Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.

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How our political prejudices affect confidence

I've realised we won't be satisfied with the state of the economy until the Liberals get back to power in Canberra. That's not because Labor's so bad, or because the Libs would be so much better, but because so many people have lost confidence in Labor as an economic manager.

The conundrum is why so many people could be so dissatisfied when almost all the objective indicators show us travelling well: the economy growing at about its trend rate, low unemployment, low inflation, rising real wages, low government debt - even a low current account deficit.

And yet the media are full of endless gloom, not to mention endless criticism of the Gillard government. Last week the NAB indicator of business confidence dropped to a 10-month low. And while the Westpac-Melbourne Institute index of consumer confidence recovered almost to par, that's a lot weaker than it ought to be.

Admittedly, the good macro-economic indicators do conceal a much greater than usual degree of structural adjustment going on. But these adjustments - which are generally good news for consumers - seem to be adding to the discontent rather than the root cause of it.

The Gillard government has been far from perfect in its economic policy, but you have to be pretty one-eyed to judge its performance as bad. Similarly, only the one-eyed could believe an Abbott government would have much better policies. It's likely to be less populist in government than it is opposition but, even so, Tony Abbott is no economic reformer.

Gillard's problem is not bad policies, it's Labor's chronic inability look and act like our leader and command the public's respect and comprehension. This is a government that doesn't believe in much beyond clinging to office, and the punters can smell its lack of principle.

To be fair, on the question of economic competence Labor always starts way behind the ball in the public's mind. Decades of polling reveals the electorate's deeply ingrained view the Libs are good at running the economy and Labor is bad.

This is what feeds both the Libs' born-to-rule complex - their utter assurance that all Labor governments lack legitimacy - and Labor's barely concealed inferiority complex.

The Hawke-Keating government did manage to turn the electorate's conventional wisdom on economic competence around for most of its 11-year term.

Labor in its present incarnation has never been able to pull this off. It's lost its race memory of how to govern. All this is compounded by the manner of Gillard's ascension, her non-maleness, her inability to make the punters warm to her and the uncertainties (and broken promises) of minority government. But the problem was apparent before Labor decided it could stomach Kevin Rudd no longer.

It's true the media environment is more unhelpful than it was in Hawke and Keating's day. Increased competition has made the media more relentlessly negative - more uninterested in anything but bad news - which must eventually have some effect on the public's state of mind.

In their search for a new audience in response to the challenge of the digital revolution, part of the media has become more partisan and more unashamedly hostile to all things Labor.

You see this in the radio shock jocks, but also in the national dailies, which have adopted the Fox News business model of telling a section of the potential audience what it wants to hear, not what it needs to know.

It seems a universal truth of the commercial media that the right-leaning audience is both more numerous and better lined than the left-leaning.

So, for instance, a favourite commercial tactic at present is to search for, and give false prominence to, all stories that portray our almost-dead union movement as a threatening monster about to engulf big business.

Boosting productivity equals making industrial relations law more anti-union. End of story. When Treasury people give speeches that fail to echo this infallible truth it's a clear sign they've been "politicised" and we need to find a few hyper-ideological economics professors to misrepresent what they said.

When Hawke and Keating were in power, business leaders judged it wise to keep their natural political sympathies to themselves and work with the elected government.

But with Gillard so far behind in the polls, so ineffective in maintaining relations with big business, with the general media so anxious to accentuate the negative and a significant part of the serious press telling them how badly they're being treated and holding out a microphone, it's not surprising big business people have become so unusually vocal in their criticism of Labor.

When God's in his heaven and the Libs rule in Canberra, business people jump on anyone they consider to be "talking the economy down". But so great is their loathing of the Gillard government that business is leading the chorus of negativity. How they see this as in their commercial interest I'm blowed if I know.

While John Howard was in power, the index of consumer sentiment showed respondents who intended voting for the Coalition to be significantly more confident about the economy than those intending to vote Labor. At the time of the 2007 election, however, the two lines crossed and Labor voters became significantly more confident than Coalition voters.

The latest figures show the overall confidence index at 99, while the Labor voters' index is up at 124 but the Coalition voters' index down at 79. Since Coalition voters far outnumber Labor voters, it's clear a change of government would do wonders for measured consumer confidence.

The same would probably be true for measured business confidence. Suddenly, business would be back talking the economy up, and the partisan media would revert to backing up our leaders rather than tearing them down.

But how much difference that would make to the objective economic indicators is another question.

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National productivity comes from firms' productivity

We've been debating what needs to be done to lift Australia's flagging productivity performance for a year, but only this week have we stopped using it in the unending political blame game and got down to some solid economic analysis.


The breakthrough came in a much-discussed speech Dr David Gruen, of Treasury, delivered to the annual Australian Conference of Economists in Melbourne.

Gruen made the apparently hugely controversial point that the primary responsibility for the productivity of the private sector - its output per unit of input - rests with the firms making up that sector and only secondarily with the government.

The government's role is in supporting the productive capability of the economy through investment in education and training, science and research, and infrastructure.

"Government involvement in these sectors is important," Gruen says. "Markets left to their own devices will tend to result in too little investment where there are social or spill-over benefits [in the jargon, 'positive externalities'] to the broader community beyond the returns available to a private investor.

"Governments influence the environment in which firms engage with each other and make investment and production decisions. They set the rules of the game, if you like, and affect the incentives that firms face, and their flexibility to respond."

But it's businesses that do the playing. So what do we know about the drivers of productivity improvement in the private sector? Well, a fair bit of empirical research has been done locally and overseas in recent years.

It shows that overall productivity improves in two different ways. One source is greater technical efficiency through innovation within the firm. Technical improvement comes about through research and development within the firm, or in partnership with the formal research sector.

But as a small country, most of the technology put into production in Australia is first developed overseas, Gruen says. A survey by the bureau of statistics shows only a small fraction of our innovative firms do things that are genuinely new to the world, or even new to Australia. Much more innovation is simply new to a particular industry.

"What usually distinguishes leading organisations is not so much their ability to create knowledge, but rather their ability to absorb technology developed elsewhere and apply it to their own circumstances," he says.

Why do firms innovate? According to the bureau's survey, three-quarters of innovative firms report undertaking innovation to improve profits. About 40 per cent also wanted to increase or maintain their market share and a quarter needed to develop products that were more competitively priced.

That's pretty much what you'd expect, but the second source of productivity gain is less obvious and less benign: it improves when production in an industry shifts from low-productivity firms to high-productivity firms.

A study of Australia firms in the 1990s found a remarkably wide range in their efficiency. The labour productivity of the most efficient firms was about four times that of the least efficient. Only about half this difference seems to be explained by differences in size.

So the productivity of an industry is improved when low-productivity firms are taken over or otherwise cease to exist, and also when new businesses with bright ideas start and grow.

Few people realise how much turnover there is of firms, even when the economy is growing strongly. According to figures from the bureau, about 8 per cent of firms close down each year. And about 40 per cent of new firms exit in less than four years.

Get this: overseas estimates suggest the net effect of the entry and exit of firms accounts for between a fifth and a half of the improvement in labour productivity over time. In high-technology industries, in particular, start-ups play an important role in promoting technological adoption and experimentation, Gruen says.

Hint to politicians: "Policies that act to slow the movement of resources will tend to limit this source of productivity improvement."

Another way to study productivity at the firm level is to look at management practices. Like productivity, management is about how well resources are used in production. So if you can rate particular management practices and give management teams a score, maybe this will help explain productivity differences across firms and even across countries.

One long-running study is doing this for 9000 medium and large manufacturing firms in 20 countries. It gives good ratings to firms that monitor what's going on in the firm and use this information for continuous improvement; set targets and track outcomes, and promote employees based on their performance.

The study shows management practices in Australia are mid-range: well below the United States, Germany, Sweden, Japan and Canada, but similar to France, Italy and Britain. And we have a larger tail of companies at the poor management end of the distribution compared with the US.

Looking at the performance of Australian firms, large manufacturers tend to be much better managed than small ones - a worry because our firms tend to be smaller than those in other countries. And it does seem clear better-managed firms are more innovative and have higher productivity.

Gruen argues periods of significant structural change - as at present - are often periods of growth and reform for the economy.

For a firm that's been doing the same thing for a long time, changes in business models are risky, difficult and may well require staff lay-offs. But when structural change means doing the same old thing is likely to be unprofitable, the opportunity cost of transforming work practices is substantially lowered. Structural change usually involves firms coming under greater competitive pressure. And tough competition and innovative activity seem to go together.

In Australia, firms that report having more competitors, that are in industries with low mark-ups, that export, or that experience downward pressure on profit margins are more likely to be innovators.

Case studies of Australian manufacturers hit by the reduction of import protection in the 1980s and '90s show the firms that succeeded did so by changing their practices. The number of plants diminished, plants became more specialised, model ranges were cut and world-best technology introduced.

Of course, some firms close down and leave the industry. But that's the harsh part of the lovely sounding productivity improvement: Competition boosts productivity partly by moving resources to more successful firms.

Get it? When politicians protect firms from closing, they risk stifling productivity improvement. For countries, comfortable and rich don't go together.

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Why retailers aren't so greedy

When you buy something in a supermarket or a department store, how much of the price you pay is the store's mark-up? And of that mark-up, how much covers the store's costs and how much is clear profit? Everyone has their own answers to these questions. But I suspect most of those answers are based on vague impressions and long-held prejudices rather than hard evidence.

When I was growing up we were always hearing about the depredations of "middlemen". The poor farmers got terribly low prices for their meat and other produce, but by the time that produce went through many hands to reach us in the city, the prices were sky high.

These days, we hear continually about the evil practices of the two big supermarket chains. They're busy screwing the life out of dairy farmers and other suppliers, just so they can use cheap milk and bread to lure us into their stores.

This may sound like a good thing for consumers beset by an ever-rising cost of living, but don't be fooled, we're told. The wicked retailers may be undercharging for a few staples, but they make up for it by overcharging for everything else. Then there are all the people discovering from the internet just how much lower prices are in other countries. More proof we're being ripped off.

In the hands of the media, it's a morality tale. The farmers and manufacturers are the good guys getting squeezed; the big retailers and other middlemen are the bad guys raking it in and doing us down.

It would be good to measure all these impressions against some hard statistical facts - facts supplied by an article in the latest issue of the Reserve Bank's Bulletin, on which I'll be drawing heavily.

Part of the problem is our lack of imagination. Many of us have only a vague idea of the role played by the businesses that operate between primary and secondary producers and you and me.

Most retail goods - including food and non-alcoholic drinks, clothing, footwear, electrical equipment, furniture and home appliances, and motor vehicles, but not "meals out" or takeaways - are produced in factories, whether locally or overseas.

The basic cost of producing those goods includes the cost of transporting them to wholesalers' warehouses, plus import duty where still applicable. Wholesalers incur costs in storing goods and transporting them around the country to retailers' stores, plus normal administrative costs. Retailers incur costs of rent, storage, display, finance and other costs.

Naturally, wholesalers and retailers employ many workers to help them carry out their role, not of making goods, but of distributing them into the hands of consumers across the nation. Indeed, the work of this "retail supply chain" accounts for about 7 per cent of the final value of all goods and services sold in Australia (gross domestic product) and about 10 per cent of total employment. So one worker in 10 is employed as a supposedly unproductive "middleman".

On average, the manufactured cost of the goods we buy accounts for about half the retail prices we pay. About 40 per cent of the prices we pay cover the costs incurred by wholesalers and retailers, with wage costs accounting for a bit less than 20 per cent and other costs for a bit more than 20 per cent.

That leaves the wholesalers' and retailers' net profits accounting for only about 10 per cent of the prices we pay, with about three-quarters of that going to the retailers.

Of course, these overall averages differ for different products. Whereas the gross profit margin (that is, before allowing for expenses) averages 50 per cent, it's closer to 60 per cent for clothing and footwear, a bit over 50 per cent for electrical equipment, a bit under 50 for furniture and appliances, about 40 per cent for food and drink, and just 25 per cent for motor vehicles.

Gross margins also vary according to the size of retail outlets and the speed at which stock turns over. Margins are higher in boutique stores than department stores, and higher in small convenience stores than big supermarkets, where the profit-making emphasis is on rapid turnover rather than high margins.

The Reserve Bank's detailed examination covered the figures for the nine years to 2007-08, though other checks suggest they haven't changed much since then. It found the production prices of locally manufactured goods rose quite strongly over the period. As well, the wage rates and other costs paid by wholesalers and retailers rose by more than 3 per cent a year.

Even so, the final prices of retail goods rose by only about 1 per cent a year. So much for the notion retailers have been getting greedier.

But how have they managed to turn costs rising by 3 per cent or so a year into retail prices rising by 1 per cent and do so without suffering any squeeze in their net profit margins?

Because, although business people are always assuring us there's nothing they can do but pass higher costs on to us, in truth there's a lot they can do.

One thing they've done is increasingly substitute cheaper imported goods for ever more expensive locally made goods. If that worries you, have a look at my little video on the website or iPad app today.

The other thing they've done is raise the productivity of their labour, with the volume of their sales rising a lot faster than the total hours of the workers they employ. They've invested in labour-saving equipment and facilities.

And note this: why have they being working so hard to limit their price rises? Because of the power of market forces - in this case, customers who don't like paying more.

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Economists have no lock on economic understanding

Many people don't realise the economics we hear from politicians, business people, economists and the media, morning, noon and night, is just one way of analysing how the economy works.

Almost everything we're told about what causes what is inspired by the "neoclassical" model. It's long been by far the dominant way of explaining why things happen and predicting what will happen, but it's not the only way. And it's far from infallible.

This conventional economics reduces all economic activity to that which happens within markets. It further narrows the operation of markets to the setting of prices, assuming movements in relative prices are the primary thing influencing the behaviour of producers and consumers.

It thus abstracts from the role of "institutions" - be they organisations, laws or conventions - in influencing market behaviour, so often leads economists to make policy recommendations that prove seriously misguided.

After the fall of communism, for instance, many economists urged the leaders of the formerly planned economies to switch to market-based economies in one big bang.

Since few people knew how to behave in a market economy, it was a disaster.

Only after economic activity had contracted massively did economists realise it was naive to assume that markets could be created out of thin air.

In the 1990s, the International Monetary Fund urged the emerging economies to open up to the free inflow of foreign capital. The result was the Asian financial crisis of 1997-98, when all the foreign capital flowed back out, leaving devastation in its wake.

Only then did economists realise that the developed economies were able to cope with swirling capital flows because of a raft of government-created institutions that had been developed over centuries: well-developed commercial law, with independent courts to enforce contracts; bankruptcy laws to deal with failed businesses; audited financial statements that were roughly believable, and so forth. Developing countries possessed none of these stabilising institutions.

Economic sociologists study the behaviour of markets, but put much emphasis on determining the role of norms of acceptable behaviour. For conventional economists to assume our behaviour in economic situations is heavily influenced by price changes but not by social norms is quite silly.

But for a good example of the way different analytical models can draw different conclusions about the same problem, consider an old economists' favourite: the "tragedy of the commons".

In situations where a piece of land is available for use by different farmers to graze their animals, it's likely to become overused and degraded. Similarly, common fishing areas are likely to be overfished, perhaps to the point where fish disappear. Common logging forests will be overlogged and laid waste.

Although the modern version of this ancient problem, that was used to justify Britain's "enclosure movement" many centuries ago, was first put forward by an ecologist, economists leapt on it with glee. It was clearly a problem of property rights.

Because no one owned the common area, no one had an economic incentive to look after it. Indeed, each individual had an incentive to get in and use as much of it as possible, as quickly as possible, before other individuals used it up.

So what was everyone's property was actually no one's property - and that was the essence of the problem. Many economists thought it obvious that the solution was to allocate private property rights over the commons.

Who they were allocated to, and how they were allocated, didn't matter much. What mattered was that once someone owned the asset, they would have the economic incentive to look after it and prevent its degradation.

In all probability they would continue to make it available to existing users, but at a price. That price would discourage those people from overusing it, while also providing the private owner with both the motive and the means to keep the asset in good repair.

Neat, eh? Of course, there were also some who saw the solution as having the government take over the common property, maintain it and allocate its use on some fair basis.

But there was one obdurate woman who, lacking an economics education, wasn't impressed by the economists' neat analysis of the problem and thought there might be another, better solution - if, indeed, it was a problem.

She was Elinor Ostrom, a professor of political science at Indiana University, who devoted much of her career to combing the world looking for examples where people had developed ways of regulating their use of common resources without resort to either private property rights or government intervention.

As The Economist records, she found forests in Nepal, irrigation systems in Spain, mountain villages in Switzerland and Japan, and fisheries in Maine and Indonesia. In all these cases people drew up sensible rules for sharing the use of the resource and combined to perform regular repairs. People who broke the rules were fined or eventually excluded.

"The schemes were mutual and reciprocal, and many had worked well for centuries," the magazine says.

For her pains, Ostrom, who died last month, was awarded the Nobel prize in economics in 2009, the first woman so honoured. Few economists had heard of her, or her model-busting work.

Why had this solution to the problem never been considered by economists?

Because of their model's implicit assumption that we only ever act as individuals, never collectively. We compete against each other, but we never co-operate to solve mutual problems.

And, since all the market's benefits come via competition, co-operation by producers is probably an attempt to rig the market, which should be outlawed.

The community pays a high price for allowing one model of how the economy works to dominate the advice we get and the way we think.

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Resources boom will lead to much bigger mining sector

A widespread fear - or maybe for some, a hope - is that the resources boom will evaporate someday soon. What will we do once it's over, a lot of people ask. Well, this week we got an answer: export at least twice the minerals and energy we do today.

You can divide the resources boom into three overlapping phases. The first phase is where the prices we receive for our exports of coal and iron ore shoot up to unprecedented levels because the world's exporters of those commodities are unprepared for the surge in demand from China and India as they rapidly industrialise.

The second phase is where our (and the world's) commodity producers seek to take advantage of those remarkable prices by expanding their production capacity as quickly as possible. At first the mining companies expand their existing mines, then they and others begin building new mines.

Much of the financial capital they require to fund this expansion comes from the retained after-tax earnings of the mining companies' shareholders (many of whom are foreigners). Much of the rest of the financial capital will be acquired from abroad. Much of the physical capital (mainly equipment) the miners install will be imported.

As part of the expansion, steps must be taken to ensure sufficient infrastructure exists to transport the minerals or natural gas to the nearest port by road or rail or pipeline, then loaded onto bulk carriers. Often this infrastructure is provided privately, sometimes it's provided by government.

The third phase is where the new production capacity comes on line and the volume of our exports starts to surge. But it won't just be us who are now exporting a lot more. The countries we compete with will also have been expanding their production capacity.

So even if you assume the demand for mineral and energy continues unabated - which is a reasonable expectation in this case - the global surge in supply can be expected to bring down the earlier sky-high prices.

Thus the prices we've been receiving for our exports are certain to fall back. Fortunately, however, this will occur as the volume of those exports is growing, thereby limiting the effect on the total value of our exports.

So, where do we stand in this process?

We've reached the point where, after a lot of global investment in new capacity, global supply has begun to expand and global prices have passed their peak and begun falling.

Thus our terms of trade - the prices we receive for our exports relative to the prices we pay for our imports - peaked in the September quarter and fell back in the two subsequent quarters. The terms-of-trade index (where 2009-10 equals 100) got to 130, but has since fallen by 10 per cent to 117.

Since it was the big improvement in our terms of trade that did most to explain the rise in our exchange rate, this deterioration in our terms of trade might explain why the dollar has fallen closer to parity with the US dollar. We can't be sure, however, because - as you might have noticed - a lot of other worries have been affecting global currency markets lately.

Similarly, although we can't be sure, most economists are confident global coal and iron ore prices won't fall back to where they were before the boom started, meaning our terms of trade will stay above their long-term average.

And, assisted by continuing strong capital inflow to Australia, the dollar will stay well above its post-float average of about US75?. (Meaning, of course, that life will stay uncomfortable for our other export and import-competing industries.)

This doesn't mean the second, investment phase of the boom is nearing its end, however. According to a Bureau of Statistics survey, the industry is expecting to spend a record $120 billion this financial year, up from $95 billion in the year just past.

Much mining investment comes under the heading of "engineering construction". It's expected to grow in real terms by more than 20 per cent in 2012-13 and by 9 per cent in 2013-14. The industry has committed to, or commenced construction on, more than half the fabled $456 billion resources-investment pipeline.

Note that much of the spending in recent times is on the development of liquefied natural gas facilities.

As for the third, export expansion phase, this week we got some new estimates from the Bureau of Resources and Energy Economics. It's expecting the volume of our total minerals and energy exports of about 700 million tonnes a year to more than double by 2025. And that's just the low-range estimate.

We now export about 400 million tonnes of iron ore a year. By 2025, this could grow to between 885 million and 1082 million tonnes. If so, our share of the world export market would go from its previous 30 per cent to between 45 and 55 per cent. Our main competitors are Brazil and West Africa.

At present we export about 20 million tonnes of natural gas a year, giving us just 2 per cent of the world export market. This could increase to between 86 million and 130 million tonnes by 2025, taking our market share to between 10 and 15 per cent. Our main competitors are Qatar, Russia and, in future, North America.

We are now exporting roughly 150 million tonnes of steaming (thermal) coal, giving us less than 20 per cent of the export market. This could rise to between 267 million and 383 million tonnes by 2025, taking our market share to between 23 and 33 per cent. Our competitors include Indonesia and, in future, Mongolia.

Our exports of coking (metallurgical) coal are roughly 150 million tonnes a year, but they could rise to between 260 million and 306 million tonnes. This would take our market share from 60 per cent to between 56 and 66 per cent. So there's a risk we lose market share to rivals such as Colombia.

All this growth isn't expected to much change the states' share of bulk commodity exports by volume. Western Australia has 60 per cent and Queensland has 22 per cent. But NSW has 15 per cent, leaving other states and territories with 3 per cent.

We'll be left with a mining sector whose share of national production (gross domestic product) well exceeds 10 per cent, making it bigger than manufacturing.

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House prices won't collapse, but won't take off either

For years when people at dinner parties worried about houses becoming too expensive for the younger generation to afford, I used to tell them not to worry: it was logically impossible for prices to rise to a level no one could afford. Why do I remind you of this? Because it's starting to look like I was right.

When prices are rising, and have been for many years, it's easy to conclude they'll go on rising forever. Even easier to conclude - as every real estate agent encouraged us to - is that house prices can only ever go in one direction.

As we're discovering, it turns out not to be true. According to Saul Eslake, of Bank of America Merrill Lynch, Australian house prices rose by 142 per cent between 2000 and their peak in late 2010, but in the 18 months since then have fallen by a national average of about 7 per cent. (In Sydney the fall's been 5 per cent; in Perth, 9 per cent, Melbourne 11 per cent, Brisbane 12 per cent.)

There's no shortage of people, particularly foreigners, who're convinced this increase went way beyond what the "fundamentals" of supply and demand could justify - a bubble, in other words - and it won't be long before the bubble bursts and prices come crashing down, as they have in the US and various other countries.

They may prove right, but I'm with Eslake, who argues it's unlikely. He estimates the present level of house prices is fully justified by the change over several decades of the two main factors determining the affordability of housing: household income and the level of mortgage interest rates.

The Australian median house price rose from 2.8 times average annual household disposable income in 1993 to four times in 2001. Since then it's been relatively stable. What allowed that multiple to rise so greatly was a "structural decline" in mortgage interest rates that occurred in the 1990s with the return to low inflation and the shift to the official interest rate being set by an independent central bank rather than politicians.

We could have used that fall in interest rates to pay off our homes much faster, or to increase our spending on other things. Instead we decided to use it to borrow more and move to a better house.

Because so many of us made that choice at pretty much the same time, we weren't all able to move to "better" (bigger, better appointed or better located) homes. Rather, the main thing we achieved was to bid up the prices of homes generally.

In the jargon of economists, we took that essentially once-only fall in the average level of mortgage interest rates - which Eslake estimates to have been about 4.5 percentage points - and "capitalised" it into the value of our homes.

Eslake argues house prices aren't likely to come crashing down because we have the income and borrowing capacity to afford the price of housing at roughly its present level, because we haven't been building more homes than the growth in the population justifies (in fact, we've been building too few), and because we haven't been borrowing against our homes to finance other consumption.

Eslake does predict, however, that house prices will rise much more modestly over the coming decade or two than they did in recent decades. Whereas they rose at the rate of 9.5 per cent a year during the noughties, he predicts rises averaging 3 per cent or 4 per cent a year in future.

Why? Because there won't be another, one-off, structural fall in the level of interest rates that greatly increases our capacity to borrow without increasing our monthly repayments. (Don't confuse the Reserve Bank's ups and downs in interest rates as it manipulates rates to manage the economy through the downs and ups of the business cycle - which get so much attention from the media - with the underlying average level of rates over a longer period.)

Without a structural shift in interest rates, house prices can't rise much faster than household incomes are growing. The indirect flow-through to households of the ever-rising prices we were getting for our mineral exports caused household disposable income to grow at an average rate of about 7.5 per cent a year over the past decade or so.

That compares with 4.5 per cent a year during the 1990s. Now commodity prices have stopped rising and are easing back, a more modest rate of growth is likely in coming years.

Which brings me back to where I started. The value of your home is easily determined: it's worth what you can find someone willing to pay for it. The value of homes generally can be no higher than what people generally are willing to pay and able to pay.

While it's always possible for prices to be higher than particular individuals can afford, it's impossible for them to be higher than most people can afford.

But it's surprising how much flexibility - room for give and take - there is in the system.

Many parents understand that, from their own privileged position as home owners, they have to assist their children to make the expensive step up to a home of their own.

For as long as enough parents see it that way, house prices will stay roughly where they are.

Were too many parents to be unwilling to help their kids make the step up, however, house prices would have to fall. This generation sells its homes to the next generation.

I take the present small falls in house prices as a sign the limits to affordability have been reached, and won't be exceeded.

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Why the banks haven't stuffed monetary policy

A new month, another meeting of the Reserve Bank board on the first Tuesday. Tomorrow, in fact. You beaut, another bout of speculation. Will they or won't they cut the official interest rate?

Thankfully, the speculation is a bit half-hearted this month. Having cut the rate two months in a row, most observers aren't expecting another cut this month.

So let's take the opportunity to discuss a more cerebral question: with the banks now going their own way on the interest rates they charge home buyers and business, does it still matter what the Reserve decides on interest rates?

In theory, it uses changes in its official interest rate to bring about changes in the market rates the banks charge households and businesses. It cuts rates when it wants to encourage borrowing and spending, and thus speed up the economy; it raises rates when it wants to discourage borrowing and spending, and thus slow down the economy.

It manipulates interest rates so as to achieve its inflation target - to hold the inflation rate between 2 and 3 per cent, on average, over the medium term - while also keeping unemployment low. Economists call this manipulation "monetary policy". But with the banks doing their own thing, is monetary policy still effective? If you listen to some bank spokesmen, moves in what the market prefers to call the "cash rate" no longer have a big effect on the decisions banks make about the rates they charge.

Don't you believe it. They're trying to justify their actions, not explain how interest rates work.

The cash rate is the cost of borrowing overnight in the money market; the rate at which the banks lend to each other. The Reserve keeps the cash rate under very tight control by means of "open market operations" - buying or selling second-hand government bonds to the banks.

Between 1999 and 2007, it was easy to see how the Reserve's ability to change the cash rate led to changes in the rates the banks charged on home mortgages and borrowing by businesses: any change in the cash rate - whether up or down - was soon passed on by the banks to their customers.

But from 2007, in the early days of the global financial crisis, that simple relationship broke down and the banks began making "unofficial" rate changes, usually in association with official changes. Why did things change? Because of the money-market disruption and changed relationships brought about by the crisis.

The cash rate is regarded as the risk-free rate of borrowing overnight and it thus forms the "anchor" for all other short-term and variable interest rates in the market. The other rates will usually be higher than the cash rate, with those other rates' margin (or "spread") above the cash rate, reflecting the extra reward to lenders for the various risks they have taken on: the "credit risk" (of not being repaid), the "liquidity risk" (of being unable to sell the debt security without loss because of limited demand for that security) and the "term risk" (of having your money tied up for a longer period).

During the period up to the start of the financial crisis, all these risks, and hence margins, stayed steady. So a change in the risk-free anchor could be passed on mechanically to the banks' borrowers.

But the crisis made people in various international markets a lot more conscious of the risks they were running, thus increasing the spreads they were demanding. Some markets actually ceased to operate for a time.

This wiped out our banks' chief competitors, the mortgage originators, which ended up being bought out by the banks. Later on, the prudential supervisors and the rating agencies decided our banks had made themselves too vulnerable to events such as the GFC by relying too heavily on short-term borrowing from overseas money markets.

So the banks began trying to lengthen the maturity of their foreign borrowing and also began competing with each other to attract more domestic deposits, particularly term deposits.

These changed conditions meant that, though the cash rate - the risk-free anchor for interest rates - remained the largest single influence over the banks' cost of funds, that cost was also influenced by other factors, such as the changing spreads required by foreign long-term lenders to our banks and by the higher rates needed to attract more term deposits from Australian savers.

Anxious to preserve their existing (very generous) "net interest margin" - the difference been the banks' average cost of funds and the average rate they charge their borrowers - the banks have become emboldened to pass any increase in their cost of funds on to their customers independent of changes in the cash rate.

After the Reserve's cut in the cash rate of 25 basis points in June, the banks decided to pass on about 20 or 21 basis points, thus demonstrating that the cash rate remains the dominant influence over market rates (in this example, 84 per cent), notwithstanding the change in the banks' circumstances and behaviour.

The more fundamental reason the effectiveness of monetary policy has not been reduced is the Reserve's repeated statements that the interest rates it cares about are those actually being paid by households and businesses, not the cash rate. So it makes whatever changes to the cash rate are necessary to get mortgage rates and business borrowing rates where it wants them to be.

Many people are highly disapproving of the banks' efforts to preserve their profitability by increasing the spread between the cash rate and the mortgage rate. But don't confuse the question of whether you approve of the banks' behaviour with the question of whether monetary policy has become less effective. It hasn't.

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Poor getting wealthier faster than the rich

There’s not much justice in the world, but there is a bit: according to a researcher at the Reserve Bank, the poor have been getting wealthy faster than the wealthy have been in recent years.

If you find that hard to believe, I don’t blame you. It’s not a conclusion you come to from looking at the Bureau of Statistics’ survey of the distribution of wealth. Rather, it comes from Richard Finlay’s decomposition of the wealth figures included in HILDA - the survey of household, income and labour dynamics in Australia.

But let’s start at the beginning. In Australia, as in all countries, the distribution of disposable income (wages and other earnings, plus welfare benefits, less income tax) between households is quite unequal. And here, as well as in other countries, the distribution of wealth (household assets less liabilities) is even more unequal.

According to the bureau’s figures for 2009-10, the best-off 20 per cent (‘quintile’) of households had 40 per cent of all the income, but 62 per cent of all the wealth. By contrast, the worst-off quintile had 7 per cent of the income, but just 1 per cent of the wealth.

Why the disparity between income and wealth? Partly because some forms of wealth (such as owning your own home) don’t generate explicit flows of income. But also because governments focus most of their efforts on redistributing income rather than wealth between rich and poor, using the tax and transfer (welfare benefits) system.

The poorest 20 per cent of households have some income because the government pays them a pension or the dole to make sure they don’t starve. They have no wealth primarily because they don’t own the home they live in.

So there’s no great mystery to wealth. The main way to acquire it is to buy a home and pay it off. The next most common way is to have a job and be compelled to put 9 per cent of your wage into superannuation saving. Then comes buying a weekender or an investment property.

Most people would have some money in the bank; some people have a lot. About a third of households own shares (directly, not just via super) and some own businesses. It’s mainly these latter that distinguish the really rich.

You’d expect the people with the highest incomes to have to most wealth, but it’s not that simple. People who own their home outright tend to be richer than people with a mortgage and people with a mortgage tend to be richer than people who rent.

As well, older people tend to be richer than younger people because they’ve had longer to save (and benefit from capital gain). Of course, once people retire they inevitably (and sensibly) run down their savings.

Naturally, the value of people’s assets has to be weighed against their liabilities. Few people acquire property without also acquiring debt, and property debt accounts for 80 per cent of all household liabilities. We worry about our credit card debt, but it pales compared with property debt, which divides 70/30 between the principal home and weekenders and investment properties.

It’s much more the rich than the poor who have debts. These days you borrow to make money and, in any case, banks are reluctant to lend to the poor. That’s particularly true of people borrowing for negatively geared property or share investments.

The top income quintile accounts for almost half the total household debt, while the top two quintiles account for more than 70 per cent.

When people see that household debt now accounts for about 150 per cent of annual household disposable income, they think of young couples getting in over their heads to buy their first home. There are some of them, of course, but for the most part the people with the most debt are those with the greatest ability to service it.

Finlay’s article in the Reserve Bank Bulletin says the real (inflation-adjusted) wealth per household was relatively flat from the late 1980s to about 1996. But then it started to increase, driven by the rising prices of property and shares. Over the following decade it grew at the real rate of 6 per cent a year.

But in 2008, ‘with the onset of the global financial crisis, household wealth fell substantially as the prices of dwellings and financial assets fell,’ he says. Wealth recovered somewhat in 2009 and 2010, but since then (and not covered in our figures, which are for 2010) house and share prices have been, as they say in the market, ‘flat to down’.

Over the four years to 2010, mean real wealth per household grew at the rate of just 1 per cent a year. But here’s a trick: whereas the mean (arithmetic average) wealth per household was almost $700,000, the median (middle) wealth was about $400,000.

It’s actually common for the mean to be a lot higher than the median in the case of income or wealth. That’s because a relatively small number of individuals or households are so much better off they push up the mean, thus making the median a better measure of the ‘typical’ household.

Another way to put it is that the distribution of wealth is ‘skewed’ in favour of people at the top. But Finlay finds the degree of skewness seems to have fallen over the past four years.

Using the median rather than the mean to characterise each quintile (which I suspect explains why his findings differ from the bureau’s), he finds that median real wealth in the lowest quintile grew by 5 per cent a year over the period, whereas the medians for the three middle quintiles grew by about 2 per cent a year and for the wealthiest quintile by less than 1 per cent a year.

Why? Partly because of a low-base effect: the less you’ve got to start with, the easier it is to have a larger percentage increase.

But also because richer households tend to hold a higher proportion of their wealth in riskier forms, such as shares. So they would have suffered bigger losses during the financial crisis and maybe smaller gains since then.

Richer households are more likely to have taken on negatively geared property and share investments. The crisis wouldn’t have been kind to them. As well, the very highest house prices tend to be more volatile than other home prices.

There’s just a bit of justice in the world.

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Carbon tax is nothing to object to

When psychologists study those sects that predict the end of the world on a certain day, they find the leaders rarely willing to admit they were wrong and their true believers rarely willing to admit they were duped.

Rather, the sect members find some dubious rationalisation. It was our prayers, brothers and sisters, that interceded for this wicked world and persuaded the Good Lord to stay his hand.

Since the day he won the leadership of the opposition on the strength of his willingness to switch from supporting to opposing putting a price on carbon, Tony Abbott has been predicting the carbon tax would wreak devastation on the economy, wrecking industries and destroying jobs.

To be fair, running scare campaigns against new taxes has always been accepted as a legitimate tactic by our ethically challenged political class.

Labor was happy to exploit the fears of the ill-informed in its opportunist opposition to John Howard's ''great big new tax on everything'', the goods and services tax.

The biggest difference is that Abbott's misrepresentations have been so much more successful.

But with the carbon tax taking effect from Sunday, the moment of truth approaches. Soon enough it will become clear that, for consumers and the vast bulk of businesses, the dreaded carbon tax will have an effect much smaller than the GST.

The retail prices of electricity and gas will rise about 9 per cent, but the increases in other prices will be very small.

Whereas the GST increased the consumer price index 2.5 per cent, the carbon tax is expected to raise it just 0.7 per cent.

Whereas the GST is expected to raise revenue of $48 billion in the new financial year, the carbon tax is expected to raise about $4 billion in its first year and about $7 billion in subsequent years.

Julia Gillard and her supporters have been hoping against hope that, as soon as this reality dawns on a fearful public, as soon as the magnitude of the Liberals' hoax is revealed, voters will switch back to Labor in droves.

I don't see it happening. It rests on an unrealistic view of the lack of self-delusion in human nature.

Political parties and their cheerleaders don't like admitting they've been dishonest - even to themselves. And you and I don't like admitting we've allowed ourselves to be conned by unscrupulous politicians and shock jocks.

So we look for rationalisations, no matter how tenuous. And in these the carbon tax abounds. With the GST, the object of the exercise was clear and simple: to raise more revenue. With the carbon tax the object is far from clear to anyone who hasn't done their homework.

For a start, it's clear the object is not to raise revenue, because much of the revenue raised is being returned to households as ''compensation'' in the form of a small cut in income tax for most people and small increases in pensions, allowances and family benefits.

But if the object is simply to discourage people from using emissions-intensive goods and services - which it is - why give back to most people the extra tax they'll be paying?

Because economists believe that to change people's behaviour it's necessary only to change the relative prices they face: to raise the prices of fossil fuels (particularly electricity and gas) relative to all other prices. It's not necessary to leave people out of pocket by keeping the proceeds from the tax you used to bring about the change in relative prices.

You may say you can't see how such a relatively modest rise in the price of electricity could make much difference to households' use of power. That's probably true, though it may encourage people to buy a more energy-efficient model next time they're replacing an appliance.

Actually, the price increase is aimed mainly at big industrial users of energy and, more particularly, the generators of electricity.

If the industrial users can be induced to eliminate wasteful use of power, this will make a difference. And if power companies can be induced to replace their present generators with less emissions-intensive models when the time comes, this will make a big difference. Raising the price of electricity produced by burning fossil fuels helps make the price of power produced from renewable sources more competitive.

But if those objections to the tax don't wash, there are plenty more. One is that the tax of $23 per tonne of carbon dioxide is way too high. I discuss this one in my little video on the website.

Yet another objection is that, since there's nothing an individual country can do to have a significant effect on global emissions of greenhouse gases, in the absence of a binding agreement to act by all the major countries there's no point in us doing anything.

Trouble with that argument is it increases the likelihood of failure. Only if enough countries demonstrate their good faith by getting on with it is effective global action likely to eventuate. We should line up with the good guys, not the bad guys - and we're far from the only good guy.

But if all else fails - if you can't find any other argument to confirm the wisdom of your original conclusion the carbon tax is a terrible thing - just tell yourself that, when the vast majority of scientists specialising in the area warn us continued emissions of greenhouse gases will lead to devastating climate change, they've got it all wrong.

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Punters turn away from share investment

The return of the prudent consumer is being accompanied by the return of the risk-averse consumer. Households aren't only saving more of their incomes, they're saving more through banks and less through shares.

In the days when the public was less economically literate, many people had no conception of saving other than putting money in the "savings accounts" offered by banks. After a season in which we thought that was for mugs, saving through bank accounts is back.

In truth, the main way Australians saved was to take on a huge home mortgage, then pay it off over the next 25 or 30 years. By the time most people retired, most of their savings were embodied in the unencumbered value of their home.

And their outright ownership of their home was a big part of the reason they were able to scrape by happily enough on little but the age pension. Although the value of the pension has been rising in line with real wages for decades, ours is the first generation convinced it couldn't possibly live on the pension alone.

So it's probably just as well that, starting in the mid-1980s, employees have been compelled to save via superannuation. Super is now the chief rival to paying off a home loan as the main way Aussies save over their working lives.

Remember when John Howard was encouraging us to become "a nation of shareholders"? That was at a time when government-owned businesses such as the Commonwealth Bank and Telstra were being privatised and non-profit outfits such as AMP and the NRMA were being "demutualised", so many households acquired tiny shareholdings of this and that.

And, having taken the plunge, many then acquired shares in the more usual way. Well, owning shares directly is no longer fashionable. Of course, working households' indirect ownership of shares via superannuation increases as each pay day passes.

But, as the Reserve Bank observes in an article in last week's quarterly Bulletin, households have shifted their "portfolios" away from riskier financial assets, such as shares, and towards less risky assets, such as deposits. I'll be drawing from that article.

I've no doubt much of households' saving has taken the form of reducing debts and getting ahead on their mortgage repayments. There was a time when Aussies' highest financial goal was to repay the mortgage as early as possible. That goal is coming back into its own with the return of the prudent consumer.

I guess the chief motivation was a desire to be unencumbered but, as a tax-effective investment strategy, repaying the mortgage has always scored highly - exceeded only by negatively geared property or share investments.

Which brings us back to risk - and risk aversion. Between 2003 and 2007, the proportion of household financial assets held in shares (both directly and via super) increased from 35 per cent to 45 per cent.

Much of this increase came from capital gain. Total return on shares averaged about 20 per cent a year over this period, compared with average deposit rates of about 5 per cent. But then came the fall in wealth caused by the global financial crisis and the mild recession of 2008-09.

Between 2008 and 2011, there were net outflows from households' direct holdings of shares of $67 billion, while holdings of deposits rose by $225 billion.

It's likely people were reacting, on the one hand, to the large capital losses in the sharemarket, but also to the market's volatility, which has doubled since 2007.

But, on the other hand, people would have been reacting to the advent of much higher interest rates offered on bank term deposits as, in the aftermath of the global crisis, the banks bid up those rates in their competition to replace now-riskier overseas funding with more stable, "stickier" funding from domestic deposits.

Over the past 30 years, the average annual real return on Australian shares (including capital growth and dividends) has exceeded the average annual real return on deposits by about 5.5 percentage points.

Since 2008, however, that's been reversed, with a return on shares of minus 5 per cent versus 2.5 per cent on deposits.

The share of households' financial assets held directly in equities has more than halved from 18 per cent before the crisis to 8 per cent at the end of last year. In contrast, the share of deposits has increased from 18 per cent to 27 per cent.

That this shift has been driven mainly by households' greater aversion to risk is confirmed by the changed answers people are giving to relevant questions in the survey of consumer sentiment and other reputable surveys.

In theory, households have shifted to a less risky risk/return trade-off and, by doing so, are willing to live with lower returns over the longer term. But whether the "equity premium" - the much higher rate of return on shares relative to fixed-interest securities - will stay as high as it's been in the past is open to doubt.

The equity premium has always looked much healthier over long periods than it has over many shorter periods, meaning people in or approaching retirement shouldn't be too mesmerised by it and should be favouring more stable returns.

So the shift from shares to deposits may well be explained partly by the baby boomers' rapidly approaching retirement.

The big super funds have also shifted their mix away from shares to some extent, though they've done so by less than the self-managed super funds, suggesting they're more wedded to "equity" than they ought to be.

Why might that be? Well, part of the problem is that the dividend imputation system means share returns are more favourably taxed than fixed-interest returns. Not good.

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Summary of many tax and benefit changes on July 1

The government has taken to announcing changes in taxes and benefits long before they take effect. But that day has to come eventually and a host of changes - big and small, good and bad - are set to start tomorrow week, July 1, the first day of the new financial year.

Actually, all the bad changes start on July 1, but some of the good ones have arrived this month.

Even so, July 1 will be the most significant day for tax changes since July 1, 2000, the start date for the goods and services tax.

Two new taxes are starting, the carbon tax and the mining tax, though combined they raise far less than the GST.

Like the GST, both taxes come as part of packages, meaning much of the proceeds from them are used to cover the cost of cuts in other taxes and increases in pensions and benefits.

But here's a difference: the government is increasing the budget's redistribution of income from higher- to lower-income earners by imposing means tests and by other means.

A means test on the 30 per cent private health insurance rebate will take effect and the 20 per cent net medical expenses tax offset will also be means-tested.

Next are changes to the taxation of superannuation. Super contributions have been taxed at the flat rate of 15 per cent. Now, workers earning up to $37,000 a year will, in effect, pay no contributions tax, whereas those earning more than $300,000 a year will pay 30 per cent.

Older workers had been permitted to make concessional contributions to super, including by salary sacrifice, of up to $50,000 a year, but this will now drop to $25,000.

The minerals resource rent tax will raise only about $3 billion a year and has been designed to have no adverse effects on the economy or retail prices.

Proceeds from the tax will be used to provide two new tax concessions for small business and cover the cost of replacing the tax rebate on parents' spending on school children's education expenses with lump-sum bonuses for each schoolchild. The first bonuses have just been paid.

Mining tax revenue will also cover the cost of a tiny increase in unemployment benefits (from March) and an increase in the family tax benefit Part A, to take effect from July 1 next year.

The carbon tax will fall mainly on the production of electricity and gas. It will add 9 per cent to household electricity and gas bills, but quite small amounts to most other retail prices.

Treasury has estimated that, all told, the tax will add just 0.7 per cent to the consumer price index. Since Treasury was right in predicting the 10 per cent GST would add 2.5 per cent to the index, you can believe it.

However, the total rise in household electricity bills from July 1 will be twice that attributable to the carbon tax.

Whereas the GST will raise $48 billion next financial year, the carbon tax is expected to raise $4 billion in its first year and about $7 billion in later years.

Because it's designed simply to raise the prices of emissions-intensive goods and services relative to other prices, much of its proceeds are being used to compensate people for their higher cost of living.

But, again, the compensation is going only to low- and middle-income earners. Means-tested pensions, allowances and family benefits have already been raised.

And a limited tax cut will take effect from July 1. The tax-free threshold will be raised from $6000 to $18,200 (but with a largely offsetting reduction in the low-income tax offset). About 60 per cent of all taxpayers will get a tax cut worth about $5.80 a week, but no individual earning more than $80,000 a year will receive a cut.

All that higher-income earners get is a separate, backhanded saving: the end of the temporary flood levy.

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We're adding the environment to the national accounts

How do you get economists and business people to take the environment and its relationship with the economy seriously? Change its name to one that resonates with commercial values. What's a word that denotes great value, preciousness to a capitalist? I know - "capital".

You've heard of physical capital (machines, buildings and other structures), financial capital (securities such as shares and bonds), human capital (an educated and skilled workforce) and social capital (the shared values and norms of behaviour that enable mutually advantageous cooperation).

So why don't we rename the environment "natural capital"? It wasn't me who thought of it, however.

It doesn't sound like a lot of progress has been made at the Rio+20 summit on sustainable development. But one thing giving me hope is the "natural capital declaration" made by banks and big businesses, including our National Australia Bank, represented by its chief executive, Cameron Clyne.

"Natural capital," it says, "comprises Earth's natural assets (soil, air, water, flora and fauna) and the ecosystem services resulting from them, which make human life possible. Ecosystem goods and services from natural capital are worth trillions of US dollars per year and constitute food, fibre, water, health, energy, climate security and other essential services for everyone.

"Neither these services, nor the stock of natural capital that provides them, are adequately valued compared to social and financial capital. Despite being fundamental to our wellbeing, their daily use remains almost undetected within our economic system.

"Using natural capital this way is not sustainable. The private sector, governments, all of us, must increasingly understand and account for our use of natural capital and recognise the true cost of economic growth and sustaining human wellbeing today and into the future," the declaration says.

It goes on to say that "because natural capital is a part of the 'global commons' and is treated largely as a 'free good', governments must act to create a framework regulating and incentivising the private sector - including the financial sector - to operate responsibly regarding its sustainable use.

"We therefore call upon governments to develop clear, credible and long-term policy frameworks that support and incentivise organisations - including financial institutions - to value and report on their use of natural capital and thereby working towards internalising environmental costs."

Lovely. Great stuff. Most enlightened. But if you think we're just at the earliest stages of realising we need to measure our impact on the environment and incorporate it into our decision making, I have good news. At the level of national accounting, we're a lot further advanced than you realise.

You often see me banging on about the "national accounts", from which key economic indicators such as gross domestic product emerge. You've also seen me pointing to the limitations of GDP as a measure of wellbeing or progress, particularly its failure to take account of the costs economic activity is imposing on the environment and of the environment's present state of repair.

The "system of national accounts" we use is laid down by the United Nations Statistical Commission for use in all countries. It's an accounting framework that measures economic activity and organises a wide range of economic data into a structured set of accounts. It defines the concepts, classifications and accounting rules needed to do this.

So here's the news: earlier this year the UN Statistical Commission adopted as a new international statistical standard with equal status to the system of national accounts, the "system of environmental-economic accounting" - SEEA.

Our Bureau of Statistics has been at the forefront in the development of SEEA. Last month, it published a document, Completing the Picture: Environmental Accounting in Practice, explaining what SEEA is. I'm drawing on this document.

SEEA is another accounting framework that records as completely as possible the stocks and flows relevant to the analysis of environmental and economic issues. So SEEA is different from the various present independent sets of statistics because it demands coherence and consistency with a core set of definitions and treatments.

Get it? An accounting framework allows you to add a lot of different things together, making sure they fit together logically and there's no double-counting. SEEA puts information about changes in the environment on the same basis as the existing information about changes in the economy, so they can be combined and give us an integrated picture of how the environment and the economy are affecting each other.

Just a small problem, however. The existing national accounts measure economic activity in money terms. To achieve this, they stick almost wholly to measuring transactions in the market, since these reveal market valuations.

But the very reason economists and business people have been taking too little notice of the environment for the past centuries is that, for the most part, it's outside the market system - a "free good". There's not one price for clean air and another for dirty. Photosynthesis, pollination and precipitation are ecosystem services to the economy that aren't paid for, so it's hard to put a figure on what they're worth.

Despite this, SEEA extends the national accounts by recording environmental data that are usually available in physical or quantitative terms in coherence with the economic data in monetary terms. Maybe one day we'll discover a way to value natural capital so we can add it all together.

There are three main types of account in the SEEA framework that are added to the existing monetary flow (the change in something over a period) and stock (the position at a point in time) accounts of the national accounts.

First are physical flow accounts that record flows of natural inputs from the environment to the economy, flows of products within the economy and flows of "residuals" (various forms of waste) generated by the economy. These flows include water and energy used in production and waste flows to the environment, such as solid waste to landfill.

Second are functional accounts for environmental transactions between different economic sectors (such as industries, households, governments). Such transactions include investing in technologies designed to prevent or reduce pollution, restoring the environment after it has been polluted, recycling, conservation and resource management.

Finally, asset accounts in physical and money terms measure the stocks of natural resources available and changes in the amount available. There'd be accounts for minerals and energy, timber, fish, soil, water and land.

The bureau is beavering away to produce more of these accounts. It's making progress in turning SEEA into an Australian reality.

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The economy isn't a Sunday school - it often hurts

When I was a kid marbles were the rage. When you played at home with your brothers and sisters, mum made sure that, whoever won, everyone got their marbles back when the game was over. When you played at school, however, the big boys insisted on "playing for keeps", so kids like me went home with a lot fewer marbles.

I also went to Sunday school, which was run by kindly mothers. If you forgot to memorise your verse of scripture, there was no comeback. If you misbehaved there was no punishment, just a look of disappointment on the face of your teacher.

We've been hearing a lot lately about people losing their jobs. Firms in manufacturing, but also other industries, are announcing redundancies. There've been so many they could give you the impression employment is falling. Fortunately, it isn't; the people losing their jobs are being more than made up for by others gaining jobs (including people who lost their jobs earlier).

Sometimes people are laid off because the economy is in recession, but at present it's happening because powerful forces are changing the industrial structure of the economy. Older industries are shrinking while newer ones are expanding.

It must be a terrible thing to lose your job through no fault of your own, even if they do give you a fat cheque as they push you out. It's anxious waiting after an announcement to see if you'll be among those tapped on the shoulder. When "downsizing" was the fashion in the 1980s and '90s, it was said even those who kept their jobs suffered "survivor guilt".

When you're a victim of structural change - or just a feeling person looking on - it's tempting to look for someone to blame. Managers have been altogether too ruthless in protecting the business's bottom line; they took too long to recognise the problem and when they did respond they could have done it far better. The government should have stepped in to protect the industry.

Since managers are as subject to human frailty as ordinary employees (just extraordinarily more highly paid), there's often some truth to these criticisms - especially with the wisdom of hindsight.

If businesses weren't so quick on the trigger in laying off workers in the early stages of a downturn, fewer downturns would turn into full-blown recessions. If they were more imaginative and innovative they'd find less painful solutions to problems (they'd probably also anticipate a lot of problems that didn't materialise).

But when there are major changes in the forces bearing down on an industry, there's no point imagining change could have been resisted, nor any way that all human pain could have been avoided.

The economy isn't run like a Sunday school. In an economy like ours, everyone - bosses, workers, customers - pursues their self-interest. The economic game is played for keeps. So everyone runs a greater or lesser risk of losing their job. Even bosses get the bullet.

All of us act in self-regarding ways that, whether or not we realise it, contribute to someone's job insecurity. And that means a fair bit of uncertainty, anxiety, fear, disappointment, loss of status, self-doubt, frustration, family discord, despair, humiliation, depression, belt-tightening and worse are part of the deal.

Nor is the risk of pain fairly distributed. Some people never lose their job in a long career, some make the transition to a new job relatively easily, some move into retirement earlier than they'd bargained for, some have considerable difficulty finding another job, some never work again.

Perhaps the greatest force driving structural change is advances in technology - people inventing new products, new things to do or new ways of doing old things. The digital revolution is reshaping our economy - destroying jobs here, creating them there - in ways and to an extent we as yet see only dimly.

Does anyone suggest we should halt technological advance because of all the economic disruption it brings - and has brought since the days of the Luddites? Does anyone imagine such an attempt could work?

Another major force driving economic change is globalisation - the lowering of natural and government-made barriers between countries, caused by technological advance and, to a lesser extent, deregulation.

The historic re-emergence of the mighty economies of China and India - and the rapid economic development of the poor countries generally - is shifting jobs around the world.

Most rich countries are benefiting from cheaper imported manufactures (gains to consumers, but job losses in manufacturing), but Aussies are also benefiting from higher prices and quantities for our rural and mineral exports (increased income for the whole nation, but pressure for capital and labour to shift to mining).

Think the poor countries' pursuit of prosperity should be stopped because of the economic disruption it's causing? Think it could be?

For decades we tried to shut out change from the rest of the world by protecting particular industries. These days we use taxpayer subsidies. But jobs in particular industries can be protected only at the expense of jobs in the unprotected industries. Import restrictions and subsidies merely shift the job pressure (which never troubles the people demanding assistance).

When you're in the thick of it, it's easy to imagine structural change leads to ever-rising unemployment. But businesses have been installing new, "labour-saving" technology continuously for two centuries without it leading to mass unemployment.

Structural change doesn't reduce jobs overall, it destroys them in some industries and creates them in others.

Market economies deliver almost continuously rising material prosperity. But they do so by continually changing, and that change comes with a fair bit of pain for many people.

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Present gloom is more political than economic

The release of two downbeat indicators of business and consumer confidence last week serves only to deepen the puzzle over the gap between how we feel and what the objective indicators are saying about the state of the economy.

My theory is we have two-track minds. Many of us are thinking gloomier than we’re acting.

As you recall, the national accounts from the Bureau of Statistics show real gross domestic product growing by a remarkable 1.3 per cent in the March quarter and a rip-roaring 4.3 per cent over the year to March.

The bureau’s latest labour force figures, for May, show employment growing by an average of 25,000 a month over the first five months of this year, with much of the growth in the ‘non-mining’ states.

I never take the initial reading of frequently revised estimates too literally. The governor of the Reserve Bank, Glenn Stevens, has noted the annual growth figure is probably inflated by a catch-up effect following the disruption to economic activity caused by the Queensland floods early last year. He’s willing to say only that the economy’s travelling at about ‘trend’ (3.25 per cent a year).

Now Dr Chris Caton, of BT Financial Group, has advanced his own theory to explain the surprisingly strong 1.3 per cent growth in the March quarter. He notes the inclusion of a leap day in the quarter - so it contained 91 days rather than the usual 90 - may have thrown out the bureau’s seasonal adjustment process.

Some components of GDP would have been adjusted for this ‘trading-day effect’, but many may not have. Sounds far fetched? Caton looked back over the five previous leap years, finding the March quarter growth figure exceeded the average rate of growth for the three preceding and three subsequent quarters in four of those years, with the excess for the five years averaging 0.46 percentage points.

But even if you accept Stevens’s judgement the economy’s growing at about trend - which I do - you’re still left saying it’s doing a lot better than implied by the gloominess of business and consumer confidence as we conventionally measure them.

NAB’s business survey for May showed business conditions (the net balance of respondents regarding last month’s trading, profitability and employment performance as good) fell to their weakest level in three years.

To put this in context, the conditions index is now 5 points below its long-term average since 1989, but nothing like as bad as it got during the global financial crisis of 2008-09, let alone the recession of the early 1990s.

The index of business confidence (how the net balance of respondents expects conditions to change in the next month) is saying something roughly similar. NAB says the survey implies GDP growth will slow to an annualised 2 per cent in the June quarter.

The Westpac-Melbourne Institute index of consumer sentiment rose a fraction in June to 96, down almost 6 per cent on a year earlier. It’s pretty low, though at nothing like the depths to which it sank in 2008-09.

The overall index can be divided into two bits, the current conditions index and the expectations index. In June the conditions index rose by 6 per cent, whereas the expectations index fell by 4 per cent. And whereas the conditions index stands at 104, the expectations index is a 90.

I’m a great believer that the mood of consumers and business people does a lot more to drive the business cycle than it suits most economists to admit (because their theory tells them little about what drives confidence and, in any case, it’s not easy to be sure what you’re measuring).

So it pains me to admit that, at present - and not for the first time - the conventional confidence indicators seem to have been bad predictors of what HAS happened in the economy, and don’t look like reliable predictors of what WILL happen.

I think there’s a gap between how people are feeling and how they’re acting. How consumers and business people feel is a function of their direct experience and what their peers are saying and doing, but also of what the media is telling them about the wider world.

They probably give a lot more weight to the former than the latter. Direct experience tells them things aren’t too bad; interest rates have dropped a long way in the past six months and, despite all the media stories, they’ve seen little in the way of job losses close to them.

On the other hand, the media are bringing them a lot of worrying news about Europe and elsewhere. It seems pretty clear this is having a big effect on how they feel. It’s less clear how much it has affected their behaviour - so far, at least.

I suspect the present mood - as opposed to present behaviour - is also affected by political sentiment. A lot of people have decided - rightly or wrongly - the economy is being badly managed.

The NAB business survey showed 47 per cent of respondents believed the May budget would have a negative effect on their business. This seems a huge overreaction to the one piece of bad news for business in the budget: the cost of a cut in the company tax rate of a mere 1 percentage point was instead being paid into the pockets of business’s customers.

And consider this: when you divide the consumer sentiment index according to federal voting intention you find the index for Labor voters stands at 119, whereas the index for (the far greater number of) Coalition voters is down to 82.

Perhaps the main thing the confidence indicators are telling us is something we already know: the Gillard government is highly unpopular with consumers and business people.

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How GST has sprung a leak

It's not a good time to be the taxman. The poor chap has fallen on hard times. But if you think that sounds like good news, you haven't thought it through. We don't pay taxes for fun and the government doesn't tear up our money when it receives it. Obviously, it's used to pay for all the services governments provide.

It's now clear how much trouble the Europeans have brought on themselves by ignoring the two sides of their budgets. It's equally clear a big part of the reason we don't share the Europeans' predicament is the acceptance by our governments - federal and state, Labor and Coalition - over many years that their spending and their tax collections must be kept in balance over time.

So if tax collections are falling short of spending, it follows that either spending must be cut or taxes increased. At present, governments are willing to contemplate only spending cuts, and are working on the theory there's enough inefficiency in the public sector to reduce costs without significantly reducing the services it delivers.

But you can push that relatively politically painless idea only so far. And the problems with tax collections are so deep-seated eventually they - and we - will have to face the terrifying prospect of higher taxes.

The federal government has structural problems with income tax, capital gains tax and company tax, but the tax with the biggest problems is the goods and services tax, as was well explained this week in the NSW government's budget papers, which I'll draw on.

When John Howard introduced the GST in July 2000, he neutralised opposition from the premiers by promising them all the proceeds from the tax in place of the feds' former general revenue grants. So GST is a federally controlled and collected tax that benefits only the states.

It's divided between them according to the principle of "horizontal fiscal equalisation", which aims to ensure each state and territory has the fiscal capacity to provide the national average standard of services and infrastructure.

This means the GST proceeds are divided in a way that ensures those states with greater capacity to raise revenue subsidise those with lesser revenue-raising capacity.

For decades this meant taxpayers in Victoria and NSW subsidised taxpayers in all other states. Since 2008-09, however, the resources boom has left the governments of Queensland and, particularly, Western Australia so flush with mining royalties they too have become subsidisers of the remaining states and territories. So, of late, NSW and Victoria haven't had to subsidise the others nearly as much.

When Howard first handed the proceeds of GST to the states, it seemed clear he'd given them the fabulous "growth tax" they'd long dreamt of. Up to 2007-08, collections grew at an average rate of more than 8 per cent a year - faster than the economy (nominal gross domestic product) was growing.

But every time the federal Treasury peers into the future it revises down its projections for growth in GST receipts. It's now expecting growth over the period from 2008-09 to 2015-16 to be just 4.5 per cent a year.

So what's the problem? Well, there are a couple. The first is that, during the 30 years in which Australian households were progressively lowering their rate of saving, their consumer spending on goods and services was (as a matter of simple arithmetic - the formula is: consumption plus saving equals income) growing faster than household disposable income.

But from about mid-2003 households began increasing their rate of saving, and after the global financial crisis in late 2008 they really got down to it. Obviously, while the rate of saving is increasing consumer spending will be growing more slowly than income.

So it's clear the GST captured only the final few years of the outsized growth in consumer spending. In its first year, 2000-01, consumer spending accounted for 59 per cent of nominal GDP. By 2007-08 it had fallen to 56 per cent and by 2010-11, 54 per cent.

But for the past 18 months the net household saving rate has been roughly steady at about 9.5 per cent of household disposable income, meaning consumer spending has been growing at much the same rate as household income. If the household saving rate has stabilised, consumer spending will continue falling as a proportion of GDP only if household disposable income grows at a slower rate than GDP, which doesn't seem likely.

But that's just the first reason the joy has come out of GST as a great little revenue raiser (of an expected $48 billion in the coming financial year, or 3.2 per cent of GDP).

Although we tend to think of GST as a tax on the purchase of all goods and services, in fact a significant slice of the value of our purchases (initially, about 36 per cent) is exempt from the tax. Our spending on rent, health and education were excluded because taxing them accurately was judged too hard. Then spending on food was excluded as part of the deal needed to get the tax passed by the Senate.

Fine. What's happened since then is, although the volume (quantity) of our purchases of these exempt items has grown pretty much in line with the volume of taxable items, the prices of the exempt items have consistently grown faster than prices of the taxable items.

So much so that over the tax's first 11 years, the value (price times volume) of taxable consumption relative to total private consumption has fallen about 4 percentage points.

Since health and education are "superior goods" (we spend an increasing proportion of our income on them as our incomes rise), and costs in both areas grow significantly faster than other consumer prices, we can expect this erosion of the GST tax base to keep rolling on.

At first blush, the feds can dismiss this as the premiers' problem. But the states are so dependent on GST revenue (in NSW's case, to the tune of a quarter of total revenue) and are so restricted by the constitution in what they may tax that, in the end, it's a problem for Canberra.

And since we know from successive intergenerational reports that most of the pressure on federal and state budgets over the next 40 years will come from health spending, the lasting solution is staring us in the face: the GST's tax base must be broadened at least to include private spending on education and health.

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Much change is structural, not cyclical

One of the first lessons economists teach us is that the economy moves in cycles of boom and bust. A second, trickier lesson is that although most of the changes going on in the economy at any moment are "cyclical" (temporary), there may also be changes driven by "structural" (longer-lasting) forces.

In a speech last week, Glenn Stevens, the governor of the Reserve Bank, implied that much of the "unrelentingly gloomy" public discussion about the economy may be caused by people mistaking structural problems for cyclical ones.

Despite the official statistics saying the economy's quite healthy, people think it's weak and want the economy's managers to get it moving by such standard remedies as a tax cut or a cut in interest rates.

But if the problem is structural - if it arises from deep-seated changes in the economic environment - such remedies will make little difference. Structural change is rarely painless - it often involves people losing their jobs and businesses failing - but it's almost always better to adapt to the way the world now works than try to resist it.

The boom in export prices and the construction of new mines arises from the historic re-emergence of the Chinese and Indian economies and is a classic example of structural change. The accompanying high dollar is helping to bring about a long-term shift of workers and capital into mining and away from manufacturing, tourism and overseas education.

But Stevens argues the resources boom is getting blamed for the problems of industries whose tough times are the product of a quite different source of structural adjustment: the markedly changed behaviour of Australian households. Consider his figuring.

In the mid-1970s, households began reducing the proportion of their disposable incomes they saved, meaning their spending was able to grow faster than their incomes. But this went into overdrive between 1995 and 2005.

Over that decade, households cut their rate of saving by a cumulative 5 percentage points. In consequence, their consumer spending grew at an average annual rate of 2.8 per cent per person, after allowing for inflation, even though their disposable incomes grew at a real annual rate of just 2.3 per cent per person.

Why did so many of us feel we no longer needed to save much of our income for use later on? Largely, it seems, because we saw ourselves getting wealthier as each year passed. The gross value of assets held by households - mainly the value of our homes - more than doubled between 1995 and 2007. That involved a real annual increase of more than 6 per cent per person.

Only a small part of this increase came from the building of additional homes. Most of it was just the rise in the prices of existing homes.

So why did housing prices rise so dramatically? Mainly because we went through a decade-long frenzy of competing with each other to move to better homes, which bid up prices.

In the process, of course, households took on a lot more debt, including for investment properties. Total household debt rose from 70 per cent of total annual household income in 1995 to about 150 per cent in 2007. This unprecedented "gearing up" by households was made possible by the deregulation of the banks and the return to low inflation and, hence, low mortgage interest rates.

All this borrowing couldn't have gone on forever, and households began to call a halt a year or two before the global financial crisis reached its peak in late 2008, after which they really began saving a lot more and trying to get on top of their debts.

While households were increasing their rate of saving, their consumer spending grew more slowly than their incomes. But their saving rate has been relatively stable - at a rate last seen in the 1980s - for about 18 months, meaning consumer spending has returned to growing at the same rate as incomes.

As part of our households' return to their former prudence, the rate at which homes change hands has fallen by a third from its average over the previous decade. And now the demand for housing has slackened, house prices have fallen back a bit. They won't keep falling forever, but nor are we ever likely to see them shooting up the way they used to.

The return of the prudent consumer is causing adjustment pains for various industries: the banks aren't doing as much business (I know your heart bleeds), nor are the real estate agents. State governments are getting a lot less revenue from conveyancing duty.

Last but not least are the retailers. The halcyon days of rapid growth in consumer spending are gone for good and they'll just have to get used to it. Those retailers selling the sorts of things people buy when they move into a new home are finding life a lot tougher.

But the end of the "platinum age" is just one source of structural change facing retailers. Another source is that retailers sell goods, but as each year passes, more of the consumer dollar goes on services and less on goods.

Yet another is the digital revolution. While shopping in one store, people are using their smartphones to check the prices being offered in rival stores, then demand they be matched. And the internet is giving people access to the cheaper prices charged by retailers in other countries.

None of these various structural changes are the fault of the government and there's little the managers of the economy can or should do to halt or even alleviate them. Business has little sensible choice but to adjust. In any case, most are for the better.

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