Reserve Bank moves to Plan B on interest rates

IT'S not at all clear that falling commodity prices - or the Reserve Bank's latest cut in the official interest rate - will lead to a lower Aussie dollar. But if it doesn't fall, and the economy doesn't look like it will stay growing at its trend rate, the Reserve will just keep cutting rates.

The best way to think of the Reserve's problem in using monetary policy (interest rates) to maintain non-inflationary growth is that for some years it's been trying to keep the economy on an even keel while we're being hit by two powerful, but opposing economic shocks: the expansionary shock from the resources boom and the contractionary shock from its accompanying very high exchange rate.

This involves predicting, then continuously monitoring the relative strengths of the opposing forces, with the objective of keeping inflation in the 2 to 3 per cent range and the economy growing at about its medium-term trend rate of 3.25 per cent a year - neither much less than that nor much more (because the economy's already close to full employment).

For most of last year the Reserve's greatest worry was that the stimulus from the resources boom, applied to an economy already near full employment, would push up inflation. By November it realised any inflation threat had passed - it was actually falling - whereas growth was on the weak side of trend. It therefore cut the cash rate by 125 basis points (1.25 percentage points) between November and June.
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The latest reassessment of the balance between the two conflicting forces bearing on the economy is that the fall in coal and iron ore prices and the shelving of expansion plans by some second-tier miners will cause mining investment spending to peak in the middle of next year, a little earlier and a little lower than expected.

This pushed the growth forecast for the overall economy a bit below trend. Hence this month's rate cut.

It's reasonable to attribute the Aussie's remarkable strength since the start of the resources boom predominantly to our high commodity export prices and vastly improved terms of trade.

That makes it reasonable to expect the fall in export prices would lead to a commensurate fall in the Aussie, thus reducing its contractionary effect on our export and import-competing industries.

But the historical correlation between our terms of trade and our exchange rate, while strong, can also be quite loose for fairly long periods. So it's not surprising the Aussie has held up so well.

The plain truth is that, because financial markets simply aren't as ''efficient'' as it suits some economists to believe, no theory they can come up with adequately and always explains the Aussie's ups and downs.

The best you can say is the terms-of-trade theory works well a lot of the time and over the medium to long term, while its main rival - that the Aussie's driven by the size of the ''differential'' between our interest rates and those on offer in the big economies - sometimes works at other times.

So it's equally unsurprising the 150-basis-point fall in our official interest rate since November has done little or nothing to get the Aussie down.

My guess is the Aussie could stay much where it is for years to come. Why? Because of a third, omnibus theory: those countries with the best growth prospects tend to have strong exchange rates whereas those with poor prospects tend to have weak exchange rates.

It's a safe bet that, even if we were to fail in our attempt to get growth back up to trend, our prospects will stay a mighty lot better than those for the United States and Europe. Then there's our AAA sovereign credit rating and exposure to the fastest-growing region, Asia, to entice capital inflows.

Remember, exchange rates are relative prices, so if some countries are down, others must be up. We're not alone in the strong-currency boat: there's also Switzerland, Canada, New Zealand and Sweden.

So, what if the Aussie stays up and its contractionary effect on the economy remains undiminished? The Reserve would just keep cutting the official rate until it foresaw growth getting back up to trend.

In principle, the only thing that could deter it from this response is rising inflation pressure, but with growth below trend that's hardly likely.

Its goal wouldn't be to get the dollar down (though that would be welcome) so much as to stimulate the presently ailing, interest-sensitive parts of the domestic economy: home building and commercial (as opposed to mining-related) construction.

This would quite possibly get house prices growing reasonably strongly which, in turn, could perk up consumer confidence, particularly for people in or near retirement.

But that's actually the vulnerability in such an approach by the Reserve. Returning to a period of exceptionally low mortgage interest rates risks igniting another credit-fuelled boom in property prices, at a time when many households remain heavily indebted and most foreign economists can't understand why we haven't had a property bust.

The rich world spent most of the 1970s, '80s and '90s worrying about how to get inflation down to acceptable levels. We now know that, particularly since the advent of independent central banks and inflation targeting, the central bankers have got (goods-and-services price) inflation licked.

One small problem: as the global financial crisis so powerfully reminded us, in the process they've aggravated the problem of asset-price inflation, with its huge bubbles and terrible busts.

To date, the world's monetary economists are at a loss on how they can control goods-price inflation and asset-price inflation at the same time.

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The Asia boom is just getting going

Have you noticed how joyfully the media trumpet the bad news they seek out so assiduously? The latest is that the resources boom is finally busting. O frabjous day! Callooh! Callay!

It's true the prices we're getting for our exports of coal and iron ore, having lifted the terms on which we trade with the rest of the world to their most advantageous level in 200 years in the September quarter of last year, have been falling ever since and have further to go.

It's true China's economy has slowed markedly in recent times and this, combined with the fall in export prices, has prompted some of our smaller mining companies to shelve their plans for new mines.

And last week the Reserve Bank warned the peak in mining investment spending was likely to occur next year and reach a lower level than earlier expected. Fearing a slowdown in the economy, it cut the official interest rate another notch.

So, is this the dumper many people have feared? Is the much ballyhooed resources boom about to disappear into the history books?

Don't be misled. As the secretary to the Treasury, Dr Martin Parkinson, argued last week, it was always misleading to think the resources boom, being just another boom, would soon bust, leaving us in the lurch with nothing to show but holes in the ground.

For a start, it's a bit previous to be kissing the boom goodbye. Spending on the building of new mines and liquefied gas plants is expected to keep growing strongly for another year before it starts to fall back. Even then it will stay way above what we normally see for several more years.

Coal and iron ore prices may be falling, but don't imagine they'll return to anything like what they were. At their best, our terms of trade - the prices we get for our exports relative to the prices we pay for our imports - were almost 80 per cent better than their average throughout the 20th century.

The econocrats now expect that, by 2019, they will have collapsed to a mere 50 per cent above that 100-year average. Nothing to show for it? This means we'll remain wealthier than we were (our exports will continue buying far more on world markets than they used to).

Taken by itself, this lasting improvement in our terms of trade suggests another thing we'll have to show is a dollar that stays well above the US70? or so it averaged in the decades following its float. That means a dollar that remains uncomfortably high for our manufacturers and tourism operators.

All this ignores a further benefit from the resources boom which, though it's already started, is largely still to come: vastly increased quantities of coal, iron ore and natural gas for export. This, too, adds to our wealth.

Before the start of this supposed here-today-gone-tomorrow "boom" - which began almost a decade ago - mining accounted for less than 5 per cent of the nation's total production of goods and services. Its share is now well on the way to 10 or 12 per cent.

At the same time, manufacturing's share will continue its decline from about 15 per cent in 1990 to 12 per cent at the start of the boom and 8 per cent today to maybe 6 per cent by the end of this decade. (Much of this decline, however, is explained by the faster growth of the services sector as we, like the rest of the rich world, move to a knowledge-based economy.)

So yet another lasting effect of this fly-by-night boom is a marked and lasting change in the structure of our economy. To the consternation of some, the non-services part of our economy is becoming less secondary and more primary.

The underlying reason for this shift is the same reason it was always mistaken to imagine this is a transitory commodity price boom like all those we've seen before: the economic emergence of the developing world, led by Asia.

With the industrialisation of China and India, the globe's centre of economic gravity is shifting from the North Atlantic to the Indian and Pacific oceans. It's happening so fast it's visible to the naked eye. All the economic troubles of the Europeans and Americans are speeding it up, not slowing it down.

Remember how the world's richest 20 per cent owned 80 per cent of the wealth? Forget it. The poor countries already account for half the world's annual production of goods and services. Over the next five years, they'll account for three-quarters of the growth in world production.

So we're witnessing a tremendous change in the structure of the world economy, something so big economic historians will still be talking about it in 200 years' time. Is it surprising the effects on our economy are so big and so lasting?

We're greatly affected because of our proximity but also because our economy is so complementary to the emerging Asian ones. We have in abundance what they need in abundance: primary commodities. Their need for our raw materials will roll on for decades, including as Indonesia transforms itself from the world's fourth most populous country to its fourth richest.

This raises the final reason the mining boom shouldn't be lightly dismissed. As Parkinson reminded us, it's just the first wave of change arising from the Asian century. Next comes the rural boom as global demand for agricultural produce surges.

The third wave is the global growth in the middle class - from half a billion to more than 3 billion souls - with its growing demand for better services, goods and experiences. Just another passing boom?

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IS THE HIGH AUSSIE DOLLAR REALLY BAD FOR THE AUSTRALIAN AND VICTORIAN ECONOMIES?

Economic Society Forum, Melbourne, Monday, August 20, 2012

Rather than plunging into a debate about whether policy makers should seek to influence our exchange rate and, if so, how they should go about it, I want to start by examining the reasons for people’s great concern about its present level. The high dollar is disadvantaging all our tradeables industries, but for the miners (and, to a lesser extent, the farmers) that’s being offset by the still exceptionally high prices they’re receiving, so we’re left with the manufacturers, tourism (which is both export and import-competing) and education of international students. But there’s been remarkably little public concern about the plight of the universities and the tourist operators. There’s been so little concern about tourism that the federal budget in May actually contained an increase in the special tax imposed on their industry, the departure tax, which went unremarked. So let’s not kid ourselves, we’re here tonight because of concern about the high dollar’s effect on manufacturing.

And I find this pretty puzzling. Why all this agonising about an industry that accounts for only about 8 per cent of the economy (and less of total employment), whose share of the economy has been declining for more than three decades? What’s so special about manufacturing? Why does news that a factory is closing and laying off 300 people cause far more consternation than news that a state government plans to lay off 10,000 people?

I can see why the punters imagine the economy to be built on the foundation of manufacturing, but I can’t see why anyone with any economic training would think it. I can see why the punters are susceptible to the physiocratic notion that goods matter but services don’t, but I can’t see why anyone with any economic training would think it. I can see why the punters are susceptible to the mercantilist notion that a country makes its living by trading with other countries, but I can’t see why anyone with any economic training would think it. So I can see why the punters imagine the economy to be composed of mining in the fast lane and manufacturing in the slow lane and not much else, but I can’t see why anyone with any economic training would think it. So I can see why the punters don’t realise that about three-quarters of the economy is the non-tradeables sector which, if anything, benefits from the high dollar via cheaper prices for imported materials and capital equipment, as well as from having customers who have higher disposable income thanks to lower prices for imported consumer goods and locally made import-competing goods.

I can see why the punters imagine we can assist manufacturing with protection, or by changing the value of the dollar, without that having any opportunity cost, but I can’t see why anyone with any economic training would think it. I can see why people who work in manufacturing are happy to advocate policies that favour manufacturing at the expense of the rest of the economy, but I can’t see why anyone with any economic training would be.

I can see why punters think retaining a large manufacturing sector is important to our self-sufficiency, but I can’t see why anyone with any economic training would think it. I can see why punters don’t understand that the way for an economy to get rich is to pursue its comparative advantage, but I can’t see why anyone with any economic training wouldn’t understand it. I can understand why the punters accept that structural change arising from technological advance can’t be argued with, but structural change arising from a change in our comparative advantage can be resisted, but I can’t understand why anyone with any economic training would think that way.

I can see why punters think mining is of little benefit to the economy because it’s so capital-intensive it employs very few workers, but I can’t see why anyone with any economic training would think that. I can see why punters imagine we live in six separate state economies that can grow at markedly different rates for years on end because they have no idea about the circular flow of income and how strong the linkages are between the states, through inter-state trade, the federal budget’s geographic redistribution of income, and the grants commission’s redistribution of state taxable capacity. I can see why punters don’t understand that one of the main means by which income is redistributed from the miners to the rest of us in the other states is, ironically, the high dollar. And why it would never occur to the punters that acting to lower the high dollar would reduce the extent to which the benefits of the resources boom were being redirected to the eastern states. But I can’t see why anyone with any economic training wouldn’t understand all that.

I can see why so many Victorians are convinced their state economy is heavily dependent on manufacturing. Victoria has a tradition of protectionism going back to the days of David Syme, there probably was a time when manufacturing accounted for a big share of the Victorian economy, Melbourne is the headquarters of the union movement and the manufacturing unions, and the Victorian media know stories about some threat to manufacturing strike a chord with their audience that stories about the problems of other industries don’t, so they happily reinforce the state’s perception of itself. But I can’t see why anyone who’s had a look at the figures lately would not have been disabused of this outdated notion.

Manufacturing’s share of national production is 8 per cent; its share of Victorian production is 9 per cent. In fact, manufacturing’s share is 8 or 9 per cent in all states bar WA, where it’s just 5 per cent. So if Victoria is just average on manufacturing, where does it stand out? Well, it has very little mining, but its great dependency is on - wait for it - business services, particularly financial services. Nationally, business services account for 23 per cent of production, but in Victoria their share is 28 per cent, which is almost as high as NSW’s 30 per cent. Business services are heavily concentrated in Victoria and NSW, where they account for at least 10 percentage points more than in the other states. The notion that Victoria and manufacturing go together is a myth.

When their attention is drawn to the difficulties facing manufacturing, the punters probably think the higher dollar is a bad thing. It wouldn’t occur to them that, apart from offering them cheap overseas holidays, the high dollar brings advantages as well as disadvantages. In particular, it represents the rest of the world volunteering to pay a premium for Australian assets. Why’s that a bad thing? And shouldn’t we think twice before doing what we can to stop them paying us so much? Taking measures to change the exchange rate involves changing the allocation of resources - probably in a less efficient direction. But it’s also, inescapably, redistributive. It involves governments deciding to take income from some people and give it to others. Let’s not kid ourselves it’s a free lunch.

I can understand why apologists for manufacturing bang on about Dutch disease. They want us to assume the resources boom will push the dollar sky-high, wipe out manufacturing, then disappear in a puff of smoke. But the analogy with the Dutch fails in two respects. First, their North Sea oil may have been used up in a few years, but our reserves of coal and iron ore won’t be. We’re going to be left with a much bigger mining sector to show for it. Second, I find it hard to see why the exchange rate isn’t going to stay uncomfortably high - well above its post-float average of about US75c - for at least the rest of the decade. It’s true commodity prices are coming down and that there’s a strong correlation between commodity prices and the Aussie dollar. But I doubt coal and iron ore prices are in the process of falling back anything like all the way to their pre-boom levels. And, in any case, the correlation has always been far from perfect. The dollar’s value is affected by an ever-changing range of factors we have no great handle on. Happy story-telling about how it’s all the fault of the Reserve Bank keeping the interest-rate differential too high, or wicked currency speculators, or wicked central banks buying Aussie bonds are delusional.

The key question is whether the uncomfortably high exchange rate is temporary or lasting. No one knows, but everything I see tells me it will stay up. If so, manufacturing - like all the rest of us - needs to get on with adapting to a changed world. The high dollar is not really bad for the economy, but it is really tough on much of the tradeables sector.

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Macro 'policy mix' returns to normal

In case you missed it, the secretary to the Treasury has spelt it out: with the budget's planned return to surplus next financial year, fiscal policy is being put back in the cupboard and the "policy mix" returned to normal.

Delivering his annual post-budget speech to the Australian Business Economists, Martin Parkinson outlined the "macro-economic framework" - the respective roles of fiscal policy (the manipulation of government spending and taxation), monetary policy (the manipulation of interest rates by the Reserve Bank) and the exchange rate.

"The primary responsibility for managing demand to keep the economy on a stable growth path consistent with low inflation" had been allocated to monetary policy, he said.

So "normal" is for monetary policy to be doing most of the work in keeping the economy steady. Its aim is "to maintain inflation between 2 and 3 per cent, on average, over the cycle". But, as you see, this doesn't mean the Reserve focuses on inflation to the exclusion of all else.

While keeping inflation low may be the target, the goal is non-inflationary growth - growth which should keep unemployment low.

And a key part of the mechanism for achieving low inflation and steady, job-creating growth is, in Dr Parkinson's words, "anchoring inflation expectations". Because the expectations of wage negotiators and businesses tend to influence the demands they make and the prices they set, keeping them expecting inflation to remain low is half the battle.

That's one of the main roles of the inflation target. Provided people are confident the Reserve will stick to its target - as they are - you can allow the economy to grow at a faster rate than otherwise.

Parkinson linked monetary policy with the exchange rate. "Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments," he said.

When, for instance, world commodity prices rise a lot and our terms of trade improve, the dollar tends to rise.

The extra national income flowing from the higher export prices would lead to a surge in demand that could be inflationary (and, in the days when our exchange rate was fixed, it was). But the higher exchange rate reduces the international price competitiveness of our export and import-competing industries which, by reducing exports and increasing imports, reduces the external component of aggregate demand (gross domestic product).

And this, combined with the direct reduction in the prices of imports, helps keep inflation under control. The exchange rate has thus absorbed some of the shock from the rise in commodity prices and so kept the economy growing steadily. When commodity prices fall, the process works in reverse.

But if monetary policy is the main policy instrument used to keep the economy on an even keel, what is fiscal policy's role?

Parkinson says a key objective of fiscal policy is "to maintain fiscal stability from a medium-term perspective". That is, to ensure we don't run so many budget deficits that, in time, we build up a level of government debt that becomes unsustainable.

(To see what nasty things can happen when you don't "maintain fiscal stability" look no further than Greece, with Italy and other European economies heading down the same track.)

But this is Parko's key message: "Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policy should work together to support activity, such as during the global financial crisis."

Let's unpack that mouthful. As we saw here last weekend, the budget contains "automatic stabilisers" that cause the budget balance to deteriorate when the economy turns down and improve when the economy turns up.

So the budget acts automatically to help stabilise the economy as it moves through the business cycle, with public sector demand expanding automatically at times when private sector demand is weak, and contracting automatically when private demand is strong.

Parkinson is saying this is a good thing and the macro framework requires that the automatic stabilisers be unimpeded in doing their job. That is, governments shouldn't take explicit ("discretionary") decisions that counter the effect of the stabilisers.

(Attempting to counter the stabilisers is exactly what the Brits and other Europeans are doing with their "austerity" policies. They've been slashing government spending at a time when the economy is weak. This weakens demand further, pushing the economy back into recession and, far from reducing the budget deficit, makes it worse. By ignoring elementary Keynesian principles, they've blundered into an adverse feedback loop.)

The next element in Parkinson's exposition of fiscal policy's role in the macro framework is that governments may take discretionary measures that reinforce the effect of the stabilisers, but only in extreme circumstances - such as a potentially serious recession.

In other words, apart from allowing the stabilisers to do their thing, it's not normal practice for fiscal policy to be used to manage the strength of demand from year to year. That's the job of monetary policy, for which it's better suited (because it can be adjusted quickly and easily and in small or large steps).

Parkinson says we've had such a "medium-term" approach to fiscal policy since the mid-1980s, "before evolving into a fully articulated framework with the development of [Peter Costello's] Charter of Budget Honesty in the second half of [the] 1980s". The charter requires the government of the day to announce a "medium-term fiscal strategy" and Wayne Swan's strategy is only marginally different from Costello's: "to achieve budget surplus, on average, over the medium term".

This formulation is carefully designed (by, I suspect, the Liberals' Senator Arthur Sinodinos) to allow the automatic stabilisers to push the budget into deficit during recessions - and even to permit governments to implement fiscal stimulus packages during recessions, as this government did - provided the stabilisers are unimpeded in returning the budget to surplus and any stimulus spending is ended.

This means that, over time, all the deficits incurred during downturns are roughly offset by all the surpluses achieved during upswings. The surpluses are used to pay off the deficits, thus keeping the level of government debt steady and sustainable over time.

So fiscal policy and monetary policy have different roles, and monetary policy and discretionary fiscal policy need to pull together only in emergencies.

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Why the budget isn't as contractionary as it looks

If you take the figures at face value, this week's budget is deeply contractionary, delivering a blow to demand at a time when parts of the economy aren't at all strong. But in economics, it's rarely wise to take things at face value.

There are different ways to assess the "stance" of fiscal policy - to work out the direction and size of the effect a budget will have on the economy. Settle back.

There's a two-way relationship between the budget and the economy. The decisions announced in the budget have an effect on the economy but, at the same time, the economy has an effect on the budget.

The budget contains elements - such as the progressive tax system and the availability of the dole to people without jobs - that have the effect of helping to stabilise the economy as it moves through the business cycle.

When the economy turns down, tax collections fall and more people go on the dole, which automatically worsens the budget balance. This worsening, however, helps to prop up (stabilise) the economy.

Then, when the economy starts to recover, these "automatic stabilisers" change direction. Tax collections grow faster than the rise in incomes and people find jobs and go off the dole. This improves the budget balance and also acts as a brake on the economy, stopping it from growing too fast and causing inflation problems.

These things happen automatically and their effect on the budget balance is called its "cyclical component". But governments can and do make their own decisions about increasing or decreasing taxes and government spending. The net effect of these discretionary moves on the budget balance is called its "structural component".

Now, when you assess the stance of budgetary policy the strict Keynesian way, you focus on the explicit policy decisions made in the budget (the structural component) and ignore the effect of the budget's automatic stabilisers (the cyclical component).

These days, however, the Reserve Bank and many economists tend to do it a simpler way that ignores the distinction between cyclical and structural. You just compare the budget balance for the old year with the planned balance for the new budget year.

The Treasurer, Wayne Swan, is expecting an underlying cash budget deficit in the financial year that's coming to an end, 2011-12, of $44.4 billion, but budgeting for a surplus of $1.5 billion in the coming year, 2012-13.

That's a turnaround of almost $46 billion. From one year to the next, the budget's net effect is to extract $46 billion from the economy - if it happens, the biggest one-year turnaround for almost 60 years.

It's equivalent to about 3 per cent of gross domestic product, which makes it absolutely huge. And since it's an extraction, you could only conclude it makes the stance of fiscal policy adopted in the budget highly contractionary. It would knock the stuffing out of the economy.

But here's where we mustn't take things at face value. Swan has had to move a lot of things around between years to make it possible to keep the Prime Minister, Julia Gillard's, election promise to get the budget back to surplus in 2012-13. When he's taken spending and pulled it forward into the last few weeks of the old financial year, that's not genuine for our purposes. For the government's accountants, whether something happens on June 30 or on July 1 makes all the difference in the world. You've got to draw the line somewhere, and that's where we draw it.

From the perspective of the budget's effect on the economy, however, a difference of a few days or a few weeks is a difference that doesn't make any difference.

And it turns out a big part of the $46 billion turnaround is explained by Swan's decision to draw spending forward into the last few weeks of the old year. There's compensation for the carbon tax (which doesn't start until July 1) of $2.7 billion, advance payment of natural disaster relief funds to Queensland of $2.3 billion, a bring-forward of infrastructure spending of $1.4 billion, the new "schoolkids bonus" cash splash of $1.3 billion, and financial assistance grants to local government of $1.1 billion.

That long list adds up to $8.8 billion. But here's the trick: when you take money out of one year and put it into the year before, you have twice the effect on the difference between the two years. So Swan's bring-forward of that spending explains $17.6 billion of the $46 billion turnaround.

Another thing to take account of is that the new year's budget is expected to benefit from increased revenue from resource rent taxes of $5.7 billion (that's from the existing petroleum rent tax as well as the new minerals rent tax). The point is that these taxes are explicitly designed to tax "economic rent", so they have no effect on the incentive to exploit petroleum or mineral deposits and thus have no effect on economic activity. A further factor is that, thanks to a quirk of public accounting, Swan's underlying cash surplus of $1.5 billion takes no account of the government's spending on the continuing rollout of the national broadband network.

The budget item "net cash flows from investment in financial assets for policy purposes" is expected to involve increased spending of about $6 billion in 2012-13. Not all of that would be the broadband network rollout. But to the extent it involves the government funding economic activity, it has the effect of reducing the budget's adverse effect on economic activity.

Put these three arguments together and you conclude the budget's drag on demand would be less than half the 3 percentage points of GDP we started with.

Even so, it's still a big effect. There's no denying the stance of fiscal policy is contractionary.

But the budget is only one of the factors affecting aggregate demand. It's also only one of the instruments available to the macro-economic managers to influence demand.

So if fiscal policy proves to be too tight, the obvious remedy will be to further loosen monetary policy - to cut the official interest rate, in plain English. The stance of monetary policy is already mildly expansionary and, if necessary, it can be made more so.

Is it a good thing to have the two arms of policy working in opposite directions? Sure it is - if you're hoping lower interest rates will lower our high dollar a little.

Such a lowering may have already occurred. If so, the effect will be expansionary.

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Let's slow down the mining boom

Innovative thinking is not only in short supply in Australia's businesses - as our weak productivity performance attests - it's also hard to find in the economic debate.

You could count on one hand the economists who do some lateral thinking and throw into the debate some new way of viewing a problem and overcoming the familiar difficulties.

But one economist who does come up with new ideas to think about is Dr Richard Denniss, director of the Australia Institute. He observes that while everyone's been debating whether the mining boom's a good thing or a bad thing, no one's focused on the obvious question: what rate of growth of the mining industry is consistent with the national interest?

And in a paper to be published today, written with Matt Grudnoff, he puts his conclusion: The Macro-Economic Case for Slowing Down the Mining Boom.

Why has this idea not occurred to anyone before? Partly because of the unthinking belief of almost all business people, politicians and economists that all economic growth is good and the faster the better.

When the new Queensland Premier announced his intention to speed up the approval process for new mines, most of the aforementioned would have nodded in approval. But why is faster than the economy can cope with better?

Partly, Denniss argues, because

of the way economists divide economic issues into micro and macro. As a micro issue the focus is on allowing private interests to make profitable investments as they see fit, with no more government intervention than is necessary to limit damage to the local environment.

As a macro issue the focus is on taking whatever strength of demand the private sector serves up and "managing" it to ensure it leads to neither excessive inflation nor excessive unemployment. If demand's too strong you raise interest rates to chop it back; if it's too weak you cut rates to beef it up.

But Denniss argues the boom's too big to fit this neat division. According to the Bureau of Agricultural and Resource Economics, there are 94 mining projects worth $173 billion at an advanced stage of development (plus a lot more at earlier stages).

For the miners to attempt such a huge amount of activity in such a short space of time inevitably creates what Denniss calls "macro-economic externalities" - adverse spillover effects on the rest of the economy, in the form of skilled labour shortages, wages pressure and probably a higher-than-otherwise dollar.

No one understands this better than the Reserve Bank, of course. But the higher-than-otherwise interest rates it has and will use to limit the inflation fallout from the boom aren't intended to (and couldn't be expected to) limit the boom.

Rather, they're intended to crimp the rest of us - in particular, consumer, housing and non-mining business investment spending - to "make room" for the boom-crazed miners. This will succeed in controlling inflation, no doubt, but what reason is there to believe it will lead to the most efficient allocation of the nation's resources?

Denniss suggests this thought experiment: if all of Australia's mineral resources were controlled by a profit-maximising monopolist, would it respond to the present exceptionally high world prices by building as many new mines as possible as quickly as possible?

Would a monopolist bid against itself for scarce labour and infrastructure capacity (to get the minerals to port and onto ships)? Or would it invest in training and infrastructure before it began expanding production?

His point is not to advocate monopoly, obviously, but to make clear the potential for conflict between the interests of the miners and the interests of the nation.

We are a monopolist in the sense that all the natural resources belong to us. Which means it's up to us to ensure they're exploited in the way that benefits us most. In this we need to remember the miners are largely foreign-owned (meaning we retain little of the after-tax profits) and the resources are non-renewable.

How much do we lose if they stay in the ground a little longer? Are we really expecting that within a decade or so the world won't be willing to pay much for them?

We're a monopolist also in the sense that it's our economy and we bear all the cost of the inflation and excessive exchange rate generated by the foreign miners' mad dash to expand production. We aren't a monopolist in the sense that we control the world supply of coal and iron ore, but we are big enough in the world market for our actions to have a significant effect on world prices.

A monopolist would be more inclined to sit back and enjoy the high world prices and less inclined to madly expand production and thereby undermine the high price (to coin a phrase). And to the extent a monopolist did expand, it would start with the most profitable opportunities and progress towards the least profitable.

Denniss's point is: why should we allow the miners to turn the decision about which mines get built first into a race rather than a ranking? And why should we bear the macro-economic costs generated by the miners' race to be first out the door with our resources?

He proposes that new mining projects be required to bid at auction for a set number of development permits. This would ensure the most profitable projects proceeded first.

And if you don't like the sound of that, he says the same effect could be achieved by removing the mining industry's present subsidies on fuel and alleged research and development spending.

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All hail mighty Aussie dollar, as it's here to stay

This year we'll see more painful evidence of Australian businesses accepting the new reality: our dollar is likely to stay uncomfortably high for years, even decades.

It has suited a lot of people to believe that just as the resources boom would be a relatively brief affair, so the high dollar it has brought about wouldn't last.

If there were no more to the resources boom than the skyrocketing of world prices for coal and iron ore, that might have been a reasonable expectation. But the extraordinary boom in the construction of new mining facilities makes it a very different story.

The construction boom is likely to run until at least the end of this decade, maybe a lot longer. The pipeline of projects isn't likely to be greatly reduced by any major setback in the world economy. That's particularly because so much of the pipeline is accounted for by the expansion of our capacity to export natural gas. The world's demand for gas is unlikely to diminish.

Last time I looked, the dollar was worth US105?, compared with its post-float average of about US75?. But that's not the full extent of its strength. At about 81 euro cents and 67 British pence it's the highest it's been against those currencies for at least the past 20 years.

In the context of the resources boom, the high exchange rate performs three economic functions. First, it helps to make the boom less inflationary, both directly by reducing the prices of imported goods and services and indirectly by lowering the international price competitiveness of our export- and import-competing industries.

Second, by lowering the prices of imports, it spreads some of the benefit from the miners' higher export prices throughout the economy. In effect, it transfers income from the miners to all those consumers and businesses that buy imports, which is all of them. So don't say you haven't had your cut.

Third, by reducing the price competitiveness of our export- and import-competing industries, it creates pressure for resources - capital and labour - to shift from manufacturing and service export industries to the expanding mining sector.

That is, it helps change the industry structure of the economy in response to Australia's changed "comparative advantage" - the things we do best among ourselves compared with the things other countries do best.

As businesses recognise the rise in the dollar is more structural than temporary and start adjusting to it, painful changes occur, including laying off workers. Paradoxically, this adjustment is likely to raise flagging productivity performance.

Economists have long understood that the exchange rate tends to move up or down according to movement in the terms of trade (the prices we receive for exports relative to the prices we pay for imports). This explains why the $A has been so strong, for most of the time, since the boom began in 2003.

But here's an interesting thing. In the December quarter of last year, our terms of trade deteriorated by about 5 per cent as the problems in Europe caused iron ore and other commodity prices to fall. They probably fell further this month.

This being so, you might have expected the $A to fall back a bit, but it's stayed strong and even strengthened a little. Why? Because when the terms of trade weakened, other factors strengthened. The main factor that's changed is the rest of the world's desire to acquire Australian dollars and use them to buy Australian government bonds.

Indeed, the desire to hold Australian bonds was so strong it more than fully financed the deficit on the current account of the balance of payments in the September quarter. It may have done the same in the December quarter. Among the foreigners more desirous of holding our bonds are various central banks.

Remember that, at the most basic level, what causes the value of the $A to rise on any day is that people want to buy more of them than other people want to sell. The price rises until supply increases and demand falls sufficiently to make the two forces equal.

So economists' theories about what drives the value of the $A are just after-the-fact attempts to explain why the currency moved the way it did. We know from long observation that there's a close correlation between our terms of trade and the $A.

But we also know this correlation is far from perfect. There have been times when the two parted company for a while. It's apparent the dollar is driven by different factors at different times.

And it now seems apparent that our relatively superior economic performance and prospects are taking over as the main factor driving the dollar higher (even though our terms of trade would have to deteriorate a mighty lot further before they were back to their long-term average).

There are various reasons why foreign investors (including central banks with currency reserves that have to be parked somewhere) would like to increase their holdings of Australian government bonds.

For a start, we're now one of the few "sovereigns" (national governments) still with a AAA credit rating. For another, the yield (effective interest rate) on Australian 10-year government bonds is almost 4 per cent, compared with about 2 per cent on US Treasury bonds or German bunds.

And the present and prospective state of our economy is a lot healthier than that of the North Atlantic and Japanese economies. Why are our prospects so much brighter and our interest rates higher? In short: the mining construction boom, of course.

It seems clear the world's financial investors are shifting their portfolios in favour of $A-denominated financial assets. And remember, because they're so much bigger than we are, what's only a small shift for them is a big deal for us.

All this suggests the Aussie will stay strong, even as our terms of trade fall back. Remember, too, the huge spending on mining construction over the years will require a lot of foreign financial capital to flow into Australia, helping keep upward pressure on the exchange rate.

This doesn't say the $A has become a safe-haven currency. Were some sudden disaster to occur in Europe it would probably take a dive as frightened investors rushed to the safe haven of US Treasury bonds.

But it probably wouldn't take long for the Aussie to recover - just as it didn't take long after the sudden disaster of the collapse of Lehman Brothers in 2008.

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Why economists are obsessed by the resources boom

The world is throwing two big things at our economy. One is new, exciting, even frightening, and is getting all the headlines. The other is old news and getting boring. But get this: the boring one is by far the more important.

The new and exciting story is the increasingly worrying developments in the euro area. The old story is the resources boom. Both come to us from the rest of the world. In terms of their effect on our economic growth, the resources boom is a huge stimulus, whereas Europe's problems are a drag on our growth. That drag is small so far but, if the worst comes to the worst, could be a big negative.

Another reason the commodity boom is less exciting is that we've had plenty of them before over our history. But one reason we shouldn't underestimate the boom is that, paradoxically, previous booms have really stuffed up our economy. And these booms can be great for some parts of the economy while making life really tough for other parts.

This week Treasury's Dr David Gruen gave a speech to the Australian Business Economists in which he compared this commodity boom with the one we had in the early 1970s. It helps you see why the econocrats who manage our economy are positively obsessed by the need to make sure we don't stuff this one up.

In contrast to this one, the commodities boom of the early '70s involved big rises in the prices we were getting for our agricultural exports. It got going under the McMahon Coalition government and continued under the Whitlam Labor government.

Comparing the two booms, after the first three years our terms of trade - the prices we receive for our exports compared with the prices we pay for our imports - had improved by about the same extent. In the '70s, they then fell back. This time, however, they continued improving to now be almost 50 per cent better than their best then.

So this boom is a mighty lot bigger - Gruen calls it a ''once-in-a-lifetime boom'' - and a lot longer. This one's been building for eight years (with a brief interruption by the global financial crisis), whereas the earlier one lasted only about three years. The reason this boom is much bigger and longer is that it arises from a historic shift in the structure of the world economy - the industrialisation of Asia - whereas the '70s boom arose merely from an upswing in the rich countries' business cycle.

The greater size and length of this commodity boom has two important implications. First, it's given our miners both the incentive and the time to invest in hugely increasing their capacity to export coal, iron ore and now natural gas. That didn't happen with farmers in the '70s. This present investment boom has added an extra dimension to this boom, thus causing its effect on the economy to be bigger.

Second, the '70s boom was too small and short to have much effect on the industry structure of our economy. But this boom will leave us with a much bigger mining and mining-related sector, thus reducing the relative size of other sectors and putting a lot of pressure to adjust on some industries, particularly manufacturing, tourism and education. It's actually changing our economy's ''comparative advantage'' (what we're good at relative to other countries).

Naturally enough, both commodity booms caused the economy to grow faster. But in the '70s growth was a lot more variable. Real gross domestic product grew almost 9 per cent over the year to March 1973, but by 1975 the economy was contracting. It recovered, then contracted again in 1977. Unemployment, which had been very low for many years, shot up and stayed up. This time, growth has been strong but steady and unemployment has fallen and then stayed pretty low.

In the '70s, the inflation rate took off, reaching a peak of 17 per cent in the mid-1970s and staying pretty high until the mid-1990s. Obviously, the '70s commodities boom can't take all the blame for this long period of economic malfunctioning. But it should get a fair bit, and it certainly got the rot off to a good start.

There's one other big difference between the two booms that does a lot to explain why this boom hasn't caused nearly as much volatility, inflation and unemployment as the first one did: the exchange rate.

The present boom quickly brought about a rise in the value of our dollar. Since June 2002 it has risen by about 45 per cent against the trade-weighted index. In the '70s, the rise didn't happen nearly as quickly or smoothly.

Why not? Because then we had a fixed exchange rate. It could be changed only by a government decision. For political reasons, the two governments waited too long and didn't do enough to get the dollar up.

The point is that our floating currency acts as a shock-absorber when the economy is hit by some shock - favourable or unfavourable - from abroad. In this boom, the higher dollar has caused the Australian-dollar income of the miners to rise by less than it would have, and has effectively handed that reduction in their income to all the other industries and individuals who buy imports. How's it done that? By making imports cheaper.

By transferring income from the miners to the non-miners, the high dollar has helped ensure the rest of Australia gets its cut from the boom, but it's also reduced the size of the commodity boom's effect on the growth in gross domestic product by directing a fair bit of the increased demand into imports. This has caused the boom to generate less inflation pressure, as well as directly reducing the prices of imported goods and services.

So it's clear the present boom has had far more benign effects on the economy than the '70s one did. Our economic managers get a lot of the credit for that, but much credit is due simply to our floating exchange rate.

Gruen concludes, ''if a sizeable boom is being generated in one part of the economy, significant restraint needs to be imposed on other parts to ensure that the economy overall does not overheat''. See what he's saying? Yes, you're right, there is a multi-speed economy and manufacturers and service exporters are doing it tough. But that's not happening by unhappy accident, it's happening by design. Live with it.

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We may be two-speed, but we are all sharing dividends

Forgive my absence at such an anxious time but I've been away on holiday in Western Australia, walking bits of the Bibbulmun Track, which runs from Perth to Albany. The wildflowers were unbelievable. And so was the affluence in Perth, where the mining companies' skyscrapers are so tall they can be seen from Rottnest Island, 19 kilometres away.

How'd you like to be living in Perth, in the winners' circle where everything is on the up, not doing it tough in Sydney or Melbourne, on the wrong side of the two-speed economy?

Actually, things in Perth aren't as wonderful as it suits envious easterners to imagine. Know what they complain about in the West? The two-speed economy. Most of them think they're missing out. Some people may be raking it in, but not me. I'm not on some fabulous salary, just paying the exorbitant house prices the well-to-do have brought about.

Now where have I heard that before? What is it about Australians at present - on both sides of the continent - that makes them so convinced they're missing out and battling to get by?

According to polling by Labor, 68 per cent of respondents believe average Australians aren't benefiting from the mining boom. Is that how you feel? If so, you haven't thought about it. As someone said, there are more things in heaven and earth than are dreamt of in your philosophy.

After such a long plane trip, I was half expecting WA to be like another country. And it's true they have things we don't: magnificent tall trees - jarrah, karri and marri - and strange animals such as quokkas. But step into the bush and it's very much part of Australia: gum trees everywhere, kangaroos and kookaburras.

It's the same story economically. They may have huge reserves of natural gas and iron ore that we don't, but their economy is really just a corner of the greater Australian economy. As the locals are the first to tell you, a lot of the money they make soon finds its way into the pockets of people Over East.

For a start, there are no customs barriers between the states, so there's a lot of trade between them. Step into a WA supermarket and you see they're selling just the same stuff ours do. Which means most of what they're selling was manufactured on the east coast.

Their big mining companies have been making huge profits for the best part of a decade. Nothing to do with you? Every east-coaster with superannuation has a fair bit of their savings invested in the shares of those big companies. So you've been getting your cut.

Your super's been looking a bit sick in recent years? That's mainly because of problems in the rest of the world. Whatever you've got, it'd be looking a lot sicker without the resources boom.

Those mining companies are subject to the federal government's 30 per cent tax on company profits. And the feds' company tax collections have been massive since the resources boom started in the early noughties.

Do you realise that under Howard and Rudd we had cuts in income tax eight years in a row? Where do you think the money came from to finance those cuts?

In the economy, everything's connected to everything else. So if you're conscious of only the direct connections you're missing a lot of the story. And no connection is more indirect - or mysterious - than the way the governments of NSW and Victoria have been benefiting from the good fortune of the WA and Queensland governments.

This arises from our longstanding commitment to the principle of ''horizontal fiscal equalisation'' - which holds that all Australians, no matter where they live, are entitled to the same quality of government services.

That ain't easy, particularly because most government services - education, hospitals, law and order, roads - are delivered by the states. The cost per person of delivering services varies with how big and decentralised the states are. But another factor is the states' varying capacities to raise revenue. These days, states gaining royalty payments from their big mining industry have considerable ''taxable capacity''.

To bring horizontal fiscal equalisation about, the Commonwealth Grants Commission does many intricate calculations which determine how the $48 billion-a-year proceeds from the feds' goods and services tax are divided among the states. The commission works out the average amount of GST paid per person throughout Australia, then decides whether each state requires more or less than that, per person, to be able to deliver services of equal standard.

This equalisation process was introduced in the early 1930s to mollify the restive West Australians. Until just a few years ago, it meant Victoria and NSW got a lot less than the national average, while South Australia and Tasmania got a lot more than average and Queensland and WA got a bit more.

In 2004-05, NSW got just 83 per cent of the national average GST paid per person, while Victoria got 84 per cent. WA got 104 per cent and Queensland got 107 per cent (with SA getting 123 per cent and Tasmania 171 per cent).

But the huge increase in the resource states' taxable capacity thanks to booming mining royalties has changed all that. This financial year NSW's cut has risen to 96 per cent and Victoria's to 90 per cent, whereas Queensland's cut has fallen to 93 per cent and WA's to - get this - 72 per cent.

It works out that, in effect, Queensland's benefit from its mining royalties this year will be reduced by $1.2 billion and WA's by $2.5 billion. Of their combined loss of $3.7 billion, NSW gains $1.3 billion and Victoria $1.8 billion.

Still think you're getting nothing from the boom?

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