The good news about ageing

Politicians and economists have been banging on about the ageing of the population for ages, but how much do we actually know about the likely economic consequences? Not much - until now.

We've been told incessantly that ageing spells bad news for the budget - greatly increased spending on pensions and healthcare - with ageing used to help justify the harsh spending cuts proposed in this year's budget.

In truth, it has suited the powers-that-be to exaggerate ageing's effect on the budget. And oldies are right to resent the way ageing has been presented as nothing but a terrible problem. If the fact that we're living longer, healthier lives is a "problem", it's the best kind of problem to have.

So let's ignore the budget and focus on ageing's other economic consequences, some of which are good. We'll do so with help from a speech given last week by Dr Christopher Kent, an assistant governor of the Reserve Bank.

Kent says population ageing is driven by three factors: the boom in babies in the early years after World War II (1945 to 1960), the subsequent sharp drop in fertility rates that created a baby-boomer bulge, plus rising longevity thanks to decades of prosperity and advances in medical science.

The authorities have been warning about the coming consequences of ageing for so long - and how bad it will be by 2040 - that I suspect many people have given up waiting for it to start.

Well, get this: although it's got a long way to go, it's already started. The baby boomers have been retiring since the turn of the century, thus reducing the share of the population that's of usual working age (15 to 64).

Kent says that, taken by itself, ageing is estimated to have subtracted from the labour force participation rate by between 0.1 and 0.2 percentage points a year over the past decade and a half. This effect has increased a little in recent years as baby boomers have begun reaching 65.

Point is, ageing's biggest and most obvious effect is not on the budget, it's on the labour market. Everyone alive contributes to the demand for labour, but only those of us willing and able to work contribute to its supply.

So ageing constitutes a reduction in the supply of labour relative to the demand. That suggests we can expect it to cause unemployment to be lower than otherwise (which is not to say it won't continue to go up and down with the business cycle).

Since Australians have worried that there aren't enough jobs to go around ever since the middle of Gough Whitlam's reign, that sounds like good news to me. We're in the process of switching from not enough jobs to not enough workers.

(What I wonder is how long it will take for our mentality to shift. The perception that there's never enough jobs is now so deeply ingrained that any shyster with a profit-making scheme he claims will "create jobs" is greeted as a hero and demands that he be showered with subsidies.)

And with demand for labour stronger than supply, this implies upward pressure on wages. Again, sounds like good news to me. Kent adds that the converse of higher wage rates is lower returns to capital.

Kent points out that the pressure on labour supply will be felt most by industries that rely more heavily on labour, mainly service industries. Prominent among those industries will be aged care and healthcare, of course.

But, Kent adds, there's likely to be scope for labour to be reallocated among service industries, with a lower proportion of young people meaning we'll require fewer workers to care for and educate children.

There'll also be relatively less demand for workers to produce goods. That's for several reasons. First, because older people tend to devote less of their spending to goods and more services.

Second, because all of us tend to spend an increasing share of our rising incomes on services. There are limits to our consumption of food, wearing of clothes and how many TVs, fridges and cars we can cram into our house.

Third, because of its greater reliance on machines, the production of goods is more amenable to continuous improvement in labour productivity than is the production of services. As one economist famously observed, you can't improve the productivity of a quartet by reducing the number of players.

All this implies the prices of services are likely to rise relative to those of goods.

But now, gentle reader, if I've trained you well enough you'll have noticed a weakness in my argument so far. I've described only the immediate effects of ageing - what economists call the "first-round effects".

That's where most people's analysis stops, but economic analysis keeps going. One of the most important questions economists ask is: "And then what happens?" It's the second-round and subsequent effects economics is supposed to illuminate.

Seen from an economist's mindset, what I've described is a change in relative prices: the price of (or return on) labour relative to the price of (or return on) capital. The prices of services relative to the prices of goods.

Kent says it's important that these relative price changes not be prevented from occurring. Why? So market forces can go to work on them, adapting to them, modifying them and, to some extent, reversing them.

The higher relative price of labour should encourage more middle-aged people to take jobs and more oldies to delay their full retirement, thus reducing the upward pressure on wages a bit. The higher relative prices of services should encourage more people to acquire the education and training needed to work in the services sector.

And greater longevity should encourage workers to save more for their longer time in retirement.

That's what happens in market economies: things adjust.

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Why health spending is sustainable and will be sustained

If you had a problem that required an operation and the doctor offered a procedure with a 90 per cent success rate or one with a 10 per cent failure rate, which would you pick? Most people say they prefer the one with the high success rate but, of course, they're equally risky. Point is, we can react quite differently to the same information depending on how it has been "framed", as the psychologists say.

When politicians engage in "spin" they're framing a problem or a solution in a way they hope will maximise the public's sympathy, a way that highlights those aspects the pollies want to draw attention to and draws attention away from aspects they don't want us to think about.

As Tony Abbott and Joe Hockey soften us up for an especially tough budget in May, we'll be subjected to much spin. Already the idea of imposing a $6 patient co-payment on GP visits has been floated, to which federal Health Minister Peter Dutton added the comment that the growth in the cost of Medicare was "unsustainable".

Spending on healthcare is highly germane to Treasury's projections that, if no changes are made to policies, the federal budget is likely to stay in annual deficit for the next 10, even 40 years.

But let me frame the projected growth in spending on healthcare in a way you won't hear from the pollies. It's a safe prediction that the real incomes of workers and households will continue growing by a per cent or two each year in the coming 10 or 40 years, just as they have in the past 40.

So, as each year passes our incomes will grow a little faster than the prices we're paying for the things we buy, leaving us to decide how to spend that extra "real" income. Every income earner and family will make their own decisions, but our past behaviour gives us a fair idea of what we'll decide.

We won't be devoting our additional real income to spending more on food, clothing and other basics. Their share of our total spending is likely to continue falling. We will be spending a higher proportion of our incomes on housing - hopefully on better-quality housing rather than just keeping up with rising prices - and on improvements in household electronics such as television, home computers and the like. We'll probably spend more on educating ourselves and our children.

And it's a safe bet we'll want to spend more on healthcare. It's hardly surprising that, as we become more prosperous, we're prepared to devote a higher share of our income to staving off death and ensuring those extra years are as free from pain and disability as possible.

Can you think of a higher priority? And the good news is that medical science is forever coming up with better pills and prosthetics, as well as better and less invasive surgery. The bad news is that the new stuff is invariably much more expensive than the technology it replaces.

And, as surgeons get better at doing particular operations, they're able to perform them on a wider range of patients, particularly the elderly.

After I started suffering angina about the time of the Sydney Olympics, and ended up having open-heart surgery, my GP told me that until this operation was developed, all the medicos could have done was give me pills that didn't work. I would just have had to keep tottering about until a heart attack carried me off. By now I'd be long dead.

If healthcare was something we bought in the marketplace, like most things we buy, that would be the end of the story. We'd go on spending a growing proportion of our increasing real incomes on healthcare and there isn't an economist or politician in the country who would see a problem.

In fact, most of the nation's spending on healthcare is done by governments, federal and state. Public hospitals are "free", visits to doctors are subsidised by the federal government and pharmaceuticals - and chemists - are subsidised by the feds.

We do it this way because, like people in almost every rich country, we believe healthcare shouldn't be denied to those who can't afford it. That's fine. But doing it this way introduces a host of additional problems: scope for greater inefficiency in the delivery of care, ideological responses from those who believe government spending is wasteful and excessive by definition and cognitive dissonance by all those punters who want ever more healthcare available to them, but don't want to pay more tax to cover the cost.

We know from successive Treasury studies that the ever-rising cost of healthcare - caused not so much by the ageing of the population as by the ever-rising cost of advances in medical technology - is by far the greatest reason for the projected increase in budget deficits. It's rarely made clear, however, that all these studies assume a limit on the growth in taxation.

Contrary to politicians' framing of the matter, the growing cost of healthcare is sustainable for the simple reason the electorate's demands leave them with no choice but to sustain it. What's unsustainable is the politicians' pretence that taxes won't have to rise.

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Rise in living standard set to slow

It's a funny thing about the awful truth: people are much more inclined to talk about it after elections than before. And it seems as though, of late, our top economists have done little but tell us our economic future is a lot more "challenging" than was contemplated during the election campaign.

The first sobering message is that getting the budget back to balance won't be as easy as it suited both sides to pretend in the three-year campaign. Indeed, it could be a struggle that goes on for at least a decade - depending on how long it takes us to face up to some tough decisions.

The next soberer is that our material standard of living is likely to improve at a much slower rate in the coming decade than it did in the last one. We got that warning in a speech last week by Dr David Gruen, the top macro-economy manager in Treasury. And we got it again in a speech this week by Dr Philip Lowe, deputy governor of the Reserve Bank.

The simple way to see what's happening to our standard of living is just to take real gross national income and divide it by the population, to give real income per person.

According to Treasury's calculations, this grew at an average rate of about 2 per cent a year during the 1970s, '80s and '90s. Over the 13 years to this year, it grew by 2.3 per cent a year. But over the coming decade to 2023, Treasury's best guess is the rate of real improvement will slow to a bit less than 1 per cent a year.

That's more than a halving in our rate of material advance. What is it that's expected to cause this marked slowdown? Well, that's a long story. Settle back.

The greatest single factor causing our standard of living to rise almost continuously over the years is improvement in the productivity of labour - that is, increased output of goods and services per hour worked. Labour productivity improves when workers are given more machines to work with, when workers' skills improve because of education and training, when improvements in public infrastructure allow firms to operate more efficiently and, particularly, because of technological advance: the invention of new and improved products and production processes.

The next most important contributor to our material standard of living is "labour utilisation": the proportion of the population that's of the right age to be in the labour force (often taken as everyone aged 15 to 64), the proportion of people of working age who actually are in the labour force, the proportion of these who are employed rather than unemployed, and the average hours worked by people employed (many of whom will be only part-time).

The standard story from economists is that the nation's income increases when we produce more goods and services. But it's not quite that simple. It's not just how much we produce, it's also what that is worth when we sell it to foreigners so we can buy what we want from them.

About 10 years ago the world started paying us a lot more for our minerals and energy - we called it the resources boom - and this increased the income we derived from the stuff we were producing. As Lowe puts it, "over time we have been able to buy more and more flat-screen televisions for each tonne of iron ore that we have sold overseas".

Economists call this an improvement in our "terms of trade" - prices we receive for exports relative to the prices we pay for imports. And the main reason our standard of living rose by a high 2.3 per cent over the past 13 years is the big improvement in our terms of trade.

It contributed about 0.8 percentage points of that 2.3 per cent growth, more than making up for a weaker rate of improvement in the productivity of labour.

But, as we all know, the fabulous prices we were getting for our coal and iron ore started falling back a year or two ago, and Treasury expects them to fall a fair bit further. Indeed, it expects the deterioration in our terms of trade to subtract about 0.5 percentage points from the annual growth in real national income per person.

And there's a second factor we'll have going against us. Until recently, we've been enjoying a "demographic dividend" as the population of working age grew faster than the overall population (mainly because of the falling rate of fertility).

Over the 30 years to 2010, the proportion of the population aged 15 to 64 rose from a bit more than 64 per cent to a peak of about 67 per cent. But now, with the continuing retirement of the baby-boomers, it's projected to fall to about 62 per cent over the coming 30 years.

So whereas until now the demographic dividend has contributed to the rate of improvement in our standard of living, over the coming decade demography will subtract from that rate (we'll have fewer producers relative to consumers).

Now, there's nothing we can do to stop world minerals prices falling back and not a lot we can do to delay the retirement of the baby-boomers. So, ready for the commercial message from your friendly econocrats?

Lowe says that "over the next decade or so, if we are to achieve anything like the type of growth in real per capita income that we have become used to, then a substantial increase in productivity growth will be required.

"If this lift in productivity growth does not take place, then we will have to adjust to some combination of slower growth in real wages, slower growth in profits, smaller gains in asset prices and slower growth in government revenues and services."

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Election well over, now for the truth

For three years Tony Abbott and company told us all our political problems were caused by Labor, and if only we elected the Coalition our problems would be no more. For three years Labor told us the budget would be back to ever-growing surpluses in next to no time.

And for six years - which coincided with our biggest boom since the Gold Rush - both sides of politics told us Australian families were having terrible trouble coping with the rising cost of living.

They encouraged us to feel sorry for ourselves, accepted the blame for the heavy burdens we were labouring under, and implied they could do more to help.

What they didn't tell us was the truth: that for most of us, wages and pensions were rising faster than the cost of living - meaning our standard of living has actually been improving - but that this was due partly to the resources boom, which couldn't last, and partly to the government doing more for us in the budget than it could afford to go on doing unless we were prepared to pay a lot more tax.

In the recent election campaign both sides promised a much enhanced scheme to help the disabled and significantly increased funding for schools. To these Abbott added more generous paid parental leave, abolition of the mining tax and abolition of the carbon tax.

What they didn't tell us was that, when you go out beyond the next four years, they had no way of paying for their promises on top of all their existing commitments, which will get ever-more expensive.

So the stories we're hearing now of the federal and state governments' longer-term budget problems must be coming as an unpleasant surprise to a lot of people.

First we had a Productivity Commission report reminding us that increased spending on age pensions, age care and healthcare (for everyone, not just the increasing proportion of old people) - not to mention the cost of superannuation tax concessions - would put growing pressure on the budget, and do so at a time when a smaller proportion of the population was working and paying income tax.

The commission recommended that the age pension age be phased up to 70 and that old people who own their homes be required to borrow against them to help cover the cost of their aged care.

Then we had a report from Melbourne's Grattan Institute estimating that the combined federal and state government budget deficit is likely to grow to $60 billion a year over the coming 10 years.

The institute provided a menu of tax increases for the politicians to pick from: broadening the goods and services tax to cover food and private spending on health and education, removing the tax-free threshold for payroll tax, getting rid of the health insurance tax rebate, restoring the indexation of petrol excise, making the family home subject to capital gains tax, eliminating the 50 per cent discount on the gains tax, or getting rid of negative gearing.

On the spending side, the pollies could cut spending on transport infrastructure, halve industry support, increase university HECS fees, greatly increase school class sizes, cut defence spending or make savings on healthcare.

But Grattan zeroed in on retirement income support. It's already planned to phase up the age pension age to 67 by 2023, but the institute proposes lifting it to 70 by 2025. It's already planned to lift the minimum age for access to superannuation from 55 to 60 in 2024, but the institute proposes lifting it to 70 by 2035. These two measures would save about $12 billion a year.

It suggests including the family home in the assets test for the age pension (saving about $7 billion a year) and reducing the tax concession on super contributions for higher income-earners (saving $6 billion).

This story that the budget will come under pressure is nothing new. We've already had it from three reports prepared by Treasury, from previous Productivity Commission reports and many others.

So let me ask you: What sort of conclusions and recommendations do you expect the Abbott government's commission of audit to come up with? My guess is, not very different to what we've been hearing - though, since it has been contracted out to the Business Council, it may go out of its way to direct the pain away from big business and the well-off.

Since we have to make a lot of tough choices if we're to avoid the North Atlantic economies' record of racking up ever-growing budget deficits and debt for decade after decade, I think pushing back the retirement age makes a lot of sense - more sense than many of the other items on the list.

The already retired and all those not far off retirement wouldn't be affected. But the notion that, despite ever-greater longevity, better health and less physical work, we should remain free in perpetuity to live in taxpayer-funded retirement for 30 years or more is insupportable.

For at least the past six years self-centredness has reigned supreme, with everyone - from big business to alleged battlers - demanding the government do more for them, but insisting others pay for any improvements.

It can't go on. Let's hope Tony's got the ticker to turn things around - and do it fairly.

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How demography is affecting us right now

WORKING out what's happening in the jobs market is trickier than you may think - and has just got trickier. On the face of it, this week's figures from the Bureau of Statistics are simple: they show employment grew by a bit more than 10,000 last month and the rate of unemployment was steady at 5.4 per cent.

But it's not that simple. The rate at which people of working age participated in the labour force (either by holding a job or actively seeking one) fell from 65.1 per cent to 65 per cent of the labour force.

At times like these, with the growth in employment slowing and the number of job vacancies falling, a decline in the participation rate is usually taken as a sign the number of ''discouraged jobseekers'' is rising. These are people who'd like to work but who, believing there are no jobs available, have stopped actively seeking one, meaning they're no longer counted as unemployed.

So, many economists would take the fall in the participation rate last month to mean the jobs market deteriorated despite the unchanged rate of unemployment.

But if we want to play this game we should really start two years ago, in January 2011, when (using the trend figures) the unemployment rate reached a low of 5 per cent. Since then it's risen only to 5.4 per cent, which doesn't seem much.

Over the same period, however, the ''part rate'' has fallen from a peak of 65.8 per cent to 65 per cent. Saul Eslake, of Bank of America Merrill Lynch, calculates that had this decline not occurred, all else being equal the unemployment rate in December last year would have been 6.6 per cent, not 5.4 per cent.

Fortunately, however, it's still not that simple. Heard of the ageing of the population? Whereas for decades it was pushing our participation rate up, it's now started pushing it down, meaning it's no longer safe to assume a fall is all the work of discouraged jobseekers.

This is an unfamiliar but important story, so settle back for a primer on demography.

We are living at a time in the world's long history when longevity is steadily rising (because of improvements in public health, increasing affluence and advances in medical science) but fertility is falling (because of improvements in contraception and rising affluence). A country's ''total fertility rate'' is the average number of children women are projected to bear over their lives.

As The Economist magazine has explained, when a country's fertility rate falls sharply, the children born before the fall become ''a sort of generational bulge surging through a society''.

In the case of the developed countries, the sharp and continuing fall in fertility was caused by the advent of the contraceptive pill, and the surging generation became known as the baby boomers. But something similar happened a few decades later in those developing countries that began developing rapidly. Access to contraception improved, girls became better educated and families decided to have fewer children.

A country in this situation enjoys a ''demographic dividend''. After a while, the earlier generation becomes old enough to be part of the labour force (they reach the age of 15) and this happens while old people are dying fairly early and fewer babies are being born.

So the country enjoys a big improvement in its ''dependency ratio'' - the ratio of people who are dependent on others for their living (because they are either too young or too old to work) to those of working age (which is often defined as everyone over 15, but for these purposes should be limited to those aged 15 to 64).

The decrease in the dependency ratio - that is, the increase in the number of potential workers relative to the number of people they have to support - is the demographic dividend. It means a country can grow faster and become richer (measured as income per person) - provided you can find jobs for all those who want to work.

The dividend continues for several decades and actually gets bigger as the bulge generation enters the ''prime working age'' of 25 to 54. It has helped keep our participation rate rising and made a significant contribution to Australia's rate of economic growth for the past 30 or 40 years.

Can you see where this story is heading? Eventually, the demographic dividend becomes a negative as the bulge generation continues to age and eventually starts retiring. As Dr David Gruen of Treasury put it last year, the tail-wind of the past becomes the head-wind of the future.

When a baby boomer stops working, the working population falls by one and the dependent population increases by one, meaning the bulge of baby boomers produces a rapid deterioration in the dependency ratio. It also means we should see a decline in the participation rate as more of the population moves from the age range where they're highly likely to be working to one where they're much less likely to be working.

The first baby boomers were born in 1946, which was 67 years ago. The last were born in 1964, which was 49 years ago.

So by now you'd expect to see the participation rate falling for reasons that are completely demographic and have nothing to do with the state of the economy and the jobs market.

Sorry, one more complication. We've known for some years that the trend to early retirement has reversed and more older workers are delaying their retirement or finding ways to keep working for a few days a week. In other words, some baby boomers aren't retiring as expected - maybe because they're not feeling old and tired or maybe because they haven't saved enough to allow them to retire in the comfort to which they've become accustomed.

Obviously, to the extent this is happening it's working to counter the purely demographic decline in the part rate. So what is happening?

The econocrats have done some figuring which shows that, over the year to December, ageing contributed minus 0.3 percentage points to the participation rate, while the trend to delay retirement contributed plus 0.1 percentage points.

In other words, the demographic dividend has reversed, although it's being partly offset by the trend of some baby boomers delaying their retirement.

So most but not all of the overall fall in the part rate can be regarded as a rise in hidden unemployment.

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How to improve investment advice to retirees

They say that at every stage of life the baby boomers reach, the world changes to accommodate their needs. So now the boomers are starting to reach retirement, it's the investment advisers' turn to lift their game.

To date, the superannuation industry's greatest attention has been paid to the accumulation phase: how much people need to save to ensure an adequate income in retirement. But the boomers' interest is switching to the retirement phase: how their savings should be managed to best effect.

And there are signs financial planners are working to improve the advice they give retirees. This seems clear from a recent speech by Dominic Stevens, of the annuities provider Challenger. Stevens made extensive use of an article by Joseph Tomlinson, "A Utility-based Approach to Evaluating Investment Strategies", published in the US Journal of Financial Planning. I'll be drawing on both sources.

To date, most advice to retirees has focused on "asset allocation" - how their investments should be divided between shares and fixed-interest securities - and on setting a safe rate at which money can be withdrawn and spent without it running out before the retiree dies.

Tomlinson's objective is to provide advice that is less one-size-fits-all, encompasses more eventualities and incorporates the insights of behavioural economics. These days, computers make it easier to provide more accurate advice and deliver it in user-friendly programs.

Remember, no one knows what the future holds. Who knows what will happen to the sharemarket - or any other financial market? So advice is based on reasonable assumptions and on averages, and advisers seek to estimate expected returns.

But more can be done to allow for the personal preferences of the particular retiree and to take account of the range of likely outcomes around the average.

The first issue is the "risk-return trade-off". The higher returns some investments offer - shares versus fixed interest, for instance - usually reflect a higher degree of risk: risk you won't get your money back, and risk that returns will vary a lot from year to year. It's generally accepted that old people who need to live off their savings can't afford to run the same degree of risk as young people with many years to recover from sharemarket setbacks.

These days more attention is being paid to "sequencing risk". Say you need to live off your savings for 15 years and it's reasonable to expect there'll be two bad years for the sharemarket in that time. Just when those two years occur makes a big difference.

If they come late, it won't be so bad; if they come early you could be almost wiped out and never recover. This suggests retirees need to hold more of their savings in fixed interest than many do.

In any case, most people are "risk averse". Consider this choice: which would you prefer, the certainly of earning $100, or a 50 per cent chance of earning nothing and a 50 per cent chance of earning $200?

If you were "rational" you wouldn't care either way because both options have the same "expected value" (for the second: 50 per cent of $0 plus 50 per cent of $200 equals $100).

If you much preferred the certain $100, that makes you risk averse (and normal). If you fancied the chance of walking away with $200, that makes you a "risk seeker". Risk aversion is pretty much the only departure from "rational" behaviour that economists regularly allow for.

A vital question in working out how much of your savings you should withdraw each year (a common rule of thumb is 4 per cent) is how long you'll live. You can't know, of course.

The advisers' standard approach is to look up in the government's actuarial life tables the average life expectancy for someone of your sex and age.

If the answer was 20 years, this would be used for your planning. But a lot of people will fall a bit below or a bit above the average, and Tomlinson's more sophisticated calculations take account of this wider range of probabilities. At present, the main objective in setting your withdrawal rate is to ensure you don't suffer "plan failure" - run out of money before you die.

The alternative to running out is to die with money left - the "bequest amount".

Conventional economics assumes that, dollar for dollar, your pain at having your money run out before you're ready to die would be equal to your pleasure at knowing you'll be leaving a bequest to your relos.

But this seems highly unlikely. As Stevens argues, if a retiree was living on $30,000 a year and that dropped to $20,000, it would have a more profound negative effect that the positive effect of income increasing to $40,000.

The two psychologists who pioneered behavioural economics, Daniel Kahneman and Amos Tversky, call this "loss aversion" (as opposed to risk aversion). They found that most people hate losing $100 about twice as much as they like gaining $100. Since running out of money before you die is a much bigger deal than losing small sums while you're working, it's likely retirees' loss aversion is a lot greater than the usual rate of 2:1. Some preliminary surveys suggest it might be as high as 10:1.

If so, this means retirees' desire to avoid running out of money (and having to fall back on the age pension) is a lot stronger than investment advisers' conventional calculations assume. And this, in turn, suggests retirees' choice of investments ought to be a lot more cautious than it often is.

Tomlinson argues that particular retirees' degree of loss aversion ought to be taken directly into account when determining the best investment strategy to meet their needs. When you do so, the bottom line of the calculation is not the average expected return on their savings but the average expected utility from those savings.

His refinement takes account of the possible size of plan failure - whether your savings are gone one year before you die or 10 years - not just whether or not failure is likely.

It also acknowledges the size of bequests is likely to suffer from diminishing marginal utility. Each extra dollar gives you less satisfaction than the one before.

Shifting the focus from expected returns to expected utility could make investment advisers' advice a lot more realistic and thus a lot more helpful.

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Aged care dilemma: tap homes, or let taxpayers pay

There's a lot more to life than money. But it's money - how much things cost and who will pay for them - that causes many of the arguments in families and most of the arguments in politics. Nowhere is that truer than in aged care.

We all agree that old people must be adequately cared for in their declining years and that governments must ensure this happens. But where does private responsibility end and public responsibility begin? More to the point, how should the cost of care be shared between the individuals involved, their heirs and successors, and the taxpayer?

The scope for duck-shoving - the temptation to push costs off on to someone else, particularly the anonymous taxpayer - is enormous. Trouble is, governments represent the taxpayer. Elected politicians know that if the demands they make on taxpayers get too high or grow too rapidly, they're in trouble.

Unless we're careful, we end up with government paralysis: politicians who aren't game to push more of the costs back on to individuals and their families, but aren't prepared to impose a lot more cost on the taxpayer.

The result is an aged care system that isn't working properly. Where some old people who need care aren't getting it because the government has imposed arbitrary limits on how much it's prepared to spend; where some individuals are getting a much bigger public subsidy than is fair, while others are paying a lot more than is fair, and where institutions are underfunded and the people who work for them are underpaid.

As last week's draft report from the Productivity Commission reminds us, that's where our aged care system is now and where it will stay until we find federal leaders with the courage to stand up to both the duck-shovers and the reluctant taxpayers.

But, actually, the system won't stay as it is for long. The ageing of the population means a lot more people will be requiring aged care in coming years, particularly when the bulge of baby boomers reaches old age.

The commission says there's no way the cost of aged care to federal taxpayers will fail to grow significantly over the years. So, barring the unlikely event of offsetting cuts in other government spending, we will have to pay higher taxes.

We can, however, limit the growth in cost to the taxpayer - as well as alleviating other deficiencies in the present system - by making the system more efficient and requiring greater contributions to aged care costs from those individuals in a position to make them.

What would be fair? The commission starts by dividing the total costs faced by old people requiring care into four categories.

First is the cost of accommodation, which is equivalent to rent or mortgage payments and home maintenance. Next are everyday living expenses, such as for food, clothing, laundry, heating and social activities.

Third is the cost of healthcare, such as nursing, therapies and palliative care. And fourth is "personal care" - the additional costs of being looked after because of frailty or disability.

The commission argues that accommodation and everyday living expenses should be the responsibility of individuals, but with a safety net for people of limited means. (Remember, this is why people receive the age pension. Those ineligible for the pension - or for a full pension - have other, private means to call on.)

The commission argues that health services should attract a universal (that is, non-means-tested) subsidy, as is a key principle of Medicare.

On the cost of personal care, the commission says individuals should be required to contribute according to their capacity to pay, but shouldn't be exposed to catastrophic costs of care. It suggests maximum lifetime payments be capped at $60,000.

We tend to think of the elderly as among the poorest in the community, but that's because we focus on their usually modest incomes. But it's a different story when the focus is on their assets.

The distribution of wealth has been shifting towards older Australians since the mid-1980s, and this trend is likely to continue. It's estimated that, in 2000, the 12 per cent of the population aged 65 and over held about 22 per cent of the total net wealth of households. It's projected that by 2030, the aged's share of the population will rise by 7 percentage points, but their share of net wealth will more than double to 47 per cent.

Where's all this wealth coming from? From the rising value of the family home. The rate of home ownership among the elderly is very much higher than among the rest of us. Yet the value of people's homes is largely ignored when calculating their aged-care charges and subsidies - until the house is sold, when everything changes.

This is what the commission says must change to make the cost-sharing fairer to those oldies who've never owned their homes or have recently sold their home, not to mention working taxpayers who may be far less well placed in the housing market.

Taking account of the value of people's homes in assessing their ability to contribute to the cost of their care - which the commission says should vary between 5 per cent to 25 per cent - would increase the pressure on people to sell their home or at least borrow against it.

It proposes widening the use of accommodation bonds - where money is lent to the care institution interest-free - but with the proviso that the size of bonds reflects the actual cost of accommodation.

Many old people and their inheritance-conscious children will hate the sound of all this. But since even John Howard lacked the courage to impose these reforms, it's doubtful whether Julia Gillard will be game to touch them.

The only trouble is, our treatment of people receiving and providing aged care will continue to worsen until we as a nation are prepared to call a halt to the duck-shoving.

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HOW AGEING AND THE RESOURCES BOOM WILL AFFECT WORKERS

Talk to Centrelink Financial Information Service Officers, Brisbane
March 24, 2010

With the recent publication of the federal government’s third intergenerational report since 2002 we’ve had another surge of concern about the ageing of the population. I want to try to clarify for you what this is likely to involve. It’s been generally portrayed as a bad thing - a threat - but, though it will certainly bring changes, many of those changes will be for the better. Let’s start by being clear on what ageing involves.

What is population ageing?

All of us get older every year, so what does it mean to say the population is ageing? It means the average age of all the people in Australia is rising - though by a lot less than 12 months each year. The average age would be falling if a lot more babies were being born to counter the fact that we’re getting older as individuals but, in fact, women are having fewer children than they used to in earlier decades (even though the fertility rate recovered a little in the noughties). The other factor is that the death rate is falling as we live longer lives. So a lower birth rate and rising longevity are the main causes of population ageing, but it’s being made more acute by the fact that the great bulge in the population that is the baby boomers (people born between 1945 and 1960), which is working its way through like a pig in a python, has reached the point where they’re turning 65 and starting to retire.

The latest report tells us that the number of people aged 65 to 84 is projected to more than double over the next 40 years, while the number over 85 more than quadruples. At present there are five people of working age to support every person of 65 or over, but this is projected to fall by almost half (to 2.7).

The ‘problem’ of ageing is exaggerated

Since a big part of the cause of ageing is that we’re living longer, you’d think this would be seen as a good thing, something to be celebrated. But ageing is almost always portrayed as a bad thing - a cause of many problems - and the latest intergenerational report is no exception. It tells us ageing will cause the economy to grow more slowly - our material standard of living won’t rise as quickly as it has been. As well, we’re told, increased spending on the aged will put great pressure on the federal budget, creating a ‘fiscal gap’ between government spending and revenue equal to 2.75 per cent of GDP by 2050, which is equivalent to about $35 billion a year in today’s dollars.

It’s true that the economy’s likely to grow a little more slowly in coming decades, mainly because of slower growth in the number of people joining the workforce. However, when you examine the report and its projections you find that most of the expected growth in government spending comes not from costs associated with the higher number of old people, but from the rising cost of new health technology and the likelihood that all of us will be demanding more and better healthcare. So the budget will have a problem with inexorably rising spending on healthcare. But though the politicians don’t like to admit it, the obvious solution to that problem is that we’ll all have to pay more tax from our rising incomes over the next 40 years.

It’s true that most other developed countries - the US, Britain, Europe, even New Zealand - will face serious budgetary problems coping with the growing cost of aged pensions and aged care. But that’s because their unfunded pension schemes are much more generous than ours, being unmeans-tested and, in many cases, related to the individual’s pre-retirement income. We don’t have problems to anything like the same degree because our age pension is so frugal, being means-tested and flat-rate. The compulsory super scheme we’ve put in to supplement the age pension - so that most people will retire with a combination of age pension and private pension - is an accumulation scheme that makes no promises about how much you’ll end up with.

Many ageing problems will solve themselves

The next point I want to make is that many of the ageing problems people point to will, to some extent, sort themselves out. Where they don’t, the government will sort them. The point is that our economy is ‘dynamic’ - it changes over time in response to situations that arise. People don’t just sit there accepting their fate, they try to do something about it. And though it’s wrong to imagine that ‘market forces’ have magical powers to eliminate all problems, it’s equally wrong to imagine they have no power to improve matters and that the only solutions come from government action.

Take for instance the often-heard complaint that the babyboomers can’t afford to retire because they haven’t saved enough. There’s truth in this complaint - even though I have to say that this problem arises because the babyboomers are sure they couldn’t get by on the age pension - even though all previous generations have - and even though they haven’t bother to save much. But here’s the real point I’m making: if it’s true the babyboomers can’t afford to retire then they won’t retire. They’ll keep working, even if only part-time. And every year they postpone their retirement is one extra year of saving plus one less year of having to support themselves in retirement.

And, indeed, this trend has already begun. In the 1980s and early 90s we saw a trend towards earlier and earlier retirement. Some of this was voluntary - such as federal public servants whose pension scheme had a quirk that encouraged them to retire just before they turned 55 - but a lot was involuntary, particularly for less-skilled blue-collar workers being made redundant from manufacturing. As you know, people are able to get access to their superannuation savings from the age of 55 - and earlier if they’re made redundant.

But that was a long time ago, and though some public servants may still be retiring early because of quirks in their super schemes, for about the past decade the tide has been turning and the proportion of 55 to 64 year-olds participating in the labour force has been rising, not falling. That is, people are tending to retire later. Since 2001 the participation rate for men aged 55 to 59 has risen from less than 72 per cent to more than 78 per cent. Since 1993 the participation rate for men aged 60 to 64 has risen from 54 per cent to almost 60 per cent. I expect this trend has a lot further to run.

You can see the federal government seeking to reinforce this trend, first by phasing up the female age pension age from 60 to 65; second, by introducing tax-free treatment of retirement income provided the individual has turned 60; and now in last year’s budget by beginning to phase the age pension age up to 67. The limited outcry over these moves is a sign they fit with people’s changing social attitudes. We’re living a lot longer than we used to, and are healthier than we used to be, so it follows that we can work for more years before we retire. It doesn’t make much sense for all of our extra years of life to be spent in retirement. What about manual workers whose bodies may not hold up for another two years to 67? We already make provision for them - disability support pension.

The pension age is being raised in most developed countries and I don’t think we’ve seen the last of our government’s efforts to raise the de facto retirement age. The next step - which may be recommended in the Henry tax reform report - would be to raise the age at which tax-free retirement benefits are available to align it with the age pension age. Nor do I think that 67 is the highest the pension age will go.

It’s often said that, whether or not older people want to keep working, they can’t because of employer prejudice against older workers. Older workers are the first to be laid off and the last to be rehired, we’re told. I’m sure there was a lot of truth to this complaint and there may be some lingering vestige of such a prejudice, but I’m equally sure it’s disappearing and probably largely gone.
Why? Because, at a time of population ageing, where skilled labour is perpetually in short supply, it’s a luxury employers can no longer afford. And most of them have already figured that out.

So I believe employers’ attitude towards older workers is in the process of reversing itself. One consequence of ageing is that fewer and fewer young people will be leaving education each year and joining the workforce (though this will be countered to some extent if we achieve high levels of skilled immigration). This being the case, employers will be anxious to retain the services of their existing, older - but skilled and experienced - workers. They’ll generally be sorry to see them retire and willing to offer the flexible arrangements necessary to have them stay on, even if only part-time.

Older workers possess something economists call ‘firm-specific knowledge’. They know how things are done; they know why they’re done that way and not some other way. When in the recessions of the early 1980s and the early 1990s big companies followed the corporate fashion of the time and sought to impress the sharemarket by announcing mass redundancies, they learnt the hard way that getting rid of your older workers involved also excising the firm’s ‘corporate memory’, so that it lost the ability to do certain things. Some of these key people had to be brought back, sometimes at great expense and as an admission of error. It’s no longer fashionable for big companies to try to impress with huge layoffs, and I suspect that part of the reason for this is the belated recognition that getting rid of your corporate memory isn’t a smart thing to do.

As older workers become more inclined to stay on, and employers become more desirous of having them stay on, governments are increasingly likely to change the tax laws to accommodate and encourage this trend. That’s because reversing the trend to early retirement represents the easiest and most obvious way to reduce the economic and budgetary costs of ageing. The next best way is to do more to help mothers return to the workforce and help more to work full-time rather than part-time. It’s probably no coincidence that we’re now finally seeing some action on paid parental leave.

The changing balance of supply and demand for labour

The key to understanding how ageing will affect workers is to understand the basic economic forces we’re dealing with - the changing balance of the supply and demand for labour. You also need to understand where we’re coming from. The economy is now emerging from a period of about 30 years - starting in the mid-1970s - when the number of people wanting to work greatly exceeded employers’ demand for workers and the rate of unemployment was always high. According to the economic textbook, such a position can’t be sustained because the price of labour (wages) will always adjust to bring supply and demand into balance. But the labour market doesn’t work the way textbooks say it does and, as I say, we went through a protracted period in which the supply of labour exceeded demand.

The supply of people wanting work was plentiful for three main reasons. First, because of the high fertility rate in the 50s, 60s and 70s, a lot of young people were entering the labour force each year. Second, because the bulge of babyboomers were at their prime working age. And third, because changing social attitudes and rising levels of educational attainment were prompting a lot of married women to return to the workforce.

As a consequence of this period of excess supply of labour, the balance of power in industrial relations shifted decisively in favour of employers. We saw a marked decline in strikes and other industrial disputes and, indeed, the steady decline of the union movement. More to the point for our present purposes, employers realised there was rarely any shortage of people wanting to work for them and so they became a lot more picky. They could demand higher levels of education than were needed to perform the tasks involved; they could favour married women over young people (more reliable); they could decline to interview any job applicant who’d been unemployed for more than a month or so and, above all, at a time of rapidly changing technology they could favour hiring young people over older people, whether those oldies were job applicants or existing employees. I can remember a time in the days of the Fraser government when there were concerns about high youth unemployment, it was considered virtuous to bundle older workers into retirement to make way for the younger generation.

Why did employers behave like this? Because the excess supply of labour allowed them to. The trouble is, because this excess lasted for 30 years, many people have come to regard it as part of the natural order - the way the world has always worked and always will.

In truth, that era has ended and we’ve entered a new era where employers’ demand for labour now exceeds the supply of people wanting to work. And this means the balance of industrial power is shifting from the employers back to the workers, just where it was in the post-war period that ended in the mid-70s. Why has the balance of supply and demand shifted? In a word, because of ageing. With an older population, you get more people who consume but don’t produce. So the demand for labour remains strong, but the supply of labour declines. To be more specific, we have fewer young people joining the workforce each year as the low rates of fertility in the 80s and 90s have their effect and as the babyboomers start surging into retirement.

The point is, it’s this change in the balance of demand and supply that gives workers the upper hand and forces employers to change their behaviour in line with the changed economic reality.

Employers will stop favouring young people over older people because they have to. There just won’t be enough young people entering the labour market to allow them to discriminate against older workers.

More generally, shortages of skilled labour will become commonplace, and rather than giving their workers a hard time, employers will have to try harder to retain the services not just of older workers but of all workers and discourage them from being poached by rival firms. Salaries will be higher, perks will be greater and employers will be a lot more solicitous of their workers’ welfare. Firms will vie to be seen as the ‘employer of choice’ in their industry. Why will they? Economic necessity.

This is the amazing thing about the portrayal of ageing as a great problem for the economy. It will be a problem for employers, but just the opposite for workers.

Before I move on, let me warn you about something. At about the time of the first intergenerational report in 2002, people focused their minds on ageing, looked at their existing workforces and noticed the high proportion of babyboomers, all of whom were about to retire. They did a bit of manpower planning and projected that, within 10 or 20 years there’d be huge shortages of doctors, nurses, teachers and many other professions. You could add all these shortages together and conclude that, with all these unfilled vacancies, the economy will surely grind to a halt. But I warn you against such a conclusion. Why? Because, as I said at the beginning, the economy is dynamic. Or to put it another way, because nature abhors a vacuum. Those massive projected shortages won’t transpire because, to a greater or lesser extent, people will find a way to overcome them. They’ll try to attract skilled immigrants, they’ll look for labour-saving solutions, they’ll allow nurses to do the work of doctors, or whatever.

I haven’t left myself much time to talk about the effect of the resources boom. In the last part of the noughties, immediately before the global financial crisis, we were in the grip of a resources boom, getting sky high prices for coal and iron ore as China and India undertake the massive and protracted installation of all manner of infrastructure needed to turn them into developed economies. The result for us was a booming economy, the lowest unemployment rate in 30 years and widespread shortages of skilled workers. We’ve been through resources booms before and the GFC seem to bring that one to an end as all the others had ended. But China and India turned out not to be greatly affected by the global recession. They have resumed their rapid march towards economic development, their demand for our resources has continued unabated and, after falling somewhat, resource prices are on the way up. We’re in for another period of huge investment in increased mining capacity, including a huge investment in LNG facilities. So the resources boom is back on, it seems like it won’t be long before the economy is back to full employment and skill shortages, and Asia’s heightened demand for our minerals and energy could run on for a decade or two.

If so, this will have profound effects on our economy. It will keep our exchange rate and interest rates high, and lead to a much bigger mining sector, but smaller manufacturing, agriculture and tourism sectors. It will change the mix of occupations accordingly, and it will change the nation’s geographic balance, favouring rapid growth in Western Australia and Queensland and much slower growth in the other states. Population will shift to the mining states as it has been for some time. That will be great for Queensland, though it will continue suffering the same problems it’s been suffering from for a while: growing pains.

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THE POLITICAL AND POLICY OUTLOOK IN AUSTRALIA 2002

Australian Business Economists Annual Forecasting Conference, Sydney, December 6, 2001

With the federal election not far behind us, this isn’t a bad time to be examining the
political and policy outlook, though I have to warn you up-front that it’s not a particularly
cheery outlook for people with the policy preferences I suspect you have. The first bad
sign is that this was the first election in many years (since the Vietnam-war election in
1966, I think) where economic issues - the state of the economy and micro reform –
weren’t dominant. Rather, the dominant issues were the boatpeople and ‘security’ –
which suited John Howard down to the ground. He may now be ashamed of the way he
stooped to pressing xenophobic and possibly racist buttons, but there is simply no
denying the overwhelming emphasis on the boatpeople issue in his advertising –
particularly in the final week – and even in the signs his people strung up around polling
places. It suited Howard to promote this mighty distraction from the public’s economic
discontents: the high price of petrol (until the last month or two), all the complaints from
people who perceive themselves to be losers from globalisation or national competition
policy, and, above all, all the lingering whinges about the GST package.

The Labor Party chose not to fight on macro issues, adopting the Government’s policies
on the inflation target and the independence of the Reserve Bank, and on the mediumterm
fiscal strategy. It even matched Howard and Costello’s stupid – but clearly
premeditated – promise to keep the budget in surplus throughout the next term. Both
sides chose not to mention unemployment, even though it’s risen by a percentage point
over the past year. The Government tried to hide its stated intention to sell the rest of
Telstra. In the end the parties were not far apart on Labor’s preferred issues of education
and health (neither side was promising the kind of sweeping changes to funding
arrangements – and funding sources – that are needed to bring genuine improvement to
these areas). And, most surprising of all, in the one policy area where the parties did have
significant, ideologically driven differences – industrial relations – both sides had their
own reasons for not wanting to raise it. The conclusion is inescapable: neither side
wanted to talk about economic issues in this campaign. And that fact does not augur well
for further economic reform in the Government’s third term.

How Howard won

It’s important to understand how Howard won the election and why Labor lost. Early this
year, after the West Australian and Queensland state elections and the Ryan federal byelection,
Howard had been written off by everyone but himself. His back-to-the-wall
survival strategy had two stages. The first stage was to remove all the negatives – all the
reasons people wanted to vote against him; the second stage was to find a positive reason
for them to vote for him. The first stage involved, in particular, doing something to
mollify each of the various interest groups with gripes about the GST. Thus we had: the
changes to the BAS, the cut in petrol excise and the abolition of indexation, the cut in the
beer excise, the temporary increase in the first-home owners grant, the $300 handout to
pensioners, the extra tax rebate for the self-funded retirees and the backdowns on various
unpopular aspects of business tax reform, such as taxing family trusts as companies and
the abuse of personal service income. As you well know, this Rollback and various
spending programs appropriated most of the prospective budget surpluses for this and the
next three financial years. The second stage of Howard’s strategy involved seizing on the
Tampa incident and exploiting it for all it was worth. In that sense, this issue involved
less good luck than ‘good’ political manipulation. Howard well knew how unpopular the
boatpeople were with most Australians, he was on the look out for an issue to use as a
diversion from the public’s economic discontents and he had the quick wittedness to see
the Tampa’s potential and exploit it shamelessly. Howard’s use of the boatpeople was an
example of the timeless effectiveness of the oldest trick in the leaders’ handbook: using a
threat from outside to unite your team. But it also had something else: whereas Howard’s
own version of GST Rollback had been about the removal of negatives, Tampa gave
people a positive reason for voting for him. They’d been reminded of an issue they really
cared about – the need to repel the alien interlopers – and been shown the perfect man for
the job.

What role did September 11 play in the election result? Did it make people feel insecure
and anxious about what the future might hold, and thereby force them back into the arms
of the incumbent? Yes, I guess it did to some extent and Howard was certainly quite
blatant in the way he sought to fan uncertainty. But I don’t think it was nearly as big an
issue as the boatpeople. And, by its depiction of alien and threatening Arabs and
Muslims, it served to reinforce the boatpeople threat. What’s more, first Peter Reith and
then Howard himself sought to link the two issues with the disingenuous statement that
he couldn’t be sure there were no terrorists among the boatpeople.

In their efforts to minimise retrospectively the central role played by the Tampa issue,
Liberal functionaries have argued that the Government’s good economy management and
the good state of the economy were major factors in its win. It’s true the public perceived
the Libs to be much better economic managers than Labor (with a strength of belief few
economists would share) and that Howard and Costello exploited this perception
brilliantly in their strategy of keeping Labor boxed in. But, even so, it’s important that
economists don’t fall for this line. The aphorism to remember is that no-one votes out of
gratitude – as Jeff Kennett, Winston Churchill and many other politicians have
discovered. The politics of economic management isn’t symmetrical: bad management
can get you tossed out, but good management can’t, by itself, get you re-elected. At best,
it’s the removal of a negative. To me, the proof that the state of the economy didn’t figure
largely in Howard’s re-election is that it wasn’t a lot different between March (when
Howard had been written off) and November (when he won). Interest rates were a bit
lower; unemployment was a bit higher. Back in March, the good state of the economy
wasn’t sufficient to outweigh the whole range of people’s economic complaints – about
petrol, globalisation, competition policy and the GST – but by November petrol prices
had fallen, much had been done to mollify the GST whingers and, above all, Howard had
managed to divert everyone’s attention to a (perceived) non-economic issue.

Why Beazley lost

Why did Labor lose? Because, once Howard had played his masterstroke, the whole
emptiness of Labor’s election strategy, its policies and its leadership was revealed. Kim
Beazley tried to get himself elected the same way Howard got elected: by making himself
a small target so that all the focus was on the public’s dissatisfactions with the Prime
Minister as a person and with his policies, notably the GST. Unfortunately for Kimbo,
Howard was no Paul Keating. It was an appropriate strategy for Beazley, a man with no
particularly strong convictions about economics, no personal reform agenda, and no
burning desire run the country much differently from Howard. Labor hit on two
genuinely important issues for the positive centrepiece of its campaign – education and
health – but it revealed little understanding of the structural problems involved, nor any
desire to tackle them. It just wanted to exploit public discontent about education and
health by promising to spend more money on them. But the real rock on which Labor’s
strategy was built was the unpopularity of the GST. It thought it was on to a winner but,
as things turned out, the GST proved a fatal distraction. As we’ve seen, Howard had
mollified much of the unhappiness with the tax package and then powerfully diverted
attention to the treat from terrorist boatpeople. In the process, however, he’d done
something else important in defusing the GST as an election issue: he’d emptied the till.

Labor could have won plenty of votes with a big program of Rollback, but the money just
wasn’t there for anything more than a laughably token effort. So, for Labor, the GST
ended up being a distraction, and the distraction proved fatal. Without the GST issue,
Labor was reveal as having few feathers to fly with. I have to say that, on this, Labor got
its just deserts – from Day 1, its position on the GST was cynical, opportunist and devoid
of principle. It’s also worth noting that it was a good thing for the long-term future of
reform in general, and tax reform in particular, to have the Government comfortably reelected.
Had it lost, tax reform would have got the blame – from both sides. This isn’t a
huge amount of comfort, however, because the Libs’ conclusion from the episode would
be that the GST brought them a mighty lot closer to the abyss than they ever want to be
again, and they’ll make sure they never take on any reform even half so unpopular.

Labor under Crean

Before we move from politics to policy, I should say a little about the new Labor leader,
Simon Crean. Crean is unelectable and everyone knows it – his party knows it and the
talkback callers know it. He got the job because there was no-one remotely better, but this
won’t protect him from recurring leadership rumblings whenever he’s judged to be
faltering. Fortunately, Crean is under no illusion that he’s regarded as unelectable and
that he’ll get only one crack at the prime ministership – if that. This is why he’s trying so
hard to be the new broom and everything that Beazley wasn’t. Labor will have plenty of
well-developed, alternative policies this time around. Like his deputy, Jenny Macklin,
Crean has an economics degree. But he’s no economist. The Canberra press gallery keeps
marvelling at how ‘dry’ he’s become since he became shadow treasurer, but this doesn’t
prove much. The gallery wouldn’t know a genuine dry if it saw one. One thing it means is
that Crean saw no alternative but to wear the fiscal straitjacket that Peter Costello so
cunningly fashioned for him with all his silly talk of perpetual surpluses. But that was
mainly about being seen to have politically correct views on fiscal issues. The other thing
it means is that Crean is what Labor politicians call ‘pro-business’. He wants business –
big as well as small – to see him as pro-business and he really is pro-business in the sense
that, when business lobbyists are on the make for a new tax break or handout, Crean will
be very keen to talk turkey. He was dead keen for Labor to be seen to be co-operating
with Costello to get the Ralph business tax reforms through the Senate. Unlike many of
his colleagues, he had no problem going along with the halving of capital gains tax, only
requiring that the Government ensure the total package was revenue neutral by including
some anti-avoidance measures (most of which it subsequently dropped when the going
got tough). What Crean is and always will be is a full-on believer in industry policy:
special deals for manufacturing, tarted up by reference to the latest fashionable
enthusiasm – R&D, IT, the New Economy, whatever. At the centre of his industry policy
is always a tripartite deal between government, unions and business. And at the centre of
the tripartite deal is always the great deal-maker and ringmaster, Captain Handout
himself, Simon Crean.

Two points about the Government before we leave politics for policy. There will be two
recurring political themes in the Government’s third term. First, after the new Senate is
installed in July and for as long as the Libs look strong in the polls, we’ll have the
Government trying to get its way with a recalcitrant Senate by threatening a double
dissolution – something that would be guaranteed to reduce the Democrats numbers.

Second, Howard is supposed to be retiring two years into this term, but he’s made no firm
promises (public or private) and the ability to quit while you’re ahead seems incompatible
with the ego required to be a successful prime minister. Knowing all this, Costello and,
just as importantly, his parliamentary supporters, will be as twitchy as hell until the
changeover is effected. You may know that there is no love lost between the two men. So
the welling of tensions to the surface will be a recurring theme and the gallery will be on
the lookout for them. Since such reports are usually unsourced and often formally denied
by the parties, there’s a temptation for Liberal sympathisers back in Sydney to see them
as products of the gallery’s overactive imagination. Not so. Stories of leadership tensions
have a high ratio of signal to noise and are often borne out by a subsequent formal
challenge. They’re usually well-founded because the journalists have politicians
whispering in their ears.

Howard’s third-term agenda

As everyone realised as soon as the election was over, John Howard had managed to get
himself re-elected without a third-term agenda of any consequence. This is typical of
politicians. When you’ve got your back to the wall, you fight to preserve your political
life and only once you’ve succeeded do you worry about what you’ll do next. By now,
however, Howard does see the need for an agenda. Quote: ‘It would be a terrible mistake
if in this term we thought everything had been accomplished and no more reform was
necessary because we a need to have an activist reform agenda’. And now his cabinet has
been appointed, he’s told them their first job is to think up a list of things that need doing.
But despite his fine words, I don’t hold much hope for genuine economic reform, for five
reasons. First, campaigning on the slogan ‘Keep Australia in safe hands’ doesn’t get you
off to a very daring start. Second, Howard’s long-held personal ‘conviction’ agenda –
which was set in concrete while he was Treasurer in the Fraser Government – has only
two major items, both of which have been ticked off (even if they haven’t been finished
properly): reform industrial relations and introduce GST. Third, what Howard really
meant by that quote is that governments are expected to keep busy. They can’t be seen to
be resting on their laurels, but must always have some big new projects on the go. It
doesn’t follow, however, that all the big new projects have to be economic. I suspect that,
from now on, a lot more of the Government’s appearance of busyness will come from
non-economic endeavours such as defence and ‘security’ and a federal government’s
version of the law-and-order agenda, such the war on drugs. Fourth, if the economic
downturn proves deeper and longer than all of you guys expect – as I suspect it may – the
public’s economic focus (and, hence, the Government’s focus) will switch back from
micro reform issues to all the old issues of macro stabilisation: what’s the Government
doing about creating jobs to reduce unemployment and, much later, what’s the
Government doing to rein in the Budget deficit?

Fifth, I fear there’s a micro-reform price to be paid for the cleverness of the boatpeople
ploy. John Edwards (in my opinion the only business economist with a good feel for
politics) reminded us during the campaign that no party was running in support of
globalisation. Not a good start towards a courageous third-term agenda, but I fear it’s
worse than that. Part of the cleverness of the boatpeople issue was that it diverted
people’s attention away from their discontents about globalisation, the effects of national
competition policy on the regions, and suchlike. People were so stirred up by the threat
posed by the boatpeople that they forgot their worries about globalisation etc. You could
argue that this is a good thing: the Libs managed to get re-elected without being punished
for the perceived evils of globalisation. But I fear it works the other way. There’d be a
close overlap between the people stirred up about globalisation and the people stirred up
about boatpeople. Why? Because the boatpeople issue is merely a novel dimension of
globalisation. Like the opposition to globalisation, the boatpeople issue is about
resistance to change, fear of foreigners, protectionism (build up border barriers to keep
the threatening world at bay) and about mercantilism (it’s OK for us to plunder other
countries’ skilled workers, but it’s a terrible loss for our brains to go abroad). Shifting the
focus from scientists to ordinary workers, it’s a fair bet that much of the fear of invading
boatpeople arises from a fear they will ‘take our jobs’.

Part of the genius of Howard’s identification of the potency of the boatpeople issue is that
it redefined the globalisation issue in a way that allowed him to get out in front of the
mob as the leading opponent of globalisation – to provide the very kind of leadership that
people in the regions and One Nation voters had been craving – without incurring the ire
of the business and economic supporters of globalisation. He found the one exception to
the globalisers’ rule: countries should be open to the free flow of all goods, services,
ideas, technology, capital and executive and highly skilled labour, but tightly limiting the
inflow of common-or-garden labour is AOK.

But what’s the opportunity cost of this cleverness? Now the Libs have experienced the
huge political benefits of setting themselves at the head of the anti-globalisation crowd,
are they really going to want to alienate that crowd by returning to a pro-globalisation
agenda? What price the business community’s push for a much bigger immigration
program? And what about the remaining islands of tariff protection? In its first term, the
Howard Government reviewed the post-2000 arrangements for the tariffs on motor
vehicles and textiles, clothing and footwear. It decided to freeze the 2000 rates for four
years, but then to catch up with the deferred reductions on the day after the freeze. In this
term, the Government’s challenge is to stick with its rather daring back-end loading,
resisting industry pressure to review the post-2004 arrangements and further postpone the
reduction. What do you reckon are the chances of it going to the barricades in defence of
free trade?

The unfinished agenda

The one area where Howard has made clear his determination to push on with reform is
industrial relations: exempting small business from the unfair dismissal law, further
limiting union access to workplaces, tightening the prohibition on secondary boycotts,
requiring secret ballots before strikes and banning unions from charging non-union
freeriders a fee for negotiating a collective agreement in their workplace. Most of these
measures have been blocked frequently in the Senate by Labor and the Democrats. The
chances of them changing their minds in this term are slim. So what’s Howard on about?
He’s playing politics, trying to knacker Crean from the start in the same way he so
successfully knackered Beazley. Howard and Costello made so much fuss about
Beazley’s $10 billion budget black hole that he was branded for all time as a bad
economic manager. Labor developed an inferiority complex about macro management, it
lived in fear of being asked ‘where’s the money coming from?’ and was never really
game to take the fight up to the Libs on the weaknesses in their economic performance.

This is why, once the Libs had raided the fiscal cookie jar, Labor was snookered. It could
see no alternative to standing up in the campaign and promising to splash out sixpence on
Rollback, sixpence on education and sixpence on health. Howard believes Crean’s
Achilles’ heel is his union background. So he’s bowling up the IR legislation as a (quote)
‘test of whether Mr Crean has really freed himself from union domination’. Crean being
Crean, he will try to find some compromise on which they can do a deal. But Howard
won’t be buying. He’s not on about getting whatever IR reform he can, he’s on about
stigmatising Crean in the eyes of the public and getting the drop over him from the off.

I believe Howard will add few if any new items to the reform agenda. There are many
unfinished items on the agenda, but I fear little progress will be made.

Telstra: has reached stalemate. Much as Howard and Costello would like to complete its
privatisation, this is unlikely. Labor and the Democrats retain control of the Senate and
their opposition is implacable. In any case, even the National Party is unlikely ever to
agree to it; the bush would never understand. For all intents and purposes, the era of
privatisation – federal and state – has come to an end.

Business taxation: many loose ends remain but, after all the angst of the past two years,
there’ll be little enthusiasm for tying them up, either from the Government or business.
Howard has promised to examine company tax arrangements affecting Australian
multinationals and is sure to do something. This could come under the heading of tax
reform, but is more likely to involve a few grudging, piecemeal concessions intended to
shut the Business Council up till next time. On another matter, if you’re still dreaming of
a cut in the top tax rate, dream on.

National competition policy: this is the progressive review of all anti-competitive state
and federal legislation. It’s meant to be micro reform on automatic pilot. But it’s grinding
along very slowly, without that fact disturbing the Howard Government or any other. The
Nats made various promises to throw further sand in the gears.

Review of Trade Practices Act and the ACCC: This election promise was intended to
look anti-Fels, but whether it ends up clipping his wings or adding to his feathers remains
an open question. The Prof gets up a lot earlier than his big-business detractors. Howard
made no bones about the purpose of the review: ‘It’s time we had another look at whether
the competition laws of this country preserve the right balance between large and small
within our community but, equally, allow for the development of sufficient critical mass
amongst our larger corporations that they can fully participate in a globalised economic
environment.’ Doesn’t sound like reform to me – more like special rates for business
mates. We’ll see how much eventuates. But there’s no doubt about the future of the Four
Pillars policy – it will still be standing inviolate in three years time.

Ageing policy: a nice, post-election idea to take this issue more seriously, but unlikely to
lead to any controversial policy measures. Howard may yield to the financial services
lobby’s pressure for a thorough review of superannuation – its adequacy and tax
arrangements – but I doubt it. His election promises on super would actually add to the
mess and amount to little more than the introduction of super tax concessions for rich
single-income families.

Fiscal policy

Turning now to fiscal policy, it won’t surprise you to hear that I’m not much impressed
with the way it’s been conducted in recent years. A key element in the Government’s reelection
strategy was to spend virtually all of the prospective budget surpluses, so as to
win votes by doing so and, just as important, so as to deny Labor the chance to do so.

Particularly in the latter objective, it succeeded brilliantly. Despite all the warning it had,
Labor was totally wrong-footed. With little to spend it had little policy to offer and little
to say about anything economic. If you fear, as I do, that the economy may be a lot
weaker next financial year than the Government’s forecasts imply, then a case can be
made for a discretionary increase in government spending, even to the point where it
takes the budget into deficit. But that case wasn’t made – either by the Government or by
Labor – and the new spending measures weren’t of an appropriately immediate, finite,
pump-priming nature.

We’ve been through five fat years in which the budget outcome has invariably come in
above budget – often well above. But I suspect that, between the raid on the surplus and
the economy’s move into what could be several years of slower growth, we may be
entering a period of lean years where budget outcomes come in below budget. In other
words, the underlying cash balance may well drop into deficit, as the fiscal balance
already has, to the turn this financial year of more than $3 billion.

But both Howard and Costello kept promising to keep the budget in surplus throughout
their new term. So, does this say we’re in for a tough, post-election budget next May to
haul the balance back into surplus? Not a snowball’s chance in hell. There’s a far higher
chance that, by then, the Government will see a need to supplement easy monetary policy
with further discretionary fiscal stimulus. But, even if we don’t reach that point, I reckon
it won’t be long before Costello has to do a lot of climbing down about the importance of
keeping the budget in perpetual surplus.

John Howard is inordinately proud of his achievement in ‘bringing the budget back to
surplus’. But Paul Keating used to be just as proud of his own, similar achievement. What
Keating discovered, however – much to his disillusionment - is that ‘bringing the budget
back to surplus’ isn’t a ‘reform’ – it isn’t something that needs to be fixed and then, once
fixed, stays fixed. It’s a chore to be repeated once-a-cycle. By the time he realised that,
despite his earlier labours, the budget had unfixed itself and needed to be ‘brought back
to surplus’ a second time, Keating had little stomach for the task. His interests had moved
on; been there, done that. It was his failure to re-apply his shoulder to the budgetary
wheel that left such a damaging inheritance for Beazley as Labor’s next leader. The
Beazley black hole crippled Labor for 5 years, robbing it of economic credibility and
budgetary flexibility. But the point is that the ultimate test of fiscal heroism is the second time-around test. We’ve yet to see whether Howard does any better on that test than
Keating did.

We know already, however, that the Government’s fiscal performance isn’t nearly as
impressive as it pretends. It’s much-trumpeted Charter of Budget Honesty has fallen well
short of expectations. It’s a flawed document, open to manipulation for political purposes,
which Costello has not hesitated to do. Despite its efforts to obfuscate the facts, we know
from John Edwards’s calculations that this Government’s levels of spending and taxation
as a proportion of GDP are remarkably high, and give the lie to its small government/low
tax pretensions. Nor does its much-boasted ‘fiscal framework’ live up to its billing. Its
medium-term fiscal strategy (to balance the budget on average over the cycle) is
admirable in principle but, since the Government’s reversal of its decision to publish
estimates of the structural budget balance, is unmeasurable in practice. We now have a
fiscal framework that is honoured by nothing more than bald assertion.

Finally, we have the Government introducing accrual accounting, converting its measures
and targets to an accrual basis (which, it assured us, was the superior measure), then
quietly switching them back to underlying cash when the going got tough. Even more
remarkable, it’s done so virtually without a peep from business economists who, if
they’ve even noticed, don’t seem to care. The fact that this year’s premature MYEFO
revealed a fiscal deficit of $3.1 billion for this financial year and $1.3 billion for next year
prompted no-one to cast aspersions on the whole bipartisan election-campaign farce of
manfully struggling to ensure that promises didn’t push the underlying cash balance into
even a million of deficit. It’s clear that business economists, as well as being weak on
politics, are weak on accounting. Someone in Treasury told them the cash measure is
more apposite for macroeconomic purposes, and they inquired no further. What that
someone didn’t both to tell them is that the cash measure is much easier to falsify than the
accrual measure. Few business economists realise the truth that the budget is already in
deficit.

Monetary policy

The market is still having a fair bit of trouble reading signals from the Reserve Bank. The
reason for that is simple: the Reserve is not very good at signalling. A big part of the
trouble is that the two institutions – the Reserve and the market – have quite different
objectives and don’t make adequate allowance for the other side’s different approach. So
there’s a lot of failed communication and, as every (successful) journalist understands,
that has to be the Reserve’s fault, not the market’s. Why? Because it’s the Reserve that’s
initiating the communication. If I write a column that’s misunderstood by thousands, it’s
idle for me to tell myself I’m surrounded by idiots. I attempted to communicate, but
failed. If I don’t like it, the only alternative is to lift my game.

The market assumes that every formal announcement from the Reserve – every statement
accompanying a policy move, every quarterly statement on monetary policy (SOMP) –
contains a signal about the Reserve’s future intentions. Sorry, it’s not that easy. The
confusing thing is that sometimes SOMPs contain a signal and sometimes they don’t.
Sometimes it suits the Reserve to signal and sometimes it doesn’t. When it doesn’t suit to
signal, the Reserve doesn’t bother. On those occasions, all the signal-like remarks in the
statement are merely backward-looking justifications of past decisions. The market is so
fanatically forward-looking that it’s incapable of recognising a backward-looking
statement when it sees one. What it forgets is that central bankers are bureaucrats, and
bureaucrats are obsessed by justifying their actions. They’re highly defensive animals. So
that’s our first culture clash.

Why would the Reserve not want to signal? Because it’s common for statements to be
issued at times when it doesn’t know what it plans to do at the next meeting. It will be
awaiting developments and reacting to them. When you break down the conduct of
monetary policy to its meeting-to-meeting moves, it’s a highly subjective business; it’s
artistry, not science. Should we go now or wait a month? Should we do 25 or make it 50?
Such decisions are the stuff of the monthly meeting, but they’ll be made on the flimsiest
of grounds. They’re not strategy, merely tactics. Often, the tactical decision will be based
on the question: which alternative would have the more helpful effect on confidence?
Often, the answer to that question will come from the governor’s gut-feel. Certainly, such
decisions will be made very late in the peace. And, without wishing to shock you too
deeply, it’s always possible that such tactical decisions will be finally determined in the
board meeting itself. (Which raises another issue: how would the board feel if the
outcome of its deliberations was regularly and clearly signalled a month before hand?)
So, while the Reserve has no desire to catch the market out, it simply can’t clearly signal
its detailed intentions in every formal statement because it doesn’t know what they are.

And here’s another major culture clash to be aware of. The Reserve is well aware that,
whether it waits a week or a month or even a few months to make its next move –
whether it does two 25s in a row or one 50 up-front – makes no discernable difference to
ultimate macro outcomes. In contrast, those distinctions mean everything to the markets. I
fear this difference of interest means the Reserve will never feel a need to keep the
market as well signalled as it would like to be.

A reality with which the Reserve needs to grapple more successfully, however, is this.
Though the Reserve may have times when it wants to send a signal and times when it
doesn’t, both the media and the markets have vested interests in receiving a signal every
time. So they’ll always find a signal, whether or not one’s been sent. That being the case,
it behoves the Reserve to do more to ensure that at least they don’t walk away with a
wrong signal. When the Reserve has no message to send and is merely boring away
justifying past actions, it should try harder to ensure it doesn’t inadvertently mislead
people as to its future intentions. It should at least leave people with the right impression
as to whether it retains a bias to tighten/loosen.
To get down to practicalities (and at the risk of st
ating the obvious), when you’re
scrutinising a statement in search of signals, there should be two items on your checklist:
one, what does it say about the balance of risks on inflation and, two, what does it say
about the balance of risks on activity? The answers to those two questions should tell you
as much as is being signalled about the Reserve’s intentions.

If we take last month’s SOMP as a case study, it did carry two signals. The first came in
the way the Reserve laid it on so thick about international conditions being ‘at their
weakest for many years’, with synchronicity being ‘all the more cause for concern’ and
how global growth had ‘turned out to be a good deal weaker than previously thought’.
Got that – or would you like some more? The second signal came with the announcement
that, at its November meeting, the board had ‘elected not to change the stance of policy
for the present’. This, I suspect, is the first time the Reserve has announced a nondecision.

What you had to work out was why. Taken a face value (and ignoring the extent
of the carry-on about the world economy), you could conclude that the Reserve was
pretty happy with the stance of policy by November 6, and only if there were more bad
news between then and now would it be likely to cut at its December meeting. But you
had to be able to supply a word that would never cross an independent central banker’s
lips – a word that started with ‘e’ and ended with ‘lection’. You had to know Ian
Macfarlane is too proud to admit that only in the most extreme circumstances would the
Reserve risk getting itself embroiled in the political fray by adjusting rates during an
election campaign. Most market participants knew that, but some – being so weak on
politics – hadn’t followed the logic through properly and wondered if the board had made
a decision at its November meeting and was waiting til after the election to announce it.

As John Edwards pointed out, you only have to think about that proposition for a minute
to realise that such behaviour would get the Reserve into at least as much trouble with the
pollies as changing rates during the campaign. But that was all the Reserve’s second
signal amounted to: if you were one of the mugs expecting a cut a day or two after the
election, forget it. There are some matters so sensitive that they’re written in invisible ink,
and you have write them in yourself. One was the Reserve’s attitude to elections, another
was the role of the GST in the Reserve’s decisions to tighten policy in the run up to July
2000.

Now for my call, which comes in five points. First, the Fed may have further to go than
the markets imagine. It will be prepared to cut further if it’s not confident that recovery is
on the way. It will regard the whole 200 basis points as available to be used and, as we
learnt last week, sees no need to keep its power dry.

Second, if the Fed eases more, the Reserve will ease more – though, as we’ve seen, not to
the same extent.

Third, our economy can’t go into recession unless consumer spending actually falls,
which isn’t likely. The downside risk that could produce such a fall is a savage bout of
cost-cutting and layoffs by big business as propitiation to the god of Shareholder Value.

Fourth, the big test for our economy should come mid-year, when housing has finished its
run. Will the US cavalry have perked up in time to rescue us? That’s the base-case hope,
but I have my doubts. Even if we are left in the lurch, however, that should mean weak
growth rather than negative growth. By the time the non-arrival of the US recovery had
become apparent, the Reserve would presumably have been easing further in anticipation
(as the Fed would have, too). By then there would be more serious consideration of the
need to supplement monetary stimulus with discretionary fiscal action.

Fifth, unless we’re very unlucky, at some point in the first half of next year both the Fed
and the Reserve will reach the end of what they need to do (though uncertainty means
they’re unlikely to signal clearly that this point has been reached). What happens then?

This is where our last culture clash arises. Central banks are perfectly happy to live with
protracted periods of inactivity, but the market (and the media) has a vested interest in
movement. So the easing phase isn’t over for five minutes before markets are bracing
themselves for the tightening phase. To rationalise this compulsive behaviour, the market
has already started telling itself how worried the central bankers will soon be about
rampant inflation. This conveniently overlooks the evident structural change in inflation
and productivity, as well as the central bankers’ track record in the sitting-on-their-hands
department. Consider our Reserve’s record. It held the cash rate steady at 4.75 per cent
for more than a year between July 1993 and August 1994, then held it at 5 per cent for 16
months between July 1997 and December 1998 and at 4.75 per cent for a further 11
months to November 1999.

So here’s my call: most of you guys will spend most of next year anticipating a rise in
rates that never eventuates.


The Political and Policy Outlook in Australia 2002

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