REGULATING FOR SUSTAINABILITY

Talk to forum on Evidence-Based Regulatory Reform
Monash University Law Chambers, December 6, 2010

Some of the most important ideas are deceptively simple. Who, for instance, could dispute that the practice of medicine, the making of government policy or the reform of government regulation should be ‘evidence-based’? I have a mate who’s an academic neurologist and when we’re at our holiday homes and getting our daily exercise toiling up and down a mountain he often tells me about the advent of evidence-based medicine. I was surprised to learn that many of the cures prescribed by doctors often aren’t chosen on the basis of hard, scientific evidence, but rather on the doctor’s habits, on what he was taught at med school, on the doctor’s impression of what other doctors do, on years of casual observation as to what works and what doesn’t, on what might minimise the doctor’s ‘medico-legal’ risk, on what the doctor remembers reading in a medical journal, or even what the doctor was told recently by a visiting drug company rep. In place of this, the medical profession is slowly and painstakingly assessing what it knows from high-quality empirical studies about the efficacy of particular treatments, with treatments and tests graded, starting with the ‘gold standard’ and working down. Doctors who follow these guidelines can expect to avoid much criticism should things go amiss. The role of professional judgment is reduced, but the effectiveness of treatment is greatly enhanced.

Now, who among us could doubt that making medicine more ‘evidence-based’ is a great step forward? I was pondering the idea of writing a radical column advocating that economists and econocrats follow the doctors’ example and make their policy recommendations more evidence-based - less reliance on theory, more on empirics - when I was amazed to see the chairman of the Productivity Commission had given a long speech advocating ‘evidence-based policy-making’. The boss of the most notoriously theoretically pure economic institution is preaching sermons about the need to take more notice of the actual evidence? And I have no doubt that, in his own mind, his commitment to taking more notice of evidence was completely genuine.

The point I want to make is that, while no one could disagree with the proposition that everything we do ought to be more evidence-based - perhaps even choosing our spouse - in practice it ain’t that simple. What I regard as evidence may not be what you regard as evidence. And the conclusions I draw from the evidence may not be those you draw from the same evidence. It may transpire that your response to the evidence was sound and mine wasn’t. But both of us will be able to claim our decisions were evidence-based. So making evidence-based decisions may improve the quality of those decisions on average, but it offers no guarantee that decisions are correct. And even the expectation that paying more attention to evidence will generally improve the quality of decisions should itself be subject to evaluation once we have more evidence about the effectiveness of evidence-based decision-making.

‘Evidence’ is a word with a wonderful air of certainty and assurance. Who could doubt the evidence? Who could argue with the evidence? Yet we know from watching telly that this is just what barristers are paid to do: argue about different interpretations of the evidence. And far more lowly paid juries have the last word on what the evidence proves. We need to think more clearly about what evidence is. I think it’s just facts. In the case of economic questions it’s often statistical facts - the statistical composition of some population; the movement in some variable over time. Maybe the movement in two variables over time, the degree of correlation between them and whether we can be sure that one caused the other, or whether both are caused by some third variable.

But the world abounds with facts, far more than we can assimilate. Some facts (and some statistics) are relevant to the question at hand and some are irrelevant. How do we decide which facts are pertinent and which aren’t? We apply our judgment. The judgment of a professional has been schooled by her professional education; she’s been trained to think along certain lines, her thinking is guided by a ‘model’. A model - which can just as easily be called a theory - is an attempt to understand a complex reality by simplifying that reality: excluding all those factors considered to be of little importance so as to focus on those factors believed to be most important in explaining how things work. All models pick and choose between the facts, all professions rely on models, and each profession’s model tends to be quite different from the others, so that, for example, a lawyer and an economist can draw quite different conclusions from the same set of facts, the same evidence. How successful each profession’s model is at explaining and predicting the way the world works depends on whether it has avoided excluding from its model factors that end up being important in explaining behaviour. In practice, all professions suffer from what I call ‘model blindness’ - a tendency to underrate factors that aren’t in their model, but turn out to be important explanators. I doubt if more emphasis on evidence will overcome the endemic problem of model blindness.

Let me make a quite different point. One reason policy-makers don’t make more use of evidence is that the evidence - particularly statistical evidence - doesn’t exist. And often it doesn’t exist because evidence is expensive to collect. So any genuine push to make decision-making more evidence-based would involve spending a lot more taxpayers’ money on collecting evidence. And collecting more evidence would annoy lots of people. Much valuable potential evidence is possessed by government agencies, but they’re often quite resistant to requests to make it available, lest they provide outsiders with a stick to beat them. Other evidence has to be collected by government agencies from business, but business greatly resents having to fill in forms for the government. It’s likely that, in the mind of business, a fair bit of the push for ‘evidence-based regulatory reform’ involves getting rid of ‘red tape’ otherwise known as evidence.

But I’m supposed to be talking about regulating for sustainability, so let me take a case study and consider the extent to which evidence could throw light on the regulatory decisions to be made. Most of us are agreed that we need to greatly reduce our emissions of greenhouse gases in the next few decades. Economists are agreed that the least-cost way to achieve this is not by prohibiting certain undesirable behaviour or by subsidising certain desirable behaviour, but by ‘putting a price on carbon’. Is this judgment evidence-based? Probably not. It’s such a new area that there isn’t a lot of evidence available, and what evidence there is would be mixed. No, this conclusion comes straight from the economists’ conventional model, which assumes that prices are always the main influence over people’s economic behaviour and that changing prices is always the least-cost way to achieve policy objectives.

But as you probably realise, there are two different ways we could put a price on carbon. We could take the cap-and-trade, emissions trading scheme approach of the Rudd government’s carbon pollution reduction scheme, and limit the quantity of carbon dioxide permitted to be emitted, thus forcing up the price of emissions. Or we could impose a tax on emissions, thus increasing their price and thereby encouraging businesses and households to reduce the quantity of their emissions. As you can see, the two approaches are essentially mirror-image and, in theory, either way should achieve the same result. From about the time the Rudd government committed itself to the trading-scheme approach, the balance of opinion among economists swung in favour of the carbon tax approach. And now with the abandonment of the Rudd scheme, but the recommitment to putting a price on carbon, the nation is facing the choice.

Was the swing in economists’ opinion in favour of a tax evidence-based? I doubt it. Could it have been? Not really; as I say, there isn’t a lot of evidence available. It does seem clear the European Union’s trading scheme has not worked well - but it’s easy to say we can see what the Europeans did wrong and will make sure we avoid making the same mistakes. So on what basis do economists divide between supporting a trading scheme and supporting a carbon tax? Because the model says they’re essentially equivalent, I think it boils down to differing judgments about their political and administrative feasibility.

We should gather more evidence and take more notice of the evidence we have, but don’t imagine this will greatly reduce the role of subjective judgment in the way governments regulate the economy.

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Gillard indulges the mendicants at her peril

It's just as well Julia Gillard and her purse-string ministers are so committed to "a strong economy" because that's just what they're about to get. And let me tell you: an economy as strong as we're getting requires a strong government - something this lot hasn't been noted for.

Contrary to last week's silliness over the national accounts, we have everything going for us. Our terms of trade - export prices relative to import prices - are the most favourable they've been in a century and are pumping an extra 12 to 15 per cent of gross domestic product into the economy.

Then there are the tens of billions the mining companies are planning to spend building mines and gas facilities. This mining construction boom could run for a decade.

The labour market is particularly strong and unemployment hasn't far to fall to reach the 4.75 per cent rate economists regard as full employment.

So the problem won't be keeping the growth going but holding it down because the demand for labour and capital will soon be outstripping the supply.

This is a problem mainly for the Reserve Bank. And it knows exactly what to do: raise interest rates whenever it fears inflation is headed up out of its 2 to 3 per cent target range.

But Gillard and her ministers have to do as little as possible to add to demand and as much as lies within their power to subtract from it.

How? By running the tightest budget they can manage. They need to let the boom push up their revenue and avoid cutting taxes. They need to control the growth in their spending as tightly as possible, getting the budget back to surplus as soon as possible.

They are, of course, committed to do just this by their deficit exit strategy and also by Gillard's promise (not just forecast) of achieving a surplus in 2012-13. The strategy requires them to stay in this fiscal chastity belt until the surplus is back to 1 per cent of GDP.

But the point Glenn Stevens of the Reserve made last week is that the government will need to maintain the budgetary discipline long after the budget's back to surplus and even after it's eliminated the net public debt.

If it follows the logic of Costelloism and starts cutting taxes and spending freely once the surplus is back to 1 per cent of GDP, fiscal policy becomes "pro-cyclical" - it adds to demand rather than restraining it - as it was in the sainted Howard government's last years.

In other words, for as long as the economy's booming you have to let the surplus get bigger and bigger every year. And to help make that easier politically, you probably need to put the surplus into some sort of stabilisation fund or sovereign wealth fund.

The hardest part, however, is resisting the temptation to splash taxpayers' money on every group with a hard-luck story. Take all the sympathetic noises the government's been making about the high cost of living.

Last week's national accounts told us the household saving rate is now at 10 per cent of disposable income. It's probably not really that high but it is clear people's incomes have been growing a lot faster than their consumer spending. Don't sound hard-up to me.

Another bad sign is the way the government's started echoing complaints about "the two-speed economy". Last week Gillard alluded to this as the "patchwork economy".

And the Treasurer, Wayne Swan, said: "We don't want to in any way inhibit the speed of the mining sector, but we also have to do everything we can to help all of those that are in the slower lane."

Sorry, but that's quite wrong headed. Anything "we do" to help those people via the budget will add to demand and, hence, put further upward pressure on interest rates and the exchange rate.

What's more, this talk conveys an exaggerated impression of the extent to which the rest of us will suffer as a consequence of the expansion of the mining sector in Western Australia and Queensland. The government should be trying to educate and correct this misperception, not pander to it.

The notion that there is, or will be, a wide and enduring gulf between the mining states and the rest is wrong. It's wrong because, in industry terms, it's not a two-speed economy it's a three-speed.

Top speed is mining and associated industries. Low speed is the non-mining tradeables sector - agriculture, manufacturing, education and tourism. But in between is the non-tradeables sector.

And get this: the non-tradeables sector accounts for about three-quarters of the economy. So the great majority of us work in neither the fast lane nor the slow lane. What's more, the non-tradeables sector benefits from the high dollar because that makes imported parts and equipment cheaper.

Note, too, that the non-tradeables sector accounts for the great majority of production and employment in all states. And though Queensland has a lot of mining, it also has a lot of tourism. This is why, when you look at the figures, you don't see the wide disparity the two-speed contention leads you to expect.

For 2009-10, WA's gross state product grew by 4.3 per cent, but Queensland's grew by 1.6 per cent - less than Victoria's 2 per cent and NSW's 1.7 per cent.

But a lot of that growth came from increased population. Look at GSP per person (to get a measure of changed material living standards) and WA's growth drops to 1.6 per cent, while Queensland's was minus 0.8 per cent. That was worse than all the other states.

A strong economy requires a government with the strength to stare down all the whingers trying to touch it for a handout.

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Keep your shirt on, life could be worse

Oh! No! The economy was roaring along in June quarter, growing by 1.1 per cent, but now it has almost come to a halt, up just 0.2 per cent in the September quarter. What's more, take out a leap in rural production and we actually went backwards.

It made a great story this week - thrills and spills in econoland - but I wouldn't believe it. Why not? Because in real life economies don't soar and dive in the space of six months without there being a very big and obvious reason - the introduction of the goods and services tax, for instance, or the collapse of Lehman Brothers and its aftermath scaring the pants off businesses and consumers.

You need to know that both the financial markets and the media have a vested interest in statistical volatility.

It gives them something to bet on or write stories about and makes their lives more interesting. So it suits them to take economic statistics literally, ignoring their well-known limitations.

Sensible people, however, always take them with a grain of salt, knowing the economy is far more stable than the stats - especially quarter-to-quarter changes - show it to be.

The making of the ''national accounts'' - the bottom line of which is gross domestic product - is like the making of sausages: you're better off not knowing what goes into them. They're pulled together using bits and pieces from thousands of different sources.

Often, inferior sources are used because the more reliable information isn't yet available. Sometimes no information is available, so the statisticians take a guess. When the better information does come along, the figures are changed. Since the better data come along at different times, the figures for a particular quarter are constantly being changed, for at least the next two years.

The original figure for growth in the December quarter of 2008 - the quarter when Lehman Brothers collapsed - was minus 0.5 per cent. It was then revised down each quarter until it reached minus 0.9 per cent. Then it was revised up each quarter, reaching minus 0.7 per cent three months ago.

This week it was revised down to minus 1 per cent. So we're now being told the contraction was twice the size we were originally told. And there were people at the time imagining that figure had been written by God on tablets of stone.

Or, let's try another one. Three months ago we were told real GDP grew by 3.3 per cent over the year to June. Now we're told it grew by 2.7 per cent over the year to September.

Why the sudden slowdown? Well, not primarily because of the alleged virtual cessation of growth in the September quarter, but because revisions shifted 0.4 percentage points of growth out of the December quarter of 2009 and into the September quarter of 2009 (which dropped out of the annual calculation).

The Bureau of Statistics acknowledges the ropiness of its figures, which is why it tries to direct users to its ''trend estimates'', which simply average out the quarterly ups and downs. But for good reasons and bad, economists, the markets and the media invariably ignore the trend figures and focus on the more volatile unsmoothed ones.

The point is that much of the quarter-to-quarter volatility in the growth figures isn't real but just ''statistical noise''. You have to ignore the noise to hear the true ''signal'' underneath it.

Remember, too, it's easy to be bamboozled by quarterly changes. If some big transaction is accidentally put into the wrong quarter, this distorts the quarterly change for three successive quarters.

Because a big thing such as a national economy - or an ocean liner - is actually quite hard to speed up or slow down, when the figures show it rapidly speeding up in one quarter, the greatest likelihood is that the figures for the following quarter will show it rapidly slowing down.

And that's just what the past two quarters' figures show. Logical deduction: the economy didn't really grow that fast in the June quarter and didn't really slow that much in the September quarter.

There's an old trick Treasury used to reduce the statistical noise and get a clearer signal: add the last two quarters together and take an average. That says the economy has probably been growing at a quarterly rate of about 0.65 per cent over the past six months ([1.1 + 0.2] ÷ 2).

That makes more sense, but even it seems too low. How can I say that? Because we have an independent (and less volatile) set of stats to measure the national accounts against: the employment figures.

These show employment growing fairly steadily over the past year, growing particularly strongly in the September quarter and increasing by 3.2 per cent for the year. That's not an economy that's suddenly run out of juice.

So when we peer through the statistical haze, what do we see in the national accounts? First, we see that the pick-up in business investment spending - particularly in the mining sector - is occurring, in line with what the companies have long been telling us about their plans for huge spending over the coming year and longer.

Second, despite strong growth in household disposable income (fed by strong growth in employment and rising real wages), consumer spending isn't growing nearly as strongly, meaning households are saving a lot more. (The figures say the household saving rate was 10 per cent of disposable income - which is too high to believe, but undoubtedly saving is high.)

This is bad news for retailers but good news for the economy generally because it postpones the time when, with the economy nearing full employment, the economic managers are struggling to cope with a massive mining investment boom and a consumption boom.

The way they'll cope with a double boom is simple: they'll jack up interest rates (which will also add upward pressure to the exchange rate) to discourage consumer spending. So the longer households keep thinking now's a good time to get on top of their debts, the better off we'll be. The bad news in the accounts, however, is the continuing weakness in the building of new homes and also in commercial (as opposed to industrial) construction.

This suggests inadequate supply will soon be pushing up rents and thus increasing inflation pressure.

So a literal reading of this week's accounts sends us just the opposite message to the true position.

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As Labor spouts its values, gap rich poor gap widens

Why do I get the feeling that, after their just-short-of-disastrous showing in the August election, Julia Gillard and her ministers aren't so much engaged in soul-searching as in trying to improve their PR. They're all giving speeches about Labor's reason for existence, and they're all saying much the same thing, as though they were all briefed by the same spin doctor.

Their central message is that Labor stands for a "strong economy". Well, sure. Which party stands for a weak economy? Anything else?

Gillard says Labor's values are "a strong economy - and opportunity for all". Wayne Swan says Labor's core purpose is "prosperity and opportunity". Neither says much about what "opportunity" means. Maybe it means whatever you'd like it to mean.

Fortunately, Penny Wong is a little more explicit. She says Labor stands for "a fair go, a just society, a strong economy. A fair go encompasses Labor's tradition of fairness, of equality of opportunity and the aspiration for equity in outcome or worth.

"A just society references our social, legal and institutional frameworks, the principles that govern

our community and the relationships within it. Our rights and shared responsibilities."

Well, that's sounding more like Labor. But if Gillard Labor still stands for Labor's tradition of fairness it's got a fair bit of work to do, as I ventured to suggest when invited to deliver the ACTU's Whitlam Lecture in Melbourne last night. And so far its record has been mixed.

Every few years the Bureau of Statistics measures the distribution of disposable income between Australia's households. It's too soon for us to have any clear evidence on what's happened to equity under the Labor government, but we do know that, after changing little between 1995 and 2004, the gap between rich and poor widened markedly between 2004 and 2008 - essentially the Howard government's last years.

If disposable income was equally distributed between households, the bottom 20 per cent of households would have 20 per cent of total income and the top 20 per cent of households would also have 20 per cent of total income.

In fact, the latest figures show that the bottom fifth has just 7 per cent of the income, whereas the top fifth has more than 40 per cent. And over just the last four years the shares of the four bottom fifths fell by about 0.5 percentage points each, allowing the share of the top fifth to rise by 2 percentage points.

Why this sudden deterioration? No one can say with any certainty. Various factors could have contributed: the resources boom and the booming sharemarket before the global financial crisis, the continued rise in executive and finance-sector salaries and maybe the succession of income tax cuts that benefited people on high incomes.

One factor that seems to have limited the rise in inequality throughout most of John Howard's reign was his large and repeated increases in family benefits. But there was a lot less of that in his later years.

But the bureau's practice of lumping together the top 20 per cent of households almost certainly conceals the extent to which the incomes of a relative handful of households at the very top have risen inordinately (and it may well be the incomes of households in the second highest 10 per cent rose at much the same rate as for the bottom 80 per cent).

Though they're not strictly comparable, and are no more recent than 2002, income tax statistics show that the top 0.05 per cent of individual taxpayers accounted for about 2 per cent of total taxable income. The top 1 per cent accounted for 9 per cent, the top 5 per cent for 21 per cent and the top 10 per cent for 31 per cent. (This last is up from 25 per cent in the early 1980s.)

These figures laugh at the notion of Australia as the great egalitarian paradise. But they only put us somewhere in the middle of the developed country pack: much more unequal than the Nordic countries, but not as bad as the other English-speaking countries: Canada, Ireland, New Zealand, Britain and the United States.

Were Labor to want to reduce inequality in Australia, the conventional starting place would be with taxation. Had Labor had its "tradition of fairness" at the top of its consciousness in the 2007 election campaign, it wouldn't have promised to introduce essentially the same three years' worth of tax cuts as those designed by Peter Costello to advantage people on incomes well above the average.

Admittedly, Labor's minerals resource rent tax will even things up a little, but it could be doing more to make the taxation of superannuation less heavily biased in favour of high income earners. The same goes for the concessional taxation of capital gains.

Remember, however, that much of the budget's redistribution of income from the rich to the poor comes from the way means-testing is used to restrict social security payments to those who are genuinely needy.

The Howard government took steps to bypass means-testing and introduce middle-class welfare. Labor has rolled back some of this, but could do more. It gave generous one-off increases in pensions, but excluded the unemployed from this munificence and limited the benefit flowing to sole parents.

One institution central to the goal of equality of opportunity is public schools. Gillard claims to have doubled funding for all schools, but so far she's done nothing to reform John Howard's biased funding formula in favour of better-off private schools.

One trend that's worked against a fair go is the many means by which employers have transferred risk from their own shoulders to those of their employees. These range from the casualisation of the workforce and making workers supposedly independent contractors to the risks of superannuation accumulation.

It would be nice to see the Gillard government doing more to act on its values rather than talk about them.

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IS AUSTRALIA THE LAND OF THE FAIR GO?

ACTU Whitlam Lecture, Melbourne, Tuesday, November 30, 2010

In writing and talking about equality and inequality, I always feel myself at a disadvantage.

Everyone thinks they know more about it than I think I know. Just about everyone has it firmly fixed in their mind that the gap between rich and poor is growing - the rich are getting richer and the poor getting poorer. This trend, they know, has been running for decades, perhaps forever. My disadvantage is that when you express your opinions in a respectable newspaper rather than the pub, you’re supposed to base them on actual evidence. And when I recount the evidence, it’s never as bad as everyone knows to be the case.

Even so, let me try to summarise the evidence about the distribution of income....

Is Australia the Land of the Fair Go

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Professed reformers spin lazy line on cost of living

Julia Gillard and her ministers are expressing their undying commitment to the economy and economic reform, but the way they pander to and even incite the punters' irrational whingeing about the cost of living gives the lie to their profession of economic faith.

For obvious reasons, the government has been saying a lot lately about Labor's values and vision for Australia. According to Gillard: "A strong economy - and opportunity for all. That's really it in a nutshell."

Wayne Swan said last week the Labor Party's "core purpose" had always started with two words: "prosperity and opportunity". (The more he said the clearer it became that, to him, Labor's reason for existence is solely materialistic: every worker should have the opportunity to own a Beemer.)

Penny Wong was a little broader in her view of what Labor stands for: "A fair go, a just society, a strong economy." (Note that none of the three saw fit to mention reconciling the economy with the environment as a priority.)

Get the message? Labor = a strong economy. So does this mean they're all economists or economic rationalists? No, it means they're politicians who've concluded that only good economic managers get to stay in office (and whose secret fear is that they aren't good economic managers).

They're pollies who've learnt to mind their economic P's and Q's - they know not to promise to control prices or re-regulate interest rates - but they haven't internalised "the economic way of thinking".

How can I be sure? Because of the way the politician in them leads them to pander to the public's complaints about the rising cost of living. And because anyone who thought like an economist wouldn't be able to resist the desire to explain to the whingers a few facts of life.

The punters are complaining about big rises in water and electricity prices. Do the pollies explain why these rises are occurring and why they're justified? Not that I've noticed. They just keep saying "I feel your pain".

Do they explain that, though water and power prices have increased a lot, other prices haven't risen much and some have actually fallen, meaning the overall cost of living hasn't been rising all that rapidly? Hell no.

The consumer price index rose by 2.8 per cent over the year to September. Over the previous year it rose by 1.3 per cent.

Behavioural economists understand how people develop exaggerated perceptions of what's happening to their cost of living. It's because people don't weight price rises according to the item's share in the basket of goods and services they buy.

Big price rises stick in their minds (with no allowance made for any improvement in the quality of the item), whereas small price falls are soon forgotten and items whose prices don't change get a weight of zero.

If economics is to be useful it should help people overcome their irrational misperceptions. But our self-proclaimed economic-reform obsessed leaders don't see a need to educate the electorate.

The obvious fact is the cost of living is always rising. That's not news. What matters is whether people's incomes are at least keeping up with the cost of living. And they are - easily. While consumer prices rose by 2.8 per cent over the year to September, the wage cost index rose by 3.6 per cent.

While prices rose by 1.3 per cent over the previous year, wages rose by 3.1 per cent. Over the five years to September, prices rose by 15.7 per cent, while wages rose by 20.8 per cent. So real wages have been rising by about 1 per cent a year.

It's because the cost of living is always rising that pensions are always being increased. They're actually indexed not to prices but to average income, meaning they grow in real terms. And last year the government gave pensioners (but not people on the dole) a big one-off increase.

So the rising cost of living is being outstripped by the rising standard of living. But still they whinge. And what do our piss-weak pollies say? "I feel your pain."

A pollie ought to understand that, because the cost of living is always rising, people complain about the cost of living when they haven't got anything more serious to complain about.

And what cause for complaint is there? Inflation is under control, employment has been growing very strongly, unemployment is a lot lower than we got used to, real wages are growing and the dollar's at parity with the greenback.

Do our pollies ever say any of this? Gosh no. Wouldn't dare.

Of course, interest rates are rising. And though far more people benefit from this than the one-third of households that have mortgages (many of them longstanding and thus quite small), the pollies compete to carry on about how iniquitous it is.

The government must think itself smart to have transferred the punters' ire from itself to the banks (aided by the carry-on of Joe Hockey). It knows the banks' double-dipping merely means one less official rate rise, but does it calm the punters with this news? Wouldn't dare.

When it comes to rate rises the government doesn't just feel your pain, it incites you to imagine it's the end of the world. This is smart? It's storing up trouble for the future.

Rate rises are the primary instrument we use to limit inflation pressure when the economy booms. And we're about to enter a mining construction boom that could run for a decade or more.

Do you reckon the strong-economy brigade has any notion of how many more rate rises we're likely to see before the next election?

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We're all paying a high price for hiding our debt

IT DOESN'T seem to have occurred to Julia Gillard that her resolve to make this the "decade of infrastructure" - with a gold-plated national broadband network as its centrepiece - doesn't fit with her core promise to return the budget to surplus in 2012-13 and eliminate government debt ASAP.

Indeed, the two policies laugh at each other. Both Gillard and Kevin Rudd succumbed to Costelloism - a brand of fiscal populism holding that all government debt is bad - as did various state Labor governments.

The upside of this abhorrence of budget deficits and obsession with the elimination of debt is it left the Rudd government perfectly placed when it needed to spend big to counter the impact of the global financial crisis.

The downside is it led to more than a decade of inadequate spending on infrastructure. Labor made much of the neglect of infrastructure while in opposition and this explains its resolve to give it a high priority. But Labor has also embraced the very mentality that caused the problem.

As Dr Nicholas Gruen, of Lateral Economics, has written in a report for Western Sydney councils, the obsession with debt may have got rid of the budget deficit, but it exchanged it for an infrastructure deficit. In truth, only some government debt is bad. It's not bad when it arises from deficits incurred during recessions. And it isn't bad when it arises from capital spending - provided those capital works are worthwhile. It is bad when it arises from the failure of governments to ensure their recurrent spending is covered by revenue during normal years.

I'm a great believer in the (Peter Costello-introduced) "medium-term fiscal strategy": to "maintain budget balance, on average, over the course of the economic cycle".

You'd never know it from the way Costello and his successors carry on, but that strategy is carefully worded to permit the budget's "automatic stabilisers" to push the budget into deficit during major downturns and also permit governments to use the budget to stimulate the economy during recessions.

So the addition of the words "on average over the cycle" makes the strategy - shock, horror - a Keynesian formulation. (Clearly, it was crafted by someone a lot wiser than Costello.) But the words "on average" make it a strictly symmetrical Keynesianism: once the recession passes you have to get the budget back to surplus and keep it there until the next recession.

There's just one weakness in this enlightened strategy: its failure to distinguish between capital and recurrent spending - that is, its failure to permit the federal government to borrow to fund infrastructure.

If Labor had a deeper understanding of economics and genuine belief in it, rather than a mere desire to portray itself as a "fiscal conservative", it would have had the courage to add that qualification to the strategy.

So how does Gillard expect to square the circle of tackling the infrastructure backlog without being able to borrow? I bet I know. She intends to use "public-private partnerships" to get the borrowing done by the private sector. Hey presto! Problem solved.

But hey presto is right. This is just creative accounting. The government initiates the need to borrow - and, directly or indirectly, guarantees the borrowing - but gets the debt put on someone else's balance sheet.

Unfortunately, the drawbacks of PPPs - which so far have been used mainly by state governments for all manner of infrastructure assets, from highways and railway stations to hospitals and desalination plants - are much greater than this.

As Gruen explains, these assets have been built at a higher cost to the public than would have been the case had they been built the way they used to be, as government-owned assets funded by borrowing.

The first cause of increased cost is the "artifice" needed to get private investors interested. They have to be reassured that some future action by the government - say, the building of a competing road or hospital - won't leave their asset stranded.

So the government has to tie its hands, promising not to do certain things and cutting off options for the future that may have been in the public's interest. And we've all seen how governments shore up private toll roads by "traffic calming" (making it harder for motorists to avoid the toll road).

But the bigger reason PPPs are so much more expensive is that government - being the government and thus having the power to raise taxes to cover its debts - can borrow a lot more cheaply than private businesses can. This is true even after you allow for the risks involved in specific infrastructure projects.

To illustrate the extra costs involved in PPPs, Gruen calculates that, had the NSW government chosen to fund the toll roads that now encircle Sydney, the state would have acquired ownership of a stream of revenue with a net present value of about $12.8 billion, at the cost of increasing its borrowings by $7 billion.

In other words, by taking on a little more risk, the state would have increased its net worth by about $5.8 billion. After allowing for that extra risk, its net worth would still be $4.6 billion higher.

By today, more than 60 per cent of the original borrowing would have been paid off, leaving a net cash flow to the budget of $380 million a year, after allowing for the interest payments on the extra debt and even after providing for further repayments of principal. And get this: in the unlikely event of the government's taking on of the extra debt prompting the ratings agencies to downgrade the state's AAA credit rating - which would increase the interest rates it had to pay on its borrowings - the budget would still be ahead on the deal.

Bottom line: the public is paying dearly for the efforts of governments to hide the debt they're responsible for.

Although we're not paying as much public debt interest as we would have been, we're paying inflated tolls on roads (as Gruen's calculations show). We're also paying heavy repayments on our mortgages partly because of governments' failure to release sufficient land and their loading of up-front infrastructure charges on the land they do release.

And we're paying with our time as we wait at peak hour in traffic that has slowed to a crawl or crowd into late trains and buses. All thanks to the demonising of government debt.

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Punters well aware of economic case against more immigration

The Big Australia issue has gone quiet since the election but it hasn't gone away. It can't go away because it's too central to our future and, despite Julia Gillard and Tony Abbott's rare agreement to eschew rapid population growth, the issue remains unresolved.

This year Rebecca Huntley of Ipsos, a global market research firm, and Bernard Salt of KPMG, a financial services firm, conducted interviews with business people and discussions with 13 groups of consumers, showing them two markedly different scenarios of what Australia could look like in 2020.

In the "measured Australia" scenario, governments limited population growth, focused on making our activities more environmentally sustainable and limited our economic links with the rest of the world.

In the "global Australia" scenario, governments set aside concerns about the environment, promoted rapid economic and population growth, and made Australia ever more a part of Asia.

Not surprisingly, the business people hated measured Australia and loved global Australia. But even though global Australia was described in glowing terms - ignoring the environment apparently had no adverse effects - ordinary people rejected it. And although measured Australia was painted in negative terms - all downside and no upside - there were aspects of it people quite liked.

The message I draw is that if governments keep pursuing rapid growth to please business they'll encounter increasing resentment and resistance from voters.

Considering the human animal's deep-seated fear of foreigners, it's not surprising resentment has focused on immigration. It's clear from the way in the election campaign both sides purported to have set their face against high migration that they're starting to get the message.

But at the moment they're promising to restrict immigration with one hand while encouraging a decade-long, labour-consuming boom in the construction of mines and gas facilities with the other. And this will be happening at a time when the economy is already close to full employment and baby boomers retire as the population ages.

Their two approaches don't fit together. And unless our leaders find a way to resolve the contradiction there's trouble ahead.

Business people support rapid population growth, which really means high immigration; there's little governments can do to influence the birth rate, because they know a bigger population means a bigger economy. And in a bigger economy they can increase their sales and profits.

That's fine for them, but it doesn't necessarily follow that a bigger economy is better for you and me. Only if the extra people add more to national income than their own share of that income will the average incomes of the rest of us be increased. And that's not to say any gain in material standard of living isn't offset by a decline in our quality of life, which goes unmeasured by gross domestic product.

The most recent study by the Productivity Commission, in 2006, found that even extra skilled migration did little or nothing to raise the average incomes of the existing population, with the migrants themselves the only beneficiaries.

This may explain why, this time, economists are approaching the question from the other end: we're getting the future economic growth from the desire of the world's mining companies to greatly expand Australia's capacity to export coal, iron ore and natural gas, but we don't have sufficient skilled labour to meet that need and unless we bring in a lot more labour this episode will end in soaring wages and inflation.

Peter McDonald, a leading demographer at the Australian National University, argues that governments don't determine the level of net migration, the economy does. When our economy's in recession, few immigrants come and more Aussies leave; when the economy's booming, more immigrants come and fewer Aussies leave. Governments could try to resist this increase, but so far they've opted to get out of the way.

To most business people, economists and demographers, the answer to our present problem is obvious: since economic growth must go ahead, the two sides of politics should stop their populist pandering to the punters' resentment of foreigners.

But it seems clear from the Ipsos discussion groups that people's resistance to high immigration focuses on their concerns about the present inadequacy of public infrastructure: roads, transport, water and energy. We're not coping now, what would it be like with more people?

And the punters have a point. In their instinctive reaction to the idea of more foreigners they've put their finger on the great weakness in the economic case for immigration.

As economists know - but don't like to talk or even think about - the reason immigration adds little or nothing to the material living standards of the existing population is that each extra person coming to Australia - the workers and their families - has to be provided with extra capital equipment: a home to live in, machines to use at work and a host of public infrastructure such as roads, public transport, schools, hospitals, libraries, police stations and much else.

The cost of that extra capital has to be set against the benefit from the extra labour. If the extra capital isn't forthcoming, living standards - and, no doubt, quality of life - decline.

If we don't build the extra homes - as we haven't been doing for some years - rents and house prices keep rising, making home ownership less affordable. To build the extra public facilities, governments have to raise taxes and borrow money. But they hate raising taxes and both sides of federal politics have sworn to eliminate government debt.

The interviews and discussion groups revealed both business people and consumers to be highly doubtful about the ability of governments - particularly state governments - to provide the infrastructure we need. As well they might be.

At present, our leaders on both sides are heading towards a future that doesn't add up.

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NBN plan has the signs of a historic stuff-up

I am starting to get a really bad feeling about Labor's plan for a national broadband network. The more it resists subjecting the plan to scrutiny, the more you suspect it has something to hide.

I fear Julia Gillard is digging herself in deeper on a characteristically grandiose scheme her swaggering predecessor announced without thought to its daunting implications, when she should be looking for ways to scale the project down without too much loss of face.

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The obvious way to start that process would have been to accede to calls for the Productivity Commission to conduct a cost-benefit analysis. The determination of governments to keep their schemes away from the commission is always prima facie evidence they know the scheme's dodgy.

But as each day passes the issue is becoming more politicised, with too much of the government's ego riding on pretending the plan is without blemish. Part of the problem is the role the plan played in winning the support of the country independents.

The independents and Greens are doing the government no favours in using their votes to allow the plan to escape scrutiny. Are they, too, afraid it wouldn't withstand scrutiny?

This is not to support the inane demands from the opposition and the media for the government to release its ''business case'' immediately rather than in a week or two's time. Mere impatience is no virtue in the eternal quest for good policy.

But by the same token, the government's implication that we can't delay the broadband rollout by pausing to check whether it's a good idea, or is being done as cost effectively as possible, is insupportable. If it's a flawed idea, better to know now rather than after the money's spent.

It's no doubt true the Liberals are being quite hypocritical in demanding the release of a government report when the Howard government refused to release so many reports, and in demanding a cost-benefit analysis when John Howard never bothered with them.

But such objections make sense only to those more interested in party-political point scoring than achieving good policy.

The case for a thorough cost-benefit analysis needs no stronger argument than that, at $43 billion, this is the most expensive piece of infrastructure this country has seen.

It's true the plan has a lot of attractions. Top of the list is the structural separation of Telstra's network from its retail business so its retail competitors get fair access to the network. This is something the Howard government should have seen to before it privatised Telstra.

I accept that, if city people are going to continue cross-subsidising the bush - as they will; it's clearly the electorate's ''revealed preference'' - there's no more sensible way to do it than ensuring the bush has access to high-quality telecommunications, thereby doing what we can to reduce the tyranny of distance.

I don't have an in-principle objection to a network with natural-monopoly characteristics being owned publicly rather than privately, provided governments don't use their powers to shore up or abuse that monopoly in a way any private owner would and should be prevented doing.

And I admire the government's consciousness of the need for us to be ready to adopt and exploit the opportunities for benefit that future technological advance will make possible.

The Productivity Commission could be required to ensure its cost-benefit analysis ranged far more widely than a mere commercial evaluation, taking account of present and potential ''social'' benefits (''positive externalities'') and acknowledging those whose value it can't quantify.

But there are three aspects of the plan that worry me. They're things economists are trained to see but to which non-economists are often oblivious.

The first is the mentality that says we've got a lot of messy and inadequate telecom arrangements at present, so let's scrap 'em all and start afresh. Copper wire to the home - make Telstra turn it off. Telstra and Optus's existing rival optical fibre-coaxial cables to many capital-city homes - close 'em down.

This Ruddish approach would be fine if resources were infinite, or if getting a brand spanking new broadband network was the Australian public's only desire.

But resources are finite, both sides of politics have sworn to eliminate all government debt and we have an infrastructure backlog as long as your arm. In two words: opportunity cost.

Second is the idea of building a gold-plated broadband network up to eight times faster than any present application needs, so we're ready for anything that may come along some time in the future.

If you think that shows vision and foresight, you're innocent of ''the time value of money''. Every dollar you spend now rather than later comes at an extra cost: the interest you have to pay between now and when you start using the idle capacity.

True, it's false economy to build something today without allowing for reasonable growth in your use of the item. But there comes a point where allowing for more growth than you're likely to see in ages becomes a waste of money.

Private businesses that do this - such as home owners who overcapitalise their properties - do their dough. Government businesses survive either by overcharging their customers or falling back on the taxpayer.

The final worry is the way that - notwithstanding the break-up of Telstra - the plan involves deliberately reducing competition from other networks in the telecommunications market. Why's that a good idea?

And why would the government plan to do it? Because it knows its network will be hugely over-engineered and the only way of charging consumers the high prices needed to recoup that excess cost is to turn broadband into a monopoly.

If Gillard had any sense of self-preservation she'd be using the Productivity Commission to get herself off a nasty hook.

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At your service, our economy's a work in progress

THE structure of our economy is set to change over the 2010s, creating winners and losers and plenty of complaints. So it's worth remembering the economy's structure has been changing continuously since the gold rush.

An article by Ellis Connolly and Christine Lewis of the Reserve Bank reminds us that, over the past 80 years or so, the economy has been transformed from one centred on the production of primary products to an urbanised economy mainly producing services.

In the 19th century, agriculture accounted for about a third of our total output of goods and services (gross domestic product), but from about the 1930s its share started declining and today is down to a mere 3 per cent.

Why? Well, not because we're producing less agricultural stuff. We're producing more than ever. No, it's just because other parts of the economy have grown a lot faster than agriculture, thus reducing its share of the total.

While we've been producing more rural stuff we've been doing it using progressively more machinery, with fewer, bigger farms to capture the machines' potential economies of scale. So agriculture has become steadily more "capital intensive", releasing workers, who've moved to the city.

As agriculture's share started to decline, the manufacturing industry's started to increase. At the beginning of last century it accounted for roughly 15 per cent of total output, but by the 1960s it had reached a peak of 25 per cent.

From that point its share began to decline, halving to about 12 per cent today, even though it too is producing more than ever. And it, too, has become more capital intensive and less labour-intensive over the years.

This brings us to the sector that was growing much faster than agriculture and manufacturing and thus reducing their shares of the economy: services. Even in the 19th century, service industries accounted for about half the economy. By the 1960s the services sector accounted for 60 per cent of output and today it's up to 80 per cent.

I have to say that, particularly among older Australians, the growing share of the services sector - something that's happened in every country - is a bit of a worry. Agriculture and manufacturing produce physical goods - goods that can be exported or used to replace imports. Can Australians really make a living performing services for each other?

Yes we can - and we do. Quite a good living. "Services" may sound ephemeral, even servile, but they're not. Do you regard the work of doctors, nurses, carpenters, plumbers, journalists and TV stars, truck drivers, bank managers, firemen, teachers, professors and prime ministers as insubstantial or inconsequential?

A lot of people aren't quite sure what "services" includes, so let me give you the list (deep breath): construction; distribution services and utilities (electricity, gas and water, wholesale and retail trade, transport, postal and warehousing, information media and telecommunications); business services (financial and insurance, rental, hiring and real estate, professional, scientific and technical, administrative); social services (public administration and safety, education and training, health care and social assistance); and personal services (accommodation and food, arts and recreation).

By their nature, service industries are generally labour-intensive rather than capital-intensive, meaning they account for a larger share of total employment - 85 per cent -

than of output.

All these are old trends. The big news is the mining industry's growing share of output: it has gone from 2 per cent in the 1960s to 8 per cent today. And since mining's share of business investment spending has shot up to 19 per cent, we can be sure its output share will go higher.

Mining is the ultimate capital-intensive industry, so its share of total employment is just 1 per cent. But if it creates so few jobs, what's the point of it? It earns lots of income, and when that income is spent, jobs are created. Where? Mainly in service industries.

Another thing that has changed with the structure of industry is the composition of our exports. In the 1960s, agriculture accounted for 62 per cent of total exports of goods and services. Today it's 18 per cent.

Then, mining's share was 15 per cent; today it's 42 per cent - meaning primary commodities account for 60 per cent of our exports. We're a commodity-exporting economy and there's no getting round it. Always have been; probably always will be.

Manufacturing's share of total exports has increased by 8 percentage points to 17 per cent and services' share has gone from 14 per cent to 23 per cent. What services do we send abroad? We don't, really. Foreigners come here to buy tourism and education.

Why does the structure of the economy keep evolving? Connolly and Lewis identify four main drivers. First is the rising demand for services. As our real incomes grow over time there's a limit to how much more we can eat, wear, drive and watch - our demand for goods, in other words.

But there's no limit on the services we demand. We're spending ever more on health, education, recreation and financial services. Since 1960, the proportion of consumer spending going on services has increased from 40 per cent to more than 60 per cent.

Second is the industrialisation of east Asia. Over the past 50 years, Asia has exploited its low cost of labour to become a big global producer and exporter of manufactures (with the main location of that production slowly migrating from Japan to South Korea and Taiwan to China, as labour costs have risen with economic success).

The Asians have needed primary commodities as raw materials for their manufacturing, and we've been nearby. Their "comparative advantage" and ours have been a great fit.

Third is economic reform.

Reductions in trade protection of manufacturing contributed to its declining share, whereas deregulation has help to increase the share of various service industries, particularly banking and finance.

The final driver of structural change is technological advance. Computerisation has made primary and secondary industries more capital-intensive while increasing the size of computer-related service industries.

Improvements in business practices (including just-in-time production and out-sourcing) have contributed to the service industries' rising share of total output and employment.

The main thing to remember is that 200 years of efforts to increase productivity by means of "labour-saving" technology haven't led to ever-rising unemployment, as people always fear it will.

That's because higher productivity leads to increased real income and as that income is spent new jobs are created elsewhere in the (services) economy.

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Others doing more than us to cut emissions

To adapt an old saying, bad news is halfway round the world before good news has got its boot on. The media love bad news because they know their customers find it more interesting. But when the news is mixed, ignoring the good bits can leave you with a false impression of reality.

You already know the latest bad news on action to limit climate change: the loss of a Democrat majority in the House of Representatives has obliged Barack

Obama to abandon his efforts to get an emissions trading scheme through Congress.

Many have taken this as further evidence - on top of our own Senate's refusal to pass a trading scheme and the failure of countries at the Copenhagen conference to agree to binding emissions-reduction targets - that action on global warming is getting ever less likely.

The sceptics keep pointing out that, since greenhouse gas emissions are a global problem, if all the major countries can't agree on action it's pointless for any individual country to bother doing anything. That's true even for the United States or China, let alone a small country like Australia, which is responsible for just 1.2 per cent of the world's emissions.

To this we get the familiar refrain from the small-minded: why should we be the first to do the right thing? Why not let someone else make the sacrifice this time?

So what's the good news? There's a weakness in the logic that, unless we all agree, it's not worth anyone doing anything. We don't actually have to reach an explicit agreement.

There's nothing to stop each of the major emitting countries from acting unilaterally in the hope that, this way, a tacit agreement to act could be formalised later. Perhaps this was always the smartest way to achieve an agreement.

Wishful thinking? Don't be so sure. Contrary to popular impression, Copenhagen wasn't a total failure. The countries did reach an accord and one thing they agreed on was to each submit a pledge of the targets they were prepared to agree to.

Dr Frank Jotzo, director of the Centre for Climate Economics and Policy at the Australian National University, has studied those pledges and been encouraged by what he found.

He looked at 13 major countries that between them account for about two-thirds of global emissions. Among the developed countries he took the US (accounting for 14 per cent of global emissions), the European Union (11 per cent), Russia (4 per cent), Japan (3 per cent), Canada (2 per cent) and Australia.

Among the developing countries he looked at China (15 per cent), Brazil (6 per cent), Indonesia (4 per cent), India (4 per cent) and Mexico, South Korea and South Africa (each with 1 per cent).

All the targets to which the countries committed themselves were for their emissions in 2020. On the face of it, they varied greatly. The developed countries pledged to reduce their emissions by some absolute amount relative to their emissions in an earlier base year, whether 1990, 2000 or 2005.

China and India pledged to reduce their "emissions intensity" by a certain percentage - that is, the amount of emissions per dollar of their gross domestic product. The other developing countries pledged to reduce their emissions by a certain percentage below what they would otherwise have been in 2020.

What Jotzo did was to put all the targets onto various comparable bases, using certain assumptions. When compared in terms of absolute reductions in emissions the pledges varied widely, with emissions by China and India continuing to grow - but reductions in all other countries, developed and developing, bar Russia.

When compared on the basis of emissions intensity, however, remarkable similar percentage reductions were pledged, with the developing countries targeting bigger reductions than the rich countries. China, for instance, is targeting a reduction of 40 to 45 per cent over 15 years.

And when compared on the basis of reductions from what emissions would otherwise have been, the targets reveal a similar degree of effort.

Because we haven't done much - and because Obama's promise to continue working to achieve emissions reductions by other means received little attention - we happily assume other countries haven't done much.

Not true - especially not for China. It is actively pursuing the target it reported to Copenhagen. It has ordered the shutdown of inefficient and high-emitting coal-fired power stations and their replacement with high-efficiency coal-fired generators. It has imposed energy performance standards for emissions-intensive industries and vehicle emission standards, is offering various incentives for clean energy and is spending bucketloads on developing renewable energy.

You can use trading schemes or a carbon tax to impose an explicit price on emissions of carbon dioxide. That's the best way to do it. But government subsidies and other measures can do the same thing indirectly.

A study sponsored by Australia's Climate Institute has sought to measure the implicit carbon price in various countries. It's $29 a tonne in Britain because its participation in the European trading scheme is backed up by various domestic measures.

It's $14 a tonne in China thanks to the measures I've mentioned and it's even $5 a tonne in the US because of federal subsidies to clean energy sources and state renewable energy targets.

And what do our bits and pieces add up to? A princely $1.70 a tonne.

Two conclusions. All the key countries - even the US - have pledged their willingness to take significant action and some, including the biggest single emitter, China, are getting on with it. As other countries see this, they'll become more active themselves.

Far from being the country that's leading the way and making sacrifices while others hang back and marvel at our naivety, Australia - a country with more to lose than most - is dragging the chain.

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Canberra's delusion: the budget is the economy

Notice anything strange about the release of the midyear budget update last week? Just about all the talking was done by politicians and political commentators, not economists and economic commentators.

Why? Because from an economic perspective the update isn't such a big deal. It is just a six-monthly update. Treasury revises its economic forecasts, but the changes usually aren't big and they're always old news because they're never very different from the Reserve Bank's forecasts, which are revised quarterly.

The revisions to the budget estimates cover the present financial year plus the next three years, but no one with any sense takes much notice of the last three. Why not? Because, with forecasting being so inaccurate, how could you take seriously mechanical "projections" about the state of the economy and the budget balance up to 3 years hence?

But if the update is of little economic significance, why did the political types get so excited? Although the midyear update is rarely used to announce new measures, this one was sharply criticised for its failure to include "deeper cuts to government spending".

So why? At the most obvious level, because some bright spark in the government had told the press gallery to expect such cuts. Robbed of this much bigger story, the media wrote it up as yet another failure of will from a weak government, whereas spin doctor incompetence is a more likely explanation.

But I think the explanation runs deeper. The denizens of the House with a Flag on Top have never really accepted that, at least since the the Reserve was made independent in the 1990s, the macro economy is no longer managed from Canberra.

Monetary policy - the manipulation of interest rates - has long been the main instrument for the management of demand, with the budget playing a much lesser role. It does get wheeled out to stimulate the economy during recessions but is then reeled back in during the recovery.

The main responsibility of the elected government and its Treasury is for micro-economic policy: combating climate change, water policy, education and training, tax reform, making particular markets more competitive and much else.

It's a vitally important role - carrying more than enough challenge for the Rudd/Gillard government to cope with - but still everyone in Canberra yearns to be back in the centre of the daily macro-management limelight.

The treasurer and Treasury want to be seen at the economy's helm. The press gallery wants in on the always prominent economy story. And there's no joy for the opposition in criticising the Reserve governor; it wants to blame every economic problem on the government.

So how does Canberra cope with its relevance deprivation syndrome? By exaggerating the economic significance of the budget. This is apparent when you see non-economists referring to the budget balance as "the economy's deficit". Whoops.

Essential to exaggerating the significance of the budget is exaggerating its relevance to the Reserve Bank's decisions about interest rates.

Since movements in the budget balance are one of many factors affecting the strength of demand, and since the strength of demand is the main factor influencing the Reserve's decisions about rates, there is a link between the two but it's much weaker and more attenuated than many in the political debate imagine.

For the opposition to blame every rate rise on the government rather than the unelected Reserve, it has to demonise rate rises as unnatural and excruciating, ignoring the millions of Australians who benefit from higher rates.

It also has to pretend that the multibillion-dollar-a-year cuts in government spending required to be sure of removing the need for just one 0.25 percentage-point rate rise could be easily and painlessly achieved, with no adverse economic consequences.

The other truth the fuss over the midyear update demonstrates is the full extent to which the government has lost control of the economic debate. Its success in limiting the effect of the global recession is the envy of governments around the world, yet the opposition has succeeded in portraying its performance as disastrous.

Even the press gallery is buying the Libs' propaganda about excessive, wasteful spending and the need for swingeing spending cuts to get the budget back on the rails. Nonsense. The real story is how amazingly responsible the government's been.

Every government spends big during recessions, but this is the first to force itself to make every spending measure temporary. In consequence, its task in returning the budget to surplus is much easier than in past recoveries. For instance, real government spending is set to fall by 1.1 per cent next financial year as the stimulus spending ends.

From the start, the government adopted a "deficit exit strategy" to bank all revenue growth and limit real spending growth to 2 per cent a year until the budget was back in surplus. No government has ever voluntarily donned such a chastity belt.

Yet it tightened the belt in last year's budget. And in the election campaign raised the status of the return to surplus in 2012-13 from a projection to a promise.

There's no reason to doubt Julia Gillard's resolve to keep that promise.

It requires a turnaround in the budget balance over three years of 4.5 per cent of gross domestic product - equivalent to about $63 billion a year - "the fastest budget turnaround on record". D'ya reckon that might have a helpful effect on interest rates?

And yet the political cognoscenti have been convinced the government is a profligate spender that isn't really trying to pull in its belt and is leaving home buyers to be tortured by central bankers.

It's not policy that's the problem, it's Labor's amateurish exposition of that policy.

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How economists forgot much of what they knew

When I started as an economics writer in the mid-1970s, the Keynesian ideas that had guided macro-economic policy through the postwar Golden Age were judged a failure and economics was in crisis.

But now, as Professor John Quiggin of the University of Queensland reminds us in his new book, Zombie Economics, the global financial crisis and the Great Recession have revealed the ideas that replaced simple Keynesianism as failures that plunged economics back into crisis.

The end of the Golden Age and the loss of faith in Keynesianism were brought about by the advent of "stagflation" - high inflation despite a stagnant economy. Keynesian theory said you could have high unemployment or high inflation but not at the same time. It could fix one or the other but not both together.

There aren't many new ideas in economics, just old ideas tarted up. Keynes's ideas were new, however. The "neo-classical" orthodoxy of his day said recessions couldn't happen, so it couldn't explain the Great Depression of the 1930s and had no policies to end it.

Keynes identified various market "imperfections" that explained the economy's malfunctioning and advocated government spending to stimulate the economy and get it growing again. When economists lost faith in Keynesianism they turned back to the discredited neo-classical orthodoxy. Milton Friedman's "monetarism", for instance, was based on the old "quantity theory of money".

Government policymakers soon gave up on monetarism's targeting of growth in the supply of money - it didn't work - but a lasting consequence of that episode was to switch the primacy in macro-management from fiscal policy (the budget) to monetary policy (interest rates).

Keynesianism was criticised because its approach at the macro (top-down) level didn't fit with the bottom-up approach of micro-economics. Its conclusions about how the whole economy worked didn't fit with the standard conclusions about how individual markets worked.

Building models of the macro economy based on neo-classical micro-economic foundations had various attractions. Giving up Keynesianism's more realistic assumptions about how the world worked made the models more rigorously logical and amenable to mathematics.

Assuming everyone was rational and in possession of perfect information got economics back to its libertarian roots, creating a presumption against government intervention in markets and favouring small government and lower taxes.

One development on the old neo-classical foundation was the "efficient market hypothesis", which Quiggin says is the central theoretical doctrine of the "market liberalism" that replaced Keynesianism.

It says financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production. And coming after the collapse of the Keynesian Bretton Woods system of fixed exchange rates, it provided a rationale for the era of finance-driven capitalism that's ended so badly.

In its "weak form", the hypothesis says movements in the prices of assets such as shares can't be predicted from their past movements as claimed by "technical analysts". Like a drunk, share prices move in a "random walk" in reaction to whatever good or bad news next comes along.

In its "strong form", the hypothesis says the market price of an asset is the best possible estimate of its value, incorporating all the available information.

If this is true, bubbles can't develop in asset markets, causing them to crash when finally the bubble bursts.

You can see how this faith - an amazing triumph of hope over centuries of experience - encouraged the excessive deregulation of banks and the financial system, which had formerly been heavily regulated in response to the banks' key role in the Depression.

At the level of macro-economic theory, monetarism was soon superseded by "new classical" economics, incorporating mathematically (and ideologically) convenient propositions such as "rational expectations" and "Ricardian equivalence".

Rational expectations assumes people's expectations about future events will always be right; everyone has the same views about how the economy works as the economics professors who built the model.

Ricardian equivalence - named after David Ricardo, the classical economist who first thought of the idea, then dismissed it - assumes that when governments engage in deficit spending during recessions this has no stimulatory effect on the economy because everyone knows taxes will eventually have to rise to pay off the debt, so they start saving.

Between them, these ideas rendered ineffective government efforts to manage the macro economy. In practice, the academics were less damning of monetary policy. Predictably, new classical economics was never popular with politicians and treasuries, but it fed the general mood that the less governments intervened in the economy the better.

These "new classical" academics developed "real business cycle" theory to explain why economies move in cycles of boom and bust, even though simple neo-classical theory says they don't and many conservative economists had argued that all unemployment was voluntary. Under this theory all fluctuations in economic activity are caused by "exogenous shocks" (developments outside the economic system) such as changes in technology, the terms of trade or workers' preferences for leisure.

Eventually academics - including those in the "new Keynesian" school, which retained remnants of the old Keynesianism - coalesced around the "dynamic stochastic general equilibrium" model. This did allow for the possibility that wages and prices might be slow to adjust, and for imbalances between supply and demand, but moved the model only a short way towards the real world.

The fact that, following the malfunctioning of the 1970s, the main economies seemed to settle down after 1985 - with inflation back under control and unemployment lower - led many economists to conclude this Great Moderation proved economics was now on the right track and the business cycle had been tamed.

Famous last words. The US housing boom proved to be a giant bubble that eventually burst, we realised what crazy games the global financial markets had been playing, the sharemarket crashed, the banking system tottered on its foundations and the developed world entered by far the worst recession since the Depression, which looks likely to linger for the rest of the decade.

And the people whose unrealistic theories helped to bring the calamity about had no idea it was coming because they were playing "rigorous" mathematical games at the time.

I haven't done justice to Quiggin's book, so if you're interested in a readable exposition of the exploits of academic economists over the past 35 years I recommend it highly. It's the story of how economists forgot much of what they knew. Please, guys, don't do that again.

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WHERE TO FROM HERE FOR THE AUSTRALIAN ECONOMY & GOVERNMENT

Talk to Watermark’s CEO lunch, Sydney
November 10, 2010

The immediate outlook for our economy is for strengthening growth. Our economy’s trend or ‘potential’ rate of growth is about 3.25 per cent a year, but the Reserve Bank is forecasting growth of 3.5 per cent this calendar year, rising to 3.75 per cent next year and 4 per cent in 2012. At present most of the growth is coming from the high prices we’re receiving for our exports of coal and iron ore. Australia’s terms of trade are the best they’ve been at least since Federation, excluding the two-quarter spike in wool prices during the Korean war. Those high prices are likely to fall back somewhat over the next year or two, but by then the stimulus to growth is likely to be coming from an unprecedented program of investment in mining and natural gas production capacity.

If you find it hard to believe the economy is travelling so well it’s probably because some parts of the economy aren’t doing all that well. Retailing is doing it tough because, though households have growing incomes, they’re saving a higher proportion of that income and tending to pay down their debts rather than add to them. This position probably won’t last long, but the longer it does the better. Why would I say that? Because the looming massive boom in business investment - mainly mining investment - will be more than enough to keep the economy growing strongly, and if we add a consumption boom on the top of that the Reserve Bank will have no choice but to limit inflation pressure by pushing interest rates up even further than it would already have had to.

If you’re still not convinced the economy is travelling so well at present you have to explain why the labour market is so strong. Employment grew by almost 340,000 over the year to September - up more than 3 per cent - and unemployment is down to 5.1 per cent. Even in what many regard as the basket-case economy of NSW, employment has grown by 2.5 per cent and the unemployment rate is down to 5.2 per cent.

That last comparison leads me to the next point I want to make: don’t overdo the two-speed economy stuff. It is true the resources boom is concentrated in Queensland and Western Australia, but the links between the state economies are strong and income flows very readily across state borders. The federal government’s taxing and spending helps to bring that about, as does the way the Grants Commission divides up the GST revenue between the states. But the states also trade with each other so money that’s earned in one state often gets spent in another. Another point to note is that Queensland’s economy isn’t travelling all that well at present, mainly because its tourist industry has been hard hit by the high dollar.

But the main thing I want to say is this: although the major developed economies are likely to experience very weak growth over the rest of the decade, we look like having a decade-long mining investment boom. It’s possible, of course, that the Chinese economy could fall over and leave us in the lurch, but I don’t think it’s very likely. I’ll worry about that if it happens. So, on the face of it, we look like having a great time while most of our rich mates do it tough. But here’s the trick: for a lot of people - a lot of industries - the great boom of the 2010s isn’t likely to be much fun. Why not? Because we’re re-entering the resources boom with the economy already close to full capacity, which means the Reserve will be eternally worried about inflation and will never have its hand far from the interest rate lever. Economists regard full employment as an unemployment rate of about 4.75 per cent. If it goes much lower than that you get growing shortages of skilled labour and upward pressure on wages, which flows through to the prices of goods and services. Just last week the Reserve made the first 0.25 percentage-point move from a neutral stance of monetary policy to a restrictive stance. It has a long way further to go as it seeks to keep inflation within it 2 to 3 per cent target range over the rest of the decade.

The high interest rates are likely to be accompanied by a high exchange rate. It will be high not so much because interest rates are high as because export prices are high, because money is pouring into Australia to finance the mining investment boom and because the prospects for our economy will be so much more attractive than for the other developed economies.

This high exchange rate means our non-mining export and import-competing industries - farming, manufacturing, tourism and education - are likely to be continuously under the gun. Life’s going to be very tough for them for a protracted period. There won’t be a lot governments can do to ease the pressure on them, and there won’t be a lot their econocrats want them to do. There is some scope for big increases in the budget surplus to limit the upward pressure on interest rates, but this is easily exaggerated. From an economist’s perspective, the pressure the high exchange rate imposes on the non-mining tradeables industries isn’t a bad thing, it’s a good thing. It’s part of the way a floating exchange rate helps to limit inflation during a protracted resources boom. With the economy already at full employment, the problem is finding the additional labour and capital needed by the expanding resources sector. But the high exchange rate causes the non-mining tradeables industries to contract, thus releasing resources to flow to the resources sector. Immigration is another source of skilled labour, of course.

The other way to think of it is that we’re likely to be entering a protracted period of a perpetually tight labour market. Combine the long boom with the ageing of the population and employers will really know they’re alive. It will be a period where they’re always on the lookout for more skilled staff, where they’re trying to accommodate baby boomers rather than have them retire and trying to encourage staff loyalty. Those with more sense will be focusing on training and internal promotion rather than poaching the staff of other firms.

Turning to the political outlook, the dust is settling after the extraordinary events of this year and a few things are becoming clearer. First point is to abandon any expectation that the minority Gillard government could fall at any moment. The independents whose votes would be needed to bring about the government’s defeat have as great a motive for not doing that as the government has for wanting to survive. In any case, we’ve had plenty of experience of minority governments at the state level and we know they tend to be long-lasting. Similarly, I wouldn’t assume that, just because the Libs came so close to winning this time, they’re dead set to win the next election whenever it’s held. If Gillard survives for the best part of three years it’s anyone’s guess as to the relative standing of the two parties at that time. Gillard may have found respect and affection in the heart of the electorate by then - she’ll certainly be trying to - or Abbott may have revealed the more erratic and manic side of his character that led so many people to write him off. Three years of unrelenting opposition to everything - punch, punch, punch - could wear very thin with an electorate that gets terribly tired of seeing politicians perpetually arguing with each other. Or Abbott may grow in stature in the job, as may Gillard. The big question is whether Gillard has a learning curve. I think Rudd had no such learning curve, but there’s little doubt this Labor government has a lot to learn about governing. Labor has proved to be remarkably amateurish, even in the matter of political spin. It thought the game was about spin; it turned out to be about communicating to the electorate your vision, determination, diligence and competence.

In contrast to Rudd - and notwithstanding pink batts and the BER - Gillard is a highly competent administrator, she listens, consults and carries people with her - her own side, the bureaucrats and even the interest groups. She’s a highly experienced and skilful negotiator. What she’s not is a person of great conviction and charisma. With the retirement of Lindsay Tanner, this government is down to just one economic rationalist, Craig Emerson - that is, just one person with a deep understanding of how markets work and a commitment to making them work well. The rest of the government just pretends to be rational reformers because they feel that, politically, they have no choice. Labor has an inferiority complex in the area of budgeting, and is very conscious of the fact that it continues in office with the consent of business - particularly big business; it is constantly seeking the approval of business and is wary of doing anything that might seriously annoy business.

Many people have been expecting this minority government to be a weak government: a government that doesn’t have much direction and doesn’t get much done because it can’t get the numbers on anything. Maybe a government that’s obliged to do stupid, wasteful things to keep in with the motley collection of independents on whose support it depends. We haven’t seen much sign of this yet - perhaps it’s too early - and I’m not sure this will end up being a major issue. From my perspective, this is likely to be a weak government more because it doesn’t believe in anything much and its lack of conviction robs it of the courage to do anything very unpopular.

In a speech she gave last night, Gillard spelt out her core beliefs - the things that drive her politically: hard work, education, respect. Hard work means being self-reliant. Education as the main way people get a chance to better themselves. Respect - some people aren’t better than others because of their title, occupation or background.

She also spelt out her government’s vision for Australia: a strong economy, and opportunity for all. More jobs, more opportunity, better life chances. For all, not some.

Finally, she left us with a clear idea of her agenda: a price on carbon, a decision on water and getting the budget back into surplus by 2012-13. No doubt you could add pressing on with the NBN, bedding down the mining tax, finding a regional solution to asylum seekers and a few other things - but an old agenda (no addition of major new items) and a modest agenda, one with about as much challenge as she feels able to cope with.

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Demand a better deal and stop moaning about banks

Forgive me if I'm less than impressed by the tirade of righteous indignation being unleashed against the banks. It's self-serving, selective and uninformed.

I guess when you get angry you forget to check things out and think them through. The media and the politicians on both sides are whipping up indignation, rather than conveying information and fostering understanding.

Much of the indignation has assumed that if the Commonwealth Bank has raised its mortgage interest rate by 0.2 percentage points more than the 0.25 percentage-point increase in the official interest rate, the other three big banks are sure to follow suit.

But so far they haven't. And I think it's unlikely they will. My bet is that some will raise their rates by more than the official increase, but by less than the Commonwealth. And at least one of them won't exceed the official increase. If that bank is National Australia Bank, its rate will be 0.32 percentage points lower than the Commonwealth's.

If I'm on the right track, the oft-repeated claim that there's no competition between the banks will be seen as false.

But let's say I'm quite wrong and all the banks do as the cynics expect and follow the Commonwealth's lead in raising their mortgage rates by almost double the official increase. In that event home buyers won't end up being any worse off.

Why not? Because the Reserve Bank has left little doubt it expects to announce further rate rises in the months ahead. With the economy back in a resources boom, it will be raising rates to discourage borrowing and spending and thus limit inflation pressure.

And here's the trick none of the rabble-rousers bothered to tell the punters: the Reserve long ago made it clear that the interest rates it cares about are those actually paid by households and businesses, not its own official rate. So if the banks get ahead of the game and raise their rates by twice the increase in the official rate, that just means we'll end up with one less increase in the official rate than we would have. It will all come out in the wash.

Another unwarranted assumption by the indignation merchants is that all of us are borrowers from the banks and none of us are lenders to the banks. Nonsense. Many people - including those in or approaching retirement, those who rent and those saving for a home deposit - have savings deposited with banks.

And those people have benefited from the same process people with home loans have been complaining about. The banks have justified their various rate rises in excess of official increases by saying the cost to them of the funds they borrow for lending to home buyers and businesses has risen by more than the increase in the official rate. This isn't always true, but it does contain a significant element of truth. And one respect in which it's true is that the banks are now paying much higher interest rates on deposits, particularly term deposits.

Before the global financial crisis, the rates the banks paid on term deposits were below the official interest rate. Now, however, they're well above it. Although the official rate is now 4.75 per cent, it's easy to get better than 6 per cent on a six-month deposit.

(And don't forget that every home buyer with money parked in a "redraw" account is a lender as well as a borrower. Most of these people would, in effect, be earning an interest rate on their savings equal to the rate they pay on their loan.)

In the aftermath of the crisis, the banks decided they'd be better off getting more of their funds from retail depositors and less from wholesale money markets here and overseas. But as they battled for more deposits, they bid up the rates on those deposits to unheard of levels - further proof that competition between the big four isn't dead.

Another sign of competition between the banks that the rabble-rousers haven't seen fit to remind us of is the way NAB has led the way in cutting its fees and charges, including unreasonable charges on credit cards.

Everyone imagines the greedy banks love picking on helpless home buyers when they're trying to protect their profit margins by passing on their higher costs of borrowing. Don't kid yourself. They hate it because they know home buyers are protected by the fuss-making media and politicians.

So what do they do? They push more of their higher costs off onto business - particularly small business - and less onto home buyers. This gives them less grief from the noise-makers while imposing a hidden cost on the economy's ability to create jobs.

We're suckers for illusions.

The media always quote the banks' announced "indicator" rates on home loans. Before the latest rise in the official rate, the average indicator for standard variable mortgages from banks was 7.4 per cent. But whereas small businesses often pay more than their indicator rate, home buyers usually pay less. The actual rate paid by people with mortgages averaged 6.75 per cent - a discount of 0.65 percentage points.

Why do bank managers charge less than the announced price? Because they're afraid of losing business to their competitors. But guess what? The biggest discounts go to those who bargain - those who look around at what others are offering and threaten to move unless their existing lender offers a better deal.

The trouble with all the media and political fuss about rates is it reinforces the impression "competition" is something the banks - or the government - should deliver to us on a plate.

Sorry, whingeing lazybones, markets don't work like that. Those who say competition between the banks is inadequate are right. But they should be looking in the mirror as they say it.

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Labor's bluff called on bank competition

There are no good guys in the fuss over "unofficial" rises in mortgage interest rates. Each of the players is on the make: the greedy banks, the self-pitying punters, the commercially driven media and the insincere pollies.

The banks have happily used the global financial crisis to gain advantage over their non-bank competitors and enhance their pricing power - though we've yet to discover the extent to which the big four exploit that power in this episode.

It is, of course, "rational" for the banks to want to stamp out competition and to exploit whatever special advantages they gain from the government's need to protect the public from instability in the banking system. But that doesn't mean we have to condone or put up with such behaviour.

The media, as usual, are bringing far more heat than light to the affair. They're playing it for all it's worth, fanning the punters' uncomprehending self-pity for commercial advantage without any real desire to help them understand the wider issues or even help them deal with their problem.

And it's hard to feel any sympathy for Wayne Swan and the Rudd/Gillard government. It's been facing the issue of unofficial rate rises virtually since its election in November 2007, but it still hasn't reached an effective strategy for dealing with it.

Throughout its life the government has exhibited three related deficiencies: a lack of values, a lack of courage and a lack of skill in managing its relations with the electorate.

Labor's approach to unofficial rate rises - like its approach to executive salaries and "the cost of living" - has been dominated by focus group-driven insincerity. There's been a lot of "I feel your pain" and "I share your outrage" rhetoric without any great intention to take effective action.

What Labor has yet to realise is that this is a good tactic for oppositions - just ask Joe Hockey - but a bad one for governments. Pretty soon the punters say the obvious: if you're so concerned, what are you doing about it? When you've been in power for three years, they say what have you done about it?

Answer: nothing that's made any difference. There are two reasons for the lack of effective action on unofficial rate rises (and executive pay and the cost of living): you don't want to do the obvious and intervene directly because you know the side-effects might be worse than the decease, and you lack the courage to do anything - sensible or otherwise - that might annoy powerful interests involved.

A big part of Labor amateurism in media management - spin, if you like - is the way so much of what it says in the media is directed at attacking the opposition. A more experienced leadership would understand that the best way to neutralise your opponents is to ignore them.

The government's unceasing response to whatever the opposition is saying gives those opinions legitimacy and more media attention than they'd otherwise get. When Swan and Julia Gillard falsely accuse the Libs of wanting to re-regulate interest rates and refix the exchange rate, they richly deserve what they've ended up with: Hockey looking like the only person with a sensible policy.

Arguing the toss with the opposition not only fails to convince the punters, it also crowds out what the government should be doing: educating the public on the complexities of the issue and on individuals' responsibility for fixing their own problems (as does all the fake I-feel-your-pain/outrage rhetoric).

All this reinforces the mistaken notion that every problem can be and should be solved by the government. At least Penny Wong has had the gumption to tell whingeing punters they should bargain with their bank manager.

One small problem with the I-share-your-outrage approach is that, thanks to the global financial crisis, at various points the banks have been justified in varying their mortgage rates differently from the official interest rate.

So the government's been right to focus its policy response on acting to enhance competition between the banks by reducing the barriers facing people wanting to move their deposit accounts or mortgages.

The problem has been the utter ineffectiveness of these efforts to date, which demonstrates the government's insincerity, its lack of genuine belief in market forces and its fear of offending the powerful banking interests.

If Labor was genuine in its economic rationalism - instead of just pretending because it's a politically convenient position for a supposedly left-of-centre government - it would have the courage to make pro-competitive interventions despite the banks' objections.

That's what we need: imposition of measures - maybe portable bank account numbers - to facilitate account-switching and legislative restrictions on unreasonable exit fees, an end to St George-like takeovers, proper pricing of government guarantees and probably restrictions on the banks' overseas adventurism (which has almost always ended in tears).

If Labor really understood and believed in market forces, it would understand that banking is (necessarily) far from a free market and that the government's extensive protection of the banks both justifies and necessitates carefully considered countervailing interventions to enhance competition and also limit the banks' moral-hazard temptation to have Australian taxpayers indirectly underwrite their foreign adventures.

After years of Labor faking it, the punters and the rabid end of the media have called its bluff: do something effective to curb the banks' market power or be judged a waste of space. We'll see if it can summon the courage.

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