AUSTRALIA’S POLICY MIX

The economy isn’t travelling too badly at present, but if you listen to what you hear from much of the media, you could be forgiven for thinking it’s in terrible shape. There are several reasons why the economy’s doing a lot better than many people imagine. A fair bit of it is political: if you don’t like the government it’s easy to conclude it must be making a mess of the economy. The world economy is not growing strongly and a lot of the bad news we get from Europe may be worrying people, even though our strong and growing links with the developing Asian economies mean we are much less affected by problems in the North Atlantic economies than we used to be. Another part of the explanation may be that all the fuss about the Gillard government’s inability to keep its promise to return the budget to surplus in 2012-13 may have been taken wrongly by some as proof it is managing the economy badly. And it remains true that some parts of the economy are under great pressure from the high exchange rate and other factors.

Economy doing better than many imagine

When you stand back from all the argument and complaints you see the economy isn’t doing too badly. Real GDP is expected to have grown at the medium-term trend rate of 3 per cent in the old financial year, 2012-13, as a whole. The budget forecasts growth will slow to a little below trend, 2.75 per cent, in the coming financial year, 2013-14.

This growth has been sufficient to hold the unemployment rate in the low 5s for several years, though it is drifting up slowly and is forecast to reach 5.75 per cent by June next year. Remember that most economists believe the non-accelerating-inflation rate of unemployment (the NAIRU) - the lowest sustainable rate of unemployment - to be about 5 per cent. So the economy is not far from full employment and thus should not be growing faster than its trend or ‘potential’ rate of growth.

Inflation remains low, with underlying inflation at 2.4 per cent over the year to March and the rate having stayed within the 2 to 3 per cent range for three years. The diminishing threat from inflation has allowed the RBA to cut the official cash rate to an exceptionally low 2.75 per cent (it was 7.25 per cent before the GFC), meaning mortgage interest rates are the lowest they’ve been since the time of the GFC.

Resources boom has presented a succession of challenges

Apart from the GFC, the biggest issue confronting the macro managers of our economy has been the resources boom. It began about a decade ago and in that time they’ve had to confront a succession of differing challenges. At first the great problem they foresaw was that the boom would lead to an outburst of inflation, as so many previous commodity booms had done. This explains why the RBA had interest rates so high immediately before the GFC and why, even though it slashed the cash rate when the GFC hit, as soon as it realised the crisis wasn’t going to precipitate a severe recession it began pushing rates up again. For some time, however, it’s been clear inflation is well under control. That’s partly because of the economic managers’ vigilance, but mainly because the appreciation in the exchange rate that accompanied the huge improvement in our terms of trade did much to dampen inflation pressure, both directly by reducing the price of imports and indirectly by worsening the international price competitiveness of our export and import-competing industries and thereby dampening production.

About this time last year, after the inflation challenge had passed, the macro managers began worrying about a second challenge. The economy was being hit by two opposing external shocks: the positive shock of the mining investment construction boom, and the negative shock of the high exchange rate and its adverse effect on our trade-exposed industries’ price competitiveness. It was important for the managers to do what they could to ensure net effect of these two conflicting forces left the economy growing at around its trend rate, thereby keep unemployment not much above 5 per cent. To help bring this about, the government pressed on with tightening fiscal policy and getting the budget back towards surplus, thus giving the RBA more scope to loosen monetary policy. It was hoped the lower cash rate would reduce the upward pressure on the exchange rate. The managers haven’t been completely successful in this - unemployment has been creeping up - but, as we’ve seen, the economy isn’t travelling too badly.

But now the macro managers face a third challenge associated with the resources boom: to manage the tricky transition from mining-led growth to broader-based growth without the economy slowing down too much.

The tricky transition from mining-led growth

Although the economy isn’t travelling badly, it is facing a potentially tricky transition in the coming financial year as the resources boom eases and we move back to relying on broader and more normal drivers of economic growth: consumer spending, housing, non-mining business investment and exports.

The resources boom began in 2003 and was divided into two parts by the global financial crisis of 2008-09. The boom has had three stages: first, much higher prices for our exports of coal and iron ore, causing our terms of trade to reach their best for 200 years. Second, a historic surge of investment spending to greatly expand our capacity to mine coal and iron ore and extract natural gas. And third, a considerable increase in the volume (quantity) of our production and export of minerals and energy.

The first stage is now over, with coal and iron ore prices reaching a peak in mid-2011 and the terms of trade falling 17 per cent since then. Now it’s likely the second stage, the growth in mining investment spending, will reach a peak sometime this financial year and then decline, making a negative contribution to growth. This is likely to be only partly offset by the recent commencement of the third stage of the boom, the rising volume of mineral and energy exports as the newly installed production capacity comes on line.

What makes it uncertain the transition from mining-based to broad-based growth will proceed smoothly - that is, without a period of quite weak growth leading to a sharp rise in unemployment - is the failure of the exchange rate to fall back as the terms of trade have fallen back. This explains why, with inflation well under control, the RBA has cut the cash rate so far since late 2011.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year, on average, until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In the 2013 budget the government focused on finding offsetting savings (including an increase in the Medicare levy) to cover the cost of phasing in two big new spending programs: the national disability insurance scheme and the Gonski reforms to education funding. On top of this, Mr Swan announced further savings intended to reduce the structural budget deficit by about $12 billion a year by 2015-16. It’s important to note, however, that the government’s net savings won’t start reducing the overall budget deficit until the year following the budget year, 2014-15. Mr Swan says this is to ensure the budget doesn’t contribute to any weakness in demand while the economy makes its transition from mining-based to broad-based growth.

The government failed to achieve its promised return to budget surplus in 2012-13 because the terms of trade fell by more than had been expected and because there was no accompanying fall in the exchange rate, thus leaving many industries’ prices and profits under pressure. If you take the budget figures literally, Mr Swan now expects to get the budget back to balance in 2015-16 and to surplus the following year. But we should have learnt by now not to take budget projections literally.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

As we’ve seen, over the year to late 2010 the RBA reversed the emergency cut in the cash rate it made at the time of the GFC, lifting the rate to 4.75 pc. By late 2011, however, it realise the inflationary threat had passed, and the greater risk was inadequate growth in the face of such a high exchange rate. So between November 2011 and May this year it cut the cash rate by 2 percentage points to 2.75 pc - its lowest level since the RBA was established in 1960. Many people have assumed the RBA is cutting the cash rate in the hope of bringing about a fall in the dollar, but this is not correct. It doesn’t expect a lower cash rate to have much effect on the exchange rate. Rather, it’s objective is to offset the contractionary effect of the continuing high dollar by stimulating the most interest-sensitive areas of domestic demand: housing, consumer spending on durables and non-mining business investment.

Conclusion

The ‘stance’ of fiscal policy adopted in the 2013 budget is roughly neutral - that is, neither expansionary nor contractionary - whereas the stance of monetary policy is clearly quite expansionary. Should signs emerge that the economy is faltering in its transition from mining-led to broad-based growth, the RBA retains the scope to cut the cash rate further. Should the long-awaited fall in the dollar materialise, however, the stimulatory effect of such a fall would discourage the RBA from cutting rates further. Were the RBA to conclude the lower dollar was threatening to rekindle inflation pressure, it would start increasing rates. For the moment, however, the greater risk is that growth will be too weak rather than too strong.

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What it's like to be genuinely poor

Don't be too alarmed by all the talk of budget black holes and everything being on the table in Julia Gillard's search for savings. It's more likely we're being softened up for a lot more budget deficits than for a horror budget in two weeks' time.

Even so, it's clear there will be more cuts in spending and tax concessions. And though they're hardly likely to be draconian, you can be sure they'll draw howls of protest from those affected, egged on by shock jocks and opposition pollies on the make.

What's more, it's a safe bet they'll be aimed mainly at the better-off. So before we're engulfed by another round of upper middle class self-pity, I thought I'd get in early and tell you a little about the lives of people who really do have difficulty making ends meet.

According to a survey conducted by the Bureau of Statistics in 2010, almost one in five Australian adults experienced "financial stress" that year, where this means not being able to pay their bills, rent or mortgage on time or make minimum repayments on their credit cards, or they had to sell or pawn something because they needed cash.

A newly published report by Dr Nicola Brackertz, of Swinburne University, for the Salvation Army (my co-religionists), tells us a lot about the who, how and why of people suffering genuine financial stress. She surveyed 225 of the clients of the Salvos' free financial counselling service, Moneycare, operating for 20 years.

The first thing to note is that a third of respondents were living alone and another 28 per cent were sole parents. Only 14 per cent were couples with dependent children.

Two-thirds were women. Almost 80 per cent had a government pension or benefit as their main source of income. Only 15 per cent had wages as their main income.

Almost 40 per cent of respondents were renting privately and 22 per cent were renting public or community housing. Only 21 per cent were paying a mortgage and just 5 per cent owned their homes outright.

Put all this together and it tells me we're dealing with people right at the bottom of the heap. Most of the respondents would be unemployed, on the disability support pension or sole parents (many of whom have been relegated to the dole by a caring government).

Since the great majority of age pensioners own their homes, we're dealing in the main with only those age pensioners living alone and renting. It all goes to show how close people on the dole live to the poverty line, the more so if they have to rent privately.

With rents as they are, it's no surprise people in privately rented accommodation on a very low income are highly likely to experience financial stress. The surprise is the disproportionate number of respondents living in public housing.

The rent these people pay is generally set at 25 per cent of their income, no matter how low that income is. This sounds pretty generous; the standard measure of housing stress is rent or mortgage payments exceeding 30 per cent of income.

The trouble is the cost of true necessities such as food, clothing and power tends to be a reasonably fixed amount, whatever your income. So if your income is very low, you may not be left with enough for spending 25 per cent of the total on rent to be easily manageable. By the same token, if your income is quite high, a lifestyle choice to devote a lot more than 30 per cent of it to housing doesn't leave you feeling the pinch.

If you're as comfortably off as I am, it's a surprise to discover how small were the total debts that got the respondents into trouble with their creditors. Although a third had debts of more than $20,000, the typical (median) debt level was $5000 to $10,000.

Almost half had three or more sources of debt, with the most common being utility bills, credit cards, phone bills and personal loans. Well over half the respondents had been experiencing financial difficulties for two years or more.

Why did the respondents get into financial trouble? In their own words, "the leading causes were insufficient income caused by retrenchment, unemployment or underemployment and an insufficient level of government allowances and pensions", the report says.

"Health reasons, including disability and mental illness, often prevented respondents from earning sufficient income." It's easy for you and me to tell ourselves these people are just bad money-managers. But American research I've been reading says they're no better or worse managers than the rest of us. Their real problem is that life at the bottom is so much more unforgiving.

When your income's so low you need all of it just to get by, there's no scope to build a buffer of savings to cover you when quarterly utility bills arrive or some unexpected expense arrives. And when you can't afford car insurance or home contents insurance, big unexpected expenses are more likely to arrive.

When some service is cut off because you haven't paid the bill, you can't get it back on until you've paid the arrears and a reconnection fee. When you borrow to tide yourself over, you pay much higher interest rates than the rest of us - including to "payday lenders" and pawnbrokers.

If none of this applies to you, count your blessings (as we used to sing in Sunday school).

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Beware the one-eyed budget brigade

A great journalistic delusion is that politicians and others are always resorting to spin, so what journos do is remove the spin and tell it like it is. But too often they replace the speaker's spin with their own.

Consider the treatment of the Grattan Institute's report on budget pressures facing Australian governments. One paper reported it as concluding that "federal and state budgets will be generating yearly combined deficits of $80 billion within a decade unless welfare, health and education spending is cut".

Another national daily's version was that "Australian governments are facing a budget black hole so large that politically painful cuts to growth in public health and education spending are all but unavoidable if the nation is to avoid a European-style debt quagmire".

What the report actually said was that strong growth in government spending - particularly health spending - combined with weaker-than-expected tax collections could leave us with deficits equivalent to 4 per cent of gross domestic product in the next 10 years.

Its figuring shows this deficiency divides equally between increased spending and weak tax collections. So what solution did it propose? "That means finding savings and tax increases of $60 billion a year."

It also said: "There is no reason why a balanced budget, or more efficient government, necessarily requires smaller government. [However] history suggests that successful budget repair invariably involves both tax increases and expenditure reductions."

See the spin? So what's their motive? Probably a combination of the editors' personal ideology, self-interest (I pay too much tax already, don't ask me to pay more) and a belief that tailoring your reporting to fit your readers' prejudices will sell more papers.

But it is not just the media that take such a one-eyed approach to budgeting. Most business lobby groups do, too, plus a lot of economists. Many economists believe the answer to budget deficits is always to cut spending and never to raise tax collections, because of the libertarian political ideology implicit in their dominant "neoclassical" model.

The model assumes people are rational in all their decisions (implying governments can never know what's in my interest better than I know myself); each of us is a rugged individualist with nothing in the model to acknowledge the benefits we gain from acting collectively; each of us has roughly equal bargaining power in the market place (that's a good one); and wide disparities in the distribution of income and wealth are of no relevance.

Even so, as the Grattan report acknowledges, there is little economic support for the view that smaller government is always better than bigger.

You often hear people noting that a high proportion of the "structural saves" Wayne Swan likes to boast about constitute tax increases rather than spending cuts, as though this was some sort of crime or con trick.

But such people reveal their economic ignorance. Most of the supposed tax increases represent not the introduction of a new tax or an increase in the rate of an existing tax but the reduction or elimination of special concessions.

Economists refer to the latter as "tax expenditures" precisely to remind us they are essentially equivalent to actual expenditure. It often doesn't make a difference whether assistance to people in some category is delivered by a cheque from the government or a reduction in the tax they would otherwise have to pay.

One-eyed economists love to quote studies showing that, on average, every $1 of tax that governments raise generates a "deadweight loss" of about 30? in reduced economic efficiency because of the tax's effect in distorting taxpayers' behaviour. They use this to imply economics teaches us to minimise taxation. But they don't mention the hidden assumptions in the calculation, particularly that $1 of tax buys, at best, $1 of gross benefit to the community. In truth, $1 of spending on public goods may deliver benefits worth another, say, 30?.

In any case, the more legitimate use of such deadweight-loss calculations is to compare the inefficiency of particular taxes, with a view to correcting the features of those taxes that make them more economically distorting than others.

This is where tax expenditures come in. The way to reduce the 30 per cent deadweight loss is to eliminate the special concessions built in to so many taxes and thereby reduce the tax's distortion of people's choices.

The list of tax expenditures whose removal could reduce the budget deficit and make the allocation of resources more efficient at the same time is long, but includes negative gearing, the senior Australians tax offset, the 50 per cent discount on capital gains tax, exemption of super payments to people over 60 and the various exemptions from the GST.

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Why a little inflation isn't such a bad thing

I was in a taxi on Wednesday when we heard on the radio that the consumer price index had risen by just 2.5 per cent over the year to March - smack in the middle of the Reserve Bank's target, leaving it room to cut interest rates further if need be. So, no probs there.

"But why do we have any inflation?" the cab driver asked me. "When I came to Australia I could buy a rock cake for 8? - the other day they wanted $3.50."

It was a simple, sensible question. Unfortunately, the answer isn't at all simple. The short answer, however, is that it's a policy choice. That is, the monetary authorities - the central bank and the government - believe a moderate rate of inflation (moderate meaning between 2 per cent and 3 per cent, on average) is, on balance, a good thing.

Inflation refers to a persistent rise in the general level of prices. It may surprise you that in Britain over many centuries there was no net rise in the level of prices. Prices would rise during wars, but then fall back after the war was over. Governments controlled the price level by tying the amount of money in circulation to the amount of gold, and then controlling the amount of gold.

But this "gold standard" broke down during the Great Depression, and after World War II it was replaced by the Bretton Woods system where each country's currency was fixed to the US dollar, with the US dollar fixed to a gold price of $US35 an ounce.

This system meant all other countries effectively imported their inflation rate from the US economy. The Americans kept inflation pretty low until they began financing the Vietnam War by printing money rather than borrowing from the public.

This caused the fixed exchange-rate system to break down in the early 1970s, with most developed countries allowing their currencies to float. This gave them the ability to control inflation for themselves.

The trick, however, is that they - and we - do so not by controlling the quantity of money in circulation (as the monetarists tried and failed to do in the old days), but by using their ability to control the price of money - interest rates - to keep the demand for goods and services pretty much in line with the supply of goods and services. But if the authorities have the ability - in principle, at least - to use their control of interest rates to control the price level, why don't they keep it completely stable, thus allowing a zero increase in the CPI? Why do they permit inflation averaging a couple of per cent a year, and call this "practical price stability" (as they do).

Short answer: because they care about unemployment as well as inflation. The first reason is their belief that, due to practical limitations, the CPI tends to overstate the rise in the price level. Huh? This is because of the delay in including new products in the CPI basket of goods and services, and also because it treats as inflation price rises actually caused by an improvement in the quality of goods in the basket. For instance, part of the reason for the price of the new model Holden being higher than the price of the previous model is that it's a better car - better under the bonnet or better accessories.

If you accept that the CPI tends to overstate inflation then achieving zero inflation as measured by the CPI would involve keeping money so tight you were actually forcing prices down, which would be quite damaging to the economy and employment.

The second reason the econocrats like a bit of inflation is that there can be times when wages grow too quickly and make employing people too expensive. Wages need to fall back a bit, but workers are hugely resistant to cuts in their wages (and sensible employers don't fancy the idea, either).

The thing is that, if there's a positive rate of inflation it's much easier to cut wages in real terms by raising them less than the inflation rate. This is what happens in every recession.

The third reason the econocrats regard a bit of inflation as helpful is that, in a deep recession, they may judge it necessary to stimulate the economy not just by cutting interest rates but by cutting them so far they're negative in real terms - that is, cutting them until they're actually lower than the inflation rate (as they are right now in the US and Britain).

Think it through: when real rates are negative, lenders are actually paying people to borrow from them (after you allow for the effect of inflation), so this should be highly stimulatory. But, clearly, you can't bring about negative interest rates - something you'd only ever do in an emergency - unless you've got a positive inflation rate to go below.

So those are the three reasons the Reserve Bank is satisfied with an inflation rate averaging 2 to 3 per cent and defines this as practical price stability.

But back to my taxi driver. It's all very well to remember how much less you had to pay for things in the old days and feel cheated, but you shouldn't forget your income is also a lot higher than it was in the old days. In fact, just about everyone's income - whether wages or the pension - grows a bit faster than prices are rising, so there's no cause to feel cheated by the system. That is, almost everyone's income has risen in real terms over the years.

This real income growth is the reason economists are so unimpressed by punters and pollies carrying on about the trouble they're having keeping up with "the cost of living". You can achieve that delusion only by focusing on what's happened to the prices you pay and ignoring what's happened to your income.

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Budget surplus suddenly out of political fashion

Something highly significant has happened in just the past week: it's become clear the tide has turned in our politicians' demonisation of budget deficits and debt. What used to be anathema is so no longer.

Predictably, it's happened not because the pollies have seen the light, but because they've been mugged by reality. In consequence, the Grattan Institute's John Daley may well be right in saying we face a "decade of deficits".

That's not to say we'll hear no more of unpopular cuts in government spending, however. We'll get more of those in Wayne Swan's budget next month, and a lot more should Tony Abbott win the election in September. But these will be about stopping the parties' expensive election promises making the budget deficit even bigger, not about getting back to surplus. In Abbott's case it will involve cutting away Labor's favourite programs and replacing them with his own.

I won't be sorry to see an end to the economically illiterate nonsense the pollies have been spouting for so long about the evils of deficits and debt. That's because there are times when deficits are exactly what governments should be running and when modest levels of debt are nothing to worry about.

But, equally, there are times when surpluses are just what governments should be running. And we'd have to be terribly unlucky for such times not to return well before another 10 years have passed.

Governments have been agonising over the need to restrain budget deficits for almost all of the four decades I've been observing them - usually without much success. But the fashion for outright demonising of deficits began when Peter Costello became treasurer in 1996, claimed to have inherited a "budget black hole" from his Labor predecessors but, after one super-tough, promise-breaking budget, soon found the budget had swung back into surplus, only to stay there for the rest of the Howard government's 11-year term.

The steady stream of surpluses, combined with the proceeds from privatising Telstra, allowed him to eliminate the manageable debt he had also inherited. Costello used this experience to argue incessantly that deficits are always bad and surpluses always good, with the Liberals the party of surpluses and Labor the party of deficits.

When the global financial crisis hit in late 2008 and pushed the budget back into deficit, with Kevin Rudd's stimulus spending adding to that deficit, the immediate effect of the crisis on our economy proved surprisingly modest and it suited both sides to claim we had escaped recession.

Labor claimed this proved what a good economic manager it was, whereas the Libs used it to prove Labor's stimulus spending was unnecessary and wasteful, leaving our children and grandchildren weighed down by horrendous government debt.

The more years have passed with unemployment, inflation and interest rates all staying low during Labor's term, the more the Libs have focused on attacking its economic management by repeating the Costello line that deficits are always bad and by exaggerating the size of its debt.

Rather than patiently explaining the economic ignorance of this deficit demonising, however, Labor capitulated to it, with Julia Gillard promising faithfully in the 2010 election campaign to have the budget back to surplus by this financial year.

Problem is, the budget has not played ball. Much to the amazement of economists (and the consternation of Treasury's forecasters), the recovery in the economy has not been accompanied by a commensurate recovery in tax collections. Among the many reasons for this, the main one seems to be that our dollar has stayed high even though the prices for our mineral exports have fallen back.

This dawning reality is what forced Wayne Swan to concede just before Christmas that the budget would remain in deficit this financial year. Knowing the weakness on the budget's revenue side is likely to continue indefinitely, he's made no new commitment on when it will be returned to surplus.

But he and Penny Wong keep saying they won't be cutting government spending just to get the budget back to surplus, for fear of this costing jobs. Clearly, they've allowed their membership of the Deficits Are Evil Club to lapse.

For years the Libs have condemned Labor's timid explanations as mere excuses and have been promising to return the budget to surplus as soon as they got back to office. But the reality of the budget's revenue weakness has finally dawned on them, too.

Last Thursday, Abbott declared that "all bets are off" on the question of when a Coalition government would achieve a surplus. He's repeated the warning since. And also on Thursday, shadow treasurer Joe Hockey advised that "we are not going to go down the path of austerity simply to bring the budget back to surplus because it would end up being a temporary surplus".

So though we can expect to hear a lot more about Labor's alleged bad budgeting, we'll be hearing nothing more about achieving surplus ASAP. For both sides it's now a mere "aspirational objective".

I fear, however, we're swinging from one extreme to the other, from falsely claiming budget deficits are always evil to complacently accepting them long after it's become prudent to eliminate them and start repaying debt.

To say deficits aren't always evil is not to say they're always OK. So be warned: when budget surpluses fall out of fashion with the politicians, it won't be long before they're back in favour with economists - and commentators such as me.

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GITTINS’ GOSPEL: THE ECONOMICS OF JUST ABOUT EVERYTHING

I read that the Anglican Archbishop of Sydney, Dr Peter Jensen, very much disapproves of playing I Did It My Way at people’s funerals, describing it as ‘vulgar egotism’. This is a pity because, in my own vulgar and egotistical way, I like to think that, in the more than 30 years I’ve been the Herald’s economics editor, I’ve tried to do it my way, not the way other journalists would do it. The besetting sin of journalists is to write to impress other journalists. Failing that, they write to impress their contacts. But I’ve always believed in writing for the benefit of the Herald’s readers, for the intelligent layperson.

Perhaps because I didn’t take enough notice of the economics they tried to teach me at Newcastle Uni, I’ve had to work to understand economics, to understand what’s happening in the economy and understand the rationale behind the economic policy of the government of the day. But once I’ve figured it out, I’ve been keen to pass on that understanding to my readers. I write for the person who, though they lack formal training in economics, knows the topic is important and is keen to learn about it.

In my latest book, Gittins’ Gospel, a selection of my columns, I confess that my father was a preacher and I’ve inherited his sermon-delivering habit. Like his sermons, mine have been less fire-and-brimstone and more about teaching, although since journalists aren’t supposed to teach I prefer to say I’m an exponent of ‘explanatory journalism’. In the first part of my career I acted as a kind of missionary, trying to convert people to the economists’ way of thinking (and, indeed, there is a section of the book devoted to helping people understand how economists think). But as my career has progressed - as I’ve read more about economics and got older and, I hope, wiser - I’ve become more aware of, and critical of, the limitations of economists and conventional economics. So these days I see my role as more like that of the Herald’s theatre critic - I explain economics and the economy, but I also offer my readers a critique of economics and economists, pointing out their weaknesses and helping readers make up their own minds on how much to believe and not believe.

The full title of the book is: Gittins’ Gospel: the economics of just about everything. ‘The economics of just about everything’ is the title for our meeting tonight, and Ross Kerridge has given me a list of just about everything he wants me to talk about. I’ll get on to that in a minute, but first I should say something about why I was so vulgar and egotistical as to call a book, Gittins’ Gospel.

Well, it was partly an allusion to the sermonising habit I inherited from my father - who, by the way, delivered his sermons to tiny congregations in New Lambton (where I was born) and Cessnock, went away for some years but came back to Lambton, Merewether, East Maitland and Shortland. But it was also a reference to the main conclusions I’ve come to in almost 40 years of studying the topic, and the main messages I’ve been trying to get over.

Economics need not be stratospheric or incomprehensible: it’s about the ordinary business of life, about going to work, earning and income, then spending that income on all the things we need. But it’s about the material side of life and, important though that is, it’s not the only dimension of our lives, and we oughtn’t to focus on it to the exclusion of the other important dimensions: the relational, the social and even the spiritual. Similarly, the community and our political leaders need to take their advice from a much wider range of experts than just economists. Nor should we allow economists to advise us on matters outside their field of competence - as they often try to do. In other words, a big part of my gospel is that economics needs to be kept in context.

Another theme of my gospel is that the modern practice of lobby groups, and even governments, commissioning supposedly ‘independent modelling’ to bolster their case for or against some policy change is almost always an attempt to blind the public with science. I see part of my role as to demystify econometric modelling. Economic modelling is at once hugely complicated and surprisingly primitive. It rarely proves what the people who paid for it say it proves. It’s always built on assumptions - which are rarely spelt out by the people waving around its conclusions - and it’s always possible to vary the assumptions to ensure you get the results the outfit paying for the research was hoping for. The media should be a lot more sceptical in its reporting of the results of supposedly independent modelling, and in the book I look at three well-publicised cases and show how the modellers managed to produce the misleading results they did.

I love being a journalist, but the longer I stay in the business the more critical I become of the way the media do their job. A lot of what they do can be misleading, and in the book I devote a section to explaining how not to be misled. Literally, the word ‘gospel’ means ‘good news’ - but the media seem increasingly, almost exclusively, full of bad news - which some readers are finding increasingly off-putting. Well, I’m an optimist and, though I’m not afraid to face up to the problems we encounter - as of course we do - nor am I reluctant to point to the respects in which we’re doing quite well. This book is a book for optimists.

Economics is meant to be about people and for people; take the people out of an economy and you don’t have an economy. But much of the economics you read seems remarkably impersonal. So another theme of my gospel is that we need to get the people back into economics. We need an economics fit for humans. You often see me writing that conventional economics incorporates a misleading model of human behaviour. Its two big weaknesses are its assumptions that we’re all coldly rational calculators of what’s in our interests, and then that we’re all rugged individualists - that our attitudes and behaviour are never influence by the attitudes and behaviour of those around us, and that we never act in groups. In truth, the findings of modern psychology show we’re highly instinctive and emotional animals, and also that we’re highly social, ‘groupish’ animals. So in recent years I’ve been reading a lot more widely than conventional economics so as to get a better picture of how humans actually behave. And when that reading leads me to something interesting and important, I pass it on to my readers. The book contains a section - We’re only human - that brings together 10 of the columns I’ve written about these findings.

For instance, rationality tells us we need to be completely realistic about the state of the world and our place in it. But psychological research tells us that’s bunkum. It turns out to be healthier and more useful to hold a few unrealistic views about ourselves and the world.

People with high self-esteem---which is most of us---believe themselves to be healthier, more intelligent, more ethical, less prejudiced and better able to get along with other people than average. Obviously, a lot of those judgments are unrealistic. But that’s beside the point. The point is that self-esteem makes us both happier and better equipped to deal with the world. The lack of self-esteem is highly debilitating.

People with the freedom to control their own lives, make their own choices and decisions---at work and at home---are happier and even healthier. But it’s a question of perception---how much control you think you have. People with a positive attitude to their boss, for instance, may see themselves as having more freedom of action than those who see their boss as censorious and untrustworthy. (What’s more, in my experience such attitudes tend to be self-fulfilling.)

But nowhere is self-deception more prominent than in the personal characteristic of optimism. Indeed, it’s virtually built into the definition of optimism. Optimists are people who take the credit for their successes but blame their failures on others or on circumstances. They regard setbacks as temporary rather than permanent, and specific (I happened to strike a bad teacher) rather than universal (all teachers are bad).

So optimists tend to overestimate their abilities and their chances of success in dealing with the world, whereas pessimists tend to underestimate their abilities and their chances of success. Fortunately, most of us are optimists, which does much to explain why most of us are reasonably happy most of the time.

So much for the virtues of a little self-deception.  Now let me ask you a personal question: how honest are you? According to the people who study these things, not as much as you think you are. In an experiment in which people were asked to solve puzzles and were paid a set amount for each puzzle they solved, some participants were told to check their answers against an answer sheet, count the number of questions answered correctly, put their answer form through a shredder, report the number of questions they got right to the experimenter and receive the money they had earnt. A second group wasn’t allowed to shred their answers before reporting how many they got right. Those whose claims about how many they got right couldn’t be checked claimed to have got significantly more correct than the second group.

Those who cheated probably counted a problem they would have answered correctly if only they hadn’t made a careless mistake. Or they counted a problem they would have got right if only they’d had another 10 seconds. In other words, they didn’t tell blatant lies, they just gave themselves the benefit of any doubt, bent the rules a little bit in their own favour. And get this: they wouldn’t have thought they were cheating. When subjects are asked to rate how ethical they are compared to other people on a scale of zero to 100, where 50 is average, the average rating is usually about 75. That is, almost all of us consider ourselves to be more ethical than other people. Clearly, that’s not possible.

We’re often unaware of how inconsistent we are. We may think of ourselves as scrupulously honest because we’d never steal and would always return a wallet we found, forgetting that we take home office stationery because this is ‘not the same thing’. That’s why it’s always hypocritical to accuse others of hypocrisy---all of us are hypocrites.

The psychologists who study ‘behavioural ethics’ say our ethical behaviour is often inconsistent and, at times, even hypocritical. ‘People have the innate ability to maintain a belief while acting contrary to it,’ they say. ‘Moral hypocrisy occurs when individuals’ evaluations of their own moral transgressions differ substantially from their evaluations of the same transgressions committed by others.’ Hypocrisy is part of the human condition; we’re all guilty of it. So you could say accusing someone else of being hypocritical is itself a hypocritical act.

One lesson from a new field of study known as ‘neuro-economics’ is that our brains seem to have different systems for ‘wanting’ and ‘liking’. Wanting is about motivation, whereas liking is about pleasure. Think of the kid who begs and begs his parents to buy a pet---or a guitar---then loses interest in it within a few days. There was a yawning gap between wanting and liking. All of us have times when we lack the motivation to do something we know we’d enjoy. That’s almost the definition of being depressed. It’s given rise to a psychological therapy called PAT---pleasant activity training: make a list of the things you enjoy doing and then do them more often. Don’t scoff.

That’s just a sample of the topics I cover in the book, so I hope you enjoy it.

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THE ECONOMIC LANDSCAPE AND FUTURE CHALLENGES

Talk to The Salvation Army Moneycare Financial Counselling Conference, Collaroy

Asking an economics specialist to talk about the economic landscape and future challenges, as Tony Devlin did, is an open invitation for the specialist to whip out all his slides and bang on about his forecasts for economic growth, unemployment, inflation, interest rates and all the rest. Fortunately, I’m an economic commentator rather than a forecaster, so I don’t have a set of forecasts to dazzle you with - or bore you with - and, in any case, I’m sceptical about the value of forecasts.  Economists don’t have a good record on accurately forecasting what will happen.

All I’d say is that, although you’d never know it from all the complaints we hear, it’s now been about 22 years since the last time Australia had a severe recession, and in that time the economy has grown at a reasonably steady rate with the official unemployment falling from about 11 per cent in 1991 to something around 5 per cent - which most economists regard as about as low as it can go without causing inflation problems. You’d have to say this record period without a severe recession obviously can’t go on forever, and when we do have another severe recession, that’s when a lot of businesses fail and unemployment shoots up, causing a lot of us to realise for the first time just how good we’ve had it for so long. It will also be when the demand for your services as financial counsellors grows far beyond your ability to cope.

But I have no particular reason to expect the next severe recession will occur any time soon, so my best guess is that the economy will continue growing much as it has been, with various industries continuing to feel the pain of a high dollar, but with enough growth to limit any great rise in the official unemployment rate. However, I do expect people - particularly business people - to cheer up a lot if, as everyone expects, Tony Abbott wins the election in September. This is partly because all newly elected governments enjoy a honeymoon period in which everyone’s pleased to see the back of the last lot and hopeful the new lot will be much better, but also because I’m convinced a lot of the gloom we’re hearing from business - big and small - has more to do with politics than the actual state of the economy. People forget the day-to-day management of the economy is done by the central bankers, not politicians.

The other thing my crystal ball tells me is that an Abbott government will have a lot of trouble keeping all the promises it has made on the budget, which means budgeting is likely to remain tight and probably get tighter in the coming years. This suggests continuing pressure on grants to outfits like the Army, particularly so when you see the Coalition promising not to make budget savings at the expense of high income-earners.

Before I move on, you may have noticed that all my references were to ‘severe’ recessions. This is because, contrary to the conventional wisdom propagated by both sides of politics, I believe we did have recession in Australia - though a mild one - at the time of the global financial crisis in late 2008 and early 2009. The claim that we escaped recession rests on the slender fact that the contraction in the economy was concentrated in one quarter (0.7pc in Dec q 08) rather than spread over two consecutive quarters, even though the rate of unemployment jumped by 1.6 percentage points in just nine months (trend figures: 4.2% in Aug 08 to 5.8% in May 2009; part rate fell by 0.3pcps; using SA figures, increased by 1.8pcps in 10 months between Aug 08 and June 09 to 5.9%). But while this deterioration was too small and too brief to be noticed by most Australians, my guess is it was noticed by the Army in the form of less generous donations and by an increase in the number of people needing financial counselling - no doubt after a delay. Because downturns always hit the bottom harder than the middle and the top, I suspect the Army’s ‘recession meter’ is a lot more sensitive than other people’s.

 I've been thinking a fair bit lately about differences in people’s perspectives and perceptions of the economy. Whereas economists form their views about the state of the economy using economy-wide statistics - meaning they view the economy from a helicopter, so to speak - most business people and ordinary citizens base their views on their own experience and the experience of those around them. What’s happening to me is what’s happening to the economy. If I’m a shopkeeper and my sales are down, it’s obvious the economy’s very weak. If I’m a worker but I haven’t been able to find a job for months, it’s obvious the economy’s stuffed.

The second, more ephemeral factor that influences the views of non-economists is what they see and hear from the media about the state of the economy. But apart from when it’s quoting the official statistics, most of what the media tell us is quite unrepresentative of what's happening to most people. Why? Because the media tell stories about the experiences of individuals, and the stories the media choose to tell are those they believe their audience will find interesting. But the stories we find most interesting are those that are unusual rather than usual, thus making them unrepresentative of the economy rather than representative. This explains the media’s overwhelming preference for bad news rather than good news: people find bad news far more interesting. So, for example, any factory that decides to lay off 350 people will hit the headlines, whereas a factory that took on 350 workers would hardly rate a mention.

Another thing to bear in mind is that, in general, the people to whom the Army provides financial counselling come from the opposite side of the tracks to the relatively well-off and well-educated readers I write for. I often take a fairly unsympathetic line to the complaints of the comfortably off precisely because I'm aware of the genuine, often extreme financial hardship suffered by people struggling to manage on very much lower incomes. But just as I try to remind my readers how comparatively well off they are, so you need to remember that the people you see are also unrepresentative of the wider economy. If one in five adult Australians experience financial stress each year, then four in five don’t experience stress to any great extent.

When the people you counsel complain about the high cost of living, I’m inclined to believe them and be sympathetic. But in recent years it’s become fashionable for people in the comfortable world also to complain about the high cost of living, and there is little objective evidence to support these complaints. Nothing special.

I suspect people complain about the cost of living when they don’t have anything more serious to worry about - such as having to find a job or even the risk they may lose their job. I also suspect the complaints of the comfortably off mostly boil down not to the high cost of living but the difficulty some people encounter achieving the higher standard of living to which they aspire. No matter how high your income, it's always possible feel financially stressed if you over-commit yourself. You can often have difficulty making ends meet if your income is always fully committed and you leave yourself no buffer to cope with unexpected expenses, such as a big increase in utility bills.

As financial counsellors well know, many people have a low level of financial literacy. Many people also have low factual knowledge of the hip-pocket effects of government tax and benefit changes. A recent survey by the progressive think tank Per Capita found that more than half of respondents believed the carbon tax had increased the price of petrol, when it doesn’t apply to petrol. Most respondents estimated the tax had increased their cost of living by $20 a week or more, whereas the Treasury estimate was just under $10 a week. And almost half of respondents claimed to have received no compensation from the government in tax cuts or benefit increases, whereas Treasury’s estimate was that 90 per cent of households would get some compensation and about two-thirds would be fully compensated.

And then, of course, there are the many better-off people who imagine themselves to be middle income-earners when they are, in fact, in the top 10, 5 or even 2 per cent.

Everyone has their own perspective on the economy. There’s the reality and the perception - and the two are often very far apart.

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Easter message to business is think relationships

At this time of year it's worth pondering: many business people and economists think of themselves as Christians, but what implications does this carry for the way they view the world and conduct their affairs?

According to Michael Schluter, founder of Relationships Global and, these days, a business consultant, Christianity is a "relational" religion. If so, it doesn't sit easily with market capitalism as it is conceptualised by economists and practised by business people.

The primary emphasis of economics and business is on satisfying the wants of the individual. In this they give little priority to individuals' human relationships.

Is Christianity much different? Certainly, in the Evangelical version I grew up with, it too focuses on the individual. And you could be forgiven for wondering whether it pays much attention to relationships.

But here Schluter begs to differ. He says all of Christianity is a relational story. It starts with humankind created in God's image, but then the relationship is ruptured in the Garden of Eden. Finally, God comes to earth as a baby and ends up dying on a cross with the expressed purpose of restoring the broken relationship with humankind.

What does God require of us? Jesus summarised it: all the law and the prophets depend on two commandments - love God with all your heart, and love your neighbour as you love yourself. What could be more relational than that?

Schluter says life can be viewed from many perspectives: financial, environmental, individual, material. But "as Christians, we need to see all of reality through a relational lens if we are to look at the world as God sees it".

All of life is ultimately about relationships. For example, he says, "every financial transaction is an expression of an underlying relationship between nations, organisations or individuals".

The development of a society can be measured not in terms of economic growth but by the quality of relationships between individuals and between ethnic and other social groupings.

Education's goal can be defined as acquisition of wisdom for children to be able to serve their family and community, rather than acquisition of technical skills merely for personal career advantage.

"At a personal level, our happiness and wellbeing are determined primarily by the quality of our relationships. Arguably, financial issues - for example, debt and savings - matter to us primarily due to their relational implications," he says.

Above a certain income, wellbeing indices point to the central importance of relationships. Even for those below this income threshold it's not clear if the priority of income is for personal benefit or for group benefit, such as the care of children.

Debt is closely associated with depression and also with divorce, child abuse and social isolation, he says. Survival rates after serious illness are more closely associated with levels of relational support than with levels of income.

"It is easier to find someone financially rich and miserable than someone relationally rich and miserable," he says. "It is hard to find someone on their death bed who says, 'I wish I had spent more time in the office'."

The individualism of our culture leads us to miscalculate the significance of events because it takes little or no account of "externalities" - that is, the effects on third parties.

For example, companies and public service agencies move staff to new locations to maximise economic productivity, and economic analysis applauds their decision to do so. But no attempt is made to measure the social or relational costs of such dislocation, especially to spouses or partners, children, friends and parents and grandparents whose relationships have been disrupted.

Schluter says business, finance and public sector organisations are increasingly coming to recognise that financial evaluation of performance is insufficient.

"The purpose of companies is increasingly defined inclusively to recognise the significance of company decisions for many stakeholders, rather than instrumentally, where customers, suppliers and so on are regarded simply as means to increase shareholder profits."

Low levels of national debt - a measure of inter-generational loyalty - decrease economic instability and aid economic growth. Political stability is a foundation for economic prosperity, but depends on peaceful relations between ethnic and religious groups and between rich and poor.

"To see the world in relational terms requires a re-education process as the media, corporate advertising and our own inclinations constantly point us towards seeing things from an individualistic or materialistic point of view," Schluter concludes.

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Being smart and being logical aren't the same

Years ago, a leading American teaching hospital admitted a 21-month-old boy we'll call Kevin. He was pale and withdrawn, drastically underweight, had constant ear infections and was refusing to eat. He'd been neglected by his parents.

A young doctor took charge of his case. He hated having to draw blood from Kevin's emaciated body and noticed the boy refused to eat after being poked with needles. Intuitively, he kept invasive testing to the minimum and instead tried to provide the boy with a caring environment. Kevin began to eat and his condition improved.

But the young doctor's superiors didn't approve of his unconventional efforts. So a host of specialists, each interested in applying a particular diagnostic technology, set out to find the cause of the boy's illness. If he dies without a diagnosis, we've failed, they reasoned. Over the next nine weeks Kevin was subjected to batteries of tests, which revealed nothing decisive. He stopped eating again, so the specialists sought to counter the combined effects of infection, starvation and testing with intravenous nutrition lines and blood transfusions.

But Kevin died before his next scheduled test. The doctors continued testing at the autopsy, hoping to find the hidden cause. One doctor commented: "Why, at one time he had three IV drips going at once! He was spared no test to find out what was really going on. He died in spite of everything we did!"

That story is told by a distinguished German psychologist, Gerd Gigerenzer, of the Max Planck Institute, in what many academics would call his hugely "counter-intuitive" book, Gut Feelings.

But here's the trick: what university-trained people are encouraged to regard as "intuitive" isn't intuitive at all. It's what all their learning has led them to believe is the right way to think or act. In this, academic sense of the word, it was the specialists who were acting intuitively: their training told them they couldn't begin to help the boy until they'd first correctly diagnosed his problem.

Thanks to this way of thinking, they tested him until their actions helped to kill him. But the way Gigerenzer uses the word, it was the young doctor who acted on his intuition, casting his professional training aside and trusting his gut feelings.

Gigerenzer's point? In this particular case, the young doctor was right to trust his instinct and his better-trained and more experienced superiors were led astray by all their learning.

What's more, he claims, cases where relying on your gut feelings rather than on careful analysis leads to better decisions are surprisingly common.

But such a conclusion - itself based on Gigerenzer's scientific (if controversial) research - is, in the academic sense of the term, hugely counter-intuitive. It's the opposite of what educated people would expect.

It's a mistake to imagine only economic rationalists are on about rationality. Ever since the Enlightenment of the 17th and 18th centuries, virtually all university teaching has stressed the need for reasoned, logical analysis. You make decisions by gathering all the relevant information you can, then weighing it up carefully and logically.

Economic rationalists assume that's the way we really do make decisions. But the American psychologist Daniel Kahneman - whose life's work is beautifully summarised in his book Thinking, Fast and Slow - won the Nobel prize in economics for demonstrating that the vast majority of the decisions we make are made unconsciously, instantaneously and instinctively.

Kahneman showed that these unconscious, snap decisions are based on deeply ingrained mental short-cuts, or rules of thumb, which psychologists call "heuristics". He further argued that a lot of these heuristics are illogical and so cause us to make many bad decisions. This is the basis for the title of the well-known book by the behavioural economist Dan Ariely, Predictably Irrational.

But this is where Gigerenzer begs to differ. He argues that in many but not all circumstances, the heuristics we use lead to good decisions - better decisions than we'd make if we took the time to gather more information and think the decision through.

And this is true even though many heuristics seem to the educated mind to be illogical. Why? Because we often must make decisions almost instantly, because deliberation can get in the way of our unconscious motor skills, because gathering information has costs (not all of which are monetary), because the future is uncertain no matter how much we know about the past, and because of our "cognitive limitations" - too much information confuses us and makes us indecisive. What's more, some information can mislead us, containing "more noise than signal".

Gigerenzer's research contradicts two core beliefs of economists and other rationalists: more information is always better and more choice is always better. Rather than building complex decision-making systems that take account of as many factors as possible, we should search for "fast and frugal" decision rules that are shown to work most of the time. Spending less time on some decisions can actually improve them.

Relying on intuition or gut feelings isn't acting on impulse or caprice. This is because our brain's use of its intelligence isn't necessarily conscious or deliberate.

"The intelligence of the unconscious is in knowing, without thinking, which rule is likely to work in which situation," he says.

"What seem to be 'limitations' of the mind can actually be its strengths."

The logic-based approach to decision-making "assumes that minds function like calculating machines and ignores our evolved capacities, including cognitive abilities and social instincts. Yet these capacities come for free and enable fast and simple solutions for complex problems ...

"Logic and related deliberate systems have monopolised the Western philosophy of the mind for too long. Yet logic is only one of many useful tools the mind can acquire. The mind, in my view, can be seen as an adaptive toolbox with genetically, culturally and individually created and transmitted rules of thumb," he concludes.

Don't get Gigerenzer wrong. His line of argument is in no way anti-intellectual. Rather, he's used his intellect and the scientific method to challenge conventional thinking about how our intellect works.

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How multinationals rort our tax system

You're familiar, I'm sure, with the Double Irish Dutch Sandwich. It sounds tasty - but only to the big multinational companies that use it to avoid tax. According to the Assistant Treasurer David Bradbury in a speech he gave late last year, it's the device Google uses to pay very little Australian company tax on the profit it makes on an estimated $1 billion a year in Australian advertising revenue.

As Bradbury explains it (using media reports, he says, not inside information), the fine print of contracts Australian firms sign with Google says they're buying their advertising from an Irish subsidiary of Google.

Our rate of tax on company profits is 30 per cent, whereas Ireland's is 12.5 per cent. But that's just the start of the sandwich. The Irish subsidiary then pays a royalty payment to a Dutch subsidiary, but it's then paid back to a second Irish holding company of Google's, which is controlled in Bermuda - which has no company tax.

The media usually attribute the invention of the double Irish to Apple, Bradbury says. But evidence given to the British public accounts committee suggests Amazon paid no tax in Britain despite about $4.9 billion in sales by routing transactions through Luxembourg, where it faced an effective tax rate of 2.5 per cent.

The committee also heard that Starbucks had paid no tax in Britain for three years, despite sales totalling about $1.8 billion - in part because of royalty payments for the use of the brand.

With their government busy raising taxes and slashing government spending to get its budget deficit down, the Brits are pretty steamed up about multinationals not bearing their fair share of the tax burden. Governments in many developed countries are deciding tougher measures need to be taken to curb the multinationals' rorting of the system, and ours is no exception.

It's a problem governments have been grappling with for decades, of course, since the early days of globalisation and the rise of companies with operations in several countries. Then, the game was simply for multinationals to shift their profits to countries where taxes were low. One way to do this was for the part of the company where taxes were lower to sell its products to subsidiaries in high-tax developed countries at inflated prices. The big countries developed rules to limit such ''transfer pricing''.

Another trick was for a subsidiary to borrow from head office most of the capital it needed, with head office then charging an interest payment that absorbed most of the subsidiary's profits. Our ''thin capitalisation'' rule limits interest deductions to $3 of debt for each $1 of share capital, and there's talk this may be tightened in the budget.

In a speech he gave this month, Bradbury says you don't need to be doing business on the internet to use something like a double Irish scheme. ''What you do need is the global presence of a multinational enterprise and the ability to attribute a large part of your profits to intangible assets,'' he says.

And we know intangible assets - such as software, databases, patents, copyright and ''goodwill'' or ''brand value'' - play an increasingly important role in the global economy. In the United States, investment in intangible assets has exceeded investment in tangible assets for more than a decade.

Existing international legal arrangements rest heavily on the notion that income should be taxed in the country of its ''source''. When economic activity was dominated by farms, factories and mines, it usually wasn't hard to see that the source of income was where the factors of production were physically located.

But now ''the increasing importance of intangible capital to production challenges the very idea that we can always objectively determine where economic activity occurs,'' Bradbury says.

All this helps explain the emergence of ''stateless income'' - income that's not taxed in the source country of the production factors that gave rise to the income, nor in the ultimate parent company's jurisdiction. It's income that doesn't belong anywhere for tax purposes.

This, in turn, explains how the profits of US-controlled corporations in Luxembourg are equivalent to 18 per cent of its gross domestic product. For the Cayman Islands and Bermuda the proportions are more than 500 per cent and 600 per cent of those countries' gross domestic product.

Stateless income is not simply a product of transfer pricing abuses, but also arises from decisions about where to place financial capital within a multinational group. It involves exploiting differences in countries' tax systems and hybrid instruments treated as borrowings in a country and shares in another.

Tricks like these can place single-country businesses at a competitive disadvantage. They - and individual taxpayers - are forced to bear an unfair share of the tax burden. But many big-business executives reject the notion that paying a fair share of tax is part of a broader social compact. Tax is just another business cost. If dodging it is legal, morality doesn't enter into it.

The Gillard government is working to ensure our transfer-pricing rules are up with world's best practice and the general anti-avoidance provision of our tax act is broadened to encompass the tricks multinationals try on.

It has asked Treasury to study what more can be done, and will work to improve the information multinationals have to make public about profits and tax payments.

The Organisation for Economic Co-operation and Development has had to lift its game in promoting multilateral action to limit tax rorting by global companies.

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