One bad budget doesn’t kill all reform

If Tony Abbott and Joe Hockey fail to keep their jobs, and the more so if their successors fail to pull the government out of its dive, the 2014 budget will go down as the most fateful budget in Australia's history, worse even than Artie Fadden's original horror budget of 1951.

Should Abbott's prime ministership or his first-term government come to an early end, all the denizens of the House with the Flag on Top will conclude it was the budget wot dunnit.

And they'd be right. Whatever Abbott's other failings, it was the unpopularity of his first budget – one over which he kept tight control – that started the slide in popularity that has continued to now.

The point is that perceptions about what caused the 2014 budget to be such a government-wrecker are forming as we speak. Those perceptions will affect the attitudes of a generation of politicians and econocrats towards the politics of budgeting and economic reform.

It doesn't take long for such perceptions to set like concrete. Once they have, they become impervious to contrary evidence. So it's important the popular wisdom about why the budget went over so badly with the electorate – and, hence, the Senate – be soundly based.

One common conclusion is that this budget heralds the end of the era of reform: the punters simply won't cop anything that imposes any kind of cost on them. This is defeatist, an attitude that condemns us to ever worsening debt and a set of economic arrangements that become ever more inappropriate to our ever changing circumstances.

Fortunately, it's an unwarranted conclusion. It's actually self-serving: we did nothing wrong except ask our fellow Australians to accept a small amount of sacrifice in the interests of getting the budget back on track, but they rejected us.

Rubbish. As everyone knows, Abbott and Hockey did a host of things wrong. Another self-serving line is: there was nothing wrong with the measures we proposed, we just failed to "sell" them effectively.

That's half true: Abbott and Hockey have proved to be even worse at explaining and justifying their policies than their Labor predecessors. But to pretend that was the only thing they got wrong is laughable.

Yet another excuse – all the blame lies with an unprincipled opposition and a few crazies in the Senate – is also too easy. We've long lived in an era where oppositions play hardball in the Senate.

It's rare for governments to have the numbers in the Senate, so an essential skill for governments hoping for a long reign is an ability to negotiate with the minor parties, plus the foresight to ensure any controversial measures bowled up in a budget have built-in wriggle room.

What was outstanding about this episode was Abbott's lack of foresight. To get into government I'm going to be utterly ruthless in my treatment of Labor, but once the tables are turned Labor won't do the same to me.

I'm going to exaggerate the deficits and debt problem, and boast about our superior ability to fix it, but that doesn't mean I should tread carefully in the promises I make to exempt particular areas of spending from the knife.

Anyone who knows anything about "fiscal consolidation" (getting deficits down) knows that pretty much every successful attempt has involved a combination of spending cuts and tax measures. Abbott tried to do it just with spending cuts and came badly unstuck.

It was a recipe for being seen as unfair. Our system of means-tested benefits means the spending side of the budget is aimed mainly at the bottom half, whereas our array of special concessions on the revenue side are of most benefit to the top half.

I'm confident most pollies will have got the message that tough budgets must be perceived to be reasonably fair. You need at least one big measure the rich really whinge about, such as John Howard's 15 per cent superannuation surcharge.

The message for the business lobbies is that even if, as happened this time, you con a naive Coalition government into exempting you from the nasties, it will come unstuck and you'll be left with nothing.

The message for econocrats and economists, trained to regard "distributional" considerations as not their department, is that you ignore fairness at your peril. They ought to have learnt by now that anyone lacking their training is utterly incapable of keeping "efficiency" and "equity" in separate boxes.

Reform is still possible, provided you haven't sworn not to do it, provided it's seen to be reasonably fair and provided you spend a lot of time explaining why it's needed.

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How Australia's supply of labour is changing

The trouble with the way the media report developments in the labour market from one month to the next is that we don't get a sense of the major shifts that occur over time.

So today let's take a much longer view, examining the trends over, say, the two decades from 1993 to 2013. We'll do so with help from an article by Professors Roger Wilkins and Mark Wooden, of the Melbourne Institute, published in the latest issue of the Australian Economic Review.

Note that this period covers most of the continuous economic upswing since the severe recession of the early 1990s. So most of the trends are reasonably good. It's true, however, that we were knocked off track briefly by the global financial crisis of 2008-09 and in more recent years have suffered a slow deterioration in unemployment as the economy makes heavy weather of the end of the mining investment boom.

But that's getting ahead of the story. Actually, it's such a long story that today I'll limit it to the side that gets least attention from the media, changes in the supply of labour. It's best measured by changes in the "participation rate" – the proportion of the population of working age who are participating in the labour market by making their labour available, either by having a job or actively seeking one.

Taken overall, the "part rate" increased pretty strongly until 2008, when it began falling back. But all of this overall increase is explained by the increased participation of women, particularly those of prime age, 25 to 54.

There's been a long-term slow decline in the participation of men. It's explained partly by young males staying longer in the education system but mainly by older workers retiring earlier – voluntarily or otherwise.

But here's where the story gets complicated. The trend to earlier retirement turned around at about the turn of the century, with participation by both men and women aged 55 and over rising significantly.

Got that? Now try this. Although more people are retiring later, the part rate reached a peak in 2008, has fallen since then and is likely to continue falling for years yet. Why? Because of the ageing of the population.

The trick is that even if the part rate is now rising in older age groups, population ageing means that an ever-rising proportion of the labour force is in those older age groups, whose rates of participation will always be a lot lower than the rates for people of prime age.

To show the significance of this ageing effect, the authors calculate that if the age structure of the population in 2013 was the same as in 1993, the overall part rate would be 2.2 percentage points higher than it actually is.

However, we do have some scope to moderate this demography-driven decline in participation. Wilkins and Wooden note that the rates of participation for 55 to 64-year-olds are between 7 and 14 percentage points higher in New Zealand than they are in Oz. If the Kiwis can do it, what's to stop us doing it?

The part rate covers the quantity of people willing to supply their labour, but there's also the question of changes in the quality of the labour being supplied.

The past 20 years have seen a big improvement in the skills – education and training – of the labour force, with the proportion of university graduates more than doubling from 12 per cent to 28 per cent. The proportion with any post-secondary qualification rose from less than 46 per cent to more than 62 per cent.

By the way, it's likely that the continuing rise in women's participation is largely explained by the dramatic increase in females' academic attainment. The higher men and women's level of education, the greater the likelihood they'll be in the labour force – exploiting the commercial value of their skills – and the less the likelihood of them being unemployed.

Of course, another part of the labour supply story is immigrant workers. Immigration has long been a major source of additional labour and today accounts for more than a fifth of the labour force. What's changed is that throughout the last century most migrants came on permanent visas, whereas today most come on temporary visas.

In March last year there were almost 900,000 people on temporary visas with work rights, including more than 200,000 on "457 visas" for skilled people and about 370,000 on student visas. If all these people actually participated they'd amount to 7 per cent of the labour force, the authors estimate.

Separate to this were almost 650,000 people on the special visas for New Zealanders, some of whom will prove to be only temporary residents. (Don't forget Aussies have reciprocal rights to work in Kiwiland.)

We now grant about 125,000 457 visas a year and about 100,000 student visas a year. This compares with about 130,000 old-style permanent visas a year to skilled immigrants, many of which are given to people already here on temporary visas.

The authors observe that the shift towards temporary migration has probably had a big effect on the labour market.

"The availability of a flexible skilled immigrant workforce that can respond to changes in labour demand relatively quickly is likely to have improved the operation of the labour market, especially from an employer perspective," they say.

Oh. Yes. To me the main drawback is not so much that employers may not try hard enough to find local workers to fill jobs, or that the availability of this external supply may limit to some extent the rise in skilled wages, but that it reduces employers' incentive go to the bother of training young workers.

Still, we mustn't forget that, these days, the economy is run for the benefit of business, not the rest of us.

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It helps to know how to save

The great middle-class virtue is the ability to delay gratification. We could spend all our money now, but wouldn't we be better off if we saved some of it for the future?

We could take the best job we can get as soon as we're old enough to leave school, but wouldn't it be better to stay on in education and eventually get a more highly paid and satisfying job?

Research confirms that the better you are at controlling your natural desire for immediate gratification, the better your life is likely to be.

But those of us who have been imbued with these attitudes and abilities by our parents have a tendency to judge those who lack them with undue harshness. We care about the poor, of course, but we have a big category for the undeserving poor.

All those who could find a job if they wanted to. All those who don't take the simple precaution of buying insurance. All those who can't even budget properly. Poor people who spend their incomes on wide-screen TVs and smartphones. Poor people who still smoke.

If we were as poor as that we'd jolly well know how to lift ourselves out of it. And if we could do it, so can they.

The truth is we're too harsh in our judgments. Partly this is a tendency to give ourselves more credit for our comfortable lives than we should. We imagine ourselves to be "self-made", taking all the credit for choosing our parents wisely. We forget how much we inherited - if not in money and a good education then in attitudes and example.

But another part of our harshness is our inability to appreciate how hard it can be to pull yourself up by your bootstraps when you're at rock bottom. Few of us have the remotest idea of how we'd make ends meet on $427 a week for a single pensioner or less than $300 a week for singles on the dole.

We have little idea of how much harder it is with not a bean to fall back on when unexpected bills arrive, or how financial difficulties can multiply when you simply can't afford insurance.

And yet it is true that some people on welfare benefits or among the working poor would benefit from being helped to acquire the saving habit.

This is where I have encouraging news. Ten years ago the ANZ Bank and the Brotherhood of St Laurence got together to design a program to encourage people on very low incomes to save. They were later joined by the Smith Family, the Benevolent Society and the Berry Street organisation. In 2009, the federal government began giving grants to help them spread the program across Australia.

On Wednesday the bank and the charities will release a 10-year review of the performance of Saver Plus, conducted by Roslyn Russell, Mark Stewart and Felicity Cull, of RMIT University.

It's been a remarkable success. So much so that this, the first matched-saving program in Australia, is now the largest and longest-running program of its kind in the world.

As it has evolved, the scheme now requires people to agree to save up to $500 over 10 months. Achieve that and ANZ will match it, leaving you with up to $1000 to spend on your child's or your own education. You set your spending goal at the outset.

The program also involves four financial education workshops covering planning and budgeting, saving and spending, everyday banking, and planning for the future. Participants have access to a Saver Plus worker for advice and help should difficulties arise.

Eligibility is limited to people with a healthcare or pensioner card and regular income from paid employment, as well as a need to cover education expenses.

The program has had more than 23,000 participants, 86 per cent of whom are women. It now operates at 60 locations across all states, with more than 500 ANZ branches making referrals.

About 15,000 people have fully achieved their target, with only 12 per cent withdrawing from the program. So far participants have saved $13.6 million, with the ANZ adding more than $10 million.

You may think ending up with savings of as little as $1000 doesn't prove much, but it's really about acquiring the saving habit. And 87 per cent of people who completed the program say they've continued saving the same amount or more.

Great majorities of completed participants say they now have increased self-esteem and increased confidence, are better able to deal with financial problems, have more control over their finances, are better equipped to deal with unexpected expenses and experience less stress about the future.

About 27 per cent have taken out insurance policies and 19 per cent have increased their super contributions.

"Having education as the saving goal ... has been a large contributing factor to the value of the program to individuals and society," the report concludes.

"It has increased access to education for many participants and enhanced the quality of education for children and adults. Positive experiences of education - for children especially - have significant long-term benefits and increase development opportunities throughout their lives."

One point to add. The program's federal funding comes up for renewal in June. You'd hope this stuff is right up the Coalition's alley.

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Don't fix the budget while the economy is weak

We are hearing a lot of muddled thinking about how the Liberal Party's leadership ructions affect the budget and the economy, much of it coming from business people. For the sake of their businesses, they need to think more clearly.

There must be some truth to the idea that the political uncertainly is adding to the lack of business confidence, but the contention it's a big factor is dubious. "Confidence" is such an amorphous thing that you can say what you like about why it's up or down without anyone being able to prove you're wrong.

What's incontrovertible is that non-mining business investment spending isn't growing very strongly - not as fast as the Reserve Bank was hoping it would be by now, nor fast enough to offset the rapid slide in mining investment.

I think the main reason for this is simply that businesses don't see much need to expand at present: their sales aren't growing all that strongly and they're not about to run out of spare production capacity.

Any chief executive who has failed to take advantage of profitable investment opportunities because he's so worried about the instability in Canberra deserves the sack.

No, I think it works the other way round: because the economy's flat and you're waiting for an attractive investment opportunity to arise, you rationalise your inactivity by drawing attention to all the failings of the pollies supposed to be running the economy.

The danger with all this hand-wringing about "confidence" is that it's supposedly hard-headed business leaders resorting to wishful thinking: "if only we could have a change of prime minister, everything in the economy would be much better".

Part of the business angst has been worries about the budget: "it's vital we get the budget back to surplus to help the economy" and "it will be a terrible thing if Abbott tries to buy back some popularity by spending big in this year's budget".

Such comments reveal a weak understanding of the macro-economic basics. The budget isn't the economy. They're quite separate things and the fate of the economy matters far more that the fate of the budget and the size of the government's debt.

Getting the budget back to surplus within a year or two wouldn't make the economy grow any faster. In fact, it would make growth much slower. You'd have to let budget deficits roll on for at least another decade before you got to the point where it was damaging the economy.

Its main downside would be a level of public debt so high it made the government reluctant to add to it by using the budget to stimulate the economy out of a recession. At some point the government's credit rating might be downgraded, but the fear of downgrades is exaggerated. Its blow to the government's ego would be greater than the cost to taxpayers or the economy.

The budget and the economy are interrelated, of course, but it's a two-way relationship. People know the budget affects the economy: cut taxes and increase government spending and you'll make the economy expand faster; raise taxes and cut spending and you'll slow the economy down.

The bit many don't get is that the economy also affects the budget. Stronger growth in the economy leads to faster growth in tax collections and so reduces a budget deficit, whereas slow growth hits tax collections and so worsens a budget deficit.

That's where we are now. The prospective budget deficits over the coming three or four years are now much higher than they were when Joe Hockey took over as Treasurer. That's partly because of the budget measures blocked by the Senate, but mainly because commodity prices have fallen much more than expected and tax collections are growing much more slowly than expected.

The point is, to start slashing and burning in this year's budget would give the economy another kick in the guts, which would slow growth even further and probably make the deficit bigger rather than smaller.

This is precisely why, contrary to popular impression, the big cuts proposed in last year's budget weren't intended to really kick in until 2017, by which time it was hoped the economy would be back to growing strongly.

We now know the return to strong growth will be delayed. That's why the Reserve Bank cut interest rates again. But even the Reserve admits that, at such low levels, monetary policy isn't as effective as it was in stimulating growth.

That's why what we should be thinking about is whether the budget ought to be used to support the economy further by investing in more infrastructure projects.

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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.

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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.

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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.

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UPCOMMING

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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.

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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.

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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.

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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.

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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.

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