Treasury boss confident big government debt is manageable

Whether they realise it or not – probably not – the people up in arms about the size of the federal public debt and criticising Scott Morrison and Josh Frydenberg for not doing more to get it down in last week’s budget are saying they should have made the same error the major economies made early in their recovery from the Great Recession.

If you’ve heard Frydenberg saying he won’t “pivot to austerity policies”, you’ve heard him vowing not to make the mistake the Americans, and particularly the Brits and Europeans, made in 2010.

After they’d borrowed heavily in response to the global financial crisis, their recoveries had hardly begun before they looked back at their mountainous debt and panicked, slashing government spending and whacking up taxes.

This policy of “austerity”, as critics dubbed it, proved disastrous. It stunted their recoveries and meant they didn’t reduce their deficits and debts much at all.

This is why, to prevent the budget’s support for the still-recovering private sector falling precipitately over the coming four financial years to June 2025, Morrison and Frydenberg decided to use most, but not all, of an unexpected improvement in forecast budget deficits to increase spending and cut taxes.

Even so, the net debt in June 2024 is now estimated to be $46 billion lower than expected in last October’s budget, as independent economist Saul Eslake has pointed out.

In a speech to the Australian Business Economists this week, Treasury secretary Dr Steven Kennedy defended the government’s two-phase economic strategy.

According to the budget papers, phase one is to promote economic growth through “discretionary fiscal [budgetary] policy and the operation of [the budget’s] automatic stabilisers” so as to “ensure a strong and sustained recovery to drive down the unemployment rate”.

We will remain in the first phase of the strategy “until the recovery is secured” and growth has driven unemployment “down to pre-pandemic levels or lower”.

“Only once the economic recovery is secured will the government transition towards [phase two and] the medium-term objective of stabilising and then reducing debt as a share of gross domestic product,” the budget papers say.

But some economists – the most well-credentialled of whom is former Treasury secretary Dr Ken Henry – are concerned this willingness to live with unusually high levels of deficit and debt for many years, and without mention of any effort to return the budget to surplus – which would reduce the debt in dollar terms, not just relative to GDP - is complacent and risky.

But, with one proviso, Kennedy argues strongly that the presently projected paths of our budget deficit, our debt and the interest bill on the debt aren’t particularly risky.

When I get to that proviso you’ll see that Kennedy and his old boss aren’t so far apart. And remember this: Henry is now free to give the government advice in public, whereas the Westminster system requires Kennedy to give all his frank advice in private, not in speeches to economists.

Starting with the budget deficit, Kennedy says it grew hugely in 2020, partly because the lockdown caused tax collections to collapse and the number of people getting the dole to leap (this being the operation of the budget’s “automatic stabilisers”), but also because of the unprecedented degree of “emergency support” provided to businesses and workers.

The deficit’s expected to peak at $161 billion (equivalent to 7.8 per cent of GDP) in the financial year soon to end, then fall to $57 billion (2.4 per cent of GDP) in 2024-25. This “relatively quick” fall happens mainly because all the emergency support was temporary.

“At this stage, [a hint that policies could change, and probably will] the deficit is expected to persist through the medium term,” Kennedy says, by which he means that, seven years later in 2031-32 (the “medium term”), the projected deficit is still 1.3 per cent.

Budget statement 3 (page 100) shows that’s about the projected size of the“structural” budget deficit – the deficit that’s left after taking account of the cyclical factors affecting the budget – by then.

Kennedy explains this as representing the government’s structural (lasting) increases in spending on what it calls “essential services” – particularly aged care, disability care and the tiny permanent increase in the rate of the dole – in this year’s budget.

Such a structural deficit isn’t huge, but its existence is a tacit admission that, if government spending isn’t going to be cut, taxes should be increased.

Turning to the projected path of the net debt, Kennedy says the budget projections suggest the government is on track to stabilise and begin reducing the debt as a share of GDP in the medium term (the next 10 years), given the present economic outlook “and policy settings” (hint, hint).

The net debt is expected to be 34 per cent of GDP at June 2022, rising to almost 41 per cent at June 2025, before improving to 37 per cent at June 2032. (Eslake reminds us all this is less than half the average for the advanced economies.)

Finally, “debt servicing costs” - fancy talk for the interest payments on the debt. As a proportion of GDP – that is, comparing the interest payments with the size of the nation’s income – net interest payments are projected to “remain low by historical standards at around 1 per cent over the medium term”.

Two eye-opening graphs in Eslake’s first-rate budget analysis show 1 per cent is much lower than we were paying throughout the last quarter of the 20th century (in the late 1980s it was above 2.5 per cent). And, in inflation-adjusted dollars per head of population, it’s much lower than we were paying in both the late ’80s and the late ’90s.

Responding to Henry’s concerns, Kennedy says “there remains fiscal space [room] to respond again with fiscal policy if the need arose”. But here’s the proviso Kennedy adds: “there will come a time where it is prudent to accelerate the rebuilding of our fiscal buffers”.

That’s as frank as Treasury secretaries get in public.

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Don't believe what lightweights tell you about debit and deficit

If you’ve gained the impression that in their pre-election budget Scott Morrison and Josh Frydenberg have gone on a wild, vote-buying cash splash spending spree, leaving us – not to mention our grandchildren – with a string of bigger budget deficits and much increased government debt, you’ve been misled.

Some of it’s simply not true, much of it’s exaggerated and the rest has been misunderstood by people who didn’t do economics at high school. They’re people who are led by their emotions and, when they hear frightening words like “deficit” and “debt”, don’t need to be told we’re all in deep doodoo. They don’t stop to read the details.

Let me give you some of those details, with help from the independent economist Saul Eslake and his first-rate budget analysis.

What would you think if you asked me my salary and I gave you a figure I’d first multiplied by four? You’d think I was big-noting. The politicians do this every budget time to make them sound more generous than they are.

They can do it because the budget shows the cost for the coming financial year, plus “forward estimates” for the following three years. The media go along with it because it quadruples their story’s impressiveness.

They told us the budget involved new spending and tax breaks costing $93 billion “over four years”, when it would have been less misleading to say the new measures will cost the budget about $23 billion a year.

Some have implied the new measures are profligate and motivated by vote-buying. Some measures are, no doubt. But the $3.8 billion a year to fix up our scandal-ridden aged care system? The $2.2 billion a year in increased support for the unemployed? The extra $2 billion a year in infrastructure? The $1.3 billion a year to subsidise apprenticeships? Another $1.3 billion in total to help hard-hit aviation and tourism? An extra $450 million a year on women’s economic security?

The extended tax relief for small business will cost a total of $21 billion in a few years’ time, but then will be clawed back. The “new” tax cut for middle-income earners costing $7.8 billion a year Frydenberg told us about is just a one-year extension of last year’s tax cut.

Doesn’t sound much of a splash to me. The increased subsidy of childcare costs doesn’t start for a year and is about a quarter of what Labor’s promised.

Next, if you’ve gained the impression all this spending will increase the budget deficit and add to the government’s debt, you’ve been misled.

At the time of last year’s delayed budget in October, Eslake points out, the net debt was expected to reach $966 billion by June 2024. In this budget the debt’s now expected to be $46 billion less by then.

How is this possible? It’s possible because the economy has recovered much more strongly than was expected even in October. So tax collections are a lot higher than expected, and dole payments a lot lower.

By design, the government’s new spending takes up most, but not all, of this improvement. The econocrats wouldn’t have thought it smart to withdraw too much of the public sector’s support for the private sector – households and businesses – before the recovery was well established and when unemployment was still so high.

The joke is, the people up in arms about the huge growth in debt are a year late. It was last April when all the damage was done. The pandemic was raging and governments decided to put our heath first and the economy second. They locked down the economy, causing the biggest collapse in the nation’s income since World War II.

But to hold the economy together so it could rebound after the lockdown was lifted, the government spent unprecedented sums on the JobKeeper scheme (that’s $90 billion right there), the JobSeeker supplement and a dozen other temporary programs.

It’s all worked far better than expected, but there’s no denying it’s come at a great cost. Should we have let all those people die of the virus? Should we have let the economy stay flat on its back? The debt panickers weren’t saying that a year ago.

The finances of national governments don’t work the way a family’s do. Eventually, parents die. They know they must have their debts paid off before then.

But though the faces change, governments and the populations they serve never die, they just keep growing. Meaning they – like big businesses – never pay off their debt. It goes down sometimes and up others, but still goes on forever.

What governments do is out-grow their debts, so it shrinks relative to the size of the economy and all the income it generates. That’s how the developed countries got on top of the massive debt they were left with after WWII.

They didn’t pay it back, they outgrew it. And the good news is, interest rates on the public debt are now lower than ever – and won’t be going back up in a hurry.

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Budget shock: Morrison hit over the head by a paradigm

The media missed the big story in last week’s budget. They were present to observe a rare event – a shift in the economic management paradigm – but all they saw was just another big-spending, vote-buying pre-election budget.

Since the post-World War II Golden Age ended in the ignominy of stagflation in the mid-1970s, the first rule of politics has been that most of it’s economics. Economies don’t run themselves, and managing them is the chief job of national governments. Bad economic management is the chief reason governments get thrown out.

(This is the story of my career as a journalist. I arrived as a dissatisfied chartered accountant looking for a career change just as the nation’s editors were getting that message. When the editor asked me what I wanted to do in journalism, I said “write about politics”. He told me that if I wanted to get ahead, I should pretend to be an economist. Advice taken.)

But that message seems to have been lost. Today’s political journalists can see the politics in everything, but not the economics. It doesn’t help that, after decades of media management, they never get to speak to the Canberra econocrats.

What this year’s budget tacitly acknowledges is that recovering from the coronacession isn’t the real problem. We seem to have that well in hand. The real problem is that returning to the pre-virus status quo doesn’t get us to where we need to be: enjoying healthy, sustainable economic growth.

The real problem is that, like all the advanced economies, we’re stuck in what former Bank of England governor Mervyn King has called a “slow-growth trap”. The causes of this trap are “structural” (deep-seated and long-lasting) not “cyclical” (temporary).

The symptoms of that trap in Oz are neatly summarised by APAC economist Callam Pickering: “Australia hasn’t experienced an unemployment rate of 4.5 per cent or lower in 12 years. We haven’t experienced wage growth of above 3 per cent in eight years, and core inflation hasn’t sniffed 2 per cent in five years.”

The political journalists noticed Treasurer Josh Frydenberg’s “pivot” in a speech 12 days before budget night, but not the pivot the econocrats’ made under cover of the coronacession. They abandoned their seven-year insistence that the weakness in wages and inflation was merely a cyclical delay and would come right in the next year or two.

If you read the speeches of Reserve Bank governor Dr Philip Lowe and Treasury secretary Dr Steven Kennedy carefully, you see their quiet acceptance that our weak growth has structural causes, and won’t be cured unless we do something different.

Such as? Using more fiscal stimulus to target a much lower rate of unemployment, in the hope this will at last get us some decent growth in wages, which would flow on to stronger growth in consumer spending and then maybe even to stronger business investment spending.

The evidence that the two institutions have stopped pretending our problems are merely cyclical can be seen in their most recent forecasts, which have the rises in wages and inflation staying weak for the next four years.

Because the political journalists saw Frydenberg’s pivot but not the econocrats’ pivot, it never occurred to them that Scott Morrison and his Treasurer’s change of tune happened because the econocrats advised them to. Nor that what journalists see as motivated purely by political expedience, most economists (and I) have welcomed.

It’s a truism that politicians never do anything without considering its political implications. But a more perceptive observation is that governments rarely make significant policy changes without at least two good reasons.

In leaping to the conclusion that the only conceivable reason for Morrison and Frydenberg to do something so contrary to their long proclaimed “ideology” is political expedience – what pollie in their right mind would cut spending or increase taxes before an election? – the political journalists have failed to see what was obvious to the economically literate: that our present circumstances presented the government with a fortuitous alignment of attractive politics and good economic management.

As the independent economist Saul Eslake has said, “the government’s decision to defer the task of ‘discretionary budget repair’ for at least another year is politically expedient, but that doesn’t make it wrong. On the contrary, it is ‘The Right and Proper Thing To Do’ [as Alf Doolittle said in My Fair Lady].”

In this Eslake is no Robinson Crusoe. A recent survey of 60 leading economists by the Economic Society of Australia found that 47 of them back the government’s decision to aim for an unemployment rate of less than 5 per cent.

Failing to appreciate the significance of this marked change in economic strategy, some political journalists are predicting that Morrison and Frydenberg will revert to their former political ideology and fear of debt and deficit as soon as they’re re-elected.

After brilliantly using a Labor-lite budget to steal Labor’s clothes and win the election, the Debt Truck will be back and the Coalition will reassert its claim to being more fiscally responsible than those profligate unwashed Labor Party people.

Having assured us three weeks ago that the government isn’t planning “any sharp pivots towards ‘austerity’,” Frydenberg will do a reverse-pivot soon after the election. Maybe, but I doubt it. If he does, he’ll have some very P-ed off econocrats, not to mention an army of critical economists.

This is not to say, however, that sometime in the coming years, after we have achieved some decent wage growth and a return to rising living standards, whichever party is in power will act to reduce the structural budget deficit.

Not by swingeing cuts in major spending programs, but by increasing taxes – letting bracket-creep rip, increasing the Medicare levy or cutting superannuation tax breaks. In the meantime, it wouldn’t be surprising to see either side abandon the third stage of Morrison’s tax cuts which, at a cost to the deficit of a mere $17 billion a year, is aimed at rewarding higher income-earners.

The simplest way to explain the economic management paradigm shift occurring before our eyes is that the econocrats have only two levers for managing the economy: interest rates (monetary policy) or government spending and taxing in the budget (fiscal policy). When one lever stops working, they switch to the other. It’s happened before, it’s happening now, it will happen again after I’m dead.

Economic management is moving away from monetary policy not just because the official interest rate has hit zero but also because, as the International Monetary Fund’s chief economist, Dr Gita Gopinath, has written, the world is caught in a “liquidity trap” – that is, there’s loads of money waiting to be borrowed, and at very low interest rates, but business isn’t keen to borrow. Cutting rates further doesn’t change that.

But even the liquidity trap is just a symptom of deeper, structural problems causing weak wage growth, weak business investment and weak productivity improvement – all of them evident in all the advanced economies since the global financial crisis.

Get it? The developed countries are changing the rules of how they manage their economies because the old rules have stopped working. Our political journalists, convinced what’s happening here is just a tawdry election trick, don’t seem to have noticed that similar things are happening overseas.

The Americans have switched their economic management paradigm simply by moving from Donald Trump to Joe Biden. Biden, actually from the cautious, compromising side of the Democrats, is spending government money far more aggressively that Obama or Clinton.

Why? Because his economic advisers are urging him to. Trump slashed the rate of company tax; Biden wants to put it back up. So does the Conservative Boris Johnson in Britain. The race to the bottom is reversing. Business won’t be getting its way nearly as often in the new world.

What’s true is that the old paradigm fitted our Liberals much more comfortably than the new one does. Morrison and Frydenberg will have their hands full sending their backbenchers to re-education camp. They’ll need to drop their populist fear-mongering over debt and deficit, and their private good/public bad rhetoric.

The new paradigm fits Labor a lot more comfortably – provided it doesn’t take too long to realise the wind has changed, and get its courage back. Watching Anthony Albanese’s budget reply last week – in which he seemed to use the word “wages” in every second sentence – made me think he may be waking up faster than the political journalists.

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The new normal: much more reliance on government spending

What this week’s budget proves is that fiscal (budgetary) stimulus really works, something many economists had come to doubt over the four decades in which monetary policy – the manipulation of interest rates – was the main instrument used to manage the economy’s path through the business cycle.

That potency’s the main reason the economy has rebounded from last year’s government-ordered deep recession far earlier and more strongly than any economist (or I) had expected.

It’s now clear that, by the March quarter of this year, the economy’s production of goods and services – real gross domestic product – had returned to its level at the end of 2019. The level of employment was a fraction higher than before the virus struck, and the rate of unemployment had gone most of the way back to its pre-virus 5.1 per cent.

And it was Scott Morrison’s massive boost to government spending – JobKeeper, the temporary JobSeeker supplement and all the rest – “wot done it”.

This week’s budget, coming on top of last year’s, confirms there’s been a lasting shift in the main policy instrument used by the macro economy managers, from monetary policy to fiscal policy.

Why? Short answer: because when the official interest rate – the lever monetary policy uses to encourage or discourage borrowing and spending – has fallen almost to zero, your instrument no longer works.

We, and all the advanced economies, are caught in what the great British economist John Maynard Keynes called a “liquidity trap”: there’s plenty of money around to be borrowed – and at very low interest rates – but few businesses want to take it. Cutting rates even further won’t change this.

The last time the developed world was caught in a liquidity trap was the Great Depression of the 1930s. Keynes immortalised himself by thinking outside the box and coming up with the solution: give up on interest rates and switch to using fiscal policy – government spending and taxation – to keep the economy growing until the private sector – businesses and households – get their mojo back.

Note that we were caught in our liquidity trap long before the virus came along. The pandemic’s just brought matters to a head. The problem the economic managers are responding to is “structural” – deep-seated and long-lasting – not “cyclical”: temporary.

So don’t imagine the switch from using interest rates to using the budget is temporary. It will continue for as long as very low interest rates keep monetary policy impotent. And for as long as the rich countries’ bigger problem remains unemployment, not inflation.

Low inflation and low interest rates go together. That’s why the Reserve Bank’s being cautious rather than brave in assuring us it’s unlikely to increase interest rates “until 2024 at the earliest”.

But why is fiscal stimulus more effective than economists realised? Why does a dollar of stimulus have a bigger effect on GDP – a higher “multiplier effect” – than they thought? Two main reasons.

One thing that reduces the size of fiscal multipliers is the “leakage” of spending into imports. But this doesn’t matter as much in a more globalised world, when all the rich economies are likely to be stimulating at the same time. As they did in the global financial crisis of 2008 and are doing now in response to the pandemic. My country’s leakage of spending becomes your country’s “injection” of exports – and vice versa.

A second factor that was keeping multipliers low is what economists call the “monetary policy reaction function”. If a government is spending big – whether for political or economic reasons – but the independent central bank thinks this will risk inflation going above its target, it will increase rates.

The two arms of macro policy will then be pulling in opposite directions. This is what we had before the arrival of the pandemic, when the Reserve was cutting interest rates to get the economy moving, but Scott Morrison and Josh Frydenberg were focused on eliminating debt and deficit.

Now, however, fiscal policy and monetary policy are both pushing in the direction of encouraging growth and lower unemployment. With fiscal doing most of the pushing, this means a higher multiplier.

Which brings us to the obvious question: is the “stance of policy” adopted in this week’s budget expansionary or contractionary? If you believed all the silly talk of a “big-spending budget” you’d be in no doubt that it’s expansionary.

But it’s trickier than that. If you judge it the simple way the Reserve Bank does, by looking at the direction and size of the expected change in the budget balance from the present financial year to the coming year, you find the budget deficit’s expected to fall from $161 billion to $107 billion.

That’s a huge $54 billion fall, suggesting the budget is contractionary. But that’s not right. Because last year’s budget underestimated the speed with which employment and tax collections would rebound and people would get a job and go off the dole, the additional stimulus measures announced in the budget stopped that fall from being a lot bigger.

And remember this: a lot of last year’s stimulus spending – something less than $100 billion-worth - won’t have left the government’s coffers by June 30 this year. And it’s been estimated that about $240 billion-worth of stimulus spending that did leave the government’s accounts is still sitting in the accounts of households and businesses, able to be spent in the coming year.

We do know, for instance, that the saving rate of households, which was 5 per cent before the coronacession began, was still up at 12 per cent of their disposable income, after peaking at 22 per cent at the end of June last year.

The government’s forecasters are expecting that a lot of the savings of households and companies will be spent on consumption and investment in 2021-22. This tells me it would be a mistake not to think of fiscal policy as still highly expansionary. Which is as it should be.

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This budget couldabeen a lot better than it is

This is the lick-and-a-promise budget. The budget that proves it is possible to be half pregnant. Which makes it the couldabeen budget. Scott Morrison and Josh Frydenberg had the makings of a champion of budgets, but their courage failed them.

It’s not a bad budget. Most of the things it does are good things to do. Its goal of driving unemployment much lower is exactly right. Its approach of increasing rather than cutting government spending is correct, as is its strategy of fixing the economy to fix the budget.

But having fixed on the right strategy Morrison, reluctant to be seen as Labor lite, has failed in its execution. Economists call this “product differentiation”; others just call it marketing.

Some are calling this a big-spending budget. It isn’t. Frydenberg has kept his promise that it would be no “spendathon”. As a pre-election vote-buying budget it hardly rates. Its “new and additional tax cut” for middle-income earners of up to $1080 a year turns out to be not a tax cut but the absence of a tax increase.

Politically, this budget had to offer a convincing response to the report of the royal commission on aged care. Reports have suggested fixing the broken system would take extra spending of about $10 billion a year.

Had he accepted that challenge, Morrison would have put himself head and shoulders above his Liberal and Labor predecessors. He settled for spending an extra $3.5 billion a year. Major patch-up at best. The scandals will continue.

Politically, Morrison had to make this a women-friendly budget, to prove he valued women’s contribution to the economy and remove impediments to their economic security. Making childcare free – as it was, briefly, during the lockdown – would have been a big help to young families, as well as greatly increasing employment. It would have backed his fine words with deeds.

That would have cost about $2 billion a year. Morrison settled for $600 million a year, limiting the new assistance to about one childcare-using family in four by excluding the great majority, who have only one child in care.

Frydenberg has said that significant investments in energy, infrastructure, skills, the digital economy and lower taxes are all aimed at driving unemployment down.

But this talk of “investments” in mainly male-dominated industries is just what led female economists to be so critical of last year’s macho budget. In any case, energy and infrastructure yield few new jobs for each billion spent.

That’s why women-friendly and job-creating both pointed to a budget that focused on growing the “care economy” – aged care, childcare, disability care.

It’s labour-intensive, employs mainly women and provides services that women care about more than men. And it’s largely funded and regulated by … the federal government. Opportunity fumbled.

If you can’t get too excited by the expectation that the economy will grow by a positively roaring 4.25 per cent in the coming financial year, and a much more sedate 2.5 per cent the following year, I don’t blame you.

For one thing, budget forecasts don’t always come to pass. For another, Frydenberg’s claim that more budgetary stimulus is needed because of continuing uncertainty over the pandemic is disingenuous.

The truth is, at this stage the economy is still running on the stored heat of last year’s massive budgetary stimulus, much of which has still to be spent. The purpose of public-sector stimulus is to get the private sector – households and businesses – up to ignition point, so it keeps going under its own steam.

That hasn’t happened yet. So the purpose of the further stimulus in this year’s budget is to keep the kick-starting going until the private sector’s engine gets going.

Much of this depends on a return to decent pay rises – which is, as yet, beyond the budget’s “forecast horizon”. We haven’t had a decent pay rise since before the election of the Coalition government.

We had been used to our standard of living getting a bit better each year. That hasn’t happened for years. A Liberal Prime Minister who can’t lift our standard of living should be peddling a lot harder than he is in this budget.

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Years of neglect won't make it easy to get wages up

In Tuesday night’s budget, it will be important to note its assumptions about when our international borders will be back to functioning normally. Not because they’re sure to be right, but because our borders will have a big impact on Scott Morrison’s new strategy of getting unemployment down to get wages – and thus living standards – up.

As the Commonwealth Bank’s Gareth Aird has reminded us, fancy calculations about how low unemployment has to fall before labour shortages force employers to bid up wages, rest on the (usually reasonable) assumption that our borders will be working the way they always have.

If our borders are temporarily closed to immigration and overseas students, however, the point where skill shortages emerge may arrive a lot earlier than the fancy calculations suggest. What’s more, it’s become clearer that the day where our border conditions return to normal may be a lot further into the future than we’d first hoped.

It will be interesting to search the budget papers for signs that these complications don’t come as news to the economic managers, but have been built into the new strategy’s design.

The point is that over the decades of what we used optimistically to call “micro-economic reform”, our employers have become used to the idea that finding enough skilled labour – or even unskilled people willing to do the crappy, badly paid jobs that most Australians aren’t, fruit-picking for instance – isn’t something you have to worry much about.

Whenever you look like running out of the workers you need, you just bring someone in on a temporary visa. If they turn out okay, you help them move to a permanent visa. Our immigration program used to be about recruiting factory fodder for the manufacturers, now it’s about people on many classes of temporary visas allowing employers instant access to skilled workers trained by someone else at some other country’s taxpayers’ expense.

The trouble with this is that it’s come at the expense of our technical education system and our young people. Our business people no longer need to worry about whether they’ll have enough skilled workers a few years down the track, so no longer put enough money and effort into training apprentices, trainees and other technical workers.

I see it as further evidence for my theory that part of the reason both productivity improvement and wages have been weak for some years is our businesses’ preference for improving their profits by cutting costs – particularly wage costs – rather than improving their efficiency.

One implication of this emphasis on employers buying skilled (or cheap) labour off the shelf, so to speak, is that the longer the economy recovers behind closed borders, and the more the government tries to use labour shortages to get some decent wage growth, the more pressure employers and their lobby groups will put on the government to open the temporary-visa floodgates.

The more the government gives in to its business mates – who are used to getting their way – the more it will sabotage its strategy for getting wages, consumer spending and the voters’ standard of living going up not sideways.

But Dr Mike Keating, a former top econocrat, argues there’s a different weakness in the new strategy: it continues the economic managers’ earlier error of analysing the wages problem in purely cyclical terms.

For seven years they told us not to worry about weak wage growth because the recovery from the global financial crisis was just taking longer than usual. Wrong. Now they’re saying the problem is too much slack in the labour market, so we must stimulate harder to reduce the rate of labour underutilisation (unemployment plus under-employment) and, once we have, healthy wage growth will return as sure as demand and supply go together.

This thinking fails to acknowledge the likelihood that the problem is more structural than cyclical. It’s not just weak demand that’s the problem, it’s a change in the structure of the labour force, particularly as skill-biased technological change has increased employers’ demand for high-skilled labour and dramatically reduced demand for semi-skilled labour, while not having as much effect on demand for services-performing less-skilled labour.

Even so, the notion that much unemployment is the result of “structural mismatch” rather than weak demand is hardly new. That is, many of the unemployed lack the particular skills employers are looking for. So it’s wrong to assume that unemployment falls in lock-step with rising demand.

We’ve been marvelling at the recent rapid increase in job vacancies, which has reduced the number of unemployed per vacancy to 2.75, well below its decade average of 3.9. Many have taken this as indicating the strength of the recovery and a sign that unemployment will continue its rapid fall.

But Keating, a labour economist, says it indicates “a substantial and increasing degree of structural mismatch in the labour market”. (It could also be a sign that our employers’ dependence on importing the skilled labour they need is already making itself felt.)

“If this mismatch continues through the economic recovery, the wage increase in some jobs will most likely exceed the increase in other jobs. Consequently, pursuit of the target rate of unemployment may well result in an increase in wage inequality, which in turn may not produce the increase in demand that economic recovery requires,” Keating says.

I think the econocrats need to remember that, in the old days, the tendency for wage rises caused by skill shortages in some occupations – or some parts of the country – to spread to all other workers was caused by the operation of the old centralised wage-fixing system. The move to enterprise bargaining was intended to stop that happening. And it has.

These days, the labour market’s only equalising tendency comes from the existence of the more amorphous “wage norms” (“other bosses are giving pay rises of X per cent, so I’ll do the same”).

Keating says the best way to remove structural impediments in the labour market is to ensure the necessary development of education and training so that people have the particular skills needed to meet the requirements for the jobs that are available.

But that, of course, is just what we haven’t been doing.

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Our closed borders have turbo-charged the economy's recovery

The economy’s rebound from the lockdowns of last year has been truly remarkable – far better than anyone dared to hope. Even so, it’s not quite as miraculous as it looks.

As Tuesday’s budget leads us to focus on the outlook for the economy in the coming financial year, it’s important to remember that the coronacession hasn’t been like a normal recession. And the recovery from it won’t be like a normal recovery either.

The coronacession is unique for several reasons. The first is that the blow to economic activity – real gross domestic product - was much greater than we’ve experienced in any recession since World War II and almost wholly contained within a single quarter.

The reason for that is simple: it happened because our federal and state governments decided that the best way to stop the spread of the virus was to lock down the economy for a few weeks. But because this was a government-ordered recession, the governments were in no doubt about their obligation to counter the cost to workers and businesses with monetary assistance.

So the second respect in which this recession was different was the speed with which governments provided their “fiscal stimulus” and the unprecedented amount of it: for the feds alone, $250 billion, equivalent to more than 12 per cent of GDP.

But there’s a less-recognised third factor adding to the coronacession’s uniqueness: this time the government ordered the closing of our international borders. Virtually no one entering Australia and no one going out.

The independent economist Saul Eslake points out that “an important but under-appreciated reason for the so-far surprisingly rapid decline in unemployment, from its lower-than-expected peak of 7.5 per cent last July, is the absence of any immigration: which means that the civilian working-age population is now growing at (on average over the past two quarters) only 8,300 per month, compared with an average of 27,700 per month over the three years to March 2020,” he says.

This means that, with an unchanged rate of people choosing to participate in the labour force by either holding a job or seeking one, a rate that’s already at a record high, employment needs only to grow at about a third of its pre-pandemic rate in order to hold the rate of unemployment steady.

So any growth in employment in excess of that brings unemployment tumbling down.

Get it? It’s not just that the bounce back in jobs growth has been much quicker and stronger than we expected. It’s also that, thanks to the absence of immigration, this has reduced the unemployment rate much more than it usually does.

To put it another way, Eslake says, if the population of working age continues growing over the remainder of this year at the much-slower rate at which it’s been growing over the past six months, employment has to grow by an average of just 17,000 a month to push the unemployment rate down to just below 5 per cent by the end of this year (assuming the rate of labour-force participation stays the same).

By contrast, if the working-age population was continuing to grow at its pre-pandemic rate, employment growth would need to average 29,000 a month to get us down to 5 per cent unemployment by the end of this year.

Now, it’s true that as well as adding to the supply of labour, immigration also adds to the demand for labour. So its absence is also working to slow the growth in employment. But this has been more than countered by two factors.

The obvious one is the governments’ massive fiscal stimulus. But Eslake reminds us of the less-obvious factor: our closed borders have prevented Australians from doing what they usually do a lot of: going on (often expensive) overseas trips.

He estimates that this spending usually amounts to roughly $55 billion a year. But we’re spending a fair bit of this “saving” on domestic tourism – or on our homes.

Of course, we need to remember that, as well as stopping us from touring abroad, the closed borders are also stopping foreigners from touring here. But, in normal times, we spend more on overseas tourism than foreigners spend here. (In the strange language of econospeak, we are “net importers of tourism services”.)

Eslake estimates that our ban on foreign tourists (and international students) is costing us more than $22 billion – about 1.25 per cent of GDP – a year in export income. Clearly, however, our economy is well ahead on this (temporary) deal.

Another economist who’s been thinking harder than the rest of us about the consequences of our closed borders is Gareth Aird, of the Commonwealth Bank.

The decision by Scott Morrison and Josh Frydenberg to “continuing to prioritise job creation” and so drive the unemployment rate down much further, has led to much discussion of the NAIRU – the “non-accelerating-inflation rate of unemployment” – the lowest level unemployment can fall to before wages and prices take off.

The econocrats believe that little-understood changes in the structure of the advanced economies may have lowered our NAIRU to 4.5 per cent or even less. But Aird reminds us that, for as long as our international borders remain closed, the NAIRU is likely to be higher than that.

“If firms are not able to recruit from abroad then, as the labour market tightens, skill shortages will manifest themselves faster than otherwise and this will allow some workers to push for higher pay,” he says.

“There is a lot of uncertainty around when the international borders will reopen, what that means for net overseas migration and how that will impact on wage outcomes.”

But “in industries with skill shortages, bargaining power between the employee and employer should move more favourably in the direction of the employee and higher wages should be forthcoming,” he concludes.

Higher wages is what the government’s hoping for, of course. Interesting times lie ahead.

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Politics and economics have aligned to permit a ripper budget

Sometimes I think the smartest thing a nation can do to improve its economic fortunes is elect a leader who’s lucky. The miracle-working Scott Morrison, for instance.

This may be a controversial idea in these days of heightened political tribalism, when one tribe is tempted to hope the other tribe really stuffs up the economy and so gets thrown out. What does a wrecked economy matter if your tribe’s back in power?

Morrison was not only lucky to win the 2019 election, there’s been as much luck as good management in his success in suppressing the virus and the way the economy’s bounced back from the coronacession. (Of course, it may be blasphemous of me to attribute his success to luck if, in truth, he’s getting preferential treatment from above.)

Anyway, it’s “providential” – as my sainted mother preferred to say – that the politics and the economics are almost perfectly aligned for Treasurer Josh Frydenberg’s budget next week.

Politically, Morrison must make an adequate response to the royal commission’s expensive proposals for fixing our aged care disaster. And must make recompense for last October’s all-macho budget by making the economic security of women a preoccupation of this one.

Economically, he must lock in the stimulus-driven rebound from the recession by “continuing to prioritise job creation” and driving the rate of unemployment down towards 4.5 per cent or less.

What’s providential is that both aged care and childcare are “industries” largely reliant on federal government funding and regulation, as well as having predominantly female customers and employing huge numbers of women.

The Australia Institute’s Matt Grudnoff has calculated that, if the government were to spend about $3 billion in each of five industries, this would directly create 22,000 additional jobs in universities, 23,000 jobs in the creative arts, 27,000 jobs in healthcare, 38,000 in aged care and 52,000 in childcare.

If ever there was an issue of particular importance to women, it’s aged care. Women outnumber men two to one among those in aged care institutions. Daughters take more responsibility than sons for the wellbeing of their elderly parents. And those working in aged care are mainly women.

The royal commission concluded the government needed to spend a further $10 billion a year to rectify aged care’s serious faults, though the money would need to be accompanied by much tighter regulation, to ensure most of it didn’t end up in the coffers of for-profit providers and big charities syphoning off taxpayers’ funds for other purposes.

With that proviso, most of the new money would end up in the hands of a bigger, better-qualified and better-paid female workforce. The Grattan Institute’s Dr Stephen Duckett estimates that at least 70,000 more jobs would be created.

If you ask the women’s movement – and female economists – to nominate a single measure that would do most to improve the economic welfare of women they nominate the prohibitive cost of childcare.

They’re right. And right to argue the issue is as much about improving the efficiency of our economy as about giving women a fair deal.

Going back even before the days when most girls left school at year 9 and women gave up their jobs when they married, the institutions of our labour market were designed to accommodate the needs of men, not women.

These days, girls are better educated than boys, but we still have a long way to go to renovate our arrangements to give women equal opportunity to exploit their training in the paid workforce – to the benefit of both themselves and their families, and the rest of us.

Wasting the talent of half the population ain’t smart. The key is to eliminate the disadvantage suffered by the sex that does the child-bearing and (still) most of the child-minding. And the key to that is to transfer the cost of childcare from the family to the whole community via the government’s budget.

This government is sticking to the legislated third stage of its tax cuts which, from July 2024, and at a cost of about $17 billion a year, will deliver huge savings to high income-earners, most of whom are old and male (like me).

We’re assured – mainly by rich old men – that this tax relief will do wonders to induce them to work harder and longer. But, as the tax economist Professor Patricia Apps has been arguing for decades, there’s little empirical evidence to support this oft-repeated claim.

Rather, the evidence says that the people whose willingness to work is most affected by tax rates and means-tested benefits are “secondary earners” – most of whom are married women.

There is much evidence that it’s the high cost of childcare that does most to discourage the mothers of young children from returning to paid work, or from progressing from part-time to full-time work.

If the huge cost of the looming tax cuts helps discourage Morrison from spending as much as he should to fix aged care and the work-discouraging cost of childcare, we’ll know his conversion to Male Champion of Change has some way to go.

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Now we're trying Plan C to end wage stagnation

Be clear on this: Scott Morrison and Josh Frydenberg are dead right to make getting the rate of unemployment down to 4.5 per cent or lower their chief objective, with the further goal of inducing some decent growth in wages. But this approach to economic recovery is very different to our econocrats’ former and more conventional advice.

That the econocrats have changed their tune so markedly is an admission that the way the economy works has changed – in ways they don’t understand, for reasons they don’t understand.

What’s changed most is the behaviour of wages. As Treasury puts it in a new research paper, “structural factors may have altered the wage and price-setting dynamics in advanced economies. These include increased competition in goods markets, increases in services being provided internationally, advances in technology and changes in the supply of labour and labour market regulation”.

That’s an econocrat’s way of saying: who knows what’s going on.

Giving priority to getting unemployment down is always a worthy objective, not only because it greatly improves the lives of those who need to support themselves, but also because households now have more money to spend, making the economy grow faster.

A side-benefit is that it improves the budget balance (more people paying tax, fewer needing to be paid the dole). And promising jobs, jobs, jobs always goes down well with voters.

This time, however, the economic managers have an ulterior motive. They’ve concluded that the only way to get wages growing again is to get unemployment down so far that employers are having trouble finding the workers they need and are forced to compete with other employers by bidding up the wages they’re prepared to pay.

This conclusion may be right – it’s certainly worth trying – but it’s a quite depressing one to come to. And one quite foreign to what the econocrats have been telling us about wages for as long as I’ve been in journalism. It’s a sign of how desperate they’ve become to escape the bog that wages have fallen into.

It’s a tacit acceptance of an obvious point many economists (and I) have been making for ages, but the government and its advisers haven’t been prepared to acknowledge: since consumer spending accounts for well over half of gross domestic product, and growth in wages is the chief source of growth in household incomes, without real growth in wages economic recovery simply isn’t sustainable.

What the econocrats are now saying is that there’s little hope of getting wages growing a percent-or-more faster than annual inflation until you put employers on the rack and generate widespread shortages of labour. To mangle a few metaphors, you’ve got to be right on the tightrope edge of re-igniting a wage-price spiral.

Let your attention wander for a moment and you tip over into a “wage explosion” of the sort we experienced under the Whitlam government and the Fraser government, whose efforts to stop the explosion ended up causing the recessions of the mid-1970s and the early 1980s.

Now, if you find it hard to believe such a disaster is very likely, I do too. As, I’m sure, do the econocrats. But that just means we’re unlikely to get much bidding up of wages, and so are unlikely to get much of an improvement in wage growth if that’s the only way an improvement can come.

Another way of putting this is that the NAIRU (the “non-accelerating-inflation rate of unemployment”) – the lowest unemployment can fall before we get accelerating wages and prices – is unlikely to be nearly as high as Treasury’s latest estimate of 4.5 to 5 per cent.

You need a PhD to know enough maths and stats to be able to run these models, but that doesn’t stop them being cartoon caricatures of the real world. The more so when, by Treasury’s own admission, the world has stopped working the way all the historical figures the model relies on say it does.

The truth is it’s never possible to know where the NAIRU lies until you’ve gone through it and wage growth becomes excessive. That’s a risk the economic managers haven’t been willing to take for decades – which explains why the idea of making restoring full employment the top objective of policy is unfamiliar to anyone who can’t remember as far back as the McMahon government.

But, as Professor Ross Garnaut has reminded us, before the pandemic the Yanks got unemployment down to 3.5 per cent without any sign of labour shortages. If they can, why couldn’t we?

There is, however, an important qualification to the belief that our NAIRU is well south of 4.5 per cent. Shortages of labour are a lot more likely for as long as our borders remain closed.

To see how much what we’re now being told is the path to healthy wage growth differs from what we’ve been told in the past, remember this. Over the 15 years to the end of 2012, wages – as measured by the wage price index – rose by 70 per cent, well ahead of the 53 per cent rise in consumer prices.

Over the eight years to last December, however, wages rose by 19 per cent, not much more than the 15 per cent rise in consumer prices. That’s what the fuss is about: since 2012, wages have barely risen faster than prices.

But in each of the six budgets up to the one in 2019, the econocrats told us the same story: don’t worry. The problem was cyclical. Wage growth may be weak again this year, but the economy was just a bit slow to recover from the global financial crisis and, in a year or two’s time, annual growth would be back to the 3 per cent or so we were used to.

“Just wait a little longer” was Plan A for getting wage growth back to a healthy rate. It didn’t work. As this solution started to wear thin, the rhetoric shifted to Plan B: well, of course, any real growth in wages must come from improvement in the productivity of labour, and it’s been pretty slow of late. So, if you want higher wages, think of something to get productivity up.

Plan B didn’t prove much. It’s not clear that what little productivity improvement we have been getting has flowed through to wages. And, in any case, you can make a good argument that the relationship also flows the other way: that the weak growth in wages is actually helping keep productivity improvement low by holding back consumer spending and thus any motivation for businesses to invest in bigger and better equipment and structures.

So now we’re onto Plan C: let’s engineer labour shortages and see if that works.

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FISCAL POLICY v MONETARY POLICY IN OUR WEAK ECONOMY

 Last year, after the arrival of the pandemic and the coronacession as governments locked down the economy to stop the spread of the virus, we witnessed a rare economic event: a changing of the guard in the main policy instrument used to stabilise demand as the economy moved through the business cycle. Monetary policy stepped back and fiscal policy stepped forward. Governments always turn to fiscal policy when recessions arrive, but this change also has deeper, more structural causes, as we shall see. But first, a quick history of the relationship between fiscal policy and monetary policy.

For the first 30 years following World War II, the main policy instrument used was fiscal policy, with monetary policy playing a subsidiary, supporting role. That changed in the late 1970s when the advanced economies acquired a serious problem with high and rising inflation, and “stagflation” destroyed confidence in the simple (Phillips curve) trade-off between inflation and unemployment and the Keynesian approach to managing the macro economy. The conventional wisdom became that monetary policy, conducted by an independent central bank, should be the main instrument used for stabilising demand, with fiscal policy playing the subsidiary role.

Fiscal policy resumes its pre-eminence

But roughly 30 years later, the coronacession has a seen a reversion to fiscal policy playing the dominant role in short-term stabilisation, leaving monetary policy as a back-up. On the face of it, this was because the need for stimulus was so great and because, with interest rates already so low, monetary policy was left with little room to move. In the recession of the early 1990s, for instance, the official interest rate was cut by more than 10 percentage points. In the response to the global financial crisis of 2008-09, the rate was cut by more than 4 percentage points. In the response to the coronacession, the RBA has been able to cut by less than 1 percentage point before taking the cash rate virtually to zero, at 0.1 per cent. Since March last year the RBA has also resorted to “quantitative easing” – buying second-hard government bonds from the banks and paying for them merely by crediting amounts to the banks’ exchange-settlement accounts with the RBA. But how much this does to stimulate demand for goods and services (as opposed to demand for assets such has houses and shares) is open to doubt. By contrast, the federal budget has provided a total of $250 billion in direct stimulus over serval years, equivalent to 13 per cent of nominal GDP in 2019-20. (This compares with stimulus in response to the GFC of 6 per cent of GDP in 2008-09.)

Secular stagnation diminished the effectiveness of monetary policy

However, behind these immediate reasons for fiscal policy resuming the leading role are deeper, structural factors. As Treasury Secretary Dr Steven Kennedy has observed, there has been “a fundamental shift in the macroeconomic underpinnings of the global and domestic economies, the cause of which is still not fully understood”. This is a reference to the “secular stagnation” or “low-growth trap” into which the developed economics – including Australia – have fallen in the years since the GFC. Your modern, independent central bank – and the policy mix that gave top billing to monetary policy – was designed to cope with the problem of high and rising inflation. But, as former Reserve governor Ian Macfarlane has explained, inflation in the advanced economies has been falling for the past 30 years and is now below central bank targets. Low inflation means low nominal interest rates, of course. And, as Treasury’s Kennedy has reminded us, the global real interest rate, similar to the “neutral” interest rate – the real official rate that’s neither expansionary nor contractionary – has been falling steadily for the past 40 years. This has been due to structural developments that drive up savings relative to the willingness of households and firms to borrow and invest, he says. This “is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.

All this says that fiscal policy’s return to primacy over monetary policy is not just a temporary development, but the culmination of structural forces building up over decades, suggesting this will be a lasting change. It may be many years before inflation returns as a problem.

Fiscal policy and monetary policy: pros and cons

In considering the choice between using fiscal policy or monetary policy to manage demand, economists have identified three “lags” or delays involved in the process of the economic managers using either instrument to bring about change. First is the “decision lag”: how long it takes to decide what should be done. Second is the “implementation lag”: how long it takes before the decision can be put into effect. Third is the “impact lag”: how long it takes for the decision to work its way through the economy and have its full effect on the behaviour of households and businesses.

Monetary policy’s great advantage is that it can be changed so quickly and easily, by a decision of the RBA board (this covers the decision lag and implementation lag), whereas fiscal policy changes involve possibly protracted development of measures and consideration by cabinet (the decision lag), and then often delays before the measures can be put into effect (the implementation lag). But, once implemented, monetary policy changes probably take longer to have their full effect on the economy (the impact lag) than do fiscal policy changes.

And fiscal policy measures – whether on the tax or spending sides of the budget - can be targeted to fixing particular problems, whereas monetary policy is a “blunt instrument” or one-trick pony: it uses interest rates to encourage or discourage borrowing and spending. Fiscal policy includes the budget’s automatic stabilisers (to which, Kennedy has argued, the JobKeeper wage subsidy scheme and the temporary JobSeeker supplement, being open-ended, were temporary additions).

Economists at the IMF and elsewhere argue that fiscal policy multipliers are higher than earlier believed. This is partly because leakages to imports are less significant when all major governments are stimulating simultaneously in response to the same global shock (such as the GFC or a pandemic). But it’s also because the effect of fiscal stimulus isn’t reduced by the “monetary policy reaction function” – the decisions of independent central banks to raise interest rates because they fear the fiscal stimulus will add to inflation pressure.

Finally, monetary policy’s comparative advantage relative to fiscal policy is controlling inflation, not stimulating demand when the economy is again caught in a liquidity trap (secular stagnation). The same applies when the economic managers need to hold the economy together during a lockdown, then boost it back to life when the lockdown ends).

Now let’s turn to the basic facts you need to know about the two arms of macroeconomic management and how they are now being used to help the economy recover from the coronacession.

The monetary policy “framework”

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. Until now it has been the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Recent developments in monetary policy

Because of six consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. For more than 2½ years after that, it left the rate unchanged – a record period of stability. It’s not hard to see why it left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy had yet to accelerate and had plenty of unused production capacity, and the rate of unemployment shows little sign of falling below its estimated NAIRU of 5 pc, which the RBA revised down to 4.5 pc before the arrival of the pandemic.

But with the economy showing particular weakness in in the second half of 2018, it cut the cash rate three times in 2019, lowering it to 0.75 pc. Then, the advent of the virus led it to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. As we’ve seen, and despite its previously expressed reservations, it also joined the US Federal Reserve and other major central banks in engaging in quantitative easing. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was no higher than the cash rate. And, to ensure the banks keep lending to small business during the recession, it announced it was prepared to lend to them at the same rate as the cash rate.

By last November, however, the RBA had cut the cash rate to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion buying second-hand bonds with maturities of 5 to 10 years. Note that all the QE measures are intended to lower the interest rates paid by governments and private firms on longer-term borrowing. Note, too, that the RBA’s extensive purchases of second-hand bonds are equivalent to it funding about half the government’s budget deficit by “printing money”.

Fiscal policy “framework”

Until the arrival of the pandemic, fiscal policy - the manipulation of government spending and taxation in the budget – had been conducted according to the Morrison government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. Since the coronacession, however, the government has adopted a two-phase strategy. Phase one, the economic recovery plan, involves huge fiscal stimulus to promote employment, growth and business and consumer confidence. It will remain in place until the unemployment rate is comfortably below 6 per cent. Phase two will involve a return to the long-standing medium-term fiscal objective. “Future adjustments in the fiscal stance will focus, in the first instance, on ensuring the economic recovery is strong, and over the medium term on stabilising and then reducing gross and net debt as a share of GDP,” the government says.

Recent developments in fiscal policy

At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But it turned out to lack enthusiasm for either cutting government spending or increasing taxes. And the years of below-trend growth caused by secular stagnation meant the debt kept growing and the budget didn’t return to balance until 2018-19. Mr Frydenberg was expecting the budget to return to surplus in 2019-20, but this was overturned by the pandemic, which caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.

The economy’s rebound from the coronacession

The initial lockdown in the economy caused real GDP to contract by more than 7 pc in the March and June quarters of last year. The unemployment rate peaked at 7.5 pc in July, and the under-employment rate peaked at 11.4 pc in September. But, to everyone’s surprise, GDP rebounded strongly in the following two quarters, to end 2020 just 1 pc below where it was in December 2019. By March this year, total employment had rebounded to be a fraction higher than it was a year earlier. The unemployment rate was down to 5.6 pc (compared with 5.1 pc before the virus struck) and the under-employment rate down to 7.9 pc (compared with 8.6 pc). This rebound is positively amazing. It’s explained by four main factors.

First, the coronacession can’t be compared with an ordinary recession. Whereas ordinary recessions are caused by weak demand by households and firms, the corona recession was caused by a government-ordered temporary cut in supply, as federal and state governments sought to suppress the virus by closed our borders, ordered many industries to cease trading and people to leave their homes as little as possible. This meant that, as the lockdown was lifted, people and businesses were able to resume (almost) normal activity. The JobKeeper program was designed to keep workers attached to their employers until the lockdown ended. The JobSeeker supplement was intended to help anyone who did lose their job keep spending. The two programs were highly effective.

Second, the rebound strategy has been hugely effective in restoring employment to roughly where it was before the lockdown. However, the rate of unemployment has fallen by more than would normally happen in response to such a rise in employment. This is because the closing of our border to immigrants has caused the size of the labour force to grow by about half the rate it normally does, thus making it easier for increased employment to lead to reduced unemployment.

Third, when you remember the massive amount of fiscal stimulus the government has applied, it shouldn’t be so surprising that the economy has grown so strongly. What this proves is that fiscal stimulus works.

Finally, some people have concluded that the economy is now “roaring back” and will growing strongly in coming years – by implication, more strongly than it was before the virus arrived. If so, the pandemic will have somehow snapped the rich countries out of the secular stagnation that gripped it. I find this hard to believe. There’s been little change in the structural factors that have caught us in a low-growth trap. Business investment spending, productivity improvement and real wage growth remain low. What’s true, however, is that the economy has yet to feel the benefit of all the fiscal stimulus the government has committed to. About 40 pc of the total $250 billion stimulus has yet to be spent. And the outsized 12 pc household saving rate tells us much of money already spend by the government is still being held by household for future spending. It’s what happens after this stimulus has waned that we should be worrying about.

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New economic rule: the budget's the only game in town

There’s a trick for governments trying to manage their economy. Once in a while – maybe every 30 or 40 years – the rules of the economic game change. What used to be the right thing to do becomes wrong, and now the right thing is something we’ve long believed was not the way to go.

Trouble is, the game change is never announced by thunder and lightning flashes from on high that everybody sees. Those paying close attention soon get the message, but many people – even many economists – don’t.

Some people have invested their careers – and their egos – in the old way of doing things and resist any talk of change. They stick to their ideology when it’s time for pragmatism and re-examination of old ideas to see if they still work.

These rare times of change are dangerous for governments. Those that don’t get the message in time stuff up and get thrown out.

Our last government to badly misread the economy’s changed circumstances was Gough Whitlam’s. And we know what happened to it. But that was more than 40 years ago, and now the sharp-eyed can see the rules have changed again.

If Scott Morrison and Josh Frydenberg can’t see it, the economy’s recovery will peter out and, sooner or later, they’ll be out.

Fortunately, it seems from Frydenberg’s speech on Thursday that they and their Treasury advisers do get it, and are acting accordingly.

For about 30 years after World War II, Australia – and all the developed economies - enjoyed a Golden Age of strong economic growth, full employment, low inflation and a narrowing gap between rich and poor.

The economy pretty much managed itself, leaving governments free to focus on other issues. After 23 years in opposition, Whitlam’s Labor came to power with a long list of economic and social reforms to be made.

It got on with “the Program” – involving massively increased government spending – not realising that inflation had got away, that “stagflation” meant rates of unemployment of less than 2 per cent would never be seen again, and that governments now had to spend most of their time worrying about the economy and making sure their “reforms” didn’t make things worse.

In the years after WWII, the rich economies’ focus was on keeping demand for goods and services growing strongly so the workforce could stay fully employed. It was decided that, of the two main “instruments” available for managing the economy, “fiscal policy” – using the budget to change government spending and taxation – was better.

The other instrument, “monetary policy” – moving interest rates up or down to discourage or encourage borrowing and spending – should play a subsidiary role by keeping rates perpetually low.

But by the late 1970s, the rich economies realised that high inflation – caused by the demand for goods and services running ahead of the economy’s ability to supply them – was the key problem, and the best instrument to control inflation was monetary policy. This would leave fiscal policy free to be used to keep budget deficits down and limit the build-up in government debt.

That’s been the conventional “assignment of instruments” for the many decades since then, the one everyone’s used to and many have come to view as the God-ordained way for the economy to be managed. It fits well with the populist fearmongering about “debt and deficit” that Tony Abbott & Co used to help get the Coalition back to power in 2013.

Trouble is, over the decades, inflation in the prices of goods and services has pretty much gone away. But weak growth in the advanced economies since the global financial crisis means unemployment has remained high – well above anything that could be called full employment.

It’s clear the basic problem we face has switched from excess demand relative to supply to insufficient demand relative to supply. Low inflation means low nominal interest rates, but when rates are already low, cutting them a bit further doesn’t do much to encourage businesses to borrow for expansion or households to borrow more for consumer spending (as opposed to bidding up the price of houses).

That’s been true for some years, but now the coronacession has pushed the official interest rate almost to zero, while “quantitative easing” only seems to push up the prices of houses and other assets.

Get it? With monetary policy having lost its potency, fiscal policy becomes the only game in town. The only policy instrument capable of being used to stimulate growth and keep our economy and everyone else’s recovering and unemployment falling.

But as well as being the only lever left, it’s also the one better suited to boosting demand and taking up idle supply capacity. When the problem is the private sector’s reluctance to expand, and the wages households use to increase their consumer spending have stopped rising, the only way to keep the economy moving until the private sector revives is spending by the public sector.

Frydenberg’s speech makes it clear he gets this and, rather than use the budget to get the deficit down, he’ll focus on continuing to use it to foster growth. In time, this will “repair the budget by repairing the economy”.

I think most voters will happily go along with this policy switch.

But there are still many economists and others who don’t get the need to change tack and will oppose it. Particularly those with a vested interest in active monetary policy – money-market people and economists specialising in monetary economics.

But also, amazingly, Labor’s Shadow Treasurer, Jim Chalmers, who’s calling for an inquiry – a royal commission? - into the Reserve Bank’s alleged mishandling of monetary policy.

He seems to think monetary policy’s steady loss of potency in Australia (and all the rich countries) over a decade or more can be explained by the Reserve Bank governor’s repeated failure to meet his KPIs for inflation.

Sack the governor, change the procedures, problem goes away. Really, Jim?

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Morrison's budget task: stop the economy's roar turning to a meow

Scott Morrison and Josh Frydenberg look like they’re sitting pretty as they finalise what may be their last budget before the federal election due by the first half of next year. Look deeper, however, and you see they face a serious risk of the economy’s recovery losing momentum over the coming financial year. But, equally, they have a chance to show themselves as the best economic managers since John Howard’s days.

So far, the strength of the economy’s rebound from the “coronacession” has exceeded all expectations. Judged by the quantity of the nation’s production of goods and services, the economy contracted hugely during the three months to June last year. As our borders were closed, many industries were ordered to stop trading and you and I were told to leave home as little as possible.

But with the lifting of the lockdown in the second half of the year, the economy took off. It rebounded so strongly in the next two quarters that, by the end of December, our production – real gross domestic product – was just 1 per cent below what it had been a year earlier, before the arrival of the coronavirus.

The rebound in jobs is even more remarkable. The number of people in jobs fell by almost 650,000 in April and May, and that’s not counting the many hundreds of thousands of workers who kept their jobs thanks only to the JobKeeper scheme.

But as soon as the lockdown was eased, employment took off. By last month, it was actually a fraction higher than it had been in March 2020. We’d been warned the rate of unemployment would reach 10 per cent, but in fact it peaked at 7.5 per cent in July and is now down to 5.6 per cent. Before this year’s out, it’s likely to have fallen to the 5.1 per cent it was before the pandemic.

The confidence of both businesses and consumers is now higher than it has been for ages. Same for the number of job vacancies. Share prices are riding high (not that I set much store by that).

Little wonder the financial press has proclaimed the economy to be “roaring”. Hardly a bad place to be when preparing another budget. What could possibly go wrong?

Just this. The main reason the economy has rebounded so strongly is the unprecedented sums the government spent on JobKeeper, the JobSeeker supplement, HomeBuilder and countless other programs with gimmicky names. Spending totalling a quarter of a trillion dollars.

What it proves is that “fiscal stimulus” works a treat. Trouble is, all those programs were designed to be temporary and the biggest of them have already been wound up. So, though not all the stimulus has yet been spent, it’s clear the stimulus is waning.

And this at a time when there’s no other major force likely to drive the economy onwards and upwards. Business investment spending is way below normal. Growth in the wage income of consumers has been weak for six years or more and, for many workers at present, frozen.

Because all the stimulus programs are stopping, the government’s update last December estimated that the budget deficit for the next financial year will be $90 billion less than the deficit for the year soon ending.

This may sound good, but it means that, whereas last year the government put far more money into the economy than it took out in taxes and charges, in the coming year it expects the budget’s contribution to growth to fall by $90 billion – the equivalent of about 4 per cent of GDP.

So that’s the big risk we face: that before long the economy’s roar will turn to no more than a loud meow.

Now to Morrison and Frydenberg’s chance of greatness. Their temptation is to get unemployment back to the pre-pandemic rate of 5 per cent and call it quits. That’s certainly what previous governments would have done.

But let me ask you a question: do you regard an unemployment rate of 5 per cent as equal to full employment? Is that where everyone who wants a job has got one?

Hardly. And, as Professor Ross Garnaut has argued in his latest book, Reset, there’s evidence that we can get unemployment much lower – say, 3.5 per cent or less – before we’d have any problem with soaring wage and price inflation.

The good news is that the answers to the Morrison government’s risk of economic failure and its chance of economic greatness are the same: keep the budgetary stimulus coming for as long as it takes the private sector to revive and take up the slack.

That means finding new spending programs to take the place of JobKeeper and the rest. And here Morrison’s political and economic needs are a good fit. Making an adequate response to the report of the aged care royal commission will take big bucks.

And he needs to make this a hugely women-centred budget in marked contrast to last year’s. Obvious answer: do what the women’s movement has long been demanding and make childcare free.

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My love letter to The Sydney Morning Herald

It’s not something any hard-bitten journalist should admit, but I’m in love with The Sydney Morning Herald. Have been since, at the age of 26, I quit chartered accounting in disillusionment and stumbled into a cadetship at the Herald. I quickly realised I’d found the only place I wanted to be.

After four years they gave me the title of economics editor and sat me in an armchair with a licence to air my opinions about anything economic. It’s probably the only job I’m capable of doing with any competence. I’ve been so fulfilled by my work that, in 47 years, I’ve never wanted another job on the paper and, certainly, never wanted to move to another paper.

I suspect that by now I’m actually addicted to column-writing and to staying one of the Herald‘s roosters rather than one of its many feather-dusters. When my designated retirement date arrived, I had no desire to hang up my boots and luxuriate on the Herald’s more-than-generous super scheme. And, apart from Jessica Irvine, detected no desire by my colleagues to wave me off.

But I promise you (and Jessica) this: I’ll be out of here the moment I find I’ve worn out my welcome with our readers or my bosses, or realise I’m starting to lose my marbles. That I’m still keen to learn more about the economy and to work rather than play, I credit mainly to three gym sessions a week with my physio trainer, Martin Doyle. Exercise is good for mental as well as physical fitness.

I did feel I should at least stay on to do my bit in helping the Herald make the seemingly improbable “transition” – what a fashionable word that’s become – from “legacy asset” to successful digital “masthead”. Fortunately – and touch wood – we’ve passed that test now we’ve switched from chasing clicks to seeking digital subscriptions.

The thought of the Herald ceasing to be appalled me. As Australia’s oldest metropolitan daily newspaper, for 190 years it’s been one of the pillars on which Sydney rests. I get an enormous kick from being a tiny part of that grand history – for, I realise to my amazement, almost a quarter of its existence. It tickles me that, in the days when governors of NSW and Anglican archbishops of Sydney were recruited from England, so were editors of the Herald.

I’m proud of the many big names to have worked for the Herald at some point in their career. Banjo Paterson was our correspondent covering the Boer War. C.E.W. Bean was a Herald writer before becoming the federal government’s official war correspondent in World War I. Angus Maude, one of our last English-export editors, became Maggie Thatcher’s Paymaster General. I remember Thatcher’s daughter Carol working for a few months in our newsroom.

The playwright and speech writer Bob Ellis’ Herald career lasted 11 days. Columnist and poet Clive James lasted longer before he went off to England to make his name. I remember author Geraldine Brooks cutting a swathe through our feature writers’ room before she went off to New York to make her name. The others wrote one feature a week; she wrote one a day.

Together with her journalist husband George Johnston, Charmian Clift was a celebrity in 1960s Sydney before the word had been invented. This was explained by the years they’d spent living on a Greek island, where (we’ve learnt only recently) they were friendly with some Canadian singer named Leonard and his girlfriend Marianne. Charmian wrote a highly popular weekly column in the Herald, before ending her life.

William Stanley Jevons, a celebrated English neo-classical economist and polymath of the 19th century, discoverer of the Jevons paradox, spent part of his early career working at the Sydney Mint. He didn’t work for the Herald, but he did write letters to the editor. Hearing that made me proud to work where I did.

The Herald has changed greatly over the years I’ve been here and, leaving aside the many journalists we lost as we made our painful adjustment to the digital revolution, mainly for the better. Some years ago, someone got the idea of honouring our longest-serving journos by presenting them with a framed copy of our front page from the day they joined the paper. I was shocked by how dreary mine was. We were busy sticking to traditional standards as the world around us was changing without us noticing.

These days we cover a wider range of subjects – crime and lifestyle interests – all in a livelier, brighter, cleaner, more cleverly written way. I like to think I’ve been part of our move to a less formal, more relaxed and conversational writing style. The old-timers would be appalled to see us saying “kids” rather than “children”.

The Herald is far from perfect – no “first draft of history” ever is – but I value being at the more careful, intellectually respectable and, dare I say, gentlepersonly end of the news media. I feel privileged to write for such a well-educated audience.

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