THE STATE OF THE ECONOMY

Economic growth: the economy’s production of goods and services (real GDP) grew by a below-trend 2.5 pc over the year to March. Non-mining business investment spending is weak, home-building and public spending are flat, but consumption is growing at below trend and net exports (exports minus imports) are growing strongly. Mining investment may have peaked. Production is forecast to grow slightly below its trend rate at 2.75 pc in 2013-14.

Inflation: he underlying inflation rate was 2.4 pc in the year to March, down from a peak of 5 pc in the year to September 2008, immediately before the GFC. It’s been back in the target range of 2 to 3 pc for three years and in the bottom half of the range for one year, suggesting no threat from inflation.

Unemployment: using trend estimates, the unemployment rate was 5.5 pc in April, having crept up from 5.1 pc over the previous year, though with the participation rate unchanged at 65.3 pc. Thus the economy has not been growing quite fast enough to hold unemployment steady. And with its growth forecast to stay a little below trend in 2013-14, the unemployment rate is forecast to continue creeping up to 5.75 pc by June 2014. But note that this unemployment rate is not much above the NAIRU, our lowest sustainable rate.

Current account deficit: CAD was $9 billion for the March quarter, or 2.2 pc of GDP. For the year to March, the CAD totalled $49 billion, made up of a trade deficit of $13 billion and a net income deficit of $36 billion. As a consequence of the high CADs in earlier years, the foreign debt has risen. At the end of March the net foreign debt was $764 billion, or 51 pc of GDP. The CAD is below its trend level of about 4.5 pc of GDP because although national investment (mining construction spending) has been stronger than usual, national saving (households and companies) has risen by more, while still being less than national investment.

Now let’s take a closer look at the state of the economy. This is a particularly interesting time to be studying the Australian economy because we have spent the past decade coping with the biggest commodity boom in our history since the gold rush, with the global financial crisis and its aftermath thrown in just to make things interesting. The boom has had big implications for the exchange rate, for change in the structure of the economy and, of course, for macro management.

Resources boom: The boom started in 2003, but was briefly interrupted by the GFC. It arises from the rapid economic development of China and India, which has hugely increased the world demand for energy and the main components of steel. This demand may stay elevated for several decades until the two most populous countries complete their economic development. The boom has involved three overlapping stages:

First, hugely increased prices for our exports of coal and iron. These caused Australia’s terms of trade to reach their most advantageous level in 200 years by June 2011, but they have since fallen back by 17 pc. Even so, we are still receiving significantly higher prices for our exports of coal and iron ore. Prices shot up as demand outstripped supply, but as Australia and other commodity exporters increase their production capacity prices are falling back.

Second, an unprecedented boom in investment in new mines and natural gas facilities as miners take advantage of the great global demand for minerals and energy. This investment spending has been a major contributor to growth for the past few years, but it is now expected to reach a peak in 2013 and, thereafter, begin subtracting from growth as it falls back. Note that, even though spending will decline from one quarter to the next, there is still considerable spending to come.

Third, significant growth in the volume of our exports of minerals and energy as new investment projects come on line. This volume growth will make a positive contribution to GDP growth and also to the trade balance and the CAD, even as falling export prices act to worsen the CAD.   

Exchange rate: As a commodity-exporting country, Australia’s exchange rate always tends to rise or fall in line with world commodity prices and our terms of trade. So our exceptionally favourable terms of trade left us with our strongest exchange rate for 30 years. The dollar is also being kept high by foreign purchases of Australian government bonds and the indirect effect of the developed countries’ use of ‘quantitative easing’ to stimulate their economies.

The higher dollar has reduced the international price competitiveness of our export and import-competing industries. Exporters are earning fewer $As from their overseas sales in $USs, while domestic industries are losing market share to now-cheaper imports. This adversely affects all industries in our tradeables sector (including the miners and the farmers), but particularly disadvantages our manufacturers and key services exporters, tourism and education (international students). These industries’ profits and their production are reduced.

Structural change: Economists argue that the long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports necessitates change in the structure of our industries, with relatively more resources of labour and capital going to mining, and relatively fewer resources going to all other industries, but particularly manufacturing and service exports. Economists further argue that the high exchange rate is the market’s painful way of helping to bring about this structural change. They say that using government subsidies or other forms of protection to help our industries resist change reduces the efficiency with which the nation’s resources are allocated. Mining production now accounts for about 10 pc of GDP (though only about 2 pc of total employment).

Retailing is another industry facing structural change as consumers shift their preferences from goods to services, and as the internet gives consumers access to overseas markets where retail prices are lower. This change is not related to the resources boom, but is related to the end of a long period when consumption grew faster than household income.

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. In other words, the ‘stance’ of fiscal policy adopted in the budget is neutral - neither contractionary or expansionary.

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: - 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.

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. The ‘stance’ of monetary policy is now highly expansionary. 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.

Microeconomic policy: The objective of microeconomic policy is to achieve faster economic growth and make the economy more flexible in its response to economic shocks. Whereas macroeconomic policy seeks to stabilise demand over the short term, microeconomic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. It does this mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 90s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.

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Latest on the debt no one mentions

It's funny that people who like to worry about the supposedly humongous size of our "debt and deficits" have focused on one debt when they could have picked another one four times bigger.

They carry on about the federal "net public debt", which is expected to have reached $162 billion - equivalent to 10.6 per cent of gross domestic product - by the end of this month. It's now expected to peak at $192 billion - 11.4 per cent of GDP - in June 2015, before it starts falling.

But that's chicken feed compared with our "net foreign debt", which reached $760 billion - 51 per cent of GDP - in December.

Whereas the net public debt is the net amount owed by the federal government to people who hold its bonds (whether they're Australians or foreigners), the net foreign debt is the net amount Australian governments, companies and households owe to foreigners.

One reason for the lack of trumpeted concern about the foreign debt is you can't score any party-political points with it. In dollar terms, at least, it's just kept growing under Liberal and Labor governments.

A better reason is there isn't a lot to worry about. Throughout the history of white settlement, Australia has always been a net importer of foreign capital because our scope for economic development has always been greater than we could finance with just our own saving.

And, as Treasury points out in this year's budget papers, there's now even less reason to worry than there used to be.

The net foreign debt is the partial consequence of a deficit that rarely rates a mention these days, the deficit on the current account of our balance of payments. (The balance of payments records all the transactions between Australians and the rest of the world.)

The current account deficit is usually thought of as the sum of our trade deficit (exports minus imports) and our "net income deficit" (our payments of interest and dividends to foreigners minus their payments of interest and dividends to us).

But it can also be thought of as the extent to which we have called on the savings of foreigners to fund that part of the nation's investment spending (on new homes, business equipment and structures, and public infrastructure) the nation has been unable to fund with our own saving (by households, companies and governments).

Actually, borrowing foreigners' savings is only one way to make up the saving deficiency. The other way is to attract foreign "equity" investment (ownership) in Australian businesses.

In December, when our net borrowing from foreigners totalled $760 billion, the net value of foreigners' equity investment in Australia was $110 billion, taking our total net foreign liabilities to $870 billion.

Our net foreign liabilities represent the accumulation of all our past current account deficits (and we've run such a deficit almost every year for at least the past 200).

Treasury makes the point that just because we don't save enough to finance all our annual new investment doesn't mean we don't save much. We save a higher proportion of national income (GDP) than many developed countries, and we've been saving a lot more since the early noughties.

Though governments are saving less, it's well known that households are saving a lot more. And companies are saving more by retaining a higher proportion of their after-tax profits. So national saving has risen to about 25 per cent of GDP.

Some of this rise has been offset by an increase in national investment spending, driven by the mining construction boom, which has taken national investment spending up to about 28 per cent of GDP.

Even so we've still reduced the gap between national investment and national saving to about 3 percentage points of GDP, which compares with an average of 6 percentage points in the years leading up to the global financial crisis. Treasury says this smaller gap (that is, smaller current account deficit) is likely to continue for at least the next two years.

Before the financial crisis, the dominant form of net capital inflow was "portfolio debt", Treasury says. This debt was held largely by our banks, but their foreign borrowing was really to meet the borrowing needs of their household and business customers.

Since the crisis, however, the household sector has ceased to be a net borrower and reverted to its more accustomed position as a net lender to other sectors of the economy.

The corporate sector (excluding the banks) is still a net borrower, but the mining companies in particular have funded a lot of their investment in new mining construction from retained earnings rather than borrowings.

Since the miners are largely foreign-owned, however, this use of retained earnings shows up in the balance of payments as an inflow of foreign equity.

This implies we've become less dependent on foreign borrowing to finance the current account deficit.

As part of this, our banks have been net repayers of their total foreign liabilities since mid-2010.

(The counterpart of this is that they've been getting a lot higher proportion of their funding from Australian household depositors, particularly through term deposits.)

One lesson from the financial crisis is that severe dislocations in foreign funding markets can impede the ability of even the most creditworthy borrowers (our banks, for instance) to obtain funds, even if only for a short time.

This helps explain our banks' subsequent move back to reliance on household deposits (made more possible by our households' changed saving behaviour, of course) and also their move to reduce their exposure to "rollover risk" (having trouble replacing a maturing debt with a new debt) by lengthening the average term of their foreign borrowers.

These days, 63 per cent of our foreign debt is more than a year from maturity, including almost a third with more than five years to run.

Finally, some people worry that, when we borrow in foreign currencies, a fall in our dollar would automatically increase the Australian-dollar amount of our debt. But Treasury points out, these days, almost two-thirds of our net foreign debt has been borrowed in Australian dollars.

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Talk to Centre for Public Christianity supporters’ lunch, Sydney,

Talk to Centre for Public Christianity supporters’ lunch, Sydney

I’m pleased to be here to talk to your supporters’ lunch today. Speaking as a fellow-traveller rather than a Christian, I think the centre does a valuable job in making public a much-need Christian perspective on contemporary developments, and one not limited to issues of sexual morality.

I want to talk to you about materialism, an issue that’s been of growing interest to me the longer I’ve stayed as an economic journalist. Of course, we’re all concerned with the material to a greater or lesser extent - and for good reason. The material dimension of our lives is important, indeed, inescapable. Even the monk who takes a vow of poverty must devote a part of each day to begging.

But I believe we live in an era of heightened materialism, one where a lot more of us give material concerns a much higher priority in our lives, to the point where it can be said many of us - perhaps even society in general - have made materialism our god. This is true not just of Australia, but throughout the developed world and much of developing world.

I believe I can see this trend developing throughout my own working life in the attitudes and values of the businesses I’ve work for - and with - and in the way things have changed at the Herald over my 40 years there. Business life has become more intensely competitive and, as has, become more overtly focused on money-making over other values.

But if you want more objective evidence of heightened materialism, it can be found, first, in the American Freshman Survey, which has polled the attitudes of students entering tertiary education throughout the United States since 1967. In that year, 42 per cent of freshers said it was very important to be ‘very well off financially’. By 2012, the proportion believing this reached a record high of 81 per cent. Over the same period, the proportion saying it was very important for them to ‘develop a meaningful philosophy of life’ fell from 86 per cent to 46 per cent.

I think we can find evidence of our growing materialism in the way we’ve chosen take the ever-rising productivity of our labour in the form of higher real wages - more money - rather than fewer working hours, thereby confounding the predictions of the futurologists who foresaw an ever-shorter working week. Part of the problem is that, increasingly, leisure activity has become professionalised and commercialised - something you buy, including ‘retail therapy’.

I think we can find evidence of growing materialism in our changed attitude towards bearing our fair share of the tax burden and being too proud to claim welfare benefits we’re too well off to need. These days a mini industry exists to help the comfortably retired hold their wealth in ways that don’t diminish their eligibility for the age pension.

I’m not sure what factor or factors initiated this heightening in materialism, but I am sure the rise of economic rationalism - micro-economic reform, neo-liberalism - in the early 80s has been both a cause and an effect of our growing materialism since then. Economists have been offering governments pretty much the same advice for decades, but perhaps the politicians became more receptive to that advice as a response to the electorate’s increased material aspirations. Economists specialise in the material, in studying the ways the community can advance its material aspirations. Generally speaking, the economists’ advice works - and, certainly, over the past 30 years our material standard of living (measured as real income per person) has risen quite strongly and our position on the developed-country league table of income per person has improved a lot.

But the trouble with economic rationalism is that it’s missionary and imperialistic. It provides a rationalisation for selfishness and tends to promote the material aspect of life as though it’s the only thing that matters, unconsciously cannibalising other aspects such as the social, cultural and spiritual.

The trouble with materialism - and with money in particular - is that it’s more powerful than other motivations, tending to crowd out those less ‘salient’ influences. A psychology experiment found that when you offer people a choice between a $80,000 a year job that’s boring and a $70,000 job that’s interesting, they opt predominantly for the higher-paid job. The experimenters say this is not because of simple materialism, but because our brains find it much easier to compare the two numbers than to imagine how much worse a boring job would be than an interesting one.

We tend to invest material, money-making activities with a greater sense of urgency than non-material activities. Almost everyone would say their family was the most important part of their lives, but usually there’s nothing urgent about our relationships. So if I see little of the family while I work this weekend, we can always make it up later. We don’t really believe it, but we end up acting as though working long hours to allow us to send our kids to a good school is more important than actually being available to our kids.

Reading the work of the CPX’s fellows makes me think the decline in Christian observance and values may offer much of the explanation for our era of heightened materialism and for its great success as a rival god. Dr Justine Toh’s fascinating interpretation of the Harry Potter books reminds me of the power of advertising and its false promise that buying stuff can give our lives the meaning and identity we feel they lack. There was a time when religious belief filled these needs.

Dr Gordon Menzies’ essay on the sexual revolution reminds me in passing that the standard economists’ model is built on an unstated assumption that to be well-functioning, the market system needs a set of social norms that guide and constrain the behaviour of agents in the market. When you deregulate the financial markets, the absence of those social norms - and maybe even deregulation’s destruction of them - means self-seeking triumphs over prudence and restraint, and you end up with the GFC.

But where do social norms of honesty, self-restraint and consideration for others come from? Well, for openers, try religious belief. My reading tells me that, predominantly, people get their notion of what’s acceptable, ethical behaviour from the attitudes and behaviour of those around them - much more so than from any inner, moral compass. You’d expect that, the weaker were Christian observance and values, the less likely it is that people’s moral compass keeps them - and all of us - out of trouble.

One of the strongest conclusions I’ve come to as an economic commentator is that the dominance of economists and economic values in the advice going to governments and in the public debate needs to be balanced by the voices of people with other, non-materialist perspectives on what’s important to our lives. This is why I think the work of the Centre for Public Christianity is so important and I’d like to see it become more influential.

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Political cycle of cynicism and naivety about to turn

They say oppositions don't win elections, governments lose them. If, as almost everyone expects, Prime Minister Julia Gillard loses the election in September, it will be a classic example of that phenomenon. Labor will be tossed not because Opposition Leader Tony Abbott's policies seem so much better but because too many of us have tired of this government's foibles and failings.

A telltale sign that a prime minister is on the skids is when nothing they say makes any difference, when the public has just stopped listening. We'd stopped listening to Paul Keating before the 1996 election and to John Howard before the 2007 election, and it seems pretty clear that we've stopped listening to Gillard.

But though this is the usual way government changes hands, it's hardly the ideal way. It means that in the months before the election, the opposition, the media and the electorate devote most attention to recounting the government's many failings, not reviewing the opposition's policies and plans.

This, of course, is just how oppositions like it. They make themselves into the smallest target possible in the hope they can slip into government with as few commitments and as little examination as possible.

And for the most part, they succeed, because we're preoccupied by our disaffection with the last lot.

Trouble is, our lack of diligence almost invariably sows the seeds of our eventual disaffection with the new lot. When we make up our mind to throw a government out, hope springs eternal that the new lot will be much better.

How do we know they'll be better? We don't really. Certainly, it's not a conclusion we reach after careful evaluation of their policies. It's just a naive hope that a new broom will sweep cleaner. That a new government with a new page won't blot it the way the last mob did.

But I've been around long enough to know the flip side of naivety is cynicism - the kind of cynicism we're seeing all around at present, the kind that causes people to stop listening and some to go into plague-on-both-your-houses mode.

The antidote to both naivety and cynicism is reasoned scepticism. And it's because we didn't exercise it from the start that we end up disillusioned and cynical. Scepticism determines what can be believed and what can't; cynicism comes to the lazy, impotent decision that nothing can be believed.

Because we don't put in enough effort to be continuously questioning, the cycle keeps repeating: having flipped to cynicism about the old lot, we flip to naivety about the new lot.

What feeds both naivety and cynicism is unrealistic expectations about what the new government will do and what any government could ever have the ability to do. As we speak, unrealistic expectations are building about an Abbott government. And that's true despite - and, indeed, partly because of - all Abbott's efforts to make himself a small target and make as few commitments as possible.

How? Well, first, by Abbott's probably successful effort to slip into government without much voter attention being paid to the unpopular cuts in government spending he knows he'll need to make after the election to pay for all his promises.

When voters discover the new government is doing things it didn't warn them were coming, they'll suffer their first bout of disillusionment.

And, second, by the opposition's unreasonable criticisms of the Gillard government's performance. It's become standard practice in Australian politics to blame governments for almost every bad thing that happens on their watch, including developments beyond their control.

This makes no sense but, since so many punters don't bother to think things through, it goes down well with your rusted-on supporters and the great unwashed. So in shadow treasurer Joe Hockey's reply to the budget last week he implicitly - but of course, not explicitly - blamed Labor because Treasury got its forecasts wrong, because the world economy keeps behaving unexpectedly and because Labor can't control the value of the Australian dollar.

Now, you may protest that both sides do this and it's long been regarded as acceptable behaviour. True. We can be sure that when Labor's back in opposition it will be returning the compliment, making the same unreasonable criticism of the Abbott government.

But that's my point. The way our pollies play the political game perpetuates the cycle of cynicism and the ever-declining credibility of their profession.

Abbott says the few commitments he's making are part of his determination to rebuild the trust of an electorate that feels alienated and disenfranchised.

Sorry, but that's what they all say - when they're in opposition. So far, it's not what they do in government, and I'll be surprised if the most successful scare-campaigner of our age turns out to be the first prime minister in living memory to get through three years of government without breaking any promises.

Hockey is promising a return to ''stable, predictable and honest government''. But how can you have stable and predictable government in an unstable and unpredictable global economy?

Honest Abbott's unqualified promise to Stop the Boats assumes there are no push-factors beyond our government's control, only pull-factors within its control. Sure. So what are the punters likely to think when, long after September 14, the boats don't stop coming?

I've got a better idea. Why don't the pollies on both sides Stop the Bulldust? And why don't the rest of us keep giving both sides a hard time until they do?

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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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