GLOBALISATION - the importance of an economically literate Australia

Business Educators Australasia Conference, Sydney, Thursday, October 4, 2012

Just as the media have lost interest in talking about globalisation it’s starting to have big effects on Australia and on the daily lives of Australians. Often, the consequences of globalisation are buried too deep to be visible to the untrained eye, but that doesn’t change the reality. Why are overseas holidays a lot cheaper these days? Why are a lot of factories laying off workers? Why have the banks started putting up interest rates off their own bat, or not passing on all of the cuts in rates? Why isn’t my super doing as well as it used to? Why are the retailers always complaining? Why do the mining companies keep running all those ads telling us what great guys they are?

The short answer to all those questions is ‘globalisation’. Whenever something changes in Australia we have a tendency to look around us for an explanation. Increasingly, however, the explanation comes from elsewhere in the world. If we want to understand what’s happening to our lives - the forces shaping our lives - we need to understand globalisation: what it is, what’s driving it, how it affects us and where it’s taking us. To be economically literate - to have an understanding of what’s going on - Australians need to understand the process of globalisation. For many of our students, high school is the main chance they’ll have to learn about a largely invisible force that’s influencing their present and their future.

What is globalisation?

Globalisation is a process - a process by which the natural and human-made barriers between countries are being reduced. The natural barriers of time and space are being reduced by advances in technology, particularly the information and communications technology revolution. The human-made barriers between countries are being reduced by deregulation - governments pulling down or greatly liberalising the rules and regulations they have made to keep their economy separate from other economies. Sometimes governments pull down their barriers because advances in technology have made it easy to get around them. The point is that, as the barriers between countries and national economies are reduced, more of the forces changing our lives are coming from abroad.

The back story

I suppose you could say the process of globalisation began with the first trade between countries, by ship or on the Silk Road. But it’s generally held that the first wave of globalisation began in the late 19th century, with the spread of steel-hulled steamships, mass migration to the New World and the invention of the telegraph and laying of undersea cables. This first wave was brought to a halt by World War I and reversed by the protectionist reaction to the Great Depression.

The second wave began slowly after World War II, with the successive rounds of reductions in import duties and restrictions on trade under the General Agreement on Tariffs and Trade, developments in transport (including invention of the jumbo jet), information processing and telecommunications, the development of offshore financial markets and the advent of the multinational company.

At first the great increase in trade was between the developed countries themselves. But then the developing countries - particularly in Asia - began switching their development strategies from ‘import replacement’ (attempting to develop manufacturing sectors behind high barriers to imports) to export-led growth. Developing countries began lowering their protection, and the last round of multilateral reductions in import restrictions under the GATT - the Uruguay round of 1994 - saw many developing countries (including China) joining the newly formed World Trade Organisation.

The emerging economies

The greatly increased trade and flows of foreign direct investment between the developed and developing countries led to strong growth in many developing countries - particularly in Asia. Multinational companies set up manufacturing operations in these countries and transferred the latest technology, effectively spreading the industrial revolution and fostering rapid industrialisation and urbanisation. The most rapidly advancing economies - which are moving from poor to middle-income - are now referred to as ‘emerging economies’. Some countries - including South Korea and Singapore - are now classed among the high-income countries, as developed rather than developing.

Before the industrial revolution began in Europe in the late 18th century, the two biggest economies were China and India. That was on the strength of their big populations. Because China and India remain the two most populous countries, and because their economic emergence began earlier than many other developing countries, their development is shifting the world’s centre of economic gravity from the North Atlantic (America and Europe) towards Asia.

The standard pattern of economic development established in Asia in the decades since World War II has been the production for export of simple, labour-intensive manufactures such as textiles, clothing and footwear, taking advantage of the main thing the poor countries have to offer the world: an abundance of poorly educated but cheap labour. As this early trade starts to lift national income, the level of education and skill rises and the country progresses to producing more elaborately transformed manufactures. Although some people in rich countries imagine it’s not happening, education, skills and national income rise and so do real wage levels. Eventually, labour becomes too expensive for the country to continue producing simple, labour-intensive manufactures, so this production moves to other poor countries that are just starting out on the road to development. Countries that export also have to import; they tend to import those raw materials they don’t produce domestically and capital equipment for further economic development. Initially, economic development probably adds to income inequality in the emerging economies, even while lifting many people out of absolute poverty. Eventually, however, rising real wage rates should work to reduce inequality.

Changing world trade patterns

Historically, the developed countries have been importers of raw materials - food, fibre, minerals and energy - and exporters of manufactures. Much of the growth in their trade with each other since the war has been based on high levels of specialisation - ‘intra-industry trade’ (eg trade between the car makers in different countries) rather than on comparative advantage. Most of their economic growth has come from growth in their services industries - health, education, business services, culture and recreation - most of which hasn’t involved overseas trade.

With the rise of the emerging economies and particularly China, however, much of the world’s manufacturing activity is moving to Asia, causing manufacturing to contract in developed economies and faster growth in their sophisticated services sectors. But the ICT revolution is also making it possible for some services to be traded between countries. Initially this has involved the ‘outsourcing’ of fairly menial jobs such as call centres and data processing, but it is growing to include such high-end services as software development and sub-editing.

Many people in the developed economies are alarmed by the shift of jobs in manufacturing and services to the cheap-labour countries. They see it as a loss with no corresponding gain. Some have even convinced themselves there’s no gain to the cheap-labour countries because multinationals appropriate all the profits. They imagine that because we would not want to work for such pay and conditions, workers in the poor countries are being exploited and gain little. In truth, the poor countries gain greatly from their export income and local workers are keen to get a job and earn an income, particularly the generally better-paying jobs offered by foreign multinationals.

The gains from trade are mutual, though not necessarily equal. Rich countries (and their workers) gain from their access to cheaper manufactures and services, and also from their access to bigger markets for their exports. This is not to deny that the outsourcing of jobs causes pain to workers displaced from their jobs and needing to find new ones, nor that the benefits from trade with poor countries may be shared unequally.

Emerging economies take the running

For many decades, the United States and the other developed countries made the running for the global economy; their growth largely determined the world’s growth. Now, however, China, India and the other emerging economies have expanded to the point where they account for more than half of gross world product (when countries’ GDPs are combined after adjusting to achieve purchasing power parity), and for at least a decade their growth has accounted for most of the annual growth in gross world product. With the North Atlantic economies still mired by the GFC, this is likely to become even truer for at least the rest of the decade, which will hasten the shift in the world’s economic centre towards Asia. Similarly, whereas the cycle in world commodity prices used to be driven by the North Atlantic economies’ economic cycle, now Asia’s cycle - and its more structural demand - will drive.

Australia and the rise of Asia

Whereas the usual pattern is for developed countries to import raw materials and export manufactures, Australia’s huge endowment of national resources means for us it has always been the other way round: we tend to mainly export rural and mineral commodities and mainly import manufactures. For most of the 20th century it looked like we were getting the losing end of the stick. World trade in commodities wasn’t growing much and prices were stagnant, whereas trade in manufactures was growing strongly with ever-rising prices. About the time of the Sydney Olympics, in 2000, it was fashionable for foreign businessmen to condemn us as an ‘old’ economy.

What changed all that was the emergence of the Asian economies, led by China. When countries start to develop they require huge amounts of steel - to make exports but also for building factories, railways, bridges, buildings and even roads. When their consumers become more prosperous they want to buy appliances and cars made of steel. It just so happens that Australia is one of the world’s chief producers and exporters of the two main components of steel: iron ore and coking coal. China’s booming demand for coal and iron ore caught the world’s producers off guard, causing global demand to outstrip global supply, forcing prices up to unknown heights. The main commodity exporters are now rushing to expand supply. As they do prices will fall back.

Since the early noughties we’ve been selling China and India ever-growing quantities of iron ore and coking coal, plus steaming coal for use in power stations, all at exceptionally high prices. This is the origin of our resources boom which, as prices start to fall back, is continuing in a boom of investment in the construction of new mines and natural gas facilities. As this additional production capacity comes on line, the volume (quantity) of our exports of coal and iron ore will be expanding, even as the prices we get for them ease back.

Studies of the stages in the economic development of other, now-developed Asian economies - such as Japan and South Korea - suggest the period during which a rapidly developing economy needs exceptional amounts of steel can last for 20 or 30 years. This explains why the resources boom is regarded as more structural (lasting) than cyclical (temporary). It also explains why the lasting increase in demand for our mineral and energy exports will bring about a change in the industrial structure of our economy. The mining industry will account for a significantly higher proportion of GDP, and its expansion will attract labour and capital from other Australian industries, whose share of GDP will decline.

The rise in the value of the dollar, which has accompanied the rise in the export prices we receive, has worsened the international price competitiveness of our export and import-competing industries, particularly manufacturing, but also tourism and the education of international students. This has the effect of reducing those industries’ sales and profits. Some manufacturers have been hit hard, with factories closing and workers being laid off. The manufacturers are demanding additional government assistance, and get much sympathy from the public. But economists point out that the high dollar and its contractionary effect on manufacturing is actually part of the market mechanism that is helping to shift resources from the contracting manufacturing to the expanding mining. This, of course, doesn’t stop the process being very painful for the manufacturers and their workers.

The high dollar is one of the main ways ordinary Australians are benefitting from the resources boom. It is redistributing income from the miners to all those firms and consumers who buy (the now-cheaper) imports. Everyone who has taken advantage of the strong dollar to go on an overseas holiday is sharing in the benefits from the resources boom, whether or not they realise it. Even so, because the miners are doing so well from the boom they have been seeking to reduce public resentment of their good fortune by running advertisements pointing to all the good things they are doing in the community.

As China and India develop economically they are acquiring a larger and prosperous middle class, which is expected to grow considerably over the next 20 years. The growth of Asia’s middle class will increase the opportunity for greater Australian exports to Asia of food (meat, wheat and dairy products), manufactures and tourism.

The digital revolution

No technological development has done more to break down the barriers between countries than the digital revolution, particularly the spread of the internet, which is now being accessed more easily via tablet devices and smart phones. This is greatly benefitting the users of the internet, but is forcing considerable structural change on many industries.

The internet has undermined the ‘business models’ - the traditional way of selling products - of the music industry, film and television and, with the advent of the e-book, publishing and bookselling. The newspaper industry is being turned on its head by the shift of classified and display advertising and news to the internet and other digital ‘platforms’. The internet is also making many formerly non-tradable services tradable.

The retail industry is being hit and forced to change by a host of different forces: the end of the period in which households were reducing their rate of saving, thus allowing consumer spending to grow faster than household incomes; and consumers’ preferences shifting from goods to services. But the biggest challenge is coming from the digital revolution. People are using their smart phones in stores to compare prices with those offered by other stores and then demand discounts. And people are using the internet to buy online, including from overseas sites. This is not yet having a big effect on retailers, but it will in coming years. Retailers complain that people buying on the internet usually avoid having to pay the GST, and that the high dollar is making overseas prices more attractive. But these are not their biggest problem. It’s that multinational companies are used to selling identical books, CDs, DVDs, software, shoes and many other things at different prices in different countries. That is, for many years many big companies have engaged in international price discrimination, generally charging much lower prices in America than in Britain, with highest prices in Australia. The internet is breaking down this discrimination and will eventually force down many Australian prices.

Financial integration

Since the 1980s, reductions in the cost of telecommunications and deregulation have been turning the many national financial markets increasingly into one big set of global financial markets. As part of this, most developed countries have floating exchange rates, with the level of those exchange rates now affected less by trade flows (the current account of the balance of payments) and more by short-term capital flows (the capital account). This has increased the frequency of financial crises, such as the Asian financial crisis of 1997-98 and the global financial crisis of 2008-09.

Greater financial integration added to the severity of the GFC and the speed with which it spread around the world. While the crisis was centred on America’s sub-prime home loan debacle, it turned out many of these toxic assets had been bought by European banks. The globalisation of the media meant news of bank failures in the US, Britain or Europe was beamed into living rooms in all the countries of the world, almost in real time. This frightening news caused an instantaneous slump in business and consumer confidence in virtually every country, including many not directly affected by the crisis, such as Australian and China and the other emerging economies.

World recessions are usually sequential - some countries are still going in while others are coming out - thus making them less severe. But the world recession precipitated by the financial crisis was highly synchronised because of the integration of global financial markets and the globalisation of the news media. This contributed to the severity of the recession.

The greater integration of financial markets has increased the likelihood of ‘contagion’ - when one country gets itself into difficulty, this may cause the financial markets to lose confidence in neighbouring countries, whether or not they have the same degree of problems as the original country. After the tiny Greek economy got into difficulties within the euro area, European officials worried the market’s loss of confidence could spread to Portugal, Spain and even Italy.

Globalisation has increased the number of ‘channels’ through which economic difficulties in one country are transmitted to other countries. Formerly, the main channel was international trade. Now there’s a financial channel, where problems with the finances of one country lead to a global rise risk premiums, increasing borrowing costs in many other countries. And there’s a psychological channel, where bad news from one part of the world can damage business and consumer confidence in other countries, even those not directly affected.

The GFC and its aftermath in the US and Europe have had a big effect on our banks, even though they had been tightly supervised by our authorities and held few of the assets that became toxic. The world’s central banks have tightened their rules for the world’s banks, requiring them to hold higher proportions of shareholders’ capital and higher proportions of their funds in liquid form. This has increased the costs facing our banks along with other countries’ banks. Before the GFC, our banks obtained a high proportion of the funds they needed to relend to Australian customers from short-term borrowing in overseas markets. At the time, these funds were very cheap. But their price increased greatly as a result of the crisis. After the crisis, our authorities realised our banks’ heavy reliance on short-term foreign borrowing made them vulnerable to further international crises. So they required the banks to borrow for longer periods overseas and to rely more on domestic deposits. The greater competition between our banks to attract local deposits has greatly increased the interest rates they have to pay on those deposits (to the benefit of Australian savers). They’ve also had to pay more for their longer-term foreign borrowings. This has increased our banks’ cost of borrowed funds quite independently of changes in the official cash rate. And it explains why the banks have been increasing their rates without reference to the cash rate and cutting rates by less than the full fall in the official rate. The Reserve Bank has retained its control over market interest rates by cutting its cash rate by more than it otherwise would have.

Our sharemarket is another of the financial markets that has become more globally integrated in recent decades. Being one of the first markets to open each morning, it takes its lead from what happened on Wall Street overnight. You would hope that, eventually, the value of an Australian company’s shares will reflect that company’s own prospects. In the short-term, however, our market tends to reflect the worries of investors in Wall Street and Europe. And the prospects for those economies are not bright at present.

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The psychological roots of morality (and politics)

Paul Keating still quotes his early mentor, Jack Lang: "In the race of life, always back self-interest - at least you know it's trying". This may be why, as treasurer, Keating so readily embraced economic rationalism. The economists' working model assumes the self-interest of the individual is the sole force that makes the world turn.

Fortunately, the latest research tells us it's not that simple.

I can't go on a sight-seeing holiday without taking a few good books for a little intellectual sustenance at the end of the day. One book I took this time was a ripper, The Righteous Mind: Why good people are divided by politics and religion, by Jonathan Haidt, a moral psychologist at the University of Virginia.

Haidt (pronounced Height) says decades of research by political scientists have concluded that self-interest is a weak predictor of voters' policy preferences.

Why? Because people care about the groups they belong to - whether they be racial, regional, religious or political. They seem to be asking themselves not "what's in it for me?" but "what's in it for my group?". Political opinions function as "badges of social membership".

Whereas the old view was that natural selection had caused us to evolve into self-seeking competitors, Haidt argues we're more accurately thought of as "homo duplex" - a creature who exists at two levels: as an individual and as part of the larger society.

Human nature is mostly selfish: our minds contain a variety of mental mechanisms that make us adept at promoting our own interests, in competition with our peers, he says. But human nature is also "groupish": our minds contain a variety of mental mechanisms that make us adept at promoting our group's interests, in competition with other groups.

"We evolved to live in groups. Our minds were designed not only to help us win the competition within our groups, but also to help us unite with those in our group to win competitions across groups," he says. "We are not saints, but we are sometimes good team players."

All this goes a long way towards explaining the psychological roots of morality. Haidt defines moral systems as interlocking sets of values, norms, practices and institutions that work together to suppress or regulate self-interest and make co-operative societies possible.

His research leads him to believe moral intuitions arise automatically and almost instantaneously in our minds, long before moral reasoning has a chance to get started. Moral reasoning is not something we do to figure out the truth. Rather, it's a skill we evolved to further our social agendas - to justify our own actions and defend the teams we belong to.

Human nature is intrinsically moral, but it's also intrinsically moralistic, critical and judgmental.

"Our righteous minds made it possible for human beings - but no other animals - to produce large co-operative groups, tribes and nations without the glue of kinship," he says. "But at the same time, our righteous minds guarantee that our co-operative groups will always be cursed by moralistic strife."

We're much more aware of other people's moral shortcomings than our own, often making us "selfish hypocrites so skilled at putting

on a show of virtue that we fool even ourselves".

Haidt says one of the hardest problems humans face is co-operation without kinship. We instinctively co-operate with people to whom we're directly related, but co-operation within wider groups carries the ever-present temptation to "free-ride" - to enjoy the benefits co-operation brings while avoiding pulling our weight.

The more people free-ride, and the more we see others failing to pull their weight, the more co-operation breaks down and we all forgo the benefits it could bring.

Haidt argues morality is, in large part, an evolved solution to the free-rider problem. We develop norms of acceptable, co-operative behaviour and find ways to sanction people who aren't co-operating.

His empirical research into the moral sentiments of people from around the world leads him to identify six dimensions to people's moral concerns. First is care/harm; we are sensitive to signs of suffering and need, and despise cruelty. Second is liberty/oppression; we resent attempts to dominate us. Third is fairness/cheating; people should be rewarded or punished in proportion to their deeds.

Then there's loyalty/betrayal; we trust and reward team players, but want to sanction those who betray the group. Next is authority/subversion; we recognise rank or status and disapprove of those not behaving properly, given their position. Finally there's sanctity/degradation; we care about what we do with our bodies and what we put into them.

Haidt believes these moral concerns are shared by people regardless of their culture, nationality or wealth. But, of course, people interpret them differently and put more weight on some than others.

Our differing moral emphases are reflected in our differing political sympathies. So the unending battle between small-L liberal and conservative policies is a manifestation of "deeply conflicting but equally heartfelt visions of the good society".

Haidt finds that small-L liberals' moral concerns are limited to just the first three dimensions: they care deeply about the harm suffered by minorities and the needs of the poor, about oppression and about fairness.

Conservatives, on the other hand, care about all six dimensions. Their most sacred value is to "preserve the institutions and traditions that sustain a moral community". So they worry also about maintaining loyalty, acceptance of authority and the sanctity of our bodies.

The conservatives' broader range of moral concerns means they understand the motivations of liberals better than liberals understand the motives of conservatives.

Haidt argues the community benefits from the ever-present tension between the two sides - each emphasises important aspects of maintaining a good society - if only we could restore a greater degree of civility between the contending parties.

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THE ECONOMICS AND POLITICS OF GOVERNMENT INTERVENTION IN THE ECONOMY

Talk to Graduate School of Government, University of Sydney

I want to give you a primer on the pros and cons of government intervention in the economy. While, as public servants, you take government policy activity for granted - it’s what you’re employed to do - the appropriate role of government (whether, and under what circumstances, governments should intervene in markets) is perhaps the most contentious topic in politics and economics. Let’s take a quick look at an aspect of the politics of intervention before we take a much closer look at the economics.

The political philosophy of intervention

The political philosophy of libertarianism - which gives primacy to individual liberty and carries a presumption against the need for government intervention - is overrepresented in the political debate in Australia and particularly the US. While by no means all economists are libertarians, most have a big streak of it in them because the dominant model of conventional, ‘neo-classical’ economics is built on three key assumptions that almost inevitably bias it against intervention. Those who come to the neo-classical model from a political perspective (giving primacy to individual freedom) rather than an economic perspective (giving primacy to the best management of the economy) adopt a fundamentalist, no-questions-asked approach to the model.

The first key assumption is that people always act ‘rationally’ in the decisions they make. That is, they act with clear-headed, carefully calculated self-interest. One of the commonest catch-cries of the libertarians is: how could the government possibly know what’s in my best interests better than I know myself?’. Well, if we all were as rational as the model assumes we are, that would be a killer argument. In reality, however, most of us are often far from rational in much of our decision-making. We act on instinct, we’re swayed by our emotions, we don’t pay enough attention - don’t read the label, the instructions or the product statement - and we tend to do what everyone else is doing. In which case, it’s perfectly possible - in principle, at least - that governments could know what’s in our best interests better than we know ourselves.

The second assumption is that markets are self-correcting or self-righting - that, in the jargon of economists, they have an inbuilt tendency to return to equilibrium. You don’t need to study the behaviour of the financial markets to doubt the veracity of that proposition. Sometimes it happens; many times it doesn’t.

The third assumption is that society consists solely of individuals - individual consumers, and firms so small relative to the size of the market they have no ability to influence the market price. So the possibility of people acting collectively - whether voluntarily or by electing a government to make decisions on their behalf - is simply excluded from model. It admits no circumstance where, by co-operating rather than competing with each other, we could achieve a superior outcome.

Put the three assumptions together - we’re always rational, markets are self-righting and individual actions are the only ones available - and you see why the only thing government intervention could do is stuff things up. Hence the advice to governments: laissez faire - leave things alone.

While the rhetoric of libertarians and some economists implies that markets have always existed and government intervention in markets is a much more recent and unwarranted intrusion, this is not historically accurate. Though it’s true humans have exchanged goods (traded with each other) for millennia, markets in the form we know - the market-based economy - are a much more recent development, dating from the dismantling and replacement of the feudal system. Markets are actually the creation of governments because they rest on government creation and enforcement of private property rights. And much of governments’ actions and interventions over the centuries have as their primary or secondary objective enhancing the functioning of the market-based economy. Think of the regulation of money as a medium of exchange and store of value, bankruptcy rules and commercial law. Even government spending on universal education and health has huge spin-off benefits for the market economy. Quite clearly, there never has been or ever will be such a thing as a ‘free market’. All there is are markets in which governments intervene to a greater or lesser extent.

Libertarians set the liberty of the individual as their supreme value, which must never be compromised. All of us set a high store on personal freedom. But most of us accept there are many other worthy objectives of government that are often in conflict with the untrammelled freedom of the individual. So the most sensible approach is to find the best trade-off between freedom and other important objectives - other dimensions of the public interest - being willing to diminish our freedom to the extent the conflicting objective is sufficiently important.

So much for libertarianism. Fortunately, economists take the question of intervention a little bit more seriously and go a lot deeper. Let’s start again, relying on an article that appeared in the 1995 edition of the Asian Development Bank's Asian Development Outlook.

The assumptions of the neo-classical model

Microeconomic theory starts with a simple model of markets in which there is 'perfect competition'. It says that, in the absence of government intervention, the interaction of self-interested consumers with profit-maximising firms will produce the most efficient allocation of the economy's resources. That is, those resources will be used to produce the particular combination of goods and services that offers the maximum satisfaction of consumers' material wants.

But to reach this desirable conclusion, the model relies on a host of assumptions. Most elementary textbooks list four key assumptions: the market must consist of large numbers of buyers and sellers; every firm must be selling an identical ('homogeneous') product; all buyers and sellers must have complete knowledge of all relevant prices, quantities, conditions and technologies; and there should be no barriers that prevent firms entering or leaving the market.

To these better-known assumptions, however, the Asian bank article adds four more: there should be no spillover or external effects, so that all parties bear the full costs and receive the full benefits of their production and consumption activities; there should be no unexploited economies of scale; all parties must know their own best interests; and there should be no uncertainties or ambiguities.

Do those assumptions strike you as realistic? Can you think of a market in which all of them hold true? Of course not. As the Asian bank says, 'these assumptions are extreme and unrealistic in their literal form'. And that's why this idealised model of perfect competition is merely the starting point of the economists’ theory of markets. 'Despite these glowing theoretical results’, the article continues, 'real-world markets may well be deficient in one or more of the necessary assumptions of the theoretical model and thus may fail to deliver the ideal efficiency that the perfect-competition model promises.'

Causes of ‘market failure’

The next step in the theory is to identify the circumstances in which markets will fail to deliver the goods. The bank lists at least seven kinds of 'market failure'.

First, market power. If there is only one (monopoly) or a few (oligopoly) dominant sellers in a market, and if entry by new firms isn't easy, the established sellers are likely to exercise market power. That is, prices will be higher and quantities produced will be lower than those promised by the competitive model. As well, quality may be lower, varieties limited and innovation diminished.

Second, ‘externality’ effects. If the actions of producers or consumers affect people outside the market, then the market's outcomes are unlikely to represent an efficient allocation of resources. In cases where these external effects are unfavourable - the generation of air or water pollution, for instance - the uncorrected market outcome yields too much of the particular activity, with prices that are too low and with too little effort made to reduce the unfavourable spillovers. In cases where the external effects are favourable - such as an innovation or new idea that others can use - the market outcome yields too little of the activity, with prices that are too high and with too little effort made to increase the externality.

Third, public goods. The two key qualities of public goods are that they are ‘non-rivalrous’ (my consumption of the good doesn’t reduce the quantity of it available to others eg knowledge, use of the internet) and ‘non-excludable’ (no one can be effectively excluded from using the good eg free-to-air television). The standard examples of public goods are lighthouses and defence spending, but there are other, less perfect examples. The free market will produce less of a public good than is in the best interests of the community because it’s so hard for private firms to make sufficient profit from producing it. This is why governments often end up producing those goods and services which have partial or complete public goods characteristics. In practice, most of the services governments provide - including health care, education, law and order, defence and much more - are thought of as public goods.

Fourth, economies of scale. If firms aren't producing in high enough volume to exploit economies of scale fully, then their activities won't achieve allocative efficiency.

Fifth, incomplete information and uncertainty. If sellers and buyers don't have compete information about how products work, the alternative products, the range of prices and even about future events, their production and consumption decisions won't yield efficient outcomes.

Sixth, asymmetric information. If, as is often the case, the sellers know a lot more about the product and the market than the buyers do, then market outcomes will not be efficient.

Seventh, the 'second best' problem. If there are uncorrected market failures in one market, then perfect competition in related markets is unlikely to yield efficient outcomes even in those markets. That's because all markets are interrelated. It follows that, if a distortion in one market can't be corrected directly, a second-best solution may be to induce compensating distortions in related markets.

The economists’ ground rules for intervention

It's because economic theory identifies all these potential forms of market failure that intervention in markets is commonplace. But while the public is always urging governments to intervene to correct problems, real or perceived, and politicians are almost always keen to leap in, economists have a two-stage test before they accept such a need: First, a significant instance of market failure has to be demonstrated and, second, the ability of government intervention to correct the market failure - or at least do more good than harm - has to be demonstrated.

Causes of ‘government failure’

This brings us to a more recent development in economists’ theory of markets, which focuses on the possibility of 'government failure'. Government failure arises where government intervention to correct market failure worsens outcomes rather than improving them, or where the modest benefits don’t justify the considerable costs (eg the various subsidy schemes for household solar power). If we're going to talk about real-world markets, we also have to talk about real-world governments. The Asian bank’s article lists at least four sources of government failure.

First, ill-defined goals. Governments often have very broad, ill-defined and even conflicting goals for interventions. In practice, trying to achieve conflicting goals can lead to arbitrary and inefficient outcomes.

Second, weak incentives and poor management. With ill-defined goals and the absence of a profit motive, public employees are likely to face weak incentives for good performance. Good management is a scarce skill and is usually highly paid. Where top salaries aren't high enough, governments find it hard to attract and retain high-quality managers, thus worsening outcomes.

Third, information problems. Governments may encounter as much or almost as much difficulty in acquiring full information as market participants do.

Fourth, 'rent-seeking' behaviour. Specific interest groups will seek to use the forces of government to create special favours for themselves at the expense of others in the community. For instance, special subsidies, tax breaks or limits on competition. They invariably seek to justify this behaviour by claiming that it's in the national interest or even that it would correct market failure.

The theory of ‘public choice’

This brings us to the relatively recent political/economic theory known as ‘public choice’, developed by James Buchanan and Gordon Tullock. The theory holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever its original motivations, all government regulation of industry ends up being ‘captured’ by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs. The regulated have a huge incentive to get to the regulators so as to modify the regulation in ways the industry finds more congenial, or to advantage the existing players against new entrants or rival industries.

I don’t accept for a moment the accusation that all regulation of industry is subverted. But I do believe there’s more than a grain of truth to the accusation: there is considerable scope for regulatory capture. And I’ve often suspected that the way most bureaucracies are organised - where the department of agriculture looks after the farmers, the industry department looks after the manufacturers, the environment department looks after the greenies, the resources and energy department looks after the miners and the tourism department looks after the tourist industry - could have been purpose-built for regulatory capture. In the various industries’ battle for their share of industry assistance, in the inter-departmental battle for influence and resources, each industry has its own special champion, those whose true role is supposed to be to keep the industry acting within the bounds of the wider public interest. Is the bureaucracy divided up this way just to gain the benefits of specialisation, or is each department’s real role to keep their particular industry happy and not making trouble for the elected government?

Another dimension of potential government failure arises because governments - and government departments and agencies - have some of the characteristics of a monopoly. They deliver public services funded by the taxpayer and there are no alternative suppliers. Monopolies are almost always bad, becoming lazy, unresponsive, self-serving and high-handed in their treatment of the individual members of the public they are supposed to serve, who can be seen as ignorant inconveniences. It’s enormously tempting to deliver services according to rules than suit the department rather than the ‘client’.

I’m never greatly impressed by all the libertarian rhetoric about ‘the nanny state’. But they do have a good point. Governments simply can’t solve all the problems we face in our lives, so we do need to be wary of weakening the ordinary person’s acceptance that the first responsibility for solving their problems rests with themselves. We’ll be helping people who can’t help themselves, and in certain circumstances we’ll be providing universal assistance but, for the most part, it’s down to you. It’s too easy for talkback radio to expect a government solution to every problem that comes along, an expectation that’s fed by the way politicians on both sides seem to be promising just that in every election campaign.

Then there’s the related problem economists refer to as ‘moral hazard’: the more people know they’re covered against risks, the less hard they try to avoid those risks, thus leading to excessive claims for assistance. This is problem with all forms of insurance, which insurance companies try to counter by such devices as no-claim bonuses and high co-payments (‘front-end deductibles’).

My conclusions from the debate

Where I do stand in this debate? I believe market failure is common and that governments should usually act to correct it. But I also believe in government failure and some degree of truth in the public choice critique. Governments and their bureaucrats do sometimes act in their own interests rather than the public’s and some regulation is captured and perverted by those being regulated. So I believe in intervention, but I’ve been around long enough to know it’s a very tricky business, with enormous potential for creating perverse incentives and other unintended consequences. We need to work hard to get the intervention right, minimising unintended consequences and doing more good than harm. This requires a lot of careful thought, trial and error, experimentation, learning from experience and project evaluation. This is why I’m pleased to see you studying Policy in Practice and interested in discussing the choice of appropriate policy instruments.

Some general principles for improving intervention

First, avoid ideological extremes. Because the truth is a hard-to-find position somewhere in the middle, it’s tempting to seek the simple certainty of one extreme or the other. But the sensible position is to be neither opposed to almost all intervention nor indiscriminate in intervening. The hard part of bureaucratic endeavour is to find the sweet spot, where interventions do more good than harm. Avoid prejudiced assumptions that the private sector is always more efficient than the public sector, or that the public sector is always more committed to quality than the private sector. Take a pragmatic, evidence-based approach.

Second, rationalise policy objectives. A great advantage of the private sector is that everything it does has a single, simple objective: to make money. For governments, things are never that simple. They have, and should have, multiple objectives. But while it may be possible to kill two birds with the one stone, it’s never possible to kill five. Politicians always what to use the same dollar to satisfy a host of interest groups and almost always lack the discipline to set priorities among all the things it would be nice to do. But multiple objectives are usually conflicting and unless bureaucrats can reduce that conflict the chances of interventions being ineffective are high.

Third, respect the power of market forces. To deny the infallibility of market forces should not be to underestimate their power. Self-interest is a hugely powerful motivator, not just among the public but also within government and the bureaucracy. And people do change their behaviour in response to changes in prices - sometimes irrationally so. When you try to suppress market forces they usually pop up somewhere else, like squeezing a balloon. People will look for and exploit the inevitable loopholes in your regulations; if there’s a system they’ll game it.

Fourth, by the same token, remember the limitations of the conventional model. Those limitations are so pervasive it’s not surprising interventions lead to so many ‘unintended consequences’. People aren’t rational; they’re influenced by their emotions, by perceptions of fairness and by what everyone else is doing. The model ignores all incentives apart from monetary incentives and disincentives, whereas non-monetary incentives - motivations, would be a better word - are often pervasive. For instance, people can work hard because they’re ambitious for power and promotion independent of the extra salary, because they love what they’re doing, because of a work ethic or a sense of duty, because of the institution’s esprit de corps. Sometimes the creation of monetary incentives - paying people to do things - can be counterproductive if it crowds out pre-existing non-monetary motivations. SES performance bonuses may be a case in point.

Fifth, try to work with the grain. Market forces are so powerful it’s often better to harness them in the service of the regulatory objective than try simply to stomp on them. This is the rational for the ‘economic instruments’, such as trading schemes and pollution taxes, used in environmental regulation. Even so, environmental subsidy schemes can often be terribly wasteful, and in specific areas the best approach can be direct intervention - legislating to raise motor vehicle emission standards or to require the weatherproofing of new-built homes.

Sixth and finally, remember the gold standard of intervention: voluntary compliance. The best laws are laws that don’t need to be enforced because so many people comply with them voluntarily. Why would they? Because they’re actually conforming to the norms of socially acceptable behaviour. Humans are social animals, preoccupied by the desire to fit in, meet the approval of their peers, be like everyone else and be no more antisocial than others. Interventions that undermine existing social norms can be far more unsuccessful and damaging than expected.

Many interventions - whether direct rules about what people may or may not do, or numerical or monetary incentives, such as KPIs - can be so onerous in robbing people of autonomy and ability to exercise their professional judgment that they become counterproductive. People stop trying and caring, and switch to looking for loopholes and ways to cheat the performance measurements. Much better to find ways to get people to internalise the values of the institution or the society, so they do what’s wanted of them out of a sense of duty, loyalty and just the satisfaction of knowing they’ve made their contribution and performed their role well. Intrinsic motivation always trumps extrinsic motivation.

Remember, however, that well-judged interventions, which use the force of law to change people’s behaviour in socially desirable directions, can end up being reinforced by the development of new norms of acceptable behaviour. Why? Because, contrary to everything rationalists assume about how the world works, people seek to reduce their cognitive dissonance by changing their values and beliefs to fit their behaviour. Force me to change my behaviour and I’ll change my values to fit. Changed attitudes towards sexual harassment in the workplace, smoking indoors, and drinking and driving are among the many examples of this process in operation.

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We pay for miners' impatience

Is patience a virtue? Our mothers taught us that it was, but much economic thinking treats it as a vice. And business people treat their impatience as though it's a virtue. But I'm with mum.

What isn't in doubt is that impatience is a pretty much universal human characteristic; we're all impatient, to a greater or lesser extent. I hardly think that makes impatience "rational" but, even so, conventional economics is careful to take full account of it.

The most fundamental reflection of our impatience is found in interest rates. No one is likely to lend money to a non-family member without charging a fee. Lenders want to be rewarded for doing you a favour and also for running the risk they won't be repaid.

But why not charge borrowers a flat fee? Why charge them at an annual rate for however long it is they have your money? Because you're impatient to get it back. So interest rates are a reflection of our impatience.

It's because lenders are always paid, and borrowers always charged, an amount of interest that varies with the length of the loan, that interest rates reflect "the time value of money". Allow for that value and you see why a dollar today is worth more than a dollar tomorrow (or in a year's time).

If you had a dollar today, you could lend it to someone and charge interest; if you needed a dollar today you'd have to pay interest. This being universally true, it becomes "rational" for economic calculations to take account of our impatience, as reflected in our charging of interest on the basis of time.

This is why, if someone promises to pay you $1 million a year for 10 years, it's not sensible to value that promise at $10 million. It's worth less than that because you have to wait so long for the money. How much less? That depends on how long you have to wait and your degree of impatience.

This, of course, explains the common business practice of "discounting" future flows of cash (both incoming and outgoing) to determine the "net present value" of a project. (A "discount rate" is compound interest in reverse, working from the future to the present rather than the present to the future.)

But this practice of discounting at a constant rate over time is far from foolproof. For one thing, behavioural economists have shown that, in real life, we're a lot more impatient in the near term than the longer term ("hyperbolic discounting").

For another, conventional discounting implies we care little about the distant future, which flies in the face of our concerns about the wellbeing of our children and grandchildren ("intergenerational equity") and sustainability - ecological or otherwise.

Business people treat delay as a vice - they're always on their high horse about government delays in approving their projects - but impatience may be motivated by selfishness, shortsightedness and even greed. We want to be richer - and we want to be richer now.

So we demand quarterly performance reports and structure chief executives' remuneration packages to reward them for getting quick results. Then we discover they're neglecting to invest in the longer term, not worrying about what will happen to the business in future years, and complain about "short-termism".

John Maynard Keynes said many wise things, but his most foolish (or misapplied) was that "in the long run we are all dead". It's not true - I'm still alive after first hearing it almost 50 years ago - and it's a maxim most of us will live to regret following.

People have understood the shortsightedness of short-termism for decades, but little or nothing has been done to correct it. The truth is, the business world is shackled by its uncontrollable impatience, to our long-term detriment.

It doesn't seem to have occurred to those people complaining about being in the slow lane of the resources boom that their problems are being compounded by the miners' impatience to get in for their cut while the going is good.

That's because, in business circles, impatience is seen as something to be admired. Among economists, the speed at which market participants wish to proceed is seen as a matter for them in their response to market incentives, not something the government should interfere with.

The more the dollar stays high, despite the fall back in coal and iron ore prices, the more likely it's being held up by the huge mining investment boom, as miners rush to get extra production capacity on line before prices have fallen too far.

Miners are elbowing their competitors aside, trying the grab the labour and other resources they need to get their mine built before other people's mines.

In their mad scramble they're attracting resources away from other industries - including major public infrastructure projects - creating shortages of skilled labour and bidding up wages. This explains why miners are demanding that environmental and other approval processes be speeded up. Worry about the environmental consequences later; let's just do it!

But their mad dash to get their mines built as soon as possible is causing indigestion problems for the rest of the economy.

They're bidding up wages to attract the workers they need, and for a long time the Reserve Bank was afraid they would cause an inflation surge.

It kept interest rates higher in consequence - thus probably adding a little to the dollar's strength - and, either way, making life tougher for the manufacturers and tourism operators.

And all because no one was prepared to tell the miners our minerals would come to no harm staying in the ground, so they should stop making trouble for others by being so impatient.

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Productivity more about technology than reform

A while back I met a businessman who'd been a big wheel in IT. He expressed utter amazement that the Productivity Commission and other economists could attribute the whole of the surge in productivity during the 1990s to micro-economic reform, without a mention of the information and communications technology revolution.

He was right; that's exactly what they do. And he's right, it's pretty hard to believe that computerisation and the digital revolution could make such a big difference to the way so many businesses go about their business without that making any noticeable difference to the nation's productivity.

Can the economists prove the productivity surge in the late '90s and early noughties was caused by the delayed effect of all the micro reforms of the '80s and '90s - floating the dollar, deregulating the financial system, phasing down protection, privatising or corporatising government businesses, reforming taxes and decentralising wage-fixing?

No they can't. The plain truth is so many factors influence productivity, and the figures themselves are so ropey, you can't say what's driving them at a particular point with any certainty.

I think the best you can say is all that reform must surely have had some positive influence. But most economists are great advocates of micro reform, so you've got to allow for salesman's bias.

But here's the big news for that incredulous businessman: for the first time, to my knowledge, the econocrats have acknowledged that IT may have played a significant part in the productivity surge.

The likelihood is accepted in an article on Australia's productivity performance by Patrick D'Arcy and Linus Gustafsson in the most recent issue of the Reserve Bank's Bulletin.

"One possible explanation for the surge and subsequent decline in multi-factor productivity growth in Australia ... over the past two decades is the pattern of adoption of information and communication technologies, which are primarily developed and produced offshore," they say.

"The widespread adoption of these technologies through the 1990s was largely complete by the early 2000s. Assuming that the introduction of computers created a gradual upward shift in the level of productivity of some workers ... this would have been reflected in strong multi-factor productivity in the 1990s, with the contribution to productivity growth moderating in the 2000s once rates of usage had stabilised."

In case you're rusty, "multi-factor productivity" growth measures the increase in the amount of output for a given amount of both labour and capital inputs.

Over the 20 years to 1994, it improved in the market sector at the rate of 0.6 per cent a year. Over the 10 years to 2004, the rate surged to 1.8 per cent a year. Over the seven years to mid-2011, it contracted at the rate of 0.4 per cent a year. Exclude mining and the utilities industry, however, and the underlying improvement was plus 0.4 per cent a year.

If you're a glass-half-full kind of guy, you can say our productivity performance in recent years is only a little worse than our long-term average. But on this score most economists prefer the half-empty view: the rate of productivity improvement has suffered a significant and worrying slowdown in recent times.

Again, that's a salesman's line. The authors observe that what's exceptional is not our present underlying performance but the unprecedented surge in the '90s.

If you're new to the productivity business you could be forgiven for thinking it occurs mainly as a result of economic reform. That's what many economists have been implying, but - as they well know - it's nonsense.

Particularly over the longer term, the primary driver of multi-factor productivity improvement - and the rise in material living standards it brings - is technological advance. That's why it never ceases to surprise me how little interest most economists take in technology and innovation.

But the authors outline what economists do know. "At a fundamental level," they say, "productivity is determined by the available technology (including the knowledge of production processes held by firms and individuals) and the way production is organised within firms and industries."

Conceptually, economists often view technology as determining the productivity "frontier". That is, the maximum amount that could be produced with given inputs.

Factors affecting how production is organised - including policies affecting how efficiently labour, capital and fixed resources are allocated and employed within the economy - determine how close the economy actually is to the theoretical maximum.

This means "trend" (medium-term average) productivity growth is determined by the rate at which new technologies become available (that is, how fast the frontier is shifting out) and also the rate of improvement in efficiency (how fast the economy is approaching the frontier).

"Overall, there is some evidence that both a slowdown in the pace at which the frontier is expanding and the pace at which Australia is approaching the frontier have contributed to the decline in the rate of productivity growth relative to the historically high growth of the 1990s," they say.

However, there is little evidence a lack of incentives to invest in physical capital has been significant in explaining the slowdown in multi-factor productivity growth, we're told.

The authors note that the slowdown in multi-factor productivity improvement has occurred despite continued strong growth in investment. In many cases, new investment involves increasing the stock of physical capital based on existing technologies. And although this "capital deepening" may improve labour productivity, it doesn't necessarily improve multi-factor productivity.

For investment to drive gains in multi-factor productivity, there need to be "spillover effects" that generate a more than commensurate increase in output than the increase in capital.

In practice, this typically requires the introduction of a new technology to be associated with some fundamental reorganisation of production processes, or the development of a genuinely new technology that has benefits greater than the research costs required to develop it.

For these reasons, economists generally view the likely drivers of multi-factor productivity as being research and development spending, investment in human capital (education and skills) and investments in capital equipment that can fundamentally change the way firms operate, such as information and communication technologies.

Figures show a fairly universal slowing in productivity growth in the noughties among the members of the Organisation for Economic Co-operation and Development.

This suggests part of our slowdown may be related to common global factors, such as the pace of technological innovation and adoption.

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We need a more balanced approach to progress

A lot of the problems the nation struggles with and argues over boil down to the considerable potential for conflict between what economists summarise as "equity" and "efficiency".

We act as though one is right and the other wrong but, in truth, sensible people want a mix of both. So, though we don't always realise it, the hard part is finding the best trade-off between the two.

"Efficiency" means taking the scarce resources of land, labour and capital available to the community and employing them in such a way that they produce the combination of goods and services that maximises the satisfaction of the community's material wants.

So it's about improving the productivity of our work effort - getting a bigger bang for our buck and minimising waste. But it's also about being flexible in our response to the change that comes along.

Technology is always improving, allowing us to achieve the things we want more efficiently or even allowing us to satisfy wants we didn't know we had. So we accept it as a force for good, but it can greatly disrupt the lives of people whose jobs have been geared to the old technology.

No one tends to argue against technological change, but we're often less willing to accept change coming from that other major source, change in how the rest of the world relates to us. Why should we change just because they've changed?

Let's say the economic development of China and India reaches the point where they need huge quantities of coal and iron ore to make steel. They're willing to pay much higher prices and their need for a lot of steel is likely to run for several decades.

Are we willing to take their money? Sure. Are we willing to build a lot more mines to accommodate their needs? Sure. Are we willing to pay the various prices that come with this good fortune: the high dollar that makes life a lot tougher for manufacturers and others, the need to shift workers and other resources to other parts of the country, the two-speed economy this will bring? Not so sure.

All this sounding familiar? The efficiency story is one we hear all the time from economists, business people and politicians.

Taken narrowly, "equity" refers to the fairness with which the proceeds from all this efficiency are distributed between individuals and households. Is income being shared more unequally between the top, middle and bottom, or less?

But I want to use the term more broadly to encompass all our non-efficiency objectives. Not just monetary fairness, but our need to preserve the natural environment, need for strong relationships with family and friends, need for recreation and our desire to live in a community that's free, democratic and subject to the rule of law, with harmony between the many groups that make it up.

You can see the scope for conflict between all these objectives. We don't want to be so efficient we're unfair, nor so fair we're inefficient.

Conflict arises partly because people tend to specialise in one objective or another. They bang on about the economy or the environment or social concerns as though their speciality was all that mattered. Business people and economists are particularly prone to having one-track minds, but they're by no means the only super-specialists.

An even bigger problem arises because so many people tend to conceal pursuit of their own interests behind the banner of a larger, worthier cause. Cutting my taxes would be great for the economy. If you care about People not Profit, you'll protect my job from change (what this implies for other people's jobs is not my concern; they can look after themselves).

I have doubts about the sincerity of business groups demanding reforms to correct our supposed weak productivity performance. Why? Because the "reforms" they choose to advocate would benefit themselves in the first instance and the rest of us only indirectly.

But, similarly, unions fight to preserve a status quo that's been overtaken by events and to protect their (surviving) members' interests at the expense of other workers.

Perhaps many of these urgers aren't knowingly dishonest in the way they frame their case, just so conscious of their own interests that they're unable to see how self-serving their arguments are.

Maybe I'm just getting old, but it seems to me the public debate about government policies is getting more self-seeking, strident and polarised.

It also seems the people who worry most about money have more of the stuff and are able to use it to buy a bigger say in the debate. We're always hearing how much money we'll lose if we fail to improve our productivity performance, but we rarely hear about what we have to give up to preserve and enhance our material affluence.

The people reminding us there's more to life than money and the things it buys don't get much of a hearing. Are we being asked to work longer hours (including at the end of a mobile phone)? Will we be required to work on weekends and public holidays? Will that mean we see less of our spouse, kids, extended family and friends? If so, how exactly will we be better off?

Will the hastening pace of modern life make us more stressed and damage our health? Will more people succumb to depression? Will greater efficiency make our jobs less secure and less permanent? Will we continue destroying the environment and losing species? If so, how exactly will we be better off?

We need a more balanced approach to progress. One that weighs the pros and cons of "reforms" more carefully and doesn't go overboard in one direction or another.

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Productivity loses in unholy Gonski money fight

We've just stuffed up a great opportunity to improve worker productivity. You didn't notice? I bet you didn't. It slipped past without the business people and economists who claim to be so concerned about productivity noticing a thing.

It happened last week. The independent schools lobby came out in full cry against the Gonski report's proposal to put federal funding of schools on a needs basis. As is now de rigueur for interest groups on the make, the lobby claimed to have ''modelling'' showing 3200 schools would lose funding under the proposal despite the government's guarantee that ''no school would lose a dollar''.

Though lists of allegedly losing schools were leaked to the Murdoch press, the modelling methodology has not been adequately documented, nor properly examined by the media (fat chance) or anyone else.

But when this attack was combined with the opposition's decision to use Gonski for another scare campaign, Julia Gillard went to water, promising ''every independent school in Australia will see their funding increase under our plan''. In real terms, no less.
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David Gonski and his committee proposed increased funding of $5 billion a year for schools - government or non-government - according to their numbers of low-income, indigenous, disabled, non-English speaking or remote-area students.

According to the calculations of Trevor Cobbold, of the public-school Save Our Schools lobby group, Gillard's promise of extra funding for independent schools regardless of educational need could cost a further $1.5 billion a year.

See what happened? Successful lobbying by the independent schools ensured that, however much extra ends up being spent on federal grants to schools, more will go to privileged students who don't need it and less to underprivileged students who do.

Should Tony Abbott win the federal election, it's likely little or nothing extra will be spent on increasing resources for the education of the underprivileged. And that will be a lost opportunity to improve the future productivity of Australia's workforce.

And yet we've heard not a peep from all those business people, economists and economic rationalists who profess to be so worried about our supposedly weak productivity performance. Why not? Two rival explanations come to mind.

One is that they're not genuine in their concern and are using the productivity argument merely as a cover for their demands the government shift the balance of industrial relations bargaining power back in favour of employers and cut the rate of company tax.

The more charitable alternative is that their thinking moves only in straight lines and familiar ruts, causing them to frame the Gonski debate as one involving ''equity'' (fairness) rather than ''efficiency''. Many economics types regard equity issues as beyond their expertise or interest.

Press them and some will say they believe in ''equality of opportunity'' but not ''equality of outcome''. If so, there aren't many proposals fitting that criterion better than ensuring disadvantaged kids get a decent education.

But you don't have to think hard to realise Gonski represents a rare - and thus highly attractive - case where equity and efficiency aren't in conflict.

When we think about human capital and its contribution to productivity improvement, we tend to think of doing more at the top of the skills ladder. But it applies just as much at the bottom.

Leaving aside the ultimate saving to the taxpayer, the better we educate the disadvantaged, the greater the productivity of their labour and its value to employers. And even if few became brain surgeons, their higher rate of participation in the workforce would increase their contribution to the nation's wealth.

It's important to realise the opportunity for ''moving forward'' we stuffed up last week. Gonski represented an attempt at compromise in the unending public-private school battle, a truce in the class conflict.

It involved an end to the division of federal school grants on the basis of schools' category, with funding growth based on the differing resource needs of disadvantaged students regardless of which system they were in. No school's funding would be reduced no matter how privileged, but in a relatively painless process over time the basis of funding would shift from past entitlement to present student need.

This required the teachers' unions and anti-state-aiders to accept that independent schools would continue to receive significant assistance regardless of need. It required privileged independent schools to accept that, over time, their share of total funding would decline in favour of the disadvantaged.

So who wasn't prepared to compromise? The ideologically crazed unions? No, the money hungry elite schools - as usual, hiding their naked greed behind the camouflage of the cash-strapped Catholic systemic schools and some far-from-loaded, relatively new independent schools.

There's nothing new about the pursuit of blatant self-interest in the eternal political money fight. But the political ''debate'' seems to be getting more selfish and aggressive as each year passes. We used to be able to compromise and co-operate for the greater good - to quietly accept that some people's need was greater than our own - but not any more, it seems.

Some of the headmasters and headmistresses of our elite schools are hugely impressive as individuals. Do they really go along with this self-seeking? Here's a good school motto: the first shall stay first and the last shall stay last.

To see so many professed followers of Jesus using all the secular world's dishonest lobbying tricks to preserve their privilege against the depredations of the undeserving poor is truly disillusioning.

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The tax base is leaking - not good news

One of Julia Gillard's proudest claims is that the federal tax burden is much lower under Labor than it was when John Howard and Peter Costello were in charge. It's true. But it's not anything to boast about - the tax base has sprung a leak. Several leaks.

In the mid-noughties, federal tax receipts hit a record 24.2 per cent of gross domestic product. This year they're expected to equal only 22.1 per cent, despite the introduction of the carbon tax and the mining tax.

The fact is the global financial crisis hit tax revenue hard and it's yet to fully recover. The budget's forward estimates see it returning only to 22.9 per cent by 2015-16.

If you don't enjoy paying tax you may be tempted to regard all this as good news, but as both the present Treasury secretary, Dr Martin Parkinson, and his predecessor Dr Ken Henry have warned in the past week or so, it's quite worrying.

It means the budget won't "whirr back into surplus" the way it did after the recessions of the early 1980s and early '90s. It will be a continuing struggle to keep the budget in surplus, meaning it will take a long time to pay off the net public debt incurred in the recession everyone says we didn't have.

Remember the happy debate about whether we should build up a sovereign wealth fund? Forget it - we just won't have the brass.

It means we'll be struggling to keep up with the growth in existing spending programs - particularly health - with little scope to pay for the disability insurance scheme, the Gonski report's proposals for education, aged-care spending and any other improvements we'd like to see, without dropping some big programs or introducing new taxes.

And as Henry reminded us this week, if the population keeps growing at the rate we expect, we'll need to spend a lot expanding the public infrastructure to accommodate them. Only some of that can be borrowed.

So what exactly is the problem with the tax base? Why has it never been the same since the global financial crisis?

The biggest problem is with company tax collections. For many years they averaged about 3 per cent of GDP, but in the long boom that preceded the crisis, they grew to an unprecedented 5.3 per cent. Last year they were 4 per cent.

Much of the trouble is the collapse of receipts from capital gains tax. The long boom of rising share and property prices resulted in many individuals, companies and pension funds building up capital gains, which became realised and taxable when the assets were sold. Capital gain tax receipts got to as much as about 1.5 per cent of GDP, most of which was paid by companies.

The financial crisis saw big falls in the sharemarket, wiping out unrealised gains and, in other cases, creating realised and unrealised losses. Share prices on the Australian stock exchange haven't yet recovered to their peak before the crisis, and it's hard to see another boom starting any time soon. Property prices are less relevant - capital gains on owner-occupied homes aren't subject to tax - but they haven't been going anywhere either.

At present, gains tax is raising only about 0.5 per cent of GDP.

The second big change in company tax revenue since the crisis concerns the mining companies. The first phase of the resources boom before the crisis saw the prices for coal and iron ore shoot up and the miners' profits with them. Pretty much 30 per cent of that increase would have been taxable.

The second phase following the crisis saw prices go even higher, but by then many of the miners had embarked on major expansion plans, so that the depreciation charges on their capital spending significantly reduced their taxable profits.

So the mining investment boom adds to GDP on one hand, but directly subtracts from company tax collections on the other. Yet another subtraction from company tax collections is the high dollar, which reduces the Aussie-dollar value of export earnings.

The problem with personal income tax collections arises from the eight tax cuts in a row announced by Peter Costello (with Labor delivering the last three). When you cut taxes that often, you do a lot more than give back the proceeds of bracket creep (known to economists as "fiscal drag"). So the real level of income tax was reduced. The second-top rate of tax was greatly reduced and the width of the tax brackets was widened, with the threshold for the top rate raised from $60,000 to $180,000 a year, thereby greatly reducing the tax scale's capacity to generate bracket creep.

What this means is that, with company tax collections then riding so high, the Howard government thought it could bring about lasting change in the tax mix, making the budget more reliant on revenue from companies and less from individuals. Then company tax revenue collapsed.

Yet another tax with big problems is the goods and services tax. With households' decade-long spending spree a thing of the past, consumption spending is now growing no faster than household incomes.

But not all consumer spending is subject to the GST, and some of the categories that aren't - particularly private spending on education and health - are growing a lot faster than the categories that are, meaning GST collections are growing more slowly than consumption.

You may think this a problem for the premiers rather than the feds, but state budgets are so heavily dependent on the GST that what's a problem for the premiers becomes a problem for the prime minister.

That's not the states' only revenue problem. They're locked in a destructive competition to raise the threshold at which payroll tax becomes payable. And the weakness of the residential property market - including the lower number of sales - has hit another key state tax, conveyancing duty.

Although some of these many problems with the tax base may go away in time, it's hard to see that time occurring in the next five to 10 years. And by then the problems for the taxman created by globalisation and the greater mobility of capital and highly skilled labour (which I wrote about last Saturday) may be starting to bite.

To many people - particularly business people - the words "tax reform" make them think of paying less tax. One day soon it will dawn on them that the reform we must bring about is new and higher taxes.

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THE EVER-EVOLVING POLICY MIX: Keeping up with changing fashions in macro management

Talk to VCTA Teachers Day, Melbourne, Friday, August 24, 2012

One of my self-appointed roles is to help economics teachers keep up to date with changing economic policy and economic thinking. Today I want to give you an update on the policy mix, but I’m going to put it in historical context and so it will also involve a bit of a refresher course. The macro managers change the policy mix in response to the economy’s ever-changing circumstances, but there’s also a fair bit of economic fashion involved.

What we call the policy mix the academic literature calls the ‘assignment of instruments’. On the one hand, the macro managers have various economic policy objectives. On the other, they have various instruments, or tools, available to use to meet those objectives. They have to decide which instruments are best-suited to use to achieve which objectives. This assignment is fairly settled, but does change over time in line with changing circumstances and changing views. The other thing that changes with the economy’s circumstances - and particularly its present position in the business cycle - is the ‘stance’ or setting of the key policy instruments.

I’m going to discuss four objectives: internal balance, external balance, fiscal sustainability and faster growth with greater flexibility. Then I’ll discuss the five instruments we’ve used on and off over the years to achieve those four objectives: monetary policy, fiscal policy, exchange rate policy, incomes policy and micro-economic policy.

Internal balance

Achieving internal balance is the single most important objective of the macro managers. It means achieving ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy at present is travelling at close to full capacity. (Remember that, although we think of full employment as referring primarily to the employment of labour, it also refers to the full employment of all factors of production.)

The other way to think of internal balance is that it involves achieving a fairly stable rate of growth. It’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a reasonably steady or stable rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’ and ‘stabilisation policy’. The greatest swearword in demand management is to call some policy decision ‘pro-cyclical’ - something that will increase the amplitude of the business cycle rather than narrowing it.

External balance

The objective of external balance (or external stability) has had a chequered history. In the years before the dollar was floated in 1983, it would have meant keeping the exchange rate fixed at the rate established under the post-war Bretton Woods system of fixed exchange rates. To be forced to devalue or revalue the exchange rate was regarded as a sign of serious economic mismanagement. To avoid having to devalue, it was necessary to ensure the economy didn’t grow too quickly and suck in too many imports, thus incurring a deficit on the current account greater than the net capital inflow on the capital account and thus running down the stock of foreign exchange reserves. This could lead to a period of uncertainty, speculation by people paying for imports and receiving money for exports, and a run on the currency while the government agonised over a devaluation. When the economy was growing too quickly and pulling in too many imports it was said the economy had hit the ‘balance-of-payments constraint’, to which the answer was always to use tight fiscal and monetary policies to crunch demand, including demand for imports.

After the exchange rate was allowed to float in 1983 - following another exchange-rate crisis earlier in the year - the RBA withdrew from the forex market and allowed the dollar’s value to be continuously determined by the relative strength of the demand for and supply of Aussie dollars. This meant the deficit on the current account was always exactly offset by the surplus on the capital account. It also meant the disappearance of the balance-of-payments constraint, though it took economists quite a few years to realise how much the rules had changed.

After the float the current account deficit became a lot bigger, with a lot more of it financed by foreign borrowing rather than foreign equity investment, thus causing the foreign debt to rise rapidly. As part of our slowness to understand the full implications of leaving the world of fixed exchange rates, the Hawke-Keating government became very concerned about the high CADs and growing foreign debt. During this period the meaning of ‘external stability’ became achieving a manageable CAD and an acceptable level of foreign debt.

Sometime after the election of the Howard government, however, academic economists led by the ANU’s John Pitchford finally succeeded in convincing Treasury (having much earlier convinced the RBA) that seeking to influence the CAD was not an appropriate objective of macro management. This case was strengthened once the federal budget returned to surplus and the government adopted its ‘medium-term fiscal strategy’ of achieving a balanced budget on average over the cycle, meaning the budget balance (net public sector saving or dissaving) would make no net contribution to the CAD over the cycle. In the early 2000s, the Howard government quietly abandoned external stability as a policy objective. This has not changed under the Rudd-Gillard government.

Fiscal sustainability

In the 2012 budget papers, the Gillard government formally articulated a new macro policy objective: ‘fiscal sustainability’. This means avoiding the build-up of an excessive stock of government debt as a consequence of many years of running budget deficits. The perils of excessive debt are now painfully apparent in Europe, where the financial markets’ unwillingness to continue funding some governments is forcing them to adopt policies of ‘austerity’ that are actually counterproductive (pro-cyclical). You can argue the Europeans’ problem was caused by the GFC, with all the borrowing needed to bail out their banks and reinflate their economies. You can also argue their problems have been greatly compounded by the unstable foundations on which their euro currency union was built. But the fact remains that, had they not run up such high levels of public debt before the GFC, they would have been far better placed to cope with its demands. By contrast, Australia’s longstanding implicit objective of fiscal sustainability left us very well placed to cope with the GFC. We were able to spend and borrow heavily to stimulate the economy, and had it been necessary to borrow to rescue our banks we would have been starting with a clean slate. In all these circumstances, it’s not surprising the government has raised fiscal sustainability to the status of a formal objective. Getting back to our earlier position of no net public debt will take a long time.

Faster growth, with greater flexibility

It was under the Hawke-Keating government (1983 to 1996) that the policy makers acquired another explicit objective: faster economic growth, combined with a more flexible economy - one capable adapting to economic shocks (shifts in the aggregate demand or aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

That brings us to the end of the policy objectives, so now let’s look at the five policy instruments used over the years.

Monetary policy

Monetary policy has been assigned the objective of achieving internal balance. The 2012 budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In developed economies, the modern approach to monetary policy involves the adoption of a ‘framework’ to govern the way it’s conducted, including an inflation target and a central bank that’s independent of the elected government ie able to change interest rates without the government’s permission. In Australia, the formal acceptance of the RBA’s independence, and its inflation target, was made by the Howard government in 1996.

Although the mechanics of monetary policy involve manipulation of the overnight cash rate via open market operations (often abbreviated to just market operations), one of the main ways it works is by achieving and maintaining low inflation expectations. Expectations matter because they tend to influence the behaviour of price setters and wage bargainers. The lower expectations are, the easier is for the RBA to keep actual inflation low without having to keep monetary policy tight and growth slow. Part of the inflation target’s role is to ‘anchor’ inflation expectations at between 2 and 3 per cent. But the target’s effectiveness in anchoring expectations rests on the RBA’s credibility - the public’s confidence that it will keep inflation within the target it has set itself. Its credibility came only after it had achieved several years of keeping actual inflation within the target range. The greater its credibility, the faster it can allow the economy to grow. And the more well-anchored inflation expectations are, the less inflation-prone the economy will be.

Implicit in all I’ve just said is that, though the expression of monetary policy’s target deals solely with inflation, it’s quite mistaken to assume the RBA cares solely about inflation and doesn’t care about growth and unemployment. What it actually indicates is the belief that a foundation of low inflation provides the only basis for sustainable growth and low unemployment. Other ways to express the goal of monetary policy is ‘non-inflationary growth’ or, as per the 2012 budget papers, keeping ‘the economy growing at close to capacity, consistent with achieving the medium-term inflation target’.

It’s important to be clear that the target is not an inflation rate of 2 to 3 pc. It’s a rate of 2 to 3 pc ‘on average, over the cycle’. This qualification is very important because it makes it clear the target is to be achieved on average, not at every point in time. It’s what makes the target a ‘medium-term’ target. It means the target doesn’t require the RBA to crunch the economy the moment inflation pops above 3 pc. What it means is that, if inflation rises above the target, the RBA must be able to demonstrate it is taking effective steps to get the rate back down into the target range within a reasonable time, without disrupting growth. Note, too, that the target is symmetrical: having the rate fall below the target range is as much a cause for concern - and for remedial action - as having it rise above the target range.

Because changes in interest rates take up to two or three years to have their full effect on economic activity, the RBA conducts monetary policy on a ‘forward-looking’ or ‘pre-emptive’ basis. It adjusts the stance of policy on the basis of its forecast for inflation over the coming 18 months to two years. It uses the latest actual figures for inflation simply to check its forecast is on track.

The ‘stance’ or setting of monetary policy being adopted by the RBA at a particular time is assessed by first determining what level of the cash rate would be ‘neutral’ in its effect on economic activity - that is neither expansionary (‘loose’) nor contractionary (‘tight’). Obviously, when the rate is above neutral it’s contractionary and when it’s below it’s expansionary. As a first approximation, the RBA judges the neutral level of rates to be their longer-term average. However, what ultimately matters to the RBA is the level of the market rates actually paid by households and businesses. So when the size of the margin between the cash rate and market rates changes, this shifts the level of the cash rate that can be regarded as neutral. The increase in our banks’ funding costs since the GFC has caused their margin above the cash rate to increase. In response, the RBA has lowered its assessment of the level of the cash rate that’s now seen as neutral. It used to be regarded as about 5 pc, now it’s regarded as about 4 pc. This means a cash rate of 3.5 pc would be regarded as ‘mildly stimulatory’.

Fiscal policy

The objective to which fiscal policy is assigned has changed many times over the years. During the High Keynesian period up to the mid-1970s, it was used as the primary instrument to achieve internal balance, with money policy playing a subordinate role. After the mid-70s, following the world-wide disillusionment with Keynesian fine-tuning and the flirtation with monetarism, the primary responsibility for achieving internal balance was shifted to monetary policy - a lasting consequence of the monetarist attack on the theoretical foundations of Keynesianism.

After the dollar was floated and CADs became a lot higher, the Hawke-Keating government assigned fiscal policy to the objective of achieving external balance and, in particular, to lowering the ‘structural’ (long-term average) CAD. This was based on the identity: CAD = capital account surplus = national investment minus national saving. Since the federal budget balance (strictly, revenue minus recurrent spending) is one of the components of national saving, improving the budget balance by reducing a deficit or increasing a surplus will cause the CAD to be less than it otherwise would be. So that became the goal of fiscal policy: to improve the CAD by improving the budget balance.

After the Howard government became confident the budget was securely back in surplus, it quietly abandoned the objective of external balance. Thereafter, fiscal policy’s de facto role was to support monetary policy in the pursuit of internal balance. During the mid-noughties, however, when the early stage of the resources boom was causing the government’s coffers to overflow and it was pursuing a policy of using spending increases and annual income-tax cuts to hold the surplus down to 1 pc of GDP, fiscal policy became pro-cyclical - it added to the amplitude of the business cycle rather than dampening it. This was because it was effectively preventing the budget’s automatic stabilisers from doing their job of slowing the surge in demand.

In 2008-09, the Rudd government’s prompt response to the GFC and the threat that the global recession would spread to Australia unleashed a huge burst of stimulus spending which propelled fiscal policy to the forefront of efforts to maintain internal balance (although monetary policy was also playing a prominent role, with the cash rate being cut by 3.75 percentage points in four months).

But here’s the point: with the stimulus spending having ceased and the budget expected to return to surplus in 2012-13, the 2012 budget papers nominate a new and different role for fiscal policy: ‘the primary objective of fiscal policy is to maintain the budget in a sustainable position from a medium-term perspective’. That is, the primary objective of fiscal policy is now maintaining ‘fiscal sustainability’.

However, it has also been made clear the budget retains an important role in assisting monetary policy achieve internal balance. How? By allowing the budget’s automatic stabilisers to be unimpeded in doing their job of helping to stabilise demand as the economy moves through the business cycle. The stabilisers bolster aggregate demand when private demand is weak and restrain aggregate demand when private demand is strong. The latter process is known as ‘fiscal drag’ - which is, of course, a helpful thing when you’re trying to keep the growth rate stable.

What does it mean to say fiscal policy’s primary objective is to achieve fiscal sustainability but the automatic stabilisers must be free to assist monetary policy in attaining internal balance? It means the policy makers are drawing a very Keynesian distinction between the effect of the automatic stabilisers (producing the ‘cyclical component’ of the budget balance) and the operation of discretionary fiscal policy (producing the ‘structural component’ of the budget balance). It’s discretionary fiscal policy that’s used to achieve fiscal stability over the medium term.

Everything I’ve just said about the modern roles of fiscal policy is consistent with the ‘medium-term fiscal strategy’. This was established by the Howard government in 1996 as ‘to maintain budget balance, on average, over the course of the economic cycle’. In 2007 the Rudd government changed the wording to maintaining a budget surplus on average - which, when you think about it, is little different. This strategy has been carefully worded to, first, permit the free operation of the automatic stabilisers and, second, permit the use of discretionary fiscal policy to stimulate the economy during a recession - provided this stimulus is withdrawn (wound back in) as the economy begins to recover. That is, the strategy has been designed to accommodate what you could call ‘symmetrical Keynesianism’. Note, the one thing the strategy doesn’t accommodate is long-term borrowing for infrastructure. That is, it doesn’t distinguish between spending for recurrent purposes and spending for capital purposes. This a weakness.

These days, best-practice macro management involves laying down ‘frameworks’ to govern the conduct of policy instruments, particularly fiscal and monetary policies. The frameworks often involve the establishment of medium-term strategies and targets. The framework for fiscal policy is established by the Charter of Budget Honesty Act, passed by the Howard government in 1998. The charter requires governments to set out their medium-term strategy in each budget, along with their shorter-term fiscal objectives and targets. It also requires full reports on the fiscal outlook and the economic outlook to be made public at the time of the budget, in the middle of each financial year and immediately after an election is called. It sets out arrangements for the costing by Treasury and the Department of Finance of the election promises made by both government and opposition - although the costing of policies for the non-government parties is now carried out by the Parliamentary Budget Office. When the Rudd government unveiled its second fiscal stimulus package in February 2009, the charter required it to set out its ‘deficit exit strategy’ at the same time. In this strategy the Rudd government imposed various restrictions and targets on itself to ensure it didn’t end up breaching its medium-term fiscal strategy.

How do you judge the ‘stance’ of fiscal policy - whether it’s expansionary, neutral or contractionary? The old Keynesian way involved working out the cyclical and structural components of the budget balance, then determining the likely net effect of all the discretionary policy decisions announced in the budget on the structural component. A worsening in the structural balance represented an expansionary stance of policy; an improvement represented a contractionary stance.

These days, however, many macro economists use a simpler approach favoured by the RBA, which ignores the cyclical/structural distinction - and hence the distinction between the effect of the stabilisers and the effect of discretionary decisions - and focuses on the expected change in the overall budget balance - the direction of the change and the size of the change. So, for example, a large expected reduction in a budget deficit would be classed as a ‘quite contractionary’ stance of policy. In my judgement, a change needs to be bigger than 0.5 percentage points of GDP to be significant. One exceeding 1 percentage point is a big deal. Note, it’s a bit odd to have the RBA choosing to ignore the distinction between the roles of the stabilisers and discretion in assessing the stance of policy, at a time when the government is using the distinction to explain how fiscal policy can have two objectives: to assist monetary policy in achieving internal balance in the short term, and to achieve fiscal sustainability in the medium term.

As covered in the Year 11 syllabus, the budget has three effects on the economy: on the strength of demand, on the allocation of resources, and on the distribution of income. In all our focus on its effect on demand in Year 12, I think it’s important not to forget to examine the effects of this year’s budget on allocation and redistribution. It’s often the case that a government’s micro-economic reform measures have major implications for the budget. And many budget measures have implications for the distribution of income, whether or not that was their purpose. Sometimes budget measures are directly aimed at influencing demand; sometimes they have a quite different motivation - even one that’s purely political. Remember that all budget measures affect demand, whether or not that was the reason for them being taken.

Exchange-rate policy

In the days after the breakdown of the Bretton Woods system of fixed exchange rates anchored to the US dollar in the early 1970s, when many developed countries’ currencies were floating while ours remained fixed, it could be thought that the government’s ability to make discretionary changes to the value of our dollar constituted an instrument of policy. When a world commodity boom caused a surge in export income, for instance, the dollar could be revalued to help fight the inevitable inflation pressure (and also redistribute some of the proceeds from the export industry to the rest of the economy). In the years immediately before the dollar was floated in 1983, it was known that Treasury favoured a slightly overvalued dollar as an aid to fighting inflation.

It’s clear the decision to float the dollar involved abandoning the possibility of using the exchange rate as an instrument of policy. In practice, however, we’ve seen that the strong (but far from perfect) correlation between the dollar and our terms of trade means the floating dollar does a much better job of helping to limit the inflationary effects of commodity booms than did discretionary adjustments to the fixed exchange rate. This may explain why, in a speech after the 2012 budget, the Secretary to the Treasury, observed that ‘monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments’.

Incomes policy

During the decades of the arbitration system of industrial relations and centralised wage-fixing until the abandonment of the national wage case in 1994, the government had a wages policy in the sense that it sought to influence the growth of wages directly by seeking to persuade the Industrial Relations Commission to limit the wage rises it granted to all award workers. This became known as an incomes and prices policy after the election of the Hawke government in 1993 and the implementation of its ‘incomes and prices accord’ with the union movement. In practice, however, it remained a wages policy, because the Accord period involved no attempt by the Labor government to influence non-wage incomes such as profits, dividends, interest and rent, nor to control the prices of goods and services (leaving aside the investigative role of the Prices Surveillance Authority). But the Accord arrangement lapsed with the election of the Howard government in 1996, meaning the government lost any instrument for trying to influence wages directly. Now wage rates are influenced indirectly via monetary policy.

Micro-economic policy

Micro-economic policy (also known as structural policy) was recognised as a policy instrument when the Hawke-Keating government began pursuing what it called micro-economic reform. At the time, Mr Keating portrayed the role of micro reform as to reduce the CAD by making Australia firms more competitive on international markets. But academic economists soon demolished this argument of political convenience, pointing out that only policies which caused an increase in national saving relative to national investment could reduce the CAD. The true objective of micro reform is faster growth, with greater flexibility.

Note that, despite its name, micro-economic policy is an instrument of macro management. What distinguishes it from the other instruments is that rather than working on the demand (spending) side of the economy, it works on the supply (production) side. As well, demand management has a short-term focus, whereas micro-economic policy works over the medium to longer term. Over the medium term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing.

The sources of growth in the economy’s productive capacity - and thus the ‘potential’ rate at which it can grow - are: growth in the population of working age combined with the rate of participation in labour force, growth in education and skills (ie human capital), growth in investment in housing, business equipment and structures, and public infrastructure, and (multi-factor) productivity. Thus the supply side grows each year, as does demand. While ever the economy retains spare production capacity, aggregate demand can grow faster than aggregate supply. Once the idle capacity has been used, however, the rate at which the supply side is growing sets the upper limit on the rate at which demand and production can grow without causing inflation pressure. It follows that achieving faster growth involves increasing the economy’s potential growth rate.

Micro policy works mainly by reducing government intervention in markets to increase competitive pressure, which leads to increased efficiency and productivity. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - is assumed by most economists to have led to a surge in the rate of productivity improvement in the second half of the 90s. But the return to more normal rates since then suggests micro reform has failed to achieve the hoped-for lasting increase in the rate at which the economy can grow.

Micro reform seems to have been more successful at making the economy more flexible and resilient in the face of economic shocks. Greater competition within many product markets, the floating of the dollar and the move from centralised wage-fixing to bargaining at the enterprise level, in particular, have greatly reduced the problem of cost-push inflation pressure and made the economy significantly less inflation-prone. It may also be argued the greater flexibility accorded to employers by industrial relations reform has made the economy less unemployment-prone, as shown by their changed response to staff retention (their preference for shorter hours rather than lay-offs) in the mild recession of 2008-09. The more flexible the economy becomes, the easier it is for the macro managers to achieve internal balance and a stable rate of economic growth.

While micro reform focused initially on reducing government intervention in markets to encourage greater efficiency, under the Rudd-Gillard government the focus has shifted to trying to achieve higher productivity by reforming and increasing the investment in human capital (education and training) and public infrastructure. The carbon pricing arrangement to which it has devoted so much attention is intended not so much to increase productivity as to help avoid the loss of productivity that climate change would cause.

Macro lags and the assignment of instruments

A long time ago the macro managers identified three lags (delays) that make their task of managing demand quite difficult. The ‘recognition lag’ is the delay in them recognising that some aspect of the macro economy is not working well and requires a policy response. This lag is caused partly by delay in the publication of economic indicators for a particular period.

The ‘implementation lag’ is the delay between realising a policy response is required, deciding what the response should be and actually putting it into implementation.

The ‘response lag’ is the delay between the time the policy measure takes effect and the time the economy has fully responded to it. Policy measures almost invariably take longer to change people’s behaviour than we expect them to.

These practical considerations have influenced the macro managers’ choices on whether to rely on fiscal policy or monetary policy for internal balance. The length of the recognition lag would be the same for both policies, but monetary policy has a clear advantage in the case of the implementation lag. The RBA board meets every month and, if necessary, it can consult more frequently by phone. Once a decision to change the cash rate has been made, the market operations needed to bring it about can be done quite simply the same day. In contrast, the changes to government spending or taxation needed to alter the stance of fiscal policy involve many meetings of the Cabinet, in which all the possibilities and ramifications are debated. In practice, the stance of fiscal policy can be changed only once a year in the budget or, at best, twice a year if a mini-budget is brought down.

Fiscal policy probably performs better on the response lag than monetary policy does. It takes a long time - two to three years - for a change in interest rates to have its full effect on demand and inflation. As we’ve seen, however, the RBA seeks to reduce this problem by taking a forward-looking approach, basing decisions about changes in the official interest rate on its forecast for inflation.

A further practical consideration is that fiscal policy is harder to tighten politically. Politically, it's easy to loosen fiscal policy. The public never objects to increased government spending or to cuts in taxes. But when the time comes to tighten fiscal policy, there is always much objection to cuts in particular spending programs or to increases in particular taxes. Though an increase in interest rates is never popular, it’s easier to achieve politically than spending cuts or tax increases.

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