THE CHANGING MACRO POLICY MIX

Economics Seminar Day, Pymble Ladies’ College, Friday, June 13, 2014

The mangers of the macro economy have various economic policy objectives. They also have various instruments, or tools, available to use to meet those objectives. So they have to decide which instruments are best-suited to use to achieve which objectives. This choice of ‘policy mix’ is fairly settled, but does change over time in line with changing circumstances and changing views. The other thing that changes with the economy’s circumstances - and particularly its present position in the business cycle - is the ‘stance’ or setting of the key policy instruments.

I’m going to discuss four objectives: internal balance, external balance, fiscal sustainability and faster growth with greater flexibility. Then I’ll discuss the three instruments we use to achieve those four objectives: monetary policy, fiscal policy and micro-economic policy. I hope this will help you put together a lot of the topics you’ve learnt about this year, by taking you up in a helicopter, so to speak, and letting you look down on the whole course and see how it fits together.

Internal balance

Achieving internal balance is the single most important objective of the macro managers. It means achieving ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy at present is travelling at less than full capacity.

The other way to think of internal balance is that it involves achieving a fairly stable rate of growth. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’ and ‘stabilisation policy’. The greatest swearword in demand management is to call some policy decision ‘pro-cyclical’ - something that will increase the amplitude of the business cycle rather than narrowing it.

External balance

The objective of external balance (or external stability) was a hangover from the world of fixed exchange rates, before the Aussie dollar was floated in 1983. Sometime after the election of the Howard government in 1996, however, academic economists led by the ANU’s John Pitchford finally succeeded in convincing Treasury that seeking to influence the CAD was not an appropriate objective of macro management. In the early 2000s, the Howard government quietly abandoned external stability as a policy objective. This has not changed under subsequent governments.

Fiscal sustainability

In the 2012 budget papers, the Gillard government formally articulated a new macro policy objective: ‘fiscal sustainability’. This means avoiding the build-up of an excessive stock of government debt as a consequence of many years of running budget deficits. The perils of excessive debt are now painfully apparent in Europe, where the financial markets’ unwillingness to continue funding some governments is forcing them to adopt policies of ‘austerity’ that are actually counterproductive (pro-cyclical).

Faster growth, with greater flexibility

It was under the Hawke-Keating government (1983 to 1996) that the policy makers acquired another explicit objective: faster economic growth, combined with a more flexible economy - one capable adapting to economic shocks (shifts in the aggregate demand or aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

That brings us to the end of the policy objectives, so now let’s look at the three policy instruments used over the years.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. Monetary policy has been assigned the objective of achieving internal balance. The 2012 budget papers said monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’.

Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of monetary policy is the overnight cash rate, which the RBA controls via market operations.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Abbott government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. The 2012 budget papers nominated a new and different role for fiscal policy: ‘the primary objective of fiscal policy is to maintain the budget in a sustainable position from a medium-term perspective’. That is, the primary objective of fiscal policy is now maintaining ‘fiscal sustainability’.

However, it has also been made clear the budget retains an important role in assisting monetary policy achieve internal balance. How? By allowing the budget’s automatic stabilisers to be unimpeded in doing their job of helping to stabilise demand as the economy moves through the business cycle. The stabilisers bolster aggregate demand when private demand is weak and restrain aggregate demand when private demand is strong. The latter process is known as ‘fiscal drag’ - which is, of course, a helpful thing when you’re trying to keep the growth rate stable.

What does it mean to say fiscal policy’s primary objective is to achieve fiscal sustainability but the automatic stabilisers must be free to assist monetary policy in attaining internal balance? It means the policy makers are drawing a very Keynesian distinction between the effect of the automatic stabilisers (producing the ‘cyclical component’ of the budget balance) and the operation of discretionary fiscal policy (producing the ‘discretionary component’ of the budget balance). It’s discretionary fiscal policy that’s used to achieve fiscal stability over the medium term.

Everything I’ve just said about the modern roles of fiscal policy is consistent with the ‘medium-term fiscal strategy’. This strategy has been carefully worded to, first, permit the free operation of the automatic stabilisers and, second, permit the use of discretionary fiscal policy to stimulate the economy during a recession - provided this stimulus is withdrawn (wound back in) as the economy begins to recover. That is, the strategy has been designed to accommodate what you could call ‘symmetrical Keynesianism’.

Micro-economic policy

Micro-economic policy (also known as structural policy) was recognised as a policy instrument when the Hawke-Keating government began pursuing what it called micro-economic reform. The objective of micro reform is faster growth, with greater flexibility.

Note that, despite its name, micro-economic policy is an instrument of macro management. What distinguishes it from the other instruments is that rather than working on the demand (spending) side of the economy, it works on the supply (production) side. As well, demand management has a short-term focus, whereas micro-economic policy works over the medium to longer term. Over the medium term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing.

Micro policy works mainly by reducing government intervention in markets to increase competitive pressure, which leads to increased efficiency and productivity. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - is assumed by most economists to have led to a surge in the rate of productivity improvement in the second half of  the 90s.

Micro reform seems to have been more successful at making the economy more flexible and resilient in the face of economic shocks. Greater competition within many product markets, the floating of the dollar and the move from centralised wage-fixing to bargaining at the enterprise level, in particular, have greatly reduced the problem of cost-push inflation pressure and made the economy significantly less inflation-prone. It may also be argued the greater flexibility accorded to employers by industrial relations reform has made the economy less unemployment-prone, as shown by their changed response to staff retention (their preference for shorter hours rather than lay-offs) in the mild recession of 2008-09. The more flexible the economy becomes, the easier it is for the macro managers to achieve internal balance and a stable rate of economic growth.  

While micro reform focused initially on reducing government intervention to encourage efficiency, under subsequent governments the focus has shifted to achieving higher productivity by reforming and increasing the investment in human capital (education and training) and infrastructure.

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Budget shows Abbott's true priorities and values

Tony Abbott has turned out to be a chameleon. Before the election, he took the guise of a populist, opposed to all things nasty and in favour of all things nice. Since the election, he's revealed himself to be a hard-line ideologue, intent on reshaping government to suit the interests of big business and high-income earners.

Before the election, he was the consummate vote-seeking politician. Since the election, he has transformed into an inflexible "conviction politician" who doesn't seem much worried about whom he offends.

Dr Mike Keating, former top econocrat, says the budget is always the clearest guide to a government's priorities and values. That's certainly true this time.

This budget scores high marks for its efforts to get the budget back on track. As almost every economist will tell you, there is no "budget emergency". But there would be problems if we allowed the budget to stay in deficit for another 10 years, which was a prospect had Abbott failed to take tough measures (all of which were in marked contrast to his sweetness and light before the election and many of which were in direct contradiction to his promises).

The budget's great strength is its approach of announcing savings while delaying their major effect until 2017-18, by which time it's hoped the economy will be strong enough to cope with the reduced spending. That, plus Treasurer Joe Hockey's efforts to increase spending on infrastructure in the interim.

But the budget goes further than is needed to fix the budget. It's our first genuine attempt to achieve (as opposed to talk about) "smaller government". So as to minimise the need for future tax increases, it puts government spending on a diet.

It does so partly by increasing user charges (for GP visits and tests, pharmaceuticals and university tuition), but mainly by changing the indexation of pensions and government grants to the states for public schools and hospitals, from indexes linked to the growth in wages to the main index linked to consumer prices.

That's a saving of at least another 1 per cent a year, cumulating every year forever (or at least until it's reversed as politically and economically untenable).

By restricting his savings to cuts in government spending and studiously avoiding all the lurks hidden in the tax system, Abbott ensured the burden of his savings is carried overwhelmingly by low and middle-income earners, leaving high-income earners largely unscathed, save for a small temporary tax levy. He also ignored almost all the government spending constituting welfare for businesses.

You would have to be terribly trusting to believe all this happened by accident rather than design.

The public's wholehearted disapproval of the budget makes it likely a lot of its measures won't make it through the Senate. Abbott's opponents will have a field day acting as our saviours.

No doubt much of this disapproval arises from simple, short-sighted self-interest. After all, Abbott spent the past four years fostering our selfish incomprehension. People got it into their heads that their cost of living was rising rapidly, causing their standard of living to slip. It wasn't true, but Abbott reinforced rather than corrected the misperception. (To be fair, the Labor government was no better.)

But I'd like to believe there's more to our disapproval than simple selfishness. John Howard says the public will accept a tough budget provided people are satisfied it's reasonably fair and in the nation's interests.

Trouble is, this budget is neither fair nor in the nation's interest - unless you share the Business Council's certainty that the world would be a much better place if only big business was allowed to do whatever it pleased and executives paid minimal tax.

What surprises me is how Abbott could change from being such a supremely pragmatic, vote-obsessed pollie in opposition to being so willing to alienate so many interest groups while in government.

I never imagined I'd see the day when any government decided to take on perhaps the most powerful voting bloc of them all, Grey Power. The fury of the old will be even greater when they fully comprehend how the planned change in pension indexation will lower their relative incomes.

Nor did I ever expect to see any government declare war on virtually the whole of the younger generation. The plan to deny education leavers the dole for six months involves high social costs with little budgetary or economic merit, but is the reappearance of one of Abbott's personal bonnet-bees.

The plan to let universities charge what they please for their courses and impose a real interest rate on students' HECS debt will saddle our brightest and best with big debts, lingering for many years. I've heard of worse injustices, but it seems a strange way to endear yourself to those who represent the future Liberal heartland.

Abbott is no doubt counting on there being a long time for voters to forgive and forget before the next election in 2016. But despite its goal of avoiding future tax rises, the budget's incorporation of a further two years of bracket creep means it will push up the tax rates faced by a lot of low to middle-income earners.

If I were Abbott, I wouldn't be counting on too much voter gratitude for fixing the budget.

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Why Hockey's budget is unsustainable

Coalition governments have been banging on about the need for "smaller government" since Malcolm Fraser started echoing Maggie Thatcher and Ronald Reagan. They've talked without doing anything. Until now.

Few have noticed, but the goal of this budget is to reduce government spending by 1.1 per cent of gross domestic product (GDP), from 25.3 per cent this financial year to 24.2 per cent in 2024-25.

If that doesn't impress you, this may: Joe Hockey's plan is to cut government spending to 0.7 percentage points below its 30-year average of 24.9 per cent.

That makes this the most ideologically driven budget we've seen - not that Hockey or Tony Abbott will admit it. They claim the budget's harsh measures are needed simply to get the budget back to surplus and start paying down the public debt.

They don't admit it was their choice to do this in a way that achieved savings more by cutting spending than by cutting tax expenditures. They cut the real growth in pensions, but left high-income-earners' absurdly generous superannuation tax concessions untouched.

They tightened up the family allowance and cut young people's access to the dole, but didn't tackle the concessional taxation of capital gains, negative gearing or company cars, while ignoring the miners' diesel fuel rebate and other business welfare. They imposed a co-payment on GP visits, but didn't abolish the private health insurance rebate.

The intended effect of this bias against spending and in favour of tax breaks is to make the budget significantly less redistributive. That's because, particularly with our tightly means-tested welfare system, government spending tends to benefit the less well-off, whereas tax expenditures go disproportionately to people at the top.

So it's the "end of entitlement" for people in the bottom half, but no change to the entitlements of the well-off, save for a small three-year tax levy.

It's true the government's 10-year "medium-term budget projection" sees tax collections rising as a proportion of GDP from 21.6 per cent this year to 23.9 per cent in 2019-20, at which point it would be prevented from rising further. (This cap is based on the average tax ratio to GDP between 2000-01 and 2007-08.)

This seems to indicate Hockey is relying more on higher taxes than lower government spending to get the budget back to a surplus of 1.5 per cent of GDP. But this impression is misleading.

At 25.3 per cent of GDP, government spending at present is only a little above its long-term average of 24.9 per cent, whereas at their present 21.6 per cent, tax collections are well below Hockey's benchmark of 23.9 per cent.

It's no secret why tax collections are unusually weak at present: because the fall in mineral export prices is causing real national income to grow more slowly than real GDP and because of the continuing revenue loss from the eight income-tax cuts in a row we enjoyed when the Howard government assumed the resources boom (and its inflated company-tax collections) would run forever.

To get tax collections back to a more normal proportion of GDP, the government is relying mainly on allowing another six years of bracket creep. The 23.9 per cent cap after 2019-20 is supposed to allow the resumption of regular tax cuts (though who will benefit most from those cuts is another matter).

What we do know is that, whereas the eight successive tax cuts weren't particularly "progressive" in their effect on the income-tax scale, its particular shape at present means the following eight years of bracket creep will be highly "regressive", causing average tax rates towards the bottom to rise a lot further than those at the top.

So even the recovery in tax collections will come mainly at the expense of the less well-off.

It's clear the government will have much trouble getting many of its more controversial measures through the Senate. What the 10-year projection will end up looking like is anyone's guess.

But even if the budget passes intact, it contains the seeds of its own destruction.

Pensions heading inexorably below the poverty line? Pressure throughout the public sector for wages - including for nurses, teachers, childcare and age-care workers - to rise no faster than inflation, while private sector wages continue rising in real terms with productivity growth?

The vice-chancellor herd given total control over how high uni fees (and graduate debts) rise, including whether they make training for jobs as nurses, teachers and even government lawyers financially untenable?

This budget is unsustainable because the wider implications of its measures haven't been thought through. By knocking back its worst features, the Senate will be doing the Coalition (and the nation) a favour.

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Mining hides news of non-mining recovery

And the smarties told you the resources boom was finito. Now it's being given most of the credit for this week's news that the economy grew by a rip-roaring 1.1 per cent in the March quarter and by an above-trend 3.5 per cent over the year to March.

The boom is far from finished. It will be adding to - and subtracting from - the growth in real gross domestic product for several years yet.

Media reports that "the mining industry accounted for around 80 per cent of growth in GDP in the March quarter" come from no lesser authority than the Bureau of Statistics itself. Sorry to say it, but this is true from a certain perspective, but essentially misleading.

It comes from the estimate that the mining industry's volume (quantity) of production grew by an amazing 8.6 per cent during the quarter, which means it made a contribution of 0.9 percentage points to the overall growth in real GDP of 1.1 per cent.

Almost all that increased production would have been exported. So it explains most of the growth of 4.8 per cent in the volume of total exports during the quarter, which itself made a contribution of 1.1 percentage points to the overall real growth in real GDP of 1.1 per cent.

But that's not the only way the mining sector affected the economy's growth during the quarter. Overall, business investment spending fell by about 1 per cent during the quarter. But Kieran Davies, of Barclays bank, estimates this was composed of a fall of about 8 per cent in mining investment, plus a rise of about 3 per cent in non-mining business investment.

And that's not all. The accounts show that the volume of imports fell by 1.4 per cent in the quarter which, since imports subtract from gross domestic product-ion, means their fall made a positive contribution to the overall growth in real GDP of 0.3 percentage points.

But if the economy is roaring along, why on earth would imports be falling?

Because such a high proportion - about half - of spending on new mines and natural gas facilities goes on imported capital equipment. And if mining investment is falling, imports of mining equipment must be, too.

Complicated, ain't it. Perhaps this will help. The resources boom, which began a decade ago, has had three stages: first, the huge rise in the prices we get for our exports of coal and iron ore; second, the massive investment in additional mining production capacity; third, a big increase in the volume of our exports of minerals and energy as the new mines come on line.

We're still being affected by all three of those stages. Export prices peaked in mid-2011 and have since fallen a fair way, though they remain a lot higher than they were before the boom started. Prices fell further during the quarter and, though this doesn't affect real GDP directly, it does represent a loss of real income to the economy, which must dampen demand indirectly.

Mining investment spending peaked in 2012 and has since started falling. It fell further during the quarter and this subtracted from growth, though less so when you take account of the related fall in imports of equipment.

Since so many mining construction projects are finishing, mining production is now growing strongly. It grew particularly strongly in the quarter because we didn't have any floods or cyclones to disrupt it. But though mining production has a lot further to grow, it can't keep growing as fast as it did this quarter.

Putting all that together, the mining sector's net contribution to growth during the quarter accounts for not 80 per cent of the growth during the quarter, but just under half, meaning the "non-mining sector" contributed just over half.

And that's good news. Why? Because this quarter's mining performance was the exception to the new rule. Mining made a net positive contribution because mining investment didn't fall as much as it could have, while mineral exports grew by a lot more than could have been expected. And neither of those two things can last.

The new general rule is that mining has been and will continue to make a net negative contribution to overall growth.

That's because the fall in mining investment spending generally outweighs the rise in mineral exports, even after you allow for the fall in mining-related imports.

The good news is that just over half the growth didn't come from mining. This is good news because for at least a year we've been worried about the economy "rebalancing", making the "transition" from mining-led to broader-based growth.

And even though the bureau did its (inadvertent) best to hide the fact from us, its accounts actually show that non-mining growth is at last taking hold.

Consumer spending grew by a not-so-wonderful 0.5 per cent during the quarter, but by an almost-OK 2.8 per cent over the year.

Home building grew by a rapid 4.7 per cent in the quarter, the first really strong quarter. But best of all, by Davies' estimate non-mining business investment grew by about 3 per cent.

Economists usually can't see the future with any clarity, but the mining investment boom is different. Because it consists of a relative small number of hugely expensive projects, it isn't hard to see how close they are to finishing and whether there are many new projects getting going.

They are, and there aren't. The macro managers have known for ages that mining will give the economy a big (net) dump in 2014-15 and 2015-16. That's why getting the non-mining economy going is so vital.

It's why the Reserve Bank has keep interest rates so low and won't start raising them until it knows we're out of the woods. It's also why, despite all his budget cuts, Joe Hockey made sure they don't do much to dampen demand until 2017-18.

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RECENT DEVELOPMENTS IN AUSTRALIA’S EXTERNAL SECTOR

UBS HSC Economics Day, Sydney, Thursday, June 5, 2014

Australia’s external sector – measured by the balance of payments, the current account deficit and exports and imports – is an important part of the syllabus and, indeed, the economy. Australia would be a very much poorer country if we had no trade with the rest of the world or no flows of capital to and from the rest of the world. And yet with the exception of discussion of the terms of trade and the exchange rate, the external sector – and particularly the current account deficit and net foreign debt – is these days rarely mentioned in the economic debate, presumably because most economists don’t think there’s much there to worry about. But this lack of interest conceals the fact that, particularly in the years since the height of the global financial crisis in late 2008, the current account deficit has been a lot smaller, and the net foreign debt seems to have stabilised as a percentage of GDP.

Is the current account deficit a worry?

To many people anything called a ‘deficit’ must be a bad thing; all deficits must be bad, just as all surpluses must be good. But I trust you’ve learnt enough economics by now to know that sometimes deficits are good rather than bad, and sometimes surpluses are bad rather than good. It all depends on the economy’s circumstances at the time and whether a deficit or a surplus is more appropriate to those circumstances.

The fact is that Australia has run current account deficits in 128 of the past 150 years, which suggests such deficits can’t be too bad or by now we’d be in a lot more trouble than we are, and we don’t seem to be in much trouble at all. And, indeed, most economists think it’s a good thing rather than a bad thing for us to be incurring all those deficits. Why? Because what they mean is that Australia is a ‘capital-importing country’ and we’d be a poorer country if we weren’t.

Remember that if we’ve been running deficits on the current account of the balance of payments for all those years we must also have been running surpluses on the capital account of the balance of payments for the same period. The key to making sense of the current account deficit is to remember that, with a floating exchange rate, the current account deficit is at all times exactly offset by the capital account surplus. In other words, the current account deficit and the capital account surplus are opposite sides of the same coin. So the current account can be analysed by looking at its components: exports, imports and the ‘net income deficit’, which is our payments of interest and dividends to foreigners minus their payments of interest and dividends to us. Or it can be analysed by looking at the changes in the components of the capital account surplus.

Components of the capital account surplus

When you think about it, the capital account surplus represents the net inflow of foreign capital to Australia. Another way of putting it is that the net inflow of foreign capital represents our call on the savings of foreigners. And our call on the savings of foreigners represent the amount by which national investment during a period exceeds national saving during that period.

It’s become a lot more common these days for economists to explain movements in the current account deficit by reference to changes in national investment and national saving and their components, but we’ll have go at doing it both ways.

Before we do, however, let me finish the point about Australia being a ‘capital-importing country’ since the beginning of white settlement. The proof that we’re a capital importer is all those years of capital account surplus, of inflows of capital almost invariably exceeding outflows of capital. Why has all that foreign capital flowed into our economy? Because, from the outset, the opportunities for investment in the economic development of our vast, resource-rich country have always far exceeded the amount that Australians could save to finance the exploitation of those investment opportunities. So, from the outset, we have always invited foreigners to bring their capital to Australia and join us in developing our economy’s potential. And when inflows of financial capital exceed outflows, this allows us to import more than we export, including imports of the physical capital equipment need for new development projects.

Our current account deficits – and our foreign debt and other foreign liabilities – got a lot larger in the 1980s after we floated the dollar, much larger than we’d been used to. It took us a few years to realise that the international shift to floating currencies was part of financial globalisation – the growing integration of national financial markets – which was making it easier for financial capital to flow around the world and so achieve a more efficient allocation of global capital. Some countries (eg Germany, Japan) save more than they have profitable domestic development projects to invest in, whereas other countries (eg Australia) have more profitable investment projects than they can finance with their own saving. So both classes of economy should be better off as a result of higher flows from surplus economies to deficit economies.

Recent developments in the CAD and net foreign debt

Over the 30 years since the floating of the dollar in 1983, the current account deficit has averaged about 4.5 pc of GDP, with peaks of about 6 pc and troughs of about 3 pc. In the five years leading up to the GFC it averaged more than 6 pc, so it seemed to be getting a lot higher. As you see from the table, however, in the five financial years since the GFC, however, it has averaged 3.6 pc, close to historical trough. And in the 2013 calendar year it was 2.9 pc.

As you also see from the table, the past decade shows our net foreign liabilities – that is, our net foreign debt plus net foreign equity investment in Australia – seem to have stabilised at about 55 pc of GDP. That is, the dollar value of our liabilities is now growing at about the same rate as nominal GDP.

Why has our current account deficit been significantly lower since the GFC, to the point where our accumulated foreign liabilities seem to have stabilised as a percentage of GDP?

Well, explaining it from current account side of the balance of payments, our export earnings were at first boosted by the exceptionally high prices we were receiving for our exports of minerals and energy as our terms of trade improved to their best in a century or two. It’s true that prices reached their peak and started falling in mid-2011, but they remain much higher than they were in earlier decades. And the volume of our mineral exports has been growing particularly strongly in the past year or two as the many new mines we’ve been building have finally started coming on line and increasing their production.

Turning to imports, imports of capital equipment to be used in our new mines and natural gas facilities grew strongly for most of the period although, with the construction phase of the resources boom now coming to an end, imports of mining equipment are now falling sharply. And while mining construction has been strong for most of the past five years, consumer spending and business investment spending in the rest of the economy have been growing at below-trend rates.

Finally, remember that, because exports and imports offset each other, most of the current account is accounted for by the net income deficit. It has declined to its lowest percentage of GDP for several decades, mainly because Australian and overseas interest rates are so low.

But now let’s try to explain the decline in the current account deficit from the capital account side – that is, from changes in national investment and national saving. Remember that the nation’s investment spending in any year has three components: the household sector’s investment in new home building, the corporate sector’s investment in equipment and structures, and the public sector’s investment in new infrastructure such as roads, railways, bridges, schools, hospitals and police stations.

The nation’s saving in any year also has three components: saving by households, saving by companies and saving by governments. Companies save when they retain part of their after-tax profits rather than paying them out in dividends to shareholders. Governments save when they raise more in revenue than in needed to cover their recurrent spending (the spending needed to keep the daily activities of government rolling on).

Looking at national investment, households’ investment in new homes since the GFC has been weaker than normal, whereas the mining construction boom has meant corporate investment spending has been much stronger than usual. And government spending on infrastructure since the GFC has be greater than usual. Adding that together, national investment has accounted for a higher percentage of GDP in recent years.

Turning to national saving, households are saving a far higher proportion of their disposable incomes since the GFC, with the household saving ratio rising from zero or about 10 pc. Companies have been saving more as mining companies retain most of their after-tax profits for investment in their new projects and non-mining companies retain earning to reduce their ‘gearing’ (their ration of borrowed capital to shareholders’ equity). Only governments – federal and state – have been saving less – dissaving, in fact - as their budgets have fallen into recurrent (‘operating’) deficit. Adding that together, national saving has accounted for a much higher percentage of GDP in recent years.

So though national investment is higher than it was, national saving has increased by more than national investment has, meaning the economy’s saving/investment gap has narrowed, the capital account surplus is lower and so is the current account deficit.

The budget papers show the government is expecting a current account deficit of 3.25 pc of GDP in the financial year just ending, 2013-14, rising to 4 pc in the coming year, 2014-15, and then falling to 3.75 pc in 2015-16.

In the coming year, the government is expecting the volume of exports to grow by 5.5 pc, whereas the volume of imports grows by only 2 per cent. However, the terms of trade – export prices relative to import prices – are expected to deteriorate by 6.75 pc. And the net income deficit may rise because about 80 pc of the mining industry’s increasing profits are owned by its foreign owners.

Financial year CAD NFD NFL

         % of GDP

04-05 6.5 46 54

05-06 5.8 50 53

06-07 6.1 50 56

07-08 6.7 51 56

08-09 3.4 49 55

09-10 5.0 52 58

10-11 3.0 47 55

11-12 3.2 49 56

12-13 3.6 50 54

Calndr 13 2.9 55 53

NFD = net foreign debt

NFL =  net foreign liabilities (debt + equity investment)

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Changes to HECS debt: a users' guide

There is one glaring exception to the rule that Tony Abbott’s budget cuts are designed to protect higher income-earners at the expense of lower income-earners: the changes to university fees.

Although uni students like to see themselves as part of the deserving poor, it’s overwhelmingly the sons and daughters of people in the upper part of the distribution of income who go to university, and do so with the goal of acquiring the qualifications that will allow them to take their own place in the upper reaches of the distribution.

So the irony of the government’s efforts is that it’s predominantly the children of the better-off who’ll be hit by the expected significant increases in the cost of a uni education. And those increases raise the hurdle faced by those wishing to join the echelon intended to benefit most from the government’s budget reordering.

Only about 17 per cent of uni entrants come from a lower socio-economic background – a proportion that has changed little over the decades. The Whitlam government’s abolition of fees was intended to increase the proportion of poor kids getting to uni, but didn’t.

The Hawke government’s reintroduction of fees was predicted by some to reduce the proportion of poor kids, but didn’t – mainly because of the success of an invention by Professor Bruce Chapman, of the Australian National University, specifically designed to ensure it didn’t: the "income-contingent loan", known to us as HECS.

Much the same was predicted when the Howard government greatly increased uni fees, but HECS ensured it didn’t happen. That was chicken feed compared with this decision to allow unis to set their own fees. If this one doesn’t reduce the proportion of poor kids at uni, it will be because of the continuing magic of HECS.

That, plus the new requirement that 20 per cent of the unis’ additional revenue be used to set up "Commonwealth scholarships" to assist students from disadvantaged backgrounds. (Where have I heard that name before? Maybe because I had one in my uni days, before Whitlam. This government is nothing if not retro.)

These days, going to uni means not so much paying fees as taking on a debt. Loans have three key variables: the size of the principal borrowed, the rate of interest charged, and the term of the loan.

Abbott’s changes will affect the first two, with major implications for the third. Once the unis are let off the leash, there’s no telling how high they’ll lift their fees. Between them, they have a monopoly over the provision of a high-status, high-value product in high demand.

And it’s not just the changes planned to take effect in 2016. The further the government cuts its funding to unis, the more the unis will up their fees. And they may not stop at covering the cost of teaching, but also require students to subsidise their lecturers’ research. So suggestions that fees could double or treble aren’t far-fetched.

That covers the principal. At present under HECS there’s no formal interest rate, but outstanding debt is indexed to the consumer price index. To economists, this says the debt is subject to a "real" interest rate of zero.

Now there’s to be a formal interest rate set at the long-term Commonwealth bond rate, 4 per cent at present, but capped at 6 per cent. This implies a real interest rate of between 1.5 per cent and 3.5 per cent.

So whereas at present outstanding debt merely keeps pace with inflation, now it will grow in real terms – will compound, particularly while no repayments are being made. (This change will apply to everyone still with a HECS debt, not just present and future students.)

Commercial loans have a fixed repayment period, with a fixed rate of repayment calculated to ensure all interest and principal is paid by the end of the period. HECS debt has no fixed repayment period.

Rather, debtors pay nothing until their annual income exceeds about $50,000. Initially their repayments are set at 4 per cent of their income, but this increases as their income rises, to a maximum of 8 per cent. (Hence the term income-contingent loan.)

So the time it takes people to repay their HECS debt varies mainly with the level of income they attain after leaving uni. The lower your income, the longer it takes to repay. This means the imposition of a real interest rate is "regressive", hitting lower-income debtors harder than those on higher incomes.

It also means that, leaving aside differences in the size of the initial principal, the people who’ll end up with the biggest debts under the new rules will tend to be students who stay at uni for a year or two before realising tertiary education isn’t for them, graduates who take time out of the workforce to raise children and then work part-time for a bit, and graduates who go overseas. These last will face an ever-growing disincentive to come back.

But none of this contradicts Abbott’s claim that a HECS debt will still be "the most advantageous loan they ever receive". That’s why it never made financial (as opposed to filial) sense to repay HECS early under the present rules, and only rarely will it make financial sense under the new rules.

People’s debt will be much bigger and they’ll stay owing it for many years longer, but their repayments will never be onerous, thanks to the loan being income-contingent.

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Hockey crafts our first decadal budget

This is the 40th budget I've studied, and it's unique. The only decadal budget we've ever had, a budget only an incoming, Coalition government would deliver, a budget with big political costs up front, but a big pay-off way into the future.

It's obviously the budget of a new government, one confident it can blame its predecessors for its harsh cuts and broken promises. But it's such a slow-burn, delayed-reward budget that only the party that knows it's born to rule - that's confident it will stay in office for at least a decade - would have the front to introduce it.

The legendary Labor finance minister Peter Walsh was proud of persuading the Hawke-Keating government to introduce budgets showing the "forward estimates" for the three years following the budget year. At last governments would be obliged to reveal the longer-term consequences of their decisions.

That was fine until the Gillard government, struggling to reconcile its big-spending proclivities with its foolhardy promise to return the budget to surplus in 2012-13, came up with the "fiscal bulldozer" it used to push its ever-mounting spending commitments off to the years beyond the forward estimates, where they couldn't be seen.

By last year's budget this trick was wearing thin, so we saw the emergence of the antidote, the latest attempt to keep governments honest, the 10-year "medium-term budget projection". We've seen that projection in every budget-cycle document since, so we must hope it's permanent.

This is the first budget we've had built around that 10-year projection. In concept, this budget is simple: it doesn't reform spending programs or drop many programs. Rather, it shifts some of the cost of programs off onto others, including the states.

It does this partly by introducing or increasing user charges, but mainly by changing indexation arrangements.

As one of the budget's glossy spin documents reveals, the changes to university funding are "part of a government-wide decision to streamline and simplify indexation for programs". That's one way to put it; I call it changing the indexation in any way that favours the government.

A remarkably high proportion of the measures in the budget involve fiddling with indexation: suspending it for a few years, introducing it where to do so would favour the budget, changing its basis where that's what would favour the budget. You don't get this budget unless you get its preoccupation with indexation.

Why indexation? I can imagine why. The new treasurer arrives and the Treasury boffins sit him down to explain the budgetary facts of life. They start by showing him the medium-term projection, which shows that, on unchanged policies, we won't be back to surplus even after 10 years.

There's worse. You must understand, minister, that returning to a healthy rate of economic growth won't reduce the deficit. Your plan to increase productivity would be great for the economy, minister, but will do little to help the budget balance.

Really? Why? Because higher productivity soon translates into higher real wages. That's great for tax collections, particularly income tax. Trouble is, it also pushes up the spending side of the budget.
Directly or indirectly, almost all spending programs are linked to wages.

Wages are by far the greatest component of operating costs throughout the public sector - federal and state, education, health, even non-government welfare organisations.

To top it off, we index pensions to wages.

Suddenly, someone gets a bright idea. I know, we'll cut the Gordian knot by shifting from indexing to wages to indexing to prices. With one bound, Joe broke free. Even the huge cuts in overseas aid can be seen as a switch from indexing to gross domestic income to indexing to prices.

The thing about the indexation solution is that the initial savings are small, but they compound with each year that passes. So provided you're still in power, you clean up down the track.

Take the resumed indexing of fuel excise: a huge political stink over a tiny tax rise, but once that's past the revenue grows inexorably without anyone noticing.

As well, this budget creates scope for big future savings, such as discretionary increases in user charges. With universities' fees off the leash, there's huge scope for further cuts in federal funding, including pushing research costs on to students.

And anyone who thinks the maturation of the new Medical Research Future Fund won't prompt the feds to cut other grants for medical research is terribly trusting. (Whoever came up with that ruse deserves the Public Service Medal.)

One small weakness in the 10-year projection approach (about which the Treasury secretary has warned): it's just a mechanical projection, and assumes we'll go for 33 years without a severe recession.

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