Wednesday, May 30, 2012

Labor's great appetite for spending but not taxing

It's taken me too long to realise it, but when I retired for a quiet meal after the federal budget lock-up this month, it struck me: there's truth to the opposition's charge that Labor is a big spending, big taxing government. Mind you, there's not as much truth to it as Tony Abbott & Co would like us to believe.

At one level, there's no truth at all. In the coming financial year, federal government spending is expected to equal 23.5 per cent of gross domestic product. It exceeded that level in nine of the Howard government's 12 budgets.

Federal tax collections are expected to equal 22.1 per cent of GDP, well down on the 23.7 per cent they reached in 2007-08, Howard's last budget. Were tax collections still that high, the taxman would be pulling in $25 billion more than he's expecting to.

So Labor can't be accused of being a big taxing government. It may be about to introduce two new taxes - the carbon tax, worth $7 billion a year when it gets going, and the mining tax, worth $3 billion a year - but it's giving back all the proceeds. That's why its expected budget surplus is wafer-thin.

So what's the problem? Well, I'm not sure if this vintage of Labor believes in Big Government but they surely hanker after its fruits. As I'm about to show, they're always initiating big spending programs.

Why then isn't their spending adding up to more than it does? Because, as their critics on the left keep pointing out, they have a fixation on returning the budget to surplus.

How do they reconcile their desire to spend big with their desire to return to surplus? By indulging in a kind of fiscal bulimia. They go through each year greedily gobbling up all these new spending delicacies, then at budget time they put their finger down their throat and vomit what they've eaten off into future years.

Kevin Rudd came to office promising an education revolution. You may not have noticed much change but it's not for want of spending. In five years, Labor's education spending has increased 60 per cent to $30 billion a year.

Rudd also promised to fix the inadequacies of the health system. Though every doctor you meet will assure you this miserly government isn't spending nearly as much as it should, under Labor federal spending on health has increased 37 per cent to $61 billion a year.

Rudd always wanted to be able to say his new policy was the biggest and best ever. He did that in 2009 when, standing in front of a frigate, he released a defence white paper that he claimed was "the most comprehensive of the modern era".

He had a much bigger and grander vision for defence than his predecessors, which he backed up by promising to spend a lot more money: a more generous indexation arrangement, plus extension of the commitment to real annual growth of 3 per cent.

But this is the most remarkable example of fiscal bulimia. In the four budgets since then, Labor has never once delivered the spending increases it promised. Another example is the deferral of Labor's promise to raise its overseas aid payments to 0.5 per cent of gross national income.

In all his time in power, Howard studiously avoided increasing the base rate of the age pension, knowing it would be far too expensive. But Rudd did it in his second budget - at a cost that, with indexation to average earnings and an ageing population, will grow and grow as the years pass.

For years, the self-seeking urgers in the superannuation industry sought to persuade the government to increase the rate of compulsory super contributions for employees. Howard always resisted but Labor gave in. Between 2013 and 2019, the rate will be increased from 9 per cent to 12 per cent of ordinary-time wages.

Ostensibly, the considerable cost to the budget of the concessional tax treatment of super contributions will be covered by revenue from the mining tax. But that cost will grow and grow - at a much faster rate than the tax grows.

Labor was keen to introduce paid maternity leave. In the good old days, a government would simply have imposed the cost of this on employers. But business gets a lot more privileged treatment these days, so this significant cost is being picked up the taxpayer.

Howard resisted pressure to increase federal spending on infrastructure but not Rudd. His greatest project is the gold-plated, Rolls-Royce national broadband network (though much of its cost is "off-budget").

You might think all this munificence came from Rudd, not Julia Gillard. Until we come to this year's budget. It includes greatly increased spending on dental health, taking us another step down the road to expanding Medicare to include dentists.

And it commits $1 billion to making a start on a national disability insurance scheme. When fully introduced, the scheme will cost $6 billion, maybe $8 billion a year. How would this cost be financed? Gillard doesn't know or care.

I must make it clear I approve of most of these new spending commitments. And I'm prepared to pay more tax to cover them. But Gillard and her party would run a mile before admitting taxes will need to be higher, not lower.

If Abbott inherits this grossly overcommitted budget - bringing with him his promises to abolish the two new taxes - just watch him walk away from Labor's grand spending projects: the national disability scheme, the overseas aid promise, the national broadband network, big education spending, the grand defence plan and the increase in super contributions.

Monday, May 28, 2012

Rudd's grandiose defence plan never flew

I'm no Colonel Blimp, but by far the biggest loser from all the fiscal bulldozing Wayne Swan had to do to budget for a surplus in 2012-13 - and keep it for the following three years - is Defence.

He used his dozer to push billions in planned defence spending off into never never land, beyond the forward estimates. And that's not the first time. Indeed, he's been doing it in every budget since the one in 2009 when, just 10 days after Kevin Rudd had unveiled his grand defence white paper promising hugely increased spending, Swan began postponing its commitments.

For the good oil on what the budget has done on defence spending it's always necessary to wait a few weeks for Dr Mark Thomson, of the Australian Strategic Policy Institute, to produce his annual analysis of the defence budget. Here's a summary - with my comments - of what he found this time.

The budget cut $5.5 billion from planned defence spending over the next four years, with spending in the coming financial year falling by more than 10 per cent in real terms, to $24 billion. In round figures, 40 per cent of this will go on personnel and 40 per cent on operating costs, leaving 20 per cent for investment in new equipment.

That real reduction is the largest annual decline since the end of the Korean War in 1953. Thomson expects spending to be equivalent to just 1.6 per cent of gross domestic product, its lowest proportion since the eve of World War II (though that doesn't necessarily prove much - what reason is there to expect our defence needs to grow at the same rate or faster than our income?)

Most of the cuts announced this month will be to investment spending: $3 billion from purchases of military equipment and $1.2 billion from the construction of facilities.

But that's not all. The budget also involves a redirection of $2.9 billion in spending within the defence budget to meet key cost pressures - areas where spending is expected to exceed previously set limits.

Most of this will be taken from planned investment in equipment. So it's the old story: whenever pollies are under budget pressure, the first thing overboard is capital works. One exception: $360 million will be saved by cutting civilian numbers by 1000 over two years.

When Rudd announced his grand plan to keep defence spending growing by 3 per cent a year in real terms, he also announced a "strategic reform program" to help cover the cost by delivering $20 billion in savings through greater efficiency.

Most of the areas where costs are growing faster than budget are areas where these efficiency savings were to be achieved. The problem seems to be partly that the savings were an accounting fiction and partly that Defence has failed to try hard enough. It would be wrong to imagine all the fault lies with the politicians.

The Defence Department's manifest failings aside, it's clear Rudd wanted a big expansion in defence spending, but neither he nor his ministers wanted it badly enough to find the money to pay for it.

Under unrelenting pressure from the opposition to prove their credentials as good fiscal managers, they gave a higher priority to getting the budget back to surplus. They won't cop any criticism from me on that.

But it's no excuse to say Rudd's grand plan was overtaken by the global financial crisis. As Thomson reminds us, the white paper was unveiled when everyone expected the crisis to hit us harder than it did.

Thomson argues Rudd's plan never added up. It had to make a clear choice about the role it wanted Defence to play in the future, then design a defence force consistent with that role, then commit to providing the necessary resources to make it happen.

It failed on each count. We're left with a Defence Department that's in disarray. It's supposed to be following a plan its political masters have sabotaged at every turn. Little wonder Julia Gillard has brought forward to next year the development of a new plan.

Let's hope this time the government formulates a plan it can afford, one consistent with its iron commitment to "fiscal sustainability" (the great buzz-phrase of this year's budget papers). This suggests it'll be a lot less superlative than Rudd's grandiose effort.

And guess what? Thomson thinks it wouldn't be such a bad thing. "For what it's worth, this author believes that Australia can responsibly adopt a less ambitious defence strategy than that set out in 2009," he says. "It's likely that the defence force we need is also the one we are willing to pay for."

But, you say, surely Tony Abbott will be the one making those decisions after 2013. Quite possibly. But don't assume his approach will be a lot different.

Thomson observes that public opinion has shifted. The strategic fears and misgivings of the post-September 11 decade have been replaced with the uncertainty and caution of the post global financial crisis decade. For the moment, at least, most people are more worried about the next financial crisis than they are about the seemingly remote prospect of a strategic crisis.

And get this: "The opposition's resistance to the latest round of cuts to defence spending has been both muted and laced with caveats. The long-standing bipartisan approach to defence policy has been trumped by bipartisan fixation on achieving a surplus."

Sure. But take a look at the dire straits decades of budget deficits have got the Europeans into and at the Americans' bitter warring over their budget. As vices go, an obsession with keeping the two sides of the budget in balance isn't high on my list of sins.

Saturday, May 26, 2012

Why we've become good savers

Who would believe it? Australia is turning into a nation of savers. We've already lifted our rate of saving - we save more than people in other developed countries - and we're likely to increase our saving rate further.

Who would believe it? Australia is turning into a nation of savers. We've already lifted our rate of saving - we save more than people in other developed countries - and we're likely to increase our saving rate further.

This the surprising message in this year's budget statement 4 - otherwise known as Treasury's sermon. The facts and figures that follow come from there.

Expressed as a proportion of gross domestic product, gross national saving fell significantly from the mid-1970s until the early 1990s. Between 1992-93 and 2004-05, it was fairly steady at 21 per cent. It began to rise in 2005-06 - well before the global financial crisis - and since the crisis it's shot up to reach almost 25 per cent last year.

This is well above the average for the developed economies of less than 19 per cent. Now, their saving rates are down because they're still trying to put the Great Recession behind them and it's arguable that some part of our increased saving since the crisis is also a passing reaction to the uncertainty it continues to cause. But we were well above them before the crisis.

The nation's rate of saving is the sum of the saving done by the three sectors of our economy: the households, the companies and the governments.

Households save when they spend less than all their income on consumption. Companies save when they retain part of their after-tax profits rather than paying all of them out in dividends. Governments save when their revenue exceeds their recurrent spending.

Most of the reason for the increase in national saving - and most of the reason for expecting it to increase further - rests with households.

The household saving rate declined steadily from the mid-1970s to the mid-noughties but then it increased significantly and is now 11.5 per cent of GDP, up from a low of just under 6 per cent in 2002-03.

One reason for this turnaround is the maturing of the compulsory superannuation system. Award-based super was introduced in 1985 but the scheme really got going in 1992, when they began phasing up employer contributions to 9 per cent of ordinary-time wages by 2002.

The value of Australia's super savings is now as much as $1.3 trillion, equivalent to 95 per cent of annual GDP (compared with the average for the developed countries of 68 per cent). Treasury estimates the scheme now makes a gross contribution to national saving of 1.5 percentage points.

Treasury says the more recent increase in household saving is likely to reflect a combination of increased consumer caution following the crisis and a return to more sustainable rates of consumption growth.

To the extent it's a return to more normal rates of growth in consumer spending, it's likely to be lasting. To the extent it's just caution, retailers and others can hope it will go away as all the upheaval stemming from the global crisis is resolved, people become more confident and lower somewhat the rate at which they're saving.

Now, no one can say how much of our higher household saving rate comes from lasting ''structural change'' and how much comes from passing caution. Until more of history unfolds, we can only make guesses.

But my guess is most of it is structural and not much of it is passing. In any case, I can't see the global economy becoming a much more placid place any time soon. Europe's weakness could roll on for a decade.

I think the econocrats are holding out false hope to retailers and others with their talk of ''the cautious consumer'', implying the tough times will end as soon as shoppers cheer up. It would be better to encourage the retailers to get on with adjusting to the new world they live in.

Treasury says the fall in household saving up to the mid-noughties primarily reflected a prolonged, but essentially one-off, structural adjustment to financial deregulation from the early '80s and the transition to a low-inflation (and hence low nominal interest-rate) environment from the early '90s.

Easier access to credit and lower rates led to greater borrowing, rising house prices, high levels of confidence and - thanks to big capital gains - people reducing their saving rate and allowing their consumption spending to grow faster than their incomes.

This adjustment process is likely to have been a significant driver of change in household saving. From the second half of the noughties, however, households began to slow their accumulation of debt and, as a result, the household saving rate began to rise.

With this process now likely to have been completed, households as a whole can be expected to consolidate their financial position over coming years by returning to more normal levels of saving and borrowing.

That's a quick explanation of why we've gone back to being good savers. But why expect our saving rate to go on rising? Partly because our (largely foreign-owned) mining companies are retaining a high proportion of their huge after-tax profits (which they're using to help finance their investment in additional production capacity).

Partly because the federal politicians (and their state counterparts) are struggling to get their budgets back into operating surplus, meaning governments are shifting from dissaving to saving.

But mainly because the compulsory super scheme will soon begin phasing up the contribution rate from 9 per cent of wages, reaching 12 per cent in 2019-20. Treasury estimates this will make a further gross contribution to the national saving rate of 1.5 percentage points of GDP over the next 25 years, with most of that expected to occur over the next decade.

Just as every punter knows in their gut that deficit and debt are always and everywhere a bad thing (it ain't true), so everyone knows saving is always a good thing. But what's so good about it?

The main reason people save is to smooth their consumption over time. For instance, you consume less while you're working so you can have a higher standard of living when you're retired. You can even use saving to pass some of your income on to the next generation. And saving makes you more resilient by providing a buffer against unexpected adverse events.

At a national level, borrowing less and saving more makes us more resilient to possible external shocks. And it helps moderate inflation pressure and so allows interest rates to be lower.

Thursday, May 24, 2012


Economics Seminar Day, Pymble Ladies’ College, Thursday, May 24, 2012

I want to start by giving you the basic facts of the budget Wayne Swan brought down on May 8, look at the forecasts for the economy included in the budget, then assess the ‘stance’ of fiscal policy adopted in the budget and finally comment on where this leaves us with the ‘policy mix’ - the government’s economic objectives and the way these objectives are divided between the arms or instruments of macroeconomic policy.

Key budget facts

Mr Swan is expecting budget receipts to grow by 12 pc in the coming financial year, 2012-13, while budget payments fall by 2 pc. This would cause the expected underlying cash deficit of $44.4 billion in the old financial year, 2011-12, to become a surplus of $1.5 billion in the new financial year. As a proportion of GDP, the budget balance would swing from minus 3 pc to plus 0.1 pc. Mr Swan is expecting the budget to remain in tiny surpluses for the following three years.

He is expecting the federal government’s net debt to peak at 9.6 pc of GDP - or about $143 billion - in June this year, then have fallen to 7.3 pc of GDP ($132 billion) by June 2016.

The main measures to take effect from the beginning of the new financial year are the minerals resource rent tax - expected to raise about $3 billion a year - and the carbon pricing mechanism, expected to raise about $7 billion a year when it’s fully under way. Neither tax is expected to contribute to returning the budget to surplus, however, because both are part of tax packages that are roughly revenue-neutral. Proceeds from the minerals tax will be used to pay for various tax concessions for small business, for various increases in benefit payments, and for the cost to the budget in forgone income-tax revenue of slowly increasing the rate of compulsory superannuation contributions from 9 pc to 12 pc of employees’ wages. Proceeds from the carbon tax will be used to pay for compensation to households (a small income-tax cut and an increase in pensions and the family tax benefit), assistance to emissions-intensive, trade-exposed industries and subsidies to encourage renewable energy projects.

These two packages were announced in earlier budgets. The new measures announced in this budget involve savings of $33 billion over five years (but $4.7 billion in the budget year), offset by new spending of $22 billion over five years (but $1.7 billion in the budget year). The main savings come from reneging on promises to cut the rate of company tax by 1 percentage point and to introduce various new tax concessions, from various reductions in ‘middle-class welfare’ and from deferring spending on defence and overseas aid.

The main new spending measures are replacing the education tax refund with a schoolkids bonus (the first payment of which will be made just before the start of the carbon tax), an increase in the family tax benefit and a tiny increase in the dole; the first stage of the national disability insurance scheme and increased spending on dental health.

Budget forecasts

The economy is forecast to return to growing at about its medium-term trend rate, expanding at an average rate of 3 pc in the old financial year and by 3.25 pc in the coming financial year. The growth in 2012-13 would be brought about by another very big increase in mining investment spending and trend growth in consumer spending, but no growth in new home building and a small contraction in public sector spending as federal and state governments seek to return to operating surplus. Domestic demand is expected to grow faster than trend, but net external demand (exports minus imports) will subtract from growth as the volume of imports increases faster than the volume of exports.

This fall in ‘net exports’, combined with a further modest decline in the terms of trade, is expected to see the current account deficit worsen from a very low 3 pc of GDP in the old year to 4.75 pc in the budget year.

The headline inflation rate is expected to worsen to 3.25 pc in the budget before returning to 2.5 pc the following year.

Employment is expected to grow by a weak 1.25 pc, with the unemployment rate creeping up to 5.5 pc and the participation rate little changed.

The forecasts for our economy are based on a forecast that world GDP will grow by a slightly below-trend 3.5 pc in calendar 2012, with strong growth in developing Asia offsetting weak growth in the developed economies. There is a significant risk this forecast won’t be achieved if the eurozone economies get into greater difficulties, or if China’s economy slows more than intended.

The stance of fiscal policy

The strict Keynesian way to assess the stance of fiscal policy adopted in the budget is to ignore the expected change in the budget balance brought about by the operation of the budget’s automatic stabilisers (known as the ‘cyclical component’ of the balance) and focus on the net effect of the explicit (discretionary) policy changes announced in the budget (the ‘structural component’).

These days, however, it’s more common for economists to take the short cut of simply looking at the direction and size of expected change in the overall budget balance from the old year to the new year. Taken a face value, the expected improvement in the budget balance of almost $46 billion - equivalent to 3.1 pc of GDP - says the stance of fiscal policy is extraordinarily contractionary.

But there are various reasons for doubting the contractionary effect is as big as it seems. The most important is that the budget includes decisions that push almost $9 billion worth of spending measures back into the last few weeks of the old financial year. Whether government spending occurs a bit before or a bit after June 30 makes little difference to the real economy, but it exaggerates the true size of the turnaround in the budget balance by almost $18 billion (ie it makes the old year $9 billion worse and the new year $9 billion better).

Another factor is that the new year’s budget is expected to benefit from increased revenue from resource rent taxes of $5.7 billion (that’s from the existing petroleum rent tax as well as the new minerals rent tax). These taxes are explicitly designed to be taxes on ‘economic rent’, so they have no effect on the incentive to exploit petroleum or mineral deposits and thus have no effect on economic activity.

A further factor is that, thanks to a quirk of public accounting, Swan’s underlying cash surplus of $1.5 billion takes no account of the government’s spending on the continuing rollout of the national broadband network. The relevant budget item is expected to involve increased spending of about $6 billion in 2012-13. Not all of that would relate to the broadband network, but to the extent it involves the government funding increased economic activity, it has the effect of reducing the budget’s adverse effect on activity.

To these arguments the Secretary to the Treasury, Martin Parkinson, has added one of his own: to some extent the budget redistributes income from higher income-earners (who would have a lower marginal propensity to consume ie be likely to save a higher proportion of their income) to lower income earners (with a higher propensity to consume), thereby tending to increase net consumer spending somewhat. Taking all these factors into consideration, Dr Parkinson has suggested the contractionary effect of the budget is probably less than 1 pc of GDP. Even so, that’s still a contractionary stance of fiscal policy.

The changing policy mix

The textbooks list two longstanding objectives of macro-economic management: ‘internal balance’ and ‘external balance or stability’. Internal balance means ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy is travelling at close to full capacity.

The point to remember is that it’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a steady rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’.

The objective of external stability meant achieving an acceptable CAD and a manageable foreign debt. Under the Hawke-Keating government, fiscal policy was allocated the role of achieving external stability. Because the CAD represents the amount by which national investment exceeds national saving, the goal was to contribute to higher national saving by achieving the biggest budget surplus possible. Soon after the election of the Howard government, however, it quietly abandoned external stability as a policy objective. Since then governments haven’t worried too much about the size of the CAD or the foreign debt.

It was under the Hawke-Keating government that the policy makers acquired a third objective: faster economic growth, combined with a more flexible economy, one capable adapting to economic shocks (shifts in the aggregate demand or the aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

Dr Parkinson made it clear in a speech after this year’s budget that the government has acquired an additional economic objective: fiscal sustainability. This is the desire to ensure we don’t run a long string of budget deficits and thus build up an excessive level of public debt (as we see has helped create the present European debt crisis).

We’re left with three macro-economic objectives: internal balance, faster economic growth and fiscal stability. To deal with these three objectives the policy makers have available for their use three economic instruments: fiscal policy, monetary policy and micro-economic policy. The policy makers’ decisions about which instrument to assign to which objective determines the ‘policy mix’.

Internal balance: the budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In the days when the exchange rate was fixed, macro economists used to think of the exchange rate as an additional instrument of policy. It could be ‘revalued’ (raised) to counter the inflation caused by a commodities boom, for instance, or ‘devalued’ (lowered) to cope with a balance-of-payments crisis. After the dollar was floated in 1983 - that is, after the market was allowed to determine the dollar’s external value - the exchange rate ceased to be an arm of macro policy. But in his recent speech, Dr Parkinson identified the macro role of the floating exchange rate, linking it with monetary policy. ‘Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments.’

Fiscal stability: Fiscal policy played a major role in the government’s efforts in 2008-09 to ensure the global financial crisis and the Great Recession it precipitated didn’t lead to a severe recession in Australia. The Rudd government announced at least three major fiscal stimulus packages. All of this spending was carefully designed to be temporary, rather than ongoing. But in his speech Dr Parkinson made it clear that this use of discretionary fiscal policy to assist monetary policy in maintaining internal balance was the exception to the rule.

‘A key objective of fiscal policy is to maintain fiscal sustainability from a medium-term perspective,’ he said. ‘Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policies should work together effectively to support activity, such as during the GFC.’

There are a few points to note about this. First, Dr Parkinson draws a clear distinction between the effects of the budget’s automatic stabilisers (cyclical component of the budget balance) and discretionary decisions to increase or decrease taxation and government spending (structural component). Second, the stabilisers should always be unimpeded in their role of helping to stabilise aggregate demand by reacting in a counter-cyclical way, thereby assisting monetary policy to achieve internal balance. Third, in normal circumstances, the role of discretionary fiscal policy is to pursue fiscal sustainability over the medium term. So, while the automatic stabilisers and monetary policy work together, in normal circumstances discretionary fiscal policy and monetary policy don’t work together because they have different objectives. Fourth, the budget’s expected return to surplus represents the return to normal circumstances.

The objective of fiscal sustainability is encapsulated in medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. Stick to this strategy and, over time, the accumulated deficits will be offset by the subsequent accumulated surpluses, leaving the government’s net debt little changed over the medium term. Note that the medium-term focus of the strategy allows for a) the unrestrained role of the automatic stabilisers and b) the application of discretionary fiscal stimulus during a major downturn in demand provided the stimulus is withdrawn promptly as the economy recovers.

At the time the government engaged in fiscal stimulus spending in 2008-09, it committed itself to a ‘deficit exit strategy’ to ensure the medium-term strategy was complied with. It set itself two targets: first, to allow the level of tax receipts to recover naturally as the economy improves (without breaching the government’s commitment to keep taxation as a share of GDP below its level in 2007-08 - 23.7 pc) - that is, to avoid unfunded tax cuts. And, second, to hold real growth in government spending to 2 pc a year, on average, until budget surpluses are at least 1 pc of GDP and while the economy is growing at or above trend.

Faster growth: the objective of faster and more flexible growth is pursued by the instrument of micro-economic (or structural) policy. Whereas macro-economic policy seeks to stabilise demand over the short term, micro-economic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. Over the medium to longer term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing. Micro policy works mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 1990s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.

Bottom line on the policy mix: Remember that, whatever job the policy makers decide they want fiscal policy to do, that doesn’t stop changes in the budget balance having an effect on demand. And, as we’ve seen, the stance of fiscal policy is contractionary. Even so, the present stance of monetary policy is mildly expansionary (market interest rates are a little below average). With inflation well controlled, however, the RBA has plenty of scope to ease monetary policy further should, for any reason, demand prove weaker than expected.

Wednesday, May 23, 2012

Why the pollies will keep fiddling with super forever

Have you noticed? Our guardians in the superannuation industry have come out swinging to defend us against the changes to superannuation announced in the budget. Mark Payne, a partner in the legal firm Hall & Wilcox, says "anyone that has turned 50 can feel dudded".

The changes "will be costly to administer, bring little revenue for the federal government and are a real disappointment for the over 50s, who will need to reassess their retirement strategies", he says.

According to John Brazzale, a managing partner of the accountants Pitcher Partners, "there's now less incentive to put money into super, particularly [for] those earning more than $300,000. They would be looking at how to get a better tax return by investing outside of super in, for example, businesses and managed funds etc".

One of his partners, Brad Twentyman, agrees.

"Superannuation at higher incomes has become very marginal and there is nothing compelling to drive self-sufficiency in retirement," he says. "This is not the system we should be aiming for. We need to be encouraging higher income earners to save for their retirement as well as lower income earners."

David Anderson, the managing director of Mercer, a financial services provider, warns that "continual changes to superannuation will unfortunately create a wave of uncertainty, confirming the commonly-held view that superannuation is an irresistible honey pot".

"There is a risk that further complicating and continually changing the rules in superannuation will reduce investor confidence in super and that would be a most unfortunate outcome," he says.

Sorry, but most of all that is self-serving tosh. For someone who's turned 50 to feel "dudded", they also need to be earning more than $300,000 a year (putting them into the top 1 per cent of taxpayers) or to have a super account balance of less than $500,000 and have been in a position to sacrifice salary of up to $25,000 a year.

The two decisions they're complaining about are to reduce the tax concession on super contributions by people on more than $300,000 from 31.5? in the dollar to 16.5? and to defer for two years the promise to raise the limit on concessional contributions from $25,000 a year to $50,000 for people over 50 with balances of less than $500,000. Few people on middle incomes could have afforded to take advantage of the higher limit.

The media have a tendency to quote uncritically business spokespeople who want to have a crack at the government of the day. But most of them are wolves in sheep's clothing.

They claim to be speaking in the interests of their customers but, for the most part, they are, in the money market phrase, "talking their book" - that is, offering advice that serves their own interests.

Even when measures have been carefully targeted to hit only the well off, they'll be shedding bitter tears and predicting dire consequences. Why? Partly because they're very highly paid themselves but mainly because they make more money out of the rich than the poor.

The guys who run super funds are in the ticket-clipping business. They take a tiny nick out of every dollar that passes through their hands and, since our super savings total $1.3 trillion, those tiny nicks add up to very big bucks.

The super industry - which includes not just the fund managers but also the (often union) trustees and the myriad outfits providing advice to them - is among the most lucrative in the country. These guys pay themselves extraordinary salaries.

And it's not just that clipping tickets is such a deceptively cheap way to make a fortune. It's also that, by compelling all employees to save 9 per cent of their wages, the government has delivered them a huge captive market.

Not content with that, however, after years of agitating they've finally persuaded the Labor government to phase up their monopoly from 9 per cent to 12 per cent - at a huge and ever-growing cost to budget in tax revenue forgone.

When this and other favourable changes were announced in 2010, no one in the industry was claiming continual changes to super were discouraging people from saving through super. They trot out this old favourite only when governments make changes that hit the industry's revenues.

Contrary to the claims we've heard, few people will need to "reassess their retirement strategies". And even for the very highly paid, the tax-effectiveness of saving through superannuation remains considerable, not "very marginal".

The proposition that the highly paid need to be bribed by tax concessions to put money aside for their retirement is laughable. Why would they be planning to live only on the age pension? And even if they do turn away from super to other ways of saving, why's that a problem for anyone but the super ticket-clippers?

When you combine this government's plan to ramp up super with the changes Peter Costello announced in 2006 - to make super payouts tax-free for those 60 and over; to sanctify the salary-sacrifice loophole and to ease the assets test on the age pension - you see it's not adding up.

The annual cost of super tax concessions is now growing so fast it's projected to equal the annual cost of the age pension by 2015-16. Such growth is simply unsustainable.

Now add the fact that these concessions go disproportionately to high-income earners, as well as advantaging the retired generation over the working young. The old don't pay income tax but the young do.

Get it? Barring the unlikely event of any politician summoning the courage to fix the whole unfair, unaffordable mess in one go, the pollies will go on fiddling at the edges of the super arrangements in just about every budget.

Monday, May 21, 2012

How spin doctors have taken control of budget papers

What if I told you the true expected budget balance for next financial year wasn't the much trumpeted surplus of $1.5 billion but a carefully buried deficit of $8.7 billion?

I'd be justified in making such a statement because that deficit figure is officially known as the "headline cash balance" and, as a journalist, I'm in the headline business.

I'd also be justified in drawing it to your attention because the government in its budget papers has made no effort to convince us the headline figure is of no macro-economic significance - rather, we should focus solely on the "underlying cash balance" of a $1.5 billion surplus.

Indeed, I'm not sure the headline figure is of no macro significance. Why not? Because I happen to know - no thanks to the government - that the difference between the two figures includes, among various things, the government's spending on the rollout of the national broadband network.

That's of no macro-economic significance? That has no effect on economic activity? Don't think so, chaps.

I'd really like to be able to tell you just what the transactions are that explain the difference between the headline and the underlying balances. But if there's a table anywhere in the voluminous budget papers spelling that out, I can't find it.

I'm sure if the econocrats had their way there'd be such a table, but the preference of the politicians and their private-office spin doctors is to conceal rather than explain. And even just the figure for the ironically titled headline balance has been carefully hidden to ensure it doesn't hit the headlines.

It didn't rate a mention in the Treasurer's budget speech; in the multicoloured Budget Overview document it was included as a "memo item" (that is, they don't tell you how it was arrived at) on page 36.

In the budget papers proper, it went unmentioned in budget statement 1 (also known as the budget overview) and got a single mention on page 9 of budget statement 3.

The hiding of the headline deficit is just one example of the way the budget papers are becoming less informative rather than more, and the way the government's spin doctors are turning them into an exercise in media management rather than transparency and accountability.

The budget speech used to be a thorough and trustworthy exposition of the new measures announced in the budget; these days it's a made-for-television rave about the budget's good points.

I suspect one reason the budget papers have become less rather than more user-friendly over the years is the spin doctors' desire to drive journalists away from the budget papers proper to the multicoloured Budget Overview, known to econocrats as "the glossy".

It's glossy by name and gloss by nature, putting the best gloss possible on the budget and focusing on whatever messages the government is trying to peddle.

It offers a seemingly useful list of the "major savings" announced in the budget, but you can't be sure all the "saves" you'd like to know about are listed. The single line for "other" savings accounts for almost a quarter of the total.

But that's honest compared with the list of "major initiatives" announced in the budget, otherwise known as "spends". It's a table without totals, meaning it doesn't even have a line for "other" spending. If it did, other would account for almost a third of the total.

Spin doctors work on the assumption journalists are both dumb and lazy, meaning they'll focus on whatever news you give them and not think to go looking for the things you conceal. They also assume journalists who benefit from background briefings and selective leaks won't be game to complain publicly about the way they're led around by the nose.

Journalists turn a blind eye to the rank hypocrisy of the Treasurer and Finance Minister piously refusing to comment on what may or may not be in the budget, while the Prime Minister's press office leaks much of its content to selected journalists, then quietly confirms the story's accuracy to those journos who missed the exclusive.

Unfortunately, there are head office-based journos who aren't part of the club and so feel no such inhibition. There are also, believe it or not, economists and even the odd private citizen who read the budget papers in the hope of enlightenment. They're getting the bum's rush.

This year AAP has accused the government of leaking budget information to selected media for broadcast during the budget lock-up. How's that for duplicity.

Budget paper No 1's coverage of revenue items is pretty thorough, but its statement on expenses leaves much to be desired. It's been stripped of its former graphs showing how spending categories have grown over the years and its tables showing the figures for major spending categories over many years. This paper used to have an index to help you follow a query through, but that was dropped long ago.

You have to delve as far as budget paper No 2 for reliable explanations of particular budget measures, but this information is listed by department rather than program or function, and little effort is made to help users find what they're looking for.

Federal bureaucrats are convinced they're superior to state bureaucrats in all respects, but the states' budget papers are generally superior to the feds' in their transparency, rigour and comprehensiveness. Federal budget papers are particularly inadequate on information about non-financial corporations, such as the NBN Co Ltd.

So tight is the spin doctors' hold on the federal budget process that some nameless operative in the "media liaison" section of the "communications unit" within Treasury's "ministerial and communications division" summarily declined, without explanation, a newspaper's request for budget tables to be supplied in spreadsheet format.

Saturday, May 19, 2012

Macro 'policy mix' returns to normal

In case you missed it, the secretary to the Treasury has spelt it out: with the budget's planned return to surplus next financial year, fiscal policy is being put back in the cupboard and the "policy mix" returned to normal.

Delivering his annual post-budget speech to the Australian Business Economists, Martin Parkinson outlined the "macro-economic framework" - the respective roles of fiscal policy (the manipulation of government spending and taxation), monetary policy (the manipulation of interest rates by the Reserve Bank) and the exchange rate.

"The primary responsibility for managing demand to keep the economy on a stable growth path consistent with low inflation" had been allocated to monetary policy, he said.

So "normal" is for monetary policy to be doing most of the work in keeping the economy steady. Its aim is "to maintain inflation between 2 and 3 per cent, on average, over the cycle". But, as you see, this doesn't mean the Reserve focuses on inflation to the exclusion of all else.

While keeping inflation low may be the target, the goal is non-inflationary growth - growth which should keep unemployment low.

And a key part of the mechanism for achieving low inflation and steady, job-creating growth is, in Dr Parkinson's words, "anchoring inflation expectations". Because the expectations of wage negotiators and businesses tend to influence the demands they make and the prices they set, keeping them expecting inflation to remain low is half the battle.

That's one of the main roles of the inflation target. Provided people are confident the Reserve will stick to its target - as they are - you can allow the economy to grow at a faster rate than otherwise.

Parkinson linked monetary policy with the exchange rate. "Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments," he said.

When, for instance, world commodity prices rise a lot and our terms of trade improve, the dollar tends to rise.

The extra national income flowing from the higher export prices would lead to a surge in demand that could be inflationary (and, in the days when our exchange rate was fixed, it was). But the higher exchange rate reduces the international price competitiveness of our export and import-competing industries which, by reducing exports and increasing imports, reduces the external component of aggregate demand (gross domestic product).

And this, combined with the direct reduction in the prices of imports, helps keep inflation under control. The exchange rate has thus absorbed some of the shock from the rise in commodity prices and so kept the economy growing steadily. When commodity prices fall, the process works in reverse.

But if monetary policy is the main policy instrument used to keep the economy on an even keel, what is fiscal policy's role?

Parkinson says a key objective of fiscal policy is "to maintain fiscal stability from a medium-term perspective". That is, to ensure we don't run so many budget deficits that, in time, we build up a level of government debt that becomes unsustainable.

(To see what nasty things can happen when you don't "maintain fiscal stability" look no further than Greece, with Italy and other European economies heading down the same track.)

But this is Parko's key message: "Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policy should work together to support activity, such as during the global financial crisis."

Let's unpack that mouthful. As we saw here last weekend, the budget contains "automatic stabilisers" that cause the budget balance to deteriorate when the economy turns down and improve when the economy turns up.

So the budget acts automatically to help stabilise the economy as it moves through the business cycle, with public sector demand expanding automatically at times when private sector demand is weak, and contracting automatically when private demand is strong.

Parkinson is saying this is a good thing and the macro framework requires that the automatic stabilisers be unimpeded in doing their job. That is, governments shouldn't take explicit ("discretionary") decisions that counter the effect of the stabilisers.

(Attempting to counter the stabilisers is exactly what the Brits and other Europeans are doing with their "austerity" policies. They've been slashing government spending at a time when the economy is weak. This weakens demand further, pushing the economy back into recession and, far from reducing the budget deficit, makes it worse. By ignoring elementary Keynesian principles, they've blundered into an adverse feedback loop.)

The next element in Parkinson's exposition of fiscal policy's role in the macro framework is that governments may take discretionary measures that reinforce the effect of the stabilisers, but only in extreme circumstances - such as a potentially serious recession.

In other words, apart from allowing the stabilisers to do their thing, it's not normal practice for fiscal policy to be used to manage the strength of demand from year to year. That's the job of monetary policy, for which it's better suited (because it can be adjusted quickly and easily and in small or large steps).

Parkinson says we've had such a "medium-term" approach to fiscal policy since the mid-1980s, "before evolving into a fully articulated framework with the development of [Peter Costello's] Charter of Budget Honesty in the second half of [the] 1980s". The charter requires the government of the day to announce a "medium-term fiscal strategy" and Wayne Swan's strategy is only marginally different from Costello's: "to achieve budget surplus, on average, over the medium term".

This formulation is carefully designed (by, I suspect, the Liberals' Senator Arthur Sinodinos) to allow the automatic stabilisers to push the budget into deficit during recessions - and even to permit governments to implement fiscal stimulus packages during recessions, as this government did - provided the stabilisers are unimpeded in returning the budget to surplus and any stimulus spending is ended.

This means that, over time, all the deficits incurred during downturns are roughly offset by all the surpluses achieved during upswings. The surpluses are used to pay off the deficits, thus keeping the level of government debt steady and sustainable over time.

So fiscal policy and monetary policy have different roles, and monetary policy and discretionary fiscal policy need to pull together only in emergencies.

Wednesday, May 16, 2012

Why a little more redistribution is justified

So, has the budget led to an outbreak of class warfare? Only if Julia Gillard's a lot luckier than she's been so far. That is, I doubt it. What I don't doubt is that her disparaging remark about the north shore was a calculated attempt to get a bit of class consciousness going to accompany her give-and-take budget.

But loyalty to parties on the basis of class is long gone. These days people's vote is as likely to be guided by the party divide on social issues as economic ones. Then there's the rise of the "aspirational" voter - people who don't mind seeing the better-off favoured by the government because they hope to be better off themselves one day.

If the public's reaction to this budget is any guide, we've either all become aspirationals or, more likely, a lot of people don't know which side their bread's buttered on. Wayne Swan brings down a Robin Hood budget and, according to last week's Herald poll, 43 per cent of respondents think it will leave them personally worse off and only 27 per cent expect to be better off. Talk about living in a fog.

Be in no doubt: this budget is the most highly redistributive in years. Whether out of desire to awaken class loyalties, to soften the blow of the carbon tax, or to buy votes, this budget gives quite a bit of money to low- and middle-income families.

The discretionary increase in the means-tested family benefit, to take effect from July next year, is well targeted to families in greater need.

The schoolchildren's bonus, the first payment of which will be made within a few weeks, goes only to parents eligible for the family benefit. It's a big improvement on the education tax refund, which mainly benefited those parents able to spend big on eligible equipment and savvy enough to keep receipts and make the claim.

The new income-support supplement, to take effect next March, will give people on the dole a princely 57? a week extra, reducing by a sliver the extent to which we require them to subsist below the poverty line. It is, nevertheless, the first real increase to the dole for more than 20 years. The budget plans for increased spending on dental health for the needy and a start to the national disability insurance scheme in July next year.

But though these measures are welcome, they hardly represent the big increase in welfare their critics claim. According to the calculations of Professor Peter Whiteford, of the University of NSW, their cost of $8 billion over four years represents an increase of less than 1 per cent of total budget spending on health and social security.

Helping to pay for these increases are cuts aimed squarely at the better-off. The top 1 per cent of taxpayers, earning more than $300,000 a year, will have the tax break on their superannuation contributions cut from 31.5? in the dollar to 16.5?, putting them on a par with most workers.

The provision allowing workers over 50 to make low-taxed super contributions up to $50,000 a year - that is, to exploit the salary sacrifice rort (as I've been doing) - will be cut to $25,000 from July. Those with super balances under $500,000 were to have been given an exemption from the cut, but this has been deferred for two years, thus largely closing the salary sacrifice loophole.

Despite the hard-luck stories, workers not on high incomes can't afford to sacrifice salary in this way.

The capped 50 per cent discount on the tax on interest income, which now won't happen, would have benefited the better off, as does the tax offset on net medical expenses, which is to be virtually eliminated.

Almost everyone - whether on the right or the left - automatically assumes company tax is a tax on the rich. So those excitable souls claiming the budget was a plan to "smash the rich" list as Exhibit A the decision not to cut the rate of company tax by 1 percentage point, as had been promised.

But Australian shareholders - including Australian super funds - get tax credits for the company tax paid on their behalf. And tax economists argue that, in the end, the burden of company tax is borne mainly by wage-earners.

So it's not at all clear to me that company tax is a tax on business or on the rich. Business was never terribly enthusiastic about the 1 per cent cut; I'm unimpressed by the bitter tears it's shedding now.

When you combine this Robin Hood budget with the way the tax cuts linked to the carbon tax are limited to individuals earning less than $80,000, with the way the temporary flood levy was aimed at the better off, with the various previous measures to reduce upper-middle class welfare and with the 2009 discretionary increase in the age pension (the largest real increase in the pension ever), you do have to conclude this Labor government, particularly under Julia Gillard, is very redistributive - though its record isn't unblemished.

And unless you're happy to see the gap between rich and poor widening - as it has been - that redistribution is not unwarranted.

According to figures from the Bureau of Statistics, between 2003-04 and 2009-10, average household disposable income rose by 26 per cent in real terms.

But the income of the bottom fifth of households rose by 17 per cent, whereas the income of the top fifth rose by 32 per cent.

Remember that next time you hear highly paid business people banging on about the budget being "more about how we carve the pie, rather than how we grow the pie". It was about time.

Monday, May 14, 2012

Swan's innovation: the budget as bulldozer

A closer look at the budget papers reveals just how contrived the budget's return to surplus is. Wayne Swan is hardly the first treasurer to resort to "reprofiling" (a word his people invented), but he's the first to use it on such a massive scale, turning the budget into a bulldozer.

Reprofiling means changing the previously announced timing of budget spending or taxation measures. Deciding not to proceed with previously promised tax changes (the 1 percentage point cut in the company tax rate, the standard deduction, the limited 50 per cent discount of tax on interest income) is one thing. In contrast, deciding to defer by two years the increase in the cap on super contributions by older workers is an example of reprofiling.

Nothing demonstrates how contrived this budget is better than the expected real growth in government spending. In the financial year just finishing, 2011-12, spending is expected to have grown by a whopping 4.8 per cent. In the budget year, 2012-13, it's budgeted to fall by a whopping 4.3 per cent.

But the following year it resumes its rapid upward climb, growing by 3.7 per cent. The year after, up by a modest (!) 2 per cent, and in the last year of the forward estimates, 2015-16, up by 2.9 per cent.

The budget papers helpfully note that, if you roll together the old year and the budget year, the average rate of growth is just 0.3 per cent. This tells us, first, much of the real fall in spending in the budget year is achieved by the simple expedient of pushing spending back into the old year.

Second, to have real spending growing for two years in a row at an infinitesimal rate is quite unnatural. And since there have been no announcements of swingeing spending cuts, such a situation could only have been contrived.

In fact, Swan was moving the budgetary furniture around in at least the two previous budgets (and last November's midyear budget review) to make ready for the miraculous return to surplus in 2012-13.

But so extensive have been his labours to bring the planned surplus about that a more robust metaphor is called for. Swan has invented the fiscal bulldozer. The Treasurer always has a big pile of spending in his blade that he's pushing forward into later years.

And, because budgets occur in May, the dozer can always be turned around and used to push spending back into the few remaining weeks of the old financial year.

But let's focus on the measures announced last week. Swan announced "saves" worth $33.6 billion over five years (the old year, the budget year and the three "forward estimate" years) less "spends" worth $22.4 billion over five years. So for every $3 he saved, he gave away $2.

Note, however, that half his saves were tax measures rather than cuts in spending. Of the total value of tax saves, only 40 per cent represents actual tax increases, while 60 per cent represents decisions to abandon or defer tax reductions included in the mining tax package.

When the package was first announced, pretty much all the revenue expected to be raised by the new tax was used to pay for "reforms" of other aspects of the tax system. These alleged reforms were very roughly based on recommendations of the Henry report. But now, roughly $2.2 billion a year of the mining tax's annual proceeds is to be used to finance increased government spending rather than reductions in other taxes.

The budget papers link the changes to the mining tax package to the plans for an increase in the family benefit, the new (pitiful) allowance for people on the dole, the switch from the education tax refund to the "schoolkids bonus", the first stage of the national disability scheme and the increased spending on dental care.

In their efforts to make announcements sound momentous, it suits the pollies and the media to quote budget costs "over four years" (or five, if costs are being pushed back to the old year).

But we budget and think a year at a time, so this practice can mislead.

It's worth noting that, of the total saves of $33.6 billion, only 14 per cent apply to the budget year. This tells us Swan drew up this budget very much with an eye to the following years. Having orchestrated the planned return to surplus in 2012-13, he then had to make sure the budget stayed in surplus over the forward estimates.

Of his total spends of $22.4 billion, a mere 8 per cent apply to the budget year. This is another indicator of how contrived the budget is.

But it also helps explain how a supposedly tight budget could appear so generous, as well as revealing another modern trick: pre-announcement.

Rod Tiffen, of the University of Sydney, has beaten the economic commentators to making a significant point - increasingly, budgets are being used to announce measures that don't take effect for more than a year. Budget headlines are built on stuff that won't happen for ages.

In the case of new taxes, such delay is unavoidable. But that's rarely true of spending. Among the measures announced last week that don't start until July 2013 are the increase in the family benefit and the introduction of the national disability scheme. The dole increase doesn't start until March 2013.

Combine all this with the knowledge the government has never once honoured its grand pledge to increase defence spending each year by 3 per cent in real terms and you conclude Swan's fiscal bulldozer will be on the job again in next year's budget - and any to be delivered by his successors.

Environmental accounting: completing the picture

Dinner Talk to ABS Conference on Environmental Accounting, Melbourne, Thursday, May 14, 2012

Ross Gittins, Economics Editor, The Sydney Morning Herald

I’m pleased to be invited to speak to this dinner of a conference convened by the nation’s official bean-counters. I don’t use that term disparagingly. Some people may think they’re far too talented or too important to waste time counting the beans, but I’m not one of them. If outputs and outcomes are important, then measuring them must be too. I’ve had two careers so far, and both have involved bean-counting. The first was as a chartered accountant, and the accountant in me meant that when I switched to economic journalism, I devoted considerable time to making sure I understood how the key indicators of the economy’s health ticked - the labour force survey, the CPI, the balance of payments, the national accounts and so on. I agree with the quote from the Stiglitz-Sen commission, which could almost be the public statisticians’ mission statement: ‘What we measure affects what we do; and if our measurements are flawed, decisions may be distorted’.

I’m also pleased to be speaking at a conference devoted to a subject so close to my heart: how we can establish a system of environmental accounts capable of being integrated with the economic accounts, to eventually produce a bottom-line figure for ‘green GDP’. It may be a sign of old age, but as the years have gone by I’ve become increasingly concerned about the interrelationship between the market economy - as we define it and measure it - and the natural environment - the ecosystem - in which it sits and on which it depends for its continued survival.

It’s clear we need to know a lot more about, and take a lot more notice of how the natural environment is changing over time, mainly as a result of human activity. That is, we need to be doing a lot more measuring of the environment, in its own right. We must keep track of what’s happening to be sure we’re not caught out by developments we didn’t quite notice before they became acute.

And, turning to the economy, the way we manage it - and the way we measure it, because measurements inform managers - needs to change over time to keep up with change in the economy and its environment, and also with developments in the scientific understanding of the way economic activity impinges on the social and natural environment in which the economy operates. Economists and statisticians have been slow to recognise the need for change in the way we define and measure ‘the economy’, but now, thankfully, real progress is being made - as witness the SEEA (system of environmental and economic accounting) and, indeed, this conference.

When you think about it, however, it’s not surprising that, at the time in the 19th century when our way of conceptualising the economy was being laid down by Alfred Marshall and the other neoclassical economists, it was considered possible to think of ‘the economy’ in splendid isolation from what then, I guess, would have been thought of as Nature, but we today have been schooled by natural scientists to think of as the ecosystem.

A hundred and fifty to 200 years ago, global economic activity was puny compared to the vastness of the global ecosystem - the vast oceans, endless forests, the geographical barriers between continents and countries, the perishingly cold winters and, in faraway climes, the intolerable heat. With humankind so puny and nature so vast as to seem almost infinite, it made all the sense in the world to view ecosystem services and environmental assets - air and water and fish and sunlight - as so infinitely available they could be treated as ‘free goods’, goods that had no price and so didn’t need to be taken into account. There was pollution, of course - factories that made loud noises, belched smoke, emitted waste material into the river and maybe left the hillside scarred - but these things were limited and local. They were unpleasant, but they weren’t something to worry too much about.

Two things have changed since those days. The first is the unbelievable growth in economic activity across the globe. Advances in public health and personal healthcare, and advances in economic production techniques, have seen the world’s population increase by a factor of seven since the dawn of the 19th century from 1 billion to 7 billion today. And advances in production techniques on their own have seen the average material standard of living across the world increase by a factor of six over the same period. Put the two together and economic activity, as measured, has increased by a factor of at least 42. Suddenly, global economic activity isn’t looking so puny and the global ecosystem isn’t looking so vast.

The second thing that’s changed since the industrial revolution is the depth of scientific understanding of the way the natural world works and the effects human activities are having on the way it works. First among these discoveries is the first law of thermodynamics which, for our purposes, tells us that economic activity can’t increase or reduce the quantity of anything, just change its form. So what the economy does from a physicist’s perspective is take natural resources and turn them into various forms of waste. Any system of environmental accounts - and any attempt to integrate environmental and economic accounts - has to take account not only of the natural inputs to the economic system but also the output of waste from the system.
Scientists have also made us aware of the way farming practices have affected river systems and underground water systems, the effects of commercial fishing, the limitations to fish farming, the extent of the destruction of species and, of course, the way the burning of fossil fuels and clearing of forests is changing the climate.

If I didn’t know I wasn’t allowed even to think it, I’d be tempted to say the extraordinary growth in global economic activity relative to the eternally fixed size of the ecosystem must surely be taking us close to the limits to economic growth - at least as we presently define growth and pursue it. Surely that’s precisely what the climate science is telling us. We’ve reached the limit to our ability go on burning fossil fuels and destroying natural carbon sinks in forests and so forth. We’re perilously close to natural tipping points - points from which there can be no return to the way things used to be. When the definition of the problem is limited to climate change, many, probably most, economists are willing to accept that things can’t continue the way they have been. But I can’t believe the environmental problem is limited to climate change; that we don’t face similar major threats to the status quo from farming practices, water and land degradation, overfishing and species destruction. I don’t believe we can go on indefinitely increasing our throughput of natural resources and our interference with the operation of ecosystem services.

This is not to say the end of the world is nigh, or even the end of economic activity. But it may well presage the end of global population growth and that part of economic growth that’s based on growth in the use of natural resources. What we don’t have to give up is the other part of economic growth, which comes from productivity improvement and technological advance. It may well be, however, that the objective of productivity improvement needs to change from economising in the use of labour to economising in the use of natural resources. Markets will always economise in the use of the most expensive resource, which in developed economies is labour. We need to turn that around, partly by ensuring natural resources are properly priced to reflect their true social costs and partly by shifting the tax system away from its present heavy reliance on taxing ‘goods’ such as labour to taxing ‘bads’ such as the use of natural resources.

When scientists talk about the limits to growth, economists always accuse them of failing to understand the ability of the price mechanism to solve or work around the seemingly looming end to the availability of particular natural resources, including the price mechanism’s ability to call forth technological solutions to the problem. To this the scientists always retort that economists are hopelessly unrealistic ‘technological optimists’.

I think the truth’s in the middle. In the economists’ mind, the price mechanism solves problems in a way that’s simple and reasonably smooth. They tend to think in comparative statics - the economy snaps from one equilibrium to another - without giving much thought to the dynamics of the adjustment process and the possibility of path dependency, of being knocked off course before you reach the expected equilibrium. I’m not confident of the ability of global commodity prices to adequately foresee emerging shortages around the corner and thereby send a clear enough, and early enough, signal to innovators to get on with finding their technological solution to the problem. If huge price increases occur with little warning and there’s a delay of some years before technological solutions emerge, considerable economic damage can be done in the interim, with unexpected flow-on effects and less-than-efficient policy responses by governments. And all because of economists’ naive faith that the real world will adjust in textbook fashion.

I was interested to see that highly orthodox institution, The Economist magazine, seriously entertaining the possibility of Peak Oil in a recent article (Buttonwood column, Feeling Peaky, April 21, 2012). It noted that global output of crude oil (as opposed to alternatives such as biofuels and liquids made from gas) has been flat since 2005. You can argue the world is ‘awash with energy’ thanks to the exploitation of American shale gas, but The Economist counters that oil is still the main fuel powering the globe’s fleet of cars and trucks. You could convert them all to liquid gas, but you can’t do it without considerable expense and delay, with the prospect of pretty bad things happening in the interim. You could find more oil - in the Arctic or in tar sands - but you couldn’t do that without a considerable increase in the price of petrol. Remember, too, that some potential alternatives to conventional oil - including biofuels and tar sands - are highly ‘energy inefficient’ - you have to expend a lot of energy to produce them. And the fact remains that, just as the industrial revolution was built on coal, so the post-war economy has been built on cheap oil. If oil and its substitutes are now to be very much more expensive, this spells significant cost, economic disruption, social hardship and weaker growth.

But I’ve provoked you enough with the threatening thought that there may be limits to growth after all. Now I want to view the case for measuring change in the environment - and for combining it with the measurement of the economy - from a different perspective. As you know, the overriding goal of microeconomics is to help the community deal with ‘the problem of scarcity’ - the fact that the physical resources available to us are finite, whereas our wants are infinite. There’s any amount of goods and services we’d like to consume, but the wherewithal to produce those goods and services is strictly limited.

But Avner Offer, a professor of economic history at Oxford, and others have advanced an interesting proposition: that the developed market economies’ attack on the problem of scarcity over the time since the industrial revolution has been so remarkably successful that we’ve actually defeated scarcity and replaced it with a different problem, the problem of abundance. Now, technically, for an economist to say that a resource is scarce is merely to say that it can only be obtained by paying a price, that it’s not so abundantly available as to be free. Clearly, in that technical sense, the problem of scarcity is still with us.

But, in the broader sense, it’s hard to deny that the citizens of the developed world live lives of great abundance. As we’ve seen, our material standard of living has multiplied many times over since the start of the industrial revolution. No one in the developed world is fighting for subsistence; even the relatively poor among us are doing well compared with the poor of Asia or Africa; we satisfied our basic needs for food, clothing and shelter a mighty long time ago; our real incomes grow by a percent or two almost every year, and each year we move a little higher on the hog. Our greater affluence can be seen in our ability to limit the size of our families, in the growth in the size and opulence of our homes, the fancy foreign cars we drive, our clothes, the private schools we send our children to, the restaurants we eat in and the plasma TVs, DVDs, video recorders, personal computers, mobile phones, stereo systems, movie cameras, play stations and myriad other gadgets our homes teem with.

How has this unprecedented and widespread affluence come about? It’s the product of the success of the market system. But above all it’s the product of all the technological advance - the invention and innovation - the capitalist system is so good at encouraging. Malthus’s dismal prediction in the late 1700s that the growth in the population would outrun the growth in food production was soon disproved.
It’s therefore reasonable to say that, when we look around us, what we see is not scarcity but abundance. This is something to be celebrated. But, as with everything in life, no blessing is unalloyed. Every good thing has its drawbacks and difficulties. As we’ve seen, the first and most obvious problem with abundance is the damage the huge expansion in economic activity is doing to the natural environment.

The next but less obvious problem with abundance is that it exacerbates humankind’s difficulty achieving self-control. Notwithstanding the economists’ assumption of rationality, humans have a big problem with self-control. It’s ubiquitous to daily life: the temptations to eat too much, get too little exercise, smoke, drink too much, watch too much television, gamble too much, shop too much, save too little and put too much on your credit card, to work too much at the expense of your family and other relationships.

The more stuff we have - the fewer among us whose main problem remains satisfying our basic needs - the more problems of self-control emerge as our dominant concern. But there’s a deeper point: humans have never been good at self-control, but as long as we were poor and resources were scarce, our self-control problem was held in check. It’s when things become abundant, when we can afford to indulge so many more of our whims, when we have a huge range of things or activities to choose from, that self-control problems become more prevalent and we have trouble making ourselves choose those options that are best for us in the longer term, not just immediately gratifying.

The topical problem of obesity provides an excellent example of the way the move from scarcity to abundance has exacerbated self-control problems. Humans evolved in conditions where nutrition was scarce. Our brains are therefore hardwired to eat everything that comes our way while we’ve got the chance, and they’re surprisingly poor at signalling to us when we’ve had enough. For as long as food remained scarce - that is, relatively expensive - and work remained highly physical, there wasn’t a problem. But as we triumphed over scarcity the former balance was lost. Technological advances in the growing, transport, storage, preservation and cooking of food greatly reduced its cost to consumers. As humans have become more time-poor, we’ve seen an explosion in inexpensive fast food, all of it cunningly laced with those three ingredients our brains were evolved to crave: fat, sugar and salt. Then, on the output side, we’ve seen technological advance strip the physical labour first out of work and then out of leisure. We don’t play sport, we watch it being played and these days we don’t even go to the effort of travelling to the grounds.

There’s a third aspect to the problem of abundance: the increased resources devoted to the socially pointless pursuit of social status through consumption. When we have long passed the point where our basic needs for food, clothing and shelter are being satisfied, but our real incomes continue to grow by a couple of percent a year, we have to find something to do with the extra money. Partly, we spend it on ‘superior goods’ - goods you want more of as you get richer - such as health and education. That’s fine. But a fair bit of the extra income is spent on ‘positional goods’ - goods whose purchase is designed to demonstrate to the world our superior position in the pecking order. The point here is that, from the viewpoint of the community rather than the individual, the pursuit of status is a zero-sum game: the gains of those individuals who manage to advance themselves in the pecking order are offset by the loss of status suffered by those they pass. From the perspective of society, a lot of resources are simply being wasted.

So that’s the case for believing that, at this late stage in our development, the problem of scarcity has been superseded by the problem abundance. It has obvious implications for the environment and the need to integrate environmental and economic measurement. I like the example of commercial fishing. Two hundred years ago the constraint was the scarcity of human capital: not enough boats to haul in all the fish available. Today, after so much technological advance in the fishing industry, the scarcity problem is reversed: far too many boats chasing far fewer fish.

You don’t need to think for long about the SEEA exercise before you realise the paucity of measurement of the many dimensions of the environment and the changes in them over time. You realise how much of the bureau’s efforts are devoted to the myriad measurements needed to support the economic accounts. Our management of the environment should be much better informed just by the more comprehensive measurement of environmental indicators in physical values. When you covert those physical values to dollars and integrate them with the economic accounts you are (to quote one of the bureau’s documents) enabling analysis of the impact of economic policies on the environment and the impact of environmental policies on the economy.

For as long as we’ve been worrying about the economy’s effect on the environment the great bugbear has been the environment’s status as an ‘externality’ to the market economy and the price mechanism. The environment isn’t part of the system and it takes a lot of alertness and effort to incorporate it into the system, case by case. My dream is that, though environmental assets will continue to go unpriced until we find a way to price them, we may be able to short-circuit the process by incorporating environmental money values into the GDP bottom line.

Saturday, May 12, 2012

Why the budget isn't as contractionary as it looks

If you take the figures at face value, this week's budget is deeply contractionary, delivering a blow to demand at a time when parts of the economy aren't at all strong. But in economics, it's rarely wise to take things at face value.

There are different ways to assess the "stance" of fiscal policy - to work out the direction and size of the effect a budget will have on the economy. Settle back.

There's a two-way relationship between the budget and the economy. The decisions announced in the budget have an effect on the economy but, at the same time, the economy has an effect on the budget.

The budget contains elements - such as the progressive tax system and the availability of the dole to people without jobs - that have the effect of helping to stabilise the economy as it moves through the business cycle.

When the economy turns down, tax collections fall and more people go on the dole, which automatically worsens the budget balance. This worsening, however, helps to prop up (stabilise) the economy.

Then, when the economy starts to recover, these "automatic stabilisers" change direction. Tax collections grow faster than the rise in incomes and people find jobs and go off the dole. This improves the budget balance and also acts as a brake on the economy, stopping it from growing too fast and causing inflation problems.

These things happen automatically and their effect on the budget balance is called its "cyclical component". But governments can and do make their own decisions about increasing or decreasing taxes and government spending. The net effect of these discretionary moves on the budget balance is called its "structural component".

Now, when you assess the stance of budgetary policy the strict Keynesian way, you focus on the explicit policy decisions made in the budget (the structural component) and ignore the effect of the budget's automatic stabilisers (the cyclical component).

These days, however, the Reserve Bank and many economists tend to do it a simpler way that ignores the distinction between cyclical and structural. You just compare the budget balance for the old year with the planned balance for the new budget year.

The Treasurer, Wayne Swan, is expecting an underlying cash budget deficit in the financial year that's coming to an end, 2011-12, of $44.4 billion, but budgeting for a surplus of $1.5 billion in the coming year, 2012-13.

That's a turnaround of almost $46 billion. From one year to the next, the budget's net effect is to extract $46 billion from the economy - if it happens, the biggest one-year turnaround for almost 60 years.

It's equivalent to about 3 per cent of gross domestic product, which makes it absolutely huge. And since it's an extraction, you could only conclude it makes the stance of fiscal policy adopted in the budget highly contractionary. It would knock the stuffing out of the economy.

But here's where we mustn't take things at face value. Swan has had to move a lot of things around between years to make it possible to keep the Prime Minister, Julia Gillard's, election promise to get the budget back to surplus in 2012-13. When he's taken spending and pulled it forward into the last few weeks of the old financial year, that's not genuine for our purposes. For the government's accountants, whether something happens on June 30 or on July 1 makes all the difference in the world. You've got to draw the line somewhere, and that's where we draw it.

From the perspective of the budget's effect on the economy, however, a difference of a few days or a few weeks is a difference that doesn't make any difference.

And it turns out a big part of the $46 billion turnaround is explained by Swan's decision to draw spending forward into the last few weeks of the old year. There's compensation for the carbon tax (which doesn't start until July 1) of $2.7 billion, advance payment of natural disaster relief funds to Queensland of $2.3 billion, a bring-forward of infrastructure spending of $1.4 billion, the new "schoolkids bonus" cash splash of $1.3 billion, and financial assistance grants to local government of $1.1 billion.

That long list adds up to $8.8 billion. But here's the trick: when you take money out of one year and put it into the year before, you have twice the effect on the difference between the two years. So Swan's bring-forward of that spending explains $17.6 billion of the $46 billion turnaround.

Another thing to take account of is that the new year's budget is expected to benefit from increased revenue from resource rent taxes of $5.7 billion (that's from the existing petroleum rent tax as well as the new minerals rent tax). The point is that these taxes are explicitly designed to tax "economic rent", so they have no effect on the incentive to exploit petroleum or mineral deposits and thus have no effect on economic activity. A further factor is that, thanks to a quirk of public accounting, Swan's underlying cash surplus of $1.5 billion takes no account of the government's spending on the continuing rollout of the national broadband network.

The budget item "net cash flows from investment in financial assets for policy purposes" is expected to involve increased spending of about $6 billion in 2012-13. Not all of that would be the broadband network rollout. But to the extent it involves the government funding economic activity, it has the effect of reducing the budget's adverse effect on economic activity.

Put these three arguments together and you conclude the budget's drag on demand would be less than half the 3 percentage points of GDP we started with.

Even so, it's still a big effect. There's no denying the stance of fiscal policy is contractionary.

But the budget is only one of the factors affecting aggregate demand. It's also only one of the instruments available to the macro-economic managers to influence demand.

So if fiscal policy proves to be too tight, the obvious remedy will be to further loosen monetary policy - to cut the official interest rate, in plain English. The stance of monetary policy is already mildly expansionary and, if necessary, it can be made more so.

Is it a good thing to have the two arms of policy working in opposite directions? Sure it is - if you're hoping lower interest rates will lower our high dollar a little.

Such a lowering may have already occurred. If so, the effect will be expansionary.

Wednesday, May 9, 2012

How Swan did his budget trick

If you are having trouble seeing the horror budget we were told to expect, that's according to plan. This government has always wanted to be tough in principle, but never in practice.

For most people, Wayne Swan's fifth effort doesn't contain much that is nasty and includes a few things that are quite nice.

To be sure, it does include some nasties for higher income earners. Individuals earning more than $300,000 a year will have the tax on their superannuation contributions doubled to 30 per cent.

Executives face a crackdown on the taxing of their golden handshakes and living away from home allowances. And the new financial year will see the means-testing of the private health insurance rebate for singles on more than $83,000 a year and families on more that $166,000.

Why are higher income earners copping it? Because there aren't many of them and few of them vote Labor anyway.

For most other people, however, the budget isn't bad. Top of the list of unexpected goodies is a lump-sum bonus of $820 or $410 a schoolchild to parents eligible for the family tax benefit part A, to be paid next month in place of the education tax rebate.

The education rebate was just an election bribe, and so this is an easier-to-obtain bonus. Its primary purpose is to soften the blow of higher electricity and gas prices when the carbon tax starts in July.

Swan says the budget contains tax cuts, but these are modest (typically, $5.80 a week), limited to individuals earning less than $80,000 a year and - in combination with special increases in pensions and family benefits - will merely compensate for the higher energy prices.

Swan says this is a "fair go budget", with the government "doing everything we can to protect lower- to middle-income earners". But not if your income is so low you are part of the undeserving poor.

"Labor values" can run to the expense of a new handout to parents of schoolchildren, but can't afford to raise the dole of $35 a day by more than about 50?.

By contrast, small business owners get instant writeoffs of the cost of new assets worth up to $6500 each, and the ability to carry back losses.

Then there is increased spending on dental care, aged care and an early start to the national disability insurance scheme.

But how does all this new spending square with all we've been told about the herculean efforts Swan would need to transform this financial year's budget deficit of $44 billion into a surplus of $1.5 billion next year?

On paper, this would be the biggest one-year budget turnaround in many decades. And, is it a sensible thing to do anyway, at time when the economy's growth is so mixed?

The first thing making it less heroic than it sounds is that Swan has been moving the budgetary furniture around for two or three years in preparation for this great day. He has been "reprofiling" his planned spending, pushing it off into the future to make his task easier.

More recently, he has brought forward spending originally intended for the new financial year - including compensation for the carbon tax and the replacement for the education tax rebate - to the last weeks of the old year, thus exaggerating the true size of the turnaround.

The second explanation for the surprising dearth of budget pain is last week's decision to defer about $5 billion worth of defence spending.

Third is the expected recovery in tax collections, particularly from companies, and fourth combines the government's many decisions not to proceed with previously promised tax concessions.

All this shows how the budget can seem so tough arithmetically without actually being very. It also explains why the budget deficit turnaround won't deliver the blow to the economy some people fear.

In any case, the outfit with the ultimate responsibility for keeping the economy growing steadily, the Reserve Bank, is in possession of a safety valve it showed last week it isn't afraid to use.

Should the economy slow, it will cut the official interest rate again. And should the banks commandeer part of the decrease, it will cut the rate some more.

Monday, May 7, 2012

Reserve steals Swan’s budget forecasts thunder

While normal people are awaiting tomorrow night's federal budget to see if the measures Wayne Swan announces are naughty or nice, misguided souls in business and the financial markets are more interested in knowing Treasury's forecasts for the economy in 2012-13.

Well, wait no more. This year the key forecast for year-average growth in real gross domestic product in 2012-13 is the budget's worst kept secret.

It's taking the people who care about such things a long time to cotton on, but the Reserve Bank always upstages the budget forecasts by issuing its own forecasts as part of its quarterly statement on monetary policy on the Friday before the budget is unveiled on the second Tuesday in May.

This year the Reserve is forecasting year-average growth in 2012-13 of 3 to 3.5 per cent. This tells you Treasury's point forecast is likely to be at the mid-point of the range, 3.25 per cent.

And at a press conference on Friday Swan obliged by confirming that 3.25 per cent is indeed the budget forecast.

If you can't see why the Reserve's forecasts are such a reliable guide to Treasury's you understand neither the bureaucratic process nor the econocratic mind.

Although in theory the two outfits are free to each set their own forecast, in practice they caucus via the quarterly meetings of the joint economic forecasting group. And, in practice, it's rare for their forecasts for any indicator to be more than 0.25 percentage points apart - a difference which, in the highly imprecise world of forecasting, they dismiss as no more than a rounding error.

Just as politicians put their spin on developments, so the media put a spin on the news, preferring to focus on the negative. Thus it was reported that the Reserve "downgraded" its outlook for economic growth.

These cuts, we were told, "underscore the challenges facing the Gillard government" in returning the budget to surplus in 2012-13 - "a task made harder by the slowing growth and the resulting weaker revenue streams".

Don't you believe it. What rate of growth in 2012-13 was Treasury forecasting at the time of the midyear budget review last November? 3.25 per cent. What rate's it forecasting now? 3.25 per cent. That's harder?

It's certainly true the Reserve lowered many of its growth forecasts relative to those in its February statement. In general it cut each of its year-ended forecasts by 0.5 percentage points.

But note this: when it came to its year-average forecasts - those most relevant to the budgeting task - the one for 2012-13 was unchanged at 3 to 3.5 per cent and the one for 2013-14 was unchanged at 3 to 4 per cent.

Here's the point: the news the media didn't think worth passing on is that, notwithstanding its downward revisions, the Reserve is still forecasting that growth will accelerate from now on.

The latest actual figures we have for GDP show it growing by just 2.3 per cent over the year to December - about a percentage point below the medium-term "trend" rate of growth.

But the Reserve now has the pace quickening to 2.75 per cent over the year to this June, to 3 per cent over the year to this December, to 2.5 to 3.5 per cent over the year to next June, the same over the year to December next year and to 3 to 4 per cent over the year to June 2014.

But how, despite all the gloomy talk we keep hearing, can the Reserve forecast a reasonably early return to trend growth? As it explained in its statement on Friday, the answer turns on the reason its forecasts have been too high up to this point.

Ask every businessman and his dog why the economy isn't growing nearly as fast as the Reserve was forecasting and they'll tell you it's because the boffins underestimated the pain being imposed on the non-mining part of the economy by the high dollar.

But that's pretty much the opposite of the Reserve's explanation. It says most of the problem was its over-estimate of growth in production by the mining sector. It assumed the Queensland coalmines flooded in early 2011 would quickly be able to return to full capacity. In fact, it took them most of last year.

The Reserve also assumed new railway and port loading capacity would permit faster growth in mining production and exports than actually occurred.

It now has us returning to trend growth mainly because these problems have been overcome.