THE GLOBAL ECONOMY

Aurora College Economics HSC Study Day, Sydney

Every year there’s some event in the news that’s relevant to your study of the global economy, and this year it’s the growing realisation that the process of globalisation has stopped and begun to reverse – “deglobalisation”. The pandemic hasn’t helped, nor has the invasion of Ukraine, but it’s the increasing tension between the US and China that has raised the spectre of the world being divided into two rival trading blocs. It’s likely the value of world trade will fall in 2023.

The arrival of the pandemic in early 2020 led to an immediate fall in world trade, but it recovered sharply the following year. However, the disruption to the supply of many imported goods has led some countries and companies to “re-shore” their supply chains, by producing more goods and components at home rather than abroad. While making their supply more reliable, this will raise the cost of those products. For some, this has just been the latest excuse for protection against competition from imports. The IMF has argued that supply chains can be diversified – made reliant on a wider range of foreign suppliers – without losing the benefits from trade.

The invasion of Ukraine has disrupted the supply of oil and gas from Russia to many European economies, as well as the supply of wheat and other foodstuffs to developing countries. This has happened not so much because of the war as because of the trade sanctions imposed on Russia by the US and its many allies. As the war drags on, the Europeans and others move to alternative suppliers, a process known as “friend-shoring” – moving your trade to countries you get on with, not necessarily those offering the best prices or service.

America’s swing to protectionism

For many decades, the US was the great champion of free trade and rules-based trading under the GATT – the General Agreement on Tariffs and Trade – and its successor, the World Trade Organisation. It was the support of the US that allowed China to become a member of the WTO in 2001, leading to huge growth in international trade and globalisation. Much manufacturing activity moved to China from the developed economies, leading to decades of lower prices for manufactured goods throughout the world, and the accelerated growth of the Chinese economy. But it also led to much unemployment for displaced factory workers in the US. While all consumers benefited from the cheaper imports, far too little was done to help those workers find employment elsewhere. This was the grass-roots cause of America’s swing to protectionism.

President Donald Trump won election in 2016 on a promise of protecting American industry against “unfair” competition from developing countries and, in particular, China. He launched a trade war with China, made changes to various trade agreements, and refused to join a US-sponsored trade agreement with Japan, Australia and various other Asian economies (which went ahead anyway). What’s now apparent is that US protectionism, and the trade war with China, have continued under President Joe Biden. He has resorted to subsidies and export controls, contrary to WTO rules.

It's now clear the US is motivated not just by protectionism, but also big-power rivalry with China. America is unwilling to share power with the rising superpower, China. It is particularly unwilling to have China overtake it as leader in advances in digital technology. When politicians and officials say they are worried about the effect of “geostrategic conflict” on world trade, this is what they mean. When they worry about the “fragmentation” of world trade, they mean they fear the world could divide into two rival trading blocs, led by America and China. This would involve great losses of the “gains from trade” through pursuit of “comparative advantage”. In October 2022, the US imposed sweeping restrictions on exports of semiconductors (chips), aimed at preventing China from advancing technologically. This also explains America’s efforts to stop Huawei and TikTok from expanding outside China.

Definition

The OECD defines globalisation as “the economic integration of different countries through growing freedom of movement across national borders of goods, services, capital, ideas and people”.

That’s a good definition, but I like my own: globalisation is the process by which the natural and government-created barriers between national economies are broken down.

Globalisation’s two driving forces

With this definition I’m trying to make a few points. One is that globalisation has had two quite different driving forces. The one we hear most about is the decisions of governments around the world to break down the barriers they have created to limit flows of goods and money between countries by reducing their protection of domestic industries and by deregulating their financial markets and floating their currencies.

But the second factor promoting globalisation is just as important, if not more so: advances in technology – including advances in telecommunications, digitisation and the internet, which have hugely reduced the cost of moving information and news around the world, as well as increasing the speed of its movement. This has allowed a huge increase in trade in digitised services. As well, advances in shipping – containerisation, bigger and more fuel-efficient ships – and in air transport have led to increased movement of goods and people between countries.  

Globalisation is a process

Another point my definition makes is that globalisation is a process, not a set state of being. Because it’s a process, it can go forward – the world can become more globalised – or it can go backwards, as national governments, under pressure from their electorates, seek to stop or even reverse the process of economic integration. Among the advocates of globalisation there tended to be an assumption that the process of ever greater integration was inevitable and inexorable. That was always a mistaken notion.

Earlier globalisation

The process of globalisation is and always was reversible. People should know this because this isn’t the first time the process of globalisation has occurred and then been rolled back. The decades leading up to World War I saw reduced barriers and greatly increased flows of goods, funds and people between the old world of Europe and the new world of America, Australia and other countries. But this integration was brought to a halt in 1914 by the onset of a world war. And the period of beggar-thy-neighbour increases in trade protection, to which countries resorted in response to the Great Depression of the early 1930s, greatly increased the barriers between national economies. Indeed, in the years after World War II, the many rounds of multilateral tariff reductions brought about under the GATT – the General Agreement on Tariffs and Trade, which has since become the World Trade Organisation – were intended to dismantle all the barriers to trade built up in the period between the wars.

The era of hyperglobalisation

The period between the end of World War II in 1945 and the late 1980s saw huge growth in trade between the advanced economies, as a consequence of those successive rounds of tariff reductions. But from the late ’80s until the global financial crisis and Great Recession of 2008 there was a period of “hyperglobalisation” in which trade between the developed and developing countries grew hugely. This was partly because of the way the digital revolution and other technological change broke down the natural barriers between countries. But also the result of the eighth and final “Uruguay round” of the GATT in 1994 reducing tariff and other trade barriers between the developed and developing countries.  Many poor countries joined the new WTO at this time, with China joining in 2001.

One measure of the extent of globalisation is the growth in two-way trade between countries (exports plus imports) as a proportion of gross world product (world GDP). Between 1990 and 2008, global trade rose from 39 pc to 61 pc of GWP – the period of rapid globalisation.

Note that the poor countries did well out of the quarter-century of rapid globalisation. Between 1995 and 2019, real GDP per person in the emerging economies more than doubled, whereas in the advanced economies it grew by only 44 pc (after allowing for differences in purchasing power).

The era of deglobalisation

But the end of hyperglobalisation can be dated to the global financial crisis in 2008, and the new era of “deglobalisation” has continued during the pandemic. Two-way trade as a proportion GWP fell after the global financial crisis, and even by 2019 had not regained its peak in 2008.

Among the signs of deglobalisation are Britain’s vote in 2016 to leave the European Union – Brexit – and thus to reduce its degree of economic integration with the rest of Europe – a decision most outsiders see as involving a significant economic cost to the Brits’ economy. Second, the Trump administration withdrew from the Trans Pacific Partnership, an agreement between the US and 11 other selected countries (including Australia) to reduce barriers to trade between them – although the remaining 11 finalised an agreement without the US.  Third, the Trump administration withdrew from the Paris global agreement on reducing greenhouse gas emissions. Fourth, Trump launched a trade war with China. President Biden has re-joined the Paris agreement and repaired America’s relations with its allies, but continues the contest with China.

The temptation of returning to protectionism

The period of hyperglobalisation saw the shift of much manufacturing from the rich countries (including Australia) to China and other developing countries with cheaper labour. But it’s likely that, in the period of slower growth that followed the global financial crisis, some countries yielded to the temptation to return to protecting their domestic industries against foreign competition, returning to the (failed) strategy of growth through “import replacement” rather than “export-led” growth. Regrettably, this trend is being led by the two biggest developing economies, China and India. China raised its import barriers against many Australian exports, but is now lowering them.

This trend has continued during the pandemic, with The Economist magazine reporting that countries have passed more than 140 special trade restrictions during the pandemic. Some of these may arise from concerns in the rich countries during the pandemic over the lack of availability of personal protective equipment, or vaccines. Worries about the pandemic’s disruption of global supply chains may be another reason for the return of protectionist attitudes in the advanced economies.

The channels of globalisation

The four main economic channels through which the world’s economies have become more integrated are:

1) Trade in goods and services

2) Finance and investment

3) Labour

4) Information, news and ideas.

Trade is probably the channel that gets most attention from the public. Donald Trump’s populist campaigning against globalisation focused on the belief that America’s greater openness to trade – particularly with developing countries – caused it to lose many jobs, particularly in manufacturing, as cheaper imports caused many domestic producers to lose sales, or as factories have been moved offshore to countries where wages are lower, without America receiving anything much in return.

Surprisingly, financial globalisation didn’t get as much blame as it could have for the global financial crisis and the Great Recession it precipitated. Most countries have not liberalised the flow of labour into their economy in the way they have the other factors of production.

Income distribution and the gains from trade

One of economists’ core beliefs is that there are mutual gains from trade. Provided the exchange of goods is voluntary, each side participates only because it sees some advantage for itself. This is undoubtedly true, but in the era of renewed globalisation we’ve been reminded that, though the gains may be mutual, they are not necessarily equal. Some countries do better than others.

Similarly, the benefits to a particular country from its trade aren’t necessarily equally distributed between the people within that country. When, for example, a country imports more of its manufactured goods because they are cheaper than its locally made goods, all the consumers who buy those goods are better off (including all the working people), but many workers in the domestic manufacturing industry may lose their jobs.

Another factor that has been working in the same direction is digitisation and other technological change which, in its effect on employers’ demand for labour, seems to be “skill-biased” – that is, it tends to increase the value of highly skilled labour, while reducing the value of less-skilled labour. It seems likely that, between them, trade and technological advance have worked to shift the distribution of income in America, Britain and, to a lesser extent, Australia, in favour of high-income families and against many middle and lower-income families.

The unwelcome surprise many politicians and economists have received from the high protest votes for Brexit, Trump and One Nation is causing them to wonder if too little has been done to assist the workers and regions adversely affected to retrain and relocate, and too little to ensure the winners from structural change bear most of the cost of this assistance.

Shares of the World Economy, 2021

GWP Exports Population

China          19   13     18

United States   16     9         4

Euro area (19 countries)   12   26         4

India     7     2       18

Japan     4     3         2

Advanced economies (40) 42   61       14

Developing economies (156) 58   39       86

            100 100     100

Source: IMF WEO statistical appendix; GWP based on purchasing power parity                

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THE BUDGET, INFLATION AND MACROECONOMIC MANAGEMENT

UBS HSC Economics Day

There’s never been a better time to be studying macroeconomics than this year. If you want to know why economics is interesting and important – why it deals with real-world problems – turn on the radio or television news, read the paper, look on the internet or just look out the window. What you see is people struggling to cope with the cost of living, as prices rise much faster than wages, as the Reserve Bank keeps increasing mortgage interest rates, rents keep rising and Treasurer Jim Chalmers makes sure his budget isn’t worsening inflation, while giving families a little relief from the rising cost of living.

Macroeconomic management involves national governments and central banks trying to smooth the ups and downs in aggregate demand – spending – as the economy moves through the business cycle of boom and bust. The economic managers try to keep the growth in demand as stable as possible because, when growth’s too weak this increases unemployment, while when growth’s too strong this causes inflation. The two tools or “instruments” the economic managers use to stabilise demand are monetary policy (the manipulation of interest rates) and fiscal policy (use of the budget to manipulate government spending and taxation).

When the Covid pandemic broke out in early 2020, the great fear was that our use of lockdowns – ordering everyone to stay at home and leave the house as little as possible – to slow the spread of the virus until a vaccine could be developed would lead to massive unemployment. To prevent this, the economic managers applied extra stimulus to demand. Interest rates were already very low, but the Reserve Bank cut them further. However, the main stimulus came from the federal government increasing government spending and tax concessions by more than $300 billion over two years.

The return to full employment

The result of all this stimulus was that the economy rebounded quickly from the lockdowns and then grew very strongly. As a result, after shooting up to 7.5 pc, the rate of unemployment quickly fell back and kept on falling until it had dropped to 3.5 pc, its lowest in almost 50 years. The rate of under-employment also fell sharply, with the rate of participation in the labour force rising to a record high. As well, an unusually high proportion of the extra jobs created have been full-time. So the one good thing we have to show for the pandemic is our unexpected return to full employment, after an absence of half a century.

The return of high inflation

For a number of years before the pandemic, economic growth was slow, the unemployment rate got stuck above 5 per cent, there was little growth in real wages, and nothing the Reserve Bank did could get the rate of inflation up into its 2 or 3 pc target range.  But about two years ago inflation began shooting up, reaching a peak of 7.8 pc at the end of last year (2022). It has since begun falling back, and was 7 pc in March this year, but this is still way too far above the target band.

Many factors contributed to this surge in inflation. One was shortages of cars, computer chips and many other things, caused by the pandemic’s disruption of their supply. Another was leaps in the world price of fossil fuels and some foodstuffs, caused by the war in Ukraine. These are cases of imported inflation, caused by shortages of supply, not demand. But it’s also clear that the strong growth in demand in our economy following the stimulus and end of the lockdowns is adding to the prices of locally made goods and services. It’s this local source of inflation pressure that has prompted the RBA to increase the official cash rate 11 times since May last year, increasing the rate by 3.75 percentage points to 3.85 pc.

The “policy mix”

Since the 1980s, Australia has followed the practice of giving monetary policy the primary role in achieving “internal balance” – price stability and full employment, aka low inflation and low unemployment. This leaves fiscal policy (the budget) playing a subsidiary role. It assists monetary policy by allowing the budget’s “automatic stabilisers” to improve the budget balance when the economy is booming and monetary policy is trying to restrain demand. Fiscal policy assists monetary policy when the economy is dropping into recession, by allowing the budget’s automatic stabilisers to worsen the budget balance.

Apart from assisting monetary policy, fiscal policy’s primary role is to achieve “fiscal consolidation” – to cut the budget deficit when the economy is recovering from a downturn, so as to limit the growth in the public debt (and the annual interest bill on it). This is so the budget and fiscal policy will be well-placed to be used to support the economy during the next recession or pandemic.

Note, however, that it is good for fiscal policy to take the main stabilisation role from monetary policy during emergencies such as recessions and pandemics. The stage we’re at now is that the emergency has passed, so the primary stabilisation role has passed back to monetary policy and it’s time to get the budget deficit down and keep it low.

The 2023 budget

The former government’s use of the budget to respond to the pandemic caused the budget deficit to blowout to $85 billion (or 4.3 pc of GDP) in 2019-20 and rise to a peak of $134 billion (6.4 pc) in 2020-21.

But most of the pandemic measures were temporary so, with the end of spending measures and the strong recovery causing the budget’s automatic stabilisers to change direction and start tax receipts growing strongly, the following year (2021-22) saw the deficit fall back to $32 billion (1.4 pc).

Mr Chalmers forecast that the budget balance would improve further in the financial year that ends next month, 2022-23, to a tiny surplus of $4 billion (0.2 pc). This further improvement was caused by the continued strong growth in the economy, with more people in jobs, pay tax and not having to get unemployment benefits. Although wages aren’t rising fast enough to keep up with prices, they are rising faster than they were, meaning more of workers’ wages is being lost to “bracket creep”. In other words, it’s the budget’s automatic stabilisers that are doing most to get the deficit down. As well, mining companies are paying more company tax because world prices for our mineral and energy exports have stayed high. So the only credit Mr Chalmers should get for this is for keeping his new spending limited, so that almost all the surge in tax collections went through to the budget bottom line.

In the coming financial year, 2023-24, the economy is expected to slow, while government spending grows faster than tax collections. This should cause the budget to return to a small deficit of $14 billion (0.5 pc) and go a bit higher to about $36 billion (1.3 per cent of GDP) in the following two financial years.

The “stance” of policy adopted in the budget

In deciding whether the budget helps or hinders its efforts to slow the growth in demand (spending) the RBA doesn’t look at particular budget measures. Rather, it looks at the direction and size of the expected change in the budget balance. Mr Chalmers is expecting the budget balance to improve from a deficit of $32 billion in 2021-22 to a surplus of $4 billion in the financial year just ending. This means the gap between how much the budget puts into the economy in spending and how much it takes out in taxes should improve by $36 billion, a tightening equivalent to 1.6 pc of GDP. But in the coming financial year, the budget balance is expected to worsen by $18 billion, a loosening equivalent to 0.7 pc of GDP. Putting the two years together, I think the RBA will conclude the budget in no way hinders its efforts to slow the growth in demand and reduce the upward pressure on prices.

On these forecasts, I judge the “stance” of fiscal policy adopted in the budget to be “mildly contractionary”.

The outlook for the public debt

Because the strength of the economy’s growth means the budget deficit has fallen much faster that was expected this time last year, the outlook for future budget deficits and levels of gross public debt is now not as bad as we’d earlier thought. Whereas a deficit of $78 billion for the financial year just ending had been expected, a surplus of $4 billion is now expected. This means no increase in the debt this year, and no consequent increase in the annual interest bill in this and subsequent years. Over the 12 years to 2033-34, this is estimated to avoid a total of $83 billion in interest payments. It also implies gross debt is now expected to reach a peak of 36.5 pc of GDP in 2025-26, five years earlier and more than 10 percentage points lower than expect in last October’s budget.

The outlook for the economy

With prices rising faster than wages, bracket creep taking a bigger bite out of wage rises and the RBA raising mortgage interest rates, it will be no surprise to see the economy’s growth slow sharply in the coming financial year. The government’s forecasts predict that, after growing by a very strong 3.25 pc in financial year just ending, real GDP will slow to a very weak 1.5 pc.

The main thing driving that slowdown is likely to be slower growth in consumer spending from 5.75 pc to 1.5 pc. This should get the inflation rate down from 6 pc at present to 3.5 pc by next June, then down into the inflation target zone by June 2025.  Wages are expected to grow by 4 pc over the year to next June – but I wouldn’t start spending the money yet. All this is expected to increase the unemployment rate to 4.5 pc, but not until June 2025. 

And if all that sounds a bit too good to be true – it probably is.

The medium-term fiscal strategy

For many years under Liberal and Labor governments, their “medium-term fiscal strategy” was “achieving budget surpluses, on average, over the economic cycle”. This left the government free to run budget deficits during years when the economy was weak, provided these were offset by budget surpluses during years when the economy was growing strongly.

 With the arrival of the pandemic and all the fiscal stimulus it involved, the liberal government changed to a two-part strategy: first, to support demand during the pandemic. But then, second, once the crisis had passed, to “focus on growing the economy in order to stabilise and reduce debt”.

The new Labor government has adopted its own, rather wishy-washy strategy: “to improve the budget position in a measured way, consistent with the overarching goal of reducing gross [public] debt as a share of the economy [nominal GDP] over time”.  The budget “will be improved in a manner consistent with the objective of maintaining full employment. The government will “allow tax receipts to respond in line with changes in the economy, directing the majority of improvements in tax receipts to budget repair”. This means the new government has abandoned the old government’s 23.9 pc cap on the level of tax receipts as a percentage of GDP.

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CONFESSIONS OF AN ECONOCRAT-WATCHER

Talk to ACT Economic Society Annual Dinner, Canberra

I’m very pleased to be invited to talk to you tonight, the biggest and best of the Economic Society’s branches. I should warn you, however, that I’m a follower of the Paddy McGuinness school of public speaking, which holds that it’s no fun talking to a group from any persuasion if you don’t say something to annoy them.

I imagine many of you are econocrats so, before I do, I want to say that I like econocrats. All journalists have “contacts” – people they talk to regularly in their search for stories – or, in my case, for explanations and opinions. In this, the contacts I speak to are overwhelmingly econocrats. I’m too old and proud to speak to ministers’ PR people, and I’ve never been able get much frankness from politicians. I should speak to academic economists more than I do, but these days I get my fill of academia by being an incessant reader of the excellent The Conversation website.

I feel comfortable talking to econocrats, for one main reason: they helped me correct one of the great mistakes of my life. When I was a student at Newcastle Uni in my late teens, I decided that accounting was really interesting, but economics was boring, theoretical rubbish that would be of no use to me in my dream career as a chartered accountant. It wasn’t until I gave up on my accounting career, washed up at the Herald as a graduate cadet, and was advised to become an economic journalist, that I realised I’d got it the wrong way round: it was accounting that was boring, whereas economics was interesting and vitally important in solving the nation’s problems.

My problem was that I’d forgotten most of what I was supposed to have learnt from the three years of economics in my commerce degree. It took me many, many hours on the phone to econocrats in the bureau, the bank, Treasury, the IAC and other agencies to relearn what I was supposed to know. So I’m forever grateful to the econocrats who spent so much of their time helping get me up to speed. I was deeply impressed by their dedication, their selfless desire to educate the public on matters economic by helping educate me. (Now, you may wonder why so many econocrats are willing to speak to me. It’s because they know I’m a columnist, not a reporter. I don’t want to quote them, I want to take those of their opinions I agree with, and make them my own. Opinion writers are in the plagiarism business.)

All this helps explain why I don’t regard myself as an economist, and don’t claim to be one. I used to say I was an accountant pretending to be an economist, but these days I say I’m a journalist who writes about economics. That’s exactly how I see myself, and where my loyalties lie. Because I’m not an economist, I’m not a member of the economists’ union, which means I’m under no fraternal obligation to defend economists and economics against all those terribly ignorant people who keep criticising us and pointing to our failings. I don’t have to believe what everyone in every occupation or industry believes: that if you’re not in our business, no criticism you make of us could possibly have merit.

Being a journalist who writes about economics, my obligation is to my readers. I see my role as similar to a movie critic. I’m an economics critic. I explain what the economists are telling the government to do and why, and then I tell my readers whether I agree with what the economists are saying. To put it more positively, I’ve spent my career trying to figure out how the economy works, then telling my readers what I’ve learnt. This means my views have evolved considerably over the decades. Hopefully, what I say today is closer to the truth than what I used to say.

When top econocrats give a very thoughtful speech about how the economy’s got to its present state, or what we need to do to improve its performance, the press gallery usually riffles through it looking for some particularly newsworthy remark – say, a hint that the cash rate’s about to rise – and then toss it aside. I see it as a big part of my job to rescue the speech from the gallery’s waste-paper basket, and use my column to make sure my readers get the benefit of the top econocrats’ thoughtful explanations and observations. Even when I don’t agree with their policy proposals, I try to give them a fair run before I register my doubts.

Partly because I’m a longstanding exponent of explanatory journalism, I write a lot about economic theory, more than most other economic journalists do. It was many years after I graduated that some economist took the trouble to explain to me the role of theory in our efforts to understand how the world works, to extract some mastery from the seeming chaos around us. About how “models” help us understand the real world by focusing on a few really powerful explanatory variables, and ignoring everything else. The neoclassical model is hugely useful, and hugely powerful in influencing the way economists think about how the economy works – and should work. This is why I keep writing about its assumptions and limitations. I think “behavioural economics” helps ensure our search for a better understanding of how the economy works isn’t held back by those assumptions and limitations.

But my interest in improving on the neoclassical model seems to bring out the defensiveness in academic economists – particularly on Twitter, where what I say is often dismissed as “simply wrong”. But what’s often not understood is that the neoclassical model I care most about is not the one written down in a set of equations, but the one lodged in the heads of econocrats. When I criticise “economists” I’m usually referring to econocrats and other economic practitioners. I care most about what practitioners think and propose because they’re the ones with most influence over policy – the ones with most influence over the economy my readers live in. But academics almost always take “economists” to be referring to them, not to their former students. Their self-absorption is revealing.

I became an economic journalist in 1974, which means I’ve been a professional watcher of the economy – and the econocrats providing economic advice – for almost 50 years. Tonight, I want to reflect on some of the conclusions I’ve reached in that time, the things I’ve learnt, and the way my views have changed. I guess I’ll be accused of being wise after the event, so let me get in first and plead guilty to exactly that. Being wiser after the event isn’t a crime, it’s a virtue. If you don’t learn from your mistakes, you’re not very bright.

When the era of “micro-economic reform” began in the mid-1980s under the influence of “economic rationalism”, I was a strong supporter. Over the 40 years since then, however, I’ve had growing doubts about many of the supposed reforms we’ve made. By now, it’s clear that governments’ enthusiasm for what came to be known as “neo-liberalism” has largely dissipated. Any number of policy changes by Liberal and Labor governments are clearly at odds with the principles of economic rationalism. But it’s not just the politicians who’ve lost their compass. I suspect that many econocrats have lost their John Stone certainty of what’s right and what’s wrong in economic policy.

I think we’re going through a period where econocrats and their fellow travellers are wandering in the wilderness searching for a new program of improvement to be working towards. Economic rationalism 2.0, if you like. Econocrats seem as reluctant as any other profession would be to publicly admit the mixed record of neo-liberalism. But I’m here to say I don’t think econocrats will get their mojo back until they’re willing to admit that many of the things done in the name of micro-economic reform turned out to make matters worse rather than better. We have to learn from our mistakes. I want to propose a couple of principles that should be at the centre of econocrats’ renewed sense of mission.

First, however, we need to think about what went wrong with that great reform push and why. Let’s be clear: the biggest of the reforms were necessary and have worked well: floating the dollar, deregulating the banks, ending import protection, ending centralised wage-fixing and, as Andrew Leigh has reminded us, introducing national competition policy.

The problem has mainly been with privatisation, outsourcing and “contestability” – “reforms” largely motivated by the belief that the provision of services will always be done better by the private sector than the public sector. This is an article of faith for the Liberal Party, but also for too many econocrats. It has succeeded in making the public sector a lot smaller – and very much smaller than it would otherwise have been – but too often this has come at the cost of higher prices (electricity), fewer services and, particularly, lower quality services, delivered by inadequately trained workers. This is true in aged care, child care and employment services. Contracting out to providers in “thin markets” – a Productivity Commission euphemism for pretending there’s a market where none exists - is a big part of the reason for the blowout in the cost of the NDIS. The states’ TAFE systems needed shaking up, but opening up to cherry-picking private providers, plus general cost-cutting, has left us with an utterly inadequate technical education system. Far too many privatisations – particularly in electricity and ports – have involved selling government-owned businesses with pricing power intact, maximising the sale price at the expense of establishing a competitive market.

None of these adverse outcomes were envisaged in the econocrats’ advocacy of these “reforms”. What went wrong when theory was put into practice? One reason is the use of privatisation, and of bureaucrats putting downward pressure contract prices, to reduce “debt and deficit” – which, when you examine it, is about politicians responding to the public’s growing demand for government services, but without asking people to pay for them with higher taxes. This was never going to add up.

But I place some blame on the naivety of our econocrats. They assumed that what works in the textbook would work just as easily in real life. Many econocrats have never worked in the private sector, but are painfully aware of the deficiencies of the public sector. This, plus the neo-classical model’s implicit assumption that markets are rational but governments aren’t, blinded them to the truth that private firms are hugely fallible. Econocrats believed in the profit motive, but didn’t understand its raw, even ruthless power. As we’ve seen from wage theft and the banking royal commission, among other examples, even our biggest, most respectable firms are perfectly capable of breaking the law in their pursuit of profit. Everyone wants to take a bite out of the government. When business people are invited to sell to the government, dollar signs appear in their eyes. They put both hands into the public purse and pull out as much as they can possibly carry away. They think the government’s always an easy touch – and too often they’re right. The bureaucratic regulators of private providers have proved no match for business people on the make.

The biggest reason so many reforms haven’t lived up to their billing, however, is the way the econocrats’ political masters have compromised the economic objectives by adding their own political objectives. Sometimes they’re trying to make the government’s finances look better than they really are. By moving debt off-balance sheet, for instance. But sometimes I suspect that the Liberals, being the party of the private sector, see moving businesses and workers from the public column to the private column as a clear win for their side of politics and loss for their Labor opponents.

There’s much more I could say about the crosses on the economic rationalist report card, but I need to get on with suggesting two key principles I think must be part of any revival of reformist zeal.

First, it’s become an empty cliché to say that policy proposals should be “evidence-based”, but it’s actually our beliefs about how the economy works that need to be more evidence-based. The great advance in academic economics in our time has been the way the information revolution has allowed it to become less theoretical and more empirical. The eternal temptation is to forget that models are just models. They’re not the economy, they’re a cardboard cut-out of the economy. They enlighten us in some circumstances, but mislead us in others. The great project in academia must be to test orthodox theory against the empirical evidence, to see what bits of the theory accurately describe the real world and what bits don’t. The classic example of this is the way empirical evidence has caused economists to change their tune on the role of minimum wages. If there’s one area of the economy where the simple neo-classical model – the one that economists carry in their heads – is an unreliable guide to how the economy works, it’s the labour market. Most econocrats have much to learn from labour economists about how the labour market ticks. Monopsony, for example.

My broader point is that economists who think the neoclassical model they memorised at uni is all they need to give wise advice on policy – whose views on how the economy works haven’t been changed by advances in industrial organisation, asymmetric information, incomplete contracts, behavioural economics and the rest – are setting themselves up for failure. The policies advocated by econocrats have been faith-based rather than empirical-evidence-based.

Second, economic rationalism 2.0 must accept the failure of the smaller-government push. The move to private providers of publicly funded care has not led to any noticeable improvement in the efficiency with which those services are delivered. Where governments have managed to hold down the growing cost of services, this has been achieved by reducing the quantity and particularly the quality of services. Where services have been delivered by for-profit providers, savings from genuine improvements in efficiency have been insufficient to make room for their necessary profit margin. The plain truth is that any savings made by outsourcing services have come simply from side-stepping the good pay rates and conditions of the original workers.

Turning the focus to general government and the budget, the quest for smaller government and its objective, lower taxes, has clearly failed – despite decades of trying. It’s failed because the growth in the public’s demand for more and better government services is inexorable. No government of either colour is prepared to make the big cuts to major spending programs that would make smaller government a reality. Some conservative politicians genuinely believed smaller government was desirable and possible. More of them saw the political attraction of claiming to be pursuing lower taxes while their opponents indulged in “tax and spend”.

Far too many econocrats believed in smaller government and lower taxes as a sure-fire way of increasing economic growth. They focused on the simple theory that taxing any activity always discourages it, while ignoring the absence of empirical evidence that lower company tax leads to increased investment, and lower marginal tax rates encourage work effort. They studiously ignored the evidence that only in the case of secondary earners (mainly mothers) are effective marginal rates likely to affect work effort.

But I think econocrats are guilty of a greater error: their commitment to smaller government – which sort of fits with their day job of using false economies to pare back this year’s embarrassingly high budget deficit – involves pursuing a will-o-the-wisp while ignoring the real challenge. Since big spending on government services is the public’s clearly revealed preference, their job is to use every opportunity to remind the public – not to mention their political masters – that demanding more government spending is fine, provided you’re prepared to pay for it with higher taxes. By omission, econocrats have played along with the delusion that higher taxes are unthinkable – both economically as well as politically – and settled for eternally struggling ineffectively to reduce budget deficits. They should have been doing all they could to stand against the demonisation of taxation for short-term and usually hypocritical political advantage.

Econocrats have spent too long struggling ineffectively to achieve smaller government, while doing little about what should be their real concern: not smaller government, but better government. Government in which the winners from globalisation and other structural change are required through the tax-and-transfer system to compensate the losers. The neglect of fairness toward the losers from micro-economic reform does much to explain why resistance to reform has grown and too many people have become susceptible to populist solutions.

Econocrats need to care more about how, for instance, assistance with housing costs can be more effective and better targeted to those needing it most. Econocrats – and particularly the accountants in Finance – have relied too heavily on crude annual percentage cuts in agencies’ budgets, and too little on building capacity to identify particular areas of waste. It takes no effort or understanding to barrack for small government or big government. What’s hard is knowing how government spending can be efficient and effective. Too often, econocrats have failed to promote and protect spending measures that should be seen as an investment in future cost reduction in return for immediate spending. Too often, the accountants have yielded to the short-term expedient of giving them the chop.

When it comes to regulation, the econocrat profession should be the repository of the nation’s knowledge of what works and what doesn’t, but it’s made little effort to become that. The new government’s commitment to an “evaluator-general” is good news. We need more rigorous evaluation of spending programs, with the results made public. This will always be resisted by ministers and department heads, but that’s all the more reason the econocrats should be unceasing in pushing for it.  Academic health economists worked for many years to build the information base that allowed governments to control their spending on public hospitals more effectively than just giving them 5 per cent more than they got last year. Eventually this “activity-based” funding model was adopted as part of the federal-state hospital agreement. To my knowledge, the econocrats did nothing to support this research effort, and were slow to realise its value.

It’s clear from all the discussion of the fiscal position inherited by the new government that we face a choice between bigger government with higher taxes, and a never-ending struggle with “debt and deficit”. Our econocrats should make sure they’re on the right side.

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