GETTING PEOPLE TO DO THEIR JOB WELL

Talk to Jobs Australia National Conference, Manly, Thursday, November 1, 2012

The last time I spoke to your national conference, many moons ago, I offered some confident predictions about the outlook for the labour market. It seemed to go down quite well, but turned out to be hopelessly wrong. So this time I propose to do something quite different, something more philosophical, something I haven’t done before, even something a bit naughty. For many months I’ve been reading and ruminating on a question of motivation: how do we get people to do their job well? The trouble is, though I’ve come to some tentative conclusions, I haven’t yet finished my search and haven’t yet decided what the answer is. Despite that, I’m going to give you a progress report on my ruminations to date.

The question of how you get people to do their job well is one facing every manager, but it’s also a key question for public policy. Governments and their bureaucrats seem increasingly concerned to ensure people are doing their jobs in the way the pollies and their advisors think they should. For instance, they’re concerned to ensure the organisations contracted by them to deliver job services to the unemployed do so efficiently, effectively and accountably. So I hope you can see why I thought my topic to be of more than passing interest to all of you.

But governments’ concern with the topic goes a lot further than the management of contractors. It’s clear, for example, the Gillard government - like many governments - is quite dissatisfied with the performance of schools and teachers, and is using a wide range of strategies in the hope of achieving improvement: the regular, national assessments of literacy and numeracy, the publication of those Naplan results and much other data on the MySchool website, the offering of incentive payments to schools and teachers etc. Another case: the state governments respond to the public’s belief that the sentencing of criminals is too lenient by reducing judges’ discretion. A different case is occupational health and safety. We don’t want workers’ health to be endangered in the workplace, but what’s the best way to get employers to exercise the necessary care?

So what do I think about all this? Well, as I say, I’m still making up my mind. But let me give you my conclusions so far. They boil down to six.

First, I accept we need accountability and transparency from organisations and their employees.

That’s particularly true for government agencies, which operate with authority (and funding) derived from the public, and also for outfits delivering services on behalf of the government. If you’re handling taxpayers’ money you have to account for it, in a way that people working in the private sector need to be supervised but not be held publicly accountable to the same extent. Of course, it’s not just the money you handle, it’s also what you do to discharge the duties you were charged with.

Second, I agree with the modern trend to greater measurement of performance.

One of the slogans that accompanies the new mania for measurement says: you can’t manage what you don’t measure. I’m not sure that’s true, but it does contain an element of truth. Actually, the hard part of being a manager is managing the unmeasurable.

Putting these first two propositions together, I don’t accept the argument of the teachers’ unions that, because measures of schools’ performance are capable of being misunderstood by parents (or misused by the media), they should not be made public. Most of these measures have been calculated by education departments for many years and used for their own management purposes, but kept strictly confidential to all but the insiders. The fact is that all statistics - every one of the thousands produced each day by the Bureau of Statistics, from the national accounts to the CPI - are capable of being misunderstood and misused. That’s a reason for educating people in their correct interpretation, not a reason for the performance of elected governments and their agencies to escape public scrutiny. It’s not an argument for keeping the public in the Mushroom Club. Having said that, however, I must add a qualification:

Third, I have grave doubts about the modern management fad of using KPIs (key performance indicators) in the attempt to ensure people do their jobs well.

It is true that measures of performance (‘metrics’ in the fashionable business jargon) are capable of being misinterpreted, even by managers, let alone by outsider amateurs and a sensation-seeking media. Most managers know little about the rules and the pitfalls of statistical interpretation. It may be that when workers are employed to perform simple, repetitive tasks - workers on a factory production line, for instance, or those employed in data entry - you can get away with using numerical targets to ensure a satisfactory rate of output, provided you combine it with some form of quality control.

But, these days, the satisfactory performance of most skilled jobs simply can’t be measured with a few key numerical indicators. Nor is the quality of people’s performance easily checked. This is because satisfactory performance of the projects people work on has too many dimensions. It would be impractical to attempt to measure every dimension, and some dimensions may not be capable of measurement. In such circumstances, supervising the quality of people’s performance will also be difficult. Even where a person’s job is to process a number of cases each day or each week, it may be easy to count the number of cases they get through, but much harder to allow for the differing difficulty of those cases, as well as monitor how well they were dealt with. That’s true even of lowly workers in a call centre. While most of the problems they deal with may be routine, we all know from experience how easy it is to ask a question that’s beyond the operator’s pay grade or to be offered confident assurances we know, or soon discover, to be wrong. We all know how unhappy we can be with the experience, even when we eventually got what we wanted.

Numerical indicators of performance are particularly unsatisfactory when the task involves dealing with individuals - because people and their problems come in so many shapes and sizes. At least three-quarters of Australia’s workforce works in the services sector, and most of those jobs involve delivering services to individuals. Am I starting to ring any bells with your own circumstances?

But the fact that performance so often can’t be satisfactorily assessed using PKIs is just the start of the problem. The deeper problem is that PKIs are so easily manipulated - so easily ‘gamed’. If the satisfactory performance of my job has, say, five dimensions, and you slap a KPI on as many as three of them, rest assured I’ll meet my targets. But I’ll do it by cannibalising the two dimensions you haven’t measured. This kind of behaviour is rife and it’s the reason I regard the use of KPIs as a fad that management will soon see to be a snare and a delusion.

Early in the days of Paul Keating’s national competition policy, someone came up with the idea of encouraging better performance by the state governments by means of what I think was called ‘benchmark competition’. The idea was to publish each year, for each of the states, a host of key indicators of their performance in all their areas of responsibility (courts, prisons, hospitals, schools etc). The public would be able to see which states were doing better and which were doing badly, and this would encourage the states to try harder. At first the relevant state bureaucracies complained the figures weren’t on a comparable basis, so much effort was put into making sure they were. But someone who’d been close to the process told me the figures - which are still produced each year - are utterly unreliable because of each state’s efforts to manipulate their indicators.

This is why I have much sympathy with the teachers’ argument that a quality education has a lot more dimensions than just the literacy and numeracy so regularly measured by Naplan. Put too much emphasis on Naplan scores and you will get schools ‘teaching to the test’ and, in the process, neglecting those dimensions of a quality education not being measured. Whether this yields a net benefit to students is a question no one bothers to measure - assuming they could.

From the developed world’s unhappy experience with monetarism and money supply targeting in the 1970s emerged something economists call Goodhart’s Law, which holds that ‘any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’. That’s what’s wrong with KPIs.

It follows that attaching monetary incentives to KPIs is equally foolish. But I would go further and say:

Fourth, I have grave doubts about the equally fashionable practice of using performance pay to try to ensure people do their jobs well.

This is not just because good performance is hard to measure, but also because money is a bad motivator. Thanks to the limitations of their model, economists unconsciously assume money is the only motivator. And, perhaps because of their own materialism, business people easily assume monetary incentives are likely to be most effective. But the obvious truth is that people are also motivated by a host of non-monetary motivations, ranging from the pursuit of power and social status to the satisfaction of working hard and doing a job well. Many people have a deep commitment to doing their job to a high standard - for the benefit of customers, but primarily for their own satisfaction.

There are two problems with performance pay. One is that the more I’m motivated just by money, the more I’m likely to cut corners, sacrificing quality. The other is that studies by psychologists show monetary incentives drive out non-monetary motives. Once you’ve trained people to do things just for the money, any subsequent decision to abandon performance pay will lead to a deterioration in performance.

Fifth, I also doubt the effectiveness of the main alternative to monetary incentives, the imposition highly prescriptive rules and regulations.

This is the approach beloved of governments and bureaucrats. David Thompson tells me the rules the department imposes on providers of job services run to 3000 pages. So I imagine this is the main way the government tries to get you guys to do your jobs well. It also applies to governments’ attempts to oblige judges to impose harsher sentences.

You probably don’t need me to tell you why this approach doesn’t work well, either. As well as burdening people with a lot of red tape and compliance costs, it limits their freedom to exercise their discretion in responding to the peculiar circumstances of each of the cases they deal with. It stifles, and therefore wastes, people’s use of their experience and expertise in discharging their responsibilities to the best of their ability. It assumes the people making rules that fit the general case know better than practitioners on the ground dealing with specific cases that may or may not fit well with the general case. It also assumes practitioners aren’t to be trusted. And rules, too, can be gamed by people who’ve been discouraged from doing their best.

Consider the industrial relations tactic of ‘work-to-rule’. Work-to-rule demonstrates that it’s actually very hard to design rules on paper than work smoothly in practice, partly because circumstances may differ so much from case to case. It shows that well-functioning organisations are organisations that honour the spirit of rules rather than the letter, that turn a blind eye to rules that don’t work well.

But if PKIs, monetary incentives and prescriptive rules don’t work in getting people to do their jobs well, what does?

This I’m still working on. But I do have some clues.

Sixth, rather than trying to control people with rules or performance targets, or bribing them to do a good job, we should be aiming to produce well-trained and well-motivated workers, free to exercise their discretion in meeting the needs of the widely varying cases that come before them.

Psychologists tell us intrinsic motivation is superior to extrinsic motivation. That is, it’s better to encourage people to do things for their own sake, rather than for the external rewards they bring. When people take a pride in doing their job well, you get better performance than using rules or whips or bribes.

Sociologists tell us people’s behaviour is heavily influenced by something most economists and business people are oblivious to: social norms of acceptable behaviour. Studies show making people attend courses on ethics does little to make their behaviour more ethical. There will be exceptions but, in practice, people tend take their ethical standards from the behaviour of those around them. If most people around me cheat, I’m likely to cheat. If most people around me work hard, I’m likely to work hard. And if my group habitually works hard, it’s likely to come down hard on any individual within the group who slacks off. The thing about ‘norms of acceptable behaviour’ is that they usually involve the imposition of informal sanctions on individuals whose behaviour the group regards as unacceptable. You don’t get fined, you get gossiped about, chipped and, in the extreme case, sent to Coventry. Humans are such social, ‘groupish’ animals - we are so pre-programmed to want to ‘fit in’ - that such informal sanctions are usually highly effective in achieving adherence to group norms.

There’s an old debate in monetary economics over ‘rules versus discretion’. The best position is probably a half-way house - discretion within a set of fairly loose rules - but I believe leaving people with discretion to use their expertise to make the best decisions to fit the particular case is likely to maximise the chance they will be motivated to do their best work. Tight rules are de-motivating.

What we need to bolster this, however, is a group norm - a ‘culture’ - that we all work hard, we all do our best to meet our clients’ needs, and if we cut corners we do it to fit a client’s needs, not for our own convenience. How do you introduce such a culture where it doesn’t exist? How do you strengthen such a culture if it isn’t strong enough?

That’s what I’m still working on. One thing I do know is that it has to start at the top. Not surprisingly, bosses are hugely influential in affecting the attitudes and behaviour of the people working for them. But they’re influential not so much in the programs they introduce and the pep talks they deliver but in how they behave. As business people say, you have to walk the talk.

Another clue lies in the original meaning of the word ‘professional’. What does it mean to be professional? These days, it may mean you play sport for money, not just the love of the game. More commonly, it means well-trained, highly proficient. But its original meaning is instructive: it used to mean putting the client’s interests ahead of your own. In other words, the complete antithesis of doing a job just for the money. To say, I’m a member of a profession, is to say I put clients first.

I suspect the culture we need to introduce into organisations to lift their performance is old-fashioned professionalism. And though I’m still working on ways to do that, I do know this: if you can get the work culture right - get the norm of acceptable behaviour right - it will tend to be self-reinforcing, without need for KPIs, performance pay or highly prescriptive rules.

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MAIN STREET & WALL STREET: the interrelationship between the real and financial economies

Comview conference, Melbourne, November 2012

Last year Glenn Stevens remarked that it was ‘very sensible of Australian households to be strengthening their balance sheets’. What on earth did he mean? In recent years we hear a lot of jargon in the economic debate that we usen’t to hear and that certainly wasn’t mentioned when we were at university. People keep on about ‘balance sheets’ - household balance sheets, business balance sheets, government balance sheets - and how they need to be ‘strengthened’ or ‘repaired’. Sometimes they talk about ‘gearing’, other times they talk about ‘leverage’ - households or businesses are ‘deleveraging’ we’re often told these days. We hear a lot more about ‘asset prices’, and credit-fuelled ‘asset-price inflation’ leading to ‘asset bubbles’.

We also hear a lot these days about the ‘wealth effect’ and about the household saving ratio - it was falling for about 30 years but then it rose rapidly, making life hell for the retailers. And economists take a lot more interest in the sharemarket than they used to. Say you’re worried about household debt being 150 per cent of household disposable income and someone will counter that household liabilities are just 21 per cent of household assets.

Then there’s the balance of payments. Express some interest in the trade deficit or the current account deficit and economists are just as likely to respond by talking about the capital account surplus and the balance between national saving and national investment. Say you’re worried about foreign debt and someone will say you should be focusing on our net foreign liabilities. Then they’ll say the nation’s foreign liabilities account for just 20 per cent of its assets.

The real economy versus the financial economy

So what’s going on? What’s going on is that historically, Keynesian macroeconomics focuses almost exclusively on the real economy, to the exclusion of the financial economy. There is, of course, only one economy, but it has two dimensions, real and financial. The real economy is the physical, touchable world of getting and spending, of the production and consumption of goods and services. Inflation and unemployment are part of the problems of the real economy, and we focus on these. Saving and investment are part of the real economy, but pretty much only to the extent they constitute leakages and injections to the circular flow of income.

The financial economy is the intangible world of borrowing and lending, assets and liabilities, of people with savings connecting with people needing funds to finance their investment, usually via an intermediary such as a bank, but also via direct borrowing in the financial markets. It’s the world where financial assets such as shares, bonds and foreign currencies are traded on financial markets.

The real economy couldn’t exist without the financial economy. You can’t produce goods and services without physical capital such as machines and factories, and you can’t sell them without shopping centres and offices. The acquisition of most of those assets has been financed by borrowing and equity capital. The financial markets exist to supply that funding. Just about every business has a significant amount of debt, with interest payments forming a significant expense.

Similarly, consumers come from households that need assets such as housing and consumer durables, the purchase of which is usually financed by borrowing. Households also own much of our big businesses via their superannuation saving or direct shareholdings.

Why talk about the financial economy is now so prominent

But conventional macro has taken little interest in the financial side of the economy. It has focused almost exclusively on the three dimensions of GDP: income, expenditure and production. As you probably know, the national accounts measure GDP these three different ways. In theory they’re equal; in practice measurement problems mean they never are so, in practice, the bureau of stats takes an average of the three and calls it GDP(A). And in practice, of course, macro economists focus mainly on the expenditure side of the real economy: GDP = C + I + G + X - M.

What’s changed is that, though Australia’s macro managers have had considerable success in controlling both inflation and unemployment over the past decade or two, a lot of different problems have emanated from the financial economy. That’s painfully evident right now in the rest of the developed world, but you can see it here if you go back a bit.

The severe recession of the early 1990s, which was quite protracted and saw the unemployment rate rise to almost 11 per cent, was caused by problems in the financial economy. Our banks and businesses overreacted to the deregulation of the financial sector, and we ended up with borrowing-fuelled booms in the housing and commercial property markets. The bust in the commercial market left many of our businesses far too highly geared and our banks with a lot of bad debts, to the extent that Westpac went close to falling over. What made the recession so protracted and severe was the way businesses sought to repair their balance sheets - to deleverage; or in plain English, to reduce their liabilities relative to their assets - by avoiding new expansion and cutting costs so as to repay debt. In particular, they cut costs by laying off workers. The banks repaired their balance sheets by widening their interest margin (not passing on all the cuts in the cash rate) and limiting their lending for new business projects. Note that problems in the financial economy soon become problems in the real economy. Economists separate them conceptually, but they can’t be kept apart in real life.

As its name implies, the Asian financial crisis of 1997-98, which led to a sharp recession in most of East Asia, had its origin in the financial side of those economies. Most had property booms fuelled by foreign capital inflow; when the foreign capital started rapidly flowing back out, countries had to devalue their fixed exchange rates. Many businesses that had borrowed in foreign currencies now found their loans and interest payments far higher than their assets. Their economies entered a sharp recession. In new phenomenon called ‘contagion’, foreigners who lose confidence in the prospects for one country tend to spread their doubts to neighbouring countries.

This brings us to the global financial crisis and the world recession it led to - which, for the countries of Europe, hasn’t ended. Again as the name implies, the causes of this recession were financial. The huge extent to which China and some other Asian countries’ saving exceeded their investment led to them running up large reserves of foreign exchange, which were then lent cheaply to the developed countries, particularly the US. This excessive supply of cheap funding led to excessive consumption, home building and borrowing by US households, which became quite highly leveraged - that is, their debts grew relative to the value of their assets. At the same time, deregulation, weak supervision and ever-increasing use of derivatives caused banks in the US and Europe to become far too highly leveraged. As well, most governments continued their longstanding practice of running budget deficits in good times as well as bad.

(‘Gearing’ and ‘leverage’ are the same: the use of borrowed capital to buy assets, thus magnifying the return to equity capital while asset prices continue rising, but magnifying the loss when asset prices start falling. Gearing is the British and Australian term; leverage is the American term.)

When, inevitably, the US house-price bubble burst, the whole financial house of cards collapsed. The sharp fall in house prices caused some households to experience ‘negative equity’ (their liabilities now exceeded the value of their assets) and others to pull their horns in and seek to ‘deleverage’. As always, this touched off a multiplier effect where fear of unemployment causes households to cut their spending and get their finances in order but this, in turn, causes the very increase in unemployment they were afraid off, touching off a further round of contraction.

While this was happening in the household sector, the banks were getting into trouble. Their excessive gearing meant it took only small levels of bad debt to wipe out their capital and bring them close to bankruptcy. Individual banks realised the other banks were in trouble, so the banks as a whole refused to lend to each other, forcing central banks to fill the gap, providing huge short-term credit to all banks. Some global financial markets actually ceased to operate for a time. The banks also became reluctant to make new loans to business. Though the problem began in the US, it quickly spread to the European banks, eventually exposing the structural weaknesses in Europe’s monetary union.

After the collapse of the investment bank Lehman Brothers in September 2008, the US Government had to bail out many banks, buying some of their now-toxic financial assets and injecting equity capital. Governments in Britain and Europe had to do something similar. Delay in approval of the US rescue package added to the rout on US and global sharemarkets, which had begun falling when the problem started to emerge about a year earlier.

Every media-publicised announcement that a bank had failed or almost failed in the US or Europe prompted another loss of business and consumer confidence around the world. In the US and, more particularly, Europe, government borrowing to bail out banks and reflate economies, when added to decades of deficit budgeting, caused government debt levels to soar, thus prompting a ‘sovereign debt crisis’ - the fear governments are so heavily indebted they may default on their debts (an event which, as Reinhart and Rogoff demonstrate in their modern classic, This Time Is Different, has happened far more times than we remember).

How and why the world has changed

In the post-war period we got used to recessions that arose from problems in the real economy. Typically, inflation problems would arise as demand grew faster than supply (production capacity) and shortages of skilled labour led to excessive wage rises. The authorities would respond with tighter monetary policy, hoping to achieve a ‘soft landing’ but overdo things and causing a recession.

Clearly, our last recession in the early 90s, the Asian financial crisis and the latest, global financial crisis were all very different from that, coming out of the financial side of the economy. Essentially, they were products of the bursting of credit-fuelled asset-price bubbles.

Why are financial crises and financial-side recessions now more common? Because the deregulation of financial markets makes credit far more accessible and often cheaper to households and firms, thus making it easier for credit-fuelled asset-price booms to emerge. Because, at least in some countries, and at least until now, the era of financial deregulation has seen banks and their innovations inadequately supervised by the authorities. Because financial globalisation has increased short-term capital flows between countries, thus increasing the likelihood of problems in one country spreading to others. And because the globalisation of the media means news of disturbing developments in one country now spreads almost instantaneously around the world, adversely affecting business and consumer confidence.

Another part of the story is that, whereas central banks have finally mastered the art of controlling goods-and-services inflation via independence and inflation targeting, thereby greatly improving demand management, their efforts seem to contribute to booms in asset prices - problems the central bankers admit can’t be countered with conventional monetary policy.

But how has the world changed? What are the consequences of recessions that arise from the financial side? They tend to be more severe and to last a lot longer. This is because ‘deleveraging’ or ‘balance sheet repair’ is an essentially deflationary process which, in economies that are already weak, take months or years to bring about. Similarly, efforts by governments to deleverage take a long time. Should governments attempt to speed up the process by cutting their spending or increasing taxes at a time when the economy is already weak, their efforts are likely to prove counterproductive - as we’ve seen in Europe recently.

A second reason financial-side recessions are more severe and protracted is that they often involve a version of a liquidity trap, in that interest rates are already very low when the recession starts. Since interest rates can’t fall below zero, there’s little room for conventional monetary stimulus. In any case, banks are often too preoccupied with repairing their own balance sheets to want to increase their lending, notwithstanding the low interest rates obtaining. All this greatly limits the effectiveness of monetary policy, pushing more of the initiative onto fiscal policy. But, where governments have themselves over borrowed in the good years leading up to the financial recession, their ability or willingness to apply fiscal stimulus is also limited, as we’re witnessing at present in the US and Europe. The next step is reluctant resort to ‘quantitative easing’ (another new bit of jargon).

I’m sure you know that ‘QE’ is a euphemism for what we used to call ‘printing money’. Of course, just like most money created by the central bank, this is not physical cash but numbers in bank accounts. What you may not know is that it involves central banks expanding both sides of their balance sheet. They buy government bonds (sometimes newly created bonds direct from the government, sometimes second-hand bonds from the ‘secondary market’) or other assets (such as mortgage-backed securities) and pay for them with extra money they have created. The money issued by the central bank is a liability of the central bank, whereas the securities it buys are an asset. Thus both sides of their balance sheet are increased.

The ‘wealth effect’ economists worry about more than they used to represents a form of feedback from the financial economy to the real economy. It occurs when households’ feelings about what’s happen to their wealth (their assets and liabilities ie their household balance sheets) affect their decisions about how much of their income they should save and, therefore, how much is left for consumer spending. When asset prices (particularly house prices, but also superannuation balances and direct shareholdings) are rising strongly, households are likely to feel wealthier, and thus see less need to save rather than consume. When assets prices aren’t rising, or maybe superannuation balances are falling, households are likely to feel less wealthy and thus save more and consume less. You’d get the same effect when the economic outlook became more threatening and households became concerned about the extent of their debts. It’s possible the ageing of the population - that is, the higher proportion of households in or nearing retirement - will make the wealth effect a more powerful influence on the real economy.

As for the increasing tendency of economists to explain the current account deficit in terms of national saving and investment, it’s a financial-side way of examining the balance of payments.

The accounting side of the story

Another reason we hear a lot more about balance sheets these days is that there are a lot more of them about. Some years ago, the UN Statistical Commission decided to switch both the system of national accounts and government finance statistics from a cash to an accrual basis. This means the (annual) national accounts now include a national, whole-economy balance sheet and a balance sheet for the household sector. We also have balance sheets for the federal and state governments.

To get a clear understanding of the distinction been the real and financial economies you have to remember there are two kinds economic variable: flow variables and stock variables. Flow variables show the size of the flow of some item (such as income or expenditure) over a period of time (usually a month, a quarter or a year); stock variables show the amount of some item (such as assets or liabilities) at a point in time(usually the last day of the period eg June 30).

In a business, the flow variables are collected together in the profit and loss statement, where the flows of expenses incurred during the period are subtracted from the flows of income earnt during the period to give the profit or loss for the period. The stock variables are collected together in the balance sheet, where total liabilities at the end of the period are subtracted from total assets at the end of the period to give the business’s ‘net worth’ at the end of the period.

For an economy, the conventional national accounts are equivalent to the profit and loss statement, while the new balance sheet is equivalent to a business balance sheet. That is, the conventional national accounts show the flows of income, expenditure and production in the economy during a period, while the national balance sheet shows the stocks of manmade, natural and foreign assets, less the stock of foreign liabilities, to give the national economy’s net worth at the end of the period. (Note that, within the nation, debts to other Australians are matched by the financial assets of other Australians, and so cancel out.)

The point to note is that it’s the flows during a period that bring about the change in stocks between the start and end of the period. If, for example, the net public debt increased from 100 to 120 between the end of period 1 and the end of period 2, this tells us government expenses exceeded government revenue during the period by 20 - that is, the government ran a deficit in year 2 of 20.

This is relevant when we say that Keynesian macro management focuses on the real economy largely to the exclusion of the financial economy. It focuses on the flows in the national accounts - or the budget - but ignores the stocks building up in the balance sheet. So Keynesians care whether household consumption is growing faster or slower than household income, but don’t take much interest in whether household net worth is rising or falling. They care whether government spending exceeds or underruns government revenue - that is, whether the government is running a deficit or a surplus - but they don’t much care what’s happening to the net public debt.

This neglect helps explain how most of the governments of the North Atlantic economies managed to go for decades building up huge stocks of government debt, which left them very badly placed to cope with the fallout from the GFC. It also helps explain why so few economists saw the GFC coming. They didn’t notice, for instance, that in the US, much of the growth in consumption and the economy in the years leading up to the GFC was, in a sense, phoney - it was financed not by rising household incomes but by rising household debt.

The trouble with the excessive focus on the real economy is that while what happens to the levels of stocks may be ignored in the short to medium term, if they are ignored for too long and allowed to build up to unsustainable levels they will eventually precipitate a financial crisis.

Conclusion

In a financially deregulated and globalised world, macro economists can no longer get away with limiting their interest to the real economy - to flow variables - and taking little interest in balance-sheet, stock variables. When financial imbalances build up, the ultimate blow to the real economy - and the lives of real human beings - can be extensive.

Technical note: much of what accountants call the ‘ratio analysis’ used commonly by economists was developed in the days before the preparation of collective balance sheets. In those days, the only stock variables produced in the national accounting process were levels of debt - public debt, household debt, foreign debt. When economists wanted to study those debt levels they compared them with the only other variables available, flow variables. Hence the practice of comparing household debt with household disposable income, or the net foreign debt with nominal GDP.

But accountants know that comparing stock variables with flow variables involves comparing apples with oranges. Ideally, stock variables should be compared with other stock variables, and flow variables with other flow variables. Before the advent of balance sheets this wasn’t possible, but now they exist economists need to change their practices to take advantage of the more relevant data available to them.

For instance, novices are greatly disturbed to hear that household debt is equivalent to 150 per cent of household disposable income. But such a comparison is largely meaningless. It implies that a day may come when someone is required to repay their mortgage, but prohibited from selling their house to satisfy most if not all of the debt. When would anyone ever be suddenly asked to repay their mortgage purely from their income? What matters is how the household’s assets compare with its liabilities (a stock-stock comparison) and, within this, how the present market value of the house compares with the size of the loan attached to it; and how the household’s cost of servicing the mortgage compares with its disposable income (a flow-to-flow comparison).

Similarly, it makes more sense to compare the nation’s foreign debt (or net foreign liabilities) with its assets (stock-to-stock), then compare the cost of servicing our net foreign liabilities (which is the net income deficit in the current account) with the nation’s income (nominal GDP) or with export earnings (both flow-to-flow).

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Macquarie University IR Panel Discussion

I want to make four points very quickly. First, I’m not convinced we have an economy-wide problem with productivity - I don’t think the statistical evidence bears that out.

Second, I don’t believe we have a nation-wide problem with unreasonable unions exploiting an IR system that a Labor government has stacked in their favour, if for no other reason than that the great majority of employers, and the great majority of employees, work in what is essentially the non-unionised sector. So let’s not kid ourselves, what’s represented here today is a quite small and unrepresentative part of the economy.

Third, I do believe we need a more flexible labour market. But we have to be clear what flexibility means. If it’s a euphemism for governments changing the IR system to allow employers to ride roughshod over their workers - that employers should have all the rights and employees should have next to none - then we don’t need it - because it’s not in the community’s overall interests - and, in any case, as the defeat of the Howard govt reaffirms, politicians are rarely stupid enough to imagine they could bias the system that far against voting employees (who account for almost 2/3rds of the adult population) and live to tell the tale.

No, the flexibility we need is willingness on the part of workers to accept the often painful changes in their arrangements necessitated by the economy’s changing circumstances - by changes in technology, changes in industry regulation and changes in the threats and opportunities created by the rest of the world. Unless we achieve that kind of flexibility - and I believe for the most part we are achieving it, even in the unionised sector - we will pay for it with declining productivity and profitability and consequently a decline in our material standard of living.

But, fourth, I don’t believe our IR law is the key obstacle to achieving that kind of flexibility, nor is changing the IR law the way to achieve it. The key obstacle is bad industrial relations - that is, bad relations between individual employers and their employees; lack of trust - and if you think the answer to bad relations with your workers is to get the IR law changed in your favour so you can force your will on your workers you’re revealing exactly why you have a problem. A bad worker blames his tools and bad employers blame the IR law. (People who work for employer groups blame IR law because that’s what justifies their continued employment).

In my experience, workers turn to unions, and allow their unions to behave unreasonably, because they don’t trust their employers. Because they believe they’ve been lied to in the past, because their employers refuse to consult, because they don’t give their workers ‘voice’ except via the union, because they refuse to explain in detail and over and over what the problem is and why their proposed solution is the best one and because they won’t assure their workers they’re not trying to pull a fast one, that they’ll do all they can to minimise the pain and disruption involved - or because such assurances aren’t believed.

Bad employers beget bad unions. Then bad employers conclude the only answer to unreasonable unions is unreasonable employers. And then bad employers campaign to have the IR laws biased in their favour. Smart employers don’t blame their problems on the government and don’t delude themselves governments can solve problems they themselves can’t solve on the ground.

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White paper shows way to Asian century

When governments make grand policy unveilings, as Julia Gillard has with her white paper on the Asian century, it’s terribly tempting for people in jobs like mine to sit back and criticise. After all, unlike you and me governments tend to be less than perfect.

If you’re disposed to criticise, there’s never a shortage of material - particularly if you’re prepared to offer mutually inconsistent criticisms, or shift your angle of attack from one week to the next.

Sometimes the media are so eager to fan controversy they hardly pause to summarise the content of a 300-page document before launching into their own and other people’s criticisms. And no matter how weighty the subject matter, you can bet it’ll be done and dusted within a week.

I prefer to be a little more considered, even more co-operative with our elected leaders (and nor do I regard a diet of unrelieved negativity as a smart way to sell news). So, though I have some major criticisms of my own, I’ll leave them for another day.

Throughout the life of the Rudd-Gillard government people have criticised its failure to articulate an ‘overarching narrative’ - an encompassing story of what Labor stands for and what it’s on about. A vision of the future; something that gives meaning and direction to our national life.

Well, it may have taken five years, but here’s Gillard’s best shot. It’s not, as some have imagined, the report of another committee headed by Dr Ken Henry; it’s a white paper, a firm statement of government policy intention.

So what do the critics say? It’s just more talk. Where are the new decisions? When will we be getting them? What about my pet project?

You may say this is a narrative with an arch that stretches from the economic to the commercial via the financial (and I may agree), but that makes it an accurate depiction of the breadth of this government’s priorities.

Some say suspiciously that the white paper includes a mention of just about every project Labor is working on: the carbon price, the national broadband network, education reform etc. Sure. That’s what overarching narratives do.

It’s a vision of increasing our material prosperity by ensuring we fully exploit the opportunities presented by our proximity to Asia, which is transforming itself from poor to rich within the short space of our lifetimes.

Within that limited purview, it’s on the right track. It’s hard to imagine our equally materialist opposition disagreeing - though you can be sure it will find plenty to criticise.

The white paper says that, to succeed in this objective, Australians need to act in five key areas. First, we need to build on our own economic strengths. In particular, we’ll need ‘ongoing reform and investment’ across ‘the five pillars of productivity - skills and education, innovation, infrastructure, tax reform and regulatory reform’.

Second, we must do more to develop the necessary capabilities. ‘Our greatest responsibility is to invest in our people through skills and education to drive Australia’s productivity performance and ensure that all Australians can participate and contribute.’

Third, we need businesses that are highly innovative and competitive. ‘Australian firms need new business models and new mindsets to operate and connect with Asian markets.’

Fourth, we need stable defence security within the region. And finally, we need to strengthen our relationships across the region at every level. ‘These links are social and cultural as much as they are political and economic.’

It’s easy to say there’s nothing new in the white paper. We already knew about the rise of Asia. And prime ministers have been banging on about our need to get closer to Asia since Malcolm Fraser.

It’s all true. But it misses the point. The experts may be full bottle, but public doesn’t know as much about Asia as it should; this is an attempt to lift our ‘Asia literacy’ as well as getting more study of Asia and its languages into curriculums.

And governments bang on about a lot of things; this is a decision to give our relations with Asia top priority. This is a long-term project and it didn’t start yesterday. It doesn’t hurt to have a grand renewal of our commitment. It maybe old to us oldies, but to our kids it’s new and sparkling.

The white paper seeks to dispel a lot of misperceptions among Australians. For one thing, it’s not just about China. It’s also about India, South Korea and developing Asia in general - and hugely populous Indonesia in particular.

For another, it’s not just about mining. Though the mining boom has further to run, it’s also about selling a lot more food and fibre to Asia at much higher prices, and supplying Asia’s burgeoning middle class with education, tourism, sophisticated niche manufactures and many services.

But deepening our economic (and, inevitably, social and cultural) relations with Asia is two-way street. Exporting more to Asia will mean importing more from it (giving the lie to criticism this is about exploiting the poor people to our north)
And increasing our business investment in Asia will mean accepting more Asian investment in our businesses.

And, as we’ve already seen with the mining boom, maximising our benefit from the rise of Asia will inevitably mean accepting change and upheaval in our economy. The more we try to preserve the world as it was, the more we pass up the opportunities Asia presents.

The other bad news is that full benefit from Asia isn’t something this government or any other can deliver us on a plate. It needs to be a national effort, with most of the heavy lifting done by business, schools, universities, unions and individuals.

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It's better to honour budget commitments

Those economists who’ve joined the smarties in proclaiming Julia Gillard’s seeming resolve to get the budget back to surplus this financial year to be purely political and of no economic merit are revealing how little they know about political economy - the politics of economic policy.

They don’t understand the vital role faithful adherence to ‘frameworks’ has played in giving Australia it’s widely envied record on fiscal (budgetary) responsibility.
It ought to be blindingly apparent just how much trouble successive governments in the United States and Europe have got themselves and their people into by their chronic failure to discipline their spending and taxing the way our governments - Labor and Liberal - have for many years.

Our pollies have done this by setting for themselves and sticking to policy frameworks - in particular, the bipartisan ‘medium-term fiscal strategy’ to ‘achieve budget surpluses, on average, over the medium term’ - regularly supplemented by more explicit, shorter-term targets.

When, in the throes of the global financial crisis, Kevin Rudd embarked on huge fiscal stimulus, he nonetheless bound the government to various strictures to keep his actions consistent with the medium-term strategy and the requirements of Peter Costello’s Charter of Budget Honesty Act.

For openers, he pledged to ensure all stimulus programs were temporary - which they were. And as early as February 2009 he committed the government to a ‘deficit exit strategy’ in which it pledged to avoid further income-tax cuts and limit the real growth in government spending to an average of 2 per cent a year until the budget was back into significant surplus.

So far, the government has stuck to that commitment. When, in the 2010 election campaign, Gillard took Treasury’s projection that the budget would be back in surplus by 2012-13 and turned it into a solemn promise, she was binding herself more that the medium-term strategy required her to.

As the future has unfolded, this has proved an ever-more difficult promise to keep, mainly because of weaker-than-expected growth in the world economy and the now-apparent structural weakness on the budget’s revenue side.

In consequence, keeping the surplus in prospect has required Gillard to find further savings in just about every budget and mid-year update since. Question is: why is that a bad thing?

It’s not as if the economy’s fallen off a cliff. It’s continued growing at about its medium-term trend rate, with unemployment steady in the low 5s for the past three years. It’s expected to continue growing at a fraction below trend, with unemployment edging up only to 5.5 per cent.

What’s more, the tightening in fiscal policy is occurring that a time when the Reserve Bank has plenty of scope to compensate by easing monetary policy - with an outside chance this could help lower the dollar a little.

This is consistent with the strategy: that, except in emergencies, fiscal policy move in a more inexorable, medium-term way, with the far more easily adjusted monetary policy used as the ‘swing instrument’.

Admittedly, a lot of the savings measures have been cosmetic. But shifting planned expenditure by more than just a few weeks either side of June 30 is real. And not all the measures have just been such ‘reprofiling’.

Wayne Swan and Penny Wong have been chipping away at middle-class welfare in a way they probably wouldn’t have were it not for their alleged ‘surplus fetish’. Why’s that a bad thing?

They’ve significantly reformed the tax treatment of superannuation, reformed the concessional treatment of company cars under the fringe-benefits tax, begun phasing out the dependent spouse tax rebate and means-tested the baby bonus and the private health insurance rebate, as well as tightening means tests elsewhere.

In last week’s effort they cut the baby bonus for subsequent children (few people remember the original rationale for the bonus: it was a substitute for paid parental leave, which has since been introduced) and further tightened the health insurance rebate (in a way that saves little in the first few years, but causes the saving to grow each year forever).

A further consequence of the surplus promise has been to strengthen the purse-string ministers’ hand in insisting new spending commitments be matched by savings on existing programs. Why’s that a bad thing?

As for the smarties’ claim that Gillard’s motive in trying so hard to keep her surplus promise is purely political, it’s naive. All of us do many of the things we do for mixed, even ulterior motives. Pollies are no exception. Indeed, if you’ve had much to do with them you know everything they do is politically motivated.

So to say Gillard fears what the opposition would say if she failed to achieve a surplus is to state the obvious. The real question is, regardless of her political motives, is what she’s been doing consistent with disciplined fiscal policy? I’ve been trying to show it is.

Balancing budgets is politically hard. Most voters, interest groups, backbenchers and even spending ministers don’t give a stuff. The temptation not to bother is huge. So it’s crazy for the one group that cares - economists - to be joining those who don’t in urging the pollies not to bother meeting their commitments to run a tight ship.

Of course, it would be a different matter if the economy was falling off a cliff. In any case, the smarties and slackos may yet get their wish. If you listen carefully to what Swan and Wong are saying about the future, it seems last week’s effort to get the surplus back on track will be their last.

Should the revenue side deteriorate much further, they’re ready to let it go.

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How the budget redistributes income

In a capitalist economy such as ours, the rich have loads of money, the poor have next to none and the government does little about it.

Is that what you suspect? It's a long way from the truth. While some (including me) may argue they could be doing more, between them our governments - federal and state - are doing a lot more to redistribute income from the rich to the poor than many people imagine.

The reason so few people realise this is the system that brings it about is very complex. To see what's going on requires a special study - which is just what the Bureau of Statistics does every six years.

In its publication, Government Benefits, Taxes and Household Income, the bureau uses several of its surveys to take all the taxation we pay - federal and state - and attempt to attribute it to households of differing incomes. It does the same for all federal and state government spending.

But not all the taxes we pay can be attributed to households - company tax, for instance. Similarly, not all government spending can be attributed - spending on defence or roads, for instance.

In the latest study, for 2009-10, it managed to attribute $194 billion, or 62 per cent, of total government revenue and $234 billion, or 51 per cent, of total government spending.

It ranks households lowest to highest according to their income, dividing them into five "quintiles" (groups of 20 per cent). This is handy because, if income was equally distributed, each quintile would have a 20 per cent share of total income. So you can judge how unequally income is distributed by comparing each quintile's actual share with that 20 per cent benchmark.

Households start out with "private income" - income they've earned themselves from wages, investments or any unincorporated business they may own. Then the government gives them cash benefits (such as the pension, the family tax benefit or the dole) and benefits in kind (such as free or subsidised education, healthcare, subsidised childcare and public housing).

But governments also take money away from households in the form of income tax and indirect taxes (such as the goods and services tax, several sin taxes and various state taxes).

Allow for all these things and you end up with households' "final income". So how much does all the governments' taxing on the one hand and spending on the other end up changing people's incomes?

Quite a bit. The poorest quintile is composed mainly of pensioners and people on the dole. Its share of total private income is less than 5 per cent, whereas its share of total final income is more than 7 per cent.

The second poorest quintile (composed mainly of self-funded retirees and the working poor) has its share of total income increased from 9 per cent to 13 per cent.

The middle quintile (composed mainly of working families) has its share raised from 15 per cent to 17 per cent.

The second-highest quintile's share is virtually unchanged at 23 per cent. But get this: the highest quintile (mainly two-income couples without dependants) has its 48 per cent share of private income reduced to 40 per cent of final income.

So the system of taxes and benefits takes 8 percentage points of total income from the top 20 per cent of households and redistributes it to the bottom 60 per cent.

But how exactly does it bring this about? For a start, income tax is "progressive" - it takes a progressively higher proportion of tax as income rises.

The bureau's figures show income tax takes about 8 per cent of the private income of households in the lowest quintile but the proportion steadily increases until you get the highest quintile, which loses more than 19 per cent.

(If that last proportion seems low, remember income tax is levied on the incomes of individuals, not households. Most top households would have two income-earning individuals, probably with one partner earning a lot more than the other, thereby lowering their average tax rate.)

Of course, you'd expect the progressive effect of income tax to be offset by the "regressive" effect of indirect taxes. A regressive tax takes a higher proportion of low incomes than high incomes.

And that's just what the bureau's figures show. On average, households in the lowest quintile lose 19 per cent of their "gross income" (private income plus cash benefits) in indirect taxes. That proportion falls steadily until you get to the highest quintile, which loses less than 8 per cent.

So what's the story when you put the two types of tax together to examine the effect of the total tax system? You find the tax burden as a proportion of gross income is very roughly U-shaped. The lowest quintile loses 24 per cent, but then the proportion drops to 22 per cent before slowly rising to reach 27 per cent for the highest quintile.

Clearly, the total tax system does surprisingly little to redistribute income from the top to the bottom.

See what that means? Though few people realise it, most of the redistribution done by the budget comes not from its tax side but from its spending side.

That's particularly the case with cash benefits which, after all, are tightly means-tested. The cash benefits received by households in the lowest quintile are equivalent to 47 per cent of their private income.

But that proportion falls sharply until you get to the highest quintile, whose cash benefits add just 2 per cent to their private income. Mental note for all lefties: means-testing makes the cash benefits system highly progressive.

By contrast, most benefits in kind are provided on a universal basis - that is, without means-testing. That's true of healthcare and education spending. So you wouldn't expect their distribution to be particularly progressive.

You wouldn't expect it, but for some reason it is. The in-kind benefits received by the lowest quintile are equivalent to 53 per cent of private income. But that proportion falls sharply to reach just 12 per cent of the highest quintile's private income.

All told, the whole tax and benefits system adds an average of $241 a week to the incomes of the bottom 20 per cent of households but subtracts an average of $484 a week from the incomes of the top 20 per cent. That's quite a redistribution.

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Budget redistributes income over life cycle

Listening to all the argy-bargy over the budget update makes you think - what strange things budgets are. The government spends all this money - hundreds of billions a year - but where does it come from? From us, of course. The politicians use the budget to take money from us with one hand, then give it back with the other.


They have one set of public servants to take our money from us and another to give it back. What's the point of all this "churning"? Wouldn't it be a lot simpler and cheaper to have lower taxes and lower spending?

If we each got back pretty much what we put in, it would indeed be a pointless, wasteful exercise. In reality, high-income earners put in a lot more than they get back, whereas low-income earners receive a lot more than they pay in taxes.

But even that doesn't adequately describe the rearranging brought about by the budget.

Every six years the Bureau of Statistics conducts a study in which, using several of its surveys, it takes all the taxation we pay - federal and state - and attempts to attribute it to different classes of household. It does the same for all federal and state government spending.

Of course, not all the taxes we pay can be attributed to households - company tax, for instance. Similarly, not all government spending can be attributed - spending on defence or roads, for instance.

In its latest study, for 2009-10, the ABS managed to attribute $194 billion, or 62 per cent, of total government revenue and $234 billion, or 51 per cent, of government spending.

Remember Shakespeare's seven stages of man? The study divides Australia's 9.8 million households into 10 main life-cycle stages. It turns out whether your household's a net payer or a net recipient depends heavily on where you are in the life cycle. We'll limit ourselves to six stages.

Most people start their working lives as single and under 35. On average, people in this category pay $226 a week in income tax and $115 a week in indirect taxes, such as the goods and services tax and the various excises.

They get back very little in cash benefits ($28 a week) and not a lot more in benefits in kind, $80 a week, mainly health care plus a bit of public spending on tertiary education.

So, on average, younger singles pay $233 a week more in taxes than they get back in benefits.

The next typical life stage is being young (under 35) and married, before the kids start coming. Households in this category - in which both partners are likely to be working - pay an average of $384 a week in income tax and $196 in other taxes.

They get back virtually nothing in cash benefits ($12), but $136 worth of benefits in kind, mainly healthcare and tertiary education.

So, on average, young childless couples pay no less than $432 a week more in taxes than they get back in benefits.

Once the kids start arriving, however, the tables turn. Somewhat older couples with dependent children, the eldest of which is aged between five and 14, pay more income tax ($454) and a bit more indirect tax at $227 (a sign of a more frugal life style).

Cash benefits jump to $133 a week (mainly family tax benefit) and benefits in kind leap to $608 a week (mainly school education, but also a lot more healthcare and a bit of childcare subsidy).

So, on average, couples with a kid or two get back $60 a week more than they put in. They think they're paying a lot of tax but, in truth, they're getting a net subsidy from other taxpayers.

Once the kids grow up, however, the tables turn again. Couples with non-dependent children average $604 a week in taxes. Against this, they get cash benefits of $176 and benefits in kind (overwhelmingly healthcare) of $328.

So older working couples revert to paying more in taxes than they get back, to the tune of $100 a week.

We've reached the last two stages of life: couples 65 and over, then single people 65 and over. On average, largely retired couples pay next to nothing in income tax and a bit in indirect taxes, totalling $168 a week. Against that, they get cash benefits of $378 (mainly the age pension) and benefits in kind (mainly healthcare) of $481.

So, on average, retired couples get back $691 a week more than they pay. For surviving single retirees it's a net gain of $475 a week.

See what all this proves? As well as redistributing income from rich to poor, the budget acts as a giant, multi-faceted mutual support scheme. At some points in your life you're a net contributor, at others a net recipient.

The system requires those without dependents to subsidise those with, particularly when the little blighters need educating. It requires the well to subsidise the sick. It requires those who work to subsidise those too old to work.

I think it's a good system, a sign we live in a reasonably caring, civilised society, where those in need get supported by the rest of us.

It's a reason we should pay our taxes with a lot less grumbling. The pity is, the system's so complex and convoluted it's not until you see a special study such as this that you realise how it works - it's inbuilt fairness and solidarity.

Something to think about next time you're tempted to justify a demand on government because you've "paid taxes all my life". You've also been benefiting all your life.

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Business cons the states out of tax revenue

WHEN we see the mid-year budget review today, all eyes will be on the savings Wayne Swan will announce to ensure he still achieves a surplus this financial year. The measures will be needed because the weakness in tax collections is even greater than expected.

Deciding how much we should cut spending is one thing, but working out what to do about the budget's structural problems on the revenue side is quite another.

One way the Gillard government is seeking to reduce pressure on its budget is by demanding bigger contributions to joint projects by the states. They, however, always see themselves as recipients of federal spending, not contributors.

I have a fair bit of sympathy for the states. They have primary responsibility for the big-ticket spending areas of education, hospitals, law and order, roads and transport, and much else, but their revenue-raising power is limited, having been progressively whittled away by the High Court.
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That's why John Howard bequeathed them all the proceeds from the goods and services tax. But the GST is no longer the growth tax it seemed to be. Consumer spending will never again grow as strongly as it did during the tax's first seven years, and an ever-growing proportion of consumer spending goes on items excluded from the GST base.

Because the revenue-raising capacity of the two levels of government is so unequal, any serious funding problem for the states ends up being the federal government's problem.

But it's harder to feel sorry for the states when you remember - as prompted by the secretary to the Treasury, Martin Parkinson, in a recent speech - the way they have knowingly and over many years perverted one perfectly good tax in their possession, payroll tax.

The states' limited taxing ability is an old problem. As long ago as the early 1970s, Billy McMahon sought to fix it for good and all by giving them the federal payroll tax.

Clearly, it didn't work. For a while the states raised the rates of their payroll taxes, but soon enough they began cutting rates to curry favour with business before election campaigns and eroding the base, thereby turning it from a reasonably neutral tax into one that distorts business choices.

Advocates of a federal system like the idea it allows a degree of competition between the states. But when the states compete to lower tax rates - or use offers of tax holidays to attract investment projects away from other states - they all lose. Business plays them off a break. The standard argument against payroll tax is that, by raising the cost of labour, it discourages employment. But this is ill-considered.

In the end, you can tax only three things: land, labour or capital. Income tax is largely a tax on labour; tax economists say company tax is largely a tax on labour, the GST is largely a tax on labour (most consumer spending is done from wages) and payroll tax is also a tax on labour.

Business people tend to approve of the GST - they're always saying its rate should be increased - but invariably oppose payroll tax, even though, in principle, the two are quite similar. Business people know the burden of GST is passed on to consumers, but many seem to imagine the burden of payroll tax remains with them. In both cases, who writes the cheque that goes to the tax man doesn't tell you who ultimately bears the tax.

Business people lap up the fashionable idea that, in a globalising world of ever-greater mobility between economies, we should be relying more on taxing land and labour, and less on taxing capital. But all the while they're inveigling the premiers into reducing payroll tax.

When Parkinson spoke in defence of payroll tax (merely echoing the opinion of all treasuries, federal or state), the states responded that the tax was bad for small business. This is pretty much the opposite of the truth.

Apart from cutting the rate at which the tax is applied, the main way the states have undermined this - the biggest of their own taxes - is by regularly raising the threshold at which the tax applies to a business's wages bill.

So high is the threshold in the various states that genuine small business doesn't pay the tax. It's actually a tax on big business. It's really medium-size business that's most affected by where the threshold is.

Although payroll tax is an efficient, non-distorting tax in principle, its way-high threshold makes it distorting in practice. It's a tax that favours small business and penalises big business.

The obvious reform, which would gradually reduce the distortion of business choices and aid the states' revenue problem without involving too much political pain, is simply to leave the threshold where it is in nominal terms, allowing wage inflation to progressively lower it in real terms.

The insouciance which has allowed the premiers to fritter away their strongest and soundest source of ''own-revenue'' makes you suspect they're privately perfectly happy with the ''vertical fiscal imbalance'' whereby the federal government gets most of the opprobrium for collecting taxes, while the states are perpetual beggars at the federal table, only ever prepared to co-operate with federal reforms if they receive a big enough bribe.

The feds are unlikely to seriously consider changes to the GST until the premiers have shown a willingness to undertake the revenue-enhancing reforms that lie within their own control.

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Game theory can be practical

Children play games. Teenagers play video games. Footballers play games. Economists don't admit to playing games. They prefer to say they study game theory.

This week two academic gamesters, the economist Alvin Roth, of Harvard Business School, and the mathematician Lloyd Shapley, of the University of California, Los Angeles, were awarded the Nobel Prize in Economics for their efforts.

This brought to 10 the number of academics who've won the prize in recent years for helping to develop game theory.

You read a lot about economics in newspapers, but you rarely read about game theory. This may be because, as yet, it's still pretty theoretical without much practical application - though, as we'll see, Roth's endeavours are a notable exception.
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But, as all those prizes attest, it's a relatively new area of economic inquiry, one the academics are greatly excited by and believe holds much promise. It's also an approach that's spread to other social sciences.

I'll try to explain it simply, using information cribbed from various sources, but it's actually highly mathematical - another reason it's so attractive to academics, who seem to be turning economics into applied maths.

Economists study how societies allocate resources between competing uses. Conventionally, they study how this is achieved by the movement of prices paid in markets bringing supply and demand into equilibrium.

The standard model assumes the buyers and sellers in those markets are each so small they have no effect on the prices being paid. In reality, many markets are dominated by a few big companies which do have the ability to influence the price.

So game theory began as an alternative way of studying the behaviour of the many ''oligopolies'' that characterise modern economies.

Game theory is the study of how people or firms behave in ''strategic'' situations - those where each player in a market, when deciding what to do, has first to consider how others might respond to that action. So, like a game of chess, the ''games'' economists study have a set of players, a set of moves or strategies available to those players and a range of ''payoffs'' (consequences) of each combination of strategies.

Economists use game theory to describe, predict and explain people's behaviour. They've used it to study auctions, bargaining, merger pricing, oligopolies and much else.

Unlike conventional analysis, game theory allows the possibility of ''multiple equilibria'' - more than one possible outcome the participants regard as satisfactory. And it studies ''decision-making under uncertainty'' - having to make decisions without knowing what the future holds.

Game theory is also able to study co-operative games (where players may form coalitions in competing with other players) as well as non-co-operative games (where all players compete as individuals).

For the most part, however, game theory retains the conventional (unrealistic) assumption of ''rationality'' - people know what's in their best interests and that's what they do.

Game theory began with simple two-player, ''zero-sum games'' - if I win, you must lose. It's moved on to multiple-player, positive-sum games - games where all players may gain because of the ''gains from trade'' (exchange) between people.

The classic game is ''the prisoner's dilemma'', where two prisoners must separately decide whether to co-operate with the other (by admitting nothing) or to ''defect'' (dob in the other in the hope of a lighter sentence). It shows why, in the absence of trust between them, the prisoners may choose not to co-operate (the ''rational'' choice for each), even though it's in their best interests to do so. This game is so famous because it studies the great problem of civilised societies: how to deal with ''free-riders'' - people who take advantage of others' willingness to co-operate.

The work of Shapley and Roth is a long way from that. Shapley, a theoretician who did most of his work in the 1960s, studied ''matching markets''. In most markets you choose what you want and hand over your money. In matching markets you make your choice, but you also need to be chosen by the other side.

If a market has an application or selection procedure, it's a matching market. Such markets determine some of the most important changes in our lives. Marriage, for instance. You don't like thinking of marriage as a market? That's why, in many matching markets, the transaction occurs without the use of money. Using money to determine who gets what would be ''repugnant''.

Shapley was concerned with reaching outcomes in non-monetary matching markets that were ''stable'' - where nobody wanted to change their pair in the belief they could do better.

(This equilibrium is the co-operative games' equivalent to a ''Nash equilibrium'' in non co-operative games. In a Nash equilibrium, each player is making the best choice they can, given the choices of the other players. John Nash, an earlier Nobel laureate, was the mentally disturbed mathematician played by Russell Crowe in the movie, A Beautiful Mind.)

Shapley's contribution, with David Gale, was to discover an algorithm (a mathematical set of rules for solving a problem) that would lead to stable pairs. Say thousands of students have applied to enter 20 universities, setting out their preferences.

The algorithm turns on ''deferred acceptance'' - the unis make their offers, the students select the best offer they've received, but delay accepting it, rejecting any other offers. The unis make further rounds of offers until the process is complete and students then accept the best offer they've had.

Gale and Shapley proved their algorithm always leads to stable pairs. They also showed the side that starts the process gets the better deal. Their approach discourages players from attempting to game the system by not stating their true preferences.

The contribution of Roth, who spent time at Sydney University this year, is more practical. He's taken the Gale-Shapley algorithm, studied it using laboratory experiments and applied it to real-world matching exercises.

He's expert in ''market design'' - changing the rules in markets so they work more efficiently in producing the best outcomes for people. He says a ''free market'' is one that moves freely in achieving efficient outcomes, not necessarily a market with no intervention by the government. In the United States, Roth has helped make changes that improve the pairing of medical interns with hospitals, the pairing of students with high schools and the matching of kidney donors with recipients. He's also done the last one in Australia, actually improving some people's lives.

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Psst. Don't tell anyone about poverty

It's remarkable that, despite all the effort and expense the government goes to in measuring gross domestic product, it doesn't run to the modest extra expense of measuring poverty. But this being so, it's hardly remarkable the media and the public pay far more attention to the gyrations of GDP than to the extent of poverty.

Why the lack of official interest in such a basic measure of how we're doing as a nation? Because, in an egalitarian country such as ours, poverty isn't much of a problem?

Err, no. In the mid-2000s, Australia's rate of poverty was the fourth highest among 18 developed economies. Surely the reason couldn't be that our record is so bad that the government would prefer us not to think about it? Hmmm.

The more I think about it, the more I want to know what there is to know about poverty in Australia.
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And, when some of our big charities - Anglicare, St Vincent de Paul and the Salvos - feel it worth expending some of their precious funds to commission a report on the subject, as they did this week, I'm inclined to take notice. Who knows when next the problem will be drawn to our attention?

As you've seen from the headlines, the report finds that more than 2 million Australians - one person in eight - is living in poverty. This poverty rate of almost 13 per cent has changed a bit but not a lot over the past decade. It's not shooting up, but neither is it falling.

What exactly is meant by ''living in poverty''? How is it measured?

There is more to being poor than just an absence of money. Another dimension is how isolated you are from the support of other people. But this measure - calculated from official surveys by the social policy research centre at the University of NSW - is a purely monetary one.

The next point is that poverty is measured differently in rich countries from poor countries.

In the developing world they measure ''absolute poverty'' - whether you're so poor you're at risk of death from malnutrition.

In rich countries few people, no matter how poor, are starving. So we measure ''relative poverty'' - how many people or households have incomes well below what's typical in our community. And how low is ''well below''? Usually, that's a case of drawing an arbitrary line, and drawing it so low there isn't much room for argument.

This study sets the poverty line at a level commonly used in comparisons between the rich countries. It ranks the disposable (after-tax) incomes of all households from highest to lowest, then draws the line at 50 per cent of the median (dead-middle) income.

The study finds almost 13 per cent of households fall below the line. Hold that thought.

The main way people avoid poverty is by having a job and earning income from it. So you'd expect that, unless people were on particularly low wages, or could find only part-time work, or had a lot of others depending on them, working households would avoid poverty.

The main way governments seek to avoid poverty in the community is by paying a range of social security benefits to those people who, for one reason or another, are unable to work.

Those too old to work get the age pension; those too sick get the sickness benefit; those physically or mentally unable to work get the disability support pension; those too busy minding children get the single parenting payment; those too busy caring for a relative get the carer payment. And those who just can't find a job get the dole.

The federal minimum wage - increased each year by Fair Work Australia - is comfortably above the poverty line which, in 2010, was $358 a week for single adults.

And, most people with children to support get the relatively generous family tax benefit.

So why do 13 per cent of people fall below the poverty line? The biggest single reason is that the levels of the various social benefits fall below the line. Way below in the case of the dole; a little below in the case of the single parenting payment and the age pension.

It follows that, unless they can supplement their payment with income from savings or a little part-time work, people living on social security payments are at great risk of poverty. Overall, 37 per cent of people on social payments live below the line. But the proportions vary widely according to the type of payment: 14 per cent of those on the age pension, 42 per cent of those on the disability pension, 45 per cent of those on the parenting payment and, get this, 52 per cent of those on the dole. Not surprising then, that people on social payments account for almost two-thirds of those in poverty.

The next most important factor explaining why people fall below the line is the high cost of housing.

In particular, the gap between the costs of owning and renting. It's a safe bet the majority of people in poverty are renters.

It may surprise you that the retired account for only about 15 per cent of those below the line. That's because so many own their homes outright.

When you're measuring relative poverty, it follows as a matter of arithmetic that the only way to reduce the proportion of people falling below the line is for their incomes to increase at a faster rate than incomes generally.

Julia Gillard could reduce poverty at a single (expensive) stroke: a decent, one-off increase in the indefensibly low rate of the dole.

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Reserve Bank moves to Plan B on interest rates

IT'S not at all clear that falling commodity prices - or the Reserve Bank's latest cut in the official interest rate - will lead to a lower Aussie dollar. But if it doesn't fall, and the economy doesn't look like it will stay growing at its trend rate, the Reserve will just keep cutting rates.

The best way to think of the Reserve's problem in using monetary policy (interest rates) to maintain non-inflationary growth is that for some years it's been trying to keep the economy on an even keel while we're being hit by two powerful, but opposing economic shocks: the expansionary shock from the resources boom and the contractionary shock from its accompanying very high exchange rate.

This involves predicting, then continuously monitoring the relative strengths of the opposing forces, with the objective of keeping inflation in the 2 to 3 per cent range and the economy growing at about its medium-term trend rate of 3.25 per cent a year - neither much less than that nor much more (because the economy's already close to full employment).

For most of last year the Reserve's greatest worry was that the stimulus from the resources boom, applied to an economy already near full employment, would push up inflation. By November it realised any inflation threat had passed - it was actually falling - whereas growth was on the weak side of trend. It therefore cut the cash rate by 125 basis points (1.25 percentage points) between November and June.
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The latest reassessment of the balance between the two conflicting forces bearing on the economy is that the fall in coal and iron ore prices and the shelving of expansion plans by some second-tier miners will cause mining investment spending to peak in the middle of next year, a little earlier and a little lower than expected.

This pushed the growth forecast for the overall economy a bit below trend. Hence this month's rate cut.

It's reasonable to attribute the Aussie's remarkable strength since the start of the resources boom predominantly to our high commodity export prices and vastly improved terms of trade.

That makes it reasonable to expect the fall in export prices would lead to a commensurate fall in the Aussie, thus reducing its contractionary effect on our export and import-competing industries.

But the historical correlation between our terms of trade and our exchange rate, while strong, can also be quite loose for fairly long periods. So it's not surprising the Aussie has held up so well.

The plain truth is that, because financial markets simply aren't as ''efficient'' as it suits some economists to believe, no theory they can come up with adequately and always explains the Aussie's ups and downs.

The best you can say is the terms-of-trade theory works well a lot of the time and over the medium to long term, while its main rival - that the Aussie's driven by the size of the ''differential'' between our interest rates and those on offer in the big economies - sometimes works at other times.

So it's equally unsurprising the 150-basis-point fall in our official interest rate since November has done little or nothing to get the Aussie down.

My guess is the Aussie could stay much where it is for years to come. Why? Because of a third, omnibus theory: those countries with the best growth prospects tend to have strong exchange rates whereas those with poor prospects tend to have weak exchange rates.

It's a safe bet that, even if we were to fail in our attempt to get growth back up to trend, our prospects will stay a mighty lot better than those for the United States and Europe. Then there's our AAA sovereign credit rating and exposure to the fastest-growing region, Asia, to entice capital inflows.

Remember, exchange rates are relative prices, so if some countries are down, others must be up. We're not alone in the strong-currency boat: there's also Switzerland, Canada, New Zealand and Sweden.

So, what if the Aussie stays up and its contractionary effect on the economy remains undiminished? The Reserve would just keep cutting the official rate until it foresaw growth getting back up to trend.

In principle, the only thing that could deter it from this response is rising inflation pressure, but with growth below trend that's hardly likely.

Its goal wouldn't be to get the dollar down (though that would be welcome) so much as to stimulate the presently ailing, interest-sensitive parts of the domestic economy: home building and commercial (as opposed to mining-related) construction.

This would quite possibly get house prices growing reasonably strongly which, in turn, could perk up consumer confidence, particularly for people in or near retirement.

But that's actually the vulnerability in such an approach by the Reserve. Returning to a period of exceptionally low mortgage interest rates risks igniting another credit-fuelled boom in property prices, at a time when many households remain heavily indebted and most foreign economists can't understand why we haven't had a property bust.

The rich world spent most of the 1970s, '80s and '90s worrying about how to get inflation down to acceptable levels. We now know that, particularly since the advent of independent central banks and inflation targeting, the central bankers have got (goods-and-services price) inflation licked.

One small problem: as the global financial crisis so powerfully reminded us, in the process they've aggravated the problem of asset-price inflation, with its huge bubbles and terrible busts.

To date, the world's monetary economists are at a loss on how they can control goods-price inflation and asset-price inflation at the same time.

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Labour market can be flexibile as well as fair

If you listen to business, we still have big problems with the labour market. John Howard deregulated it, but then Julia Gillard re-regulated it and now we can't do a thing with it.

The business people are right to this extent: particularly at a time when the economy is under so many pressures for change in its structure - the rise of the emerging market economies and the resources boom it has produced, the digital revolution, the return of the prudent consumer, and more - we do need a labour market that's "flexible".

But what exactly does flexibility mean? Well, not what some bad employers think: unilateral freedom to change their staff's working arrangements without recompense or consultation. That's one-sided flexibility.

No, what flexibility should mean is the ability of the labour market to adjust to the shocks that hit the economy without generating excessive inflation or unemployment. You get some, but it doesn't linger for years.

Another word for it is "resilience" - the ability to take the punch, then bounce back.

So how are we doing on that score? A lot better than business's complaints may lead you to believe. In a speech this week, Philip Lowe, the deputy governor of the Reserve Bank, reeled off a host of respects in which the labour market is more flexible.

He started by noting that, despite all the gloominess - and notwithstanding its apparent rise to 5.4 per cent last month - the official unemployment rate is still very low by the standards of the past 30 years.

In that time there have been only four years in which the unemployment rate has averaged less than 5.25 per cent. (Note for sceptics: contrary to urban myth, the method of calculating the rate hasn't changed in that time.)

Lowe reminds us Australia has one of the lowest unemployment rates among the advanced economies - "an outcome that seemed improbable for much of my professional career".

Although the unemployment rate has been virtually unchanged for more than two years, this conceals a great deal of coming and going from jobs. The figures show that in February this year, about 2.3 million people - almost a fifth of the workforce - were newly employed, having been in their job for less than a year.

Whereas a little less than half of these people were starting work for the first time (or for the first time in a long time), 1.2 million people moved from one job to another. And this in a year when the net growth in employment was a mere 23,000.

In other words, a fraction more people gained jobs than lost them, even though the media trumpeted the job losses and said next to nothing about the job gains.

About three-quarters of the job changes were voluntary, including for personal reasons or to take advantage of new opportunities. The remaining quarter was involuntary, including because employers went out backwards or changed the nature of their business.

It's always true that far more people move around than we imagine when we see the small net changes from month to month. In the jargon, "gross flows" far exceed net change. But Lowe finds some evidence all the structural pressures affecting the economy at present have led to a higher rate of job turnover.

If you take all the people who left their job over the year to February and compare it with the all people employed at some time during the year, this was the highest in two decades.

That's true for both voluntary and involuntary "separations" - meaning it's a sign of greater flexibility in the labour market. It suggests that, while a lot of jobs ceased to exist, at the same time a lot of new job opportunities opened up in other parts of the economy and many displaced workers were able to find new jobs without much drama.

Another indication some parts of the labour market are expanding while others are contracting is that the official measure of the number of job vacancies has remained relatively high, even though the growth in employment overall has been so small.

Consider this: since 2007, about 300,000 net additional jobs have been created in the health care sector, 200,000 in professional and scientific services, and about 130,000 each in mining and education.

So where's the downside? Employment in manufacturing has fallen by about 70, 000 and the number of jobs in retailing has stopped growing.

Despite this significant variation in employment growth by industry, there hasn't been any widening of the rates of unemployment among the nation's 68 local regions. Compared with 10 years ago, the average unemployment rate is lower and the variation between regions is lower, not higher.

About half the regions have unemployment rates below 5 per cent and almost three-quarters have rates below 6 per cent. In only three regions is the rate above 8 per cent, compared with 13 regions a decade ago. That's lovely, but what about wages? Here there has been increased dispersion. Since 2004, average wages in mining have risen by about 10 per cent relative to the economy-wide average. Workers in professional services have also experienced faster-than-average increases, Lowe says.

Conversely, relative wages have declined in the manufacturing, retail and the accommodation industries, each of which has experienced difficult trading conditions in recent times.

Sounds pretty flexible to me. This adjustment of relative wages has help move workers around the changing economy so shortages of skilled workers in some areas have been fairly limited.

Lowe observes the adjustment of relative wages has occurred "without igniting the type of economy-wide wages blowout that contributed to the derailment of previous mining booms".

He declares the industrial relations system is more flexible than it was two decades ago and says it's essential the labour market retains its flexibility. But though industrial relations laws and practices are important in this, "they are by no means the full story".

"Flexibility also comes from having an adaptable [my emphasis] workforce - one that has the right general skills, the right training and the right mindset," he concludes.

"Whether or not Australia fully capitalises on the opportunities that the growth of Asia presents depends critically upon the ability of both workers and business to adapt, and to build and use our human capital."

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The Asia boom is just getting going

Have you noticed how joyfully the media trumpet the bad news they seek out so assiduously? The latest is that the resources boom is finally busting. O frabjous day! Callooh! Callay!

It's true the prices we're getting for our exports of coal and iron ore, having lifted the terms on which we trade with the rest of the world to their most advantageous level in 200 years in the September quarter of last year, have been falling ever since and have further to go.

It's true China's economy has slowed markedly in recent times and this, combined with the fall in export prices, has prompted some of our smaller mining companies to shelve their plans for new mines.

And last week the Reserve Bank warned the peak in mining investment spending was likely to occur next year and reach a lower level than earlier expected. Fearing a slowdown in the economy, it cut the official interest rate another notch.

So, is this the dumper many people have feared? Is the much ballyhooed resources boom about to disappear into the history books?

Don't be misled. As the secretary to the Treasury, Dr Martin Parkinson, argued last week, it was always misleading to think the resources boom, being just another boom, would soon bust, leaving us in the lurch with nothing to show but holes in the ground.

For a start, it's a bit previous to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to keep growing strongly for another year before it starts to fall back. Even then it will stay way above what we normally see for several more years.

Coal and iron ore prices may be falling, but don't imagine they'll return to anything like what they were. At their best, our terms of trade - the prices we get for our exports relative to the prices we pay for our imports - were almost 80 per cent better than their average throughout the 20th century.

The econocrats now expect that, by 2019, they will have collapsed to a mere 50 per cent above that 100-year average. Nothing to show for it? This means we'll remain wealthier than we were (our exports will continue buying far more on world markets than they used to).

Taken by itself, this lasting improvement in our terms of trade suggests another thing we'll have to show is a dollar that stays well above the US70? or so it averaged in the decades following its float. That means a dollar that remains uncomfortably high for our manufacturers and tourism operators.

All this ignores a further benefit from the resources boom which, though it's already started, is largely still to come: vastly increased quantities of coal, iron ore and natural gas for export. This, too, adds to our wealth.

Before the start of this supposed here-today-gone-tomorrow "boom" - which began almost a decade ago - mining accounted for less than 5 per cent of the nation's total production of goods and services. Its share is now well on the way to 10 or 12 per cent.

At the same time, manufacturing's share will continue its decline from about 15 per cent in 1990 to 12 per cent at the start of the boom and 8 per cent today to maybe 6 per cent by the end of this decade. (Much of this decline, however, is explained by the faster growth of the services sector as we, like the rest of the rich world, move to a knowledge-based economy.)

So yet another lasting effect of this fly-by-night boom is a marked and lasting change in the structure of our economy. To the consternation of some, the non-services part of our economy is becoming less secondary and more primary.

The underlying reason for this shift is the same reason it was always mistaken to imagine this is a transitory commodity price boom like all those we've seen before: the economic emergence of the developing world, led by Asia.

With the industrialisation of China and India, the globe's centre of economic gravity is shifting from the North Atlantic to the Indian and Pacific oceans. It's happening so fast it's visible to the naked eye. All the economic troubles of the Europeans and Americans are speeding it up, not slowing it down.

Remember how the world's richest 20 per cent owned 80 per cent of the wealth? Forget it. The poor countries already account for half the world's annual production of goods and services. Over the next five years, they'll account for three-quarters of the growth in world production.

So we're witnessing a tremendous change in the structure of the world economy, something so big economic historians will still be talking about it in 200 years' time. Is it surprising the effects on our economy are so big and so lasting?

We're greatly affected because of our proximity but also because our economy is so complementary to the emerging Asian ones. We have in abundance what they need in abundance: primary commodities. Their need for our raw materials will roll on for decades, including as Indonesia transforms itself from the world's fourth most populous country to its fourth richest.

This raises the final reason the mining boom shouldn't be lightly dismissed. As Parkinson reminded us, it's just the first wave of change arising from the Asian century. Next comes the rural boom as global demand for agricultural produce surges.

The third wave is the global growth in the middle class - from half a billion to more than 3 billion souls - with its growing demand for better services, goods and experiences. Just another passing boom?

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We need to talk about the budget

I have a terrible fear that just as the rest of the developed world is demonstrating how much better off our three decades of budgetary discipline have left us, we're in the early stages of letting it slip.

Australians have drawn many (usually disheartening) conclusions from the tribulations of the Europeans and Americans since the global financial crisis, but they don't seem to be getting the most obvious message: thank god we've kept our nose clean on the budget.

You can look at the Europeans' problems and say the key to them is the unsound basis on which they built their common currency, but the euro wouldn't be in trouble were it not for the decades of fiscal (budgetary) indiscipline of so many of its member countries.

They've gone for 30 years or more not bothering to balance their budgets and, as a consequence, building up huge levels of government debt. Add the crisis and its need to bail out banks and stimulate economies, and debt levels jump to the point where a banking crisis morphs into a sovereign debt crisis.

This story of laxity is matched in the United States (not to mention Britain). Although America's long-term bond rates are extraordinarily low - evidencing little sign of concern by the bond market - it's clear the Americans face considerable difficulty getting their growing deficit and debt levels under control.

In marked contrast, Australian governments - federal and state - have been obsessed by the need to restrain deficits and debt since the early 1980s, notwithstanding the ups and downs of the business cycle in that time.

The development of a suitably responsible but cyclically flexible "framework" for the conduct of fiscal policy began with the Hawke government's budget "trilogy" and culminated in Peter Costello's charter of budget honesty and medium-term fiscal strategy, requiring the budget to be balanced "on average over the medium term".

What makes our performance so remarkable isn't our early start in the design of budgetary commitments, but that successive governments have stuck to them.

That's true even of our budgetary response to the financial crisis. Kevin Rudd was able to unleash huge budgetary stimulus because net federal debt had been eliminated. But the medium-term strategy effectively required the increased spending to be temporary, and so it was.

Many Australians probably don't realise the Europeans' and Americans' budgets face enormously increased pressure over the next decade and more as the baby boomers retire. Why? Because governments long ago set up highly generous public pension schemes that haven't been adequately funded by employee contributions.

Yet again, we're in the clear. The cost of our low, flat-rate, means-tested age pension will not blow out much as the baby boomers retire. (Admittedly, the tax concessions attached to superannuation are far too expensive, though that's not a baby-boomer problem. And the Rudd-Gillard government is taking steps to wind them back.)

The depth of Australians' aversion to deficits and debt is well demonstrated by the opposition's success in frightening the punters over the modest rise in public debt following the financial crisis, and the government's manic determination to get back to surplus in 2012-13 come hell or high water.

So why my fear that, in terms of our commitment to fiscal rectitude, this is as good as it gets? That, just when we're witnessing the huge trouble we've avoided by being so disciplined, we're preparing to lurch into indiscipline?

Because both sides of politics are gearing up for next year's federal election with wildly expensive commitments they'll have enormous trouble fitting into a balanced budget. And because, though neither side wants to admit it, the revenue side of the budget is in so much trouble.

Each side is leading us down a different garden path. Labor is trying to buy the election with promises of vastly increased spending on a disability insurance scheme, grants for schools and much else. It's given us absolutely no indication of how it will pay for this spending "going forward".

For his part, Tony Abbott is trying to buy the election with promises to abolish the two new taxes that raise about $10 billion a year, the proceeds from which are already fully committed. For good measure, he's promising to lower the tax burden generally.

It's hard to believe either side would have sufficient discipline - sufficient willingness to impose deeply unpopular spending cuts - to pay for their promises and leave the budget bottom line heading ever further into surplus as we steadily eliminate the net public debt both sides profess to be so concerned about.

And that's before you take account of the two complications the Treasury secretary, Dr Martin Parkinson, reminded us of in a major speech on Friday. First is that economic growth - and hence, tax collections - in coming decades will be slower for demographic reasons (more on that another day).

Second, the serious structural problems on the budget's revenue side: income tax's loss of bracket-creeping power thanks to eight years of tax cuts; company tax's problems with the miners' huge depreciation deductions and the evaporation of capital gains, and the goods and services tax's problems with the return to normal growth in consumption and the changing pattern of consumer spending.

All these weaknesses say it will be a long time before tax revenue returns to its earlier proportion of gross domestic product, if it ever does.

"Combined," Parkinson says, "the slowing economic growth, rising expectations of government, and a constrained revenue base, are likely to force an explicit debate about the size and scope of government."

Bring it on.

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How the financial system works

It’s amazing to think the mighty, mysterious, overawing edifice of high finance - run by people much smarter and infinitely better-paid than us - is built on a pathetically simple, often fickle emotion: trust.

This is something economists and bankers understand in theory but, in their world of high-falutin’ mathematical models, keep forgetting in practice - to everyone’s cost. In this they exhibit the very human fallibility they so often assume away in their fancy calculations.

It’s also so elemental - and so humbling - they rarely talk about it. So when someone in authority spells it out for the benefit of mere mortals, it’s work taking note. An assistant governor of the Reserve Bank, Dr Guy Debelle, did so in a speech last week.

He started by explaining what banks and the financial sector do. They act as ‘intermediaries’ between savers and borrowers, taking the funds they raise from savers - through deposits, for instance - and lending them to those who wish to borrow, whether they’re businesses, governments or householders.

The financial sector is an intermediate sector, Debelle says. It’s not at the end of a production chain producing something that directly generates satisfaction. Rather, it’s a critical link along the way; the oil that keeps the economy ticking over. ‘When the oil dries up,’ he says, ‘the economic engine starts to malfunction and can ultimately grind to a halt.’

So the financial sector is different from other parts of the economy and its central role in keeping the rest of the economy functioning explains why it’s subject to considerably more government regulation and oversight than other industries (something many governments forgot in the years before the global financial crisis).

But why do we need financial intermediaries? Why don’t savers lend to borrowers directly? Mainly because of ‘asymmetric information’. This just means I know more about my affairs than you do. It’s hard for a saver to know whether the person or business to which they’re going to lend money will use the money wisely and be in a position to repay the loan when it falls due.

In contrast, a bank is practiced at making such an assessment of credit-worthiness and so can reduce (but never eliminate) the degree of asymmetry. The size of the interest rate charged by the bank should reflect its assessment of the degree risk of not being repaid.

The other main advantage of lending via intermediaries is their scope for ‘diversification’ - making a range of different loans to people or firms in different circumstances means the bank should not be overly exposed to a particular loan going bad.

So banks are able to ‘mutualise’ risk in a way individual savers can’t. ‘If there is a problem with one loan, the lender should be earning sufficient interest on the rest of its loan portfolio to cover the loss,’ Debelle says.

Now we see where trust comes into it. Largely because of the problem of asymmetric information, there has to be trust between depositors and the bank that their funds are safe. And there is trust between the bank and its borrower that the borrower has provided accurate information and will act in good faith.

Trust is needed to cover the asymmetry that remains despite the ‘due diligence’ of the depositor in assessing the riskiness of the bank and of the bank in assessing the riskiness of the borrower.

Trust is particularly important because banks engage in ‘maturity transformation’ - in the jargon, they ‘borrow short and lend long’. Banks will let you deposit your money ‘at call’ (you can withdraw it at any time) but, on the other hand, will lend this money for periods up to 30 years.

Were too many depositors to lose trust in their bank at the same time, it would not be able to call in all its loans and so would not be able to return the depositors’ money. To prevent such a thing occurring, central banks stand ready to lend to banks if they need it. The trust in these arrangements is almost always enough for them not to be needed, Debelle says.

Banks don’t always hold on their own books all the risk (debt) they’ve taken on, but use devices such as ‘securitisation’ (bundling many consumer loans into a bond, which is then sold to investors) to distribute the risk around the financial system.

This means the process of financial intermediation often has a number of links in the chain. This, in turn, means trust needs to be present at every stage in the chain. ‘One breakdown in this chain of trust between ‘counterparties’ can throw a spanner in the works of the whole process,’ he says.

Guess what? The global financial crisis can be explained as a consequence of the breakdown of trust.

The years leading up to the crisis were a period of what Debelle calls ‘lazy trust’. Things were going along fine, so too many people relaxed their due diligence. Too many borrowers were taken at their word, without checking.

‘Moreover, with long chains of intermediation involved, there was often too much distance between the ultimate holder of the risk and the source of the risk. Too many links means that details get lost or misheard. If the due diligence is necessarily incomplete by the very nature of financial transactions, then that incompleteness is likely to get magnified, the more chains there are in the transaction.

‘The due diligence gets dissipated along the chain. There is a presumption that someone further up the chain did the due diligence.’

Such behaviour was anything but rational. As Debelle concedes, ‘good times beget complacency’. ‘It does seem to be a trait of human behaviour that has been evidenced many times in financial history.’

Lazy trust evaporated. The financial system switched rapidly from complacency to deep mistrust. In particular, trust broke down between financial institutions. Knowing they had a lot of bad loans on their own books, institutions assumed the same was true of their competitors, though to an unknown extent.

Institutions stopped lending to each other, so intermediation broke down. Central banks had to step in and provide banks with the funds they needed. This is still true in Europe, and a lack of trust in the longevity of the euro has made people unwilling to lend even to some governments.

The trouble now is that trust can be quickly and easily shattered, but takes a long time to rebuild.

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