Hockey reacts wisely to budget deficit blowout

The news from the mid-year budget review isn't as bad as it might seem. And I give Joe Hockey high marks for his wise response to it.

Despite any contrary impression the denizens of Canberra might have left you with, the budget is not the economy.

The economy, in which you and I live, work and spend, is much bigger and more important than Hockey's budget.

The $10 billion blowout in the expected budget deficit for this financial year is largely the result of falling mineral commodity prices and weaker-than-expected growth in employment and wages, leading to lower growth in tax collections, plus a bit from the government's troubles with the Senate.

In other words, the blowout is mainly a reflection of problems in the economy, not a cause of them.

It doesn't add to those problems, so it's not a reason for people to be any less confident than they have been about our economic future.

Indeed, the blowout is good news in the sense that it represents the budget helping to maintain growth in the economy by having the government's spending exceed tax collections, at a time when private spending isn't as strong as we would like.

So Hockey is, as he says, allowing the budget to act as a kind of shock absorber, which is exactly what he should be doing.

What he's promising not to do is attempt to get the budget back into surplus in short order by cutting government spending or raising taxes at a time when the economy is far from strong.

To pursue such a policy of "austerity" - as conservative parties in the United States, Britain and Europe have done - would be counterproductive. It would most likely make the economy even weaker and thus make the budget deficit bigger rather than smaller.

In setting his face against austerity, as he said he would in the last weeks before the election, he is affirming the policy he pursued in the May budget.

That budget proposed many cuts in spending but, in net terms, their dampening effect wouldn't have hit the economy until 2017-18, by which time it was expected to be growing strongly and capable of withstanding the drag.

The fact that the public and the Senate judged many of the specific spending measures Hockey proposed to be unfair shouldn't cloud the truth that, in its long-delayed dampening effect on the economy, Hockey was acting with commendable judgment and restraint.

So, whatever his failings as a judge of fairness or as a salesman, as a manager of the economy Hockey has proved much wiser in government than he seemed likely to be when in opposition.

Don't take much notice of the opposition's outraged criticisms of this midyear budget update.
That's just Labor trying to get even after all the unfair criticism and silly things Hockey said when it was in government.

None of this means returning the budget to surplus doesn't matter. It does - we can't run deficits forever. But the time for that is once the economy is back to strong growth. Until then, it can wait.

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How the medical research fund is a trick

As an accountant turned journo, I try to ensure the creative accounting used to make the budget figures look better than they really are doesn't go unexposed. But I've never seen a con as audacious as the proposed medical research future fund.

I wrote at length about all the accounting tricks perpetrated by the Gillard government, but now it's the Abbott government's turn.

In their budget update during last year's election campaign, the heads of Treasury and Finance signed off on a deficit estimate for 2013-14 of $30 billion. But four months later Joe Hockey and Mathias Cormann popped up with their own mid-year review claiming the deficit they'd inherited would be closer to $47 billion.

Today you'll hear Hockey repeat that claim. But that higher number was largely the result of our heroes indulging in a little creative accounting of their own.

About $7 billion of the $17 billion increase since the election was explained by Treasury revising down its forecasts for employment and wage growth and, hence, tax collections. Fair enough. But most of the remaining $10 billion involved dubious transactions our heroes claimed to have been forced to make because Labor had left them hanging.

The biggest was a transfer of $8.8 billion to the Reserve Bank - an amount the Reserve hadn't asked for and Treasury had recommended against. Its effect was to make Labor's last deficit look bigger and to make it easier for the Reserve to pay higher dividends into Hockey's subsequent budgets.

When in this year's budget Hockey announced the GP co-payment and various other cuts in health spending, he explained that these savings would be put in a new medical research future fund.

Once the money in the fund had built up $20 billion, the annual interest on the money in the fund would be used to pay for medical research. But under the changes announced last week, these payments from the net interest earned would instead begin in 2015-16.

This is an accounting trick, but it seems only students of government accounting rules can see it. People think that since the savings are being spent building up the fund, there won't be any net saving to the budget until after the $20 billion target has been reached.

Not so. The saving to the budget bottom line is immediate, though the change means this saving will be reduced a fraction by the increased spending on research.

Like many budget fiddles, this one relies on exploiting loopholes in the definition of the bottom line, the "underlying cash deficit".

The best way of thinking of it is that transactions recorded "above the line" affect the size of the deficit, whereas those recorded "below the line" don't. Below-the-line transactions are regarded as affecting only the way the deficit is financed.

The Medicare spending cuts are recorded above the line, but the decision to put an amount of money equivalent to those savings into a special fund goes below the line. It is, after all, only a decision to move money around the government's balance sheet. It doesn't involve the government spending a cent, just moving money between its accounts.

Of course, since the government is in deficit, it doesn't actually have any money to put into its medical research future fund account. So to its normal borrowing to cover the deficit it will have to add borrowing to finance the money it puts into the research fund.

This extra will add to the size of its gross public debt, but not to its net debt, since the latter is the gross debt (everything the government owes other people) minus all the money in the various parts of the future fund, which has been used to buy shares and bonds, and so represents all the money other people owe the government.

However, when the government spends the interest on the medical fund on medical research, this spending will be recorded above the line and so will add to the deficit.

Once the dust has settled, however, I expect to see a second leg of the trick brought to fruition. In a subsequent budget the government may decide that, now it's spending more on medical research via the future fund, it's able to spend less on medical research via the National Health and Medical Research Council. This brilliant con job will be complete.

What's the point of it all? Partly it's an attempt to bamboozle doctors, but mainly it's designed to allow the government to break its election promise not to cut health spending while claiming it hasn't broken it, just "reprioritised" health spending.

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Widening income gap slows economic growth

One of the most significant developments in applied economics in recent times is something we've heard little about in Australia, where we seem to be living in our own little cocoon, oblivious to advances in the rest of the world.

For decades, economic policy in Australia - and most other developed countries - has been based on the assumption that there's a trade-off between economic efficiency and fairness (or "equity" as economists prefer to call it).

If governments try to make the distribution of income between households less unequal by, say, using taxes and government spending to redistribute income from rich to poor, or by setting a reasonable minimum wage, it's long been believed, this will make the economy less efficient and so cause it to grow more slowly.

On the other hand, if governments don't do as much to redistribute income away from high-income earners, this will provide stronger incentives for people to work harder, invest and accept risk in the pursuit of greater profits.

This, in turn, will cause the economy to grow faster, leaving us all better off. What's more, the rich have a higher propensity to save, and greater saving will finance additional productive investment.

So, sorry about that, but we have to go easy on high-income earners because this makes the economy work better.

This belief that fairness reduces growth but unfairness fosters it lies behind many of the tax "reforms" we've seen over the years.

The moves to cut the top income tax rate from 67 per cent to 47 per cent, to tax capital gains at half the rate applying to other income, to end the double taxation of dividends and to use introduction of the goods and services tax to increase indirect taxation and cut income tax, are all motivated by the belief this would be better for the economy.

Trouble is, there's been surprisingly little empirical evidence to support this theory - a theory, you'll be surprised to hear, rich people really like (just ask the Business Council).

In recent years, however, the academic tide has turned and researchers are finding increasing evidence that inequality may actually be bad for economic growth. The tide has turned so far it's reached the international economic agencies (though not our econocrats).

Early this year, three researchers at the International Monetary Fund, Jonathan Ostry, Andrew Berg, and Charalambos Tsangarides, published a paper on Redistribution, Inequality and Growth, which found that lower inequality was reliably correlated with faster and longer-lasting economic growth.

What's more, they found that redistribution - the thing economists have long assumed would dampen incentives - seems to have no adverse effect on growth, except perhaps in extreme cases.

"We should be careful not to assume that there is a big trade-off between redistribution and growth. The best available macro-economic data do not support that conclusion," they found.

And now, this week, the Organisation for Economic Co-operation and Development has published a paper by Federico Cingano, Trends in Income Inequality and its Impact on Economic Growth, that comes to similar conclusions.

In most OECD countries, the gap between rich and poor is at its highest in 30 years. In the 1980s, the top 10 per cent of households earnt seven times what the poorest 10 per cent earnt. Today it's 9 1/2 times. (In Oz it's 8 1/2 times.)

Cingano says that doing something about this trend has moved to the top of the policy agenda in many countries.

"This partly due to worries that a persistently unbalanced sharing of the growth dividend will result in social resentment, fuelling populist and protectionist sentiments and leading to political instability," he says.

But another, growing reason for policy-makers' interest in inequality is its possible effect in reducing economic growth and slowing the recovery from the Great Recession.

His econometric comparisons of the performance of OECD countries over the past 30 years confirm earlier findings that increasing income inequality has an adverse effect on later economic growth. In New Zealand, for instance, its total growth over the 20 years to 2010 would have been more than 10 per cent greater had its income disparity not widened as much as it did over the 20 years to 2005.

For both the United States and Britain, their cumulative growth would have been more than 20 per cent greater.

You could argue that just because inequality reduces the rate of economic growth, this doesn't mean government measures to redistribute income will make things better. Those measures could, by reducing economic incentives, make their own contribution to reducing growth.

You could argue it, but you'd get no support from Cingano's analysis of the evidence. "These results suggest that inequality in disposable incomes is bad for growth, and that redistribution is, at worst, neutral to growth," he finds.

But get this: he found that what does most to inhibit growth is an increasing gap between low-income households (the bottom 40 per cent) and the rest of the population.

"In contrast, no evidence is found that those with high incomes pulling away from the rest of the population harm growth," he says.

So the rich attract most envy and resentment, but they're not what inhibits growth. What is it about inequality in the bottom half of the distribution that leads to weaker economic growth in later years?

Cingano finds support for the "human capital accumulation theory", suggesting that lower relative increases in the incomes of families in the bottom half make it harder for them to invest in the education and training that increases the value of their labour and the size of their contribution to growth.

But I've got an idea. Why not get a businessman, say, David Gonski, to propose ways of making sure the socially and economically disadvantaged get a good education?

And why don't we hugely increase university fees? That's bound to make us grow a lot faster.

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Growing signs young won't do as well as their olds

Will today's young people end up better off than their parents? That used to be a stupid question. Of course they will. But these days, it's much less certain.

We've come to expect that each generation will be better off than its parents, with more income, better housing and better healthcare.

But many young adults have begun to doubt it. According to one opinion poll, only 22 per cent of respondents under 30 considered they would have a better life than their parents.

And now a report by the Grattan Institute think tank, The Wealth of Generations, has found evidence to support the fear that today's generation of young Australians may have lower standards of living than their parents at a similar age.

It's a question of what's likely to happen to their incomes and what's happening to their wealth.

Our wealth is our assets (property, superannuation and other financial investments, and money in the bank) less our liabilities (mainly debts).

Wealth is like congealed income. We can usually turn it back into money should we need to. Some of it produces income (rental properties, financial investments) and some reduces our need for income, such as when we live in our own homes rather than renting.

We add to our wealth when we save some of our annual income. Most of us save more than we think we do, by paying off a mortgage over 20 or 30 years, or by having our employer fulfil the government's requirement to put 9.5 per cent of our wage into super.

We also add to our wealth when the market value of the assets we own rises – "capital gain". And, of course, when we inherit the wealth of our relatives or receive a gift of money from them.

The wealth of Australian households has grown a lot over the years, even after allowing for inflation, as all the figures I'll quote do. But the report, by John Daley and Danielle Wood, finds that over the past decade, older households captured most of the growth in the nation's wealth.

Despite the global financial crisis, households aged between 65 and 74 in 2011-12 were, on average, $215,000 better off than households of that age range were eight years earlier. Those aged 55 to 64 were $173,000 richer, on average.

But the average household in the 35 to 44 age group was only $80,000 richer. And get this: those aged 25 to 34 actually had less wealth than people of the same age 8 years earlier.

Why? Various developments have conspired to bring this disparity about. Probably the biggest is what's happened to house prices and home ownership.

Rates of home ownership have fallen over the past two decades for all but the oldest households, the report finds. Going further back to 1981, more than 60 per cent of 25 to 34-year-olds were home owners. Thirty years later only 48 per cent of people in that age group were owners.

An increasing proportion of those born after 1970 will never get on the property ladder, according to the authors. If increasing education debts aren't already discouraging younger households from taking out mortgages, it sounds like it won't be long before they will be.

This means a higher proportion of the younger generation missed out on rising housing wealth as house prices boomed. Between 1995 and 2012, house prices increased by an average of 4.3 per cent a year faster than inflation. This was much faster than the rise in full-time wages.

The boom was caused by the greater availability of home loans, the return to low inflation in the mid-1990s and by our failure to build enough new dwellings to keep up with population growth.

The later you were to get in on it, the less the boom's capacity to increase your wealth, particularly because you had to borrow so much to join. But the worst of it for young people is that, though house prices are likely to stay high (making it hard to afford the entry fee), they can't possibly keep rising at the same rate (meaning the prize for getting in won't be as big as it used to be).

There's more to the problem than housing, however. Incomes also grew fastest for older people, allowing them to add more to their wealth through saving. In 2004, households aged 55 to 64 were net spenders; by 2010, with average annual incomes $4600 higher, their net annual saving was $2700.

Although households aged 25 to 34 kept their spending controlled, their average incomes increased by $3100 and their saving by $1500.

A big part of the reason for this is that, over the years, government spending and taxation policies have become more favourable to the elderly than they were. The age pension's been made more generous while income from super is now tax-free.

Who has gained most from the big budget deficits we've been running since 2009? The old. Who will eventually have to pick up most of the tab? The young.

All this wouldn't be such a worry if we could be confident that incomes will keep growing as strongly in the future as they have been for 70 years. They may.

But it isn't hard to think of reasons why they may not – including the thing none of us is allowed even to think about: climate change.

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Economy: not good, but not disastrous

Don't drop your bundle. It's not clear the economy has slowed to the snail's pace a literal reading of the latest national accounts suggests. As for the talk of a "technical income recession", it's just silly.

What is clear is that, at best, the economy continues to grow at the sub-par rate of about 2.5 per cent a year, a rate insufficient to stop unemployment continuing to edge up. This has been true for more than two years.

A literal reading of last week's national accounts from the Bureau of Statistics says the economy - real gross domestic product - grew by a mere 0.3 per cent in the September quarter, down from growth of 0.5 per cent in the previous quarter and 1 per cent in the quarter before that.

But if we've learnt anything by now, it's that it's folly to take the quarterly national accounts too literally. They're just a first stab at the truth, based on incomplete and often inaccurate data.

The initial estimate for growth in any quarter will be revised - up and down - up to a dozen times before the bureau is satisfied it has got it pretty right. Reserve Bank governor Glenn Stevens referred recently to "the vagaries of quarterly national accounting".

Frankly, I don't believe the economy slowed markedly in the three months to September, or the six months, for that matter. If it were true, surely we wouldn't need to be told about it by the national accounts two months after the fact.

Since all individual economic indicators have their weaknesses and inaccuracies - meaning none should be taken too literally - the only adult way to proceed is to see if the signal coming from one key indicator fits with the overall message coming from the other indicators.

On the basis of what all the other indicators are saying, the forecasters - official and unofficial - expected growth in the September quarter of 0.6 per cent or 0.7 per cent, which would be consistent with the view we're still travelling at about 2.5 per cent a year.

When the published figures turn out to be half that, this suggests either that all the forecasters got something badly wrong, or that it's the published initial estimate that's wrong and likely to be revised up to something closer to what we expected.

The way we'll be able to tell whether the economy really has slowed to a crawl is by watching the rate at which unemployment rises in coming months. At the 2.5 per cent a year speed, it's worsening at a rate averaging 0.1 percentage points a quarter.

If that average rises, we'll know things are much worse than they were.

As for the "technical income recession", it proves little. Make a note that, in this context, the word "technical" is warning that what follows is based on an arbitrary rule with little sense to it.

"Technical" means two quarters of contraction in a row equal a recession. So one quarter of huge contraction isn't a recession, and two negative quarters separated by a zero quarter aren't a recession, but two consecutive negative quarters are a recession no matter how tiny the falls (or whether one is subsequently revised away).

"Real gross domestic income" is real gross domestic product adjusted for the change in our terms of trade during the quarter. Since, as we've seen, real GDP growth was weak in the past two quarters, the deterioration in our terms of trade in both quarters caused real income to decline by 0.3 per cent in the June quarter and by 0.4 per cent in the September quarter.

What happens to our terms of trade - and, hence, our aggregate income - is important. But, in this particular case, it's hard to get too excited.

As Dr Shane Oliver, of AMP Capital, has explained: "There is a danger in dwelling too much on the slump in real gross domestic income flowing from the falling terms of trade ... while swings in the mining and energy export prices are very important for resource companies, and hence for government revenues, their impact on the rest of the economy is far more modest."

In other words, the main impact is on mining company profits, and mining is about 80 per cent foreign owned. More their problem than ours.

If I thought the economy was sliding into genuine recession I'd say so. But I don't believe in exaggerating the bad news because it makes for more exciting betting on financial markets, makes a better story or because you've always hated whichever party happens to be in power at the time.

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Why we're doing so much better on recessions

With the economy growing below par and spirits so flat that people have started making up new and silly terms like "technical income recession" just to spook us, it's time we put our present discontents into context.

And who better to provide it than the unfairly sacked secretary to the Treasury, Dr Martin Parkinson, who on Friday gave the last of his final speeches in a farewell tour equal to Johnny Farnham's (though well short of Nelly Melba).

On his last day in the job, Parko reflected on all the economic reforms he'd seen since he joined Treasury in 1981 and the economy's greatly improved performance since then. We are, after all, in our 24th year of growth since the severe recession of 1990-91.

Parkinson observed that about half the people of working age today weren't old enough to work at the time of that recession. They thus have little conception of how terrible recessions are. Or why oldies like me object to the R-word being invoked with such flimsy justification.

In that recession, the official unemployment rate rose from 5.8 per cent in December 1989 to 11.1 per cent in October 1992, an increase of more than 5 percentage points.

But, as Parkinson reminds us, up to that point we were used to having recessions about every seven years. In the Whitlam government's recession of the mid-1970s, which continued for some years into the Fraser government's term, the unemployment rate rose by about 4 percentage points.

Then came the Fraser government's own recession, in which unemployment rose from 5.4 per cent in June 1981 to 10.3 per cent in May 1983.

It was the era of "stop-start growth". In banging on about 23 years of uninterrupted growth, however, it's important to remember there were several periods of slower growth in that time, as Parkinson acknowledges.

Indeed, Reserve Bank governor Glenn Stevens observed recently that "but for the vagaries of quarterly national accounting we might well have called the end of 2000 a recession; we would have called the end of 2008 one, in fact I would call it that ... I think we had a recession then, but it was a brief one.

"It wasn't terribly deep and we got out of it fairly quickly. The question isn't how you can go another 23 years without a recession, it is how you have small ones and get out of them quickly."

Just so. Parkinson notes that, in 2000-01, the unemployment rate increased by about a percentage point, and during the global financial crisis of 2008-09, it went up by about 2 percentage points.

But this acknowledgment that we've had a few mini-recessions in the past 23-plus years only enhances Parkinson's point: compared with the previous 20 years, we've got vastly better at macro-economic management, at smoothing the business cycle.

"Those recessions of the 1970s, '80s and '90s were devastating to the economy," Parkinson said. "There was the direct loss to economic output of having around 5 per cent of our workforce thrown out of jobs.

"And there were the social and personal costs of increased unemployment that are more difficult to measure, but likely just as large, or larger, and more persistent, than the direct loss to economic output.

"Large numbers of people experienced long periods of unemployment following these recessions. In many cases, those long-term unemployed never worked again."

In the past 23 years we weren't knocked off course by the Asian financial crisis of 1987-88 or by the bursting of the technology bubble and subsequent recession in the United States in the early 2000s.

You can't put such a record down to good luck. So what changed to make our economic performance so much better than it had been? Parko identified three main factors.

First, all the micro-economic reforms of "product markets" (for oil, air travel, telecommunications, manufacturing, agriculture, rail, waterfront, water and electricity, bread and eggs) and "factor markets" (the exchange rate, banks and financial markets; labour market decentralisation).

These reforms not only improved the allocation of resources and so added to national income, they also made the economy more flexible in its response to economic shocks: less inflation-prone and unemployment-prone.

This, in turn, made the economy's growth more stable and the macro managers' job easier.

Second, there were reforms in the way macro-economic management was conducted, with the introduction of "frameworks" (rules and targets) and greater transparency. Monetary policy (control of interest rates) is now conducted independently by the Reserve Bank, guided by an inflation target.

Fiscal policy (the budget) is now conducted according to the Charter of Budget Honesty with a "medium-term fiscal strategy" and regular reviews.

Third, the building of economic institutions with operational independence in regulating the economy (Australian Prudential Regulation Authority, Australian Securities and Investments Commission, Australian Competition and Consumer Commission and Australian Taxation Office) and in advising the government (Productivity Commission).

Parkinson stressed that these reforms were "an important pre-condition for stronger and more stable growth" but the growth itself was produced mainly by Australia's businesses and households.

"Australia is not immune from economic cycles," he concludes. "But the economic reforms of the 1980s, 1990s and 2000s mean recessions will happen less frequently and be less severe, on average, than if we still had the economic policies and structures of the 1970s."

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War on drugs succeeding from economists' perspective

How goes the war on drugs? On the face of it, not well. But in thinking about the drug problem it helps to know a bit of economics. When you do, you see things aren't as bad as they seem.

Most people agree that the use of heroin, cocaine and amphetamines such as speed and ice can become highly addictive and, when they do, a lot of harm is done to users and their families.

So most of us agree that governments should be working to limit the use of such harmful drugs. The arguments come over how best to do it. The conventional approach is to make the production, importation, distribution, sale and consumption of such drugs illegal. Problem solved.

But we've been pursuing this prohibition approach for years, spending a fortune on policing, the courts and the high proportion of drug offenders in our jails. With all this has come a fair bit of police corruption.

And yet illegal drug use remains widespread, with still too many drug overdoses and drug deaths. The seizures, arrests and prison sentences roll on, seemingly to little effect. People may be using less heroin, but its place has been taken by ice which, if anything, seems worse.

If prohibition so clearly isn't working, shouldn't we try a different approach?

Last week the NSW Bureau of Crime Statistics and Research published research that seems to provide powerful support for the contention that the conventional approach is broken.

We've all seen TV news reports of police proudly displaying the seemingly huge quantity of drugs they've just seized after an intricate detection operation. We're told the "street value" of the seized drugs, with the implication that this success will put a hole in drug consumption.

The take-away message is clear. See? The tide has turned and we're winning the war after all.

But the study took the figures for seizures and arrests of suppliers of illegal amphetamines, cocaine and heroin, and compared them with the figures for two indirect measures of drug use: hospital emergency department admissions for drug overdoses and arrests for drug use or possession. The figures were for the whole of Australia, over the 10 years to June 2011.

The study found no evidence that increases in drug seizures and arrests of drug suppliers reduced the number of emergency department admissions or the number of arrests for use or possession.

The study also analysed three specific NSW police operations - named Balmoral Athens, Tempest and Collage - identified by the NSW Crime Commission as being so successful they had the potential to affect the market for cocaine.

It found that the operations did have the effect of reducing arrests for use or possession of cocaine, but that effect was only temporary.

In fact, the study found that increases in drug seizures were often associated with increases in hospital admissions and arrests of users. Huh? The likely explanation is that at times when there is a lot more of the drugs available, the police will be able to increase the amount they seize.

What more proof do you need? Prohibition isn't working and we should try something else. Many medical people would like to see less emphasis on criminalisation and more on harm reduction. Just imagine if we could take all the money poured into catching and punishing people and use it to help people get off drugs and sort out their lives.

But Dr Don Weatherburn and the other authors of the study argue strongly against using its findings to conclude that drug law enforcement is a waste of money.

Why not? Because, when you look at the issue the way an economist would, you realise there's more to prohibition than just attempting to stamp out all illicit drug use.

The other thing it does is force up the price of drugs. Research suggests the black-market price of cocaine in the US is between 2 1/2 and five times what it would be in a legal market. For heroin it was between eight and 19 times higher.

Economists, as you know, are great believers in the power of prices, and in using prices to change people's behaviour. There's little reason to doubt that the high price of illegal drugs hugely reduces the number of users and the amount each user uses.

Before we write off prohibition we need to consider what economists call the "counterfactual": what would the world be like if these drugs weren't outlawed? Far more people would be using them and the amount of harm needing to be reduced would be infinitely greater.

But the law enforcers need to remember what it is that's keeping the price of drugs so high. It's obviously not their success in greatly limiting the supply of drugs relative to the demand.

No, it's the high incomes drug producers and traffickers need to earn to induce them to run the great risk of imprisonment that working in this industry entails. As an economist would think of it, it's the big "risk premium" suppliers add to the prices they charge that keeps prices so high.

This suggests that rather than trying to maximise the size of the seizures they can parade on telly to prove how successful they are, law enforcers should maximise the risks of traffickers getting caught, thereby inducing them to charge a higher risk premium.

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Why Hockey's budget flopped so badly

Who could have predicted what a hash a Coalition government would make of its first budget? If Joe Hockey wants to lift his game in 2015, as we must hope he will, there are lessons the government - and its bureaucratic advisers - need to learn.

The first and biggest reason the government is having to modify or abandon so many of its measures is the budget's blatant unfairness. In 40 years of budget-watching I've seen plenty of unfair budgets, but never one as bad as this.

Frankly, you need a mighty lot of unfairness before most people notice. But this one had it all. Make young people wait six months for the dole? Sure. Cut the indexation of the age pension? Sure. Charge people $7 to visit the doctor, and more if they get tests, regardless of how poor they are? Sure.

Charge people up to $42.70 per prescription? Sure. Lumber uni students with hugely increased HECS debts that grow in real terms even when they're earning less than $50,000 a year? Sure.

What distinguished this budget was that even people who weren't greatly affected by its imposts could see how unfair it was to others.

Unfairly sacked Treasury secretary Dr Martin Parkinson is right to remind us we have to accept some hit to our pocket if the government's budget is to get out of structural deficit. But any politician or econocrat who expects to get such public acquiescence to tough measures that aren't seen to be reasonably fair needs to repeat Politics 101.

This is particularly so when a government lacks the numbers in the Senate - as is almost always the case. Without a reasonable degree of support from the electorate, your chances are slim. Especially when you subjected your political opponents to unreasoning opposition when they were in office.

A related lesson is that successful efforts to restore budgets to surplus invariably rely on a combination of spending cuts and tax increases. To cut spending programs while ignoring the "tax expenditures" enjoyed by business and high income-earners, as this government decided to do, is to guarantee your efforts will be blatantly unfair and recognised as such.

Move in on "unsustainable" spending on age pensions while ignoring all the genuinely unsustainable tax breaks on superannuation? Sure. Our promise to the banks not to touch super trumps our promise to voters not to touch the pension. This makes sense?

But a politically stupid degree of unfairness isn't the only reason this budget was such a poor one. Its other big failing was the poor quality of its measures.

It sought to improve the budget position not by raising the efficiency and effectiveness of government spending, but simply by cost-shifting: to the sick, the unemployed, to the aged, to university students and, particularly, to the states.

There are various ways to improve the cost-effectiveness of the pharmaceutical benefits scheme - though this would involve standing up to the foreign drug companies and to chemists - but why not just whack up the already high co-payment?

There are ways to reform the medical benefits scheme - by standing up to specialists - but why not just introduce a new GP co-payment, even though we already have a much higher degree of out-of-pocket payments than most countries?

The claim that introducing a GP co-payment constitutes micro-economic reform because it gets a "price signal" into Medicare lacks credibility. For a start, I don't believe that's the real motive. Who doubts that, once a co-payment is introduced, it won't be regularly increased whenever governments see the need for further cost-shifting?

For another thing, the notion that introducing a price signal would deter wasteful use without any adverse "unintended consequences" is fundamentalist dogma, not modern health economics.

Similarly, the notion that deregulating tuition fees would turn universities into an efficient, price-competitive market with no adverse consequences to speak of is first-years' oversimplification, not evidence-based economics worthy of PhD-qualified econocrats.

I'm not convinced the range of savings options Treasury and Finance offered the government was of much higher quality than the options it picked.

This budget was so bad because so little effort was put into making it any better.

I'm starting to fear our governments and their econocrats have got themselves into a vicious circle: because the econocrats can't come up with anything better, they fall back on yet another round of that great Orwellian false economy, the "efficiency dividend".

But the never-ending extraction of what have become inefficiency dividends is robbing the public service of the expertise it needs to come up with budget measures that would actually improve the public sector's efficiency.

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Treasury boss's parting advice is daunting

One of Tony Abbott's first acts on becoming Prime Minister was to sack the secretary to the Treasury, Dr Martin Parkinson. Parkinson's crime was to believe - as did the government he had been serving - that we need to take effective action against climate change.

Abbott also sacked Parkinson's obvious successor at Treasury, Blair Comley, for the same crime. It was a disgraceful, vindictive way to treat loyal and proficient public servants.

But Parko's departure from Treasury was delayed, first so he could help the new government prepare its first budget and then because his experience was sorely needed to help Abbott and Joe Hockey prepare to chair the G20 meeting this month.

But the time for his departure has finally arrived and this week he gave one of the last of many speeches during his distinguished career. It was a tour of the short-term and longer-term challenges and opportunities that lie ahead. He professed to be very optimistic about our prospects, but I found his remarks pretty daunting.

Starting with the rest of the world, Parkinson observed that, even this far on, the big, developed economies' recovery from the global financial crisis was slow and uneven. Forecasts for global growth next year had been downgraded again, to 3.75 per cent, following a pattern that had become familiar over the past few years, he said.

"We now have a situation where 200 million people around the world are looking for work. As the International Monetary Fund's Christine Lagarde noted, if the unemployed formed their own country, it would be the fifth-largest in the world."

The financial crisis led to rapid accumulation of public debt, and governments in many countries had neither the political support nor market tolerance to use deficit spending to stimulate their economies, he said.

In normal times, countries might use monetary policy to offset fiscal tightening, supporting demand by cutting interest rates and boosting economic activity by having their exchange rates fall. But many countries already had their interest rates at zero.

So their efforts to cut spending and raise taxes while their economies are still so weak - known as a policy of austerity - ran the risk of weakening demand further and making the budget deficit bigger.

Many countries had resorted to "quantitative easing" - metaphorically, printing money - to offset the budgetary tightening. Trouble was, we are yet to see the massive increase in funding this has generated translate into growth-inducing investment, he said. It was leading to too much financial risk-taking (buying high-priced shares and bonds) but not much economic risk-taking (increasing production capacity).

This was why our move to get each of the G20 members to agree to take measures that would cause their growth over the next five years to end up 2 per cent higher than otherwise, particularly by increased investment in infrastructure, made so much sense.

In the short-term construction phase, it adds to aggregate demand. If it's done well, it adds to the economy's supply capacity and boosts productivity for the long term. And if you price access to the infrastructure properly, it might even help the budget in the medium term.

Turning to our economy, the short-term outlook was dominated by our transition from resources investment-led growth and risks associated with continued weakness in the global economy and the potential for renewed financial instability, he said.

But our transition to broader sources of growth was occurring more slowly than we might have expected. In particular, the dollar hadn't fallen as much as expected, considering how far commodity prices had fallen, so the boost to the non-mining economy hadn't been as great as hoped.

The limited fall in the dollar was explained by the big countries' quantitative easing, which was pushing their currencies down relative to ours.

Our consumers were also cautious in their spending and businesses seemed unwilling to invest until they saw consumer spending picking up. It was looking likely the economy would have grown below trend for seven of the eight years to 2015-16.

The long-delayed return to healthy growth created a risk that cyclical (temporary) unemployment turns into structural (lasting) unemployment. However, working the other way was our moderate growth in wages, which was a sign that the labour market was adjusting flexibly, even though it was also likely to be limiting consumer spending.

Turning to our longer-term challenges and opportunities, our big opportunity arose from the shift in the centre of global economic growth to Asia. By 2050, four of the five largest economies in the world would be in our region: China, India, Japan and Indonesia.

In this decade, the number of Asian middle-class consumers would equal the number in Europe and North America. These people would increase their demand for a wide range of goods and services that we could help supply.

But if we were to grasp these opportunities, we would need to work for them, and work hard, Parkinson said. There were no grounds for complacency.

We must use the opportunity provided by all the present reviews - of the tax system, the workplace relations system, the financial markets, competition policy and the functioning of our federation - to make decisions that improve our productivity growth and position ourselves to reap the most from our prospects.

Our other big problem was achieving a more sustainable fiscal position - getting the budget back to surplus. Australia had a "structural" budget problem - that is, one that wouldn't disappear once the economy had returned to normal growth - requiring a sustained and measured response, involving people giving up benefits.

It was important we start the process of repairing the budget now, he said. We had recorded 23 years of consecutive growth and the budget projections were based on an assumption that this would continue for another decade.

Such an outcome - 33 years of uninterrupted growth - would be without precedent. Get it? We're unlikely to be that lucky.

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Why house prices will stay high

Why are house prices so extraordinarily high? Short answer: because Australians have an unusual relationship with their homes. The reasons for that strange relationship aren't new, but until now they haven't been well understood. And among foreigners they still aren't.

House prices in cities such as Sydney and Melbourne don't just seem high to you and me, they're high by international standards. According to the International Monetary Fund, Australia has the third highest house prices, relative to the level of people's incomes, among 24 advanced economies.

Our house prices are so high that just about every foreign economist who looks at them becomes convinced we're sitting on a bubble that could burst at any moment. But few Australian economists agree with them.

Though there's no guarantee prices will keep shooting up the way they have been lately and nothing to stop them falling back a bit - there's plenty of precedent for periods of either stable or falling house prices in our recent history - most local economists see little prospect of an American-style collapse in prices.

But what is it that's holding our prices so high? For the full explanation of Australian exceptionalism I'm relying on a typically thorough report by one of our top business economists, Saul Eslake, of Bank of America Merrill Lynch.

Much of the explanation comes from the insights of economic geography, the study of how we're affected by the spatial dimension of the economy and, in particular, of the way big cities work.

Eslake says foreigners tend to think of Australia as a country of wide-open spaces - "a land of sweeping plains" - where people live with kangaroos grazing peacefully on their front lawns. In truth, most of us live on the edge of the continent, crammed into a few very big cities, making us one of the most urbanised countries on the planet.

Almost 60 per cent of Australians live in cities with populations of more than one million, a proportion exceeded only by Japan, Hong Kong and Singapore. Of our six state capitals, all but Hobart fit that description.

Urban geography research suggests real estate prices are usually a lot higher in cities with populations of more than a million. So an unusually high proportion of Australians live in big cities where house prices are safe to be higher.

Second, compared with cities in other countries, Australian cities are large in terms of area, relative to the size of their populations. Trouble is, Eslake says, public transport and arterial roads in the outer suburbs of Australian cities are generally inadequate for the task of moving large numbers of people from those suburbs to the central business district.

But, because of this, many Australians choose to spend a higher proportion of their incomes on housing so as to spend a smaller proportion of their time commuting. In the process, we bid up the prices of houses and units closer in.

So houses prices are higher in Australia partly because commuting times are so long. The recent return of the delusion that building more expressways will reduce traffic congestion is unlikely to make things better.

Third, Australian house and apartment prices are higher because our homes tend to be bigger than those in other countries. Three-quarters of us live in detached houses, a much higher proportion than in most other rich countries. Our average size of a new house - 206 square metres - is a fraction higher than America's, with daylight third. And our housing is usually constructed using more expensive materials.

The international comparisons purporting to show how expensive our houses are never allow for differences in size and quality. If our housing is of higher quality than other people's, you'd expect it to cost more.

Eslake's fourth point is that, thanks partly to the resources boom and two decades without a severe recession, Australians are richer than we were, even relative to other high-income countries. Guess what? Better-off people tend to devote a higher proportion of their income to their housing.

We can afford to, so we do. Sounds pretty Australian to me.

Another part of the explanation is that, for more than a decade, we've been building too few houses and units to keep up with the growth in the population. Since the turn of the century we've had relatively fast growth averaging 1.4 per cent a year with 60 per cent of that coming from immigration.

During the 1990s we built 145,000 new dwellings a year, but though the annual increase in the population has doubled since then, our construction of new places has averaged just 150,000 a year. It was estimated that by June 2011 we'd built 284,000 fewer homes than needed to maintain housing patterns the way they were.

Supply isn't keeping up because of excessive restrictions and charges by state and local authorities. So this is putting some upward pressure on house prices. But it's just the opposite of what happened in most of the countries where prices tanked.

Finally, Eslake argues that a further part of the reason our house prices are so high is our unusual tax incentive encouraging people to invest in residential housing. It wouldn't be so bad if it added as much to the supply of homes as it adds to the demand for them but, in fact, 94 per cent of "negatively geared" investors buy established dwellings, not new ones.

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Students pay for status under uni fee rise

With the Senate as unco-operative as it has become, it's not at all certain Education Minister Christopher Pyne's proposal to deregulate university fees will become a reality. But if it does it will involve harnessing the university status drive to help balance the budget.

The government's plan is to allow the universities to set their own undergraduate tuition fees for new students from January 2016. But this would be accompanied by a cut averaging 20 per cent in the government's contribution towards the cost of courses.

Joe Hockey has argued that fee control is holding back our unis, stopping them competing with the best overseas.

"Australia should have at least one university in the top 20 in the world, and more in the top 100," he said.

So the economic rationalists' claim that fee deregulation would make the unis more efficient is being combined with a status argument: we need to raise our top unis' rankings on the various international league tables.

What's the link between fees and higher international status? Allowing our top, research-oriented "sandstone" unis to charge much higher fees would allow them to divert more funds to their research effort (probably including paying higher salaries to attract higher-status foreign researchers), the thing that would do most to boost their international rankings.

This is the very motive for the sandstone (Group of Eight) unis' vigorous support for fee deregulation.

Both the proponents and the opponents of fee deregulation assume that the immediate fee increase needed to allow all unis to at least recover the cost of the reduction in the government's contribution to course costs would be just the first of many.

This, I have no doubt, is the main motive for the purse-string departments' advocacy of fee deregulation: giving the unis freedom to raise their fees whenever they want to will allow the government to continue to reduce its own funding of them - not just for teaching costs but also for research via the Australian Research Council.

The fact is, successive governments have been reducing their funding support for unis for decades. Although total spending on universities as a percentage of gross domestic product in Australia is about average among the advanced economies, by 2004 the proportion paid by government was third lowest. Fee deregulation would allow it to go a lot lower.

I don't doubt the econocrats are genuine in their instinctive belief that de facto privatisation of our unis would increase the competition between them, making them more efficient and improving the quality of service to students.

But this motivation would come a distant second to reducing the unis' drain on the budget. And I doubt the econocrats have given any serious consideration to the many instances of "market failure" involved in partially deregulating a government-owned oligopoly with considerable market power.
The scope for stuff-ups - "unintended consequences" - is enormous.

If the tertiary education "market" did operate in roughly textbook fashion, with individual unis lacking pricing power, competition between them would greatly limit their combined ability to raise their fees very far.

And yet it's clear the government and the sandstone universities are confident of their ability to impose big fee increases over a few years.

Why? Because they know that - though it's assumed away in the textbook model - the higher-status unis would be able to get away with making students pay for that higher status along with the cost of their tuition.

The tuition fees unis charge foreign students have long been deregulated. They vary widely between unis, with the sandstones able to charge a lot more than the "red bricks" (as the Poms would call them). As well, the level of fees charged varies by course, with those for higher-paid professions higher than for lesser-paid, regardless of differences in the actual costs of delivering such courses.

The econocrats assume deregulated fees for local students would follow the same patterns, but that's not guaranteed. There ain't a lot of precedent for this radical experiment.

Since the buyers' knowledge of the relative quality of degrees is far from perfect, there's a high risk the lesser-status unis would hike their fees by more than expected precisely to avoid sending a signal that their product was of lesser quality.

The non-sandstone unis don't like the sound of all this, but they won't openly oppose it because they don't want to publicly acknowledge their lesser status.

Meanwhile, some status-seeking students at sandstone unis could be obliged to pay not only the full cost of their tuition but also to cross-subsidise their uni's research effort.

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