SUSTAINABILITY: AN ECONOMIC PERSPECTIVE

Talk to Master of Sustainability students, University of Sydney

Tony Masters has invited me to talk to you about sustainability from an economist’s perspective, which I’m happy to do, though I must warn you that my perspective is very different from the majority position among economists who, though they’re happy to use the word, attach a very different meaning to it than the one I do, and that many of you may.

As I’m sure you’ve realised, ‘sustainability’ means different things to different people. This is partly because it’s a very fashionable to talk about sustainability - everybody’s doing it, the sustainable adjective or adverb can be slapped on the front or the back of almost every noun: our Treasury talks about ‘fiscal sustainability’, I read about sustainable agriculture, business sustainability, even sustainable culture. The word gets used a lot because it’s something no one can disagree with: who could say they’re opposed to sustainability? Who could admit they want to keep doing something even though it’s un-sustainable? After all, as the US economist Herb Stein famously said, ‘if something cannot go on forever, it will stop’. Or ‘trends that can’t continue, won’t’.

But, because it’s a word no one could oppose, we need to keep its meaning vague so it doesn’t involve something we don’t fancy, having to stop doing things we would prefer to keep doing. The term ecological sustainability ought to be pretty unambiguous, but this may be why the UN Bruntland Commission in 1987 settled on the less specific term ‘sustainable development’. And this lack of specificity may be why the report started the sustainability craze. The report did define sustainable development to mean development that meets the needs of the present without sacrificing the ability of the future to meet its needs.

That might sound good, but it leaves a loophole for economists to jump through. The secretary to the Treasury, Dr Martin Parkinson, gave a speech in 2011 he called ‘sustainable wellbeing’. He said ‘sustainable wellbeing requires that at least the current level of wellbeing be maintained for future generations’. This required that each generation bequeath a stock of capital that is at least as large as the stock it inherited. This should include all forms of capital: man-made capital, human capital, natural capital and social capital. ‘Note, though,’ he goes on, ‘that drawing down any one part of the capital base may be reasonable as long as the economy’s aggregate productive base is not eroded. For example, reducing our natural resource base and using the proceeds to build human capital or infrastructure may offer prospects of higher future wellbeing.’

See the loophole? The implicit assumption is that all the different forms of capital are good substitutes for each other. It’s saying that, provided we leave the next generation with a sufficiently high level of education and a sufficient quantity of man-made capital, it may not matter than we wrecked the natural environment in the process. You can see this mentality in the way many economists, business people and lobby groups approach environmental problems: yes of course the environment matters, but so do a lot of other things, and the objective must be to find the best trade-off between all our many conflicting, but equally desirable, objectives. In this process, the environment will get better treatment, but it won’t get all it wants. Don’t be greedy, be reasonable. The trouble is, you can’t ask a dying river system to be reasonable, to put up with more degradation because many people’s livelihoods depend on that degradation continuing. You can’t bargain with nature, you can either sustain it or continue with unsustainable practices.

Why can’t economists, business people and politicians see that? Because they don’t want to see it. Because they’re committed to unending economic growth and so don’t want to accept there may be physical limits to growth, that the economy is a sub-system of the natural environment - the ecosystem - and so, because the size of the ecosystem is fixed, there must be physical limits to how much the economic sub-system can grow.

My guide in this area is Herman Daly, a professor of economics at the University of Maryland, and a founder of the school of economic thought known as ‘ecological economics’ (not to be confused with the far more conventional ‘environmental economics’). His definition of sustainable development is much tighter: development without growth beyond environmental carrying capacity, where development means qualitative improvement and growth means quantitative increase.

When it comes to economists (and business people and politicians), the big area of conflict with ecologists and people in the physical sciences, the big stumbling block, the big reason they want to interpret ‘sustainability’ their own way, is the question of growth. The economists want it to continue forever; the scientists say it must stop. But the first point I want to make is that there’s enormous terminological confusion between scientists and economists on what exactly they mean by the word ‘growth’. Scientists take it to mean something very different from what economists do, which means much of what little debate passes between them flies over the heads of the other side. I’m sure the ground of disagreement between them would be greatly reduced if only this terminological confusion could be ended.

What ecologists want is an end to growth in the ‘throughput’ of natural resources. If you think of the economy as a machine, we put inputs in one end of the machine, and take outputs out of the other end. To an ecologist, the inputs of concern to them are natural resources and ‘ecosystem services’; the outputs of concern to them are an equivalent amount of waste - in the form of landfill, sewage and all the many types of pollution, including greenhouse gases. In conformity with the laws of thermodynamics, the ecologists worry as much about the emission of waste - and the ecosystem’s ability to absorb that waste - as they do about the using up of natural resources. This is why what they seek is an end to growth in the throughput of such resources. I think many of them imagine this would be achieved if GDP ceased to grow.

But the economists conceptualise things very differently. To them, the inputs to the economic machine aren’t just natural resources, but also the other economic resources: labour and capital - physical capital in the form of machines, structures and infrastructure. (The input from ecosystem services is ignored.) To their eyes, the output from the economic machine isn’t waste (it gets ignored) but all manner of goods and services. What real GDP measures is the growth in the output of goods and services over time. (Since those of us who work earn our income from our contribution to the output of goods and services, real GDP also measures the growth in real income.)

So what is it that causes GDP - output of goods and services - to grow? Two things. First, any increase in the throughput of economic resources: natural resources, but also labour and capital. But, second - and this is the bit that goes straight over the heads of most ecologists - any increase in the efficiency of the economic machine at turning inputs into outputs. Economists call this ‘productivity’, which they define as output per unit of input. The productivity of the economic machine increases almost continuously each year, and has done since the start of the industrial revolution. What causes ‘multi-factor’ productivity to improve is the continuing pursuit of economies of scale, the increasing specialisation of labour, the rising knowledge and skill of the workforce, and technological advance: the invention of better machines and better ways of doing things. Now get this: over the long term, productivity improvement accounts for the lion’s share of our rising real income per person and our rising material standard of living.

The point is that when economists hear people say they want an end to growth, they assume that means they want an end to productivity improvement. They find this prospect appalling. But this is not what ecologists want. All they want to stop is growth in the throughput of natural resources - which isn’t something most economists would relish, but isn’t nearly as frightening. And this means GDP could still increase, provided that increase came from improved productivity, not increased use of natural resources.

Clearing up this misunderstanding allows us to envisage more clearly what a steady-state economy would look like - that is, an economy that conformed to Daly’s definition of sustainable development. It would be an economy that didn’t get bigger in its impact on the environment - that was ecologically sustainable - but did get better, in terms of the quality of our lives. It would be an economy that didn’t grow, but it wouldn’t be an economy that was stagnant, that never changed. It wouldn’t be an economy where people had to stop striving - to build a better mousetrap, write a symphony or find the cure for cancer. Many economists instinctively fear a steady-state economy would stifle the incentive to innovate. But that fear’s not justified. Indeed, you could argue that, with the quantitative route to improvement blocked off, the qualitative route would gain more attention. Herman Daly’s way of making the distinction is to say economic growth (pushing more resources through a physically larger economy) is bad, but economic development (squeezing more welfare from the same throughput of resources) is fine.

But how would we go about reorganising the economy so that we no longer increased the throughput of natural resources? It wouldn’t be easy, but nor would it be terrifically hard. It actually represents nothing more than a design problem - one the economics profession is well-equipped to solve, should the community decide to give it that task. We’d still have a capitalist, market economy where market forces continued to determine economic outcomes and to drive the push for greater efficiency in resource use, within the framework set by government. The big difference would be the government adding a new constraint to the operation of market forces: a limit on the consumption of natural resources.

How would we achieve that limit? By using the same ‘economic instrument’ we’ve already begun using to limit the burning of fossil fuels: a system of tradable permits. You impose a cap on the total quantity of a certain class of natural resource permitted to be consumed in a year, and auction to producers permits to use the resource up to the cap. The more efficient firms are at doing what they want to do while using fewer natural resources to do it, the less they have to spend on permits - thus harnessing market forces to help reduce the use of those resources. Firms that discover they have more permits than they need are able to trade them for money to firms that discover they need more permits than they have. By such means the burden of limiting resource use to the cap is transferred to those firms able to reduce their resource use most cheaply, thereby limiting the loss of income to the community involved in achieving the limit on resource use. As firms became more efficient at reducing their natural resource use - including by the invention of new technological solutions to the problem - it would possible, if desired, to lower the cap and, hence, the quantity of resources used, at no increased cost to the community.

The purpose of such a cap-and-trade scheme would be, of course, to raise the price of natural resources - and the prices of goods with a high natural-resource component - relative to the prices of all other goods and services. In line with the most orthodox economics, it’s this change in relative prices which would motivate producers and consumers to reduce their resource use, and do so with minimum loss of economic efficiency. Economists believe changes in relative prices are very effective in bringing about changes in the behaviour of producers and consumers.

This process would, of course, lead to a once-off increase in the general level of consumer prices, which might be quite a significant increase. Many of you would be concerned about the effect on the cost of living, particularly for pensioners and low income-earners. But, as with our present carbon tax, once the cap-and-trade scheme had brought about the desire changed in relative prices, the proceeds from the sale of permits - analogous to the proceeds from a carbon tax - are available for use to reduce the rates of other taxes - the obvious one being income tax - and increase the rates of pensions and benefits such as the family allowance, thereby compensating households for the increase in their cost of living. So I don’t see a reason to be concerned about the effect of the move on the welfare of low income-earners. Such a re-jig of the tax system would be a classic example of what environmental economists mean when they call for the burden of tax collection to be shifted from taxing ‘goods’ (such as labour and capital) to taxing ‘bads’ (such as greenhouse gas emissions and the consumption of natural resources). You raise the same amount of total tax revenue but, in the process, you discourage activities you want to discourage rather than activities you don’t want to discourage.

Raising the prices of natural resources relative to the prices of other resources - labour and capital - could be expected to have various desirable side-effects. First, it would increase the economic incentive for people to recycle natural resources and repair rather than replace appliances with a high materials-component.

Second, changing the relative prices of economic resources could be expected to change the focus of the private sector’s continuing search for greater efficiency - economising, if you like - in the use of economic resources and, hence, improved productivity. For all the time since the Industrial Revolution, most of the economising effort - including most technological advance - has been, quite logically, directed towards economising in the use of the most expensive resource: labour. But if we were to make natural resources more expensive than labour - particularly if the scheme involved a fall in the main tax on labour, income tax, thereby lowering its effective cost - this should mean a lot more entrepreneurial effort would be directed towards reducing the economy’s despoiling of the natural environment.

There are many more implications of a steady-state economy I could explore, but that’s enough to be going on with. Is a steady-state economy feasible? Yes it is.

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Waiting for PEFO just Hockey's excuse to delay truth

I have a feeling Joe Hockey would make a much better treasurer than many imagine, but all politicians talk a fair bit of nonsense while in opposition and Hockey is no exception. Ministers know what they say is under much closer scrutiny.

Hockey professes hardly to believe a word of Wayne Swan's budget. It "lacks integrity" and he has "deep reservations about the numbers", which "at the very best are optimistic".

He claims not to lack faith in the work of the Treasury, only in the Treasurer. But he criticises various budget assumptions about how spending on certain items will change over the next four years (he seems terribly confident about the accuracy of his own crystal ball), implying Swan has imposed his own, implausible figures on the econocrats.

So what's he on about? Part of it is no doubt just an attempt to further destroy the credibility of the man who, in last year's budget, boasted it "delivers [note that word] a surplus this coming year, on time, as promised, and surpluses each year after that, strengthening over time". Oh dear.

Well, Hockey wouldn't be a pollie if he didn't exploit that golden opportunity to put in the boot. And he's right to cast doubt on the likelihood of a $6.6 billion surplus in four years' time - not because the government has got at Treasury and Finance but because no one, not even Hockey, can have any certainty about how the economy will unfold between now and then.

That's just common sense. It's the simple souls who take medium-term projections literally that Hockey should be wising up, not implying he can know the future better than Swan can, or that Treasury's forecasts would be right on the money were Swan not forcing them to be wrong.

There's no reason to believe a change of government would make any difference to the likelihood of budget forecasts proving off-beam because of unforeseen developments. The world will not suddenly become more stable or predictable on September 14.

But I think Hockey's motives in rubbishing the budget forecasts are more devious. He dribbles out the odd example of unpopular spending cuts but, since he doesn't know the budget's true position, he can't do more than that. He doesn't know how much he's got in the kitty to play with - or, rather, how big is the "true" deficit that will constrain the promises the Coalition will make.

Get it? He claims the budget figures are politically tainted because this justifies him delaying publication of his costings until only about three weeks before election day - which is when we'll receive the PEFO, the pre-election economic and fiscal outlook, signed off not by Swan and Penny Wong, but by the secretaries of Treasury and Finance.

The "pee-foe", part of Peter Costello's charter of budget honesty, is a good idea gone wrong. Its purpose was to stop future incoming governments doing what Costello did in 1996 (and Paul Keating did in 1983): claiming to have uncovered a "budget black hole" left by their predecessors and using this as an excuse for a horror budget, in which cuts not mentioned in the campaign materialise and promises retrospectively declared to be "non-core" are broken.

That's fine, but successive oppositions have used it ever since as an excuse to leave revelation of their plans and costings to the last moment.

Trouble is, last week Treasury secretary Martin Parkinson (who said he'd been authorised by Finance secretary David Tune to speak also on his behalf) undercut Hockey's excuse, saying that had the PEFO been released at the same time as the budget, it would have said the same thing.

So if the PEFO differs from the budget it will be because of government policy decisions and developments in the economy, not because the econocrats are no longer being leaned on.

Note that, if he follows past practice, Swan is likely to publish an updated economic and fiscal outlook document just a week or two before the PEFO. Why? So he can take any policy measures needed to prevent the econocrats' latest forecasts from comparing too badly with the budget.

Hockey says "we must return stable, predictable and honest government to Australia". Well, if he can magically make the economy more stable and predictable, good luck to him. As for restoring honesty, it would be a good thing. But by using such a weak excuse to keep the electorate in the dark about his plans until the last moment, he's not off to a good start. The next honesty test will be whether his costings are checked by the Parliamentary Budget Office or by some back-street accountant who has certified only that the arithmetic's OK.

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Structural budget reveals tax cuts are the problem

They say it's only when the tide goes out you discover who's been swimming naked. It's the same when you calculate the "structural" budget balance. And we've just learnt that though Wayne Swan's cossie has slipped revealingly, Peter Costello was completely starkers.

This week both the new Parliamentary Budget Office and Treasury published estimates of the federal budget's structural balance from the start of the noughties to 2016-17, in the office's case. The figures used were actual outcomes up to 2011-12 and then the forecasts and projections contained in last week's budget. The two agencies' conclusions are very similar.

When you look at the figures for the overall budget balance you get the story the Liberals have been drumming into us non-stop since 2009: we were fabulous managers of the government's finances, but Labor's been absolutely hopeless. We left office in 2007 having produced six budget surpluses in a row. As a result, we paid off the debt we inherited from the Keating government and left office with $45 billion in the bank. But from the moment Labor took over, everything went to pot. If it gets tossed out in September, Swan will have presided over six deficits in a row and, according to his own figuring, no return to surplus for another three years. He will have left us with a net debt of about $178 billion.

That's all arithmetically correct and it sounds pretty damning. But it glosses over the fact that Costello's luck was a lot better than Swan's. Costello presided over the first part of the resources boom when the government's coffers were overflowing, whereas Swan wasn't in office long before the global financial crisis hit.

He spent a lot of money trying to stave off recession but, though he had much success, the government's revenues still haven't fully recovered. And though the resources boom soon resumed, it was very different from the first stage, with the miners' investment spending meaning they didn't pay much company tax and the high dollar meaning other tradeable industries didn't pay much either.

When you take the overall budget balance and adjust it to determine the structural (or underlying) budget balance, what you're doing, in effect, is removing the part of the budget balance that's the result of luck.

By trying to ascertain what the budget balance would have been had the economy been having an average year - with it neither booming nor very weak - you're taking away Costello's good luck and making up for Swan's bad luck. And by doing that you're getting at whether each man was a good manager or a bad one.

You're trying to remove the effect of the business cycle and other temporary factors so as to reveal the structural (lasting) changes that took place. These mainly result from the overt decisions governments make to change their spending or taxing arrangements.

Don't think this is a bit of sophistry cooked up to explain away Swan's failure to get the budget back to surplus as promised. It's a calculation with a long history in macro-economics, that's done for us each year by both the International Monetary Fund and the Organisation for Economic Co-operation and Development.

But that doesn't make it a simple or certain calculation.

As with so much in economics, it involves making a lot of assumptions, and everyone who does it comes up with a different answer. In our case, the big imponderable is what's going to happen to our terms of trade (essentially, the prices we get for our exports of coal and iron ore).

For clarity, I'll quote the mid-point of the range of estimates of the structural balances calculated by the budget office. It finds the budget began the noughties in structural surplus, but then the structural balance declined steadily between 2002-03 and 2011-12, from a surplus equivalent to about 2.5 per cent of nominal gross domestic product to a structurally balanced budget in 2007, before falling to a structural deficit of about 3.75 per cent of GDP in 2011-12.

Based on the figures in last week's budget, the structural deficit then shows a sharp improvement to a bit over 2 per cent this financial year. In the next four years to 2016-17 the structural deficit is expected to improve to a bit under 1 per cent of GDP.

So what are the causes of this deterioration and then improvement? From the structural balance's biggest surplus in 2002-03 to its biggest deficit in 2011-12, the structural level of revenue fell by about five percentage points of GDP, while the structural level of spending rose by about one percentage point.

From 2011-12 to 2016-17, the structural level of revenue is expected to rise about 1.75 percentage points, while the structural level of spending declines by about one percentage point, with the combined effect significantly reducing the structural deficit.

The budget office says more than two-thirds of the initial five percentage point decline in structural revenue was caused by the cumulative effect of the six tax cuts in a row delivered or promised by Costello. (Two-thirds seems too much to me. I suspect it doesn't allow for the notional indexation of the tax scale and so counts this as structural rather than cyclical.)

A further quarter of the five points, the office tells us, results from a decline in excise receipts, caused by Costello's decision to end the indexation of petrol excise in the 2001 budget and by a decline in smoking (and thus tobacco excise).

The expected 1.75 percentage point rise in revenue between 2011-12 and 2016-17 is mainly the result of rising income-tax collections because of bracket creep and the budget's initial net benefit from the increase in the Medicare levy until the new disability scheme is fully phased in.

See what this means? The Libs keep saying the problem is Labor's unrestrained spending but, in fact, it's almost all on the tax side. The tax weakness arises overwhelmingly from Costello's eight delivered or promised tax cuts. Swan's main failings were to actually deliver the last three of those cuts and to not restore the indexation of petrol excise.

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News on economy not as bad as it sounds

Good grief! It seems all the news about the economy this week has been terrible. Is the roof about to fall in?

First we heard consumer confidence took a 7 per cent hit after Treasurer Wayne Swan's all-bad-news budget, then we hear the sharemarket has taken a dive because the Americans can't decide whether things are getting better or still as bad as ever.

By now the dollar's down about US6c. New figures show the mining investment boom is no more and, to top it off, we hear Ford is ceasing production with up to 10,000 jobs to go.

So, is the roof falling in on the economy?

Fortunately, it's not as bad as it sounds. My guess is the economy will continue motoring along (sorry), not doing brilliantly but not doing too badly either.

Let's put the bad news in context. For a start, the ups and downs in measures of consumer confidence must mean something, but they are an unreliable guide to the prospects for consumer spending.

We all know the sharemarket goes up and down from one day to the next, and of late there has been more up days than down.

The fall in the dollar might be bad news for people planning overseas holidays or buying imported goods, but it's good news for our hard-pressed manufacturers and tourist operators. My fear is it won't last.

Ford might have announced its closure this week, but it won't actually happen for another three years. That gives its workers plenty of time to find new jobs.

In any case, our workforce of 11.6 million often grows by 10,000 or more in just a month. That might sound like a lot of jobs but, compared with the size of our economy, it's microscopic.

The economy's been growing at an average rate of 3 per cent a year. That's been enough to hold unemployment below 5.5 per cent, though it's true the budget expects the economy to slow a fraction in the coming financial year, thereby allowing unemployment to creep up to 5.75 per cent by next June.

It's true the end of the mining boom is likely soon to be reducing rather than adding to the economy's growth, but that is why the Reserve Bank has been cutting interest rates back to their lowest since the global financial crisis: to encourage borrowing and spending on consumer durables, housing and business investment.

And remember this: every time we get a new government hope springs eternal and people cheer up, with punters spending more and businesses investing in renewal and expansion.

How long the good mood lasts depends on the new government's performance, of course.

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BEHAVIOURAL ECONOMICS: PERCEPTION AND REALITY

Keynote address to External Dispute Resolution forum, Sydney

Since Fiona Guthrie has billed me as talking about behavioural economics I want to talk about a subject of little interest to conventional economists: the sometimes yawning gap between the way we perceive the economy and our place in it and the way the objective indicators say it actually is and where they say we fit into it. I’ll do so with special reference to financial counsellors and the people they counsel.

I was to start by observing that 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. I can think of four reasons why the economy’s doing a lot better than many people imagine. First, a fair bit of it is political: if you don’t like the Gillard government it’s easy to conclude it must be making a mess of the economy. Second, 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. Third, 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 this year may have been taken wrongly by some as proof it is managing the economy badly. But, fourth, it remains true that some parts of the economy are under great pressure from the high exchange rate and other factors and, as we’ll see, many people have a tendency to think that  if I’m doing it tough the whole economy must be stuffed.

When you stand back from all the argument and complaints, however, you see the economy isn’t doing too badly. It’s been growing at about its medium-term trend rate of 3 per cent a year, though the budget forecasts it will slow to a little below trend in the coming financial year. The rate of unemployment has been a bit above 5 per cent for the past few years - which is quite low by the standards of the past 30 years - though it’s now drifting up slowly and may reach 5.75 per cent by June next year. Inflation remains low at about 2.5 per cent and has stayed within the 2 to 3 per cent range for three years. The diminishing threat from inflation has allowed the Reserve Bank 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.

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 you provide 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.

Dr Nicola Brackertz, of Swinburne University, has prepared a report for the Salvation Army (my co-religionists) that tells us a lot about the circumstances of people suffering genuine financial stress. She surveyed more than 200 of the clients of the Salvos’ free financial counselling service, Moneycare.

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 of them 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 off 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, people on the disability support pension or sole parents (many of whom have been relegated to the dole by a grateful 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 the way they are, it’s no surprise that people living 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 their income is. That sounds pretty generous; the standard measure of housing stress is rent or mortgage payments exceeding 30 per cent of income. The trouble is that the cost of true necessities such has 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, 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 the comfortable to tell themselves 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 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 money to cover you when quarterly utility bills arrive or some unexpected expense arrives. And when you can’t afford comprehensive car insurance of home content 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.

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.

Compare that with ‘Michael’ who was outraged when my colleague Peter Martin wrote that anyone earning more than $210,000 a year was ultra-rich, in the top 1 per cent. Michael wrote that $210k gross translated to $140k after tax. “Assuming a $600k mortgage (appropriate to this level of income) and two children in private schools plus additional outgoings this leaves a balance of only $21k for holidays and other incidentals and/or saving.” Peter wrote back assuring him that, however difficult his circumstances, 99 per cent of Australians earned less than he did.

There is plenty of research evidence suggesting people’s notions of where they fit in the distribution of family income - from low to middle to high - are often wildly astray. Everyone wants to think they’re somewhere near the middle. So let me give you Peter’s test: what at do you think was the average income reported to the Tax Office in 2010-11 (excluding all the low earners who don’t end up paying tax)? The average income earned by the Australians who did pay tax was less than $67k.

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.

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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Both sides' big secret: taxes must go up, not down

Someone said the reason the political debate in Australia has become so bitter and personally abusive is that, at bottom, there's not a lot of difference between the two sides on policy issues. There are a few issues on which they offer clear alternatives, but not many.

You may think, for example, there's a big difference between them on taxation. But, as it has become clearer in the past week, the supposed differences are more contrived than real.

The parties are as one in their refusal to acknowledge the truth that strikes whoever examines the many studies inquiring into future spending pressures on federal and state budgets: there's only one way taxes can go and that's up.

I'm sure all our political leaders understand this but, fearing what the other side would say, they pretend the problem isn't looming. When I tax cabinet ministers with the topic, they don't tell me I'm talking nonsense, they look aghast and mutter "we couldn't possibly say that".

As so often with economic matters under the Rudd-Gillard government, in the politicians' determination not to confront voters with the harsh realities on taxation it's the Liberals who take the offensive and Labor that's defensive.

Tony Abbott initially put a lot of work into exploiting and reinforcing the voters' deeply held misperception that the Liberals are the party of low taxation, and Labor the party of high taxes. He promised to abolish Labor's "great big new taxes" on carbon emissions and the impoverished mining companies. Bronwyn Bishop repeated virtuously that the Liberals are always opposed to big new taxes.

I wanted to ask her, do the letters GST ring a bell? When you measure the burden of federal taxes as a proportion of the nation's income - as you should - Peter Costello was our highest taxing treasurer. Wayne Swan can't hold a candle to him. Only if you ignore inflation and the real growth in the economy can you pretend Swan is extracting more tax than his predecessor.

But when it comes to cynical and hypocritical exploitation of the public's presumed opposition to higher taxes, both sides have form. Remember how hard Labor campaigned against John Howard's iniquitous goods and services tax in 1998?

It was immoral and would greatly damage the economy. Yet when Labor returned to power nine years later, the idea of repealing or even modifying the tax never once crossed its mind.

Abbott's grandstanding on the horrendous cost and economic damage to be wrought by the carbon tax has been the most successful yet utterly dishonest scare campaign of modern times.

But now Labor is preparing to return the compliment. Prevented by all his crocodile tears over Labor's "debt and deficits" from acting on his promise to return the budget to surplus forthwith while still introducing a tax cut, Abbott is now giving the appearance of action by promising yet another review of the tax system, this time not excluding the goods and services tax.

So Labor is gearing up for another scare campaign on the GST, which will be dishonest not because an expansion of the tax is unlikely - it's highly likely within a few years - but because Labor will portray it as unneeded and economically disastrous, all the while standing ready to benefit from the tax when the party next returns to office.

The pressure for more revenue from the GST is the clearest, most immediate reason for believing we'll be paying a higher proportion of our incomes in tax in the future. It has turned out not to be the great "growth tax" and saviour of the state governments.

The era in which households were running down their savings, thus allowing consumer spending to grow perpetually faster than household income, has ended and won't be returning. What's more, the two main areas of household spending excluded from the GST (apart from food) - health and education - are growing faster than the spending included, meaning the tax applies to an ever-declining proportion of total consumer spending.

Since the states are so heavily dependent on revenue from the GST to finance their own considerable spending, this a big worry for the premiers, who by now must be desperately hoping a way can be found to raise the rate of GST or broaden its scope, or preferably both.

What's a problem for all the premiers becomes a problem for Canberra. And big business is partial to higher GST, hoping the proceeds could be used to cut the rate of company tax (vain hope).

It's often charged that most of the many budget "savings" Swan boasts of are actually increases in taxation. It's true. But note this: last week Abbott warned he reserved the option of implementing all of Labor's savings if he gets into power (no matter what nasty things he'd said about them at the time).

The disability insurance scheme represents a clear extension of the social safety net. Nothing could make more sense than saying such an extension would need to be covered by higher taxation.

Yet Julia Gillard, proud mother of this historic reform, lacked the courage to propose such an obvious measure until forced by budget realities just a week or two ago.

But here is the point: No-new-taxes Tony immediately embraced a 0.5 percentage point increase in the rates of income tax. And voters copped it almost without murmur. The era of higher taxes is dawning.

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This budget less dishonest than last year's

When it comes to forecasting the economy - and thereby the budget balance - the econocrats of the Reserve Bank and Treasury are on a hiding to nothing.

When they get it pretty right that's no better than it should be. But when they get it wrong - for whatever reason - they're fools and probably knaves as well.

The obvious truth is no economists are consistently good at forecasting the economy. It's those non-economists who forget this - including Wayne Swan and Julia Gillard - who are the fools, not the economists who cater to humankind's irrational but unquenchable desire to pretend the future can be known.

Budget week is open season for anyone who can find a microphone to claim Treasury's forecasts are wildly optimistic. But though the econocrats' record is pretty bad, I've yet to discover any non-official forecaster whose record is better.

And whereas the budget-time know-alls are rarely held to account, the econocrats are always accountable. Their forecasts are on the record for the whole world to judge after the event.

The proof of their high standard of accountability is that they often conduct systematic reviews of their forecasting accuracy, which they make public so as to keep themselves humble and to warn users of their forecasts' fallibility.

According to my quick squiz, the leading business economists' forecasts for real gross domestic product are only a fraction lower than Treasury's, but their forecasts for nominal GDP are significantly lower, mainly because they expect our terms of trade (export prices, essentially) to fall by a lot more than Treasury does.

If they are right, you'd expect Treasury's revenue forecasts again to prove too high. But to give the business economists their due, they haven't been trumpeting their differences with Treasury, either for cheap publicity or to prove what fools they are in Treasury.

No, this year the vociferous criticism of Treasury's forecasts and assumptions has come from the Opposition (they would say that), partisan economists and shock jocks who wouldn't know the difference between a forecast and a projection if it bit them on the backside.

The irony is, this is a less dishonest budget than the past few that Swan produced as he realised the long-promised return to surplus in 2012-13 would need help from performance-enhancing accounting.

One trick used extensively last year was to take spending planned for the early weeks of 2012-13 and switch it into the later weeks of the old year, thereby overstating spending in the old year and understating the budget year. Every $1 you switch increases the difference by $2.

This year Swan's creative accounting has been limited to bringing forward $1.1 billion in payments to local government - presumably to hide the fact that the budget year's deficit is actually a little higher than the previous year's.

As every accountant knows, the trouble with shifting expenses is that it comes back to bite you the following year. The government's strategy requires it to limit the real growth in its spending to 2 per cent a year, on average.

The games played in last year's budget caused real government spending to grow by 4.8 per cent the previous year, then fall by 3.2 per cent in 2012-13. But that year's fall means, despite this year's restraint, spending is expected to jump by 4.3 per cent. The comparison would be even worse without this year's fiddle.

Another trick last year was to use Swan's fiscal bulldozer to push spending commitments off into the future beyond the forward estimates, where they became invisible.

This year he's done something new, showing how the offsetting savings (including sinful tax increases) are more than sufficient to cover the growing cost of the disability scheme and the Gonski education reforms, not merely over the forward estimates but over the next 10 years.

Those who think politics but never economics saw this move as a cunning attempt to "wedge" Tony Abbott. If so, it didn't work. But I see it as a marked improvement in budget transparency, needed to prove the fiscal bulldozer had been left in its shed.

The transparency has, however, allowed Saul Eslake, of Merrill Lynch - who invariably produces the most penetrating analysis of the budget - to note that, though the disability scheme will cost only $1.9 billion over the four years to 2016-17, the linked increase in the Medicare levy will raise $11.6 billion in that time.

Eslake says about two-thirds of the net improvement in the budget balance attributable to policy decisions over the four years to 2015-16 comes from this discrepancy.

He further notes that, if you switch your focus from the "underlying" to the "headline" cash balance (thus taking account of the off-budget building of the national broadband network), the budget should still be in deficit in the last two years of the forward estimates.

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Worry more about the economy than the budget

Most of those who take a political approach to the budget assume that if it's in deficit, the way you get it back to surplus is to cut government spending or, if you're a really bad person, increase taxes. They forget it's the budget itself that's supposed to do the heavy lifting.

When the severe recession of the early 1990s turned Paul Keating's budget surpluses into big deficits, he told people not to worry: as the economy recovered, the budget would "whirr back to surplus".

He was right, it did. Only trouble was it took a while to happen, and by then the chap in charge of the budget was Peter Costello - who, as any politician would, took all the credit.

When Wayne Swan and Julia Gillard began predicting the budget would be back to surplus this financial year, 2012-13, they were assuming it would happen pretty much automatically. The budget would again whirr back to surplus after all the weakness of the global financial crisis.

It hasn't happened. As we learnt this week, the budget balance for this year is now expected to be a deficit of $19.4 billion rather than a surplus of $1.5 billion.

Why? Not because the government has continued to spend like a drunken sailor, as some would have you believe, but because the budget didn't whirr back as it was expected to. Rather than growing strongly, tax collections grew by a lot less than expected.

Contrary to what most economists were expecting, when the high coal and iron ore prices feeding the resources boom began to fall back, the dollar didn't fall back with them.

So the miners' profits have fallen, but the high dollar has continued to squeeze the profits of our other trade-exposed industries as well. They haven't been able to earn as much from their exports, nor charge as much for the stuff they sell in our domestic market because imported goods and services have stayed cheap.

So far, this hasn't adversely affected economic activity. The quantity of goods and services we produce (real gross domestic product) has continued to grow at a reasonable rate, but the rise in prices has been weak, meaning nominal GDP hasn't grown as fast as real GDP.

This means we haven't had to worry about inflation, but the profits of our miners, manufacturers and tourist operators (and, for different reasons, our wholesalers and retailers) have been squeezed.

For the budget, it means collections from company tax have grown more weakly than expected, as has the tax on capital gains. (Collections from the new mining tax have been a fraction of what was expected, but for a quite different reason: because the tax was new, Treasury overestimated how much it would raise in its early years.)

So the budget hasn't whirred back to surplus as expected because, for quite unusual reasons, the recovery from the GFC hasn't proceeded normally. The spending and taxing decisions of the government have had little to do with this.

Here's the point: if problems in the economy have prevented the budget from returning to surplus, we should worry about those problems, not the delayed return to surplus.

As the budget papers say: "Fiscal [budgetary] objectives are not ends in themselves. They matter because of their implications for employment, incomes and wellbeing. In essence, good fiscal policy entails allowing the fiscal position [the budget balance] to vary in response to economic conditions in the near term, while ensuring fiscal settings are sustainable over the medium-to-long term."

What causes the budget balance to vary in response to economic conditions are the "automatic stabilisers" built into the budget. They're what does the whirring, pushing the budget into deficit when the economy goes down and pushing it back into surplus when the economy comes back up.

The main built-in stabilisers are the progressive income-tax scale and the availability of the dole but, as we've just been reminded, the other taxes also play a part.

So much for the economy's effect on the budget balance. In budget week we need to look also at the budget's effect on the economy; to assess the "stance of policy" adopted in the budget.

The Reserve Bank's way of doing this is simply to look at the expected change in the underlying cash budget balance, from a deficit of $19.4 billion this financial year to a deficit of $18 billion next year, 2013-14.

But Wayne Swan has fiddled this comparison by taking payments to local councils worth $1.1 billion and paying them in the old year when they weren't due until the new year. If you adjust the figures to remove this fiddle, you get a deficit of $18.3 billion in the old year and one of $19.1 billion in the new. This says the budget overall will have a tiny expansionary effect on total demand in the economy.

The Reserve will take this into account - along with many other factors - when it decides whether a further easing in the "stance" of monetary policy (another cut in interest rates) is needed.

However, the strict Keynesian way of assessing the stance of fiscal policy is to ignore the effect of the automatic stabilisers and focus on the net effect of all the discretionary policy changes announced in the budget.

Doing it this way shows that, after correcting for the fiddle, those changes will add $1.2 billion to the deficit for the old year and $1.4 billion to the one for the new year. This says the policy stance is stimulatory, but only to the tiniest extent (remember, nominal GDP will be $1.6 trillion).

It is true, as you've heard, that the effect of all the spending and tax changes announced this week would (if they are implemented by the government that wins the election) improve the budget balance by a net $28.4 billion over five years.

But this discretionary tightening isn't planned to start until the year after next, 2014-15, by which time we can expect the economy (and the budget) to be a lot stronger.

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Swan's last budget: weird in a good way

This is the weirdest budget you or I are ever likely to see. That doesn't make it bad - just very strange.

With just four months until the election, it's the most unlikely pre-election budget you could imagine, with loads of nasties and next to no sweeteners. It is more like a post-election budget, particularly the kind you get after a change of government.

But its strangeness doesn't end there. The Parliament has so few weeks left to sit, it is likely most of its controversial measures won't become law before the election (with the increase in the Medicare levy the main exception).

That makes it less a budget than an election policy speech. Only if Julia Gillard is re-elected can we be sure the budget measures will become a reality.

And since the chances of Labor's re-election seem low, this is more Tony Abbott's budget than Gillard's. It will be he who decides which measures survive and which don't; whether Labor's last budget becomes anything more than its final, impotent gesture.

Do you think Gillard doesn't know that? This is the budget of a government that knows it's a dead duck.

Usually when governments know they are going to lose, they go for broke, offering electoral bribes they know they will never have to find a way to pay for, aiming to minimise their loss of seats.

Not this time. This budget is more likely to cost Labor votes than win it any.

No, the purpose of this budget is not vote-buying - it is reputation-rescuing, a last-ditch attempt to influence what history will say about the Rudd-Gillard government as an economic manager.

History will be impressed by this budget - and a lot more forgiving of Labor's shortcomings than voters are likely to be on September 14.

At this time in 2010, Wayne Swan seized on a Treasury projection three years into the future and boasted about his feat of returning the budget to surplus in 2012-13.

In the following election campaign, Gillard foolishly turned that long-range projection into a solemn promise.

This time last year, Swan boasted of budgeting for four surpluses in a row, as though they were in the bag. His surplus of $1.5 billion for the financial year just ending is now expected to be a deficit of $19.4 billion (but even that isn't yet certain). This year his boast of being able to get the budget back to a surplus of $6.6 billion in 2016-17 (again on the basis of Treasury's long-range projections) will draw understandable cynicism.

But just as Swan and Gillard should have more sense than to attach much weight to economists' forecasts, so should the rest of us. Treasury's crystal ball will be no more reliable after a change of government. Less initial naivety on the part of the media and the public would reduce ultimate cynicism.

The strength of this budget - should it come to pass - is that Swan has found sufficient saving measures (90 per cent of them tax increases) to cover the cost of the painfully slow phase-in of the disability insurance scheme, the Gonski school funding reforms and other new spending measures.

He has found other savings to make a start on reducing the budget's significant "structural" deficit - the product of excessive generosity by successive governments - and eventually getting the budget back to surplus, but without endangering the economy's tricky transition from mining-driven to consumer and business investment-driven growth over the coming year.

These additional, structural deficit reductions build from nothing in the coming financial year to $6 billion in the following year and $12 billion in each of the next two years. Being saving measures, these figures are less dependent on predictions about the state of the economy and so are easier to believe.

By my rough figuring, they will eventually reduce the structural deficit - that is, claw back unfunded handouts - by about 60 per cent.

It has to be said, however, that few of the nasties in the budget will cause voters to lose much sleep. They are aimed mainly at the well-off and foreign multinationals.

Even so, for a government that's been far too timid in tackling unjustified spending programs and tax breaks, this budget is surprisingly brave.

And if, by being the one to propose last night's unpopular measures, Gillard makes it easier for Abbott to agree to them now or to introduce them after the election, Labor will deserve respect for initiating such a heavily disguised form of bipartisanship.

For what it's worth, this is a good budget. But that is the trouble: under these strange circumstances, it ain't worth a lot.

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Budget becomes Canberra's con job on the nation

Tuesday night's budget may have become the central plaything in the dog fight between Labor and Liberal, but its economic importance is a shadow of what it used to be.

It suits no one in Canberra to admit it - not the pollies of either side, the econocrats, the business lobbyists nor the journalists - but these days the budget is not of great significance in the macro management of the economy.

True, it's still of great newsworthiness because the decisions the government makes about changes to spending programs and taxes do affect the pockets of people across Australia.

And these decisions are of micro-economic significance because they affect the efficiency with which the nation's economic resources are allocated. They also affect the fairness with which income is distributed between low, middle and upper-income households.

But with so many people having made up their minds on whom they'll vote for, and so many of the nasties already leaked to the media (or selectively leaked to the morning papers before being announced the same day), I doubt the budget will have much political significance.

And that's even if, following the usual budget media-manipulation script, the government has held back a few nice measures for the media to give exaggerated attention to on the night.

Even so, Canberra's dirty little secret is that the decisions we'll be making so much fuss about on Tuesday night will have surprisingly little effect on how the macro economy performs over the coming financial year.

That's for two reasons. First, politicians' decisions have much less effect on the budget than the daily decisions made by the 98.4 per cent of Australians living outside the ACT.

If, as seems likely, most of the budget deficit we're told about on Tuesday is accounted for by the "structural deficit" - that is, the net cumulative effect of unwise decisions by governments of both colours over many years - this will prove how much tosh the pollies have been spouting about the bad state of the economy.

Even the government has long been crying crocodile tears about how tough people are finding it to keep up with the rising cost of living. Julia Gillard and Wayne Swan keep doing this because their focus groups tell them the cost of living is all the punters can find to complain about.

They make sympathetic noises even though they know the economic indicators say real incomes are rising, not falling.

The second reason the budget's macro-economic significance is exaggerated by the denizens of Canberra is that, as the fine print in the budget papers admits every year, the primary responsibility for the day-to-day management of macro economy rests with monetary policy (the manipulation of interest rates), which is determined by the Reserve Bank in Sydney without reference to the pollies in Canberra.

It's true changes in the budget balance affect the strength of aggregate demand in the economy, but what the Keynesian Rip van Winkles haven't woken up to is that so do a lot of other things - the exchange rate, for openers.

The point is, the budget is just one of various factors the Reserve takes into account when deciding whether to use its interest-rate lever to stimulate or restrict demand. In other words, monetary policy is the "swing instrument".

Sometimes the Reserve chooses to push in the same direction as the budget, sometimes it chooses to counteract the budget by pushing in the opposite direction (as it did in the Howard government's later years when it was using its budget to worsen rather than improve the business cycle).

Much will be made on Tuesday night of the forecasts for the economy contained in the budget papers. We'll be told how fast Treasury expects the economy, inflation and all the rest to grow next financial year, as though this is news of great significance.

It isn't. Why not? Partly because it's the forecasts of the macro managers that matter and, as we've seen, neither Treasury nor its masters manage the economy. It's the Reserve Bank's forecasts that matter.

Actually, Treasury makes sure its forecasts (which it uses primarily to help it estimate budget spending and revenue) are little different from the Reserve's. Why? Because the Reserve's independence of the politicians makes it the more credible forecaster.

And get this: the forecasts we'll be told about with great fanfare on Tuesday will be old news. Why? Because they'll be the same as the forecasts the Reserve announced last Friday. The economy's growth should average 3 per cent in 2012-13 and about 2.5 per cent in 2013-14. The forecasts for inflation will be 2.25 per cent and about 2.5 per cent respectively.

Why does everyone in Canberra have an interest in misleading us about the budget's macro-economic significance? Because, as the ACT's principal export to the rest of Australia, the budget is how they make their living.

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How to worry about the budget deficit

Far too much fuss is being made about this year's budget because politics has overtaken economics. I'm adding to the fuss, of course, but at least I'm trying to help people assess the economic significance of all the political argy-bargy.

When we see the budget on Tuesday night the deficit is likely still to be very big. How worried should we be about that deficit? And how urgent is it for the government to get the budget back to surplus?

For the politically partisan, these are easy questions. If you're a one-eyed Liberal supporter, any deficit is a terrible thing and it should be eliminated ASAP. If you're a one-eyed Labor supporter, budget deficits aren't a great problem and to reduce them while the economy is in its present state could do great damage.

If you're interested in an economic analysis, however, it's not as simple as the political partisans imagine.

To decide how worrying a budget deficit is you have to know about the state of the economy at the time. This is because - although the political types don't know it, or keep forgetting it - the budget balance at any moment is a product of two different forces: the economy's effect on the budget, on one hand, and the government's effect on the budget on the other.

When the economy's in the upswing part of the business cycle the budget's likely to be in or heading towards surplus. That's because people will be earning more income and paying a lot of tax on it, while others will be finding jobs and going off the dole.

When the economy's in the downswing part of the cycle the budget's likely to be in or heading towards deficit. That's because people will be earning less income and paying less tax, while others are losing their jobs and going onto the dole.

But though the economy's effect on the budget balance via the business cycle is usually the bigger effect, we still have to take account of the government's effect on the balance. The economy's effect is known as the ''cyclical component'' of the budget balance and the government's effect is called the ''structural component''.

The structural component should be the cumulative effect of all the policy decisions the government has made - some going back quite a few years - to change taxes and government spending (although it may also include the effect of changes in the underlying structure of the economy).

The point of all this is that if the deficit at a particular time was largely the product of the weak state of the economy, the weak state of the economy would be something to worry about, but the deficit it produced wouldn't be.

So to decide how worried we should be about the budget deficit we see on Tuesday, we need to know how much of it is cyclical and how much is structural. Whatever part of it is cyclical is justified by the state of the economy and something that will fix itself as the economy strengthens.

If a significant part of it is structural, that could be justified only if the economy was so weak the government was adding its own stimulus to that provided automatically by the budget's ''automatic stabilisers''. (These are built-in elements of the budget - particularly the progressive tax scale and the dole - the operation of which is what creates the cyclical component of the budget deficit or surplus.)

The way economists divide the budget balance into its cyclical and structural components is to work out where the budget balance would be if the economy were running at trend levels - on its medium-term average growth path, averaging out all the ups and downs in the cycle. The extent to which the actual budget balance departs from this trend estimate represents the structural component.

As with so many concepts in economics, the idea's easy to grasp but putting a number on it ain't. You have to make a lot of assumptions and estimates, meaning different economists come up with different figures.

This week Chris Richardson, of Deloitte Access Economics, published his estimates that the overall cash budget deficit will be $22.2 billion for the year just finishing, 2012-13, and $20.2 billion for the coming year.

His corresponding estimates for the structural deficit are $22.8 billion (equivalent to 1.5 per cent of gross domestic product) and $20.2 billion (1.3 per cent). In other words, the overall deficit is totally explained by structural factors.

Note that these figures are on a ''no-policy-change basis''. That is, they're estimates of the ''starting-point deficit'' before the government began deciding on all the policy changes to be announced on Tuesday (and which it has been leaking as part of its media manipulation). Richardson says the small improvement in the structural deficit between the years is probably mainly the result of a year's worth of bracket creep.

Does it surprise you that, according to Richardson's figuring, no part of the overall deficit is cyclical? If it does, it shouldn't. You've been listening to politicking, not reading the economic indicators. Reserve Bank governor Glenn Stevens said this week the economy is growing at only ''a bit below trend''.

And this week we learnt the smoothed unemployment rate has been at 5.5 per cent for three months. Remember, economists regard full employment as an unemployment rate of about 5 per cent.

All this says most of the deficit we see on Tuesday will be structural. As we saw in last week's column, however, much of it will be the legacy of unwise decisions made by the Howard government (including, Richardson reminds us, its decision to stop indexing the excise on petrol, which is now costing about $5 billion a year).

To be sustainable, the recurrent budget does need to be in balance on average over the cycle. It would risk damage to the economy to try to eliminate a big structural deficit in one hit. But that will not excuse any failure by the Gillard government to get on with reducing it.

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The economic geography of big cities

If you've seen those ads the mining industry is running you probably realise the entire economy is riding on the miners' backs, and if asked to pay another dollar more in tax they'll up sticks and shift their mines to some better-run country like Peru or Nigeria.

If you've spoken to a farmer any time in the past 50 years you'll know it's actually farming that's propping the economy.

In either case you'll be surprised to know the truth: according to estimates by the Department of Infrastructure and Transport, 80 per cent of Australia's economic activity takes place in Australia's major cities.

That's because the great majority of us live in big cities. We live there because that's where most of the jobs are. Equally, most of the jobs are where the people live because most jobs involve doing things for people (such as bringing them the news).

But it's not by accident that so many of us happen to be piled into a handful of cities (as are people in all developed countries and, increasingly, many developing countries). We pile together because it's more efficient economically, thus making us more prosperous.

For one thing, it saves on transport and other distribution costs. For another, outfits such as hospitals and schools - even shopping centres - gain economies of scale when they have more people to serve.

But that's just the start of the "economies of agglomeration", as Jane-Frances Kelly and Peter Mares point out in their report for the Grattan Institute, Productive Cities.

We're used to dividing up the economy by sector - agriculture, mining, manufacturing and the big one, services - and focusing on how these sectors' shares of the economy are changing. But this blinds us to an important development.

"One of the most significant long-term shifts in advanced economies is towards knowledge-intensive activities. These take place across all sectors of the economy," the authors say. In other words, there are knowledge-intensive jobs in each of the sectors - but almost all of them are located in the cities.

Knowledge-intensive activities tend to involve customised problem solving, which requires significant intellectual effort. So such workers solve problems and generate ideas. Their jobs are clean, safe, well-paid and intellectually satisfying. They're the way for Australia to go if we want a better future than just farming and mining (lucrative though they are).

But here's the point: knowledge-intensive activities grow best in big cities. This is because people and businesses learn from each other, and the closer together they are the more they learn. According to the urban economist Edward Glaeser, the "central paradox of the modern metropolis" is that even as the cost of connecting across distance falls, so the value of being close to other businesses rises.

As well, the more businesses and workers cluster together, the more they each benefit from "deep" labour markets. Firms have more workers to pick from; workers have more firms to pick from. Jobs can become more specialised, and ever-increasing specialisation is one of the main ways economies have become richer over the past 200 years.

When you specialise in something you get better at it. And the individual worker more closely fits the needs of the individual employer (which makes the worker more valuable and able to command a higher salary). But the more specialised you are the more contact you need with others in your specialty to help you keep up.

The report says that, adapting to changing economic circumstances, Australia's largest cities have evolved from compact colonial cities where jobs and houses were close together and most people walked to work, to cities that spread outwards into suburbs.

"This transition was made easier by changing transport technologies: first trams and trains, then buses and cars. The transition further separated the worlds of work and home, an arrangement that was well suited to a 20th-century economy driven largely by manufacturing, when industry could often be a dirty and noisy neighbour."

Initially this led to the "hollowing out" of inner cities as both residents and jobs moved to the suburbs. In the decades since 1980, however, the trend began to turn around, as services began to replace manufacturing as the main source of new jobs.

Combined with factors such as traffic congestion and rising fuel prices, this helped to prompt a resurgence of CBDs and inner suburbs as places to live and work.

The point here is that the economic efficiency of cities - their ability to generate well-paying jobs - turns on where the jobs are, where the homes are and the adequacy of the transport system that allows us to move between the two.

But the report finds that labour markets are shallow in significant parts of Australia's biggest cities. "In many suburbs - particularly outer suburbs - residents can reach fewer than 10 per cent of all metropolitan jobs with a reasonable commuting time," it says.

The answer is not for governments to try (and often fail) to create jobs in outer suburban areas. People want to live closer in, and many of them want units rather than houses. So the answer is to remove the disincentives faced by developers building in established suburbs and stop established suburbs from being "locked down" by restrictive zoning and planning rules.

The way to reduce traffic congestion and increase the capacity of city transport systems is to start charging for the use of roads and use the revenue to expand public transport.

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Pain hits business before it hits the budget

As we approach the budget next week we're hearing a lot about how the strangely weak growth in nominal gross domestic product has hit tax collections, particularly from company tax.

But we're hearing a lot less about what this implies is happening to the "real" economy.

What's causing nominal GDP to be so weak - weaker than real GDP - is that although the prices of our mineral exports have fallen a fair bit, the dollar hasn't also fallen, as it was expected to. This means we're getting the worst of all worlds.

The miners are getting lower prices, but still losing as much from the high dollar. The other export and import-competing industries - farmers, manufacturers, tourist operators and others - who gained little from the resource boom are still being robbed of their international price competitiveness when they could have expected to be getting a bit of relief by now.

If company tax collections aren't growing as strongly as had been expected, this must be because corporate profits are weak.

In fact, the national accounts version of corporate profits ("gross operating surplus") has fallen in nominal terms for five quarters in a row and by 4 per cent over the year to December.

So company profits are being squeezed - which is really only what you'd expect when the dollar's been so high for so long. Even so, it helps explain why businesses are so unhappy and blaming the Labor government for their troubles.

But the consumer price index for the March quarter showed puzzling things are happening to a sector you'd expect to benefit from a high dollar: retailing.

It showed that whereas the retail prices of "non-tradeables" - goods and services not able to be traded internationally - rose by a hefty 1.3 per cent in the quarter and 4.2 per cent over the year to March, the retail prices of "tradeables" fell by 1.2 per cent in the quarter and 0.2 per cent over the year.

This is further evidence manufacturing and tourism are under a lot of pressure.

But it's also a puzzle because it's only when the dollar is rising that you would expect the prices of tradeables to be falling. As Paul Bloxham of HSBC bank has observed, the Australian dollar has been broadly steady for more than two years.

According to the CPI, retail furniture prices fell 6.8 per cent in the quarter and 2.3 per cent over the year.

Household textile prices fell by 6.7 per cent and 4.3 per cent. Appliance prices fell by 2.5 per cent and 4.4 per cent.

Retail prices of audio-visual items fell 4.7 per cent and 13.5 per cent, while overseas holiday prices fell by 5.2 per cent and 0.4 per cent.

Michael Workman of Commonwealth Bank argues the lower prices of imported goods and services are a reflection more of weak global consumer markets for European and Asian producers than the effect of the high dollar.

That is, foreign suppliers are cutting the prices they charge Australian importers so as to keep their sales up. If so, the lower prices our retailers are charging customers aren't coming out of their own hide.

Well, that's one theory. But others aren't so reassuring. Another theory is that weak demand and intense competition between retailers is obliging them to cut their prices at the expense of their profit margins.

They may be starting to feel the heat from customers using the internet to discover the lower prices being charged overseas, or using their smartphones to seek lower prices from other stores while haggling with shop assistants. If so, their profits are being "compressed" as the econocrats put it.

I have a theory retailing is suffering from a lot of excess capacity - too many stores - because it geared itself to a world where the rate of household saving kept falling, so that consumer spending grew consistently faster than household incomes.

Now the saving rate seems to have stabilised at 10 per cent, spending can grow no faster than incomes, meaning stores are competing to see who survives and who doesn't.

If so, this would be squeezing profits - at least until the losers shut up shop, so to speak.

Yet another possibility - which would apply to the manufacturers and tourist operators as well as the retailers - is that several years of heightened competitive pressures have obliged firms to find tough ways of lifting their productivity and then pass the savings through to their customers rather than taking them to the bottom line.

Whatever the truth of the situation - maybe some combination of all the various possibilities - it's not hard to see why the retailers are just as unhappy as the manufacturers. And don't forget a big part of small business is in retailing.

But not to worry, chaps. As soon as Julia's out and Tony's in, he'll fix everything.

Pain under the Libs is much easier to take.

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Ghost of Costello haunts Swan's budget

If you're a rusted-on supporter of the Coalition there can't be a shadow of a doubt that all the budget problems we're hearing about are the product of the Gillard government's incompetence. And if you don't think much about economics, it's perfectly believable.

After all, the budget had been in surplus for eight years straight when the Howard government lost office in late 2007. In that time Peter Costello not only paid back the $96 billion net public debt he inherited from Labor, he clocked up a credit balance of $45 billion.

In marked contrast, Labor's first budget went straight into deficit and has stayed there ever since, despite its solemn promise to get back to surplus this year. Wayne Swan soon chewed up all the money the Libs left him and racked up a net debt of about $140 billion and counting.

What more do you need to know?

Well, a bit of economics would be nice. Failing that, a bit of commonsense. The good guys/bad guys story I've just told rests on two silly assumptions.

First, everything that happens to the federal budget happens because of the actions of the government. Nothing happening in the rest of the economy - or the rest of the world - could possibly affect the budget balance. In other words, nothing happens that's beyond the treasurer's control.

Second, from the day a new treasurer takes over, everything that happens must be in consequence of his actions. Nothing his predecessors had done could still be having an effect on the budget long after they'd been tossed out.

Clearly, life - and budgeting - is a little bit messier than that. Economists well know that things beyond the treasurer's control actually have a bigger effect on the budget than things that are within the government's control.

That's true regardless of whether you're Labor or Liberal and whether what the economy does to your budget is good or bad.

It's equally true that some of the decisions made by a treasurer can still be affecting his (we've never had a female treasurer) successors many years later.

So, as with everything else in work or life, the budgetary performance of a government is some combination of luck and management.

Costello's management was good in many respects but, as we'll see, not as good as many have assumed. Swan's management has been the opposite: far from perfect, but not as bad as it has suited many people to claim. As for luck, there's no contest: Costello's luck was great; Swan's has been lousy.

To a partisan of the right, the trouble Swan is facing in getting the budget back to surplus any time in the foreseeable future is explained solely by Labor's chronic inability to stop spending. All the recent talk of "structural" (that is, long-lasting) problems on the revenue side of the budget is just excuse-making.

It's true Labor has trouble controlling its urge to splurge. But it's also true that the slowness of tax collections to return to their normal healthy rate of growth as the economy grows is partly the result of weaknesses that go back to decisions made by the Howard government.

Increasingly, economists are realising our governments mishandled the revenue windfall from the first phase of the resources boom, spending too much of it and saving too little.

Not only did John Howard allow government spending to grow at Labor-like rates in the noughties, but Costello responded to the temporary boost in collections from company tax by cutting income tax eight years in a row (though, to be sure, the last three of his cuts were actually delivered by Labor).

Usually, income tax is cut only every three years or so, and cut close to an election so voters haven't forgotten it happened. Does it surprise you that cutting income tax so much can reduce its revenue-raising power today and in coming years? It shouldn't.

The Australia Institute has used the well-regarded Stinmod micro-simulation model to estimate that, had the income-tax scale for 2004-05 still been in use last financial year, 2011-12, collections from the tax would have been almost $39 billion higher.

Now, you may object that we couldn't have gone for all that time without any tax cut. Since our tax scales aren't indexed for inflation, we need regular tax cuts just to counter the effect of bracket creep.

Fair point. So next the institute compared the actual tax scale in 2011-12 with the 2004-05 scale with its tax brackets indexed up to allow for all the inflation in between. It found the indexed scale would have raised an additional $25 billion. So Costello's many tax cuts cut the real rate of income tax - on the strength of a surge in company tax collections that proved to be temporary.

Think how much smaller the budget deficit (and the accumulated debt) would be now had he limited himself to offsetting the effect of bracket creep. (Remember too that, particularly in the years before the global financial crisis, his decisions to spend rather than save the tax windfall from the resources boom obliged the Reserve Bank to raise interest rates higher than otherwise, to prevent this recycling from causing inflation.)

It's worth noting that the successive tax cuts were biased in favour of the better-off, with the cut-in point for the top tax rate trebled to $180,000 a year. As a result, the value of tax cuts going to the top 10 per cent of income earners exceeded that of the cuts going to the bottom 80 per cent.

If that doesn't convince you responsibility for the present and future state of the budget has to be shared between Labor and the Coalition, remember the other irresponsible revenue decision Costello made when the government was temporarily flush with funds: making income from superannuation totally tax free for people 60 and over.

Even at the time, economists warned this handout to the better-off was unsustainable - and so it has proved.

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