Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.

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How our political prejudices affect confidence

I've realised we won't be satisfied with the state of the economy until the Liberals get back to power in Canberra. That's not because Labor's so bad, or because the Libs would be so much better, but because so many people have lost confidence in Labor as an economic manager.

The conundrum is why so many people could be so dissatisfied when almost all the objective indicators show us travelling well: the economy growing at about its trend rate, low unemployment, low inflation, rising real wages, low government debt - even a low current account deficit.

And yet the media are full of endless gloom, not to mention endless criticism of the Gillard government. Last week the NAB indicator of business confidence dropped to a 10-month low. And while the Westpac-Melbourne Institute index of consumer confidence recovered almost to par, that's a lot weaker than it ought to be.

Admittedly, the good macro-economic indicators do conceal a much greater than usual degree of structural adjustment going on. But these adjustments - which are generally good news for consumers - seem to be adding to the discontent rather than the root cause of it.

The Gillard government has been far from perfect in its economic policy, but you have to be pretty one-eyed to judge its performance as bad. Similarly, only the one-eyed could believe an Abbott government would have much better policies. It's likely to be less populist in government than it is opposition but, even so, Tony Abbott is no economic reformer.

Gillard's problem is not bad policies, it's Labor's chronic inability look and act like our leader and command the public's respect and comprehension. This is a government that doesn't believe in much beyond clinging to office, and the punters can smell its lack of principle.

To be fair, on the question of economic competence Labor always starts way behind the ball in the public's mind. Decades of polling reveals the electorate's deeply ingrained view the Libs are good at running the economy and Labor is bad.

This is what feeds both the Libs' born-to-rule complex - their utter assurance that all Labor governments lack legitimacy - and Labor's barely concealed inferiority complex.

The Hawke-Keating government did manage to turn the electorate's conventional wisdom on economic competence around for most of its 11-year term.

Labor in its present incarnation has never been able to pull this off. It's lost its race memory of how to govern. All this is compounded by the manner of Gillard's ascension, her non-maleness, her inability to make the punters warm to her and the uncertainties (and broken promises) of minority government. But the problem was apparent before Labor decided it could stomach Kevin Rudd no longer.

It's true the media environment is more unhelpful than it was in Hawke and Keating's day. Increased competition has made the media more relentlessly negative - more uninterested in anything but bad news - which must eventually have some effect on the public's state of mind.

In their search for a new audience in response to the challenge of the digital revolution, part of the media has become more partisan and more unashamedly hostile to all things Labor.

You see this in the radio shock jocks, but also in the national dailies, which have adopted the Fox News business model of telling a section of the potential audience what it wants to hear, not what it needs to know.

It seems a universal truth of the commercial media that the right-leaning audience is both more numerous and better lined than the left-leaning.

So, for instance, a favourite commercial tactic at present is to search for, and give false prominence to, all stories that portray our almost-dead union movement as a threatening monster about to engulf big business.

Boosting productivity equals making industrial relations law more anti-union. End of story. When Treasury people give speeches that fail to echo this infallible truth it's a clear sign they've been "politicised" and we need to find a few hyper-ideological economics professors to misrepresent what they said.

When Hawke and Keating were in power, business leaders judged it wise to keep their natural political sympathies to themselves and work with the elected government.

But with Gillard so far behind in the polls, so ineffective in maintaining relations with big business, with the general media so anxious to accentuate the negative and a significant part of the serious press telling them how badly they're being treated and holding out a microphone, it's not surprising big business people have become so unusually vocal in their criticism of Labor.

When God's in his heaven and the Libs rule in Canberra, business people jump on anyone they consider to be "talking the economy down". But so great is their loathing of the Gillard government that business is leading the chorus of negativity. How they see this as in their commercial interest I'm blowed if I know.

While John Howard was in power, the index of consumer sentiment showed respondents who intended voting for the Coalition to be significantly more confident about the economy than those intending to vote Labor. At the time of the 2007 election, however, the two lines crossed and Labor voters became significantly more confident than Coalition voters.

The latest figures show the overall confidence index at 99, while the Labor voters' index is up at 124 but the Coalition voters' index down at 79. Since Coalition voters far outnumber Labor voters, it's clear a change of government would do wonders for measured consumer confidence.

The same would probably be true for measured business confidence. Suddenly, business would be back talking the economy up, and the partisan media would revert to backing up our leaders rather than tearing them down.

But how much difference that would make to the objective economic indicators is another question.

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National productivity comes from firms' productivity

We've been debating what needs to be done to lift Australia's flagging productivity performance for a year, but only this week have we stopped using it in the unending political blame game and got down to some solid economic analysis.


The breakthrough came in a much-discussed speech Dr David Gruen, of Treasury, delivered to the annual Australian Conference of Economists in Melbourne.

Gruen made the apparently hugely controversial point that the primary responsibility for the productivity of the private sector - its output per unit of input - rests with the firms making up that sector and only secondarily with the government.

The government's role is in supporting the productive capability of the economy through investment in education and training, science and research, and infrastructure.

"Government involvement in these sectors is important," Gruen says. "Markets left to their own devices will tend to result in too little investment where there are social or spill-over benefits [in the jargon, 'positive externalities'] to the broader community beyond the returns available to a private investor.

"Governments influence the environment in which firms engage with each other and make investment and production decisions. They set the rules of the game, if you like, and affect the incentives that firms face, and their flexibility to respond."

But it's businesses that do the playing. So what do we know about the drivers of productivity improvement in the private sector? Well, a fair bit of empirical research has been done locally and overseas in recent years.

It shows that overall productivity improves in two different ways. One source is greater technical efficiency through innovation within the firm. Technical improvement comes about through research and development within the firm, or in partnership with the formal research sector.

But as a small country, most of the technology put into production in Australia is first developed overseas, Gruen says. A survey by the bureau of statistics shows only a small fraction of our innovative firms do things that are genuinely new to the world, or even new to Australia. Much more innovation is simply new to a particular industry.

"What usually distinguishes leading organisations is not so much their ability to create knowledge, but rather their ability to absorb technology developed elsewhere and apply it to their own circumstances," he says.

Why do firms innovate? According to the bureau's survey, three-quarters of innovative firms report undertaking innovation to improve profits. About 40 per cent also wanted to increase or maintain their market share and a quarter needed to develop products that were more competitively priced.

That's pretty much what you'd expect, but the second source of productivity gain is less obvious and less benign: it improves when production in an industry shifts from low-productivity firms to high-productivity firms.

A study of Australia firms in the 1990s found a remarkably wide range in their efficiency. The labour productivity of the most efficient firms was about four times that of the least efficient. Only about half this difference seems to be explained by differences in size.

So the productivity of an industry is improved when low-productivity firms are taken over or otherwise cease to exist, and also when new businesses with bright ideas start and grow.

Few people realise how much turnover there is of firms, even when the economy is growing strongly. According to figures from the bureau, about 8 per cent of firms close down each year. And about 40 per cent of new firms exit in less than four years.

Get this: overseas estimates suggest the net effect of the entry and exit of firms accounts for between a fifth and a half of the improvement in labour productivity over time. In high-technology industries, in particular, start-ups play an important role in promoting technological adoption and experimentation, Gruen says.

Hint to politicians: "Policies that act to slow the movement of resources will tend to limit this source of productivity improvement."

Another way to study productivity at the firm level is to look at management practices. Like productivity, management is about how well resources are used in production. So if you can rate particular management practices and give management teams a score, maybe this will help explain productivity differences across firms and even across countries.

One long-running study is doing this for 9000 medium and large manufacturing firms in 20 countries. It gives good ratings to firms that monitor what's going on in the firm and use this information for continuous improvement; set targets and track outcomes, and promote employees based on their performance.

The study shows management practices in Australia are mid-range: well below the United States, Germany, Sweden, Japan and Canada, but similar to France, Italy and Britain. And we have a larger tail of companies at the poor management end of the distribution compared with the US.

Looking at the performance of Australian firms, large manufacturers tend to be much better managed than small ones - a worry because our firms tend to be smaller than those in other countries. And it does seem clear better-managed firms are more innovative and have higher productivity.

Gruen argues periods of significant structural change - as at present - are often periods of growth and reform for the economy.

For a firm that's been doing the same thing for a long time, changes in business models are risky, difficult and may well require staff lay-offs. But when structural change means doing the same old thing is likely to be unprofitable, the opportunity cost of transforming work practices is substantially lowered. Structural change usually involves firms coming under greater competitive pressure. And tough competition and innovative activity seem to go together.

In Australia, firms that report having more competitors, that are in industries with low mark-ups, that export, or that experience downward pressure on profit margins are more likely to be innovators.

Case studies of Australian manufacturers hit by the reduction of import protection in the 1980s and '90s show the firms that succeeded did so by changing their practices. The number of plants diminished, plants became more specialised, model ranges were cut and world-best technology introduced.

Of course, some firms close down and leave the industry. But that's the harsh part of the lovely sounding productivity improvement: Competition boosts productivity partly by moving resources to more successful firms.

Get it? When politicians protect firms from closing, they risk stifling productivity improvement. For countries, comfortable and rich don't go together.

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Why retailers aren't so greedy

When you buy something in a supermarket or a department store, how much of the price you pay is the store's mark-up? And of that mark-up, how much covers the store's costs and how much is clear profit? Everyone has their own answers to these questions. But I suspect most of those answers are based on vague impressions and long-held prejudices rather than hard evidence.

When I was growing up we were always hearing about the depredations of "middlemen". The poor farmers got terribly low prices for their meat and other produce, but by the time that produce went through many hands to reach us in the city, the prices were sky high.

These days, we hear continually about the evil practices of the two big supermarket chains. They're busy screwing the life out of dairy farmers and other suppliers, just so they can use cheap milk and bread to lure us into their stores.

This may sound like a good thing for consumers beset by an ever-rising cost of living, but don't be fooled, we're told. The wicked retailers may be undercharging for a few staples, but they make up for it by overcharging for everything else. Then there are all the people discovering from the internet just how much lower prices are in other countries. More proof we're being ripped off.

In the hands of the media, it's a morality tale. The farmers and manufacturers are the good guys getting squeezed; the big retailers and other middlemen are the bad guys raking it in and doing us down.

It would be good to measure all these impressions against some hard statistical facts - facts supplied by an article in the latest issue of the Reserve Bank's Bulletin, on which I'll be drawing heavily.

Part of the problem is our lack of imagination. Many of us have only a vague idea of the role played by the businesses that operate between primary and secondary producers and you and me.

Most retail goods - including food and non-alcoholic drinks, clothing, footwear, electrical equipment, furniture and home appliances, and motor vehicles, but not "meals out" or takeaways - are produced in factories, whether locally or overseas.

The basic cost of producing those goods includes the cost of transporting them to wholesalers' warehouses, plus import duty where still applicable. Wholesalers incur costs in storing goods and transporting them around the country to retailers' stores, plus normal administrative costs. Retailers incur costs of rent, storage, display, finance and other costs.

Naturally, wholesalers and retailers employ many workers to help them carry out their role, not of making goods, but of distributing them into the hands of consumers across the nation. Indeed, the work of this "retail supply chain" accounts for about 7 per cent of the final value of all goods and services sold in Australia (gross domestic product) and about 10 per cent of total employment. So one worker in 10 is employed as a supposedly unproductive "middleman".

On average, the manufactured cost of the goods we buy accounts for about half the retail prices we pay. About 40 per cent of the prices we pay cover the costs incurred by wholesalers and retailers, with wage costs accounting for a bit less than 20 per cent and other costs for a bit more than 20 per cent.

That leaves the wholesalers' and retailers' net profits accounting for only about 10 per cent of the prices we pay, with about three-quarters of that going to the retailers.

Of course, these overall averages differ for different products. Whereas the gross profit margin (that is, before allowing for expenses) averages 50 per cent, it's closer to 60 per cent for clothing and footwear, a bit over 50 per cent for electrical equipment, a bit under 50 for furniture and appliances, about 40 per cent for food and drink, and just 25 per cent for motor vehicles.

Gross margins also vary according to the size of retail outlets and the speed at which stock turns over. Margins are higher in boutique stores than department stores, and higher in small convenience stores than big supermarkets, where the profit-making emphasis is on rapid turnover rather than high margins.

The Reserve Bank's detailed examination covered the figures for the nine years to 2007-08, though other checks suggest they haven't changed much since then. It found the production prices of locally manufactured goods rose quite strongly over the period. As well, the wage rates and other costs paid by wholesalers and retailers rose by more than 3 per cent a year.

Even so, the final prices of retail goods rose by only about 1 per cent a year. So much for the notion retailers have been getting greedier.

But how have they managed to turn costs rising by 3 per cent or so a year into retail prices rising by 1 per cent and do so without suffering any squeeze in their net profit margins?

Because, although business people are always assuring us there's nothing they can do but pass higher costs on to us, in truth there's a lot they can do.

One thing they've done is increasingly substitute cheaper imported goods for ever more expensive locally made goods. If that worries you, have a look at my little video on the website or iPad app today.

The other thing they've done is raise the productivity of their labour, with the volume of their sales rising a lot faster than the total hours of the workers they employ. They've invested in labour-saving equipment and facilities.

And note this: why have they being working so hard to limit their price rises? Because of the power of market forces - in this case, customers who don't like paying more.

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Economists have no lock on economic understanding

Many people don't realise the economics we hear from politicians, business people, economists and the media, morning, noon and night, is just one way of analysing how the economy works.

Almost everything we're told about what causes what is inspired by the "neoclassical" model. It's long been by far the dominant way of explaining why things happen and predicting what will happen, but it's not the only way. And it's far from infallible.

This conventional economics reduces all economic activity to that which happens within markets. It further narrows the operation of markets to the setting of prices, assuming movements in relative prices are the primary thing influencing the behaviour of producers and consumers.

It thus abstracts from the role of "institutions" - be they organisations, laws or conventions - in influencing market behaviour, so often leads economists to make policy recommendations that prove seriously misguided.

After the fall of communism, for instance, many economists urged the leaders of the formerly planned economies to switch to market-based economies in one big bang.

Since few people knew how to behave in a market economy, it was a disaster.

Only after economic activity had contracted massively did economists realise it was naive to assume that markets could be created out of thin air.

In the 1990s, the International Monetary Fund urged the emerging economies to open up to the free inflow of foreign capital. The result was the Asian financial crisis of 1997-98, when all the foreign capital flowed back out, leaving devastation in its wake.

Only then did economists realise that the developed economies were able to cope with swirling capital flows because of a raft of government-created institutions that had been developed over centuries: well-developed commercial law, with independent courts to enforce contracts; bankruptcy laws to deal with failed businesses; audited financial statements that were roughly believable, and so forth. Developing countries possessed none of these stabilising institutions.

Economic sociologists study the behaviour of markets, but put much emphasis on determining the role of norms of acceptable behaviour. For conventional economists to assume our behaviour in economic situations is heavily influenced by price changes but not by social norms is quite silly.

But for a good example of the way different analytical models can draw different conclusions about the same problem, consider an old economists' favourite: the "tragedy of the commons".

In situations where a piece of land is available for use by different farmers to graze their animals, it's likely to become overused and degraded. Similarly, common fishing areas are likely to be overfished, perhaps to the point where fish disappear. Common logging forests will be overlogged and laid waste.

Although the modern version of this ancient problem, that was used to justify Britain's "enclosure movement" many centuries ago, was first put forward by an ecologist, economists leapt on it with glee. It was clearly a problem of property rights.

Because no one owned the common area, no one had an economic incentive to look after it. Indeed, each individual had an incentive to get in and use as much of it as possible, as quickly as possible, before other individuals used it up.

So what was everyone's property was actually no one's property - and that was the essence of the problem. Many economists thought it obvious that the solution was to allocate private property rights over the commons.

Who they were allocated to, and how they were allocated, didn't matter much. What mattered was that once someone owned the asset, they would have the economic incentive to look after it and prevent its degradation.

In all probability they would continue to make it available to existing users, but at a price. That price would discourage those people from overusing it, while also providing the private owner with both the motive and the means to keep the asset in good repair.

Neat, eh? Of course, there were also some who saw the solution as having the government take over the common property, maintain it and allocate its use on some fair basis.

But there was one obdurate woman who, lacking an economics education, wasn't impressed by the economists' neat analysis of the problem and thought there might be another, better solution - if, indeed, it was a problem.

She was Elinor Ostrom, a professor of political science at Indiana University, who devoted much of her career to combing the world looking for examples where people had developed ways of regulating their use of common resources without resort to either private property rights or government intervention.

As The Economist records, she found forests in Nepal, irrigation systems in Spain, mountain villages in Switzerland and Japan, and fisheries in Maine and Indonesia. In all these cases people drew up sensible rules for sharing the use of the resource and combined to perform regular repairs. People who broke the rules were fined or eventually excluded.

"The schemes were mutual and reciprocal, and many had worked well for centuries," the magazine says.

For her pains, Ostrom, who died last month, was awarded the Nobel prize in economics in 2009, the first woman so honoured. Few economists had heard of her, or her model-busting work.

Why had this solution to the problem never been considered by economists?

Because of their model's implicit assumption that we only ever act as individuals, never collectively. We compete against each other, but we never co-operate to solve mutual problems.

And, since all the market's benefits come via competition, co-operation by producers is probably an attempt to rig the market, which should be outlawed.

The community pays a high price for allowing one model of how the economy works to dominate the advice we get and the way we think.

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Resources boom will lead to much bigger mining sector

A widespread fear - or maybe for some, a hope - is that the resources boom will evaporate someday soon. What will we do once it's over, a lot of people ask. Well, this week we got an answer: export at least twice the minerals and energy we do today.

You can divide the resources boom into three overlapping phases. The first phase is where the prices we receive for our exports of coal and iron ore shoot up to unprecedented levels because the world's exporters of those commodities are unprepared for the surge in demand from China and India as they rapidly industrialise.

The second phase is where our (and the world's) commodity producers seek to take advantage of those remarkable prices by expanding their production capacity as quickly as possible. At first the mining companies expand their existing mines, then they and others begin building new mines.

Much of the financial capital they require to fund this expansion comes from the retained after-tax earnings of the mining companies' shareholders (many of whom are foreigners). Much of the rest of the financial capital will be acquired from abroad. Much of the physical capital (mainly equipment) the miners install will be imported.

As part of the expansion, steps must be taken to ensure sufficient infrastructure exists to transport the minerals or natural gas to the nearest port by road or rail or pipeline, then loaded onto bulk carriers. Often this infrastructure is provided privately, sometimes it's provided by government.

The third phase is where the new production capacity comes on line and the volume of our exports starts to surge. But it won't just be us who are now exporting a lot more. The countries we compete with will also have been expanding their production capacity.

So even if you assume the demand for mineral and energy continues unabated - which is a reasonable expectation in this case - the global surge in supply can be expected to bring down the earlier sky-high prices.

Thus the prices we've been receiving for our exports are certain to fall back. Fortunately, however, this will occur as the volume of those exports is growing, thereby limiting the effect on the total value of our exports.

So, where do we stand in this process?

We've reached the point where, after a lot of global investment in new capacity, global supply has begun to expand and global prices have passed their peak and begun falling.

Thus our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - peaked in the September quarter and fell back in the two subsequent quarters. The terms-of-trade index (where 2009-10 equals 100) got to 130, but has since fallen by 10 per cent to 117.

Since it was the big improvement in our terms of trade that did most to explain the rise in our exchange rate, this deterioration in our terms of trade might explain why the dollar has fallen closer to parity with the US dollar. We can't be sure, however, because - as you might have noticed - a lot of other worries have been affecting global currency markets lately.

Similarly, although we can't be sure, most economists are confident global coal and iron ore prices won't fall back to where they were before the boom started, meaning our terms of trade will stay above their long-term average.

And, assisted by continuing strong capital inflow to Australia, the dollar will stay well above its post-float average of about US75?. (Meaning, of course, that life will stay uncomfortable for our other export and import-competing industries.)

This doesn't mean the second, investment phase of the boom is nearing its end, however. According to a Bureau of Statistics survey, the industry is expecting to spend a record $120 billion this financial year, up from $95 billion in the year just past.

Much mining investment comes under the heading of "engineering construction". It's expected to grow in real terms by more than 20 per cent in 2012-13 and by 9 per cent in 2013-14. The industry has committed to, or commenced construction on, more than half the fabled $456 billion resources-investment pipeline.

Note that much of the spending in recent times is on the development of liquefied natural gas facilities.

As for the third, export expansion phase, this week we got some new estimates from the Bureau of Resources and Energy Economics. It's expecting the volume of our total minerals and energy exports of about 700 million tonnes a year to more than double by 2025. And that's just the low-range estimate.

We now export about 400 million tonnes of iron ore a year. By 2025, this could grow to between 885 million and 1082 million tonnes. If so, our share of the world export market would go from its previous 30 per cent to between 45 and 55 per cent. Our main competitors are Brazil and West Africa.

At present we export about 20 million tonnes of natural gas a year, giving us just 2 per cent of the world export market. This could increase to between 86 million and 130 million tonnes by 2025, taking our market share to between 10 and 15 per cent. Our main competitors are Qatar, Russia and, in future, North America.

We are now exporting roughly 150 million tonnes of steaming (thermal) coal, giving us less than 20 per cent of the export market. This could rise to between 267 million and 383 million tonnes by 2025, taking our market share to between 23 and 33 per cent. Our competitors include Indonesia and, in future, Mongolia.

Our exports of coking (metallurgical) coal are roughly 150 million tonnes a year, but they could rise to between 260 million and 306 million tonnes. This would take our market share from 60 per cent to between 56 and 66 per cent. So there's a risk we lose market share to rivals such as Colombia.

All this growth isn't expected to much change the states' share of bulk commodity exports by volume. Western Australia has 60 per cent and Queensland has 22 per cent. But NSW has 15 per cent, leaving other states and territories with 3 per cent.

We'll be left with a mining sector whose share of national production (gross domestic product) well exceeds 10 per cent, making it bigger than manufacturing.

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House prices won't collapse, but won't take off either

For years when people at dinner parties worried about houses becoming too expensive for the younger generation to afford, I used to tell them not to worry: it was logically impossible for prices to rise to a level no one could afford. Why do I remind you of this? Because it's starting to look like I was right.

When prices are rising, and have been for many years, it's easy to conclude they'll go on rising forever. Even easier to conclude - as every real estate agent encouraged us to - is that house prices can only ever go in one direction.

As we're discovering, it turns out not to be true. According to Saul Eslake, of Bank of America Merrill Lynch, Australian house prices rose by 142 per cent between 2000 and their peak in late 2010, but in the 18 months since then have fallen by a national average of about 7 per cent. (In Sydney the fall's been 5 per cent; in Perth, 9 per cent, Melbourne 11 per cent, Brisbane 12 per cent.)

There's no shortage of people, particularly foreigners, who're convinced this increase went way beyond what the "fundamentals" of supply and demand could justify - a bubble, in other words - and it won't be long before the bubble bursts and prices come crashing down, as they have in the US and various other countries.

They may prove right, but I'm with Eslake, who argues it's unlikely. He estimates the present level of house prices is fully justified by the change over several decades of the two main factors determining the affordability of housing: household income and the level of mortgage interest rates.

The Australian median house price rose from 2.8 times average annual household disposable income in 1993 to four times in 2001. Since then it's been relatively stable. What allowed that multiple to rise so greatly was a "structural decline" in mortgage interest rates that occurred in the 1990s with the return to low inflation and the shift to the official interest rate being set by an independent central bank rather than politicians.

We could have used that fall in interest rates to pay off our homes much faster, or to increase our spending on other things. Instead we decided to use it to borrow more and move to a better house.

Because so many of us made that choice at pretty much the same time, we weren't all able to move to "better" (bigger, better appointed or better located) homes. Rather, the main thing we achieved was to bid up the prices of homes generally.

In the jargon of economists, we took that essentially once-only fall in the average level of mortgage interest rates - which Eslake estimates to have been about 4.5 percentage points - and "capitalised" it into the value of our homes.

Eslake argues house prices aren't likely to come crashing down because we have the income and borrowing capacity to afford the price of housing at roughly its present level, because we haven't been building more homes than the growth in the population justifies (in fact, we've been building too few), and because we haven't been borrowing against our homes to finance other consumption.

Eslake does predict, however, that house prices will rise much more modestly over the coming decade or two than they did in recent decades. Whereas they rose at the rate of 9.5 per cent a year during the noughties, he predicts rises averaging 3 per cent or 4 per cent a year in future.

Why? Because there won't be another, one-off, structural fall in the level of interest rates that greatly increases our capacity to borrow without increasing our monthly repayments. (Don't confuse the Reserve Bank's ups and downs in interest rates as it manipulates rates to manage the economy through the downs and ups of the business cycle - which get so much attention from the media - with the underlying average level of rates over a longer period.)

Without a structural shift in interest rates, house prices can't rise much faster than household incomes are growing. The indirect flow-through to households of the ever-rising prices we were getting for our mineral exports caused household disposable income to grow at an average rate of about 7.5 per cent a year over the past decade or so.

That compares with 4.5 per cent a year during the 1990s. Now commodity prices have stopped rising and are easing back, a more modest rate of growth is likely in coming years.

Which brings me back to where I started. The value of your home is easily determined: it's worth what you can find someone willing to pay for it. The value of homes generally can be no higher than what people generally are willing to pay and able to pay.

While it's always possible for prices to be higher than particular individuals can afford, it's impossible for them to be higher than most people can afford.

But it's surprising how much flexibility - room for give and take - there is in the system.

Many parents understand that, from their own privileged position as home owners, they have to assist their children to make the expensive step up to a home of their own.

For as long as enough parents see it that way, house prices will stay roughly where they are.

Were too many parents to be unwilling to help their kids make the step up, however, house prices would have to fall. This generation sells its homes to the next generation.

I take the present small falls in house prices as a sign the limits to affordability have been reached, and won't be exceeded.

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Why the banks haven't stuffed monetary policy

A new month, another meeting of the Reserve Bank board on the first Tuesday. Tomorrow, in fact. You beaut, another bout of speculation. Will they or won't they cut the official interest rate?

Thankfully, the speculation is a bit half-hearted this month. Having cut the rate two months in a row, most observers aren't expecting another cut this month.

So let's take the opportunity to discuss a more cerebral question: with the banks now going their own way on the interest rates they charge home buyers and business, does it still matter what the Reserve decides on interest rates?

In theory, it uses changes in its official interest rate to bring about changes in the market rates the banks charge households and businesses. It cuts rates when it wants to encourage borrowing and spending, and thus speed up the economy; it raises rates when it wants to discourage borrowing and spending, and thus slow down the economy.

It manipulates interest rates so as to achieve its inflation target - to hold the inflation rate between 2 and 3 per cent, on average, over the medium term - while also keeping unemployment low. Economists call this manipulation "monetary policy". But with the banks doing their own thing, is monetary policy still effective? If you listen to some bank spokesmen, moves in what the market prefers to call the "cash rate" no longer have a big effect on the decisions banks make about the rates they charge.

Don't you believe it. They're trying to justify their actions, not explain how interest rates work.

The cash rate is the cost of borrowing overnight in the money market; the rate at which the banks lend to each other. The Reserve keeps the cash rate under very tight control by means of "open market operations" - buying or selling second-hand government bonds to the banks.

Between 1999 and 2007, it was easy to see how the Reserve's ability to change the cash rate led to changes in the rates the banks charged on home mortgages and borrowing by businesses: any change in the cash rate - whether up or down - was soon passed on by the banks to their customers.

But from 2007, in the early days of the global financial crisis, that simple relationship broke down and the banks began making "unofficial" rate changes, usually in association with official changes. Why did things change? Because of the money-market disruption and changed relationships brought about by the crisis.

The cash rate is regarded as the risk-free rate of borrowing overnight and it thus forms the "anchor" for all other short-term and variable interest rates in the market. The other rates will usually be higher than the cash rate, with those other rates' margin (or "spread") above the cash rate, reflecting the extra reward to lenders for the various risks they have taken on: the "credit risk" (of not being repaid), the "liquidity risk" (of being unable to sell the debt security without loss because of limited demand for that security) and the "term risk" (of having your money tied up for a longer period).

During the period up to the start of the financial crisis, all these risks, and hence margins, stayed steady. So a change in the risk-free anchor could be passed on mechanically to the banks' borrowers.

But the crisis made people in various international markets a lot more conscious of the risks they were running, thus increasing the spreads they were demanding. Some markets actually ceased to operate for a time.

This wiped out our banks' chief competitors, the mortgage originators, which ended up being bought out by the banks. Later on, the prudential supervisors and the rating agencies decided our banks had made themselves too vulnerable to events such as the GFC by relying too heavily on short-term borrowing from overseas money markets.

So the banks began trying to lengthen the maturity of their foreign borrowing and also began competing with each other to attract more domestic deposits, particularly term deposits.

These changed conditions meant that, though the cash rate - the risk-free anchor for interest rates - remained the largest single influence over the banks' cost of funds, that cost was also influenced by other factors, such as the changing spreads required by foreign long-term lenders to our banks and by the higher rates needed to attract more term deposits from Australian savers.

Anxious to preserve their existing (very generous) "net interest margin" - the difference been the banks' average cost of funds and the average rate they charge their borrowers - the banks have become emboldened to pass any increase in their cost of funds on to their customers independent of changes in the cash rate.

After the Reserve's cut in the cash rate of 25 basis points in June, the banks decided to pass on about 20 or 21 basis points, thus demonstrating that the cash rate remains the dominant influence over market rates (in this example, 84 per cent), notwithstanding the change in the banks' circumstances and behaviour.

The more fundamental reason the effectiveness of monetary policy has not been reduced is the Reserve's repeated statements that the interest rates it cares about are those actually being paid by households and businesses, not the cash rate. So it makes whatever changes to the cash rate are necessary to get mortgage rates and business borrowing rates where it wants them to be.

Many people are highly disapproving of the banks' efforts to preserve their profitability by increasing the spread between the cash rate and the mortgage rate. But don't confuse the question of whether you approve of the banks' behaviour with the question of whether monetary policy has become less effective. It hasn't.

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Poor getting wealthier faster than the rich

There’s not much justice in the world, but there is a bit: according to a researcher at the Reserve Bank, the poor have been getting wealthy faster than the wealthy have been in recent years.

If you find that hard to believe, I don’t blame you. It’s not a conclusion you come to from looking at the Bureau of Statistics’ survey of the distribution of wealth. Rather, it comes from Richard Finlay’s decomposition of the wealth figures included in HILDA - the survey of household, income and labour dynamics in Australia.

But let’s start at the beginning. In Australia, as in all countries, the distribution of disposable income (wages and other earnings, plus welfare benefits, less income tax) between households is quite unequal. And here, as well as in other countries, the distribution of wealth (household assets less liabilities) is even more unequal.

According to the bureau’s figures for 2009-10, the best-off 20 per cent (‘quintile’) of households had 40 per cent of all the income, but 62 per cent of all the wealth. By contrast, the worst-off quintile had 7 per cent of the income, but just 1 per cent of the wealth.

Why the disparity between income and wealth? Partly because some forms of wealth (such as owning your own home) don’t generate explicit flows of income. But also because governments focus most of their efforts on redistributing income rather than wealth between rich and poor, using the tax and transfer (welfare benefits) system.

The poorest 20 per cent of households have some income because the government pays them a pension or the dole to make sure they don’t starve. They have no wealth primarily because they don’t own the home they live in.

So there’s no great mystery to wealth. The main way to acquire it is to buy a home and pay it off. The next most common way is to have a job and be compelled to put 9 per cent of your wage into superannuation saving. Then comes buying a weekender or an investment property.

Most people would have some money in the bank; some people have a lot. About a third of households own shares (directly, not just via super) and some own businesses. It’s mainly these latter that distinguish the really rich.

You’d expect the people with the highest incomes to have to most wealth, but it’s not that simple. People who own their home outright tend to be richer than people with a mortgage and people with a mortgage tend to be richer than people who rent.

As well, older people tend to be richer than younger people because they’ve had longer to save (and benefit from capital gain). Of course, once people retire they inevitably (and sensibly) run down their savings.

Naturally, the value of people’s assets has to be weighed against their liabilities. Few people acquire property without also acquiring debt, and property debt accounts for 80 per cent of all household liabilities. We worry about our credit card debt, but it pales compared with property debt, which divides 70/30 between the principal home and weekenders and investment properties.

It’s much more the rich than the poor who have debts. These days you borrow to make money and, in any case, banks are reluctant to lend to the poor. That’s particularly true of people borrowing for negatively geared property or share investments.

The top income quintile accounts for almost half the total household debt, while the top two quintiles account for more than 70 per cent.

When people see that household debt now accounts for about 150 per cent of annual household disposable income, they think of young couples getting in over their heads to buy their first home. There are some of them, of course, but for the most part the people with the most debt are those with the greatest ability to service it.

Finlay’s article in the Reserve Bank Bulletin says the real (inflation-adjusted) wealth per household was relatively flat from the late 1980s to about 1996. But then it started to increase, driven by the rising prices of property and shares. Over the following decade it grew at the real rate of 6 per cent a year.

But in 2008, ‘with the onset of the global financial crisis, household wealth fell substantially as the prices of dwellings and financial assets fell,’ he says. Wealth recovered somewhat in 2009 and 2010, but since then (and not covered in our figures, which are for 2010) house and share prices have been, as they say in the market, ‘flat to down’.

Over the four years to 2010, mean real wealth per household grew at the rate of just 1 per cent a year. But here’s a trick: whereas the mean (arithmetic average) wealth per household was almost $700,000, the median (middle) wealth was about $400,000.

It’s actually common for the mean to be a lot higher than the median in the case of income or wealth. That’s because a relatively small number of individuals or households are so much better off they push up the mean, thus making the median a better measure of the ‘typical’ household.

Another way to put it is that the distribution of wealth is ‘skewed’ in favour of people at the top. But Finlay finds the degree of skewness seems to have fallen over the past four years.

Using the median rather than the mean to characterise each quintile (which I suspect explains why his findings differ from the bureau’s), he finds that median real wealth in the lowest quintile grew by 5 per cent a year over the period, whereas the medians for the three middle quintiles grew by about 2 per cent a year and for the wealthiest quintile by less than 1 per cent a year.

Why? Partly because of a low-base effect: the less you’ve got to start with, the easier it is to have a larger percentage increase.

But also because richer households tend to hold a higher proportion of their wealth in riskier forms, such as shares. So they would have suffered bigger losses during the financial crisis and maybe smaller gains since then.

Richer households are more likely to have taken on negatively geared property and share investments. The crisis wouldn’t have been kind to them. As well, the very highest house prices tend to be more volatile than other home prices.

There’s just a bit of justice in the world.

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Carbon tax is nothing to object to

When psychologists study those sects that predict the end of the world on a certain day, they find the leaders rarely willing to admit they were wrong and their true believers rarely willing to admit they were duped.

Rather, the sect members find some dubious rationalisation. It was our prayers, brothers and sisters, that interceded for this wicked world and persuaded the Good Lord to stay his hand.

Since the day he won the leadership of the opposition on the strength of his willingness to switch from supporting to opposing putting a price on carbon, Tony Abbott has been predicting the carbon tax would wreak devastation on the economy, wrecking industries and destroying jobs.

To be fair, running scare campaigns against new taxes has always been accepted as a legitimate tactic by our ethically challenged political class.

Labor was happy to exploit the fears of the ill-informed in its opportunist opposition to John Howard's ''great big new tax on everything'', the goods and services tax.

The biggest difference is that Abbott's misrepresentations have been so much more successful.

But with the carbon tax taking effect from Sunday, the moment of truth approaches. Soon enough it will become clear that, for consumers and the vast bulk of businesses, the dreaded carbon tax will have an effect much smaller than the GST.

The retail prices of electricity and gas will rise about 9 per cent, but the increases in other prices will be very small.

Whereas the GST increased the consumer price index 2.5 per cent, the carbon tax is expected to raise it just 0.7 per cent.

Whereas the GST is expected to raise revenue of $48 billion in the new financial year, the carbon tax is expected to raise about $4 billion in its first year and about $7 billion in subsequent years.

Julia Gillard and her supporters have been hoping against hope that, as soon as this reality dawns on a fearful public, as soon as the magnitude of the Liberals' hoax is revealed, voters will switch back to Labor in droves.

I don't see it happening. It rests on an unrealistic view of the lack of self-delusion in human nature.

Political parties and their cheerleaders don't like admitting they've been dishonest - even to themselves. And you and I don't like admitting we've allowed ourselves to be conned by unscrupulous politicians and shock jocks.

So we look for rationalisations, no matter how tenuous. And in these the carbon tax abounds. With the GST, the object of the exercise was clear and simple: to raise more revenue. With the carbon tax the object is far from clear to anyone who hasn't done their homework.

For a start, it's clear the object is not to raise revenue, because much of the revenue raised is being returned to households as ''compensation'' in the form of a small cut in income tax for most people and small increases in pensions, allowances and family benefits.

But if the object is simply to discourage people from using emissions-intensive goods and services - which it is - why give back to most people the extra tax they'll be paying?

Because economists believe that to change people's behaviour it's necessary only to change the relative prices they face: to raise the prices of fossil fuels (particularly electricity and gas) relative to all other prices. It's not necessary to leave people out of pocket by keeping the proceeds from the tax you used to bring about the change in relative prices.

You may say you can't see how such a relatively modest rise in the price of electricity could make much difference to households' use of power. That's probably true, though it may encourage people to buy a more energy-efficient model next time they're replacing an appliance.

Actually, the price increase is aimed mainly at big industrial users of energy and, more particularly, the generators of electricity.

If the industrial users can be induced to eliminate wasteful use of power, this will make a difference. And if power companies can be induced to replace their present generators with less emissions-intensive models when the time comes, this will make a big difference. Raising the price of electricity produced by burning fossil fuels helps make the price of power produced from renewable sources more competitive.

But if those objections to the tax don't wash, there are plenty more. One is that the tax of $23 per tonne of carbon dioxide is way too high. I discuss this one in my little video on the website.

Yet another objection is that, since there's nothing an individual country can do to have a significant effect on global emissions of greenhouse gases, in the absence of a binding agreement to act by all the major countries there's no point in us doing anything.

Trouble with that argument is it increases the likelihood of failure. Only if enough countries demonstrate their good faith by getting on with it is effective global action likely to eventuate. We should line up with the good guys, not the bad guys - and we're far from the only good guy.

But if all else fails - if you can't find any other argument to confirm the wisdom of your original conclusion the carbon tax is a terrible thing - just tell yourself that, when the vast majority of scientists specialising in the area warn us continued emissions of greenhouse gases will lead to devastating climate change, they've got it all wrong.

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