Labor deserves credit, not death at ballot box

We may live in a globalised world but it hasn't made our election campaigns any less parochial and inward-looking. Perhaps in an effort to raise Australians' economic literacy, the Economic Society recently sponsored a national tour by Professor Joe Stiglitz, a Nobel prize winner and one of the world's most illustrious economists.

Some brave soul asked him if he'd learnt anything while he was here. Well, he said politely, there were a few things that had puzzled him. He couldn't understand why we didn't know the success of the Rudd government's budgetary stimulus - explained by its size, timing and design - was the envy of the other G20 countries.

He couldn't understand why we were so worried about budget deficits and debt when our accumulated federal government debt was about 5 per cent of gross domestic product, whereas just one year's budget deficit in the US was 10 per cent of its GDP. And he couldn't understand why so many people were opposed to requiring the mining companies to pay a fair price for the use of our resources.

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Now more than 50 Australian economists have issued a statement saying they're ''convinced by the evidence that the co-ordinated policies of the Australian Labor government have prevented the Australian economy from a deep recession and prevented a massive increase in unemployment''.

Economic management is the dominant issue in almost every election campaign and I don't imagine it's much different in other countries. But that Labor could be in danger of losing the election after doing such a good job of guiding the economy through the worst global recession in 70 years is remarkable.

The usual pattern is for governments to be re-elected until finally they preside over a recession, when they're promptly tossed out. That's true of the Whitlam government (recession of the mid-1970s) and the Fraser government (recession of the early '80s). It's also true of the Hawke-Keating government (recession of the early '90s) although, thanks to the miscalculations of John Hewson, Paul Keating's execution was delayed until 1996.

The exception to the rule is John Howard. After more than 11 years he was tossed out without presiding over a recession. Indeed, the economy was booming at the time.

I have to admit that, back in 2007, I thought this wasn't a good election for Kevin Rudd to win. A recession was overdue, it was bound to occur within his first term, he'd get the blame and be tossed out after only three years. Right risk; wrong logic.

Much more than in the past, this downturn was very much the cause of external factors, in the form of the global financial crisis. But to the surprise of close observers, including the government and its econocrats, the recession proved to be so mild and short-lived many people have concluded there wasn't one. I'm sure many people who don't follow these things closely have since concluded the whole thing was a media beat-up.

(The media didn't invent the collapse of various local fringe financial institutions, nor the 0.8 per cent fall in real gross domestic product in the December quarter of 2008 and the weak growth in later quarters, nor the 230,000 rise in unemployment and the bigger rise in underemployment, nor the much tougher borrowing conditions for small business, nor the present weakness in retail sales and home building as the effects of budgetary stimulus have worn off.)

Many factors contributed to the mildness of our recession: the absence of serious banking problems, the strong growth in immigration, China's rapid bounce-back following its own massive stimulus, and the Reserve Bank's 4.25 percentage point cut in the official interest rate.

But like most (although, of course, never all) economists, I have no doubt about the central role of the Rudd government's large, early and carefully targeted budgetary stimulus. Its impact is clear from the statistics, including the remarkably early recovery in business and consumer confidence.

Most voters aren't interested in that kind of causal detail, of course. By their usual simple standard - did you or didn't you preside over a noticeable recession? - the government has passed with flying colours. So why isn't it coasting to an easy election win?

Partly because of its chronic inability to explain and defend its policies. But also because, if anything, the government has been too successful at staving off the usual symptoms of recession. There's little sense of gratitude, or even relief, because the period of fear - of losing your job, of wondering whether you might lose your home, of watching your kids spend months seeking a job - was too brief.

Our adversarial political system means the opposition always needs to find fault with the government's performance. It would dearly love to have been able to berate the government for its failure to hold off recession and prevent a huge rise in unemployment.

In the absence of that, however, the Liberals have switched to the claim that Labor has been on an unnecessary spending spree. It has racked up a frightening level of government debt to be left to our grandchildren and, if that wasn't bad enough, most of the money has been wasted.

There has been waste. Trying to spend money quickly means a degree of waste is inevitable. But with the willing help of sections of the media, the Libs have left voters with a quite exaggerated impression of the extent of that waste.

We're being asked to believe Rudd and Julia Gillard invented government waste. It never occurred under Howard and would never occur under an Abbott government.

But in all the hypocritical talk of waste, a far more important form of waste has been forgotten: the waste of material production and the waste of human well-being had the rise in unemployment not been stopped at 675,000 souls and been allowed to reach the 1 million originally feared.

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Blowing the whistle on unfair costings game

I refuse to dignify the parties' predictable squabbling over the cost of each other's promises by taking it seriously. I don't know who's right and I don't much care. There are more important things to worry about. It's a three-yearly farce that drips with hypocrisy and fake importance.

I'm not sure why the parties always fall to furious arguing about Costing Blunders. Perhaps it's always started by the government of the day - because it's seeking to exploit the advantage of incumbency - and whoever's in opposition feels obliged to muddy the water by sniping back at the government.

These arguments are so arcane I'm sure the swinging voters at whom election campaigns are aimed take zero interest. So perhaps the pollies carry on about costs because it makes them look active and responsible, while distracting journalists from inquiring into more important matters.

It's the gross unfairness of the game that turns me off. Governments have year-round access to Treasury and the Department of Finance to get their costings done by the experts, using a process of iteration: "If you do it that way, minister, it will cost you 2X, but if you change this detail here the cost falls to X."

Governments pepper the econocrats with what-if questions in the weeks before the start of the election campaign. So only if they really cock things up are their costings ever found wanting when their promises are submitted to the people who costed them in the first place.

Oppositions, on the other hand, get no access to such official advice. They have to hunt for clues as to what things cost or pay an accounting firm big bucks to do their costings and, likely as not, get them wrong because the relevant information is so closely held by the econocrats.

This game of both sides submitting their promises to the econocrats for costing arose from Peter Costello's Charter of Budget Honesty. He knew it was stacked in the government's favour. Labor whinged repeatedly about the unfairness of it all and sought to minimise the (high) risk of embarrassment by submitting its costs at the very last minute.

In power, however, Labor's reforming zeal evaporated and it has delighted in turning the screws on the Libs as they did on it. And these guys wonder why they have lost so many supporters and are struggling to win what should have been their easiest-ever election.

Lemme give you a tip, Wayne: "We're no worse than the other lot" isn't a great rallying cry.

In opposition Labor lacked the courage to challenge this unfair arrangement but, fortunately, the Natural Party of Government had no such inhibitions. It has used the occasion of the leak of a flaw in its costings (more likely to have come from Labor than the econocrats) to refuse to submit further promises.

Good. If oppositions refuse to play ball, some government will be obliged to introduce a fairer system if it wants to stay in this silly game.

Because they're not in government with the econocrats' advice on tap, all oppositions have difficulty saying how they would pay for their promises. They are never game to give the honest - and quite satisfactory - answer: if we win, Treasury will tell us how - that's what it's paid to do.

Treasury and Finance know where all the waste is. They also know how to tweak promises in ways that greatly reduce their cost.

So great is the pollies' proclivity for solving problems with a chequebook, however, that neither side has been able to stick to its vow to find savings to cover all the cost of its promises over the "forward estimates" (that is, until June 2014).

They searched out a loophole: promise to spend money beyond the forward estimates. According to my colleague Jessica Irvine's estimates, by last Wednesday Labor had made promises worth $6.6 billion in this never-never land, while the Libs had IOUs worth $6 billion.

No doubt both figures are higher by now. It's remarkable to think the punters' votes are being bought with promises to spend money after the next election.

While we're on the subject of government spending - when have we been off it ? - I trust you noted Tony Abbott giving notice at his campaign launch that, should he win, he'll pull the standard trick of incoming governments: declare a fiscal crisis and introduce a horror budget.

He said he would set up a "debt reduction taskforce" in his first week to "get to the bottom of Labor's waste and mismanagement, to see the real state of the government's books and to prepare a comprehensive plan to start repaying Australia's $90 billion debt". In one month an economic statement would be issued "outlining Australia's risks and opportunities and the new government's response to them".

It's known in the trade as Doing a Mother Hubbard. You come to office, discover to your horror the cupboard is bare, and say you have no choice but to break promises and make emergency spending cuts you didn't mention in the campaign.

It's a harder trick to pull off these days because the Charter of Budget Honesty's "pre-election economic and fiscal outlook" statement, signed off by the econocrats early in every campaign, is designed to ensure everyone knows the latest state of the books.

But Abbott would claim the extent of wasteful spending was far worse than expected. In politics, a wasteful program is one your heartland supporters have no interest in.

That's the point. Though some effort would be made to reduce net spending, the objective is to cut out your predecessors' pet programs and replace them with your own.

Should Abbott win, he's already taken out fiscal insurance.

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Miners moan, but we need our fair share

It's easy to forget that the future of the minerals resource rent tax - the most significant tax reform since the goods and services tax was introduced a decade ago - hangs on the outcome of this election.

Should Tony Abbott win, he won't proceed with introducing the mining tax in July 2012, meaning he won't proceed with most of the tax concessions the new tax would pay for.

Labor has justified the tax as necessary to give Australians a fairer share of the profits from mining the now hugely more valuable coal and iron ore deposits the community owns. Exploitation of these resources is subject to royalty charges levied by state governments, but these payments have failed to keep up with the resources' higher market value.

Against this, the Liberals have claimed this "great big new tax" would do great damage to the mining industry and hence the economy. The big three mining companies - BHP Billiton, Rio Tinto and Xstrata - initially agreed with this claim, but dropped their objections after the incoming Julia Gillard did a deal with them that significantly watered down the original "resource super profits tax".

However, the smaller coal and iron ore mining companies - which weren't part of the deal - now believe (correctly) they were dudded by the big boys and have continued their opposition, claiming the tax means "families will be hurt with job losses in every community across Australia".

It's not hard to see why miners would object to paying more tax, but the tax was recommended by the Henry tax review and it is hard to see why these eminent economists would advocate a tax that could damage the economy.

The very reason for levying a tax on the "economic rent" derived from mining (that is, on the "super-normal profit" earned in excess of the "normal profit" needed to keep the mining companies' resources employed in the mining business) is to ensure the tax does not discourage mining activity.

Indeed, the review argued that, as well as raising revenue that could be used to reduce other, less efficient taxes, the resource rent tax would tax the resources sector more efficiently. That is, over time it would lead to a bigger mining industry, not a smaller one.

As originally proposed, the tax had three main advantages in terms of encouraging the efficient allocation of resources. First, using an increase in the tax on immobile resources (such as minerals) to finance a reduction in the tax on internationally mobile resources (such as financial capital, via company tax) would improve Australia's ability to compete against other countries in attracting foreign investment.

Second, using the tax to effectively replace state royalties would do much less to discourage mining activity. Royalty payments are inefficient because they're levied either on the volume of minerals mined or on their market price. This means royalties take no account of the cost of mining the minerals, which varies with the quality of the mineral being mined and how hard it is to get at.

The effect is to discourage the mining of low-grade deposits and discourage miners from continuing to mine the more costly, deeper-down minerals once the less costly stuff near the top has been won.

Third, the royalty system does nothing to recognise the high risks involved in setting up a mine. You can spend a lot of money, then discover it isn't profitable after all. The royalty system ignores all your costs, but starts charging you from the first tonne you manage to produce.

The great (but much misunderstood) beauty of the original resource super profits tax was it went as close as it practically could to the symmetrical treatment of profits and losses. You'd pay 40 per cent tax on your net profits, but if you incurred a net loss the government would cover 40 per cent of it. If you couldn't immediately deduct the 40 per cent from other mining tax payable, you could carry it forward, with its real value preserved by indexation to the long-term bond rate. If you abandoned the mine as unprofitable, the taxman would refund 40 per cent of your indexed accumulated loss.

Many critics of the tax got terribly muddled over this unfamiliar arrangement, accusing the government of using the (risk-free) long-term bond rate to measure the economic rent, when everyone knew you should use the risk-adjusted rate of return.

They failed to see it was the government guarantee of 40 per cent of losses that took account of risk. This recognition of risk meant fewer firms would be discouraged from undertaking risky investments by the tax system's failure to make adequate allowance for those risks.

So, as originally designed, the mining tax was highly efficient in its effect on the allocation of resources. Trouble was, it would have raised more than double the revenue Treasury originally estimated. That was the real thing bugging the big three companies.

Gillard should have responded merely by halving the rate of the tax from 40 per cent to 20 per cent. Instead, she cut it to an effective 22.5 per cent and butchered its design for good measure. In the process, she greatly reduced - but didn't eliminate - its efficiency benefits.

Originally, the tax involved a complete, up-front rebate of state royalties; now all you'd get is a deduction against any mining tax you owe. Originally, the tax applied to all minerals; now it applies only to coal and iron ore, with an exemption for those firms owing less than $50 million in mining tax. Originally, 40 per cent of losses were guaranteed by the government; now 7 percentage points have been added to the bond-rate "uplift factor" (which arbitrarily leaves some projects better off and some worse off).

It was always the case that virtually all the new tax was to have been paid by the big three companies; in some years, more than all. In other words, excluding the other minerals and the coal and iron-ore tiddlers may actually have saved the government revenue. If so, those other firms are worse off under the changes. They'd remain subject to all the drawbacks of the state royalty system. And fewer mining projects are likely to be started because their potential promoters will find the prospect of early losses more daunting.

Even so, a butchered mining tax would be better than no mining tax.

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Gillard's Law of economics at a crass roots level

Frederick Taylor, the American inventor of "scientific management" a century ago, believed workers were dumb and lazy. So the tasks they were required to perform had to be broken down into the simplest of steps and they needed to be closely supervised. The only way to motivate them was by paying piece rates - what today we'd call "performance pay".

I'm sure Julia Gillard would never admit to regarding "hardworking Australians" as dumb and lazy. But she believes school teachers need to be spurred to greater effort by "a bonus payment under a new performance framework".

This is in addition to her plan for rewards of up to $100,000 to the 1000 schools that each year show the most improvement in attendance, literacy and numeracy or, in the case of high schools, year 12 results and the number of students going on to further education, training or work.

Top performers, about 10 per cent of teachers, would receive annual bonus payments of between $5400 and $8100, determined by the achievement of their students, their contribution to the school community and their participation in extracurricular activities.

I doubt the wisdom of this idea. I can understand why company boards feel they need to pay executives extra money to get off their backsides but teachers are meant to be professionals and it's a strange way to treat professionals.

Gillard professes to hold teachers in great respect (do I feel an election coming on?) but I suspect many of them would be amazed to hear it.

It's said the one thing economists agree on is: incentives matter. Trouble is, most economists assume the only incentives that matter are monetary. It wouldn't occur to them that offering teachers money for "contributing to the school community" contains a contradiction.

Teachers contribute to the school community and take part in extra-curricular activities because they want to. I've seen teachers putting extraordinary amounts of their time and effort into preparing kids for a school play, coaching debating teams and so forth. They do it because they regard the activity as worthwhile and of benefit to their kids, but also because they enjoy doing it.

It would be nice to think these intrinsic motivations - doing things for their own sake - could be pepped up by adding money (an extrinsic motivation, where you do things because of external benefits they bring). That's what economists assume can be done. Gillard, clearly, has started thinking like an economist.

But as I discuss in my new book, The Happy Economist (Allen & Unwin), psychologists have discovered it doesn't work that way. Economists have something called Gresham's Law: bad money drives out good. It turns out monetary motives drive out non-monetary motives.

Once you start paying people to do good works the selfish, materialist mentality takes hold and they stop doing those things unless they're paid. People who did good works because it made them feel good about themselves no longer feel that way. Those who contribute to the school community without winning a bonus may be discouraged in their well-doing.

So, should this scheme be implemented, don't expect a surge in School Spirit (as it was called at my school) and don't be surprised if it leads to a decline in teachers' second-mile contributions.

If I'm right, we will have discovered Gillard's Law.

This crass attempt to motivate teachers is symptomatic of the election campaign. More than ever it's been obsessed by money: budget deficits, public debt, wasteful spending. The only major non-monetary issue has been our intense objection to foreigners entering our territory without permission.

Both sides conduct their campaigns on the assumption we're quite selfish and mesmerised by money. For individuals, both sides have rolled out monetary bribes: cash for clunkers, higher family benefits for the parents of teenagers, incentives for age pensioners to do paid work, a more generous paid parental leave scheme. For marginal electorates, a new road or building.

Although it's been hidden by the negativity of this campaign and its obsession with budgeting, the underlying assumption of both sides is that the job of governments is to continually raise our material standard of living because this is what will make us happy.

They seem oblivious to the evidence, recounted in my book, that decades of rising living standards have done nothing to increase people's happiness or "subjective well-being".

It's time politicians reached a more enlightened view of what they could do to increase national happiness. They could start by rethinking their attitude to work.

The economists' model assumes we work only for the money it brings us. The rationale for Work Choices was: give employers more freedom to hire and fire, to call people in to work at times when it best suits the business without penalty payments, and the greater efficiency with which labour is deployed will raise our material standard of living to the benefit of all.

In truth, most people gain a lot of satisfaction from their work. That satisfaction can be diminished if people become less secure in their jobs and in the hours and days of the week they'll be required to work. An understanding of this seems implicit in Labor's opposition to Work Choices and in Tony Abbott's promise not to reintroduce it.

But why not make that understanding explicit? If work is a primary source of our happiness - as the evidence says it is - why not encourage employers to see the provision of secure, satisfying work as an end in itself, a primary reason for the existence of the business?

Why not help employers see that happy workers contribute more to the success of the business (or the school) - as the evidence increasingly says they do?

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Claims of stimulus waste were greatly exaggerated

Media reporting and opposition politicking have left many people with the impression much, if not most, and maybe even all of the billions spent on school buildings under the Rudd government's stimulus package has been wasted.

It's an impression based on the piling up of unproved anecdotes about waste or rorting of particular school building projects. Which means it's an impression that's not genuinely "evidence-based".

Enough anecdotes have been produced to demonstrate that some degree of waste has occurred. But that's hardly surprising: there's a degree of waste involved in most spending, public or private.

The real question is how significant that waste has been. And no amount of piling up of unproved allegations can satisfactorily answer that question. Only a thorough investigation of the complaints can determine the extent of the waste and the reasons for it.

It's important to understand - as most people don't - that news reporting practices aren't intended to give us a representative picture of what's happening. Indeed, what's "newsworthy" is often quite unrepresentative.

News focuses on the unusual not the usual, the bad news not the good, the contentious not the widely accepted. (That's why climate change-denying scientists get a degree of media publicity out of proportion to the relevance of their qualifications or how representative they are of scientific opinion.)

This is why you wouldn't expect the media to do justice to the reassuring conclusions of the independent taskforce established to investigate complaints about the Building the Education Revolution spending.

For one thing, reassurance isn't very newsworthy. For another, any critical comments will be given more prominence than generally approving comments.

But there's more to the school building issue than just the limitations of news reporting. The complaints have been seized upon and played up by elements of the media and others with either partisan or ideological motives for seeking to discredit the use of budgetary stimulus in response to the downturn in our economy prompted by the global financial crisis and the world recession.

These people want us to conclude there was never any threat to the economy, thus making the stimulus spending unnecessary and, as it turned out, quite wasteful. Those with an ideological opposition to fiscal stimulus want us to conclude it NEVER works.

That's why I've read for myself the interim report of the taskforce, chaired by Brad Orgill, and want to give you a balanced account of its findings.

The taskforce was established to receive and investigate complaints about the school building program and to determine whether schools are achieving value for money. So far it has received complaints affecting 254 schools, representing only 2.7 per cent of all schools involved in the program.

Almost all the complaints relate to the part of the program that promised to build and upgrade infrastructure in all the nation's primary schools. The $14 billion cost of this element accounts for almost 90 per cent of the total cost of the program.

It will have delivered more than 10,500 construction projects to more than 7900 primary schools by late next year. About a third of the money is going on multi-purpose halls, almost 30 per cent on classrooms and a quarter on libraries, with the remainder going on covered outdoor learning areas and other things.

Spending of the money is being administered by 22 state government, Catholic and independent school authorities. Although the NSW government accounts for 22 per cent of the projects, it attracted 56 per cent of the complaints. The Victorian government, with a 12 per cent share of projects, attracted 20 per cent of the complaints.

More than half the complaints relate to value for money. "From our investigations to date, the majority of complaints raise very valid concerns, particularly about value for money and the approach to school-level involvement in decision making," the report says.

The report acknowledges - as many of the critics don't - that the primary reason for spending the money was to help counter the downturn in the economy by providing employment for building and construction workers throughout the country. It was also hoped the new buildings would improve the quality of our kids' education.

The report finds the stimulus "prevented many construction organisations from reducing staff or the size of their operations to match an otherwise decreasing workload resulting from the global financial crisis".

But the stimulus motive meant it was important to get the money spent quickly and this involved a trade-off. It meant less time for consultation with individual schools and less choice and customising of projects. That meant a degree of waste and, certainly, dissatisfaction on the part of some schools.

Cost per square metre was very much higher in NSW government projects, mainly because of big project management fees, which were 5 percentage points higher than normal. But these fees are partly explained by the high priority the NSW government gave to getting its projects completed quickly. Those states in less of a hurry incurred lower costs per metre.

The report says that, overall, delivering the projects within the short time-frame to achieve the economic-stimulus objective may have added a premium to normal costs of 5 to 6 per cent.

"Notwithstanding the validity of issues raised in the complaints, our overall observation is that this Australia-wide program is delivering much-needed infrastructure to school communities while achieving the primary goal of economic activity across the nation," the report concludes.

So the impression of widespread waste the media and people with axes to grind have left us with is greatly exaggerated.

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ONLY CAPITALISM CAN SAVE THE PLANET

IQ2 Debate, Sydney City Recital Hall
Tuesday, August 10,2010

The older I get, the more I worry about saving the planet. The past 200 years have seen a phenomenal expansion in economic activity around the world. In that time, the world’s population has exploded from one billion to 6½ billion. Over the same period, the average standard of living of all the people in the world has increased sixfold. Multiply the two together and you see the amount of economic activity in the world has increased by a factor of 45.

I fear that this huge expansion of human activity over just the past 200 years has reached a point where it’s starting to do significant damage to the natural environment - the ecosystem. The trouble is that, while the economy grows exponentially (that is, at a reasonably steady percentage rate) - the ecosystem doesn’t. It’s fixed in size. This says there must be natural limits to growth, and I suspect we’re close to those limits. That certainly seems to be the case with global warming: 200 years of growing use of fossil fuels have caused a build-up of carbon dioxide and other greenhouse gasses in the atmosphere that exceeds the earth’s capacity to absorb it, and this is starting to interfere with the climate in ways that are soon likely to do great damage to the economy. And the threat to the planet isn’t just from global warming. We also have big problems with water, soil, fish stocks and the destruction of species. As I say, I fear we’re reaching the limits to growth in our use of natural resources.

And yet I have no hesitation in supporting the motion that ‘Only capitalism can save the planet’. Why? Because, as Maggie Thatcher used to say: TINA - there is no alternative. And because capitalism is malleable. It’s changed a lot over the past 200 years as circumstances have changed, and it can change further as our needs dictate.

If you doubt that, it’s because you’re reacting to a comicbook definition of capitalism. Capitalism is just a pejorative term for a market economy - an economy where the means of production are largely privately owned and decisions about supply and demand are made in markets, with those markets receiving a greater or lesser degree of guidance from government. The world’s experiments with alternatives to market economies - central planning as in the former communist countries or heavily regulated socialist economies (such as pre-reform India) have failed and been abandoned. Those economies that retain vestiges central control are generally moving closer to a market model.

Don’t fall for either criticism or praise of The Free Market. Free markets don’t exist - never have, never will. In all real world economies freedom is constrained by government intervention to a greater or lesser extent. That’s really the point: the choice we face is not between markets that are totally unregulated or markets that are so tightly regulated they cease to be markets. The answer to our problems will never be found at one extreme or the other; it will always be found somewhere in the middle. Finding the optimal degree of regulation isn’t easy, particularly because regulating markets is much harder than it looks. It’s terribly easy to get reactions you weren’t expecting. So there’s plenty of scope for debate about where the line should be drawn.

Clearly, with the global financial crisis, the line in America was drawn too far in the direction of deregulation, great damage ensued, and now it’s clear the line needs to be redraw further in the direction of regulating. Note that we didn’t have any significant problem with our banks. So does that mean the Americans had a capitalist economy and we didn’t? Of course not. It just means we drew the regulatory line in a better spot than the Yanks did.

If the other side wants to argue that market economies are far from perfect, they won’t get any argument from me. Of course markets are far from perfect. That’s particularly true in the case of the environment, where many scarce natural resources don’t have prices and so don’t get into the market process. They’re external to the market system and so don’t benefit from the market’s usual ability to ensure those resources aren’t wasted or used to excess. But that just means governments have to find ways to get prices on them and thus get them into the market system.

Guess what? The planet is in danger and making the appropriate modifications to the capitalism system offers the best chance we have of saving it.

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Don't be fooled by debt spin

In an ideal world, the economic debate between the two sides in election campaigns would leave voters with an accurate picture of the issues and choices. If one side said something wrong or misleading, this would be quickly refuted by the other.

Unfortunately, it doesn't work like that. Both sides are seeking votes, not enlightenment. When one side makes a misleading but seemingly persuasive point against the other, the reaction may be to change the subject rather than correct the error.

Rather than push them further apart, competitive pressure tends to push both sides towards the centre ground. So it may suit both to perpetuate the same misconceptions.

One simple truth that gets lost in election campaigns is that the primary responsibility for the day-to-day management of the economy rests not with the politicians, but with the bureaucrats in the central bank. It's they who determine the level of short-term interest rates, and it's the manipulation of interest rates ("monetary policy") that has most effect on the strength of demand (spending) in the economy.

The instrument of macro-economic management the elected government controls, the budget ("fiscal policy"), is secondary to monetary policy (although it does play a more prominent role during recessions). This leaves the denizens of Canberra (including journalists) with an inclination to exaggerate the role of fiscal policy in the management of the economy.

One way the Liberals do this (so far it hasn't suited Labor to run this line) is to exaggerate the effect of the budget on the level of interest rates. One rarely fully articulated argument is that budget deficits - which have to be covered by government borrowing - leave fewer funds available to be borrowed by the private sector and thus force up interest rates.

This would be true if our capital markets were cut off from the rest of the world but, since they're not, it isn't. Effectively, both our public and private sectors borrow in the global market, where their demand is too small to have any effect on world interest rates.

A better argument is that changes in the budget balance affect the strength of "aggregate" (total) demand in the economy and so affect the Reserve Bank's decisions about whether rising inflation pressure requires it to raise interest rates to discourage borrowing and spending. A fall in the budget deficit or a rise in the budget surplus could in this sense reduce upward pressure on rates.

But though this is true in principle, remember - as the denizens of Canberra keep forgetting - the federal government's budget balance is only one of the factors influencing the strength of aggregate demand. Other factors include the volume of exports versus imports, the terms of trade (the prices of exports and imports), the exchange rate and the strength of business and consumer confidence.

So, in practice, the effect of changes in the budget balance on the Reserve Bank's decisions about interest rates is usually pretty limited, as repeated comments by its governor make clear. But the whole Canberra obsession with (budget) deficits and debt, particularly in this campaign, can leave the unwary with an exaggerated impression of the federal budget's place in the scheme of things. You see this when journalists ask politicians when they plan to get "the economy" (or even "the country") out of deficit or out of debt. Sorry, the economy isn't in deficit, now or ever. It's just the budget that's in deficit, and there's a world of difference between the two.

Federal government spending is equivalent to only about a quarter of the economy as measured by gross domestic product, and even this exaggerates the budget's importance because much government spending merely involves transferring money between taxpayers and welfare recipients rather than producing goods and services (which is what GDP measures). No, it's important to understand that, apart from being a device for managing its own incomings and outgoings, the federal government's budget is an instrument that has effects on the economy without being the economy.

That's important because it helps you see the budget is merely a means to an end, not an end in itself. It's there to serve the economy; the economy isn't there to serve the budget. It's the economy that matters because the economy is us - it's the sum of the economic dimension of our lives, all the consuming and producing you and I do.

There's been such extraordinary fuss about the budget and its balance in this campaign that the uninitiated could be forgiven for concluding economic management is all about balancing the budget and avoiding debt.

Rubbish. Economic management is about keeping unemployment and inflation low (fortunately, this is the bit the Reserve Bank takes primary responsibility for). In conventional terms, it's about pursuing economic growth so as to continually raise our material standard of living.

To the more enlightened, it's about ensuring economic activity doesn't lead to the malfunctioning of the ecosystem, the most pressing instance of which is global warming. Both sides are running from their responsibility to combat climate change; their obsession with deficits and debt is a diversionary tactic. It will be a long time before they face up to the deeper question of whether endless economic growth is compatible with preserving an ecosystem that doesn't grow.

Economic management is about reforming those government interventions that reduce the efficiency of resource use without sufficient social justification. It's also about correcting market failures - instances where, left to its own devices, the market fails to maximise our wellbeing. That is, the federal government is responsible for micro-economic reform.

Government - state as well as federal - is responsible for ensuring the provision of certain vital services and infrastructure. We need, but don't have, sufficient investment in education and training - ranging from early childhood to schools to technical education to universities - to ensure a bright future for Australians and leave us with something to show for our mineral wealth.

To overcome present deficiencies and assure our future we need a lot more investment in economic and social infrastructure, particularly in transport and telecommunications.

If it's to happen, much of this investment will have to be financed by government. The notion that the Howard government left us with a debilitating infrastructure backlog used to be an incessant cry of the Labor government.

But the continuing obeisance to Costelloism - the doctrine that all public debt is bad - in this campaign suggests neither side would do much to deliver the infrastructure we need.

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Stop beating about the bush and talk about Big Australia

Something significant has happened in this hollow, populist election campaign: the long-standing bipartisan support for strong population growth - Big Australia - has collapsed. Though both sides imagine they're merely conning the punters, it's hard to see how they'll put Humpty Dumpty together again. Which will be no bad thing.

The original bipartisanship was a kind of conspiracy. The nation's business, economic and political elite has always believed in economic growth and, with it, population growth, meaning it has always believed in high immigration.

Trouble is, stretching back to the origins of the White Australia policy, the public has had its reservations about immigration. Hence the tacit decision of the parties to pursue continuing immigration, but not debate it in front of the children. That's why we've never had a formal population policy.

John Howard used his harsh treatment of boat people to divert attention from his rapidly growing immigration program. Kevin Rudd continued the high immigration, but without the camouflage.

Growing punter angst about the return of the boat people collided with Rudd's announcement of Treasury's latest projection that, given various assumptions, the population could reach 36 million by 2050 and his happy confession to believing in a Big Australia. The punter reaction was negative. Rudd never used the phrase again, but appointed a minister for population whose main job was to repeat that the 36-million figure was merely a Treasury projection, not a policy or a target.

Fanned by the shock jocks and an opportunist opposition, the angst about boat people grew. In her efforts to neutralise the asylum-seeker issue - and, no doubt, informed by focus-group research - Julia Gillard judged it necessary to say she did not believe in a Big Australia. She wanted an Australia that was sustainable, and had added that word to the population minister's title.

But then she claimed population had nothing to do with either natural increase or immigration, which suggests her intention was to make soothing noises rather than change policy. Not to be outdone, Tony Abbott popped up with a policy to get immigration to levels "we believe are economically, environmentally, and politically, if you like, sustainable". He planned to rename the Productivity Commission the productivity and sustainability commission and get it to advise which population growth path it considered sustainable.

Gillard and Abbott have attracted criticism from commentators wedded to the old way of doing things, but the end of the conspiracy of silence is a good thing. Whatever the public's reasons for frowning on immigration, it does have disadvantages as well as advantages and the two ought to be weighed and debated openly.

The two leaders' adoption of the term "sustainable" has been attacked as vacuous - who, after all, would want any policy that was unsustainable? - but we do need to be sure the population policy we're pursuing is sustainable. That, in Abbott's words, it does not "rob future generations of the quality of life and opportunities we currently enjoy".

It's true politicians and economists have used the term to mean whatever they've wanted it to mean, but that's why it needs to be held up to the light. I suspect those scientists who argue we're close to the limits of our natural environment's "carrying capacity" are right, and the economists' airy argument that technological advance will solve all problems is wrong.

So let's get both sides out of their corners to debate the issue in front of us. We can't continue treating the economy like it exists in splendid isolation from the natural environment. And even when you ignore the environmental consequences, the proposition that population growth makes us better off materially isn't as self-evident as most business people, economists and politicians want us to accept. Business people like high immigration because it gives them an ever-growing market to sell to and profit from. But what's convenient for business is not necessarily good for the economy.

Since self-interest is no crime in conventional economics, the advocates of immigration need to answer the question: what's in it for us? A bigger population undoubtedly leads to a bigger economy (as measured by the nation's production of goods and services, which is also the nation's income), but it leaves people better off in narrow material terms only if it leads to higher national income per person.

So does it? The most recent study by the Productivity Commission found an increase in skilled migration led to only a minor increase in income per person, far less than could be gained from measures to increase the productivity of the workforce.

What's more, it found the gains actually went to the immigrants, leaving the original inhabitants a fraction worse off. So among business people, economists and politicians there is much blind faith in population growth, a belief in growth for its own sake, not because it makes you and me better off.

Why doesn't immigration lead to higher living standards? To shortcut the explanation, because each extra immigrant family requires more capital investment to put them at the same standard as the rest of us: homes to live in, machines to work with, hospitals and schools, public transport and so forth.

Little of that extra physical capital and infrastructure is paid for by the immigrants themselves. The rest is paid for by businesses and, particularly, governments. When the infrastructure is provided, taxes and public debt levels rise. When it isn't provided, the result is declining standards, rising house prices, overcrowding and congestion.

I suspect the punters' heightened resentment of immigration arises from governments' failure to keep up with the housing, transport and other infrastructure needs of the much higher numbers of immigrants in recent years.

This failure is explained partly by the rise of Costelloism - the belief all public debt is bad - but mainly because the federal hand has increased immigration while the state hand has failed to increase housing and infrastructure.

At its best, the message to the elite from the unwashed of the outer suburbs is: if you want more migrants, first get your act together.

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Labor's no worse, and no better, than the Libs

To the superstitious, the meaning is clear: Julia Gillard and her Labor mates must be OK on economic management, otherwise God wouldn't have let her off the hook by causing the quarterly inflation reading to be low and thus averting a mid-campaign rise in interest rates.

Or perhaps all it proves is that God is a woman.

But there's a better reason for believing Gillard is a genuine fiscal conservative: the revelation that, as a member of Kevin Rudd's Gang of Four, she queried the cost of the decisions to introduce paid parental leave and significantly increase the age pension (while ensuring the benefit to sole parents was limited and the benefit to people on the dole non-existent).

As Tony Abbott has proceeded to demonstrate, Labor's paid parental leave scheme wasn't particularly expensive. Particularly not when you take account of how readily it can be justified in terms of both horizontal equity (reducing the biases facing women in the workforce) and economic efficiency (reducing the wastage of female skilled labour).

But the pension increase was hugely expensive, with costs that will keep growing until the end of time. And it was far more generous than the inquiry into pension adequacy recommended. It said there was no justification for increasing the married rate, but Rudd slung them $10 a week anyway.

Even with the single pension, the inquiry said it was mainly people who were renting who were struggling (the great majority of age pensioners own their homes outright), but Rudd ignored this targeted approach and granted all singles a $30 a week increase.

It was a profligate decision, one John Howard would never have countenanced. I've no doubt it was motivated by politics rather than fairness, being Rudd's attempt to buy the grey vote - a futile gesture. If Gillard queried the politics of it, she showed better judgment than her leader.

It's true the ever-growing cost of the pension increase was covered by ever-growing savings measures: phasing up the pension age to 67, tighter means testing of the pension and family tax benefits, reductions in superannuation tax rorts and means testing the private health insurance rebate (a measure the Liberals have blocked in the Senate).

But the opportunity cost of using those (eminently justified) savings to cover the cost of a needlessly generous pension increase is that they're no longer available to help return the budget to structural balance.

So if Gillard was querying the cost of the pension increase, good on her. Just a pity she didn't push harder.

But there's a deeper conclusion to be drawn. It soon became clear Rudd, the self-proclaimed fiscal conservative, was addicted to spending. Even so, he made sure his stimulus measures were T-for-temporary, enunciated a plausible "deficit exit strategy" and stuck to and strengthened it in his last budget.

I concluded the two purse-string ministers in the Gang of Four - Wayne Swan and Lindsay Tanner - were working hard to keep Rudd's spending proclivity in check and make his professed fiscal conservatism a reality.

Now, however, it's clear they were getting strong support from the third member of the quartet, Gillard. That's a good sign.

But though budgetary responsibility - sticking to the medium-term fiscal strategy of achieving budget surpluses, on average, over the economic cycle - is important, it's not the be-all-and-end-all of economic management that Abbott and Joe Hockey portray it as.

It's an inadequate substitute for courageous micro-economic reform, starting with immediate implementation of an emissions trading scheme. No party that squibs on acting early to protect the economy from the hugely adverse consequences of climate change can claim to be a good economic manager.

It's noteworthy that once the Liberals had abandoned their commitment to using a price-based approach to combating climate change, it didn't take Labor long to abandon its own commitment.

Similarly, once the Libs set their face against the highly equitable and economically efficient resource super profits tax, it wasn't long before Labor went into retreat.

It could merely have slashed the rate of the tax when it discovered how much more it would raise than had ever been contemplated, but for good measure it butchered the design of the tax, greatly reducing its economic efficiency benefits as a substitute for the inflexible state royalties.

And it's the Liberals' Costello-instigated obsession with budget deficits and public debt (though certainly not current account deficits and foreign debt) that does most to explain why Labor has donned the same hair shirt. Labor began by arguing we needed to overcome the Howard government's neglect of economic infrastructure, but soon succumbed to Costelloism.

See what this means? This government is so lacking in self-confidence on matters economic it takes its lead from its political opponents - even when they're led by that unabashed economic irrationalist, Abbott.

Elect Gillard and what you'll get is Abbott populism at one remove. What you won't get is a government with the confidence to decide for itself what the economy needs and what is politically achievable, if there is a willingness to put up a fight and lose a bit of skin.

Why is the Rudd-Gillard government so reactive when it comes to economic management? Because, when the public is asked which party is better at managing the economy, its answer almost always favours the Liberals. By 47 per cent to 35 per cent, according to a recent Newspoll.

The public is convinced the party of the workers wouldn't be much good at running the economy. And in its heart, Labor fears the public is right.

If by some chance Labor fails to get itself re-elected, there'll be one overwhelming explanation for such an extraordinary result: the punters aren't impressed by timidity and lack of conviction. Bring back Paul Keating.

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Now the good news, if you can believe it

Strange things happen in election campaigns. When we learnt this week that consumer prices rose only modestly in the June quarter, the media greeted this as great news for Julia Gillard and even for the Reserve Bank governor, Glenn Stevens.

But no one observed it was great news for all those voters who, the pollies inform us, have been whingeing loud and long about the rising cost of living.

And you wouldn't believe it: Joe Hockey portrayed it as bad news for voters. Proof positive they had plenty to whinge about.

The figures from the Australian Bureau of Statistics showed the consumer price index rose by 0.6 per cent during the quarter and by 3.1 over the year to June. Doesn't sound too terrible to me.

But the jubilation conferred on Gillard rose from the news on "underlying inflation" - the general trend in prices, with exceptionally large price changes removed - which showed a rise of 0.5 per cent for the quarter and 2.7 for the year.

This is the first time the underlying rate has been within the Reserve Bank's 2 to 3 per cent target range for almost three years, and was a lot lower than economists were expecting. It eliminated the likelihood the Reserve Bank board would see a need to raise the official interest rate another notch at its meeting on Tuesday.

You'd think this was good news primarily for people with mortgages and other loans (and bad news for people with fixed-interest investments), but for political journalists it's good news for Gillard and her government.

But how did the opposition contrive to believe it was bad news for people worried about the rising cost of living? Easy. The prices of some items in the basket of goods and services that makes up the index have risen a lot in recent times, whereas other prices have fallen a bit.

Put the two together and you're left with the overall cost of living rising only a little faster than usual.

But why do something so sensible? Why not ignore the prices that fell or rose only moderately and focus solely on those that rose a lot? Just what Hockey did. He pointed to increases in the price of electricity (up 18 per cent over the year to June), gas (10 per cent), water rates (14 per cent) and health services (6 per cent).

"For everyday Australians, the bills that they have to pay have gone up dramatically," he concluded.

And all he had to do to reach that convenient conclusion was ignore the falls in the prices of cheese, breakfast cereals, beef, pork, bacon and ham, fruit, eggs, jams and spreads, tea and coffee, and fats and oils, which helped to limit the annual increase in the cost of food (a major item in any household's budget) to just 1.4 per cent.

Clothing and footwear prices were down by almost 4 per cent, furniture and furnishings prices were down 1 per cent, major household appliances prices down 2 per cent, toiletries and personal care product prices down 2 per cent and motor car prices down almost 1 per cent.

Audio, visual and computing equipment prices were down 20 per cent, sporting equipment prices down 3 per cent, toys and game prices down a fraction and domestic holiday prices down 2 per cent.

All those were changes over the year to June. Looking just at the June quarter, only 49 of the 90 price categories recorded rises, the lowest number in more than five years.

So for Hockey to conclude this week's figures justified people's complaints about the rising cost of living, all he had to do was ignore about 86 categories where prices were well-behaved - with

. a surprising number of them falling -

. and focus on four categories that really were bad.

Those categories account for less than 14 per cent of household budgets. So ignore 86 per cent of your budget and focus on just 14 per cent of it and, yes, you do have a real gripe.

Does this make Hockey a liar and a cheat? No, just a politician on the make. The worst of it is that he's doing only what the whingeing punters are doing: focusing on a few bits that are going badly and ignoring all the many bits that are going fine.

Like politicians on both sides, these days, Hockey has no desire to educate the electorate - help people see they're misinformed or not thinking logically. Government pollies are happy just to humour people's mistaken notions; opposition pollies seek to exploit them.

Because humans aren't the rational calculation machines economists assume them to be, we all do this. It's the way our brains work: we remember the things that stick out (big price rises, for instance) and tend to forget things that are normal.

We remember price rises (bad news) more clearly than price falls (good news) and we simply ignore any items in our budget where the price doesn't change. In our mental consumer price index, the items whose prices rose a lot get a weight of up to 100, while those that don't change get a weight of zero and those don't rise by much or even fall don't do much better.

It's a crazy way to work out what's happening to your cost of living, but it's the way most people do it. And it explains why so many people are convinced the consumer price index has been cooked up by the government.

But what's going on with prices? Why are a few going through the roof while others are falling? What Hockey will never tell you is that a big part of the reason for the hefty rises in utility prices - electricity, gas and water - is the success of Peter Costello and his Liberal successors in demonising deficits and debt.

These outfits have delayed borrowing to expand their capacity (in the case of water this neglect has prompted heavy investment in desalination plants) and, even now, are trying to minimise their borrowing by making the present generation of users cover more of the capital cost in their quarterly bills. Thanks, Pete.

Why are so many prices falling? Partly because the appreciation of the dollar has reduced the cost of imported items, but mainly because the weakness of consumer demand following the recession the pollies say we didn't have has obliged many retailers to discount their prices to attract sales.

But all that discounting, we're asked to believe, has had no effect on the cost of living.

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Don't take the bait on debt

I've had to cut short my leave because of the election campaign, but those who follow the political debate faithfully might be better off taking an overseas holiday for the next three weeks. It's clear they'd miss little but aggravation.

The paradoxical truth is that modern election campaigns are aimed at those who aren't much interested in the topic. Swinging voters are assumed to be completely self-interested and short-sighted, driven by emotion rather than intellect, ill-informed and easily conned by slogans and television ads.

Hence all the nonsense we're hearing from both sides. For those of us who do take an intelligent interest, the best response is to conduct our own debate, ignoring the silliness as much as we can.

This election is the battle of the scare campaigns. Pollies are trying to frighten us about big new taxes, the return of Work Choices, the threat from boat people, and deficits and debt. I've written a lot in recent times about why we don't need to be too worried by budget deficits and public debt. But observing all the trouble the major developed countries are having has caused me to see the matter in a different light.

Many of the European economies and, to a lesser extent the United States, are worried about the huge levels of public debt they have racked up and the risk that the financial markets will begin to doubt their ability to repay those debts.

As a result, the British, German and other governments have embarked on austerity campaigns, cutting government spending and increasing taxes at a time when their economies are very weak. To slash budget deficits at such a time is likely to make their economies even weaker, meaning the actual progress they make in reducing their deficits is likely to be small, notwithstanding the pain the austerity measures are inflicting.

How did they get themselves into such a predicament? Well, the global financial crisis left them with no alternative but to borrow heavily to rescue their mismanaged banks, and then borrow again to try to reflate their economies. Had they failed to prop up their banks - as happened in the Great Depression of the 1930s - things would have been much worse. Fortunately, the worst was averted. But it would be wrong to conclude all the borrowing of recent times is what has got the main economies into trouble.

No, the real problem is they went into the crisis with such high budget deficits and levels of public debt. Throughout the long boom that preceded the crisis, most governments were running annual deficits rather than surpluses, thereby adding to accumulated debt rather than paying it off. They had failed to get their houses in order during the good times and so were badly placed when the bad times struck.

Why were they caught out? Because their politicians had been indulging voters who want ever-increasing government services but are most resistant to higher taxes. Rather than forcing their voters to face financial reality, they just went on year after year putting the shortfall on tick.

When you consider the genuine worries of the big countries, you realise how silly it is for us to worry about our tiny budgetary problem. They have levels of public debt up about 80 or 90 per cent of their annual national incomes (gross domestic product). Our present budget deficits and consequent borrowing are expected to leave us with a net public debt that peaks at $94 billion in 2013.

Does that sound a lot? If it does it's because you don't realise how big our government and the Australian economy really are. It will represent just 6 per cent of our annual national income.

Let me ask you a personal question: how big is your mortgage relative to your annual income? If it amounted to just 6 per cent of your annual income, how worried would you be? It's common for people to take out home loans that are three or four times their annual income.

Unlike the rest of the developed economies, we went into the global financial crisis with no net debt. Peter Costello and the Howard government get the credit for this.

They introduced and stuck to a "medium-term fiscal strategy" of keeping the budget in balance on average over the economic cycle. That is, it's OK for the budget to go into deficit during recessions, provided it goes back into surplus during the recovery, thereby eventually paying off the debt incurred during the period when the economy was weak and the budget was propping it up. The Rudd/Gillard government is following this same strategy. Indeed, so successful has the opposition been in putting the frighteners on the public over deficits and debt that Labor is on its best behaviour, promising to find spending cuts to offset all new spending promises. The usual vote-buying auction has turned into a Dutch auction. Amazing.

As I've argued all along, the Liberals' relatively recent obsession with deficits and debt (it was the creation of Costello, never being part of John Howard's rhetoric when he was treasurer or in opposition) is way overdone. But when you look at the problem the Europeans' and Americans' budgetary laxity has got them into, you realise our antipodean obsession with avoiding public debt has its advantages.

We've been more frugal than we've needed to be, but it has certainly kept us out of trouble.

In economics, however, there are no free lunches. Everything comes at an (opportunity) cost. So successful has Costello been at demonising all government debt - state and federal - that we've failed to invest in enough economic and social infrastructure. Our debt level is minor, but we're living in the worst house in the street.

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Is it our future to be China's quarry? Decision 2010

Australia's traditional economic challenges will be turned on their head in this decade.

WHAT our economy needs in the 2010s is success in balancing supply and demand. Does that sound obvious and not very hard? It's neither.

A big part of the problem is neither you nor I nor the politicians are used to thinking of the economic problem in those terms. And even when we do, we define the problem in conventional terms, failing to take account of the ultimate provider of both supply and demand: the natural environment.

Speaking at the nationwide level, when demand exceeds supply we get inflation. When supply exceeds demand we get unemployment. So we need to keep them in alignment to minimise both problems.

But both demand and supply are moving targets. The economy keeps growing, so we need to keep both demand (spending on goods and services) and supply (capacity to produce them) growing at much the same rate.

If the severe difficulties facing European economies were to spread - including to China, India and the developing world - our problem would be one of deficient demand relative to supply, leading to slow growth and rising unemployment.

But the greater likelihood is that our overarching problem will not be deficient demand but deficient supply as we struggle to greatly expand our capacity to meet developing Asia's voracious appetite for our minerals and energy.

Supply is by far the better deficiency to have. It's the problem of the prosperous and successful, not the waning and struggling. But that doesn't stop it being a problem.

In early 2008, before the global financial crisis hit, we were in the midst of a resources boom. Relative to the prices we were paying for our imports, the prices for our exports were the highest in 50 years.

Our economy was operating at close to full capacity. Unemployment was down to 4 per cent, shortages of skilled labour were emerging, factories and other businesses were flat-chat and real wages were rising, although inflation pressure was building and the Reserve Bank had pushed its official interest rate to a 14-year high.

Mainly because Asia's demand for our exports scarcely missed a beat, but also because our domestic recession was so mild, the likelihood is that the resources boom will soon resume and we'll soon return to full capacity.

Everyone assumes it is hardest to manage Australia's economy in bad times. Recessions are painful and economic managers come in for criticism, but it's the good times that are hardest to manage.

Why? It is easy to stimulate demand - with increased government spending, tax cuts and much lower interest rates - but hard to conjure up increased supply. That requires more skilled workers, housing, machines, factories, mines and offices, as well as more public infrastructure: roads, bridges, public transport, power stations, coal loaders and ports.

In the past the solution was to minimise inflation by using high interest rates or tax increases to suppress demand. But we've usually done too much too late and ended up in recession.

However, past booms have been temporary, "cyclical" events caused by brief periods of strong growth in the developed world. This boom, which began in 2003, seems more lasting ("structural") because it arises from the two most populous countries entering decades of economic transformation from underdeveloped to developed.

We're likely to go through an extended period in which supply grows rapidly - we greatly increase the economy's productive capacity. But we're already close to full employment.

Assuming Asia's strong demand for commodities continues, an increase in our capacity to produce coal, iron ore and natural gas is already in train. Business spending on physical investment will soon take its highest share of gross domestic product in half a century.

But when our labour and capital are already pretty much fully employed, the only way we can put more resources into new mines, gas terminals and related infrastructure is by taking those resources from somewhere else.

Some industries (and states) have to give up resources so the mining industry (and the states it is in) can have more resources. This doesn't necessarily mean other industries and states have to contract in absolute terms, it may just mean the lion's share of future annual growth in employment and physical capital goes to mining and the mining states.

Governments can help by adding to the supply of skilled labour (through increased training and skilled migration), well-located land for home building and necessary public infrastructure. But even though the nation's supply constraint moves out each year, and can be made a little faster, it's still a constraint. It still limits how much more we can do. If we try to exceed that limit, all we get is inflation.

A big part of the political problem governments will face is that, after 30 years of high unemployment, the public is locked into a mentality that our key problem is deficient demand, with the implication that any proposed project claimed to create jobs is unquestionably worthy of government support.

The notion that if project X is to create 500 jobs, those workers will have to be taken from jobs elsewhere is foreign to our thinking. What's more, the higher wages it needs to attract workers could provoke a wages bidding war that adds to inflation.

Can you imagine any politician saying a new project requiring 500 workers didn't sound like such a good idea? Welcome to the future challenge.

The economy has a natural mechanism for helping the needed geographical and industrial change in its structure: the floating exchange rate. By going high during resource booms, it squeezes those export and import-competing industries whose demand isn't booming.

But this automatic mechanism will need reinforcement from overt government policy. Adding to supply often involves adding to demand in the first instance. Demand can be divided into spending on consumption and spending on physical investment.

If supply constrains the demand we can accommodate without inflation, but an increased share of demand needs to be devoted to investment - in business plant, housing and public infrastructure - that leaves less room for consumer spending.

A lasting resources boom needs to constrain growth in consumer spending if it's not to involve runaway inflation. Households need to spend less and save more.

The economic managers have ways of combating inflation pressure and discouraging excessive growth in consumption (particularly spending on consumer durables such as cars and major household items, which are usually bought on credit): raise interest rates.

So the bigger and longer the resources boom, the higher you can expect interest rates to be.

Don't like that solution? A better (but only partial) substitute would be for the federal government to run ever-increasing budget surpluses even after its debt is paid back, with the money invested anywhere but in Australia.

We look like we'll need some unfamiliar and controversial policies from the next and future federal governments if we're to exploit our geological and geographical luck without coming unstuck.

And that's just the conventional analysis, which conveniently ignores the natural environment. Responding to the way economic growth is damaging the ecosystem and starting to feed back adversely on the economy will require an extra dimension of unfamiliar and controversial policies.

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HISTORY, MEMORY AND TRUTH

Talk to Independent Scholars Association, Sydney
July 24, 2010

I’m not a historian, philosopher or even an independent scholar, so I confess I find today’s topic rather daunting. So I’ll make a few general observations and then comment on the topic very much from a journalist’s perspective, which I imagine is the most useful contribution I can make.

I’m old enough to believe there is such a thing as objective truth, if only we could find it. But the truth is elusive. It’s known to God, but we mere mortals merely seek it, never knowing for certain how close we’ve come to it. Of course, in the search for truth some people try harder than others. Plenty of people are happy to give us ‘the truth as I see it’ without making any great attempt to offer a balanced account. It’s often a safe bet that such accounts are far from even-handed. And some of us are happy to repeat that version - sometimes unadorned, sometimes as part of a more conscientious attempt to discern the truth of the matter.

As for memory, it’s highly fallible. Last year I was invited to speak to the annual dinner of the old boys’ association of my school, Newcastle Boys’ High. I did a lot of thinking back to my time at school in the early 1960s, and mentioned to a friend that one of the things I planned to mention was my memory of being in the school playground when the news came through that President Kennedy had been shot. My friend said I’d better check it because he was sure the news came through on a Saturday. I checked and he was right. So what it is that I have such a clear memory of I now have no idea.

The illustrious psychologist Daniel Kahneman, who won the Nobel Prize in economics for discovering behavioural economics, has more recently turned his mind to the study of happiness, particularly the definition and measurement of it. His recent research - too recent to be included in my new book, The Happy Economist - draws a distinction between experienced happiness and remembered happiness. He found that when you ask people how happy they are during an event - a holiday, for instance - you get a different answer to the one you get if you ask them after the event how happy it was. People are generally happier about things in retrospect than they were at the time. Which of the two perspectives represents the truth?

Earlier, Kahneman did a famous experiment that asked people how they felt about their colonoscopy examination, which in those days seems to have been a lot more painful than it is today. What emerged from this was the psychologists’ ‘peak-end rule’. How people felt about their experience was determined by two factors: how it felt at its worst, and how it felt at the end. This meant that doctors could influence how painful people remembered the procedure as being simply by leaving the scope in for an extra minute or so without moving it and making it painful. I think this tells us something about the fallibility and susceptibility of memory.

It’s often said that newspapers provide ‘the first draft of history’. I guess that’s true, but since I imagine many of you refer to newspapers in your research, I want to stress what a rough and ready first draft it is. Newspapers - and the media more generally - offer only the roughest and potentially quite misleading first draft for many reasons. One is the haste with which the first draft is prepared. Media outlets are increasingly understaffed these days and, in any case, journalists are required to produce their reports in only a few hours. Economic and political journalists, for instance, have to summarise the purport of lengthy government reports or budget documents before they could possibly have had time to read them properly.

The more the media turn to ‘breaking news’ - as even the morning newspapers are now doing on their websites - the more they’ll be telling us things that are undigested, ill-considered, incomplete and probably wrong in some respects. That’s true almost by definition. With breaking news, the highest priority goes to getting the news out within minutes of it occurring. In the case of a set-piece event (such as the announcement of a change in interest rates) it has be on the site within seconds. It’s all about racing your competitors, and accuracy runs a very poor second. An editor once said to me that the only way you could produce breaking news was to use the principle: ‘Never wrong for long’. Trouble is, the media are reluctant to admit and correct their mistakes. More generally, they pass judgment too quickly and are reluctant to return to stories they regard as old hat. They’re weak on follow up, often not following stories to their conclusion.

People are always claiming to have been misquoted or misrepresented by the media. The media’s attitude is generally ‘they would say that, wouldn’t they’. And it is true that people say things then, when they see them in the paper for all the world to see (including their boss), have second thoughts and claim to have been misreported. But I’ve been interviewed and reported on by print journalists a few times in my life, and I’ve been quite unimpressed by the results. They’ve not understood what I was on about, they’ve misquoted me or taken me out of context, or they’ve filled in facts without asking me and not got them right.

There may have been a time when newspapers took a pride in being ‘journals of record’, but those days are long gone, even for the broadsheets. Much that transpires - even government decisions - is these days regarded as too boring to waste space on. Newspapers face a lot more competition from the electronic media - radio, television and now the internet - which means they’re often bring their readers news the readers have already heard. They compensate for this by search for new ‘angles’, reporting reaction and by ‘taking the story forward’ - which means they assume their readers already know the basic facts of the story and don’t bother repeating them, or allude to them only well down in the fine print of the story.

But the main thing I want to say to you is that the media simply aren’t in the truth business. You may be seeking the truth, but we aren’t. You’re entitled to expect us to be truthful - that is, to get our facts right and resist the temptation to distort - but not to imagine we’re seeking the truth. We’re not in the truth business, we’re in the news business. We’re literally in the business of selling news. That is, our primary motivation is commercial - to make a profit - not ideological or scholarly. What’s more, humans’ evolutionary drive to compete means that, despite its lack of commercial motivation, the ABC behaves much the same way as its profit-motivated rivals do.

Why aren’t we seeking the truth? Because much of the time the truth is dull. Media owners are dedicated to profit maximisation, and their minions seek to do this by selling a product called ‘news’. What is news? Whatever sells. What sells - what’s ‘newsworthy’ as journos say? Anything happening out there that our audience will find interesting or important, although the interesting will always trump the important. Paris Hilton is interesting but of no importance; the latest change in the superannuation rules is important but deadly dull - guess which one gets more media coverage?


Maybe 99 per cent of what happens in the world is of little interest: it’s the old, not the new; the good, not the bad; the usual, not the unusual. It’s dog bites man, not man bites dog. Much of the criticism of the media rests on the unspoken assumption that the media’s role is to give us an accurate picture of the world around us. We don’t have first-hand experience of much of what’s happening around us and we need the media to inform us.

Sorry, but that’s just not what we do - because we don’t think there’s much of a market for it. Let me tell you a story or two to demonstrate how we select news - how what we do bears no relation to the scientific method that guides so much of what scholars do. Once when I was answering a question at a Treasury seminar in Canberra it occurred to me to say this: when social scientists take a random sample they may examine the sample and discard any outliers that could distort their survey, throwing them on the floor. A journalist is someone who comes along, finds them on the floor and says, ‘these would make a great story’.

Final story: I happened to be in the Herald’s daily news conference in February 2009 on the day Kevin Rudd’s $42 billion stimulus package was announced, with all its (then) $950 cash handouts. We discussed searching for a farmer who’d get $950 because he was in exceptional circumstances, $950 because he paid tax last year, $950 because his wife also works, $4750 because he has five school-age kids, and maybe another $950 because one of the kids is doing a training course. And, of course, he’d have a big mortgage, meaning he’d also save $250 a month because of the 1 per cent cut in interest rates announced the same day. Had we found such a person and taken a good photo of him he’d have been all over our front page. The point is that we were search for the most unrepresentative person we could find. Why? Because our readers would have been fascinated to read about him. It’s reasonable to expect the media to be accurate in the facts they report but, even if they are, it’s idle to expect them to give us a representative picture of the world. They’re not in that business.

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Economists waive any responsibility on climate

Julia Gillard's stop-gap substitutes for Labor's abandoned emissions trading scheme is unlikely to produce much reduction in emissions or be cost-effective. I reckon just about every economist would agree with that proposition, just as they'd agree with its corollary: the key to reducing emissions is to put a price on carbon.

Yet the nation's economists were neither unanimous nor active in supporting the Rudd government's carbon pollution reduction scheme.

Why weren't they? Why do so many economists behave in such an uninterested and even disinterested way on the subject?

Dr Martin Parkinson, the secretary of the Department of Climate Change, observed in a recent speech that, unlike with other, earlier economic reforms, ''there has not been a broad consensus within the economics profession on the merits of action to reduce Australia's greenhouse gas emissions, nor on the general approach to how it should be implemented''. With a few notable exceptions, he said, it had been surprising ''how little serious engagement we have seen from economists in the carbon pollution reduction scheme debate''.

Economists' preference for a carbon price signal was where agreement among economists ended. ''There is disagreement on the detail required for practical implementation, such as the timing, level and nature of the mechanisms that should be used to provide a carbon price signal, and in some cases disagreement on whether action should be taken at all,'' he said.

So why is there this lack of broad consensus and engagement by economists? Parko suggests four possible reasons.

First, some economists see climate change as an environmental problem rather than a multi-disciplinary problem. If it's an environmental issue, it's probably being dominated by environmentalists who are interventionist and anti-growth. In truth, the policy response to climate change is based on work coming from scientists, not greenies.

Note that Parkinson is a former deputy secretary of Treasury and has a quite a few ex-Treasury people around him. Emissions trading is an ''economic instrument'' and it was being designed and implemented by highly orthodox economists.

''When it comes to climate change science and projections, it is probably reasonable that economists without expertise in the relevant scientific disciplines should let scientists be the professional experts in this area,'' Parko said.

Even where some economists are genuinely sceptical of the scientific evidence, ''it has been surprising that some economists have resisted serious consideration of the professional application of the precautionary principle - that is, that taking action on climate change today is a form of insurance''.

Second, economists usually deal with marginal issues and have little experience with issues having potentially catastrophic outcomes. To a neo-classical economist trained in ''marginal analysis'', marginal doesn't mean of little importance, but quite the reverse. All the interesting things happen on the margin.

But climate change has the potential to involve a complete change in the state of the world, including the possibility of catastrophic outcomes. Economists have little experience in dealing with ''non-trivial'' (that is, worth taking seriously) probabilities of such outcomes occurring, or the related application of the precautionary principle and need for risk management.

This is the ''fat-tailed'' or ''black swan'' problem that's very difficult to assess using economists' conventional ''expected-value'' risk analysis: that is, a tiny probability of an unthinkable event.

The third reason economists have failed to provide strong support may be that, though they understand ''externalities'' in principle, in practice they have a strong preference for leaving things to the market.

The existence of market failure doesn't automatically justify government intervention in the market. You also have to be satisfied intervention will do more good than harm, otherwise all you end up with is ''government failure''.

This highlights the cost of inaction, which both Britain's Stern report and our own Garnaut report have shown is very high. This being so, the chances are high that, without guidance from economists, governments will pursue remedies involving high efficiency costs.

Parko's fourth possible explanation for economists' lack of support is that they prefer to be pure in their proposed solutions to problems and are suspicious of politically negotiated outcomes and transitional assistance.

Academic economists in particular love an ''elegant'' solution to a complex problem, but policy action is a messy, compromised business, that never starts with a clean slate and involves building coalitions around concrete policy proposals.

No sooner had the Rudd government fixed on an emissions trading scheme than economists came out of the woodwork arguing a carbon tax would be better. That trading schemes had long been the centre of international efforts to achieve a co-ordinated reduction in emissions troubled them not a bit.

''These proposals are generally put forward at a conceptual level, where they may be models of elegance and simplicity, untrammelled by questions of practical implementation or political reality,'' Parko said.

As for the objection to transitional assistance, ''no one ever suggested that tariff reform wasn't worth doing because it was implemented gradually and with generous transitional assistance packages - yet despite the careful attention paid to preserving the abatement incentives and ensuring that assistance is provided for a transitional period only, this is exactly what many are saying about the carbon pollution reduction scheme''.

Parkinson concludes that economists' lack of agreement on key implementation questions renders their preference for a carbon price signal largely meaningless in practice. In fact, it undermines public support for least-cost solutions. Well done.

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Why economists didn't see the big crunch coming

Psychologists call it "framing". When rarely they think about it, economists call it "models". What it means is that our understanding of things and our reactions to them are heavily influenced by the way we choose to look at them.

Macro-economics - the idea that governments can manage the economy as it moves through the business cycle - has really only been going since World War II. But it involves a particular way of looking at national economies, a way heavily influenced by the priorities of John Maynard Keynes and his followers.

Economic variables come in two kinds: they're either "flows" or "stocks". When you watch something increasing or decreasing over a period of time you're watching a flow variable.

It might be your wage, which comes in every week over a year, or it might be your spending on groceries, which is added to every time you go to the supermarket over a period.

When you measure something at a point in time you're looking at a stock variable. It might be how much you've got in the bank on a particular day - June 30, for instance - or how much you owe the bank. Or you could get a real estate agent to value your house.

That value applies at the time it was assessed, but may not be accurate a few months later. So a stock value is like a photograph: it shows you what the world looked like at the moment the photo was taken.

If you know anything about company accounts, you know about flows and stocks. The profit and loss statement shows flows: the flow of sales over the period, the flow of expenses over the period and the profit or loss made over the period.

The balance sheet, on the other hand, shows stocks: the stock of assets owned by the business on the last day of the period, the stock of debts and other liabilities owed by the business on that day, with the difference between the two being the value of the business to its owners on that day.

Here's the point: from the start, macro-economists developed the habit of focusing on flows and taking little interest in stocks. They studied the economy-wide equivalent of the profit and loss statement - the components of gross domestic product - and ignored the balance sheet. (National balance sheets have been added to the national accounts only in recent years.)

Another way to put it is that economists tend to focus on the "real" economy of getting and spending, production and consumption, not on the "financial" economy of who owns and owes what - assets and liabilities.

Yet another kink in the way macro-economists look at the economy is that they focus on the demand side of the economy (what people are spending their money on, consumption or investment) rather than the supply side (the economy's capacity to produce goods and services for people to buy).

The rationale for this focus on the demand side is that governments can influence demand in the short run, but supply (the number of machines and factories, the size of the labour force and its degree of skill) can be influenced only in the longer run. Hence macro is called "demand management".

Why am I telling you all this? Because all these biases in the way economists tend to think about the economy help explain the global financial crisis - which the world's sharemarkets' recent reaction to developments in Europe shows isn't over - and why economists didn't see it coming.

The global financial crisis had its origins in the financial economy (which most macro-economists don't take a great interest in), but this inevitably damaged the real economy of spending and employment.

What's happening in Europe (and to a lesser extent the US) is that people are getting increasingly worried by governments' high and rapidly rising levels of debt. What happens if the financial markets lose confidence in governments' ability to repay their debts?

Debts are a stock, incurred as a consequence of deficits, which are a flow. You have to borrow to allow a deficit to be incurred during a period and that leaves you with a (higher) stock of debt at the end of the period.

Because deficits - budget deficits, trade deficits, current account deficits - are flows, they're part of the purview of macro-economists. But deficits matter only because they add to debt levels, and if it's not your practice to take much interest in debt (because it's a stock) you face a great temptation not to worry too much about deficits, not to be aware of how they're starting to mount up.

Economists didn't cause the public debt build-up. It was caused by politicians pandering to electorates that want more and more government spending, but don't want to pay higher taxes. But economists, with their focus on annual flows, failed to raise the alarm over mounting debt levels.

Then you have a global financial crisis that threatens to bring down the banking system and the real economy with it. You have no choice but to borrow heavily to prop up the banks and borrow again to try to get the economy moving.

One small problem: put all that borrowing on top of already high levels of public debt and suddenly everyone in the financial markets is worried about "sovereign risk" and whether you'll be able to repay your debts.

(That some of the people now carrying on about governments' huge debts were the same people whose reckless behaviour - and accumulation of huge levels of private debt - required the government to bail them out, allows you to call them rude names but not to ignore their ability to bring down those governments.)

Urged on by financial-side economists, governments in Europe are seeking to stave off a possible loss of financial market confidence in those governments' ability to repay their debts by slashing their spending and raising taxes, even while their economies are weak and the austerity programs will make them weaker.

But Keynesian macro-economists are appalled by this and locked in a furious debate with the financial economists. The financial guys are saying it's stocks (of public debt) that matter most and they must be cut at whatever cost; the macro guys are saying it's flows of spending and production that matter most, and to cut them now is madness.

Thankfully, our Liberal Party's obsession with budget deficits and debts has left us in the clear.

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Show us your ticker, Gillard, before we vote

Excuse me, but what's the tearing hurry? We've had a new Prime Minister for five minutes, but we're being rushed off to an election before we can get her measure. Why? Is there a fear, if the election were delayed until October, the gloss would have worn off and we'd see Julia Gillard in a less hopeful and flattering light?

Is the new leader's fleeting honeymoon all that stands between Labor and electoral defeat? Is Labor's record in government that bad? Is Tony Abbott such a formidable opponent?

I'm not impressed by what we've seen of the Gillard government so far. We've seen the triumph of political expediency over good government. From her first day she's left little doubt three running political sores - the mining tax, resentment of boat people and the vacuum left by Labor's abandonment of its emissions trading scheme - needed to be staunched quick smart if the government's re-election were to be secured.

But what hasty, amateurish patch-up jobs we've seen. Wayne Swan has fudged up figures purporting to show the revenue cost of the deal done with the three biggest mining companies was minor, whereas sharemarket analysts are saying the extra tax to be paid by the companies will be minor. Then we had the fearful muddle over the Timor solution the Timorese hadn't agreed to, and now we're getting the climate change policy you have when you don't have a climate change policy.

The trouble with all this is it's terribly reminiscent of Kevin Rudd. Lacking in courage, not thought through and thrown together at the last moment. None of these stop-gap solutions will have been legislated before the election. So is that to be Gillard's agenda for Labor's second term: finishing off all the stuff not finished in the first term? Is that to be as inspiring as it gets? First re-elect my government and then I'll have time to think up my own agenda?

I'm sure the government has plenty of announcements up its sleeve to make between now and election day, but I'm not sure they'll add up to anything more than a grocery list. Bit of this, bit of that, tinker with this, fine-tune that. Nothing controversial, of course, and (given the budget deficit) nothing too expensive.

Before we vote on whether to retain Gillard we need to know a lot more about her and, more particularly, where she proposes to take us.

She tells us she believes in hard work, egalitarianism and the value of education, and she's proud of her mum and dad. I doubt if there are many who'd disagree, but if that's as big as her vision gets she's not ready to be our leader.

One of Rudd's biggest problems was he couldn't set priorities for himself. He took on too much, wanted the biggest and best in everything, and ended up not getting much achieved. He took on a couple of big economic reforms - the emissions trading scheme and the resource rent tax - but took them far too cheaply, underestimated the amount of explaining that needed to be done, then when the going got tough, turned turtle.

So what are Gillard's priorities? What does she plan to devote most of her attention to at the expense of all the other things she could focus on? Does she know but doesn't want to tell us, or hasn't she had time to think about it? Will she work it out as she goes along?

We know, despite her protestations, climate change won't be one of her second-term priorities. She says (correctly) we need to put a price on carbon, but then says she won't get ahead of public opinion and won't act on a carbon price until after 2012. Her next term will be spent doing the explaining that should have been done this term.

I fear most of what passes for economic debate in the election campaign will be of little consequence. Labor dumped its emissions trading scheme and emasculated its resource super profits tax for fear of being accused of introducing "a great big new tax", but that won't stop both sides accusing each other of planning to do just that.

Both sides will express their determination to get the budget into surplus as soon as possible and eliminate our (tiny) public debt post haste, while accusing the other of profligacy.

If there's one thing we don't need to worry about it's deficits and debt. Why not? Because we worry about it so much. The Libs make such a fuss about it it's a crime Labor wouldn't dare to commit.

The big economic issues facing us include how we'll make room for a greatly expanded mining sector in an economy already close to full employment, whether there's more tax reform in the Henry report we should be getting on with, and how we'll fix the ever-growing shortage of housing, including improving public transport to make homes in the outer suburbs more accessible.

Far from spending the next three years chatting about whether to get serious about combating climate change, we need to debate our unquestioned commitment to unlimited economic growth.

Does ever-rising affluence - much of it used to fuel an unending status competition - make us happier as both sides of politics assume? Are we paying a hidden price for it in damage to our family and social relationships? Is it really possible for the rich world to keep increasing its consumption of natural resources while the developing world - led by China and India - rapidly raises its standard of living towards Western levels without this irreparably damaging the ecosystem?

A bit too much for a prime minister from the left desperate to prove she's not left-wing? Far too threatening a subject for either of the political parties? I fear so. Much safer to have a furious argument about great big new taxes and the budget deficit.

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