All work creates wealth

You'll find this hard to believe but not every reader of my columns agrees with everything I write. And when I wrote recently that jobs lost in manufacturing would be offset by jobs gained in other parts of the economy, one reader emailed to say he could see a gaping hole in my argument.

My point was that the high dollar wouldn't destroy jobs so much as "displace" them: shift them from contracting industries to expanding industries.

This would happen because the high dollar was the market economy's way of helping us restructure our economy to take full advantage of the marked and long-lasting change in what the rest of the world wants to buy from us at higher prices (primary commodities) and sell to us at lower prices (manufactures and tradeable services such as tourism).

So employment would fall in manufacturing and tourism but would increase in mining and construction, as well as in the services sector.

(This is not to imply that all the workers losing their jobs in manufacturing would move simply and easily to jobs in the expanding industries. Some may encounter difficulty making the switch, which is why governments should help them retrain and relocate. Some older workers will never make the transition. And some of the new jobs will go to people from outside manufacturing.)

People are often vague about which industries are included in the services sector, so I offered some examples of those likely to expand: "health, education and training, public administration, the science professions and arts and recreation".

Ah, said my reader, gotcha. "Surely the funding for many of the job types identified comes from the public purse, that money being generated by taxes on employees, companies, profits from investment in local manufacturing and [from] the businesses, secondary and tertiary, generated from manufacturing," he wrote.

"Where is your viable break-even point here between job creation and taxes/wealth creation sufficient to create those [public sector] jobs?"

See his argument? You have manufacturing and the rest of the private sector it supports, which creates the wealth and the jobs and pays the taxes governments use to finance all their activities, creating public sector jobs in the process.

If you allow the manufacturing sector to contract, you erode the economy's wealth- and job-creating capacity, thus reducing the tax governments are able to collect and use to create jobs in the public sector.

So there must be some point below which you can't allow the private sector to fall, otherwise you also destroy jobs in the public sector.

Convinced? I'm not. The reader's riposte is built on two related misconceptions.

One is that the private sector is productive - it generates the wealth and creates the jobs - whereas the public sector is essentially parasitic: it appropriates some of the private sector-created wealth via taxation and redistributes it to presumably worthy causes, employing public servants in the process.

Sorry, not true. What is this "wealth" that's being created? It's more accurately described as income: the income that's generated when employers and employees produce all the goods and services that make up the nation's gross domestic product.

So "wealth" is generated when people go to work and their employer provides them with the equipment and direction to do what they do. The workers receive income in return for their work. They pay some of that income in direct and indirect taxes but most of the rest they spend on the goods and services they need, which generates continuing demand for all the stuff that they and other workers have produced.

If you think this description of the economy is circular, you're right: supply (production) creates demand (spending) and demand leads to supply. Point is, there's no important distinction between goods and services produced in the private sector and those produced in the public sector. Nor between goods and services paid for in the marketplace and those paid for via taxation.

To imagine otherwise is to imply that someone working on a production line producing cans of beans is productive (generating "wealth") but doctors and nurses who fix broken legs and save lives, or people who teach our children to read and write, are unproductive (generating no wealth).

Many doctors are self-employed and there are plenty of private hospitals; many teachers work for non-government schools. We're being asked to believe that those in the private sector are productive wealth-generators but those in the public sector are unproductive wealth-appropriators.

We could, if we wished, leave the whole of healthcare and education to the private sector. Would that make the economy vastly more productive? Hardly. (What it would mean is a lot of people being unable to afford education or healthcare.)

The reader's argument also implies that only people working in the private sector pay tax and contribute to the cost of publicly-provided goods and services. Rubbish. Everyone who works is productive and everyone who earns and spends income pays taxes, regardless of their sector.

The second misconception is that economies are built like the pharaohs built the pyramids: one level on top of another. You start with a base of primary industry (farming and mining), then put secondary industry (manufacturing) on top of that and tertiary industry (services) on top of that.

Take away one of the lower building blocks and you lose the basis on which to build the levels above it. If you had no manufacturing sector, for instance, how could you have a services sector?

If you were building a closed economy - one that didn't trade with other economies - that's the way you'd do it. But, like all economies, we have considerable trade with other countries. Why? Because it makes us wealthier.

We specialise in producing things we're relatively good at, they specialise in producing what they're relatively good at, and we trade. That leaves both sides better off and means you don't have to do everything to have a viable economy. Indeed, the more you insist on doing things you're not good at, the more you forgo wealth.

These days, the rich countries of Europe have little mining and waste taxes propping up their inefficient farmers when they could buy from us more cheaply. Our natural endowment (plus 200 years of experience) makes us highly-efficient producers of rural and mineral commodities, which are now in great demand as poor countries develop. The workforces in the rich countries are too highly skilled and expensive for them to be used to make things in factories, so manufacturing in these countries is shifting to Asia.

So where are the jobs being created in the rich economies? In the services sector. The range of simple to sophisticated services we can perform for other people in our country - or for foreigners - is infinite.

And everyone with a job that involves "doing things" is generating wealth.

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Education is mainly about teachers

Thank goodness for that. David Gonski and his committee have produced a comprehensive review of school funding without setting off a bitter debate between the proponents of government and non-government schools.

They've done it by focusing not on how the lolly is divided between the rival systems but on the needs of students, with greater funding to be shifted over time to those suffering disadvantage.

Their report has been warmly welcomed by most groups, though not so their request for governments to spend an extra $5 billion a year. And just how willing the states will be to rejig their spending according to the committee's recommendations remains to be seen.

Some have suggested the report, worthy though it is, will be quietly pigeonholed, but I'm not so pessimistic. Just as Ken Henry produced his report on tax reform not for immediate implementation but to provide a road map for change over the coming decades, so the Gonski report will provide a guide to policy-makers on the right - and wrong - direction in which to head.

And now we have that guide to how the funds should be directed, perhaps we can move on to the question of what we most need to do to improve the performance of our schools.

Have you noticed how often our furious debates about education and health are debates about how they should be funded rather than what we should be doing with the money? We seem to be extraordinarily preoccupied with who gets what rather than what they do with it.

Why this obsession with money? Partly because allocating funds is the main thing the federal government does. While the states run the schools and the hospitals, it's the feds who raise most of the tax revenue and decide how it's divided.

But also because all the interest groups involved - the doctors, teachers, health funds and private schools, not to mention the premiers - have an obvious motive to push for a bigger slice. These contesting groups use the media to enlist the support of the electorate, and you and I end up arguing endlessly about funding rather than the substance of education and health.

One attraction of the study that Dr Ben Jensen has been doing on education for the Grattan Institute is its focus on what we could be doing better.

As measured by the Organisation for Economic Co-operation and Development's regular testing of the performance of 15-year-olds at reading, maths and science under its program for international student assessment (PISA), Australia is doing well. We don't do as well as Finland and Japan, but we're consistently better than the Americans, British, Germans and French and about the same as the Canadians.

As more Asian countries are added to the comparisons, however, we're slipping down the rankings. We also have a worryingly wide gap between the performance of our best and poorest students.

So we shouldn't be resting on our laurels. What can we do to improve our schools' performance? Well, it's not simply a matter of spending more money.

Jensen says most studies show more effective teachers are the key to producing higher performing students. "Conservative estimates suggest that students with a highly effective teacher learn twice as much as students with a less effective teacher," he says.

"Teachers are the most important resource in Australian schools. Differences in teacher effectiveness account for a large proportion of differences in student outcomes - far larger than differences between schools. In fact, outside of family background, teacher effectiveness is the largest factor influencing student outcomes."

Jensen says there are five main mechanisms to improve teacher effectiveness: improving the quality of applicants to the teaching profession; improving the quality of teachers' initial education and training; appraising and providing feedback to improve teachers once they're working in the profession; recognising and rewarding effective teachers; and moving on ineffective teachers who've been unable to increase their effectiveness through improvement programs.

His greatest interest is in appraisal and feedback. "Systems of teacher appraisal and feedback that are directly linked to improved student performance can increase teacher effectiveness by as much as 20 to 30 per cent," he says. Such an improvement would lift the performance of Australia's students to the best in the world.

Jensen says our present systems of teacher appraisal and feedback are broken. This is not to attack teachers, which would be both unfair and counterproductive. On the contrary, it acknowledges the central importance of the work of individual teachers and argues we should be investing in their greater effectiveness.

Indeed, no one understands the inadequacy of the present arrangements better than teachers themselves. A survey finds 63 per cent of them say appraisals of their work are done purely to meet administrative requirements. More than 90 per cent say the best teachers don't receive the most recognition and reward, and 71 per cent say poor-performing teachers in their school won't be dismissed.

"Instead, assessment and feedback are largely tick-a-box exercises not linked to better classroom teaching, teacher development or improved student results," Jensen says.

He proposes a new system of teacher appraisal and feedback that avoids a centralised approach. "Instead, schools should have the responsibility and autonomy to appraise and provide feedback to their own teachers."

Appraisal should be based on a "balanced scorecard" that recognises all aspects of a teacher's role. It thus shouldn't rely solely on students' performance in national competency tests but should include such things as teachers observing and learning from other teachers, direct observation in the classroom by more experienced teachers, and surveys of students and parents.

Such an approach would require a culture change in many schools, but it offers huge benefits for relatively little cost.

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How manufacturing will survive the high dollar

Beware of dire predictions that manufacturers will be wiped out by the strong dollar unless they're propped up by the government. All our experience says it won't happen.

Manufacturers and their (highly vociferous) unions gave us the same warning in the 1980s when the Hawke-Keating government decided to take away their protection from imports. It didn't happen - the industry adapted, and survived to complain another day.

Though manufacturing's share of the nation's total output (gross domestic product) and total employment has been declining for the best part of 40 years, little of this is due to the removal of protection.

Most is explained by the services sector growing at a faster rate than manufacturing grew. On the employment side, it's also explained by computerisation and other technological advances raising the productivity of labour in manufacturing, so that the same quantity of output could be produced using fewer workers. (Agriculture and mining have the same characteristic, in contrast to the labour-intensive services sector.)

So it's only in recent years that the absolute quantity of Australia's manufacturing production has begun to decline. Manufacturing survived the removal of protection by rationalising its production, becoming leaner and fitter.

And probably by hastening its introduction of the latest labour-saving technology. When employers get their unions to pressure Labor governments to provide protection (or, these days, direct government grants), the workers imagine they're protecting jobs.

In truth, all they can protect is profits. That's certainly the history of what happened in manufacturing during protection's last hurrah in the decade before 1987.

One way manufacturing responded to the removal of protection was by getting into the business of export. That was utterly contrary to the prediction that without protection against imports it would cease to exist.

When vested interests make such claims they're playing on the public's lack of knowledge of economic history, lack of imagination and lack feel for how market forces work.

In a market economy, nothing stays static. Industries could just sit there doing nothing until their last customer leaves, but they don't. They take evasive action. They cut their coat according to their cloth. More formally, they adapt to their changed economic environment.

Individual firms may bite the dust, but the industry regroups and survives. Consider the advent of television from the mid-1950s. Many people imagined it would spell the end of radio.

Instead, radio changed its programming markedly and survived. It went from being something people sat in the living room listening to, to something they carried around with them, particularly in their cars. They listened to it while they were doing something else: driving somewhere or cooking the dinner.

Many people imagined television would spell the end of the cinema. It's true most of the cinemas in every suburb were converted to supermarkets, but then along came the video cassette recorder and video lending shops.

Finally, someone invented the multiplex cinema, a classic example of exploiting economies of scope (producing more than one product at the same plant). Today a wider range of movies would be showing in any city than when suburban cinemas were at their height.

So what can we say about how manufacturers may adapt to a prolonged high exchange rate? Well, one possibility is that they simply move their production abroad to where labour is dirt cheap.

You have to suffer all the illusions and delusions of protectionism and mercantilism to think that would be a terrible thing; that most of the displaced workers wouldn't be able to get work elsewhere in the economy. But, in any case, I doubt if nearly as much of it will happen as is feared.

So what else? People say the high dollar reduces the international competitiveness of our manufacturers. Actually, it reduces their price competitiveness. So one way to respond is to search for ways to reduce their production costs - by becoming yet more capital intensive (raising the productivity of their labour) or finding other efficiency improvements.

Another response is to find non-price ways to stay competitive. A reputation for high quality can justify pricing at a premium. Indeed, if you're smart you can get into the space where the causation is reversed: people take your higher price as a sign of higher quality (utterly contrary to the most basic assumptions of conventional economics).

You can use superior design to justify charging higher prices. You can beat the foreign mass-producers by being more carefully and quickly attuned to changing fashion. Or you can be more willing and adept at customising your product. If all else fails you can get yourself a reputation for giving good after-sales service.

This is an old Australian angle, but still relevant: look for niches to occupy. One advantage of our smallness relative to the rest of the world is that what seems too small to the big boys seems quite big to us.

If manufacturers are to get their cut from the much-foreshadowed blossoming of the Asian middle class, it's pretty safe to be in niche areas that are too small for our bigger rivals to worry about, or that somehow exploit the novelty of our Australianness.

I think this time it is quite likely manufacturing's output will decline. But it's even more likely we'll retain a manufacturing sector that's leaner and fitter than it is today.

If it does survive and prosper it will be because manufacturers and their employees find ways to raise their productivity and respond with a wave of innovation. There's nothing like having your back to the wall to call forth such an uncharacteristic response.

And it's a safe bet those firms that do best in adapting will be those that do best at enlisting the engagement and initiative of their employees.

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Jobs aren't lost, just moved

As the media keep reminding us, the many pressures for change in the structure of our economy are causing some workers to be thrown out of their jobs. But this is unlikely to cause a decline in overall employment. Huh?

The structure of the economy - as represented by the relative sizes of the various industry sectors - is always changing. Normally the rate of change is so slow we don't notice it. At present, however, the pace of change is much quicker than usual.

These pressures are coming from outside Australia. Many are the consequence of the rapid transition of various populous economies from developing to developed. Some of these "emerging" economies are in South America; most are in Asia.

One big consequence of this development is that much of the manufacturing undertaken in the world is moving from the developed to the emerging economies, where labour is more abundant and thus cheaper. This is hitting manufacturing in all the developed economies, not just us. (They're not enjoying it, either.)

Because the emerging economies' immaturity means they're growing a lot faster than the rich economies, another consequence is that most of the growth in the global economy comes from them. That's been true for years; it will be even truer in the coming decade because the North Atlantic economies damaged their prospects so badly with their financial crisis.

A further consequence is that the cycle in the world prices of primary commodities - food and fibre, minerals and energy - is now driven more by the emerging economies than the rich economies.

And the different needs of the emerging economies - for energy, steel and high-protein foodstuffs - have produced a long-lasting change in the structure of world trade, where the demand for primary commodities is growing faster than the demand for manufactures, meaning the prices and volumes of commodities are growing faster than those for manufacturing.

Because the emerging economies have much more economic development to do, and because there's a pipeline of countries coming behind China and India, the increased global demand for commodities relative manufactures is likely to last for many moons.

This is bad news for the real incomes of most of the developed countries (which tend to import most of the primary commodities they use, while gaining most of their export income from manufactures), but great news for us, since our imports are mainly manufactures and our exports mainly commodities.

Of course, both the big advanced economies and we face painful structural change as a consequence of this shift in the structure of the global economy, but I know whose shoes I'd prefer to be in.

In Australia we have to shift resources of labour and capital to the expanding mining (and agricultural) sectors from the declining manufacturing sector and elsewhere in the economy.

The improvement in our trading fortunes relative to the rest of the world is reflected in our higher exchange rate - which is thus likely to stay high for the foreseeable future. To many people, this sounds like terribly bad luck (when they're not thinking about their next overseas holiday, that is).

To economists, however, it's all part of the same deal. Our trading position has improved, so our exchange rate has appreciated to help us bring about the change in the structure of our industries needed to fully exploit that improved position.

In other words, by making it harder for our manufacturers (and tourist operators and education providers) to compete on international markets, the higher dollar is helping shift resources out of manufacturing and into mining and elsewhere.

Of course, the era of the emerging economies isn't the only factor forcing change on our industries. The other big one is the continuing information technology revolution, which is presenting considerable challenges to our established media companies, the book industry, retailers and shopping-centre owners.

I started by asserting that the job losses being caused by structural change were unlikely to lead to a fall in employment overall. Why not? Because what creates jobs is the spending of income.

Starting with the mining boom, it's bringing a lot of additional income to Australia (first from higher prices per tonne, then from a lot more tonnes). But, people object, mining is highly capital intensive so it doesn't employ many people. It may account for 10 per cent of the value of all we produce (gross domestic product), but it accounts for only 2 per cent of total employment.

True, but what happens to all the income the miners earn that isn't paid to their employees? Some of it goes to foreign owners and is spent abroad, but the rest goes to local shareholders and local suppliers to the industry, with Australian governments also getting a big chunk (as they should).

When the local shareholders, suppliers and governments spend that income, jobs are created. Where? At present, a lot are in the construction industry but, more generally, all round the services sector.

How can I be so sure? Because the services sector (including construction) accounts for about 85 per cent of all employment and because it has accounted for all the net jobs growth for the past 40 years.

Next, the advent of new technology often prompts employers to retrench staff as machines replace workers. People imagine these jobs have been "lost", but economists know they've merely been "displaced" (moved).

Why? Because when companies make changes that improve their productivity (output per worker), they raise the economy's real income. The company shares the benefit from its higher productivity among its remaining workers, its shareholders and the taxman, but often competition forces the benefit through to its customers in the form of prices that are lower than they otherwise would be. And lower prices mean higher real incomes.

The point is that as this income is spent around the economy it creates jobs around the economy. Where? Somewhere in the services sector.

Ah, you say, but are all the workers "displaced" from manufacturing able to take up the new jobs in mining or the services sector? A lot more are than you imagine will be able to, but some will have a struggle and some individuals won't make it.

That's why the smart response from governments to pressures for structural change is not to help companies carry on as if nothing in the world had changed, but to help individual workers adjust to that change with help to retrain and relocate.

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Yes, there is more to life than happiness

Fed up with all the wrangling and speculation over who should be leading the Labor Party? Want something more substantial? How about the meaning of life - that weighty enough for you?

The question has been an object of contemplation by clerics and philosophers throughout the ages, of course, but in more recent times many psychologists and even a few economists have taken to studying it.

Psychologists' traditional focus has been on the abnormal - on relieving misery, helping people suffering from depression, alcoholism, schizophrenia, trauma and the like.

But for at least the past 30 years some psychologists and economists have been researching the nature of happiness. A spate of books has been written on the subject (including one by yours truly).

Then, about a decade ago, there sprang up among psychologists a new school known as "positive psychology", dedicated to helping the normal live more satisfying lives. The practitioners of positive psychology seemed to take over the happiness business.

The person most responsible for starting the positive psychology movement is Professor Martin Seligman, of the University of Pennsylvania. Seligman regularly works in Australia, and will speak at the Happiness and its Causes conference in Sydney next week, subtitled Life, Death and Everything. But is happiness all there is to the meaning of life? A lot of people doubt it. The spate of happiness books is now prompting a flow of anti-happiness books - including one by our own (eminently sensible) Hugh Mackay.

I think a lot of the problem lies with the word happiness. It's an eye-catching, emotive word beloved of book publishers and headline writers. But what does it actually mean? Different things to different people.

The critics interpret it very narrowly, as being perpetually in an upbeat, ho-ho-ho mood. And perhaps being a Pollyanna - looking on the bright side of everything and refusing to acknowledge problems.

If that's what happiness means it deserves to be ripped into by the critics. It's neither possible nor desirable to live like Dr Pangloss, and you could do yourself a mischief trying to.

Seligman points out that such an ideal favours those with an extroverted personality, disadvantaging the half of the population who are less expressive and more introverted.

Mackay argues that nature equipped us with the capacity to feel negative emotions - pain, sorrow, fear, even anger - for good reason.

But I've always used happiness to mean something much broader and more substantial. The seeking of pleasure and avoidance of pain is mere hedonism, and that's life without meaning.

Most of the academic study of happiness relies on surveys that ask people to rate their satisfaction with their lives on a scale of, say, one to 10. That's a bit broader, but recent research suggests people's answers to such a question are too greatly influenced by how they were feeling at the time they were asked.

Seligman has been giving the question much thought and the result of his cogitation is outlined in his latest book, Flourish. His objective is to guide the positive psychology movement away from happiness as its goal to something more encompassing, which he dubs "wellbeing".

Wellbeing, he argues, has five elements, of which only the first, "positive emotion", covers the narrow conception of happiness. He calls this "the pleasant life".

His second element is "engagement". Living the engaged life means regularly being in a state of "flow", where you become so absorbed in what you're doing you lose sense of time and consciousness of yourself.

It can involve your work or a hobby, but it requires an equal match between the challenge you face and your ability to meet that challenge. People in a state of flow realise they were happy only in retrospect.

Seligman's third element is "meaning". The meaningful life involves "belonging to and serving something that you believe is bigger than the self," he says. This is where other people first enter the picture.

"Today it is accepted without dissent that connections to other people and relationships are what give meaning and purpose to life," he says.

The fourth element is "accomplishment" - something Seligman added to his list only after a student told him his theory of what humans choose had a huge hole in it: "It omits success and mastery. People try to achieve just for winning's own sake."

Well, that's certainly the way it appears, though a leading economist researcher in this area, Andrew Oswald, of the University of Warwick, would argue that people want to win not for its own sake, but to increase their social status.

Billionaires scrabbling for their next billion aren't motivated by greed. They just want to demonstrate - to themselves and others - how good they are at playing the money game.

Anyway, Seligman now accepts that people pursue success, accomplishment, winning, achievement and mastery for their own sakes. He stresses, however, that his objective is to describe what people actually do to get wellbeing.

"Adding this element in no way endorses the achieving life or suggests that you should divert your own path to wellbeing to win more often," he says.

His fifth element is "positive relationships". When another founder of positive psychology was asked to say what it was about in two words or fewer, he replied "other people". Seligman says "other people are the best antidote to the downs of life and the single most reliable up".

No doubt, but that sounds a bit self-centred. For relationships to be "positive" they have to be two-way; you have to give as well as get. Whatever you call it - happiness, wellbeing, flourishing - it won't work if it doesn't have relationships at its core.

That's what we keep forgetting.

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High dollar’s job losses will raise productivity

If your goal is to raise Australians' material standard of living, the debate about what must be done to increase our flagging productivity is vitally important. But if we want the debate to achieve something, we should stop talking so much weak-headed nonsense.

People are talking about productivity as if it's motherhood for businessmen - all fluffy and soft. Sorry, productivity is more nasty than nice. Sometimes it's red in tooth and claw. It always involves effort and unsettling change, and often involves people being thrown out of their jobs.

As the headlines scream at us every day, many of our industries are being put through the wringer at present, and are shedding workers to prove it. This is not a downturn in the economy, it's the economy being hit by multiple pressures for structural change.

Manufacturers (and tourism and education - not that anyone cares about them) are being hit by the high dollar. Retailers are being hit by the end of a 30-year period in which consumer spending grew faster than household income and by globalisation as the internet breaks down longstanding national price-discrimination schemes. Shopping-centre owners are also in the gun.

Banks are still adjusting to the continuing global financial crisis, which has increased their cost of funds while also increasing their pricing power. Newspaper and media companies, and book publishers and sellers, are adjusting to the information and communication revolution. Qantas is adjusting to deregulation and globalisation.

Guess what? All these nasties are in the process of increasing Australia's productivity - as we speak. To the extent firms are shedding labour faster than their unit sales are declining, they're increasing their productivity as a matter of simple arithmetic.

More fundamentally, structural change is presenting all these firms (bar the banks) with an ultimatum: shape up or die. As they fight for corporate survival in a radically changed world, they will become leaner and fitter. In the process, they'll almost certainly contribute to an increase in national productivity.

What this means, however, is that all the business people, union leaders, opposition politicians and commentators pressuring the government to protect industries from change are fighting to prevent productivity improving. And every time the government gives in to those pressures it's acting to stop productivity improving.

I'm convinced many of the worthies banging on about productivity don't actually know what it is. Productivity is output per unit of input. That means it's about comparing quantities, not prices or values.

This is why productivity and profit (or profitability - profit relative to the equity capital or assets employed to earn the profit) are quite different concepts, not pretty much the same thing - as many business people seem to imagine.

Usually productivity is measured as output divided by units of labour inputs (hours worked), giving the productivity of labour. If you divide output by units of both labour and capital inputs you get "multi-factor [of production] productivity" (which always grows at a much slower rate).

The great delusion of the productivity debate - one inadvertently fostered by crusading economists - is that productivity improvement is a gift governments deliver to business, provided they have the political courage to implement "reform".

Rubbish. As our great private-sector productivity expert Saul Eslake has said: "Productivity only happens as a result of the decisions that are made and implemented in places of work."

So there's an obvious question no one is asking: why have Australia's chief executives failed to increase their firms' productivity for the past decade? Obvious answer: because it's been easier for them to increase their profits without doing much to increase their productivity. (And a big part of the reason for this is that the economy's been growing reasonably strongly, year after year, for 20 years - with just a mini-recession in 2008-09.)

Research suggests few firms actually measure their labour productivity. That's no surprise: the goal of firms isn't to increase their productivity it's to increase their profit - which is what they do measure, carefully and often.

Increased national productivity may be the key to rising material living standards, but increased productivity is just an incidental by-product of a firm's efforts to increase its profit. There are often many easier ways to increase profit than to improve your productivity.

Sometimes firms increase their productivity in response to opportunities or incentives - carrots - created by governments. This is what chief executives dream about while primitive tribes dream about planes dropping cargo from the sky.

Sometimes firms increase their productivity in response to governments beating them with sticks to force them to lift their game. This is known as "micro-economic reform". You slash protection against imports, allow the dollar to float, dismantle a host of interventions designed to give industries an easy life and tighten up the Trade Practices Act.

All this increases the competitive pressure on firms - from imports and local competitors - forcing them to lift their performance and their productivity. Is this the "reform" the business lobbies are crying out for? I doubt it.

Sometimes national productivity is improved by nothing more than firms doing what they do: striving to increase their profits. But, as we've seen, that hasn't been happening for a decade.

Alternatively, national productivity is improved as a by-product of firms grappling with adverse changes in their economic environment that threaten their profits and even their survival.

That's what's happening in our economy right now. You want higher productivity? Your wish is about to come true. When we've got through the present bout of structural adjustment we'll have a much more efficient set of industries. But everyone seems to be hating it.

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Herd behaviour, fashion and status seeking

Think for more than a moment about the causes of the global financial crisis - the fallout from which is still hurting the US and Europe - and you realise herd behaviour had a lot to do with it.

People paid extraordinarily high prices for houses because they felt they were trailing the Joneses. Brokers sold unsound mortgages because they had to keep up with rival brokers. Funds managers - remunerated according to their relative performance against other managers - traded shares with the same motive.

So, the study of herd behaviour must be a pretty important part of economics, right? Wrong. Between 1970 and the onset of the crisis only nine out of 11,500 articles in three esteemed economic journals discussed herd behaviour. And when they did discuss it they usually viewed it as "informational learning" - learning what I should do from your behaviour. If you hear a fire bell and see people running for the exit, you don't inquire further, you just join them.

Yeah, sure. That explains it. Fortunately, one economist who's taken a great interest in herding is Professor Andrew Oswald, of the University of Warwick, in Britain, and the IZA research institute, in Bonn. Oswald spoke about herd behaviour and keeping up with the Joneses at a conference this week to celebrate the contribution of Professor Ian McDonald, of Melbourne University.

Unlike his peers, Oswald has spent his career crossing the boundaries between economics and the other social sciences. Now he's forging links with the physical sciences and is on the board of editors of the journal Science.

On herding, Oswald took his lead from a seminal zoological paper written in 1971. "Before that article, the standard theory in biology was that herds had some inexplicable communitarian instinct," Oswald says. But the article argued that an animal clusters with others because its relative position is what matters. When you're being threatened by a predator, clustering with others reduces the chance it will pick you as its prey.

What has this to do with humans? Just our preoccupation with our position relative to others. Our desire to be in fashion - to wear what our peers are wearing - is motivated subconsciously by our strong desire to keep up.

And falling back worries us because it involves dropping down the status ladder. So, our often demonstrated desire to do what other people are doing seems to show a deep, though unconscious, concern to defend or advance our status (or rank) relative to others.

Economists have long been suspicious of survey evidence, of asking people what they think about things or why they do things. It's too subjective; how can you be sure they're telling you the truth? This is one of the profession's reservations about the study of happiness (of which Oswald has been a leader among economists).

So, Oswald has been interested in finding more objective ways to measure feelings such as happiness. When I compare your rating of your satisfaction with life with your spouse's or your friend's rating of your satisfaction, do they line up? (Yes, they do.)

He's done a lot of work using the British medical profession's system for rating people's mental health, rather than just asking people how they feel about their lives.

Another approach is to use magnetic resonance imaging (MRI scanning) to see what happens inside people's brains when they have certain feelings or encounter certain ideas.

Yet another approach Oswald is pursuing is the use of "biomarkers": can changes in a person's physiology - their heart rate or blood pressure, say - tell us about what they're thinking and feeling?

Oswald quotes the results of a study by German economists who put pairs of people in adjacent brain scanners and asked them puzzle questions, with money rewards for correct answers. They found that outperforming the other guy had a positive effect on the reward-related parts of the brain. People compare themselves with others and enjoy feeling they're winning.

You reckon that's pretty obvious? Not to an economist. Their standard model assumes away all interpersonal comparison. My likes and dislikes ("preferences") are unaffected by other people's preferences and never change over time.

Raise my income by $10 and my satisfaction ("utility") increases. Raise my income by

$20 and there's a commensurately greater increase in my utility. Raise my income by

$10 while you increase my mate's income by $20 and I won't mind a bit.

Actually, we know from happiness research that relative income (how my income compares with yours) has a big effect on how satisfied people feel with their lives.

Oswald asks whether our satisfaction from social status accelerates or decelerates as we increase in status. That is, does our pursuit of status bring increasing marginal utility or decreasing marginal utility?

This question is still being researched empirically. Oswald quotes the case of top tennis players. The gain in utility from going from being third in the world to second is likely to be much bigger than the gain from going from eighth to seventh.

But increasing marginal utility is probably limited to the very top of the status ladder, with diminishing utility applying to most of us.

We know, for instance, that though people with high incomes are happier than those with low incomes successive increases in income buy progressively smaller and smaller increases in satisfaction with life.

Another thing we know is that the rising average real incomes the developed economies have achieved over the decades haven't led to any increase in average levels of satisfaction.

This raises what Oswald calls a "disturbing possibility". "Maybe modern society is stuck," he says. "Individually, we chase higher income and 'rank', but for society as a whole this cannot be achieved."

Here's another worry: "Herd behaviour is often very natural and individually rational. But it has the potential to be disastrous for the group," he says.

"When rewards depend on your relative position it will routinely be dangerous to question whether the whole group's activity is flawed, and be rational simply to compete hard within the rules that govern success."

In the dotcom bubble a decade ago - where the shares of internet companies that had never made a dollar of profit traded for ever more ridiculous prices - those analysts who said it made no sense got fired.

"In financial markets, people are now routinely rewarded in a way that depends on their relative performance" - whether they're in the top quartile, second quartile or whatever. "That's dangerous," he concludes.

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Jobs market isn't nearly as bad as you think

Economists don't have a good record on forecasting what will happen to the economy, but here's a prediction I make with great confidence: whatever happens, it won't be as bad as you think it is. That applies particularly to the jobs market.

Consider this. One day you pick up a newspaper and on page five you read a small story saying employment grew by 10,000 last month, leaving the rate of unemployment unchanged at 5.2 per cent. A couple of days later, every time you turn on the car radio or look on the internet, then settle down at home to watch the evening news, you're told about the car company that's announced its intention to lay off 350 workers. The next day the big news is that a bank intends to lay off 1000 workers.

Question is, what conclusion do you come to about the state of the jobs market? You wouldn't be human if you didn't think things were in pretty bad shape.

You'd need the steel-trap mind of an economist to say to yourself: "These stories I'm hearing about layoffs here and there are sad news for the individuals involved, but they don't really prove anything. To make a balanced assessment of what's happening in the labour market I need aggregate statistics, not anecdotes - and the last stats I saw said that, overall, employment is growing sufficiently to hold the unemployment rate steady at 5.2 per cent."

The human mind isn't particularly good with statistics. Some people even have trouble pronouncing the word. Figures are too cold and impersonal. We're interested in other people, not numbers. So there's a sense in which we're moved more by a story of 350 people losing their jobs than by one saying 10,000 jobs had gone. Of course, what would really engage us is a story, with pictures, about the plight of just one sacked worker, worried about the mortgage and not at all sure where their next job was coming from.

But there's a distinction between fellow-feeling for someone who's struck hard times and assessing how worried we should be about the state of the world.

Already this year we've heard a lot of stories about people being laid off in manufacturing, retailing and now banking. It's a safe bet we'll be hearing a lot more, and that each announcement will get much attention.

How could this not leave most of us with the impression the economy's going to hell in a foreign-made handcart? Yet this impression will almost certainly be exaggerated, and may well disguise a position where, overall, the economy is holding its own.

One reason we're misled is that we're unduly impressed by very small figures. To put it another way, we don't appreciate just how big the economy is. There are 11,421,300 people in the labour force, either in a job or actively seeking one. So 350 people represent 0.003 per cent of the total.

The point is not that the fate of 350 people is unimportant, but that it makes a minuscule difference to the fate of workers generally. Make it 10,000 people and we're still only up to 0.09 per cent.

Another reason we're unduly impressed by news of people losing jobs is we don't realise how much turnover there is in the labour market. Julia Gillard keeps saying that every year about a million workers change jobs - with about a quarter of them also changing the industry they work in. When I checked that surprisingly large figure with an expert, he said it was too low.

(Gillard emphasises the remarkable degree of change in the economy by adding that, every year, about 300,000 businesses close - and 300,000 new ones start up.)

So every month many thousands of people leave their jobs - voluntarily or involuntarily - and many thousands move into jobs. What's another 350?

By now you may have realised we get told about only the tiniest fraction of all the coming and going. In fact, we get told when a big company announces it's decided to get rid of a block of workers. It makes an announcement because it wants to impress the sharemarket or pressure the government for assistance.

But we don't get told when big companies decide to hire a block of workers or, more usually, to hire people in dribs and drabs. And we're told virtually nothing about the hiring and firing by small business. Get the feeling we're being given a biased impression?

There is, however, another, more fundamental reason we'll be getting a distorted impression of what's happening in the economy this year. We're getting the idea the high dollar is causing the economy to slow down and shed jobs.

In truth, the high dollar and the factors that brought it about aren't destroying jobs so much as shifting jobs from one industry to another. That's painful for the contracting industries - and we're hearing their cries loud and clear - but, predictably, we're not hearing much from the expanding industries.

While jobs are being lost in manufacturing and elsewhere, employment will be growing in mining and the construction industry, pretty obviously, but also in the services sector, including in health, education and training, public administration, the science professions and arts and recreation.

I'll be surprised if, overall, we don't see continuing growth in employment. Whether this growth will be sufficient to cope with the natural growth in the labour force and thus hold unemployment steady, I'm not as sure.

But I do know this: with inflation under control, if the Reserve Bank sees unemployment drifting up it will cut interest rates further to encourage borrowing and spending and thus foster faster growth in employment.

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TALK TO FAIRFAX MEDIA SENIOR MANAGEMENT FORUM

Sydney, Monday, February 13, 2012

Greg has asked me to talk to you about the state of the world economy we find ourselves coping with, particularly the problems in the euro zone. But before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

I can say that confident you will take an interest in what I say because everyone already knows economists aren’t good at forecasting but it’s never stopped them asking for another forecast. That’s because the human animal has an insatiable curiosity about the future - an incurable belief that it’s possible to know about the future and the more we know about it the better our chance of controlling it. John Kenneth Galbraith said economists were created to make astrologers look good, but I prefer to say that if people don’t have economists to ask about the future, they’ll settle for asking witchdoctors.

Perhaps economists are modern-day witchdoctors. But I draw a distinction between understanding what’s going on in the economy and predicting what will happen next, so I’m going to focus more on what and why things are happening rather than what will happen next.

I’ll say a bit about China eventually, but I’m sure you realise the big problem area in the world economy at present is the North Atlantic economies, the United States and Europe (including Britain). Most people automatically assume that if these big economies are in trouble that spells trouble for us, but I think it’s important understand the various ‘channels’ by which developments in other countries flow through to us. The first and most obvious channel is via trade: if they reduce their demand for our exports that’s bad for us, of course. But these days the EU accounts for less than 10 pc of our export income and the US for only 5 pc, so direct trade with the North Atlantic shouldn’t be greatly affected. A second channel is via the global financial markets. We know that worries about worries about major problems in the world can push our sharemarket down. And now compulsory superannuation has made a lot more Australians conscious of sharemarket falls. We also know problems with banks can cause some international funds markets to freeze or can push up the cost of overseas funding to our banks, as is happening to a small extent at present. The third channel thru which adverse developments in other economies can adversely affect our economy is via confidence. Consumers and business people hear all the bad news and it tends to make them less confident and more uncertain about the future. Consumers tighten their belts, increase their saving and pay down debts and avoid making new commitments. Businesses put expansion plans on hold, try to improve their gearing, cut non-essential spending such as advertising and maybe lay off staff.

It’s clear this third, psychological channel is the main channel by which worrying developments in the North Atlantic economies become a worrying development in our economy. The more I see of the ups and downs of the business cycle, the more convinced I become that ‘confidence’ - and particularly our collective swings from excessive optimism to excessive pessimism - is the biggest single factor determining the swings in the economy. There are ‘real’ factors at work, of course, but they are greatly amplified by the way business people and consumers are feeling at the time. The trick is that when the way we feel affects the way we act, the merely emotional becomes real. To take an example close to home, when I decide to cut my advertising budget because I’m uncertain about the future, the effect on businesses that sell advertising is very real. And when negative sentiment takes hold, it tends to feed on itself, becoming self-fulfilling and self-reinforcing. This is why, as you may have noticed, in my writing I’m putting a lot more emphasis on ensuring I give our readers a reasonably balanced assessment of how good or bad things are, even tho it’s a lot more fun to scare the pants off them.

Two factors do most to explain why the North Atlantic economies have been in so much bother since the global financial crisis reached its peak with the collapse of Lehman Brothers in 2008, and why they’re unlikely to be completely out of bother for many years. The first is ‘debt’ and the second is the euro. The crisis in 2008 brought an end to a debt-fuelled boom in the developed economies that lasted - with interruptions from mild recessions - for about 20 years. In the US it’s clear households borrowed too much, for housing and to maintain lifestyle; in their efforts to maximise profits banks became too highly leveraged, and the US government ran too many annual deficits and racked up too much debt. In Europe, the banks became far too highly geared and governments were far too undisciplined in their budgeting. When the crisis peaked, governments in the US and Europe borrowed heavily to rescue their banks, then borrowed again to get their economies moving. Coming on top of the already high debts acquired during the long boom, this took most governments to quite unsustainable levels.

But this brings us to a paradox: for individual households or businesses or banks, the best way to get on top of your debts is to tighten your belt; for whole economies, however, the best way is to grow your way out of them. The ideal for governments is to keep growing, while slowly mending your ways. The trouble for governments with lax budgeting records, however, is that markets, German governments and others don’t trust their promises to be good boys tomorrow but not today. This does much to explain the flirtation with policies of austerity which, by making economies even weaker, can make it even harder to reduce budget deficits. Then markets react badly when they see economies weakening. Of course, when a government reaches the point where people are no longer willing to lend to it - as with Greece - it has no choice but to accept austerity.

A point to note is that, because of this debt overhang, it’s idle to imagine (as I suspect some people still do imagine) there’s some way Europe - or even America - can get back to normal rates of growth within a year or two. For a start, the rates of growth we came to regard as normal in the 90s and the noughties turned out to be debt-propelled. It will be a long time before we see its like again. For another thing, the process of ‘deleveraging’ is always protracted. So the only options available to the North Atlantic economies are weak growth for the rest of the decade, or economic disaster for the rest of the decade.

Starting with the US, its households are likely to be preoccupied with getting on top of their debts for many years yet, which will constrain the growth of consumption spending. It has unsustainably high levels of government deficit and debt, but its ‘debt crisis’ is political rather than economic. The two sides in Congress can’t agree on how and when to get its budget under control but, in marked contrast to the Europeans, global financial markets remain so willing to continue financing its deficit that the yield on US Treasury bonds has fallen to 2 pc.

One point I want to leave you with is that the outlook for the North Atlantic economies has improved markedly since late last year. In the case of the US, its recovery faltered in the middle of last year, but has improved a lot since then. The economy grew at an annualised rate of 2.8 pc in the December quarter and the unemployment rate has been falling slowly for the past five months. The US sharemarket is up about 20 pc on its low point in October. Growth isn’t likely to continue at that healthy rate, but all the talk of a double dip has evaporated.

What makes Europe’s story much more worrying that America’s is the euro. The rationale for the single currency area was more political than economic. Even without the addition of the former communist countries, the economies of the foundation members of the area were at far too disparate states of development for this to be a sensible arrangement. The interest rate and exchange rate levels appropriate for Germany and France were never likely to be appropriate for Portugal, Ireland, Greece and Spain - even for Italy. The removal of currency barriers between the 17 members of the euro does increase trade between them and, for a time, the governments of the less developed and less fiscally disciplined members did benefit from being able to borrow in euros at much lower interest rates then they’d been paying.

But, as is now all too painfully evident, all that did was lure Greece and others into borrowing far more than was good for them. And now they’re having difficulty servicing that excessive sovereign debt, the drawbacks of the currency union are painfully apparent: no ability to regain lost competitiveness with the rest of Europe by devaluing your exchange rate rather than cutting nominal wage rates; no ability to set interest rates at levels appropriate to your own needs. And, indeed, no easy way to escape the straitjacket of the currency area. Greek firms that had borrowed in euro would find their debt levels greatly increased when expressed in new drachmas.

The founders of the Euro understood that budgetary indiscipline was the greatest threat to the single currency’s survival, and established deficit and debt limits and targets accordingly. But they failed to live up to or enforce those limits, and now they’re chained together whether they like it or not.

It’s by no means certain the Europeans can make the euro work. And it’s hard to imagine a way it could break up that wouldn’t turn the mild recession they’re already in, into a deep and prolonged recession that worsened the US recovery and made life a lot tougher for us as well. They’re having a lot of trouble agreeing on what they need to do, and the longer they dither the greater the risk of some unexpected but damaging accident.

But having conceded that, I have to remind you of my point that, even with Europe, the situation is now looking a lot less on-the-brink than looked late last year. Under a more pragmatic president, the European Central Bank has provided its banks with huge amounts of cheap three-year liquidity, which has calmed market concerns about the banks. They’ve used much of that liquidity to buy the bonds of euro governments, which has significantly lowered the rates those governments face when they borrow. The euro governments are moving towards a new fiscal responsibility treaty which, at least, seems to have mollified the Germans somewhat. And the Greeks have passed another milestone.

The IMF, the Reserve Bank and Treasury base their forecasts for growth in Europe on the assumption the euro leaders manage to ‘muddle through’ without a disaster occurring. That’s the only sensible basis on which a forecast could be based and, thankfully, it’s easier to see it coming to pass than it was three months’ ago.

I haven’t left myself enough time to talk about China and the rest of developing Asia, but let me make a few quick points. The adverse effect on trade from the North Atlantic economies comes to us mainly via China. So China is the economy whose health we need to be most concerned about. Fortunately the news from the orient is a lot less worrying. It’s true its exports to the North Atlantic have been hit, but many people overestimate its continuing reliance on export-led growth. It’s true the Chinese authorities have been acting to slow their growth and reduce inflation pressure, but they and other emerging Asian economies retain plenty of scope to stimulate domestic demand should the rest of the world slow by more than we’re expecting at present.

The IMF is forecasting world growth of 3.3 pc this year, which is below the average rate of about 4pc, but well above the 2 pc level regarded as a world recession. When you weight that 3.3 pc to take account of the countries to which we send most of our exports, you add 1 percentage point.

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What happens now on interest rates

Until last week, the financial markets and most business economists thought the Reserve Bank had several rate cuts up its sleeve and would start doling them out this month. The smarter ones don't think that any more.

When the Reserve failed to cut the official interest rate last week, some observers swung to the opposite view of expecting no further cuts for the foreseeable. And with all the fuss about the banks' small "unofficial" increases in mortgage rates, you can bet the punters are now convinced rates are heading back up.

Needless to say, the official rate is unlikely to rise. With luck, it won't need to be cut further. But if the outlook for the economy deteriorates, it will be.

Since the Reserve cares most about the rates households and businesses actually pay, and has no desire to tighten the interest-rate screws, the tiny unofficial increase will be one factor - but only one - favouring another cut in the official rate sooner rather than later.

Why didn't the Reserve cut last week? Because you may have convinced yourself the economy's in trouble, but the Reserve hasn't.

For the markets and business economists to have been so sure the Reserve would cut, it was necessary for them to be convinced of the truth of one or both of two propositions.

First, that the outlook for the world economy is now worse than it was late last year. It's true that, in recent times, the Reserve has judged the state of the rest of the world to be the greatest single threat to the continuing growth of our economy.

But almost all the news we've received from abroad so far this year has been reassuring. Things have calmed down a lot in the euro zone, with the actions of the European Central Bank making people a lot less worried about the European banks than they were, with sovereign bond yields falling back to more sensible levels, with banks able to raise funds with new bond issues, with Greece looking like it may reach a deal with its saviours, and with world sharemarkets looking up.

None of this implies the Europeans don't have a lot more to do, nor that there's little chance of something somewhere suddenly going badly wrong. The continuing risk that things could deteriorate in Europe remains the greatest single reason the Reserve could cut rates again this year.

But you do have to say the improvement in conditions in Europe so far this year makes it easier to believe the Europeans will muddle through.

As for the United States, its economy isn't roaring, but it is doing better than it was, growing fast enough to slowly reduce unemployment. For China, it's slowed a bit, but is still growing strongly.

The second proposition you'd need to believe to have been so confident the Reserve would cut last week is that the domestic economy is clearly slowing.

The tribulations of particular parts of the economy - notably manufacturing and retailing - have generated so many negative headlines I've no doubt many people are convinced the economy's in trouble.

Certainly, the belief the economy is slowing is widely held. But that's what happens when the news is mixed, with the bad bits trumpeted and the good bits played down. Just why the commercial media regard misinforming the public in this way as good for business I'm blowed if I know.

Do they imagine only the Labor government will suffer if they succeed in talking the economy down? Do they think it's like "a Martian ate my baby"? It's just entertainment and no one actually believes them?

The unrecognised truth is, the economy's speeding up a little, not slowing down. That's because we're recovering from the effects of the bad weather this time last year. Abstract from the weather effect and the economy's been travelling at about its medium-term trend annual rate of 3.25 per cent for the past two years or so, and is expected to grow at that rate this year.

With the unemployment rate steady at just 5.2 per cent and underlying inflation in the centre of the target range and expected to stay there for the next two years, you'd have to conclude the economy is right on normal.

In which case, the present level of interest rates - close to their own trend rate - must surely be pretty right. But it's clear from the Reserve's rhetoric that it retains a weak "bias to ease" (cut rates further): "the current [favourable] inflation outlook would, however, provide scope for easier monetary policy should demand conditions weaken materially".

How would such a weakening be manifest? Well, obviously by a deterioration in the world economy. Were Europe to implode, the flow-on to the rest of the world would be considerable - even for us. In this case we know how the Reserve would react: by slashing interest rates in a few big, bold steps.

But the requisite material weakening could also be brought about by a deterioration in essentially domestic factors.

The way the Reserve sees it, the economy is being hit by two powerful but opposing shocks: the expansionary effect of the once-in-a-century mining construction boom and, against that, the contractionary effect of the high exchange rate, which has reduced the international price competitiveness of our export and import-competing industries.

At present, the two conflicting forces are roughly offsetting each other, leaving the economy travelling at its trend rate. Should it become clear the high exchange rate is doing more restricting than the construction boom is doing expanding, which would show itself in slowly but steadily rising unemployment, the Reserve will cut rates further.

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How fiscal policy does and doesn't work

It's remarkable that the politicians of Europe and America are making things much worse for themselves and their people because they've unlearnt the economic lessons of the past 70 years.

Economists spent many years studying what policymakers did wrong in the Great Depression of the 1930s, making it much worse than it needed to be. One well-understood lesson was not to try to get the government budget back into balance too quickly.

This is counter-intuitive to many people. The government's tax revenues have collapsed, its spending has increased, it has a yawning budget deficit and government debt is piling up. Surely it's obviously right to get spending and your income back into line as quickly as you can.

Not if you're a national government. Why not? Because governments are so big that what they do affects the rest of the economy. Remember, governments can borrow more for longer than the richest individual or corporation, since they represent the whole community and have the power to pay their bills by levying taxes.

Economic downturns, recessions or depressions almost always manifest themselves in consumers and businesses cutting their spending. The more they cut, the more people lose their jobs and their businesses and the greater the decline in spending.

In such circumstances, it's not possible for the private sector to lift itself up by its bootstraps. Clearly, the government needs to do something that helps the private sector get back on its feet.

One thing the central bank can do is cut interest rates to encourage borrowing and spending. In normal times this is usually effective, but in really bad times a lot of people are too uncertain about the future to want to borrow and expand, no matter how low rates are. And if interest rates are already very low - as they are in the advanced economies at present - you can't cut them below zero.

The next tool available to help the private sector is "fiscal policy" - the budget. The first way to help is do nothing: when fewer people paying tax and more people on the dole cause the budget deficit to blow out, don't do anything to counter it.

This process happens automatically when the private sector turns down, and the fact that some people are paying out less money to the government while others are getting more money from it means the government is helping to cushion the private sector's fall, stopping it from falling further. Thus economists say budgets contain "automatic stabilisers".

If you try to counter the effect of these stabilisers by cutting spending or increasing taxes, you'll push the private sector down further and, because of that, probably won't succeed in getting the budget closer to balance in any case.

The second way to help is more active: stimulate the private sector by cutting taxes or increasing spending. If you were to do this when the economy was strong, you'd just worsen inflation. But if you do it when the economy is flat on its back, it will probably be effective, particularly if you increase spending rather than cutting taxes (which would allow some people to save their tax cuts).

Once you get the economy growing again, tax collections will improve and people will go off the dole, thus causing the deficit to reduce. This is the automatic stabilisers working the other way. Keep it up and the budget balance will turn to surplus, which you can then use to repay government debt.

See the point? Exercise enough discipline and patience and eventually the budget problem will fix itself.

All this had been well understood by economists and politicians for many years. It was how governments responded to the global financial crisis in 2008. But governments in Britain and the euro zone, and the US Congress, are now doing pretty much the opposite.

Their economies are still quite weak but they want to increase taxes or - more commonly - slash government spending to get their big budget deficits down in a hurry. In consequence of this policy of "austerity", the European economies are heading back into recession and their deficits getting worse.

Why are they doing something so counter-productive? Because their stock of government debt is so unsustainably high. Whereas sensible policy involves running surpluses and reducing debt during the good years, they kept running deficits and piling it up in the noughties.

When the global financial crisis struck in 2008, many had to borrow heavily to rescue their banks and then borrow even more to kick-start their economies. Their debt is now so high the financial markets have started wondering whether they'll be able to repay it.

But the flighty financial markets are an unreliable guide to good policy: though they seemed to approve when governments announced their austerity programs, they started disapproving when they saw those programs were causing economies to weaken.

Of course, when a country's sovereign debt gets so high that markets will soon refuse to lend more to it at any price, it has no choice but austerity. You can renege on your debts, but you can't run a deficit if no one will finance it.

Even if some international institution bails you out, it will punish you for your profligacy by insisting on austerity. Will this make things worse long before it makes them better? Inevitably.

That's the case of Greece. But most of the European countries aren't in those dire straits, so why are they slashing spending?

What they should be doing is promising and laying plans to reduce their spending down the track, as their economies recover and can take it in their stride.

Why don't they? Because, after decades of fiscal indiscipline, they don't have much credibility when making promises to be good tomorrow.

But that doesn't change economic reality: cut when the economy's weak and you make it weaker. The answer is to find ways of making their promises more credible.

As for the Americans, they too have years of fiscal indiscipline and a way-too-high level of debt. But though it suits President Obama's critics to claim the US has a "debt crisis", it doesn't. The world is still so anxious to lend to the US government that the yield (effective interest rate) on its long-term debt is down to 2 per cent.

It has plenty of time to get its budgetary house in order but, at present, a hostile Congress has the budget set up to crunch the US economy next year. These guys have learnt nothing.

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Propping up private heath insurance unfair, inefficient

Despite the untiring efforts of Julia Gillard and Tony Abbott to make themselves seem poles apart in their policies - he/she is hopeless, I'm really good - the ideological gap between the two sides has never been narrower.

If you look carefully, that's true even in one of the few remaining points of ideological difference: the funding of healthcare, particularly private health insurance.

When John Howard resumed leadership of the Liberals in 1995, he abandoned their long-standing opposition to Labor's Medicare (and Medibank before it). But that didn't stop him using a succession of carrots and sticks to get people back into private health insurance.

When Labor returned to power in 2007, it lost no time in seeking to water down those incentives. In its first budget it raised the income thresholds at which middle- and high-income earners became liable for the additional, 1 per cent Medicare levy surcharge if they didn't have private insurance.

In its second budget it sought to means test the 30 per cent health insurance rebate, reducing it for higher-income earners and removing it for those even higher up. Labor seems to have wanted this as part of its efforts to pare back all the middle-class welfare Howard introduced to health and social security payments.

But the measure was knocked back by the Senate, mainly because of the implacable opposition of the Libs. Labor has sent the bill back to the Senate every year since then, only to have it rejected.

This week the newish Minister for Health, Tanya Plibersek, is conducting discussions with the independents and the Greens in the hope of having more success this year. Strangely, if the Greens join forces with the Libs to block the bill one more time, it will be because they profess to believe it doesn't go far enough.

Plibersek has sought to demonstrate the unfairness of the rebate with figures showing that while just 12 per cent of couple taxpayers earn more than $160,000 a year between them, they account for 21 per cent of the couples benefiting from the rebate - worth, typically, about $1000 a year. For single taxpayers, the 14 per cent earning more than $80,000 a year account for 28 per cent of the singles getting the rebate. It's a concession for the well-off.

The health funds and the Liberals oppose the means test because, they claim, it would lead many people to abandon private insurance.

Leaving aside the question of why that would be such a bad thing, this is a weak argument.

Treasury's calculations show that only about 0.3 per cent of the 10 million people with insurance would quit. And it's not hard to see why. Higher earners are essentially compelled to hold private insurance by the Medicare surcharge. And Labor's plan actually involves increasing the size of that stick.

It's clear Labor's motives are to make the system a little less unfair and save the budget a little money (its means test would reduce the $3 billion annual cost of the rebate by about $700 million) without harming private insurance.

So, just as the Libs now accept the legitimacy of Medicare, so Labor now accepts the legitimacy of taxpayer-subsidised and enforced private health insurance. One of the few remaining ideological gaps has greatly narrowed.

The pity is that, as John Menadue and Ian McAuley explain in a new paper published by the Centre for Policy Development, subsidising private health insurance doesn't only advantage the better-off (including yours truly), it makes healthcare more expensive than it needs to be.

Healthcare costs to the community - whether funded by the taxpayer or privately - are already growing rapidly and are set to keep outpacing most other costs, becoming by far the greatest pressure on government budgets.

That makes healthcare the greatest source of pressure for rising taxes. Nothing wrong with that - provided we get value for money. But that's just where private insurance lets us down.

Howard's subsidy of health fund premiums was really a vote-buying election promise and a gift to the well-insured Liberal heartland. He tried to justify it by claiming that getting more people into private insurance would relieve the pressure on public hospitals.

As all the experts predicted at the time, it didn't work. It shifted patients from public to private, but it also shifted doctors from public to private, leaving public queues little changed. It did, however, subsidise the better-off in their efforts to jump the queue.

As anyone who's done high school economics could tell you, the benefit from a government subsidy of the price of something is shared between the buyer and the seller. The health funds have become a lot more profitable than they used to be.

All arrangements that separate the true cost of something from what you appear to pay for it at the counter encourage overconsumption, overservicing and overcharging. That's true of Medicare as well as private insurance.

But unlike private insurance, Medicare has countervailing advantages. Being a single national payer, it has lower administrative costs and, more to the point, greater ability to counter the market power of healthcare providers.

Our many private health funds have little ability - and little incentive - to counter overservicing and overcharging. It's a well established principle in health economics that those countries with the greatest reliance on private insurance to finance healthcare have the most expensive healthcare - without a commensurate improvement in their health. The United States is the classic case.

Using carrots and sticks to prop up private insurance not only subsidises a two-class health system, it delivers its greatest benefit to the incomes of medical specialists. Great idea.

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Asia well-placed to withstand global slowdown

Perhaps it's our natural eurocentricity, but we've been hearing a lot more about recession and the risk of worse in Europe than about the resilience of our own region. Fortunately, the International Monetary Fund set the record straight last week.

At a briefing in Washington, the director of the fund's Asia and Pacific department, Anoop Singh, focused on the counter-weight to the weakness in the North Atlantic economies.

If the euro zone is expected to contract by 0.5 per cent this year and the United States to grow by only 1.8 per cent, how come the world is still expected to grow by a not-so-terrible 3.3 per cent? Mainly because "developing Asia" is forecast to grow by a buoyant 7.3 per cent.

Singh made four main points. First, while growth in Asia has slowed, Asian economies have generally proved resilient to the increased turbulence in global financial markets and are helping to support global growth.

Second, there's certainly a risk of contagion to Asia from any further deterioration in global financial conditions.

But, third, the fund believes that, in the event of further slowdown in the global economy, most economies in Asia have room for "a strong policy response" - that is, room to stimulate their economies to offset the effects from abroad.

And fourth, the recent decline in the current account surpluses of China and many other Asian economies is very welcome. Sustained efforts to continue this decline in the medium term will reduce Asia's exposure to the external risks it's experiencing now, thereby maintaining its support for global growth.

"So, in both the short term and medium term, there are positive factors coming from Asia," Singh said.

On his first point, economic activity in Asia has slowed mainly because the growth in its exports has lost momentum, thanks to weaker growth in regional as well as global trading partners. But robust growth in domestic demand is helping offset this drag from external demand.

In China, the two main components of domestic demand - investment spending and consumption spending - have remained resilient, supported by strong corporate profits and rising household income.

And Asian banks have so far used their strong balance sheets to step in and ensure a continued flow of credit and trade finance in the face of the reduction in lending growth by European banks. As growth has slowed in Asia, inflation pressures have waned. So it's not surprising governments have paused the pace of tightening macro policies, or in some cases reversed it. The fund expects inflation to recede further this year.

The fund expects growth in the overall Asia-Pacific region to remain closed to 6 per cent this year, recovering to 6.5 per cent next year. Within this, emerging Asia will remain the fastest-growing region in the world, led by China and India. In China, growth will remain in the 8 to 8.5 per cent range this year, returning close to 9 per cent next year. In India, growth will stay about 7 per cent.

On his second point, these are just the fund's central forecasts. There's a clear risk an escalation of Europe's debt crisis could cause global growth to be 2 percentage points lower than the central forecast of 3.3 per cent.

Were this to happen, Asia would be greatly affected because the usual effect on its exports would be compounded by an adverse effect on business and consumer confidence, as well as by contagion in the financial sector. So there would be a knock-on effect from external demand to domestic demand.

Moving to his third point, were such a deterioration to occur, policy responses by Asia would be needed, without which the impact on Asia's growth would be substantial. But the fund believes many countries have the room to respond.

For many, the room is greater on the fiscal (budgetary) side than the monetary (interest rate) side. The pace at which countries are reducing their budget deficits could certainly be slowed, particularly in those with low levels of public debt, such as China. More than that, some countries could undertake another round of fiscal stimulus.

"Indeed, many Asian countries could advance their plans, which they already have over the medium term, to boost social safety nets and increase consumption and investment," Singh said.

These policies would have long-term positive effects on "rebalancing" - increasing domestic demand and thus reducing reliance on external demand - and growth, as well as reducing income inequality, which remains an issue in many Asian countries.

As for monetary policy, monetary tightening has appropriately been paused in many Asian economies, with some beginning to reverse this tightening. But the room for further easing is limited in economies where underlying inflation pressures remain, such as India. China has little room because it's still absorbing the stimulus from its previous credit expansion of the past two years.

As usual on these occasions, Australia hardly rated a mention. Except for this: "The authorities have certainly committed to return to [budget] surplus by 2012-13, and we have supported that. The authorities have believed that an exit from fiscal deficits is needed to rebuild fiscal buffers and support monetary policy," Singh said.

"Having said that, it is also the case that were downside risks to materialise, with a further slowing of the global economy, in Australia the authorities probably have more policy flexibility than almost any other advanced economy.

"Why? It currently has probably one of the highest policy interest rates, and it probably has the lowest net public debt-to-GDP ratio.

"So, clearly, Australia has the ability to take actions if there were to be a further external deterioration."

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Why economic modelling is so tricky

When I was studying economics at university in the mid-1960s, I wasn't quite sure what a "model" was. These days, politicians and business people are always using the word, and most of us think we know what they mean.

In case you're not sure, here's an explanation I would love to have seen at uni, provided by Dr Richard Denniss, executive director of the Australia Institute, in his new paper, The Use and Abuse of Economic Modelling.

"A model, be it a model car or an economic model, is a simplified representation of a more complex mechanism. A model is typically smaller, simpler and easier to build than a full-scale replica. A model sheds light on the main features of the reality it seeks to represent," Denniss writes.

"An economic 'model' is not a physical thing, like a model car. Rather, it is a mathematical representation of the linkages between selected elements of the economy."

Thus an economic model is, unavoidably, a simplified version of the economy, or an aspect of the economy. It includes those aspects of reality the model-builder regards as most important in explaining what happens, and leaves out all those aspects that don't seem to make a big difference.

So the results you get from a model are only as good as the modeller's choice of what to include and what to leave out. In practice, the model's predictions will often prove astray because some factor the modeller assumed wouldn't be important turned out to be.

Different types of economic models are used for different purposes. Earlier this week I used Denniss's paper to discuss the input-output model that industry lobbies use to make their industry sound bigger than it is.

Today let's discuss the most sophisticated models economists have developed; "computable general equilibrium" models. These are often used to shed light on the effect of a major policy change on the economy over the next 10 or 20 years.

Economists often analyse only a part of the economy, called a "partial equilibrium analysis", while assuming ceteris paribus (all other things remain equal) in the rest of the economy. This is unrealistic because, in the economy, everything is connected to everything else. Changes in one bit lead to changes in other bits, which then feed back on the first bit. So general equilibrium models attempt to capture all these interactions between different industries and markets. (In practice they can't capture all of them, so they still rely on the ceteris paribus assumption to cover those they leave out.)

If you remember nothing else about models, remember this: their weakness is they are built on a host of assumptions, and therefore are only as good as the assumptions on which they are built. Some assumptions are obviously unrealistic and couldn't possibly hold; some happen to be overtaken by events.

Models are sets of equations with dependent and independent variables. The modeller decides the values of the independent (or "exogenous") variables and the model calculates the values of the dependent ("endogenous") variables. So, if the modeller puts in the wrong independent variables (usually assumptions or guesses about the future), the dependent variables will be wrong, too.

The model-builder also specifies the "elasticity" (sensitivity) of the relationships between the variables. For instance, when the exchange rate rises will the reduction in exports be big or small? Elasticities are partly based on empirical evidence, but they also reflect the model-builder's beliefs about how the economy works. Should that belief be wrong, the model's results will be wrong.

It's common for general equilibrium models to be Keynesian in the short run (up to 10 years) but neoclassical in the long run (20 years or more). That is, key variables such as inflation, unemployment and economic growth are determined by the strength of aggregate (total) demand in the short run, but by the strength of aggregate supply in the long run.

This means the economy is assumed to be at full employment in the long run, and economic growth over the period is assumed to be determined solely by the growth in the labour force (the population of working age and its rate of participation in the labour force) plus the rate of improvement in the productivity of labour.

How do you know what the average rates of growth in population and productivity will be over the next 20 years? You take an educated guess, then plug them in. But here's the trick: once you've done that, you've predetermined where the model's results will end up, regardless of whatever policy changes you simulate happening to the economy in the meantime.

No matter how much some change knocks the economy off its assumed long-run course, the model's specifications assume it will not only get back on course but also catch up to where it would have been.

The economy can take up to 10 years to return to its "steady state".

So, the bigger the initial departure from the long-run trend, the bigger the ultimate bounce back - by design. And, by design, nothing can ever happen that changes our destiny.

Thus the model assumes away "path dependency" - the idea that where we end up is determined by what happens to us on the way; that some developments leave us permanently better off, while some leave us permanently worse off. This is clearly unrealistic.

But see what it means? It means the policy change you're purporting to be testing doesn't stand a chance of making much lasting difference, for good or ill. And that means your test is a sham. You give the appearance of testing some proposition, but the outcome is essentially predetermined.

I think such models should be used only in private by consenting economists. They have a good understanding of the assumptions on which the model's results are built and they know whether they share the modeller's faith that the economy works the way her model assumes it does.

When the results of these models are paraded before the public - by governments and treasuries, as well as interest groups - they can't help but mislead. They appear to be proving some policy change would be good or bad but, in truth, they're coming to predetermined conclusions.

The sign that the sponsors and modellers are out to mislead is shown by their failure to highlight their model's key assumptions in some sort of comprehensible product disclosure statement.

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Talk to Fairfax employment group, Sydney, 6.2.12

I want to say a few words about the outlook for the economy in general and employment in particular, but before I do I have to issue a standard consumer warning: economists have a very bad record in forecasting what will happen in the economy, so you’d be wise not to take a blind bit of notice of anything I say.

But let me give you my prediction: the economy’s performance this year is likely to be just a fraction below average, but it will feel a lot worse than average - particularly when it comes to employment. Why? Because the media will be making it sound worse than it is.

Let’s start by talking briefly about the overseas situation. We’ve heard a lot about the troubles of the euro area - and those troubles are very real - but the forecast I’m about to give and all the forecasts we’ve been hearing lately are based on the assumption the Europeans muddle thru: they go through a period of significant weakness, where they’re a drag on the rest of the world economy, but they don’t implode and become a major restraint on world growth. In recent days the situation in Europe has been looking a bit better - a bit less like it’s about to implode - which is nice, and may it continue. Even so, the risk of things in Europe turning really bad is still uncomfortably high.

Around the middle of last year there was a lot of concern about the weakness of the US economy, but it’s been looking a bit better in recent times - not brilliant, but growing fast enough to slowly reduce unemployment. So that’s good.

In such a world - but, of course, with China and the rest of developing Asia still growing quite strongly - the outlook for us, which the Reserve Bank is likely to announce later this week, is for the economy - real gross domestic product - to grow by 3.25 per cent this year. This is the economy’s long-run rate of growth. Where will the growth come from? Particularly from the huge surge in business investment spending on the construction of new mines and, especially, natural gas facilities. But also - and contrary to anything you might have heard - from reasonably strong consumer spending. It used to be true that households were increasing their rate of saving, but it hasn’t been true for some time. The rate of household saving has been steady at 10 pc of disposable income for about a year, meaning consumer spending must being growing at the same rate as disposable income is growing. If you find that surprising, it may be because you’re confusing consumer spending with retail sales. Retail sales have been very weak, but they account for only about a third of consumer spending.

The labour force grows by a percent or so every year thanks to natural increase and immigration, so employment has to grow by that much just to hold unemployment steady. Normally growth at the average rate of 3.25 per cent a year would be sufficient to hold unemployment steady, but employment grew unusually strongly in 2010, and since then a lot of employers seem to have been holding off hiring more workers, allowing their existing workers to work more hours, but waiting to see what happens to the economy. If they keep thinking this way it seems likely the unemployment rate will slowly creep up, from its present 5.2 pc to about 5.5 pc in June and maybe 6 pc by December. That wouldn’t be good, but remember that an unemployment rate of between 5 and 6 pc is still a lot better than we experienced for most of the past 20 years. And 5 pc is getting towards the lowest point the Reserve Bank will allow unemployment to fall to because of its concern to keep inflation under control. As the unemployment rate falls close to 5 pc or lower, the Reserve starts to raise interest rates; if it starts rising towards 6 pc the Reserve starts cutting interest rates. It did that twice towards the end of last year, and if it doesn’t cut them again tomorrow, most economists are confident we’ll get more cuts this year.

Just because unemployment is likely to rise a bit doesn’t mean no new jobs will be created. For a start, and as we’ve just seen, total employment can still grow modestly even though unemployment is drifting up. Only if unemployment is shooting up is it likely that total employment is unchanged or falling. But, in any case, there’s a further point to understand - one that’s very important to the job you guys are doing. The figures the media quote each month for employment and unemployment are figures for the net change between this month and last month. If total employment around Australia is up by, say, 35,000, it’s easy to jump to the conclusion that only 35,000 positions were filled during the month; every existing worker stayed in their job, and they were joined by 35,000 more workers, presumably coming from being unemployed. Fortunately, it’s not like that. The truth is that, on average, every month about 370,000 people leave their employers and about the same number take up jobs with a new employer. So when the figures tell you employment rose by 35,000 last month, what this actually means is that the number of people taking up new jobs exceeded the number leaving jobs by 35,000. In other words, there’s huge turnover in the job market every month - even in the depths of a recession - even if the net change in total employment isn’t very big - in either direction. If you think that figure of 370,000 is so huge it’s hard to believe, you’re forgetting how big the workforce is. It’s almost 11.5 million, meaning about 3 per cent of workers leave their jobs every month - to get a better one, to have a baby, to retire, to go on an extended overseas trip, or whatever. My point is, don’t think just because employment is likely to be growing only slowly and unemployment to be creeping up, there won’t be many potential customers for you. There should be.

Finally, I said the economy wouldn’t be too bad this year, but the media will be making it sound worse than it is. Why do I say that? Because the media, knowing we regard bad news as a lot more interesting than good news, will be doing what it always does: emphasising the bad news about the economy and not saying much about things that are going OK. But I suspect there’ll be a special reason this year. The very high dollar is making life particularly tough for manufacturers, the tourist industry and overseas-student education. Some employers have been laying off workers, and it’s a safe there’ll be more. It’s an equally safe bet those lay-offs will be highly publicised by the media. This is likely to create the impression in people’s minds that the jobs market is a lot weaker than it actually is - for three reasons. First, people don’t realise how big our economy is, so they’re more impressed by relatively small numbers than they should be. Last week Toyota announced its intention to reduce its numbers by 350. That seems a lot, but beside the third of a million workers who leave their jobs every month it’s a fleabite. Second, you wouldn’t know it from the way the media talk, but the high dollar isn’t destroying Australian jobs so much as reducing them in some industries and increasing them in others. People may be losing jobs in manufacturing, but employment will be rising in other industries. Such as? Mining and construction, as the obvious ones, but also many parts of the services sector: health care, finance and insurance, public administration, various professions and arts and recreation. Finally, people tend to lose their jobs in bulk, whereas employment tends to increase in dribs and drabs. We get to hear about the big layoffs, but not the individuals being taken on.

All up, it should be too bad this year.

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