Secret of successful economy is 'frameworks'

The proof we suffer from an economic cringe as well as a cultural one is our tendency to attribute our better position relative to the other advanced economies purely to good luck. In truth, it's owed as much to our markedly superior economic management over the past 20 years.

What? Poor little Oz runs its economy far better than the mighty Yanks and the haughty Europeans? You betcha.

Last week both Ric Battellino, deputy governor of the Reserve Bank, and Dr Martin Parkinson, secretary to the Treasury, warned we would not be immune from the public debt troubles of Europe and the United States.

However, Parkinson said, we can take some comfort from our starting position. ''We are located in the fastest growing region in the global economy with a number of opportunities likely to present themselves over the next decade,'' he said.

''Equally, the flexibility of our economy and our medium-term oriented policy frameworks have assisted Australia manage the impacts from external volatility.''

According to Battellino, we need to monitor the unfolding European situation carefully and remain alert to the risks. ''Having said that, I remain confident that Australia, with its strong government finances, resilient banking system, relatively low exposures to the troubled countries and strong links to the dynamic Asian region, is well placed to deal with events that may unfold,'' he said.

So it's true we're enjoying the good luck of being close to Asia and loaded with the very natural resources it's willing to pay so dearly to get its hands on. But it's also true our leaders have understood the need for us to ''enmesh'' our economy with Asia's since Malcolm Fraser's day, and have worked towards that end.

Our econocrats can take a lot of the credit for the sound state of our banks. They didn't fall for - and didn't let their political masters fall for - all the happy talk about deregulation and free markets.

But wait, there's more - much more. And Battellino offered a big clue to it. He noted that government debt in the euro area had been rising as a proportion of gross domestic product for much of the period since the 1970s.

''This occurred because governments loosened fiscal [budgetary] policy during recessions, but did not fully reverse those policies during the subsequent cyclical recoveries,'' he said. ''In aggregate, budgets in the countries that now form the euro area have been continuously in deficit for the past 40 years.''

And here's the clue: ''Clearly, there was no fiscal rule that aimed to balance the budget over the economic cycle, as there is in Australia.''

He could have said much the same about the build up of public debt in the US, which saw its credit rating downgraded this year and looks likely to induce a fiscal crunch in 2013.

The truth is our economy was quite badly managed in the 1970s and much of the '80s. But whereas that's still true of Europe and the US, it hasn't been true of us for at least the past 20 years - during which time, you'll recall, we haven't had a serious recession, while the others have had two or three.

So what's the secret of our success? Our econocrats' commitment to making the conduct of fiscal policy and monetary (interest-rate) policy subject to clearly defined medium-term ''frameworks'' - systems of rules and targets - so as to reduce their susceptibility to short-term political expediency.

With monetary policy, that's been straightforward. In 1993, then Reserve Bank governor Bernie Fraser joined the international trend for monetary policy to be conducted by the central bank independent of the elected government, guided by an inflation target. Fraser's genius was in specifying such a sensible, flexible target: 2 per cent to 3 per cent on average over the cycle.

This regime was adopted formally by the incoming Howard government in 1996. The framework has achieved its goal of reducing and ''anchoring'' inflation expectations, so the target has been achieved without great restraint on economic growth. And successive governments - Liberal and Labor - have copped without anything more than a grumble all the Reserve's moves to raise interest rates at politically inconvenient times.

As the towering public debts of the North Atlantic economies attest, the pursuit of a framework for fiscal policy has been much more our own work, with little overseas precedent to guide us. It began with the ''trilogy of commitments'' unveiled in the Hawke government's first budget of 1983, and was reinforced with new targets for reducing the budget deficit in the Keating government's post-recession budget of 1993.

But the biggest stride towards a rigorous framework came with Peter Costello's enactment of the Charter of Budget Honesty upon election in 1996. At the charter's centre was Costello's ''medium-term fiscal strategy'' to ''maintain budget balance, on average, over the course of the economic cycle''. He lived by this strategy, achieving 10 budget surpluses during his term, before the onset of the global financial crisis (to which should be added Keating's three surpluses before the recession of the early '90s).

The present Labor government endorsed the Libs' medium-term strategy and its response to the crisis was consistent with it. In Labor's second stimulus package of February 2009 it conformed to the charter's requirement that it spell out a ''deficit exit strategy'', choosing to limit real growth in its spending to 2 per cent a year and forswearing any further tax cuts until a healthy budget surplus was restored.

''Frameworks'' are a boring subject, little mentioned by the media. But they've been our secret weapon in producing vastly superior outcomes to the Europeans and the Yanks.

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Economy follows wherever our moods take us

To anyone but the economists and financiers, getting to the bottom of what the problem is in Europe is hellishly complicated. The more you read the more confused you get. But you can boil it down to the combination of the availability of credit and what Keynes called ''animal spirits''.

To anyone but the economists and financiers, getting to the bottom of what the problem is in Europe is hellishly complicated. The more you read the more confused you get. But you can boil it down to the combination of the availability of credit and what Keynes called ''animal spirits''.

Animal spirits refer to the tendency of the human animal to go through alternating waves of excessive optimism and excessive pessimism. Because we're a highly social animal, we tend to all be optimistic or pessimistic together. Animal spirits are contagious.

In principle, the availability of credit is a wonderful thing, allowing families to buy a home long before they could pay cash for it and businesses to expand beyond their owners' savings.

Taken separately, the existence of credit and animal spirits isn't a big problem. Taken in combination, however, they can be lethal. Animal spirits - also known as ''confidence'' and ''expectations'' - are the main factor causing the economy to speed up and slow down, speed up and slow down again.

Add the availability of credit - which, once availed of, becomes debt - and the amplitude of the ups and downs is greatly increased to produce the business cycle of boom and bust.

The potentially toxic combination of credit and confidence can be a problem for households, businesses, banks or governments. The risk is they borrow too much while everyone's confident the present up-and-up will last forever, then get into trouble when the mood switches and everyone fears the end is nigh.

In Europe's case the main problem is with excessive borrowing by governments. As Ric Battellino, retiring deputy governor of the Reserve Bank, explained this week, government debt in the euro area has been growing faster than gross domestic product for the past 40 years.

The 17 countries' combined net public debt at the start of the global financial crisis equalled about 45 per cent of GDP. Since then it's jumped a third to 60 per cent. If those net figures don't impress you (most of those you see are gross, taking no account of the countries' financial assets), note that these euro-wide averages include Greece with a net debt of about 130 per cent of GDP and Italy with about 100 per cent.

The trouble with debt, of course, is it has to be ''serviced''. You have to pay the interest as it falls due and sometimes also repay part of the principle. Businesses and governments tend not to repay their borrowings but just roll them over (renew them)when they come to the end of their term.

You pay interest out of current income. This is rarely much of a problem while everyone's optimistic and your income keeps growing. But when the mood swings to pessimism and the economy turns down - or when the economy turns down and the mood swings to pessimism; it's often hard to be sure which causes which - it can get a lot harder to keep up your interest payments when your income isn't growing as fast or is falling.

The trouble with interest payments, of course, is they're not optional. Many households and firms have to cut back their other spending to make sure they can make their interest payments. When too many of them have to do that, the economy takes another lurch down, taking confidence with it.

Governments, on the other hand, tend merely to run bigger budget deficits. But when you're borrowing just to meet your interest payments, your debt and your interest payments grow rapidly.

And you find you've got another problem. The very people who lent to you so happily during the optimistic phase now turn on you. They say you're a hopeless money-manager, they worry about whether they'll get their money back, they'll only lend you more money at a much higher interest rate and may even press you to repay some principal.

Whereas during the optimistic phase they probably didn't charge you an interest rate high enough to adequately reflect their risk that you wouldn't be able to repay them, in the pessimistic phase - when you're at your most vulnerable - they probably charge you more than needed to cover that risk.

It's all terribly illogical, unfair and, worse, counterproductive. The people who shouldn't have lent you so much blame you, not themselves. They go from being too optimistic, to too pessimistic; too easy to too tough. And by doing so they threaten not only your survival, but their own.

Great system, eh? It's one of the great weaknesses of the generally highly beneficial capitalist system. It occurs because the humans who inhabit the system are emotional, herd animals, contrary to economists' happy assumptions that we're all rational and markets never get it wrong. It occurs when, as until recently, economists, regulators and politicians start believing their own bulldust.

All this helps explain why the governments of the euro area, having borrowed far more than they should have over many years, are now in so much trouble. Some, of course, have borrowed a lot more than others. These are the ones in the most trouble. But since they're all yoked together in the euro, they're all in trouble together.

Once the worst case - Greece - focused their attention, the financial markets began turning one by one on the other bad cases, as markets do. Trouble is contagious. Even the strong countries - Germany and France - are sus because their strength may not be sufficient to prop up all the others.

In the modern world, countries aren't allowed to go bankrupt. They always get bailed out, usually by the International Monetary Fund. In the case of the euro area, much of the bailing out will probably be done by the European Central Bank.

But salvation for sinners always comes with hefty punishment attached, to make sure they learn their lesson. Punishment comes in the form of ''austerity'' - big cuts in government spending and increases in taxes - which initially make things worse rather than better.

At present we're going through a drawn-out period of uncertainty while all the politicians involved argue about taking their medicine. I'm confident they'll eventually get their act together but, even if they do, Europe is in for an unpleasant decade.

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PM Gillard: hard worker, hard-nosed, hard to read

Having observed Julia Gillard's government for more than a year, I must say she's hard to pigeon-hole. Is the woman who changed the government's mantra from "working families" to "hard-working families" a typical Labor prime minister, as many business critics of Fair Work believe, or a pale imitation of a Liberal leader, as her willingness to sell uranium to India and her opposition to same-sex marriage lead many critics on the left to conclude? Does she stand up to powerful industries or kowtow to them?

You can make a surprisingly long list of social changes you'd expect the Labor heartland to be pretty happy about (even though it seems far from enamoured of its first female federal leader).

The introduction of paid parental leave (which, admittedly, occurred under Kevin Rudd) is an important step in reforming the institutions of the labour market to make them more suited to the needs of the better-educated sex.

Equal pay for women in the community sector - most of the cost of which will be borne by the federal budget - remedies an age-old injustice, which never made sense and couldn't have survived in a world of shortages of labour.

Plain-packaging for cigarettes is preventive-health reform that leads the world. The international tobacco industry has few friends, but very deep pockets to fight the Gillard government with advertising and legal action.

But global tobacco has a fraction of the power the licensed clubs have in opposing compulsory pre-commitment for people using poker machines. Although this issue was forced on Gillard by her lack of a majority, she has yet to waver in her determination to get it passed by Parliament. And though it, too, is a reform without international precedent, it could do much to reduce the gambling industry's indefensible exploitation of people addicted to poker machines.

Rudd should get most credit for several other social improvements: the national homeless strategy, the national rental affordability scheme (tax breaks for investors in affordable housing) and the first injection of funds into social housing in many a long day.

Rudd started, but Gillard has continued, Labor's many measures to pare back John Howard's middle-class welfare by declaring a family on $150,000 a year to be not rich, but comfortable. These measures don't just save money, they make the budget more redistributive in favour of the genuinely deserving.

And Gillard has defied the powerful private health insurance industry by continuing Rudd's efforts to get means-testing of the health insurance tax rebate approved by Parliament.

Gillard has committed herself to making introduction of a national disability insurance scheme her top social reform in the rest of her term. By providing help to people who inherit their disability or acquire it from an accident around the home, this would fill a longstanding gap in our social safety net. It would be a historic advance (and is one of the few reforms Tony Abbott hasn't opposed).

But against all that there are a couple of areas where Gillard's performance has been anything but what you would expect from Labor. The first is her education "reforms" copied from the American Republican Party.

Trying to "incentivate" school teachers as though they were as money-hungry as chief executives merely insults their professionalism. Providing parents with greater information about the performance of schools is fine, but doing so before summoning the courage to correct the bias in federal school funding in favour of well-off schools risks hanging under-resourced public schools out to dry.

Gillard has spent four years postponing change to Howard's middle-class-welfare school-funding formula. Her response next year to the belated review will show whether her courage has recovered.

The tax concessions attached to superannuation have long been heavily biased in favour of high income earners such as yours truly. To call them middle-class welfare would be an understatement.

Rather than using the opportunity provided by the decision to phase-up compulsory employee contributions from 9 per cent to 12 per cent of salary (a multi-billion-dollar gift to the financial services industry) to shift the tax benefit from high to middle and low income earners, the government will merely use some of the revenue from the mining tax to correct the position where workers on the 15 per cent income tax rate gain no concession on their contributions.

But the most puzzling and indefensible aspect of Rudd policy continued by Gillard is the mistreatment of sole parents and, more so, people on unemployment benefits. Both groups were explicitly excluded from the over-generous pension increase in 2009.

For many years, age and invalid pensions have been indexed to average earnings, meaning they rise faster than inflation, whereas the dole has been indexed only to inflation. In consequence, the dole paid to single adults is now less than two-thirds of the single pension, a shortfall of $131 a week.

The dole is now so low it's just 36 per cent of median household income, putting it well below the commonly drawn poverty line of half median income. It's also just 45 per cent of the after-tax minimum wage - meaning there is little risk its generosity is deterring people from taking a job.

One defence of low unemployment benefits is that most people aren't on them for long. But more than half the people on the dole have been on it for a year or more. And the government is also limiting the assistance it gives the long-term unemployed to help them find a job.

This discrimination against the unemployed is now so extreme the Henry tax reform recommended it be corrected. And even the Business Council agrees.

Perhaps Gillard's lack of sympathy for the unemployed arises because, being unable to find a job, they're not hard-working.

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Reserve has re-assessed outlook for world growth

Just as a stopped clock is right twice a day, so the financial markets' belief that Europe's sovereign debt problems are the primary factor influencing the Reserve Bank's decisions about interest rates, having been wrong for most of the year, has finally proved on the money.

A psychologist would say the financial markets have been suffering a "salience" problem. Their judgments about how the Reserve will adjust the official rate have been overly influenced by the factor sticking out in their minds and also on their minds most recently: Europe.

If Europe is on their front burner, it must also be on the Reserve's. Since the outlook for Europe is so worrying and so conducive to slower economic growth, the markets have for months been predicting that big falls in our official rate are imminent.

Month after month the markets have stuck to this view, ignoring the Reserve's twice-monthly explanations of its thinking, which, while acknowledging the worries and uncertainties over Europe, have repeatedly emphasised the state of the domestic economy and, in particular, the outlook for domestic inflation, as key considerations.

So when, on Melbourne Cup day, the Reserve acted for the first time in a year and chose to lower interest rates by a notch, the markets weren't surprised. But they were right for the wrong reason. As the Reserve made clear, it was able to ease a notch because the economy wasn't accelerating to the extent it had been expecting, thus making the Reserve more confident inflation would stay on track over the next year or two.

But all that changed last week, when the Reserve eased the rate another notch, this time making it clear its decision had been influenced by the changed prospects for the global economy.

So what exactly were its motivations? Was it taking out a little insurance, fearing the worst might come to the worst in Europe? No, nothing so dramatic.

It doesn't take many brain cells to get the wind up over Europe and assume the worst. It takes more brain power to quietly assess the probability of a complete disaster. And more again to assess the strength of any troubles in Europe by the time the ripples reach the Antipodes via China.

By now, the shape of the solution to Europe's problem is reasonably clear. The 17 member countries of the euro area (or, if they insist, almost all the members of the European Union) need to sign up to a new fiscal compact, which imposes limits on the size of their budget deficits and levels of public debt relative to gross domestic product, with automatic penalties for countries that breach these limits.

The pact would also impose timetables for countries presently well in excess of those limits to comply with them, again with penalties for breaches.

Once these strictures had been ratified - thus plugging the obvious hole in the euro currency union, as well as guaranteeing the errant borrowers would mend their ways - the European Central Bank would be willing to start buying up the bonds of member countries, thus forcing down their yields.

It would cut its official interest rate to next to nothing and engage in "quantitative easing" (buying government bonds to cover deficit spending and so, in effect, printing money). Thus all the budgetary contraction would be offset to some extent by monetary stimulus.

While it's painfully apparent the European leaders are having trouble getting their act together - thus increasing the risk of disaster occurring by accident - it's also apparent they're neither fools nor suicidal.

So to assume Europe is headed inevitably for an implosion - as many punters seem to - strikes me as nothing more than unthinking pessimism. Our more experienced observers put the probability of a complete disaster no higher than about one chance in three.

This says the chances are twice as high that Europe will muddle through. But it's clear that even if the full calamity of a collapse in the euro is averted, even if everyone dons their fiscal straitjacket, the financial markets calm down and ordinary life resumes, the outlook for the European economy is particularly weak.

All those economies committed to the fiscal austerity of tax increases and swingeing spending cuts - and it will be quite a few of them - face the dismal prospect of fiscal contraction leading to reduced revenue, reduced revenue leading to a need for more fiscal contraction, and so on and on.

If you wonder how any politician could agree to such an appalling exercise, you're starting to understand why Europe's politicians have had so much trouble getting themselves up to the barrier. They've had to reach the realisation the financial markets - which went for years happily lending them more money than was good for them - are now not going to tolerate any easier or more sensible work-out of their debt problems.

For our purposes, it's now clear the greatest likelihood is negative to flat growth in Europe for at least the next year or two (the forecast period) and probably far longer. It's also clear that, while the US economy has gained momentum recently, it too faces unavoidable fiscal contraction, if not next year then in 2013.

With evidence China's exports to Europe are already being hit, the Reserve decided last week to revise down its forecasts for world growth. This will change its forecasts for domestic growth and inflation only a little, but it was enough to raise the Reserve's confidence it could cut rates another notch without jeopardising achievement of its inflation target.

Meanwhile, the financial markets are betting the official rate will have fallen by another 1.5 percentage points by the middle of next year. I call that courageous.

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Nice set of figures should shut up the gloomsters

Something strange is happening to the Australian psyche at present. A lot of people are feeling down about the economy. They're convinced it's pretty weak, and any bit of bad news gets a lot of attention.

But most of the objective evidence we get about the state of the economy says it is, under the circumstances, surprisingly strong. Consider the national accounts we got this week.

They show the economy - real gross domestic product - grew by 1 per cent in the September quarter, more than most economists were expecting. And not only that, the Bureau of Statistics went back over recent history, revising up the figures.

Originally we were told the economy grew by a rapid 1.2 per cent in the June quarter, but now we're told it grew by an even faster 1.4 per cent. Originally we were told the economy contracted by 1.2 per cent in the March quarter because of the Queensland floods and cyclone, but now we're told the contraction was only 0.7 per cent.

Those figures hardly fit with all the gloominess. So how fast is the economy travelling, on the latest numbers? We're told it grew by 2.5 per cent over the year to September, but that figure includes the once-off contraction in the March quarter, which is now ancient history.

We could do it the American way and say we grew at an ''annualised rate'' of 4 per cent in the September quarter (roughly, 1 per cent x 4), but that's too high because this quarter (and the previous one) includes a bit of ''payback'' (or, if you like, catch-up) as the Queensland economy got back to normal after its extreme weather.

(There's likely to be more catch-up in the present quarter as the Queensland coalmines finally pump out all the water and resume their normal level of exports, suggesting the Reserve Bank is reasonably safe to achieve its forecast of 2.75 per cent growth over the year to December.)

So the best assessment is that at present the economy is growing at about its ''trend'' (long-term average) rate of 3.25 per cent a year. If so, everything's about normal.

Ah yes, say the gloomsters, but all the growth's coming from the mining boom. Before we check that claim, let's just think about it. If we were viewing our economy in comparison with virtually every other developed economy, we'd be thanking our lucky stars for the mining boom.

But not us; not in our present mood. We're feeling sorry for ourselves because, for most of us, the benefits of the boom come to us only indirectly. (The other thing we ought to be thankful for apart from our luck is 20 years of clearly superior management of our economy. In stark contrast to Europe and the US, we have well-regulated banks and stuff-all public debt.)

It's true the greatest single contributor to growth in the September quarter was the boom in investment in new mines. New engineering construction surged 31 per cent in the quarter and total business investment spending rose by almost 13 per cent.

But though most of that remarkable boost is explained by mining, there was also a healthy increase in manufacturing investment.

And here's a point some people have missed: the second biggest contribution to growth in the September quarter (a contribution of 0.7 percentage points) came from the allegedly cautious consumer.

Consumer spending grew by 1.2 per cent in the quarter and by 3.8 per cent over the year to September. That's actually above its long-term trend. And consumer spending was strong in all the states, ranging from rises of 0.8 per cent in Victoria, 0.9 per cent in Western Australia (note) and 1.1 per cent in NSW, to 1.9 per cent in Queensland (more catch-up).

Although households are now saving about 10 per cent of their disposable incomes, this saving rate has been reasonably steady for the past nine months. So consumer spending is growing quite strongly because household income is growing quite strongly.

It's noteworthy that, according to Treasury, non-mining profits rose by 4.7 per cent in the quarter. And according to Kieran Davies, of the Royal Bank of Scotland, non-mining GDP grew by a solid 0.7 per cent in the quarter, just a fraction below trend.

So the notion that mining (and WA and Queensland) might be doing fine but everything else is as flat as a tack is mistaken. It's true, however, that some industries are doing it tough. Consumers are spending at a normal rate, but their spending has shifted from clothing and footwear and department stores to restaurants, overseas travel and other services.

Home-building activity declined during the quarter - a bad sign. The continuing withdrawal of the earlier budgetary stimulus meant that government spending fell by 2.5 per cent during the quarter. Public spending was a drag on growth in all states bar WA and Queensland (more catch-up).

Our terms of trade - export prices relative to import prices - improved by 2.7 per cent in the quarter (and by 13 per cent over the year to September) to be their best on record. But that's likely to be the peak, with key export prices falling somewhat in the present quarter.

The volume of exports rose by 2 per cent in the quarter, but the volume of imports rose by 4.3 per cent, mainly because of imports of capital equipment. So ''net exports'' (exports minus imports) subtracted 0.6 percentage points from overall growth in real GDP during the quarter.

Ah yes, say the gloomsters, but all this is old news - the September quarter ended more than two months ago. The economy must have slowed since then. After all, look at this week's news of a rise in the unemployment rate to 5.3 per cent in November.

It does seem true the labour market isn't as strong as the strength of economic activity would lead us to expect. This could indicate a degree of caution on the part of employers. But the rise in unemployment is slow and small, and if it's only up to 5.3 per cent we're still doing very well by the standard of the past 20 years.

As for the tempting line that everything's gone bad since the strong growth in the September quarter, just remember: that's what the gloomsters said when they saw the good growth figures for the previous quarter. Turned out to be dead wrong.

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Breakdown in relations is everyone's business

I get to meet a lot of famous and interesting people in my job, but few have had more influence on me than Dr Michael Schluter, the social thinker, social entrepreneur and founder of Britain's Relationships Foundation.

They say genius is being the first to say the obvious. If so, Schluter is one. I'm sure Socrates or Aristotle beat him to it but, in our time, Schluter is the first to forcefully remind us of something we all know: the importance of our human relationships.

We are, above all, social animals. After we've secured our physical survival, the most important thing in our lives is our relationships: with friends, neighbours, workmates and, above all, with our families - our parents, siblings, spouse and children.

Even if we've avoided speaking to them for years, even if they're dead and gone, we can't stop thinking about them. If we've cut ourselves off from our families, be sure we've sought to fill the vacuum with other relationships. Take away all our relationships and who'd have much reason to live?

So much for stating the obvious. But here's Schluter's simple, unarguably telling, point: if our relationships are so fundamental to our well-being, why do we keep forgetting to take account of them in our strivings? Wouldn't we be better off if we got into the habit of viewing all our endeavours through a lens that focused on their implications for our relationships?

How often do divorce lawyers advise people to avoid all attempts at reconciliation with their estranged spouse for fear of weakening their legal position? How often do doctors treat physical symptoms that aren't what's really troubling their patient?

How often do politicians who loudly proclaim their support for the family then consider 101 policy proposals without a thought as to their implications for people's relationships? As for economists, their model is so narrowly focused on the individual that they become oblivious to the potential effects of the policies they advocate on the relationships that sustain all individuals.

The truth is much of our ever-increasing material affluence over the past 200 years has been achieved at the expense of our relationships; by making the workings of the economy ever bigger, more complex and impersonal; by encouraging economic transactions between people who've never met, let alone had a relationship with each other.

Back to Schluter's insistent reminder: aren't we paying a price for ignoring the relational implications of all this? Wouldn't we be better off if we put the protection and promotion of our relationships back into the formula?

So far have we strayed from recognising the primacy of our relationships that the proposals of the mild-mannered, respectable, god-fearing Schluter sound positively radical.

About 150 years ago, the invention of the limited-liability company allowed people with money to invest to become owners of companies without taking any part in their management. The development of stock exchanges allowed people to buy and sell their shares in a company as easily and often as they liked. From these innovations came the huge corporations that dominate the economy today.

Economists see them as milestones on our path to prosperity. Schluter sees the downside. So, last month, in troubled Britain, he and a colleague, Jonathan Rushworth, launched a plan, Transforming Capitalism from Within: a Relational Approach to the Purpose, Performance and Assessment of Companies.

He proposes that enlightened firms submit themselves to the discipline of a 10-step ''relational business charter''. Step one is for the company to include in its articles of association a goal to become a profitable and sustainable business for the benefit of all its stakeholders - owners, directors, managers, employees, suppliers and customers - and the wider society.

Step two is to promote dialogue among company stakeholders, preferably through regular, face-to-face meetings.

Step three seeks to reduce ''relational distance'' between shareholders and the employees and other stakeholders by promoting share ownership by named individuals and family trusts rather than institutional investors such as pension funds.

The goal could be 25 per cent direct ownership pursued, partly, by encouraging employees to own shares. Ideally, a growing proportion of shareholders will live close to the company's main base.

Next, to achieve commitment, involvement and responsibility by shareholders, relational firms should encourage long-term ownership, perhaps by issuing additional shares to those who hold their shares for long periods.

Step five is for companies to help their employees achieve work-life balance by minimising long working hours and work at unsociable hours (including weekends) wherever possible. These things have a direct effect on the families of employees, particularly if the employee will not be present to share the bringing up of children.

Then firms will seek to respect the dignity of all employees by minimising remuneration differentials within the business. A ratio of 20:1 between top and bottom would be a good benchmark.

Relational companies will treat suppliers fairly and with respect, paying them promptly and giving them support to develop their businesses.

Relational companies will treat their customers and the local community fairly, respecting their concerns about reasonable payment terms and adequate service.

Step nine involves companies protecting their business and stakeholders by minimising the risk of financial instability, limiting their ''gearing'' - ratio of borrowing to shareholders' funds.

Finally, relational companies will fulfil their obligations to the wider society by paying a reasonable proportion of profits in tax in the country where those profits were earned. They will also spend a reasonable proportion of profits on corporate social responsibility.

The musings of a hopeless dreamer? I think our companies' present ruthless pursuit of profit at any cost is an excess that can't last. Schluter is a prophet pointing the way back to more sensible capitalism.

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Business economists play politics over budget surplus

Business economists have been surprisingly critical of Julia Gillard's efforts to keep her promise to return the budget to surplus next financial year, but if I were her I'd have done much the same thing.

She, her cabinet and her econocrat advisers turn out to have a much better understanding of real-world macro-economic management than the know-it-all business economists.

Their repeated statements that the government's obsession with achieving budget surplus in 2012-13 is a ''purely political'' objective show how little they understand political economy. Paradoxically, it's they who are playing politics in making such a claim.

In an ideal world - a rational world - it wouldn't be necessary for Wayne Swan and Penny Wong to turn the fiscal somersaults they did last week just to keep the budget's forward estimates pointing to a laughably microscopic surplus.

(All the ''reprofiling'' - read creative accounting - to which the budget ministers needed to resort is explained not so much by the economy's now weaker-than-expected strength of recovery, but by the extent to which the carbon tax package was, predictably, revenue negative in its first year.)

In such an imaginary world, it wouldn't matter if the budget's return to surplus was a year or two earlier or later than the year first projected. In such a world, the punters wouldn't imagine a surplus of $1.5 billion was a totally different animal to a deficit of $1.5 billion, instead of the same thing: a near-as-dammit balanced budget.

In such a world, voters would not set the bar higher for Labor treasurers than Liberal treasurers.

In such a world, voters would laugh to scorn the efforts of such reliable witnesses as Tony Abbott, Joe Hockey, Andrew Robb and Barnaby Joyce to convince them all budget deficits are bad and Australia's public debt is mountainous.

But the business economists so freely accusing the government of being ''purely political'' are guilty of more than naivety. Their political double standard is showing.

Where were they with their accusations of politicians being ''purely political'' when, almost from the first fiscal stimulus package, the Liberals began trying to inculcate their pre-Keynesian nonsense in the minds of an economically illiterate electorate?

I don't remember hearing from them. In fact, with the honourable exception of Saul Eslake, I can't remember ever hearing a business economist dare to criticise a Liberal government or opposition.

Under Abbott the Libs are at their most populist, protectionist and anti-rationalist in decades. They've been working overtime to exploit and frustrate any attempt by Labor to implement unpopular reforms. The notion of Abbott in government is frightening.

But do we hear a breath of criticism from the business lobbies or the business economists? Gosh no. The Libs might take offence.

But take a shot at a Labor government, especially one that's out of favour with big business and looks on the ropes? Sure, why not. How could the boss object to that?

Labor's problem is not that it's had bad economic policies - its response to the global financial crisis was almost too successful for its own good; its carbon price scheme was compromised more by the reneged-on deal with Malcolm Turnbull than by the subsequent deal with the Greens - but that it can't explain itself, can't educate the electorate.

Is it surprising politicians adopt less-than-pure policies when they know that, were they to be more courageous, the nation's economists - academic and business - would be missing in action when the guns were firing?

But this episode doesn't just reveal the business economists' partisanship and their dereliction in helping to educate a gullible electorate. It reveals that, even after our experience with the global financial crisis, they don't understand the central role of psychology - confidence - in any government's efforts to manage the economy through the business cycle.

The present low levels of consumer and business confidence are a consequence of various factors, not just forebodings about the turmoil in Europe. Other factors would be fears about the devastating effects of the carbon tax and, after years of propagandising by the opposition and the Murdoch press, a lack of confidence in the government's ability to manage the economy.

In such circumstances, would it really be of no consequence for the government to be seen to have broken its promise to return the budget to surplus? Can you imagine how the opposition would carry on? Do you really think that would have no effect on confidence?

There may even be some truth in the government's argument that, in view of the global financial markets' concerns about sovereign debt, this is no time for our government to renege on promises to stop adding to government debt.

So much for the naive belief the government's concern to protect its reputation as an economic manager is ''purely political''. But wait, there's more.

If there's one lesson to be learnt from the problems in the United States as well as Europe, it's the difficulty governments have in keeping the two sides of their budget within cooee. We, of course, are exemplary by comparison.

Why have we exercised so much fiscal discipline? Because of our tight ''framework'' of rules and targets to guide fiscal policy. Rules and targets governments of both colours have adhered to.

In an ideal world, governments would have no trouble exercising discipline over their spending and taxing. In the real world, governments have to give discipline a helping hand by drawing essentially arbitrary lines in the sand, then sticking to them.

Gillard's promise to achieve a surplus in 2012-13 is just such an arbitrary line. That line could be washed away by a tidal wave from Europe, of course. But sensible economists think twice before urging governments to cast aside their self-imposed pre-commitment devices.

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How budget update affects stance of fiscal policy

The most remarkable thing about this week's mini mini-budget is how many words the media could spill without clarifying a rather important question: how will it affect the economy?

One of the ways politicians (and journalists) make such announcements sound big is by giving us the cost of measures ''over four years''. But the economy is lived through, and managed, one year at a time. So it's the year-by-year figures that matter most.

We know the avowed purpose of the spending and tax measures announced along with the midyear budget update was to get the budget back on track to return to surplus in 2012-13, as Julia Gillard promised in the election campaign.
The return to surplus had been put in doubt by the effect of the turbulence in Europe on the confidence of our consumers and business people, which is stopping the economy growing as quickly as had been expected at budget time.

In consequence, tax collections are now expected to grow by about $5 billion in 2011-12 and $6 billion in 2012-13 less than earlier thought. With other revisions, this would have turned the expected surplus in 2012-13 of $3.5 billion into a deficit of $1.4 billion.

So what did Wayne Swan and Penny Wong do about it? Ostensibly, they found savings sufficient to get back to an expected surplus of $1.5 billion. But, as we'll see, it's not that simple.

We've been told repeatedly the announcement involved savings measures worth $11.5 billion over four years. We've been told less often it also involved new measures with a cost to the budget of $4.7 billion over four years.

So the measures' net effect is to improve the budget balance by a much more modest $6.8 billion over four years. Of this, just $2.9 billion relates to next financial year, the year the government's concerns are focused on.

Is $2.9 billion a lot or a little? To you or me it's a king's ransom, more than we'd ever see in 400 lifetimes. But that's not the relevant comparison. Since we're interested in the budget's effect on the economy, it's the size of the economy that's the appropriate comparison.

The nation's annual income (from its production of goods and services, gross domestic product) is about $1.4 trillion ($1400 billion). So $2.9 billion represents a mere 0.2 per cent of our annual income.

You'd thus be justified in concluding that, from a macroeconomic point of view, the measures included with the revised budget estimates on Tuesday weren't worth worrying about. But there are ways of viewing this week's new information that make it seem a much bigger deal.

Consider this. The Reserve Bank's rough-and-ready way of judging the budget's effect on the economy is to look at the direction and size of the change in the budget's underlying cash balance from one financial year to the next.

At the time of the budget in May, the government was expecting a deficit in 2010-11 of $49.4 billion (equivalent to minus 3.6 per cent of gross domestic product) falling to a deficit of $22.6 billion (minus 1.5 per cent) in the present year, 2011-12, and then becoming a surplus of $3.5 billion (plus 0.2 per cent) in the target year, 2012-13.

So, measured against GDP, it was expecting an improvement in the budget balance of 2.1 percentage points this financial year, followed by an improvement of 1.7 percentage points next year.

Now, those proportions of GDP clearly were a big deal. They represented a very rapid reduction of the budget's net support to the economy. So I judged the ''stance'' (setting) of fiscal (budgetary) policy envisaged in the budget to be ''highly contractionary''.

This turnaround in the budget balance was to be brought about by three factors. First, the withdrawal of the earlier fiscal stimulus as its temporary spending came to an end. Second, the effect of the government's ''deficit exit strategy'' of holding the real growth in its spending to no more than 2 per cent a year and granting no further cuts in income tax.

But the third factor was central: the economy's expected strong recovery from the mild recession of 2008-09 would cause faster growth in tax collections and a fall in spending on dole payments. In other words, much of the improvement would come from the operation of the budget's in-built ''automatic stabilisers''.

Right. So how has that picture been changed by the revised forecasts for the economy and the new spending and tax measures announced on Tuesday? The government recorded an actual budget deficit of $47.7 billion (minus 3.4 per cent of GDP) last financial year. It's now expecting a deficit of $37.1 billion (minus 2.5 per cent) this year and a surplus of $1.5 billion (plus 0.1 per cent).

Looking at that the way the Reserve does, the government is now expecting an improvement of 0.9 percentage points (rather than the earlier 2.1 points) this year and 2.6 percentage points (rather than 1.7 points) next year.

Taking those figures at face value, you'd say the stance of fiscal policy was now planned to be much less contractionary this year, but a fair bit more contractionary next.

Some economists have observed that this would involve ''the sharpest improvement in the budget balance for four decades'' and would mean the budget acting as a ''substantial drag on economic growth'' in 2012-13.

Just one small problem. Much of the alleged blowout in this year's deficit and seeming rapid improvement in the budget balance next year arises not from the revised economic forecasts or the substantive spending measures, but from what the government euphemistically refers to as ''reprofiling'' - shifting intended spending and tax measures around between years.

In particular, the government took net spending of roughly $4.8 billion that should have occurred in the target year, 2012-13, and moved it forward to the last two months of this year, 2011-12, thus artificially worsening the comparison of the two years by double that amount, roughly $9.6 billion.

It also improved the target year's budget balance by about $850 million by delaying for a year the start of various tax concessions associated with the mining tax package.)

So, measured the Reserve Bank way, the ''underlying'' stance of fiscal policy remains pretty contractionary in both years - and, after you look through the reprofiling, not greatly changed.

This stance seems appropriate, remembering the economy is close to full employment and monetary policy can be eased (interest rates cut) should that prove necessary.

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Farmers fall silent while food brings home the bacon

Sometimes, as when Sherlock Holmes solved a mystery by noting the dog that didn't bark, the story is not what happened but what didn't happen. If so, don't hold your breath waiting for the media to tell you such a story. Omission is much harder to notice than commission.

But let me ask you - in this year of endless complaint about the supposed two-speed economy - what's been missing? The retailers have been doing it tough and they've let everyone know. The high dollar is great news for consumers - overseas holidays are booming - but bad news for those of our industries that sell on export markets or compete against imports in the local market.

We keep hearing about the difficulties our manufacturers have encountered and, to a lesser extent, the problems facing our tourism industry (see above). Now we're hearing of staff cutbacks in universities because foreign student numbers are down.
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But who haven't we heard from?

A clue - which dog usually barks the house down every time the dollar goes up? Another - which industry contributed to our economy's boom and bust in the mid-1970s by virtually forbidding the McMahon government to revalue our currency in response to a world commodity boom?

That's right, the farmers. So, have they been suffering in silence for once in their lives? Have they, unlike other industries, stoically resisted the temptation to blame all their problems on a Labor government?

No, nothing so worthy. We've heard nothing from the farmers because they've been doing quite well for themselves. And we never hear from farmers when times are good. City slickers never get invited to the harvest festival for fear of undermining the media's stereotype that ''the man on the land'' is ALWAYS doing it tough. In any case, who's interested in GOOD news about the economy?

You can find the story in the official statistics and forecasts, of course, but public officials know always to understate good news about the farm sector for fear of bringing the farmers' ire down on their heads. The few parts of farming that are the exceptions to the rule will declare all you say is lies.

Our farmers export about three-quarters of what they produce. With the exception of wool, the stuff they sell abroad is priced in US dollars. So when the Aussie dollar goes up, the money they earn in US dollars isn't worth as much to them back home.

That's just as true of our miners. They, too, have suffered from the rise in the Aussie. But they're not complaining because the prices they're getting in US dollars have risen by far more than the Aussie has gone up.

It's a similar story for the farmers, though on a much smaller scale. Since the start of the resources boom in early 2003, the prices being received by our miners have risen by 380 per cent in US-dollar terms. Thanks to the Aussie dollar's rise against the greenback, they've risen by a smaller 175 per cent in Australian-dollar terms - which is what the miners care about.

Over the same period, the prices being received by our farmers have risen 90 per cent in US-dollar terms and almost 10 per cent in Australian-dollar terms. (The rise in the Aussie isn't just a matter of bad luck for our miners and farmers. Since our dollar's been floating it has always risen, or fallen, roughly in line with world commodity prices. What these comparisons show is that rising rural commodity prices contributed to the higher dollar, along with rising minerals and energy prices.)

If that was all there was to the story we probably WOULD have heard whingeing from the farmers. But what matters to our farmers even more than what's happening to prices is what the weather's doing to the size of their harvests and other kinds of production. Whatever the price, the world will always take however many tonnes our farmers are able to produce.

And the truth is that, despite exceptions (West Australian wheat for one; the effects of flooding and cyclones), the weather's been a lot kinder to our farmers over the past year or two. It's rained when rain has been needed, there's been more water for irrigation and the moisture content of the soil has improved, allowing more dryland plantings.

This year's winter wheat crop is expected to be a near-record high of about 40 million tonnes and this follows a good harvest last year.

This financial year, our agricultural export earnings are expected to be the second-highest since 2002-03, even after allowing for inflation. Last year's earnings were pretty good, too.

Rises in export earnings are expected for wheat, wool, rice, canola, cotton and lamb, though wine exports continue to languish.

After a bad year in 2009-10, real farm income more than doubled last financial year. This year it's expected to be down only a bit from that.

Why are world agricultural prices so strong? Various reasons, but mainly because of the development of Asia and the steady rise in incomes of its many hundreds of millions of people. As low incomes rise, food consumption tends to increase. And the increase is concentrated in the more expensive types of food.

So food prices are rising for much the same reason minerals and energy prices are rising. And that says they've got a long way further to rise over coming years. Whichever way you look, Australia is sitting pretty in the Asian century. The only shadow over the future of farming comes from climate change and our long mismanagement of water.

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Econocrats get smarter on dodgy forecasts

You've heard the joke that economic forecasters are there to make weather forecasters look good. What you haven't heard is that the nation's top economic forecaster, Glenn Stevens, the governor of the Reserve Bank, thinks the joke "has something going for it".

There's an even older joke: everybody complains about the weather, but no one does anything about it. Actually, nothing we could do would change the weather. But, as Stevens remarked in a speech to the Australian Business Economists last week, some decisions based on economic forecasts can alter what happens (thus making forecasting the economy even harder than forecasting the weather).

That's true of the decisions made by central banks and governments, but it's also true of decisions made by businesses and households - even when their "forecast" is no more sophisticated than a bad feeling or a good feeling about how the economy's travelling and what lies ahead.

Actually, you can't not make a forecast. Even if you refuse to think about the future, you're implicitly making a forecast that things will stay as they are.

The Reserve Bank has no choice but to make the best forecasts it can because it can take two or three years for a change in the official interest rate to have its full effect on the economy. So the Reserve has to act before things get off the rails. Were it to wait until problems actually happened, it would always be acting too late.

But something I've always admired about the Reserve, and Stevens in particular, is their humility and realism on the subject of forecasting.

"It is only natural to desire certainty," he says. "Everyone wants to know what will happen. We all want to believe that someone, somewhere, does know and can tell us what to expect. But the truth is that the best we can do when talking about the future is to speak about likelihoods and possible alternative outcomes."

Like almost everyone else, the Reserve has expressed its forecasts as a "point estimate" - one number. But this gives forecasts an air of precision they don't possess. They're actually a "central forecast" within a range of possibilities.

People (and journalists) who don't understand this can attach too much significance to small changes in forecasts, or to small differences between the Reserve's forecasts and Treasury's. (Tip: they're never going to be very different because they're produced in the same factory, the Joint Economic Forecasting Group.)

Stevens says that "when consideration is given to the real margin for error around central forecasts, such differences are often, for practical purposes, insignificant". "When comparing forecasts, if we are not talking about differences of at least 0.5 percentage points, the argument is not worth having."

Consider this. In the case of a year-ended forecast for the growth of real gross domestic product four quarters ahead, the record over the past couple of decades says the probability of a point forecast being accurate to within 0.5 percentage points is about 20 per cent.

Experience since the start of inflation targeting in 1993 says the probability of underlying inflation over the next year or the next two years being within 0.5 percentage points of the central forecast is about 67 per cent. That is, if the forecast was 2.5 per cent, the chances of the outcome being between 2 and 3 per cent would be about 67 per cent.

"So any point forecast will very likely not be right," Stevens says.

According to Stevens, it would be vastly preferable for discussions of forecasts to be couched in more "probabilistic" language than tends to be the case, and for there to be more explicit recognition that the particular numbers quoted are conditional on various assumptions. To this end, the revised forecasts the Reserve published earlier this month, particularly those for the year to December 2013 (that is, more than two years away), were expressed as a 0.5 percentage point or even 1 percentage point range. Now you know why.

And, Stevens adds, the forecasts include "more extensive discussion these days of the ways in which things could turn out differently from the central forecast". "This goes at least some way to recognising the inherent uncertainties in the forecasting process, and is also important in relating the forecast to the policy decision."

But if forecasts are so dodgy, why bother? Why not merely assume things don't change, since that at least would be quicker and cheaper? Stevens insists economists can shed useful light on the future.

"We know something about average rates of growth through time," he says. That is, forecasts that the economy will return to its trend rate of growth are likely to be closer to the truth than forecasts that it will stay at the rate it is now.

Stevens says economists also know something about the long-run forces that produce economic growth: productivity and population growth. "We know that there have been, and will be again, periods of recession and recovery, though our ability to forecast the timing of those episodes is limited," he says.

"We know from experience some things about the nature of inflation, including its characteristic persistence, and the things that can push it up or down." But above all, Stevens says, we know some of the "big forces" working on the global and local economies at any time. The two big (and conflicting) forces at present are the resources boom and the troubles of the euro.

A lot of the work of forecasting boils down to weighing up the net effect of the conflicting big forces at the time. We'd be better off debating and understanding the effects of those forces than arguing about point estimates.

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Why economists are obsessed by the resources boom

The world is throwing two big things at our economy. One is new, exciting, even frightening, and is getting all the headlines. The other is old news and getting boring. But get this: the boring one is by far the more important.

The new and exciting story is the increasingly worrying developments in the euro area. The old story is the resources boom. Both come to us from the rest of the world. In terms of their effect on our economic growth, the resources boom is a huge stimulus, whereas Europe's problems are a drag on our growth. That drag is small so far but, if the worst comes to the worst, could be a big negative.

Another reason the commodity boom is less exciting is that we've had plenty of them before over our history. But one reason we shouldn't underestimate the boom is that, paradoxically, previous booms have really stuffed up our economy. And these booms can be great for some parts of the economy while making life really tough for other parts.

This week Treasury's Dr David Gruen gave a speech to the Australian Business Economists in which he compared this commodity boom with the one we had in the early 1970s. It helps you see why the econocrats who manage our economy are positively obsessed by the need to make sure we don't stuff this one up.

In contrast to this one, the commodities boom of the early '70s involved big rises in the prices we were getting for our agricultural exports. It got going under the McMahon Coalition government and continued under the Whitlam Labor government.

Comparing the two booms, after the first three years our terms of trade - the prices we receive for our exports compared with the prices we pay for our imports - had improved by about the same extent. In the '70s, they then fell back. This time, however, they continued improving to now be almost 50 per cent better than their best then.

So this boom is a mighty lot bigger - Gruen calls it a ''once-in-a-lifetime boom'' - and a lot longer. This one's been building for eight years (with a brief interruption by the global financial crisis), whereas the earlier one lasted only about three years. The reason this boom is much bigger and longer is that it arises from a historic shift in the structure of the world economy - the industrialisation of Asia - whereas the '70s boom arose merely from an upswing in the rich countries' business cycle.

The greater size and length of this commodity boom has two important implications. First, it's given our miners both the incentive and the time to invest in hugely increasing their capacity to export coal, iron ore and now natural gas. That didn't happen with farmers in the '70s. This present investment boom has added an extra dimension to this boom, thus causing its effect on the economy to be bigger.

Second, the '70s boom was too small and short to have much effect on the industry structure of our economy. But this boom will leave us with a much bigger mining and mining-related sector, thus reducing the relative size of other sectors and putting a lot of pressure to adjust on some industries, particularly manufacturing, tourism and education. It's actually changing our economy's ''comparative advantage'' (what we're good at relative to other countries).

Naturally enough, both commodity booms caused the economy to grow faster. But in the '70s growth was a lot more variable. Real gross domestic product grew almost 9 per cent over the year to March 1973, but by 1975 the economy was contracting. It recovered, then contracted again in 1977. Unemployment, which had been very low for many years, shot up and stayed up. This time, growth has been strong but steady and unemployment has fallen and then stayed pretty low.

In the '70s, the inflation rate took off, reaching a peak of 17 per cent in the mid-1970s and staying pretty high until the mid-1990s. Obviously, the '70s commodities boom can't take all the blame for this long period of economic malfunctioning. But it should get a fair bit, and it certainly got the rot off to a good start.

There's one other big difference between the two booms that does a lot to explain why this boom hasn't caused nearly as much volatility, inflation and unemployment as the first one did: the exchange rate.

The present boom quickly brought about a rise in the value of our dollar. Since June 2002 it has risen by about 45 per cent against the trade-weighted index. In the '70s, the rise didn't happen nearly as quickly or smoothly.

Why not? Because then we had a fixed exchange rate. It could be changed only by a government decision. For political reasons, the two governments waited too long and didn't do enough to get the dollar up.

The point is that our floating currency acts as a shock-absorber when the economy is hit by some shock - favourable or unfavourable - from abroad. In this boom, the higher dollar has caused the Australian-dollar income of the miners to rise by less than it would have, and has effectively handed that reduction in their income to all the other industries and individuals who buy imports. How's it done that? By making imports cheaper.

By transferring income from the miners to the non-miners, the high dollar has helped ensure the rest of Australia gets its cut from the boom, but it's also reduced the size of the commodity boom's effect on the growth in gross domestic product by directing a fair bit of the increased demand into imports. This has caused the boom to generate less inflation pressure, as well as directly reducing the prices of imported goods and services.

So it's clear the present boom has had far more benign effects on the economy than the '70s one did. Our economic managers get a lot of the credit for that, but much credit is due simply to our floating exchange rate.

Gruen concludes, ''if a sizeable boom is being generated in one part of the economy, significant restraint needs to be imposed on other parts to ensure that the economy overall does not overheat''. See what he's saying? Yes, you're right, there is a multi-speed economy and manufacturers and service exporters are doing it tough. But that's not happening by unhappy accident, it's happening by design. Live with it.

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Outlook for politics and government in 2012

Talk to Australian Business Economists Annual Forecasting Conference
Sydney, November 24, 2011

Taken as a whole, the first full year of the Gillard government has been terrible. Julia Gillard has hardly taken a trick all year and her present standing in the polls is worse - much worse, consistently worse - than it was at last year’s election, when she failed to attract enough votes to form government in her own right. Her present primary vote in the low 30s would give her zero hope of winning an election. Only if she could get it up to at least 40 per cent would she be in the hunt. This time last year - three years out from the next election, assuming the government runs full term - I fearlessly predicted Labor would lose it, because ‘this generation of Labor is terminally incompetent’.
Having made that call, I’m sticking to it. I’m doing so even though I know full well how easily the political outlook can change over a period as long as a year, let alone two years. After all, who would have predicted in October 2009 that the election would be months early and fought not between Kevin Rudd and Malcolm Turnbull, but between Gillard and Tony Abbott, that Abbott would come within a whisker of winning and that Labor would be forced into an alliance with the Greens and rag-tag independents?

But I have to add that, at the end of her first year, Gillard and her government are looking in better shape than they did half way through it. The first point to acknowledge is that she’s held her minority government and its alliances together for a year - longer than many people expected - and it’s never seriously looked in trouble. The second is that it’s been a year of great achievement. The opposition has frequently criticised Labor for being unable to actually do anything but, as was always Gillard’s intention, this has been a year of ticking off items on the to-do list - in particular, the various items inherited from Rudd. Of the three big problems he left her, the carbon tax has been put to bed, the mining tax is well on the way and only the asylum-seeker issue remains chronically unresolved. Along with Gillard’s opportunity to be seen looking like a leader on the international stage with other leaders, these runs on the board do much to explain her recent slow improvement in the polls, in the two-party preferred and, particularly, as preferred prime minister.

While the polls continue moving in the right direction - however slowly and with however far to go - Rudd is unlikely to mount a challenge. There’s no reason to doubt his desire to return, and should the poll recovery falter, we’re likely to hear from him. Would the caucus ever turn back to him? There is so much continuing dislike of him they’d have to be terribly desperate, but it’s not impossible. Would it help? No. His grass-is-greener popularity in the polls would soon evaporate as voters were repulsed by this ultimate proof of Labor’s disloyalty, ruthlessness and lack of principle.

Next year should be a year of consolidation and less frenetic policy making, with the government needing to be sure the introduction of the carbon price arrangements goes smoothly. Should the world economy stay on track, the government will press on with its priority of returning the budget to surplus - as, in all the circumstances, it should. Should things go really bad in Europe, the primary response will be from the Reserve Bank, but the government will at least have to reverse its rhetoric and allow the budget’s automatic stabilisers to widen the budget deficit, and may need to consider a new round of fiscal stimulus. For Abbott and the opposition it will need to be a year where, finally, they make their contribution more constructive, outlining their own plans for improvement - even if, as ever, they leave the revelation of their detailed policies until much closer to the election. The longer Abbott continues with his relentless negativity, the more he risks trying the patience of voters.

Can we be sure the minority government arrangement will hold together for another year? No. But the grubby deal to install the former-Liberal Peter Slipper as speaker means it now would take two by-election losses to bring Labor undone. It also reduces Labor’s dependence on any particular independent. And by now it ought to be clear to all that the independents on whose votes Gillard relies have much to gain by continuing to prop her up and much to lose by deserting her. It should also be clear that achieving continued co-operation from the people whose votes she needs is one of the things Gillard is good at.

Why Labor is so bad at it

I have no problem putting the boot into politicians who are flying high, but I don’t enjoy kicking people when they’re down. If for no other reason than that I prefer to be ahead of the conventional wisdom. But I can’t take a look at the political scene and not address the obvious challenge for political analysts: why exactly is this version of Labor so bad at governing?

A host of explanations has been offered, many of which have only some degree of truth and some of which are more in the nature of excuses. One we can dispense with is that it’s all down to the personal failings of Rudd. He had many failings and he left Gillard with a terrible inheritance of a far too long agenda of half-finished policy projects, but we’ve seen enough to know things didn’t immediately look up after his departure.

A favourite excuse of Labor and its supporters is that it’s been turned on by the Murdoch press. It’s true The Australian has turned from being a newspaper to a product aimed at gratifying the prejudices of a particular segment of the audience, but it is - by commercial design - preaching to the already converted. Its influence is limited to those silly people in Canberra who continue to take it seriously, imagining it still to be a newspaper. As for the depredations of Sydney’s Daily Telegraph, it was ever thus. That organ has been a vehicle for foisting the bosses’ views on workers since it was owned by Frank Packer. It’s true the radio shock jocks often take their line from those two outlets, but were they not available the jocks would just have to work harder to find their sources of daily indignation. So, sorry, but I think the Murdoch excuse is greatly overdone. It falls into a class of argument politicians trot out to sustain the faith of the party faithful, not because they believe it or expect the uncommitted to believe it.

I think part of the problem attaches to Gillard herself. The brutal circumstances in which she came to power count against her in the mind of many voters. I don’t doubt there’s an element of misogyny in the electorate’s failure to warm to her and that many people find her voice grates. But her deeper problem is her inability to come over on television as a warm and likable person. Some pollies have that ability, others don’t. Other politicians manage to substitute an air of paternal authority - don’t worry, father is in charge - for likeability (eg Malcolm Fraser, Maggie Thatcher), but Gillard can’t manage that, either.

Lack of an air of authority - leaders who look like leaders and hence command respect and compliance; leaders who seem legitimate - has plagued the Rudd-Gillard government. I’ve come to the conclusion that - at the federal level, at least - the Liberals really are the natural party of government. That’s what the electorate thinks, what business thinks, what the media think, what the Libs themselves think and what, deep down, even Labor thinks. On the central polling question of which party is best to handle the economy, the Libs always win. The Hawke-Keating government managed to out-poll the Libs for a while, but Rudd and Gillard never have. This is not a question of track record, but of long-held and deeply held stereotypes. The party of the bosses will always be better at managing the economy than the party of the workers.

This is what allows Abbott to turn opposition to outright obstruction without attracting criticism. It’s what allows Abbott to take the support of business for granted, while Labor knows it must always be seeking business’s approval. It’s what has allowed business to conclude Labor is anti-business even while Labor modifies its policies - including Fair Work - to avoid offending business. It’s what, in the battle over the mining tax before Rudd’s overthrow, allowed the public to believe the foreign mining giants’ ads claiming the tax would destroy the economy over their own government’s ads assuring them the tax wouldn’t be a problem.

It’s what explains the Libs’ ability to wind up the electorate over Labor’s mountainous deficits and debt and why few economists intervened to dispel the nonsense. It explains why the opposition has had an excessive influence over the government’s fiscal policy and why Labor is obsessed by returning the budget to surplus in 2012-13. It also explains why only at this point have economists entered the debate to attack the government’s deficit mania.

Labor’s universally assumed inferiority - combined with journalism’s highly selective approach to quoting evidence - explains the success of The Australian in convincing almost everyone - punters, gallery journalists and even Labor politicians - that most of the money spent on Building the Education Revolution was wasted.

Associated with Labor’s lack of apparent authority is the phenomenon of the slippery slope. When you’re in power and on top you get a lot of co-operation, compliance and tacit support from interest groups and the public generally - all of which help you stay on top. These benefits of incumbency give you the strength to stand up to particular vested interests and tide you through the ups and downs of the polls. But when your weakness in the polls becomes sustained, you hit the slippery-slope part of the curve where it becomes a lot easier to fall further than to claw your way back up. Where things start to unravel as people who formerly accepted the reality of your continuing authority begin to wonder how long you’ll survive, whether they should give you a push on your way and whether they should start cosying up to your likely vanquisher.

Though she seems to have made a little progress back up the greasy pole in recent days, Gillard has spent most of her time as PM sliding down the slippery slope. It’s a situation that emboldens your critics and opponents while making your supporters more cautious. So things have been unravelling. The denizens of the House with the Flag on Top - pollies on both sides, staffers and journalists - revere success, fear the successful and despise failure. Lindsay Tanner says the press gallery is either at your feet or at your throat. It shifts when it sees you languishing in the polls, emboldened to be a lot more probing and critical and take a lot less on trust. The denizens take the polls so seriously that everyone starts expecting anything you do will fail, and their expectations tend to be self-fulfilling.

One interest group that’s particularly susceptible to this behaviour is business. Business will live with a housetrained Labor government with a steady grip on power. But it does so against its natural preferences. Big business people expect Labor to court them, while quietly accepting it when the Libs choose to ignore or pressure them. Business is very unhappy with Labor and I have no doubt its disenchantment and its increasing willingness to make its unhappiness known is magnified by its perception the Gillard government is not long for this world. It’s willingness to accept the carbon tax has been diminished by Abbott’s success in turning public opinion against the tax. Its complaints against Fair Work - which don’t seem to have great substance - are directed mainly at persuading the next government to shift the balance back in favour of employers. If this does collateral damage to Labor between now and the election, so much the better.

Both the Rudd and Gillard governments seem remarkably inexperienced. This shouldn’t be an excuse because it’s unusual for incoming federal cabinets to have many members with previous ministerial experience. Labor doesn’t seem to realise that maintaining good relations with business isn’t just a matter of senior ministers trying to fit in as many boardroom lunches as possible, or even keeping in touch with the business lobby groups. It means having big business chiefs feel they can ring the PM about a problem and their being on the receiving end of calls from the PM to inquire about their views on relevant matters. The main union leaders would have such a relationship with the PM, but I doubt the business chiefs do. They’d know this and would feel alienated from Labor, especially because Howard was such a great private phoner of power-holders.

Similarly, Labor’s failure to make sure the big miners knew what to expect well before the unveiling of the resource super profits tax is a sign of inexperience. The name of that tax - chosen by Labor’s spin doctors - did much to convince the rest of the business community Labor was anti-profit and anti-business, without doing much to arouse the punters’ resentment of foreign mining giants. Labor’s PR people have been far too young, lacking much journalistic experience, let alone political experience. It should have recruited some old hands. Rudd treated his staff so badly he burnt through a generation of good advisers.

But Labor’s chronic inability to sell its policies to the electorate can’t be explained simply in terms of the inexperience of its spin doctors. It isn’t primarily about spin doctors. I think the root of this generation of Labor politicians’ problem - the key reason they’re so bad at governing - is their background. Unlike earlier generations, almost all of them are apparatchiks; they come from Labor’s professional political class: people who start working for ministers or unions straight from university and climb the Labor career path, never making a success of a career in the outside world or even spending a lot of time as an on-the-ground union official dealing with ordinary workers and disparate employers.

The trouble with this system is that it seems to be breeding a generation of politicians who don’t have a good feel for human nature and, above all, don’t give up their profession and enter parliament with a burning desire to make the world a better place. Their burning desire is to make cabinet minister. Their entry to parliament is a promotion and a pay rise, not any sacrifice. These guys don’t have deeply held values and convictions they’re prepared to fight for and run risks for. Their lack of conviction robs them of the ability to explain policies that arise from their framework of belief. They can’t fashion a compelling narrative of what drives them and where the government wants to take us. They lack the missionary zeal of someone like Paul Keating; they have no desire to convert. They think ‘selling’ policies is a matter for spin doctors and advertising agencies, not of working tirelessly to help people understand the vision and see why it’s so important. When you’re not passionate about explaining your policies, when you’re just a political player, you do what Labor has done from the moment it took office: focus on attacking your opponents, thus conferring them and their criticisms a status they wouldn’t otherwise have. When you’re not a passionate explainer, you avoid answering questions and merely repeat prepared lines.

The problem with all this isn’t just that you fail win public support for your policies, it’s also that the public can sense your lack of commitment and conviction, your preference for self-preservation over leadership, your interests over theirs. You lose authority and respect in the eyes of voters. Courage comes from convictions; public confidence in governments comes from people’s perceptions of your courage and conviction. As John Howard demonstrated with the GST, voters are perfectly capable of giving you grudging respect for pursuing a policy they don’t like the sound of.

Minority government may be the making of Gillard

But having said all that, I now have to highlight a qualification. At the end of its fourth year, Labor has now amassed an impressive list of achievements. Leaving aside its remarkably effective response to the global financial crisis, we have: paid parental leave, equal pay for community workers, plain packaging for cigarettes, the foundations for a national disability insurance scheme, a price on carbon, the likely passage of the minerals resource rent tax, and the continuing pursuit of compulsory pre-commitment on poker machines. (Admittedly, the mining tax was butchered and Labor’s health and hospital changes fell far short of their billing.)

Some of the items on that list may not greatly appeal to you, but they would to the Labor heartland. And it’s noteworthy that some of the items wouldn’t have been there had it not been for the insistence of those whose votes Labor has depended on to stay in government. On the carbon price, in particularly, Gillard had no choice but to press on with its early introduction. See what’s happened? The circumstances of minority government and the ferocious opposition of Abbott have left Gillard with no option but to take principled positions and stick to them through thick and thin. If her improvement in the polls proves lasting, it will be because her failure to win a majority has forced her to exhibit all the impressive qualities she seemed not to possess. Her steadfastness and ultimate achievement may be winning her the grudging respect of the electorate.

Provided she can hold the numbers in the House for another two years, Gillard should benefit from the effluxion of time. It will give people more time to get used to her idiosyncrasies and more time to tire of Abbott’s. And there’d be something very wrong if more than a year of living under the carbon tax didn’t cause people to lose their fear of it.

It’s interesting to observe the way conservatives have transferred the mantle of bogyman from the ALP to the Greens. Labor’s greatest crime is not being typically wrongheaded Labor, but falling under the spell of the demonic Greens. Exhibit A would have to be the carbon scheme. But, apart from its higher levels of compensation to industry, it was little different from Rudd’s carbon pollution reduction scheme, which the Greens rejected out of hand. It’s not politic to say so but, in the end, it was the Greens who changed their tune, much more than Labor did.

The prospect of Abbott

Abbott has been far more effective as opposition leader than I and other smarties expected. He quickly learnt to keep disciplined and avoid putting his foot in his mouth, and quickly displayed his greatest, most enviable strength as a politician: an ability to ‘cut through’ - to have the things he says noticed and broadcast by the media.

His policy of blanket opposition to all the government’s policies has served him well. Many expected the electorate to tire of his relentless negativity, but it hasn’t happened yet. Even so, some strains are beginning to show. His autocratic style has put noses out of joint within the party and, should his standing in the polls ever slip, we will hear from his detractors. There is much discontent within the party and in business over his refusal to criticise Fair Work and propose any changes that could reawaken the spectre of Work Choices.

Despite the opposition’s remarkably strong standing in the polls, Abbott is not personally popular. He has a 55 per cent disapproval rating for his job as opposition leader. And the authoritative Australian Election Study, in which ANU political scientists surveyed voters soon after the last election, found that Abbott’s unpopularity was the main reason he failed to win enough seats. Though Gillard’s popularity rating was low, Abbott’s was a lot lower - lower even than Keating’s in the 1996 election.

Abbott has little interest in economics and no commitment to economic rationalism. His policy positions reek of populism, protection and direct controls. His solemn promises to roll back the carbon and mining taxes, but not reverse the goodies they will be paying for, leave him with a funding gap of many tens of billions he has, as yet, made no attempt to fill. How such a man could bring himself to outline the sweeping spending cuts needed to make good his promise to return the budget to surplus without delay is hard to imagine. He has, however, taken the precaution of refusing to use the services of the new Parliamentary Budget Office to cost his promises. There is no precedent for parties promising to abolish major new taxes already in operation, nor for governments actually doing it. I find it very hard to believe it would happen.

Should Abbott be elected, we face either a monumental breaking of promises or a government totally consumed by the effort needed to turn back the clock. Why the part of the electorate that cares most about good macro management and micro reform has had so little to say about Abbott’s incredible performance I don’t know. Perhaps they’ll have more to say as the reality of an Abbott-led government draws closer.

Observations on monetary policy

I normally begin this section by observing that the market and the business economists have had another bad year in their efforts the second-guess the Reserve Bank’s moves in the cash rate, but this year I have to declare the second-guessers to be ahead on points. The notion that the Reserve might cut rates entered the futures market’s head a lot earlier than it entered the Reserve’s head, so the market has to get credit for that. I’m not sure the market was particularly prescient on size and timing - suggesting it might have been right for the wrong reason. I suspect the market was dominated by foreign players who merely projected North Atlantic conditions onto the Antipodes, making insufficient allowance for local conditions. But, as all of us in the prediction business know full well, a win’s a win. I wouldn’t make those criticisms of the other great hero of this episode, Bill Evans. He stuck his neck out ahead of all of us, we marvelled at his folly, but he turned out to be right and he deserves all the accolades he got.

From where I sit it’s clear to me that to make a legendary call like Bill’s you have to get well ahead of the game, well ahead of the data - and you have to be right. When I saw Bill make his call I thought, that’s not in the Reserve’s plan, so he’ll only be right if he foresees developments the Reserve doesn’t foresee and those developments are big enough to change the plan. He did and they were.

The Reserve begins each year with a view of how the year’s going to pan out and a rough idea of the policy adjustments the outworking of that view will necessitate. It must have such a view because it has an on-the-record forecast, and that forecast is its view. The trick for you guys is to work out what its forecast tells you about the policy adjustments needed to bring the inflation forecast about, given the growth forecast.

This year the Reserve was expecting growth to accelerate as the effects of the resources boom spread through the economy, adding to inflation pressures at a time when we were already close to full employment. It was therefore expecting to have to tighten a few times as the year progressed. But here’s the point: it’s continuously testing its forecasts and its expectations against the data as they roll in. And it makes its judgments about whether policy needs to be adjusted one board meeting at a time. As events unfolded, the economy didn’t accelerate in the way it had been expecting, and so the Reserve never reached a point where it saw the need to act on its ‘bias to tighten’. At first there was the temporary setback of the Queensland floods - which proved less temporary than first thought - and then there was the backwash from the growing sovereign debt problems in Europe, mainly on business and consumer confidence. By November it was clear the economy wasn’t taking off the way the Reserve had expected - mainly because of the confidence backwash from Europe - so the Reserve wasn’t going to have the trouble keeping inflation within the target range it had expected to have, thus allowing it to make what it expects to be a once-off reduction in the cash rate to get it back to neutral. It’s worth noting that part of the scope for this move came not from the effects of Europe but from the past and future revisions to the underlying inflation figures arising from the Bureau’s reweighting of the index.

I don’t think the Reserve has very firm ideas about where the stance of policy goes from here. The economy is pretty much in equilibrium, policy is set at neutral, so the rate will stay where it is until developments occur that knock the economy off its equilibrium path - and off the Reserve’s forecast - in one direction or the other and require a policy response. Clearly, the balance of risks is very much to the downside.

But Bill has made another call and, as I understand it, is predicting another three cuts -presumably 25-basis-point cuts - next year. Here again you see him getting well ahead of the game; well ahead of the Reserve’s thinking, as expressed in its forecast. He can see something coming down the pike the econocrats can’t, and he may again prove himself to be more prescient than them. What would fit Bill’s call of three further cuts over the course of 2012 would be for the economy to slow down rather than speed up as forecast - for it to run out of gas, presumably because of growing caution and uncertainty on the part of business and consumers in response to continued turmoil in Europe. This would be manifest in a continuing rise in unemployment and an inflation outlook that was even more benign, thus allowing the rate to be lowered another click. Of course, were Europe to turn into the full catastrophe, we all know from the events of late 2008 how the Reserve would react. In that case I wouldn’t be surprised to see three cuts next year, but they’d probably come thick and fast, and each be nearer 100 points than 25.

I remarked in my column last Saturday that when the news is full of stories about some economic issue and the authorities pop with a policy change, all the instincts of the media and the punters are to assume that A caused B. In this case, we hear all this bad stuff from Europe, which makes us think the European economy is stuffed, therefore we must be stuffed and that must be what caused the Reserve to slash its forecast and cut the rate. I think all humans have a tendency to string together chains of cause and effect in this way and for our thinking to be unduly influenced by those events that have ‘salience’ (prominence in our consciousness) because they are so dramatic, so highly publicised or so recent.

My point is that this defective reasoning may be very human, but economists need to do better. Because the markets and business economists spend so much time studying developments overseas - usually the US, but these days, Europe - and they do that because national financial markets are so highly integrated - these developments have great salience in their minds, which can tempt business economists to over-weight them when forming views about likely developments in our economy - our real economy.

We need to remember that overseas events may be very exciting and very important, but they’re only relevant to us, our forecasts and our policy stance to the extent that, by some clearly identified channel, they have an effect on our real economy. They may be big in Europe, but are they still big by the time they reach us? Our real economy isn’t nearly as well integrated with the world as our financial markets are. Our domestic demand (GNE) accounts for almost all of our aggregate demand, sometimes more than all. As I keep reminding my readers, roughly 80 per cent of what Australians produce they sell to other Australians and roughly 80 per cent of what they purchase they buy from other Australians. Of course, the sharemarket is a more important channel than it used to be, and so - thanks to an ever-more globally integrated media - are confidence effects. I say all this simply because I keep hearing business economists making predictions about what the Reserve will do, and explaining why it’s done what it’s done, much more in terms of overseas development than I see in all the Reserve’s detailed exposition of why it did what it did. You’ve got to get your direction of causation right. The Reserve is managing our economy, it’s responsible for our inflation rate. Its highest consideration will be what’s happening in our economy and its interest in what’s happening in other people’s economies is limited to assessing the extent to which those events impinge on our economy. That’s obvious, but people who know a lot about what’s happening in other economies seem to keep forgetting it. Sometimes I think the traditional order in which the econocrats set out their analysis - start with the world, then move on to the domestic - may confuse people as to which is the more important.

Last year I advanced my theory that the timing of rate changes is influenced by ‘bureaucratic neatness’. At the time I said:

"Over the past five years the Reserve has changed rates 20 times. Since there are 11 meetings a year, if decisions to change rates occurred at random, each month would have a 9 per cent chance of being chosen for a rate change. The four meetings a year that are preceded by the release of the CPI and followed immediately by the release of the statement on monetary policy, would account for just over 36 per cent of random chances. But, in fact, the SoMP months - February, May, August and November - accounted for 65 per cent of rate changes, with November alone accounting for 25 per cent. The point is that the Reserve has set up a pattern in which the SoMPs come soon after the meeting that comes soon after the CPI release, and two of the SoMPs come not long before the Reserve’s twice-yearly appearance before the parliamentary committee. Remember, too, that the release of the CPI is a key influence on the revision of the Reserve’s inflation forecasts, which are published in the SoMP and which heavily influence decisions about rate changes. The SoMP serves as the main vehicle the Reserve uses to explain and defend its rate decisions. Is it surprising that, having carefully set up the timing of its key publication and parliamentary appearances, the Reserve is more inclined to fit its decisions into that timetable? But why in the past five years has the November pre-SoMP meeting had more than twice the hits that the other three pre-SoMP meetings have had? Perhaps because of an unconscious desire to get the books straight before the end of the year and the knowledge that what you’ve done has to tide the economy over until February."

That was a year ago. What’s happened since then? We’ve had just one rate move and it happened on . . . Melbourne Cup Day, making it the sixth cup day move in a row. Still think it’s mere coincidence? Last year when I advanced my crazy, utterly economics-free theory, my mate Rory Robertson was the first to express his scepticism. So I asked some relevant econocrats what they thought of it. They thought it had some validity. Provided the Reserve hasn’t got behind the curve, and thus needs to catch up ASAP, it will be more inclined to move in those months that fit its carefully constructed reporting cycle.

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