How to limit looming interest rate rises

It's a pretty safe bet we'll get another rise in the official interest rate this year and several more next year.

A rise next Tuesday is possible, though the Reserve Bank board has a predilection for changing rates on Melbourne Cup day, after it has seen the quarterly consumer price index figures.

After the minutes of last month's board meeting and the speech the governor, Glenn Stevens, gave last week, there's not much doubt rates will be rising soon enough.

Why? Because the economy is already growing at trend (3.3 per cent over the year to June) with little spare capacity (the unemployment rate is down to 5.1 per cent), but the strength of job advertisements suggests further growth in employment is coming and the Reserve is expecting an acceleration to above-trend growth.

What's worrying the Reserve is that, whereas business investment spending has been flat (though at a remarkably high level relative to gross domestic product), the survey of firms' capital expenditure plans suggests it could grow by as much as 24 per cent in nominal terms next financial year, with mining accounting for most of that.

Although sky-high commodity prices will be feeding incomes and flowing into consumption, it's such huge rates of increase in physical investment that will make the resources boom so big and so potentially inflationary - ''the largest minerals and energy boom since the late 19th century'', according to Stevens.

Our history tells us it's investment booms and improvements in the terms of trade, rather than recessions, that pose the greatest challenges for macro-economic policy - mainly because mismanaged booms invariably lead to recessions.

Because booms are such pleasant things, in the past governments have tended to ignore the building inflation pressure until it can be ignored no longer. Then they panic, jam on the brakes, keep raising interest rates because they don't seem to be working and eventually the economy runs off the road and crashes, hurting passengers and bystanders alike.

Rest assured the Reserve won't be letting that happen this time. Having already returned the stance of monetary policy - the level of interest rates - to normal (or ''neutral'') levels, it will tighten further to keep the economy growing pretty much in line with the trend rate to prevent inflation pressures building up.

What's more, the Reserve will act pre-emptively, basing its moves on its forecast for inflation rather than waiting to see hard statistical proof a problem is building. (Actual inflation figures are important mainly because they're used to revise the forecasts.)

With the economy already so close to full capacity, we can be sure any forecast for growth much above trend, or for inflation heading up out of the target range, implies the need for higher rates, and higher rates will be forthcoming. One thing the economic managers have going for them in this boom rather than those of the past is the floating exchange rate. By floating up, it helps to limit the build-up of inflation pressure by redirecting some part of demand into the now-cheaper imports.

And by limiting demand for the products of non-mining export and import-competing industries - particularly manufacturing, education and tourism - it frees up labour and other resources to meet the ever-expanding needs of the minerals sector. This helps limit wage inflation.

Even so, if anything like the expected increase in investment spending occurs, rates have a fair way to go yet.

One thing that could limit the need for further rate rises is subdued consumer spending as households seek to get on top of their debts. Consumers take a breather, thus leaving more room for investment spending.

The ratio of household debt to disposable income has been steady for the past few years and it would be nice to see it falling over coming years. But how long it will take for the boom to overwhelm households' present restraint is anyone's guess. Mine is: not long.

Remember that, though it may not be long before commodity prices fall back from their present heights - while remaining high relative to their long-term trend - the investment phase of the boom could run and run, perhaps for a decade.

So, barring some global or China-centred catastrophe, it's reasonable to expect the exchange rate and interest rates to be uncomfortably high for many years to come. But is there anything the government could do to take some of the pressure off rates?

Without wishing to give comfort to the dishonest nonsense talked by the opposition - which implies that all interest rate rises (even those needed merely to return the official rate from the emergency lows achieved during the financial crisis) are the simple and direct consequence of the government's failure to slash its spending - there is something that could be done.

While the government will have its work cut out turning last financial year's $54.8 billion budget deficit into the now-promised surplus by 2012-13 - and this turnaround will exert a useful restraint on demand - the real challenge will come thereafter.

By all the ignorant logic of Costelloism, governments can ease up once the budget is back to surplus, granting tax cuts and allowing strong growth in spending - just as John Howard and Peter Costello did in the resources boom Part 1.

But just as this behaviour left the Reserve needing to raise interest rates somewhat more than would otherwise have been necessary, so Julia Gillard and Wayne Swan will face a similar choice. This, of course, is because tax cuts and increased spending add to private demand.

The answer is for Labor to continue its present strictures on tax cuts and spending, allowing the budget surplus to grow ever-bigger each year, something that could be readily justified to the mesmerised punters as needed to pay back our supposedly stupendous public debt.

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Setting rates by the rules has worked a treat

I touch wood as I say this - hubris has a long history in economics - but we're doing a lot better at the day-to-day management of our economy than we used to.

That's clear when you compare our management with most of the rest of the developed world at present, but it's also clear when you look back on our performance over the years.

When I got into this business 36 years ago, the economy was out of control. So was the budget deficit. And monetary policy wasn't much better.

But progressively from the election of the Hawke government in 1983 we've got things under control. How? Micro-economic reform has helped by making the economy more flexible, more resilient in the face of shocks to the economy, and less inflation-prone.

The floating exchange rate has been a great boon, shifting up or down in just the direction needed to help us cope with a particular shock, in precisely the way predicted by the textbook.

But also because of macro-economic reform: improvement in the way we deploy the instruments of macro management - monetary policy and fiscal policy. We've adopted ''frameworks'' or rules to guide the conduct of policy, we've stuck to them, and they've worked.

With monetary policy, for instance, we adopted the latest fashion of making the central bank independent of the elected government and giving it an inflation target. We designed our own flexible target - to hold inflation between 2 and 3 per cent, on average, over the cycle - which foreigners criticised as too high and too imprecise, but eventually came to accept (and imitate) as more sensible than their lower, less flexible targets.

Guess what the inflation rate has averaged over the 17 years we've been pursuing that target? Excluding the one-off effect of the introduction of the goods and services tax in 2000, 2.5 per cent - bang in the middle of the target.

And while we've been keeping inflation under control we've made steady progress in lowering unemployment.

We've been particularly well served by the three econocrats who've had charge of the Reserve Bank and monetary policy over that time. Bernie Fraser pioneered the new way of operating - he showed his successors how it was done - and had a great feel for how the economy was travelling.

Ian Macfarlane was highly perceptive in discerning changes in the forces affecting the economy, being the first to identify the role the financial economy played in the severe recession of the early 1990s and the implications of a protracted period of ''balance-sheet repair'' (now known as ''deleveraging''). He was never taken in by the fashionable enthusiasm for the (elegant but stupid) ''efficient markets hypothesis''.

Glenn Stevens has been notable for the courage with which he has, when necessary, raised interest rates without political fear or favour, and for the alacrity with which he's changed direction when the economic winds have switched suddenly, as they did in September 2008.

He's built on the lead of his predecessors in greatly increasing the role of ''liaison'' - systematic consultation with big firms and industry groups in each of the states - in seeking to bridge the gap between casual anecdotal evidence and belated, oft-revised official statistics.

I particularly admire his realism and frankness about economists' poor forecasting record. As he said in a speech this week: ''The future is of course unknowable, and economic forecasts unfortunately are not very reliable. But we have no option but to try to form a view of how things will probably unfold.''

After outlining the Reserve's present ''central forecast'' he added: ''Of course that central forecast could turn out to be wrong. Something could turn up - internationally or at home - that produces some other outcome. We spend a fair bit of time thinking about what such things could be.''

The Reserve's handling of monetary policy over the 17 years hasn't been perfect, of course. In 2007, for instance, it waited too long to raise rates, having been wrong-footed by a couple of misleading results for the consumer price index.

But while at any moment there's never a shortage of people willing to criticise the Reserve's actions - particularly people living in Canberra, for some reason - when you look back on the record you don't find a lot to complain about.

When the Reserve first enunciated its inflation target many people thought it meant the central bankers cared only about inflation. Some suspected it was imposing a 3 per cent speed limit on the growth of gross domestic product.

No one says that today. Under the inflation-targeting regime, the level of unemployment has been a lot better in the past decade than it was in the previous two. And though the same can't be said of all the world's central bankers, it was never true that our Reserve had a one-eyed view of economic management.

Even so, I don't remember any of his predecessors spelling it out more clearly than Stevens did this week. Answering the question of what the objectives of monetary policy were, he said: ''Put simply, our job is to preserve the value of money over time and to try, so far as possible, to keep the economy near its full-employment potential.''

He added that ''over the long run, these are mutually reinforcing goals, not conflicting ones''. Just so. When the Fraser government first adopted the slogan Fight Inflation First, many people had doubts, including me.

But the Reserve's successful implementation of inflation targeting has proved the slogan right (in a way Malcolm Fraser and his treasurer, John Howard, never could). Keep inflation always under control and, in time, unemployment will come right.

Note, however, that once the economy is close to full employment (of all factors of production, not just labour), as it is now, then our medium-term trend rate of growth of about 3.25 per cent a year - also known as our ''potential'' growth rate - does set a non-inflationary speed limit for the economy.

Note, too, that nowhere did Stevens (or any of his predecessors) say keeping interest rates low is an objective of policy. Interest rates are seen as a means to the end of low inflation and unemployment, not an end in themselves.

But if inflation is kept under control then nominal interest rates will at least be a lot lower than in the days when our inability to control price rises saw mortgage interest rates up at 17 per cent.

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The word we ignore at our peril

Symbolism is important because it affects the way people think and act. Symbolism is particularly important to politicians because it influences people's perceptions, and pollies know that, with voters, perceptions are often more real than the reality.

That's why it was such a bad sign for Julia Gillard to announce her cabinet - initially, at least - without mention of the word ''education''. She had Chris Evans as Minister for Jobs, Skills and Workplace Relations, Peter Garrett as Minister for Schools, Early Childhood and Youth, and Kim Carr as Minister for Innovation, Industry and Science. So research didn't rate a mention, either.

This from the party that promised an Education Revolution? This from the woman responsible for advancing that revolution during Labor's first term?

Turns out we were meant to know that ''skills'' was a reference to universities as well as tech colleges. No wonder the academics complained. And no wonder Gillard quickly saw the wisdom of restoring the E-word to prominence.

One of the big questions for Gillard's new term is: does she still believe in anything apart from whatever it takes to get re-elected? Labor's apparent lack of convictions and the courage to fight for them - whether under Kevin Rudd or Gillard - was a big part of the explanation for its poor showing in the election. Not only did it fail to attract the swinging voters, but many in its heartland turned away in disillusionment.

If Labor and its leader can't rediscover some values, I don't fancy their chances at the next election. If they have any sense they'll stop portraying themselves as a pale imitation of the Liberals.

Despite all the evidence to the contrary, Gillard does seem to understand the need to be seen to stand for something. She keeps saying she believes in the value of hard work, and it's clear she practises what she preaches - what careerist doesn't? - but that's hardly enough to get people rallying round the flag.

She also says she believes in the ''transformative power of education'', which is another less than controversial sentiment, but does meet the needs of the hour. The truth is that education suffered during the Howard years. The universities' funding was squeezed unmercifully, while technical education was neglected, early childhood development got little more than lip-service and the main achievement with schools was to bias the government's grants in favour of the better-off private schools.

If ever there was a time to be leaving education on automatic pilot, now is not it. As the returning resources boom and the high exchange rate it engenders put the squeeze on agriculture, manufacturing and our main service exports - education and tourism - there'll be much concern about the way the boom is hollowing out the rest of industry. What will be left when the boom is over? And what will we have to show for the exploitation of our non-renewable resources?

There'll be much pressure on the government to increase assistance to manufacturing - pressure to which Labor's links to the union movement will make it particularly susceptible. But to yield to that pressure would be to try to hold back time, to resist change in the industrial structure of our economy that's inevitable. Around the world, manufacturing is moving from the developed to the developing countries.

No, the way for us to secure the future rather than the past, the way to ensure workers of the future have clean, safe, well paid, intellectually satisfying jobs, is to emphasise education. The way to ensure we have something to show for the resources boom - apart from encouraging people to save rather than spend - is to foster the accumulation of ''human capital'' via increased education and training.

Overseas, economists are abuzz over the discovery that technological change is hollowing out the structure of occupations in developed countries. There are more unskilled jobs at the bottom and a lot more very high-skilled professional and management jobs at the top, but computerisation means there are fewer jobs in the middle: salespeople, bank clerks, secretaries, machine operators and factory supervisors.

This should come as no surprise to us. Mark Cully, now of the National Centre for Vocational Education Research in Adelaide, showed the existence of this phenomenon in Australia almost a decade ago.

Again the answer is obvious: more emphasis on raising the level of educational attainment among our young people (with more scope for middle-aged workers to return to the education system for additional training).

So far, I've been conforming to the modern, economics-obsessed fashion of emphasising the utilitarian dimension of education: education as a handmaiden to commerce, education meeting the needs of business (and increasingly taking its marching orders from business people).

As we've seen, it's all true: education is a key to greater material prosperity. But we're already prosperous, and it's entirely appropriate for a prosperous nation to devote a fair bit of its treasure to education and research, to finding out more and more about how humans, their world and their universe work. In other words, education should be seen not just as a means, but also as an end in itself.

One of the great characteristics of the human animal is its insatiable curiosity. Just as George Mallory's best explanation of why he wanted to climb Everest was ''because it's there'', so we need no better justification for the pursuit of education and knowledge than that we just want to know.

Education increases life satisfaction. It opens minds to the wonders of science and glories of history and culture. We learn about ourselves and about others, which makes us more tolerant of people different to us (including boat people).

All this, I suspect, is why the vice-chancellors were so disturbed to find the word education replaced by ''skills'' and no mention of ''research''. It's a pity they didn't have the courage to spell it out: we believe in knowledge for its own sake.

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Don't make taxpayers subsidise status seeking

Sometimes I despair of our politicians. They went through the election campaign carrying on about wasteful spending and the desperately urgent necessity to get the budget back to surplus and eliminate the public debt - all while promising to add to middle-class welfare.

Take the federal government's spending on grants to private schools, under which more than half the schools receive more than they're entitled to under John Howard's funding formula based on socio-economic status.

This waste continued throughout the Howard government's time in office and the Rudd government's first term. During the campaign Julia Gillard promised to continue it at least until 2013 - the year of the next federal election - and Tony Abbott promised to retain it forever. Abbott also said he would widen Labor's dubious tax rebate for education expenses to include school fees.

When it comes to welfare for the genuinely poor - the unemployed and sole parents - both sides promise ever-greater vigilance in ensuring the undeserving wretches get not a cent more than they're entitled to. The standard case against middle-class welfare is simply that it's our heavily means-tested system that does most to make Australia a low-tax country compared with the rest of the developed world and we should take care not to weaken it.

The more government spending is means-tested, the more redistributive the budget is without requiring high levels of taxation, and the less ''churning'' occurs - taking money from the same people you give it back to. Middle-class welfare increases the dreaded churning.

The Hawke-Keating government put a lot of effort into tightening up means-testing, but Howard was heavily into avoiding it, using unmeans-tested benefits to gratify the Liberal heartland as well as buy the allegiance of ''aspirational'' voters in the outer suburbs. He greatly increased taxpayer subsidies for private schooling and private health insurance, as well as adding to the means-tested childcare benefit an unmeans-tested 30 per cent childcare tax rebate (which Rudd later increased to 50 per cent). You exclude better-off parents with one hand and include them with the other.

What economists call middle-class welfare I prefer to call subsidising ''positional goods'' - goods that are intended to demonstrate to others our superior position in the pecking order.

When, rather than buying a perfectly satisfactory locally made Toyota for $30,000, for instance, we prefer to buy an imported BMW for $100,000, we're spending $30,000 on a car and $70,000 on positional goods.

We tell ourselves how much we value the Beemer's superior qualities, but in truth we want to demonstrate to neighbours and relatives we're doing as well as they are - if not better.

When you remember that most people in rich countries such as Australia long ago passed the point of being able to afford the necessities of life, you realise an ever-increasing proportion of our ever-rising real incomes is devoted to buying positional goods to impress other people.

(The main qualification to this is that as our real incomes rise we also devote more of them to buying ''superior goods'', such as healthcare and education, without that involving a search for greater prestige. For instance, the richer you are the more money you can afford to devote to one of our most evolutionary urges: to postpone death and disability.)

I suspect the pressure on governments to keep taxes low is motivated by our desire to spend more on positional goods. We need more and more disposable income just to keep up with the Joneses, let alone get ahead of them.

It's a free country and if people want to devote their ever-growing affluence to playing such games, that's their choice. But there are some important points to note.

First, such status competitions are socially wasteful. They're a zero-sum game: those who win do so at the expense of those who lose.

What's more, it's a competition that's never resolved: if you get ahead of me in this round, I stretch to overtake you in the next.

Second, if all the angst we go through to achieve greater efficiency and faster economic growth is doing little more than supplying more fuel to a never-ending status competition, it's hardly a noble enterprise. This is making the world a better place?

Third, it makes no sense for governments to be compelling taxpayers to subsidise those who want to play these status games. It's likely a fair bit of the subsidy ends up in the hands of the suppliers rather than the purchasers of the private schooling or whatever.

But get this: even to the extent the subsidy achieves its obvious (but never stated) goal of assisting those who would otherwise be unable to afford the positional good to attain it, it's actually self-defeating.

Why? Because, by definition, positional goods signal your superior standing only if they're something most people can't afford. So subsidising positional goods is a politicians' con: the aspirational punters are deluded into thinking they're being helped to achieve something that's actually unattainable.

When you consider how many demands there are on government revenue - particularly the looming growth in spending on health and aged care - it makes no sense for governments to be subsidising status seeking. Especially not when they're neglecting the provision of non-positional, public goods that would deliver greater benefit, such as reducing commuting times and improving the natural environment.

Economists need to embrace a new principle of budgeting: governments should devote whatever funds they have to delivering good quality public services in such areas as education and health, leaving those who'd prefer to buy those services privately free to do so if they can afford it.

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Getting richer as we mess up our world

I guess you've heard the good news: the devastation of the Christchurch earthquake will be a godsend to New Zealand's gross domestic product, giving it an almighty and much-needed boost.

So maybe it's a pity earthquakes don't happen more often. Perhaps we could do the Kiwis a favour and send our air force bombers over there to use a few cities for target practice.

If you think this sounds stupid, you're right. To anyone in their right mind, an earthquake that destroys many buildings, roads, bridges and vehicles - and disrupts many people's lives - can't possibly be a good thing.

But it will boost gross domestic product. GDP measures market production (and the income that production generates). So as the South Islanders spend a couple of billion repairing and rebuilding their main city, much extra production will occur and many additional jobs will be created.

But what about the loss of all the valuable assets destroyed by the quake - doesn't that count? Short answer: no. GDP is a sum that's all pluses and no minuses. It counts the benefits, but ignores the costs.

It doesn't count the destruction caused by natural disasters, nor the depletion of renewable and non-renewable resources. Production involves the emission of many forms of pollution, but this cost too is ignored.

If the clearing of land to build a town involves destroying the habitat of animals, perhaps leading to their extinction, the cost of the clearing and the building counts as a plus, but the loss of habitat or species doesn't count as a minus.

So, does that make GDP a giant con job? Yes and no. Economists will tell you GDP is an accurate measure of what it's intended to measure: market production and national income; it's not, and was never intended to be, a measure of the nation's well-being.

But this is disingenuous. Economists don't understand it's possible to know things without that knowledge being reflected in our behaviour. And though all economists know GDP is not a measure of well-being, they still treat it as though it is, obsessing over it, ignoring other indicators and encouraging us to do the same.

If GDP is so defective as a measure of well-being or social progress, why doesn't someone try to fix it? Well, many people have tried, but they've had little success. Trouble is, many of the factors affecting our well-being can't be measured in dollars, so they can't be included in the sum that is GDP.

This is the conclusion our own Bureau of Statistics soon came to when it set out to answer the question: is life in Australia getting better? To answer that you need to look at a diverse range of indicators and it's not possible to convert those indicators to a common basis so they can be added up to give a single, summary indicator.

Instead, each year the bureau produces Measures of Australia's Progress. It collects 17 indicators, gathered under three headings - economy, society and environment - trying to judge whether we've progressed or regressed on each indicator over the past 10 years.

Its latest issue was released this week to coincide with its NatStats conference on the topic, "Measuring What Counts: economic development, well-being and progress in 21st century Australia".

It shouldn't surprise you we've made progress on most of the economic indicators. Real net national disposable income (about the most meaningful derivative of GDP) increased from $35,000 a year per person in 1999 to $45,300 in 2009. It grew at an average rate of 2.6 per cent a year, well up on 1.5 per cent annual growth for the previous decade.

The nation's real net worth (assets minus liabilities) grew at the average rate of 0.9 per cent a year over the decade to reach $314,000 per person.

But not all the key economic indicators are good. The affordability of rent by low-income households - that is, housing costs as a proportion of gross income for low-income renters - has stayed constant at 27 per cent over the decade.

And the level of "multifactor productivity" - a measure of the efficiency with which the economy transforms inputs into outputs - has been relatively flat throughout most of the decade. So our economic growth came more from using additional inputs than from using inputs more efficiently.

With that mixed picture on the economy, let's move on to the key social indicators. Over the past decade, life expectancy at birth has increased by 2.2 years for girls and 3.3 years for boys. Over the same period, the proportion of people aged 25 to 64 who have a vocational or higher education qualification has risen from 49 per cent to 63 per cent. And the annual average rate of unemployment fell from 6.9 per cent to 5.6 per cent.

On crime, 6.3 per cent of all Australians aged 15 and over say they were victims of at least one assault in 2008-09. On family, community and social cohesion, there's no summary measure that captures the story. But the proportion of children living without an employed parent has fallen from 18 per cent to 13 per cent; the proportion of adults doing voluntary work during a year has risen by half to 34 per cent, and suicide rates have fallen for both sexes.

Turning to the environment, the past decade has seen the number of threatened fauna species increase from 312 to 427. In that time our net greenhouse gas emissions per year have increased by 16 per cent.

We have no summary indicator on our use of land, but the amount of annual land-clearing has fallen by a third, whereas the area of native forest remaining has fallen by 10 per cent. There's no summary indicator of our use and abuse of inland waters, oceans and estuaries. The volume of waste generated in Australia has nearly doubled.

We're entitled to draw two conclusions. First, when you drill down you find the general impression of ever-increasing well-being given to us by politicians, business people and economists is misleading. GDP might be growing rapidly, and the available social indicators may be all right, but we're going backwards on most environmental indicators.

Second, it's clear that, historically, much of the bureau's effort has gone into measuring the components of GDP, with too little effort being devoted to measuring the other, social and environmental dimensions of our well-being. Until that imbalance is corrected, the bureau's output will continue to mislead us.

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Our deprived country folk, and other myths

So, we're back to worrying about RARA - rural and regional Australia. Thanks to the newly acquired political leverage of the two country independents, we're now being told the regions haven't been given their fair share and, in future, "equity principles" should prevail.

There's a lot of righteous indignation on the part of many country people and, I suspect, quite a bit of sympathy on the part of city folk. But there are also a lot of misconceptions.

Many people have the impression there has been a continuous flow of people leaving the country for the big city. It's not that simple. The capital cities' share of Australia's population hasn't been increasing. While there has been a flow of people leaving inland regions for the cities, there's also been a flow of people - particularly the retired - leaving the cities for coastal regions. So many coastal towns and cities (such as Rob Oakeshott's Port Macquarie) have been growing strongly. Their problem is not declining population but keeping up with the increasing needs of an ever-bigger population.

Even with the inland regions it's not simply a matter of everyone leaving for the big city. In many cases it's people leaving small towns and villages for bigger regional centres (such as Tony Windsor's Tamworth).

Leaving aside the sea change factor, people have been drifting from country to city for the best part of a century. Why? Because of the increasing mechanisation of agriculture. There is unceasing pressure for farmers to use more and better machines to replace human labour. Our farms produce more than they ever have, but need fewer people to do it.

With the increased use of expensive machinery there's continuing pressure for individual farms - including dairy farms - to be bigger to better exploit economies of scale. That is, for farmers to sell out to their bigger neighbour and find work elsewhere - in the nearest regional centre or in the state capital.

The pressure comes in the form of their bigger neighbours being able to operate profitably despite falling real prices for their produce - prices at which smaller, less efficient producers can't survive. Real prices fall not so much because of the rapacious behaviour of Woolworths and Coles but because market forces - competition between producers - cause the benefit of economies of scale to be passed on to end consumers (via the much traduced Woolies and Coles). In a well-functioning market economy it's not the producers who win, it's the consumers.

Country people don't enjoy seeing people leaving the district, and small farmers don't enjoy being forced off the land. But are these long-standing trends a bad thing? They're the product of the capitalist system (you're not a socialist, are you?) and the technological advance it fosters and exploits (nor a Luddite?).

The notion that the regions should be given a fair go is appealing, even to city slickers. But what is fair? Country people are convinced they're being ripped off: they pay all this tax, but the city people spend most of it on themselves and send only a trickle back to the regions.

One small problem: it ain't true. For a start, on a per-person basis country people pay less tax than city people do. That's because incomes in rural areas are generally lower and they have a higher proportion of retired people.

What would be a fair distribution of government spending - equal amounts per person in country and city? Actually, governments spend more per person in the country than they do in the city. According to calculations by a government agency, spending on hospitals is 7 per cent higher in moderately accessible regions than in the highly accessible capital cities.

In remote areas the cost differential per person rises to 14 per cent and in very remote areas to 44 per cent.

For schools, spending per student is 12 per cent higher in moderately accessible regions, 34 per cent higher in remote areas and 60 per cent in very remote. The story for spending on policing is similar.

But how is this possible when it's so clear the quality of these services in country areas is less than the quality people receive in the city? It's possible because the cost of delivering services in the regions is so much higher relative to the (small) number of people for whom the services are being provided (and relative to the number of country taxpayers).

It's much cheaper to deliver services to people when they're all crammed together in a big city. Citysiders have economies of scale working for them, whereas country people have scale economies working against them. That's no one's fault, it's just a fact of nature.

When governments install some new and expensive facility in the big city, tens of thousands of people are able to take advantage of it and so reduce its cost per person (and per taxpayer). Were such a facility installed in some small town, the cost per person assisted would be remarkably high. Even if it were installed in a big regional centre, the cost per person would still be a lot higher.

So now you know why facilities are so much better in the cities than in the region: hard economics. If you say that's not fair and people in the country deserve equality in the quality of services provided, you're saying you want city taxpayers' subsidy to country taxpayers to be even greater than it is (so you are a socialist, are you?).

Most Australians crowd into big cities and they do so for good reasons: more and better-paying jobs, plus better services, both public and private. They put up with the drawbacks of city living: much higher housing costs, unpleasant commuting, congestion, tar and cement, and less feeling of community.

Country people prefer living in the regions for the opposite sets of reasons. It's a free country and that choice is up to them.

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AN ECONOMIC MANAGEMENT UPDATE: TAX REFORM

Talk to Victorian Commercial Teachers Association
September 13, 2010

The survival of the Gillard government with the support of the various independents has breathed new life into the debate about tax reform and the recommendations of the Henry tax review. Ms Gillard has agreed with the two country independents to hold a tax summit before July next year to discuss the economic and social effects of the reforms proposed by the review. The Labor government’s survival also allows it to press on with its intention to enact the revised minerals resource rent tax and the package of measures it will pay for. All of the four members of the House whose votes the government needs have indicated their support for the mining tax in some form, as have the Greens, who will have the balance of power in the Senate after June next year. About $6 billion of the $10 billion regional assistance package negotiated with the independents will be funded from the proceeds of the mining tax, via the Regional Infrastructure Fund.

The Henry tax review

The tax package was produced as the government’s response to the Henry review panel’s comprehensive review of the Australian tax and transfer system, federal and state. It’s the first comprehensive review since the Asprey report of 1975. Just as the Asprey report set the direction for tax reform over the following 25 years, so Ken Henry’s goal was to lay down a blueprint to guide further reform over coming decades, whether by this government or its successors. Henry set out proposals to:

• concentrate federal and state revenue-raising on four broad-based taxes: personal income, business income, rents on natural resources and land, and private consumption. Other taxes should be retained only where they serve social purposes or internalise negative externalities (eg gambling, tobacco and alcohol taxes, petrol taxes, pollution taxes). State taxes on insurance, conveyancing and other stamp duties and payroll tax should be replaced by a comprehensive 1 pc land tax and a ’broad-based cash flow tax’ (a simplified GST-type tax). (The objection to payroll tax is not that it’s a tax on labour - so is the GST - but that its high threshold means only larger businesses are taxed.)

• change the mix of taxation to reduce reliance on taxing mobile resources (eg business income) and increase reliance on taxing immobile resources (eg land and resources, and consumption). The company tax rate should be reduced from 30 pc to 25 pc. State royalty charges on minerals should be replaced by a resource rent tax levied at 40 pc.

• introduce a new two-step income tax scale with a tax-free threshold of $25,000 (but with the low-income tax offset and other offsets abolished), a 35 pc rate to $180,000 (but the 1.5 pc Medicare levy abolished) and (the present) 45 pc rate above that.

• regularise the widely disparate rates of tax on income from savings by allowing a 40 pc discount on income from interest, rent and capital gains, but also on deductions for interest expense of rental properties.

• improve the targeting of cash transfer payments.

• reform the taxation of superannuation by abolishing the 15 pc tax on contributions. People’s contributions should be taxed at their marginal rate, but they should receive a tax offset designed to ensure low income earners pay no net tax on contributions, middle income earners pay no more than 15 pc and only high income earners pay more than 15 pc. This would greatly improve the present inequitable distribution of the super tax concession. The tax on fund earnings should be halved to 7.5 pc. These two measures would lead eventually to greater super payouts, particularly for low and middle earners, making a rise in the compulsory contribution rate unnecessary.

• improve the taxing of roads by introducing congestion pricing that varies by time of day, using the proceeds to replace the tax element of motor vehicle registrations and possibly fuel taxes. Heavy vehicles should pay changes reflecting the damage they do to roads.

• reduce the complexity of the tax system, including by using an optional standard deduction for work-related expenses to simplify the completion of tax returns and save on tax agents’ fees.

Contents of the original tax package

A week before the 2010 budget was announced, the Rudd government unveiled the tax reform package that was its response to the Henry review and also the centrepiece of its budget. The package consisted of one big new tax, originally called the resource super-profits tax, which would cover the cost of various tax cuts and increased tax concessions. The mining tax effectively replaced the states’ various royalty charges for the use of minerals owned by the Crown. Although the states would continue to charge these royalties, miners would have their payments refunded by the feds. The resource tax was originally expected to raise a net $12 billion in its first two years of operation.

Proceeds from the resource tax would finance a range of tax reductions:

• Company tax rate phased down from 30 pc to 28 pc

• Small business to receive company tax rate cut earlier than other companies, plus instant write-off of new fixed assets worth less than $5000

• The present tax deduction for resource exploration costs to be turned into a ‘refundable tax offset’ at the prevailing company tax rate, making it more valuable to explorers and much more expensive to the government

• The concessional treatment of superannuation made more concessional in several ways, including: the 15 pc contributions tax for people earning up to $37,000 a year is effectively eliminated and the higher cap on contributions by people over 50 will be continued permanently for those with inadequate super. The package would also cover the cost to revenue of the decision to slowly phase up the compulsory contribution rate for employees from 9 pc to 12 pc between 2013 and 2019. (The cost to revenue arises because wages that formerly would have been taxed at the employee’s marginal rate will now be taxed at the 15 pc rate of the contributions tax. The legal incidence of the increased contributions falls on the employer, but economists believe it is shifted to the employee by means of wage rises that are lower than otherwise.)

• Tax on interest income to be subject to a 50 pc discount (similar to the tax on capital gains) up to a limit of $1000 interest income.

• As a step towards simplifying tax returns, rather than itemising their work-related expenses (and tax agent’s fees), people may opt to claim a standard deduction of $500, to be raised to $1000.

As well as these tax measures, the government announced that part of the proceeds from the resource tax will be contributed to a ‘regional infrastructure fund’ and distributed to the states, particularly the resource-rich states, to finance resource-related infrastructure.
Timing: the resource tax isn’t due to begin for more than two years - July 2012 - and so all the other parts of the package are begun or phased in from that date.

The original package as tax reform

The Rudd government’s response to the Henry tax review was surprisingly limited. Of the review’s 138 recommendations, the government accepted and acted upon just a couple, explicitly rejected 19 politically controversial proposals and failed to comment on the rest. In other words, it cherry-picked the report, selecting just a few things it thought would bring short-term electoral benefit.

The report contained many politically difficult recommendations but one that was particularly attractive: a proposal to introduce a whole new source of revenue by using a federal resource rent tax to replace the states’ mineral royalty charges. Here the government had some highly respected economists urging it to introduce a lucrative new tax on an unpopular, mainly foreign-owned industry and assuring it the tax would do nothing to discourage mining or hurt the economy.

It could use the new tax to pay for various politically attractive ‘reforms’, to be introduced after it was re-elected. The resource rent tax it announced was in line with Henry’s recommendations, except for a spin-doctor-inspired name change to the ‘resource super-profits tax’. The tax was opposed by the Opposition and bitterly resisted by the mining companies, which won a fair bit of sympathy from wider business community. This resistance caused many voters to wonder whether the tax would be bad for the economy, but almost all the criticisms were unjustified. Precisely so as to ensure the tax didn’t do the bad things it was accused of, it was hugely complex, meaning that many of its critics simply didn’t understand how it would work.

When you look at the other supposed reforms, however, you find they bear little resemblance to the Henry report’s recommendations:

• It did propose a cut in the company tax rate, but to 25 pc not 28 pc.

• It did propose the instant write-off of assets, but for those costing less than $10,000 not $5000.

• On superannuation, the report proposed that the cost of increasing the concession on contributions by lower income earners be covered by reducing the concession to higher income earners. The government did the nice bit but not the nasty bit. The government did nothing about halving the tax on fund earnings as recommended. The report specifically avoided recommending an increase in the rate of compulsory contributions, but we got on anyway.

• The report recommended a thorough overhaul of the tax on savings, with the 50 pc discount on capital gains cut to 40 pc and the 40 pc discount extended to interest income and the interest expense deductions on rental property. The government introduced a 50 pc discount for interest income, but with a cap of $1000 in interest income. It made no changes to the capital gains discount or to negative gearing.

• The introduction of a standard deduction for work-related expenses was in line with the report’s proposals (though it may have been more generous that the report had in mind) and the report said nothing about introducing a new infrastructure fund.

The package as amended by Julia Gillard

The original resource tax drew considerable opposition from the mining industry, which reduced the Rudd government’s standing in the opinion polls and contributed to Kevin Rudd’s removal by his party and replacement by his deputy, Julia Gillard. Within a week of her taking the top job - and just two months after its announcement - the resource super profits tax was extensively modified after negotiations with the three biggest mining companies and renamed the minerals resource rent tax. The coverage of the tax was reduced to just those firms mining coal and iron ore. Even those firms are excluded if their liability would be less than $50 million a year. The rate of the tax was reduced from 40 pc to a nominal 30 pc, but an effective 22.5 pc. The guaranteed rebate of 40 pc of losses was replaced with a higher cut-in point for the rent tax: the long-term government bond rate plus 7 percentage points. Whereas under the original arrangement all firms were given an automatic rebate of the state royalty payments, under the revised arrangement they will merely receive a deduction against their liability for the resource rent tax, meaning if they pay no rent tax they receive no relief from royalty payments. Various other changes were made and the existing 40 pc petroleum resource rent tax was extended to cover all offshore and onshore oil, gas and coal-seam gas projects.

The government originally expected to raise a net $12 billion over the first two year of the super profits tax but, as Mr Swan revealed when announcing the revised tax, later realised it would have raised ‘about double’ this amount (mainly because Treasury had greatly underestimated the expected production volumes of the three big mining companies). This explains why, despite the near-halving of the rate of the tax and other concessions, the proceeds from the tax are expected to fall by only $1.5 billion to $10.5 billion. This loss of revenue was covered by abandoning the plan to turn the tax deduction for exploration costs into a refundable rebate and by limiting the cut in the rate of company tax to 1 percentage point, not 2.

The economic rationale for the new resource rent tax

The present state government royalties - which aren’t so much taxes as charges for the use of mineral resources belonging to the community - are quite inefficient because they are based either on quantity (a price per tonne) or on a certain percentage of the market price. This means they take no account of the cost of mining the mineral, which varies from site to site and may increase as the exploitation of a particular site moves from the easily extracted to the hard-to-extract. Thus the present royalties can have the effect of making a prospective site uneconomic and discouraging the full exploitation of a site. This inflexibility limits the ability of state governments to raise the rate of the royalty when world commodity prices are high. (They may also be inhibited by perceived competition between the states or unduly close relations with the mining companies.)

The beauty of the new tax (and the existing petroleum resource rent tax) is that, because they are based on taking a share of super-normal profits, they don’t discourage the exploitation of marginal sites, nor encourage the under-exploitation of existing sites. They are highly flexible, taking higher royalties when world commodity prices are high, but automatically reducing the take when world prices fall. There will be times when world prices fall to the point where some sites are paying no royalty-equivalent (the resource tax) and there will be some sites with high production costs that never have to pay royalties.

Super-normal profits are profits received in excess of those needed to keep the capital employed within the business rather than leaving in search of more profitable opportunities. So super-normal profit represents ‘economic rent’ - any amount you receive in excess of the amount needed to keep you doing what you’re doing, your opportunity cost. Accountants and economists calculate profit differently. Accountants take revenue, subtract operating costs and regard the remainder as profit. But economists also subtract normal profit - the minimum acceptable rate of return on the capital invested in the business - which they regard as an additional cost, the cost of capital. The appropriate rate of return must be ‘risk-adjusted’ ie the higher the risk of the business operating at a loss, the higher the rate of return above the risk-free rate of return, usually taken to be the long-term government bond rate.

(This is what’s so silly about the mistaken claim that the original resource tax regarded any profit in excess of the bond rate as super profit. The risk was taken into account not by adding a margin to the bond rate [as occurs with the petroleum resource rent tax] but directly, by having the government, in effect, bear 40 pc of the cost of the project, including losses.)

Most taxes on an economic activity have the effect of discouraging that activity. This is clear in the case of the existing royalty charges. But resource rent taxes are carefully designed to have minimal effect on the taxed activity. Because the return on capital remains above its opportunity cost, activity should not be discouraged, meaning there should not be any adverse effect on employment or economic growth. Indeed, because of the more favourable treatment of marginal projects, there should be more employment and growth.

Economic theory says a resource rent tax should not add to the prices being charged by the taxed firms because it does nothing to add to their costs (as opposed to the effect on their after-tax profits) and because the firm is already charging as much as the market will bear. In practice, it may not be charging as much as it could. So a better argument is that our mining companies are price-takers on the international market, with Australian producers’ share of the world market not big enough to have much effect on the world price.

The fact that resource rent taxes have been explicitly designed not to do all the bad things the vested interests accuse them of doing explains the strong support for such taxes from economists. The resource rent tax is actually the proud invention of Australian economists, available to be copied by other countries.

The package as short-term macro management

The tax package is roughly revenue neutral over the next four financial years. It can be thought of as detachable - should the mining tax not be passed by the Senate, none of the measures it finances would go ahead, thus leaving the budget little affected.

This means it’s wrong to imagine the resource tax would play a significant part in returning the budget to surplus. The budget is projected to reach (negligible) surplus in 2012-13 for three reasons:

• the effect on the budget’s automatic stabilisers of the economy’s expected return to strong growth

• the always-planned completion of the government’s temporary stimulus measures

• the government’s adherence to its ‘deficit exit strategy’ of allowing the level of tax receipts to recover naturally as the economy improves (ie avoid further tax cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1 pc of GDP has been achieved.

The fact that the government now expects the return to surplus to occur three years’ earlier than it expected in last year’s budget is explained by the much milder recession than it expected and the much stronger forecasts for the next four years. Various factors caused the recession to be so mild, including the V-shaped recovery in China and the rest of developing Asia, and the consequent bounce-back in coal and iron ore prices.

In view of the government’s commitment to limiting the real growth in its spending to 2 pc, it’s worth noting that virtually all the things on which it intends to ‘spend’ the proceeds from the resource tax are tax cuts and tax concessions. That is, the package has been structured so as to add little to the government’s difficultly in meeting its 2 pc target. The qualification to this is the plan to put about $700 million a year into the new state infrastructure fund. My guess is that contributions to the fund have been designed to be the ‘swing instrument’ - that is, to be reduced or even eliminated should collections from the resource tax fall short of projections.

The package as long-term macro management

Because the resource tax is designed to be heavily influenced by the ups and down in world commodity prices, receipts from it are likely to be highly variable over the years. By contrast, the cost to revenue of the tax cuts and concessions it finances is likely to be far less variable. For an accountant-type, as Peter Costello appeared to be, this would be a worry. The tax package will make the budget balance much more cyclical. For an economist, however, this is a virtue: by introducing the resource tax the government has added a new and powerful automatic stabiliser to its budgetary armoury.

Because Australia is such a major producer of mineral commodities, the cycle in world commodity prices is likely to align pretty closely with our business cycle. Whenever we’re in a resources boom, close to full capacity and with the Reserve Bank worried about inflation pressure, the resource tax will take more revenue from the boom sector and send it to the budget. Provided this extra revenue isn’t spent or used to repeatedly cut income tax (as it was in John Howard’s day) it will act as a drag on the economy, reducing inflation pressure and hence the need for higher interest rates. Whenever we’re in a resources bust, the economy has turned down and unemployment is rising, resource tax collections will collapse, the budget will go more quickly and more deeply into deficit and this will be the automatic stabilisers working to help prop up the private sector and put a floor under the downturn.

The tax package can be seen as an attempt to improve the economic managers’ ability to manage the economy during resources booms: to chop the top off them and make them less inflationary, but also to ensure we have more to show from them when they’ve passed. The contributions to the state infrastructure fund are a way of requiring the miners to contribute more towards their own additional infrastructure requirements.

More significantly, the linking of the minerals tax with an increase in compulsory superannuation contributions should ensure at least some of the income from the boom is saved rather than spent. Empirical evidence suggests the introduction of compulsory super has done more to increase national saving than conventional analysis led us to expect. (The practical weakness in the argument is that the super increase is being phased in so slowly - the first tiny increase takes place in July 2013 and the last in July 2019 - the boom could be long past its peak by then.)

Ceteris paribus, an increase in national saving will cause our current account deficit and foreign liabilities to be lower than otherwise - always remembering that the resumed resources boom is expected to cause the CAD to be high for a protracted period. The small cut in company tax may make Australia more attractive as a destination for foreign investment, particularly equity investment. Combined with the higher national saving and potential for interest rates to be less high than otherwise (less weight on monetary policy), it’s possible to see this leading to a lower exchange rate than otherwise.

The economic effects of Julia Gillard’s changes to the mining tax

When the government finally realised its tax would extract about twice as much from the miners as it had expected to, it should simply have halved the rate of the tax from 40 to 20 per cent. This would have left all the efficiency benefits and macro stabilisation benefits of the tax intact. Instead, the government almost halved the effective rate of the tax (from 40 to 22.5 per cent) but also butchered the tax, thus reducing - though not eliminating - its economic benefits.

Originally, the tax involved a complete, up-front rebate of state royalties; now all a firm gets is a deduction against any mining tax it pays. 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. So whereas originally the whole of the mining industry would have benefited by being released from the state royalty system, now all non-coal and iron ore miners and many small coal and iron ore projects will stay subject to the inefficient, activity-discouraging royalty system. Originally, 40 per cent of losses were guaranteed by the government. Now 7 percentage points have been added to the bond-rate ‘uplift factor’. This arbitrarily leaves some projects better off, but 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. Many projects would have been permanently relieved from paying royalties while only sometimes having to pay resource rent tax. If so, those other firms are worse off under the changes. They would 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.

When the mining tax involved a 40 per cent take from profitable mining projects, but a 40 per cent rebate for unprofitable projects, this made the proceeds from the tax highly cyclical. They would shoot up when world commodity prices were high, but collapse when resource prices were low. In those years, the government might be paying out almost as much on unprofitable projects as it was receiving from profitable projects. So the replacement of the 40 per cent rebate on losses with a higher uplift factor reduces the extent to which the new tax would act as one of the budget’s automatic stabilisers.

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Rationalists just don't get the new paradigm

The dismay with which economic rationalists have greeted the ascension of Julia Gillard's "weak and hopefully short-lived government" is overdone. What we're getting is different from what we expected, but I'm not convinced it'll be any worse.

What the rationalists want is continued sound management of the macro economy plus loads of unpopular micro-economic reform to lift our flagging productivity improvement. Considering most of the macro management task is handled by the Reserve Bank, and the parties' mutual obsession with getting the budget back to surplus, we can expect the macro economy to remain as remarkably well-managed as ever.

There's been much disapproving talk about pork-barrelling - as if the practice had been invented in the past fortnight - but the emerging details of how Gillard offered the independents a lot less than Tony Abbott, yet had her offers accepted by three out of four, is a cause for confidence all round: the more responsible side won and the indies restrained their avarice.

What we've learnt since the election about the quality of the Liberals's costings and the abandon with which Abbott tried to win office undercuts all his claims to be a prudent money-manager.

By contrast, it's clear most of Gillard's promised increase in spending in the regions will be achieved by "reprioritisation" - rural will be moved to the front of the queue at the expense of some other, less squeaky wheel (the outer suburbs, probably).

The rationalists are impatient to get on with big micro reforms. But they seem to be projecting their pent-up frustration onto Gillard and her motley crew as though, had she not managed to survive, a much better alternative was on offer.

Such as? John Howard - the man whose commitment to big reforms was limited to the goods and services tax and Work Choices (which he himself watered down when he realised how unpopular it was)? Paul Keating - who took great strokes as treasurer, but not as prime minister?

Let's get real. Whether the rationalists like it or not, the era of widespread reform is long gone. The notion that, had Abbott won, we might be back to the glory days is delusional.

Abbott, a man who has hitherto shown no great interest in economics, fought an almost completely negative campaign and resorted to blatant populism. He promised faithfully to avoid all changes to industrial relations, never introduce a price on carbon, ditch the mining tax (which was intended to reform the tax system by shifting the mix towards immobile resources) and shun anything that could be labelled "a great big new tax".

And don't forget he agreed to far more items on Bob Katter's anti-competitive 20-point wish list. The rainbow coalition is more susceptible to populism? Not on the evidence so far.

Of course, had Gillard been re-elected in the normal course, we couldn't have expected much better. She'd have proceeded with the mining tax, but done nothing useful on climate change nor anything more on the Henry tax review.

But here's what the rationalists have missed: Gillard's need to win the support of the independents may increase the likelihood of a few reforms going through. Andrew Wilkie, Tony Windsor and Rob Oakeshott each support serious action on climate change and a tax on mining.

We're now likely to get some movement towards a carbon price during this term. For good measure, the rural independents have obliged Gillard to reopen consideration of the pigeonholed Henry review.

Much of the rationalists' gloom arises from the Greens gaining the balance of power in the Senate. But this was always going to happen. The psephologists were telling us to expect it long before Labor's troubles began with its repudiation of its emissions trading scheme. What's more, the Greens took more Senate places from the Libs than from Labor.

Some people are delighting in quoting spooky things from the fine print in the Greens's policy statement - did you know they want to bring back death duties? Oh no! But anyone with any sense knows not to take that stuff too literally.

The strange fact is the Greens are now the only party committed to a rationalist, price-based response to climate change. They're also committed to the resource rent tax (and only a fool would fear they could bid Gillard back up to a 40 per cent rate for the tax).

It is likely there'll be a fair bit of public debating of policy options between the government and the indies. It will be a messy process. And it's guaranteed the opposition and the Murdoch press will portray this as disunity, indecision and chaos.

But I think it could be the making of Gillard. Once we got a hung parliament, messiness and continuous negotiation-mode were inevitable. But Gillard has already shown herself much better suited to this challenge than either Abbott or Kevin Rudd.

After Labor's disastrous first term, it has a lot to learn. But I reckon Gillard has a much steeper learning curve than Rudd. One thing Labor must learn is to stand its ground and fight for unpopular policies, not get its spin doctors to change the subject.

Fortunately, the need to garner the independents's votes on every major issue will now leave Labor no choice but to explain, explain, explain.

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A FISCAL POLICY UPDATE

VCTA Student Revision Lectures
September 12, 2010

The economy has been on a roller-coaster ride from resource boom to global financial crisis to recovery from the mildest of recessions to the likelihood of an early return to the resources boom and an economy at near full employment. Monetary policy played its accustomed role in all this and Keynesian fiscal policy returned to the fore. But did we have a recession? And just what was the role played by fiscal/budgetary policy?

Yes, we did have a recession

The widespread belief - encouraged by the Rudd government - that Australia avoided recession is based solely on the notion that a ‘technical’ recession occurs when real GDP contracts for two quarters in succession. But though this rule is widely used by the media, it’s merely rule of thumb with no status among economists. It’s quite arbitrary, and doesn’t always give the right answer. A better definition of recession was given by Dr David Gruen of Treasury: ‘a sustained period of either weak growth or falling real GDP, accompanied by a significant rise in the unemployment rate’.

The evidence that we did have a (very mild) recession is clear: we saw the collapse of various local fringe financial institutions, a 0.7 per cent fall in real GDP in the December quarter of 2008 and weak growth in later quarters, a rise of 230,000 (1.8 percentage points) in unemployment and a bigger rise in under-employment, much tougher borrowing conditions for small business, and weakness in retail sales and home building as the effects of budgetary stimulus wore off.

The reasons why the recession was so mild and short-lived were many: our banks didn’t get into difficulties, the continued strength of our exports to China, the strong growth in the population, the reluctance of employers to retrench their skilled staff and the dramatic cuts the official interest rate. But much of the credit must go to the fiscal stimulus, which was particularly effective in turning around the collapse in business and consumer confidence following the US and European banking crisis.

Fiscal policy

Definition: the manipulation of government spending and taxation to influence the strength of demand.

Instruments: variation of the size and composition of government spending and taxation.

Objective: to serve as a backup to monetary policy in achieving internal balance - low inflation, low unemployment and a relatively stable rate of economic growth. It is conducted in accordance with the government’s ‘medium-term fiscal strategy’: to ‘achieve budget surpluses, on average over the medium term’.

This strategy, which the Rudd government essentially took over intact from the Howard government, was carefully worded so as to fully accommodate a Keynesian approach to fiscal policy. It implies that fiscal policy will support economic growth and jobs by allowing the budget to move into temporary deficit during an economic downturn. So it was deliberately framed in a way that permits the automatic stabilisers to respond to a downturn by turning the budget balance from surplus to deficit. But it also permits the Government to apply discretionary fiscal stimulus, provided the budget balance is brought back into surplus once the economy recovers. In this way, the deficits in the bad years will eventually be offset by surpluses in the good years, thus causing the budget to be balanced (or even in surplus) on average over the full cycle. In other words, the strategy is constructed to permit what I call ‘symmetrical Keynesianism’.

The fiscal stimulus

During the boom, fiscal policy was given a limited role to play in the policy mix, with the heavy lifting left to monetary policy. Once the economy turned down, however, fiscal policy came to fore. The Government announced its first fiscal stimulus package (worth $10 billion) in October 2008, then a second package (worth $42 billion) in February 2009. And it announced a $22 billion national infrastructure program in the 2009 budget.

The measures included in the various packages were intended to comply with three principles enunciated by Treasury and known as the ‘three Ts’: measures needed to be timely, targeted and temporary. Timely meant they should take effect as soon as possible; targeted meant the spending should go to those people or activities most likely to involve spending rather than saving; temporary meant they should involve only a one-off cost to the budget (eg cash bonuses, specific capital works) rather than a continuing cost (eg tax cuts, pension increases).

Some people have the impression that most of the stimulus spending went on cash bonuses. In fact, they cost about $22 billion, less than a third of the Government’s total stimulus spending of $74 billion over the four financial years to2011-12. The remaining two-thirds went on ‘shovel-ready’ minor capital works (road black spots, level crossings, public housing, roof insulation and primary schools) and major infrastructure projects (roads, rail, ports and broadband).

Whereas in May 2008 the government was projecting a long run of budget surpluses, it is now projecting large budget deficits, leading to an increase in the Australian Government’s net debt. It is important to understand, however, that most of this deterioration has been caused by the operation of the budget’s automatic stabilisers, rather than by the Government’s explicit spending decisions. Lower prospective tax collections required the Government to write down its projected revenue by $110 billion over the five years from 2008-09 to 2012-13. Higher prospective dole payments would also have contributed to the deterioration in the budget balance.

The latest estimates suggest the government is expecting the budget deficits over the four years to 2011-12 to total $135 billion. Thus discretionary fiscal stimulus accounts for only a bit over half of the accumulated deficits, with the automatic stabilisers accounting for the rest.

Stimulus spending by governments is intended to have ‘multiplier effects’. Empirical research shows, however, that, particularly because of leakages to saving and imports, the multiplier effects are much smaller in real life than in textbooks. In the Treasury’s calculations for the budget it used highly conservative (pessimistic) multipliers of 0.6 for the Government’s cash bonuses and 0.85 for capital works spending. It now seems clear that the fiscal stimulus has been far more successful than even its promoters expected. That is, the multipliers seem to have been greater than expected.

The changing policy mix

The Opposition’s calls for the stimulus spending to be curtailed now the economy has begun to recover fail to take account of the originally planned phase-down as the T-for-temporary spending programs expire. According to Treasury’s calculations, after the December quarter of 2009 the stimulus spending’s contribution to GDP growth swung from positive to negative. This occurred because, though more stimulus money was spent in the March quarter, it was less than the stimulus money spent in the December quarter. And this meant it subtracted from the rate of growth in GDP (even though it still added to the level of GDP). In other words, from the end of December the stance of fiscal policy switched from expansionary to (mildly) contractionary as the stimulus was withdrawn. To hasten this planned withdrawal would make fiscal policy more contractionary.

By contrast, the various increases in the cash rate we’ve seen, taking it to 4.5 per cent, merely represent moves to take the stance of monetary policy from stimulatory to neutral.

What we have to show for the fiscal stimulus

The Opposition runs hard with the line that, thanks to all the fiscal stimulus, we’re left with nothing to show but a lot of deficits and debt. This isn’t true. Clearly, we’ll be left with all the shovel-ready capital works - rail crossings, fixed black spots, social housing, school buildings and ceiling insulation - and major infrastructure.

But that’s not all - though you have to be an economist to see it. Even the money spent on the cash splashes and unneeded assembly halls has left us with something to show. All the spending - discretionary and automatic - reduces the time it will take for the level of real GDP to return to its previous peak. And that leaves us better off than we would have been in two respects. First, the smaller the rise in unemployment and thus the fewer people unemployed - and the shorter the time they spend unemployed - the less the atrophy (wasting away) of individuals’ skills. Reducing this problem, which economists call ‘hysteresis’, is a benefit not just to the individuals involved, but also to the community.

Second, the milder the recession, the fewer viable businesses go bust, thus avoiding the destruction of various forms of tangible and intangible capital. Some capital equipment - and some understandings, networks and arrangements the firms have made - that could have been used to produce goods and services in the upswing is destroyed. So the milder the recession, the less the loss of productive potential because of the destruction of human, physical and intangible capital.

The opposition opposed all but the first stimulus package and has been continually finding fault. At first it argued the measures - particularly the cash splash - wouldn’t work. But it’s clear from the economic indicators - for retail sales, home loan approvals, new home building approvals and business investment in equipment - that the measures were highly successful in leading to increased private spending. It’s true some of the cash was saved rather than spent, but the marked improvement in business and consumer confidence at the time suggests this saving made many people less anxious about their debts and so less keen to cut back their spending as a precautionary measure.

Later the opposition switched to claiming much of the stimulus - particularly the spending on ceiling insulation and school buildings - had been wasted. It’s true the insulation program should have been much more carefully administered and that there was a degree of waste in the school building program. However, an official inquiry received complaints from only 2.7 per cent of schools, suggesting the extent of waste had been greatly exaggerated by the opposition and sections of the media. Stimulus spending always involves a difficult trade-off between conflicting objectives: the macroeconomic objective (getting the money spent as soon as possible so as to limit downturn in activity) and the value-for-money objective (making sure we have something of lasting value to show for the spending). The way to avoid waste is to take as long as necessary to ensure the money is spent well. So when speed is a high priority, some degree of waste is inevitable. Note, too, that even when spending is wasted on classrooms no one wants, it still creates jobs.

The tax reform package

The main measure announced in this year’s budget was a tax reform package, in partial response to the report of the Henry review of the tax system. After its amendment by Julia Gillard, the package consisted of a minerals resource rent tax, expected to raise about $10 billion in its first two years, the proceeds from which would be used to cover the cost of reducing the company tax rate from 30 per cent to 29 per cent, plus tax concessions for small business, superannuation and individuals. Note that the new tax won’t take effect until July 2012, so the measures it pays for will be phased in from that date. Note, too, that the package is roughly revenue neutral, meaning it’s wrong to imagine the resource tax will play a significant part in returning the budget to surplus.

Mr Swan is now expecting a budget deficit for the old financial year (2009-10) of $57 billion (or 4.4 per cent of GDP), falling to a deficit in the present financial year of $40 billion (2.8 per cent). With the cessation of most stimulus spending programs, this means the stance of policy adopted in the budget is mildly contractionary.

The budget is projected to reach a small surplus in 2012-13 for three reasons: First, the effect on the budget’s automatic stabilisers of the economy’s expected return to strong growth; second, the always-planned completion of the government’s temporary stimulus measures; and third, the government’s adherence to its ‘deficit exit strategy’ of allowing the level of tax receipts to recover naturally as the economy improves (ie avoid further tax cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1 pc of GDP has been achieved. The fact that the government now expects the return to surplus to occur three years’ earlier than it expected in last year’s budget is explained by the much milder recession than it expected and the much stronger forecasts for the next four years.

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Debt is good when it means investment

One of the most remarkable, but unremarked, features of the election campaign was the extraordinary fuss made about a net federal government debt expected to peak at a mere $90 billion, while not a word was said about Australia's net foreign debt of $670 billion - and rising.

Similarly, despite all the feigned concern about the size of federal budget deficit, nothing was said about the current account deficit, which is almost always much bigger.

This just proves politicians carry on about what it suits them to. It hasn't suited the opposition to bang on about the current account deficit because it was consistently high throughout the Howard government's 11 years - meaning the net foreign debt just kept getting bigger.

But the Liberals - and Labor, for that matter - aren't alone in not wanting to talk about the current account deficit (which is the amount by which our imports and income paid to foreigners exceed exports and income received from foreigners) and the resulting net foreign debt (which is the money Australians owe foreigners, less the money they owe us).

These days, the nation's "external accounts" hardly rate a mention in the media, either. So surprisingly little has been made of the news that, at $4.2 billion, the current account deficit for the June quarter was the lowest in almost a decade.

It turned out our export earnings were up 24 per cent on the previous quarter, whereas our imports were up 6 per cent, causing the trade balance to swing from a deficit of $2.8 billion to a surplus of $7.8 billion. Trade surpluses aren't all that common, and this one was our biggest since 1973.

For good measure, our net income payments to foreigners (covering interest payments on the foreign debt and dividend payments to foreign owners of Australian businesses) were down by a bit under $1 billion to about $12 billion, yielding the current account deficit of $4.2 billion. Wow. Why such an improvement? Because everything went right with our exports. For a start, there was a big increase in the prices we received for our exports of coal and iron ore. The volume of coal exports was up, as were exports of gold. Exports of oil were up as two new oil fields off the coast of Western Australia came on line.

But it's not such a bad thing the media didn't make a fuss about the improvement. Why? Because it can't last. It's the calm before the storm.

When our terms of trade improve - when export prices rise relative to import prices - as they have mightily this year, people always expect this to lead to an improvement in our trade balance and current account deficit, but it rarely does. They think this because they forget to ask one of the great economists' questions: but what happens then? You never get the right answer until you take account of what economists call "second-round effects".

What happens then is the rise in exports leads to a rise in imports. This happens several ways. First, the improved terms of trade represent an increase in the nation's real income. As this real income is spent, a fairly high proportion is spent on imports: imports of consumer goods, but also imports of components and capital equipment.

This process is accentuated because an improvement in our terms of trade usually leads to an appreciation in the exchange rate. The higher dollar makes imports cheaper, thus encouraging people to buy more of them relative to locally produced goods and services.

Second, a rise in world prices for minerals and energy encourages our mining industry to expand its production capacity, building new mines and natural gas facilities. A high proportion of the equipment needed for these expansions is imported. Take the coming Gorgon natural gas project on Barrow Island. It's expected to involve investment spending of about $50 billion over five years. Roughly half that money will go on imports.

The truth is the return of the resources boom is expected to involve a return to the big current account deficits (and thus faster-rising levels of foreign debt) we have seen since the start of the boom in the early noughties. So whereas the current account deficit got down to the equivalent of just 1.6 per cent of gross domestic product in the June quarter, the econocrats are expecting it to go back up to 5 or 6 per cent during the rest of the decade.

To see why this isn't as worrying as it sounds - and to debunk the Liberals' dishonest implication that anything labelled "deficit" or "debt" must always be bad - it's useful to pull another economists' trick and switch the discussion of our "external imbalance" from the language of exports and imports to the language of saving and investment.

Huh? Just as Australia almost always imports more than it exports, so the nation also spends more on investment (in new housing, business equipment and structures, and public infrastructure) than it saves (whether by households, companies or governments).

All physical investment spending has to be financed from savings, and when we don't save enough to finance all our investment we make up the difference by borrowing the savings of foreigners. This is why Australia runs a surplus on the (financial) "capital account" of our "balance of payments" to and from the rest of the world, which exactly matches and finances the deficit on the "current account" of the balance of payments.

The current account deficit is low at present because private sector investment spending fell somewhat in the economic downturn, while the mining companies are saving (as retained earnings) much of their extra income from higher world commodity prices.

Soon enough, however, national investment spending will boom as households build more houses, ordinary businesses invest in better equipment and, in particular, as the miners hugely increase their investment spending.

All this is likely to happen without much increase in the nation's rate of saving. If so, the capital account surplus is likely to be much bigger as we call more heavily on the savings of foreigners - and so is its mirror image, the current account deficit (as we import more capital equipment).

If the worsening in the current account comes from higher investment spending rather than lower national saving - as happened in the first part of the resources boom and is expected to happen now - we don't have a lot to worry about. Eventually, the investment will pay for itself.

5302.0

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Perhaps now politicians will stop trashing their reputations

Let's hope it's not back to politics as usual. And let's hope the fortnight or so since the voters' collective refusal to award the election to either of the major parties has allowed both sides time to reflect on something that hasn't troubled them to date: when will the political profession decide to call a halt to its trashing of its own reputation?

The process by which our politicians have slowly destroyed their credibility with the electorate has been running for so long it's easy for them - and us - to be unconscious of what is happening. But it reached a new low in this campaign, so it shouldn't have been such a surprise when the electorate couldn't decide who it distrusted less.

The disdain with which we've come to regard our politicians struck me when I considered the success of the mining industry's advertising campaign against the resource super profits tax. With world coal and iron ore prices at record highs, the largely foreign-owned mining companies are raking in unbelievable profits.

The Labor government said the new tax was needed to ensure the people who actually owned these resources - you and me - got a fairer price for them. The miners claimed the tax would cripple them, discourage further development and cause people to lose their jobs.

You might have expected the public to respond to these over-the-top claims with scepticism - they would say that, wouldn't they?; whoever likes paying more taxes? - but it seems many people believed them.

(Think about it: we were being asked to believe the Secretary to the Treasury, the high priest of economic rationalism, backed up by two highly regarded economists and the chief executive of a major business association, was proposing a tax that would lay waste to the mining industry and seriously damage the economy.)

So why was the word of fat-cat miners favoured over that of our own government? Because the credibility of our politicians is at rock bottom. Even big businesses on the make are judged more likely to be telling the truth.

Surveys of the reputation of various occupations show politicians well down the list (but above journalists, advertising people and car salesmen). The company pollies keep on the list makes it clear: the public has a low opinion of people they have come to believe seek to manipulate them and tell them things that aren't true.

The more politicians have relied on the techniques of market research - polling, focus groups, advertising and direct mail - the more they've sought to con us.

Top of the list of behaviour that has cost politicians our respect is broken promises. We have seen it so many times from both sides we have come to view all political promises with suspicion. Consider the possibility that Gillard's last-minute promise to build the on-again-off-again Parramatta to Epping rail link cost Labor as many votes as it gained.

It will always be that some promises aren't kept because they have been overtaken by events and it would be foolish, even impossible, to press on with them. But so many promises have been broken many voters believe they are often given without any intention to keep them.

My guess is the process is more cavalier. Pollies think: if I win that's when I'll worry about whether I can honour them all.

The answer is for pollies to be a lot more cautious in making promises. But why do they make so many? Because of the way, under the influence of marketing techniques, election campaigns have come to take the committed voters for granted and focus on winning the votes of swinging voters in marginal electorates. Swinging voters are judged to be people with little interest in politics, whose only thought is what's in it for them and their families. Hence the temptation to keep promising goodies.

Election campaigns have become increasingly unreal. The pollies create a fairytale world in which nothing bad ever happens. They'll spend more on this and that, but without increasing taxes and, of course, while also eliminating deficits and debt.

In this imaginary world, the law of opportunity cost doesn't operate. We can have everything we want, without price. The pollies encourage people to believe the government can - and should - solve all their problems. Is it any wonder disillusionment is rife?

Often - as with all the pseudo-sympathetic talk about the rising cost of living in this campaign - the pollies seek to appear empathetic while carefully avoiding promising to do anything. They think they're being clever, but when people gain the impression you're going to fix their problem and you don't, they feel just as cheated as if you really had promised it.

In Queensland, voters feel they were ambushed by Anna Bligh because she waited until after the election to announce unpopular tax changes and privatisations.

That's the "positive" way politicians have damaged their reputations. Of late they've resorted more to negative methods: trashing each other. This campaign boiled down to rival scare campaigns about Work Choices, the mining tax, the "Woollies and Coles tax", mountainous debt and boat people.

Politicians wouldn't resort to scare campaigns and negative advertising if they didn't work. They play on the gullibility of people who don't think much about politics. But what works in the short term comes at a long-term cost to the politicians' credibility. The same goes for oppositions automatically opposing everything governments do and the endemic abuse of statistics.

Many voters are naive and gullible. But when eventually they realise they've been conned, they switch not to reasoned scepticism but utter cynicism about the untrustworthiness of our political leaders.

Many politicians believe John Howard lost office because voters had simply "stopped listening" to him. Those who deposed Kevin Rudd concluded voters had "stopped listening". If this isn't ringing alarm bells in the political profession, it should be.

The hung parliament offers politicians the chance of a circuit breaker in this mutually destructive process.

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Our economic challenge will be feast not famine

Perhaps we're seeing the emergence of a new law of elections: the real issues facing the economy in the next term won't bear any resemblance to those discussed during the campaign.

In the 2007 campaign, the Liberal slogan was Go for Growth and Labor wanted the growth to involve more investment in training and infrastructure. In reality, the Reserve Bank was hauling on the interest-rate brakes because of rising inflation pressure, and we ended up spending most of the term fending off the worst global recession in 60 years.

In this campaign, the Libs defined our biggest economic problem as combating Labor's horrendous budget deficits and struggling to overcome Labor's mountainous public debt. They assumed their net cuts in spending (which Treasury and Finance later found to be largely illusory) were the only thing that could return the budget to surplus.

Lacking convictions and the courage of them, Labor - which had done a remarkably good job of shepherding the economy through the global financial crisis - fell in with this bookkeeper's vision of economic management.

But two weeks after the election, the June quarter national accounts have swept away all the nonsense of the campaign. The resources boom is back, the economy is roaring along, the government's filling coffers will soon get the budget back into surplus without the pollies doing any more than resolving not to spend all of it, and the economy's big problem will be growing at full employment without overheating.

Before we explore those challenges that await us, why is economic debate during election campaigns so off-beam?

It's partly because the modern practice of aiming election campaigns almost exclusively at swinging voters in marginal electorates - people known to be uninterested in politics, without ideology, economically illiterate and of a self-centred, what's-in-it-for-me? disposition - means nothing unpleasant or even faintly serious can be raised.

Consider the recent British elections. Anyone taking the slightest notice would have known that whichever side won the election would immediately plunge into sweeping spending cuts and tax increases to hack into a budget deficit that really was a worry. But all sides studiously avoided engaging with the issue.

The other reason election campaigns are so unreal is that even economists can be quite ill-informed about the state of the economy and direction in which it's headed.

Throughout this campaign most economists thought consumer spending and home-building were quite weak, with the worries about the US and European economies, and maybe even the disincentive effects of the new mining tax, putting a question mark over the medium-term prospects for our economy.

Most of those doubts and misconceptions have been swept away by last week's figures, including the survey of firms' capital expenditure plans, which exposed how much the mining companies were lying about the resource super profits tax's supposed threat to their future activities.

I've come to the view that few people - even economists - have a good feel for how the economy's travelling at any moment. It's never very clear what's happening until we see the national accounts. Then, of course, any fool can tell you what the score is.

I suppose it's possible a double dip in the US and lingering weakness in Europe could be sufficient to knock China, India and the rest of emerging Asia off its stroke and thus bring our resources boom to a sudden halt, but I doubt it's likely.

It is likely coal and iron ore prices are near their peak and will fall back as world supply catches up with world demand. But prices could fall a fair way and still settle well above their long-term level. Part of what we lose on price we'll make up on increased volume. And the miners and natural gas companies have maybe a decade's worth of construction projects in the pipeline.

We're back to growing at the trend rate and are already close to full employment. As in all Australian commodity price booms, our big problem will be how we manage the inflation pressure as the extra export income is spent.

Can we keep travelling at full-employment level without overdoing it and having to induce a recession? Rest assured, the Reserve Bank will raise interest rates to whatever level is needed to keep inflation in check, but can we do better than that?

Could we keep tightening budgetary policy to take some of the pressure off monetary policy and interest rates? The bookkeeper's approach to economic management doesn't augur well. The flipside of the nonsense we heard in the campaign is that once the budget's back in surplus, whoever's in government will imagine they're able to spend more freely (just as John Howard did during the first stage of the boom).

To help with the macro management part of the problem, but also to ensure we have something to show for the boom, we need to save a higher proportion of the extra national income. Perhaps we need a sovereign wealth fund to justify ever-higher budget surpluses.

The idea of increasing compulsory superannuation contributions to raise national saving is attractive, but a Coalition government wouldn't go ahead with it and Labor's present scheduled phase-up is too delayed to be of much use.

We need to revisit - more intelligently - the question of population growth, but ask whether meeting the mining industry's need for more labour actually requires open slather on skilled immigration (with all the increased spending on public infrastructure that would necessitate).

Now the election's (almost) out of the way, there's so much we need to debate about economic policy.

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