Showing posts with label SPEECHES. Show all posts
Showing posts with label SPEECHES. Show all posts

Monday, July 3, 2023

CitySwitch Awards Night, December 3, 2012

No one ever promised moving to a green economy - an economy making minimal use of fossil fuels - would be easy, and so it has proved. Indeed, in recent years the challenge has look dauntingly tough. It’s too easy to leave it to other people - and other countries - to make the first move. It’s too easy to make excuses and even to deny there is a problem. Sometimes I think I’m glad I didn’t do much science at high school, so I’m not tempted to think I can explain to the scientists where they’re getting it all wrong.

Even so, I get the feeling we’re making more progress in recent days - and that we’ve been making more progress than popularly believed. Here in Australia, the breakthrough may have come with the introduction of the carbon tax on July 1 which - as many of us prophesied - wasn’t nearly as catastrophic as the public had been led to expect. The tax had been designed to be as least disruptive as possible, and so it has proved. With any luck, this anticlimax will see a turning of the tide in our resolve to get on with preparing for a green future. I read that the carbon tax is now more popular than Tony Abbott - though that’s not setting the bar very high. (46/44; -31 net approval)

In recent days we’ve seen a number of new authoritative reports - mainly from scientific authorities, but also from no more unexpected body than the World Bank - reminding us the climate change problem hasn’t been wished away. It’s still there and, if anything, getting more pressing. That’s hardly good news, but I get the feeling these reports have been getting more media attention than they would have done a year ago.

Another bit of encouraging news is that, soon after his comfortable re-election, President Obama reaffirmed his view that man-made emissions of greenhouse gases are contributing to global warming, and stated his intent to continue to take action to reduce greenhouse gas emissions. He said: “I am a firm believer that climate change is real, that it is impacted by human behaviour and carbon emissions,” noting that, “we have an obligation to future generations to do something about it.”

It’s true the US Senate has declined to agree to an emissions trading scheme, but though that may be the best way to progress the move to a green economy, it’s not the only way. And the Obama Administration has made great strides in instituting stringent new fuel efficiency standards for cars and light trucks. A related approach is greenhouse gas regulations issued by the US Environmental Protection Agency, which would limit emissions from certain power plants. And we shouldn’t forget that California and several other states are proceeding with trading schemes.

Similarly, many people don’t realise how much progress China is making in the development of renewable energy sources such as wind and, particularly, solar. When Julia Gillard’s recent white paper on the Asian century included projections for the growth in Chinese demand for our coal, Professor Ross Garnaut expressed the view that these seemed far too high because they underestimated the extent to which China would be relying on green energy sources.

And then, of course, there’s the little publicised fact that the Chinese government is proceeding with an emissions trading scheme on a trial basis in various provinces. Knowing the Chinese way of doing things, I won’t be surprised to see this develop into a nation-wide scheme.

The final bit of good news is the way so many of our own businesses are seizing the challenge and the opportunity to become front-runners in the shift to a green economy. This is occurring in various areas of business, but - as we’ve heard - in none more successfully than in the CitySwitch program. It’s great to see building managers and tenants combining with city councils to use energy more efficiently. They say there are no free lunches in the economy, and it’s true many lunches that look free aren’t really, but there are some, and when you can combine doing the right thing by the planet - and by our grandchildren - with saving on energy costs, this surely qualifies. If doing the right thing and saving on costs also brings competitive advantages - including by making more conscientious employees keener to work for such an enlightened employer - then all I can say is: you deserve it. I’m pleased to be here tonight to honour all the participants in the CitySwitch program as well as those receiving awards.
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Economics and wellbeing: beyond GPD

Economic Society, Sydney, Tuesday, December 11, 2012

We had been hoping to have a speaker willing to argue that GDP was good enough to guide our policy decisions without need for modification or supplementation, but he’s unable to attend - which is a pity because I would have been interested to hear his arguments. In the absence of someone in the audience willing to argue that position, I think there’s a lot we can agree on. Where we’re likely to differ is in our degree of enthusiasm for the beyond-GDP project and how exactly we should go about developing a supplementary measure or range of measures.

Starting with the ‘agreed facts’, as the lawyers say, I doubt there are many if any economists who need to be lectured by greenies or lefties on the various reasons why GDP is an inappropriate measure of wellbeing or social progress. We all know about defensive expenditures and so forth. Further, we all know GDP was never intended or designed to be such a measure.

And I think all of us here tonight can agree that GDP is a reasonable measure of what it was designed to measure - production and income - and that the continued calculation of GDP is vitally important as an aid to the management of the macro economy. So no one here wants to abolish GDP.

It’s worth noting, however, that the 2009 report of President Sarkozy’s Commission on Economic Performance and Social Progress - the Stiglitz, Sen, Fitoussi report - did offer some significant criticisms of GDP just from a quite conventional, narrow, material wellbeing perspective. It noted that GDP had given Americans in particular an exaggerated impression of how well they were doing in the years leading up to the GFC, with company profits overstated because they were based on asset values inflated by a bubble and with a lot of the growth built on consumers and governments spending money they’d borrowed rather than earnt. It argued that in measuring material wellbeing, the focus should be shifted from production (GDP) to real household income and consumption, since household income can grow at a different rate to GDP. It further argued that income and consumption should be judged in conjunction with households’ net wealth, and that focusing on median income rather than average income is a better, easy way to take at least some account of the distribution of income.

A lot of the report’s criticisms can be met merely by switching from GDP to another aggregate published each quarter in the national accounts (but given almost no attention): real net national disposable income - ‘rinndi’. This measure switches from production to disposable income, takes account of the depreciation of manmade capital, the effect of movements in our terms of trade and the truth that, particularly for an economy with a huge net income deficit like ours, national product is a more appropriate measure than domestic product.

As you may know, I’ve been banging on about the limitations of GDP, and the need for it to be supplemented by a better, broader measure of wellbeing for some time. I was greatly reinforced in this view by the report of such luminaries as Stiglitz and Sen. For more than a year now, Fairfax Media has commissioned Nicholas Gruen to prepare such a broader measure, the Herald-Age Lateral Economics wellbeing index, for publication a few days after the quarterly national accounts.

The HALE index starts by turning GDP into real net national disposable income - rinndi - but then it adds adjustments for as many wider aspects of wellbeing as Nicholas could find decent measures of: the value of the net depletion of natural resources (after allowing for new discoveries), the estimated cost of future climate change, the gain in human capital from all levels of education and training, changes in income inequality, the gain or loss from various measures of the nation’s health and the state of employment-related satisfaction.

If you’re interested in getting your teeth into what a beyond-GDP measure of wellbeing might look like, we’re happy to explain and defend the HALE index. I asked Nicholas to come up from Melbourne tonight for that purpose. We don’t make any claim the index is a complete measure of every dimension of wellbeing, we don’t claim there’s nothing about its methodology that’s open to debate, but we do claim it’s an honest attempt to measure broader wellbeing - welfare, if you like - not some lefty attempt to think of as many negatives as possible to subtract from GDP.

The most obviously debatable part of the methodology is the decision to produce a single, modified-GDP figure for wellbeing. We know Stiglitz and Sen opted for the ‘dashboard’ approach - produce a range of relevant indicators of the various dimensions of wellbeing - rather than a single magic number. And we know the Bureau of Statistics, with all the effort it has put into its MAP project - Measures of Australia’s Progress - is also very much in the dashboard, they-can’t-be-added-up camp. So what are the reasons to prefer a single measure and, once you’ve decided to go down that track, how on earth do you add them together?

These are questions Nicholas, as the designer of the index, is far better qualified to respond to than I am. But I do want to say something from a more psychological, behavioural economics, political economy perspective. Why is it so many people have fallen into the habit of treating GDP as though it was a measure of social progress, even though it isn’t? The first part of my explanation is that economists, by their behaviour rather than their conceptual understanding, have led the uninitiated - politicians, business people, the media - into assuming GDP is the only indicator that matters because they get so excited about it so often, and don’t get so excited about anything else.

They say that what gets measured gets managed, and what doesn’t get measured doesn’t get managed, so if you accept there’s more to our wellbeing that just GDP (or even rinndi) that’s the first reason for wanting to publish something to sit beside GDP. In terms of human psychology, part of the reason for the great attention GDP gets is that new figures are published so frequently and that they’re always changing to an interesting extent.

Finally, we know from the findings of neuroscience that, contrary to our assumption of rationality, humans have surprisingly limited mental processing power and can’t weight up more than one or two dimensions of a problem at the same time, which - among many other implications - means humans are irresistibly attracted to bottom lines - to ‘net net’, as they say in the markets. People want a bottom line, will probably pick one by default, and GDP looks likes it is one. Dashboards may be more methodologically pure, but in a world of human frailty and limited attention, they just don’t cut it.
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Sunday, June 11, 2023

THE ECONOMY AND THE POLICY MIX

June 2012

If you’re not quite sure what’s happening in the economy at present, don’t feel bad. Some people are saying the economy’s in bad shape; others are saying it’s doing pretty well. The reason for the confusion is that the economy’s being hit by three different factors, at present: one expansionary, one contractionary and one that sounds worse than it actually is - so far, at least. These conflicting factors are affecting different industries differently and different states differently. This is because they’re bringing about a change in the structure of our economy, and structural change is often painful. The three factors are: first, the resources boom; second, the high exchange rate the resources boom has brought about and, third, the problems in the developed economies of the North Atlantic, particularly the Europeans’ debt crisis and worries about the survival of the euro. Let’s start with the troubles in the North Atlantic, then move to the boom then on to the high exchange rate.

Problems in America and Europe

The mighty US economy is recovering only very slowly from the Great Recession of 2008-09. But the problems are much more severe in continental Europe, as well as Britain. Europe’s basic problem of excessive levels of public debt is greatly complicated by the now-exposed structural weaknesses in the euro currency union. Most governments have resorted to the policy of ‘austerity’ - attempting to reduce budget deficits by slashing government spending and raising taxes at a time when their economic recoveries were still very weak. Unsurprisingly, this policy has proved counter-productive and has pushed various economies back into recession.

The media have given great publicity to Europe’s troubles and its tribulations have caused weakness in global sharemarkets, including ours. But the real question is the extent to which Europe’s problems affect our economy. They could do so via three main channels. First, the financial channel: they could cause certain global lending markets to seize up for a time, or increase the risk premiums paid by Australian banks or businesses borrowing in those markets. Second, the confidence channel: media reports of problems in Europe could damage the confidence of Australian consumers and business people. Third, the trade channel: weak growth or contraction in Europe could reduce our exports.

So what damage have we suffered so far? Europe’s tribulations have added a little to our banks’ costs of borrowing overseas. They do seem to have added to the uncertainty of our business people, helping to explain the weakness of non-mining business investment spending. But it’s hard to be sure Europe has had much effect on consumers because the household saving rate has been steady for more than a year and consumer spending has been growing at its trend rate. Europe accounts for less than 10 pc of our exports, so its weakness has had little direct effect on our export income.

However, Europe is a significant customer of our biggest export customer, China. So any adverse effect from Europe’s weakness could come to us via China - unless China were to offset the fall in its export income from Europe by stimulating its domestic demand, as it seems willing and able to do.

Bottom line: Europe’s problems have had some negative effect on us, but so far, not much. This could change, however, if the euro arrangement collapsed. Were something really bad to happen in Europe, the RBA would react quickly with big cuts in the official interest rate.

Resources boom

The big expansionary shock to the economy is coming from the resources boom, the biggest we have experienced since the gold rush. The rapid industrialisation of China and India has pushed prices for our exports of coal and iron ore to extraordinary heights, with our terms of trade only now starting to fall from their best level in 200 years. The improvement in the terms of trade represents a significant increase in the nation’s real income which, when spent, adds to demand. The boom has also added to demand by sparking a huge surge of investment spending on the construction of new mines and liquid-gas facilities. The emerging economies’ demand for the main components of steel is likely to stay strong for a decade or two. So, though the price of our exports of coal and iron ore is likely to fall back to less extreme levels, the volume of our exports is likely to continue growing for many years.

High exchange rate

The big contractionary shock to the economy is coming from the still very high exchange rate caused by the resources boom. An improvement in our terms of trade almost always leads to a rise in our exchange rate. Our dollar is likely to stay unusually high for some years, even as commodity prices fall back, because of the significant net inflow of foreign capital needed to finance the expansion of our mining sector. The high exchange rate helps to prevent the resources boom from leading to inflation by, first, directly reducing the price of imports and, second, reducing the international price competitiveness of our export and import-competing industries, thus reducing their production and so working in the direction of diminishing demand.

Structural change

The public is used to thinking about the economy in cyclical terms: it’s either booming or turning down. At present, however, because these two big shocks to the economy - the resources boom and the high dollar - are working on opposite directions, the economy is neither booming nor busting. It’s easier to understand what’s going on in the economy if you think of it in structural terms: the interplay of the two conflicting forces bearing on the economy is causing some industries to expand while others contract. The mining industry and mining-related parts of the construction industry and the manufacturing industry - accounting in total for up to 20 per cent of GDP - is expanding rapidly, whereas most of the other trade-exposed industries (manufacturing and service export industries such as tourism and education) are likely to get relatively smaller. The other industry that’s suffering from structural change is retailing. The pressures it’s facing have little to do with the high dollar, however. It’s being affected by the digital revolution and the rise of e-commerce.

Outlook for the economy

Over the year to March, the economy grew by an exceptional 4.3 pc, lead by strong consumer spending and the boom in mining investment. But now the economic managers are expecting growth to return to its trend rate of 3.25 pc for the coming financial year, 2012-13, as a whole. But this is expected to involve quite disparate growth in the components of GDP: 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.

And note that the other economic indicators are looking pretty good at present. The latest figures say underlying inflation is running at 2.2 pc - almost down to the bottom of the RBA’s 2 to 3 pc inflation target. The latest figures say unemployment is running at about 5 pc - which economists say is down very close to our NAIRU - the non-accelerating-inflation rate of unemployment, which is the lowest point to which unemployment can fall before labour shortages start causing wage and price inflation. That is, unemployment is very close to its lowest sustainable rate.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Aware the unemployment rate was only a little above the NAIRU and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as the RBA had forecast. Instead, the outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by 0.5 points in June by a further 0.25 points, taking the cash rate down to 3.5 pc, more than offsetting the banks’ efforts to preserve their profit margins, and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.

Conclusion

Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.
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Saturday, November 9, 2013

Rent-seeking stymies genuine reform



For most of the past decade I’ve defended Australia’s mining companies and their boom against unreasonable criticism. So I could hardly be said to be anti-mining. But one of my failings is that don’t get any fun out of telling people what they’d like to hear. So when I was asked to speak at the federal government’s annual conference on resources and energy last month I decided to tell the miners a few home truths. This is a shortened version of what I said.

With the change of government I'm sure you're a lot happier about the prospects for the economy and its management, and a lot more confident of a sympathetic hearing from the new government. I wouldn't be so sure.

I suspect the mining industry's lobbying success is reaching its zenith as we speak. It won't surprise me if, looking back on the life of the Abbott government, you come to realise the big gains the industry made actually occurred under the Labor government. They occurred no thanks to Labor, and all thanks to the Coalition, but they occurred in reaction to the policies of Labor as part of Tony Abbott's successful four-year campaign to fight his way back into office.

Why did Abbott immediately oppose the mining tax and promise to repeal it? Because he genuinely believed it would wreck the mining industry and do damage to the wider economy? I doubt it.

He did it primarily because he saw opposing the tax as a popular cause and was hoping for a lot of monetary support from the big miners in the 2010 election.

Why did Abbott set his face against the carbon pricing scheme? Because it was the price of getting the backing within the party that allowed him to wrest the Liberal leadership from Malcolm Turnbull and because he could see what a popular cause it would be to oppose this "great big new tax on everything".

Now, I have no doubt that keeping his promises to get rid of the mining tax and the carbon tax will be among his priorities. But my point is this: having delivered so handsomely for the mining industry, I doubt if he'll feel in any way indebted to the miners.

Indeed, he may well feel he's the one that's owed. Certainly, he'll feel the miners have had enough favours to be going on with.

And it won't surprise me if that's the attitude other industries take: that the miners have had their turn and it's time to give other industries a go.

Does this analysis seem cynical? Sorry, it's just being brutally realistic. We all pursue our self-interest, but we all cloak our self-interest in arguments about how this would be in the best interest of the economy. All I'm doing is stripping away the bulldust.

Most people in business are hoping that with a more enlightened government in power with a big majority in the lower house and a workable Senate after July, we'll see some major economic reform, if not in Abbott's first term then certainly in his second. I think this is an idle hope.

In a prophetic speech he delivered in May - and which he's in the process of expanding into a short book - Professor Ross Garnaut argued that our political culture has changed since the reform era of 1983 to 2000, in ways that make it much more difficult to pursue policy reform in the broad public interest.

"If we are to succeed, the political culture has to change again," he said. Policy change in the public interest seemed to have become more difficult over time as interest groups had become increasingly active and sophisticated in bringing financial weight to account in influencing policy decisions.

"Interest groups have come to feel less inhibition about investment in politics in pursuit of private interests.
"For a long time, these past dozen years, it has been rare for private interests of any kind to be asked to accept private losses in the interests of improved national economic performance.

"When asked, the response has been ferocious partisan reaction rather than contributions to reasoned discussion of the public interest in change and in the status quo," Garnaut said.

I would remind you that, though John Howard's introduction of the GST is a notable exception, many of the reforms of the Hawke-Keating era were achieved with bipartisan support - something that's unthinkable today.

Much of that reform, particularly in taxation, involved packages of measures in which particular interest groups suffered some losses, offset by other gains. As Garnaut argues, and I'm about to demonstrate, this kind of co-operative give-and-take between interest groups willing to accept reforms in the wider public good isn't conceivable today.

My way of making Garnaut's point is that since the reform era of the 1980s and '90s, we've regressed to a culture of rent-seeking. You can see this at the level of the political parties and at the level of the industry lobbies.

When Howard had the courage to propose introducing a GST, Labor saw its chance to regain office by running a populist scare campaign against it, and came within a whisker of winning the 1998 election. At the time it professed to be righteously opposed to such a regressive tax, but when it finally regained power seven years later, the idea of doing something about that supposedly abhorrent regressivity never crossed its mind.

When, in turn, the Rudd government attempted the risky reforms of installing the "economic instrument" most economists recommend for responding to climate change, and rebalancing the tax system by reforming the taxation of mineral deposits and using the proceeds to reduce taxes elsewhere, Abbott lost little time in deciding to take advantage of Labor's vulnerability.

Do you really think the events of the past three years will have no bearing on the Labor opposition's attitude to any controversial reforms Abbott might propose in the next six years, or that Abbott's foreknowledge of this attitude will have no bearing on his willingness to propose such reforms?

The truth is the nation has fought itself to an impasse on controversial reform - of the labour market as well as taxation - and, among the industry lobbies, the miners have played a more destructive role than the rest.

Now, you can respond that the miners did no more than what you'd expect them to do: oppose taxes they perceived to be contrary to their industry's interests. But this is making my point: the reason the outlook for reform is now so bleak isn't solely because the two sides of politics have regressed to short-sighted, self-interested advantage seeking, it's also because the industry lobby groups have done the same thing.

There's nothing new about industry lobbying but in the past dozen years it's become far more blatantly self-interested and far more willing to devote large sums to advertising campaigns to oppose whatever government reforms an industry sees as contrary to its interests. What hasn't yet occurred to many business people - but you can be sure is well understood by the politicians and their advisers - is that when industries lobby governments for favours, or in opposition to new imposts, the various industries are in competition.

It's easy to imagine the government's coffers are a bottomless pit but, in fact, there's only so much rent to go around. As an economist would say, all concessions have an opportunity cost. It's easy to believe all industries could pay less tax if the pollies would only make households pay more tax, but I wouldn't hold my breath waiting for it to happen. I doubt either side of politics would see that as consistent with their own self-interest.

The truth is, when one industry gets in for a big cut, there's less left in the pot for the others. That industries don't understand this simple point about opportunity cost - don't realise they're in competition with each other - is easily demonstrated by the demise of Labor's mining tax package.

Think about the original package: the big three miners were going to pay more tax on their resource rents, but most of the proceeds were going to be distributed to other industries.

In particular, all companies (including miners, big and small) were getting their company tax rate cut by 2 percentage points, small miners were getting a resource exploration rebate, small business was getting instant write-off of most assets, the banks were getting more concessional taxation of depositors' interest income, and the financial services industry was getting its dream of having compulsory super contributions jacked up from 9 per cent to 12 per cent, a one-third increase in contributions.

So three big miners had a lot to lose, but the rest of industry had a lot to gain. So what was the rest of industry's attitude to the resource super profits tax? Didn't like the sound of it.

And what did they do when the miners sought to scuttle the new tax? Precisely nothing.

What happened then? The exploration rebate was to first thing to disappear and, in several stages under Labor, the cut in the company tax rate got whipped off the table.

Now, with Abbott's plan to abolish the cut-down mining tax, the small business concessions are being withdrawn and the phase-up of compulsory super has been deferred for two years.

With all the pressure on the Abbott government's budget, and the super industry extracting a promise from Abbott not to make any further savings on the concessional taxation of super, I'm prepared to bet the two-year deferment will become permanent.

Thus did the rest of business allow the miners to screw them over. And thus did the miners destroy faith in one of the techniques tax reformers believed made major tax reform possible: put together a large package with a mixture of wins and losses and the various industry lobbies keep each other on board in the wider interest.

But it doesn't stop there. When the miners and the rest of business dream of further tax reform under the Abbott government what do they have in mind? Mainly, a big cut in the company tax rate. Do you really see the Abbott government daring to fund such a cut by increasing the GST?

Had the minerals resource rent tax survived and got past its accelerated depreciation phase, the fact that the most highly profitable part of the corporate sector (along with the banks) was paying a lot more tax on its profits would have greatly strengthened the argument for a general cut in the company tax rate. This is particularly so because mining is so heavily foreign-owned. So the absence of the resource rent tax makes a cut in the company tax rate a lot less likely.

One way a cut in the rate could still be afforded is if it was covered by a broadening of the base by the removal of sectional concessions. But the bitter experience of the demise of the mining tax package makes it less likely any government would risk proposing such a compromise.

We can continue going down the road of ever-more blatantly self-interested behaviour by political parties on the one hand and industry lobby groups on the other, but while we do so it's idle to dream of major reform.

What we can do - as the miners have shown - is veto any reform we don't fancy.
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Thursday, October 3, 2013

THE POLITICAL ECONOMY OUTLOOK FOR REFORM

Australian National Conference on Resources and Energy, Talk to conference dinner, Canberra, Wednesday, October 3, 2013

I suppose I should start by warning you I’m an adherent to the Paddy McGuinness school of public speaking, which holds that there’s no point in speaking to an audience unless you say something that makes them sit up, challenges their comfortable assumptions and gives them something uncomfortable to think about. This has become, I admit, a terribly unfashionable way to engage an audience. The fragmentation of the media that’s occurring in the digital age is increasingly allowing consumers of the media to customise their news and opinion, selecting those items they’ll find congenial and reinforcing, and selecting out anything that jars with their long-held view of the world. And it’s certainly the case that the main organs of business news have switched to a strategy of only ever telling the captains of industry what they want to hear, of echoing their own opinions back to them.

Sorry, but I’m too close to retirement and too comfortably off to be bothered abasing myself in such a way. In Paddy McGuinness’s heyday the business bible saw its role as being devil’s advocate to business and that’s a role I’m much more comfortable with. And since I didn’t ask to be paid to talk to you tonight, I’m going to do it my way. So I imagine many of you won’t enjoy what I’ve got to say and may even heartily disagree with some of it. Feel free to think of some disparaging label to attach to me and use as an excuse to close your mind to the challenging things I say. I’ll still bother saying them in the hope at least some of you are bosses who don’t want to be surrounded by yes-men and do want to be challenged to rethink some of your more comforting beliefs.

Perhaps among all the labels you could use to dismiss my views the least abusive is that I’m ‘anti-mining’. I assure you I’m not. I’ve spent the past decade singing the praises of the resources boom to my readers, arguing staunchly that this reinforcement of Australia’s comparative advantage in the provision of minerals and energy to the rest of the world is a blessing, and that the rest of our economy has to cop the painful structural adjustment this new stroke of good fortune makes necessary.

What I’m not, however, is pro-mining. I’d like to think I’m not pro any particular sector of industry. When I got into the economic commentary business 40 years ago it was the farmers and the manufacturers who were always trying to tell us they were special, that the rest of the economy rode on their back and that this entitled them to special consideration. It was self-serving self-delusion then, and it still is. What’s changed is that, these days, we also have the miners trying to tell us they’re special, that the rest of the economy rides on their back and that they’re entitled to special consideration. Sorry, not buying that one, either.

With the change of government I’m sure you’re a lot happier about the prospects for the economy and its management, and a lot more confident of a sympathetic hearing from the new government. I wouldn’t be so sure. I suspect the mining industry’s lobbying success is reaching its zenith as we speak. It won’t surprise me if, looking back on the life of the Abbott government, you come to realise the big gains the industry made actually occurred under the Labor government. They occurred no thanks to Labor, and all thanks to the Coalition, but they occurred in reaction to the policies of Labor as part of Tony Abbott’s successful four-year campaign to fight his way back into office. Why did Abbott immediately oppose the mining tax and promise to repeal it? Because he genuinely believed it would wreck the mining industry and do great damage to the wider economy? I doubt it. He did it primarily because he saw opposing the tax as a popular cause and was hoping for a lot of monetary support from the big miners in the 2010 election campaign. Why did he set his face against the carbon pricing scheme? Because it was the price of getting the backing within the party that allowed him to wrest the Liberal leadership from Malcolm Turnbull and because he could see what a popular cause it would be to oppose this ‘great big new tax on everything’.

Now, I have no doubt that keeping his promises to get rid of the mining tax and the carbon tax - delivering on the commitments he made as a result of policies pursued in Labor’s term - will be among his highest priorities. But my point is this: Having delivered so handsomely for the mining industry, I doubt if he’ll feel in any way indebted to the miners. Indeed, he may well feel he’s the one that’s owed. Certainly, he’ll feel the miners have had enough favours to be going on with. And it won’t surprise me if that’s the attitude other industries take: that the miners have had their turn and it’s time to give other industries a go. I suspect the mining industry’s lobbying power has just reached its zenith.

Does this analysis shock you? Does it seem extraordinary cynical? Sorry, it’s just being brutally realistic. We all pursue our self-interest, but we all cloak our self-interest in arguments about how this would be in the best interest of the economy. All I’m doing is stripping away the bulldust.

Most people in business are hoping that with a more enlightened government in power with a big majority in the lower house and a reasonably workable Senate after July, we’ll now see some major economic reform - if not in Abbott’s first term then certainly in his second. I think this is an idle hope.

In a prophetic speech he delivered in May - and which he’s in the process of expanding into a short book - Professor Ross Garnaut argued that our political culture has changed since the reform era of 1983 to 2000, in ways that make it much more difficult to pursue policy reform in the broad public interest. ‘If we are to succeed, the political culture has to change again,’ he said. Policy change in the public interest seems to have become more difficult over time as interest groups have become increasingly active and sophisticated in bringing financial weight to account in influencing policy decisions, Garnaut said. ‘Interest groups have come to feel less inhibition about investment in politics in pursuit of private interests. ‘For a long time, these past dozen years, it has been rare for private interests of any kind to be asked to accept private losses in the interests of improved national economic performance. When asked, the response has been ferocious partisan reaction rather than contributions to reasoned discussion of the public interest in change and in the status quo,’ he said.

I would remind you that, though John Howard’s introduction of the GST is a notable exception, the many reforms of the Hawke-Keating era were achieved with bipartisan support - something that’s unthinkable today. Much of that reform, particularly in the area of taxation, involved packages of measures in which particular interest groups suffered some losses, offset by other gains. As Garnaut argues - and I’m about to demonstrate - this kind of co-operative give-and-take between interest groups willing to accept reforms in the wider public good simply isn’t conceivable today.

My way of making Garnaut’s point is that since the reform era of the 1980s and 90s we’ve regressed to a culture of rent-seeking. You can see this at the level of the political parties and at the level of the industry lobbies. When Howard had the courage to propose introducing a GST, Labor saw its chance to regain office by running a populist scare campaign against it, and came within a whisker of winning the 1998 election. At the time it professed to be righteously opposed to such a regressive tax, but when it finally regained power seven years later, the idea of doing something about that supposedly abhorrent regressivity never crossed its mind. When, in turn, the Rudd government - in its own quite ham-fisted way - attempted the risky reforms of installing the ‘economic instrument’ most economists recommend for responding to the challenge of climate change, and rebalancing the tax system by reforming the taxation of mineral deposits and using the proceeds to reduce taxes elsewhere, Abbott lost little time in deciding to take advantage of Labor’s vulnerability.

Do you really think the events of the past three years will have no bearing on the Labor opposition’s attitude to any controversial reforms Abbott might propose in the next six years, or that Abbott’s foreknowledge of this attitude will have no bearing on his willingness to propose such reforms? The truth is the nation has fought itself to an impasse on controversial reform - of the labour market as well as taxation - and, among the industry lobbies, the miners have played a more destructive role than the rest.

Now, you can respond that the miners did no more than what you’d expect them to do: oppose two new taxes they perceived to be contrary to their industry’s interests. But this is making my point: the reason the outlook for major economic reform is now so bleak isn’t solely because the two sides of politics have regressed to short-sighted, self-interested advantage seeking, it’s also because the industry lobby groups have done the same thing. There’s nothing new about industry lobbying but, as Garnaut says, in the past dozen years it’s become far more blatantly self-interested and far more willing to devote large sums to advertising campaigns to oppose whatever government reforms an industry sees as contrary to its interests.

What hasn’t yet occurred to many business people - but you can be sure is well understood by the politicians and their advisers - is that when industries lobby governments for favours or in opposition to new imposts, the various industries are in competition. It’s easy to imagine the government’s coffers are a bottomless pit but, in fact, there’s only so much rent to go around. As an economist would say, all concessions have an opportunity cost. It’s easy to believe all industries could pay less tax if the pollies would only make households pay more tax, but I wouldn’t hold my breath waiting for it to happen. I doubt either side of politics would see that as consistent with their own self-interest. The truth is, when one industry gets in for a big cut, there’s less left in the pot for the others.

That industries don’t understand this simple point about opportunity cost - don’t realise they’re in competition with each other - is easily demonstrated by the demise of Labor’s mining tax package. Think about the original package: the big three miners were going to pay a lot more tax on their resource rents, but pretty much the whole of the proceeds was going to be distributed to other industries. In particular, all companies (including miners, big and small) were getting their company tax rate cut by 2 percentage points, small miners were getting a resource exploration rebate, small business was getting instant write-off of most assets, the banks were getting more concessional taxation of their depositors’ interest income and the financial services industry was getting its great dream of having compulsory super contributions jacked up from 9 per cent to 12, a one-third increase in contributions. So three big miners had a lot to lose, but the rest of industry had a lot to gain. So what was the rest of industry’s attitude to the resource super profits tax? Didn’t like the sound of it. And what did they do when the miners sought to scuttle the new tax? Precisely nothing. What happened then? The exploration rebate was to first thing to disappear and, in several stages under Labor, the cut in the company tax rate got whipped off the table. Now, with Abbott’s plan to abolish the cut-down mining tax, the small business concessions are being withdrawn and the phase-up of compulsory super contributions has been deferred for two years. With all the pressure on the Abbott’s budget, and the super industry extracting a promise from Abbott not to make any further savings on the concessional taxation of super, I’m prepared to bet the two-year deferment will become permanent.

Thus did the rest of business allow the miners to screw them over. And thus did the miners destroy faith in one of the techniques tax reformers believed made major tax reform possible: put together a large package with a mixture of wins and losses and the various industry lobbies keep each other on board in the wider interest.

But it doesn’t stop there. When the miners and the rest of business dream of further tax reform under the Abbott government - perhaps after yet another root-and-branch tax review - what do they have in mind? Mainly, a big cut in the company tax rate. Do you really see the Abbott government daring to fund such a cut by increasing the GST? Had the minerals resource rent tax survived and got past its accelerated depreciation phase, the fact that the most highly profitable part of the corporate sector (along with the banks) was paying a lot more tax on its profits, would have greatly strengthened the argument for a general cut in the company tax rate (this is particularly so because mining is so heavily foreign-owned). So the absence of the resource rent tax makes a cut in the company tax rate a lot less likely. One way a cut in the rate could still be afforded is if was covered by a broadening of the base by the removal of sectional concessions. But the bitter experience of the demise of the mining tax package makes it less likely any government would risk proposing such a compromise.

We can continue going down the road of ever-more blatantly short-sighted and narrowly self-interested behaviour by political parties on the one hand and industry lobby groups on the other, but while we do so it’s idle to dream of major, controversial reform. What we can do - as the miners have shown - is veto any reform we don’t fancy.
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Thursday, September 12, 2013

MACRO MANAGEMENT AND THE SUPPLY SIDE


Management of the macro economy has moved to a more sophisticated and thus more medium-term approach, which has increased the focus on the supply side. I want to discuss some less familiar technical terms that have become part of the debate: ‘trend’ growth, the ‘potential’ growth rate, the ‘output gap’ and how macro policy and micro policy fit together.

The meaning of ‘trend’ growth

It has become common to hear the RBA or the treasurer saying the economy (or private consumption or some other key macro variable) is growing at, below or above ‘trend’ - and expecting people to know what this means.

It can be a bit confusing because the Bureau of Statistics uses the word ‘trend’ to mean something quite different. So let’s get that out of the way first. The bureau presents its estimates of key indicators on three bases: original, seasonally adjusted (which allows valid comparisons to be made between adjacent months or quarters) and ‘trend’, which would be better described as ‘smoothed seasonally adjusted’. To remove some of the ‘noise’ in the seasonally adjusted figures - and thus make their underlying direction more readily apparent - you subject the series of observations to an averaging process called a 5-term (for quarterly data) or 13-term (for monthly data) centred ‘Henderson’ moving average. The advantage of this statistical technique is that it makes the direction in which the variable is moving very clear without moving any turning-points. The disadvantage is that you don’t know the final value of an observation until two further quarters (or six further months) have passed. Until then, the estimate is subject to regular revision.

But as the term is used by macro economists (as opposed to the statisticians), ‘trend’ means an indicator’s medium-term to long-term average, with ‘medium-term’ meaning a period of more than two or three years, and long-term meaning maybe 10 or 20 years. For instance, the Rudd government’s economic statement before the 2013 election campaign showed the 30-year average growth rate for real GDP is 3.25 per cent a year.

But here’s where it gets a bit tricky. As well as using ‘trend’ to refer to this backward-looking historical average growth rate, the macro managers also use it to refer to the forward-looking average rate of growth over the future medium term. This forward-looking ‘trend’ is the same as the economy’s ‘potential’ rate of growth.

The meaning of the ‘potential’ growth rate

The potential rate of growth in production (output or real GDP) is the maximum average rate at which it can grow over the medium to longer term without worsening inflation. It thus has similarities to the non-accelerating-inflation rate of unemployment (NAIRU), which is the lowest rate to which unemployment can fall without worsening inflation. Both are measures of full employment or full capacity or the ‘sustainable’ rate of growth.

The three Ps of economic growth

A common way to examine economic growth is to decompose it into ‘the three Ps’: population, participation and the productivity of labour. It is, in fact, a labour-market oriented way of thinking about economic growth. Over the medium to longer term, the economy’s rate of growth can be seen as determined by the rate of growth in the population (in particular, the population of working age), any change in people’s participation in the workforce, and the rate at which the productivity of labour is growing.

Now, when economists treat the backward-looking medium-term ‘trend’ rate of growth as essentially the same as the forward-looking ‘potential’ growth rate they’re implicitly assuming there’s no reason to expect any of the three Ps to change in the coming decade or so from what they’ve been over the past few decades.

But that’s not a reasonable assumption, particularly at present. And this is why Treasury’s more forward-looking, potential-oriented approach to trend has led it to keep revising down its estimate for trend. We can make whatever guesses we like about whether the medium-term rate of improvement in labour productivity will be faster, slower or about the same as it’s been in the past. But the two other Ps - population of working age and the rate of participation - being demographic variables, can be projected with more confidence. And one thing that leaps out from the demography and the ageing of the population is that the great population bulge which is the baby-boomers (those born between 1946 and 1961) is rapidly entering an age cohort with a significantly lower rate of participation than the cohort they are leaving. (This remains true even if it’s also true that many baby-boomers are retiring later than had been expected). If you’ve noticed that Treasury has been revising down its estimate of trend growth, this is the main reason for it. Actually, this process has been occurring for some time. According to Treasury’s PEFO issued early in the 2013 election campaign, forward-looking trend growth was taken to be 3.5 per cent from 1998, then lowered to 3.25 per cent in 2005 and to 3 per cent in 2006. These downward revisions also reflected ‘lower projected productivity growth’. The trend rate is expected to be lowered further to 2.75 per cent some time ‘early next decade’.

The way to determine what Treasury’s estimates are for trend rates of growth in other key macro variables is to look at its annual mechanical ‘projections’ used for the last two years of the budget’s ‘forward estimates’. Trend growth in real GDP of 3 per cent is consistent with annual growth in total employment of 1.5 per cent and an unemployment rate steady at 5 per cent. This implies Treasury’s estimate of the NAIRU - full employment or unemployment’s ‘long-term sustainable level’ - is also 5 per cent. It further implies that, on average, employment needs to grow by 1.5 per cent just to hold the rate of unemployment steady. These estimates, in turn, fit with a CPI inflation rate of 2.5 per cent (ie the mid-point of the RBA’s medium-term target range) and annual growth in nominal GDP of 5.25 per cent (implying inflation as measured by the GDP deflator averages a fraction less than as measured by the CPI because, in the present environment, the terms of trade are assumed to trend down, which reduces growth in the GDP deflator but not the CPI).

While we’re on the three Ps, the charter of budget honesty requires Treasury to produce an ‘intergenerational report’ every five years. We’ve already seen three such reports. Treasury prepares projections of the major classes of government spending for the following 40 years (which always suggest massive growth in federal spending on health care), and estimates the size of the ‘fiscal gap’ if the growth in tax collections is to be capped as a percentage of GDP. But just as interesting are Treasury’s underlying estimates of the three Ps, past and future. In the 2010 IGR, the average annual rate of growth in real GDP over the past 40 years was 3.3 per cent, with growth in the population of working age contributing 1.7 percentage points, change in participation (broadly defined - see below) contributing minus 0.2 points and productivity improvement 1.8 points. Treasury projected that, over the coming 40 years, real GDP will grow at a slower average rate of 2.7 per cent a year, with growth in the working-age population contributing 1.3 percentage points, change in participation contributing minus 0.2 points and productivity improvement contributing 1.6 points. So most of the slowing in growth is explained by slower population growth and the rest by slower productivity growth. Of course, the reason we want to see the economy growing strongly is to increase our material standard of living, which is simply measured as growth in real GDP per person. Treasury estimates that the growth in GDP per person will slow by a smaller gap: 1.9 per cent over the past 40 years versus 1.5 per cent over the coming 40. In this case, the gap is explained equally by slower growth in the population of working age and slower growth in productivity.

Note that the expected slowdown in productivity improvement is no more than Treasury’s best guess. In both 40-year periods the working-age population grew a fraction faster than the population over all, but the difference between working-age and overall growth is expected to change sign in the coming 40 years because of the ageing of the population. It shouldn’t surprise you that participation is expected to fall and thus make a negative contribution to growth in the coming 40 years. But it may surprise you that participation also made a negative contribution in the past 40 years, at a time when we know the participation of women grew strongly. The explanation is that this improvement was more than offset by the higher rate of unemployment during the period and by a decline in average hours worked per worker as the proportion of part-time workers increased.

Speed limits and the ‘output gap’

One term you may be more familiar with is the ‘output gap’. This is the difference between the actual level (not the growth rate) of GDP and the level of potential GDP. In any particular year, actual growth is determined by the strength of aggregate demand, whereas the potential growth rate is the maximum sustainable rate of growth over the medium-term, set by the growth in aggregate supply.

So if in any particular year actual growth exceeds the trend (potential) growth rate this could be taken to mean that aggregate demand is growing faster than aggregate supply, and so is known as an ‘inflationary gap’. But it’s not that simple. Whether or not growth in excess of trend is inflationary depends on whether the economy is already operating at full employment (of all resources, not just labour) or full capacity. If it is then, yes, such growth will be inflationary (and will involve attempting to drive the unemployment rate below the NAIRU). If, however, the economy is operating well below full capacity (with factories and workers not fully employed) then short-term growth in excess of trend will not be inflationary. Indeed, the usual pattern in the first few years after a recession - in which, of course, actually capacity falls to levels way below full capacity - is for growth to far exceed trend. This is not a problem, it’s desirable.

So trend should be thought of as setting a ‘speed limit’ for the rate at which the economy should be growing only after the economy has returned to full capacity. Remember, too, that full capacity is not a fixed point. It grows every year. By how much? On average, by the trend rate of growth - this is what trend measures: the average rate at which the economy’s capacity to produce goods and services expands every year.

Factors leading to growth in the economy’s productive capacity

What factors cause the economy’s supply side - its capacity to produce goods and services - to grow each year? That’s easy: growth in the three Ps. Aggregate supply grows in line with the growth in the labour force, new business investment and public infrastructure, gains in the human capital of the workforce (education and training) and productivity gains arising from economies of scale and advances in technology.

Governments can exert some influence over the growth in the labour force by their policy on immigration and by reforming policies that have the effect of discouraging participation in the labour force. Government policies can also have an influence on the NAIRU. As well, governments can exert some influence over productivity improvement by the incentives and disincentives they create affecting primary research, research and development, and the tax and transfer system generally. They also exert influence by the size and effectiveness of their spending on education and training, as well as on economic infrastructure.

The Gillard government’s budget of May 2011 provided an interesting example of a government using its budget not just to influence aggregate demand but also to influence aggregate supply. It sought to add to supply, especially the supply of labour, particularly skilled labour. It involved a modest expansion of the immigration of skilled workers, the reform and expansion of vocational education and training (TAFE), and the use of sticks and carrots to encourage greater participation in the labour force by disadvantage workers (the long-term unemployed, sole parents and the disabled) and by wives in single-income couples who were under 40 and had no children to look after.

How macro and micro policy fit together

On the surface, the traditional instruments of macroeconomic management - monetary policy and fiscal policy - are very different to the relatively new idea of ‘microeconomic policy’. The traditional instruments are aimed at demand, whereas micro reform is aimed at supply; they work in the short term, whereas micro policies generally effect change only over the medium term. But despite appearances, microeconomic policy is actual an instrument of macro management.

Historically, the macro managers focused solely on managing demand, trying to get it up to the potential growth rate in the recovery phase after recessions, and trying to hold it down to the potential growth rate during booms. The era of micro-economic reform, however, represents the realisation by the economic managers that they can increase the economy’s rate of growth (rather than just keeping it as stable as possible) by improving the flexibility and efficiency of the supply side and also by actually increasing supply.

So the traditional macro instruments are aimed at achieving a stable rate of growth whereas micro policy aims at achieving a higher rate of growth over the medium term, at raising trend. Another way to think of it is this: if avoiding inflation means keeping demand and supply growing at the same rate, one solution (the traditional solution) is to ensure demand doesn’t grow too fast. But another, more creative solution is to do what you can to hasten the growth of supply. To the extent you can do this, you can get faster growth without inflation problems.
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Friday, August 23, 2013

ECONOMICS FAQ

Talk to VCTA Teachers Day, Melbourne, Friday, August 23, 2013

Often when I talk to economics teachers I focus on helping them keep up to date with the latest thinking on some topic, believing they need to know a lot more background information than their students do and leaving it for them to decide how much of what I’ve said they need to pass on to their kids. But this time I’m going straight to the classroom to give you answers to what I imagine are frequently asked questions by your students - and maybe even by you. The full version of my speech is a lot longer than I’ll have time to talk to today, so make sure you get a copy. Even so, I’m sure there are many more FAQs than I’ve had time to write about - or even think of. So if you’ve got questions I didn’t answer, I’d be grateful if you’d write them down and give them to me - or send me, if you think of them later - and I’ll use them for another talk or bear them in mind for my Saturday column, which has high school economics students as primary target audience.

Can we trust the official unemployment figures?

Short answer: yes and no. Yes we can trust the figures in the sense that, contrary to a widely believed urban myth, there was no time in the past when some government - Labor or Liberal - doctored the figures to make them look better. The figures are calculated by the Bureau of Statistics, which is not a government department but, like the ABC, has a high degree of independence of the elected government and doesn’t let politicians tell it how to measure things. The bureau, which is regarded as one of the best statistical agencies in the world, sticks closely to the statistical conventions laid down by the UN Statistical Commission, the IMF and, in the case of the labour force survey, the ILO. The definitions it uses to decide who is employed, unemployed or ‘not in the labour force’ haven’t changed significantly for many decades.

Remember that the labour force figures come from a sample survey conducted every month by the bureau, using a sample of 26,000 households - up to 20 times those used in media opinion polls. Even so, this does mean it is subject to sampling error, and the results jump around from month to month, meaning it’s best to look at the ‘trend’ (smoothed seasonally adjusted) figures.

Many people assume that the number of people said to be unemployed by the bureau is the same as the number on the dole. This isn’t true. You can be on the dole but not counted as unemployed in the survey (say, because you picked up a few hours of casual work during the week) or you can be counted as unemployed by the survey but not on the dole (say, because your spouse’s job gives you too much income to be eligible). Some old people have ideas in their heads that are a hangover from the time before 1978, when the Fraser government paid to have the labour force survey moved from quarterly to monthly, so that it replaced the old method of measuring unemployment as the number of people registered with the Commonwealth Employment Service.

I suspect some people’s false memories of the government fiddling with the figures stem from their memory of controversies over governments changing rules about how much work you can do and still be eligible for disability benefits or the dole. It’s sometimes claimed that a government has tried to hide some of the unemployed by putting them on training schemes. But people have been making such claims for years and the claim implies the training schemes are phoney, that they’d be of little value to the job seeker and are motivated only by a desire to fudge the figures. Whether a person is classed as unemployed depends not on how they’re classified by a government department, but on what answers they give to the bureau’s interviewers.

So, yes, we can trust the official figures in the sense that they haven’t been fiddled. But, no, we can’t trust them in the sense that they don’t give an accurate picture of the extent of unemployment. It is true - and has been for decades - that, under the international convention, someone who’s done as little as an hour’s work in the previous week is classed as employed, not unemployed. This means the official definition of unemployment is too narrow, making it too hard to qualify as unemployed and thus understating the full extent of joblessness. Note that very few people actually work only a few hours a week. It’s also true that the majority of people working part time (ie less than 35 hours a week) are happy with the number of hours they’re working. Many full-time students, young mothers and semi-retired people don’t want to work full-time.

Even so, a significant number of part-timers do wish they could get more hours, so we have a significant problem with under-employment. I suspect this measurement problem has arisen because the decision to call someone employed if they worked for only a few hours was made long ago when part-time and casual employment was quite rare. As it has become increasingly more common, the original definition of unemployment has become increasingly misleading.

The bureau has tacitly acknowledged this by calculating the rate of underemployment and adding this to the official unemployment rate to get the rate of ‘labour force underutilisation’. This broader measure of unemployment is calculated every quarter and published with the monthly labour force survey. From July 2014 the bureau plans to calculate and publish the broader measure monthly. Let’s hope this will prompt economists and the media to give it more attention.

In May 2013 the trend unemployment rate was 5.5 pc, while the underemployment rate was 7.3 pc, giving an underutilisation rate of 12.8 pc. Note that the measure counts as underemployed not just people working part-time who’d prefer to be full-time, but also those part-timers who’d like only a few more hours. So to that extent its definition of unemployment is probably a little too broad.

For many years I’ve used the rough rule of thumb that the easy way to correct the official unemployment rate is to double it. If you’re making comparisons with the past, however, you have to remember to double both the starting point and the end point. And remember that even if the level of the official rate is too low, it should still give a reasonably reliable indication of whether unemployment is rising, falling or staying the same.

Does the RBA still control interest rates when the banks can do as they please?

Short answer: yes it does. The RBA uses market operations to keep the overnight cash rate under very tight control. The cash rate has acted - and still acts - as the anchor for all other short-term and variable interest rates. Of course, all the other interest rates - from bank bill rates to mortgage interest rates - are a margin (or ‘spread’) above the cash rate because they involve riskier lending, but for several years before the global financial crisis world financial markets were very steady and those margins changed little. This gave people the impression mortgage interest rates always move in lock-step with the cash rate. After the turmoil of the crisis, however, many of the margins widened. The banks passed this increase in their cost of funds on to their borrowing customers. In the case of people with home loans, the banks did this by increasing their mortgage interest rates by more than any increase in the cash rate, or by failing to pass on the whole of any cuts in the case rate. Note that the banks increased the rates they charge their business borrowers by a lot more than they increased the politically sensitive mortgage rates.

For a brief period during the GFC the overseas financial markets in which our banks borrowed a high proportion of the money they lent to their customers ceased to operate. When trading resumed their margins were a lot higher. Realising the extent of our banks’ over-dependence on overseas ‘wholesale’ markets, the share market, the credit rating agencies and the official regulators put pressure on our banks to borrow more of the funds they needed from domestic depositors, whose deposits tended to be ‘sticky’ (slow to move away in search of higher returns) and thus more dependable. The resulting sudden surge in all the banks’ demand for deposits forced up the interest rates they paid on deposits, particularly term deposits, raising them from below the cash rate to above it. This, of course, was a great benefit to Australian savers, but the banks passed this higher cost on to their borrowers.

Could the banks have absorbed these higher borrowing costs? They could have - their profitability (not just the absolute size of their profits, but the rate of their profits relative to the value of their total assets or their shareholders’ capital) is very high by world standards or by the standards of other Australian industries - but they chose not to. And the limited degree of competition between the members of the big-four banking oligopoly gave them the pricing power to pass their higher costs on to borrowers and preserve their rate of profitability.

But don’t confuse the rights and wrongs of the banks’ actions with the quite separate question of whether their behaviour has robbed monetary policy of its effectiveness. It hasn’t. Why not? Because although the RBA uses the cash rate as its instrument, what does the real work of monetary policy are the market interest rates actually paid by businesses and households, so the RBA focuses on getting market rates where it wants them to be. If the independent actions of the banks cause market rates to be higher than where the RBA wants them, it simply cuts the cash rate by more to achieve its desired result. In other words, the fact that the banks’ margin above the cash rate is now wider than it was before the GFC simply means the RBA has had to cut the cash rate by more than it otherwise would have to get markets rates to where it wants them.

Does monetary policy still work?

Short answer: yes. When the share and property markets were booming in the late 1980s, the RBA spent several years raising interest rates to get the boom under control. The rise in rates didn’t seem to be working, and it became fashionable to say that monetary policy had become ineffective. I was still wondering whether this could be true when the economy started the slide that became the recession of the early 90s, the worst recession since the Depression, in which unemployment got close to 11 pc. Then all the smarties started saying interest rates had been held ‘too high for too long’.

There could be no better experience to cure me of ever doubting that monetary policy was effective. And yet we hear such claims whenever people observe a delay between the RBA starting to move the cash rate and making clear its desire to speed up or slow down demand but nothing seems to be happening. When the RBA cuts the rate but there’s a delay before demand picks up, people use an old Keynesian phrase that using interest rates to try to stimulate demand is like ‘pushing on a string’. But that analogy is appropriate only when the economy is in a liquidity trap - which the North Atlantic economies may be in at present, but we certainly aren’t.

In 40 years of watching the management of the Australian economy I can’t recall any time when monetary policy has failed to move demand in the desired direction. The problem is just that, as you well know, monetary policy operates with a lag that’s ‘long and variable’. Another thing that makes the process slow and adds to people’s impatience is that the RBA almost invariably moves in baby steps of 0.25 percentage points. Clearly, a single 25 basis point change isn’t likely to have a big effect on decisions about borrowing and spending. It’s probably true, too, that the response to a monetary tightening or loosening episode isn’t proportional or linear. That is, you may adjust rates several times without getting much effect, but then anther click finally has a big impact. The RBA uses the rule of thumb that most of the effect of a monetary policy on demand occurs within two years, with maybe two-thirds of the full effect occurring in the first year. The effect on inflation - which, of course, runs via the effect on demand - is longer again.

Would a big cut in the cash rate produce a fall in the dollar?

Short answer: no. This question has been asked a lot in recent times as trade-exposed industries such as manufacturing have be hard hit by the high dollar associated with the resources boom.

The first point to understand is that, in practice, economists don’t have a good handle on what factors determine movements in the exchange rate over short periods of less than a year of so. There are rival theories, but no particular theory always gives a convincing explanation of why the exchange rate has moved - or not moved - as it has in recent weeks. Instead, one theory tends explain recent events better than another does at a particular time, so economic practitioners tend to switch between the rival theories depending on which one seems to be working better at the time. I think the reason no theory seems to work well at all times is that the global foreign exchange market isn’t nearly as rational as the perfect market hypothesis assumes.

In the old days, a common theory was that the currency of a country with an excessive current account deficit would tend to depreciate, so as to help bring it back to equilibrium and, similarly, the currency of a country with an excessive current account surplus would tend to appreciate. These days, you rarely hear this theory relied on because there’s little if any empirical support for it. I think it was a hangover from the days of fixed exchange rates, when it was clear the authorities’ decisions on whether to devalue or revalue the currency were determined by pressures on their current accounts. In these days of floating currencies and the removal for foreign exchange controls, it’s clear the ‘driver’ of floating exchange rates has switched from the current account to the capital account - that is, from trade flows to capital flows.

These days, and particularly from an Australian perspective, there are three main, rival theories to explain exchange rate movements. The first is that the biggest influence over our exchange rate is our terms of trade, and particularly world primary commodity prices. There is much empirical support for this view if you look at a graph of the two over the years, though you can see the correlation breaking down over some shorter periods. The second theory is that the biggest influence over our exchange rate is our ‘interest-rate differential’ - the size of the difference between our official interest rate (or short-term commercial rates) and those of the major developed economies, particularly the United States. The higher our rates are relative to the others, the more our exchange rate is likely to be high and rising, and vice versa. Note that this is very much a capital-flows driven theory. The third theory is a kind of combination of the first two: countries with strong economic prospects relative to the major developed countries should have strong currency, whereas countries with weak prospects relative to the majors should have a weak currency. This theory makes a lot of sense and often seems to be pretty true, but there are times when it’s far from true.

Australia’s very strong exchange rate over most of the past decade is commonly explained by the resources boom and our exceptionally favourable terms of trade as a result of record high prices for coal and iron ore. Its rise can not be explained by any increase in our interest rates relative to the major economies, even though their rates have been at rock bottom since the global financial crisis. But this has not discouraged people adversely affected by the high dollar from convincing themselves the high rate is the product of currency market speculation or our relatively high rates since the GFC, and then arguing the RBA should make a big cut in our cash rate with the express purpose of engineering a big fall in the dollar.

Our terms of trade began falling in about September 2011, but the dollar didn’t start to fall until April 2013. This delay probably encouraged people to switch to a different theory. They may have thought the RBA was being too cautious in the speed at which it was bringing rates down.

Although no one can be too dogmatic about these things, the RBA does not believe the interest rate differential has very much effect our exchange rate. And this is despite the signs we see that expectations about whether the RBA will or won’t move rates haves an immediate effect on the bill rate. These effects are very temporary. During the period in which the RBA was lowering rates and openly expressing its hope that the dollar would fall to a more appropriate level, many people concluded it was cutting rates in the hope this would lower the exchange rate. It wasn’t. Rather, it was loosening monetary policy because the exchange rate wasn’t coming down. That is, it was trying to ease pressure on the tradeables sector as a substitute for a lower dollar.

Although the Aussie stayed high for about 18 months after commodity prices had fallen sharply, it has fallen by about 10 per cent since April 2013. Some people may attribute this to steady easing in policy over most of that time, but the BRA doesn’t agree with them. A much more likely explanation is that the Aussie finally began falling when Wall Street began worrying that the long-awaited pickup in the US economy would prompt the Fed to start ‘tapering’ the size of its quantitative easing. QE - the central bank’s purchase of bonds and other securities which are paid for merely with bank credits - puts downward pressure on a country’s exchange rate.

The point to note is that the exchange rate is a relative price - the value of my currency relative to the value of yours. So it shouldn’t be so surprising that changes in the level of our exchange rate need to be explained in terms of changed conditions in the US as well as changes in Australia.

Why are our interest rates always higher than other people’s?

Short answer: because we’re riskier. It’s true our interest rates are almost invariably higher than those in the major economies. This has been true for many years. It wasn’t hard to understand before the mid-1990s - when our inflation rate was still well above everyone else’s - but it remains true even when you compare real interest rates.

The explanation seems to be that, as a nation of perpetual net borrowers from the rest of the world (we run a persistent current account deficit), we are required to pay our foreign lenders a significant risk premium on top of the going international rate to compensate them for the extra risks they run in lending to a country that already has a very large net foreign debt and that, being a relatively small economy, is perceived to be more volatile (even though that’s not always true).

Another way of putting it is that Australia always has higher interest rates because we’re a country with an abundance of potentially profitable investment projects relative to the major economies. Our projects have to be relatively profitable or we wouldn’t be able to continue borrowing despite the high risk premium foreign lenders require us to pay.

Does a budget deficit mean fiscal policy is expansionary and a surplus mean it’s contractionary?

Short answer: no they don’t. Life would be very simple for students of macroeconomics if they did, but unfortunately they don’t. Why not? Because what macro economists focus on is not the level of economic activity, but the change in the level - that is, whether the economy has been/will be expanding or contracting. That means they’re interested in determining whether the budget - fiscal policy - is making a positive or negative contribution to economic growth. So it’s the change in the budget balance - and the direction of the change - that matters when assessing whether a particular budget is expansionary or contractionary.

These days the RBA and most market economists assess the stance of policy adopted in a particular budget simply by looking and the direction - and size - of the expected change in the budget balance between the previous year and the budget year. An expected reduction in a deficit or increase in a surplus is regarded as contractionary; any expected increase in a deficit or decrease in a surplus is regarded is expansionary. As a guide, the change needs to be equivalent to at least 0.5 pc of GDP to be significant. A change of 1 pc or more is extremely significant.

Strict Keynesians, however, define the stance of fiscal policy differently, distinguishing between changes in the cyclical component of the budget balance (caused by operation of the budget’s automatic stabilisers as the economy moves through the business cycle) and changes in the structural component (caused by governments’ explicit changes to taxes and spending programs). So they define the stance of policy adopted in a budget according to the direction of the expected change in the structural component arising from the net effect of the spending and taxing changes announced in the budget. They ignore the change in the budget balance caused by the economy’s effect on the budget, focusing on the change caused by the budget’s effect on the economy.

Note, changes in the stance of fiscal policy will be only one of the factors contributing to whether the economy is expanding or contracting. Other factors include: the stance of monetary policy, movements in the exchange rate, changes in the world economy and in confidence.
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