Labor's lick and promise to beached job-seekers

You have to feel sorry for pollies in government. While economists (who have a built-in bias against government intervention) are forever pressing them to cut government spending, and the punters are perpetually refusing to pay more tax, everyone is urging them to do something about an endless number of genuinely worthy causes.

How can they win? They can't. Unfortunately, rather than limiting the number of problems they know they can afford to tackle, they have a tendency to want to give the appearance of fixing every problem they're asked to fix.

Take one of the budget's highlights, its package of measures to raise the workforce participation of welfare recipients of working age. With the exception of the package to assist the mentally ill, it's hard to think of a worthier cause.

It ticks so many boxes. We know the mining construction boom will soon create widespread shortages of skilled labour and even unskilled labour. So getting people off welfare and into paid employment - adding to the supply of labour - really helps us cope with the boom in a non-inflationary way. What make sense economically also makes sense socially. I have no doubt that getting these people into jobs is the best thing we could do to advance their wellbeing. I don't doubt that most of them would be delighted to have a job and be normal, even a job that isn't so wonderful - and even though more than a few of them have slipped so deep into the Slough of Despond they aren't thinking straight.

Only the ignorant and prejudiced would imagine people enjoy not having to work, being on the outer of society and living on a pittance. But even these misguided fools - of whom there are many - would be gratified to know the supposedly lazy had been put back to work.

Julia Gillard has said we will need to find 2 million extra workers in coming years. It so happens there are 2 million social-security recipients of working age: in round figures, 800,000 people on the disability support pension, 450,000 on sole-parent benefits (most with preschool children), 600,000 on the dole (most of them unemployed for more than a year) and 150,000 on the carer payment.

Of course, many of these people - the seriously disabled, for instance - aren't capable of working no matter how much they'd like to. And there are other sources of potential workers on which employers can draw: people who delay their retirement and mothers who can do paid work or more paid work. But as unemployment falls, those still out of work are the highly disadvantaged. About a third of those on the dole have been out of work for more than two years, and most of these "very long-term unemployed" have less than year 12 qualifications.

So a major investment in training, work experience in ordinary jobs, mentoring, childcare and health and disability services will be needed.

Gillard makes a good start in the budget with wage subsidies for the very long-term unemployed, vocational training and mentoring for teenage sole parents, and more help from Jobs Services Australia providers for early school-leavers to complete their education.

But the scale of these measures is pathetically small: 10,000 wage subsidies a year to share between more than 200,000 very long-term unemployed, and the teenage mums who get special help account for just 3 per cent of all those on sole-parent benefits.

Those measures that are on a large scale - such as 11 months a year of intensive job search activity for all very long-term unemployed and quarterly interviews with all disabled people under 35 who have some capacity to work - are the ones least likely to get results.

The 11 months of intensive activity - equivalent to two days a week - will be funded to the tune of just $1000 a person. Whoopee-do.

One good move is to make it more attractive for sole parents on the dole to do part-time work by cutting the rate at which their benefits are withdrawn from 60c in the dollar to 40c. But the cost of this will be paid for by the sole parents themselves. Those presently on the sole-parent benefit will be moved on to the dole once their youngest child reaches 12 (instead of the Howard government's 16), causing them to lose $56 a week.

Similarly, the cost of the measure making it more attractive for unemployed youths on the youth allowance to do part-time work will be more than covered by the decision to move unemployed people aged 21 off the dole and on to the youth allowance, causing them to lose $42 a week. The rationale for the latter move is to remove a financial disincentive for 21-year-olds to stay in education. Fair enough. But the government could have achieved the same effect by increasing the youth allowance for low-income students to the level of the dole.

It would be nice to believe the cuts in benefits to some of the most disadvantaged people were motivated by penny-pinching, rather than a desire to be seen punishing people widely regarded as the undeserving poor. (That news of the "crackdown" was leaked to the Murdoch tabloids does make you wonder.)

There is a range of likely outcomes from all this: employment gains and better skills for a small percentage of people on social security, financial pain for those whose payments are cut, and little change (apart from inconvenience) for the majority of those social-security recipients who have some potential to work.

Lacking enough money to actually fix the plethora of problems they're asked to fix, pollies have a tendency to spread the money they've got very thinly, so that none of the problems gets fixed. Everything gets a lick and a promise.

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Adapt or die: the high dollar is here to stay

The big ''known unknown'' facing the economy is how long commodity prices and the Aussie dollar will stay so high. That's why some people worry so much about the Chinese economy coming unstuck.

But while the new secretary of the Treasury, Dr Martin Parkinson, acknowledges the risks facing China's economy, his ''central scenario'' is that commodity prices and the Aussie will stay high for a long time.

This means that, though he declined to actually say the words in his speech to the Australian Business Economists in Sydney this week, he's no believer in ''Dutch disease'' - the idea that resources booms lead to a high exchange rate, which wipes out other export and import-competing industries before the boom collapses and leaves you high and dry.

No, Parkinson has a tough message for manufacturers and others asking for assistance to help them cope with the excruciatingly high dollar: get used to it. Adapt.

There are risks facing the Chinese economy, but they are short-term risks around a positive long-term outlook. ''Our central scenario, outlined in the budget, is one of solid medium-term growth for Australia,'' he said, fuelled by high commodity prices and a mining construction boom.

The global economy is undergoing a transformation unprecedented in the last 100 years. Global strategic and economic weight is moving inexorably from the Western advanced economies towards the emerging market economies. And the pace of this transformation is faster than many expected.

The key emerging markets from our perspective are China and India, which together account for slightly more than a third of the world's population. They're growing rapidly and should continue to do so. China should overtake the United States to become the world's largest economy by 2016 and, in turn, be overtaken by India by mid-century.

''There is nothing pre-ordained about these growth paths, and size does not automatically confer economic or strategic weight,'' Parkinson said. ''But these transitions - whether smooth or rocky - have important implications for Australia. Indeed, they constitute probably the most significant external shock Australia has ever experienced.''

Urbanisation and industrialisation in China and India have resulted in strong demand for our energy and mineral resources. The resulting improved terms of trade have increased our real income as the purchasing power of our exports increased.

Looking ahead, a growing Asian middle class will boost demand for our commodities, and for our services exports - education, tourism and professional services - and for niche, high-end manufactures.

But these developments expose our economy to increased macro-economic volatility and, more importantly, to a difficult adjustment process. That's Parkinson's point: it's not just China and India that are economies in transition, it's us, too.

Our terms of trade are now at 140-year highs and the budget assumes they fall back only slowly, by about 20 per cent over 15 years. As for the Aussie dollar, it can be expected to move roughly in line with the terms of trade over the longer term. It's therefore expected to also remain persistently high.

''The implications of a sustained increase in the terms of trade and a persistently high exchange rate are significantly different to those of a temporary shock - particularly for the structure of the economy,'' Parkinson said.

Most Australian businesses are well equipped to deal with short-term exchange rate volatility, but this sustained shift ''will challenge a number of existing business models''.

''Inevitably, this will see calls for support for producers that are suffering from a lack of competitiveness due to a 'temporarily' high exchange rate,'' he said, before going on to explain why such calls should be resisted.

Higher resource prices will see capital and labour shift towards the mining sector, where they are more valuable. This shift will be facilitated by the appreciation of the exchange rate, which shifts domestic demand towards imports and reduces the competitiveness of exports and import-competing activities.

Manufacturing and other trade-exposed sectors that aren't benefiting from higher commodity prices will come under particular pressure, but all sectors will be affected. The longer-term shift away from parts of the traditional manufacturing sector, which began in the middle of the last century, will continue - though it would be wrong to assume all manufacturing will be adversely affected.

And while mining and related sectors (including the mining-related part of manufacturing) can be expected to continue to grow - drawing resources from the rest of the economy - they will be overshadowed by the longer-term shift towards the services sector.

This change to our economy - its structural evolution - reflects a prolonged shift in our comparative advantage that began in the second half of last century, as rapidly industrialising Asian countries emerged as labour-abundant (read cheap-labour) competitors.

The latest phase in this evolution is raising understandable concerns in people's minds: how are the benefits of the boom shared throughout the community? Will our manufacturing sector be ''hollowed out'' and ''lost forever'' leaving us as ''nothing but a quarry''? What if the boom suddenly stops, as all previous booms have?

''Concerns like these are being reflected in calls for measures to protect sectors threatened by the structural shift in our terms of trade,'' Parkinson said. ''They drive calls for strengthening anti-dumping legislation, intervention to deliver a lower exchange rate and increased industry assistance.''

Why is there so much discomfort in the community about this transformation? Because it involves change and change is often difficult. Because the short-term costs of adjustment are concentrated in particular sectors. But also because what's happening - the longer-term structural nature of the change - is not well understood.

People need to be reminded, for instance, that a higher exchange rate helps spread the benefits of the resources boom through the community by reducing the price of imported goods and services.

They need to be reminded the economy is always changing - far more than we realise. Each year, about 300,000 businesses are born and a similar number die. About 2 million workers start new jobs and a similar number leave their jobs. And about 500,000 workers a year change industries.

The gravity point of world trade is shifting closer to us, giving us the opportunity to become a lot richer.

''However, if we are to take advantage of these opportunities it is likely to require more change in the structure [of the economy] and, perhaps more importantly, in the mindset of Australian businesses and the skill sets of Australian workers.''

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Tough love or kindness - a taxing dilemma

Something very important is at stake in this year's budget and the opposition's response to it: the shape of Australia's welfare state. Will it continue to be needs-based, or will we progressively make benefits universal - available to everyone regardless of income?

Historically, people on the conservative side of politics have strongly supported means-tested benefits, whereas people on the left have been attracted to the idea of universally available benefits, thus removing the ''stigma'' attached to the receipt of benefits.

These days, however, we're witnessing a strange role reversal where the Liberals move away from needs-based benefits and Labor seeks to return to them.

Our means-tested welfare system is an inheritance from the Menzies era. The Whitlam government introduced universal health benefits in the shape of Medibank and began phasing in a non-means-tested age pension. The Fraser government was conflicted: it dismantled Medibank and restored a watered-down means test, but introduced a more generous, non-means-tested family allowance.

The Hawke-Keating government restored Medibank as Medicare, but put a lot of effort into tightening up means-testing, imposing it on the family allowance and making considerable savings to the budget.

Then came John Howard, the great disciple of Menzies, who spent all his 11 years introducing what economists have come to disparage as ''middle-class welfare''. He introduced an only lightly means-tested family tax benefit, repeatedly increasing it. He added an extra benefit for single-income families - Part B - which was means-tested only to the extent that mothers who did any paid work were rendered ineligible.

He inherited the means-tested childcare benefit but, rather than abolishing it, he added the non-means-tested 30 per cent childcare tax rebate on top. So whereas the first measure carefully excluded better-off families, the second brought them back onto the public teat.

He did something similar for the self-proclaimed ''self-funded retirees''. Older people judged too comfortably off to receive the age pension were given a special senior Australians tax rebate and a seniors health card that entitled them to pay what pensioners pay for pharmaceuticals, $5.60 a pop, rather than the $34.20 even the poorest working family pays.

Perhaps the biggest move in the direction of middle-class welfare was the decision to make superannuation payments tax-free for people 60 or older. Before, how much income tax you paid was a function of the size of your income; now it's also a function of your age. Old comfortables don't pay it, young strugglers do.

Rather than introducing paid maternity leave, Howard brought in the baby bonus, payable without means-testing to women who hadn't been in paid work as well as those who had.

He introduced a non-means-tested 30 per cent tax rebate on private health insurance and changed the formula for grants to private schools in a way that produced winners and losers, then let the losers keep the extra to which they weren't entitled.

The Rudd-Gillard government has been under continuous pressure from economists to roll back Howard's middle-class welfare. One of its first acts went the other way: fulfilling an ill-judged election promise, it increased the childcare tax rebate from 30 per cent to 50 per cent. It has also kept a promise not to change the winners-but-no-losers formula for grants to private schools. But most of its other actions have gone in the Hawke-Keating direction of tightening up means-testing. It imposed a cut-off of $150,000 a year on eligibility for the family tax benefit Parts A and B, the baby bonus, tax rebates for dependants and soon the paid parental leave payment.

The $150,000 a year sometimes applies to a couple's combined income, but often it applies just to income of the ''primary earner''. To avoid adding to the problem of high effective marginal tax rates (where the rate of gradual withdrawal of a benefit as income rises adds on to the rate of tax on the additional income), it's a ''sudden-death cut-off'': on $150,000 you get the benefit, on $150,001 you don't. Because of the sudden-death nature of the cut-off, it was set at a very high level. Even today, only about the top 17 per cent of households have pre-tax incomes of more than $150,000. And only the top 4 per cent of individuals earn more than $150,000. Arithmetically, there's no way people on these incomes can be said to be in the middle; they aren't rich as James Packer is rich, but they are undoubtedly high income-earners.

The $150,000 hasn't been indexed for inflation since it was announced in 2008 and the decision last week was to leave it unindexed until July 2014. This means the level of the cut-off is actually falling in real terms, removing more people from receiving the benefit as the years pass. The budget's other main move to reduce benefits to the comfortably off was the decision to phase out the tax rebate for dependent spouses under 40 and without children.

Tony Abbott and the Liberals have attacked these measures, condemning them as ''class warfare'' and ''the politics of envy''. Abbott has yet to say whether he will oppose them in the Senate, but his party's longstanding opposition to Labor's attempt to impose a means test on the private health insurance rebate suggests he will.

Much is at stake. You may think you pay a lot of tax, but people in almost every other developed country pay a lot more than we do, even the Kiwis. The single greatest reason for our relatively low level of taxation is our inheritance from Menzies of a lean and mean welfare system: low, flat-rate, means-tested benefits. Most other developed countries pay former-income-linked, universal benefits and have high taxes and huge government debt to show for it.

We can take our welfare system in whatever direction we choose, mean or generous. But the more generous we make it, the more tax we'll end up having to pay.

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Gillard's budget critics run for cover

One reason governments aren't nearly as "tough" as economists and others urge them to be is their knowledge that when the going gets rough - when the losers from that toughness start vigorously objecting - the urgers will be missing in action.

The reaction to last week's budget offers a good example. On budget night every petshop galah was complaining it wasn't tough enough - a "missed opportunity", the last Julia Gillard will get before the next election.

What they were on about was the need to roll back all the middle-class welfare John Howard inserted into the budget.

But there was a fair bit of rolling back in the budget and, on day two, when battlers on more than $150,000 a year (egged on by the media) were screaming blue murder, claiming to be on middle incomes and insisting "$150,000 a year isn't rich", almost all the previous day's urgers were out to lunch. (The media are always accusing the pollies of spin, but the media often put their own spin on the pollies' words. Neither Labor nor any politician would be stupid enough to claim people on more than $150,000 a year were "rich" rather than just comfortable, but the media happily put that emotive word into the pollies' mouths.)

Our small army of taxpayer-subsidised commentators from the libertarian think tanks - the Institute of Public Affairs in Melbourne and the Centre for Independent Studies in Sydney - had surprisingly little to say (with the honourable exception of the centre's Jessica Brown). Presumably, they were too busy preparing another jihad against "churning". You get the feeling Labor cops more criticism for its slowness to roll back middle-class welfare than Howard got for putting it there (here the economist Saul Eslake is the honourable exception). Certainly, the smaller-government brigade is a lot tougher on the government for its timidity than it is on the opposition for its blatant populism and inconsistency.

And if some of the measures proposed in the budget fail to get through the Senate, just watch as economists and media commentators blame it all on the Greens, not the Libs.

But I'm fairly confident most of the measures will get through. I have a feeling they were selected to be acceptable to the Greens and lower-house independents.

Against that, however, the failure of the pure at heart to offer the government any support in its battle with rent-seeking punters, an increasingly partisan media and an unprincipled opposition is a good way to increase the likelihood that those with the balance of power will decide the issue has become too hot so they dare not risk supporting the reforms.

It's funny commentators who last year were claiming Gillard's minority government would be incapable of achieving any reform are now berating it for this "missed opportunity". What were they hoping for: a truckload of tough measures that didn't stand a chance of getting through?

What the two attitudes have in common is they both frame Gillard as a loser. We know about Aussies' love of cutting down tall poppies, but here we're seeing something darker: if someone's down, why not join all those who are kicking them.

It's surprising how those who profess to care so deeply about the good government of the country see so little need to help a weak government be stronger. With our reform advocates it's all care but no responsibility.

As for the notion that governments can only do unpopular things in their first budget after an election, I don't think it applies to minority governments.

In any case, a look at the budget figures makes it clear Gillard is sailing close to the wind in being sure of achieving a small budget surplus in 2012-13 and keeping that surplus in the following few years.

There's a high likelihood that, to increase her margin of safety (and meet her pledge to limit real spending growth to 2 per cent a year), Gillard will need to achieve further spending cuts in her next two budgets - whether she fancies the idea or not.


Last Monday I wrote that the Reserve Bank governor's pay (I should have called it his total remuneration package) of $1.05 million a year had jumped 85 per cent in the past five years. This calculation was based on information in the Reserve's annual reports.


Now the chairman of the Reserve's remuneration committee writes that the figures used in this calculation are not comparable because of the changed accounting treatment of non-cash benefits. He says the cumulative pay rise over the period was in fact 34 per cent.


I have been unable to confirm his calculation from publicly available information. I am puzzled by it because the figure used as the base for my calculation, $570,000, was described in the Reserve's 2005 annual report as the governor's "remuneration package", which included "cash salary, the Reserve's contribution to superannuation, housing assistance, motor vehicles, car parking and health insurance and the fringe benefits tax paid or payable on these benefits".


The letter the previous chairman of the remuneration committee wrote to the Treasurer in September 2009 (made public because of a freedom-of-information request) advised that the value of the governor's total remuneration package had risen by 33 per cent just between 2008 and 2009.


I note that the incorporation into the governor's base salary of "other allowances (including motor vehicle)" worth $44,600 a year - which also included an unused entitlement to spouse travel, valued at $25,800 a year - led to a commensurate increase in his employer's superannuation contribution, which is made at the rate of 21.3 per cent.

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Lousy budget? Don't be fooled by harsh critics

If you listen to the economists and commentators complaining the budget wasn't tough enough - a "missed opportunity" - and involves budget deficits higher than earlier expected, you could easily conclude it's a weak effort that does little to keep the economy on the right track. But you'd be misled.

It's true the budget's estimate of an underlying cash deficit of $49.4 billion for the financial year just ending is about $8 billion higher than expected in November. And the estimated deficit for the coming financial year of $22.6 billion is about $10 billion higher than earlier expected.

But just about all of that deterioration is caused by a weaker-than-expected economy, not by government spending decisions. The government's expected tax collections over the two years have been cut by $16 billion as a result of all the natural disasters locally and in Japan, the appreciation in the dollar (which cuts the foreign earnings of Australian companies) and the lingering effect of the recession we supposedly didn't have, which left many companies with losses (which they are now charging against their more recent profits, thus reducing their liability for company tax).

So these setbacks can't be blamed on a government that isn't trying.

It's also true that, though Wayne Swan - or more likely, Penny Wong - achieved savings worth $22 billion over four years (with two-thirds of the savings coming from spending cuts and the remainder from the temporary flood levy and cuts in "tax expenditures" or concessions), these have been offset by new spending programs worth about $17 billion over four years.

Net savings of $5 billion over four years isn't a lot to write home about. That's what the critics were saying.

But here's another truth: Swan is expecting this year's deficit of $49.4 billion to turn into a surplus of $3.5 billion in 2012-13, just two years' time. And that would be the fastest turnaround ("fiscal consolidation") in the 44 years that records go back.

Sound like a weak effort to you? It's a turnaround equivalent to 3.8 percentage points of gross domestic product - 2.1 points in the coming year and 1.7 points in 2012-13.

This means that, in the simple way most economists (including those at the Reserve Bank) measure it these days, the "stance of policy" is highly contractionary.

During the recession we supposedly didn't have, the turnaround in the budget balance, from a surplus of $19.7 billion in 2007-08 to a peak deficit of $54.8 billion (4.3 per cent of GDP) in 2009-10, represented the budget being highly stimulatory, helping to prop up the private sector and minimise the downturn in the economy.

Now, however, it's doing the reverse. The budget's net contribution to demand is negative - contracting rather than expanding - thus leaving more room for private sector demand to expand without generating as much inflation pressure.

With high coal and iron ore prices doing so much to increase the nation's income and a massive mining construction boom getting under way, this fiscal (budgetary) contraction won't be sufficient to remove all inflation pressure, so the Reserve is likely to continue making its "monetary policy" more contractionary by raising interest rates. The fiscal contraction, however, should give the Reserve less to do.

Back to the point: if the budget's such a weak effort, how come the deficit will turn to surplus so quickly? First, it's because, contrary to the impression many people have gained, more of the deterioration in the budget balance was "cyclical" (caused by the downturn in the economy, otherwise known as the budget's "automatic stabilisers") than it was "structural" (caused by the government's explicit decisions to stimulate the economy with higher spending or tax cuts). Second, it's because the government has stuck to the highly disciplined strategy it imposed on itself at the time it was worsening the budget balance with its discretionary stimulus.

The first part of the strategy was to ensure all the stimulus spending measures were temporary. Once the designated amount of money had been spent, they would stop.

So the stimulus would be withdrawn automatically; it wouldn't be necessary to make an explicit decision to turn off the tap. This means the budget would return to surplus automatically as the recovery in the economy caused a cyclical recovery in the budget's tax collections and a fall in spending on dole payments.

That's how it would work in principle. To make sure it also worked in practice, the other part of the strategy was for the government to exercise special restraint in its spending and taxing decisions until the budget was well back into surplus.

It pledged to "allow the level of tax receipts to recover naturally as the economy improves", which means it swore not to have any further tax cuts for the duration. So it promised to put the proceeds from bracket creep into improving the budget balance.

On the other side of the ledger, it pledged to limit the real growth in its spending to 2 per cent a year. This is lower than the natural rate of growth in spending if left to its own devices, so many critics were sceptical that Labor would have the discipline to achieve it.

Well, so far the government is on track to achieve it. The budget expects real growth in spending of 0.7 per cent in the year just ending, 0.5 per cent in the coming "budget year", minus 0.1 per cent in 2012-13 (the year of the promised return to surplus) and 1.9 per cent in each of the following two years. That's average real growth of 1 per cent a year over the coming four financial years. It compares with average growth of 3.7 per cent a year over the 10 years before the financial crisis, when Peter Costello controlled the purse strings.

This says the Labor government's record on fiscal responsibility isn't bad. It's true, however, that the speed with which the budget is expected to return to surplus is owed also to the return of the resources boom. So one critic has written that "the inadequacy of Wayne Swan's fourth budget has left Australia highly vulnerable to the gathering risks in the global economy, punting everything on our China luck continuing to hold".

It's true that, should China fall in a hole, our return to budget surplus would be greatly delayed. But can you spot the weakness in that argument? If our boom evaporated, the need to get back to surplus ASAP would also evaporate.

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Despite apparent contradictions, Swan shows courage

Julia Gillard and her government may be suckers, but they deserve an even break. Every budget contains things to criticise but, overall, this one is good. We were warned it would be tough and it is - especially on the better-off.

It could have been more excruciating - economists are hard to please when it comes to inflicting pain - but it's tougher and more courageous than all but the first of the 12 budgets the now-sainted Peter Costello delivered.

Wayne Swan plans to tighten up on people with company cars, private health insurance and family trusts. He will get at those who pay their university fees up-front, mothers who stay at home and wealthier couples with dependent children and older workers using salary sacrifice to supplement their super.

Not only is this the first budget in nine years not to include a tax cut, it imposes the temporary flood tax levy. Tony Abbott will be righteous in his condemnation - but the man's so relentlessly negative he would have ripped into the budget whichever way Gillard jumped, adjusting his criticism to fit.

So why is a government that is travelling so badly in the polls, and without a majority in either house, proposing so many unpopular measures? Because there's nothing like having your back to the wall to focus the mind.

This government, in both its incarnations, got nowhere trying to be popular and to avoid offending anyone who matters. What it desperately needs is respect. The way to win it is to be seen as willing to make the hard decisions needed to secure our future.

Whatever the voters' immediate reaction, I suspect in time there will be a grudging recognition that Gillard has guts.

But what exactly is the problem? Why the obsession with the returning the budget to surplus? And what's the tearing hurry - why must it happen in 2012-13 without fail?

It's true Gillard's motive for hastening the return to surplus is heavily political. She upgraded a forecast to a promise in the election campaign and is afraid of what the opposition would say if it wasn't kept, whatever the reason.

Even so, the justification for a quick return is soundly economic - especially if you don't like paying higher interest rates.

The trouble for Gillard is it's a complicated and confusing story. Swan says the deep cuts in spending are necessary to return the budget to surplus because the economy isn't as strong as expected and tax revenue is weaker than expected, which seems contradictory. If the economy's not travelling strongly, what's the hurry? It's that the causes of the present patchiness - the lingering effects of the financial crisis, the recent natural disasters and maybe even the weakness of retail sales - are temporary.

Come next year, the economy's likely to be roaring ahead, fuelled by sky-high commodity prices and a huge mining construction boom that surely will run and run.

So the faster Swan can get the budget back to surplus and keep it growing (paying off the public debt in the process), the more the budget acts as a counterweight to the booming private economy, thus easing inflation pressure as the economy starts running out of production capacity.

This will reduce the need for the Reserve Bank to apply its own brakes: higher interest rates. But here's another apparent contradiction: economists are predicting the Reserve will raise rates again within a month or two. Will this prove Swan was lying or that his budget has failed?

No. Improvements in the budget balance aren't a perfect substitute for higher rates in the struggle to stop the economy's demand growing faster than its ability to supply. But the greater the improvement in the budget balance, the fewer rate rises will be needed.

To ensure this commodity boom doesn't end in tears and and that it ends with something to show for it, we need to, first, keep demand and supply growing in tandem and thus avoid inflation pressure and, second, increase our savings from the proceeds of the boom and, third, ensure the extra jobs go to our own people rather than immigrants.

The early return to surplus helps with the first two objectives; the budget's new programs to improve vocational training and increase the workforce participation of disadvantaged workers helps with the third.

Not a bad effort.

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Stevens sells his moral authority

Everyone who's seen The Godfather knows how the Mafia works: it's more than happy to do you a favour, but once it has it owns you forever. Our coterie of grossly overpaid chief executives and directors operates much the same way.

They're a mutual pay-raising society - you raise my pay and I'll raise yours - and more than a year ago they induced the governor of the Reserve Bank, Glenn Stevens (a most estimable fellow in every other respect), to join their club.

Stevens accepted the recommendation of the Reserve board's "remuneration committee" that his salary be raised to $1.05 million a year. This is at least double what the heads of federal departments get, and far more than almost all other central bank chiefs get.

It's about five times what the US Federal Reserve chairman, Ben Bernanke, gets. Stevens's pay has jumped 85 per cent in five years, equivalent to annual rises of 13 per cent.

This compares with a former governor's "line in the sand" many years ago setting 4.5 per cent a year as the maximum non-inflationary pay rise for ordinary mortals (a limit that these days would be too high because of our weaker productivity growth).

The price of Stevens's admission to the lowest rung of the indefensible-salaries club is the loss of his - and the Reserve's - moral authority on the question of excessive pay rises for punters. (He also forfeits the ability to be at all critical of the example set by his fellow club members.)

The chances of skilled-labour shortages turning into a general round of excessive wage increases in the next few years are high. If that happens, Stevens has lost the ability to fight it with "open-mouth operations" in the way his predecessor, Ian Macfarlane, sought to talk down the housing boom in 2003 - with some success. No, Stevens will be left with only one instrument: higher interest rates. And consciousness of his self-inflicted impotence in the moral suasion department may lead him to raise rates just that little bit higher than otherwise.

If so, he will have added injury to his insult to wage slaves. The more some workers seek a fraction of the percentage wage settlements Stevens has been accepting, the more others of them will be priced out of a job.

But how does it come about that Stevens is now paid so much more than other central bank bosses? The rest have boards composed largely of economists and public servants. Pretty much only in Australia is the board composed largely of business people.

So what more is natural than this group of chief executives and professional board members seeking to run chief-executive remuneration at the Reserve the way they run it on money-obsessed private-sector boards? And what is more natural than them cutting a nice guy like Stevens in on the easy dosh?

Studies by psychologists show that people engaged in ethically dubious practices are commonly anxious to convince others - and themselves - that "everyone's doing it". And now the governor's just as morally compromised as I am. Told you.

The Reserve's delay in making Stevens's pay rise public - or even privately informing the Treasurer - for almost a year suggests it knew full well it was out of line with "community expectations" and had done something to be ashamed of.

The arguments members of the Reserve's "remuneration committee" have offered in defence of their actions are characteristically weak. The Reserve has to compete with "lucrative offers in the financial sector" to retain staff, we're told.

At the level we're talking about, that's rubbish. These guys aren't real bankers, they're economist bureaucrats who know a lot about monetary policy, but not much else. They could never run a real bank; some could run a dealing room or be a chief economist.

If any of the Reserve's top people have had "lucrative offers" lately it would be nice hear about them. I'll bet they haven't. Even if they had, they wouldn't be tempted.

Anyone who hangs in at the Reserve long term, and thinks they have a shot at being governor, is motivated by something no private-sector job can offer: the knowledge you're playing a significant role in steering the Australian economy. As a bonus, you get to sign banknotes.

It's true salaries need to be reasonably competitive with the financial sector much lower down in the Reserve hierarchy. That's where good young people are often tempted away - especially since the intellectual firepower needed to progress up the Reserve's ranks is formidable.

But that's the joke. In line with the ethic of the indefensible-salaries club, lower salaries aren't increased commensurately. It's demigods only. Little trickles down.

Asked how the yawning gap between Stevens's and Bernanke's salaries could be justified, one genius on the "remuneration committee" argued it was all about how much you could earn after you ceased being governor. Bernanke would command $250,000 a speech. That's a market-forces argument?

In truth, retiring Reserve governors - who have excellent superannuation - can earn vastly higher incomes by accepting all the positions on boards they're offered. Their inside knowledge allows them to become professional directors overnight - and help jack up other top people's salaries. The only constraint is their personal ethics.

It seems clear the Remuneration Tribunal intends to raise the salaries of federal department heads to reduce the gap with Stevens's $1.05 million, on the grounds of comparable responsibilities.

So we start with a bulldust market-forces argument and progress to fairness arguments. When workers argued this way in the old days it was called "comparative wage justice" and every economist condemned it as economically irresponsible. The demigods live by different rules.


Letter From Donald McGauchie to the Treasurer - 18 September 2009


Letter From the Treasurer to Donald McGauchie - 15 September 2010


Letter From Jillian Broadbent to the Treasurer


Letter to the Editor, May 12:

I write as chairman of the Reserve Bank Board's Remuneration Committee to correct a misinterpretation in a recent article by Ross Gittins (BusinessDay, 9/5) that claims there had been an 85 per cent increase in the remuneration of governor of the Reserve Bank Glenn Stevens between 2005 and 2010.

The cumulative pay rise over that five-year period was, in fact, 34 per cent. The numbers used by Gittins are not comparable owing to the changed accounting treatment of non-cash benefits between 2005 and 2010.

Roger Corbett, chairman, Remuneration Committee, Reserve Bank Board


Last Monday I wrote that the Reserve Bank governor's pay (I should have called it his total remuneration package) of $1.05 million a year had jumped 85 per cent in the past five years. This calculation was based on information in the Reserve's annual reports.

Now the chairman of the Reserve's remuneration committee writes that the figures used in this calculation are not comparable because of the changed accounting treatment of non-cash benefits. He says the cumulative pay rise over the period was in fact 34 per cent.

I have been unable to confirm his calculation from publicly available information. I am puzzled by it because the figure used as the base for my calculation, $570,000, was described in the Reserve's 2005 annual report as the governor's "remuneration package", which included "cash salary, the Reserve's contribution to superannuation, housing assistance, motor vehicles, car parking and health insurance and the fringe benefits tax paid or payable on these benefits".

The letter the previous chairman of the remuneration committee wrote to the Treasurer in September 2009 (made public because of a freedom-of-information request) advised that the value of the governor's total remuneration package had risen by 33 per cent just between 2008 and 2009.

I note that the incorporation into the governor's base salary of "other allowances (including motor vehicle)" worth $44,600 a year - which also included an unused entitlement to spouse travel, valued at $25,800 a year - led to a commensurate increase in his employer's superannuation contribution, which is made at the rate of 21.3 per cent.

Monday May 18

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Sack the Treasury head, make Victoria look good

ARE you very trusting of the way politicians handle taxpayers' money? Do you fear a lot of government spending is wasted on vote-buying, frippery and gimmickry? Do you want to pay higher taxes?

Do you worry about pollies running big budget deficits and racking up too much government debt? Do you think state politicians are more fiscally responsible than their federal counterparts or less? Do you really believe Labor is hopeless at budgeting but the Libs are fine?

I think I know your answers to these questions. Few of us want to pay more tax and all of us fear a lot of our taxes are wasted on spending that does more to advance the pollies' interests than the public's. Many of us don't like the sound of all that government debt.

If anything, state pollies are more of a worry than federal pollies. And you have to be terribly one-eyed to be confident all the fiscal irresponsibility is contained on one side of the political fence.

The hard truth is, democratic politics puts governments under enormous temptation to be financially irresponsible. All governments succumb to a greater or lesser extent.

Trouble is, although all of us believe government spending is excessive and wasteful as a general proposition, as soon as we get down to cases we change our tune. We can all think of particular problems governments need to fix, usually with wads of money. By definition, wasteful vote-buying spending must please some voters. And any attempt to cut spending usually meets an indignant outcry.

This wouldn't be such a problem if we were prepared to pay the taxes needed to cover all that spending, but we're not. We want to have our cake and eat it. And the pity is that, rather than set us straight on the realities, the pollies rarely resist the temptation to pander to our happy delusion that how much governments spend need bear no relation to how much tax we pay.

Election campaigns are about all the new spending both sides are promising, with never any suggestion of higher taxes. It's not uncommon for pollies to promise both more spending and lower taxes.

So the two sides of the budget have a natural tendency to pull apart. And what makes it trickier is that no one with any sense says they must always move in lock step. It's not a problem for the budget to go into deficit when the economy's weak. And, up to a point, government debt isn't a worry, particularly if it's helping to finance worthwhile infrastructure spending.

Paradoxically, this qualification makes it all the harder for governments to resist the temptation to let their spending and their taxing get too far out of line. When you think about it, it's a wonder governments don't get into more bother than they do. And here's the point: have you ever wondered why they don't?

It's because it's the duty of one department - Treasury - to hold the show together. Every other department is busy urging the government to spend money, and only one department is trying to hold the line, minimise the need for tax increases, oppose wasteful spending and avoid the accumulation of excessive debt.

There's never any shortage of people from spending departments willing to bad-mouth Treasury, but that's because treasuries are the taxpayers' champion within government.

Treasuries have a long and honourable history of fighting hard in defence of fiscal responsibility, of keeping their governments out of financial trouble. When you think of it, the strength and persistence of this ethos over the decades is quite remarkable.

Of course, to be effective in their efforts, treasuries rely heavily on the effectiveness of the treasurers who lead them. And, even assuming the treasurer is up to it, he or she relies on the support of their premier or prime minister in the unending battle with ministers who just want to keep spending and hang the consequences.

Without a premier with the wit to understand the essential role played by Treasury and its treasurer in keeping him out of financial trouble, even the most able and determined treasury won't be able to save a government - and the public - from its folly.

This makes it all the more remarkable that the first act of the new Premier and Treasurer of NSW, Barry O'Farrell and Mike Baird, was to sack their treasury secretary, Michael Schur. Schur was not a political appointment but a career public servant. He was diligent, capable and innovative. He'd prepared a particularly thorough briefing for the incoming government, full of proposals for reform.

Whereas the audit commissioned by the incoming Baillieu government was focused on proposing longer-term improvements, O'Farrell's audit seemed aimed merely at proving the previous Keneally government had been cooking the books, as O'Farrell had repeatedly claimed.

It seems that when the audit failed to find such evidence, O'Farrell covered his embarrassment by sacking Schur. What worthy candidate would want to succeed him?

Once again, the New South Welshpersons have made Victoria look good.

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Make people employable

Australia is sitting pretty. We avoided the worst of the global financial crisis and now the return of the resources boom means the world is paying extraordinary prices for our coal and iron ore. Those prices will ease back but, even so, huge investment in new mines and natural gas facilities is likely to keep the economy growing strongly for at least the rest of the decade.

The other developed economies would kill for prospects as rosy as ours. They're in dire straits and we've won the lottery - with a soaring dollar to prove it. The main challenge is to make sure we end up with something to show for all this good fortune. One thing we need to do is make sure we save a fair bit of the extra income coming our way.

We can do this partly by returning the budget to surplus, paying off government debt and then putting budget surpluses into some kind of sovereign wealth fund we could call on when times got tough again.

But the other big thing we need to do is increase our investment in ''human capital'' - in educating and training our people. It worries a lot of us that digging stuff out of the ground and flogging it to foreigners seems a primitive and unsustainable way to make a living. What do we do when the stuff runs out or the boom busts?

Well, we don't delude ourselves we can get back into manufacturing in a big way, in competition with high-tech countries such as Germany or low-cost ones such as China. That game's over. No, if we're recycling income from primary industry we've got to move it past secondary industry to tertiary - the services sector. Apart from minerals and farming, the main thing we have to sell the world (and meet our domestic needs) is labour.

We've got to make our labour as valuable as possible, which means making it as skilled as possible. And that means becoming obsessed with education and training.

Another way to think about it is: this: we're embarking on a long mining construction boom at a time when our unemployment rate is already below 5 per cent. Few of those unemployed possess much in the way of skills, and shortages of skilled labour are about to become acute.

We can solve this the lazy way by relying largely on bringing in skilled immigrants, or we can make sure more of our own people get to benefit from the resources boom by lifting our game on education and training. We really do need an education revolution at every level - from early childhood development to universities. But one less fashionable area where we must do a lot better is vocational education and training (the government part of which is TAFE - technical and further education).

Yesterday Chris Evans, the Minister for Skills, among many other things, issued a report from Skills Australia, Skills for Prosperity, a ''road map for vocational education and training''. The report says Australia will need an additional 2.4 million skilled workers by 2015 to meet the growing needs of business, after allowing for the replacement of retiring baby boomers. By 2025 we'll need 5.2 million. Many will have to be trained by the voc ed system.

We'll need the output of qualified tradespeople and technicians to grow by about 3 per cent a year over that period. To this end, the report recommends that funding for voc ed be increased by 3 per cent each year in real terms.

This averages real growth in spending of $310 million each year. That's an expensive commitment. But because skilled workers earn more and pay more tax than they otherwise would, the report argues this extra spending will more than pay for itself from the government's perspective. Spending on education and training really is an investment, with an ultimate monetary pay-off for governments, the people receiving the training and the rest of us.

As you can guess, the extra money would come with strings. Merely pouring the extra dough into the voc ed system as it stands would be unlikely to produce as many extra skilled workers as required. The single most important proposed reform involves moving away from funding the institutions providing voc ed to an entitlement system, as already applies to schools and universities. In other words, how much funding training organisations received would depend on their enrolments, thus allowing student demand to determine the allocation of resources for most qualifications.

For all courses there would be ''full contestability'' for public funding between government and private sector providers. This competition and choice is expected to lead to a more responsive and efficient training system. (You can tell what school these guys went to.)

To find and recruit all the extra bodies it would need to meet its targets, the system would need to increase the proportion of disadvantaged people it attracts. Disadvantaged doesn't only mean disabled, it also means early school-leavers and others with inadequate literacy and numeracy.

Voc ed is the part of the education system best suited to picking up the stragglers, so to speak. And part of our effort to make sure we make lasting gains from the resources boom should be doing more to improve the skills - and hence the employability - of people at the bottom of the pile.

Helping the disadvantaged is expensive, but the report says the extra costs can be covered by the system improving its completion rates. These are as low as 20 to 35 per cent at present. That fact alone tells us voc ed is in need of major reform.

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Games show how economists lead us astray

In universities these days they play a lot of games - though when the economists play they prefer to call it "game theory". And game playing is one of the most potentially useful things academics do.

The most famous game played by social scientists is "the prisoner's dilemma". As described by Wikipedia, two suspects are arrested by the police. The police have insufficient evidence for a conviction, but they keep them separate and offer each the same deal.

If one testifies for the prosecution against the other (that is, "defects" from a position of solidarity with the other) and the other remains silent (that is, "co-operates" with the other), the defector goes free and the silent accomplice receives the full 10-year sentence.

If both remain silent, both are sentenced to only six months for a minor offence. If each betrays the other, each receives a five-year sentence. So each prisoner must choose whether to betray the other or remain silent.

Each is assured the other won't know about the betrayal before the end of the investigation. So how should the prisoners act?

As a group, the two prisoners are better off if they each stay silent - each gets only six months' jail.

As individuals, however, the risk of being betrayed by the other means the "rational" choice is always to dob in the other guy. If he stays silent, you get off while he gets 10 years. If he dobs you in too, you both get half the full sentence, whereas if you were to stay silent while he dobbed you in you'd cop the full 10 years. Barry Schwartz and Kenneth Sharpe, in their new book Practical Wisdom, observe that social scientists love the prisoner's dilemma game because it embodies many situations in life in which co-operation would make everyone better off, but choosing to co-operate makes you vulnerable to exploitation by people who choose not to co-operate.

It's noteworthy that, though the economists' model leads them to predict that everyone will make the "rational" choice to be unco-operative, when the once-only game is played with experimental subjects a significant minority of people choose to co-operate.

See what's happening? It turns out that the economists' conventional, neo-classical model is just one way of "framing" the economic problem - the problem of how to make a living.
The model frames the problem as a problem for individuals: how do I look after myself in a world composed of other individuals whose main aim is to look after themselves as individuals?

In other words, the model sees the economic world as fundamentally competitive. It highlights the risk that others will choose not to co-operate with me, and highlights the benefit to me of "free-riding" - taking advantage of those who do choose to co-operate.

The one thing it doesn't highlight is the opportunity cost - whether to me or to all of us - of our mutual failure to reap the benefits of co-operation.

So "the economists' way of thinking" is a way of framing the economic problem that's biased in favour of competition and against co-operation. But it's just one way of framing the problem; framing it another way could emphasise the benefits of co-operation and the costs of excessive competitiveness.

When we're taught to think about the economic problem the way economists conventionally think about it, our thinking becomes biased against recognising the benefits of co-operative solutions: "communitarian" or "collective" solutions, whether agreed between people informally or - to overcome the problem of free-riding - delivered by governments using compulsory mechanisms such as taxation.

Conventional economic analysis will always be biased against government intervention because it frames the economic problem as one to be solved by individuals, not by society.

A crude reading of evolution says it's all about competition - the survival of the fittest. A more modern, sophisticated reading says the supremacy of the human animal is as much the product of co-operation between humans as about competition between them. Both co-operation and competition are key components of our winning formula.

The fact is that a huge proportion of economic activity involves co-operation between people rather than competition in markets. There are all the goods and services produced within households.

And there's all the activity that occurs inside big companies, including trade between the different parts of national and trans-national corporations. Economists know surprisingly little about this activity.

To emphasise the point that conventional economics (and, indeed, all economics) involves framing, Schwartz and Sharpe note that the participants in one experiment were giving the same version of the prisoner's dilemma game, except that one group was told it was the Wall Street Game whereas the other group was told it was the Community Game.

You guessed it: people playing the Wall Street game were much more likely to defect. In a similar game, those told they were taking part in the Social Exchange Study were more likely to co-operate than those told they were taking part in the Business Transaction Study.

The latter researchers say the social-exchange frame induced a motivation for the players to do what was right, whereas the business-transaction frame induced the motivation to get as much money from playing the game as possible.

All this suggests the success economists have had in recent decades in propagating their way of framing the choices we face has subtly influenced our thinking and behaviour, making us more competitive and self-seeking and less co-operative and public-spirited.

If so, we're the poorer for it. We need to frame the economic problem more carefully.

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Its all in the frame (behavioural economics)

It's a long weekend, so let's play a game. Tell me this: are eagles large? And, next, are cabins small? If you said yes to both, congratulations - you're right. But if you said no to both, you're not wrong. In fact, you're just as right as the others are.

Relative to other birds, eagles are large. And relative to other buildings, cabins are small. But if you compare an eagle with a cabin, eagles are small and cabins are large.

Get it? Whether eagles and cabins are large or small depends on what you're comparing them with. Or, as they say in the classics, everything's relative.

And this, believe it or not, is one of the great discoveries of cognitive psychology.

Part of that discovery is that the way we react to situations or propositions is heavily dependent on the way they're framed, as psychologists say - the way they're packaged, the context in which they're put.

We can react differently to the same proposition depending on how it's framed. A classic example: even doctors say a 90 per cent success rate for operations is more acceptable than a 10 per cent failure rate.

The people who didn't need psychologists to tell them our reactions to things are influenced by the way they're framed are advertising and marketing types. They know that draping a girl in a bikini over a sports car can help sell more of them. What's the logical link between a good-looking young woman and a motor car? There's none - but the young bucks (and ageing baby boomers) who buy sports cars can imagine one.

Although it comforts economists to kid themselves that advertising is purely informational, in truth almost all advertising is about framing - drawing unspoken links between the product you're trying to flog and some attractive situation or emotion. Their not-so-subtle message is, buy my margarine (or sliced bread) and you'll have a happy, healthy family. In the advertisers' adage, you sell the sizzle, not the steak.

But framing goes far wider than advertising. It's the reason you should be sceptical of the results interest groups quote from the opinion polls they commission. It's too easy to influence the answers you get by the way you frame the questions you ask.

And don't forget that political spin is a form of framing. It's about portraying situations or decisions in ways that reflect more favourably on the pollies involved.

Their opponents, of course, try to frame the same situations or decisions in a more negative light.

But in Practical Wisdom, a new book by two academics at Swarthmore College, near Philadelphia, Barry Schwartz and Kenneth Sharpe, they observe that stories like these have given framing a bad name that's unwarranted.

Why? Because there's no alternative to framing. That's the great discovery of cognitive psychology: just about the only way we can get our minds around anything is to compare it with something we already know about.

Years ago an editor reminded me of the classical rule of rhetoric that argument by analogy is invalid. Sorry, it turns out that the only way we learn is by comparing things we don't understand with things we do understand.

This doesn't mean every analogy-based argument is correct, of course, just that there's no other way to argue.

The term frame is itself a metaphor. Schwartz and Sharpe say it's a wonderful one because it emphasises our capacity to take the chaos of the social world around us and organise it in an understandable way.

The capacity we have to frame enables us to do one of the most important things the exercise of practical wisdom demands: discern what's relevant about a particular context or event in regard to the decision we face.

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Looking to Aristotle for a guide on reform

How things have changed. When I was growing up Labor portrayed itself as the party of reform, out to fix an unjust world. The Liberals were conservatives, satisfied with the world as it was and trying to keep change to a minimum. Needless to say, the Libs kept winning.

These days, however, both sides portray themselves as parties of reform. And the faster the world changes the more certain both sides become of the need for further reform - even if, as with Work Choices, the new lot's reform is merely to reverse the reforms of the previous lot.

There is one small problem with all this reform: it's not always clear the changes actually make things better. The pollies see things that aren't working well, make changes intended to improve the situation, but often don't succeed. Then they, or their successors, do more in the same vein or try the opposite approach, with neither seeming to work.

When politicians see institutions they think aren't performing - the health system, the education system, the courts, the banks - they tend to apply one of two tools. The first is to toughen up the rules and regulations governing the institution; be more explicit about what people are required to do.

The second is to sharpen the incentives (and disincentives) faced by people in the institutions. With private-sector institutions - banking, for example - the approach is usually to reduce government regulation and then rely on competition and the profit motive to improve performance.
With public-sector institutions - health and education, say - the approach is to impose numerical tests and targets (''key performance indicators'') and maybe introduce monetary rewards for good performance.

As the international experience with banking indicates, the reformers sometimes alternate between the two approaches when they find the other hasn't worked. After the Great Depression we tightly regulated the banks, but in the 1980s we decided they weren't performing well and the answer was to deregulate them. Now, after the global financial crisis, the world has swung back to thinking tighter regulation is the key to better performance.

A long memory, however, suggests it won't be that simple. Why is it that neither rules nor incentives seem to do the trick? And what else can we do that stands a better chance of working? Well, while I was away on holiday in Italy I read a book that offers some answers. It's Practical Wisdom, by Barry Schwartz, a professor of psychology at Swarthmore College in Pennsylvania, and Kenneth Sharpe, a professor of political science at the same college.

It's noteworthy that both approaches proceed from a low opinion of the people working in these institutions: they don't really care about their work. The notion that tightening up the rules will improve the performance of practitioners assumes they are dumb (they don't know the right thing to do) and uncommitted to doing their job well. The notion that introducing numerical targets and monetary incentives will improve performance assumes practitioners are lazy and motivated only by self-interest. Both approaches are top-down: the politicians know what should be done to improve the performance of the courts or whatever, and seek to impose their judgment on the practitioners.

That gives us a clue as to why neither approach is particularly effective. Both are demoralising - in both senses of the word. They reduce the practitioners' scope to exercise their discretion when objectives conflict (as they often do in this increasingly complex world) and the circumstances of individual cases differ.

This demotivates professionals as well as removing the moral element from their jobs. They become responsible for obeying rules or meeting targets, not ensuring the ultimate objectives are achieved.

Modern jobs are multi-faceted, with multiple objectives. Numerical targets and monetary incentive payments inevitably narrow practitioners' objectives and increase their focus on monetary rewards, driving out other motivations.

And when you eliminate the moral element you encourage people to try to beat the system. The more rules you make, the more you encourage demoralised workers to look for loopholes. The more you measure people's performance with numerical indicators, the more you encourage them to game the system. Whatever elements of their performance aren't covered by a performance indicator will be cannibalised to help achieve those you are measuring.

Under both approaches quantity improves at the expense of quality, partly because quantity is easy to measure and quality is hard.

So what's the answer? Schwartz and Sharpe say that, though we will always need rules and rewards in the running of institutions, increasing the emphasis on rules and incentives discourages and diminishes the third, more elusive element needed to make institutions work well: what Aristotle called phronesis and translates as practical wisdom.

People exercising practical wisdom use their skills and experience to achieve to the best of their ability the ''telos'' or true purpose of their activity. Practical wisdom involves finding the right way to do the right thing in the particular case you are dealing with.
People are motivated to exercise practical wisdom not to obey rules or increase their income but because they know it's the right thing to do, to benefit their students, patients, clients or customers and obtain personal satisfaction in the process. It's about intrinsic motivation - doing a good job for its own sake - rather than the extrinsic motivation of obeying rules or making more money.

Institutions would work better if, rather than discouraging practical wisdom by tighter rules and bigger incentives, they gave practitioners more flexibility to innovate, improvise and generally exercise their own judgment in doing the right thing by the individuals they help. Reformers haven't got far by assuming doctors, teachers, judges, public servants and the rest are dumb and lazy and must be compelled or bribed to do better. Why not assume the majority of these professionals want to do a good job and give them more scope to do the right thing in the right way?

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Economists part of Inside Job (Movie previews!)

It always takes the movie world a while to catch up with real life, but it's finally caught up with the global financial crisis. There's the Oscar-winning documentary Inside Job and a classic Hollywood job, The Company Men. I recommend both.

Inside Job deals with the origins of the crisis on Wall Street; The Company Men deals with consequences on Main Street from the resulting Great Recession. Let's start with the "real economy".

America's unemployment rate started rising in October 2008, reaching 10 per cent a year later. It's still about 9 per cent. Say it quickly and it doesn't sound too bad. People lose their jobs when the economy turns down - what else is new?

The great strength of The Company Men is the way it shows us what happens to the lives of three men who lose their jobs when their company decides to "rightsize". These aren't ordinary workers, they're executives close to the top of the tree, which gives them further to fall.

They are well-paid guys who seem to have committed themselves for almost all they earn. First is the humiliation of their lowly status at the outplacement agency and then the disillusionment as their repeated efforts to find another job get nowhere.

At first they attempt to conceal the shame of their unemployment from their children, neighbours and relations. Then comes the steady divestment of the big toys they can no longer afford. Marriages are strained by money worries. Their self-identity came from their job; their job is no more.

They were let go because their company's share price had fallen in the crash and something big must be done to restore it. But every company's share price fell, so what's the problem? The problem turns out to be the chief executive's need to raise the value of his share options. Whether on Main Street or Wall Street we see the new morality of corporate capitalism: look after No. 1 and don't feel any responsibility for the consequences of your actions for customers or colleagues.

In the words of one reviewer, Inside Job is the story of a crime without punishment. Wall Street's reckless behaviour caused the crisis and the huge damage it did to businesses, workers and retirement savings in America and Europe.

The banks were bailed out at great expense to the taxpayer, but so far almost no one has been punished for misconduct or negligence. Many of the perpetrators walked away with millions. The payment of outrageous bonuses hardly skipped a beat.

The film's graphics do a good job of explaining the central role - and the madness - of toxic derivatives such as collateralised debt obligations and credit default swaps.

Many of the docos you see on political and economic themes are acts of left-wing self-indulgence. Not this one. The sense of outrage it builds up in the audience is eminently justified. Indeed, it leaves you wondering how the American public has been so easily diverted from demanding Wall Street be brought to heel.

The outrage arises as you realise Wall Street is virtually a law unto itself. It was progressively deregulated at its own urging by congresses of both colours. Now its immense wealth and lobbying ability prevent it from being effectively reregulated.

For the most part, administrations' key economic regulators - Federal Reserve governors (Paul Volcker, Alan Greenspan) and Treasury secretaries (Robert Rubin, Hank Paulson, Tim Geithner) - come from the upper reaches of Wall Street.

When the big business-dominated Bush administration was replaced by the reformist Barack Obama, Republican-affiliated Wall Streeters were replaced by Democrat-affiliated Wall Streeters.

But it's not just the politicians who are compromised. The film's director, Charles Ferguson, shows how many of America's big-name academic economists are also on the Wall Street payroll. He outlined the case against economists in an article in The Chronicle of Higher Education. Ferguson's leading academic villain is Larry Summers of Harvard. He has long been a champion of privatisation and deregulation and as deputy secretary then secretary of the Treasury in the Clinton administration he oversaw the repeal of the Glass-Steagall Act, which had kept commercial banks separate from investment banks since the Depression.

Between 2001 and his entry into the Obama administration as director of the National Economic Council, Summers made more than $20 million through consulting and speaking engagements with financial firms.

Martin Feldstein, also of Harvard, a major architect of deregulation in the Reagan administration and president for 30 years of the non-government National Bureau of Economic Research, was on the board of the failed insurance giant, AIG, which paid him more than $6 million, and also on the board of the subsidiary whose dealings in credit default swaps brought the company down.

Feldstein's arrogant performance in the film was exceeded only by that of Glenn Hubbard, chairman of the Council of Economic Advisers in the Bush administration and dean of Columbia Business School. He's an adviser to many financial firms, resigning from the board of Capmark, a major commercial mortgage lender, shortly before its bankruptcy in 2009.

Frederic Mishkin, a professor at the Columbia Business School and a member of the Federal Reserve Board from 2006 to 2008, was paid $124,000 by the Icelandic Chamber of Commerce to write a paper praising its regulatory and banking systems, two years before Iceland blew up.

Laura Tyson, a professor at Berkeley and director of the National Economic Council in the Clinton administration, is on the board of Morgan Stanley, which pays her $350,000 a year.

Some of America's leading academic economists, from the most prestigious universities, make frequent pronouncements on public policy in the media, expecting to be venerated as disinterested experts. They rarely see a need to disclose their conflicts of interest.

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When the price is right you're on the right track

if economists wore T-shirts what they'd say is PRICES MAKE THE WORLD GO ROUND. Conventional economists are obsessed by prices. It took me ages to realise that economics isn't actually about the economy. It's about markets. So economists tend to ignore those parts of the economy that don't involve markets, such as the production and consumption of goods and services that go on inside households.

Economic sociologists also study markets and what they see is the way unwritten rules of social relationships influence the behaviour of producers and consumers, sellers and buyers.

Economists, however, don't see any of that. What they see is the way prices adjust until supply and demand are in balance ("equilibrium"). They see the price mechanism as the fulcrum on which the market economy rests.

Sometimes economists say economics is the study of incentives. That's just a fancy way of saying they study prices. Lower prices are an incentive to consumers to buy more, but an incentive to producers to produce less. Higher prices create the opposite incentives. Higher wages (which are a price) are an incentive to work more, and so forth.

But what fascinate economists are relative prices - the price of this item compared with the prices of other items. They think changes in relative prices have an almost magical ability to change people's behaviour.

Inflation involves rises in the level of prices generally. Economists disapprove of inflation mainly because when the prices of everything are rising this makes it harder for people to see and react to changes in the thing economists really care about: relative prices.

Last week an assistant governor of the Reserve Bank, Dr Philip Lowe, gave a speech in which he predicted the resources boom would cause a significant change in the structure of Australia's industries. What would bring this change about? Changes in relative prices, of course.

The most basic relative price in this story is our terms of trade - the prices we get for our exports relative to the prices we pay for our imports. The super-high prices we're getting for our coal and iron ore make our terms of trade possibly the most favourable they have ever been and about 90 per cent better than their average for the 1990s.

The change in this relative price is the main reason for the change in another key relative price: our exchange rate - the price of our dollar relative to the price of the US dollar, the yen or the euro.

But Lowe points to some relative price changes that are much less remarked. One is the price of manufactured goods (such as clothing, footwear, furniture and floor coverings, vehicles, audio, visual and computing equipment) relative to the price of other goods and services.

The prices of manufactures have been falling relative to the prices of services around the world for many years. This is because productivity in manufacturing has improved faster than productivity in services and because more of the world's manufacturing is being done in developing countries where labour is cheap.

But in recent years that process has been accelerated in Australia by the appreciation of the dollar. So much so that the Australian retail prices of manufactured goods (many of which are imported) have not only been falling relative to the prices of other goods and services, but also falling in absolute terms.

Looking at the consumer price index over 2010, the prices of other goods and services rose by about 7 percentage points more than the prices of manufactured goods.

The next important change in relative prices is the price of "investment goods" (machinery and equipment) relative to the price of "output" (all goods and services produced in Australia). When the price of new machines is low relative to the price of the goods and services produced using those investment goods, investment in new machines tends to be high - which is just what we've seen over the past decade.

The relative price of investment goods tends to be cyclical, but there is also a clear downward trend over time. This secular decline is driven largely by technological improvements lowering the price of computing power. But, again, the decline over the past decade has been particularly large because of the high dollar (much machinery is imported).

The final key change in relative prices is the price of labour. For workers, what matters is their wage relative to the price of the goods and services they buy with that wage. Economists call this the "real consumption wage".

For firms, what matters is the wages they pay relative to the prices they get for the goods and services they produce and sell. This is the "real producer wage". Usually, these two relative wages should be pretty similar because the goods and services people buy are much the same as the goods firms produce.

In recent years, however, this correspondence has broken down because of the improvement in the terms of trade. By definition, Australian firms produce exports but not imports, but Australian consumers buy imports but not exports.

Since 2000, the economy-wide ("aggregate") real consumption wage has risen by about 25 per cent (great news for workers), whereas the aggregate real producer wage has risen by only about 10 per cent (good news for firms).

But these aggregate figures conceal big differences between industries.

In industries where productivity is improving quickly - such as manufacturing - the real producer wage tends to rise because competition passes the benefits of the higher productivity through to customers in the form of lower prices.

By contrast, in many service industries real producer wages have been pretty flat. And in mining the real producer wage has fallen significantly: although miners' wages have grown very strongly, the prices the mining companies have been getting for their coal and iron ore have risen infinitely faster.

See where this is leading? All the relative price changes we've discussed will be working to change the allocation of resources within the economy in the same direction: away from manufacturing (and other export or import-competing industries, such as tourism) and towards mining and those parts of the manufacturing and services sectors that hang off it.

Mining's share of total annual private and public sector investment spending has reached almost 20 per cent - roughly double its usual share - and may rise as high as

25 per cent before long.

However, the great bulk of the economy - the services sector, accounting for more than three-quarters of total employment - will be little affected.

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We are watching our pennies, at last

Not so long ago people used to scandalise over the rate at which we were racking up credit card debt. Not any more. These days a new frugality is gripping us and credit card and other personal debt is growing at a snail's pace.

Starting in the mid-1990s, our return to low inflation caused interest rates to fall sharply and oscillate around a much lower level - remember when the mortgage rate was up at 17 per cent? - and this coincided with the banks becoming much keener to lend to ordinary mortals.

They pushed their credit cards, offering reward schemes as a new incentive, and inventing home loans that allowed you to redraw without fuss money you had paid off the principal. Whereas for decades people had tried to pay off their mortgage as quickly as possible, now they were seizing the opportunity to add to it.

The great bulk of the borrowing was for housing - including investment housing - but we also borrowed enthusiastically for cars and other durables, as well as hitting the credit card. Over the year to June 2007, outstanding credit card debt grew by more than 11 per cent. Add in personal loans and total personal debt (excluding housing debt) grew by 19 per cent.

Over the year to this January, however, total personal debt grew by less than 2 per cent. And over the year to February, the average credit card debt rose by less than 1 per cent - way below the rate of inflation - and the number of new cash advances fell by almost 2 per cent.

So what has changed? Probably a couple of things. The first is that we've adjusted to life in a world of easily obtained credit. We've borrowed hugely in the competition to obtain a better home, pushing the price of housing to unknown heights. Housing has now become much less affordable and it has occurred to us that house prices can mark time or even fall as well as rise inexorably.

After an uncharacteristic period of allowing the proportion of our collective equity in our homes to decline, we've returned to our accustomed position of increasing our equity by keeping ahead of our repayment schedule wherever possible.

Similarly, we seem to have gained a little more self-control when it comes to wielding our credit cards.

A second factor may be the lingering effect of the global financial crisis. Many Australian households may well have realised they were carrying far too much debt, which would leave them vulnerable (or, if you prefer, vonnerable) should they ever lose their jobs. (This is certainly what's happening with a vengeance in the United States and Britain.) If so, many people would be trying to avoid new commitments and repay old ones.

Another suggestion is that it's particularly the baby boomers who have changed their behaviour. In 2008 they witnessed the sharemarket crash slash the value of retirement savings - with share prices still not fully recovered - and now they've realised they need to knuckle down and start saving while there is still time.

Whatever the reasons, the figures say that whereas in the early noughties households had "negative saving" - their consumption spending exceeded their incomes - now they are saving almost 10 per cent of their disposable incomes. That's the highest our rate of saving has been since the mid-1980s.

Saving and borrowing are closely linked, of course - roughly, opposite sides of the same coin. So it shouldn't surprise that much of the money we're saving is being used to reduce our debts. (Nor should it surprise that, while many people are reducing their credit card balance, others are adding to it, so that total debt is still rising fractionally.)

We save by limiting our consumption relative to our income, but much of our spending - on rent or mortgage interest, council rates and electricity, for instance - isn't particularly discretionary. Where we have most discretion is in our spending at discount and department stores and it's these stores (plus newspapers dependent on retail advertising) that are feeling the pinch of our new frugality.

What goes with department stores? Credit cards. Why do so many people have trouble with credit cards? Professor Joshua Gans, of the Melbourne Business School, says many poor consumer decisions have two dimensions: sophisticated versus naive, and disciplined versus undisciplined.Sophisticated consumers are adequately informed about the products they are purchasing and about the mental biases which, if unchecked, may influence their decisions. Disciplined consumers are able to overcome their own biases, even if they aren't always well informed.

Ian McAuley, of the University of Canberra, has applied this matrix to credit cards. A sophisticated and disciplined consumer uses a credit card in the interest-free period and pays it off before the monthly deadline. Sophisticated but undisciplined consumers use the credit card, intending to pay it off, but when the time to do so arrives they suffer the bias of short-sightedness and go into high-interest debt.

Naive and undisciplined consumers use the credit card, perhaps to the limit, without even considering the opportunity to pay it off in the interest-free period.

Naive but disciplined consumers may refuse to use a credit card at all.

I doubt we've become much more sophisticated, but we do seem to have become more disciplined. Certainly, the figures say more of us - about 65 per cent - are paying off our accounts in full each month.

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No one's trying to reduce government waste

Government waste is like the weather: everyone disapproves, but no one does anything about it. Oppositions accuse governments of creating it, but governments don't seem to try too hard to eliminate it.

And this doesn't seem to worry you and me too much because our main use for government waste is as an excuse to oppose every suggestion that we pay more tax - and, indeed, to resent the extortionate amount we pay already (always conveniently forgetting what we read time and again: that Australia's total tax burden is quite low compared with other advanced economies).

Were someone to magically eliminate all government waste, would we then be willing to pay more tax? Somehow, I doubt it.

This makes it likely we have an exaggerated view of the extent of waste. It suits us to believe waste is endemic. The sums we hear about seem huge - they are huge relative to our household budgets - but we're bad at putting them into the context of the billions of dollars our governments play with. We have no conception of how big Australia is when you add up its 8 million households and more than 1 million businesses.

That's my guess - that we have an exaggerated view of the extent of waste - but I can't prove it. I doubt if anyone has surveyed our impressions on the topic. Nor do we have any figures on the actual size of government waste, whether it's getting better or worse, or which side of politics has the worse record.

I guess no one's game to spend money measuring the extent of waste for fear of the talkback know-alls who'd say this was itself a waste of money.

And, of course, measuring waste wouldn't be nearly as easy as many of the sidewalk supervisors imagine. Waste is deceptively easy to allege, not so easy to prove and very hard to eliminate.

I've no doubt waste exists, and will always exist. There's plenty of waste in our own homes - the excess food we buy, the expensive gadgets we rarely use, the empty bedrooms, the kids who don't take advantage of the expensive educations we've provided, the holiday houses that are rarely occupied, the boats that rarely enter the water or leave their mooring - so why do we imagine governments could ever conduct their affairs without waste?

Because some degree of waste is inevitable it would nice to have some measure that allowed us to say whether its present level was excessive. And there are different types of waste. Often what the casual observer regards as waste merely reflects their lack of knowledge of all the circumstances.

Often there's a lot of subjective judgment involved. Is it wasteful to have bedrooms that are rarely occupied? Is it wasteful not to bother trying to rent out your holiday house when you're not using it? Or is it just the way you choose to enjoy your affluence?

At the government level, there's undoubted waste but there's also debatable waste. I may consider paying the family tax benefit to someone on your income a case of wasteful spending, but you probably disagree.

Tony Abbott and his colleagues are always accusing the Rudd-Gillard government of wasting money - as though waste was a recent invention - but when they're obliged to come up with their own list of spending cuts they're pretty light on. Too many possibilities that could cost votes.

It's no doubt a good thing oppositions carry on about waste - there'd probably more of it if they didn't. Even so, you don't get the feeling governments put much effort into hunting it down. They're always boasting about cracking down on petty welfare fraud, but not much else.

And when you consider how little publicity the media give to auditor-general certified waste, you get the feeling the public isn't all that worried about waste beyond using it to justify their objection to higher taxes.

One class of waste is ineffectiveness: government spending that doesn't achieve its stated objectives, or doesn't achieve them as well as some other program might. You'd think that, in this day and age, governments would put a lot of effort into assessing the effectiveness of their spending programs, but in this we lag well behind the Americans.

Perhaps because of the crowing they know the Opposition might do, ministers and their department heads have little enthusiasm for reviewing the effectiveness of their programs. They don't want the auditor-general poking his nose in and what evaluation occurs is usually pretty Mickey Mouse.

In the US, by contrast, it's common for Congress, when passing spending bills, to earmark a small proportion of the funds for program evaluation and to specify the rigorous methodology to be used. They've even got to the point where they're using randomised controlled trials. You have a treatment group and a (non-treatment) control group and you allocate participants between the groups by the toss of a coin.

Provided both groups are big enough, this approach makes it more likely the differences in outcomes between the two groups are the result of the treatment rather than extraneous factors.

Such an approach, which is widely used in medical trials, could be used to evaluate many - but not all - social spending programs.

And Dr Andrew Leigh, a federal Labor backbencher and former economics professor, has moved a private member's bill proposing we do just that. I'd like to see Abbott and the soon-to-be-elected O'Farrell government promising rigorous evaluation of spending programs. That would test their sincerity. And the Baillieu government in Victoria could get right in and do it now.

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