Monday, June 17, 2019

Economic reform is stalled until politicians get back our trust

For those who care more about good policy than party politics, there are unpleasant conclusions to be drawn from the federal election. The obvious one is that it was a case of policy overreach leading to failure.

The less obvious one is that decades of misbehaviour by both sides have alienated so many people from the political process and turned election campaigns into such a cesspit of misrepresentation and dishonesty that, henceforth, neither side will be game to propose or implement controversial reforms.

The election was lost by the party proposing to remove a long list of sectional tax breaks and use the proceeds to increase spending on hospitals, schools and childcare, and won by the party that couldn’t agree on any major policies bar a humongous tax cut.

The risks to good economic policy are obvious. Labor concludes only a mug would try to get themselves elected on the back of good policy; the Coalition concludes you don’t need to be promising to do anything much to get re-elected.

Labor’s conclusion could be used to reinforce the political class’s widely held view that controversial reforms should only be pursued once in government, never from opposition.

Trouble is, the Coalition’s conclusion could be used to argue that, if you can get re-elected without any plans to fix things, why take the risk of proposing anything that could be unpopular?

But I think the threat to good policy runs even deeper. It comes from the electorate’s ever-growing disillusionment and alienation from politics and politicians, and from the two main parties in particular.

The vote for a changing array of third parties continued to rise, while the primary vote for both the majors was down – though more so for Labor than the Coalition. Until now, the rise of One Nation and other populist parties of the right has been a much bigger worry for the Coalition than the Greens have been for Labor.

This time, however, many former Labor voters in outer suburban and regional electorates used One Nation and Clive Palmer’s United Australia Party as a bridge to switch their vote to the Liberals.

In numerical terms, that’s why Labor lost. The point for good-policy advocates to note is that, when so many voters tune out of the political debate, but are still required to vote, they tend to make a last-minute choice based not on a well-informed assessment of how they would be affected by the rival parties’ policies, but on superficialities (“that nice Mr Rudd” or “Shorten looks shifty to me”), scare campaigns and negative advertising.

In other words, in a world where switched-off swinging voters aren’t even guided by informed self-interest, the scare campaign is king. To be blunt, the best liars win.

The Libs were convinced that former prime minister Malcolm Turnbull came so close to losing the 2016 election because of the success of Labor’s Mediscare campaign, conducted at the last minute using social media.

My theory is that, this time, the Libs resolved to turn the tables. This time they made much superior use of social media to run bigger scare campaigns about Labor’s “retirement tax” and “housing tax”. That was mere misrepresentation of Labor’s policies (most of which had strong support from economists and econocrats). The anonymous soul who dreamt up the “death tax” was an outright liar.

I think the biggest single reason so many outer-suburban and regional voters turned away from Labor was its opponents’ success (with much help from Palmer’s blanket advertising) in convincing those voters that Labor planned to increase their taxes.

My guess is that the next federal election will either see each side battling to out-scare the other – an orgy of lies - or, more likely, neither side being game to propose any reform of consequence, for fear of having it grossly misrepresented by the other side.

The more the bad behaviour of both sides – the broken promises, the hypocrisy, the spin, the abuse of statistics, the preference for bad-mouthing your opponents rather than explaining your policies – continues, the more both sides will turn from substance to empty populism.

And guess what? The more they do, the more voters will disengage and become more susceptible to lies and superficialities.

From the noises Anthony Albanese has been making, everything Labor did was wrong, and every triumphalist Liberal explanation of why Labor lost is right. The trouble with Labor selecting leaders from its Left faction is that they’re so anxious to prove they’re not left wing (which, these days, they aren't) they end up standing for nothing.

It would be nice if, having worked a miracle and established his authority over the Coalition’s warring tribes, Scott Morrison now turns his mind to fixing at least some of the many bits of the economy that need fixing. We can but hope.

Saturday, June 15, 2019

It's the budget, not interest rates, that must save the economy

According to a leading American economist, there are two views of the way governments should use their budgets ("fiscal policy") in their efforts to manage the macro economy as it moves through the business cycle: the old view – which is now wrong, wrong, wrong – and the new view, which is now right.

In late 2016, not long before he stepped down as chairman of President Obama’s Council of Economic Advisers and returned to his job as an economics professor at Harvard, Jason Furman gave a speech in which he drew just such a comparison.

I tell you about it now because, with our economy slowing sharply, but the Reserve Bank fast running out of room to cut its official interest rate so as to stimulate demand, it’s suddenly become highly relevant.

Furman says the old view has four key principles. First, "discretionary" fiscal policy (that is, explicit government decisions to change taxes or government spending, as opposed to changes that happen automatically as the economy moves through the ups and downs of the cycle) is inferior to "monetary policy" (changes in interest rates) as a tool for trying to stabilise the economy.

This is because, compared with monetary policy, fiscal policy has longer "lags" (delays) in being put into effect, in having its intended effect on the economy and in being reversed once the need for stimulus has passed. Scott Morrison’s inability to get his tax cut through Parliament by July 1, as he promised he could, is a case in point.

Second, even if governments could get their timing right, stimulating the economy just when it’s needed, not after the need has passed, discretionary fiscal stimulus wouldn’t work.

It could be completely ineffective because, according to a wildly theoretical notion called “Ricardian equivalence”, people understand that a tax cut will eventually have to be paid for with higher taxes, so they save their tax cut rather than spending it, in readiness for that day. Yeah, sure.

Or it could be partially ineffective because the increased government borrowing need to cover the budget deficit would force up interest rates and thus "crowd out" some amount of private sector investment spending.

Third, use of the budget to try to boost demand (spending) in the economy, should be done sparingly, if at all, because the main policy priority should be long-run fiscal balance or, as we call it in Oz, "fiscal sustainability" – making sure we don’t end up with too much public debt.

Now, I should explain that this view is the international conventional wisdom that eventually emerged following the advent of "stagflation" in the early 1970s, and the great battle between Keynesians and "monetarists" that ensued.

But Furman adds a fourth principle to the old view of fiscal policy: policymakers foolish enough to ignore the first three principles should at least make sure that any fiscal stimulus is very short run, so as to support the economy before monetary stimulus fully kicks in, thereby minimising the harm done.

Remind you of anything? The package of budgetary measures – the cash splashes and shovel-ready capital works – designed mainly by Treasury’s Dr Ken Henry after the global financial crisis in 2008 which, in combination with a huge cut in interest rates, succeeded in preventing us being caught up in the Great Recession, was carefully calculated to be "timely, targeted and temporary".

Furman says that, today, the tide of expert opinion is shifting to almost the opposite view on all four points.

That’s because of the prolonged aftermath of the financial crisis, the realisation that the neutral level of interest rates has been declining for decades, the better understanding of economic policy from the past eight years, the new empirical research on the impact of fiscal policy, and the financial markets’ relaxed response to large increases in countries’ public debt relative to gross domestic product.

Furman admits that this "new view" of the role of fiscal policy is essentially the "old old view" dating back to the Keynesian orthodoxy that prevailed between the end of World War II and the mid-1970s.

Furman outlines five principles of the new view of fiscal policy. First, it’s often beneficial for fiscal policy to complement monetary policy.

This is because the use of monetary policy is constrained by interest rates being so close to zero.

This isn’t new: the real interest rate has been trending down in many countries since the 1980s and was already quite low before the financial crisis.

Second, in practice, discretionary fiscal policy can be very effective. Experience since the crisis shows that Keynesian “multipliers” (where stimulus of $1 adds more than that to GDP) are a lot bigger than formerly thought.

And when you apply fiscal stimulus at a time when private demand is weak, there's little risk of inflation, so central banks won’t be tempted to respond by tightening monetary policy and lifting interest rates, thus countering the fiscal stimulus.

Third, governments have more “fiscal space” to run deficits and increase debt than formerly believed. The economic growth that fiscal stimulus causes means nominal GDP may grow as fast or faster than the increase in government debt.

Partly because of reform, the ageing of the population won’t be as big a burden on future budgets as formerly thought.

Fourth, if government spending involves investment in needed infrastructure, skills and research and development, it not only adds to demand in the short term, it adds to the economy’s productivity capacity (supply) in the medium term.

And finally, when countries co-ordinate their fiscal stimulus – as they did in their initial response to the financial crisis - the benefit to the world economy becomes much greater. This is because one country’s “leakage” through greater imports is another country’s “injection” through greater exports, and vice versa.

It seems clear Reserve Bank governor Dr Philip Lowe understands all this.

But whether the present leaders of Treasury, and Treasurer Josh Frydenberg’s private advisers, have kept up with the research I wouldn’t be at all sure.

Wednesday, June 12, 2019

For every problem there’s a job, and no shortage of problems

With the economy subsiding in a heap within days of Scott Morrison winning re-election thanks to the Coalition’s superior economic management skills, he and his ministers are being swamped with helpful hints about how they can get things moving again.

The business lobby groups are proffering some novel solutions: what would do the trick is to cut the rate of company tax and reform industrial relations so the unions are no longer running the country and extracting exorbitant pay rises from employers.

But, in doing what they always do, the lobby groups are selling business short. The conclusion I suspect our smarter business people are drawing is that the surprise re-election of a government that isn’t able to agree on many policies means that if they’re waiting for these guys to fix their problems, they’ll be waiting a long time.

We’ve entered the DIY economy: if you’ve got a problem, fix it yourself. Since the government can’t agree that climate change is more than a lip-service problem, the electricity industry will have to find its own solution.

Same goes for our low rate of productivity improvement. The nation’s productivity improves when the nation’s businesses work smarter, not from government planes dropping policy cargo from the sky.

That’s what I like about a new report from Deloitte Access Economics, The Path to Prosperity: Why the future of work is human.

According to its lead author, David Rumbens, “we don’t face a dystopian future of rising unemployment, aimless career paths and empty offices. Yes, technology is driving change in the way we work, and the work we do, but it’s ultimately not a substitute for people.

“Technology is much more about augmentation than automation, and many jobs will change in nature because of automation, rather than disappear altogether. We can use technology to our advantage to create more meaningful and productive jobs, involving more meaningful and well-paid work.”

Rumbens’ boss, Richard Deutsch, says that “for every problem there’s a job, and the world isn’t running out of problems”.

Just so. The report disputes the popular notion that robots will take our jobs. “Technology-driven change is accelerating around the world, yet unemployment is close to record lows, including in Australia,” it says.

“New technologies will have the capacity to automate many tasks, but also create as many jobs as they kill, and employment is growing in roles that are hardest to automate.”

Another mistaken notion is that people will have lots of different jobs over their careers. Despite all the things people who wouldn’t know try to tell you, overall, work is becoming more secure, not less. Australians are staying in their jobs longer than ever.

The gig economy is not taking over, and the proportion of casual jobs isn’t changing, despite what the unions claim. This is not opinion, it’s statistical fact.

Why are jobs becoming more secure rather than less? Because, with more tasks being done by machines, the kinds of skills employers need their workers to possess are changing. And the skills employers increasingly need are in short supply.

When you find people who possess the skills you’re looking for, you don’t make them casuals, you try to keep them. If they left, they’d be hard to replace. That’s particularly true if they’ve acquired those skills on the job – at the boss’s expense.

It shouldn’t surprise you that employers’ demand is shifting from manual skills to cognitive skills – from the hands to the head – and from routine to non-routine jobs. Manual and routine white-collar jobs are most easily done by machines.

What may surprise you is that, as machines get better at doing routine cognitive jobs, employers increasingly require skills of the heart rather than the head – the “soft skills” needed for “interpersonal and creative roles, with uniquely human skills like creativity, customer service, care for others and collaboration, that are hardest of all to mechanise”.

Such heart skills will be needed most in the services sector, where people rather than machines are the key to driving how value is created – government services, construction, health, professional services and education.

So, what must the government be doing to meet this need? The report doesn’t say. Its focus is on what employers – private or public – should be doing.

“With skill requirements changing faster and becoming more job-specific [good point], the future of work will require much more, and much better, on-the-job learning than Australia has today,” it says.

“Business leaders will have to make active choices, and just buying skills won’t be enough, they will have to adopt an investment frame of mind, and train them.

“With investment in on-the-job training cheaper, more relevant and more focused than classroom learning, the future of work will be a combination of learning and work integrated into one. And refreshing the skills of current, experienced workers will be just as critical as producing students and graduates with the skills they need.

“By making workers smarter and better suited to the jobs of the future, and improving the match between what businesses need and what workers have, we will make our workplaces happier and more productive.”

Who’d have thought one of the big four chartered accounting firms could talk so much sense?

Monday, June 10, 2019

ABBA was right: Rockonomics shows the winner takes it all

Why do we live in the era of superstars – whether people or businesses? Why is there such a thing as winner-take-all markets? Why do the top 1 per cent of households get an ever-bigger slice of the pie?

Short answer: because the digital revolution is disrupting far more of the economy than we realise.

It’s explained in the new book, Rockonomics: What the music industry can teach us about economics and life, by Alan Krueger, and summarised in his article in the New York Times, from which I’ll quote. Krueger, an economics professor at Princeton University, died in March at the age of 58.

Krueger says the first economist to explain the growing income gap between superstar businessmen and everyone else was the great English economist Alfred Marshall, in the late 1800s.

Marshall argued that a remarkable development in communications technology, the undersea telegraph, allowed top entrepreneurs “to apply their constructive or speculative genius to undertakings vaster, and extending over a wider area, than ever before”.

Ironically, Marshall used the music profession as his counterexample. Because the number of people who could be reached by a human voice was so limited, it was unlikely that any singer could better the £10,000 that the great soprano Elizabeth Billington was said to have earnt in a season.

What the superstar businessmen had, but Billington and her rivals lacked, was the ability to scale up at no prohibitive cost. Of course, Krueger notes, the other thing you need to become a superstar is what economists call “imperfect substitutes”. In English, you must have your own unique style and skills.

Today, of course, music is a most extreme and obvious example of superstars and winner-take-all markets. Why? Because technological advance has provided the economies of scale lacking in Marshall’s day.

Start with amplification of the human voice and then musical instruments. Then, the advent of enhanced recording technology. Finally, the internet and digital streaming of individual tracks anywhere in the world.

“Scale magnifies the effect of small, often imperceptible differences in talent. With the ability of scale, the rewards at the top can be much greater for someone who is slightly more talented than his or her next-best competitor, because the most talented person’s genius can reach a much greater audience or market, in turn generating much greater revenue and profit,” Krueger says.

Album sales and digital streaming clearly reflect the superstar phenomenon, he says. In 2017, the top 0.1 per cent of artists accounted for more than half of all album sales. Song streams and downloads are similarly lopsided.

But a strange thing has happened. Because digital recording has made it so easy to copy and share recordings, the revenue earned by artists and record labels has collapsed. These days, musicians make most of their income from live performances – from nobodies playing in pubs to superstars touring the world’s major venues.

Krueger says that, in 2017, the top 1 per cent of artists increased their proportion of total concert revenue to 60 per cent, compared with 26 per cent in 1982.

Another funny thing: it's now so cheap and easy to record your performance and get it onto the internet, where it’s available to the whole world, that anyone can do it. But does that make you famous? No way. The amount of music available on the net is so vast that the chances of your genius being discovered are tiny.

If you’re already famous, it’s easy to become more so. We hear of some unknown’s YouTube video getting a million clicks, but these are the exceptions. And if that happens it does so because something about the video is exceptional, and because a cascading network of people hear about it and recommend it to their friends. Do you make any money out of it? Probably not.

What happens is not a normal, “bell-shaped” distribution of listens – or dollars – but a “power-law” distribution in which a small number of people get huge scores, which quickly fall off until you get to everyone else getting next to nothing.

In 2016, Krueger says, the most popular artist, Drake, was streamed 6.1 billion times, followed by Rihanna (3.3 billion streams), Twenty One Pilots (2.7 billion) and The Weeknd (2.6 billion). Move down just 100 places and you get to Los Tigres del Norte (0.5 billion).

See how quickly it falls away? That’s a power-law distribution. So is the “80/20 rule”.

Krueger says that the whole United States economy has moved in the direction of a superstar, winner-take-all market. Since 1980, more than 100 per cent of the total growth in income has gone to the top 10 per cent of households, with two-thirds of that going to the top 1 per cent, while the share of the remaining 90 per cent has shrunk.

Saturday, June 8, 2019

Election hype about strong growth now back to grim reality

The grim news this week is that the weakening in the economy continued for the third quarter in row, with economic activity needing to be propped up by government spending.

The Australian Bureau of Statistics’ “national accounts” showed real gross domestic product – the nation’s production of market goods and services – grew by just 0.3 per cent in the September quarter of last year, 0.2 per cent in the December quarter and now 0.4 per cent in the March quarter of this year, cutting the annual rate of growth down to 1.8 per cent.

That compares with official estimates of our “potential” or possible growth rate of 2.75 per cent a year. It laughs at Treasurer Josh Frydenberg’s claim in the April budget – and Scott Morrison’s claim in the election campaign - to have returned the economy to “strong growth”, which will roll on for a decade without missing a beat.

It suggests Frydenberg’s boast of having achieved budget surpluses in the coming four financial years – and Labor’s boast that its surpluses would be bigger – are little more than wishful thinking, manufactured by a politicised Treasury.

The future may turn out to be golden but, even if it does, the econocrats have no way of knowing that in advance – they’re just guessing - and the road between now and then looks pretty rocky.

Why is the immediate outlook for the economy so weak and uncertain? Not primarily because of any great threat from abroad – though a flare-up in Donald Trump’s trade war with China could certainly make things worse – but primarily because of one big and well-known problem inside our economy: five years of weak growth in wages.

When you examine the national accounts, that’s what you find. Over the nine months to March, the income Australia’s households received from wages grew by 3.5 per cent, before adjusting for inflation.

That wasn’t because of strong growth in wage rates, but because more people had jobs. Weakness in other forms of household income meant that total household income grew by just 2.4 per cent.

But households’ payments of income tax grew by 4.5 per cent, thanks mainly to bracket creep. This helped cut the growth in household disposable income to 2 per cent. Even so, households’ spending on consumer goods and services grew by 2.2 per cent – meaning they had to reduce their rate of saving.

Actually, the last big fall in households’ rate of saving occurred in the September quarter. Since then, households have tightened their belts, cutting the growth in their consumer spending so as to raise their rate of saving from 2.5 per cent of their disposable income to 2.8 per cent.

Reverting to “real” (inflation-adjusted) figures, this explains why consumer spending has grown by only about 0.3 per cent a quarter since June, reducing its growth over the year to March to an anaemic 1.8 per cent.

The bureau noted that the weakness in consumer spending was greatest in discretionary spending categories, including on recreation, cafes and restaurants, and clothing and footwear – a further sign that households are feeling the pinch.

Since consumer spending accounts for almost 60 per cent of GDP, that’s all the explanation you need as to why the economy’s now so weak. But there are other factors contributing.

One is the end of the housing boom. Home-building’s contribution to growth peaked in the September quarter, with building activity falling by 2.9 per cent and 2.5 per cent in the following two quarters. It will keep falling for some time yet.

And business investment is also weak. While non-mining investment grew by 2 per cent in the quarter, mining investment fell a further 1.8 per cent. Overall, business investment was up 0.6 per cent in the quarter, but down 1.3 per cent over the year to March.

External demand is helping, however. With the volume of exports growing, while the volume of imports was “flat to down” - another sign of weak domestic demand - “net exports” (exports minus imports) are contributing to growth.

Even so, total private sector demand (spending) has actually fallen for the second quarter in a row. So, apart from the contribution from net exports, any growth is coming from public sector demand.

It grew by 0.7 per cent in the quarter to be 5.5 per cent higher over the year. This reflects the rollout of the National Disability Insurance Scheme and state spending on infrastructure. It means government spending contributed half the growth in GDP during the quarter and more than 70 per cent of total GDP growth over the year to March.

Note, it’s not a bad thing for government spending to be contributing to growth. That’s exactly what it should be doing when private demand is weak. No, the concern is not that public spending is strong, it’s that private spending is so weak.

Dividing GDP by the population shows that GDP per person fell fractionally for another quarter, and grew by a mere 0.1 per cent over the year to March.

This tells us not that the economy is on the edge of recession – how could GDP contract when a growing population is making it ever bigger? – but that, as Jo Masters of Ernst & Young has said, “growth is being driven by population growth alone, and not increased participation or productivity”.

The economy’s getting bigger, but it’s not leaving us any better off.

Speaking of productivity, the productivity of labour deteriorated by 0.5 per cent in the March quarter and by 1 per cent over the year.

Is this a terrible thing? Well, before you slit your wrists, remember that when employment is growing a lot faster than the growth in the economy would lead you to expect, a fall in GDP per worker (or, in this case, per hour worked) is just what the laws of arithmetic would lead you to expect.

Surprisingly strong growth in employment – most of it full-time – doesn’t sound like a bad thing to me. It’s just hard to see how it can last much longer.

Tuesday, June 4, 2019

Interest rate cuts may not do much to counter slowdown

This won’t be the only cut in interest rates we see in coming months – which may be good news for people with mortgages, but it’s a bad sign for the economy in which we live and work.

The Reserve Bank is cutting rates because the economy’s growth has slowed sharply, with weak consumer spending and early signs that unemployment is rising.

In such circumstances, cutting interest rates to encourage greater borrowing and spending is the only thing it can do to try to push things along.

Whether we see just one more 0.25 percentage-point cut in a month or two’s time, or whether there will be more after that depends on just how slowly the economy is growing. The Reserve – and the rest of us - will get a much better idea of that on Wednesday morning, when the Australian Bureau of Statistics publishes the quarterly “national accounts”, showing by how much real gross domestic product grew during the first three months of this year.

If you’re thinking that cutting interest rates by a mere 0.25 per cent isn’t likely to make much difference, you’re right. That’s why we can be sure there’ll be at least one more cut.

While it’s true that, with the official interest rate now at a new record low of 1.25 per cent, the Reserve has limited scope for further cuts, don’t expect it to follow the advice from some chief executives that it should refrain from responding to further evidence of weakness in the economy with further cuts so that, once the economy’s reached the point of being really, really weak, the Reserve will still have something left to use to give it life support.

Let’s hope these executives are better at running their own businesses than they are at offering the econocrats helpful hints on how they should be doing their job.

No, we can be confident that, until it believes the economy is picking up, the Reserve will keep doing the only thing it can to help – cutting rates further.

Should this mean the official rate gets to zero, Scott Morrison and his government will then have no choice but finally to respond to governor Dr Philip Lowe’s repeated requests – repeated again only two weeks ago – that they put less emphasis on returning the budget to surplus and more on helping to keep the economy growing, by spending more on needed (note that word) infrastructure and doing it soon, not sometime in the next decade.

Morrison got himself re-elected by claiming to be much better at running the economy than his political opponents. In the next three years we’ll all see just how good he is. Boasting about budget surpluses while unemployment rises is unlikely to impress.

But back to the efficacy of interest rate cuts. Even if we get several more of them, the economy’s circumstances are such that this wouldn’t offer it a huge stimulus.

One part of this is that while interest rates are an expense to borrowers, they are income to lenders, so that a rate cut reduces the spending power of the retired and others. This is always true, but it’s equally true that borrowers outnumber lenders, so the net effect of a rate cut is to increase spending.

In principle, the mortgage payments of households with home loans will now be a little lower, leaving them with more to spend on other things. In practice, many people leave their payments unchanged so they’re repaying the mortgage a little faster.

In principle, lower mortgage rates allow people to borrow more. And moving houses almost always involves increased spending on consumer durables - new lounge suites and the like. In practice, Australian households are already so heavily indebted that few are likely to be tempted to borrow more.

In principle, lower interest rates should also encourage businesses to borrow more to expand their businesses. In practice, what’s constraining businesses from borrowing more is poor trading prospects, not the (already-low) cost of borrowing.

In principle, lower rates are good news for the property market. But the Reserve wouldn’t be cutting rates if it thought the property boom might take off again. Combined with the removal of Labor’s threat to negative gearing, the likely result is a slower rate of fall in house prices, or maybe a floor for them to bump along for a few years. The home building industry won’t return to growth for some years yet.

The rate cuts should, however, cause our dollar to be lower, which may not please people planning overseas holidays, but will give a boost to our export and import-competing industries.

Putting it all together, even if we get a few more rate cuts that isn’t likely to give the economy a huge boost. Which means it’s unlikely to do much to fix the underlying source of the economy’s weakness: very small increases in wages.

The Fair Work Commission’s decision to raise all award minimum wage rates by 3 per cent will help about 2.2 million workers, but few of the remaining 10.6 million are likely to do as well.

Morrison’s promised $1080 boost to tax refund cheques, coming sometime after taxpayers have submitted their annual returns from the end of this month, will provide a temporary fillip, but it's a poor substitute for stronger growth and the improved productivity it helps to bring.

I have a feeling Morrison and his merry ministers will really be earning their money over the next three years.

Monday, June 3, 2019

How to dud manufacturing: be the world’s biggest gas exporter

Did you know Australia has now overtaken Qatar to be the largest exporter of natural gas in the world? But, thanks to private profiteering and government bungling, this seeming triumph comes at the risk of further diminishing manufacturing industry in NSW and Victoria.

It’s yet another example of naive economic reformers stuffing things up because real-world markets don’t work the way they do in textbooks.

Last week Dow Chemical announced it would close its Melbourne manufacturing plant due, in part, to high gas prices. This came after RemaPak, a Sydney-based producer of polystyrene coffee cups, and Claypave, a Queensland-based brick and paving manufacturer, went belly-up citing rising gas prices as an important contributing factor.

“Many other manufacturers are close to making critical decisions on their future operations,” according to Australian Competition and Consumer Commission boss Rod Sims. “If wholesale gas prices do not [come down], it is just a matter of time before they follow Dow, RemaPak and Claypave.”

When expected world liquefied natural gas prices rose last year, Australian gas suppliers were quick to raise their prices to local manufacturers, which use much gas in their production processes.

But expected world prices have fallen significantly over the past six months. Have the three suppliers dominating our east coast market cut their prices with the same alacrity? No. Most commercial and industrial users will pay more than $9 a gigajoule for gas this year, with some paying more than $11.

Why haven’t suppliers cut their prices? Because their pricing power means they don’t have to if they don’t want to. Why would they want to? Only because the government threatens them with something worse if they rip too much off their customers.

This was the big stick the softly spoken Sims was carrying last week as he urged them to do the right thing.

Is this the best way to regulate a market? No, but once you’ve stuffed it up you have little choice. The stuff-up evolved over some years, under federal governments of both colours and, predictably, with a lack of federal-state co-ordination.

It began in the resources boom, when Labor’s Martin Ferguson approved the construction of no less than three gas liquefaction plants near Gladstone in Queensland. That was one plant too many.

The companies secured the cost of building their plants by writing future contracts to export LNG to foreign customers. The first two companies secured the supply of sufficient gas from local sources, but the third had to scramble for what it needed to meet its sales contracts.

They expected far more gas to be available than transpired because they failed to anticipate the NSW and Victorian governments’ moratoriums on fracking for unconventional gas from coal seams.

Until the construction of the liquefaction plants – which enabled gas to be shipped overseas – the east coast gas market was cut off from the world market. This meant its prices were much lower than world prices.

The federal government knew that allowing the plants to be built meant opening the east coast market to the (much bigger) world market, forcing local prices up to the “export-parity price” or LNG “netback” price.

But, as Sims noted in a speech last week, the east coast was "just about the only region in the world that allowed unrestricted exports”. By contrast, when our west coast gas market was opened up, the West Australian government insisted on reserving sufficient gas to meet the needs of local users at local prices.

So, the east coast market opening was textbook pure (and much to the liking of the gas companies). Trouble was, the market worked nothing like the textbook promised. Lack of competition meant prices shot up to way above the export price.

The gas producers were able to overcharge the big industrial users, the three big gas retailers – AGL, EnergyAustralia and Origin – charged the smaller industrial users even more, and the pipeline owners whacked up their prices, too. Retailers’ prices peaked at $22 a gigajoule.

The threat to manufacturing was so great that Malcolm Turnbull eventually stepped in. Arming himself with the “Australian gas domestic security mechanism” (permitting him to set up a domestic reservation scheme), he forced the LNG producers to agree to offer domestic users sufficient gas on reasonable terms.

Now, however, prices have drifted back above export-parity. And the Australian Energy Market Operator is warning that gas shortages in NSW and Victoria could arise as soon as 2024 in the absence of major pipeline upgrades to allow more gas to flow from Queensland, or new sources of supply emerging.

This uncertainty adds to the risk of manufacturers giving up the struggle. The easiest and best solution would be for the Victorian government to lift its restrictions on development of – would you believe – conventional gas deposits.

Saturday, June 1, 2019

As you were: getting back to budget surplus no longer urgent

Sometimes, changes in fashion are shocking. In economics, the fashion leaders are top American economists. Their latest fashion call is highly relevant to Australia’s circumstances, but will shock a lot of people: stop worrying so much about debt and deficit.

Among the various big-name economists advocating this change of view, the one who made the biggest splash was Professor Olivier Blanchard, of the Massachusetts Institute of Technology, in his presidential lecture for the American Economic Association early this year.

Blanchard was formerly chief economist at the International Monetary Fund, and had a big influence on the advanced economies’ response to the global financial crisis. He offered a simpler version of his lecture in a paper for the Peterson Institute for International Economics in Washington.

When governments spend more than they raise in taxes, they cover their deficit by borrowing via the sale of government bonds. If you run deficits for many years, you rack up much debt.

So the conventional wisdom – which we heard from both sides in the election campaign – has long been that, as soon as the economy has recovered from its downturn, governments should raise more in taxes than they spend, so as to run an annual budget surplus. They use the surplus to buy back some of the bonds the government has issued, and thus reduce its debt.

Why do most people – and many economists still - think this is the right thing to do? Because when you borrow money you have to pay interest. The more you borrow, the more interest. And the only way to stop having to pay interest is to repay the debt.

Blanchard calls this the “fiscal [or budgetary] cost”. In the end, interest payments and repayments of principal have to be covered by the higher taxes extracted from people, which may discourage them from working or distort their behaviour in other ways.

But Blanchard realised there may be no fiscal cost because interest rates are so low – especially for governments, whose debt is regarded as risk-free (or “safe” as he calls it). Governments are almost always able to repay their debts because, unlike the rest of us, they can get the money they need by increasing taxes. Or they could simply print more money.

Safe interest rates in the rich economies – including Australia – are so low that, after you allow for inflation, the “real” interest rate may be close to zero, or even negative. If they’re zero they’re costing the government nothing.

If they’re negative, the lender is actually paying the government to borrow from them (once you remember that, because of inflation, the lender will be repaid in dollars with less purchasing power that the dollars originally borrowed).

But that’s not all. A government’s revenue-raising capacity tends to grow in line with the size of the economy – nominal gross domestic product. And nominal GDP almost always grows faster than the nominal safe interest rate.

If so, the government can go on, year after year, paying the interest on its debt and continuing to run a budget deficit - provided it isn’t too big – without its debt growing relative to the size of the economy.

Now, you may object that interest rates are so low at present only because it’s taking so long for the world economy to recover from the global financial crisis and the Great Recession.

But if interest rates are higher in the future, that will be because there’s stronger demand to borrow relative to the supply of funds available, and this, in turn, should mean the economy is also growing at a faster rate.

In any case, Blanchard and others have shown that nominal GDP growth has been higher than the safe interest rate for decades.

So, unless budget deficits are very high, the value of the debt should decline over time as a percentage of GDP. This, in fact, is the way all countries got on top of the massive debts they incurred during World War II.

The second conventional reason for worrying about government debt is the cost to the economy, which Blanchard calls the “welfare cost”. When governments borrow to fund their deficit spending, they compete with private sector borrowers, driving up the interest rates firms have to pay and so “crowding out” some business borrowers.

This causes firms’ investment in renewing or expanding their businesses to be lower than otherwise which, in turn, leads to less economic growth and job creation than otherwise.

(That’s the standard argument, used since Milton Friedman’s day. It’s still relevant to an economy as huge as America but, in an economy as small as ours, it stopped applying after we floated the dollar and our financial markets became integrated with the global market. In Australia, if crowding out happens, it does so via the inflow of borrowed foreign capital causing our exchange rate to be higher than otherwise and thus making our export and import-competing industries less price competitive.)

But Blanchard argues that, in fact, the welfare cost of high government debt is probably small. If the average rate of return on business investment projects is higher than the rate of growth in nominal GDP, this implies there is a cost to the welfare of people in the economy.

On the other hand, if the safe interest rate is lower than the rate of growth in nominal GDP, this implies a welfare benefit from the government debt. Putting the two together implies that the welfare cost, if any, wouldn’t be great.

Blanchard is quick to warn, however, that these arguments don’t “add up to a licence to issue infinite amounts of [government] debt”. Debt and deficit make sense when government spending is countering the weakness in private sector spending. When this fiscal stimulus succeeds in restoring strong growth in private sector spending, governments should pull back to avoid excessive inflation pressure.

And, to be on the safe side, government borrowing should be used mainly to support investment in needed infrastructure, education and healthcare, so it’s adding to the economy’s productive capacity, not just to consumption.