The economy is a lion disguised as a lamb

The big divide in economists' views on the outlook for the economy - and hence, for interest rates - is whether they regard the present weakness in consumer spending as worrying or welcome. And that turns on how forward-looking they are.

I suspect it's also affected by what psychologists call "salience" - the tendency for our judgments to be most affected by those events that are highly visible and memorable, those that make the biggest impression on us. Looking at the economy now, what stands out is the weakness of consumer spending, including quite anaemic growth in retail sales. Tourism - whether inbound or domestic - is another area of weakness, badly affected by the high dollar.

So weak is consumer spending that it's putting downward pressure on a lot of retail prices. As Dr Philip Lowe, of the Reserve Bank, pointed out last week, over the past year the Bureau of Statistics' price index for clothing has fallen by 6 per cent (assisted by a fall in import duty on footwear, clothing and textiles at the beginning of last year).

The various indexes have fallen by 4 per cent for major household appliances, 1.5 per cent for furniture and furnishings and by 18 per cent for audio, visual and computing equipment. Indeed, apart from processed food, the prices of very few manufactured goods rose during the past year.

Lowe suspects the weak consumer spending has led to a faster than usual pass-through to retail prices of the substantial appreciation of the dollar, which has lowered the cost of imported goods and services (and also put downward pressure on the prices of locally made goods and services that compete against imports in the domestic market). His suspicions are confirmed by the research of Kieran Davies, of Royal Bank of Scotland, who found the weakness of retail prices was more likely to be the result of pass-through of the higher exchange rate than the compression of retailers' margins.

Davies notes that, unless the dollar appreciates further (not something I'd wish for), the exchange rate's dampening effect on inflation will soon start to wane.

All this spells tough times for the retailers, and their lamentations have had much publicity. So it's easy to see the economy as going through quite a weak patch. This impression will be compounded when we see the way the Queensland floods and cyclone Yasi have taken a bite out of the growth in gross domestic product in the December and, more particularly, March quarters.

Little wonder the financial markets aren't expecting any further increases in the official interest rate until quite late this year, and the governor of the Reserve Bank, Glenn Stevens, thinks rates are "about right for the medium-term outlook". But I think there's a lot more strength behind the economy than all the surface noise would suggest. If I'm right, the rate rises will resume earlier than the markets presently expect.

For a start, the blow from the extreme weather events largely represents the displacement of activity from the March quarter to the June and later quarters. The Reserve is expecting the level of GDP to be no lower by the end of this year than was expected before the floods happened.

For another thing, the weakness in consumer spending is occurring because of a reversion to our earlier saving habits and a (presumably temporary) bout of caution. In other words, consumers aren't short of a bob, they're choosing not to spend.

It's not the sort of thing the media shout about, but household disposable income grew by 6.4 per cent over the year to September in nominal terms. It's being boosted by two major sources of present and future growth: our most favourable terms of trade in 140 years and strong growth in employment. The Reserve's index of commodity prices has risen by almost half over the past year. This doesn't add to GDP directly, but it does add to the nation's real income which, when spent, becomes more visible.

Another less salient factor is the strength of the labour market. Over the year to January, total employment grew by 3 per cent. Within that, full-time employment grew by 3.4 per cent. The unemployment rate is down to 5 per cent, while the rate of participation in the labour force is at a near record high of 65.9 per cent.

This is not the hallmark of a weak economy - quite the reverse. It also gives the lie to the silly talk of a two-speed economy. You may object that the labour market's yet to register the effect of the weak retail sector but, in fact, the various forward indicators suggest employment will continue growing strongly.

And to top off all that there's the least salient factor of all: the looming wall of mining construction spending. Consider this quote from the latest statement on monetary policy: "For some time, the [Reserve] has been expecting very strong growth in resources sector investment.

"The information received over recent months has provided greater confidence in this forecast, with announced plans to date at least as strong as had been expected."

All this is what you see when you lift your eyes from hard-pressed retailers and look at what's in the pipeline. When you do you see that, from a wider perspective, the fact we're not yet adding a consumption boom to a business investment boom is more welcome than worrying.

The economy's potential rate of economic growth is only about 3.25 per cent a year and, with unemployment already down to 5 per cent, we have little spare production capacity.

Even so, the Reserve is forecasting growth of about 4.25 per cent over this year, with growth of 3.75 to 4 per cent in the following years.

Sounds like a recipe for higher interest rates to me.

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Urge to splurge fades as savers born again

The punters, pollies and shock jocks who tell us we're groaning under the weight of the rapidly rising cost of living need to answer a question: if so, how come households are managing to save 10 per cent of their disposable income?

It has drawn remarkably little comment, but the household saving ratio - saving as a proportion of household disposable (that is, after-tax) income - is the highest it has been in more than 20 years.

You wonder why the retailers are doing it so tough? That's why. With wage rates increasing and more people in jobs, household income has been growing quite strongly. But in recent years we've been much less inclined to rush out and spend every cent that comes our way.

That's what saving is: the bit that's left over when you don't spend all your income on consumption. In fact, economists define saving as ''deferred consumption''.

Most of us think of saving as putting money in bank accounts. We've been doing more of that lately, but it's not the main way we save. Historically, the main way Australians have saved is by borrowing a shed-load of money to buy a house, then paying it off over the next 25 years. Your savings are embodied in the proportion of the house that's owned by you rather than the bank - your ''equity'' in the house.

The household saving ratio was at 15 per cent in the early 1980s, but then it fell for more than two decades to reach a low point of minus 2 per cent in the early noughties. We were ''dissaving'' - consuming more than we earnt.

How's that possible? By running down past savings or by borrowing.

Since the mid-noughties, however, the saving ratio has shot up to 10 per cent. You could be forgiven for not knowing this because much of the increase has suddenly appeared as a result of the Bureau of Statistics' revisions to the national accounts.

The bureau doesn't measure saving independently, just takes it as the residual when it compares two huge numbers: for household income and for household consumption. So any errors in measuring those two big numbers will be reflected in the figure for saving, making it volatile and subject to revision as better information comes to hand.

Since 2004 household disposable income has grown strongly, averaging 7.3 per cent a year in nominal terms (that is, before allowing for inflation). Over the same period, household consumption has grown by 5.4 per cent a year.

Dr Philip Lowe, an assistant governor of the Reserve Bank, expressed the figures differently in a speech he gave this week. In quite a few of the years during the decade and a half to 2005, household consumption increased by more than a dollar for every extra dollar of household disposable income received.

Since then, however, only about 65¢ in every extra dollar of income has been spent. (Small prize if you realised this measure is that old Keynesian workhorse, the ''marginal propensity to consume''.)

The evidence that something has changed in our attitude to saving can be seen in other indicators. One example comes from the annual survey of Household, Income and Labour Dynamics in Australia.

In the surveys between 2000 and 2005, there was a clear trend of fewer and fewer households with mortgages reporting they were ahead of schedule in their repayments (a way of saving). But this downtrend slowed in about 2005 and then in 2009 - the most recent year for which results are available - there was a marked increase in the share of people saying they were ahead of schedule.

Similarly, over the past couple of years there has been an increase in the proportion of households who say they pay their credit card balance in full each month. It has gone from about 60 per cent to almost 65 per cent.

Then if you look at the Westpac-Melbourne Institute monthly survey of consumers you find there has been a marked increase in the number of households saying the wisest thing to do with their savings is to pay down debt or build up bank deposits.

Correspondingly, there has been a decline in the perceived attractiveness of more risky investments.

A final bit of evidence comes from the estimates of how much equity households are adding to the housing stock. Until the late 1990s, it was normal for the value of newly constructed homes each year to be significantly greater than the increase in the amount we all owed on our housing.

Why? Because, while the people buying the newly-built homes would usually borrow most of the cost of the home, other, established home owners would be trying to pay back their mortgages as quickly as they could (mainly by keeping their monthly mortgage payments higher than the bank's minimum requirement).

In other words, the proportion of the nation's total amount of housing that wasn't owed to banks would increase each year. Economists call this ''equity injection''.

But during the early part of the noughties this changed and the household sector was withdrawing equity. Now here's the point: in recent years things have changed again and we've returned to the usual pattern of increasing equity.

So what's going on? Why did we stop saving and why have we started again? Over the decade to 2005, there was a large run-up in household debt and a related rise in the (gross) value of household assets such as homes and shares, while our rate of saving declined.

This seems to have been a period of adjustment to the fall in nominal interest rates (caused by our return to low inflation) and financial innovation (banks keener to lend for housing, with new products such as home-equity loans and reverse mortgages).

Lower nominal mortgage rates allowed us to borrow more, which many of us did at much the same time, thus bidding up house prices in the process. Some of us even increased our mortgage to pay for an overseas trip.

But it seems this period of adjustment to new possibilities was largely completed by the mid-noughties and we've gone back to our usual preference for paying off the mortgage as soon as we can.

And then this episode of ''structural adjustment'' seems to have been reinforced by the global financial crisis, which has led some households to rethink their spending and borrowing decisions. Some people are a lot more cautious and a lot less sure that house and share prices can only ever go up.

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Inflation whingers bite the very hand that feeds them

Have you been struggling to cope with the rapidly rising cost of living? Well, tell it to the pollies because I don't believe it. Actually, the pollies probably don't believe it either but they'll pretend to rather than risk offending you by telling you to stop feeling sorry for yourself. They care about your approval, not your edification.

Ever since 1957, when the British prime minister Harold Macmillan caused uproar by telling the Poms they'd "never had it so good", politicians have been wary of incurring the voters' ire by reminding them of their growing prosperity.

Many people prefer to see themselves as put-upon and pollies are happy to go along with the self-deception as long as it keeps them out of trouble. The really weak ones would agree with a proposition that you'd never had it so bad if they thought it would humour you. (And the shock jocks are no better.)

My theory is that if people are reduced to whingeing about the cost of living, it's a sign they don't have any more pressing problems to complain about. The cost of living is always rising, so there's always something to complain about if you're that way inclined.

Many people have long believed living costs are rising considerably faster than the official measure of inflation, the consumer price index, and now the Bureau of Statistics has appeared to confirm their suspicions by publishing special cost-of-living indices for particular types of households.

The CPI is an imperfect guide to living costs, partly because it's an average for all capital-city households, whereas different types of households have differing spending patterns. Mainly it's because, for "conceptual reasons", the CPI takes no account of the ups - and downs - of mortgage interest payments.

This week the bureau issued figures showing that, whereas the CPI said prices rose by 2.7 per cent over the year to December, the cost of living for employee households rose by 4.5 per cent, as it did for non-aged welfare recipients.

For age pensioners costs rose by 3.1 per cent, whereas for the self-proclaimed self-funded retirees they rose by about the same as the CPI: 2.6 per cent.

So, does this prove life is as expensive as you think, as one headline had it? No, it doesn't. Why not? Because you think your cost of living rose by a mighty lot more than 4.5 per cent last year.

What it proves is that, while the CPI may at times understate the rise in your cost of living, it doesn't understate it by nearly as much as you'd like to believe. And remember this: at times when mortgage interest rates (and fruit and vegetable prices) are falling rather than rising, the CPI is likely to overstate the rise in your living costs.

This means that, since interest rates and fruit and vegie prices regularly go up and down, over time much of the difference between CPI inflation and the cost of living comes out in the wash.

Consider this: over 11 years to December, the CPI rose by 43.8 per cent, whereas the living-cost indices rose by 43.6 per cent for self-funded retirees, 48 per cent for employees, 48.4 per cent for age pensioners and 50.3 per cent for non-aged welfare recipients.

A difference of 4 percentage points or so over a period as long as 11 years isn't a lot to write home about. The perpetually self-pitying self-funded retirees have nothing to complain about but the people with most to complain about, those on sole-parent pensions or the dole, are the people we feel least sympathy for (which is precisely why successive governments have screwed them).

Why is it so many of us imagine our living costs to have risen by far more than any official measure of price increases records? Because of the frailties of human nature. We make casual observations of changes in the prices we pay, whereas the Bureau of Statistics - which sends people out to check prices in supermarkets and many other retail outlets around the nation - calculates it all very thoroughly.

You and I take no account that the car or computer we buy today does more tricks than the last one we bought but the bureau makes allowance for this "quality improvement" so as to distinguish between rises in the cost of living and rises in our standard of living.

More pertinently, you and I vividly remember the big prices rises we've suffered - electricity and water rates in recent times, petrol prices at other times - while being vaguer about the small price falls we've enjoyed and taking no notice of the many prices that don't change (but which, of course, are working to hold down the rise in our cost of living).

The high dollar and weak retail sales have brought more falls in prices than most of us realise.

The bureau's records show the prices of clothing and footwear fell by 4.8 per cent last year. The combined prices of household contents and services fell a fraction, while the prices of new cars fell by 1.5 per cent, the prices of phone calls and internet service providers fell by 0.6 per cent, the prices of electronic entertainment devices and computers fell by 7.8 per cent.

The prices of overseas holidays fell by 1.2 per cent, and those for domestic holidays fell by 3 per cent.

And while the overall cost of living was rising, so were our incomes. To quote Macmillan in full: "Let us be frank about it. Most of our people have never had it so good."

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Fiscal heaven is pollies worrying about deficits

The most surprising thing in the great debate over how Julia Gillard should finance the cost of "rebuilding Queensland" is the alacrity with which some economists have urged her to just add it to the budget deficit rather than - gulp - temporarily increase taxation.

Admittedly, the best argument for putting it all on the tick is that the sum involved - $5.6 billion over three or four years - is too small to worry about.

And some economists have pointed out that, since most of the cash will be paid out this financial year and next, the cost is highly unlikely to endanger Gillard's election promise to return the budget to surplus in 2012-13, as she has claimed it would. (Though putting it on the tick would add to the stock of public debt, of course.)

But for the sake of argument, let's pretend the amounts involved - including the horrendous impost of the one-year flood levy - are big enough to worry about so we can debate the principles involved. What's amazed me is seeing economists telling the government it's far more worried about the urgency of getting the budget back into surplus than it needs to be; that it's propagating pre-Keynesian nonsense. This year, next year, the year after - what's it matter?

Funny thing is, I don't remember any of these guys offering that advice when the opposition was shouting populist nostrums about the evil of deficits and debt and, in the process, painting into a corner a deeply insecure government.

Seems like it took the threat of having to pay a bit more tax to get these guys to speak out about fiscal silliness. So short are our memories that no one seems to have noticed the remarkable role-reversal we're witnessing: the pollies - on both sides - more worried about budget deficits than the economists are.

We've been playing the must-get-the-deficit-down game on and off since Malcolm Fraser's day. And in case you're too young to remember, the way the game's played is that,

. in the aftermath of a recession, Treasury and a few economist

. supporters bang on endlessly about the need to reduce the deficit, while the pollies pretend to care and the electorate yawns.

Now, believe it or not, the pollies are leading the charge to get the budget back to surplus, with

Treasury trailing in their wake. And the punters have been convinced it really matters.

The point is, economists should think twice before they pour cold water on this fashion, even if the reasons the non-economists think it's so important are dubious and their sense of urgency is greater than needed.

Much of the credit for this remarkable role-reversal goes to my old mate Peter Costello. He started the fashion of using deficits and debt to beat the heads of his Labor opponents, and some good has come of it.

Costello and his charter of budget honesty also get the credit both for asserting the need for adherence to a medium-term fiscal strategy and for the sounder-than-it-looks formulation of that strategy: "to maintain budget balance, on average, over the course of the economic cycle".

Contrary to the impression he and his mates might leave you with, that formulation makes full allowance for the operation of the budget's automatic stabilisers in pushing it into deficit during recessions (and restoring it to surplus during recoveries) and for adding discretionary Keynesian stimulus on the top, provided that stimulus is wound back as the economy recovers.

Whether because of her innate sense of fiscal responsibility or her fear of Costello's successors, Gillard is determined to stick to this strategy and has imposed various strictures on the government - such as limiting the real growth in government spending to 2 per cent a year - to ensure it's achieved.

Sensible economists should think twice before telling her she's trying harder than she needs to. They should also avoid being too picky about exactly when the return to surplus is to be achieved.

Whenever governments seek to "operationalise" a nice economic concept, whenever they turn a "medium-term strategy" into a target to be hit (or missed), they're drawing a line in the sand that smarties can condemn for being quite arbitrary. What's so magical about 2012-13? Why not a year earlier or later?

But such criticism is too smart by half. It fails to understand the simple human difficulty in achieving objectives that are too flexible. The difficulty prime ministers, treasurers and finance ministers have in preventing their colleagues from doing what comes naturally: spending taxpayers' money too freely.

If more economists were familiar with behavioural economics, they'd see Gillard's promise to return the budget to surplus in 2012-13 not as an irrational "political" act but as a "pre-commitment device" - a calculated act of self-control - akin to what the Productivity Commission wants to be available to problem gamblers.

And there's one other point to note: who says there's no urgency to get the budget back to surplus? I bet that's not what the econocrats are telling Gillard.

It seems the expectations of many business economists have been too influenced by the weakness of consumer spending. The September quarter national accounts purported to show the economy slowing to a crawl, and these guys believe it.

Well, let me tell you, the econocrats don't. They see record terms of trade, low unemployment and a wall of mining construction spending about to descend on the economy.

With such an outlook, the faster Gillard returns the budget to surplus the better.

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A carbon price can't save the planet by itself

I have a love-hate relationship with economic rationalism. I have great respect for the power of market forces - individuals and firms do change their behaviour in response to changing prices - but I'm well aware of their limits.

To me the test of economic understanding is whether it's pragmatic and "evidence-based" or ideological and faith-based. Is the neo-classical model simply a tool of analysis, suited to some jobs better than others, or is it an infallible guide to the universe?

A good test for economists is their attitude to climate change. A few - particularly those associated with the Lavoisier Group and libertarian think tanks such as the Centre for Independent Studies and the Institute of Public Affairs - would prefer to deny the weight of scientific opinion rather than admit that global warming represents an instance of "market failure" needing to be corrected by government intervention.

I'm convinced the great majority of economists, however, accept the existence of global warming and the need for intervention. They argue the best way to tackle the problem is to use a carbon tax or emissions trading scheme to incorporate the cost of the damage done by greenhouse gas emissions into the prices faced by the producers and consumers of emissions-intensive goods and services, harnessing market forces in the service of the environment.

Agreed. But the next stage of the evidence-versus-faith test is whether an economist thinks "putting a price on carbon" is all we need to do the trick, or whether "complementary policies" are needed to bolster the pricing policy. Such complementary policies may involve government subsidies or tax concessions, or laws imposing certain requirements or prohibiting certain behaviour.

This issue arises because Julia Gillard is proposing to cover much of the cost of rebuilding Queensland's public infrastructure by ending or capping various government spending programs intended to reduce emissions. She's defended this by saying they'll no longer be needed once we get a price on carbon.

Actually, most of the programs she wants to chop would be no loss because they're far from cost-effective in reducing emissions. But should they be replaced by programs that are cost-effective or will the carbon price be sufficient, as Gillard implies?

The present secretary of the Department of Climate Change and soon-to-be secretary to the Treasury, Dr Martin Parkinson, is in no doubt that complementary measures are necessary.

He said in a speech last year that "the lack of a carbon price signal is fundamental, and no long-term policy solution is possible without the creation of [price] incentives to protect the integrity of our climate system and reduce the risks of dangerous climate change.

"But it needs to be complemented by other measures. These include support for the development of new low-emission energy technologies, integration of climate considerations into transport planning, provision of general energy efficiency information, and addressing split incentives in rental markets."

In a discussion paper issued this week by the Australia Institute, Dr Richard Denniss and Andrew Macintosh remind us that governments have a long history of using complementary policies to augment price-based measures in changing behaviours.

In their efforts to discourage smoking, for instance, governments used taxes to raise the price of cigarettes but also used subsidised access to quit treatment plus restrictions on advertising, sales to minors, who may sell cigarettes and where they may be smoked.

To encourage the use of unleaded fuel, governments cut the tax on unleaded but also required all cars sold after 1998 to run on unleaded petrol.

So when are complementary measures necessary and how should they be designed? Denniss and Macintosh set out six principles. First, measures should be cost-effective. The budgetary cost of measures to reduce emissions should be compared with the quantity of emissions likely to be prevented, thus expressing the cost as dollars per tonne of carbon dioxide. This can be compared with the price on carbon created by the tax or the trading scheme.

Second, measures must be in response to a clear case of market failure. It's because in practice markets sometimes fail to deliver the benefits the economists' model promises that putting a price on carbon isn't enough.

One example of market failure is "split incentives": if a tenant incurs the cost of installing insulation in a rental property, it's likely to be future tenants who capture most of the benefits. And if a landlord installs insulation it's the tenant who will benefit from better temperatures and lower electricity bills.

Another example is "public goods": sometimes people can't be excluded from benefiting from services they haven't helped to pay for, making it unprofitable for the market to provide these services in sufficient quantity. Research and development spending has this characteristic, meaning it should be subsidised by government in the public interest.

Third, complementary policies should work in conjunction with, not in opposition to, other policies aimed at reducing emissions.

For instance, the Rudd government's emissions trading scheme was designed in such a way that any reduction in emissions caused by its subsidies for households installing solar panels would simply reduce the effort required by other polluters, not add to the overall reduction.

Fourth, the complementary policies of the federal government should fit with the policies of state governments. Rudd's emissions trading scheme gave the feds all the responsibility for reducing emissions, while leaving with the states the responsibility for "adaptation" - coping with the effects of climate change - even though in some areas the states were better placed to reduce emissions.

Fifth, complementary policies should be equitable. While it's accepted that low-income earners should be compensated for the effects of a carbon price, much less attention is paid to the fairness of complementary policies.

For instance, only the well-off could afford to install photovoltaic solar panels but the cost of the generous feed-in tariffs they enjoy is borne by all electricity users, rich or poor.

Finally, complementary measures need to involve accountability. As we saw with the home insulation scheme, it's easy for such measures to be badly administered or for a lot of money to be spent without much effect, particularly where subsidies are involved.

So the objectives of complementary measures need to be spelt out clearly and the schemes need to be monitored regularly against those objectives.

It's no bad thing for Gillard to abandon those complementary measures that have proved wasteful. But the limitations of market forces mean doing no more than imposing a price on carbon emissions is unlikely to reduce emissions to the extent we need.

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Carbon price is no fix-all

Our wide brown land has always been subject to ''extreme weather events'' - droughts, floods, cyclones, bushfires and heatwaves. That's why no one can say the extreme events we've been suffering lately are a direct consequence of climate change.

But scientists have long predicted that one effect of global warming would be for extreme events to become more extreme, which is just what seems to be happening. So it would be a brave or foolhardy person who denied recent events had anything to do with climate change. And, certainly, the insurance industry, which keeps careful records of these events, is in no doubt that climate change is making things worse.

All this being so, you'd expect it to strengthen our determination to get on with doing our bit to reduce emissions of greenhouse gases. Yet cuts in spending on climate change programs are one of the main ways Prime Minister Julia Gillard proposes to cover the cost of rebuilding public infrastructure in Queensland. The cuts will save almost $1.7 billion over four years, compared with the $1.8 billion the temporary tax levy will raise.

So what on earth is Gillard on about?

She says the key to it is her determination to deliver a carbon price. ''There is complete consensus that the most efficient way to reduce carbon is to price carbon. Some of these policies are less efficient than a carbon price and will no longer be necessary - others will be better delayed until a carbon price's full effects are felt,'' she says.

She's right that there's strong agreement among economists and others that the most efficient - that is, the least costly in terms of economic activity discouraged - way to reduce our emissions of carbon dioxide is to build the cost of the damage done by the emissions into the prices of the emissions-intensive goods and services we produce.

This is the way to enlist market forces - our tendency to change our behaviour in response to changes in the prices we pay - in the service of the environment. It encourages us to find ways to reduce our emissions while giving us freedom to choose the ways that work best for us.

It also removes the price disadvantage suffered by the various forms of renewable energy because the prices of fossil fuels don't include the cost of the damage they're doing to the environment.

But, as the Australia Institute's Richard Denniss and Andrew Macintosh point out in a paper to be released today, imposing a price on carbon emissions won't solve the problems most of the affected climate programs were intended to tackle.

For instance, the cash-for-clunkers scheme and the Green Car Innovation Fund are designed to reduce emissions from cars. But the government's former emissions trading scheme specifically excluded petrol, and there's been no suggestion the new arrangements will include it.

The government plans to cut research into carbon capture and storage. But though raising the price of coal in Australia will provide some incentive for coal companies to continue pursuing clean-coal technology, they're unlikely to put in nearly as much money as the government was promising because the technology is not at all promising.

The government plans to cap or cancel various programs aimed at encouraging households to install solar panels. Again, it's doubtful whether raising the price of coal-based electricity will be sufficient to overcome the various impediments to better energy use in the home. So Gillard's claim that a price on carbon will remove the need for other measures to discourage emissions doesn't stand up.

But that's not to say she shouldn't be cutting back or getting rid of those particular measures. Most of them would be no loss. The cash-for-clunkers scheme is a hugely expensive way of encouraging a modest reduction in omissions. The green car fund is just a disguise for giving further help to car makers.

And the hope that the carbon dioxide emitted during the generation of electricity from coal could be captured and stored underground in a commercially viable way is probably a pipedream.

As for the schemes to encourage households to go solar, they've been far too generous, requiring the taxpayer to pay much too much for the reduction of emissions - up to $280 a tonne in the case of one scheme.

No, the disappearance of most of these programs will be no loss. But in claiming they will be made redundant by a carbon price, Gillard is trying to cover the government's embarrassment because most of them were introduced by Labor itself. And, as Denniss and Macintosh argue, she is inflating expectations about how much a carbon price could achieve. It may be the most important thing we need to do, but it's not the only thing.

Because market forces are powerful but far from perfect, the carbon price needs to be complemented by other measures. Getting rid of bad complementary measures is fine, but they need to be replaced by measures that are more cost effective.

And if Gillard is looking for cost savings to help pay for flood damage, she should start by getting rid of programs that actually subsidise the use of fossil fuels: the concessional taxation of company cars, the exemption from fuel excise for aircraft and natural gas and certain other tax concessions. Getting rid of those would not only help reduce emissions, it would save the budget more than $4 billion a year.

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All views about the levy are political

Some economists stress that Julia Gillard's decision to finance part of the Queensland infrastructure rebuild by means of a temporary tax levy is a "political" choice, not one dictated by the needs of economic management.

It's true. But the economists don't go on to acknowledge that their almost universal opposition to the levy is based not on value-free (or "positive") economic reasoning, but on a political philosophy buried so deep within their model - and so deep in the way economists are trained to think - that many of them don't know they're being just as political as the pollies.

I have to admit that, as I argued in this space last Monday, the sums involved in this exercise are too small to be worth arguing about. Even so, it's worth debating the principles involved in preparation for the time when the sums are material.

The fact is that the economists' basic, neoclassical model doesn't acknowledge the legitimacy of government intervention in the economy. So it's not surprising they're so predisposed to opposing government spending and taxation. The presumption against the legitimacy of government activity comes mainly from the model's unit of analysis: the individual. Economies are made up of individuals. End of story. What individual consumers and producers want is paramount.

The notion that individuals could choose to confer power on elected governments isn't contemplated. Nor is the notion that non-market institutions such as governments could create benefits for society that wouldn't otherwise exist. This is the basis for Margaret Thatcher's famous assertion: "There is no such thing as society: there are individual men and women, and there are families."

The next anti-government element of the model is its assumption individuals are "rational" - they always know their own mind and act in their own best interests. Since each of us is, in effect, infallible, no government can ever know what's in our interests better than we know ourselves.

So how could I ever be better off allowing government to confiscate some of my income via taxation and give it back to me (or worse, to poor people) in government spending programs? The third anti-government element of the basic model is its implicit assumption that markets always work perfectly in maximising our welfare. So who needs governments to put an oar in? This could only ever stuff things up.

All this means neoclassical economics is founded on the political philosophy of libertarianism: maximum freedom for the individual. Now, in principle, all economists accept there can be instances of "market failure". Even the libertarians accept markets can't be relied on to protect the private property rights of the individual. So they support government intervention to provide law, order and defence.

In principle, most economists accept the existence of "public goods", which only governments will supply in sufficient quantity (because the nature of the good or service renders it unprofitable to private producers). But the economic rationalist revival involves a new reluctance to accept instances of market failure.

It's also heavily influenced by a relatively new and highly political line of economic thought - "public choice", which holds that "government failure" is ubiquitous: when governments intervene they almost invariably make matters worse.

All this submerged intellectual baggage explains economists' knee-jerk opposition to using a temporary tax increase to help finance the rebuilding of public infrastructure and their almost universal preference for covering the cost by cutting "wasteful government spending".

Many economists are convinced wasteful government spending abounds. And, once again, they fail to acknowledge how highly subjective, even political, these judgments are.

Like beauty and fairness, wastefulness lies in the eye of the beholder; it's a value judgment, not something that proceeds from value-free economic analysis (which doesn't exist). Many economists refuse to take a position on fairness questions because they're so subjective, while being happy to denounce this or that spending as wasteful.

There wouldn't be many cases where government spending involved significant "deadweight losses" - pure waste, the elimination of which would leave no one worse off. Rather, most government spending involves losses to the taxpayers, who pay for it, and gains to the recipients of the spending.

Non-recipients may well regard a program as wasteful, but you can be sure the recipients don't. Economists in their wisdom may judge a program wasteful, but the recipients will vigorously disagree.

So decisions about how much to cut and what to cut will always be influenced by political considerations. As an example, the Prime Minister announced plans to cut the funding for the building of low-cost rental housing (which would have added to the supply of housing at a time of unmet demand) rather than scrap the first home buyer's grant (which adds to the demand for housing - and thus raises prices - without adding to supply). Why did she cut what I consider to be the wrong one? Because renters are a lot less politically powerful than home owners. So whether spending cuts will actually lead to a reduction of waste is anyone's guess.

Economists oppose hypothecated (earmarked) tax levies on the basis of arguments that would make sense if voters and taxpayers were rational. You need a feel for behavioural economics to see the virtue of taxes linked to certain spending programs.

They're an attempt to deal with the public's chronically asymmetric attitude to governments and budgets: the way we're always thinking of things the government should be doing to fix the world's problems, but are so reluctant to pay the taxes needed to pay for all the things we want done.

I support special levies - including most of the Howard government's levies - because they teach a freeloading electorate the most basic economic lesson: if you want it, you have to pay for it.

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Productivity, or a future paved with gold?

Economists are convinced our highest priority is to keep increasing our material standard of living as rapidly as possible. I'm not sure they're right. But if they are, we have a problem.

There are three ways for a country to get richer, to raise its real income (gross domestic product) per person. The first is to keep increasing the labour and physical capital being used to produce goods and services at a faster rate than the population is growing.

The second way is to be lucky enough to have the rest of the world pay us higher prices for the stuff we sell it.

The third way is to increase our productivity - to find ways of producing more goods and services each year from the same quantities of labour and capital. We achieve this mainly through technological advance.

Trouble is, we've got problems with two out of three of these - and the third can't last.

We used to have no trouble increasing the total number of hours we worked faster than the population was increasing, but the ageing of the population means we won't be able to keep this up.

Not to worry. The world is paying us more for the stuff we sell it, particularly our coal and iron ore. Hugely more. That's why we have been getting a lot richer for most of the past decade. Unemployment has been falling and wages and other incomes have been rising faster than prices.

But this is the bit that can't last. The prices we're getting for our exports of coal and iron ore can't keep rising from their present stratospheric heights. And sooner or later they will fall back to more reasonable levels.

Now, none of this would matter all that much if we were going OK on productivity improvement. Productivity improvement through continuous technological advance is actually the bedrock of material living standards, which in the developed countries have been rising continuously since the industrial revolution.

This is the magic of the capitalist system. Every year we get a little bit more efficient and a little bit richer. Only when you're as old as I am can you look back and realise that these days we're a lot smarter about the way we do things than we used to be.

But here's the problem: over the past decade there has been a dramatic deterioration in Australia's productivity performance, with the broadest measure of productivity actually getting worse over the past five years.

Why haven't you heard about this major reversal? Because its effect on our pockets has been concealed by all the extra income flowing in from China and our other trading partners. But that's what can't last.

This remarkably under-remarked story is revealed in a report issued this week by Saul Eslake and Marcus Walsh of the Grattan Institute, Australia's Productivity Challenge.

Eslake reminds us that, whereas in the 1990s real GDP grew at an average rate of 3.4 per cent a year, with improvement in the productivity of labour accounting for 60 per cent of that growth (2.1 percentage points a year), in the noughties GDP growth averaged 3.1 per cent a year, with labour productivity improvement accounting for only about 45 per cent (1.4 percentage points a year).

But it's actually worse than that because the average for the noughties conceals a steady decline over the course of the decade. Whereas the annual rate of improvement in labour productivity kept increasing over the '90s to reach a peak of 2.8 per cent a year during the five years ended 2001-02, since then it has slowed continuously, reaching a low of just 0.8 per cent during the five years ended 2008-09.

One way to increase the productivity of labour is to give workers more machines (physical capital) to work with. And we did a lot of that during the noughties.

So if we switch from looking at the productivity of labour to looking at the productivity of labour and capital combined (known as ''multi-factor productivity''), we find it has actually been going backwards since the mid-noughties.

Why haven't we heard a lot more about this remarkably poor performance (which, as you can see, began long before the Rudd government came to office)? Mainly because it has been concealed by the riches of the resources boom, but also because the econocrats have argued it's the product of special, temporary factors in a couple of sectors.

The mining sector, for example, has been spending on a huge expansion of its production capacity, but a lot of the extra production hasn't yet come on line. So, arithmetically, its productivity performance has been appalling.

Then if you look at utilities - electricity, gas and water - you find that, after neglecting to invest in increased production capacity to keep up with population growth, in the noughties governments have had to invest heavily (including in five new desalination plants), installing capacity that won't all be used until the population has grown further.

Finally, the output of the agricultural sector has been hard hit by drought over the past decade, wrecking its productivity figures.

The econocrats have argued that these three problem areas are sufficient to explain the deterioration in our productivity performance overall.

But Eslake disputes this, producing new figures to show there has been a substantial deterioration in overall labour productivity growth even when mining and utilities are excluded.

He argues ''it may be dangerously complacent to assume that the decline in productivity growth over the past decade will be automatically reversed at some point during the coming decade''.

So how does Eslake explain the decline? By the absence of further significant micro-economic reform during the noughties (compared with the big payoff from earlier reform during the second half of the '90s), but also by an increase in ''productivity-stifling legislation and regulation'', much of it in pursuit of ''national security'' (in the aftermath of the terrorism attacks on September 11, 2001) and improved standards of corporate governance (following a series of corporate scandals in the US and Australia).

But Eslake also blames the ''paradoxical downside of economic success''.

We have managed to keep the economy growing strongly for a record period since the recession of the early '90s, but this may have sapped our enthusiasm for further reform as well as permitting firms to be less vigilant in their pursuit of higher productivity. Finally, the return to near full employment permitted by the long expansion phase has led to productivity-reducing shortages of skilled labour and bottlenecks in transport and other infrastructure.

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Floods expose national loss of respect

It's a pity Julia Gillard announced her flood levy after Australia Day rather than before it. Instead of spending the day telling ourselves what wonderful people Aussies are, we could have reflected on our darker side - why we're developing a Jekyll and Hyde personality.

As many acts of minor and major heroism during the Queensland floods have reminded us, Aussies are good people to be around in times of crisis.

We rise to the occasion; we pull together. If we're on the spot and see someone in difficulties we'll do all we can to help them, then look around for anyone else who needs helping.

Even if we're not personally involved, even if all we know of the disaster comes to us on the TV news, our hearts go out. We yearn to contribute towards the needs of those poor sods. Sling $20 or $50 into a bucket for the Premier's Relief Fund? Think nothing of it.

But ask the better-off half of us to pay a temporary tax levy to help fund the rebuilding, which will cost only the wealthiest among us more than $5 a week, and all hell breaks loose. Suddenly, we can think of half a dozen reasons why we shouldn't have to pay.

I've already donated - why are you coming back for more? If you compel people to pay, fewer will donate. I pay too much tax already, why are you hitting me again? Why can't you just cut some of all that wasteful government spending? Why are you so obsessed with balancing the budget - why can't you just add the cost to the deficit? Don't you realise how much the cost of living's rising?

They sound like reasonable arguments but, in truth, we just don't want to pay no matter how worthy the cause. Why such a change of tune? Because the government got involved. When we thought it was personal - I give my time or money to help other people in need - that's fine.

But introduce the government and it all becomes impersonal and amorphous. The link between me and my money and the people it will help is broken. The government's budget is a vast, bottomless pit. Why ask me to throw more money into it? Surely there's someone earning far more than me who should contribute? And, in any case, what about all the money you're already wasting?

Many objectors don't seem to have paused long enough to learn that their donations go to helping individual families who've suffered loss, whereas the levy will go towards rebuilding public "infrastructure" - otherwise known as roads, bridges and ports.

So alienated have we become from the work of government we regard it as a giant soft cop - a magic pudding, where the idea is to take out as much as possible ("I've paid taxes all my life ...") and put in as little as possible. How is this circle squared? Who knows, who cares?

But there's more to this affair than just our pathological objection to paying more tax. It's a dramatic demonstration of the way Australians are losing the ability to fall in behind a leader.

All of us know the nation's problems won't be overcome without decisive leadership. We regularly bewail our politicians' lack of courage and conviction, their reluctance to risk their personal survival in the country's best interests.

Yet we give our leaders so little loyalty. The announcement of a government decision is taken as the occasion for the outbreak of dissent. All those with a reason for objecting cry out and their criticism is amplified by the media, whereas those who agree fall silent. No one feels obliged to actively support the leader, even if just because she is our leader and someone has to accept ultimate responsibility for deciding what we'll do and how we'll do it.

Of course, no one wants to live in a country where the leader's will is never challenged. We each have the democratic right to oppose all government decisions by all legal means. But we also have the democratic right to support, defend or even just acquiesce in the judgment of the people we elected to lead us.

Why are we becoming so much more prone to arguing the toss than falling into line? And how do we imagine making leadership so much more difficult for the leader of the day will leave us better governed? Why are we training our governments to timidity?

Part of the explanation is partisanship - our willingness to put loyalty to party ahead of loyalty to our community and its need for effective leadership. I didn't vote for these people, so I'll regard everything they try to do as illegitimate.

Trouble is, there is little partisanship running the other way. Consider the deathbed bastardry of Labor's own Kristina Keneally in objecting that NSW taxpayers deserve special concessions under the levy.

No, there's more to this than partisanship: there is a general loss of loyalty and respect for whoever is our leader. The government is always and everywhere fair game. Consider the lack of public censure of the Opposition Leader, Tony Abbott, for his utterly obstructive behaviour.

Having narrowly lost the last election, he's behaving like a spoilt child, refusing to support any policy proposed by the government, whether good, bad or indifferent.

His self-righteous opposition to the flood levy and all tax increases is extraordinarily hypocritical, considering he proposed his own special levy in the election campaign and supported at least six temporary levies imposed by the Howard government, not to mention that ultimate "great big new tax on everything" known as the GST.

What he's saying to the nation is: I'll do all in my power to make Parliament unworkable until you make me leader.

Oh yeah, we reply, fair enough.

We have a democratic right to make our country ungovernable - and it seems we're well on the way to doing so.

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Floods' economic pain greatly exaggerated

Most of us are back at work, but the silly season won't be over until we get the Queensland floods into perspective. They are a great human tragedy, but they're not such a big deal for the economy.

It's not surprising the public has been so excited about such amazing scenes and so much loss of life and property. Nor is it surprising the media devoted so much coverage to the floods when, with most of us at the beach, there's been so little other news.

It's not even surprising the Gillard government has been beating up the story, making it out to be the biggest thing since the global financial crisis. At one level this is just the pollies doing their instinctive I-feel-your-pain routine. They could seem heartless if they tried telling people things weren't as bad as they seemed.

At another level it's easy to see Julia Gillard trying to gain the same boost to her popularity as Anna Bligh. She'd be well aware of all the seats Labor lost in Queensland at the election in August. It's an almost inevitable assumption by the punters and the media that if an event is huge in human and media terms it must be just as big in its effect on the economy. When the punters tire of seeing footage of people on roofs, you "take the story forward" by finding some expert who'll agree it also spells disaster for the economy.

The wise and much-loved econocrat Austin Holmes used to say that one of the most important skills an economist needed was "a sense of the relative magnitudes" - the ability to see whether something was big enough to be worth worrying about.

That sense has been absent from the comments of those business and academic economists on duty over the silly season, happily supplying the media's demand for comments confirming the immensity of the floods' economic and budgetary implications.

With the revelation last week of the econocrats' estimates of the likely magnitudes, it's clear the figures supplied by business economists were way too high. And the economists' furious debate over how the budgetary cost of the rebuilding effort should be financed is now revealed as utterly out of proportion to the modest sums involved.

Of course, you still wouldn't have twigged to this had you focused on the government's rhetoric rather than its figures. In Gillard's speech on the budgetary costs and Wayne Swan's speech on the economic impact both were busily exaggerating the size of the crisis, even while revealing how small it really was.

Gillard said it was "the most expensive disaster in Australia's history" and that the "cost to the economy is enormous". The government's task, she kept repeating, was to "rebuild Queensland".

Swan repeated that "this is likely to end up being the most costly disaster in Australian history", which was "going to cost Australia dearly" and involves a "massive reconstruction effort". The closest he got to the truth was his observation that "the economic questions pale into insignificance next to the human cost of what we've seen".

If this is the most expensive natural disaster in Australian history, all it proves is the cost of earlier disasters was negligible. If you can "rebuild Queensland" for just $5.6 billion, it must be a pretty tin-pot place.

If $5.6 billion seems a lot, consider some "relative magnitudes": the economy's annual production of goods and services (gross domestic product) totals $1400 billion, and the budget's annual revenue collections total $314 billion.

Note that, though no one's thought it worthy of mention, the $5.6 billion in spending will be spread over at least three financial years, making it that much easier to fund.

We know that more than a third of the $5.6 billion will be paid out in the present financial year with, presumably, most of the rest paid in 2011-12. So just how the flood reconstruction spending could threaten the budget's promised return to surplus in 2012-13 is something no one has explained.

And if $5.6 billion isn't all that significant in the scheme of things, how much less significant is the $1.8 billion to be raised from the tax levy? The fuss economists have been making about it tells us more about their hang-ups over taxation than their powers of economic analysis.

And how they can keep a straight face while claiming it could have a significant effect on consumer spending (well over $700 billion a year) is beyond me.

Turning from the budget to the economy, Treasury's estimate is that the floods will reduce gross domestic product by about 0.5 percentage points, with the effect concentrated in the March quarter.

Thereafter, however, the rebuilding effort - private as well as public - will add to GDP and probably largely offset the initial dip. So the floods will do more to change the profile of growth over the next year or two than to reduce the level it reaches.

Most of the temporary loss of production will be incurred by the Bowen Basin coal miners. But, though it won't show up directly in GDP, their revenue losses will be offset to some extent by the higher prices they'll be getting as a consequence of the global market's reaction to the disruption to supply.

And despite all the fuss the media have been making over higher fruit and vegetable prices, Treasury's best guess is that this will cause a spike of just 0.25 percentage points in the consumer price index for the March quarter, with prices falling back in subsequent quarters.

So the floods do precious little to change the previous reality that, with unemployment down to 5 per cent and a mining investment boom on the way, the economy is close to its capacity constraint and will soon need to be restrained by higher interest rates.

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It's about China, and steel

You wanna make guesses about what will happen to the economy this year? Here's a tip: forget the floods and take more notice of China.

Australia's business economists have already got the message that China dominates the rest of the world's effects on us, whereas their mates in the money markets are slower on the uptake, retaining their obsession with all things American.

China matters, first, because, with a population of 1.35 billion, it's the most populous country in the world. That gives it 20 per cent of the world's population, making it 11 times larger than Japan.

The second reason China matters is because its economy has been growing so rapidly for so long: an average rate of 10 per cent a year for three decades, meaning it's been doubling every eight years.

This means that, since 1980, it's gone from being the 12th-largest economy in the world to the second-largest. This is measured using "purchasing power parity" - that is, taking account of the fact that one US dollar buys far more in China than it does in the US.

So China's economy has moved from being 9 per cent of the size of America's to about 60 per cent in 2009. The International Monetary Fund is expecting it to reach 90 per cent in 2015. If so, it won't be long before China's the biggest economy.

Of course, this still leaves the average Chinese a lot poorer than the average American. Income per person in China has reached only 18 per cent of American incomes - suggesting the Chinese have scope for a lot more growth yet (provided the world has enough idle resources to make it possible).

When you combine China's huge population with its rapid economic growth you find this growth accounted for a quarter of all the growth in the world economy during the noughties. Get that. America's share of world growth would have been very much smaller.

The third reason China matters so much to us: its economy is in our part of the world and is such a good fit with ours. China needs to buy what we've got to sell, and vice versa.

According to figures from the Department of Foreign Affairs and Trade, last financial year China became both our largest export market and our largest trading partner. Our two-way trade in goods and services grew by more than 18 per cent to $90 billion.

China has been our biggest market for exports of goods for some time but last year it overtook the United States to become our largest market for services as well.

Over the course of the noughties China's share of our two-way trade increased from 5 per cent to almost 18 per cent. Its ascension means Japan is now our second-largest export market. And get this: our third-largest is India.

Our top three imports in 2009-10 were travel ($19 billion), passenger vehicles ($15 billion) and petroleum ($15 billion). But to get back to the point, our top three exports were coal ($36 billion), iron ore ($35 billion) and education ($19 billion).

Why's that the point? Because coal and iron ore are the main things we sell China. Iron ore and coking coal are the main components of steel - and, as part of their economic development, the Chinese are producing huge quantities of steel.

So the well-versed economy watcher needs to know more than a bit about China's steel industry. Its story was summarised by James Holloway, Ivan Roberts and Anthony Rush in an article in the latest Reserve Bank Bulletin.

China is now the world's largest producer and consumer of steel. Ten years ago it accounted for 15 per cent of global steel production; today its share is 45 per cent.

Just how much of a country's gross domestic product is devoted to steel is determined by its stage of economic development. Undeveloped countries don't use much steel and advanced countries aren't very "steel-intensive" because much of their economic infrastructure has been built and most of their growth is coming from expanding services.

In between, however, countries are rapidly industrialising and urbanising. And that's where China is. Remembering its average rate of growth in GDP of 10 per cent a year for the past three decades, its steel production grew at average annual rates of 7 per cent in the 1980s, 10 per cent in the '90s and almost 20 per cent in the noughties.

The Chinese steel industry is highly decentralised, with plants scattered throughout the country and with a small number of large, advanced, state-owned steel makers and a large number of small and medium-sized private firms. The Chinese government's policy is to consolidate the industry, to improve economies of scale and reduce the use of high-polluting facilities.

The industry mainly produces steel directly from iron ore and coking coal using the blast furnace and basic oxygen converter method. This means that, on average, each tonne of steel produced requires about 1.7 tonnes of ore and 0.5 tonnes of coking coal.

China has its own extensive reserves of iron ore, but their ore content averages only about 33 per cent, compared with 62 per cent in Australia and about 65 per cent in Brazil and India, making local ore more expensive. So now more than half the ore used is imported.

Until recently China was self-sufficient in coking coal. But many of its deposits are relatively inaccessible and thus costly to mine. And many of its mines are unsafe. So since 2009 there's been a surge in demand for our coal.

More than half China's annual steel production is used for investment in buildings, structures and machinery. (Total public and private investment spending's share of GDP is a remarkably high 45 per cent - a sign China's in the industrialisation phase of development.)

At least a quarter of steel production is used for manufacturing cars, home appliances and much else. A lot of these would be consumed locally but most are probably exported.

The authors conclude that China's steel-intensive industrialisation phase - and hence its strong demand for our iron ore and coking coal - is likely to continue "over the next decade or so".

One conclusion from this is that the floods' biggest effect on our economy is likely to be the temporary disruption to the Queensland mines' production and export of coal.

Think of China, think of steel; think of Chinese steel, think of Australia making big bucks

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Aged care dilemma: tap homes, or let taxpayers pay

There's a lot more to life than money. But it's money - how much things cost and who will pay for them - that causes many of the arguments in families and most of the arguments in politics. Nowhere is that truer than in aged care.

We all agree that old people must be adequately cared for in their declining years and that governments must ensure this happens. But where does private responsibility end and public responsibility begin? More to the point, how should the cost of care be shared between the individuals involved, their heirs and successors, and the taxpayer?

The scope for duck-shoving - the temptation to push costs off on to someone else, particularly the anonymous taxpayer - is enormous. Trouble is, governments represent the taxpayer. Elected politicians know that if the demands they make on taxpayers get too high or grow too rapidly, they're in trouble.

Unless we're careful, we end up with government paralysis: politicians who aren't game to push more of the costs back on to individuals and their families, but aren't prepared to impose a lot more cost on the taxpayer.

The result is an aged care system that isn't working properly. Where some old people who need care aren't getting it because the government has imposed arbitrary limits on how much it's prepared to spend; where some individuals are getting a much bigger public subsidy than is fair, while others are paying a lot more than is fair, and where institutions are underfunded and the people who work for them are underpaid.

As last week's draft report from the Productivity Commission reminds us, that's where our aged care system is now and where it will stay until we find federal leaders with the courage to stand up to both the duck-shovers and the reluctant taxpayers.

But, actually, the system won't stay as it is for long. The ageing of the population means a lot more people will be requiring aged care in coming years, particularly when the bulge of baby boomers reaches old age.

The commission says there's no way the cost of aged care to federal taxpayers will fail to grow significantly over the years. So, barring the unlikely event of offsetting cuts in other government spending, we will have to pay higher taxes.

We can, however, limit the growth in cost to the taxpayer - as well as alleviating other deficiencies in the present system - by making the system more efficient and requiring greater contributions to aged care costs from those individuals in a position to make them.

What would be fair? The commission starts by dividing the total costs faced by old people requiring care into four categories.

First is the cost of accommodation, which is equivalent to rent or mortgage payments and home maintenance. Next are everyday living expenses, such as for food, clothing, laundry, heating and social activities.

Third is the cost of healthcare, such as nursing, therapies and palliative care. And fourth is "personal care" - the additional costs of being looked after because of frailty or disability.

The commission argues that accommodation and everyday living expenses should be the responsibility of individuals, but with a safety net for people of limited means. (Remember, this is why people receive the age pension. Those ineligible for the pension - or for a full pension - have other, private means to call on.)

The commission argues that health services should attract a universal (that is, non-means-tested) subsidy, as is a key principle of Medicare.

On the cost of personal care, the commission says individuals should be required to contribute according to their capacity to pay, but shouldn't be exposed to catastrophic costs of care. It suggests maximum lifetime payments be capped at $60,000.

We tend to think of the elderly as among the poorest in the community, but that's because we focus on their usually modest incomes. But it's a different story when the focus is on their assets.

The distribution of wealth has been shifting towards older Australians since the mid-1980s, and this trend is likely to continue. It's estimated that, in 2000, the 12 per cent of the population aged 65 and over held about 22 per cent of the total net wealth of households. It's projected that by 2030, the aged's share of the population will rise by 7 percentage points, but their share of net wealth will more than double to 47 per cent.

Where's all this wealth coming from? From the rising value of the family home. The rate of home ownership among the elderly is very much higher than among the rest of us. Yet the value of people's homes is largely ignored when calculating their aged-care charges and subsidies - until the house is sold, when everything changes.

This is what the commission says must change to make the cost-sharing fairer to those oldies who've never owned their homes or have recently sold their home, not to mention working taxpayers who may be far less well placed in the housing market.

Taking account of the value of people's homes in assessing their ability to contribute to the cost of their care - which the commission says should vary between 5 per cent to 25 per cent - would increase the pressure on people to sell their home or at least borrow against it.

It proposes widening the use of accommodation bonds - where money is lent to the care institution interest-free - but with the proviso that the size of bonds reflects the actual cost of accommodation.

Many old people and their inheritance-conscious children will hate the sound of all this. But since even John Howard lacked the courage to impose these reforms, it's doubtful whether Julia Gillard will be game to touch them.

The only trouble is, our treatment of people receiving and providing aged care will continue to worsen until we as a nation are prepared to call a halt to the duck-shoving.

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First of a line of green Treasury bosses

In the olden days you didn't get to be boss of a major company, government department - or this newspaper - until you were in your late 50s or early 60s. You stayed in the job until you reached what was then imagined to be the official retirement age of 65. So whether they performed well or badly, no one spent all that long in a top job.

(Going not that far further back, you didn't get to be governor of NSW, Anglican archbishop of Sydney or editor of the Herald unless you were an Englishman, recruited from the Old Country. Having done your bit in governing the colonies, you retired to the Home Counties.)

These days, top jobs go to much younger people, which means they get a longer go at it - assuming they work out - but have to give it up and let someone else have a turn well before they're old enough to retire.

Dr Ken Henry was 43 when he became secretary to the Treasury in 2001. His five-year term was renewed in 2006, so he's held the job for almost a decade and now it's time to move on. He's likely to take a long break before accepting another job.

Henry is what his present political masters aren't: a believer. Like all his predecessors - and his successor, Dr Martin Parkinson - he's an economic rationalist. He believes in the power of market forces and the need to ensure they're harnessed to advancing the wellbeing of the community. Sometimes they need to be let off the leash, sometimes they need to be channelled, sometimes they need to be introduced to an area where they haven't existed but can be used to improve its performance (though sometimes this is a bad idea).

At a time when our politicians seem bereft of bedrock beliefs and values, and most government departments seem to have lost their compass, it's good to have a central agency with a clear view of what constitutes good policy in the public interest and an unwavering willingness to argue for it.

Henry continued to inculcate the Treasury View among his troops - maintaining their esprit de corps - and within the government.

Parkinson is a macro-economist, but Treasury is no longer involved in the day-to-day management of the macro economy - except to the extent that its secretary is an ex officio member of the outfit that does manage the economy, the Reserve Bank board.

Henry is a micro-economist, and Treasury has more than enough to do urging governments to take a rational approach in all the many markets it has influence over. And nowhere is that need greater than in using "economic instruments" - such as a price on carbon and the trading of water rights - to reconcile the conflict between economic activity and preserving the natural environment.

Henry is an environmentalist (as well as an active defender of kangaroos and wombats). He played an important part in developing the Howard government's plans for an emissions trading scheme, as did Parkinson, and Treasury modelling informed the Rudd government's initial attempt to get a scheme up.

There was a joke that the people running Treasury were greener than those running the Environment Department.

Parko, originally Henry's deputy in Treasury, left to work on trading schemes, taking various senior people with him and eventually being appointed to head the new Department of Climate Change.

Now he'll be succeeded by another Treasury man, Blair Comley. So under Henry, Treasury managed to colonise the environmental departments.

Is Henry "one of the greatest of all Treasury secretaries" as Julia Gillard has said? No doubt. Is he the greatest? He's the greatest in my memory.

Treasury was at its most influential during the term of the Hawke government, but I give the credit for that to our greatest ever treasurer, Paul Keating, a man with a deep understanding of how to obtain and use political power, and who needed a purpose to fight for. Treasury supplied that purpose, affecting his conversion to economic rationalism.

Treasury's highest institutional objective has long been to dominate the economic advice going to the government, and no secretary has been more successful in this than Henry, thanks to the arrival of the deeply insecure Rudd government, which sought to hide behind the authority of the supposedly independent Treasury.

Henry obliged - after all, Treasury is not and never could be independent - and became a key adviser to the prime minister, as well as being appointed to every policy committee worth being on.

That was Treasury's institutional reward, the rent it received for the use of its authority. Henry's personal reward was being allowed to head his own comprehensive review of the federal and state tax system.

Those who condemn the government's cursory dismissal of the Henry report have missed the point. Henry's ambition was to lay out a blueprint for long-term tax reform, which would provide a guide to his Treasury successors and an antidote to political ad-hockery for decades to come.

Tax reform was Henry's first love and he played an important part in all the reforms of the past 25 years. He was the first Treasury secretary to acknowledge the validity and usefulness of behavioural economics.

His tax report would have been better had he made more use of behavioural precepts.

Despite its loss of day-to-day macro management, Treasury - and budgetary policy - comes into its own when recession threatens. Here the micro-economist excelled himself.

He played a central role in the Rudd government's response to the global financial crisis and, learning from the policy errors in the severe recession of the early 1990s, urged Rudd to "go hard, go early, go households".

Most punters will never know it, but many owe their continued employment to that wise advice.

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Take a break and we'll all be happy

Psychologists have a form of treatment for unhappy people called PAT: pleasant activity training.

It's quite simple: you make a list of the things you like doing, then do them more often. It's not as silly as it sounds. We've learnt our brains have one system that controls wanting and one that controls liking. The wanting system tends to dominate the liking system, so we often end up doing less of what we like than we'd like to.

I suspect that's true of taking holidays. A survey conducted by Professor Barbara Pocock of the University of South Australia, as part of the Australian Work and Life Index, found 57 per cent of full-time employees would prefer an extra two weeks' paid annual leave to a pay rise of 4 per cent.

So it seems we like taking holidays (and it sounds like a good idea to me). And yet there's a wealth of evidence that many of us don't take the leave we've already got. A survey conducted regularly by Roy Morgan shows that only about 70 per cent of Australians aged 14 or older intend to take at least one holiday over the next 12 months.

Another survey conducted for Reuters by a global market research company, Ipsos, found that only 47 per cent of Australians expected to use all their annual leave. This was the lowest proportion for any country bar the Japanese, on 33 per cent. By contrast, 89 per cent of the French, 77 per cent of the Brits, 75 per cent of the Germans and even 57 per cent of the Americans expect to take all their annual leave.

Australia's governments have required employers to provide their workers with paid annual leave since 1941. In 1973 it was increased to four weeks. At the time many people thought this extravagant, but it's about average. The French get six weeks, while the Finns, Norwegians and Swedes get five.

Pocock's survey shows 60 per cent of Australian employees stockpile at least some of their annual leave. And according to calculations by Roy Morgan, the stockpile has reached 117 million days.

But if people like annual leave, why don't they take it all? According to Pocock's survey, 31 per cent of full-time employees say they're too busy at work and 13 per cent say they couldn't get time off that suited them. Nine per cent say they prefer to work.

And 41 per cent say they're saving their leave for a future holiday - though I'm not sure I believe it. If it were true - if people were merely delaying their holiday-taking - unused leave wouldn't have piled up the way it has.

It may be that some young people want to combine a few years' leave for an extended overseas trip, but I think "saving for later" is just something you say when you don't get around to taking it all.

I guess it's true that, consciously or unconsciously, some employers don't encourage their workers to take their leave, especially key employees.

But is all this a problem? Why turn unused leave into another crisis? Well, a lot of employers think it is a problem, including one quite close to me. If an employee takes all her leave during the year, the business suffers an expense of 52 weeks' wages on her behalf. But if she works all year without taking leave, the expense rises to 56 weeks' wages, with the extra four weeks of untaken leave owing to her adding to the firm's liabilities. (What's more, the firm doesn't get a tax deduction until the leave's actually taken.)

In theory, insisting that everyone take their leave during the year means the firm has to employ more people. In practice, it means we all have to work a bit harder when we're not on leave to cover for those of us who are. Whistle-blowing economists call this "work intensification" - but it comes from employer penny-pinching, not from the leave itself.

Another group that sees untaken leave as a great problem is Tourism Australia, the federal government's tourism marketing body. Last year the minister, Mar'n Fer'son, launched a campaign called No Leave No Life to encourage us to take our leave and spend it in Australia, complete with commercial TV show.

Tourism Australia can think of many reasons why it's good to take your leave (and for employers to offer a "leave-friendly workplace"). Achieving work-life balance, we're told, comes with improved physical and mental well-being.

Taking your leave helps you avoid the stress of exhaustion and burnout. You get greater job satisfaction when you approach your task in a refreshed state. Taking leave helps you "rediscover your friends, your family and most importantly yourself".

The figures show we're taking more, shorter breaks rather than blowing the lot in one go. Maybe this explains why we have trouble making sure we've taken it all. There's some evidence that taking more short breaks is more re-creational (though I like to make sure of it by taking short breaks through the year and a big break at the end of it). Tourism Australia says there are so many great experiences to be had we should "take the opportunity to visit some more of Australia and gain some lasting memories as well as some great stories to share with others".

It may be advertising copy, but it does have evidence behind it. Psychologists have shown that one reason we get more satisfaction from buying experiences rather than things is the memories and stories we're left with.

Recent research also shows that much of the pleasure we gain from holidays is in thinking about them before we take them. But please don't think that's what I've been doing in this column. And if you're working through, please don't think I'm trying to make you guilty or envious. But I'm off.

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Beware gurus selling high migration

The economic case for rapid population growth though immigration is surprisingly weak, but a lot of economists are keen to give you the opposite impression. Fortunately, the Productivity Commission can't bring itself to join in the happy sales job.

I suspect that, since almost all economists are great believers in economic growth as the path to ever higher material living standards, they have a tendency to throw in population growth for good measure. There's no doubt a bigger population leads to a bigger economy; the question is whether it leads to higher real income per person, thereby raising average living standards.

Of course, business people can gain from selling to a bigger market, regardless of whether the punters are better off. So I'd be wary of advice coming from economists employed by business or providing consulting services to business.

In 2006 the Productivity Commission conducted a modelling exercise to assess the effect of a 50 per cent increase in our skilled immigrant intake. It found that, after 20 years, real gross domestic product was only about 4 per cent higher than otherwise.

And the increase in real income per person was minor. What's more, most of the gains accrued to the migrants themselves, with the existing population suffering a tiny net decline in income. Why this lack of benefit? You'd expect the extra skilled labour to raise the proportion of the population participating in the labour force, thus boosting production per person.

But most of the productiveness of workers are achieved by the physical capital they're given to work with. So unless your extra workers are given extra capital equipment - a process known as "capital widening" - their productivity is likely to decline, thus offsetting the gain from having more workers.

Note, too, that we have to increase the housing stock to accommodate the migrant workers and their families, as well as providing the extra public infrastructure for a bigger population. So the migrants are paid to supply their labour, but the rest of us have to provide the extra economic and social capital they need if standards aren't to fall.

Last week Tony Burke, the federal minister responsible for developing a "sustainable population strategy" next year, released an issues paper to encourage discussion. It was accompanied by the reports of three advisory panels, including one on the economic aspects, led by Heather Ridout of the Australian Industry Group.

Ridout's report sets out to talk up the economic case for high migration by dispelling "myths" and pointing to hard-to-quantify benefits "often ignored by low-growth advocates when they skim the literature" (that's what they call a professorial put-down).

The main hard-to-quantify benefits left out of the Productivity Commission's modelling are the economies of scale arising from a bigger market. But why after all these years have economists been unable to produce good empirical evidence of something as straightforward as scale economies?

And why wax lyrical about unmeasurable benefits without mentioning unmeasurable costs? In its recent booklet on population and immigration, the commission acknowledges that as well as economies of scale there could be diseconomies.

The Ridout report objects that the commission's modelling measured the benefit of increased immigration only over 20 years. Sorry, but if you have to wait more than 20 years for the payoff you're not talking about a powerful effect.

A relatively new argument in favour of high immigration is that it could foster economic growth by countering to some extent the decline in labour-force participation caused by the ageing of the population. But, since immigrants age too, all this can do is put off the evil hour (not a course of action usually promoted by economists). To continue postponing the crunch you have to keep upping the dose of immigration.

The Productivity Commission is blunt: "changes in migration flows are unlikely to have a significant and lasting effect on the ageing of Australia's population".

The Ridout report argues that a faster-growing, immigration-fuelled economy would require greater levels of investment by businesses and in public infrastructure. This greater capital spending would generally involve investment in more productive capital equipment, as recent technological improvements will be embedded in the newer stock. In this way, faster growth of the size of the economy would drive the productivity gains that are central to advances in material living standards, we're told.

Huh? The proposition is that by taking on a need for considerable investment in capital widening (to provide the extra workers with the equipment and infrastructure they need to be as productive as the existing workers) we're increasing the scope for capital deepening (giving each worker more and better capital equipment).

Am I missing something? This is a twist on a common economists' argument I've never managed to fathom: we need to grow more and do more damage to the natural environment because when we're richer we'll be able to afford to fix the damage we've done to the environment.

The Ridout report asserts that provided population growth is "balanced and managed well", living standards will rise. It needs to be "matched by greater commitments to education and skills development, more and better investments in infrastructure, greater attention to the development of our cities and regions and to our natural environment".

In other words, to give business the extra population it wants but prevent this from worsening all those things, governments at all levels will really need to lift their game as well as spend a lot more. Turn in a perfect performance and high immigration won't be a problem.

I prefer the commission's way of putting it: "population growth and immigration can magnify existing policy problems and amplify pressures on 'unpriced' entities, such as the environment, and urban and social amenity".

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A reality check at last on what we take for granted

A recurring theme in my writing this year has been to point out the limitations of gross domestic product as a measure of wellbeing, particularly as related to the environment. But today I have good news: something is being done about it. Economists and statisticians long ago developed a "system of national accounts" to measure developments in the economy, based on Keynesian theory about how economies work.

Although these accounts give much detail about income, production, spending and saving during a period and, these days, a balance sheet outlining the values of the nation's assets and liabilities to the rest of the world on the last day of the period, we tend to focus on a single bottom line: the change in the real value of goods and services produced during the period, otherwise known as GDP.

A United Nations commission sets down an international standard for all countries to follow in preparing their national accounts, using the same theory, concepts and definitions so each country's figures are comparable and can be added together to give gross world product. But as we've become more aware of the problems economic activity is creating for the natural environment - degradation of rivers and soil, depletion of non-renewable resources, use of renewable resources faster than their ability to renew themselves, destruction of species and generation of waste and pollution, including greenhouse gases - we've realised that little of this cost is taken into account in measuring the change in our income.

It's as though we've been thinking of and measuring "the economy" - the production and consumption of goods and services - in total isolation from the natural environment in which the economic activity occurs.

The environment provides the economy with many "ecosystem services", which a leading ecological economist, Professor Robert Constanza, of Portland State University, defines as "the benefits provided to humans through the transformations of resources (or environmental assets, including land, water, vegetation and atmosphere) into a flow of essential goods and services,

for example clean air, water and food".

These ecosystem services are treated as though they're "free goods" - goods in such abundant supply they have no value or cost - while, as we've seen, most of the damage economic activity does to the ecosystem is also ignored.

The main reason for these limitations is that, with some exceptions, the national accounts and GDP don't actually measure "the economy" but rather market transactions within the economy. So, for instance, it ignores all the production and consumption that occurs within households without money changing hands. It measures professional sport, but not amateur sport.

It's clear we can't go on effectively ignoring the relationship between the economy and the environment. The damage economic activity does to the environment diminishes our wellbeing, as well as rebounding on the economy and damaging it. We can go on ignoring the damage excessive irrigation is doing to the Murray-Darling so as to avoid disrupting the livelihoods of the irrigators, but if we eventually turn the river into a drain, irrigation will be no more.

We need to recognise and measure the interrelationship between the economy and the environment because we don't want to give ourselves a false impression of the progress we're making, even in a narrow, material sense. Measurement is important because "what we measure affects what we do; and if our measurements are flawed, decisions may be distorted".

To this end the UN commission and its member national statistical agencies have agreed on a "system of integrated environmental and economic accounting", which will become an international standard in 2012. This brings environmental and economic information together within a common framework, meaning information from each side is on a comparable basis and can thus be combined.

Well that's great. But our longstanding focus on purely economic measurement means we don't yet collect all the data we would need to produce environmental accounts that could be integrated with the economic accounts to give us a more balanced picture of the progress we're making (although, of course, this says nothing about other dimensions of progress, such as the quality of our health, extent of our education, inequality in the distribution of income and treatment of minorities).

It turns out the efforts of our Bureau of Statistics have been concentrated heavily on collecting the reams of statistical information needed to produce the quarterly national accounts.

So that's the first stumbling block. The second is that, with the environment, you have to start with physical measures (millilitres, petajoules, hectares or tonnes) then see if you can convert them to dollar values - as they must be if they're to be combined with the economic accounts. (That's the problem with non-market activities, of course. When something is bought or sold, you know its dollar value.)

The bureau of stats has issued a paper describing its progress in moving Towards an Integrated Environmental-Economic Account for Australia. It needs to produce six accounts that will add up to the environmental side.

A water account (released a few weeks ago and now to be produced annually) includes the physical flows of water supplied to, and used by, the economy, and water returns to the environment. It includes monetary supply and use tables and indicators of the water productivity of industries.

An energy account (to be produced annually from mid next year) includes physical and monetary supply and use tables for various energy products, by industry. A land account (to be produced annually from early next year) includes physical and monetary land use by industry, land cover by industry and changes in land cover over time.

An "environmental protection expenditure" account (to be produced annually from late 2012) gathers together protective spending already included in GDP for things such as waste water treatment. A waste account (to be produced three-yearly from late 2012) covers physical generation and disposal of waste by industry, type of waste and destination.

It would be nice if, having done all this measurement, we could produce from the integrated environmental-economic accounts a single, bottom-line figure for "green GDP", that we could watch as closely as we watch the present brown GDP. As yet, however, the world's statistical agencies haven't agreed on a definition of green GDP, nor agreed on how to convert all physical quantities into dollar values. But there will be enough information to allow outfits or academics to calculate their own versions of green GDP using their own assumptions. And it should be possible to produce a figure for GDP after adjustment for environmental depletion and degradation.

That will be a big step forward.

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