Monday, April 29, 2013

Beware the one-eyed budget brigade

A great journalistic delusion is that politicians and others are always resorting to spin, so what journos do is remove the spin and tell it like it is. But too often they replace the speaker's spin with their own.

Consider the treatment of the Grattan Institute's report on budget pressures facing Australian governments. One paper reported it as concluding that "federal and state budgets will be generating yearly combined deficits of $80 billion within a decade unless welfare, health and education spending is cut".

Another national daily's version was that "Australian governments are facing a budget black hole so large that politically painful cuts to growth in public health and education spending are all but unavoidable if the nation is to avoid a European-style debt quagmire".

What the report actually said was that strong growth in government spending - particularly health spending - combined with weaker-than-expected tax collections could leave us with deficits equivalent to 4 per cent of gross domestic product in the next 10 years.

Its figuring shows this deficiency divides equally between increased spending and weak tax collections. So what solution did it propose? "That means finding savings and tax increases of $60 billion a year."

It also said: "There is no reason why a balanced budget, or more efficient government, necessarily requires smaller government. [However] history suggests that successful budget repair invariably involves both tax increases and expenditure reductions."

See the spin? So what's their motive? Probably a combination of the editors' personal ideology, self-interest (I pay too much tax already, don't ask me to pay more) and a belief that tailoring your reporting to fit your readers' prejudices will sell more papers.

But it is not just the media that take such a one-eyed approach to budgeting. Most business lobby groups do, too, plus a lot of economists. Many economists believe the answer to budget deficits is always to cut spending and never to raise tax collections, because of the libertarian political ideology implicit in their dominant "neoclassical" model.

The model assumes people are rational in all their decisions (implying governments can never know what's in my interest better than I know myself); each of us is a rugged individualist with nothing in the model to acknowledge the benefits we gain from acting collectively; each of us has roughly equal bargaining power in the market place (that's a good one); and wide disparities in the distribution of income and wealth are of no relevance.

Even so, as the Grattan report acknowledges, there is little economic support for the view that smaller government is always better than bigger.

You often hear people noting that a high proportion of the "structural saves" Wayne Swan likes to boast about constitute tax increases rather than spending cuts, as though this was some sort of crime or con trick.

But such people reveal their economic ignorance. Most of the supposed tax increases represent not the introduction of a new tax or an increase in the rate of an existing tax but the reduction or elimination of special concessions.

Economists refer to the latter as "tax expenditures" precisely to remind us they are essentially equivalent to actual expenditure. It often doesn't make a difference whether assistance to people in some category is delivered by a cheque from the government or a reduction in the tax they would otherwise have to pay.

One-eyed economists love to quote studies showing that, on average, every $1 of tax that governments raise generates a "deadweight loss" of about 30? in reduced economic efficiency because of the tax's effect in distorting taxpayers' behaviour. They use this to imply economics teaches us to minimise taxation. But they don't mention the hidden assumptions in the calculation, particularly that $1 of tax buys, at best, $1 of gross benefit to the community. In truth, $1 of spending on public goods may deliver benefits worth another, say, 30?.

In any case, the more legitimate use of such deadweight-loss calculations is to compare the inefficiency of particular taxes, with a view to correcting the features of those taxes that make them more economically distorting than others.

This is where tax expenditures come in. The way to reduce the 30 per cent deadweight loss is to eliminate the special concessions built in to so many taxes and thereby reduce the tax's distortion of people's choices.

The list of tax expenditures whose removal could reduce the budget deficit and make the allocation of resources more efficient at the same time is long, but includes negative gearing, the senior Australians tax offset, the 50 per cent discount on capital gains tax, exemption of super payments to people over 60 and the various exemptions from the GST.

Saturday, April 27, 2013

Why a little inflation isn't such a bad thing

I was in a taxi on Wednesday when we heard on the radio that the consumer price index had risen by just 2.5 per cent over the year to March - smack in the middle of the Reserve Bank's target, leaving it room to cut interest rates further if need be. So, no probs there.

"But why do we have any inflation?" the cab driver asked me. "When I came to Australia I could buy a rock cake for 8? - the other day they wanted $3.50."

It was a simple, sensible question. Unfortunately, the answer isn't at all simple. The short answer, however, is that it's a policy choice. That is, the monetary authorities - the central bank and the government - believe a moderate rate of inflation (moderate meaning between 2 per cent and 3 per cent, on average) is, on balance, a good thing.

Inflation refers to a persistent rise in the general level of prices. It may surprise you that in Britain over many centuries there was no net rise in the level of prices. Prices would rise during wars, but then fall back after the war was over. Governments controlled the price level by tying the amount of money in circulation to the amount of gold, and then controlling the amount of gold.

But this "gold standard" broke down during the Great Depression, and after World War II it was replaced by the Bretton Woods system where each country's currency was fixed to the US dollar, with the US dollar fixed to a gold price of $US35 an ounce.

This system meant all other countries effectively imported their inflation rate from the US economy. The Americans kept inflation pretty low until they began financing the Vietnam War by printing money rather than borrowing from the public.

This caused the fixed exchange-rate system to break down in the early 1970s, with most developed countries allowing their currencies to float. This gave them the ability to control inflation for themselves.

The trick, however, is that they - and we - do so not by controlling the quantity of money in circulation (as the monetarists tried and failed to do in the old days), but by using their ability to control the price of money - interest rates - to keep the demand for goods and services pretty much in line with the supply of goods and services. But if the authorities have the ability - in principle, at least - to use their control of interest rates to control the price level, why don't they keep it completely stable, thus allowing a zero increase in the CPI? Why do they permit inflation averaging a couple of per cent a year, and call this "practical price stability" (as they do).

Short answer: because they care about unemployment as well as inflation. The first reason is their belief that, due to practical limitations, the CPI tends to overstate the rise in the price level. Huh? This is because of the delay in including new products in the CPI basket of goods and services, and also because it treats as inflation price rises actually caused by an improvement in the quality of goods in the basket. For instance, part of the reason for the price of the new model Holden being higher than the price of the previous model is that it's a better car - better under the bonnet or better accessories.

If you accept that the CPI tends to overstate inflation then achieving zero inflation as measured by the CPI would involve keeping money so tight you were actually forcing prices down, which would be quite damaging to the economy and employment.

The second reason the econocrats like a bit of inflation is that there can be times when wages grow too quickly and make employing people too expensive. Wages need to fall back a bit, but workers are hugely resistant to cuts in their wages (and sensible employers don't fancy the idea, either).

The thing is that, if there's a positive rate of inflation it's much easier to cut wages in real terms by raising them less than the inflation rate. This is what happens in every recession.

The third reason the econocrats regard a bit of inflation as helpful is that, in a deep recession, they may judge it necessary to stimulate the economy not just by cutting interest rates but by cutting them so far they're negative in real terms - that is, cutting them until they're actually lower than the inflation rate (as they are right now in the US and Britain).

Think it through: when real rates are negative, lenders are actually paying people to borrow from them (after you allow for the effect of inflation), so this should be highly stimulatory. But, clearly, you can't bring about negative interest rates - something you'd only ever do in an emergency - unless you've got a positive inflation rate to go below.

So those are the three reasons the Reserve Bank is satisfied with an inflation rate averaging 2 to 3 per cent and defines this as practical price stability.

But back to my taxi driver. It's all very well to remember how much less you had to pay for things in the old days and feel cheated, but you shouldn't forget your income is also a lot higher than it was in the old days. In fact, just about everyone's income - whether wages or the pension - grows a bit faster than prices are rising, so there's no cause to feel cheated by the system. That is, almost everyone's income has risen in real terms over the years.

This real income growth is the reason economists are so unimpressed by punters and pollies carrying on about the trouble they're having keeping up with "the cost of living". You can achieve that delusion only by focusing on what's happened to the prices you pay and ignoring what's happened to your income.

Wednesday, April 24, 2013

Budget surplus suddenly out of political fashion

Something highly significant has happened in just the past week: it's become clear the tide has turned in our politicians' demonisation of budget deficits and debt. What used to be anathema is so no longer.

Predictably, it's happened not because the pollies have seen the light, but because they've been mugged by reality. In consequence, the Grattan Institute's John Daley may well be right in saying we face a "decade of deficits".

That's not to say we'll hear no more of unpopular cuts in government spending, however. We'll get more of those in Wayne Swan's budget next month, and a lot more should Tony Abbott win the election in September. But these will be about stopping the parties' expensive election promises making the budget deficit even bigger, not about getting back to surplus. In Abbott's case it will involve cutting away Labor's favourite programs and replacing them with his own.

I won't be sorry to see an end to the economically illiterate nonsense the pollies have been spouting for so long about the evils of deficits and debt. That's because there are times when deficits are exactly what governments should be running and when modest levels of debt are nothing to worry about.

But, equally, there are times when surpluses are just what governments should be running. And we'd have to be terribly unlucky for such times not to return well before another 10 years have passed.

Governments have been agonising over the need to restrain budget deficits for almost all of the four decades I've been observing them - usually without much success. But the fashion for outright demonising of deficits began when Peter Costello became treasurer in 1996, claimed to have inherited a "budget black hole" from his Labor predecessors but, after one super-tough, promise-breaking budget, soon found the budget had swung back into surplus, only to stay there for the rest of the Howard government's 11-year term.

The steady stream of surpluses, combined with the proceeds from privatising Telstra, allowed him to eliminate the manageable debt he had also inherited. Costello used this experience to argue incessantly that deficits are always bad and surpluses always good, with the Liberals the party of surpluses and Labor the party of deficits.

When the global financial crisis hit in late 2008 and pushed the budget back into deficit, with Kevin Rudd's stimulus spending adding to that deficit, the immediate effect of the crisis on our economy proved surprisingly modest and it suited both sides to claim we had escaped recession.

Labor claimed this proved what a good economic manager it was, whereas the Libs used it to prove Labor's stimulus spending was unnecessary and wasteful, leaving our children and grandchildren weighed down by horrendous government debt.

The more years have passed with unemployment, inflation and interest rates all staying low during Labor's term, the more the Libs have focused on attacking its economic management by repeating the Costello line that deficits are always bad and by exaggerating the size of its debt.

Rather than patiently explaining the economic ignorance of this deficit demonising, however, Labor capitulated to it, with Julia Gillard promising faithfully in the 2010 election campaign to have the budget back to surplus by this financial year.

Problem is, the budget has not played ball. Much to the amazement of economists (and the consternation of Treasury's forecasters), the recovery in the economy has not been accompanied by a commensurate recovery in tax collections. Among the many reasons for this, the main one seems to be that our dollar has stayed high even though the prices for our mineral exports have fallen back.

This dawning reality is what forced Wayne Swan to concede just before Christmas that the budget would remain in deficit this financial year. Knowing the weakness on the budget's revenue side is likely to continue indefinitely, he's made no new commitment on when it will be returned to surplus.

But he and Penny Wong keep saying they won't be cutting government spending just to get the budget back to surplus, for fear of this costing jobs. Clearly, they've allowed their membership of the Deficits Are Evil Club to lapse.

For years the Libs have condemned Labor's timid explanations as mere excuses and have been promising to return the budget to surplus as soon as they got back to office. But the reality of the budget's revenue weakness has finally dawned on them, too.

Last Thursday, Abbott declared that "all bets are off" on the question of when a Coalition government would achieve a surplus. He's repeated the warning since. And also on Thursday, shadow treasurer Joe Hockey advised that "we are not going to go down the path of austerity simply to bring the budget back to surplus because it would end up being a temporary surplus".

So though we can expect to hear a lot more about Labor's alleged bad budgeting, we'll be hearing nothing more about achieving surplus ASAP. For both sides it's now a mere "aspirational objective".

I fear, however, we're swinging from one extreme to the other, from falsely claiming budget deficits are always evil to complacently accepting them long after it's become prudent to eliminate them and start repaying debt.

To say deficits aren't always evil is not to say they're always OK. So be warned: when budget surpluses fall out of fashion with the politicians, it won't be long before they're back in favour with economists - and commentators such as me.

Monday, April 1, 2013

Easter message to business is think relationships

At this time of year it's worth pondering: many business people and economists think of themselves as Christians, but what implications does this carry for the way they view the world and conduct their affairs?

According to Michael Schluter, founder of Relationships Global and, these days, a business consultant, Christianity is a "relational" religion. If so, it doesn't sit easily with market capitalism as it is conceptualised by economists and practised by business people.

The primary emphasis of economics and business is on satisfying the wants of the individual. In this they give little priority to individuals' human relationships.

Is Christianity much different? Certainly, in the Evangelical version I grew up with, it too focuses on the individual. And you could be forgiven for wondering whether it pays much attention to relationships.

But here Schluter begs to differ. He says all of Christianity is a relational story. It starts with humankind created in God's image, but then the relationship is ruptured in the Garden of Eden. Finally, God comes to earth as a baby and ends up dying on a cross with the expressed purpose of restoring the broken relationship with humankind.

What does God require of us? Jesus summarised it: all the law and the prophets depend on two commandments - love God with all your heart, and love your neighbour as you love yourself. What could be more relational than that?

Schluter says life can be viewed from many perspectives: financial, environmental, individual, material. But "as Christians, we need to see all of reality through a relational lens if we are to look at the world as God sees it".

All of life is ultimately about relationships. For example, he says, "every financial transaction is an expression of an underlying relationship between nations, organisations or individuals".

The development of a society can be measured not in terms of economic growth but by the quality of relationships between individuals and between ethnic and other social groupings.

Education's goal can be defined as acquisition of wisdom for children to be able to serve their family and community, rather than acquisition of technical skills merely for personal career advantage.

"At a personal level, our happiness and wellbeing are determined primarily by the quality of our relationships. Arguably, financial issues - for example, debt and savings - matter to us primarily due to their relational implications," he says.

Above a certain income, wellbeing indices point to the central importance of relationships. Even for those below this income threshold it's not clear if the priority of income is for personal benefit or for group benefit, such as the care of children.

Debt is closely associated with depression and also with divorce, child abuse and social isolation, he says. Survival rates after serious illness are more closely associated with levels of relational support than with levels of income.

"It is easier to find someone financially rich and miserable than someone relationally rich and miserable," he says. "It is hard to find someone on their death bed who says, 'I wish I had spent more time in the office'."

The individualism of our culture leads us to miscalculate the significance of events because it takes little or no account of "externalities" - that is, the effects on third parties.

For example, companies and public service agencies move staff to new locations to maximise economic productivity, and economic analysis applauds their decision to do so. But no attempt is made to measure the social or relational costs of such dislocation, especially to spouses or partners, children, friends and parents and grandparents whose relationships have been disrupted.

Schluter says business, finance and public sector organisations are increasingly coming to recognise that financial evaluation of performance is insufficient.

"The purpose of companies is increasingly defined inclusively to recognise the significance of company decisions for many stakeholders, rather than instrumentally, where customers, suppliers and so on are regarded simply as means to increase shareholder profits."

Low levels of national debt - a measure of inter-generational loyalty - decrease economic instability and aid economic growth. Political stability is a foundation for economic prosperity, but depends on peaceful relations between ethnic and religious groups and between rich and poor.

"To see the world in relational terms requires a re-education process as the media, corporate advertising and our own inclinations constantly point us towards seeing things from an individualistic or materialistic point of view," Schluter concludes.