How and why the tide of globalisation has turned

Politicians banging on about “security” should always be suspected of having ulterior motives, but when you to see the secretary to the Treasury giving a speech on security, that’s when you know the world has changed radically.

That’s what Treasury secretary Dr Steven Kennedy did last week. It was a sign of how much the distinction between economic issues and defence and foreign affairs has blurred as rivalry between the United States and China has grown.

We used to think of “Australia in the Asian century” as one big opportunity for us to make a buck but, Kennedy says, “we are facing a more contested, more fragmented and more challenging global environment, where trade is increasingly seen as a vulnerability as much as an opportunity”.

“In light of these challenges, it is incumbent on Australian policymakers to work together to develop sound policy frameworks and institutional arrangements that match the times. That take the long view and protect both economic and strategic interests,” he says.

We must strike a fine balance, he says. “If we fail to adequately adapt and respond to the new reality we face, we risk exposing our economy and our country to excessive risk...”

But “if we over-correct and adopt a zero-risk approach, shutting ourselves out of global markets and seeking to be overly self-sufficient, we will quickly undermine the productivity, competitiveness and dynamism of our economy,” he says.

Our economy benefited from decades of rising prosperity as international economic integration – globalisation – flourished under a stable, rules-based international order.

At the same time, economic reforms opened our economy to global competition by cutting tariffs (import duties), floating the exchange rate and deregulating the financial system.

But now, “tectonic shifts in the global economic order are underway” as the engines of global growth have shifted from west to east. China has gone from accounting for about 6 per cent of growth in the global economy in 1981, to more than 25 per cent today.

The United States’ share of growth has fallen from 26 per cent to 13 per cent.

However, this move to a more multipolar global order has brought with it “a sharpening of geostrategic [country versus country] competition and a far more contested set of global rules, norms and institutions,” Kennedy says.

As Treasurer Jim Chalmers has said, we are facing “the most challenging strategic environment since World War II” after a difficult decade and a half punctuated by the unmistakable signs of climate change, a pandemic and a European war, which exposed fragilities in our supply chains.

In this changing world, economic resilience – the capacity to withstand and recover quickly from shocks to the economy – is an essential component of assuring our national security.

The trade wars between the US and China during the Trump years have sharpened into an overt strategic rivalry and a contest for global influence.

The US has said it is not seeking to decouple from China – due to the significant negative global repercussions of a full separation – but is “de-risking and diversifying” by investing at home and strengthening linkages with allies and partners around the world.

In this new paradigm, Kennedy says, economic and financial tools are being deployed much more aggressively to promote and defend national interests.

According to the International Monetary Fund, more than 2500 new policies were introduced last year in response to concerns about supply chains, the climate and security. Since 2018, measures restricting trade flows have outnumbered measures that liberalise trade by about three to one.

Our primary economic and strategic (defence) partners are no longer the same. China now accounts for 30 per cent of our two-way (exports plus imports) trade, whereas the G7 countries combined account for just 26 per cent. China is now a larger trading partner than the US for more than 140 countries.

In the new world of greater rivalry, there is a small set of our systems, goods and technologies that are critical to the smooth operation of our economy and to the security of our country. Systems that are vulnerable to interventions and where a disruption could impact lives and threaten our national interest in a time of conflict.

In these parts of the economy there’s a clear role for government in regulating their operation and their ownership. This approach is called the “small yard, high fence” strategy, where a strong set of protections are put around a few critical economic activities.

But the key challenge in these types of reforms is to prevent overreach. The risk of foreign disruption has to be balanced in such a way that economic activity is not unnecessarily curtailed.

And there’s also a different kind of risk: that these types of regulatory regimes could be used as a form of industry protection, or to respond to community pressure, rather than to address genuine security risks.

Whereas our security and intelligence agencies are best placed to understand the vulnerabilities in our systems and the methods most likely to be used to exploit those vulnerabilities – including as part of the foreign investment screening process – they need to be in partnership with economic experts, such as Treasury.

We can’t afford to take the attitude that there should be zero risk of problems, nor dismiss the long-term economic costs of these restrictions.

There should be a high bar for what government puts inside the protected yard and each decision should be carefully weighed, we’re told, with both benefits and costs considered.

As for supply chain problems, it’s often argued that countries should build sovereign capability in areas of risk. This is often argued with little consideration of other ways of solving the problem, or of the cost of doing so.

But as Treasurer Chalmers has made clear, a Future Made in Australia cannot mean pursuing self-reliance in all things. That would undermine our key economic strengths and leave us less able to exercise strategic weight, not more.

Security, it turns out, is too important to be left to diplomats and generals.

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It's time to dig deep - but not deeper than the taxman expects

I have a request to make of all Australian taxpayers: please give more to charity because you’re making me look bad. Like a cheat, in fact. I’ll explain shortly, but first, a self-interested public service announcement. Hurry, hurry, hurry. You have only the rest of this week to make a tax-deductible donation if you want to get some of it back in your next tax refund.

June 30, the biggest day of the year for the nation’s accountants, is fast approaching. It’s also the most important time of year for the nation’s charities. If you’ve ever made a donation to any of them, I bet they sent you a letter in the last few weeks reminding you how good it would be if you did so again ASAP.

But, as we were reminded by a strategically placed story last week, this is likely to be a bad year for charities. Why? Because in a cost-of-living crisis many of us decide that charity begins at home.

According to polling by academics at the University of Queensland, 78 per cent of people have reduced their donations because of the crisis facing their own budgets.

This is particularly bad timing for those charities that help people having trouble affording food and other necessities, such as the Salvos. The demand for their services has jumped for the same reason people are finding it harder to give. (Yes, the Salvos have “reached out” to me lately. And as I did myself in my uniformed youth, they waved a collection box under my nose.)

Perhaps it’s the accountant in me that makes me particularly attracted to donations that are tax-deductible. As everyone soon learns, you can’t make a profit out of tax deductibility. You can only reduce a cost.

But I like it because it lets me send a bit of taxpayers’ money in a direction chosen by me, not the politicians. The pollies mightn’t give a stuff about the wellbeing of refugees and asylum seekers, but I do. And to some small extent, I can make them kick the tin.

Also last week, purely by chance, I’m sure, we were reminded that, though Australians like to think of themselves as generous, we’re actually tighter than people in other English-speaking countries. Even the Kiwis are more giving than we are.

Which brings me to my beef about donations. Now, I’ve long been a defender of the Tax Office. It does an important job in making sure we pay as much tax as we should. One reason I got out of accounting was because I decided the only interesting part of it was giving tax advice, but I didn’t want to spend my life helping the well-off avoid doing their duty to the community.

But a few weeks ago, I got a letter from the Tax Office, via the myGov website, naturally, that was the strangest I’ve ever had from them. And it really pee’d me off.

The standard form letter said they’d happened to notice that my claim for donations was a lot higher than other people’s, and they were just wondering whether I might possibly have made some mistake.

They hoped I knew you could only claim for donations to outfits that had been awarded tax deductibility. And they hoped I knew I shouldn’t be claiming for any donation for which I couldn’t produce a receipt.

If, on reflection, I realised I had made some terrible “mistake”, I was free to amend my return and thereby, they hinted without saying, avoid possible further investigation and penalty.

But, failing that, there was no suggestion I do anything about their veiled accusation, except, presumably, sit there shivering, waiting for the taxman’s knock on the door.

It may be true, as coppers always say, that if you’ve done nothing wrong you’ve got nothing to fear, but that doesn’t stop you resenting an unwarranted insinuation that you’re dishonest.

What gets me is that, knowing my claim was large, I would have happily included a detailed list with my return, but the taxman made no provision for me to do so. Nor, when he sent his accusatory letter, did he invite me to explain or substantiate my claim.

And I get the feeling that the taxman’s algorithm just found an outsized number and dispatched a letter without further consideration. Did he know that I always make a big claim? Did he allow for the likelihood that people on high incomes can afford to be more generous? Did he note that I’d been a tax agent for many years and so didn’t need reminding of the rules?

Well, I know the taxman doesn’t want to be burdened by any extra information from me, but I’ll give him a heads-up anyway. My claim for this financial year won’t be as big as last year’s, but the one for next year will be a whopper. I’m thinking of setting up a charity of my own. All above board, naturally.

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Yikes! Our tiny manufacturing sector makes us rich but ugly

At last, the source of our economic problems has been revealed. Our economy is badly misshapen, making it unlike all the other rich economies. Did you realise that our manufacturing sector is the smallest among all the rich countries?

Worse, our mining sector’s almost five times as big as the average for all the advanced economies and our agriculture sector’s twice the normal size.

Do you realise what an ugly freak this must make us look to all the other rich people in the world? We’re like the millionaire who made his pile as a rag and bone man with a horse and cart. Yuck.

It’s something about which we should be deeply ashamed and very worried, apparently.

How do I know this? It’s all explained in an open letter signed by about 70 academics who, because they’re banging on about economic matters, have been taken to be economists. But they don’t sound like any economist I know.

Indeed, they devote most of their letter to explaining why some of the most fundamental principles of economics are not only wrong, wrong, wrong, but sooo yesterday.

They condemn “outdated ‘comparative advantage’ theories of trade and development – according to which, countries should automatically specialise in products predetermined by natural resource endowments” which theories, they assure us, “have been abandoned” by other rich countries.

Rather, “there is new recognition that competitiveness is deliberately created and shaped, through proactive policy interventions that push both private and public actors to do more than market forces alone could attain”.

Get it? When you’re trying to make a living in a market economy, it’s a mistake to worry about what you’re good at, or to think you’ll sell something you’ve got that they don’t. No, with the right policies, governments can make you “competitive” without any of that.

You may think we’ve done pretty well among the other rich countries but, in truth, we’ve been getting it all wrong. When those Europeans were sailing round the South Pacific looking for an island they could take from its local inhabitants, their big mistake was to pick Australia.

They thought our island would have a lot of good farmland. And surely somewhere in all that space there must be some gold or other valuable minerals. But this turned us into hewers of wood and drawers of water.

Worse, some of us became the lowest of the low, digging stuff out of the ground and shipping it off somewhere. We turned our country into a quarry. And there’s only one thing lower than running a quarry: providing “services” to other people. You know, being a cleaner or chambermaid or waiter.

All of which tempted us away from the one honest, noble way to earn a living: making things. And if only our island hadn’t been good for farming and mining, making things would have been the only way left to make a living.

Really? As the independent economist Saul Eslake has said, this isn’t economics, it’s the fetishising of manufacturing. It’s the one worthy occupation. All the rest are rubbish.

Now, I’m sure the open letter-signers would protest that they’re only arguing for a big manufacturing sector, they’re not saying we shouldn’t have farmers, miners or servants.

Trouble is, as Eslake points out, all the parts of an economy can’t add to more than 100 per cent of gross domestic product or total employment. If some parts’ shares are bigger than others, the other bits’ shares must be smaller.

When you think about it, this is just an application of the economists’ most fundamental principle: opportunity cost. You can’t have everything you want, so make sure what you pick is what you most want.

To anyone who’s been around a while, it’s clear the letter-signers are on the left. Nothing wrong with that. At its best, the left cares about a good deal for the bottom, not just the top. But for some strange reason, a lot of those on the left see themselves as linked to manufacturing by an umbilical cord.

The joke is, few if any of the letter-signers would ever have worked in manufacturing – or ever want to. (My own career in BHP’s Newcastle coke ovens lasted two days before I scuttled back to the comfort of a chartered accountants’ office.)

Academics, more than anyone, should understand that the future lies in services, not manufacturing. The good jobs come from what you know, not what you can make.

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The RBA has squeezed us like a lemon, but it's still not happy

Let me be the last to tell you the economy has almost ground to a halt and is teetering on the edge of recession. This has happened by design, not accident. But it doesn’t seem to be working properly. So, what happens now? Until we think of something better, more of the same.

Since May 2022, the Reserve Bank has been hard at work “squeezing inflation out of the system”. By increasing the official interest rate 4.25 percentage points in just 18 months, it has produced the sharpest tightening of the interest-rate screws on households with mortgages in at least 30 years.

To be fair, the Reserve’s had a lot of help with the squeezing. The nation’s landlords have used the shortage of rental accommodation to whack up rents.

And the federal government’s played its part. An unannounced decision by the Morrison government not to continue the low- and middle-income tax offset had the effect of increasing many people’s income tax by up to $1500 a year in about July last year. Bracket creep, as well, has been taking a bigger bite out of people’s pay rises.

With this week’s release of the latest “national accounts”, we learnt just how effective the squeeze on households’ budgets has been. The growth in the economy – real gross domestic product – slowed to a microscopic 0.1 per cent in the three months to the end of March, and just 1.1 per cent over the year to March. That compares with growth in a normal year of 2.4 per cent.

This weak growth has occurred at a time when the population has been growing strongly, by 0.5 per cent during the quarter and 2.5 per cent over the year. So, real GDP per person actually fell by 0.4 per cent during the quarter and by 1.3 per cent during the year.

As the Commonwealth Bank’s Gareth Aird puts it, the nation’s economic pie is still expanding modestly, but the average size of the slice of pie that each Australian has received over the past five quarters has progressively shrunk.

But if we return to looking at the whole pie – real GDP – the quarterly changes over the past five quarters show a clear picture of an economy slowing almost to a stop: 0.6 per cent, 0.4 per cent, 0.2 per cent, 0.3 per cent and now 0.1 per cent.

It’s not hard to determine what part of GDP has done the most to cause that slowdown. One component accounts for more than half of total GDP – household consumption spending. Here’s how it’s grown over the past six quarters: 0.8 per cent, 0.2 per cent, 0.5 per cent, 0.0 per cent, 0.3 per cent and 0.4 per cent.

A further sign of how tough households are doing: the part of their disposable income they’ve been able to save each quarter has fallen from 10.8 per cent to 0.9 per cent over the past two years.

So, if the object of the squeeze has been to leave households with a lot less disposable income to spend on other things, it’s been a great success.

The point is, when our demand for goods and services grows faster than the economy’s ability to supply them, businesses take the opportunity to increase their prices – something we hate.

But if we want the authorities to stop prices rising so quickly, they have only one crude way to do so: by raising mortgage interest rates and income tax to limit our ability to keep spending so strongly.

When the demand for their products is much weaker, businesses won’t be game to raise their prices much.

So, is it working? Yes, it is. Over the year to December 2022, consumer prices rose by 7.8 per cent. Since then, however, the rate of inflation has fallen to 3.6 per cent over the year to March.

Now, you may think that 3.6 per cent isn’t all that far above the Reserve’s inflation target of 2 per cent to 3 per cent, so we surely must be close to the point where, with households flat on the floor with their arms twisted up their back, the Reserve is preparing to ease the pain.

But apparently not. It seems to be worried inflation’s got stuck at 3.6 per cent and may not fall much further. In her appearance before a Senate committee this week, Reserve governor Michele Bullock said nothing to encourage the idea that a cut in interest rates was imminent. She even said she’d be willing to raise rates if needed to keep inflation slowing.

It’s suggested the Reserve is worried that we have what economists call a “positive output gap”. That is, the economy’s still supplying more goods and services than it’s capable of continuing to supply, creating a risk that inflation will stay above the target range or even start going back up.

With demand so weak, and so many people writhing in pain, I find this hard to believe. I think it’s just a fancy way of saying the Reserve is worried that employment is still growing and unemployment has risen only a little. Maybe it needs to see more blood on the street before it will believe we’re getting inflation back under control.

If so, we’re running a bigger risk of recession than the Reserve cares to admit. And if interest rates stay high for much longer, I doubt next month’s tax cuts will be sufficient to save us.

Another possibility is that what’s stopping inflation’s return to the target is not continuing strong demand, but problems on the supply side of the economy – problems we’ve neglected to identify, and problems that high interest rates can do nothing to correct.

Problems such as higher world petrol prices and higher insurance premiums caused by increased extreme weather events.

I’d like to see Bullock put up a big sign in the Reserve’s office: “If it’s not coming from demand, interest rates won’t fix it.”

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It's slowing the spin doctors' spin that keeps me busy

Do you remember former prime minister John Howard’s ringing declaration that “we will decide who comes to this country and the circumstances in which they come”? It played a big part in helping him win the 2001 federal election. But it’s only true in part.

The job of economic commentators like me is supposed to be telling people about what’s happening in the economy and adding to readers’ understanding of how the economy works.

But the more our politicians rely on spin doctors to manipulate the media and give voters a version of the truth designed always to portray the boss in the most favourable light, the more time I have to spend making sure our readers aren’t being misled by some pollie’s silken words.

These days, I even have to make sure our readers aren’t being led astray by the economics profession. For the first time in many years, I’ve found myself explaining to critical academic economists that I’m a member of the journos’ union, not the economists’ union.

Like many professions, economists are hugely defensive. And they like to imagine my job is to help defend the profession against its many critics. Sorry, I’m one of the critics.

My job is to advise this masthead’s readers on how much of what economists say they should believe, and how much they should question.

It’s not that economists are deliberately misleading, more that they like to skirt around the parts of their belief system that ordinary people find hard to swallow.

And then there’s the increasing tendency for news outlets to pick sides between the two big parties, and adjust their reporting accordingly. My job is to live up this masthead’s motto: Independent. Always.

So, back to Howard’s heroic pronouncement. It’s certainly true that “we” – the federal government – decide the circumstances in which people may come to Australia. If you turn up without a visa, you’ll be turned away no matter how desperate your circumstances. If you come by boat, your chances of being let in are low.

But if you come by plane, with a visa that says you’ll be studying something at some dodgy private college when, in truth, you’re just after a job in a rich country, in you come. If we’ve known about this dodge, it’s only in the past few weeks that we’ve decided to stop it.

No, the problem is, if you take Howard’s defiant statement to mean that we control how many people come to this country, then that’s not true. We decide the kinds of people we’ll accept, but not how many.

There are no caps because, for many years, both parties have believed in taking as many suitable immigrants as possible. It’s just because the post-COVID surge in immigration – particularly overseas students – has coincided with the coming federal election that the pollies are suddenly talking about limiting student visas.

But remember, the politicians have form. Knowing many voters have reservations about immigration, they talk tough on immigration during election campaigns, but go soft once our attention has moved on, and it’s all got too hard.

It’s a similar thing with Anthony Albanese’s Future Made in Australia plan. Polling shows it’s been hugely popular with voters. But that’s because they’ve been misled by a clever slogan. It was designed to imply a return to the days when we tried to make for ourselves all the manufactured goods we needed.

But, as I’ve written, deep in last month’s budget papers was the news that we’d be doing a bit of that, but not much. It’s just a great slogan.

On another matter, have you noticed Treasurer Jim Chalmers’ dissembling on how he feels our pain from the cost-of-living crisis, which is why he’s trying so hard to get inflation down?

What he doesn’t want us thinking about is that, at this stage, most of the pain people are feeling is coming not from higher prices, but from the Reserve Bank’s 4.25 percentage-point increase in interest rates.

Get it? The pain’s coming from the cure, not the disease. The rise in interest rates has been brought about by the independent central bank, not the elected government, of course. But when Chalmers boasts about achieving two successive years of budget surplus, he’s hoping you won’t realise that those surpluses are adding to the pain households are suffering, particularly from the increase in bracket creep.

And, while I’m at it, many people object to businesses raising their prices simply because they can, not because their costs have increased. This they refer to disapprovingly as “gouging”.

But few economists would use that word. Why not? Because they believe it’s right and proper for businesses to charge as much as they can get away with.

Why? Because they think it’s part of the way that market forces automatically correct a situation where the demand for some item exceeds its supply. In textbooks, it’s called “rationing by price”.

Rather than the seller allowing themselves to run out of an item, they sell what’s left to the highest bidders. What could be better than that?

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No one's sure what's happening in the economy

Treasury secretary Dr Steven Kennedy let something slip when he addressed a meeting of business economists last week. He said it was too early to say if the economy was back in a more normal period, “perhaps because no one is quite sure what normal is any more”.

This was especially because “unusual economic outcomes are persisting,” he added.

Actually, anyone in his audience could have said the same thing – but they didn’t, perhaps because they lacked the authority of the “secretary to the Treasury”.

No, standard practice among business economists and others in the money market is to make all predictions with an air of great certainty. Forgive my cynicism, but this may be because their certain opinion changes so often.

Often, it changes because something unexpected has happened in the US economy. Many people working in our money market save themselves research and thinking time by assuming our economy is just a delayed echo of whatever’s happening in America.

If Wall Street has decided that America’s return to a low rate of inflation has been delayed by prices becoming “sticky”, rest assured it won’t be long before our prices are judged to have become sticky as well.

But predicting the next move in either economy has become harder than we’re used to. Kennedy noted in his speech that, in recent years, the global economy, including us, had been buffeted by shared shocks, such as a global pandemic, disruptions to the supply of various goods, and war.

One factor I’d add to that list is the increasing incidence of prices being disrupted by the effects of climate change, particularly extreme weather events, but also our belated realisation that building so many houses on the flood plain of rivers wasn’t such a smart idea.

All these many “shocks” to the economy have knocked it from pillar to post, and stopped it behaving as predictably as it used to. But, as we’ll see, not all the shocks have been adverse.

Right now, the change everyone’s trying to predict is the Reserve Bank’s next move in its official interest rate, which most people hope will be downward.

Normally, that would happen just as soon as the Reserve became confident the inflation rate was on its way down into the 2 to 3 per cent target range. And normally, we could be confident the first downward move would be followed by many more.

But since, like Kennedy, the Reserve is not quite sure what normal is, and Reserve governor Michele Bullock says she expects the return to target to be “bumpy”, it may delay cutting rates until inflation is actually in the target zone.

If so, and remembering that monetary policy, that is, interest rates, affects the economy with a “long and variable lag”, the Reserve will be running the risk that it ends up hitting the economy too hard, and causing a “hard landing” aka a recession, in which the rate of unemployment jumps by a lot more than 1 percentage point.

Kennedy was at pains to point out that the rise in the official interest rate of 4.25 percentage points over 18 months is the “sharpest tightening” of the interest-rate screws since inflation targeting was introduced in the early 1990s.

He also reminded us how much help the Reserve’s had from the Albanese government’s fiscal policy, which has been “tightened at a record pace”. Measured as a proportion of gross domestic product, the budget balance has improved by about 7 percentage points since the pandemic trough. Add the states’ budgets and that becomes 7.5 percentage points.

That’s a part of the story those in the money market are inclined to underrate, if not forget entirely. Kennedy reminded them that, since 2021, our combined federal and state budget balance has improved by more than 5 percentage points of GDP. This compares with the advanced economies’ improvement of only about 1.5 percentage points.

So, has our double, fiscal as well as monetary, tightening had much effect in slowing the growth of demand for goods and services and so reducing inflationary pressure?

Well, Kennedy noted that, over the year to December, households’ consumption spending was essentially flat. And consumer spending per person actually fell by more than 2 per cent.

When you remember that consumer spending accounts for more than half total economic activity, this tells us we’ve had huge success in killing off inflationary pressure. And this week, when we see the national accounts for the March quarter, they’re likely to confirm another quarter of very weak demand.

So, everything’s going as we need it to? Well, no, not quite.

Last week we learnt that, according to the new monthly measure of consumer prices, the annual inflation rate has risen a fraction from 3.4 to 3.6 per cent over the four months to April.

“Oh no. What did I tell you? The inflation rate’s stopped falling because prices are “sticky”. It’s not working. Maybe we need to raise interest rates further. Certainly, we must keep them high for months and months yet, just to be certain sure inflation pressure’s abating.”

Well, maybe, but I doubt it. My guess is that a big reason money market-types are so twitchy about the likely success of our efforts to get inflation back under control is the lack of blood on the streets that we’re used to seeing at times like this.

Why isn’t employment falling? Why isn’t unemployment shooting up? Why are we only just now starting to see news of workers being laid off at this place and that?

It’s true. The rate of unemployment got down to 3.5 per cent and, so far, has risen only to 4.1 per cent. Where’s all the blood? Surely, it means we haven’t tightened hard enough and must keep the pain on for much longer?

But get this. What I suspect is secretly worrying the money market-types, is something Kennedy is pleased and proud about.

“One of the achievements of recent years has been sustained low rates of unemployment,” he said last week. “The unemployment rate has averaged 3.7 per cent over the past two years, compared with 5.5 per cent over the five years prior to the pandemic.”

Our employment growth has been stronger than any major advanced economy over the past two years, he said. Employment has grown, even after accounting for population growth.

And we’ve seen significant improvements for those who typically find it harder to find a job. Youth unemployment is 2.6 percentage points lower than it was immediately before the pandemic.

So, what I suspect the money market’s tough guys see as a sign that we haven’t yet experienced enough pain, the boss of Treasury sees as a respect in which all the shocks that have buffeted us in recent times have left us with an economy that now works better than it used to.

And Kennedy has a message for the Reserve Bank and all its urgers in the money market.

“It is important to lock in as many of the labour market gains as we can from recent years. This involves macroeconomic policy aiming to keep employment near its maximum sustainable level consistent with low and stable inflation,” he said.

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Australia's future to be made under Treasury's watchful eye

The Albanese government’s Future Made in Australia has had a rapturous reception from some, but a suspicious reception from others (including me). In a little-noticed speech last week, however, one of our former top econocrats gave the plan a tick.

Rod Sims, former chair of the Australian Competition and Consumer Commission, and now chair of Professor Ross Garnaut’s brainchild, the Superpower Institute, has been reassured by the plan’s “national interest framework”, prepared by Treasury and issued with the budget.

But first, the budget announced that the government would “invest” – largely by way of tax concessions – $22.7 billion in the plan over the next decade.

Treasury’s framework will be included in the planned Future Made in Australia Act. It will “clearly articulate” how the government will identify those industries that will get help under the act, to “impose rigour on government’s decision-making on significant public investments, particularly those used to incentivise private investment at scale,” according to Treasury.

So, Sims is reassured by the knowledge that the framework – and Treasury – will ensure that “sound economics has been applied”. “In my view, [the plan] represents a growth and productivity opportunity every bit as bold as seen under previous governments,” he says.

Some of those giving the plan a rapturous reception believed it was “a welcome return to activist industry policy and making more things and value-adding in Australia,” Sims says. But “despite what has been said for political reasons, this is not the logic driving [the plan] as described by Treasury”.

Sims says we don’t need to revisit old and tired debates about protectionism. But as it happens, he notes, making more things in Australia will be an outcome of the plan.

Some said the plan represented the end of “neoliberalism” and a return to interventionist thinking. “It is not that either,” he says. “[The plan] relies on sound economics, and any change in economic thinking is a return to the application of sound economics.”

The way I’d put it is that to intervene or not to intervene is not the question. A moment’s thought reveals that governments have always intervened in the economy. (One of the most incorrigible interveners is a crowd called the Reserve Bank, which keeps fiddling with the interest rates paid and received in the private sector.)

No, as we’ll see, the right question is usually whether the intervention is adequately justified by “market failure” – whether, left to its own devices, the market will deliver the ideal outcomes that economic theory promises.

Others have approved of the plan because it’s about encouraging some local production in necessary supply chains. Sims admits there’s an element of this, as local battery and solar panel manufacture are mentioned, but they are a small part of the program.

Similarly, some move to make supply chains less at risk of disruption may be involved, but it’s not the driving logic of the plan.

Yet others have said the plan is copying the United States and its (misleadingly named) Inflation Reduction Act. “This is incorrect,” Sims says. The Americans’ act “spreads money widely, whereas [the plan] is targeted to Australia’s circumstances”.

The US act “also has many destructive features that we will not copy, such as its protectionist approach.”

But, to be fair to the sceptics, he adds, “the policy’s introduction was poorly handled. It was linked to making solar panel modules, when they can be purchased much more cheaply from China, and then there was the announcement of $1 billion for quantum computing.”

“It helps neither global mitigation [of climate change] nor Australian development to force manufacture here, if the final products are produced most cost-effectively elsewhere.”

So, if the plan isn’t mainly about protectionism, what’s its main purpose? Achieving the net zero transition and turning Australia into a renewable energy superpower.

Treasury’s national interest framework says the net zero transition and “heightened geostrategic competition” (code for the rivalry between the US and China) are transforming the global economy.

“These factors are changing the value of countries’ natural endowments, disrupting trade patterns, creating new markets, requiring heightened adaptability and rewarding innovation,” the framework says.

“Australia’s comparative advantages, capabilities and trade partnerships mean that these global shifts present profound opportunity for Australian workers and businesses.” We can foster new, globally competitive industries that will boost our economic prosperity and resilience, while supporting decarbonisation.

In considering the prudent basis for government investment in new industries, the framework will consider the following factors: Australia’s grounds for expecting lasting competitiveness in the global market; the role the new industry will play in securing an orderly path to net zero and building our economic resilience and security; whether the industry will build key capabilities; and whether the barriers to private investment can be resolved through public investment in a way that delivers “compelling public value”.

So, that’s quite a few hurdles you have to jump before the government starts giving you tax breaks. And proposals will be divided between two streams: the net zero transformation stream and the economic resilience and security stream. We can only hope that a lot more of the money goes to the former stream than the latter.

To justify government intervention, the framework requires evidence of “market failure” such as “negative externalities” that arise because the new clean industry is competing against fossil fuel-powered industries which, in the absence of a price on carbon, haven’t been required to bear the cost to the community of the greenhouse gases they emit.

Another case of market failure are the “positive externalities” that arise when the first firms in a new industry aren’t rewarded for the losses they incur while learning how the new technology works, to the benefit of all the firms that follow them.

Politicians being politicians, I doubt whether Treasury’s policing of its national interest framework will ensure none of the $22.7 billion is wasted. But we now have stronger grounds for hoping that Treasury’s oversight will keep the crazy decisions to a minimum.

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THE BUDGET, INFLATION & UNEMPLOYMENT

UBS HSC Economics Day, May 29, 2024

I want to talk to you today about the federal budget two weeks ago and how it relates to the two key issues the managers of the economy need to keep under control: inflation and unemployment. Right now, inflation is still at the top of our worry list, but we shouldn’t forget that we’ve been doing exceptionally well on unemployment, and it’s important we do what we can to avoid fixing inflation at the expense of making unemployment our new problem.

Of course, what most voters see as our big economic problem – thereby making it the government’s biggest political problem - is the cost-of-living crisis. You may think that’s the same thing as what economists think of as the inflation problem, but it’s not that simple. When people complain about the pain they’re feeling from the cost of living, what they want is some immediate relief. By contrast, what economists want is a lasting reduction in high inflation. And this distinction matters because the economists’ standard solution to the pain caused by high inflation is to make it better by first making it worse. It’s actually the pain caused by this solution that people are complaining about most.

Economists know that the only cause of inflation their shorter-term macroeconomic levers can do anything about is inflation caused by the demand for goods and services growing faster than the economy’s ability to produce – supply - more goods and services. When demand exceeds supply, businesses use the opportunity to raise their prices. So, if you want to stop them raising their prices so freely, you have to reduce the demand for whatever it is they are selling. How do you do this? By putting the squeeze on households’ finances, thus making it harder for households to keep up their spending. How do you do this? The main way is for the RBA to raise interest rates, thus greatly increasing monthly mortgage payments. But it adds to the squeeze when bracket creep means the government takes a bigger tax bite out of workers’ pay rises. And it also helps if the government finds other ways to take more money out of the economy with its taxes relative to what it puts back into the economy by its own spending. That is, when you are reducing a budget deficit or increasing a budget surplus.

Before we get to this month’s budget, we need to understand where the economy is now by going back to see where it’s come from.

The recovery from the pandemic and the return to full employment

After the COVID virus arrived in Australia in early 2020, governments sought to slow its spread through the population until a vaccine could be developed. They closed our international borders, limited travel between our states, and locked down the economy, getting people to work from home if possible, closing schools and closing many shops and venues. The idea was for people to stay in their homes as much as possible. The result was a sudden collapse in economic activity – a sort of government-caused recession, with unemployment shooting up.

But governments knew they had to do what was necessary to hold the economy together during this temporary lockdown so that, as soon as it could be ended, the economy would quickly resume normal activity. So the economic managers unleashed huge monetary and fiscal stimulus. The RBA cut the official cash rate almost to zero, and the federal government spent loads of money on JobKeeper grants to employers and many other things. The state governments also spent a lot. From an almost balanced budget in the financial year to June 2019, the federal budget balance blew out to a deficit of $85 billion (equivalent to 4.3 pc of GDP) in the year to June 2020, then a peak deficit of $134 billion (6.4 pc of GDP) in the year to June2022.

But when the lockdowns ended, all the stimulus caused the economy to rebound. People started catching up with their spending, employment grew strongly and unemployment – and underemployment – fell like a stone. The economy boomed. With our borders still closed to immigrants, the rate of unemployment fell to 3.5 pc, it’s lowest in almost 50 years. So we had returned to full employment for the first time in five decades.

This strong growth did wonders for the budget balance. The temporary spending programs ended. When people go from being on JobSeeker to having a job, they start paying income tax – a double benefit to the budget. When people who want to are able to go from working part-time to full-time, they pay more tax. And when workers get bigger pay rises, their average rate of income tax rises, often because they’ve been pushed into a higher tax bracket. People call this “bracket creep”. But economists call it “fiscal drag”. They know it’s the budget’s inbuilt “automatic stabilisers” changing direction and acting to reduce workers’ after-tax income, thereby limiting the rate at which the economy is growing and adding to inflation pressure. (Another factor increasing tax collections was the world prices for iron ore and other commodities we export, which stayed high and cause our mining companies’ payments of company tax collections to be higher than expected.)

You can see this in the change in the budget balance. From a deficit of $134 billion (6.4 pc of GDP) in the year to June 2021, it fell to a deficit of $32 (1.4 pc) in the year June 2022. And then, in the first financial year of the Albanese government, it flipped to a budget surplus of $22billion (0.9 pc). This was all very lovely. But while it was happening, trouble was brewing: inflation was building up.

The return of high inflation

Since the early 1990s, we – and the other advanced economies – had enjoyed a low and stable rate of inflation within the RBA’s 2 to 3 pc target range. Or, in recent years, even a bit lower than the target. But with the economy booming, from early in 2022 the rate of inflation started rising rapidly. In May 2022, just before the election in which government passed from the Morrison Coalition to Albanese’s Labor, the RBA started raising interest rates to slow the growth of demand. By November 2023, it had raised the official “cash” interest rate 13 times, from 0.1 pc to 4.35 pc. Now, 4.35 pc is not high by the standards of earlier decades, but this was the biggest and quickest increase in interest rates we’ve seen, imposing great pain on households with big home loans. For separate reasons, we’ve seen an acute shortage of places to rent, allowing landlords to make big increases in the rent they charge.

So, while the RBA was raising interest rates to slow demand, consumer prices kept rising, with the inflation rate reaching a peak of nearly 8 pc – 7.8 pc to be exact - by December 2022. Last year, 2023, the RBA kept tightening monetary policy, and the inflation rate started falling, reaching 3.6 pc over the year to March, 2024.

It’s important to remember that not all of the rise in prices was caused by strong demand within Australia. A fair bit of it was caused by overseas disruptions to the supply of various goods we import. The disruption was caused by the pandemic and by Russia’s invasion of Ukraine, which pushed up the prices of petrol and gas. The resolution of these disruptions helped get our inflation rate down. And while all this was happening, the squeeze on households’ budgets had pretty much stopped any growth in consumer spending, thus slowing the economy’s growth. This meant a weakening in the demand for labour, causing the rate of unemployment to rise from its low of 3.5 pc to 4.1 pc by April this year. Now, that was where the economy was at when Mr Chalmers announced his budget two weeks’ ago.

The 2024 budget

The part of the Mr Chalmers’ budget that got most attention from the media was the decision to give all households a one-year, $300 rebate on their electricity bills. This had the political benefit to the government of giving voters some relief to cost-of-living pain they have been demanding the government provide. But it was designed also to produce a benefit to the economy: combined with an increase in the rent allowance paid to people on welfare payments, it is expected to reduce the consumer price index by 0.5 percentage points during the coming financial year, 2024-25. This device will come at a cost to government spending of $4.4 billion over two years. Some economists criticised the rebate, arguing that its cost to the budget would actually add to inflationary pressure. They noted that all the new measures announced in the budget would worsen the budget balance by almost $10 billion in the new financial year, and by a total of $24 billion over the coming four years. So they denounced the budget as inflationary at a time when the RBA and the government were still battling to get inflation heading down to the inflation target of 2 to 3 per cent, so that the RBA could start lowering interest rates.

But what the critics have missed is that the measure that will do by far the most to worsen the budget balance from an expected further surplus of $9 billion (equivalent to 0.3 pc of GDP) in the financial year just ending, to a deficit of $28 billion (1 pc of GDP) in the coming year, is the stage 3 tax cuts. These have been government policy since 2018, but were rejigged a few months ago to ensure that more of their benefit went to low and middle-income taxpayers. Their cost in the first year of $23 billion, accounts for more than 60 pc of the total expected turnaround in the budget balance of $37 billion.

The other big announcement in the budget was the government’s Future Made in Australia program. This is a most important change in the government’s micro-economic policy. But the expected cost to the budget of about $23 billion will be spread over 10 years, with little of it spent over the next few years. This means it is not a big issue for the short-term management of the macro economy.

The new macro “policy mix”

So where does the budget leave the authorities use of the two instruments of macro demand management – monetary policy and fiscal policy? It leaves us with the “stance” of monetary policy having got progressively more restrictive over the past two years, with the long lag in policies having their full effect on demand meaning there is more contractionary effect to come.

The huge growth in tax collections caused by the budget’s automatic stabilisers has caused the budget to have two financial years of surpluses, meaning a restrictive stance of fiscal policy has added to the contractionary pressure from monetary policy. But, although Mr Chalmers has denied it, there can be no doubt that, thanks mainly to the stage 3 tax cuts, the budget changes the “stance” of fiscal policy from restrictive to expansionary.

The government’s critics argue that this expansion will jeopardise our efforts to get inflation down to the target range. I disagree. The economy is weak, expected by Treasury to have grown by only 1.75 pc in the financial year just ending, and to grow by only 2 pc in the coming year. If anything, that’s probably on the optimistic side. At 3.6 pc over the year to March, the inflation rate has already fallen close to the 2 to 3 pc range, and it’s easy to believe it will keep falling in the coming year, as Treasury forecasts. After a lag, the tax cut will take some of the pressure off household spending. But, with luck, it will help ensure the economy’s slowdown doesn’t become a recession. Even so, Treasury’s forecast that the economy’s continuing weakness will push the rate of unemployment no higher than 4.5 pc is probably also on the optimistic side.

Outlook for the budget and the public debt

Treasury’s forecasts and projections suggest the budget is likely to remain in small but declining deficits over the decade to 2034-35. The federal government’s gross public debt is expected to be $904 billion (34 pc of GDP) at June, 2024. The gross debt is projected to peak at 35 pc of GDP in June 2027, then decline to 30 pc by June 2035. This proportionate decline would occur because the economy was growing faster than the small deficits were adding to gross debt.

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The pollies have twigged that our crazy housing game can't go on

Last week, a fairly ordinary place in our street, similar to ours, sold for $4.7 million. I suppose I should be congratulating myself on how well I’ve done in the capitalist game. And it’s only fair since I’ve “worked hard all my life”. In truth, all we’ve done is pay the exorbitant price of $180,000 for our place, then hung around for 40 years. This makes sense? Surely, this crazy game can’t keep going onward and upward forever.

It’s now been two weeks since Treasurer Jim Chalmers delivered his budget, but I’ve only just realised its main content is not the one-year $300 electricity bill rebate we’ve obsessed over, it’s the evidence the government has finally accepted our housing system is dysfunctional and must be fixed. The budget papers include a long statement spelling out what’s wrong with housing with a candour I’ve not seen before.

The hard truth is that, until now, the pollies on both sides have only pretended to care about how hard the young were finding it to afford a home of their own. Why? Because the number of voters who own a home – whether outright or still with a mortgage – greatly exceeds the number who’d merely like to become a homeowner. As John Howard used to say, he’d never heard any homeowner complain about the rising value of their property.

All the things pollies do in the name of helping first-home buyers – such as cutting stamp duty on the purchase price – don’t actually help, and probably aren’t intended to. When they claim to be helping you afford the high price, they’re really helping to keep it high. If they helped you and no one else you’d be advantaged. But when they also help the people you’re bidding against, it’s actually the seller who benefits.

It’s the same with the Bank of Mum and Dad. The more parents help their kids afford the high prices – as I have – the higher those prices will stay. Again, the sellers benefit.

When the value of the oldies’ homes just keeps going up, this constitutes a transfer of wealth from the younger to the older generation. The Bank of Mum and Dad transfers some of the wealth back to the youngsters. The losers, however, are those kids who didn’t have the sense to pick well-off parents.

But what makes me think the Albanese government has seen the light?

Well, for a start, it makes more political sense than it used to. Not only are younger people having trouble affording their first home, they’re being hit with big jumps in rent thanks to an acute shortage of rental accommodation.

The budget statement admits that the median price of dwellings in the eight capital cities has more than doubled since the mid-noughties. So have advertised rents. It now takes more than 11 years to save a 20 per cent deposit on a house.

Politicians have been favouring the old at the expense of the young for decades, but the young are getting restive. Labor has more than its share of the votes of young adults. It risks losing those votes if it doesn’t start delivering for the younger generation.

Labor sees that house prices and rents are rising because the supply of homes has failed to keep up with growth in the population. Part of the reason for this is what the statement admits has been a “long-term, chronic under-investment in social housing”.

Why all these frank admissions? Because the Albanese government has decided to do something big to ease the problem. The budget announced new measures worth $6 billion which, added to those already announced, amount to a $32 billion plan to deliver 1.2 million new, well-located homes in the five years to June 2029. This would be equivalent to a city the size of Brisbane.

As with so many of our problems, the feds have most of the money needed to fix the nation’s housing, but the actual responsibility for housing rests with the states and even local government. The plan’s attraction is that it’s been agreed with the states and includes monetary incentives for them to co-operate.

The words “well-located homes” are code for many of them involving medium and high-density housing in the capital cities’ “missing middle”. It requires the states to take on their local government NIMBYs (see monetary incentives above).

It would be wrong, however, to see this plan as the simple solution to a housing system that’s been performing poorly for decades. It will be some years before it makes much difference, and experts have questioned whether so many new homes can be built in just five years.

It’s an advance to see the new emphasis on improving the system’s ability to supply more houses, but the vexed question of fixing the distortions to demand caused by misguided tax concessions remains to be faced.

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Politicians don't control migrant numbers, and usually don't want to

Suddenly, everyone’s talking about high migration and the way it’s disrupting the economy. Why is the government letting in so many people, and why hasn’t it turned off the tap?

Short answer: because, the way we run immigration, it has little control over the tap.

But, at times like this, that’s not something either side of politics wants to admit. The truth is, they could exercise more control over immigration, but neither side has particularly wanted to.

Usually, the pressure on them to keep immigration high greatly exceeds the pressure to keep it low. The upward pressure comes from business, which finds it easier to increase profits when it has a continuously growing market.

For many years, business’s main interest was in getting more factory fodder. More people to buy the products of our highly protected manufacturing industry and give it a little of the economies of scale it lacked.

This was why it had to be protected from imports from overseas manufacturers with much bigger domestic markets. As well, our manufacturers needed a steady supply of less-skilled workers to staff their production lines.

In more recent decades, the emphasis has switched from factory fodder to preferring those immigrants with the skills we particularly need to fill shortages as they arise. This, I fear, has allowed our employers to take less interest in ensuring they were always training up enough locals to meet their industry’s future needs.

Another change has been from focusing on permanent migration to encouraging people to come here for a while on temporary visas: workers with skills coming to see what it’s like, students coming to gain further education and young people coming on working holidays, aka backpackers.

We’ve become quite dependent on this huge inflow and outflow of temporary migrants, which far exceeds people coming on permanent visas. Businesses often want their temporary skilled workers to stay on.

The sale of education to overseas students has become one of our biggest exports, one on which our universities have become heavily dependent. Our hospitality industries rely on the casual employment of overseas students and backpackers. And farmers and country towns rely on backpackers for fruit picking and other unskilled work.

On top of all that, federal governments have become reliant on high migration to make our GDP growth figures look better. They often boast about how well our growth compares with the other rich countries, without ever mentioning that most of this is explained by our faster population growth.

And right now, of course, the economy’s growth is so weak we’d be in recession if not for the recent immigration surge.

All these are the reasons successive federal governments want to maintain strong immigration, despite the public’s longstanding reservations. Former prime minister John Howard did a great line in diverting the punters’ attention to resentment of some uninvited arrivals by boat, while he ushered in visa-wielding immigrants arriving by the plane load.

It’s only when high immigration becomes an issue before elections, as now, that the pollies make noises about slowing the inflow. It’s true that, since we reopened our borders following the lockdowns, our “net overseas migration”, people arriving minus people departing, but not counting those on brief visits, leapt to 528,000 in 2022-23, more than double what it was in 2018-19. And it may exceed another 400,000 in the financial year just ending.

This surge does seem to have contributed to the present acute shortage of rental accommodation and the big jump in rents, but Opposition Leader Peter Dutton is drawing a long bow in blaming the recent surge for the unaffordability of buying a home, which has been worsening for decades.

The telltale sign that Dutton is fudging is his plan to make more homes available by cutting the government’s permanent migration program from 185,000 a year to 140,000.

The government does control the size of this program, and often moves it up or down a bit, but the size of the program makes little difference to what matters most for the economy: annual net overseas migration.

The trick is that about 65 per cent of the permanent visas go to people who are already here on temporary visas. Changing their visa status makes no difference to net overseas migration.

At times like this, the pollies would like you to think they have the power to move immigration up or down according to the economy’s needs at the time.

But they don’t. For the most part, the level of net migration is, as economists would say, “demand determined”. And, as the demographers will tell you, net migration tends to go up and down with the state of our economy.

When the economy’s booming, migrants are keen to come to Australia, and our employers are keen to have them, particularly if they have skills. What’s more, locals and former immigrants are more likely to want to stay here than go overseas.

It’s a different story when our economy’s weak. Employers are less keen to bring in people and migrants are less keen to come.

Now, our present circumstances don’t fit that long-established cyclical pattern. But that’s mainly because the economy’s been returning to normal after the end of the pandemic. This is particularly true of the people most disrupted by the pandemic, and who’ve done most to account for our recent downs and ups in net migration: overseas students.

Most students went back home during the lockdowns, but now many of them, and many newbies, are coming back in. We’ve had a lot more students than expected because, to encourage their return, the Morrison government removed the limit on how much paid work they could do. It took the Albanese government too long to wake up and end the concession.

If you find it hard to believe the government has little control over the number of immigrants it lets in, note this. To be given a temporary visa, you have to fit one of the many categories the government wants: skilled, student, backpacker and so on. But there are no limits on the number of applicants accepted in each category.

Until now. Because it’s the students who’ve contributed most to the recent surge, the government is planning to impose caps on how many it will admit. The opposition is promising something similar.

Remember this, however. The economy is weak – and it is forecast to remain so for a year or two – so it’s reasonable to expect that, even without the caps on overseas students, net migration will fall back soon enough.

But an election is coming. Voters are unhappy about high migration and the high cost of housing, and both sides want to be seen doing something about it. How much the winner actually bothers to do after the election, may be a different matter.

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INFLATION, TAX & THE COST OF LIVING

May 2024

The economy has been going through huge ups and downs since COVID arrived in early 2020. Since most of you weren’t taking a great deal of notice of the economy that long ago, let me give you a quick summary. To slow the spread of the virus while a vaccine was being developed, governments locked the economy down, getting as many people as possible to work from home, closing schools and many shops, and telling people to stay in their homes as much as possible. Australia’s borders were closed to people coming and going, though many overseas students were encouraged to return to their home countries. The Australian states closed their borders to interstate travel.

This hugely reduced economic activity, causing an immediate recession and sending unemployment shooting up. But to ensure this didn’t cause lasting damage to the economy, the Reserve Bank cut the official interest rate to almost zero and the federal government spent a fortune on JobKeeper payments and many other things. As well, the state governments spent up big.

This worked like a charm. As soon as the lockdowns ended, the economy rebounded. Once people were allowed out of their homes, they really caught up with their spending. The economy boomed, with employment growing and unemployment falling like a stone. The boom, coming before our borders had been reopened to immigrants, caused the rate of unemployment to fall to 3.5 per cent, its lowest in almost 50 years. With job vacancies far exceeding unemployment, the economy had returned to full employment for the first time in five decades. Everything seemed wonderful, until we – like the other advanced economies – noticed prices shooting up.

The return of inflation

Until then, and like all the advanced economies, Australia had enjoyed years of low inflation, with the rate of price increases staying in the RBA’s target range of 2 to 3 pc on average since the mid-1990s. In the years before the pandemic, the RBA even had trouble getting inflation up to the bottom of the target range. But from early in 2022, prices started rising rapidly and, by the end of 2022, inflation reached a peak of 7.8 per cent. Similar things were happening in the other advanced economies. What caused this sudden surge in inflation, the worse we had seen for 30 years?

Two quite separate developments. The first factor was us being hit by global supply-side price shocks arising from disruptions caused by the pandemic. When people were locked up in their homes, they couldn’t get out and buy services such as restaurant meals, go to shows and sporting matches, or travel. But they could use the internet to buy things to improve their homes, new appliances or even new cars. So, while spending on services collapsed, spending on goods took off.  This sudden surge in the purchase of goods led to shortages – including a shortage of computer chips - and higher prices. Because, these days, all the rich countries import many manufactures from places such as China, this surge in demand for goods led to shortages of ships and shipping containers. So the pandemic led to temporary supply shortages, which pushed up prices.  As well, Russia’s attack on Ukraine caused a big increase in oil and gas prices.

But the second factor, adding to these problems on the supply – or production – side of the economy, was a strong surge in the demand for goods and services. Where did this come from? From all the economic stimulus the managers of the macro economy had applied during the lockdowns to hold the economy together. The official cash rate was already down to 0.75 per cent, but the RBA cut it almost to zero, 0.1 per cent. It also used unconventional measures – “quantitative easing”, or the buying of second-hand government bonds – to lower medium-term interest rates. As well, from a virtually balanced budget in the financial year to June 2019, the government’s hugely increased spending caused annual deficits of $85 billion (4.3 pc of GDP), $134 billion (6.4 pc of GDP) and, in 2021-22, $32 billion (1.4 pc). The state governments greatly increased their spending also.

With the wisdom of hindsight, it’s clear the economic managers provided a lot more monetary and fiscal stimulus than turned out to be needed. As a result, this excess demand for goods and services outstripped our businesses’ ability to increase their production of goods and services, thus causing prices to rise. So the surge in prices in 2022 had two quite different causes. The supply-side problems were beyond our control, but would sort themselves out in time. The excessive demand, however, was caused by our own miscalculations and so required the economic managers to move the two instruments for managing the strength of demand – monetary policy and fiscal policy – from a stimulatory setting to a restrictive setting.

The policy response to high inflation

The RBA responded to the worsening inflation in May 2022, just before the federal election in which the Morrison Coalition government was replaced by the Albanese Labor government. The RBA began increasing the official cash rate and, by November 2023, had raise it 13 times, from 0.1 pc to 4.35 pc. Note that, although 4.35 pc is not high by the standards of earlier decades, this was the biggest and fastest increase in rates ever, meaning it had a particularly sharp effect on those households with big home loans. There’s no doubt the present “stance” of monetary policy is very restrictive.

The surge in tax collections

And while all this was happening to monetary policy, the budget’s “automatic stabilisers” were tightening fiscal policy. Since the change of government in May 2022, the boom in the economy and the return to full employment caused income tax collections to grow strongly. (As well, the world prices of iron ore and other export commodities have stayed much higher than Treasury was expecting, causing mining companies to pay more company tax than expected.)

When more people get jobs, they go from being on JobSeeker to paying income tax. When strong demand for labour allows those who want to to move from part-time to full-time work, they pay more income tax. And when higher inflation causes people to get bigger pay rises, this increases their average rate of income tax, often by pushing them into a higher tax bracket. What people call “bracket creep”, economists call “fiscal drag”. It’s one of the budget’s main built-in, “automatic stabilisers” which, without any explicit decision by the government, act automatically to take a bigger tax bite out of people’s pay rises, so leaving them less to spend and helping to slow demand.

The incoming Labor Treasurer Jim Chalmers’ main part in this has been to spend as little of this revenue windfall as possible, allowing almost all of it to flow through to the budget’s bottom line. So, from a deficit of $32 billion in the year to June 2022, the budget flipped to a surplus of $22 billion in the year to June 2023. That’s a turnaround of $54 billion, equivalent to 2.3 pc of GDP. The “stance” of fiscal policy switched from expansionary to contractionary, adding to the downward pressure on demand coming from monetary policy. And we know from the new budget that fiscal policy stayed contractionary in the financial year just ending, 2023-24, with another surplus of $9 billion expected.

The price mechanism and “gouging”

Before I move on to the question of the cost of living, I must tell you about a big difference between the thinking of economists and the thinking of normal people. Economists believe that the best way to allocate resources in an economy is via the use of markets. They believe that the forces of supply and demand in a particular market interact to set the price of the particular good or service. And they believe that, when something happens to disrupt the market, the “price mechanism” works to bring demand and supply back together, and re-establish “equilibrium”. If something happens that causes the demand for a product to exceed its supply, sellers are able to increase the price they are charging. This price increase sends different messages to the buyers than to the sellers. The message to buyers is: don’t use any more of this product than you have to, and see if you can find cheaper substitutes for it. The message to sellers is: producing this product has become more profitable, so make more of it. So, putting the two sides together, the “price mechanism” works to reduce demand and increase supply, thus causing the price to fall back to pretty where it was before the disruption.

I hope you know all that. The point is that when businesses respond to excess demand for their product by using the opportunity to raise their prices, economists regard this as the completely normal way markets work to restore equilibrium. It’s thus a good thing. But consumers see it very differently. They often object to businesses raising their prices even though their costs haven’t increased. They criticise it as “gouging” the customers. (My opinion? I think markets don’t always work as well as economic theory assumes they do.)

The cost of living

Whereas economists focus on inflation and ensuring prices don’t rise too rapidly, and worry about wages rises in response to the higher prices helping to keep inflation high, ordinary people worry about the rising “cost of living”. They focus on how fast prices are rising – particularly the prices they see in the supermarket - but tend not to notice that what matters most to them is whether their wage or other income is keeping up with prices. And many may not notice that they suffer when their wage rises cause their average rate of income tax to rise, leaving them less money to spend.

Voters have had a lot to complain about in the past two years or so. Consumer prices have rising at a much faster rate than usual. As well, until recent months their wages haven’t kept up with the rise in prices. And the government has been taking a bigger tax bite out of their wages.

But what makes it worse is that the standard way central banks and governments stop the cost of living rising so fast is to make it worse to make it better. When prices are rising because households’ demand for goods and services is rising faster than the economy’s ability to supply them, the standard response by the economic managers is to squeeze households’ budgets so they can’t spend as much. When this causes demand for their products to slow, businesses aren’t able to raise their prices as much. The main way the RBA squeezes households is by raising the interest rates they pay, particularly on their mortgages. And this time, for different reasons, rents have been rising rapidly.

All this presents a problem for our politicians. The voters are crying out for them to do something to fix the cost-of-living crisis. But the only way the authorities can achieve a lasting improvement in the rate at which prices are rising is to keep the pain on for a while yet. This is why Mr Chalmers is doing fairly minor things like giving every household a $300 electricity rebate. What will do much more to ease some of the pain is the rejig of the long-planned stage 3 tax cuts. Those tax cuts are the main reason the budget is now expected to swing from a surplus of $9 billion in the year just ending, to a deficit of $28 billion in the new financial year. The budget’s forecasts say this move to expansionary fiscal policy will not stop inflation returning to the target range in the coming year and will ensure we avoid recession and achieve a “soft landing”, with the unemployment rate rising no higher than 4.5 pc. Let’s hope this is what happens.

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