ‘People have the innate ability to maintain a belief while acting contrary to it,’ they say. ‘Moral hypocrisy occurs when individuals’ evaluations of their own moral transgressions differ substantially from their evaluations of the same transgressions committed by others.’ Hypocrisy is part of the human condition; we’re all guilty of it. So you could say accusing someone else of being hypocritical is itself a hypocritical act.

One lesson from a new field of study known as ‘neuro-economics’ is that our brains seem to have different systems for ‘wanting’ and ‘liking’. Wanting is about motivation, whereas liking is about pleasure. Think of the kid who begs and begs his parents to buy a pet---or a guitar---then loses interest in it within a few days. There was a yawning gap between wanting and liking. All of us have times when we lack the motivation to do something we know we’d enjoy. That’s almost the definition of being depressed. It’s given rise to a psychological therapy called PAT---pleasant activity training: make a list of the things you enjoy doing and then do them more often. Don’t scoff.

That’s just a sample of the topics I cover in the book, so I hope you enjoy it.

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