Why the jobs will come, though we can't say where

Take the news that Toyota is joining Holden and Ford in ceasing to make cars in Australia, then add the news that unemployment is now the highest it has been in a decade and you see why everyone's asking the obvious question: where will the new jobs be coming from?

Bill Shorten has joined others in demanding to see the Abbott government's ''jobs plan''. If the government has no plan to ensure there are new jobs to replace the thousands being lost, particularly in manufacturing, what hope is there?

Sorry to be snippy, but although all this may be the obvious question, it's actually a stupid question. Has everyone suddenly turned socialist? Do they imagine we live in a planned economy?

It amazes me that people who spend their entire lives living in a market economy don't have a clue about how market economies work.

Well, let me give you one: market economies are driven by market forces, not governments.

I'm no libertarian and, these days, I'm a poor apology for an economic rationalist. I don't believe there's such a thing as a ''free market''. I believe market economies are the creation of government and that any government with half a brain knows its job is to provide guidelines for the market and ensure it doesn't run off the rails - as happened in the global financial crisis.

But, by the same token, it ought to be obvious that the vast majority of decisions made in a market economy are made by private sector producers and consumers, each acting in what they imagine to be their own interests.

In other words, the greatest single factor driving the economy forward is self-interest: business people trying to make a buck (and make more bucks than last year) and households spending about 90 per cent of their income, trying to get maximum satisfaction for their money.

Those silly people demanding to see the government's ''jobs plan'' and concluding that, unless it successfully pursues such a plan, few if any future jobs will be created, seem to assume the economy works like a glove puppet: unless the government sticks its hand in the puppet and moves it, nothing happens.

If you want to know in which particular industries or occupations the government plans to ensure new jobs are created - which winners the government has picked - the answer is: none. It's leaving the market to determine all that.

But it does have a ''jobs plan'' of sorts. It's a two-step plan. Step one: leave the primary responsibility for ensuring the economy keeps growing and creating jobs to the Reserve Bank. Step two: get started on ensuring we don't end up destroying jobs the way the Europeans and Americans have been by getting the budget back under control, while ensuring this ''fiscal consolidation'' doesn't weaken demand and so discourage employment in the next few years.

So what's the Reserve's ''jobs plan''? You ought to know. It's to encourage borrowing and spending on consumption and investment - and, in the process, counter the employment-dampening effect of our still-too-high exchange rate - by keeping interest rates at near-record lows. With any luck, our dollar will fall further as the US Federal Reserve phases out its policy of ''quantitative easing'' (creating money).

What makes our Reserve so confident doing this will, before too many months have passed, create lots of additional jobs and get the unemployment rate heading back down towards 5 per cent? Well, apart from orthodox economic theory, decades of experience. It's worked every other time, why won't it work now?

As for the government itself, there is more it could be doing to enhance the economy's job-generating capacity. One is to borrow as much as necessary to provide our businesses with adequate public infrastructure and ensure existing infrastructure is used efficiently through such things as appropriate pricing.

Another is to ensure our education and training system - from early childhood to postgraduate - is doing enough, and is effective enough, in raising the skills of our labour force. As part of this, the Gonski reforms are a good start towards increasing the employability of kids at the bottom end.

And, recognising the market failure that leads to inadequate private investment in research and development, making sure economy-wide government incentives are adequate and effective.

There may be a role for ''industry policy'', though I've yet to see programs that aren't just disguised protection of favoured industries, amounting to propping up losers rather than picking winners. Most ''innovation'' programs have been a sham.

I've spent my career being asked where the jobs will come from. It's something people ask after every severe recession. It's a symptom of the pessimism that grips the public mood at the bottom of the business cycle (in reaction to the equally unreal mood of optimism that drives booms).

It's a question I've never been able to answer. But having lived through three severe recessions my answer is now: ask me again in five years' time and I'll look up the figures and tell you precisely where they came from.

I'm supremely confident they'll come because we've never yet had a downturn from which we failed to recover, with total employment ending much higher than before the downturn.

Since the last recession, total employment is now 3.6 million jobs above its peak in June 1990, an increase of 45 per cent, with full-time jobs accounting for almost half the increase.

In terms of occupations, the biggest growth has been among managers, professionals and associate professionals, with the weakest growth in semi-skilled occupations.

I don't know where the jobs will come from this time, but I'll give you a hint: virtually all of them will be in the services sector.

How can I be so sure? That's where virtually all additional jobs have come from for the past 50 years.

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Why the end of car-making isn't such a terrible thing

One advantage of getting old is meant to be a greater sense of perspective. You've seen a lot of change over your lifetime and seeing a bit more doesn't convince you the world is coming to an end. Unfortunately, getting old can also leave you convinced every change is for the worst as the world goes to the dogs.

A lot of people have been disturbed by the news that Toyota's closure as a car maker in 2017 will bring an end to the manufacture of cars in Australia, with the loss of many jobs also in the parts industry.

But my guess is the most disturbed observers will be the old, not the young. I doubt if many young people had been hoping for a career in the car industry. And I know that few people - young or old - buy Australian-made cars.

That's not a cause for guilt, but for being sensible. To regret the passing of an industry whose products few of us wanted is just sentimentality, making no economic sense.

A lot of the dire predictions we're hearing won't come to pass. However many jobs the vested interests are claiming will be lost, they're almost certainly exaggerating.

That's particularly true of the alleged flow-on effects, which are often calculated on the assumption that any money which would have been spent buying the product in question will now not be spent on anything.

I've never believed car making was of special strategic significance to advanced technology. Every industry claims to be special. And I've heard the claim that this spells "the end of manufacturing in Australia" too many times in the past to believe it.

You think 35,000 is a huge number of jobs to be lost? It isn't. It's 0.3 per cent of all jobs, equivalent to about two months' net job creation in a normal year. You think this could put the economy into recession? We're overdue for another recession but this isn't nearly big enough to be the main cause of one. Even if it was, it wouldn't happen until 2017.

It's true some of the workers who lose their jobs won't be able to find alternative jobs, and some that do won't find jobs as well paid. But far more will find jobs than many of us imagine. Naturally, it's important for governments to give affected workers a lot of help to retrain and relocate.

Some people assume an imported car creates no jobs. Far from it. Are you able to buy an imported car for anything like the price at which it crosses our docks? Of course not. Most of the gap between the landed price and the retail price goes on creating jobs for Australian workers in our extensive car-distribution industry.

The fact is the sale, fuelling, servicing and repair of cars has always involved far more jobs than the making of cars and car parts has.

I've been responding to people's fears about the decline in manufacturing for almost as long as I've been a journalist because manufacturing's share of total employment began declining well before I joined Fairfax in 1974.

The truth is the industrial structure of our economy has been changing slowly but continuously since the First Fleet. A lot of angst has been generated over that time but the fact remains we're infinitely more prosperous today than we were then - with a much higher proportion of the population in the paid workforce.

The changing mix of industries is actually a primary cause of our greater affluence. Countries that try to prevent their industry structure changing are the ones that stop getting richer.

To put the latest developments into context, let me show you the bigger picture of Australia's economic history, drawing on a Reserve Bank article. Throughout much of the 19th century, agriculture accounted for about a third of the nation's total production, with mining bigger than manufacturing.

By Federation, agriculture provided about 25 per cent of total employment, with manufacturing providing 15 per cent and mining about 8 per cent. By the 1950s, however, manufacturing had grown to 25 per cent, agriculture was falling towards 10 per cent and mining was down to 1 per cent.

So as the shares of agriculture and mining declined, manufacturing's rose. But from the 1960s, manufacturing's share of total employment started falling from its peak of about 25 per cent to be down to about 8 per cent today.

Remember, however, that an industry's declining share of the total doesn't necessarily mean it's getting smaller in absolute size. Although today agriculture accounts for only about 3 per cent of the total, the quantity of rural goods we produce has never been higher. And manufacturing's output began falling only in recent years.

So an industry's share falls mainly because other industries are growing faster. And, with the exception of mining, the sector that has provided virtually all the growth is services. It accounted for half our jobs even in the 19th century, but from the 1950s its share took off, rising sharply to about 85 per cent today. Most of the growth has been in health, education and a multitude of "business services".

Many older people find the relative decline of manufacturing disturbing but I can't see why. Services sector jobs tend to be cleaner, safer, more skilled, more value-adding, more satisfying and better paid.

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We need a wage problem, so let's imagine one

It's been two decades since we had reason to worry about excessive wage growth. This remains true despite cabinet ministers and some economists saying we have a problem.

The structural reason we don't have to worry is the continuing effect of the Hawke-Keating government's micro-economic reforms - particularly the floating of the dollar, the removal of protection against imports, deregulation of many industries and the move from central wage-fixing to bargaining at the enterprise level - in making the economy far less inflation prone, as well as more flexible in responding to economic shocks.

Micro reform failed to deliver the expected lasting rise in the rate of productivity improvement, but it did deliver the unheralded benefit of making the macro-economy much easier to manage. You would expect people who profess to care so much about reform to know this.

Starting with the cabinet ministers, it's understandable that a conservative government that made a solemn promise to make no significant changes to industrial relations law in its first term would want to camouflage its lack of pro-employer militancy by turning up the volume on its anti-union rhetoric.

That the union movement is a shadow of its former self is no impediment to the gratification it gives the Liberals (and the national dailies) to portray the unions as the economy's great bogeyman.

Trouble is, the ministers don't seem to have looked at the stats lately. As the Reserve Bank summarised the story on Friday: "Various measures of wage growth are now around the lowest they have been over the past decade or longer."

Since the economy has been growing at below trend, with slowly rising unemployment, for quite a few quarters, this is hardly surprising.

More worthy of serious discussion is the argument of Professor Ross Garnaut and others that, if the economy is to gain lasting stimulus from the belated fall in the dollar, it will need to be accompanied by a fall in real wages.

It is true that a fall in the dollar leads to a rise in the prices of internationally tradeable goods and services.
It is also true that the fall in the nominal exchange rate has to be accompanied by a fall in the real exchange rate (the nominal rate adjusted for our inflation rate relative to those of our trading partners) if it is to cause a lasting improvement in the price competitiveness of our trade-exposed industries.

What doesn't follow is that the real exchange rate can fall only if real wages fall. For a start, it doesn't require wages to grow no faster than the inflation rate for that rate to be unchanged.

All that's need is for wages to grow no faster than the inflation rate plus the trend rate of improvement in the productivity of labour (often taken to be 1.5 per cent a year).

Thus are the benefits of productivity improvement spread around the economy in the form of rising real wages (and, thanks to indexation, rising real pensions) without adding to inflation. As it loved reminding us, this is just what happened throughout the Howard government's term.

It follows that real wages would need to fall only to the extent that the increase in inflation caused by the fall in the dollar exceeded the trend rate of productivity improvement. (Of course, the need for slower wage growth would also be reduced to the extent that our trading partners' inflation rate happened to be higher than ours.)

Let's do some figuring. The Reserve's rule of thumb is that a 10 per cent fall in the dollar adds between 0.25 and 0.5 percentage points to the annual inflation rate over each of the following two years or so.

Since its peak last April, the Aussie has fallen by about 15 per cent against the US dollar. But it's misleading to focus on temporary peaks, so a more representative fall would be less than 14 per cent. And we really should use the fall against the more economy-wide trade-weighted index, which reduces the depreciation to about 11 per cent.

There may be a fair bit more to come, of course, but so far we don't have a lot to worry about. There's no sign we need a fall in real wages, just lower-than-normal real growth.

And if you take the danger level of economy-wide nominal wage growth to be 4 per cent (that is, the inflation-target mid-point of 2.5 per cent plus trend labour productivity improvement of 1.5 per cent), we're looking very restrained.

The wage-price index never got out of hand even at the height of the resources boom, and by September its annual rate of increase had slowed to a terrifying 2.7 per cent. Not.

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Top 10 economic reforms that transformed Australia

1. Floating the dollar
Letting the market set the value of the Aussie dollar after December 1983 allowed it to fluctuate between US48c and $US1.10 so far, making it an absorber of shocks from the rest of the world. This has made the economy more stable and stopped the resources boom causing an inflation blowout.

2. Deregulating the banks
Introducing foreign banks and allowing banks to set their own interest rates made it much easier to get a loan and increased competition between banks and other lenders, but led to excessive lending to businesses and caused the deep recession of the early 1990s.

3. New taxes on capital gains and fringe benefits
In October 1985 Paul Keating announced new taxes but cut the top income-tax rate from 60 per cent to 49 per cent. He also abolished negative gearing, but reversed this under pressure from estate agents.

4. Removing import protection
In May 1988 Keating announced the virtual phasing out of the import duties and quotas imposed on most manufactured goods. Predicted demise of manufacturing industry did not materialise.

5. Privatising government businesses
Sale of the Commonwealth Bank began in 1991 and Qantas in 1992. The Howard government sold Telstra in three tranches from 1997. State governments sold their banks, insurance companies and some power producers and distributors.

6. Enterprise bargaining
In 1993 the Keating government ended centralised wage-fixing through a "national wage case" and introduced collective bargaining at the enterprise level. In 2005, Work Choices sought to promote individual contracts by reducing worker protections, further encumber unions and end reliance on industrial rewards. The Rudd government reversed the most extreme parts of Work Choices, but left much of it in force.

7. National competition policy
In 1995 Keating sought to encourage deregulation and privatisation by state governments and tighten the Trade Practices Act's restrictions on anti-competitive behaviour. Premiers tended to drag their feet.

8. Central Bank independence
In 1996 Peter Costello allowed the Reserve Bank to make its decisions independent of the elected government, endorsing its target of holding inflation between 2 per cent and 3 per cent, on average. The Reserve has raised interest rates more than a politician would - including during the 2007 election campaign - but this has kept inflation under tighter control than when politicians were in charge.

9. Goods and services tax
The start of the GST in 2000 came 25 years after it had been proposed by a major inquiry. It replaced wholesale sales tax and various unconstitutional or inefficient state taxes. Much death and destruction were predicted; little eventuated. But now GST is showing signs of wear and needs renovation.

10. Taxes on mining and carbon
Wayne Swan planned to raise huge sums from taxing miners' high profits and use the proceeds to give tax cuts and concessions to business and individual savers. He also used a tax to impose a price on carbon dioxide emissions. Both reforms were badly mishandled and Tony Abbott has pledged to reverse these reforms.

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Our three top treasurers in 40 years

In the 40 years I've now been an economic journalist for Fairfax Media I've given 12 federal treasurers the benefit of my free advice. I doubt it has made much difference, but I do know this: despite all you read in the paper, our economy is now far better managed than it used to be.

For this I give most of the political credit to just three of them: Paul Keating, by a country mile, Peter Costello and one you won't believe: Wayne Swan.

That the economy is now far better managed is easily proved. We went from boom to recession in my first year, 1974, back into a severe recession in 1982 under treasurer John Howard, and then again in 1990 with Keating's "recession we had to have".

Each was worse than the one before and each was correctly labelled "the worst recession since the Great Depression". I formed the view that recessions happened about every eight years.

But as Paul Bloxham, of the HSBC bank, has reminded us, Australia is now in its 23rd year of continuous economic growth. Must be doing something right.

To have achieved such an unprecedented gap since the last severe recession we had to escape the Asian financial crisis of 1997-98, the US "tech-wreck" recession of the early 2000s and the Great Recession that followed the global financial crisis in 2008 - and still isn't really over.

Reckon that was all down to good luck?

We owe it at least as much to good management. I know because I remember the roller-coaster ride the economy was on before the econocrats got it back under control.

Wages rising 25 per cent in a year and inflation hitting more than 17 per cent under the Whitlam government; inflation back up to 12 per cent under treasurer Howard and unemployment peaking above 10 per cent after his recession; mortgage interest rates hitting 17 per cent and unemployment peaking at 11 per cent in Keating's recession.

Turns out the present growth period accounts for just over half my 40 years. And of my 12 treasurers, Keating, Costello and Swan were in office for well over half.

Keating is our best treasurer by far because he instigated the sweeping reforms that transformed the economy and laid the groundwork for better day-to-day management of it. He made the economy less inflation-prone and more flexible, thus able to reduce unemployment faster.

Costello's greatest achievement was to free the Reserve Bank to change interest rates as it saw necessary, meaning the economy is now managed more by econocrats than politicians. He also ensured our banks were tightly supervised while the Americans were letting theirs create so much havoc.

Swan deserves a spot on the treasurers' honour board purely for his surprisingly deft handling of stimulus spending and human confidence after the GFC, ensuring we suffered only the mildest of recessions.

Aided by some in the media, his political opponents have had great success in rewriting that recent history. But later historians won't be deceived.

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A short history of the economy

To me it doesn't seem all that long ago, but looking back I have to admit the economy has changed hugely since my first day as an over-age cadet journalist on February 7, 1974. Some things are worse, but a lot are better.

What strikes me most, however, is the roller-coaster ride we have been on to get from then to now.

In those days, just eight years after we moved from pounds, shillings and pence, TV was still black and white and my new employer had a five-digit phone number. Gough Whitlam was prime minister and Billy Snedden was opposition leader.

An ambitious young suburban solicitor named Howard was preparing to take a seat in Parliament at the election to be held three months later. (Outlasted you, John.)

As a cadet I earned about $100 a week, a big comedown from my former pay as a chartered accountant, but a lot better than the $45.50 a week paid to married pensioners. It would take me some years to get up to the top tax rate of 66.7 per cent, which cut in at $40,000 a year.

Child endowment was 50c a week for the first kid and $1 for the second.

The standard interest rate paid on passbook savings accounts of 3.75 per cent doesn't look too bad today, and the mortgage interest rate of 8.4 per cent probably isn't as low as you expected. But remember that the inflation rate was 14 per cent.

A few years after I joined Fairfax we bought a not-so "ideal first home" in the inner city for $27,000. Its value would have increased at least 20-fold since then. Incomes have also increased a lot, of course, there are a lot more two-income families, and even established houses get ever bigger and better. But, even allowing for all that, we have bid up the prices of houses and units relative to other things.

The rate of unemployment was 2.4 per cent in 1974, which was up from 1.8 per cent the previous year and so considered high. It would hit 4.6 per cent by the time the Whitlam government was dismissed in November 1975.

Almost two-thirds of the labour force was male and only one worker in eight was part-time. Today women account for a bit less than half the labour force and almost one worker in three is part-time. The number of people in jobs has almost doubled to 11.6 million.

These days, a higher proportion of students stay on to year 12 and a high proportion go on to uni. Biggest difference: females have a higher rate of "educational attainment" than males.

Then, almost one in four workers worked in manufacturing (which in those days included John Fairfax Limited, manufacturer of newspapers) whereas today it's about one in 12.

The big jobs growth has been in health, education and all manner of "business services". The fastest-growing occupations have been managers, professionals and associate professionals. Beats blue-collar work.

The value of the Australian dollar was fixed at $US1.49 but, in those days before the advent of the jumbo jet, overseas travel was much more expensive, relative to other things, than it is today.

Forty years ago imports accounted for 13 per cent of the value of all we bought. Today it's more than 21 per cent. But then we exported less than 13 per cent of all we produced, whereas today it's almost 21 per cent.

Thanks particularly to the efforts of Paul Keating and Bob Hawke, our economy is these days a lot more open to the rest of the world. Less of our trade is with America and Europe and a lot more is with Asia - China, Japan, South Korea and India.

When I started my economy-watching, the value of all the goods and services Australia produced in a year was $54 billion. Today it's more than $1.5 trillion. But don't forget consumer prices have increased by 700 per cent since then and the population has gone from less than 14 million to more than 23 million.

Even so, Australia's real income per person has almost doubled, so there's no doubting we are far better off materially.

What price we have paid for this in strained relationships, stress and mental ill-health, greater inequality and damage to the environment is another matter - one we prefer not to think about and put too little effort into measuring.

From the viewpoint of economic news, the timing of my arrival at Fairfax was perfect. In 1974 the postwar Golden Age of low inflation and full employment throughout the developed world came to an abrupt end.
It was ushered out by the first OPEC oil price shock, which hit in late 1973, and the advent of an ugly word to describe a new and ugly state of affairs - stagflation, the combination of high inflation with high unemployment.

It was a turning point in the history of the world economy and the Whitlam government had no idea what hit it. It was undeterred in its efforts to correct 23 years of perceived Liberal backwardness within a three-year term.

But it wasn't just the politicians who didn't get it. It took the world's economists at least a decade to work out why things had gone wrong and how economies should be managed so as to keep both inflation and unemployment low.

It took the rich world's governments even longer to get their economies back in working order and it took longest in Australia, mainly because of the Whitlam government's excesses, which took longer to work off.

When I arrived at Fairfax the economy was booming, with wages set to rise by 25 per cent in a year and prices headed for an inflation rate of 17.7 per cent.

But before the year was out the economy was contracting thanks to a Treasury-inspired "short, sharp shock". Despite Dr Jim Cairns' frantic efforts to revive it, the Whitlam recession had begun.

Malcolm Fraser happily echoed all the "smaller government" rhetoric coming from Maggie Thatcher and Ronald Reagan, but didn't really believe it. He thought it was just a case of not doing the things Whitlam had done and everything would get back to the way it had been before the arrival of the interlopers.

It didn't. He dismantled Medibank because it annoyed the doctors so much, but couldn't bring himself to cut government spending hard. Unlike his treasurer, Howard, he was no economic rationalist.

The economy did pick up a bit. The inflation rate fell, but by September 1982 it was back up to 12 per cent. There was talk of a mining boom, but instead we got the severe recession of the early 1980s, with unemployment reaching a peak of 10.3 per cent just a month or two after the election of the Hawke government.

Hawke's timing was perfect. The drought broke and the recession ended within months of his ascension. He used his Accord with the union movement to cut real wages and the result was very strong growth in employment.

The election of March 1983 gave voters no indication that Labor's treasurer, Keating, was about to completely remodel the economy - though, as Keating reminded the ABC's Kerry O'Brien recently, he did spell out his intentions in an interview with me within a few weeks of taking the job.

Labor floated the dollar, deregulated the banks, reformed the tax system, largely removed protection against imports, privatised most federal government-owned businesses, ended centralised wage-fixing and moved to enterprise bargaining.

It was most un-Labor-like behaviour and many supporters hated it. But with their new-found freedom the banks went crazy with their lending to business, the economy boomed and unemployment got to a brief low of 5.9 per cent in late 1989, which was when the government's frantic efforts to slow the economy took mortgage interest rates to 17 per cent.

The result was the severe recession of the early 1990s, in which unemployment peaked at 11 per cent in the first half of 1992. Because so many businesses had borrowed so much to buy assets now worth a lot less than they had paid, the recession was particularly protracted and the recovery painfully slow.

After Dr John Hewson muffed things, Howard was perfectly placed in 1996 to benefit from all Keating's economic reforms as well as the "recession we [didn't] have to have". Inflation got back under control late in Keating's term, but Howard didn't get unemployment back under 6 per cent until late 2003.

He made few further reforms apart from granting policy independence to the Reserve Bank, introducing the Goods and Services Tax and over-reaching on industrial relations.

Peter Costello steered the ship steadily until the revenue flooding in from the resources boom led him to go crazy with tax cuts and unsustainable superannuation concessions, thus laying the foundations for the present chronic budget problems now being blamed solely on Kevin Rudd and Julia Gillard.

Their failings are too recent to need repeating, but already we've forgotten Labor's greatest macro-economic achievement: limiting the fallout from the global financial crisis to a mild downturn. Anyone could have done it? Don't believe it.

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How my views have changed over 40 years

They say if you still believe at 50 what you believed when you were 15, you haven't lived. Just this week I've now worked at Fairfax Media as an economics journalist for 40 years. Those ages don't quite fit, but my views today are certainly very different from what they were when I started.

When, disillusioned with life as a chartered accountant, I began at Fairfax, most of my effort went into relearning the economics I was supposed to have learnt at university. There it didn't make much sense to me and I had trouble remembering enough of it to pass exams. Once passed, it was promptly forgotten.

A lot of my re-education came at the hands of the nation's most high-powered econocrats, who are remarkably generous with the telephone tutorials they're willing to give journos who seem genuine.

So at first most of my effort went into mastering and then propagating economic orthodoxy. I still see it as an important part of my job to help readers understand what it is that leads economists to do and say the things they do.

Newspaper economics tends to be pretty basic. Doing the job year after year is like answering the eternal year 12 economics essay question: "From your knowledge of economic theory, comment on ..." Joe Hockey's budget preparations, cabinet's decision not to give SPC Ardmona a $25 million subsidy, the government's inquiry into the financial system.

But one ambition has been to introduce something a little more sophisticated, to lift the level of analysis from introductory to intermediate. To this end I've devoted a fair bit of my free time to reading the latest books about developments in economics and, increasingly, psychology.

Though Australian academic economists write books that seem intended to impress by being incomprehensible, leading American academics write (carefully footnoted) books that explain their findings to the average intelligent person. Sometimes they even make the best-seller lists.

I've been looking for stuff that would interest readers, but also trying to deepen - and broaden - my understanding of the topic. It's this broadening that's done most to change my views about economics and how I should do my job.

Economics is the study of "the daily business of life" - earning money and spending it, buying and selling assets such as homes and shares, borrowing to finance the purchase of assets and saving to repay debts. Macro-economics is the study of how whole economies work and how governments can "manage" them, seeking to limit inflation and unemployment and promote growth.

So, contrary to my conclusions at uni, economics has a lot of practical application. There's always plenty of interest in the topic and plenty of coverage in the media.

But as I've got older and read more widely I've realised that, if anything, we tend to take economics too seriously. It deals only with the material side of life - getting and spending - and in this more materialist age we run a great risk of focusing excessively on getting and spending at the expense of other, equally important aspects of our lives. I've concluded there's more to life than economics.

Our heightened materialism means we take economists far more seriously today than we did 40 years ago. Their message is that we're not trying hard enough: not doing enough to change ("reform") our economic arrangements to foster faster growth in the economy and hence a more rapidly increasing material standard of living.

But I've concluded economists suffer from the same failing as other specialists. In their enthusiasm for their topic they want to take over your life. The economists' union wants to make becoming more prosperous the nation's central objective. And these guys urge us on with little thought about what trying harder and doing more may imply for the other dimensions of our lives.

You and I know most of the satisfaction in our lives comes from our personal relationships. But relationships aren't part of the economists' model, so they urge particular "reforms" without any thought about the implications for our relationships. Politicians act on their advice without such thought, either.

So, to borrow a cliche, economists need to be kept on tap but not on top. These days I try to explain the rationale for economic policies - what they're trying to achieve and how they're supposed to work - but also play the role of a sort of economics theatre critic, adding a critique of economics, economic policies and economists.

I've learnt there's little correlation between being a successful business person and having a good understanding of economics. They seize on an argument that seems to support the line they're pushing. Whether it's logical they seem not to know or care.

Economists study and advocate efficiency in the way we combine economic resources - land, labour and capital - to produce goods and services. This is supposed to maximise material prosperity. The position I've come to is that we should strive for efficiency unless we've got a good enough reason to be inefficient.

For instance, it's inefficient to have government rules specifying minimum levels of local content on television. It would be much cheaper to buy not just most but all our TV programs from America. But I agree it's better to force our TV channels to produce a bit of Aussie drama. Culture matters.

Even so, knowing where to draw the line on inefficiency ain't easy. It's too short-sighted to expect that those industries, interest groups or regions that have managed to extract assistance from government in the past retain their privileges forever, or that industries adversely affected by overseas developments be given ever-growing government assistance so nothing needs to change and all pain is avoided.

Life's a bit tougher than that. Change is unrelenting. It's our continuously changing circumstances - and, I hope, our improving understanding of how to respond to challenges - that keeps me going.

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Hockey faces daunting budget challenge

In shaping this year's budget - their most important macro-economic task for the year - Tony Abbott and Joe Hockey face a dilemma: the timing for a particularly tough budget may be right politically, but it's anything but right economically.

It's clear they intend to follow the example of John Howard and Paul Keating by using the first budget after their election to have an almighty cleanout and strike a lasting blow for fiscal sustainability.

A lot of this simply involves replacing policies favouring your predecessors' heartland supporters with those favouring your own supporters - that is, making room for your election promises - but it has to go further and achieve a significant net improvement in the "structural" budget balance (the balance we would have if this were a normal year in the business cycle).

The first budget after a government's election is the one where it can take unpopular measures with greatest political impunity. You blame it all on the incompetence of your predecessors, and you give voters the maximum time to forgive and forget before the next election.

Fine. But the economy is so fragile at present, and its transition from mining-led to non-mining-led growth so tentative and uncertain, that Hockey would be crazy to produce a budget that cut the deficit significantly in the coming financial year or even the one after.

You can't be forecasting growth as weak as 2.5 per cent, with slowly worsening unemployment this year and next - implying below-trend growth for three years in a row - and also be tightening fiscal policy. After all, the Labor government's eminently worthy "deficit exit strategy" (which it only pretended to stick to) kicked in only "once the economy returns to above-trend growth".

The sad truth is the economy's prospects are so uncertain - and the fall-off in mining construction spending so unpredictable - that Hockey must not only avoid doing anything that adds to the weakness, but also stand ready to inject emergency fiscal stimulus the moment it becomes clear a collapse in mining investment threatens to push us into overall contraction.

The point is that, while it's undeniable we need to return the budget to cyclical surplus (and structural balance), this shouldn't happen - and, thanks to our still low level of public debt, doesn't need to happen - with any urgency.

So, how should Hockey resolve this contradiction between smart politics and responsible macro-management and avoid the charge that he's descended to a counter-productive policy of "austerity"?

One solution would be to announce all the tough measures in May, and get them through Parliament, but time them to start only slowly, then build up rapidly in the "out years" - by which time, we presume, the economy will have returned to healthy growth.

An alternative, but riskier approach would be to press on with the deficit-reducing measures, but offset their contractionary effect by embarking on a big new program of spending on infrastructure. This makes the point federal governments have hitherto ignored in their rhetoric: it's only the recurrent (or operating) budget that needs to be balanced over the cycle.

It's perfectly responsible for capital works spending to be financed partly by borrowing - thereby requiring future generations to contribute to the cost of the long-lasting infrastructure they benefit from - provided the projects aren't wasteful but yield a high social return.

Another worry is Hockey's statement before Christmas that his budget-repair measures would be limited to cuts in government spending, which was reinforced by Abbott's homily at Davos praising smaller government and lower taxes.

As John Daley of the Grattan Institute has noted, there's no precedent for successful fiscal consolidation here or elsewhere that didn't involve both spending cuts and tax increases.

The plain fact is that, though there's much scope for spending cuts - reduced business welfare, including subsidies to chemists, inefficient arrangements with fee-for-service doctors, home-made submarines, excessively generous grants to well-off private schools and so on - no remotely plausible list of spending cuts would be sufficient to achieve fiscal sustainability.

This is mainly because the greatest single contributor to Treasury's projections of unending budget deficits is the inexorable real growth in spending on healthcare. Any pollie who imagines they could do any more than temporarily slow that growth, or cover its cost by never-ending cuts in other areas of spending, is an ideologically crazed fool.

The other problem is that for many years much "spending" by governments has taken the form of tax exemptions, rebates and other concessions. Unless Hockey and Abbott's definition of spending cuts includes cuts in "tax expenditures" I can tell you now their efforts will fall far short.

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Outlook for the economy: short-term and long

A lot of people believe Tony Abbott and Joe Hockey begin their first full year in office facing a daunting economic challenge, even a crisis. But what is the nature of the challenge? How daunting is it, and how pressing?

Well, let's analyse it - and do so using some of the standard distinctions economists use to get their heads around a problem.

People see the government as having a problem with the economy and with its budget. To the casual observer, the economy and the budget seem pretty much the same thing. But, though the two are obviously interrelated, economists draw a clear distinction between them.

The government's budget (its spending and revenue-raising) has an effect on the economy (the whole nation's production and consumption of goods and services, income-earning and spending) and, equally important, the much-bigger economy has an effect on the government's budget.

But we'll get a clearer picture of what's happening if we deal with the two separately. Let's focus on the economy and leave the budget for another day. (Don't worry, you'll hear a lot more about the budget in coming weeks.)

And in thinking about the economy, let's use the economists' trick of distinguishing between cyclical and structural factors. Cyclical factors are those temporary influences that are causing the economy to speed up or slow down at present and over the coming year or two.

Structural factors are those that operate underneath the cyclical factors, affecting the economy less dramatically at any particular moment, but having a much longer-lasting and hence more important influence in changing its shape.

Starting with the cyclical outlook, it isn't too hot. The economy's production of goods and services (real gross domestic product) grows at an average rate of about 3 per cent a year, sufficient to keep the rate of unemployment steady and inflation within the Reserve Bank's 2 per cent to 3 per cent target range.

But we've been growing more slowly than 3 per cent for the past few years, and Treasury's expecting growth to slow to just 2.5 per cent this financial year and next, 2014-15. The recent slow growth explains why unemployment has been creeping up - to 5.8 per cent on the latest reading - but inflation hasn't been a worry.
The forecast of continued weak growth implies unemployment will continue creeping up - to 6.25 per cent by June next year - but inflation will stay controlled.

The reasons for the past and coming slow growth are well known: the end of the resources boom's investment phase and the high dollar the boom brought with it. Most growth was coming from mining construction, with the rest of the economy pretty subdued, but now mining construction is expected to fall off rapidly, with the rest of the economy only slowly getting back on its feet to take up the slack.

We've already done what we need to get the economy growing faster: the Reserve Bank has cut interest rates to historic lows, and the dollar has fallen by about 16 per cent (partly because the Reserve has been talking it down). Now we're waiting to see how long it will take for the medicine to work.

Remember that primary responsibility for managing the macro-economy rests with the Reserve Bank, not the elected government. Hockey's main job is to make sure the budget doesn't add to the present weakness, but also stand ready to apply emergency fiscal stimulus should mining construction spending unexpectedly collapse at some point.

So the economy's short-term, cyclical position isn't wonderful, but there's isn't a lot more we can or need to do. Leaving aside the inevitability that one day our record period of expansion since the last severe recession will have to end, the economy's longer-term, structural position is vaguely similar: it's not as dire as some imagine but, as usual, there's plenty of room for improvement.

While Labor was in power, it suited some business lobby groups to claim our rate of improvement in productivity (output per unit of input) had stalled. Surprisingly, the answer was always for the government to give them the rent-seeking privileges they wanted.

The truth is less apocalyptic. It's true we had an uncharacteristically strong burst of productivity improvement in the second half of the 1990s, but then weak to non-existent improvement through much of the noughties. Since then, however, productivity has been improving at a rate that's OK but hardly wonderful. Analysis of our formerly weak performance suggests much of it was explained by one-off factors and measurement problems.

But in Treasury's periodic intergenerational reports, it has consistently projected slowing in our long-term rate of growth in real GDP. Most recently, in 2010, it projected that the annual rate of growth in GDP per person would slow from 1.9 per cent over the previous 40 years to 1.5 per cent over the coming 40.

This may not sound disastrous - and to me it isn't - but to our deeply materialist economists and business people it is. So note that half the decline is explained by a fall in the proportion of the population participating in the labour force as the baby boomers retire and the population ages.

This can be predicted reasonably confidently, but the other half is explained merely by Treasury's assumption that our 40-year average rate of improvement in the productivity of labour will fall from 1.8 per cent to 1.6 per cent a year.

Plenty of economists around the world share Treasury's fear that productivity improvement will be slower in coming years. And this probably wouldn't take anything like 40 years to become apparent.

So for the Abbott government and those who share its professed commitment to maintaining strongly rising material affluence (and don't worry about little annoyances such as the survival of the planet), there is a reason to pursue reforms that improve labour force participation and labour productivity.

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Why health spending is sustainable and will be sustained

If you had a problem that required an operation and the doctor offered a procedure with a 90 per cent success rate or one with a 10 per cent failure rate, which would you pick? Most people say they prefer the one with the high success rate but, of course, they're equally risky. Point is, we can react quite differently to the same information depending on how it has been "framed", as the psychologists say.

When politicians engage in "spin" they're framing a problem or a solution in a way they hope will maximise the public's sympathy, a way that highlights those aspects the pollies want to draw attention to and draws attention away from aspects they don't want us to think about.

As Tony Abbott and Joe Hockey soften us up for an especially tough budget in May, we'll be subjected to much spin. Already the idea of imposing a $6 patient co-payment on GP visits has been floated, to which federal Health Minister Peter Dutton added the comment that the growth in the cost of Medicare was "unsustainable".

Spending on healthcare is highly germane to Treasury's projections that, if no changes are made to policies, the federal budget is likely to stay in annual deficit for the next 10, even 40 years.

But let me frame the projected growth in spending on healthcare in a way you won't hear from the pollies. It's a safe prediction that the real incomes of workers and households will continue growing by a per cent or two each year in the coming 10 or 40 years, just as they have in the past 40.

So, as each year passes our incomes will grow a little faster than the prices we're paying for the things we buy, leaving us to decide how to spend that extra "real" income. Every income earner and family will make their own decisions, but our past behaviour gives us a fair idea of what we'll decide.

We won't be devoting our additional real income to spending more on food, clothing and other basics. Their share of our total spending is likely to continue falling. We will be spending a higher proportion of our incomes on housing - hopefully on better-quality housing rather than just keeping up with rising prices - and on improvements in household electronics such as television, home computers and the like. We'll probably spend more on educating ourselves and our children.

And it's a safe bet we'll want to spend more on healthcare. It's hardly surprising that, as we become more prosperous, we're prepared to devote a higher share of our income to staving off death and ensuring those extra years are as free from pain and disability as possible.

Can you think of a higher priority? And the good news is that medical science is forever coming up with better pills and prosthetics, as well as better and less invasive surgery. The bad news is that the new stuff is invariably much more expensive than the technology it replaces.

And, as surgeons get better at doing particular operations, they're able to perform them on a wider range of patients, particularly the elderly.

After I started suffering angina about the time of the Sydney Olympics, and ended up having open-heart surgery, my GP told me that until this operation was developed, all the medicos could have done was give me pills that didn't work. I would just have had to keep tottering about until a heart attack carried me off. By now I'd be long dead.

If healthcare was something we bought in the marketplace, like most things we buy, that would be the end of the story. We'd go on spending a growing proportion of our increasing real incomes on healthcare and there isn't an economist or politician in the country who would see a problem.

In fact, most of the nation's spending on healthcare is done by governments, federal and state. Public hospitals are "free", visits to doctors are subsidised by the federal government and pharmaceuticals - and chemists - are subsidised by the feds.

We do it this way because, like people in almost every rich country, we believe healthcare shouldn't be denied to those who can't afford it. That's fine. But doing it this way introduces a host of additional problems: scope for greater inefficiency in the delivery of care, ideological responses from those who believe government spending is wasteful and excessive by definition and cognitive dissonance by all those punters who want ever more healthcare available to them, but don't want to pay more tax to cover the cost.

We know from successive Treasury studies that the ever-rising cost of healthcare - caused not so much by the ageing of the population as by the ever-rising cost of advances in medical technology - is by far the greatest reason for the projected increase in budget deficits. It's rarely made clear, however, that all these studies assume a limit on the growth in taxation.

Contrary to politicians' framing of the matter, the growing cost of healthcare is sustainable for the simple reason the electorate's demands leave them with no choice but to sustain it. What's unsustainable is the politicians' pretence that taxes won't have to rise.

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How to save money and wreck productivity

I've just had a great idea for raising the productivity of Australia's knowledge workers: try treating them with greater consideration so as to improve their concentration.

Simple hard-headed economics tells us that the scarcer the skills of workers, the more you have to pay for their services and the better you have to make their working conditions.

It's only those workers with few skills and who can be easily and cheaply replaced that you can get away with treating badly.

But many modern managers seem to regard these simple truths as no longer applicable. Businesses may be becoming ever more reliant on their knowledge workers and their ability to do their work well - perhaps to counter the effect of work intensification as head counts are reduced - but why not skimp on their working conditions?

Open-plan offices have been becoming more prevalent for decades, but these days it's not just a matter of replacing a warren of private offices with a cubicle farm. Why not get rid of the dividers and the modicum of privacy they provide - purely to encourage collaboration and break down silos, you understand - and move to "hot-desking" - providing fewer desks than the number of people you employ?

Even more progressive is the move to the "virtual office", where workers are issued with their own mobile phone, a laptop and a locker, but denied a particular desk. You want them moving from desk to desk each day, even morning to afternoon.

To ensure they don't break the rules and bags a particular desk, you impose a "clean-desk policy" where cleaners are instructed to toss away anything they find on desks overnight.

They may be knowledge workers but they're not likely to need books or papers for reference, are they? That's what Google is for.

I'm sure the reduced office space required has yielded savings, but I suspect it's a false economy when you take account of the effect on workers' productivity. Indeed, there is growing evidence the costs of these policies exceed the benefits.

Diane Hoskins, of Gensler, a big US office design firm, has been researching the question using surveys of more than 90,000 people from 155 companies across 10 industries.

Her people found that knowledge work consists of four modes: focus (individual work involving concentration and attention devoted to a particular task), collaboration (working with another person or group to achieve a goal), learning (acquiring knowledge of a subject or skill through education or experience) and socialising (interactions that create trust, common bonds and values, collective identity and productive relationships).

They found that the most significant factor in workplace effectiveness is not collaboration - the stated justification for most of the office changes - but individual focus work. Whoever would have thought being able to concentrate on your work could be so important?

They also found that focus is the thing the new-style offices make hardest. "Co-worker interruptions, auditory and visual distractions all combine to make focus work the modern office's most compromised work mode," she found. Who could have known?

The four work modes are highly interconnected, the researchers found, with focus as the primary component and the key predictor of all other effectiveness.So office arrangements that sacrifice individual focus in pursuit of collaboration result in decreased effectiveness for both.

Other research by Gensler finds that workers who can focus effectively are 57 per cent more able to collaborate, 88 per cent more able to learn and 42 per cent more able to socialise in their workplace than their peers who are unable to focus.

Justine Humphry, of Sydney University, says clean-desk policies are used as a way to prevent employees from "nesting": settling in one place for too long and giving it their personal stamp. This is intended to yield cost savings and productivity gains by reducing overall floor space and facilitating collaboration among staff, thereby breaking down the silos and barriers of the standard cubicle office.

Her research finds that workers continue to go about personalising and nesting in their work environments, undermining the design of a mobile and flexible office. "Studies have highlighted identity expression and professional status as key reasons for personalisation at work," she says.

"But in my ... research conducted on professional knowledge workers, it was found that personalising or nesting is also performed for practical reasons ... to enhance wellbeing, to create opportunities for privacy or collaboration, to facilitate social interaction and to save time."

It couldn't be that penny-pinching and fads in office design are part of the explanation for our less than sterling productivity performance since the 1990s, could it?

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Darwin improves on Adam Smith

What can the theory of evolution tell us about how the economy works? A lot. But probably not what you think it does.

Famous economists such as Joseph Schumpeter (author of the notion of "creative destruction") and Milton Friedman, and the contemporary economic historian Niall Ferguson, have viewed economies as Darwinian arenas: competition among firms reflects the ruthless logic of natural selection. Firms struggle with each other, with successful firms surviving and unsuccessful ones dying.

Thus evolution seems to support three pillars of the conventional, neoclassical model of the economy. First, that "economic actors" are self-interested, second, that self-interest works to the good of the public (propelling Adam Smith's "invisible hand") and, third, that together these lead the market to deliver the community ideal outcomes ("optimisation").

But there's a basic fault in this contention, as Dominic Johnson, of Oxford University, Michael Price, of Britain's Brunel University, and Mark van Vugt, of Amsterdam's VU University, point out in their paper, Darwin's Invisible Hand.

In conventional economics, "economic actors" can be either individuals or firms, although the theory tends to treat firms as though they were individuals. In reality, however, firms are groups of individuals - in the case of big national and multinational companies, thousands of them in one firm.

So if Darwinian selection applies to competitive markets, this implies that selection pressure acts on groups, not individuals. And group selection, as opposed to conventional Darwinian selection at the individual level, leads to the emergence of traits that act against self-interest.

With group selection, "we should expect the suppression of self-interest among individuals, not its flourishing", the authors say.

"Firms with less self-interested workers will compete more effectively and spread at the expense of firms with more self-interested workers, which will compete less effectively and decline. In other words, the model predicts nasty firms but nice people.

"Firms vie for market share and profits, group selection would predict, while individuals within those firms sacrifice their own interests for the good of the group. They will work long hours, accept low status and low salaries, co-operate with each other, share resources, accept hierarchy, obey their bosses, volunteer for extra duties and never help - or move to - rival firms."

Does that sound realistic to you? No, me neither.

"In reality," the authors say, "firms are made up of individual human beings, with various goals and motives but, most importantly, considerable self-interest.

"Darwinian selection at the level of groups implies that the interests of group members are weaker or synonymous with the interests of the group as a whole. In the real world, they are not. There is often some overlap, of course: the boss will want his workers to perform well; the workers will want the firm to survive.

But we also have strong personal desires for salary, status, rank, reputation, free time and better jobs.
"In short, any evolutionary model must account for two opposing processes that operate simultaneously: competition between firms and competition between the individuals within them."

So the authors are adherents to a relatively new school of thought holding that selection occurs at both levels: "multi-level selection theory". And this leads them to conclude that taking account of the role of evolutionary selection doesn't really bolster the conclusions of the neoclassical model.

Economic actors are self-interested only sometimes. Self-interest promotes the public good only sometimes. And these things mean markets produce optimal results only sometimes.

Great. But where does that get us? The authors argue that being more realistic by integrating the factors at work at group level with those at work at the individual level allows us to make better predictions on which interests - individual or group - will dominate in particular circumstances.

"A one extreme, if selection among groups is frequent and severe, we may expect an increased alignment of individual and group interests resulting in successful firms with hard-working, groupish, highly committed employees," they say.

"At the other extreme, if selection among groups is rare and weak, we may expect increased conflicts of interest resulting in inefficient firms and lazy, self-interested workers."

By group selection they mean cultural selection - some ideas and practices beat others - not biological selection. And, because ideas can spread so quickly, not needing to wait for genetic evolution to occur generation by generation, cultural evolution is much faster and more powerful.

The authors say competition between firms may be a quintessential example of cultural selection.

A weakness of the neoclassical model is that it exalts competition between economic agents while ignoring the co-operation within firms that is such an important part of real-world competition in markets.
The evolutionary approach, however, does much to illuminate the role of co-operation.

"Individuals are adapted to co-operate in groups but do so in individually adaptive ways," they say. "That is, we are co-operative, but only so long as our own individual costs and benefits are taken into account."

People want to be rewarded for their contribution but also to see that their reward doesn't compare badly with the rewards fellow workers are getting relative to their contribution.

But whereas the conventional economic model focuses on only monetary rewards and punishments, the evolutionary approach predicts that individuals will be powerfully motivated to strive for social status and prestige within their firm, even at the expense of material rewards or the risk of punishment.

The evolutionary approach also offers a better explanation of why individuals would want to take on stressful and time-consuming leadership positions, which are not always compensated by higher salaries: higher social status rewards.

The key to improving the performance of firms, we're told, is not to strike some inefficient compromise between the interests of individuals and their group but to work with the grain of human nature to bring individual and group interests into alignment. If you know what you're doing, this can be achieved relatively easily and at low cost.

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Blame for budget worries widely shared

For months I've been having a nightmare: what if Australia's period of exemplary fiscal policy - which began with Paul Keating's return to budget surplus in 1987-88 - is already over and we've joined most of the other rich economies in running budget deficits every year, not just in the aftermath of major downturns?

That is, what if we've collectively lost the political will to make ourselves pay enough tax to cover the cost of all the things we require our governments to do for us?

The nightmare returned last week when Joe Hockey unveiled Treasury's projection of a further decade of budget deficits, assuming unchanged policies (including unending bracket creep).

On the other hand, it's worth remembering that even if this undisciplined scenario came to pass, the federal government's net debt would peak as a proportion of gross domestic product at 16.2 per cent in June 2019, then slowly fall as GDP grew faster than the debt grew. So the feds' triple-A credit rating would not be threatened.

With Hockey busily shifting all the blame for this daunting outlook onto Labor, it's worth examining its political antecedents. Since we've known we had a long-term ''fiscal gap'' problem at least since the first intergenerational report of 2002, the blame for making things worse must be shared not just by the former Labor government, but also by the Howard government and even the Abbott government.

The Howard government probably did most to add to the existing problem by the way it frittered away the proceeds of the first phase of the resources boom, which it treated as a permanent rather than temporary boost in tax collections.

It allowed government spending to grow very strongly - by real growth averaging 3.7 per cent a year in its last 10 years - instigated eight income-tax cuts in a row (with Kevin Rudd taking over responsibility for the last two) and greatly increased the concessional taxation of superannuation to the point where only one in five people over 60 pays income tax.

To this Labor added very strong real spending growth of 3.5 per cent a year over its last five years - including an unduly generous and ever-more expensive real increase in the age pension, now long-forgotten - and used Wayne Swan's ''fiscal bulldozer'' to push its spending commitments off beyond the forward estimates where they couldn't be seen.

Hockey's 10-year budget projections now reveal what Labor's bulldozer hid: a prospective real spending growth rate of 3.7 per cent. Specifically, on unchanged policy, spending on overseas aid, the national disability scheme and the Gonski education funding reforms positively shoots up after 2016-17 (see the remarkable graph on page 21 of the midyear review).

If anyone should have understood all this it was Hockey and Tony Abbott. But while making misleading claims about the ''budget emergency'' and promising to fix it painlessly, they added to the problem by promising to repeal the carbon tax and replace it with a more expensive solution to climate change; repeal the mining tax before it had a chance to raise significant revenue (after the accelerated depreciation allowances are used up); cut the rate of company tax by 2 percentage points and make paid parental leave absurdly more generous.

Now, Hockey will claim that since all those promises were fully funded by spending cuts and tax increases - which is true enough - his government has done nothing to add to the medium-term fiscal dysfunction it inherited.

But that makes him a Treasurer who doesn't understand opportunity cost. Had the Coalition not made all those expensive promises, it could have used its spending cuts and tax increases to reduce the fiscal imbalance it inherited.

Instead, it wasted them on vote-buying promises. And don't forget it also said ''me too'' on the disability scheme and the first four (cheap) years of Gonski.

All this on top of the underlying long-term budget problem that is no government's fault but which all governments have known about for at least a decade: the likelihood of never-ending strong growth in health spending - state as well as federal - caused not so much by ageing as by ever-more-expensive advances in health technology, to which the electorate demands immediate access.

What made the recurrence of my fiscal nightmare so scary was Hockey's fatuous statement that ''no country has ever taxed its way to prosperity'', which signalled his resolve to get the deficit down purely by cuts in government spending.

Seriously? That's a sign he still doesn't understand the nature and severity of his problem. No treasurer has ever purely cut his way to budget balance. Not an encouraging sign.

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Hockey's midyear budget forecasts are plausible

In this week's midyear budget review, Joe Hockey's claim to have found a black hole left by Labor was dishonest, but the revised forecasts for the economy and the budget deficit are credible and not the product of political spin.

In other words, there was nothing wrong with the document - it was prepared with Treasury's and the Finance Department's usual diligence and professionalism - just with what Hockey said about it.

Paradoxically, Hockey deserves credit for making the budget document a lot more transparent and informative than it was under Labor. Some of this is the result of the deal he did with the Greens to remove the silly Tea Party-style ceiling on government borrowing introduced by Labor and replace it with a lot more detail about the composition of the debt. But Hockey has included much more new information than that.

One innovation is that Treasury is now providing ''confidence intervals'' for its key forecasts. For instance, its forecast is for real gross domestic product to grow by just 2.5 per cent this financial year. This means that if Treasury's forecast errors are similar to those in the past 15 years, there is a 70 per cent probability the actual growth rate will prove to be somewhere between 1.5 per cent and 3.25 per cent.

With that sobering consumer warning, Treasury finds there has been a ''substantial deterioration'' in the outlook for the domestic economy just since the pre-election budget review in August. The economy's transition from resources to non-resource drivers of growth is now likely to be slower than previously forecast.

''Resources investment is expected to fall more sharply, while activity in the non-resources sectors has been subdued, with positive signs in those sectors thus far limited to the established housing market, above average measures of consumer sentiment and improving business sentiment,'' it says.

The forecast growth in real GDP of 2.5 per cent in the present financial year is unchanged since the election, but the composition of that growth has changed a lot. Forecasts for consumer spending, home building and business investment are all revised down to the point where growth in domestic demand (gross national expenditure) has been cut by 0.75 percentage points to 1.25 per cent.

But this is offset by an upward revision in the contribution to overall GDP growth made by external demand (''net exports'' - volume of exports minus volume of imports) of 0.75 percentage points to 1.25 percentage points.

The strong contribution from the external sector comes from strong growth in mineral exports as the resources boom moves to its production and export phase. But the upward revision arises because weaker domestic demand means weaker demand for imports.

Treasury has revised its forecast for growth in real GDP next financial year, 2014-15, down from 3 per cent (our medium-term trend rate of growth) to 2.5 per cent. That is, another year of clearly below-par growth, leading the unemployment rate to keep drifting up to 6.25 per cent.

This expected weaker performance is explained by downward revisions to forecasts for consumer spending and business investment. This time, however, it's not offset by an upward revision in the expected contribution from net exports.

Moving from the economy to the budget, it's obvious that slower than expected growth in real GDP and slowly rising unemployment mean slower growth in tax collections and faster growth in government spending on the dole.

But, as Wayne Swan used to say, we live and pay tax in the nominal economy, so it's what happens to nominal GDP that has more influence on the budget, not real GDP. And though the forecast for real GDP growth in this financial year hasn't changed, the forecast for nominal GDP growth has been cut by 0.25 percentage points to just 3.5 per cent.

And get this: the forecast for nominal GDP growth in 2014-15 has been cut by a huge 1 percentage point to 3.5 per cent.

Why? Remember, nominal GDP equals real GDP plus inflation. We already knew that the national accounts, production-oriented measure of inflation (known as the GDP ''deflator'') would be lower than other, consumption-oriented measures of inflation because the prices we get for mining exports are falling.

What's new is the greater weakness in the domestic economy, which should mean the prices of goods and services produced for domestic use rise more weakly than expected. In particular, wages growth is expected to be very low. This domestic weakness explains the big downward revision in GDP inflation.

Although most of the deterioration in the expected budget deficit for this financial year is explained by government policy decisions (the ones Hockey tried to blame on Labor), for the following three years the expected deterioration is almost wholly explained by Treasury's changed economic forecasts and projections.

At present, Treasury forecasts only the next two years. For the following two it uses mechanical projections based on the assumption the economy has returned to trend rates of growth. But this can look quite unreal when (as is expected in 2014-15) the economy is a long way from trend in the last forecast year.

This is why Treasury has changed its projection methodology a little, raising its projections for the unemployment rate in the last two years from 5 per cent to 6.25 per cent. It's likely to move to forecasting all four years.

Treasury has also moved to a much more detailed and careful method of guessing what will happen to mining export prices in future.

Some conspiracy theorists have claimed these changes were designed to make the outlook for the budget deficit worse than it really is, to soften us up for big cuts in May.

But the fine print shows the change to unemployment projections accounts for just $3.7 billion of the four-year total $68 billion worsening in the budget bottom line, while the export prices change contributes just $2 billion. No conspiracy.

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Why KPIs are a dangerous fad

You have heard of painting by numbers, but these days the great fad is management by numbers. I call it the metrification of business - although it's just as prevalent in the public sector. If you know what the initials KPI stand for, you'll know what I'm talking about.

I've been a bean-counter all my working life, first as an accountant, then as an economic journalist. So I've long believed in the importance of measurement, of getting the measurement as accurate as possible and of understanding the strengths and weaknesses of particular measures.

Much of my apprenticeship as an economic journalist was spent making sure I understood how all the economic statistics were put together. But as I've watched the enthusiasm for "key performance indicators" and other "metrics" grow, I've become increasingly sceptical about their usefulness.

The rise of metrification has been built on repetition of the seeming truism that what gets measured gets managed. It follows that what isn't measured isn't managed.

It's certainly true that what we measure affects what we do and the way we think about the phenomenon being measured. So in the drive to hold workers accountable - that is, to increase control over them - and improve their performance, it's become fashionable among managers - private and public sector - to measure key aspects of an organisation's performance.

It's only a small step to setting targets for the performance measures and, often, raising those targets from year to year. You might have targets for the performance of organisations, but also for the performance of individuals. And it's only another small step to link performance to remuneration. We pay for results - what could be fairer?

The rapid escalation of executive remuneration over the past 20 years has occurred not so much because of the rise in basic salaries as the proliferation of "performance pay". A study by Mihir Desai, of the Harvard Business School, found that, in America, the proportion of the total pay of senior managers that is based on share prices rose from 20 per cent in 1990 to 70 per cent in 2007.

But, as The Economist reported last year, Desai found this had warped incentives and fostered malfeasance. Managers had won huge payouts simply because the share market had gone up, regardless of whether they had personally added value.

"They have also gamed the system, sometimes illegally, to hit targets that put fat sums in their pockets," it said.

The trouble with this measurement approach to accountability and reward is that, as the American psychologist Martin Seligman has said, "If you don't measure the right thing, you don't get the right thing."

When the push for micro-economic reform was at its height, someone got the bright idea that if you calculated and made public the equivalent of key performance indicators for all the many responsibilities of the state governments, you'd encourage them to compete among themselves to improve their standing in the league tables.

The Productivity Commission has now compiled and published these indicators for many years. But someone who should know warned me they'd become completely unreliable. Why? Because managers in each state had manipulated their results to make them look good against the competition.

In 2005 the website Crikey.com.au ran a letter from an anonymous public servant reporting their experience with management by KPI.

"Early in June our manager discovered we were a few percentage points away from meeting operational requirements for the financial year. Rather than explain to his boss that staff cannot perform well when there are continual computer problems and weekly changes in procedures and priorities, he instituted a series of ludicrous schemes to improve the statistics," the person wrote.

"Any work that was already out of time was placed on the backburner, not to be touched until after July 1, when it would be counted in the next year's statistics. In other words, work that was overdue would not even be looked at for another fortnight.

"For two days staff did nothing but go through their files searching for cases that could be closed without further action or referred to another area. We achieved absolutely nothing in terms of genuine output for those two days, but our percentage of resolved cases sky-rocketed. We then started on the new work, but only worked on simple cases that could be closed well within the acceptable operational time frame...

"On June 30 our manager proudly announced that we had achieved operational requirements."

I've been around long enough to know that measurement can be a trap. People can be mesmerised by numbers. Because they're objective, people take them to be infallible. They forget (if they ever knew) the assumptions and other limitations on which they're based, they take them to be measuring something they're not and they forget how easily others can manipulate them for their own purposes.

It's easy to measure quantity, but much harder to measure quality. Most jobs are multi-dimensional, but you can't have a KPI covering every dimension. In which case, I can always meet my KPIs by cannibalising some dimension - some aspect of quality - not covered by a KPI.

Einstein said "not everything that counts can be counted". The modern preoccupation with metrics is an attempt to over-simplify the managerial task by confusing quantity with quality.

Sorry, life wasn't meant to be that easy.

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Budget deterioration is real, but Labor not to blame

How on earth did we convince ourselves this bunch would be miles better at fixing the budget than the last lot?

Joe Hockey claims his midyear budget update is an honest assessment of the state of fiscal affairs he inherited from Labor. It isn't.

Rather, it is an attempt to lower our expectations about the speed and ease with which the Coalition will be able to get the budget back on track. He won't be able to achieve it for many years - he's not saying when - and not without significant and painful, but as yet unidentified, cuts in government spending.

In short, he is unlikely to be able to do it much faster than Labor would have. What's likely to differ is who will bear most pain. Labor would have erred in the direction of higher taxes, particularly on the better-off. Hockey has ruled out higher taxes and is hinting at cuts in government spending on "welfare, education and health".

Contrast this grim slog with all the Coalition said in opposition about the budget deficit being purely the result of Labor mismanagement, which it could quickly put right if only it was in government.

This time last year Tony Abbott and Hockey were promising to deliver a budget surplus in each year of their first term. By the election campaign the return to surplus had been delayed until the first year after the next election. Now even that's in doubt.

Hockey claims the midyear review and the latest deficit estimates it contains draw "a line in the sand". From now on, he says, he will take responsibility for budget estimates. In truth, he is trying to shift the goalposts in his favour.

Although the pre-election budget statement, certified by the most senior econocrats, was specifically instigated by the Howard government to remove all doubt about the true state of the budget at election time, Hockey is claiming to have uncovered a budget black hole.

This financial year's budget deficit is now expected to be $17 billion bigger, while the cumulative deficits for the next four years are expected to be $68 billion bigger. Little of this can be fairly attributed to the previous government.

More than 60 per cent of the expected worsening in this year's deficit is attributed to decisions made by the Abbott government, most particularly the capital grant of almost $9 billion to the Reserve Bank, which the Reserve didn't ask for and Treasury recommended against.

It represents a piece of creative accounting, loading up the deficit in the year for which Labor can be blamed so as to improve the deficit in the years for which the Coalition will be responsible.

When you look at the expected deterioration over four years, however, 80 per cent of it is attributable to the worsening in the outlook for the economy just since the election. Hockey is trying to shift the blame for this deterioration on to Labor but, in truth, if it comes to pass it will be caused by factors largely beyond the control of any government.

Hockey is right in his claim that government spending grew a lot faster under Labor than it tried to have us believe. He is right, too, in saying the present prospect of another decade of deficits cannot be accepted.

We are being softened up for a tough budget in May. What remains to be seen, however, is whether Hockey and Abbott have the toughness needed to get the budget back on track and do so without damaging the economy in the short term or sharing the pain unfairly.

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How six states became one economy

It's been a year of anniversaries: 50 years since The Australian Financial Review became a daily, 30 years since the floating of the dollar, 21 years since the Council of Australian Governments replaced the special premiers' conference and 15 years since the start of the national electricity market.

In the Fin Review's self-congratulatory anniversary edition - apparently, the paper brought about micro-economic reform single-handedly - one of my old bosses, Vic Carroll, made a point most of us have forgotten, if we ever knew.

Before Paul Keating began opening Australia to the world in the 1980s, we first needed to break down the barriers between the six states to get one national market. In theory we've had a common market since Federation; in practice it didn't start until the 1960s.

We had separate stock exchanges and even big companies tended to stick to their own state. Coles and Woolworths didn't start to invade each other's home states until the 1960s. The big banks were concentrated in their home states until eight merged to become four in the early 1980s.

For many years the brewers defined much of the Riverina as part of Victoria and thus out of bounds to Sydney-based Tooth and Co. It took the Trade Practices Act of 1974 to make agreements on competition-reducing territorial carve-ups illegal.

A main role of COAG has been to gain agreement between the states to align their regulation of markets and in other ways facilitate cross-border trade. Progress has been painfully slow and at Friday's meeting it gave up trying to introduce a national occupational licensing scheme.

But that makes COAG's initiative of establishing a national electricity market (covering all states bar WA) in 1998 the more remarkable. Before then, we had six separate, state-owned vertically integrated monopolies.

The Australian Energy Market Commission has celebrated the national market's 15th anniversary by commissioning KPMG consultants to prepare "a case study in successful micro-economic reform". The idea was to record the insights of key players before they were carted off to retirement homes.

It took eight years of preparation before the market began. Step one was for each state to break its monopoly electricity commission into separately owned power generators and separately owned electricity retailers, leaving the transmission and distribution network ("poles and wires") as the irreducible natural monopoly.

The generators could be made to compete with each other (and probably privatised) and the retailers made to compete with each other (and privatised) by giving them equal access to the network.

The hard part was setting up the continuously trading wholesale auction market in which competing generators supply power to competing retailers. Once the state networks had been physically connected to a single grid, this was made possible by the "fungibility" of electricity. If one unit of power is identical to any other, I don't have to actually generate the power I end up selling you.

That's handy, but it makes the market, with all its derivative contracts, horrendously complex. Its smooth operation is a notable tribute to the economist's art: it's a quite artificial, geek-designed, government initiated and regulated market. T. Abbott and other sceptics please note.

The case study should prove a useful guide to would-be reformers. One tip is that this radical change was achieved through many small steps. Each state set up its own market before they merged into one after many trial simulations.

Though the federal government had no responsibility for electricity, it was deeply committed to micro reform and, since it would benefit from higher tax collections, transferred these to the states as incentive payments for reforms achieved.

No business people or economists need telling that many people find money highly motivating. Premiers more than most. But the study warns "there are risks that the incentive becomes payment maximisation rather than policy optimisation".

Likewise, establishing a competitive industry structure must take precedence over doing things to maximise the proceeds from privatisation. "Incentive payments are not a substitute for mutual commitment to policy outcomes," we're told.

Careful planning, widespread consultation and good processes are all necessary, but the study emphasises the key role of committed leaders. At the political level, reform was pushed by Bob Hawke and Nick Greiner, by Paul Keating and Jeff Kennett, then by John Howard.

But the person who deserves greatest approbation was the chairman of the National Grid Management Council, John Landels, formerly of Caltex. His strengths were he was beholden to no one, kept the board focused while letting the technocrats get on with the details, and he had pull with prime ministers and premiers. And I doubt he was doing it for the money.

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Holden's fate will have little effect on economy

Contrary to appearances, the economy is not falling apart nor has the Abbott government taken leave of its senses.

The threat to the economy from Holden's decision to cease making cars has been greatly exaggerated by those with axes to grind - the opposition, the motor vehicle union and other industry apologists, plus the overexcited media.

The greatest threat comes not from what happens to the car industry - nor from Qantas' plan to lay off 1000 workers - but from the risk that all the talk of job losses could leave people in industries far removed from the troubled sector with an exaggerated impression of their chances of losing their own jobs, prompting them to become more cautious in their spending and housing decisions.

There is no denying the Abbott government is off to a rocky start, with its backing and filling over the Gonski education reforms, its ruminations over continued Australian ownership of Qantas, and its refusal to permit the foreign takeover of GrainCorp casting doubt over Tony Abbott's election-night claim that Australia is now ''open for business''.

What we have had from Abbott is clunkiness. It's been hard to detect the hand of a government that knows what it is doing and where it is heading, let alone one that can articulate its destination and reasons for wanting to take us there.

But its most controversial decision so far - to decline to keep paying the protection money demanded to defer General Motors' departure from production in Australia - offers hope that this is a government with the courage to give genuine leadership, to make the unpopular decisions needed to secure our economic future.

If we want the economy to return to a healthier rate of growth, with rising job opportunities, the answer is for our businesses to find new and better ways to make profits, not for them to become ever more reliant on government subsidies.

It is for us to face up to, and adapt to, a rapidly changing world economy, not use taxpayers' money to try to prevent change, eventually turning our economy into an industrial museum.

If we want the federal budget to be returned to balance without huge hikes in taxation, part of the answer is to stop providing welfare to industries as well as people.

It is understandable for older Australians to be sentimental about the end of car making by our first car maker - even though most of us stopped buying locally made Holdens many moons ago, just as most of us have stopped using Qantas to fly overseas.

How much tax are you prepared to pay for sentimental reasons?

It is also understandable for older Australians to worry about the decline of manufacturing. If we stop making things, where will the jobs come from?

Employment in manufacturing has been falling since the early 1970s, during which time the workforce has doubled. Manufacturing now accounts for only about 8 per cent of total employment.

Do you really believe the remaining 92 per cent of us have phoney, inconsequential jobs? The big jobs growth has been in education, health, community and business services. Where will the jobs come from? That's where. The same thing is happening in all the rich countries.

The prospect is for the rate of unemployment to keep creeping up next year until the effect of record low interest rates causes spending on consumption, home building and business investment to recover and take the place of the now-declining investment in new mines.

What happens in car-making will have a negligible effect on what happens to unemployment everywhere except Adelaide. For a start, few jobs will be lost until the plants close in 2016 and 2017.

It's planned that 2900 jobs will go from Holden, with a greater flow-on to the parts-makers. But car and component manufacturing account for only about 0.4 per cent of total employment.

Even the end of local car-making wouldn't mean the end of cars. Saul Eslake of Bank of America Merrill Lynch reminds us there are five times as many people employed in the wholesaling, retailing and maintenance of cars as are employed building them.

Car-making ended in Sydney in the 1980s. Steel-making ended in Newcastle in 1999. Since then, both cities have not only survived, but prospered.

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Multi-factor productivity not what it's cracked up to be

Figures for the economy's productivity performance haven't looked good for the past decade, causing consternation among economists and business people. But a careful study by the Productivity Commission has failed to find any particular problem, nor anything we could do to make the figures look better.

Productivity is a measure of the efficiency with which the economy turns inputs of labour and capital into outputs of goods and services. Thus productivity is measured as output per unit of input.

The more we can improve productivity the better off we are. We have in fact being increasing it a little almost every year since the Industrial Revolution, and this is what has made us so much more prosperous. So if you believe the goal of economic management should be to increase our material standard of living (which I don't), nothing is more important than ever-improving productivity.

The simplest (and probably least inaccurate) way to measure productivity is to take the quantity of goods and services produced during a period (real gross domestic product) and divide it by the number of hours of labour required to achieve that production.

Doing this each year shows that our "productivity of labour" improved unusually rapidly in the second half of the 1990s, but then showed little further improvement during most of the noughties. Over the past two or three years, however, it has returned to a reasonably healthy rate of improvement.

But you can improve the productivity of labour simply by giving workers more machines to work with. And this tells us nothing about the efficiency with which the economy's physical capital is being used. So in recent years it has become fashionable to focus on a more sophisticated measure called "multi-factor productivity".

This is the growth in real GDP (output) that can't be explained by any increase in inputs of both labour and physical capital. So, in principle, multi-factor productivity represents "technological progress" - the invention of better physical technology and the discovery of better ways to organise the production of goods and services. It's technological advance that does most to raise material living standards.

When you look at our performance over the past few years you find that, though the productivity of labour has been improving at a reasonable rate, multi-factor productivity hasn't improved. It was this that staff at the aptly named Productivity Commission set out to investigate in a study published last week.

They found that the flat performance of multi-factor productivity in the market economy was explained mainly by an actual decline in the multi-factor performance of manufacturing. So they focused their investigation on manufacturing.

Estimates by the Bureau of Statistics show that between 1998-99 and 2003-04 multi-factor productivity in manufacturing improved at a rate of 1.3 per cent a year. But between 2003-04 and 2007-08 it fell by 1.4 per cent a year. Since then (up to 2010-11) it has deteriorated at the slower rate of 0.8 per cent.

Delving further, the researchers found that two-thirds of the deterioration between the first two periods could be explained by just three of manufacturing's eight sub-sectors. From worst to least worse: petrol and chemicals, food and beverages, and metal products.

Trouble is, they could find "no overarching systemic reason for the decline". That is, no problem or problems you could tell the government it needed to fix.

What they found were several factors that made the figures look bad but weren't actually bad themselves, plus one factor we all know about, can't do much about, but have reason to hope will improve soon: the high dollar.

The metal products industry's poor performance was explained mainly by a big expansion in alumina refining capacity which had yet to come on line. Obviously a temporary problem.

The petroleum and chemicals industry's poor performance was explained to a significant extent by increased investment by petroleum refineries to meet new environmental standards. That is, there was an improvement in the quality of their output which the figures didn't pick up.

The food and beverages industry's poor performance was partly explained by a change in consumer preferences in favour of products made in smaller-scale, more labour-intensive bakeries. No probs if that's what the punters want.

In both petroleum and chemicals and food and beverages the poor performance was explained also by reduced use of production capacity, caused largely by the effect of the high dollar in reducing exports and increasing competition from imports.

But now I must give you the product warning economists keep forgetting. Like so many other concepts in economics, multi-factor productivity is simple in principle but as ropey as hell in practice. Putting a number on the concept requires you to make a lot of unrealistic assumptions (perfect competition, equilibrium, for instance) and use statistics that don't accurately measure what they're supposed to measure.

As the researchers acknowledge, multi-factor productivity is measured as a residual: after you estimate the amount of production you subtract an estimate of the amount of labour used and an estimate of the amount of capital used (particularly dodgy) and what's left is multi-factor productivity.

It's what a modeller would call an "error term" - the net result of all the mismeasurement of output, labour input and capital input. So, as the researchers acknowledge, the figures they have used can't be taken as a reliable measure of technological progress.

My word for it is ragbag: technological progress may be in there somewhere, but so will be a lot of other things, real and non-existent.

You can work out the figures for multi-factor productivity, but if they look good you don't know whether they really are, nor why they are. If they look bad it's the same.

What the Productivity Commission's study tells me is that even with figures that look really bad, it can find nothing amiss. Worrying about measures of multi-factor productivity is jumping at shadows.

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