Thursday, February 28, 2008


Talk to the Economic Society evening seminar, Sydney, Tuesday February 26, 2008

It occurs to me that, as the journalist of the panel, the most useful thing I could do is to give you a reporting job on the new policy directions the Rudd Government actually is heading in before giving you some of my opinions about the directions it should be heading in. Ill start with macro management and move to micro-economic reform.

Macro management directions

Here the story should be familiar to you. The Government is genuinely anxious to end the period when fiscal policy was held in neutral and bring it back into the game, using it to assist monetary policy. It wants to allow the automatic stabilisers to work. To that end it has announced its intention to plan for a budget surplus of at least 1.5 per cent of GDP and to allow any further upward revision of revenue estimates to add to the surplus. The expenditure review committee is engaged in a protracted round of spending cuts – although well see how much it has the courage to come up with. Wayne Swan has warned the budget will be unpopular, but well see how unpopular. At one level Labor is just engaged in the now traditional practice of incoming governments slashing away at the pet programs of their predecessors, but I do think it is genuine in its desire to reactivate fiscal policy.

As youve probably seen me write, I believe Labor will be crazy if it goes ahead with its promise to deliver $7 billion in tax cuts in the May budget. Rudd seems genuinely committed to keeping his promises, and to renege would invite invidious comparisons with Keatings L-A-W tax cuts but, even so, I havent completely given up hope that Labor will postpone them. Im surprised to see business economists of the wisdom of Saul Eslake accepting the tax cuts as inevitable. We dont do the politicians any favours when we knuckle under to the boys-will-be-boys logic of political expediency rather than staying a staunch advocate of good policy. If they are to break irresponsibly-given promises they need to do so against a background in which all the top commentators and experts are urging them to. I also think that, when we keep banging on about the tax cuts, we at least increase the likelihood that they will be diverted into superannuation. Another compromise would be to continue the cuts aimed at improving work incentives for part-timers and other low income-earners, but to postpone raising the thresholds of the two top tax rates ($75k to $80k and $150k to $200k). The efficiency, supply-side case for the latter cuts is weak – much as I, like you, would enjoy receiving them.

I havent yet given up preaching against the tax cuts because I know that, if they are to be abandoned or modified, such a decision wouldnt be announced now, at a time when the Treasurer and Finance minister are intent on putting maximum pressure on the spending ministers. Revenue-side decisions always come last.

A point of information: its a generally accepted rule of thumb in Canberra (but not necessarily in Martin Place) that the trade-off between fiscal policy and monetary policy is that each increase in the budget outcome over last years outcome of $3 to $4 billion has the same effect on demand as a 25 basis point increase in the cash rate. Note, however, that the forecasts announced on budget night often bear little relation to final outcomes. Thats true even of the estimate of the old years surplus.

Having reported what I believe are the facts of the macro story, let me add a few of my own opinions. The first is that, if the new government is to budget for an ever-growing surplus – a politically difficult prospect – it will need to come up with emotionally satisfying things to do with the surplus. The best suggestion Ive heard comes from Saul Eslake, who suggests the surpluses be allocated to buckets, to be drawn down over subsequent years, as economic conditions allow, in order to meet long-term goals that had previously been put in the too hard or too expensive basket. Saul suggests seven different attractive labels for buckets.

Second, let me make the obvious point that any efforts by the Rudd Government to allow the automatic stabilisers to work – as measured by an increase in the surplus – could be offset by opposite changes in the states cash budget balances. Its surprising weve heard nothing about this from the Government. Maybe, again, its too soon in the budget cycle.

Third, the whole area of the role of fiscal policy needs a big rethink – perhaps a report by Vince FitzGerald – to a) return some rigor to the medium-term fiscal strategy of balancing the budget over the cycle, b) get the Government off the hook of past me-too statements about eternal budget surpluses and the demonising of all deficits and debt, c) re-establish the legitimacy of government borrowing for capital works and adopt a medium-term strategy that distinguishes between capital and recurrent spending, and d) elucidate the latest thinking about how best fiscal policy can share with monetary policy the burden of achieving internal balance.

Fourth, on a quite different tack, the whole world needs to keep working on the problem that monetary policy seems good at controlling inflation, but not credit-fuelled asset booms, the unhappy aftermaths of which seem to be playing an increase role in the amplitude of the cycle and in the onset and severity of recessions. Perhaps part of the answer is for fiscal policy to play a bigger role.

Micro reform directions

Again lets start by reporting the facts. The Rudd Government has put a strong emphasis on – and made early steps towards – achieving further micro reform through the COAG process – that is, through greater federal-state co-operation. It is seeking state co-operation with the implementation of many of its key election promises covering hospitals, vocational training, schools, climate change, housing and indigenous affairs. More importantly, it is seeking to revive interest in and make progress on the National Reform Agenda. This is the replacement to Keatings National Competition Policy. It was developed and pushed largely by the Victorians, and was officially adopted two years ago, but little has happened since – a measure of the Howard governments lack of interest in micro reform. A major reason for the lack of progress was Howards decision not to repeat the NCPs incentive payments to the states.

The NRA pursues reform under three heads: competition, reduced regulation and human capital. The competition head covers Rod Simss unfinished business on infrastructure reform; the reduced regulation head covers reducing red tape in 10 cross-jurisdictional hot spots; the more novel human capital head covers measures to raise labour force participation via improvements in health (including preventive health) and early childhood development, child care, education standards, school retention rates and so forth.

The COAG process has been beefed up, with new participation by federal and state treasurers alongside the prime minister and premiers. Four meeting are planned this year and many new working groups have been established. And Rudd seems likely to come to the party on incentive payments. Hes starting with the reform of special purpose payments, which are to be rationalised from several hundred separate schemes to just a handful of broad categories. This must surely involve a significant reduction in federal attempts to micro-manage the states. In any case, the focus of the conditions attached will be changed from inputs to outputs and outcomes. The newly rationalised collection of SPPs will be indexed, with the feds offering incentive payments on the top. Under NPC it was almost impossible politically to deny payments to states that had performed poorly. This time its indented to establish outcome targets and give states that achieve 90 per cent of their target 90 per cent of the incentive payment.

In addition to being finance minister, Lindsay Tanner is minister for deregulation. He will be ably assisted in this by the minister for small business, Dr Craig Emerson (the only qualified economist in the ministry). It seems to me, however, that so far Tanner has been too pre-occupied with ERC to have given deregulation much attention.

Of course, policy decisions relevant to micro reform are being made continuously by other ministers, such as Kim Il Carrs efforts to establish a new industry policy for motor vehicles and the much-trumpeted deal on open skies with America, which continues to keep the skies clear of competition from Singapore Airlines.

Thats the reporting job. Let me just add a few comments. First, any reform of education will need to involve significant increases in government spending. The back-door privatisation of the universities weve seen has created many problems and inefficiencies. Second, the one big area within the public sector thats crying out for major reform is health care. The plethora of federal and state intergenerational reports all make that crystal clear. In health the goal is not to raise efficiency so as to reduce spending – the pressure for greater spending is unceasing and irresistible – but to ensure the public gets value for money and also ensure not too much of the increased spending ends up fattening the incomes of medical specialists.

Finally, I agree with all the sensible people saying that climate change represents Australias (and the worlds) greatest economic as well as environmental challenge. The challenge is, as Ross Garnaut put it so starkly in last weeks report, to end the linkage between economic growth and emissions of greenhouse gases. Thats an extraordinarily tall order that will require an enormous degree of leadership and economic pain. So far, weve had a lot of grand gestures from our pollies, but not one really tough decision. But if we dont meet that challenge to break the link between growth and emissions, we – and the world – will have hit the limits to growth. If so, all our other reform efforts will count for little.