How cutting interest rates affects demand and inflation

Although many people have their doubts, the Reserve Bank cut interest rates last week believing it would help the economy grow faster and reduce unemployment. But how exactly is this meant to work?

Monetary economists believe interest rates affect the strength of demand (spending) in the economy via several "channels" or mechanisms. Eventually the effect on demand affects the degree of pressure for higher prices.

As we work through these channels we'll see why some people didn't want interest rates to be cut further, why some believe monetary policy (the manipulation of interest rates) is at a point where it's less effective and why others (such as me) believe the further cut risks fuelling a house-price bubble.

The first channel goes by the fancy name of the "inter-temporal substitution" effect. Inter-temporal means "between time periods" and it's making the point that the rate of interest is the opportunity cost of choosing to spend now rather than later.

If you want to buy a car but don't have the money to pay for it, the cost of buying it now rather than waiting until you've saved the money is the interest you pay on the loan. But even if you already have the money in the bank to buy the car, the opportunity cost of buying it now rather than later is the bank interest you forgo by taking your money out.

So when the Reserve brings about a fall in interest rates it's hoping the lower cost of borrowing (or the lower opportunity cost of reducing the money in your bank account) will encourage households and businesses to bring forward their spending on consumer durables and assets from a future period to the present period. This is inter-temporal substitution.

The next channel is the cash flow effect. In principle, cutting interest rates reduces monthly mortgage payments, leaving people with more cash to spend on other things. Equally, the lower repayments make it easier for would-be home buyers to go ahead.

Remember, however, that although almost all businesses have debts, only about a third of households have mortgages. Roughly a third have paid off their homes, leaving about a third renting.

This suggests that about two-thirds of households are "net lenders" (they have more money in bank accounts and the like than they owe on credit cards and personal loans), leaving only a third of households as "net borrowers".

But as any retiree will unhappily remind you, a fall in interest rates might be good news for borrowers, but it's bad news for lenders. So about two-thirds of households (including oldies and young people saving for a house deposit) will be left with less cash to spend on goods and services.

It's true, however, that the remaining third of households gain more overall than the two-thirds lose, because the amount they owe exceeds the amount the two-thirds have in bank accounts and securities.

This is why you'd expect the cash flow channel to be a further mechanism that, in net terms, was encouraging spending and growth. Trouble is, a high proportion of people with home loans leave their monthly mortgage payments unchanged despite the fall in rates. That is, they don't spend their saving in interest, they save it.

A third channel by which a cut in interest rates should hasten economic growth is the exchange rate effect. When our interest rates fall relative to other countries' rates - thus reducing our "interest rate differential" - this should make bringing foreign funds into Australia less attractive and so reduce the demand for Aussie dollars, causing it to fall relative to other currencies.

A lower dollar makes Australian businesses more price competitive by making our exports cheaper to foreigners and imports dearer to Australians. This should encourage greater Australian production of goods and services, increasing employment.

It's a nice, neat chain of logic but, as the Reserve notes in its description of the monetary channels on its website, they are "far from mechanical in their operation". Lots of other factors affect our exchange rate beside the interest differential.

There's a strong, but far from automatic, correlation between our dollar and the prices we get for our commodity exports. Our exchange rate is also affected by the things our trading partners do in their economies, such as manipulating their exchange rate by engaging in "quantitative easing".

Don't forget, our dollar was falling during the 18 months that our interest rates were unchanged.

Even so, my guess is that trying to keep the Aussie's recent downward momentum going was a big part of the Reserve's reason for cutting rates last week. It knows forex markets are affected by speculation and bandwagon effects that don't get much coverage in textbooks.

Another part of the channels story is that cutting the return on safe financial investments such as bank accounts has the effect of encouraging individuals and businesses to seek higher returns by buying riskier assets. Retirees move from bank term deposits to shares, while some households respond to lower interest rates by buying negatively geared investment properties.

Lower rates lead to more borrowing to buy houses, which pushes up house prices. Rising house prices encourage more people to buy, particularly investors seeking capital gain. If you're not careful this becomes a house price bubble that inevitably ends in tears.

Left out of the standard story about the channels through which lower interest rates cause faster growth is that the era of greater reliance on monetary policy has also been the era of credit-fuelled asset price booms and busts. As witness, the global financial crisis.

Why did the Reserve wait 18 months before cutting interest rates to a new low? Because it knows it's running a high risk of sparking a housing boom and bust. But with the economy now so weak, it felt it had no choice.

Read more >>

How to get yourself more time

Had a little too much politics of late? Much prefer an earnest discussion about why we're having so much trouble getting the economy moving? No, I thought not. Let's change the subject. Let's talk about time.

Do you spend much time thinking about time? Most of us spend a lot of time thinking how little time we have, but that's not the same thing. We spend little time actually thinking about time, which I'm coming to think is a big mistake.


Time is an economic resource, so it's surprising even economists don't think much about it. Apart from Stephen Hawking and his physicist mates, it's probably psychologists who do most of the thinking, but even they don't do much.

People say time is money, which is true enough, but the fact that most of us get most of our money by exchanging it for our time is only half the reason time is an economic resource. Economics is the study of the problem of scarcity, and there's nothing scarcer than time.

No matter how rich or poor we are, each of us gets the identical daily ration of precisely 24 hours. So it's one dimension of life working to reduce the gap between rich and poor.

But time is an economic resource in another sense. When we exchange time for money we use time as a means to an end. We use the money to buy things we hope will make us happy. But time is also an essential part of the end itself. We need time to enjoy the things we've bought with the money.

And the more time we spend earning money, the less time we have to enjoy ourselves - including by doing things that don't cost much if any money.

In an article in the Journal of Consumer Psychology, Jennifer Aaker, Melanie Rudd and Cassie Mogilner, marketing experts at Stanford and the University of Pennsylvania, remind us of the ultimate reason why time is an end as well as a means: the way each of us chooses to spend our time and the experiences we accumulate over the years quite literally constitute our lives.

So let's forget money and focus on time. How can we maximise the "utility" - satisfaction or happiness - we derive from the limited, if unknown, quantity of time we've been allotted? The authors survey the psychological studies of time and distil them into a number of helpful hints.

Their first principle is: spend your time with the right people. Because we're social animals, the most satisfying thing we do is spend time with our nearest and dearest and close friends. We should allocate more of our time to being with them and enjoying the intimate conversations we have with them.

But if it's so satisfying, why do we need reminding? Because of all the time we need to devote to making money, but also because we seem to be programmed to worry more about getting money than about using our time in ways we find satisfying. We have an inbuilt bias to worry more about means than ends.

This raises the question of how we could get more joy from all the time we spend at work, but that's so important I'll leave it for a column of its own.

A less obvious principle is: enjoy the experience without spending the time. Research in neuroscience has shown that the part of the brain responsible for feeling pleasure can be activated by merely thinking about something pleasurable, such as drinking your favourite brand of beer or driving your favourite brand of sports car.

"In short, this research suggests that we might be just as well off, or even better off, if we imagine experiences, but not have them," the authors say.

If that sounds a bit whacky, try the next principle: expand your time. You can, of course, buy yourself more time by paying someone to do the household chores you don't enjoy (in my case, mowing the lawn and washing the car).

One way or another, the more discretionary time we can organise for ourselves, the more we're likely to enjoy our time. This is partly because of the two-way relationship between the scarcity of time and its value to us.

It's not just that having little makes it feel more valuable, the authors say. It's also that, according to research results, when time is more valuable, we perceive it to be scarcer.

Many people advocate focusing on the present moment rather than the future as a way of increasing happiness. This may work because research suggests being present-focused slows down our perception of the passage of time, allowing us to feel less rushed.

But get this: again according to the research, you can achieve a similar effect simply by taking long, slow breaths for, say, five minutes.

Having greater control over how we spend our time - or even just feeling that we do - makes us happier, less depressed and physically healthier. Freely chosen activities increase happiness, whereas obligatory activities lower it - unless, of course, we can get ourselves into the right frame of mind.

I've often thought that the way to feel more relaxed and rested after the weekend is to be less greedy about all the things you want to fit in. I think it, but I don't always do it.

Read more >>

Worried officials opt for risky strategy

My guess is the Reserve Bank is a lot more worried about the weak state of the economy than it's prepared to admit in its soothing words and the small downgrade to its growth forecast.

That's the only explanation I can think of for its decision to cut the official cash rate by 0.25 percentage points last week, despite governor Glenn Stevens' most recent "forward guidance" that "the most prudent course is likely to be a period of stability in interest rates".

The Reserve  could have preserved the credibility of its formal signalling regime by delaying such a tiny rate cut by just four weeks and using last week's statement to change its guidance, but such was its impatience that it reverted to its formerly forsworn practice of briefing selected journalists.

The financial markets got the message - thus giving the Reserve the self-generated justification that it had to act because the market was expecting it to - but most business economists didn't. In their naivety, most economists regard the word of the governor as more reliable than media speculation.

Despite the rate cut - and the assumption of at least one further cut - on Friday the Reserve shaved its forecast for real growth this year by 0.25 percentage points to 2.75 per cent, but left its forecast for next year unchanged at a midpoint of 3.5 per cent.

So what was so worrying that the Reserve, having sat on its hands for 18 months, couldn't wait another four weeks so as to protect its reputation?

The old story. This year has long been expected to be when mining investment spending falls hardest, leaving a huge hole in activity, to be filled by the resurgence of the non-mining economy, particularly ordinary business investment.

The Reserve worries that business investment isn't recovering fast enough. So, despite having already cut the official interest rate from its peak of 4.75 per cent in late 2011, it decided to take off another click or two.

It might make all the difference, but I doubt the high cost of borrowing is what's holding businesses back from expanding. More likely, they don't see any great scope for making a bigger buck, and they're not in any mood to try their luck.

As central banks in other developed economies have discovered, when "animal spirits" aren't helping, you can get to a point where even exceptionally low rates do little to encourage borrowing and spending, when cutting rates to encourage growth is like "pushing on a string".

There's one exception, however: borrowing for homes. The main reason the Reserve has waited so long to cut rates further is its fear this would do more to encourage musical chairs in the housing market - the buying and selling of existing homes - including yet more negative gearing.

This doesn't do much to increase economic activity, but does bid up house prices and so add to the risk of a price bubble developing, particularly in Sydney and Melbourne.

It also leads to faster growth in household debt. Saul Eslake, of Bank of America Merrill Lynch, notes that after stabilising for some years, the ratio of household debt to annual household income has been rising to more than 150 per cent and will now go higher.

With their official interest rates down virtually to zero, the Americans, Europeans and Japanese have already got close to the limits of monetary policy. They've had to resort to "quantitative easing" (creating money out of thin air), but this has done a lot more to distort exchange rates and inflate prices in asset markets than it has to encourage real economic activity.

At 2.25 per cent, our official rate is still well above zero but, even so, we're close to the point where the costs and risks of a rate cut threaten to exceed the benefits.

The upshot of the great battle between Keynesians and monetarists in the 1970s was agreement that monetary policy was the most effective way to fight the opposing evils of inflation and unemployment.

By the 1990s, some concluded that manipulation of interest rates by independent central banks had conquered the problem of keeping economies on an even keel. Yeah, sure.

We discovered a fatal weakness in the new macro management: monetary policy was great at controlling ordinary inflation, but when used to stimulate weak demand it was prone to encouraging excessive borrowing and asset-price bubbles which, when inevitably they burst, caused deep and protracted "balance-sheet" recessions.

From our perspective, the answer to our present problem isn't more risky rate cuts, it's greatly increased federal spending on infrastructure to fill the hole created by the fall in mining investment.

Read more >>

UPCOMMING

Read more >>

Privatisation: neither very good nor very bad

The era of privatising government-owned businesses is pretty much done and dusted, but two governments have dragged their feet, making opposition to their efforts to complete their privatisation programs a key issue in the Queensland election last week and the NSW election next month.

Voters have always disapproved of privatisation, but that hasn't stopped a lot of it happening. Particularly in recent years, however, voters' doubts have been fed by the dire predictions of those unions whose members fear they will be adversely affected. Let private owners loose and prices to consumers will skyrocket!

So what evidence is there that the prices charged by privatised businesses are higher than those of government-owned businesses? And where's the evidence that privatisation is good for the economy, anyway?

Malcolm Abbott, of Swinburne Business School, and Bruce Cohen, of the Grattan Institute, have conducted a meta-analysis (a study of studies) of the effects of privatisation in Australia, published in the latest issue of the Australian Economic Review.

If you're surprised to learn that most of what could be privatised already has been, and that most of it happened quite a while ago, let me quote their facts and figures.

They estimate that the sale prices of all the privatised businesses since 1987 total $194 billion. The bulk of those sales occurred in the 1990s. The federal government accounted for just over half that total, with Victoria taking a quarter and NSW and Queensland 7 per cent each, with South Australia and Western Australia making up the remaining 8 per cent.

Broken down by industry, communications (mainly Telstra) accounts for a third of the total proceeds, electricity for a quarter, financial services (Commonwealth Bank, state banks and state insurance offices) for 15 per cent, aviation (Qantas, Australian Airlines and many airports) for 9 per cent, gas for 8 per cent and, among the tiddlers, gambling (TABs and lotteries) for 2 per cent.

One thing this list proves is that though many people disapprove of selling off government businesses, once it has happened we get used to it pretty quickly.

The stated reasons for believing privatisation to be a "reform" vary. For the Howard government, the attitude was: "Everyone knows privately owned businesses are better managed than government-owned, so why not sell our businesses and use the proceeds to reduce debt?"

A more sophisticated rationale is that deregulating an industry to foster competition in it is far more important in encouraging productive efficiency (higher productivity) and better service to consumers. Once that greater competitive pressure has been achieved, you might as well sell the business you own and use the proceeds for some more beneficial purpose.

So what do all the studies tell us about how the great privatisation experiment has worked out? The evidence is, in the authors' words, "far from conclusive". Despite the extensive privatisation that has occurred, only a limited amount of research has been undertaken.

In the case of government-owned banks, the industry had been extensively deregulated before they were sold. Their productivity did improve, but not until long after they had been sold.

And it's hard to know how much this improvement was because of deregulation and greater competition, rather than privatisation.

I think it's still true that the banks' interest margin - the gap between what they pay to borrow and what they charge to lend - is lower than it was before deregulation. I doubt if privatisation has made much difference to this.

In the case of aviation, the government deregulated its two-airline policy well before it allowed Qantas to take over Australian Airlines and then be privatised. I don't think there's much doubt that domestic air fares have been lower than they would have been had deregulation not occurred.

The lower international air fares are explained by privatisation and deregulation in many countries, combined with the advent of bigger, more cost-effective planes.

The process of deregulating telecommunications, including the admission of new competitors such as Optus and Vodafone, began long before the staged privatisation of the former monopolist, Telstra.

I think the sale of Telstra could have been done in a way that did more to promote competition - no doubt at the cost of a lower sale price for the monolith - but there's little reason to believe privatisation has made prices higher than otherwise or reduced productive efficiency.

Of course, the spread of mobile phones and use of the internet have transformed the telecom industry. Distance phone calls are cheaper than they've ever been. Technological advance explains most of this, but increased competition would have helped.

It's a similar story with electricity. It's the break-up of the old state-by-state monopolies, the introduction of competition and the formation of the national wholesale electricity market, much more than privatisation, that's done most to affect the efficiency of the industry and the prices we're paying.

Most of us have forgotten the big real price falls achieved in the 1990s, even before the major reforms took place. The more recent series of big price rises occurred despite the success of the national market in holding down wholesale prices.

The rises were caused by failure in the regulation of prices charged by the privately and publicly owned monopolies responsible for distributing the power (the "poles and wires"). But this failure has been corrected and the distribution component of retail prices is likely to fall now.

Studies suggest that, in competitive markets, whether businesses are publicly or privately owned makes little difference. It follows that consumers have little to fear from privatisation in electricity.

So how would new private owners make room for the profit they seek if they have little scope for lifting prices? By removing any remaining overstaffing and workers' perks.

That's why the unions are running scare campaigns about soaring prices.

Read more >>

Voter volatility caused by politicians' bad behaviour

The latest political excitements in Queensland and Canberra leave a lot more at stake than the future of Tony Abbott and the fortunes of the Coalition. They show the rules have changed in Australian politics, with lessons for politicians on both sides.

What's important for the good government of the country and the economy, however, is that the pollies draw the right conclusions.

Abbott's ministers are right to conclude that politics has become quite volatile, with voters capable of swinging from one extreme to the other between one election and the next. That's what we saw in Queensland on Saturday, and what we may see - to a lesser extent - in NSW next month. It's what the polls say would happen federally if an election were held today.

The first implication of this volatility is that, across the nation, no party stays in the wilderness for long.

In consequence, parties that indulge in blanket negativity in opposition, or vindictiveness towards their opponents when in government, won't have long to wait before the other side gives as good as it gets.

Until that lesson is learnt, it will be a race to the bottom in standards of political behaviour, which will only heighten voters' willingness to throw out governments.

Another implication is the end of the fair go. With the defeat of Coalition governments in Victoria last year and Queensland last week, the comfortable assumption that voters invariably give first-term governments a second chance to prove themselves has gone.

What's more, Julia Gillard's Labor government went within a whisker of defeat in 2010.

There's been a breakdown in voters' "brand loyalty". Some people remain rusted on to Labor and some will vote Coalition no matter what, but the proportion of voters willing to change their vote from election to election - and vote one way federally and the other in their state - is much higher than it was.

The classic swinging voter used to be regarded as someone who took little interest in politics between elections, but if my pilgrimage is any guide, they've been joined by people who follow the politicians' antics closely.

So what has brought this change about? The politicians want to blame the advent of the 24-hour media cycle, including social media. The game moves ever faster, with far more pressure on governments to react to every little thing that comes along and on pollies who "misspeak" in some way.

The media's attention span is much shorter, which makes it harder for governments to explain and justify their reform proposals. Mixing metaphors, this should make it easier for someone in the gun to stonewall until the spotlight has moved on. In practice, the intensity of the blowtorch is so great that offenders crack, adding to the instability.

There's a fair bit of truth to this complaint, but if the pollies think it does most to explain their predicament, they're deluding themselves. The greater explanation is that decades of ever more manipulative behaviour by our politicians have destroyed their credibility and eroded our trust and loyalty.

One problem is their preference for appearing to solve problems rather than actually tackling them. Another is the utter unreality of election campaigns, with all their unaffordable bribes and pretence of painless solutions to problems.

The biggest problem, of course, is decades of broken promises by both sides. Gillard broke her promises to balance the budget and not to introduce a carbon tax. Campbell Newman promised not to sack public servants. Abbott campaigned on the restoration of trust and high standards, but also made promises he can't have intended to keep - and didn't need to make to win.

The great risk from all this is that politicians ignore their own part in causing voters' caprice and convince themselves the public will no long countenance unpopular economic policies.

The biggest issue in the Queensland election was voters' rejection of a massive program of privatisations used largely to reduce government debt. But I'd wait for the outcome of the NSW election - where Mike Baird is promising to devote the proceeds from a smaller program to building new infrastructure - before concluding asset sales are now verboten.

Some Abbott ministers are concluding the public's rejection of last year's budget means voters don't care enough about debt and deficits to be willing to bear a little hip-pocket pain. This is self-delusion.

It conveniently forgets the calculated unfairness of Joe Hockey's choice of budget savings, all the broken promises and the government's ignominious climb-down from its pre-election claim that a "budget emergency" existed but could be fixed instantly and without pain.

The ubiquitous strategy of oppositions getting elected by making themselves a "small target", with promises to do nice things and not do a host of nasty things, is now revealed as a dangerous weapon. It works well enough if the incumbent government is on the nose, but leaves you without a mandate to tackle the difficult problems you inherit.

There's a difference between being tough and being extreme. Newman was sacked and Abbott is in trouble because of their unforeshadowed extremeness - both in their policies and their way of implementing them.

Trust can be restored and tough measures accepted if our politicians stop lying to us and playing favourites in the solutions they propose. Putting up leaders who are remotely likeable would also help.

Read more >>

Economists shouldn’t be apologists for business

As the nation's economists gird their loins for a year of furious debate over economic management and reform, there's a soul-searching question they need to face.

This year's policy agenda will be dominated by economic issues. First is what's to be done about what wasn't done last year: the failure to get the budget on a credible course towards eliminating the structural deficit.

What can be done to reduce wastefulness in health spending that makes more sense than GP co-payments? Is it really a smart idea to partially deregulate government-owned and highly bureaucratic universities with their high degree of pricing power?

Apart from the government's response to last year's review of the financial system, there's the various inquiries being conducted this year: the review of the tax system, review of federal-state responsibilities and review of industrial relations.

In these things the government's big-business backers have very strong views about which reforms it should take for ratification at next year's federal election.

But while the economists are willing the politicians to "show leadership" there's a tough question they should be asking themselves: is conventional economics in reality just a rationalisation of the interests of business? Are economists spin doctors seeking to advance the greed of the rich and powerful?

That's certainly not what economics is supposed to be about. Its stated ethic is that the interests of consumers should always trump those of producers. Adam Smith's Wealth of Nations carries a powerful condemnation of business people's propensity to engage in rent-seeking.

But that's just the theory. In practice these days, it's hard to find many economists pushing such a line in the public debate. One honourable exception is Professor Ross Garnaut, who has pointed to the way the push for economic reform has degenerated into rival interest groups striving for nothing more than sectional advantage.

Why are so few of his colleagues joining him in this cause? Why do so many economists stay silent while business interests distort the principles of economics to disguise their self-seeking? And, indeed, many economic consultants make their living by crafting such distortions - often through modelling - for whoever can afford their services.

One reason for the economists' silence is that most are employed by bosses who don't want them criticising business. The business economists may speak endlessly on whether or not the Reserve Bank will cut interest rates, but on little of lasting importance. Econocrats aren't supposed to express personal opinions and, in any case, their masters - of either colour - wouldn't want them offending business.

Even the academic economists enjoy less freedom to critique business behaviour in an era where the backdoor privatisation of universities has made them more dependent on business donors and where individuals are too busy publishing or perishing in journals with zero interest in Australian issues.

But the full explanation goes far deeper. Biases hidden in the neo-classical model of how markets work have caused "the economists' way of thinking" to be deeply suspicious of government intervention in markets and unthinkingly supportive of business behaviour.

One bias is the assumption that economic agents always behave rationally in pursuit of their self-interest. So individuals always know better than governments and any strange behaviour by businesses can be explained only by their rational response to distortions caused by interfering politicians.

Another bias arises from the model's unit of analysis: the individual firm or consumer. This leaves no room in the model for any kind of benefit from collective action. Rather, the market's "invisible hand" transforms agents' rational self-interest into the public good.

So economists keep mum while governments assume the budget can be returned to surplus only by reducing government spending, not by increasing taxation, and that all government spending is dubious, but distorting "tax expenditures" (which, purely by chance, heavily favour business and high income-earners) aren't a problem.

Even so, many economists are inclined to agree with business lobbies that the one exception to the fatwa against higher taxes could be an increase in the goods and services tax - provided the extra revenue is used to reduce the tax on companies or high income-earners.

As for industrial relations, conventional economic theory's primitive analysis of the labour market - which largely assumes away differences in the quality of labour, as well as assuming units of labour are no different from units of any commodity - leaves many economists happy to accept that the more bargaining power employers enjoy the better off all of us will be.

Many of these ingrained prejudices are being challenged by empirical research, but "evidence-based policy" that doesn't fit with business's perceived interests is being studiously ignored by most economists.

Read more >>

The CPI isn't just made up in an office somewhere

So, the Bureau of Statistics has spoken. This week we learnt that prices rose by a mere 0.2 per cent in the three months to December, reducing the annual rate of inflation to just 1.7 per cent. But how does the bureau come up with such figures? And who believes them?

Short answer: not everyone. The public knows so little about how the consumer price index is calculated, and the bureau's figures seem so much lower than the impressions of rising prices people gain from their own experience, that many people suspect the figures are just cooked up by bureaucrats in an office somewhere.

In reality, the structure of the CPI has been carefully thought through and a lot of effort and shoe-leather goes into ensuring the figures we are given each quarter are as reliable as possible. It's a trickier business than you might imagine.

For a start, there are lots of different ways to measure inflation. The bureau publishes maybe half a dozen different measures, of which the CPI is just one. You can measure the change in prices paid by businesses ("producer prices") or those paid by consumers, or a combination of both.

Even so, the CPI is by far the most widely used measure. As explained by the bureau on its website, it measures changes in the price of a fixed basket of goods and services bought by consumers in the households of the nation's eight capital cities.

Each quarter the bureau checks the prices of about 100,000 items. Prices are collected by visiting supermarkets, restaurants, department stores, schools and websites. These physical visits, in all states and territories, are supplemented by prices collected by telephone or the internet.

The aim is to collect the prices people are actually paying, so when items are on special or being discounted, the lower price is counted.

The 100,000 separate prices are grouped into 87 broad expenditure classes. These are then categorised into 33 sub-groups and 11 main groups: food and beverages; alcohol and tobacco; clothing and footwear; housing (rents, new house prices, repairs and maintenance, council rates, water, electricity and gas); furnishings, household equipment and services; health (including private health insurance); transport (motoring and fares); communication (telecommunication equipment and services, postal); recreation and culture (including audio-visual and computing equipment and services; newspapers and books; holiday travel and accommodation; sports, toys, hobbies and pets); education (public and private preschool, primary, secondary and tertiary); and insurance and financial services.

About every six years the bureau does a large survey, asking people to record exactly what they're buying and how much of their income they're spending in each category. It then adjusts the items included in the CPI basket of goods and services to ensure they are up to date.

More significantly, it uses this "household expenditure survey" to give each of the items in the basket the right "weight", or relative importance. You can't just throw in one loaf of bread, one new refrigerator and one new car. Bread is cheap but we buy several loaves a week, while refrigerators and cars are expensive, but we buy a new one only occasionally.

The bureau has been revising the content of the CPI basket and the weights given to the various spending categories every few years since 1948, as our habits and the economy have changed. Over such a long period, the relative importance of spending categories has changed a lot.

Then, and on average, food accounted for 31 per cent of household budgets, whereas today it's less than 17 per cent. Similarly, clothing and footwear has dropped from 22 per cent to 4 per cent. And household supplies and equipment have gone from more than 13 per cent to 9 per cent. Alcohol and tobacco have gone from almost 11 per cent to 7 per cent.

But if all these things are taking a smaller proportion of the household budget, it's only partly because they have become relatively cheaper. It's mainly because we are spending on things now that didn't exist 67 years ago, or choose now to devote a higher proportion of our hugely higher real incomes to some things but not others.

The classic example of the latter effect is housing: its share of household budgets has almost doubled to more than 22 per cent. And with most households now owning at least one car, spending on transport has almost doubled to 12 per cent of budgets.

Then there are the spending categories that have pretty much popped up out of nowhere: recreation and culture, 13 per cent; health, more than 5 per cent; insurance and financial services, 4 per cent; and education and communications, 3 per cent each.

One point to add: though the Reserve Bank's inflation target - to hold the inflation rate between 2 and 3 per cent on average over the cycle - refers to inflation as measured by the CPI, in practice it pays most attention to the average of various measures of "underlying" inflation, derived from the CPI.

This is because the "headline" CPI is quite volatile. It tends to bounce around because of the ups and downs in such things as petrol prices and the prices of fresh fruit and vegetables (caused by the weather), but also because of the one-off effect of government policy changes, such as the abolition of the carbon tax.

The Reserve Bank is interested in assessing the strength of general inflationary pressure in the economy and doesn't want to be distracted by temporary price changes that have extraneous causes. So it uses various statistical techniques to remove this volatility.

Its measures of underlying inflation showed that prices rose by 0.7 per cent in the December quarter and by about 2.3 per cent in 2014. Taken by itself, this gives the Reserve no reason to change the official interest rate on Tuesday.

Read more >>

We face a year of furious debate leading to very little

Let me start my year with a confession: listening to the Australian of the Year, Rosie Batty, arguing at length for more attention to be paid to domestic violence, my first thought was she was laying it on a bit thick. There are lots of problems in the world and domestic violence is just one of them.

But then another thought occurred: this year we'll be listening to hundreds of men banging on about problems far less important than domestic violence. The vast majority of the problems we hear about - and I write about - will be economic. Is the economy speeding up or slowing down? Will the Reserve Bank cut interest rates at its next board meeting?

Above all, they'll be worried about preventing a slowing in the rate of improvement of our standard of living. That is, they'll be almost wholly concerned with the material, tangible aspect of our lives. Few will concern the more feminine, airy fairy "social" side of our lives.

For the most part, our politicians will leave such touchy-feely concerns to single-issue campaigners such as Rosie Batty. They focus on the really big, important issues, and think about the lesser, social issues only when the Rosie Battys gain enough public support for the pollies to decide they'd better be seen doing something.

Truth is, the political year we face won't be any fun (except for the media). It will be another year in the difficult education of not-so-young Tony. He's having trouble learning what John Howard well knew: even prime ministers don't have much power to do as they please.

You can push through a few silly self-indulgences, such as reinstituting knighthoods, but even that will cost you politically. And what you can't do is reshape the world in a way that favours the rich and powerful while the rest of us nod approvingly.

This year a lot of ugly chickens will come home to roost. Part of the way Abbott got himself elected was to promise he'd do nothing unpopular in his first term. All the "reforms" being urged on him by the big end of town would be inquired into and, if it was decided radical changes were needed, they'd be taken to the next election for voter approval.

Abbott dragged his feet in commissioning these inquiries, but it will be full-on this year. Ostensibly, much of the agonising will arise from our refusal to contemplate paying higher taxes in return for greater government services and from the Coalition's claim to be able to achieve lower taxes.

In reality, the problem is the government's refusal to solve its revenue problem by cracking down on all the rorting of the tax system by business and high income-earners. Turns out many of these people are prepared to make an exception to their fatwa against higher taxes: surely an increase in the goods and services tax wouldn't hurt?

We face a year of contention as business rent-seekers seek to further advantage themselves, all in the name of much-needed "reform" and ensuring the continued rapid rise of our material standard of living (starting, of course, with theirs).

But ask yourself this: can you really see the ever-popular Tony going into next year's federal election with a proposal to increase the GST or any planned industrial relations changes his opponents could characterise as the restoration of Work Choices? And, even if he did, can you see him winning?

See? We face a year of furious economic and political debate leading to very little.

If you haven't guessed, I'm not facing such a year with any enthusiasm. And Rosie Batty reminds me we'll be earnestly debating over running repairs to the capitalist system while largely ignoring the social issues that, for far too many of us, stop our high material standard of living from translating into a high quality of life.

Take the question of increased longevity. Joe Hockey has signalled we'll be hearing a lot about this after the release of another intergenerational report in a few weeks' time.

The pollies will pay quick lip-service to the notion that living longer may not be such as bad thing, before portraying it as a terrible problem threatening "unsustainable" growth in government spending on pensions, aged care and healthcare.

But I have good news for those who obsess about the economic while ignoring the social. There is increasing evidence that how long people live is strongly influenced by the quality of their relationships with family and friends, particularly their face-to-face contact.

Around the world there is evidence of the number of people's very close relationships declining, of more people living alone and increasing loneliness. Australia is unlikely to be an exception.

So the solution to the fiscal longevity problem is at hand. All we have to do is hope people's intimate relationships continue to decline and loneliness continues to increase. And the best news is we've already instituted the main policy response needed: malign neglect.

Of course, it would speed things up if we were to step up the federal and state funding cuts to community organisations that help people in need. I'd start with Meals on Wheels. And don't forget that ignoring the obesity epidemic will do much to stop babies living to 150.

I reckon we should make it a national KPI to get life expectancy down to 75 by 2055.

Read more >>

Free emotions come with a price tag

At times such as the Martin Place siege and its tragic aftermath, it doesn't help to have been trained to think like an economist, to analyse the situation as coolly and rationally as possible, keeping your emotions in check. I feel like I'm from Mars, while everyone else is from Venus.

Nor does it help to be among those who respond to such events as part of their job. Inevitably, the police, security agencies, politicians and the media see things differently from bystanders free from vested interests or responsibility.

I wonder why this event has attracted so much public attention, concern and outpouring of emotion. It strikes me that humans have emotional as well as physical muscles, for which they seek regular exercise.

When we don't have enough emotion-stirring events in our lives we seek release mainly through fiction, including crime fiction, but nothing beats the real thing.

When we express great interest and concern about the tribulations of others - when we buy flowers to lay on an impromptu shrine - we see this as heart-warming proof of our empathy and sensitivity. Our humanity. We're proud of ourselves - we care.

Sorry, but I'm sceptical. What occurs to my hard head is that had two people been killed in a car crash on the Sydney Harbour Bridge at the same time as the siege, this would have attracted little interest and no sympathy.

Why would the reaction to the events be so different? One reason is the siege's greater novelty. People die on the roads every day. Another is its greater suspense. It took 16 hours of continuous TV broadcasting by the new, just-keep-talking "breaking news" industry before the outcome was known.

And from the moment the gunman produced his black flag it became possible to jump to the conclusion the siege was a terrorist attack, as almost everyone did. This lifted the event to a new level of menace and excitement, something even people in other countries were interested in.

But to me this sounds more like entertainment than compassion.

It proved to be the criminal act of a disturbed individual seeking notoriety. Yet so invested in the spurious link to terrorism had so many individuals and organisations become that many sought to keep the terrorism theme going. Somehow a common criminal was still a terrorist.

Rather than seeking the views of security consultants and anti-terrorism trainers, I'd like to have heard more psychologists and sociologists explain why we react so emotionally to such events.

Why, since the death of Princess Di, we've taken to displaying our grief so conspicuously. I feel sorry for the families of victims - of course I do - but I don't feel I have to demonstrate it with flowers.

Being in the business, I'm conscious of how many institutions see a buck to be made, metaphorically or literally, out of heightened concern about terrorist attacks.

"Security" must surely be one of our fastest-growing industries, whether within government, in the private sector or private contracting to government. Every time we give ourselves a thrill by imagining a terrorist threat we create the conditions for more ill-judged spending on security.

Humans are well known to overestimate the likelihood of low-probability events, and fear of terrorism, or even criminal sieges, is the classic case.

After the thrill come the inquiries, the righteous indignation, the recriminations and hindsight wisdom. This is where the politicians come into the frame. You can be sure their primary motive will be to shift any blame to others.

The more they push the blame on to the police or security agencies, the more those outfits will demand more resources and more power to intrude on the rights of citizens. And don't think the taxpayer won't be forthcoming.

Politicians will promise to redouble their efforts to make us all secure. The one thing they'll never admit is that it isn't possible to ensure no one ever gets through the net, no matter how tight you make it.

Nor will they admit that, once you've covered the basics, you quickly get into diminishing returns - you have to spend more and more to achieve less and less.

But spend more they will. Why? So they've got something to point to should a genuine incident ever slip through. Making it harder for people to get bail will punish many innocent people and greatly increase prison overcrowding and costs.

Pollies love creating the appearance of action. Rushing through Parliament laws giving the security agencies powers they already have is a favourite trick. So is proving you're on the job by annoying people at airports.

We enjoy a good release of emotion, but don't doubt there'll be a tab for taxpayers to pick up.

Read more >>

Materialist era a qualified success

Tired of obsessing over what happened in the economy yesterday? Let's go to the other extreme and look at what's been happening in the past 200 years, and broaden the focus from poor, ailing Australia to the world.

In October, the Organisation for Economic Co-operation and Development published a report, How Was Life? Global Well-Being Since 1820. It's an extension of the work of great economic historian Angus Maddison.

His life work was to piece together estimates of real gross domestic product for all the big countries and regions of the world between 1820, which he took to be the end of the (first) industrial revolution, and 2000.

This latest study has extended the GDP figures to 2010, but also tried to estimate measures of various other socio-economic indicators of well-being.

It paints a picture of the way economic development has spread throughout the world, raising living standards, widening but then narrowing the gap between incomes, fostering population growth and, when you combine the two, causing great damage to the globe's natural environment.

The world's population was about 1 billion at the start of the 19th century, but has grown to more than 7 billion today. That growth was both a cause and a consequence of economic development and the technological advance it promotes.

Advances in public health, particularly sewerage and clean water, led to falling death rates, which slowly encouraged people to have fewer children. Then advances in medical science took over, eventually including more effective means of contraception.

However, these improvements took a long time to spread from Western Europe and the "Western Offshoots" (Maddison's name for the United States, Canada, Australia and New Zealand) to the rest of the world.

This is the story of the huge challenge the world economy has faced in the past 200 years: how to feed, clothe and house this growing population. Overall, we've done it.

Between 1820 and 2010, the world's average real GDP per person increased by a factor of 10. Multiply that by the sevenfold increase in population and world real GDP rose by a factor of 70.

The first weakness in this materialist success story is obvious: this economic growth was spread very unevenly. In 1820, the richest country, Britain, was at most five times as wealthy as the poorest countries. By 1950, the richest countries were more than 30 times as well off.

Only recently has the spread of industrialisation to China and India, which between them contain about one-third of the world's population, caused global income inequality to begin to decline.

Another indicator the study examines is the movement in the real wages of unskilled labourers. They rise more or less in line with real GDP, suggesting that some income does indeed trickle down, even if it has to be helped along by government interventions such as minimum wages.

During the first half of the 19th century, unskilled wages were above subsistence level only in Europe and the Western Offshoots. Now, however, world unskilled real wages are about eight times what they were then.

They were always highest in the Western Offshoots, with Western Europe catching up only since World War II, and they are still low in south-east Asia and Africa.

Turning to education, in 1820 less than 20 per cent of the world's population was literate, and most of these were in Europe and its offshoots. Today, literacy is nearly 100 per cent almost everywhere, although in south-east Asia, the Middle East and North Africa, it's about 75 per cent, and in the rest of Africa it's only 64 per cent.

Much of the increase in literacy has been achieved since the war and decolonisation. It has been accompanied by rising average years of education in all parts of the world. Levels of global inequality are much lower for education than for income.

At the start of the industrial period, average life expectancy was about 40 years in Europe and its offshoots, and 25 to 30 in most of the rest of the world. Only after the late 1890s did life expectancy start to rise significantly. Now, it's about 80 in the rich countries. Elsewhere, the catch-up started after the war, with most of the other world regions now up to about 60 to 70, and only Africa lagging significantly behind.

Income inequality within particular European and offshoot countries has followed a U shape, declining between the end of the 19th century and about 1970, since when it has risen sharply. In other parts of the world, particularly in China, recent trends have led to greater income inequality.

However, when we look at global income inequality, it was driven largely by increasing inequality between countries, as opposed to within them. It worsened until the 1950s, but has since stabilised.

The other big weakness in the success story is, of course, what we have done to the quality of the environment. There has been a long-term decline in biodiversity worldwide. Emissions of carbon dioxide have been rising since the industrial revolution, with its shift to fossil fuels such as coal and oil.

Although almost all the greenhouse gases that have built up in the atmosphere since the early 19th century are the result of economic activity in the developed countries, China's huge population and remarkably rapid industrialisation mean that it has now taken over from the US as the world's largest emitter.

Something tells me that, from here on, climate change and other environmental damage will be the main factor limiting the spread of industrialisation and prosperity to the remaining less-developed parts of the world.

Read more >>

Greenery has magic properties

I've just got to get through extended Christmas festivities - and subsequent mopping up - and I'll be off on my hols. What am I doing this year? Same as most years: heading for the bush. This time, we're going to the mountains.

As a denizen of the inner city, I've long had a great desire to get out into the country whenever possible. Get into the grass and trees, where the air is clean and the sleeping seems better.

There's a place we rent not far up the coast that backs on to a national park. I call it Lyrebird Lodge. And even when we go overseas, I often find the country towns beat the big cities.

In recent times, I've been singing the praises of big cities: how efficient they are and how they promote creativity and productivity, particularly in the era of the information economy.

But cities have their dark side and insufficient grass and trees is it. That's more than just a personal preference. Environmental psychologists and others have been gathering impressive evidence of the health-giving properties of greenery.

It's evidence to support the US biologist E. O. Wilson's "biophilia" hypothesis: because humans evolved in natural environments and have lived separate from nature only relatively recently in their evolutionary history, people possess an innate need to affiliate with other living things.

Research published last year found that people who live in urban areas with more green space tend to report greater well-being - less mental distress and higher life satisfaction - than city dwellers who do not have parks, gardens or other green space nearby.

Mathew White and colleagues at the University of Exeter Medical School used a national longitudinal survey of households in Britain to track the experience of more than 10,000 people for 17 years to 2008.

They found that, on average, the positive effect on well-being was equivalent to about one-third of the difference between being married rather than unmarried and a 10th of the effect of being employed rather than unemployed.

A different study followed the experience of more than 1000 people over five years, in which time some moved to greener urban areas and some to less green areas. The results showed that, on average, people who moved to greener areas felt an immediate improvement in their mental health. This boost could still be measured three years later.

"These findings are important for urban planners thinking about introducing new green spaces to towns and cities, suggesting they could provide long term and sustained benefits for local communities," the lead author of the study said.

A study from Canada began by summarising all the various benefits from contact with nature that other research had found: it can restore people's ability to pay attention, improve concentration in children with attention-deficit hyperactivity disorder, and speed recovery from illness. It might even reduce the risk of dying.

Yet another study notes that the first hospitals in Europe were infirmaries in monastic communities where a garden was considered an essential part of the environment in that it supported the healing process.

This study of studies, from Norway, says: "In most cultures, both present and past, one can observe behaviour reflecting a fondness for nature. For example, tomb painting from ancient Egypt, as well as remains found in the ruins of Pompeii, substantiate that people brought plants into their houses and gardens more than 2000 years ago."

Many studies find health benefits from contact with nature. The Norwegian paper says a key element in this may be nature's stress-reducing effect. Stress plays a role in the causes and development of cardiovascular diseases, anxiety disorders and depression.

Contact with nature may help "simply by being consciously or unconsciously pleasing to the eye".

Office employees seem to compensate for lack of a window view by introducing indoor plants or even just pictures of nature. One study found that having a view to plants from the work station decreased the amount of self-reported sick leave.

One of my favourite blog sites, PsyBlog, conducted by the British psychologist Dr Jeremy Dean, notes research estimating that people now spend 25 per cent less time in nature than they did 20 years ago. Instead, recreational time is often spent surfing the internet, playing video games and watching movies.

But this is more up my line: Dean reports a study finding that taking group walks in nature is associated with better mental well-being and lower stress and depression.

The study evaluated a British program called Walking for Health, and involved nearly 2000 participants, divided into two matched groups of those who took part in the walks and those who did not.

The walks, which extended over three months, combined three elements, each of which you'd expect to make people feel better: walking, being in nature and being with other people.

Those who seemed to benefit most were those who had been through a recent stressful life event, such as divorce, bereavement or a serious illness.

"Our findings suggest that something as simple as joining an outdoor walking group may not only improve someone's daily positive emotions, but may also contribute a non-pharmacological approach to serious conditions like depression," one of the study's authors said.

You beaut. When I get to the mountains, I'm hoping to do a lot of bush walking.

Read more >>

Midyear forecasts do add up - sort of

Did you catch the apparent contradiction in this week's mid-year budget update? It left unchanged the forecast that the economy would grow by 2.5 per cent this financial year, but then blamed a weaker-than-expected economy for most of the $10 billion blowout in the expected budget deficit.

How on earth is that explained? By a widening gap between real gross domestic product and nominal GDP.

We tend to focus on the growth in real GDP - GDP adjusted for inflation - as the best guide to how many additional jobs are being created and, in normal circumstances, what's likely to be happening to our material standard of living.

Trouble is, as former treasurer Wayne Swan kept saying, we live - and work, earn income and pay taxes - in the nominal economy, not one that's already been adjusted for inflation.

At budget-time Treasury was expecting nominal GDP to grow by 3 per cent and real GDP by 2.5 per cent, implying that the prices of all goods and services Australia produces would rise by 0.5 per cent.

Now, however, it's expecting nominal GDP to grow by just 1.5 per cent, implying it's expecting the overall price of the stuff we produce to fall by 1 per cent.

So initially Treasury was expecting "producer" prices to rise only a little overall and now it's actually expecting them to fall. Why? Because of falls in the prices our producers of commodity exports receive, particularly for iron ore.

The budget in May assumed the price of iron ore would stay at $95 a tonne, but now Treasury's assuming it will stay at its recent level of $60. Lower export prices mean lower mining company profits which, in turn, mean lower collections of company tax - by $2.3 billion this financial year, and more in subsequent years.

But there's another major factor contributing to the lower growth in nominal GDP: nominal wage rates are now expected to grow by only 2.5 per cent, not 3 per cent. This (plus lower growth in employment) is expected to reduce the growth in collections of income tax by a further $2.3 billion.

Adding a few other items, expected total tax receipts have been cut by $6.2 billion, with all the delays and deals in the Senate explaining most of the remainder of the $10 billion increase in the now-expected budget deficit of $40 billion.

The mid-year document says that if nominal GDP grows by only 1.5 per cent in 2014-15, this will be its weakest growth in more than 50 years. But the truth is nominal GDP has been growing by much less than its usual 5.5 per cent or so (real growth of 3 per cent plus inflation of 2.5 per cent) ever since mining export prices peaked in 2011.

The writedown in expected tax receipts of $6.2 billion this financial year increases to $31.6 billion over the four years of the "forward estimates". And that brings the total writedown in tax receipts since the Abbott government was elected to more than $70 billion.

Wow. The prices we get for our mining exports have been falling much further and faster than Treasury has expected. Of course, the rot set in during Julia Gillard's term. It was the biggest reason she failed to keep her promise to get the budget back to surplus in 2012-13.

Back then, Joe Hockey was having none of Swan's claim that nominal GDP and tax collections had collapsed under him. No, there was just a single explanation for the continuing budget deficit: Labor's uncontrolled spending.

Different story now you're Treasurer, eh Joe. You've got it right now.

But there's a lesson in this week's budget blowout for Labor, too. In last year's mid-year update, Hockey produced an estimate for the 2013-14 budget deficit of $47 billion, up $17 billion on the $30 billion the secretaries of Treasury and Finance signed off on during the election campaign.

About $10 billion was creative accounting and other dubious transactions Hockey claimed were Labor's fault. The remaining $7 billion was explained by Treasury revising down its forecasts for employment and wage growth and, hence, tax collections.

Former Labor ministers were convinced Hockey lent on Treasury to make its revenue forecasts worse than they needed to be and so make Labor look bad. My guess, however, is that Treasury had been over-forecasting revenue for so long it seized the opportunity to try to get ahead of the game and, if anything, start under-forecasting revenue.

Subsequent events have confirmed the wisdom of Treasury's downward revisions at that time. They proved pretty right. But as this week's further downward revisions for the following financial year show, Treasury is yet to get ahead of the game in accurately forecasting the extent of the slowdown in the growth of tax receipts.

So, Labor, no conspiracy, just the usual stuff-up. That's to say, the usual human frailty. Treasury is no better at predicting what will happen to commodity prices than the rest of us.

There remains one more puzzle to be explained. If Treasury is now expecting slower growth in employment and wages this financial year, how can this not have led it to revise down its forecast of real GDP growth of 2.5 per cent?

Good question, but you'll be sorry you asked. Part of the explanation is a change in the expected composition of the growth - some components were revised up, some down.

But longstanding convention requires official forecasts to be expressed in fractions of a quarter, so as to avoid "spurious accuracy". Strictly, the forecast is 2 1/2 per cent, not 2.5 per cent. Treasury's actual, decimal-point forecast has been revised down, from a bit above 2 1/2 to a bit below.
But not enough below to be closer to 2 1/4 than to 2 1/2.

Don't say I didn't tell you.

Read more >>

There has to be more to our future than the budget

The end of last year was too early to make judgments about Tony Abbott and his government, but by now we can make a reasonable assessment. And it's hardly a favourable one, even by those who couldn't wait to see the back of infighting Labor.

But though it's easy to bang on about the Abbott government's failings, I'm beginning to think it's too easy. Maybe our politicians are an uninspiring lot because their citizens aren't much better.

My strongest feeling in recent days is what a mentally incestuous, intellectual backwater we've allowed Australia to become, even in an age of instant access to the newest and best ideas.

It's all there to enlighten and guide us into better paths, but few of us seem to be taking it in - not our politicians, our bureaucrats, our media commentators, maybe not even our academics. Just a few of our think-tanks - most notably, the Grattan Institute.

The future is pregnant with exciting possibilities, but we sweat the small stuff and keep chasing the same tired old reform ideas round and round the track.

Monday's midyear budget review was a depressing reminder that this government or the next is likely be wrestling to get the budget back to surplus for up to a decade.

Can you imagine how much effort and attention from our politicians, econocrats and media this will consume? This year's argument played out every year for many years?

And for what? To get the budget back to balance. I'm not saying balancing the budget is unimportant; of course it's important. But it's just housekeeping. It has to be done, but once it has been it's just the avoidance of a problem.

It doesn't achieve anything positive. And yet we're hoping that, sometime within the next decade, we'll be able to list it as one of our great achievements.

So bogged down and obsessed by the budget has our elite become that, in all our fiddling with government spending and taxation, an attitude is developing - especially in the purse-string departments - that it doesn't much matter what measures we take so long as they reduce the deficit.

This is impoverished, desperation thinking. We ought to be choosing budget measures that kill two birds with one stone; that improve the government's efficiency or the economy's efficiency or the fairness of our tax-and-transfer system - or even, dare I say it, improve the quality of our lives - as well as cutting the deficit.

But when you look at this year's budget you see little sign of such broader thinking. Take the way successive governments have imposed Orwellian "efficiency dividends" on government departments and agencies, which by now actually sets off another round of compulsory redundancies.

Such savings draw approval rather than complaint from a shiny-bums hating public, but the notion that so many jobs can be cut without impairing the public service's ability to do its job - and to give the government high quality advice - is crazy.

Staff cuts in the Taxation Office are one reason tax collections have fallen short. Staff cuts in Treasury and Finance are one reason the budget was so bad. And why do you think the Bureau of Statistics is having so much trouble telling us what's happening to unemployment?

We're indebted to a think-tank - not the econocrats - for reminding us how unequal the distribution of wealth between the generations has become. To a fair extent this arises from longstanding and increasing discrimination between the generations in the government's tax and spending policies.

Did the budget seize the opportunity to fashion its savings in ways that reduced this problem? Did anyone even think to assess the proposed savings from the perspective of their effect on this imbalance? What do you think?

Similarly, we're indebted to the Grattan Institute for bringing to us relatively new research showing how important the efficient functioning of big cities is to the efficiency of the economy and to promoting economic growth.

To boil it down, a key issue is how long it takes people to get from their home to work. Did it occur to anyone to suggest to the government that this efficiency consideration should affect its choice of state infrastructure projects to fund?

Then there's all the orthodoxy-busting research - now coming even from the official international economic agencies - finding that that income inequality acts as a drag on economic growth. Did the government know - or did anyone warn it - that by preferring budget cuts biased against the bottom half it could be hindering its professed goal of faster growth?

In any time remaining after it has struggled with the budget, the government plans reviews of the tax system and industrial relations, leading to major proposals to reform the economy and get it growing faster.

Really? One more time? That's the best advance you've been able to think of? That's the best the whole nation has come up with? Another argument about the GST? Another argument about bringing back Work Choices?

The tax system will always need running repairs, but for so many of us to see tax reform as the Stairway to Heaven is delusional. Same goes for another fiddle with wage bargaining.

It reveals the limits to our ambition, the incestuous nature of our policy debate, the limits to our imagination and even the limits to our use of Amazon.
 

Read more >>

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.

Read more >>

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.

Read more >>

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.

Read more >>