OECD’s message to our inflation warriors: calm down, she’ll be right

Last week a bunch of international public servants in Paris launched a rocket that landed in Sydney’s Martin Place, near the Reserve Bank’s head office and the centre of our financial markets. It carried a message we should already know. Australia has a big problem with real wages: they’re too low. In which case, why are you guys so anxious about continuing high inflation?

The Organisation for Economic Co-operation and Development’s annual Employment Outlook says Australia’s real wages in May this year are still 4.8 per cent lower than they were in December 2019, just before the pandemic.

This is one of the largest drops among OECD countries. It compares with real falls of 2 per cent in Germany and Japan, and 0.8 per cent in the United States. Real wages have risen by 2.4 per cent in Canada and 3.1 per cent in Britain.

The organisation observes that, “as real wages are [now] recovering some of the lost ground, profits are beginning to buffer some of the increase in labour costs. In many countries, there is room for profits to absorb further wage increases, especially as there are no signs of a price-wage spiral”.

Just so. But this isn’t something you’re allowed to say out loud in Martin Place. When the Australia Institute copied various overseas authorities in calculating the contribution that rising profits had made to our rising prices, it was dismissed by the Reserve Bank and the financial press.

Apparently, it’s OK for the Reserve to say it must increase interest rates because demand is growing faster than supply and adding to inflation, but it’s not OK to say that businesses have used the opportunity to raise their prices and this has increased their profits.

No, in the Reserve’s eyes, the problem with prices soaring way above its inflation target has never been greedy bosses, but always the risk of greedy workers using their industrial muscle to prevent their real wages from falling and thus causing a price-wage spiral that perpetuates high inflation.

It was a worry that anyone who knew anything about the changed power balance between employers and workers and their unions – anyone who wasn’t still living in the 1970s – could never have entertained.

For many years, the Reserve Bank benefited greatly from having a senior union official appointed to its board along with the many business people. But John Howard soon put a stop to that.

Since then, the Reserve has had to fall back on the primitive understanding of how labour markets work that you gain from a degree in neoclassical economics. Fortunately, since last year the board has included Iain Ross, former president of the Fair Work Commission.

The Reserve’s great sense of urgency in getting the inflation rate back down since it began raising interest rates in May 2022 has been driven by two worries about wages. First, when excessive monetary and budgetary stimulus caused the post-lockdown economy to boom while our borders were closed to imported labour, it worried that shortages of skilled and even unskilled labour would cause wages to leap as employers sought to bid workers away from other firms.

Although job vacancies more than doubled, reaching a peak in May 2022, annual wage growth had risen no higher than 4.2 per cent in December last year, even though consumer price inflation had peaked at 7.8 per cent a year earlier.

So, though no one’s bothered to mention it, our first period of acute labour shortages in decades hardly caused a ripple. It’s probably fair to say, however, that had the shortages not occurred, wages would have fallen even further behind prices than they did.

The Reserve’s second reason for feeling a sense of urgency in getting inflation back down to the target range is its fear that, should we leave it too long, inflation expectations may rise, causing actual inflation to move to a permanently higher level.

Indeed, the signs that our return to target will be slow have been used by the Reserve’s urgers in the financial markets to call for another rate rise or two. Apparently, every week’s delay in getting inflation down could see inflation expectations jump.

But this is mere pop psychology. Even if the nation’s workers and unions were to expect that inflation will stay high, they lack the industrial muscle to raise wage rates accordingly. If you didn’t already know that, our outsized fall in real wages should be all the proof you need.

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Forget smaller government, let's shoot for better government

We pay our taxes, then governments spend them. But where does all that money go? And how much of it is wasted? Well, where it goes is no secret, but how much of it does little to benefit us is something we don’t really know. Why not? Because we put so little effort into finding out.

In 2022-23, the federal and state governments spent almost $890 billion. Nearly 33 per cent of that went on social security payments; 21 per cent on healthcare (hospitals, doctors, medicines); 15 per cent on education (from pre-primary to university); 5 per cent each on defence and law and order; plus transport, the environment, housing, recreation and culture, and much else.

People who resent the taxes they pay like to think it goes to council workers leaning on shovels and public servants sitting around drinking tea, but really, they should be thinking of doctors, nurses and ambos; teachers and lecturers; soldiers, sailors and fliers, coppers, firies and garbos.

Those people are busy almost all the time doing what they’re paid to do. If some government departments once were overstaffed, years of cost-cutting should have fixed that.

No, the trouble isn’t that workers in the public sector aren’t working hard. It’s that they can be working away on programs that seem like they should be delivering for taxpayers, but aren’t.

Consider these four plausible propositions. First, parents are more likely to get their kids to school if threatened with the loss of government payments. Second, testing students’ literacy is an accurate way to assess their ability.

Third, early childhood staff have all the skills they need. Fourth, a health program designed by both educators and their students will be more likely to discourage risky behaviours.

Sorry, turns out none of those programs worked.

In 2016, researchers discovered that the Northern Territory’s efforts to improve school attendance by making welfare payments conditional on getting kids to show up had no effect on attendance.

In Dubbo, other researchers found that if you made a literacy test more culturally relevant by changing a story about lighthouses to one about the dish-shaped telescope in Parkes, you halved the gap between the scores of Indigenous and non-Indigenous kids.

In NSW, researchers found that giving early childhood staff a half-year professional development program boosted the achievement of their kids, especially their literacy.

Yet more researchers – in Brisbane, Perth and Sydney – found that, despite the students’ involvement in designing the Health4Life program, it had no effect on alcohol use, smoking, screen time, physical inactivity, poor diet or poor sleep.

What all these research efforts had in common was that they evaluated these programs using RCTs – randomised controlled trials. This involves using the toss of a coin to divide similar participants in the trial into two groups. One group gets the treatment and the other “control” group doesn’t. You then compare the two, confident that any differences between them have been caused by your intervention.

Point is, this is a far more rigorous way of judging whether government spending programs achieve the benefits you were hoping for, rather than just doing a pilot program and deciding whether it seems to have worked.

But these four careful trials are the exception, not the rule. A study by the Committee for Economic Development of Australia examined a sample of 20 federal government programs worth more than $200 billion. It found that 95 per cent of them hadn’t been properly evaluated. The committee’s examination of state and territory government evaluations reported similar results.

“The problems with evaluation start from the outset of program and policy design,” it said. Across the board, the committee estimated that fewer than 1.5 per cent of government evaluations use a randomised design.

Similarly, a Productivity Commission report in 2020 into the evaluation of Indigenous programs concluded that “both the quality and usefulness of evaluations of policies and programs … are lacking”.

This is in marked contrast to the medical profession, where controlled trials are standard in the evaluation of medical operations. These have demonstrated that the treatments preferred by experts were often worse for patients.

For instance, radical mastectomies for breast cancer disfigured 500,000 women while doing nothing to increase their odds of survival. Many treatments found to be harmful had been supported by expert opinion and low-quality before-and-after studies.

If you can feel a commercial message coming on, you’re right. Dr Andrew Leigh, former economics professor and now Assistant Minister for Treasury and many other bits and bobs, has been championing the use of randomised controlled trials in government program evaluation for years.

And last year the Albanese government set up within Treasury the Australian Centre for Evaluation, with Leigh responsible. It aims to expand the quality and quantity of program evaluation in co-operation with other government departments. Its leader, Eleanor Williams, has a modest budget and a staff of more than a dozen. A key principle is that high-quality evaluation of a program’s impact needs to be built into the design of the program from the get-go. The centre will also collaborate with evaluation researchers outside government.

And now the Paul Ramsay Foundation, Australia’s largest charitable foundation, is providing a $2.1 million round of grants for people to run randomised trials on important social problems. The centre, which has been given access to a wealth of “administrative data” – statistical information collected by government departments – will make this available to academics and others receiving grants.

I think this is all to the good. And about time. Econocrats went for decades supporting the push for smaller government, which led to the privatising of many government-owned businesses (including a national electricity market now dominated by three big companies) and much outsourcing of government services to private businesses – which, as should have been expected, have proved highly efficient at increasing their profits.

Great. What we could use now is a lot more attention to achieving better government.

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The moribund political duopoly is rapidly self-destructing

Why do we have so many economic problems, and why do our governments make so little progress in fixing them? Because the two main parties just play politics and by now have boxed each other in. Neither side is game to make tough decisions for fear of what the other side will do to them.

Our tax system needs repair, but neither side dares to make changes somebody somewhere might not like. So we put up with poor government services, growing waiting lists, tax avoidance by the highly paid, bracket creep and phony tax cuts.

We have a system where people with mortgages get squeezed unmercifully whenever inflation gets too high. There are fairer and less painful ways to fix the problem, but neither side has the courage to change.

When occasionally the two sides agree on some policy, it’s often a bad one. Many defence experts quietly doubt the wisdom of AUKUS. By the time the nuclear subs arrive in many years’ time – if they ever do – they’ll probably have been superseded.

But the political duopoly’s most egregious failing is its inaction on climate change. For a while, it looked like the climate wars had ended, with the Albanese government making very cautious progress towards net-zero emissions.

Now, however, Peter Dutton has come up with a new reason for delay: let’s go nuclear instead. And we don’t have to do anything unpleasant for a decade or two. It will probably never happen, but what it has done is rob commercial investors of the certainty they need to keep investing in solar and wind farms at the rapid rate we need them to. With our ageing coal-fired power stations so close to the grave, our transition to renewable energy could be very bumpy.

So, what can we do to free ourselves from the clutches of a two-party political system that’s stopped working? Well, we’re already doing it. Voters are increasingly taking the law into their own hands by opting for the minor parties and independents. We saw this at the last federal election, in 2022, where the two big parties’ combined share of first-preference votes – which has been declining since World War II – fell to 68.3 per cent, its lowest level since the Great Depression.

So, the share of first-preference votes going to minor parties and independents is now just a little short of a third. In consequence, the number of crossbenchers in the House of Representatives rose to a record 16.

It’s not difficult to judge that the duopoly’s poor performance on climate change explains much of their decline. Labor loses votes to the Greens while, for the first time, teal independents took six previously safe seats from the Liberals.

Nor is it hard to believe that Labor’s caution and the Liberals’ nuclear red herring may add to the big parties’ loss of first preferences at next year’s election.

New research by Bill Browne and Dr Richard Denniss, of the Australia Institute, finds there are now no safe seats in House of Representatives. While some Labor seats are safe from being taken by the Liberals, and some Liberal seats are safe from Labor, such seats aren’t safe from the Greens or an attractive independent candidate.

In the supposedly safe Liberal seat of Mackellar on Sydney’s northern beaches, the teal independent Dr Sophie Scamps won the seat with a two-candidate preferred swing of more than 15 per cent. A strong independent candidate’s advantage is that they can pick up the preferences of the minor parties, plus those of the other big-party candidate who was never going to win.

It’s usual for the big parties to focus on the “marginal seats” that could be won or lost if a few “swinging voters” change their votes. And it’s mainly these marginals that one big party loses to the other.

But it’s not usual for the minor parties and independents to pick up such marginal seats. No, they’re much more likely to win supposedly safe seats.

So while the big guys focus on winning or retaining the marginals, they leave themselves open to the small guys when they neglect the concerns of voters in their heartland seats. Again, climate change would be the classic concern.

The standard way of predicting the results of elections using the psephologist Malcolm Mackerras’ famous pendulum has been overtaken not just by the lack of a uniform national swing between the two majors, but by the rise of the minors and independents.

I think it will be rare for governments to be elected with big majorities in future. Wafer-thin majorities will be the norm, with “hung” parliaments common. The big guys will warn us this will lead to chaos and inaction.

Don’t you believe it! It’s never been true at the state level where, at present, only five of the eight state and territory parliaments are dominated by a majority party.

I think a move to more power for crossbenchers at the federal level could be a good way to break the big-party logjam. It’s hard to see how it could be worse than what we’ve got.

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Yes, we need tax reform, but it offers no easy answers

When we’re reminded that income tax cuts represent merely the partial return of the proceeds of earlier bracket creep, and that the process of clawing back the latest tax cut starts the same day it arrives, it’s easy to join the impassioned cry for tax reform. Sorry, it ain’t that simple.

Surely if we could end the crazy business of bracket creep, we’d pay less tax? Well, yes – but no.

Bracket creep occurs because our income tax scales ignore the reality of inflation. When our wages rise to take account of inflation, we’re no better off in real terms, but we’re often pushed into a higher tax bracket, which raises the average rate of tax we pay on the whole of our income. (If we’re not literally pushed into a higher bracket, our average tax rate still goes up because a higher proportion of our income is now taxed at a higher rate.)

So we’ve long known how to (largely) end bracket creep: do what the Americans do and increase all the bracket limits once a year, in line with the annual increase in the inflation rate. Then, it would only be rises in your real income that pushed up your average tax rate, which is fair enough.

Mission accomplished. Now we’ll all be paying less tax.

Except that the net profit the taxman makes after all the to-ing and fro-ing on bracket creep isn’t just kept in a jam jar somewhere. It’s used to help cover the ever-growing cost of all the services the government gives us, and thus to limit the size of budget deficits and government debt.

So, without the benefit of bracket creep, governments would be forced to keep making explicit increases in the rates of income tax, or to announce new taxes.

Wouldn’t that be an improvement? In principle, yes. In practice, our (politician-fed) aversion to paying higher taxes would just make politics an even bigger shoot-fight than it already is. The pollies would spend more time abusing each other and less time getting on with fixing our problems.

One thing we can be sure of is that it wouldn’t do much to slow the growth in government spending. Why not? Because our demand for more and better government services is insatiable. Because both sides of politics fight every election campaign promising more and better services – and by never showing us the tax price tag on whatever it is they are selling.

How can I be sure tax indexation would do little to slow the growth in government spending? Because that’s what happens in America. They keep running bigger budget deficits and amassing more government debt than the other rich countries (except Japan).

But they get away with it because their economy’s so big, and they’re the centre of the world financial system. A middle-level economy like ours could never pull it off.

So tax indexation isn’t high on my list of desired tax reforms. Bracket creep turns out to be just one of the dirty little tricks by which the politicians who’ve done so much to make our political system almost unworkable keep it staggering along.

It’s easy to agree on the need for tax reform, but its advocates want to reform differing things and have differing motives. “Reform” is a lovely, positive word, but you need to beware of people whose idea of reform is: I pay less, you pay more.

All the alleged reform advocated by the (big) Business Council, for instance, takes that form. They want a lower rate of company tax and a lower top rate of personal income tax – all paid for by a higher goods and services tax.

Spruikers for the highly paid make a big fuss about the government’s heavy reliance on income tax – which they exaggerate – and always claim discourages them from working and investing.

But economic theory doesn’t support these claims, and the empirical evidence – which would be more persuasive – doesn’t either. The people whose behaviour is influenced by the rate of tax on additional earnings are “secondary earners”, who have more ability to increase or decrease the hours they work because they have part-time jobs. But the nation’s executives don’t worry much about them.

No, the tax reform I think we need is higher tax on capital gains, less concessional tax on the superannuation of people such as me, a decent tax on highly profitable mining companies and, probably, a tax on big inheritances.

But don’t hold your breath waiting for that to happen.

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If you care about your offspring, you should support 'nature positive'

The most pressing problem we face is climate change. It’s even more important than – dare I say it – getting inflation down to 2 per cent by last Friday. But we mustn’t forget that climate change is just the most glaring symptom of the ultimate threat to human existence: our continuing destruction of the natural environment.

Economists are often accused of being too narrowly focused on markets and the market prices that move up or down to bring supply and demand into balance.

But one way they’ve widened their scope is by broadening the meaning of “capital”. Capital refers to anything that helps us produce the many goods and services we consume as part of our standard of living.

Historically, it has meant “physical” capital: the human-made tools, machines, factories, shops, offices and other buildings, as well as infrastructure such as roads and bridges.

To this, economists have added the “human” capital we have in our brains: the education, training and on-the-job knowledge that adds to the productive value of our labour.

And then they took account of “social” capital: the human relationships and networks, norms of acceptable behaviour and, particularly, the trust between people that make markets work more smoothly and lower the costs of doing business.

Finally, economists have recognised the importance of “natural capital”: the world’s stocks of natural assets, such as geology, soil, air, water and all living things. These natural assets deliver to us “ecosystem services” ranging from pollinating birds and insects, sources of fresh water, forests, marine life, arable soils and various absorbers of wastes.

As a former Treasury secretary, Dr Ken Henry, reminded us in a speech last week, human progress has relied on forms of industrial production, including modern agricultural practices, involving extracting non-renewable raw materials, such as iron ore, coal and gas, and making extensive use of ecosystem services.

Two hundred years ago it was possible to believe that all this economic activity was having no significant impact on our stocks of natural assets and their ecosystem services to us. Today, scientists tell us a very different story – and it’s much easier to see with our own eyes the damage we’ve done.

As Henry puts it, the extraction of non-renewable natural resources for industry has depleted the stock of natural capital directly. But it has also had an indirect impact. Most obviously, the burning of fossil fuels has damaged the atmosphere, the total supply of water in all its forms, and the earth’s surface, in a set of complex processes we call climate change.

But that’s not our only contribution to the degradation of natural capital. Because the industrial rate of use of ecosystem services has exceeded nature’s capacity to regenerate for at least several centuries, the stock of natural capital has been depleted – just as machines used in production depreciate more rapidly if worked harder and not properly maintained.

The depletion of natural capital over time reduces its capacity to supply ecosystem services that are critical to production. For example, soil fertility, the availability of well-watered farming land, and capacity of the atmosphere and the land to absorb the waste left by economic activity have all fallen over time.

“A degraded biosphere [of land and air] affords less protection from fire, droughts, floods and storms, all of which are growing in incidence and severity because of human-induced atmospheric change,” Henry says.

Wait, there’s more. The depletion of natural capital also reduces “environmental amenity” – our enjoyment of being out in nature. It also imposes adverse cultural impacts on indigenous peoples.

Economists are very aware that, to some extent, labour and physical capital can be substituted for each, one source of energy can be used to replace another, and resources can be used to produce machines that increase what we have available to consume.

These are the reason some economists have dismissed the fear that we have, or could ever, approach the “limits to [economic] growth”.

But Henry’s not convinced. “None of this human ingenuity, nor [physical] capital accumulation, nor increasing work effort has, thus far, done anything to halt the rate at which the stock of natural capital is being depleted,” he says.

“To the contrary, new technologies and more [physical] capital-intensive modes of production have accelerated its rate of depletion. And they have done little to reduce the dependence of industry upon the stock of natural capital.”

The distinguished American economist Robert Solow argued that for economic growth to be sustainable, the present generation has a moral obligation to “conduct ourselves so that we leave to the future the option or the capacity to be as well-off as we are”.

But Henry responds that: “The historical loss of natural capital denies us reason to believe that future generations will have the capacity to achieve our level of wellbeing. To put it another way, it would be irrational of us to suppose that we, in this generation, are custodians of sustainable development.”

Wow. He goes on to argue that so much has been lost, and with such serious consequences, a consensus has emerged that we must now commit to nature repair.

Have you heard of “nature positive”? It means halting and reversing nature loss, so that species and ecosystems start to recover.

Henry says the nature positive position “argues that for some time, perhaps generations, we must seek to restore environmental condition, understanding that without doing so, we cannot be confident that future generations will have the capacity to be as well-off”.

Wow. This is radical stuff. And it’s coming not from some Greens senator, but from a former Treasury secretary and former chair of the National Australia Bank.

In an interview in April, Henry said the Albanese government should establish a public fund to spur corporate involvement in nature positive protection and repair. The cost would be enormous, he admitted.

A last thing to surprise you. The world’s first global nature positive summit will be held in Sydney in early October. It will be hosted by the federal Minister for the Environment, Tanya Plibersek.

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Despite what we're led to believe, tax cuts are no free lunch

Isn’t it wonderful that the Albanese government – like all its predecessors – has been willing to spend so many of our taxpayers’ dollars on advertising intended to ensure no adult in the land hasn’t been reminded, repeatedly, about the income tax cuts that took effect on Monday, first day of the new financial year?

But believe me, if you rely only on advertising to tell you what the government’s up to with the taxes you pay – or anything else, for that matter – you won’t be terribly well-informed. The sad truth is there’s a lot of illusion in the impressions the pollies want to leave us with when it comes to tax and tax cuts.

For instance, none of those ads mentioned the eternal truth that, when we have income tax scales that aren’t indexed annually to take account of inflation, the taxman gradually claws back any and every tax cut the pollies deign to give us. And this slow clawback process – known somewhat misleadingly as “bracket creep” – begins on the same day the tax cuts begin.

So readers of this august organ are indebted to my eagle-eyed colleague Shane Wright, who asked economists at the Australian National University to estimate how long it would take these tax cuts to be fully clawed back, using plausible assumptions about future increases in prices and wages.

A tax cut reduces the average rate of income tax we pay on the whole of our taxable income. A middle-income earner’s average tax rate will fall from 16.9 cents in every dollar to 15.5¢. The economists calculate it will take only two or three years for inflation to have lifted most taxpayers’ average tax rate back up to where it was last Sunday.

So that’s the terrible truth the pollies rarely mention. But don’t let that make you too cynical about the tax-cut game. Just because this week’s tax cut will have evaporated in a few years’ time doesn’t mean it’s worthless today. Actually, as tax cuts go, this is quite a big one. Someone earning $50,000 a year is getting a cut worth almost $18 a week. At $100,000 a year, it’s worth almost $42 a week. And on $190,000 and above, it’s worth $72 a week.

Is that enough to completely fix your cost-of-living problem? No, of course not. But if you think it’s hardly worth having, please feel free to send your saving my way. I’m not too proud to take another $18 no one wants.

Remember, too, that had Anthony Albanese not broken his promise in January and fiddled with the stage 3 tax cuts he inherited from Scott Morrison, most people’s saving would have been a lot smaller, even non-existent.

Everyone earning less than $150,000 a year got more, while those of us struggling to make ends meet on incomes above that got a lot less. In my case, about half what I’d been led to expect.

But the politicians’ illusions are built on our self-delusions. Our biggest delusion is that government works quite differently to normal commercial life. We know that when you walk into a shop you have to pay for anything you want. If you want the better model, you pay more.

Somehow, however, we delude ourselves that governments work completely differently. That the cost of the services we demand from the government need to bear no relationship to the tax we have to pay.

The politicians actively encourage this delusion in every election campaign by promising us this or that new or better service without any mention that we might have to pay more tax to cover the cost of the improvement.

Any party foolish enough to mention higher taxes gets monstered – first by the other side and then by the voters. No one wants to admit that what we get can never be too far away from what we pay.

For the near-decade of the Liberals’ time in government, they drew many votes by branding Labor as “the party of tax and spend” while claiming they could deliver us the services we want while keeping taxes low.

This was always a delusion. So they squared the circle by using various tricks they hoped we wouldn’t notice, such as underspending on aged care, allowing waiting lists to build up and secretly ending the low- and middle-income tax offset, thus giving many people an invisible tax increase of up to $1500 a year.

But the main trick they relied on was the pollies’ old favourite: bracket creep.

Get it? When we delude ourselves that we can have the free lunch of new and better services without having to pay more tax, they resort to the illusion that income tax isn’t increasing by letting inflation imperceptibly increase our average tax rate.

This is the tax-cut game. As an economist would say, our “revealed preference” is for no explicit tax increases, but for tax to be increased in ways we don’t really notice and for tax cuts to be only temporary.

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Interest rate speculators should get back in their box

There’s nothing the financial markets and the media enjoy more than speculating about the future of interest rates. And with last week’s news that consumer prices rose by 4 per cent over the year to May, they’re having a field day.

Trouble is, the two sides of the peanut gallery tend to egg each other on. They have similar ulterior motives: the money market players lay bets on what will happen, while the media can’t resist a good scare story – even one that turns out to have scared their customers unnecessarily, thus eroding their credibility.

But the more the two sides work themselves up, the greater the risk they create such strong expectations of a rate rise that the Reserve Bank fears it will lose credibility as an inflation fighter unless it acts on those expectations.

Fortunately, the Reserve’s newly imported deputy governor, Andrew Hauser, has put the speculators back in their box with his statement that “it would be a bad mistake to set policy on the basis of one number, and we don’t intend to do that”.

He added that there was “a lot to reflect on” before the Reserve board next meets to decide interest rates early next month. Just so. So, let’s move from idle speculation to reflection.

For a start, we should reflect on the wisdom of the relatively recent decision to supplement the quarterly figures for the consumer price index with monthly figures.

This has proved an expensive disaster, having added at least as much “noise” as “signal” to the public debate about what’s happening to inflation. Why? Because many of the prices the index includes aren’t actually measured monthly.

Many are measured quarterly, and some only annually. In consequence, the monthly results can be quite misleading. Do you realise that, at a time when we’re supposedly so worried that prices are rising so strongly, every so often the monthly figures tell us prices overall have fallen during the month?

In an ideal world, the people managing the macroeconomy need as much statistical information as possible, as frequently as possible. But in the hugely imperfect world we live in, paying good taxpayers’ money to produce such dodgy numbers just encourages the speculators to run around fearing the sky is falling.

The Reserve has made it clear it’s only the less-unreliable quarterly figures it takes seriously but, as last week reminded us, that hasn’t stopped the people who make their living from speculation.

The next thing we need to reflect on is that our one great benefit from the pandemic – our accidental return to full employment after 50 years wandering in the wilderness – has changed the way our economy works.

I think what’s worrying a lot of the people urging further increases in interest rates is that, as yet, they’re not seeing the amount of blood on the street they’re used to seeing. Why is total employment still increasing? Why isn’t unemployment shooting up?

One part of the answer is that net overseas migration is still being affected by the post-pandemic reopening of our borders – especially as it affects overseas students – which means our population has been growing a lot faster than has been usual after more than a year of economic slowdown.

But the other reason the labour market remains relatively strong is our return to full employment and, in particular, the now-passed period of “over-full employment” – with job vacancies far exceeding the number of unemployed workers.

With the shortage of skilled workers still so fresh in their mind, it should be no surprise that employers aren’t rushing to lay off workers the way they did in earlier downturns. As we saw during the global financial crisis of 2008-09, they prefer to reduce hours rather than bodies.

It’s the changing shares of full-time and part-time workers – and thus the rising rate of underemployment – that become the better indicators of labour market slack in a fully employed economy.

The other thing to remember is the Albanese government’s resolve not to let the ups and downs of the business cycle stop us from staying close to the full employment all economists profess to accept as the goal macroeconomic management.

This resolve is reflected in the Reserve Bank review committee’s recommendation that the goal of full employment be given equal status with price stability, which the Reserve professes to have accepted.

This doesn’t mean the business cycle has been abolished, nor that the rate of unemployment must never be allowed to rise during a period in which we’re seeking to regain control over inflation.

What it does mean is that we can’t return to the many decades where the commitment to full employment was merely nominal, and central banks and their urgers found it easier to meet their inflation targets by running the economy with permanently high unemployment.

The financial markets may persist in their view that high inflation matters and high unemployment doesn’t, but that shouldn’t leave them surprised and dissatisfied with a central bank that’s not whacking up interest rates with the gay abandon they’ve seen in previous episodes.

But there’s one further issue to reflect on. It’s former Reserve Bank governor Dr Philip Lowe’s prediction in late 2022 that we’d be seeing “developments that are likely to create more variability in inflation than we have become used to”. As someone put it: shock after shock after stock.

The point is, it’s all very well for people to say we should keep raising interest rates until the inflation rate is down to 2 per cent or so, but what if price rises are being caused by problems on the supply (production) side of the economy, not by excessive demand?

High interest rates have already demonstrated their ability to end excessive demand, as quarter after quarter of weak consumer spending, and a collapse in the rate of household saving, bear witness. But if high prices are coming from factors other than excess demand, there’s nothing an increase in interest rates can do to fix the problem.

What surprises me is how little attention market economists have been paying to what’s causing the seeming end to the inflation rate’s fall to the target range.

Look at the big price increases that have contributed most to the 4 per cent rise over the year to May – in rents, newly built homes, petrol, insurance, alcohol and tobacco – and what you don’t see is booming demand.

Right now, all we can do to push inflation down is attempt to hide the effect of supply-side problems on the price index by putting the economy into such a deep recession that other prices are actually falling.

This was never a sensible idea, and it’s now ruled out by the government and the Reserve’s commitment never to stray too far from full employment.

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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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