How politics came to trump economics in Canberra

How does the federal government really work? Is it as we were told in Yes, Minister, with the bureaucrats actually in charge, quietly manipulating the politicians? Or are public servants actually the servants of their political masters, as the pollies focus more on getting re-elected than running the country well?

Does Treasury dominate the other departments and the economic advice going to government? Do bureaucrats still give ministers "frank and fearless" advice, or has their role been usurped by the ever-growing army of ministerial staffers, politically aligned think tanks and lobby groups?

In truth, it’s hard for outsiders to be sure. But a new book by a former 30-year senior Treasury officer, Paul Tilley, Changing Fortunes, is surprisingly frank and fearless in spelling out how things work, and how Treasury’s relationship with the elected government has "changed dramatically in recent times".

Last month Scott Morrison said he saw the bureaucrats’ role as implementing the government’s policies. Their advisory role was limited to advising the government of any problems that might arise during that implementation.

Tilley makes it clear this isn’t just what Morrison would like, it’s pretty much what he and his recent predecessors have long had. Treasury gives much information to the treasurer, but avoids giving written policy advice it believes would be unwelcome. What little frank advice is given comes verbally, as part of the private discussion between the treasurer and Treasury secretary.

Tilley says the art of policy advising involves understanding the true nature of the problem, predicting the consequences of policy options and framing effective policy advice.

To be influential, however, policy advisers need to find a balance between having sufficient separation from the raw politics of government to maintain a strong policy framework, on one hand, and having sufficient responsiveness to ministers to be listened to, on the other.

"Treasury’s influence spectrum had ‘frank and fearless advice’ at one end and full ‘responsiveness to government’ at the other," he writes. The trick was the find the right spot in the middle.

But by 2014, under Tony Abbott, "Treasury was now at the full responsiveness-to-government extreme," he writes.

His book is a history of Treasury from its establishment in 1901. "Treasury has long considered itself to be the best economic policy advising agency in Australia.

"Its favoured economic policy framework has for the most part been grounded in neoclassical economics - a belief in the power of markets, and the inherent tendency of supply and demand forces to move towards equilibrium.

"Non-achievement of equilibrium must be caused then, by some market impediment or government interference, and Treasury has seen it as its job to tackle those impediments or that interference.

"If there has been one enduring belief within Treasury – its light on the hill – this is it," he writes.

This is what Tilley means by Treasury’s possession – unlike so many other departments - of a "strong policy framework".

"If there has been a central defining culture in Treasury, it has been around analytical excellence – having the strongest policy framework and the best ideas. If there has been one recurring constraint on Treasury’s policy effectiveness, it has been too narrow in its focus and closed to alternative perspectives," he says.

Tilley’s title, Changing Fortunes, recognises that, over its 118-year life, Treasury’s influence has waxed and waned.

For its first 30 years it was the government’s bookkeeper. It evolved into an economic policy agency only after the Great Depression revealed its inability to provide authoritative advice on economic policy.

The economists arrived from the 1930s, with the advent of Keynesianism. The "golden years" for the economy in the 1950s and ‘60s were also golden for Treasury, which grew in size and status, leading the debate about economic ideas and allowing its influence and strength to give it "a level of arrogance".

This did not sit comfortably with the increasingly assertive governments of the post-Menzies era. Treasury was pushed out into the cold by Gough Whitlam, and kept there by Malcolm Fraser. Treasury’s advice remained frank and fearless, but was considered dogmatic, and often wasn’t listened to. I think this was when our Yes, Minister era ended.

Relations became more constructive when Bob Hawke and Paul Keating arrived, and continued so under John Howard and Peter Costello. "There was a sense of partnership in the Treasury-government relationships, and with the advancement of economic reforms that Treasury advocated it again influenced the policy agenda."

But for the past decade, first under the Rudd-Gillard-Rudd government, then under Abbott-Turnbull-Morrison, the "political chaos" has robbed governments of the sustained political capital needed to pursue difficult reforms. Governments fighting for their political survival have maintained a "relentless push for message over substance".

"In the daily political and media battles of the last decade, Treasury policy advice has not been sought, and at times not very effectively given. In those battles, it has been economic and budget facts and figures, not policy advice, that have been demanded," we’re told.

"The habit has developed of not providing policy advice that ministers don’t agree with. Policy advice on contentious issues now is discussed with ministers’ offices in its preparation and if the office indicates that the minister would not be comfortable with the proposed advice an information brief goes instead.

"The office’s (politically attuned) policy advice can then be provided over the top of the Treasury information brief."

The balance of policy influence has shifted to the political offices and external stakeholder groups, with the public service becoming more information providers and implementers of government decisions, he says.

"The government, therefore, is left without a strong source of genuine policy advice. The consequent lack of a consistent economic narrative over the last decade is plain for all to see."

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Memo PM: governing goes better with a sharp public service

For good or ill, much of the attitudes and strategies of the modern Liberal Party have been shaped by its greatest leader since Menzies, newly turned octogenarian John Howard.

After Bob Hawke defeated Malcolm Fraser as prime minister in 1983, Howard, his treasurer, reflected unhappily on how little the Fraser ministers had achieved during their seven years in office. Why was that? Because, Howard concluded, the public servants had kept talking them out of doing what they’d intended to do.

So when Howard became prime minister in 1996, he resolved not to let that happen to his government. He began with a “night of the long knives” in which he sacked the heads of six government departments.

When Tony Abbott took over from Labor in 2013, he repeated the process with a “night of the short knives” in which the heads of four departments got chopped.

Nothing could be better calculated to send a message to top public servants that survival in their jobs rests on the continuing approval of the prime minister and his ministers, and that any frank and fearless advice they offer will be at their own risk.

We can be reasonably confident that, by now, it would be rare for ministers to be given unwelcome advice.

Which doesn’t sound smart to me. No leader has all the answers. The manager who surrounds themselves with Yes-persons is more likely to fall in a hole than achieve great things.

Last week Scott Morrison did what’s become the accepted practice of prime ministers from both sides and moved to install his personal choice to head his department and, in effect, be boss of the other department heads.

He shifted a former chief-of-staff of his private office, Phil Gaetjens, from Treasury to Prime Minister and Cabinet. Gaetjens’ replacement at Treasury is Dr Steven Kennedy, a Treasury-trained and highly experienced macro-economist, with much experience in other areas. His appointment suggests a step back from the politicisation of Treasury.

Asked about public servants’ role in giving advice, Morrison said “it is the job of the public service to advise you of the challenges that may present to a government in implementing its agenda. That is the advisory role of the public service. But the government sets policy. The government is the one that goes to the people and sets out an agenda, as we have”.

Get it? He sees the bureaucrats’ role as to implement the government’s policy. If they see any problems during that implementation, they are free to draw them to their masters’ attention. But, by implication, they’re not invited to suggest items that need adding to the policy agenda.

It should go without saying that the government sets policy and the public service puts it into practice. Feeling you have to say it suggests a lack of confidence and a fear of having to debate with people who know more about the topic than you do.

But if the Morrison government used the recent election to set out a busy agenda of reforms, I must have missed it. Makes you suspect the agenda for the next three years will just be responding to problems as they arise. Policy without having a policy, perhaps.

But the Abbott-Turnbull-Morrison government’s seeming antipathy towards public servants runs deeper than that. I get the feeling ministers and their staffers regard them as class enemies. People who vote for the other side and so are neither likeable nor to be trusted.

This government took years to reach enterprise agreements with many of them. And though the disaster of Abbott’s first budget killed off almost all the Coalition’s enthusiasm for cutting government spending, it remains strong in two (not particularly big) areas.

It’s willingness to cut spending on public administration is exceeded only by its annual “crackdowns” on benefit payments to the disadvantaged. It knows there’ll be no objection from voters generally, while its heartland supporters will be much gratified see the leaners and loafers get their comeuppance.

The annual cuts to departmental admin budgets – laughably known as the “efficiency dividend” – long ago degenerated into rounds of redundancies that have significantly reduced the size of the public service.

Thus has the public service become less efficient – including taking longer to get things done – and lost much of its corporate memory, plus most of its policy experts.

So it may be just as well the Libs think they don’t need policy advice from public servants. When they do need it, they pay megabucks to the big four accounting and consulting firms. What would they know about public policy? A fair bit now they’ve hired many of the policy experts the government let go.

The great advantage of using private-sector consultants, of course, is that they invariably give the paying customer the advice they think it wants to hear. Good luck, Scott.

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Treasury signs off on budget fantasy forecasts

While we were preparing for the Easter-Anzac super long weekend, the secretary to the Treasury and the secretary of the Finance Department released the PEFO – pre-election economic and fiscal outlook – their official, once-every-three-years licence to tell us anything the government hasn’t told us but should have. And what was that? Not a sausage.

They made trivial updates to the budget figures and solemnly swore that all the rest of it “reflects the best professional judgement of the officers of the Treasury and the Department of Finance”. Wow. Really?

This despite the fact that, taken at face value, this is the most fiscally irresponsible budget since Whitlam. It’s a budget claiming to be able to cut income tax by $300 billion over 10 years and spend $100 billion on infrastructure over 10 years, while still returning to continuous surplus and eliminating the net debt over the same period.

No sensible person could believe all that was likely to come to pass. Far more probable that, should those tax cuts and spending increases actually happen, it wouldn’t be long before the budget was back in deficit and the debt was growing not falling.

We owe it to the Grattan Institute’s Danielle Wood and her team for joining the dots, provided in the bowels of the budget papers, to reveal how the cost of the tax cuts stays small until the last year of the budget’s “forward estimates”, 2022-23, then leaps to a cost of about $35 billion a year, rising to about $45 billion a year in 2029-30.

Never before have we had tax cuts remotely approaching such a cost.

The reason this grandiosity reminds no one of the Whitlam era is that no one takes it at face value. No one believes it could possibly happen. It’s a description of a future fantasyland.

First, it’s the budget of a chronically unpopular government desperately trying to bribe its way back to office, with little chance of succeeding.

Second, its supposed action is many years – and two or three elections – off in the future. Whatever transpires over the next decade, we can be pretty sure it won’t bear much resemblance to the scenario painted in the budget papers.

But if it’s all harmless bulldust, it can hardly reflect Treasury’s “best professional judgement” unless Treasury’s joined the happy fiction business. And the fact remains that, even more than its predecessors, this is a budget calculated to mislead.

What Treasury declines to make sure we realise is that the magic is all achieved by assumption. Convenient assumption.

Just as Wayne Swan’s promised return to permanent surplus – and his later assurance that his hugely expensive disability insurance scheme and Gonski school funding, though carefully hidden beyond the forward estimates, were “fully funded” – were based on overly optimistic assumptions that failed to come to pass, so is Josh Frydenberg’s promised return to permanent surplus and his assurance that his $300 billion in tax cuts and $100 billion in infrastructure spending are fully funded.

The trick has two parts. First, assume (as you did in each of the seven previous budgets) that, within a year or two, the economy’s growth will have returned to the old normal, where it will stay forever.

Second, assume the government will be able to sustain for many years a degree of spending restraint never achieved in the past. Make sure this heroic assumption is turned into a cabinet resolution, so it can be passed off as the seemingly innocuous assumption of “unchanged policy”, not the mere New Year’s resolution it really is.

Swan’s claim (proved by lovely graphs) that his hidden spending plans were fully funded was based on government policy to limit spending growth to 2 per cent real a year on average – a goal he repeatedly claimed to be achieving, but never did.

Frydenberg’s claim (with lovely graphs) that his post-forward-estimates tax cuts and spending increases are fully funded is based on a government policy to limit real spending growth to even less than Swan’s 2 per cent, which will cause total government spending to fall from 24.9 per cent of GDP to an unbelievable 23.6 per cent by 2029-30.

Again, we’ve had to rely on Grattan’s Wood to join the dots the budget papers don’t and tell us Frydenberg’s happy assumptions imply annual spending cuts increasing to about $40 billion a year by the final year. (She has also explained the tricks on which the government’s claim to have limited its real spending growth to 1.9 per cent a year relies.)

Meanwhile, back in the real world, the economic outlook is so strong the Reserve Bank is deciding whether it needs to start cutting interest rates immediately, or can afford to wait until unemployment starts rising.

And continuing strong growth, we’re asked to believe, is Treasury’s best professional judgement.

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Budget office fills vacuum left by politicised Treasury

I see the federal Auditor-General has been less than complimentary about the Turnbull government’s cashless welfare card. The cheek! I say the man should be removed and replaced by a Liberal Party staffer forthwith.

Always provided the staffer has done at least a year or two of accounting at uni, of course. Wouldn’t do for voters to gain the impression his chief qualifications were his years of loyal service as a ministerial flunky.

If this ironic scenario seems over the top, it’s not way over. If the present Auditor-General actually had incurred the government’s serious displeasure, it would be more likely to wait until his statutory term had expired before replacing him with someone less likely to provide it – and us – with critical advice.

You don’t have to be very long in the workforce to realise that one of the hallmarks of a bad manager is his (or occasionally her) penchant for surrounding themselves with yes-men. See that happening and you know you’re in the presence of a disaster waiting to happen.

But installing a tame auditor-general wouldn’t be a big step beyond the flouting of convention and good governance we’ve seen the government engaged in over the past two weeks.

Following Tony Abbott’s unprecedented dismissal of the secretary to the Treasury in 2013, and his replacement with hand-picked candidate John Fraser, Malcolm Turnbull and Scott Morrison have now completed the politicisation of Treasury.

What an accomplishment for Malcolm to include when he boasts in his memoirs about the glorious achievements of his reign.

With the sudden resignation of Fraser, he was replaced by Philip Gaetjens, whose service as chief-of-staff to Peter Costello and then Morrison himself was interspersed with his time as secretary of the NSW Treasury, appointed by the O’Farrell government after it sacked the apolitical secretary it inherited from the Keneally government, Michael Schur.

The timing of Fraser’s departure was portrayed as all his own inconvenient idea, which may well be true. But, with the federal election so close, it reminds me of a trick practised by the self-perpetuating boards of the mutual insurance companies of old.

Any director not wishing to serve another term would resign just a few months before his term expired. This would allow the board to select his successor, and that successor’s name to go onto the ballot paper with an asterisk beside it, certifying to the voting punters that he was a tried-and-true incumbent.

Morrison then topped off this innovation in Jobs for the Boys by installing Simon Atkinson, a former chief-of-staff to Finance Minister Mathias Cormann, as a deputy secretary in Treasury.

Worse, Atkinson got the job to replace Michael Brennan, who’s been moved up to be the new chairman of the Productivity Commission, which has had a long and proud tradition of independence, giving fearless advice to governments of both colours.

We’ll see how long that lasts. Morrison tacitly admitted Brennan’s appointment was questionable by using his press release to make Brennan sound like a career public servant, conspicuously failing to mention he’d been a staffer for two Howard government ministers and a Liberal Victorian treasurer, not to mention a candidate for Liberal state preselection.

My greatest fear is that the next Labor federal government will use this bad precedent to behave the same way, thus making the politicisation of government departments and supposedly independent agencies bipartisan policy. What a great step forward that would be.

Fortunately, as trust in the professional integrity of Treasury forecasts and assessments declines, the vacuum is being filled by the rise of the Parliamentary Budget Office, which has the same expertise as Treasury, Finance and the spending departments, but is independent of the elected government.

Just last week it produced a most revealing report on the sustainability of federal taxes, one Treasury would have had trouble getting published even in the good old days.

Its message is that there are structural vulnerabilities limiting the future revenue-raising potential of most federal taxes, with the main exception being income tax and that eternal standby of dissembling politicians on both sides, the supposed evil they only pretend to disapprove of: bracket creep.

This is the last thing either side would want us thinking about before the election.

After all, thanks to the budget’s chronically overoptimistic forecasts and what-could-possibly-go-wrong 10-year projections of endless budget surpluses and ever-falling public debt, they can afford to turn the coming election into a tax-cut bidding war.

Vote for me and I’ll cut taxes more than the other guy.

The budget office has punctured that happy fantasy. After the election, whomever we vote for will have to find a way to cover not just the cost of ever-growing but untouchable spending on health, education and all the rest, but also the tax system’s built-in inadequacies.

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Economists do little to promote bank competition

The royal commission into banking, whose public hearings start on Monday, won't get a lot of help from the Productivity Commission's report on competition within the sector. It's very limp-wristed.

The report's inability to deny the obvious - that competition in banking is weak, that the big four banks have considerable pricing power, abuse the trust of their customers and are excessively profitable – won it an enthusiastic reception from the media.

Trouble is, its distorted explanation of why competitive pressure is so weak and its unconvincing suggestions for fixing the problem. It offered one good (but oversold) proposal, one fatuous proposal (to abolish the four pillars policy because other laws make it "redundant") and a lot of fiddling round the edges.

It placed most of the blame for weak competition on the Australian Prudential Regulation Authority, egged on by the Reserve Bank, for its ham-fisted implementation of international rules requiring banks to hold more capital, and for its use of "macro-prudential" measures to slow the housing boom by capping the banks' ability to issue interest-only loans on investment properties.

The banks had passed the costs of both measures straight on to their customers. It amounted to an overemphasis on financial stability (ensuring we avoid a financial crisis like the Americans and Europeans suffered) at the expense of reduced competitive pressure on the banks.

This argument is exaggerated. Even so, it's quite likely that, in their zeal to minimise the risk of a crisis, APRA and the Reserve don't worry as much as they should about keeping banking as competitive as possible.

The report's proposal that an outfit such as the Australian Competition and Consumer Commission be made the bureaucratic champion of banking competition, to act as a countervailing force on the committee that makes decisions about prudential supervision, is a good one.

The report's second most important explanation for weak competition is inadequacies in the information banks are required to provide to their customers. Really? That simple, eh?

See what's weird about this? It's blaming the banks' bad behaviour on the regulators, not the banks. If only the bureaucrats hadn't overregulated the banks, competition would be much stronger.

Why would the bureaucrats in the Productivity Commission be blaming other bureaucrats for the banks' misdeeds? Because this is the prejudiced, pseudo-economic ideology that has blighted the thinking of Canberra's "economic rationalist" econocrats for decades.

Whatever the problem in whatever market, it can never be blamed on business, because businesses merely respond rationally (that is, greedily) to whatever incentives they face. If those incentives produce bad outcomes, this can only be because market incentives have been distorted by faulty government intervention.

Market behaviour is always above criticism; government intervention in markets is always sus.

When the report asserted that the big banks had used the cap on interest-only loans as an excuse for raising interest rates, and would pass the new bank tax straight on to customers, there was no hint of criticism of them for doing so. They were merely doing what you'd expect.

In shifting the blame for these failures onto politicians and bureaucrats, the report fails to admit that the distortion that makes interest-only loans a worry in the first place is Australia's unusual tolerance of negative gearing and our excessive capital gains tax discount.

In criticising the bank tax, the report brushes aside the case for taxpayers' recouping from the banks the benefit the banks gain from their implicit government guarantee, and the case for taxing the big banks' super-normal profits (economic rent), doing so in a way that stops the impost being shunted from shareholders to customers.

Here we see a hint that the rationalists' private-good/public-bad prejudgement​ is only a step away from Treasury being "captured" by the bankers it's supposed to be regulating in the public's interest, in just the way it (rightly) accuses other departments of being captured.

The report's criticism of existing interventions would be music to the bankers' ears. Its fiddling-round-the-edges proposals for increasing competitive pressure have one thing in common: minimum annoyance to the bankers.

The Productivity Commission's rationalists can't admit that the fundamental reason for weak competition in banking comes from the market itself: as with many industries, the presence of huge economies of scale naturally (and sensibly) leads to markets dominated by a few big firms.

Market power and a studied ability to avoid price competition come with the territory of oligopoly. Have the rationalists spent much time thinking about sophisticated interventions to encourage price competition in oligopolies? Nope.

Have they learnt anything from 30 years of behavioural economics? Nope. When you've learnt the 101 textbook off by heart, what more do you need?

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Labor plans further blow to Treasury power

It's a process that's gone on for so long few people have noticed it: the waning influence of the once-mighty federal Treasury.

There was a time, 40 years ago, when Treasury sought to monopolise the economic advice going to the federal government. But those days are long gone.

The peak of Treasury's influence came with the sweeping micro-economic reforms and opening up of the economy in the 1980s and 1990s. It first convinced its minister, John Howard, of the need for widespread reform, but he made little progress under Malcolm Fraser.

Under a much more sympathetic Bob Hawke, Howard's successor as treasurer, Paul Keating, delivered on Treasury's reform agenda beyond its wildest dreams.

Since 2000, after Howard as prime minister won Treasury's 25-year battle to introduce a broad-based consumption tax, it's been largely downhill all the way on micro reform, with its loss of momentum, direction and purity of motive.

This is what's so significant about the Productivity Commission recently seizing the initiative to Shift the Dial and revive and redirect the reform agenda. Its "new policy model" could never have come from a tired and hidebound Treasury.

When Fraser sought to punish Treasury in 1976 by dividing it in two, Treasury and Finance, the initial judgment was that he'd succeeded only in doubling its vote in favour of budget rectitude at the cabinet table.

Forty years on, I now doubt that. Its bifurcation has diminished Treasury's effectiveness in the endlessly recurring task of "fiscal consolidation" (getting the budget deficit down) by robbing it of both the expertise and the motivation to find innovative, politically sustainable ways to limit the growth in government spending.

This trickier side of the budget has largely been left in the hands of the Finance accountants, whose vision rarely extends beyond this year's budget task, and who know more about creative accounting than the wider economic consequences of their crude spending cuts.

On the revenue side, Treasury shares the Business Council's unending obsession with tax reform. Why? To a surprising extent, for the simple, institutional reason that tax policy still lies within its own ministerial responsibility.

Treasury's become more inward looking and less concerned to oversee ("co-ordinate") the activities of other departments.

With one glaring exception. Treasury's greatest loss of influence came with the recognition of Reserve Bank independence in the mid-1990s.

From that time, the day-to-day management of the macro economy moved to the Reserve, with Treasury merely retaining a seat on the bank board and the ear of the treasurer.

Yet there's been great reluctance on Treasury's part to acknowledge this loss of power. It pretends nothing's changed, devoting far too many of its shrinking human resources to second-guessing the Reserve.

The Reserve devotes many resources to "liaison" (gathering businesses' views on the state of the economy), so Treasury must do it too.

The Reserve has an extensive forecasting round each quarter, so Treasury must do its own – but half-yearly, because its only actual forecasting need is for a set of macro-economic "parameters" to plug into its budget estimates of spending and revenue.

The Reserve regularly investigates the latest macro puzzle – say, why non-mining business investment is so slow to recover – so Treasury must do its own. Its new Treasury Research Institute focuses on macro management issues.

What gets neglected is Treasury's oversight of the big micro reform issues. Think health, education, infrastructure. Without an institutional understanding of the detail of these areas, Treasury simply isn't up to speed on either micro reform or budget sustainability.

So its recent establishment of a "structural reform" division seems a step in the right direction – until you learn that the group's first big project was to inquire into non-mining business investment's slowness to recover.

Another part of Treasury's decline is its politicisation, particularly Tony Abbott's decision to sack the Treasury secretary, Dr Martin Parkinson, and replace him with someone whose views he felt more comfortable with, John Fraser.

Recent Coalition governments have preferred Treasury and other departments to be less the fearless policy advisers and more the handmaidens to the minister and their office.

This politicisation makes it ever-harder to believe Treasury's persistently over-optimistic economic and budget forecasts are the product of forecaster fallibility rather than political interference.

Trouble is, the more your influence and authority decline, the more people want to take a crack at you.

Should Labor win the next election, it says it will shift responsibility for budget forecasting and the five-yearly intergenerational report (whose credibility Joe Hockey destroyed by turning it into a political tract) from Treasury to the more independent Parliamentary Budget Office.

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Politicised Treasury bites own tail, covers for Turnbull

Shadow treasurer Chris Bowen is right: One of the Abbott-Turnbull government's various acts of economic vandalism is its politicisation of the once-proud federal Treasury.

Among Tony Abbott's first acts upon becoming prime minister in 2013 was to sack the secretary to Treasury, Dr Martin Parkinson.

Even so, Parkinson was left in place for more than a year before being replaced by John Fraser, a retired funds manager, hand-picked by Abbott.

Fraser had risen through the ranks of Treasury under the formative influence of the legendary John Stone, until he left in the early 1990s to make his fortune in the money market.

When Fraser returned in triumph to take the top job, singing the praises of Margaret Thatcher, Ronald Reagan and David Cameron's austerity policy in Britain, it seemed clear he hadn't spent the intervening decades keeping up with developments in thinking about fiscal (budgetary) policy.

The Abbott government's next act of politicisation came a few months later with the publication of Treasury's fourth five-yearly intergenerational report.

It had been turned into a partisan propaganda rag, full of dubious figuring intended to prove the Abbott government's failure to return the budget to surplus as promised was all the fault of the previous Labor government. The media tossed the report aside.

The latest stage in the politicisation of Treasury came last week with its publication of a report on The Effectiveness of Federal Fiscal Policy, commissioned from Professor Tony Makin, of Griffith University.

If you've never heard of Makin's work, you'll be surprised to learn he regards fiscal policy as utterly ineffective and probably counterproductive.

If you have heard of it, you won't be. Makin's views on the ineffectiveness of fiscal "activism" – using budgetary stimulus to assist recovery during recessions – are well known, unchanged and unchanging.

He's the go-to guy for anyone who'd like an independent report asserting that fiscal policy doesn't work – never has and never could.

In all the decades since Makin made up his mind on this question, all the academic theorising and empirical evidence from the real world have served only to confirm the wisdom of that decision.

His paper's "review" starts by rubbishing that deluded fool John Maynard Keynes – who, presumably, will never attain the intellectual heights reached by Makin and his mates – and praising such giants of the profession as Robert Mundell, Marcus Fleming, Robert Lucas and Thomas Sargent.

It then reprises Makin's well-rehearsed argument that the Rudd government's budgetary stimulus – undertaken at the urging of the then Treasury secretary, Dr Ken Henry – was unnecessary and unhelpful.

And finally it does a lot of hand-wringing about the rapid growth in the public debt (especially when you exaggerate the size of the debt by quoting gross rather than net, a trick Makin seems to have learnt from Barnaby Joyce), the burden being left to our children, and the need to make reducing recurrent government spending our top fiscal priority.

One small problem – the last time Makin ran his anti-activism line, in a paper commissioned by the Minerals Council, Treasury issued a detailed refutation. Makin seems to have taken none of its substantive criticisms into account in his Treasury-commissioned version.

This is a measure of the extent to which politicisation has changed Treasury's tune.

Apart from correcting various factual errors, old Treasury noted that the 1960s-era Mundell-Fleming open economy model Makin uses relies on extreme assumptions that don't hold in Australia's case, and certainly didn't hold during the global financial crisis.

Makin is unimpressed that, at that time, such lightweights as the International Monetary Fund and the Organisation for Economic Co-operation and Development heaped praise on the Rudd government's budgetary stimulus.

So why has new Treasury chosen now to pay one of its former critics to repeat his ill-founded criticisms?

One reason is that Fraser left Treasury not long after it had advised the Hawke government not to use fiscal policy to respond to the severe recession of the early 1990s, but to rely solely on monetary policy (lower interest rates).

Henry and others in Treasury eventually realised how bad that advice had been. Indeed, Henry's advice to Rudd was influenced by a determination not to repeat the mistake. But Fraser had left the building by then and didn't read the memo.

Another reason is that, now, both the IMF and the OECD are urging the Turnbull government to help strengthen the economy by increasing its spending on worthwhile infrastructure.

What's more, some guy called Dr Philip Lowe has been saying the same thing. Forcefully.

Makin has been hired to tell these idiots they don't know what they're talking about.

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Smarter thinking on budget is long overdue

I've been writing about the federal budget for 43 years, for 28 of which it's been in deficit.

So almost two-thirds of my career has been spent backing up Treasury in its recurring campaigns to pressure the government of the day to get the budget back to surplus. Sorry, not any more.

I've resigned from the budget-hectoring brigade because it finally dawned on me there has to be a better way.

You can put the blame for our eternally recurring budget crisis on the voters, whose demand for increased government spending is limitless, but whose willingness to countenance either spending cuts or tax increases is tiny.

Or you can blame the pollies – on both sides – who spend every election campaign pandering to and thus reinforcing this unreal thinking.

They wait until after elections to spring the bad news about the laws of arithmetic, then wonder why it's so hard to be economically responsible.

But I think some of the blame has to be shared with Treasury and Finance. It's true that treasuries – state as well as federal – accept ultimate responsibility for getting the budget back to balance. They care about budget balance above all other policy objectives.

Which is just as well. If Treasury didn't accept ultimate responsibility for fiscal rectitude, who do you reckon would? Certainly not the politicians, nor the media, nor the electorate.

That's why for so long I was happy to throw my puny weight behind Treasury's budget-repair campaigns.

I've stopped because, in all that time, there's been no sign of a learning curve. Treasury goes about attempting repair of the budget in just the same primitive way it did in the mid-1970s.

In all that time it's learnt almost no new tricks. It's applied no new science to its core responsibility of expenditure control, just kept on with the same old, same old simplistic cost-cutting approach.

Economists elsewhere have come up with inventive ways to make government spending more efficient and cost-effective: income contingent loans, activity-based health funding, the investment approach to welfare spending, early learning and other preventive programs, rigorous program evaluation and more.

Some of these techniques are being used in the federal budget, but not to the extent they should be and, to my knowledge, not because they were long championed by Treasury and Finance.

Indeed, it wouldn't surprise me if some had been opposed, or long-term investment in preventive medical programs sabotaged for a quick saving.

The best Treasury has come up with is the Orwellian annual "efficiency" dividend imposed on departments and agencies, and the rule that departments proposing new spending programs must also propose offsetting spending cuts of equivalent value.

Both crude devices have been relied on year after year, to the point where their economies are more likely to be false ones.

The efficiency dividend has become a euphemism for indiscriminate compulsory redundancies, which has robbed Treasury and Finance, and even the spending departments, of many of their policy experts.

Not to worry. If we need policy advice we'll buy it from one of the big accounting firms. They'll pretend to know what they're talking about and cost a fortune, but can be relied on to give us the recommendations we were hoping for.

The offsetting-savings rule has turned inefficiencies into valuable currency, to be husbanded jealously by their departments and given up only in return for equivalent spending increases.

It transfers responsibility for finding efficiencies away from the co-ordinating departments and into hands of departments just as likely to have been captured by the business interests they're supposed to be regulating.

The accountants of Finance can hardly be blamed for thinking like accountants. Trouble is, Treasury people too often think and act like accountants rather than economists.

They tend to view spending control as an annual scramble to knock the budget into shape, not a medium-term exercise in delivering value for money to the citizenry the government serves.

Too often they fail to consider the broader economic consequences of the cuts they push through. Like accountants, they think in terms of chopping spending down to the required size, not improving the efficiency and effectiveness of government service delivery.

They bang on about the nation's poor rate of productivity improvement while forgetting they themselves possess considerable scope to raise the efficiency of two of the economy's biggest and fastest growing industries, the two spending areas that dominate combined federal and state budgets and that will, unless made more efficient, do most keep budgets in crisis for decades to come: education and health.

No, no, leave that to the departments – or the other level of government.

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Econocrats’ report card: Turnbull not really trying

Economically and fiscally, the Turnbull government is flying by the seat of its pants. It hasn't done enough to secure future "jobs and growth", nor to get the budget balance improving strongly and government debt falling in coming years.

That's the conclusion you draw from the econocrats' oh-so-politely worded commentary in their "pre-election economic and fiscal outlook" issued on Friday, independently of the elected government, as legally required.

Treasury secretary John Fraser and Finance Department secretary Jane Halton made virtually no changes to the budget estimates and economic forecasts and projections contained in the budget delivered less than three weeks earlier.

What they did was highlight the key vulnerabilities they had alluded to deep within the voluminous budget papers they had prepared for the government.

The 10-year budget projections out to 2026-27, they warned, were underpinned by an assumption that annual growth in productivity would be the same as the average of recent decades.

However, "continued economic reform would be required in order to achieve this growth," they said.
The "crucial importance" of increased productivity would require "renewed vigour in encouraging and delivering structural reform across all parts of the economy" – something they'd seen little sign of so far in the election campaign, they hinted without saying.

Doesn't sound to me like a ringing endorsement of the adequacy of the budget's "economic plan for jobs and growth".

They warned further that these "medium-term projections" showing the budget returning to surplus in 2020-21, then staying at 0.2 per cent of gross domestic product for the following six years, were "very sensitive to the underlying assumptions".

In other words, with such a wafer-thin surplus – equivalent to just $3.5 billion in today's dollars – the budget could easily fall back into deficit.

And "should Australia experience a significant negative economic shock, the fiscal [budgetary] position would be expected to deteriorate rapidly".

Since Australia had run current account deficits on the balance of payment for much of its history – the consequence of our heavy reliance on foreign investment to exploit our rich endowment of natural resources – it was "prudent for Australia to run a relatively conservative fiscal stance".

But the stance isn't looking too prudent at present, they implied.

The medium-term budget projections – the device successive governments have used to reassure us that everything in the budgetary garden is going fine, and thus a fit subject for the off-the-leash econocrats to zero in on – assume that tax receipts will be capped at 23.9 per cent of GDP (the average during the period from 2000 to the global financial crisis) from 2021-22, by means of annual tax cuts.

But that being the case, the econocrats warned, it wouldn't be possible to get the budget surplus rising to 1 per cent of GDP [and thus make big strides in paying off government debt] "without considerable effort to reduce spending growth".

"Reducing spending growth has proved difficult in practice", they said with monumental understatement.

Indeed, after the beating Tony Abbott took in the polls thanks to his one attempt to reduce government spending, both he and his successor have retreated to doing no more that ensuring they don't actually add to spending by finding sufficient cuts to offset their new spending programs (of which there are always plenty).

The econocrats said that, even if spending were reduced from the levels projected for 2026-27 in this year's budget to their long-term average of 24.9 per cent, achieving a surplus of 1 per cent of GDP by then would require tax receipts to be allowed to rise to 24.2 per cent. (Don't forget the government also receives non-tax revenue.)

See what they're saying? Let me say it more bluntly.

It's all very well for Scott Morrison to keep saying the budget has a spending problem, not a revenue problem, but if you're not actually game to cut spending – because you know full well the electorate won't let you – then your only remaining choice is between higher taxes or higher debt.

In the election campaign, it's all very well to say Labor is high spending and high taxing. It's true enough. But what reason do we have to believe it's not true of the Coalition?

Its plan to cut the rate of company tax will be hugely expensive. The budget shows that, over the first four years of the phase-down, the cost will be covered by increasing the tax on smokers, multinational tax shirkers and people with too much superannuation.

The medium-term projections imply that the remaining phase-in cost of $43 billion will be covered by allowing bracket creep to rip until 2022-23 and by running a wafer-thin surplus.

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Too busy chopping to make spending effective

The federal government spends a lot of money trying to "close the gap" between indigenous Australians and the rest of us. Actually, we've been spending a lot for years without making much headway. So what should we do?

I suspect there are people within Treasury and Finance who think the answer's obvious: if the spending ain't working, give it the chop. Didn't you know we have a deficit problem?

But the gap between us is so wide in so many respects - life expectancy, health, income, employment, victimisation, incarceration and education - we couldn't in all conscience abandon our efforts to reduce it.

So I have a radical suggestion: why don't the people in charge of the government moneybags get off their backsides and put a hell of a lot more effort into ensuring taxpayers' funds are spent more effectively? Instead of wringing their hands, why don't they bring a bit of science to bear?

Last week Dr Rebecca Reeve, a senior research fellow of the Centre for Health Economics Research and Evaluation at the University of Technology, Sydney, outlined to a meeting of the Economic Society the results of her research evaluating the policies aimed at closing the gap.

She used econometric tools to analyse several surveys conducted by the Bureau of Statistics, noting that the nature of indigenous disadvantage and the best solutions to it may depend on where people are located.

It may surprise you that indigenous disadvantage isn't limited to people living in remote areas. And the majority of Aboriginal and Torres Strait islanders don't live in remote areas. Indeed, more live in NSW than other states or territories. Of those who do, 43 per cent live in major cities and another third live in inner regional areas. Reeve's studies focused on people in the major cities of NSW.

She found that rates of poverty were much higher for indigenous people, home ownership was lower, significantly fewer had completed year 12 and rates of employment were lower. The proportions reporting their health to be poor or fair were at least double those for other people. And the proportion who had been victims of assault was a lot higher.

Although indigenous people make up only about 3 per cent of the NSW population, they accounted for 23 per cent of prisoners. Young people are 26 times more likely to be in juvenile detention.

That's the gap. Reeve used sophisticated regression analysis to identify the key drivers of those gaps. She found that having been at school beyond year 10 made you more likely to be employed, as did participating in more than four types of social activity.

Being a lone parent, being a married female with children or being disabled made you significantly less likely to be employed.

The most significant predictors of having been a victim of physical or threatened violence in the past year were being disabled or having suffered stress from drug or alcohol use.

In this context, "disabled" means having a health problem lasting six months or more. Reeve found that by far the most significant predictor of being disabled was having been a victim of assault.

By far the most powerful predictor of being in jail was having been charged with some offence as a child. And by far the most powerful predictor of having been charged as a child was being male.

What these findings demonstrate is the interdependence of the various aspects of indigenous disadvantage. Problems such as involvement with the criminal justice system, long-term ill-health, victimisation and not having a job are all connected.

In a way, this is good news. It means targeting areas that are expected to reduce one or more of these problems should also mean improvements in other problems.

For instance, Reeve finds that an extra year of education should improve someone's employment prospects directly, but also improve them indirectly by reducing the likelihood of the person being in jail.

And get this one: her findings suggest that reducing drug and alcohol problems should reduce victimisation, which should reduce long-term health problems, which should increase employment, which should increase income.

The downside, however, is that failure to generate improvements in the key drivers of disadvantage will hinder progress in many areas.

The Council of Australian Governments' national indigenous reform agreement recognises the significance of interdependency: an improvement in one building block is reliant on improvements in other building blocks.

But though the COAG reform agenda aligns with Reeve's econometric evidence, the "close-the-gap report card" finds that targets have not been achieved in many areas. And in some areas gaps are widening.

A separate study by Reeve and colleagues on factors driving the gap in rates of diabetes also finds that, although programs are targeting the right areas, there's been no reduction in the high prevalence of diabetes among indigenous people.

I'd be surprised if Treasury and Finance have shown any interest in learning from Reeve's research. The usefulness of that research in showing "what works and what doesn't" seems to have been limited by the lack of detail in the existing official surveys it relied upon.

If we're to become better informed about why all the money we're spending isn't delivering better value we probably need to undertake more detailed, even purpose-built surveys, including longitudinal surveys that make it easier to distinguish between cause and effect.

But as we were reminded this week with all the problems the bureau has had with its jobs survey, successive governments have been reducing our statistical effort, not increasing it.

If Treasury and Finance warned the Abbott government that extracting yet more "efficiency dividends" from government agencies has become counterproductive - making government spending more wasteful in the name of making it less wasteful - there's been no whisper of it.

Reminds me of one of my father's sayings: too busy chopping wood to sharpen the axe.

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Treasury secretary cracks the whip over super funds

When Peter Costello announced his mindbogglingly generous changes to the taxation of superannuation in 2006, the air was thick with economists prophesying such profligacy would soon prove unsustainable.

Even in business circles, the good news was widely judged too good to last. Super payouts would be tax-free for those 60 and over (thus making people's age as well as the extent of their income a criterion for how much tax they paid) and the salary-sacrifice lurk for the better off was opened wide.

At the time, Treasury, whose advice seemed to have been followed by the Howard government, wasn't having a bar of the conventional criticism, and I volunteered to make sure the government's side of the story got an airing.

Since the arrival of the Rudd-Gillard government, however, the approach to super seems to have changed, suggesting the policy advice may also have changed. Despite (or maybe because it is) planning to phase up the compulsory employer contribution rate from 9 per cent of salary to 12 per cent, Labor has been chipping away at the cost - and the unfairness - of the super tax concession. It has largely eliminated the salary-sacrifice lurk, corrected the situation where those on low incomes gained no concession on their contributions and, in effect, restored the Howard government's 15 per cent super surcharge for those earning more than $300,000 a year.

Last week, the present secretary to the Treasury, Dr Martin Parkinson, removed any doubt that Treasury's attitudes have changed in a tough speech to the super funds association. He warned that, looking ahead, there were challenges for the present super arrangements. An obvious one, he said, was the ageing of the population. Although Australia was much better placed than many of the developed economies to cope with the budgetary costs of ageing, "the question remains, however, whether the current framework for our superannuation system will be sustainable into the future. While changes to the superannuation guarantee have been important for improving adequacy, they will clearly come at the cost of forgone revenue. Also, governments over time have introduced a range of concessions that encourage increased voluntary saving in superannuation. Again, these concessions come at a cost, indeed a very significant cost.

"With the Commonwealth budget coming under increasing pressure over the next few decades, the fiscal sustainability of all policies, including superannuation, will demand greater public scrutiny. This scrutiny will be even more important to the extent that existing concessions are seen to favour some at the expense of the majority."

When you remember all the promises both sides are taking into next year's election, and the difficulty whoever wins will have keeping the budget on track, it is not hard to guess where Treasury will be suggesting they look for savings.

Apart from the motor industry, there are not many sectors greedier in their rent-seeking than the super sector. Dr Parkinson took the opportunity to remind the funds in person he is no soft touch. How is this for frankness: "The government ensures the superannuation sector is provided with a steady, guaranteed and concessionally taxed supply of money. No other industry has this guarantee. None."

That sounds to me like a heavy hint the government is entitled to, first, keep the industry pretty tightly supervised and, second, expect a high standard of performance. He who pays the piper ...

"I would suggest that the superannuation industry has a responsibility to its stakeholders, including members and the government, to invest money prudently so the returns are in the best interests of members and to develop new products to meet the demands of our ageing population," he said.

"To date, the superannuation sector has focused primarily on the accumulation phase. But as the system matures, as more people move into the withdrawal phase, and as people in general live longer, there will be increased demand on the industry to assist individuals to manage the various phases of retirement and key risks like longevity ...

"Members reasonably ask: What has super delivered for me? And, more importantly, what will super deliver for me into the future? That means asking tough questions about the industry's readiness and capability to meet future challenges."

Now cop this: "I am not necessarily advocating any particular investment pattern, although I do have reservations about excessive reliance on equities."

It is a safe bet that, not long after the contribution rate reaches 12 per cent of salary, the industry will resume agitating for it to be raised to 15 per cent.

Dr Parkinson left the super funds in no doubt where he stands on the question of super's adequacy, quoting the example of a 30-year-old entering the workforce today, earning median wages and working for 37 years. They are projected to retire with an income equivalent to 90 per cent of their standard of living while working.

He said the level of super funds' management fees had been "a concern for Treasury". To tackle this concern, the government commissioned the Cooper review, from which had emerged its "stronger super" reforms, including SuperStream and MySuper.

SuperStream will see greater automation, common date standards and a network to centralise information and transactions. MySuper will provide a low-cost default super product that removes unnecessary and costly features.

The reforms could increase the retirement payout of a typical young worker by $40,000. I get the feeling that, should industry resistance prevent the reforms from delivering as expected, the issue will stay on Treasury's to-do list.

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Storm clouds over Europe, but sun is shining elsewhere

If you're confused about what's happening in the European economies, why it's happening and what it means for the world economy, don't feel you're alone.

The media's great strength is the speed with which they can bring us myriad details about the latest happening in Greece, Italy or anywhere else. Unfortunately, their great weakness is their inability to digest all that information and summarise what it means. The closest they go is in relaying the opinions of 101 supposed experts from Greece, Britain, America or anywhere else. Listen to more than one or two and you're soon none the wiser.

But this week our own secretary to the Treasury, Dr Martin Parkinson, gave us his tight summary of what and why and what next.

He began by warning that ''the global economy is heading down a winding road, with twists and turns ahead that we can't predict''. Following the global financial crisis, it was expected that the global economy would recover at a modest pace as the financial excesses were worked out of national, business and household balance sheets.

Instead, we've seen events occur that threaten to derail this recovery. ''The unfolding saga of the European sovereign debt crisis sees events change on a daily (if not hourly) basis,'' Parkinson says.

''It's not just events in Europe either, with the unprecedented downgrade by Standard and Poor's of their US sovereign credit rating in August providing yet another twist.''

He says there are four ''proximate'' (immediate) causes of the present situation in Europe. The first is the unsustainable sovereign (government) debts of some economies in the euro area, which reflect a period of weak economic growth and big budget deficits. This suggests a need for microeconomic reforms to enhance the country's international price competitiveness (because membership of the euro prevents the country from gaining competitiveness by devaluing its currency) and for more competitive taxation and social welfare policies.

The second cause of Europe's problem is policy responses from governments that are inadequate considering the size of government debt. This raises the fear of ''contagion'' (spreading disease) throughout the European banking system.

Third, the markets' continuing fear that political institutions are incapable of implementing concrete and credible responses to the problem.

And finally, a growing recognition by markets that the economic recoveries in both the US and Europe will be weaker than previously expected, making it even harder to work down their already excessive levels of government debt.

Financial markets around the world have been gripped by uncertainty and aversion to risk because of the prospect of weak global growth and the European sovereign debt crisis. Volatility has become the new norm.

The euro-area leaders' summit late last month finally made some much-needed announcements, but though markets initially reacted positively to these measures - despite the absence of detail - this was very short-lived.

Political developments in Greece and Italy in the past fortnight have further undermined confidence in the commitment of governments to deal with the underlying problems. Europe will remain a source of market volatility until governments' commitments are seen as clear and credible.

Market participants have become very reluctant to hold the bonds of certain governments, which is reflected in the market yields (effective interest rates) participants require to hold the bonds of particular governments.

The yield required on Spanish and Italian bonds, for instance, is about 5 percentage points higher than that for German government bonds. For Irish bonds this ''spread'' got as high as 12 percentage points, but has since fallen to about 7 points. For Portuguese bonds it's 10 percentage points and for Greek bonds it's about 30 percentage points.

Across the Atlantic, growth in the US weakened significantly in the first half of this year. Though it's strengthened a bit since then, the recovery remains vulnerable to external shocks such as a re-intensification of the European debt crisis.

''In the longer term we can have confidence that the US economic system will drive the innovation and investment needed to spur competitiveness and growth,'' Parkinson says. ''The question is whether the US political system can mobilise itself to address its medium-term fiscal challenges.''

But while both Europe and the US face budgetary challenges, there are some crucial differences, he says. Critically, the US has its own currency and monetary policy and a fiscal (budgetary) union between its 50 states.

And with the yield on 10-year US Treasury bonds at about a 60-year low, there's zero pressure from the market to force political action - and a political compromise - on a substantial medium-term reduction in the US budget deficit.

But until such a plan is agreed and legislated, the US will remain at risk of a sudden shift in market sentiment, as Italy has discovered in recent months.

Parkinson remarks that, with economic commentary focused on the short term and the North Atlantic, it's easy to overlook the bigger picture. We are in the midst of a once-in-a-century global economic transformation as the world's centre of economic gravity shifts from the advanced economies to the emerging market economies.

We focus on the rapid growth of China and, to a lesser extent, India. But we shouldn't overlook the strong growth of Indonesia and Vietnam. With a population of almost 240 million, Indonesia is the world's fourth most populous country. If we measure it using purchasing-power parity (as we should), Indonesia's economy overtook Australia in size in 2005.

Parkinson also points out that the rise of the developing countries isn't limited to Asia. ''We see a similar story developing in other emerging economies,'' he says.

''For example, a young population and improvements in human capital will likely contribute to an expected doubling in South Africa's gross domestic product in the next 20 years and Nigeria is expected to increase three-fold to displace South Africa as the continent's largest economy by the late 2020s.

''Latin America also continues to surge forward, with Brazil and Chile leading the way - with both expected to double in size by 2030.''

Returning to Asia, despite rapid growth in living standards, China and India remain at the early stages of their economic development. Assuming broad trends continue, China and India's cities will be populated by an increasing wealthy and mobile middle class in the decades ahead. ''On some projections, there will be 1.7 billion middle-class consumers in the Asia-Pacific region by 2020 - more than the rest of the world combined.''

Remember, however, all these projections rest on the economists' de rigueur assumption that there's no way shortages of natural resources or environmental pressures could prevent the global economy from continuing to grow forever.

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Productivity weak, but that's not all bad

Before you get too panic-stricken about Australia's poor productivity record, consider this: maybe it's a good sign. If you've been given the impression productivity can be weak only for bad reasons, you've been misled. Productivity - output per unit of input - is only what you could call a key performance indicator; a means to an end, not an end in itself.

The end is the material well being of the Australian people. And there are plenty of things that improve our well-being (or ''welfare'' as economists call it) while worsening measured productivity.

This is an uncontroversial point among economists and has been acknowledged by the leading protagonists in the productivity debate, the secretary to the Treasury, Dr Martin Parkinson, and Saul Eslake of the Grattan Institute. But you have to read their fine print to find that acknowledgement.

The productivity of labour in the mining industry has declined by about 40 per cent since 2001-02, but that's mainly because much work is being done on the installation of additional production capacity, without that additional capacity yet coming on line and adding to output. When eventually it does, the industry's productivity will be much improved.

Another factor affecting mining is that the exceptionally high prices we're receiving for our minerals have prompted firms to mine lower-grade or harder-to-get-at ore. Is it a bad thing it's now economic to mine and sell second-grade minerals? Hardly - well, not from our standard materialist viewpoint.

Labour productivity has dropped by about a third in our utilities sector (electricity, gas and water). Electricity and gas businesses are investing heavily to expand their production capacity, replace ageing transmission infrastructure and meet renewable energy targets.

Similarly, governments have undertaken significant investment in water infrastructure - including desalination plants in five states - to guarantee security of supply during droughts.

Once again, none of these developments is bad, notwithstanding their adverse effect on measured productivity. The experts disagree on how much of the overall deterioration in productivity is accounted for by mining and utilities. Some say a lot of it.

But another factor contributing to our poor productivity performance is that, with an unemployment rate of 5 per cent or so for more than a year, we're close to full employment. This means firms are having to employ people who wouldn't be their first pick for the job, thereby lowering the average productivity of their workforce.

Is this a bad thing? On the contrary, it's wonderful the economy is in a position to provide work for these people. This, after all, is one of the main things we want from our economy: that it generate jobs for all those who want them.

It's possible something similar is happening to the productivity of our capital equipment. Some firms may be using whatever old or second-rate machines they can get their hands on so as to keep up with demand. Again, not such a bad thing.

I wrote some weeks ago that the big microeconomic reform push of the 1980s and '90s proved disappointing in its effect on productivity. It produced a once-off lift in the level of our productivity, but failed to achieve the lasting increase in our rate of productivity improvement.

But there was a different respect in which micro reform yielded a quite unexpected benefit: it made the economy a lot more flexible and resilient in response to economic shocks. By increasing the degree of competition in many markets, it reduced firms' pricing power (and hence their unions' bargaining power), thus making the economy significantly less inflation-prone.

In consequence, the macro economy became much easier to manage. Combine that with the authorities' adoption of more disciplined frameworks for the conduct of monetary and fiscal policies, and you probably have much of the explanation for our record of 20 years without a severe recession.

Is that a good thing? Of course it is. It's a remarkable achievement. But in economics everything has an opportunity cost and even good things have their drawbacks. It's highly likely the drawback of going for so long without a serious recession is an ever-weakening productivity performance.

As Dr Diane Coyle wrote in her book, The Economics of Enough, ''a recession is a period of faster industrial restructuring rather than simply an economy-wide reaction to a common shock''.

When times are good - and, despite our recent complaints, times have been very good for most of our businesses for many years - firms aren't under a lot of pressure to improve their performance. It often takes adversity to oblige firms to try harder and lift their game. Inefficiencies and unsuccessful projects can be overlooked when times are good. They tend to accumulate. But when times get tough there's a lot of spring cleaning.

So, as Coyle implies, structural change tends to occur in bunches at the time of recessions, rather than continuously as textbooks assume.

Of course, this process of ''creative destruction'' during recessions can be very painful, involving a lot of workers losing their jobs.

As a case in point, it's likely the adjustment being imposed on our manufacturers by the high dollar will leave productivity a lot higher in what's left of manufacturing. Many firms will really have to improve their performance if they're to survive.

So, not to worry. Sooner or later the economy will face another severe recession - the business cycle is far from dead - and once it has done its worst and we're into the recovery phase our productivity figures are likely to look much better.

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Sustainable well-being

What does federal Treasury believe? What are the values that underlie the strong line it takes in its advice to governments? A lot of people think they know, but this week its newish boss, Dr Martin Parkinson, spelt it out in an important speech.

And some of the people who think they know all about the ''Treasury line'' may be surprised. Parkinson's title was ''Sustainable well-being'' .

What does he mean by well-being? It's ''what we in the Treasury think of primarily as a person's substantive freedom to lead a life they have reason to value'', he says.

What does he mean by sustainability? ''Sustainable well-being requires that at least the current level of well-being be maintained for future generations.

''In this regard, we can consider sustainability as requiring, relative to their populations, that each generation bequeath a stock of capital - the productive base for well-being - that is at least as large as the stock it inherited.''

But because well-being is a multi-dimensional concept, he says, going well beyond material living standards - and even the environment - we can see that the stock of capital should include all forms of capital, of which there are four.

First, physical and financial capital: the value of fixed assets such as plant and equipment and financial assets and liabilities.

Second, human capital: the productive wealth embodied in our labour, skills and knowledge, and in an individual's health.

Third, environmental capital: our natural resources and the ecosystems, which include water, productive soil, forest cover, the atmosphere, minerals, ores and fossil fuels.

Fourth, social capital: which includes factors such as the openness and competitiveness of the economy, institutional arrangements, secure property rights, honesty, interpersonal networks and the sense of community, as well as individual rights and freedoms.

Running down the stock of capital in aggregate diminishes the opportunities for future generations, Parkinson says. In one way or another, eroding the productive base will lead to lower future well-being. ''Note, though,'' he adds, ''that drawing down any one part of the capital base may be reasonable as long as the economy's aggregate productive base is not eroded.

''For example, reducing our natural resource base and using the proceeds to build human capital or infrastructure may offer prospects of higher future well-being.

''A necessary, but not sufficient, condition for this to be the case is that those resources are priced appropriately and that the returns are invested sensibly.''

When you think about well-being rather than gross domestic product, he says, it quickly becomes apparent that society doesn't get an adequate return on many environmental goods. For example, water and carbon are not yet priced appropriately.

In the case of minerals and energy, arguably society is not sharing sufficiently in the returns from their exploitation, with the vast bulk of the benefits accruing to the shareholders of the firms doing the mining. As such, society is not getting the resources it would need to build up other parts of its capital stock.

''Unsustainable growth cannot continue indefinitely - if we reduce the aggregate capital stock in the long run, future generations will be made worse off. The problem is that we can be on an unsustainable path for a long period - and by the time we recognise and change, it could be too late.''

Our economy faces a number of pressures on environmental sustainability, including: climate change, salinity and resource depletion, in addition to water availability and pressures on biodiversity. Climate change policy - both in relation to reducing emissions and adapting to climate changes - is not just an environmental issue, Parkinson says. ''It is more fundamentally an economic and social challenge.''

The impact of decisions today will be felt in decades to come, and the progression of climate change impacts is unlikely to be linear (occurring at a steady rate of change). ''There are significant risks and uncertainties arising from our imperfect knowledge of the climate system. It is possible that climate impacts could suddenly accelerate. In fact, certain impacts to the climate system may lead to a tipping point where sudden, irreversible changes arise.''

Parkinson says Treasury, to do its job, needs ''an understanding of well-being that recognises that well-being is broader than just GDP, that sustainability is more than an environmental issue''.

''A focus on well-being and sustainability continue to be important parts of Treasury's culture and identity: they assist in providing context and high level direction for our policy advice; and they facilitate internal and external engagement and communication.

''Almost a decade ago we attempted to put more structure around the issue by writing down a well-being framework to provide greater guidance to staff on our mission.'' The framework is based on five dimensions.

First, the set of opportunities available to people. This includes not only the level of goods and services that can be consumed, but good health and environmental amenity, leisure and intangibles such as personal and social activities, community participation and political rights and freedoms.

Second, the distribution of those opportunities across the Australian people. In particular, that all Australians have the opportunity to lead a fulfilling life and participate meaningfully in society.

Third, the sustainability of those opportunities available over time. In particular, consideration of whether the aforementioned productive capital base needed to generate opportunities is maintained or enhanced for current and future generations.

Fourth, the overall level and allocation of risk borne by individuals and the community. This includes a concern for the ability, and inability, of individuals to manage the level and nature of the risks they face.

Fifth, the complexity of the choices facing individuals and the community. Treasury's concerns include the costs of dealing with unwanted complexity, the transparency of government and the ability of individuals and the community to make choices and trade-offs that better match their preferences.

These five dimensions ''reinforce our convictions that trade-offs matter deeply - trade-offs both between and within dimensions'', Parkinson says.

Well, that's what he thinks.

What do I think? I think Treasury has come a long way and is at its point of greatest enlightenment. But it has further to go - in principle as well as in practice.

In particular, I doubt how much trading off is possible when it comes to the environment.

Ensuring our kids are richer than we are, while destroying the natural environment because we refuse to accept the physical limits to economic growth, doesn't sound sustainable to me.

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Is economic reform worsening productivity?

The North Atlantic economies have pressing problems to grapple with, but here at home the biggest thing we have to worry about is our weak rate of productivity improvement. And we won't get far if we stick to the received wisdom it's all the fault of excessive government intervention.

If our econocrats want to preserve their monopoly over the advice their political masters seek, they need to be less model-bound in their thinking. Since it doesn't take much thought to realise ''more micro reform'' is unlikely to make a big difference, we need more lateral thinking.

Rather than merely assuming market failure wouldn't be a material part of the problem - or assuming nothing could be done to correct market failure that wouldn't make things worse rather than better - perhaps we should look harder to see if market failure is part of the story.

After all, it's the market that's failing to generate as much productivity improvement as it has in the past.

Then we could start looking for cleverer forms of intervention that don't end up being counterproductive. Here we could put a lot more effort into evaluating interventions, so as to build up our understanding of what works and what doesn't.

The acute government debt problems in the United States and Europe are a reminder of how much more fiscally disciplined our governments have been, going right back to the Hawke-Keating government with its various budget limits and targets.

It's a great temptation to give the public the ever-increasing government spending it demands, but then fail to summon the courage to make people pay the extra taxation needed to cover that higher spending.

For all their failings, however, our politicians have achieved balanced budgets on average over the cycle and have kept government debt levels - federal and state - quite low and manageable.

But could it be we've paid for our fiscal responsibility with lower productivity improvement? It seems clear we've been underspending on public infrastructure as part of our efforts to keep debt levels low, but adequate public infrastructure is needed to permit the private sector to raise its own productivity.

As well as physical capital there's human capital. As part of our abstemiousness, we've gone for several decades underspending on all levels of education and training: early childhood development, schools, vocational training and universities. Particularly universities.

If we've gone for so long underspending on human capital, is it any wonder our productivity performance has worsened? It's true the Rudd-Gillard government has loosened the purse strings in recent years, but there's safe to be a delay before that leads to an improvement.

Another possibility worth exploring is whether the microeconomic reforms of the past have had unintended consequences that damaged our productivity.

Micro reform is almost always aimed at increasing firms' efficiency by subjecting them to great competitive pressure - whether from rivals in the domestic market or from imports.

But the human animal has achieved the great things it has not only as a result of competition between us but also as a result of our heightened ability to co-operate in the achievement of common objectives. The economists' conventional model is big on competition, but sets little store by co-operation, since it assumes we're all rugged individualists. Could it be that, by greatly increasing the competition most firms face in their markets, micro reform has reduced the amount of productivity enhancing co-operation?

A further possibility is that, in turning up the heat of competition in so many markets, and in spreading market forces into areas formerly outside the market, micro reform has diminished our ''social capital'' in ways that adversely affect economic performance.

There's no place for trust, feelings of reciprocity or norms of socially acceptable behaviour in the economists' model, so they tend to under-recognise their importance. But you only have to observe a loss of trust within the community to realise the high cost that loss imposes on the economy as well as society.

The less we feel we can trust each other, the more avoidable costs we impose on the economy in spending on supervision and monitoring, security devices and security people.

Micro reform seeks to increase the community's income without paying any attention to the equitable distribution of that extra income. If higher earners end up with more than their fair share, the disaffection of those who lose out may detract from their productivity.

It seems clear the increased competitive pressure on firms has led many to take a more ruthless attitude towards their employees.

Firms are more anti-collective bargaining, more prone to laying off staff as soon as business turns down, more willing to award huge pay rises to executives without a thought as to how this might make other employees feel, more inclined to pay some workers more than their peers, more inclined to expect people to work split shifts or on weekends and public holidays without extra pay and more likely to demand unpaid overtime (which last does increase measured productivity, however).

Is it so hard to credit that all this might have made workers less co-operative and productive rather than more?

In the Treasury Secretary's recent speech on our poor productivity performance, Dr Martin Parkinson nominated health and education as the next candidates for major micro reform. He's right, there's plenty of scope for improvement.

But these are service-delivery sectors where it's the performance of professionals that's crucial. And economists' notions about what motivates people and how you encourage excellence are so blinkered - they assume money is the only incentive and key performance indicators work a treat - that you'd have little confidence their ''reforms'' would make things better.

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Adapt or die: the high dollar is here to stay

The big ''known unknown'' facing the economy is how long commodity prices and the Aussie dollar will stay so high. That's why some people worry so much about the Chinese economy coming unstuck.

But while the new secretary of the Treasury, Dr Martin Parkinson, acknowledges the risks facing China's economy, his ''central scenario'' is that commodity prices and the Aussie will stay high for a long time.

This means that, though he declined to actually say the words in his speech to the Australian Business Economists in Sydney this week, he's no believer in ''Dutch disease'' - the idea that resources booms lead to a high exchange rate, which wipes out other export and import-competing industries before the boom collapses and leaves you high and dry.

No, Parkinson has a tough message for manufacturers and others asking for assistance to help them cope with the excruciatingly high dollar: get used to it. Adapt.

There are risks facing the Chinese economy, but they are short-term risks around a positive long-term outlook. ''Our central scenario, outlined in the budget, is one of solid medium-term growth for Australia,'' he said, fuelled by high commodity prices and a mining construction boom.

The global economy is undergoing a transformation unprecedented in the last 100 years. Global strategic and economic weight is moving inexorably from the Western advanced economies towards the emerging market economies. And the pace of this transformation is faster than many expected.

The key emerging markets from our perspective are China and India, which together account for slightly more than a third of the world's population. They're growing rapidly and should continue to do so. China should overtake the United States to become the world's largest economy by 2016 and, in turn, be overtaken by India by mid-century.

''There is nothing pre-ordained about these growth paths, and size does not automatically confer economic or strategic weight,'' Parkinson said. ''But these transitions - whether smooth or rocky - have important implications for Australia. Indeed, they constitute probably the most significant external shock Australia has ever experienced.''

Urbanisation and industrialisation in China and India have resulted in strong demand for our energy and mineral resources. The resulting improved terms of trade have increased our real income as the purchasing power of our exports increased.

Looking ahead, a growing Asian middle class will boost demand for our commodities, and for our services exports - education, tourism and professional services - and for niche, high-end manufactures.

But these developments expose our economy to increased macro-economic volatility and, more importantly, to a difficult adjustment process. That's Parkinson's point: it's not just China and India that are economies in transition, it's us, too.

Our terms of trade are now at 140-year highs and the budget assumes they fall back only slowly, by about 20 per cent over 15 years. As for the Aussie dollar, it can be expected to move roughly in line with the terms of trade over the longer term. It's therefore expected to also remain persistently high.

''The implications of a sustained increase in the terms of trade and a persistently high exchange rate are significantly different to those of a temporary shock - particularly for the structure of the economy,'' Parkinson said.

Most Australian businesses are well equipped to deal with short-term exchange rate volatility, but this sustained shift ''will challenge a number of existing business models''.

''Inevitably, this will see calls for support for producers that are suffering from a lack of competitiveness due to a 'temporarily' high exchange rate,'' he said, before going on to explain why such calls should be resisted.

Higher resource prices will see capital and labour shift towards the mining sector, where they are more valuable. This shift will be facilitated by the appreciation of the exchange rate, which shifts domestic demand towards imports and reduces the competitiveness of exports and import-competing activities.

Manufacturing and other trade-exposed sectors that aren't benefiting from higher commodity prices will come under particular pressure, but all sectors will be affected. The longer-term shift away from parts of the traditional manufacturing sector, which began in the middle of the last century, will continue - though it would be wrong to assume all manufacturing will be adversely affected.

And while mining and related sectors (including the mining-related part of manufacturing) can be expected to continue to grow - drawing resources from the rest of the economy - they will be overshadowed by the longer-term shift towards the services sector.

This change to our economy - its structural evolution - reflects a prolonged shift in our comparative advantage that began in the second half of last century, as rapidly industrialising Asian countries emerged as labour-abundant (read cheap-labour) competitors.

The latest phase in this evolution is raising understandable concerns in people's minds: how are the benefits of the boom shared throughout the community? Will our manufacturing sector be ''hollowed out'' and ''lost forever'' leaving us as ''nothing but a quarry''? What if the boom suddenly stops, as all previous booms have?

''Concerns like these are being reflected in calls for measures to protect sectors threatened by the structural shift in our terms of trade,'' Parkinson said. ''They drive calls for strengthening anti-dumping legislation, intervention to deliver a lower exchange rate and increased industry assistance.''

Why is there so much discomfort in the community about this transformation? Because it involves change and change is often difficult. Because the short-term costs of adjustment are concentrated in particular sectors. But also because what's happening - the longer-term structural nature of the change - is not well understood.

People need to be reminded, for instance, that a higher exchange rate helps spread the benefits of the resources boom through the community by reducing the price of imported goods and services.

They need to be reminded the economy is always changing - far more than we realise. Each year, about 300,000 businesses are born and a similar number die. About 2 million workers start new jobs and a similar number leave their jobs. And about 500,000 workers a year change industries.

The gravity point of world trade is shifting closer to us, giving us the opportunity to become a lot richer.

''However, if we are to take advantage of these opportunities it is likely to require more change in the structure [of the economy] and, perhaps more importantly, in the mindset of Australian businesses and the skill sets of Australian workers.''

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