SURVEYING THE SCENE - PANEL DISCUSSION

Institute of Public Administration Australia NSW State Conference, Sydney

The most useful contribution I can make is to talk about the general economic and budgetary environment I think you’re likely to be facing in the next few years. I don’t want to depress you, but my best guess is that it’s likely to be increasingly challenging.

For a start, the Australian economy isn’t likely to be getting a lot of help from the rest of the world. The US economy looks like it’s finally on the mend, but it’s not likely to be setting any records for growth. The Europeans are still mired in their own problems - which could easily get a lot worse - and are likely to stay a drag on the world economy for many years to come. The Japanese economy has its own problems. As for China, it’s possible it will fall in a heap as the pessimists fear, but if it did it would bounce back pretty quickly and I think it’s more likely we’ll China continuing to grow, tho at rates of 6 or 7 per cent rather than 10 or 12. All told, we won’t be getting a lot of help from abroad.

As I’m sure you’ve heard, the big issue for our economy is for a ‘rebalancing’ - we need to make a transition from mining investment-led growth to growth in the rest of the economy, particularly home building and non-mining business investment. It may be we make this engine-swap without too much of a hiatus, but it’s not clear we will, and were mining investment to fall sharply before these other sources of growth got going properly it’s not inconceivable the economy could contract. The more we see the dollar fall the more confident we can be, and it’s likely we’ll see more cuts in interest rates.

All this says it’s hard to see federal or state tax revenue growing strongly in the coming years, which will inevitably keep a lot of pressure on the spending side of federal and state budgets. The Reserve Bank is very keen to avoid a real estate boom that would cause states’ collections from conveyancing duty to grow strongly, and consumer spending is likely to grow no faster than household incomes, which isn’t likely to be rapid. Added to this we have the structural weakness in collections from the GST, which is likely to keep a lot of pressure on the premiers before, eventually, the pressure gets so great that the premiers and the prime minister do a deal and increase the rate of the tax, or widen its base, or a bit of both.

Your problem isn’t just that the ordinary natural upward pressures on the spending side of state budgets are likely to be stronger than the upward pressure on the revenue side, it’s compounded by the medium-to-longer term structural spending pressures identified by successive federal intergenerational reports. It suits the politicians to portray this problem as the ageing of the population. If that were true, there wouldn’t be a lot for premiers to worry about. Unfortunately, the real problem is the irresistible pressure for very strongly growing health spending arising from expensive advances in medical technology - meaning it’s very much a problem for the premiers and well as the feds. When the states did their own intergenerational exercises a decade ago they found that hospital spending had the potential to take over their budgets in coming decades and I doubt anything’s changed. That says the health department will be under intensifying pressure to control cost growth, but its nonetheless rapid growth will keep pressure on every other state spending category.

One bit of good news is that, between the states, it’s now NSW’s turn to be among the faster growers, with Queensland and WA much harder hit by the downturn in mining investment. Another point worth remembering is that, tho the pressure to limit staff numbers and annual pay rises will remain, much of the strong growth in spending during the previous Labor government’s term went into correcting the long-running deficiency in public sector wage rates relative to private sector rates.

There HAVE to be better, more cost-effective ways to deliver the services the state government is responsible for delivering without great loss of quality - which is fortunate because the pressure on you guys to find those ways will only intensify in the next few years. If you’re planning to stick around my advice is to accept that reality and get on with finding those ways rather than thinking that if you drag your feet for long enough the brighter fiscal days will return. That makes it fortunate this conference is addressing itself to this challenge.

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Egalitarian facade hides growing inequality

One thing that makes me proud to be Australian is our tradition of egalitarianism. I love living in a country where Jack is as good as his master, where first names are so commonly used and men are more likely to address each other as "mate" than "sir".

When catching a cab overseas, I have to remind myself not to sit in the front with the driver and I love the way our government ministers - male and female - invariably sit up front in their chauffeur-driven cars, with staff members in the back seat.

It makes me proud to hear that in prisoner of war camps, the American soldiers tended to turn them into little economies and the Brits stuck rigidly to class privileges, whereas the Aussie officers and men shared all their meagre resources on the basis of need - meaning more of them survived.

And I was chastened years ago on an industrial relations junket as a guest of the German government. The Aussies in the group went out to see the sights one night in Munich. When, eventually, we decided to go back to the hotel we realised one of the group was missing.

I said I thought he was old enough and ugly enough to look after himself but an old union secretary demurred. "You blokes go back to the pub," he said quietly. "I'll have a look round for him. You never leave your mates behind."

You might think this egalitarianism would be reflected in a reasonably equal distribution of income between Australian households but that's far from the case. As the economics professor turned Labor politician Andrew Leigh reminds us in his most readable new book, Battlers and Billionaires, the latest figures show us having the ninth highest level of inequality among 34 rich countries.

It's probably not terribly well understood that, between Federation and the late 1970s, the gap between the highest and lowest incomes narrowed steadily, whereas since then, it has widened significantly.

The standard way to study the distribution of income is to compare the fortunes of the poorest fifth of households with those of the middle fifth and the top fifth. But Leigh has led the way in using income tax statistics to focus on changes in the share of total income commanded by the top 1 per cent of income earners.

He finds that, in the 1910s, the top 1 per cent (individuals who, by today's standards, enjoy pre-tax income of more than $200,000 a year) received about 12 per cent of all personal income. That is, 12 times what they'd get if incomes were distributed equally.

But this share declined steadily to reach a low of about 5 per cent of total income by 1980.

What caused this marked decline in inequality? Leigh shares the credit between the effect of the union movement (and, I'd add, our system of arbitration and conciliation) in protecting and improving wage levels, our governments' increasing reliance on income tax (with its progressively higher tax rates on higher income earners) and the development of our heavily means-tested system of welfare benefits, such as the age pension, child endowment and unemployment benefits.

He says the welfare system has twice the equalising force of the tax system.

The result was that, "under the prime ministership of Malcolm Fraser, the share of income held by the richest 1000th of Australians was only a quarter of what it had been under Billy Hughes [in the late 1910s]".

Since sometime in the late 1970s, however, this equalising trend - bringing the way the nation's income is shared more into line with our egalitarian ideals - has been reversed. The share of the top 1 per cent of income earners has recovered from 5 per cent to about 9 per cent.

Why? Leigh estimates the rise in inequality over the past generation can be attributed roughly equally to three factors, the first of which is technology and globalisation.

New technology's ability to give the best entertainers, sportspeople and even lawyers and other professionals access to a global market has hugely increased the incomes of a relative handful of individuals. Efforts to attract foreign chief executives to lead Australian companies have helped to force up the incomes of all chief executives.

Second is the decline of the union movement (including the move from collective bargaining to individual contracts), which has allowed many workers' wages to grow less strongly than other incomes.

Third is taxation, with moves to make income tax rates less progressive and rely more on indirect taxes.

My way of putting it is that, since the early 1980s, we have become more overtly materialistic in our values and political leaders have reacted by undertaking micro-economic "reforms", emphasising the primacy of economic growth and generally becoming more receptive to the demands of business.

The result is a lot more income, but also a lot less equal distribution of that income. The people urging this greater emphasis on materialism have captured most of the benefits while the rest of the community doesn't quite seem to have noticed what's going on.

I confess, I've been a winner from this process. What I'm not sure of is whether it leaves us better off as a community. Perhaps one day, the egalitarian facade will collapse and we won't like what we see.

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Sorry, productivity isn't almost everything

To be frank, I don't lay awake at nights worrying about how Australia is going to lift its rate of productivity improvement back to 2 per cent a year. Contrary to the impression Kevin Rudd is trying to convey with his seven-point productivity plan, higher productivity would do little to help us make the transition to the post-resources boom world.

The biggest risk in the potential hiatus between the waning of the boom and the return to healthy growth in the non-mining economy is an unacceptable rise in unemployment, and higher productivity won't fix that.

For one thing, the threat to employment is immediate and relatively short term, requiring deft management of the macro-economic levers, not the longer-term measures needed to enhance our productivity performance.

More fundamentally, improved productivity is about increasing our material standard of living - real income per person - not about increasing employment (which, in any case, shouldn't be more than a temporary problem).

I worry a lot more about whether our existing high material standard of living is compatible with the preservation of a healthy natural environment - including one that avoids excessive global warming - than about how we can drive our consumption levels even higher. The origins of the very resources boom we're struggling to adjust to - and our hand-rubbing contemplation of Asia's rapidly growing middle class - ought to be making us wonder whether the globe's natural resources and ecosystem will be able to cope with so much affluence.

So if we fail to get productivity improving at the rate of 2 per cent a year rather than 1.6 per cent, I won't be shedding too many tears. Apart from ecological sustainability, I give improving our non-material quality of life a much higher priority than increasing the number of cars, TV sets and gadgets per home.

But for all the business people, economists and politicians who profess to care so deeply about accelerating our rate of consumption let me offer some advice: you won't get far until you can see past your sectional interests and ideological hang-ups. If the hyper-materialists were genuine in their drive for faster productivity improvement they'd be ascertaining those measures likely to do most to enhance productivity and resolving to pay whatever price was necessary to bring them about.

But that's not what they're doing. Rather than asking which measures would be most effective, they're asking which measures they'd be most comfortable with. Whether the most comfortable measures would be particularly effective doesn't seem to worry them. Take the business lobbies. They're proceeding on the theory that anything making life easier for business must surely be good for productivity. So top of their list is a return to individual bargaining in industrial relations, followed by measures that reduce the tax burden on business and increase it for everyone else. As for the economists, they're really only interested in measures that fit their model's built-in presumption against government intervention in the economy.

So their preference is for measures that reduce intervention - micro-economic reform - and do little to add to government spending and taxation. The first problem with this approach is that it's generally unpopular with the electorate and invokes fierce opposition from vested interests, mainly business interests.

Successive governments have been reluctant to undertake further micro reform for well over a decade. So if more micro reform is the key to faster productivity improvement don't expect to see much improvement.

The second problem with the economists' approach is it means they have little enthusiasm for productivity enhancing measures that involve significantly increasing government spending.

Trouble is, this includes the two areas where big productivity gains are most likely to be found: greater investment in education, training and research to increase human capital, and greater investment in public infrastructure to improve the conditions in which our businesses operate.

It shouldn't be assumed that all we need to improve education and infrastructure is a lot more spending. But nor should it be assumed - as many economists do - that all that's needed is reformed government intervention in these areas. In truth, both better intervention and a lot more spending are needed. The first part is tricky, the second is ideologically unfashionable (as well as requiring higher taxes).

To be sure, the Labor government is already spending a lot more on education and training, and this should favourably affect productivity in due course. Ideological blinkers have prevented many people from seeing that the Gonski reforms to direct greater funding to disadvantaged students should have a productivity pay-off - as should the national disability insurance scheme.

My guess is any improvement we see in our productivity performance will happen more in spite of all the speech-making on the topic than because of it.

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Yes, we are going through a weak patch

The economy is going through a weak patch. The resources boom is coming off, but the rest of the economy has yet to take up the slack. That's partly because the dollar has been so high until recently and partly because business and consumer confidence have been weaker than they should be.

I was lecturing an interviewer on our tricky transition when he stopped me in my tracks by asking what "metrics" I based this judgment on. Since he was used to interviewing business people, I suppose it was a fair enough question.

I could have said I based it on the high rate of company tax, the carbon tax or some other fashionable business complaint.

But being a boring economics writer, the "metrics" I was using were the obvious ones: what the Bureau of Statistics' quarterly national accounts are telling us about the rate at which the economy's growing and what its monthly survey of the labour force is telling us about employment and unemployment.

The two indicators act as largely independent checks on each other. The latest national accounts, for the March quarter, showed real gross domestic product growing by 2.5 per cent over the year to March, and by about the same annualised rate in the March quarter itself.

How do we know whether 2.5 per cent is good or bad? Well, it's well short of the economy's "trend" growth rate of about 3 per cent. The economy's trend rate of growth is its "potential" growth rate: the maximum rate at which our production of goods and services can grow over the medium term without causing inflation pressure.

Our potential growth rate is set by the average rate at which our productive capacity is expanding as a result of growth in "the three Ps" - the population of working age, that population's actual rate of participation in the workforce and the productivity of its labour (determined by business investment in equipment, public investment in infrastructure, the skill levels of the workforce through education and training, and technological advance).

The econocrats' estimate of our potential growth rate has recently been cut from 3.25 per cent to 3 per cent a year because the continuing retirement of the baby boomers is reducing the participation rate.

As the word "trend" implies, our potential growth rate is a medium-term average. When the economy's coming out of a recession it can grow faster than its trend rate until all its spare production capacity (including unemployed and underemployed workers) is taken up.

So when the economy is growing below its trend rate, this implies it isn't growing fast enough to create sufficient additional jobs to stop unemployment rising.

And that's just what the labour force figures confirm is happening. The figures we got this week for June, for instance, show the rate of unemployment creeping up from 5.6 per cent to 5.7 per cent.

In truth, it's been creeping up for some time. Using the bureau's much clearer smoothed seasonally adjusted figures (also confusingly known as the "trend" estimates), the unemployment rate was 5.2 per cent in June last year, but 5.7 per cent in June this year.

Last December it was 5.4 per cent, implying its rate of worsening is a little faster in recent months. This, in turn, suggests the economy's rate of growth in the June quarter may have been a little slower than a 2.5 per cent annualised rate.

Note that employment is still growing, though at a slower rate - only about 7500 jobs in June, compared with about 18,000 jobs a month around the turn of the year - with almost all the new jobs being part-time.

The trick is that size of the workforce keeps growing - as a result of natural increase and immigration - so if the economy isn't generating enough additional jobs, unemployment must rise.

Just how long the economy goes on slowing and by how much are questions we can only guess at. It will be determined, obviously, by how quickly the resources boom comes off, on the one hand, and how long it takes the non-mining economy to pick up speed on the other.

The huge growth in investment spending on new mines and natural gas facilities looks like it's at its peak, but we don't yet know whether it's reaching a plateau or will fall away quite quickly. Since mining investment has been the biggest factor driving economic growth in recent years this is a key question.

Similarly, it's hard to predict how long it will take the rest of the economy to recover its mojo and return to normal rates of growth. In particular, non-mining business investment has been a lot weaker than usual, as has households' investment in home building.

What reason is there to expect the non-mining economy to return to more normal rates of growth? One reason is the belated (and, as yet, still insufficient) fall in the dollar following the retreat in our mineral export prices.

This will act as a stimulus to our export and import-competing industries. Another source of stimulus is the easing in monetary policy. The Reserve Bank has been lowering the official interest rate since November 2011, cutting it from 4.75 per cent to 2.75 per cent. Monetary stimulus takes a fair while to have its full effect on the willingness of businesses and households to borrow and spend.

It's always possible the economy could slow to the point where it was contracting rather growing, but it's rare for growth to simply peter out in such a way - partly because it can be seen coming, leaving the economic managers time to take corrective action.

Just as the Reserve has been doing, of course. With this week's evidence of further weakness - and assuming it's confirmed by a low inflation report on July 24 - it won't be surprising to see the Reserve cut rates again.

After that, the next stimulus weapon would be fiscal policy - the budget. The new Treasurer, Chris Bowen, would be well advised to keep his options open.

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The jobs will come, as they always have

I can't make myself sleep on the long plane trip to or from Europe. These days I just keep myself distracted by the plane's entertainment system. Returning at the weekend from a walking holiday in England, I really enjoyed rewatching the Jack Nicholson movie As Good As It Gets, with its theme tune, an American-sanitised version of Always Look on the Bright Side of Life.

In Australia we're usually a land of bright-siders, though this hardly makes us unique. It's actually this optimism about the future that keeps our economy moving onwards and upwards.

At present, however, we're looking on the dark side. Until recently it was fashionable to complain that, whoever was benefiting from the resources boom, it wasn't you or me. These days, the worry is that with the initial stages of the resources boom passing its peak, it's hard to know where the growth and the jobs will be coming from.

Did you detect the logical inconsistency between those two worries? They can't both be true. If most of us gained nothing from the boom, most of us have little reason to mourn its departure. All the two positions have in common is their pessimism.
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Yet despite all the political and economic commentary to which we're exposed, it took a speech last week from Reserve Bank governor Glenn Stevens to point out the contradiction.

The truth is you and I got plenty of benefit from the resources boom. The reason so few of us realise it is that most of those benefits were indirect. We often have trouble joining the economic dots.

One of the most easily detected indirect benefits of the boom is the high dollar which, among other things, has made it so much cheaper for us to take overseas holidays (and, until recently, left the world crawling with Aussie tourists).

Now, with the resources boom receding and the American economy finally picking up, the dollar is coming down again, allowing those who never acknowledged the high dollar's benefit to complain about its departure.

But the trick is that everything that happens in the economy - whether popularly judged to be good or bad - has both advantages and disadvantages. So to every seemingly good thing that happens there's always a downside, while to every bad thing there's an upside.

The disadvantage of the high dollar was that it made it harder for Australian businesses to compete on export markets and against imports in the domestic market. So the advantage of a lower dollar is that it takes pressure off a lot of Australian businesses - not least of which are our tourism operators - making it easier for them to expand their sales and employment.

When I was younger I used to dread times like this, where the economy was looking flat and everyone was demanding to know where the jobs would be coming from. How should I know?

Usually that question is asked in the later stages of a severe recession, when people are depressed and doubtful whether the economy has a future. We haven't had a severe recession for more than 20 years - a record for us and better than any other rich country can say - and yet we're feeling down. (Sometimes I think we're feeling down precisely because so many of us have no recollection of what genuine economic hardship feels like.)

By now, however, I no longer dread being asked where the jobs will be coming from. I know from the experience of three severe recessions that there's always a tomorrow. I don't know the precise details, but I do know the jobs will come. Always have in the past and no reason to doubt they will again.

What's more, in this case past performance does offer a reasonable guide to the future. As Stevens reminded us in last week's speech, over the 21 years to mid-2012, our production of goods and services roughly doubled. Only 3 percentage points of that 100 per cent increase came from manufacturing.

The largest contributions came from financial services (13 percentage points), mining (10 points), construction (9 points), professional services (8 points) and healthcare (7 points).

But though production and employment are related, they're not the same, with some industries being a lot more labour-intensive than others. Over the same period the number of jobs in the economy has increased by about half. About two-thirds of this increase is attributable to growing employment in the provision of various kinds of services to businesses and households.

There's been growth across the board in services sector employment, but healthcare accounts for 9 per cent of the increase and professional services for 7 per cent.

One beauty of the services sector is that it provides unskilled jobs - for waiters, cleaners, shop assistants and the like - but also, and increasingly, highly skilled jobs for managers, medicos, teachers, lawyers and all manner of professionals and para-professionals.

So that's where the jobs will come from, and come they will. It's not the government's job to ''create'' those jobs any more than it was its job to conjure up the resources boom. That's the job of business and, indirectly, households.

It will happen when businesses and householders get their confidence back - which we can be sure they will. What we can't be sure of is that this will happen on cue.

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AUSTRALIA’S CONFLICTING MACRO POLICY

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.

Australia’s conflicting macro policy

At the time the macro managers responded to global financial crisis in late 2008 and the threat that our economy would be caught up in the Great Recession, both policy arms were moved to the same setting of ‘extremely stimulatory’. The cash rate was slashed from 7.25 pc to 3 pc. The automatic stabilisers moved the budget from surplus to deficit, to which the Rudd government added significant discretionary stimulus spending.

Once the emergency had passed and it became clear severe recession had been avoided, however, the managers began using the two arms to pursue different objectives. On fiscal policy, the temporary stimulus spending was allowed to finish, the government stuck to its deficit exit strategy and the automatic stabilisers were allowed to push the budget back towards surplus. The RBA quickly returned monetary policy to a neutral stance but, with inflation under control, from November 2011 it began easing policy to counter the high dollar and encourage growth in spending.

At the time of the 2012 budget the stance of fiscal policy was quite restrictive as the government sought to keep its election promise to return the budget to surplus in 2012-13, while the stance of monetary policy was expansionary.

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 highly 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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In the business game, less is often more

It's a holiday, so let's talk about sport not business - for openers, anyway. Indoor handball is a team sport where players face a constant stream of quick decisions about what to do with the ball: pass, shoot, lob or fake?

Players have to make these decisions in an instant. Would they make better decisions if they had more time and could analyse the situation in depth?

In an experiment with 85 young, skilled handball players, each stood in front of a screen, dressed in his uniform with a ball in his hand. On the screen, video scenes of high-level games were shown. Each scene was 10 seconds long, ending in a freeze-frame.

The players were asked to imagine they were the player with the ball and, when the scene was frozen, to say as quickly as possible the best action that came to mind.

After these intuitive judgments, the players were given more time to inspect the frozen scene carefully, and name as many additional options as they could. For instance, some discovered a player to the left or right they had overlooked, or noticed other details they weren't aware of under time pressure.

Finally, after 45 seconds they were asked to conclude what the best action would be. In about 40 per cent of cases this considered judgment was different from their first choice.

OK, that's enough fun. Back to business. We live in a business world where the thinking of educated people has been heavily influenced by rational analysis. For instance, one rational conclusion is that to make good decisions we need the best information possible. To be better informed is to perform better.

These days, all switched-on managers know they need an adequate business information system - the right "metrics" - to be fully informed about their business's performance and so be able to make the right decisions to keep it scoring goals.

To the rationally trained person, more information is always better and more options to choose from are always better. Economists add the qualification that information is often costly, so you shouldn't keep collecting it beyond the point where the additional cost exceeds the additional benefit.

Practical managers know there's a trade-off between speed and accuracy. It's good for decisions to be as accurate as possible, but it's also good for decisions to be made without much delay. So the smart manager finds a happy medium between accuracy and speed, knowing they're sacrificing some accuracy for a speedy decision.

Back to handball. This experiment was recounted by German psychologist Gerd Gigerenzer, of the Max Planck Institute in Berlin, in his book Gut Feelings. To measure the quality of the actions the players proposed, the experimenters got professional-league coaches to evaluate all proposed actions for each video.

They found that, contrary to the notion of a speed-accuracy trade-off, taking time and analysing didn't generate better choices. The players' gut reactions were, on average, better than the actions they chose after reflection.

Indeed, the order in which possible actions came to the players' minds directly reflected their quality: the best came to mind first, the worst came last. This result is consistent with many experiments showing that, though the inexperienced need to think it through carefully before they take a golf shot, drive a car, or tie their shoe laces, the experienced do better if they don't think about what they're doing but simply do what comes naturally.

This is consistent with another finding that chicken sexers, chess masters, professional baseball players, award-winning writers and composers are typically unable to explain how they do what they do.

In some circumstances, more information and more time to process it is better. But a surprising amount of the time less turns out to be more.

Gigerenzer says this will be so in cases where we're relying on unconscious motor skills. It's also true when the limits of our brain power mean we make better decisions if we don't confuse ourselves with too much conflicting information.

Our brains seem to have built-in mechanisms, such as forgetting a lot of things and starting small, that protect us from some of the dangers of possessing too much information.

A famous experiment involving selling different flavours of jam in a supermarket found that having too many choices leads to decision-making paralysis. Offering a choice of six led to more sales than a choice of 20. It doesn't follow, however, that offering an even smaller choice would increase sales further.

Gigerenzer's other conclusion - of particular relevance to business decision-making - is that empirical testing can reveal simple rules of thumb that predict complex phenomena as well or better than complex rules do.

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Economy yet to make transition to post-boom world

The economists' buzzword of the week - and probably the year - is "transition". If it's not in your lexicon add it immediately. You'll need it - because this week we learnt how tricky it's likely to be.

As the construction phase of the resources boom nears its peak, the economy needs to make a transition from mining-led growth to growth led by all the normal sources: consumer spending, home building and non-mining business investment.

This week the national accounts for the March quarter from the Bureau of Statistics showed growth in real gross domestic product of just 0.6 per cent for the quarter and 2.5 per cent for the year to March.

For once this seems a reasonably reliable reflection of how the economy's travelling. It's not disastrous, but nor is it satisfactory.

The economy needs to be growing at its medium-term trend rate of about 3 per cent a year. Growth of that order is needed just to hold unemployment constant. And since we've been falling short of it for about a year it's not surprising that, over the year to April, the unemployment rate has drifted from 5.1 per cent to 5.5 per cent.

(If you had it in your mind our trend growth rate was nearer 3.25 per cent, you're not wrong, just out of date. The econocrats have lowered it to 3 per cent to take account of the ageing of the baby boomers, which means a larger proportion of the population is now in an age range with lower participation in the labour force.)

The worrying thing about this week's figures is that they reveal the pressing need for a transition from mining-led to broader growth, but not much sign it's about to happen.

As best he can determine it, Kieran Davies, of Barclays bank, estimates mining investment spending fell about 7 per cent in quarter. Rather than rising, however, non-mining investment spending fell about 3 per cent.

At the same time, new home building (including alterations) was flat. Consumer spending strengthened to grow 0.6 per cent, but this was still below trend.

Public sector spending grew 1.1 per cent, but this followed a much bigger fall the previous quarter and with all the pressure on state and federal governments to balance their budgets, we shouldn't expect much help from the public sector.

According to the opposition, the Gillard government's been doing far too much to help.

It turned out a lot of the growth in the March quarter came from "net external demand". The volume (quantity) of our exports grew 1.1 per cent, whereas the volume of imports fell 3.5 per cent, meaning "net exports" (exports minus imports) made a positive contribution to growth of 1 percentage point.

Some silly people have been saying if it hadn't been for net exports the economy would be in a bad way - which is a bit like saying if we cut off one of our arms we'd be in a bad way. What they're missing is that the growth in export volumes will be lasting (they grew 8.1 per cent over the year to March) because it's coming from strong growth in exports of coal and iron ore, as new mines come into production and the third phase of the resources boom kicks in.

In other words, it's wrong to imagine the boom's about to leave us high and dry. Mining production and exports have a lot further to grow in coming years. Even the fall in imports (which constitutes a reduction in their negative contribution to growth) is linked to the boom: reduced investment in new mines means reduced imports of capital equipment.

As for the second, construction phase of the boom, spending from quarter to quarter is too variable to allow us to conclude this quarter's fall means the peak has been passed. Maybe, maybe not. Nor is it clear how precipitous the fall will be when it arrives. It may be fairly gentle since the miners' pipeline of committed projects still stands at a record high of $268 billion.

What reason is there to hope the non-mining sources of growth will strengthen? The main one is that the Reserve Bank has cut the official interest rate 1.5 percentage points in a little over a year, taking the "stance" of monetary policy to its most stimulatory in many a moon.

Everything we know tells us lower interest rates encourage borrowing and spending, particularly in interest-sensitive areas such as housing and the purchase of consumer durables. We also know it often takes a while to work. In my experience, it's just when people are running around saying it isn't working that it starts to.

Of course, a significant fall in the dollar would help a lot by improving the international price competitiveness of our export and import-competing industries, particularly manufacturing and tourism. It would help them produce more for export and replace imports in the domestic market. (So much for those who think it makes sense to assume away net exports.)

The dollar does seem to have fallen about US7? in the past few weeks. This may be some help, but it's far short of what would be justified by the deterioration in our terms of trade (the passing of the first phase of the boom) and what our traders need to restore their competitiveness.

The best hope for further falls in the exchange rate is not further cuts in our official interest rate (its role is widely overrated) but better prospects for the US economy leading to expectations of the cessation of "quantitative easing" (metaphorically, printing money), which has the side effect of putting downward pressure on the greenback. The Reserve has been cutting rates since November 2011, not to induce a fall in our dollar so much as to offset the contractionary effect of its failure to fall as export prices have fallen.

Should the dollar keep falling the Reserve won't cut rates any further. Should the dollar fail to keep falling, it probably will.

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LATEST DEVELOPMENTS IN THE ECONOMY AND MONETARY POLICY

Economic growth: the economy’s production of goods and services (real GDP) grew by a below-trend 2.5 pc over the year to March. Non-mining business investment spending is weak, home-building and public spending are flat, but consumption is growing at below trend and net exports (exports minus imports) are growing strongly. Mining investment may have peaked. Production is forecast to grow slightly below its trend rate at 2.75 pc in 2013-14.

Inflation: the underlying inflation rate was 2.4 pc in the year to March, down from a peak of 5 pc in the year to September 2008, immediately before the GFC. It’s been back in the target range of 2 to 3 pc for three years and in the bottom half of the range for one year, suggesting no threat from inflation.

Unemployment: using trend estimates, the unemployment rate was 5.5 pc in April, having crept up from 5.1 pc over the previous year, though with the participation rate unchanged at 65.3 pc. Thus the economy has not been growing quite fast enough to hold unemployment steady. And with its growth forecast to stay a little below trend in 2013-14, the unemployment rate is forecast to continue creeping up to 5.75 pc by June 2014. But note that this unemployment rate is not much above the NAIRU, our lowest sustainable rate.

Current account deficit: CAD was $9 billion for the March quarter, or 2.2 pc of GDP. For the year to March, the CAD totalled $49 billion, made up of a trade deficit of $13 billion and a net income deficit of $36 billion. As a consequence of the high CADs in earlier years, the foreign debt has risen. At the end of March the net foreign debt was $764 billion, or 51 pc of GDP. The CAD is below its trend level of about 4.5 pc of GDP because although national investment (mining construction spending) has been stronger than usual, national saving (households and companies) has risen by more, while staying less than national investment.

Now let’s take a closer look at the state of the economy. This is a particularly interesting time to be studying the Australian economy because we have spent the past decade coping with the biggest commodity boom in our history since the gold rush, with the global financial crisis and its aftermath thrown in just to make things interesting. The boom has had big implications for the exchange rate, for change in the structure of the economy and, of course, for macro management.

Resources boom: The boom started in 2003, but was briefly interrupted by the GFC. It arises from the rapid economic development of China and India, which has hugely increased the world demand for energy and the main components of steel. This demand may stay elevated for several decades until the two most populous countries complete their economic development. The boom has involved three overlapping stages:

First, hugely increased prices for our exports of coal and iron. These caused Australia’s terms of trade to reach their most advantageous level in 200 years by June 2011, but they have since fallen back by 17 pc. Even so, we are still receiving significantly higher prices for our exports of coal and iron ore. Prices shot up as demand outstripped supply, but as Australia and other commodity exporters increase their production capacity prices are falling back.

Second, an unprecedented boom in investment in new mines and natural gas facilities as miners take advantage of the great global demand for minerals and energy. This investment spending has been a major contributor to growth for the past few years, but it is now expected to reach a peak in 2013 and, thereafter, begin subtracting from growth as it falls back. Note that, even though spending will decline from one quarter to the next, there is still considerable spending to come.

Third, significant growth in the volume of our exports of minerals and energy as new investment projects come on line. This volume growth will make a positive contribution to GDP growth and also to the trade balance and the CAD, even as falling export prices act to worsen the CAD.   

Exchange rate: As a commodity-exporting country, Australia’s exchange rate always tends to rise or fall in line with world commodity prices and our terms of trade. So our exceptionally favourable terms of trade left us with our strongest exchange rate for 30 years. The dollar is also being kept high by foreign purchases of Australian government bonds and the indirect effect of the developed countries’ use of ‘quantitative easing’ to stimulate their economies.

The higher dollar has reduced the international price competitiveness of our export and import-competing industries. Exporters are earning fewer $As from their overseas sales in $USs, while domestic industries are losing market share to now-cheaper imports. This adversely affects all industries in our tradeables sector (including the miners and the farmers), but particularly disadvantages our manufacturers and key services exporters, tourism and education (international students). These industries’ profits and their production are reduced.

Structural change: Economists argue that the long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports necessitates change in the structure of our industries, with relatively more resources of labour and capital going to mining, and relatively fewer resources going to all other industries, but particularly manufacturing and service exports. Economists further argue that the high exchange rate is the market’s painful way of helping to bring about this structural change. They say that using government subsidies or other forms of protection to help our industries resist change reduces the efficiency with which the nation’s resources are allocated. Mining production now accounts for about 10 pc of GDP (though only about 2 pc of total employment).

Retailing is another industry facing structural change as consumers shift their preferences from goods to services, and as the internet gives consumers access to overseas markets where retail prices are lower. This change is not related to the resources boom, but is related to the end of a long period when consumption grew faster than household income.

Monetary policy: MP 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.

Since monetary policy is the primary instrument used by the managers of the economy, its history encapsulates their efforts to cope with the various stages through which the resources boom has passed and also with the GFC. We can divide the RBA’s management of monetary policy over the past decade into five distinct phases:

First, inflation worries. When it became clear after 2003 that we were entering a huge resources boom, the RBA worried that it might lead to a surge in inflation as many commodity price booms had in the past, with them often ending in policy-induced recessions as the authorities struggle to control inflation pressures. These worries were compounded by the RBA’s belief the economy was not far from full capacity, with the unemployment rate not far above the non-accelerating-inflation rate of unemployment (NAIRU) - our lowest sustainable rate of unemployment - thought to be about 5 pc. So the RBA progressively tightened monetary policy, lifting the cash rate to a very contractionary 7.25 pc by early 2008.

Second, the GFC. But with the financial crisis reaching a peak with the collapse of Lehman Brothers in September 2008, the RBA realised the inflation threat had evaporated and been replaced by the threat of our economy being sucked down into the Great Recession. It quickly slashed the cash rate, lowering it to a highly expansionary 3 pc by April 2009.

Third, resources boom resumes. By October that year, however, the RBA realised the emergency had passed, we’d avoided serious recession, the resources boom had resumed and the dollar had gone back up. It thus resumed its worries about inflation. It began tightening in steps of 0.25 percentage points. By November 2010 it had returned the cash rate to 4.75 pc, a level it considered to be just a fraction more restrictive than neutral.

Fourth, high dollar starts to bite. By November 2011, however, the RBA realised the inflation threat had passed. The economy was being hit by two conflicting external economic shocks. One, the positive shock of the resources boom, which had boosted real incomes and mining investment spending. And, two, the related negative shock of the high exchange rate, which was cutting import prices directly, but also reducing the international price competitiveness of our export and import-competing industries. This was reducing their production and squeezing their prices and profits. So the RBA began cutting the cash rate, lowering it to 2.75 pc, its lowest level in the history of the RBA. This makes the stance of policy highly stimulatory in order to offset the contractionary effect of the continuing high dollar.

Fifth, the transition to normal growth. With the terms of trade now deteriorating and the mining investment about to pass its peak, we need to make a transition from mining-led growth to growth led by its normal forces: consumption, housing and non-mining business investment. But this transition is being hindered by the continuing high dollar, which has not (or not yet) fallen in line with the decline in the term of trade. The longer it takes before the non-mining sector takes up the running, the more growth will fall below its 3 pc trend rate and unemployment will rise. A fall in the dollar will help ease the transition. Failing that, the RBA stands ready to cut the cash rate again and make monetary policy yet more stimulatory.

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We can be fairer and more efficient at the same time

Humans are a pattern-seeking animal but also a categorising animal. We're forever trying to get a handle on how the world works by sorting things into different boxes. When we can slap a label on something or someone, we think we've understood them.

It's fashionable among our business people to divide the world into "wealth creators" (them) and "wealth distributors" (everyone else but particularly governments). Wealth creators are the source of all prosperity; wealth distributors are essentially parasitic.

Economists' favourite boxes are similar, but not quite so crude. They divide policy objectives into "efficiency" (promoting economic growth) and "equity" (ensuring a reasonably fair distribution of the fruits of that growth).

For the most part, economists see efficiency and equity as in conflict. They care deeply about promoting efficiency but often leave it to others to worry about equity - unless they fear some equity measure would lead to inefficiency.

But sometimes our habitual ways of categorising things can be a hindrance to understanding and progress. Sometimes the labels on boxes don't adequately describe their contents, which can have more in common than we realise. Sometimes we "frame" problems in ways that conceal their solutions.

A new book, Inclusive Growth in Australia, proposes just such a new way of thinking about equity and efficiency. It's edited by Professor Paul Smyth, of Melbourne University and the Brotherhood of St Laurence, and Professor John Buchanan, of the workplace research centre at Sydney University.

A lot of economists and business people are worried about a fall in the rate at which the economy's productivity is improving. Productivity measures the efficiency with which we take inputs of land, labour and capital and turn them into outputs of goods and services. It normally improves by a per cent or two a year but it's been weak for about a decade.

It's our improving productivity - brought about by advances in technology, improvements in public infrastructure and a better educated and more skilled workforce - that causes our material standard of living to keep improving. It also helps to have a higher proportion of the population participating in the workforce.

To date, the deterioration in our productivity performance has been concealed by the resources boom, with its higher prices for our exports and hugely increased construction of new mines. But, the economists worry, now the boom is passing its peak, people will really feel the absence of ever-rising incomes.

So what's the Gillard government doing about it? Ignoring wealth creation and worrying about perfecting the way it's distributed. It's going to the election with two policy changes in pride of place: a disability insurance scheme and the Gonski changes to school funding.

All very worthy, no doubt, but talk about fiddling while Rome burns. But here's where the proponents of "inclusive growth" have a useful perspective. They say that far from being an irrelevance or an indulgence, social policy can, if you do it right, constitute an investment in improving the economy's performance.

As it happens, both the disability scheme and the Gonski reforms are good examples. Many physically and mentally disabled people - and their voluntary carers - would dearly love to make a greater contribution to the paid workforce, if they were enabled to.

And intervention to assist the disabled can be strategic: do it the right way at the right time and much subsequent expense - not to mention personal anguish - can be avoided. No more soft-headed authority than the Productivity Commission attests to the ability of the disability scheme to add to national income.

Similarly, it doesn't take too much thought to realise changing the basis for federal grants to public and private schools to one that gives more to schools with disadvantaged students can been seen either as a move to greater fairness - improving their equality of opportunity - or a move to greater efficiency.

We have no trouble seeing the benefit of doing more to assist the education and training of our brightest and best but much trouble realising the same applies at the bottom end. If, by giving them greater and more timely assistance, we could reduce the number of kids who drop out of school - or make it through with inadequate levels of literacy and numeracy - we'd be making them more productive workers.

The main lesson to be learnt from the league tables showing how our students' educational attainment compares with those in other countries is not that our best students aren't keeping up but that there's a widening gap between our best and our worst.

Another theme of the inclusive growth advocates is "flexicurity" - improving unemployment benefits and assistance to the jobless so as to reduce resistance to the unceasing change in the structure of our economy as the poor countries develop and the digital revolution proceeds.

I think the search for ways to kill two birds with one stone is a good one - just as long as it doesn't devolve into a miser-like attitude that economic efficiency is all that matters and we help people only to the extent we can see a buck in it.

We are - and will stay - a rich country. We can afford to educate ourselves well because to be educated is one of the joys of life, a benefit from being rich. And we should need no better reason for sharing our wealth fairly than that it's right thing to do.

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