AUSTRALIA’S CONFLICTING MACRO POLICY

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

Economy doing better than many imagine

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

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

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

Resources boom has presented a succession of challenges

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

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

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

The tricky transition from mining-led growth

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

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

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

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

Fiscal policy

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

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

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

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

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

Monetary policy

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

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

Australia’s conflicting macro policy

At the time the macro managers responded to global financial crisis in late 2008 and the threat that our economy would be caught up in the Great Recession, both policy arms were moved to the same setting of ‘extremely stimulatory’. The cash rate was slashed from 7.25 pc to 3 pc. The automatic stabilisers moved the budget from surplus to deficit, to which the Rudd government added significant discretionary stimulus spending.

Once the emergency had passed and it became clear severe recession had been avoided, however, the managers began using the two arms to pursue different objectives. On fiscal policy, the temporary stimulus spending was allowed to finish, the government stuck to its deficit exit strategy and the automatic stabilisers were allowed to push the budget back towards surplus. The RBA quickly returned monetary policy to a neutral stance but, with inflation under control, from November 2011 it began easing policy to counter the high dollar and encourage growth in spending.

At the time of the 2012 budget the stance of fiscal policy was quite restrictive as the government sought to keep its election promise to return the budget to surplus in 2012-13, while the stance of monetary policy was expansionary.

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

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In the business game, less is often more

It's a holiday, so let's talk about sport not business - for openers, anyway. Indoor handball is a team sport where players face a constant stream of quick decisions about what to do with the ball: pass, shoot, lob or fake?

Players have to make these decisions in an instant. Would they make better decisions if they had more time and could analyse the situation in depth?

In an experiment with 85 young, skilled handball players, each stood in front of a screen, dressed in his uniform with a ball in his hand. On the screen, video scenes of high-level games were shown. Each scene was 10 seconds long, ending in a freeze-frame.

The players were asked to imagine they were the player with the ball and, when the scene was frozen, to say as quickly as possible the best action that came to mind.

After these intuitive judgments, the players were given more time to inspect the frozen scene carefully, and name as many additional options as they could. For instance, some discovered a player to the left or right they had overlooked, or noticed other details they weren't aware of under time pressure.

Finally, after 45 seconds they were asked to conclude what the best action would be. In about 40 per cent of cases this considered judgment was different from their first choice.

OK, that's enough fun. Back to business. We live in a business world where the thinking of educated people has been heavily influenced by rational analysis. For instance, one rational conclusion is that to make good decisions we need the best information possible. To be better informed is to perform better.

These days, all switched-on managers know they need an adequate business information system - the right "metrics" - to be fully informed about their business's performance and so be able to make the right decisions to keep it scoring goals.

To the rationally trained person, more information is always better and more options to choose from are always better. Economists add the qualification that information is often costly, so you shouldn't keep collecting it beyond the point where the additional cost exceeds the additional benefit.

Practical managers know there's a trade-off between speed and accuracy. It's good for decisions to be as accurate as possible, but it's also good for decisions to be made without much delay. So the smart manager finds a happy medium between accuracy and speed, knowing they're sacrificing some accuracy for a speedy decision.

Back to handball. This experiment was recounted by German psychologist Gerd Gigerenzer, of the Max Planck Institute in Berlin, in his book Gut Feelings. To measure the quality of the actions the players proposed, the experimenters got professional-league coaches to evaluate all proposed actions for each video.

They found that, contrary to the notion of a speed-accuracy trade-off, taking time and analysing didn't generate better choices. The players' gut reactions were, on average, better than the actions they chose after reflection.

Indeed, the order in which possible actions came to the players' minds directly reflected their quality: the best came to mind first, the worst came last. This result is consistent with many experiments showing that, though the inexperienced need to think it through carefully before they take a golf shot, drive a car, or tie their shoe laces, the experienced do better if they don't think about what they're doing but simply do what comes naturally.

This is consistent with another finding that chicken sexers, chess masters, professional baseball players, award-winning writers and composers are typically unable to explain how they do what they do.

In some circumstances, more information and more time to process it is better. But a surprising amount of the time less turns out to be more.

Gigerenzer says this will be so in cases where we're relying on unconscious motor skills. It's also true when the limits of our brain power mean we make better decisions if we don't confuse ourselves with too much conflicting information.

Our brains seem to have built-in mechanisms, such as forgetting a lot of things and starting small, that protect us from some of the dangers of possessing too much information.

A famous experiment involving selling different flavours of jam in a supermarket found that having too many choices leads to decision-making paralysis. Offering a choice of six led to more sales than a choice of 20. It doesn't follow, however, that offering an even smaller choice would increase sales further.

Gigerenzer's other conclusion - of particular relevance to business decision-making - is that empirical testing can reveal simple rules of thumb that predict complex phenomena as well or better than complex rules do.

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Economy yet to make transition to post-boom world

The economists' buzzword of the week - and probably the year - is "transition". If it's not in your lexicon add it immediately. You'll need it - because this week we learnt how tricky it's likely to be.

As the construction phase of the resources boom nears its peak, the economy needs to make a transition from mining-led growth to growth led by all the normal sources: consumer spending, home building and non-mining business investment.

This week the national accounts for the March quarter from the Bureau of Statistics showed growth in real gross domestic product of just 0.6 per cent for the quarter and 2.5 per cent for the year to March.

For once this seems a reasonably reliable reflection of how the economy's travelling. It's not disastrous, but nor is it satisfactory.

The economy needs to be growing at its medium-term trend rate of about 3 per cent a year. Growth of that order is needed just to hold unemployment constant. And since we've been falling short of it for about a year it's not surprising that, over the year to April, the unemployment rate has drifted from 5.1 per cent to 5.5 per cent.

(If you had it in your mind our trend growth rate was nearer 3.25 per cent, you're not wrong, just out of date. The econocrats have lowered it to 3 per cent to take account of the ageing of the baby boomers, which means a larger proportion of the population is now in an age range with lower participation in the labour force.)

The worrying thing about this week's figures is that they reveal the pressing need for a transition from mining-led to broader growth, but not much sign it's about to happen.

As best he can determine it, Kieran Davies, of Barclays bank, estimates mining investment spending fell about 7 per cent in quarter. Rather than rising, however, non-mining investment spending fell about 3 per cent.

At the same time, new home building (including alterations) was flat. Consumer spending strengthened to grow 0.6 per cent, but this was still below trend.

Public sector spending grew 1.1 per cent, but this followed a much bigger fall the previous quarter and with all the pressure on state and federal governments to balance their budgets, we shouldn't expect much help from the public sector.

According to the opposition, the Gillard government's been doing far too much to help.

It turned out a lot of the growth in the March quarter came from "net external demand". The volume (quantity) of our exports grew 1.1 per cent, whereas the volume of imports fell 3.5 per cent, meaning "net exports" (exports minus imports) made a positive contribution to growth of 1 percentage point.

Some silly people have been saying if it hadn't been for net exports the economy would be in a bad way - which is a bit like saying if we cut off one of our arms we'd be in a bad way. What they're missing is that the growth in export volumes will be lasting (they grew 8.1 per cent over the year to March) because it's coming from strong growth in exports of coal and iron ore, as new mines come into production and the third phase of the resources boom kicks in.

In other words, it's wrong to imagine the boom's about to leave us high and dry. Mining production and exports have a lot further to grow in coming years. Even the fall in imports (which constitutes a reduction in their negative contribution to growth) is linked to the boom: reduced investment in new mines means reduced imports of capital equipment.

As for the second, construction phase of the boom, spending from quarter to quarter is too variable to allow us to conclude this quarter's fall means the peak has been passed. Maybe, maybe not. Nor is it clear how precipitous the fall will be when it arrives. It may be fairly gentle since the miners' pipeline of committed projects still stands at a record high of $268 billion.

What reason is there to hope the non-mining sources of growth will strengthen? The main one is that the Reserve Bank has cut the official interest rate 1.5 percentage points in a little over a year, taking the "stance" of monetary policy to its most stimulatory in many a moon.

Everything we know tells us lower interest rates encourage borrowing and spending, particularly in interest-sensitive areas such as housing and the purchase of consumer durables. We also know it often takes a while to work. In my experience, it's just when people are running around saying it isn't working that it starts to.

Of course, a significant fall in the dollar would help a lot by improving the international price competitiveness of our export and import-competing industries, particularly manufacturing and tourism. It would help them produce more for export and replace imports in the domestic market. (So much for those who think it makes sense to assume away net exports.)

The dollar does seem to have fallen about US7? in the past few weeks. This may be some help, but it's far short of what would be justified by the deterioration in our terms of trade (the passing of the first phase of the boom) and what our traders need to restore their competitiveness.

The best hope for further falls in the exchange rate is not further cuts in our official interest rate (its role is widely overrated) but better prospects for the US economy leading to expectations of the cessation of "quantitative easing" (metaphorically, printing money), which has the side effect of putting downward pressure on the greenback. The Reserve has been cutting rates since November 2011, not to induce a fall in our dollar so much as to offset the contractionary effect of its failure to fall as export prices have fallen.

Should the dollar keep falling the Reserve won't cut rates any further. Should the dollar fail to keep falling, it probably will.

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LATEST DEVELOPMENTS IN THE ECONOMY AND MONETARY POLICY

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: the 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 staying 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.

Monetary policy: MP 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.

Since monetary policy is the primary instrument used by the managers of the economy, its history encapsulates their efforts to cope with the various stages through which the resources boom has passed and also with the GFC. We can divide the RBA’s management of monetary policy over the past decade into five distinct phases:

First, inflation worries. When it became clear after 2003 that we were entering a huge resources boom, the RBA worried that it might lead to a surge in inflation as many commodity price booms had in the past, with them often ending in policy-induced recessions as the authorities struggle to control inflation pressures. These worries were compounded by the RBA’s belief the economy was not far from full capacity, with the unemployment rate not far above the non-accelerating-inflation rate of unemployment (NAIRU) - our lowest sustainable rate of unemployment - thought to be about 5 pc. So the RBA progressively tightened monetary policy, lifting the cash rate to a very contractionary 7.25 pc by early 2008.

Second, the GFC. But with the financial crisis reaching a peak with the collapse of Lehman Brothers in September 2008, the RBA realised the inflation threat had evaporated and been replaced by the threat of our economy being sucked down into the Great Recession. It quickly slashed the cash rate, lowering it to a highly expansionary 3 pc by April 2009.

Third, resources boom resumes. By October that year, however, the RBA realised the emergency had passed, we’d avoided serious recession, the resources boom had resumed and the dollar had gone back up. It thus resumed its worries about inflation. It began tightening in steps of 0.25 percentage points. By November 2010 it had returned the cash rate to 4.75 pc, a level it considered to be just a fraction more restrictive than neutral.

Fourth, high dollar starts to bite. By November 2011, however, the RBA realised the inflation threat had passed. The economy was being hit by two conflicting external economic shocks. One, the positive shock of the resources boom, which had boosted real incomes and mining investment spending. And, two, the related negative shock of the high exchange rate, which was cutting import prices directly, but also reducing the international price competitiveness of our export and import-competing industries. This was reducing their production and squeezing their prices and profits. So the RBA began cutting the cash rate, lowering it to 2.75 pc, its lowest level in the history of the RBA. This makes the stance of policy highly stimulatory in order to offset the contractionary effect of the continuing high dollar.

Fifth, the transition to normal growth. With the terms of trade now deteriorating and the mining investment about to pass its peak, we need to make a transition from mining-led growth to growth led by its normal forces: consumption, housing and non-mining business investment. But this transition is being hindered by the continuing high dollar, which has not (or not yet) fallen in line with the decline in the term of trade. The longer it takes before the non-mining sector takes up the running, the more growth will fall below its 3 pc trend rate and unemployment will rise. A fall in the dollar will help ease the transition. Failing that, the RBA stands ready to cut the cash rate again and make monetary policy yet more stimulatory.

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We can be fairer and more efficient at the same time

Humans are a pattern-seeking animal but also a categorising animal. We're forever trying to get a handle on how the world works by sorting things into different boxes. When we can slap a label on something or someone, we think we've understood them.

It's fashionable among our business people to divide the world into "wealth creators" (them) and "wealth distributors" (everyone else but particularly governments). Wealth creators are the source of all prosperity; wealth distributors are essentially parasitic.

Economists' favourite boxes are similar, but not quite so crude. They divide policy objectives into "efficiency" (promoting economic growth) and "equity" (ensuring a reasonably fair distribution of the fruits of that growth).

For the most part, economists see efficiency and equity as in conflict. They care deeply about promoting efficiency but often leave it to others to worry about equity - unless they fear some equity measure would lead to inefficiency.

But sometimes our habitual ways of categorising things can be a hindrance to understanding and progress. Sometimes the labels on boxes don't adequately describe their contents, which can have more in common than we realise. Sometimes we "frame" problems in ways that conceal their solutions.

A new book, Inclusive Growth in Australia, proposes just such a new way of thinking about equity and efficiency. It's edited by Professor Paul Smyth, of Melbourne University and the Brotherhood of St Laurence, and Professor John Buchanan, of the workplace research centre at Sydney University.

A lot of economists and business people are worried about a fall in the rate at which the economy's productivity is improving. Productivity measures the efficiency with which we take inputs of land, labour and capital and turn them into outputs of goods and services. It normally improves by a per cent or two a year but it's been weak for about a decade.

It's our improving productivity - brought about by advances in technology, improvements in public infrastructure and a better educated and more skilled workforce - that causes our material standard of living to keep improving. It also helps to have a higher proportion of the population participating in the workforce.

To date, the deterioration in our productivity performance has been concealed by the resources boom, with its higher prices for our exports and hugely increased construction of new mines. But, the economists worry, now the boom is passing its peak, people will really feel the absence of ever-rising incomes.

So what's the Gillard government doing about it? Ignoring wealth creation and worrying about perfecting the way it's distributed. It's going to the election with two policy changes in pride of place: a disability insurance scheme and the Gonski changes to school funding.

All very worthy, no doubt, but talk about fiddling while Rome burns. But here's where the proponents of "inclusive growth" have a useful perspective. They say that far from being an irrelevance or an indulgence, social policy can, if you do it right, constitute an investment in improving the economy's performance.

As it happens, both the disability scheme and the Gonski reforms are good examples. Many physically and mentally disabled people - and their voluntary carers - would dearly love to make a greater contribution to the paid workforce, if they were enabled to.

And intervention to assist the disabled can be strategic: do it the right way at the right time and much subsequent expense - not to mention personal anguish - can be avoided. No more soft-headed authority than the Productivity Commission attests to the ability of the disability scheme to add to national income.

Similarly, it doesn't take too much thought to realise changing the basis for federal grants to public and private schools to one that gives more to schools with disadvantaged students can been seen either as a move to greater fairness - improving their equality of opportunity - or a move to greater efficiency.

We have no trouble seeing the benefit of doing more to assist the education and training of our brightest and best but much trouble realising the same applies at the bottom end. If, by giving them greater and more timely assistance, we could reduce the number of kids who drop out of school - or make it through with inadequate levels of literacy and numeracy - we'd be making them more productive workers.

The main lesson to be learnt from the league tables showing how our students' educational attainment compares with those in other countries is not that our best students aren't keeping up but that there's a widening gap between our best and our worst.

Another theme of the inclusive growth advocates is "flexicurity" - improving unemployment benefits and assistance to the jobless so as to reduce resistance to the unceasing change in the structure of our economy as the poor countries develop and the digital revolution proceeds.

I think the search for ways to kill two birds with one stone is a good one - just as long as it doesn't devolve into a miser-like attitude that economic efficiency is all that matters and we help people only to the extent we can see a buck in it.

We are - and will stay - a rich country. We can afford to educate ourselves well because to be educated is one of the joys of life, a benefit from being rich. And we should need no better reason for sharing our wealth fairly than that it's right thing to do.

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Garnaut cries from the economic wilderness

Professor Ross Garnaut, now at the University of Melbourne, is our most prophetic economist. In a much-discussed speech last week he prophesied that the easing of the resources boom would bring "hard times after more than two decades of extraordinary prosperity".

He says we face three big challenges if we're to avoid the end of the long boom leaving us with much to regret. The first is that our real exchange rate now needs to fall a long way to be consistent with full employment.

The second big challenge, he says, is to change entrenched expectations that living standards will rise inexorably over time; that household and business incomes and public services will rise and taxes will fall, as they have done for a generation.

"Those expectations must be reversed in the process of dealing with the legacy of the boom, or our efforts in reform will be defeated by bitter disappointment with political leadership and eventually political institutions," he says.

I think he's making two points. One is that economic life consists of downs as well as ups, losses as well as gains, and anyone who imagines governments should or even could shield them from all unpleasantness is destined for disillusionment. The need for income earners not to be compensated for the higher cost of imports caused by a fall in the dollar is a case in point.

The other point is we must disabuse ourselves of the notion economic life is about sitting around waiting for another serve of prosperity to be handed to us on a plate. Outside of resources booms, we have to make our own luck.

The third big challenge we face is that our political culture has changed since the reform era of 1983 to 2000, in ways that make it much more difficult to pursue policy reform in the broad public interest. "If we are to succeed, the political culture has to change again," he says.

Policy change in the public interest seems to have become more difficult over time as interest groups have become increasingly active and sophisticated in bringing financial weight to account in influencing policy decisions, he says.

"Interest groups have come to feel less inhibition about investment in politics in pursuit of private interests.

"For a long time ... it has been rare for private interests of any kind to be asked to accept private losses in the interests of improved national economic performance. When asked, the response has been ferocious partisan reaction rather than contributions to reasoned discussion of the public interest in change and in the status quo.

"A new ethos has developed in which there can be no losers from reform. Business has asserted a property right to continuing benefits of regulatory mistakes. It demands compensation for corrections to errors in policy.

"Households have been led to expect that no policy changes will cause any of them to be worse off."

Garnaut says that whether comprehensive public interest reform is possible depends a great deal on the quality of political leadership. Quality of leadership is partly about capacity to explain to citizens the nature of the choices that must be made on their behalf. He's no doubt right about the need for better leadership, but when the rest of us dwell on that lack it becomes a cop-out. It's actually a symptom of the very easy-prosperity syndrome Garnaut is warning about.

The Business Council in particular is prone to sitting around praying for God to send us leaders "prepared to lose their jobs to get things done". That's a quality as rare among politicians as it is among chief executives. If we wait for a policy suicide bomber we'll be waiting a while.

In truth, politicians are more followers than leaders. They deliver those changes being urged on them by what I'd call the nation's opinion leaders and Garnaut calls "a substantial independent centre of the national polity".

Pollies make risky reforms when they know these people have already done much educating of community power-holders on the necessity for the reforms in the public interest, and when they're confident the urgers will stand by them when the flak is flying. (The Business Council always finks out at that point.)

And Garnaut offers a further warning to those who, like the Business Council, dream of "reforms" that advance their private interests at the expense of the rest of us. Reform must be clearly in the public interest if certain groups are to be persuaded to cop losses for the greater good.

Finally, "it is a lesson of Australian history that successful periods of restraint require the equitable sharing of sacrifice". Developing a framework of equity will be important to the success of a choice by the nation to put the public interest ahead of business as usual.

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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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