We may be two-speed, but we are all sharing dividends

Forgive my absence at such an anxious time but I've been away on holiday in Western Australia, walking bits of the Bibbulmun Track, which runs from Perth to Albany. The wildflowers were unbelievable. And so was the affluence in Perth, where the mining companies' skyscrapers are so tall they can be seen from Rottnest Island, 19 kilometres away.

How'd you like to be living in Perth, in the winners' circle where everything is on the up, not doing it tough in Sydney or Melbourne, on the wrong side of the two-speed economy?

Actually, things in Perth aren't as wonderful as it suits envious easterners to imagine. Know what they complain about in the West? The two-speed economy. Most of them think they're missing out. Some people may be raking it in, but not me. I'm not on some fabulous salary, just paying the exorbitant house prices the well-to-do have brought about.

Now where have I heard that before? What is it about Australians at present - on both sides of the continent - that makes them so convinced they're missing out and battling to get by?

According to polling by Labor, 68 per cent of respondents believe average Australians aren't benefiting from the mining boom. Is that how you feel? If so, you haven't thought about it. As someone said, there are more things in heaven and earth than are dreamt of in your philosophy.

After such a long plane trip, I was half expecting WA to be like another country. And it's true they have things we don't: magnificent tall trees - jarrah, karri and marri - and strange animals such as quokkas. But step into the bush and it's very much part of Australia: gum trees everywhere, kangaroos and kookaburras.

It's the same story economically. They may have huge reserves of natural gas and iron ore that we don't, but their economy is really just a corner of the greater Australian economy. As the locals are the first to tell you, a lot of the money they make soon finds its way into the pockets of people Over East.

For a start, there are no customs barriers between the states, so there's a lot of trade between them. Step into a WA supermarket and you see they're selling just the same stuff ours do. Which means most of what they're selling was manufactured on the east coast.

Their big mining companies have been making huge profits for the best part of a decade. Nothing to do with you? Every east-coaster with superannuation has a fair bit of their savings invested in the shares of those big companies. So you've been getting your cut.

Your super's been looking a bit sick in recent years? That's mainly because of problems in the rest of the world. Whatever you've got, it'd be looking a lot sicker without the resources boom.

Those mining companies are subject to the federal government's 30 per cent tax on company profits. And the feds' company tax collections have been massive since the resources boom started in the early noughties.

Do you realise that under Howard and Rudd we had cuts in income tax eight years in a row? Where do you think the money came from to finance those cuts?

In the economy, everything's connected to everything else. So if you're conscious of only the direct connections you're missing a lot of the story. And no connection is more indirect - or mysterious - than the way the governments of NSW and Victoria have been benefiting from the good fortune of the WA and Queensland governments.

This arises from our longstanding commitment to the principle of ''horizontal fiscal equalisation'' - which holds that all Australians, no matter where they live, are entitled to the same quality of government services.

That ain't easy, particularly because most government services - education, hospitals, law and order, roads - are delivered by the states. The cost per person of delivering services varies with how big and decentralised the states are. But another factor is the states' varying capacities to raise revenue. These days, states gaining royalty payments from their big mining industry have considerable ''taxable capacity''.

To bring horizontal fiscal equalisation about, the Commonwealth Grants Commission does many intricate calculations which determine how the $48 billion-a-year proceeds from the feds' goods and services tax are divided among the states. The commission works out the average amount of GST paid per person throughout Australia, then decides whether each state requires more or less than that, per person, to be able to deliver services of equal standard.

This equalisation process was introduced in the early 1930s to mollify the restive West Australians. Until just a few years ago, it meant Victoria and NSW got a lot less than the national average, while South Australia and Tasmania got a lot more than average and Queensland and WA got a bit more.

In 2004-05, NSW got just 83 per cent of the national average GST paid per person, while Victoria got 84 per cent. WA got 104 per cent and Queensland got 107 per cent (with SA getting 123 per cent and Tasmania 171 per cent).

But the huge increase in the resource states' taxable capacity thanks to booming mining royalties has changed all that. This financial year NSW's cut has risen to 96 per cent and Victoria's to 90 per cent, whereas Queensland's cut has fallen to 93 per cent and WA's to - get this - 72 per cent.

It works out that, in effect, Queensland's benefit from its mining royalties this year will be reduced by $1.2 billion and WA's by $2.5 billion. Of their combined loss of $3.7 billion, NSW gains $1.3 billion and Victoria $1.8 billion.

Still think you're getting nothing from the boom?

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Brave economist blows whistle on bosses' pay

You could be forgiven for not knowing it, but economists are meant to be tough on business. Their ideology holds that capitalism is good not because it's good for capitalists, but because it's good for consumers - and consumption is "the sole end and purpose of all production".

So said Adam Smith, who added that "the welfare of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer".

The economists' ideology holds that, when markets are working properly, most of the benefit flows to consumers in the form of lower prices and better service, with businesses making no more that "normal" profits (the lowest rate of profit needed to keep the firm's resources employed in its present industry).

Economists should also distinguish between the capitalists (the suppliers of capital - the shareholders) and the managers, who are supposed to be merely the agents of the shareholders who must at all times represent the true interests of the shareholders, never their own interests. Likewise, company directors are supposed to represent the shareholders' interests, not management's interests.

So economists are supposed to be pro-market, not pro-business and certainly not pro-management.

That's how it's supposed to be, but often not the way it is. In practice, economists who work for business aren't free to criticise it in public. The same goes for those who work for conservative governments (or Labor governments anxious to keep on side with business). And few academic economists take an interest in such mundane issues.

But another factor that helps explain the gap between principle and practice is that the economists' basic model recognises no role for collective action, including action by governments. So when things go wrong in markets, economists' first inclination is to defend the market and blame governments.

All this explains why economists have such a poor record in speaking out about excessive executive remuneration - as witness, the Productivity Commission's report on the subject of a few years back. That this is a case of market failure is as plain as a pikestaff, but the commission's economists searched under every rock without finding it.

One honourable exception to this glaring dereliction, however, is Diane Coyle, who tells it as it is in her latest book, The Economics of Enough. As her previous bestsellers attest, Dr Coyle - whose PhD is from Harvard - is a most orthodox economist.

Seeking to explain the origins of the explosion in executive pay, she attributes it to the deregulation of the financial markets in the US, Britain and elsewhere.

"Organised crime aside," she says, "the most ostentatious flaunting of wealth has emanated from the banking sector. As it turns out, these vast earnings and bonuses were undeserved. The bankers [in the US and Britain] ran up large losses, ruined their shareholders, and left taxpayers with the bill. It will be extraordinary if they turn out to have fooled, scared or bullied politicians around the world into stepping back from fundamental reform of the banking sector."

But the key point is the impact such high incomes in banking have had on the rest of society.

"The bonuses far in excess of salaries, and the spending on big houses, fast cars and designer clothes they funded, did create a climate of greed," she says.

"People in other professions who are in reality in the top 1 per cent or even 0.1 per cent of the income distribution were made to feel poor by the bankers.

"Banking bonus culture validated making a lot of money as a life and career goal. It made executives working in other jobs, including not only big corporations but the public sector too, believe that they deserved bonuses.

"Remuneration consultants, a small parasitic group providing a fig leaf justification for high salaries, helped ratchet up the pay and bonus levels throughout the economy.

"The whole merry-go-round of bonuses and performance-related pay is a sham. In almost every occupation and organisation it is almost impossible to identify the contribution made by any individual to profits and performance - complicated modern organisations all depend on teamwork and collective contributions."

So what can be done about it? In late 2009, the British government introduced a penal tax on bonuses above #25,000 in banking. The tax was criticised, not only by bankers but also by others who thought the measure impractical.

"But it was one of the few measures any government has so far taken that was absolutely right. The symbolism is vital even if by itself the measure doesn't bring to an end the corrosive culture of greed. Whatever the practical limitations on their actions, governments can still achieve a lot in symbolic terms, which should never be underestimated when it comes to impact."

And governments could do a lot more to change the social norms that helped destroy the Western financial system. For example, they could halt bonus payments in the public sector altogether, or introduce a general additional tax on non-fixed parts of people's pay packages.

"I am not opposed to people making more money if they studied hard or worked hard for it, or took the risk of setting up a successful new business - on the contrary, effort and entrepreneurship must be rewarded amply," Coyle says.

"Nevertheless, governments have to give a lead in restoring the sense of moral propriety and social connection between those people who are part of the extraordinarily wealthy global elite and the great majority of those with whom they share their own nation.

"Senior bankers should also contribute to this task of making greed and excess socially unacceptable once again." Amen to that.

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Understanding the Aussie dollar

Economic theory tells us the level of the exchange rate is an important factor in the health of the economy. Unfortunately, there's nothing in economic theory that can explain the Aussie dollar's strange behaviour in recent weeks. It's hard to know whether to cheer or boo.

We do know the Aussie has a strong and longstanding tendency to move in line with the prices we're getting for our commodity exports so, since during the past few years the prices of coal and iron ore have moved to record highs, it hasn't been surprising to see the Aussie rising to heights not seen since before it was floated in 1983.

It hit a peak of 110 US cents in early August, but seemed to settle at about 105 US cents. But in late September, during a bout of considerable anxiety on world markets about the state of the North Atlantic economies, it fell below parity, eventually getting down as low as 95 US cents.

But then this week it began going back up, reaching comfortably above parity, jumping 3 US cents in just 12 hours on Wednesday.

It's possible we've reverted to an earlier pattern where, when the global financial markets get particularly anxious about economic prospects, investors liquidate their short-term investments offshore and bring their money home to the safe haven of investment in government bonds. So the dollar appreciates (rises in value) and most other currencies depreciate (fall in value). Remarkably, this knee-jerk reaction can occur even when uncertainty about the fate of the economy is a major part of the anxiety.

That's step 1. Step 2 is for investors to calm down and start moving their money back overseas to destinations such as Australia in pursuit of higher returns than offered by bonds. If so, maybe that's what happened this week.

And if that's so, maybe step 2 has merely taken us back to square 1 - a dollar that settles well above parity. But who could be sure US cents Who knows what will happen the next time something really scary happens in Europe or the US cents Will the Aussie drop to, and stay at, a new level significantly below the 105 US cents it seemed to have settled at, or will it just go through a period of high volatility without actually changing its general level US cents

A point to note is that, though the media and markets' focus is always on our exchange rate with the greenback, economics teaches that what matters to the economy is our exchange rate with all our trading partners, not just the Americans.

Say you were taking a holiday in Britain. What would matter to you is our exchange rate with the pound. If you were going to Japan, it would be our exchange rate with the yen. In neither case would you regard our exchange rate against the greenback as particularly relevant.

It's the same story when Australian firms trade with Britain or Japan. Even if the price happens to be set in dollars - as it often is - the Aussie firm will translate that price into Aussie dollars, while the British or Japanese firm will translate it into their own currency.

Put the two together and what matters for the transaction is the Aussie-pound or Aussie-yen exchange rate. So we should be interested in our exchange rate with each of the countries with which we trade. And how much each bilateral exchange rate matters to us depends on how much trade we do with the particular country.

See where this is leading US cents The exchange rate that matters to the economy overall is the average exchange rate for all our trading partners, with each country's currency weighted according to its share of our two-way trade. Economists call this our ''effective'' exchange rate, which is represented by the trade-weighted index.

When you look at what's happened to our exchange rate against that index, you find the volatility in recent weeks is less. While we've depreciated against the greenback, we've appreciated against the euro and the Korean won.

There's always a lot of focus on what's happening to interest rates because we all know how important the rate of interest is to the strength of the economy. A rise in rates will slow economic growth by discouraging borrowing and spending; a fall in rates will hasten growth by encouraging borrowing and spending.

What's less well recognised is that the level of the exchange rate also affects the strength of the economy. So much so that the Reserve Bank brackets the two - interest rate and exchange rate - as ''monetary conditions''. When the exchange rate appreciates, this tends to slow the economy by reducing the price-competitiveness of exports and those domestically produced goods that compete against the now-cheaper imports in our domestic market.

It doesn't have much effect on domestic demand (our spending), but it does slow the growth of aggregate demand (our production - gross domestic product, in fact) by reducing exports and by diverting more of our spending into imports.

Conversely, when the exchange rate depreciates, this tends to speed the economy by improving the price-competitiveness of our export and import-competing industries. Domestic demand isn't much affected, but GDP improves because we export more, and more of our spending goes on domestically produced goods and services rather than imports.

This, of course, is why our manufacturers have been doing it tough under the high exchange rate. They've found it harder to export and to compete against imports. Though it's received far less public sympathy, our tourist industry has suffered in the same way, with fewer foreigners coming to Australia and more Aussies holidaying abroad rather than locally.

Our universities and other education exporters have been hit also.

So I'm quite sorry to see the dollar going back up this week after having fallen by up to 10 per cent from its heights. It would have been great to take a bit of the pressure off the manufacturers, tourist operators and education exporters.

The econocrats have a rule of thumb saying a sustained fall in the exchange rate of 10 per cent should lead to a rise in real GDP of about 0.75 percentage points over the following two years - say, 0.4 points in each year. (The rule also holds for a rise in the exchange rate causing slower GDP growth.)

So whereas a lasting fall in the Aussie might have been bad news for motorists (price of petrol) and people planning overseas trips, it would have helped make our multi-speed economy a little less uneven.

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Look within to pick up productivity

One of the tricks to success - in business, or in life - is to focus on the things that matter, not the things people (and hence, the media) are getting excited about this week. Of late we seem to be doing a lot of worrying about the wrong things.

For instance, our preference for bad news over good means we've been doing a lot of hand-wringing over the economic problems in Europe and the US. What's happening in China and the rest of developing Asia may be far less worrying - and hence, less interesting - but it's also far more important to the fate of our economy.

When we look at our economy, we give much more attention to the alleged two-speed economy - who's feeling hard done-by this week? - than to the truth that, with limited exceptions, the economy has been travelling well, is travelling well and is likely to continue travelling well.

As part of this, of late we've been devoting inordinate attention to the problems of the manufacturing sector (which accounts for 9 per cent of total employment), without any concern for the services sector (accounting for a mere 85 per cent of employment), even though two big service industries - tourism and education - have also been hard hit by the high dollar.

But even those of us happy to acknowledge how well our economy's travelling, thanks to high export prices and the mining construction boom, are less conscious of the sad truth that, underneath all that, the economy's productivity - output per unit of input - has stopped improving.

We're getting richer because the world is paying us a lot more for our exports and is engaged in a massive expansion of our mining industry, not because our businesses are getting more efficient at what they do.

That message is, however, getting through to big business and its various lobby groups. Only trouble is, in their search for a solution to the productivity problem they've been looking outside their firms, not inside. Perhaps if the government reformed the tax system, that would lift productivity. Or maybe going back to Work Choices would help.

It's possible that, while they come to our attention only when they're putting their oar into the public debate, most chief executives are busily engaged attending to their own, internal affairs. It's possible, but there doesn't seem much evidence of it.

That's why the most useful thing to come from last week's jobs forum in Canberra was the unveiling of a study on the leadership, culture and management practices of high-performing workplaces, sponsored by the Society for Knowledge Economics with funding from the federal government.

A team of academics from the University of NSW, the Australian National University, Macquarie University and the Copenhagen Business School examined 77 businesses in the services sector with more than 5600 employees. Most were medium size, and included law and accounting firms, advertising companies, consulting firms and employment agencies.

It's probably the most comprehensive study of workplace performance undertaken in Australia in the past 15 years. The performance of businesses was measured in six categories: profitability and productivity, innovation, employee emotions, fairness, leadership and customer orientation.

The study identified 12 high-performing workplaces and 13 low-performing workplaces, leaving most of the firms studied somewhere in the middle. So what are the characteristics of high-performing workplaces and how much better are they than the low-performing?

Well, not surprisingly, the best performers were more profitable and productive. According to the lead researcher, Dr Christina Boedker, high-performing workplaces are up to 12 per cent more productive and three times more profitable.

And it's not too surprising the best performers are better at innovation. They generate more new ideas and are better at capturing and assessing their employees' ideas. In consequence, they make more improvements to services and products, production processes, management structures and marketing methods.

But some treat-'em-mean-to-keep-'em-keen managers will be surprised that high-performing outfits do better on employee emotions. They have higher levels of job satisfaction, employee commitment and willingness to exert extra effort, and lower levels of anxiety, fear, depression and feelings of inadequacy. Part of the bottom-line consequence of this is lower rates of staff turnover.

The employees of high-performing firms tend to be more satisfied people, are being paid fairly and company policies are being implemented fairly.

High-performing firms rate better on customer experience. They try harder to understand customer needs, are better at acting on customer feedback and better at achieving their own goals for customer satisfaction.

But the study is particularly concerned with the performance and attitudes of managers, which business-types these days put under the heading of ''leadership''. In high-performing outfits, managers and supervisors devote more time to managing their people, have clear values and practise what they preach.

They welcome criticism as a learning opportunity. They foster involvement and co-operation among staff, give them opportunities to lead activities, encourage development and learning, give them recognition and acknowledgement and encourage them to think about problems in new ways.

The management practices that do best, according to the study, are being highly responsive to changes in customers' and suppliers' circumstances, encouraging high employee participation in decision-making, achieving on-the-job learning through mentoring and job rotation, making effective use of information and technology and attracting and retaining high quality people.

Of course, different managers have different cultures or styles. Some emphasise results, some their people and some coping with change. The study finds all three approaches can make a high-performance workplace. The one style that doesn't work is the ''control'' culture.

Wow. How'd you like to work for such a boss in such an enlightened business? Pity is, such firms accounted for only 15 per cent of the sample.

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Taxation reform is a cargo cult for business

When you look at the varied contributions to the public policy debate made by business people and their lobby groups, one attitude unites them: the politicians owe them a living.

Government, it seems, has one overwhelming responsibility: to make life easier for business. You see this in business people's views on "competitiveness". Economics has a lot to say about competitiveness, but not what business people imagine it says.

To them, competitiveness refers to the ability of Australian firms to compete in international markets against the enemy, firms from other countries. It's a zero-sum game, apparently: either we win and they lose, or they win and we lose.

Hence our government's obligation to improve our team's competitiveness by cutting the taxes Australian firms have to pay or by weakening the bargaining power of employees and so cutting our firms' labour costs.

What economics actually says is, first, trade is a positive-sum game: both countries win by exploiting the "gains from trade". Second, competitiveness isn't a gift governments confer on their businesses, it's a stricture they impose as the best way of ensuring firms aren't able to make excessive ("super normal") profits at the expense of the intended beneficiaries of competitiveness, Aussie consumers.

Most of the micro-economic reform project was aimed at increasing competitiveness by making life tougher for business: by reducing protection against competition from imports (the exports of our supposed enemies), by removing regulations that inhibited competition between local firms, and by beefing up prohibitions on anti-competitive practices.

We know micro reform failed to achieve a lasting increase in the rate of productivity improvement. Its lasting benefit has been to make the economy more flexible and resilient in response to economic shocks.

In particular, by increasing the intensity of competition in so many markets it has robbed many businesses of their former pricing power - including their ability to conclude sweetheart deals with their unions - and made our economy markedly less inflation-prone.

So much for the happy notion micro reform involves governments making life easier for business.

Further evidence of business's cargo-cult attitude to the role of government can be seen in its approach to tax reform. Business has an insatiable obsession with taxation. It wouldn't matter how much reform we'd achieved, its demands for more reform would be undiminished. That's because it's convinced the less tax it has to pay the easier its life will be.

There's a large element of self-delusion in this. Neither business people nor punters genuinely understand that, in the final analysis, companies - being inanimate objects - don't bear any tax burden. In the end, only humans pay tax - whether they're the owners, the managers, the employees or the customers of the company.

Just how the ultimate burden of all the various taxes companies pay is shared between those groups does matter, of course, but that's a complex empirical question with uncertain answers. And it's a safe bet all the sparring over company tax at last week's tax forum was motivated more by perceptions and appearances than empirical realities.

The key reform demanded at the forum, pushed hard by the Business Council, was for the rate of company tax to be cut from 30 to 25 per cent, with the cost to be covered by an increase in the GST.

Don't like the sound of that one? Neither did the union reps. But, cried the business people and the tax economists, didn't you know empirical studies show the ultimate "incidence" of company tax falls largely on labour? Since much the same is true of the GST, what rational reason could unions have to object to such a neutral rebalancing of the tax mix? But that question cuts both ways. If the ultimate incidence of company tax is borne by labour, why are company executives so desperately keen to get its rate reduced? (And how do the tax economists explain why such a shifting of the furniture would be so clearly beneficial for the economy overall?)

A point rarely mentioned is that the existence of dividend imputation means the local shareholders of companies have nothing to gain. For them, a lower company tax rate just means smaller franking credits. And that being the case, exactly why does big business imagine a lower company tax rate would be such a benefit? Perhaps because many, maybe most, of the chief executives who make up the Business Council actually represent the interests of foreign shareholders, who aren't subject to the imputation system.

For further evidence of business's cargo-cult mentality, consider what I call the "leadership theory of tax reform", so much in evidence at the forum. Consider the air of righteous disappointment exhibited by business leaders and commentators when Julia Gillard failed to meet the Business Council's demand that she commit to a 10-year program of tax reform.

Oh, if only the government would exhibit some Leadership, they cried. Come again? This government is already knee-deep in unfinished tax reform, all with no active support from business (the deeply divided Business Council) and much active opposition (the business coalition running TV ads against the carbon tax).

This is even though some businesses urged the reform on the government (we want certainty on the price of carbon) and many parts of business stand to gain from the mining tax (20 per cent of the desired cut in the company tax rate, concessions to small business and a one-third increase in the captive market compulsory super delivers to the financial services industry).

All the righteous calls for politicians to show Leadership on tax reform come without the slightest commitment that business will back up the leader when the going gets tough. Dream on, guys.

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Doomsday rate cut scenarios off mark

If the Reserve Bank ends up cutting the official interest rate by 0.25 percentage points on Melbourne Cup Day, it won't be because the economy has weakened so much as because it's not looking as strong - and thus, inflationary - as the Reserve had earlier expected.

The air is full of uncertainty and fear about the fate of the European and American economies, with one excitable pundit even predicting a ''world recession''. But, short of a major meltdown, the North Atlantic countries' troubles won't be a big part of the Reserve's reasons for fine-tuning the stance of its monetary (interest rate) policy.

No one knows what the future holds, and there's a ''non-trivial probability'', as the economists say, that the US economy will start contracting again and, more significantly, the problems in Greece will be so badly handled that the European economies implode.

Were that to happen, be in no doubt: the Reserve wouldn't just be lowering rates by one or two clicks, it would be slashing rates in much the way it did in the global financial crisis of 2008-09. But that's far from the authorities' ''central forecast''. They expect the US to grow by a bit under 2 per cent next year, while the euro area achieves no growth.

What would plunge Europe and the world back into crisis - with Europe entering a period of severe contraction - would be for Greece to leave the euro. That's because of the panic this would cause to euro depositors in many other member-countries.

It's likely the Europeans well understand what they need to do to avoid a conflagration: first, restructure the Greek government's debt (which means bond holders accepting big write-downs); second, recapitalise those European banks hard-hit by the write-down; third, have the European Central Bank purchase large quantities of European governments' bonds so as to lower bond yields and, hence, commercial interest rates.

So the Europeans' problem isn't knowing what to do, it's achieving the agreement of 17 squabbling member-countries to do it. The likeliest outcome is that they do enough to avert catastrophe, but not enough to prevent recurring episodes of financial-market jitters.

Our authorities' forecasts for 2012 aren't far from those the International Monetary Fund published last month. These have the US growing by 1.8 per cent and the euro area by 1.1 per cent. If so, that leaves the world economy growing by, what - 1.5 per cent? No, by 4 per cent - which is about the trend rate of growth. Huh?

What's missing from the sum is China's growth, expected to slow to a mere 9 per cent, and India's, to a paltry 7.5 per cent. Even Latin America is expected to grow by 4 per cent and sub-Saharan Africa by 5.8 per cent.

So much for a world recession.

Weakness in the North Atlantic doesn't equal weakness in Australia by a process of magic. You have to trace linkages between them and us. An important one is psychological: the effect of a sliding sharemarket, worrying news from the North Atlantic and over-excited talk of world recessions on the confidence of Australian consumers and business people.

As for ''real'' (tangible) linkages, these days the US and Europe aren't big export customers of ours. So the key question is the extent to which weakness in the North Atlantic leads to weakness in China, India and the rest of developing Asia.

These days, China is a lot less dependent on exports to the North Atlantic than it used to be. And the Chinese authorities have both the political imperative and the economic instruments needed to keep domestic demand growing fast enough to prevent much of a slowdown in production and employment growth.

So, barring a European implosion, the North Atlantic troubles' effect on us is likely to be limited mainly to their effect on confidence. If so, what are the domestic factors that could lead the Reserve to lower interest rates a little?

In May the Reserve was forecasting growth in 2011 of 4.25 per cent. In August it cut that to 3.25 per cent. Today it would probably say 3 per cent.

But get this: the overwhelming reason for these revisions is the temporary effect of the Queensland floods, in particular the loss of output from coalmines that are taking far longer than expected to resume production.

There have been various highly publicised areas of weakness in the domestic economy - the troubles our manufacturers are having coping with a high exchange rate, very weak department store sales and weak housing starts - but overall (and excluding extreme weather events), there's little sign of weakness.

Despite the much-publicised fall in

consumer confidence, consumer spending grew by 3.2 per cent over the year to June, bang on trend. Business investment has been strong and is sure to get stronger. And earlier figures showed worsening inflation and worryingly strong growth in labour costs per unit of production.

Indicators released this week show strong growth in exports and strengthening retail sales, home building approvals and non-residential building approvals.

The strongest evidence of weakening is in the labour market, with employment growth clearly slowing from its earlier fast past, and the unemployment rate jumping 0.4 percentage points to 5.3 per cent in just two months.

But this is a puzzle because, though growth in employment is weak, growth in hours worked isn't. And though surveyed unemployment is supposed to have jumped, the number of people on the dole is steady.

So how does the Reserve come to be contemplating lowering the official interest rate a little? Because its job is to keep interest rates at a level sufficient to keep inflation travelling within its 2 to 3 per cent target range, and the outlook for inflation has become less threatening.

For a start, the Bureau of Statistics has revised the underlying inflation rate over the year to June from 2.75 per cent to 2.5 per cent. Second, the outlook for economic growth isn't quite as strong as it had been. And third, the atmospherics of the labour market have improved, with more consumers worried about losing their jobs and employers less worried about the emergence of excessive wage demands.

The present stance of monetary policy is ''mildly restrictive''. But if the risk of inflation rising above the target range is now much reduced, the stance of policy should be returned to neutral. That would require a fall in the official rate of just one click - two at most.

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Tax cut buffet but no appetite for fixes

Seen anything on the tax reform smorgasbord you fancy? How about cuts in the top two rates of income tax? How about abolition of conveyancing duty? Or maybe an end to stamp duty on insurance policies?

For business people there's a special range of goodies on display: a cut in the company tax rate to 25 per cent, special tax breaks for mining and construction companies that use Australian steel, abolition of payroll tax. Or maybe cuts in company tax that are limited to small businesses.

Don't see anything that particularly appeals? That's OK, why not concoct your own, custom-built concession? It's a bit late, but why not email it in as a submission to the tax forum? Be sure to say it will do wonders for the economy - which is why you're proposing it, naturally. I'm sure it will get as much consideration as all the other submissions.

Sorry, but the tax forum reminds me of nothing so much as a bunch of kiddies lining up to sit on Santa's knee and whisper into his ear what they'd like for Christmas. Dream on, kids. The harsh truth is that neither the federal nor the state governments are in any position to simply cut this tax or that. They're all struggling to get their budgets back to surplus.

So one of the ground rules Wayne Swan laid down was that all proposals for tax reform had to be "revenue neutral" - if you cut one tax you have to increase another by the same amount. You'd like to pay less income tax? No probs - we'll just increase the rate of the GST to cover it. Or maybe we could increase the rate and remove the exemptions for food, education and health care. That would make the GST a far more robust revenue-raiser.

Increase GST revenue far enough and we could also afford to abolish the payroll tax business keeps whingeing about. As for conveyancing duty, the ideal way to finance its abolition would be to broaden annual land tax to cover owner-occupied homes. Someone has suggested local government could be paid a fee to collect it along with council rates.

Kind of takes the fun out of tax reform, doesn't it?

Of course, were governments to get serious about reform there are a lot of other worthy but nasty things they could do. Bite the bullet and get rid of negative gearing, for instance. Stop family trusts being such a tax lurk. Crack down on the abuse of work-related deductions (especially by doctors and lawyers jetting off to conferences at exotic resorts).

Then there's superannuation. It's always been taxed heavily in favour of high income-earners, but Peter Costello's decision to make all private pension income tax-free to people 60 and over was the ultimate in favouring wrinklies over workers.

I should tell you the latest fashion among tax-reform aficionados is for income (particularly high incomes) and capital (particularly companies and capital gains) to be taxed more lightly, with consumption and real estate taxed more heavily.

This is because financial capital and high income earners are more mobile internationally - more capable of moving to countries where they're taxed more lightly - whereas wage-slaves and consumers are far less mobile and real estate is utterly immobile.

So, in an era of growing tax competition between countries, you tax those who can't escape more heavily and those who can escape less heavily. That this means the well-off pay less tax while the middle class and the workers pay more is purely coincidental, I assure you.

If you're detecting a touch of cynicism in my reaction to all this, you're not wrong. Economists, business people and professional lobbyists would happily meet in Parliament House once a month to preach to each other about the need for tax reform.

But if ever there was a country that runs a mile at the hint of tax reform, we're it. Most of the rest of the developed world introduced a GST in the 1960s and '70s, but we trembled on the brink for 25 years before taking the plunge in 2000.

The way tax reform works in Australia is that whenever governments are persuaded to introduce some major reform, the opposition automatically opposes it and starts a hugely successful scare campaign, urged on by every adversely affected interest group, the shock jocks and any other media outlets looking for cheap cheers.

Meanwhile, the people who'd benefit from the reform - even those who pressed the government to take it on - fall silent or, like the Business Council, get cold feet and run around saying the time is not yet ripe. All the academic urgers peel off the moment the government introduces a less-than-pure element to its scheme.

The obvious truth is Julia Gillard would need her head examined to take on more tax reform at present. Her plate is already over-full. You'd never know it from all the chat this week, but we're already engaged in two vitally important tax reforms: the carbon tax and the mining tax. The first is complicated but minor in its effect on household budgets; the second is a no-brainer.

Yet Tony Abbott has been hugely successful in his dishonest scaremongering against both taxes. He is campaigning against all tax reform, promising to reverse both measures and pretending taxes only ever need to be cut. Are the Liberal-leaning reform advocates doing anything to set him straight? Hell no - that's Julia's lookout. And the polls say the man with the neanderthal views on tax reform will be swept into office at the first opportunity.

When it comes to tax reform, Australians are utterly lily-livered.

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Two minds make us all muddled thinkers

Conventional economics got set in its ways long before neuroscientists discovered something that helps explain why the decisions consumers and business people make are often far from rational: our brains have two different, and sometimes competing, systems for deciding things.

Psychologists call it system one and system two thinking. System one is our intuitive system of processing information. It's fast, automatic, effortless, implicit and emotional. It's controlled by the earlier, more primitive part of our brain. It's highly efficient and is thus the most appropriate tool for the majority of mundane decisions we make every day.

By contrast, system two thinking is slower, conscious, effortful, explicit and more logical. It's controlled by the more recent, frontal part of our brain. When we weigh the costs and benefits of alternative courses of action in a systematic and organised manner, we're engaged in system two thinking.

In the hands of scholars who study behavioural ethics - such as Max Bazerman and Ann Tenbrunsel, the authors of Blind Spots - system one is seen as our "want-self" and system two as our "should-self". Almost all of us regard ourselves as ethical. Before decisions arise our should-selves think "I should behave ethically, therefore I will".

When we're looking back on decisions, our should-selves think: "I should have behaved ethically, therefore I did." Trouble is, when the decision is actually being made, our want-selves take over and we often do things that ignore the ethical implications of our actions.

The task for behavioural ethicists, therefore, is to help us find strategies that allow our should-selves to dominate our want-selves. In another context, psychologists say we have different systems for wanting things and liking things. So some of the stuff we really want, and spend a lot of time pursuing, doesn't give us as much satisfaction as we thought it would once we've got it.

This explains why children will spend weeks nagging parents to buy them a guitar or a pet but quickly lose interest once they have it.

It also explains a lot of futile adult behaviour. I suspect our two thinking systems explain the paradox of advertising. I'm not influenced by all the advertising I see, but a lot of people are. Do you think that, too? Trouble is, most people think it.

If it's true, just who are the dummies that fall for advertising? And how come so many businesses spend millions on advertising, convinced it's money well spent?

I think all of us are more susceptible to advertising than we realise. Most advertising is designed to appeal to our emotions and instincts, not our intellect. In other words, it's aimed at our unconscious, system one decision-maker and we're not conscious of the way it affects the choices we make. Meanwhile, our conscious, reasoning system two brain is unimpressed by the illogical connections we see in ads.

I'm sure they're not all Robinson Crusoe, but economists often show signs of having two-track minds. They believe certain things intellectually, but these beliefs don't seem to have the effect on their behaviour that you'd expect.

For instance, when you criticise their model for its absurd assumption that people are always rational - carefully calculating and self-interested - they'll tell you they don't actually believe people are rational; that's just a convenient assumption needed to get the model going.

But then they'll argue vigorously for propositions that come from the model, oblivious to the way those propositions rest on the assumption that people are indeed rational in all they decide.

Or, take the exaltation of gross domestic product. When you argue that GDP is a poor measure of national well-being and point out its various limitations, economists will agree. But that won't stop them continuing to treat GDP is though it's the one thing that matters.

One of the most ubiquitous problems in daily life - and thus in the economy - is one the economists' model assumes away: achieving self-control. We need to control our natural urges to eat too much, to smoke, to drink too much, to gamble too much, spend too much, watch too much television, get too little exercise and even to work too much.

Here, again, we seem to have two selves at work: an unconscious self that's emotional and shortsighted and a conscious self that's reasoning and farsighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain.

When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you'd got off your backside and played a bit of sport, sought a further qualification at tech, studied harder for exams, spent more time talking to your children, etc - are not so clear-cut.

Similarly, the reward from eating food is instant whereas the costs of overeating are uncertain and far off: being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger, etc.

As everyone who has tried to diet, give up smoking, control their drinking, save or get on top of their credit card debt knows, it's hard to achieve the self-control our conscious, future-selves want us to achieve.

People have developed many strategies to help their future-selves gain control over their immediate-selves, including pre-commitment devices - similar to those proposed by the Productivity Commission to assist problem gamblers.

Economics will become a more useful discipline when its practitioners catch up with developments in neuroscience and offer us solutions to common behaviour problems it now assumes away.

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You're not as ethical as you think

Another long weekend, another personal question: how honest are you? According to the people who study these things, not as much as you think you are.

In an experiment in which people were asked to solve puzzles and were paid a set amount for each puzzle they solved, some participants were told to check their answers against an answer sheet, count the number of questions answered correctly, put their answer form through a shredder, report the number of questions they got right to the experimenter and receive the money they had earned.

A second group wasn't allowed to shred their answers before reporting how many they got right. Those whose claims about how many they got right couldn't be checked claimed to have got significantly more correct than the second group.

Those who cheated probably counted a problem they would have answered correctly if only they hadn't made a careless mistake. Or they counted a problem they would have got right if only they'd had another 10 seconds.

In other words, they didn't tell blatant lies, they just gave themselves the benefit of any doubt, bent the rules a little bit in their own favour. And get this: they wouldn't have thought they were cheating.

When subjects are asked to rate how ethical they are compared with other people on a scale of 0-100, where 50 is average, the average rating is usually about 75. That is, almost all of us consider ourselves to be more ethical than other people.

Clearly, that's not possible. In their book, Blind Spots, Max Bazerman, a professor of business administration at Harvard Business School, and Ann Tenbrunsel, a professor of business ethics at the University of Notre Dame, say most of us behave ethically most of the time.

Even so, most of us overestimate our ethicality relative to others. We're unaware of the gap between how ethical we think we are and how ethical we actually are. We suffer from blind spots.

Bazerman and Tenbrunsel are exponents of the emerging field of ''behavioural ethics'' - the study of how people actually behave when confronted with ethical dilemmas. They say our ethical behaviour is often inconsistent and, at times, even hypocritical.

''People have the innate ability to maintain a belief while acting contrary to it,'' they say. ''Moral hypocrisy occurs when individuals' evaluations of their own moral transgressions differ substantially from their evaluations of the same transgressions committed by others.''

Hypocrisy is part of the human condition; we're all guilty of it. So you could say accusing someone else of being hypocritical is itself a hypocritical act.

Some people are consciously, deliberately unethical. But Bazerman and Tenbrunsel stress their interest is in unintentional ethical misbehaviour. How can we behave unethically and not realise it?

We suffer from ''bounded ethicality'' because we suffer from ''bounded awareness'' - the common tendency to exclude important and relevant information from our decisions by placing arbitrary and dysfunctional boundaries around our definition of a problem.

One way we limit our awareness is by making decisions on the basis of the information that's immediately available to us - maybe that someone has presented to us - rather than asking what information would be relevant to making the best decision, including other aspects of the situation and other people affected by it.

An organisation's ethical gap is more than just the sum of the ethical gaps of its individual employees, the authors say. Group work, the building block of organisations, creates additional ethical gaps.

Goupthink - the tendency for cohesive groups to avoid a realistic appraisal of alternative courses of action in favour of unanimity - can prevent groups from challenging questionable decisions.

And functional boundaries can prevent individuals from viewing a problem as an ethical one. Organisations often allocate different aspects of a decision to different parts of the organisation.

''As a result, the typical ethical dilemma tends to be viewed as an engineering, marketing or financial problem, even when the ethical relevance is obvious to other groups,'' the authors say. So everyone can avoid coming to grips with the ethical issue by assuming someone else is dealing with it.

Now consider this. You're a 55-year-old and have just been diagnosed with early-stage cancer. You consult a surgeon, who wants to operate to try to remove the cancer. You consult a radiologist who recommends blasting the cancer with radiation. You consult a homeopathic doctor who believes you should use less intrusive medicine and wait to see how the cancer develops.

Many of us would assume each specialist is lying so as to drum up business. But it's actually more complicated. Each person genuinely believes their treatment to be superior, but they fail to recognise their beliefs are biased in a self-serving manner.

They don't realise their training, incentives and preferences prevent them from offering objective advice. They just don't realise they're facing an ethical dilemma. They don't see they face a conflict of interest because they view conflicts of interest as problems of intentional corruption.

Bounded ethicality occurs because our cognitive limitations - the limitations of the way our brains work - leave us unaware of the moral implications of our decisions. Aspects of everyday work life - including goals, rewards, compliance systems and informal pressures - contribute to ''ethical fading,'' a process by which ethical dimensions are eliminated from a decision.

It's common for decisions at work to be classified as a ''business decision'' rather than an ''ethical decision,'' thus increasing the likelihood we will behave unethically.

Sometimes differences in language allow ethical fading. Albert Speer, one of Hitler's ministers and trusted advisers, admitted after the war that by labelling himself an ''administrator'' of Hitler's plan he convinced himself that issues relating to the treatment of people were not part of his job.

Why does the way we classify decisions matter? Because classification often affects the decisions that follow. When we fail to recognise a decision as an ethical one, whether due to our own cognitive limitations or because external forces cause ethical fading, this failure could well affect how we analyse the decision and steer us towards unintended, unethical behaviour.

Why do we predict we will behave one way and then behave another way, over and over throughout our lives? General principles and attitudes drive our predictions; we see the forest but not the trees. As the situation approaches, however, we begin to see the trees and the forest disappears.

Our behaviour is driven by details, not abstract principles.

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Pinned down by fear of possibilities, not outcomes

It's not something economists emphasise. Indeed, they prefer not to think about it because it reminds them of the limits of their so-called science. But the peregrinations of the economy are as much about psychology - moods and feelings - as tangible economic forces.

When you view the economy from outside, what you see is might and power.

Big corporations with towering offices, branches in every suburb, huge factories, gleaming shopping complexes, thousands of employees, annual turnover of hundreds of millions of dollars.

Then you have the big governments supposedly running the show. The federal government spending a budget of $360 billion a year.

The Reserve Bank moving interest rates up, or down, at will. The total value of all the goods and services Australia produces in a year is $1.4 trillion.

And against all that is me or you. No wonder we feel like pawns in a huge game, pushed this way and that by forces beyond our control.

But, last week, a student reminded me how bizarre it is that the world economy is built on something as nebulous as ''confidence''.

We may be as insignificant as ants, but when enough of us push in the same direction, we can make the global economy tremble. Take banks. They accept deposits from people who are free to withdraw their money at will, but then they lend that money to someone for 25 years.

So were it not for government protections, a run of depositors demanding their money back could bring the mightiest bank crashing down. When people see a queue forming outside a bank, all their instincts tell them to join it.

Take the sharemarket. If people are keener to sell a company's shares than to buy them at any moment, down comes the price - and, if it's one of our big companies, the retirement savings of people across the land take a dip.

If a company's shares fall, or if shares fall generally, the chances increase that the next move will be down rather than back up.

Take consumer confidence. When the economy looks like it's slowing and people worry about the possibility of losing their job, they postpone taking on new commitments and cut their spending on inessentials, just to be on the safe side. If enough people think and act that way, their fears become self-fulfilling and a self-reinforcing cycle develops.

Their reduced spending causes businesses to lay off staff, news of this causes others to become more precautious, and this, and the greatly reduced spending of the jobless, prompts another round of job losses and belt-tightening.

Our being social animals - our moods and actions are heavily influenced by the moods and actions of the people around us - means these swings easily develop momentum.

They work in both directions, of course. When we're confident, we spend, move to bigger or better homes and push up share prices with gay abandon.

When things are on the up, we can't imagine they'll ever stop rising; when things are heading down, we can't imagine they'll ever stop falling.

These swings in consumer confidence are matched by swings in business confidence. Business people take their lead from consumers, but they're just as susceptible to the mood swings of their own class.

The availability of credit amplifies these swings.

Households and businesses borrow heavily to take advantage of the good times, get ahead of rising property prices and keep the party going. On the way down, their high levels of debt add to their fears, caution and cuts.

So the economy is driven by alternating waves of excessive optimism and excessive pessimism.

At all times it looks terribly tangible, huge and inscrutable. But the booms and slumps are being driven by the nebulous moods and feelings of the human animal. Note, it doesn't matter whether the fears that set off these chains of adverse developments - runs on banks, falls in share prices, loss of consumer confidence - are well-founded or ill-founded.

Their consequences are real, regardless of their origins.

Adding to the insecurity and uncertainty - especially at times like these - is one of the hallmarks of the human animal, our insatiable curiosity.

We always want to know what's happening, why it's happening, how the world works and what the future holds.

The economies of Europe have serious debt problems. They've been grappling with those problems for months without resolving them.

We have no idea how well or badly this episode will end, nor even when. But every other week the world's financial markets suffer another bout of nerves and drop share prices further.

This increases the pressure on Europe's politicians to find a solution, but probably also increases the likelihood of disaster.

Every time our shares take another dive, the saga moves to the media's centre stage and they attempt, yet again, to explain its complexities and ask more experts to predict how things will turn out.

Our crazy, unceasing urge to ask people who can't know to speculate about what the future holds arises from what psychologists call our ''illusion of control'' - our tendency to overestimate our ability to control events.

We want to know all about the events in Europe and elsewhere and how they will affect us because ''forewarned is forearmed'', and just in case there is something we can do to protect ourselves.

In truth, however, the main thing we are doing is putting the wind up ourselves long before it is possible to know what will happen and how seriously it will affect us in Australia.

My guess is, what will hurt us most is our fear of the possibilities, not the ultimate events.

The trouble with moods and feelings is their ability to influence hard economic facts.

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Memo bosses: happier staff work better

In the quest to lift the flagging productivity of labour, we can go back to old, failed ideas or move on to new ones. Last week Peter Reith came out of retirement to urge the Liberals to get tough with workers and reopen class warfare.

Want to get more out of your workers, make them work at unsociable hours for normal hourly rates, keep wage rises tiny or simply whittle away at their conditions? Re-introduce statutory individual contracts and split workers off from their union so they lose all bargaining power.

Does this mean you spend most of the year negotiating one-on-one with your employees because Mary wants to leave early on Mondays, Jenny and Julie want to job-share and Bill wants time off to do a tech course?

Hell, no. That's just the advertising. In reality you get your lawyer to cook up a single contract document that runs all your way and tell each of your employees to feel free to leave if they don't want to sign.

It's a good way to minimise wage costs if you don't mind having a surly, resentful staff, if they're supervised tightly enough for you to be confident they won't be able to find ways to get back at you, if they're mainly unskilled and if unemployment is high.

But if their work is skilled, if you need them to accept a high degree of responsibility with limited supervision, if there are shortages of skilled labour and rival employers are on the poach, it's a great way to damage a good business.

I'm sure there are second-rate business people urging the Libs to restore their former ability to screw their workers with impunity, but I hardly think it's the way to a brighter, more productive future.

The first stage of employer enlightenment comes when they seek to improve employees' performance with monetary incentives: merit increases to selected workers, bonuses or other forms of performance pay.

This approach makes sense to model-bound economists and money-minded executives, but industrial psychologists know it often backfires. Workers do care about pay, but they care less about the absolute level of their pay than about its relative level - that is, what they're getting compared with others are getting, particularly those they consider their equals. In other words, play favourites with pay and you're just as likely to create dissatisfaction as satisfaction.

The other thing to remember (which many economists and business people don't) is that when you establish a culture that good performance is rewarded with money, you tend to demotivate people from performing well for other, more intrinsic reasons. You debase the currency, so to speak.

What never occurs to second-rate managers - the sort of managers who run to politicians for legal solutions to their inadequate relationships with their workers; the sort who never reach the ultimate stage of human-relations enlightenment - is that most workers want to work in an environment in which they can trust their bosses and be trusted by them, where they can give and receive loyalty.

Why wouldn't you want to work in such an environment? Recent research by two Canadian economists, John Helliwell, of the University of British Columbia, and Haifang Huang, of the University of Alberta, shows that life satisfaction - happiness - is significantly higher among workers who work where they rank management trustworthiness highly.

For example, the roughly one quarter of surveyed workers who rated trust in management at nine or 10 on a 10-point scale also rated their satisfaction with life at 8.3 on a 10-point scale, compared with an average of 7.5 for the quarter or more who rated trust in management at five or below.

And, get this: for the whole sample of workers, a change in trust in management of just 0.7 points had the same effect on life satisfaction as a 31 per cent change in income. But why should a hard-headed manager care about the happiness of the people working for them?

Well, one reason is that, unless managers are money-hungry to a quite inhuman extent, they themselves would get more satisfaction being the boss of an outfit where everyone gets on and pulls together.

Even a manager should see there is more to life than money (and, please, spare me the sermon about how corporation law requires you to maximise profits for the shareholders). But, if that's not a good enough argument for you, try this: longitudinal research finds that happier people tend to be more successful in all dimensions of their lives - their incomes, their careers, their health and their relationships.

It's not hard to believe successful people are happier, but this is saying the reverse: being of a happier disposition tends to make people more successful. More specifically, happy workers make more money, receive more promotions and better supervisor ratings, and are better citizens at work.

So, if employers want to offer a satisfaction-inducing working environment, what must they do? The British psychologist Peter Warr has identified five factors as important to job satisfaction. First, opportunities for personal control. This means having some discretion - autonomy - in how to tackle problems, apply skills and envisage outcomes.

Second, jobs with a variety of tasks. Many jobs are naturally varied but highly repetitive jobs are soul-destroying. When workers work in teams, roles can be shared.

Third, good supervisors provide a balance of freedom and supervision. The ideal ratio of positive to negative feedback is about six to one.

Fourth, jobs that afford people respect and status are likely to engender feelings of competence and pride. In the best organisations, the respect that is inherent in some high-status jobs can be extended to all jobs.

Finally, have clear requirements and information on how to meet the requirements.

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Retail despair as consumers spurn goods for services

There's a bumper sticker that says: if you think money doesn't buy happiness, you don't know where to shop. It's just a joke. But there's actually a bit of science in it. Research by psychologists says buying stuff doesn't bring us as much satisfaction as buying experiences - such as a holiday or even a restaurant meal.

Experiences are more satisfying than goods because they leave us with memories to think over (which we often enhance by forgetting the bad or boring bits) and give us something to talk about with our friends. And, after all, what are we but the sum of our experiences?

Experiences are services rather than goods and it's possible Australians are taking the psychologists' findings to heart because, as Dr Philip Lowe of the Reserve Bank pointed out in a speech to the Australian Economic Forum this week, consumers have been switching their spending towards services and away from goods.

The Bureau of Statistics' household expenditure survey shows that, over the quarter century since 1984, the proportion of household spending devoted to food felLby more than 3 percentage points to just 16.5 per cent.

The proportion devoted to clothing, footwear, household furniture and appliances fell from about 14 per cent to just over 8 per cent. Similarly, the share going to spending on alcohol and tobacco dropped by almost 1.5 percentage points to less than 4 per cent.

Over that period we're also spending smaller proportions of our budgets on cars and petrol and - get this - fuel and power, the latter of which now accounts for less than 3 per cent of the average household's budget.

But if we're devoting smaller shares to all those things, what things are getting bigger shares? Top of the list is housing, which is up from less than 13 per cent to 18 per cent. That includes people who are renting as well as people with mortgages and people who've paid off their mortgages.

We're also devoting higher proportions to spending on healthcare, education, household services (including childcare, cleaning, lawn mowing and gardening) and recreation (including audiovisual equipment, toys, sporting goods, pets and holidays).

As you see clearly from all that, we're devoting less of the consumer dollar to goods and more to services. While our politicians are giving speeches about the need for Australia to ''make things,'' we're busy making it a place that ''does things''.

This trend's been running for many moons but why? Long story. The first thing to remember is that just because we're devoting a smaller share of our budgets to food, clothing and footwear doesn't mean we're starving ourselves and running round barefoot and naked. It's not that we're spending any less on goods, it's that our spending on services has been growing faster than our spending on goods, thereby reducing goods' proportion of the total.

Part of the reason services' share is up is that the prices of services are rising faster than the prices of goods. That's because it's easier to increase the productivity of labour in the production of goods. People keep inventing ever-better labour-saving equipment, which allows the prices of manufactured goods to stay fairly stable or, in some cases, actually fall.

Many of the manufactured goods we buy are imported and the prices of imported manufactures are being kept low by various factors over the years: by increased competition from China and other Asian developing countries putting downward pressure on the world prices of many manufactures, by the phasing down of protection for domestic producers of clothing, footwear and cars, and lately by the higher dollar.

In marked contrast, services tend to be more labour-intensive, with less scope for better machines to increase the productivity of labour. Even so, real wage rates in the services sector tend to keep pace with the improvement in economy-wide productivity (most of which comes from the other sectors).

But though it's true we're spending more on services because their prices are rising faster, it's also true the quantity of services we're buying is rising faster than the quantity of goods we're buying. As real household income increases over time we have to spend the extra income on something, but there's a limit to how much more we can eat, how many clothes we can wear and cars and fridges we can use. By contrast, we're well short of the limit on the things we'd like to pay other people to do for us as we get more able to afford it. Enterprising businesses keep thinking of new things to do for people.

A ''superior good'' is one to which we devote a higher proportion of our spending as our income grows. And most superior goods are, in fact, services. Healthcare and education are superior goods, as is recreation and ''meals out'', as the bureau calls them.

But the glaring case in recent times is housing. Its share of our budgets has risen by more than 5 percentage points, with most of that occurring in the past decade. The reason is not higher mortgage interest rates - they go up and down - but higher house prices and bigger mortgages, thus leading to higher interest payments.

As an individual, you may think you had little choice but to pay the higher house prices. But what's true for the individual isn't true for the whole. House prices have risen so much because all of us bid them up in our (largely futile) efforts to use our higher disposable incomes to buy better housing.

That explains the long-term trend towards services and away from goods. But, as Lowe pointed out, over just the past year, the trend's become supercharged. According to the national accounts, real consumer spending over the year to June rose by 1.75 per cent for goods, but about 4 per cent for services.

Consumer spending on education services was up by 5 per cent, on hotels, cafes and restaurants by more than 6 per cent, on recreation and culture by 7 per cent, and on ''transportation services'' by 16 per cent. This last is mainly people taking cheap overseas holidays. (Other research shows that even people on lower incomes are spending more on holidays.)

So now you know why the retailers - who sell goods, not services - are doing it so tough but, despite widespread misapprehension, overall consumer spending is growing fine.

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Sydney too must go up to go green

As a denizen of the inner city, I love getting away to the countryside. Away from the tar and cement and exhaust fumes to the trees and grass and clean air. In the country or on the coast you feel closer to nature, leading a simpler, cleaner life, doing less damage to the environment. I always feel that, being more natural, trees and grass are good for the spirit.

So it comes as a bit of a shock to read in Triumph of the City, the latest book by America's leading urban economist, Professor Edward Glaeser, of Harvard, that cities are a lot greener than the suburbs and countryside.

''Cities are much better for the environment than leafy living,'' Glaeser says. ''Residing in a forest might seem to be a good way of showing one's love of nature, but living in a concrete jungle is actually far more ecologically friendly.

''We humans are a destructive species, even when ? we're not trying to be. We burn forests and oil and inevitably hurt the landscape that surrounds us. If you love nature, stay away from it.''

We could minimise our damage to the environment by clustering together in high-rises and walking to work, he says. We maximise our damage when we insist on living surrounded by greensward. Lower densities inevitably mean more travel, and that requires energy. While larger living spaces certainly have their advantages, large suburban homes also consume much more energy.

Anyone who believes global warming is a real danger should see dense urban living as part of the solution. Over the next 50 years, China and India will cease to be poor rural nations, and that's a good thing. They, like the West before them, will move from farms to urban living.

''If billions of Chinese and Indians insist on leafy suburbs and the large homes and cars those suburbs entail, then the world's carbon emissions will soar ? The critical question is whether, as Asia develops, it will become a continent of suburban drivers or urban-transit users.''

Historically, the wealthy managed to combine city and country living by having two homes. Winter months were spent in the city, while hot summers were spent on the country estate.

Less expensive solutions were to surround towns and cities with a green belt. Failing that, big city parks were established. But the emergence of faster, cheaper transportation made it possible to live with trees and work in the city.

Homes and cars account for about 40 per cent of the average American household's emissions of carbon dioxide, half of which is attributable to cars. People could buy more fuel-efficient cars, but the big difference is whether you drive 500 kilometres a year or 50,000, which depends on whether you live in a city or a suburb. Cities are also greener than suburbs because city households use less electricity.

''Smart environmentalism requires thinking through the inadvertent side-effects of different environmental policies and recognising those that actually do more harm than good,'' Glaeser says. The conservationists who keep the San Francisco Bay area free from new construction are preventing development in the greenest part of America. They are consequently increasing development in America's browner areas, such as baking-hot, air-conditioned Texas.

''In older cities like New York, NIMBYism hides under the cover of preservationism, perverting the worthy cause of preserving the most beautiful reminders of our past into an attempt to freeze vast neighbourhoods filled with undistinguished architecture.

''In highly attractive cities, the worst aspects of this opposition to change are that it ensures that building heights will be low, new homes will be few, prices will be high, and the city will be off-limits to all but rich people.''

People seem surprisingly ignorant of how supply and demand work. When the demand for a city rises, prices will rise unless more homes are built. When cities restrict new construction, they become more expensive.

Cities grow by building up or out. When a city doesn't build, people are prevented from experiencing the magic of urban proximity. Preserving a city can, in fact, require destroying part of it, Glaeser says.

The modern desire to preserve Baron Haussman's Paris has helped turn the affordable Paris of the past - with its history of impecunious but ultimately celebrated artists - into a boutique city that today can be enjoyed only by the wealthy.

There is great value in protecting the most beautiful parts of our urban past, but cities shouldn't be embalmed in amber. Too much preservation stops cities from providing newer, taller, better buildings for their inhabitants.

Height restrictions - in Paris, New York and Mumbai - should be of interest and concern to far more of us than just the planning professionals. ''These rules are shaping the future of our cities and our world,'' Glaeser says. ''If the cities' history becomes a straitjacket, then they lose one of their greatest assets: the ability to build up.''

Height, he says, is the best way to keep prices affordable and living standards high.

Glaeser's observations seem of obvious relevance to Sydney and the decisions facing the O'Farrell government. Our sky-high house and unit prices are partly the product of strong demand being met by a woefully inadequate supply of additional houses and units. Now those high prices are contributing significantly to Sydney and NSW's weak rate of economic growth.

The lack of additional supply comes partly from our topography, but mainly from excessive government restrictions on development. But there are limits to how far Sydney can be allowed to sprawl - including the inadequacy of public transport.

Sydney needs to go up, and part of that up is more medium-density housing in north shore Liberal electorates, including the Premier's own.

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New budget office must clarify, not confuse

Economists believe people should be judged by their ''revealed preference'' - by what they do, not what they say. If so, Wayne Swan is supremely confident Labor will romp home at the next election, whereas Joe Hockey is not at all sure the Liberals will win this time round.

You can deduce this from the different positions the two men take on the legislation to establish a parliamentary budget office. Swan has presented a bill that offers tightly defined benefits to the opposition of the day, whereas Hockey wants to give oppositions a much wider licence to argue the toss with the government. Both seem to be ''taking no thought for the morrow''.

The idea of a parliamentary budget office - roughly modelled on the independent US Congressional Budget Office - has potential to greatly improve the quality of the debate about how much election promises would cost and how they'd be paid for, imposing greater discipline on the parties.

Peter Costello's charter of budget honesty was intended to bring this about by giving both sides the ability to have their policies costed by Treasury and the Department of Finance during the election campaign. But Costello biased the rules against the opposition of the day, meaning they have proved unworkable. The present arrangements require the heads of Treasury and Finance to publish in their own name a pre-election economic and fiscal outlook - giving revised forecasts for the economy and the budget balance - soon after each election is called. No problem there.

It also allows both sides to submit their announced policies to Treasury and Finance for costing. These costing are published by the two departments as soon as they are done. This is fine for governments, which are able to privately bombard the departments with requests to cost a host of possible policies before the election is called. In a process of iteration, treasurers are able to refine their proposals in the light of advice about what things will cost and alternative ways of skinning the cat.

Then, once the election's called, they announce their policies and bowl them up to be ticked by the same people who costed them in the first place.

But oppositions get no pre-election access to the econocrats to try out different proposals. They have to painstakingly gather facts about the cost of this and that, or spend a fortune paying Canberra consultants to cost their policies, knowing those consultants can't necessarily do it the way Treasury does it - especially so after Access Economics retired hurt from the game, having been monstered once too often by the lovely Costello.

The problem is that if Treasury and Finance judge the opposition's costing to be wrong - as there's a high chance they are - this is announced during the campaign and the treasurer carries on about the incompetence and irresponsibility of his opponents.

Swan's bill follows the unanimously agreed recommendations of a multi-party committee. The office would be established as a department of the Parliament, independent of the government. It would give all non-government members the ability to have policy proposals costed in a private, iterative process until the start of the campaign.

The costings for policies submitted during the campaign would be automatically made public. This would put the opposition on the same basis as the government, provided the office had adequate access to the unique information base and costing models used by Treasury and Finance.

It would give the Greens and independents access to accurate costing for the first time, a big step forward. The office would be required to use the same economic forecasts, budget parameters and costing conventions as Treasury and Finance, which would put all costings on a comparable basis and mean the costings used by an opposition during a campaign were essentially the same as those Treasury would incorporate into the budget should the opposition become government.

The office would not have the power do its own forecasts, nor undertake modelling of the economic (as opposed to budgetary) consequences of possible policy reforms.

But Hockey has proposed amendments to the government's bill to give the office a wider range of powers. It would have the same powers as the Auditor-General to demand information of government departments. It would be able to use different forecasts and costing conventions to those in the budget.

Non-government members would be able to have confidential dealings with the office even during election campaigns, making their own decisions about whether and when to make costings public. The Gillard government's funding allocation for the office - about $6 million a year for four years - would be indexed to Treasury's funding.

These Liberal counter-proposals demonstrate a degree of mistrust of governments - and governments' ability to interfere with Treasury forecasts and budget estimates - that seems common among oppositions but is unwarranted.

Not since the Hawke-Keating government have governments interfered in Treasury's economic forecasts and budget figurings. Treasury's forecasts are often wrong and even its costings can prove astray, but there's no reason to believe any other outfit could do better. I think it fair enough to require oppositions to get their policies decided and costed before the campaign starts, just as the caretaker convention requires governments to.

If the taxpayer has to pay for an additional costing body it's vitally important the work of this body helps to clarify the debate not make it even more confusing than it already is.

It's infinitely preferable that all parties' costings be prepared on the same basis, rather than allowing oppositions to chose different economic forecasts or different budget parameters and costing conventions.

If we can avoid that tower of Babel the parliamentary budget office will be a big improvement.

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Thrift paying big dividends on current accounts

The nation's econocrats have been pondering the resources boom for years, but one thing they've been expecting isn't coming to pass: we're not getting huge deficits on the current account of the balance of payments.

Last week's figures showed a deficit of just $5.3 billion for the June quarter, about half what it was in the March quarter. This included a surplus on the balance of (international) trade in goods and services of

$7.5 billion - the fifth quarterly surplus in a row - offset by a deficit on net income payments (our payments of interest and dividends to foreigners less their payments to us) of $12.8 billion.

Switching to the year to June, the current account deficit was $33.6 billion, down from $53.3 billion the year before. Expressed as a proportion of gross domestic product, this was an amazingly low 2.4 per cent, down from 4.1 per cent the year before.

So why were the econocrats expecting bigger deficits? Because most of the money to finance the surge of investment in new mines and natural gas facilities would have to come from foreigners, thereby adding to the surplus on the capital account of the balance of payments which, with a floating currency, is always exactly balanced by a deficit on the current account.

And why haven't the big deficits come to pass? Because household saving has been a lot greater than the econocrats were expecting. The more the nation saves, the less it has to call on the savings of foreigners to finance its investment spending.

Last financial year's current account deficit is down because saving is up while the mining investment boom is only just getting started.

As that boom gets under way, the current account deficit is likely to grow. This year's budget forecast a deficit of 4 per cent of GDP for this financial year, rising to 5.25 per cent in 2012-13. Even so, those figures are smaller than the econocrats had been expecting before they realised how much more households were saving.

Last week's national accounts showed households saving a net (that is, after allowing for the year's depreciation in the value of household assets) 10.5 per cent of household disposable income. This is unlikely to be an aberration; it's more likely to be a reversion to our earlier thrifty habits.

If you're more used to thinking about the current account deficit in terms of exports and imports, I should explain that these days economists tend to look on the other side of the coin, which shows saving and investment.

The current account deficit equals the capital account surplus, which represents the net inflow of foreign financial capital to the Australian economy. As we've seen, we call on the savings of foreigners to finance that part of our investment in new physical capital than can't be financed by our own saving.

This net inflow of foreign financial capital allows us to import more goods and services than we export, including imports of capital equipment.

The net capital inflow also helps us finance our net payments of interest on the nation's net foreign debt and our net payments of dividends on net foreign equity investment in Australia's businesses - though the ultimate justification for our foreign borrowing is the profits we make from our physical investments.

The nation's annual investment spending includes not just business investment in equipment and structures, but also public investment in infrastructure and households' investment in the construction of new homes.

Similarly, the nation's annual saving includes not just the amount saved by households, but also the saving companies do when they retain part of their after-tax profits rather than paying them all out in dividends and the saving governments do when they raise more in revenue than they need to cover their recurrent spending.

According to an article in the federal Treasury's latest Economic Roundup, in the decade or so before the first stage of the mining boom began in 2003, the current account averaged 3.7 per cent of GDP. During the first stage it averaged 5.7 per cent, but since the global financial crisis it's averaged 3.3 per cent.

Before the mining boom, gross national investment spending (that is, before allowing for the annual depreciation of assets) averaged 24.3 per cent of GDP. Since the start of the mining boom it's averaged 27.9 per cent.

Had the level of gross national saving stayed unchanged, that would have increased the average current account deficit by 3.6 percentage points. In fact, national saving has increased from 22.2 per cent to 24.5 per cent.

While households have been saving a lot more in the period since the global financial crisis, federal and state governments have fallen into operating deficit, meaning they've gone from saving to dissaving. As they get their budgets back to operating surplus in the next year or two they'll be adding to rather than subtracting from national saving.

Company profits have been high in recent years and many companies have been saving a fair bit. Mining companies, in particular, have been reinvesting a lot of their after-tax profits in expanding their activities. (To the extent that those retained earnings are owned by foreign shareholders, and were initially counted in the balance of payments as capital outflows, their reinvestment is counted as foreign capital inflow, even though the actual dollars never left the country.)

Australia's persistent current account deficit has always reflected a high rate of national investment rather than a low rate of national saving. Although our household saving rate was quite low during the decade or so to the mid-noughties, our overall, national rate of saving has been around the average for the developed economies.

Point is, should our current account get a lot bigger in the next few years, it will be because the mining construction boom involves a lot more investment spending, not because we're saving less.

We've done much hand-wringing lately about ''the cautious consumer'' (especially when we imagined consumer spending was weak, which we learnt last week it isn't), but the fact that increased household saving has stopped the strong growth in household income translating into booming consumer spending has some big advantages.

If we can avoid a consumption boom occurring at the same time as an investment boom, the Reserve Bank won't need to increase interest rates as much to control inflation and this, in turn, will avoid adding upward pressure to the Aussie dollar.

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Terrorism. A vast cost of feeling a little more secure

Now the 10th anniversary of the terrible events of September 11, 2001, has passed, it's time for plain speaking.

You've often seen me criticise economists for their bloodless rationalism - their excessive focus on efficiency in the satisfaction of our material wants and neglect of our emotional and social needs. Yet it's possible to go too far the other way, to be too emotional and not sufficiently hard-headed in our reaction to events.

And that's just what we've been in our response to the destruction of the World Trade Centre towers. We've exaggerated the threat from terrorism and spent far more than is sensible in trying to reduce it.

As usual, we have better information on the Americans' response than on our own, similar response. But there's much to learn from a study of the American experience by John Mueller, a professor of national security studies at Ohio State University, and Mark Stewart, a professor of civil engineering at our own University of Newcastle.

In the months after September 11, it was almost universally assumed the events represented not an aberration but the start of a new era of greatly increased terrorist threat. Intelligence sources estimated there were as many as 5000 al-Qaeda operatives in America.

So, like we did, the Americans hugely increased their spending on security. They established a new Department of Homeland Security and, in the time since then, increased spending on homeland security by a cumulative $US360 billion ($348 billion). They increased spending on federal intelligence by a cumulative $US110 billion, while state and local governments increased their spending by the same amount. The private sector's increased spending on security measures is estimated to be similar.

All that totals $US690 billion. Now Mueller and Stewart add the opportunity costs of terrorism insurance premiums, passenger delays caused by airport screening, the value of lives lost because people drove to their destination rather than suffer airport delays, and other losses in consumer welfare.

That totals $US420 billion, taking the grand total additional cost since 2001 to well over $US1 trillion.

Those figures don't include the cost to US taxpayers of the terrorism-related wars in Iraq and Afghanistan. The equivalent figure for Australia (which does include the cost of the wars) is about $30 billion.

The question people often ask is, are we safer? That's a silly question. Of course we're safer. The posting of a single security guard at the entrance to one building makes us safer, if only microscopically.

The sensible question is, are the gains in security worth the amount we're paying? Or, in the words of one risk analyst, "How much should we be willing to pay for a small reduction in probabilities that are already extremely low?"

The fact is, despite the escalation in our fear of terrorism, and despite the considerable publicity given to cases where the authorities have foiled bungling terrorist intentions, there's been no great increase in terrorist attacks outside war zones.

In 2005, after years of well-funded sleuthing, the FBI and other investigative agencies admitted that they had been unable to uncover a single al-Qaeda sleeper cell anywhere in the US.

So any terrorist threat derives from small numbers of home-grown people, often isolated from each other, who fantasise about performing dire deeds and sometimes receive a bit of training and inspiration overseas.

Home-grown Islamist potential terrorists are estimated to represent one in every 30,000 Muslims in the US. Muslim extremists have been responsible for a 50th of 1 per cent of the homicides committed in the US since 2001.

Around the world, the number of people killed since 2001 by Muslim extremists outside of war zones is 200 to 300 a year. That's 200 to 300 people too many, of course.

But it's less than the number of people in the US who drown in bathtubs each year.

The increased delays at US airports because of new security procedures have prompted many people travelling short distances to drive rather than fly.

But driving is far riskier than air travel and the extra road traffic is estimated to result in 500 or more extra road deaths each year.

More than 100 Australians have been killed by terrorists since 2001. But all of them have been overseas, the majority in the Bali bombing of 2002. There have been no terrorist attacks in Australia, though our security agencies claim to have foiled four "mass casualty events".

Stewart says the risk of an Australian being killed in a terrorist attack is one in seven million each year, which is about the same as the risk of being struck by lightning.

Why have we spent such huge sums trying to reduce such a small risk? And why have governments paid so little attention to whether we're getting value for money, especially at a time when budgets are tight and so many worthier causes are going begging?

Partly because we demand it of them. As someone said, "we have come to believe that life is risk-free and that, if something bad happens, there must be a government official to blame". Apart from the desire of security forces and spooks to work in a growth industry, politicians face distorted incentives. It's safer to spend more and risky to spend less.

Osama bin Laden's stated goal in launching his attack and threatening more was to lead the US into bankruptcy. He didn't succeed, but he has provoked a reaction that's contributed significantly to the US government's severe budgetary problem, which seems likely to cripple the American economy for the rest of the decade.

Meanwhile, we're left with security measures at airports and elsewhere that do more to inconvenience the public than the terrorists and amount to little more than security theatre.

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