If there's no 'price gouging' how come interest rates are so high?

The nation’s economists have a dirty little secret. They all believe that what the punters denigrate as “price gouging” is actually a good thing, part of the mechanism by which a market economy returns to “equilibrium” (balance) after it’s been hit by an inflationary shock.

But they have a visceral hatred of terms such as “price gouging” and “profiteering”, and are always producing graphs and calculations purporting to prove that the recent surge in inflation – the worst in about 40 years – has produced no increase in company profits.

What they don’t seem to have noticed, however – or maybe are hoping none of us have noticed – is that you can’t argue that demand has been growing stronger than supply and so causing price increases, thus justifying using higher interest rates to slow down demand, and at the same time claim there’s no evidence that profits have risen.

Sorry, guys. You can’t have it both ways. If you claim there’s been no noticeable rise in profits, you’re contradicting the Reserve Bank’s main justification for its 13 increases in the official interest rate since May 2022. (Which is funny, considering the Reserve has been prominent among those seeking to deny that profits have risen.)

That main justification has been that much of the worsening in the rate of price increases has been caused by “excessive demand”, thus necessitating higher interest rates to discourage us from spending so much.

But how exactly does excessive demand lead to higher prices? It’s simple. When there are more people wanting to buy my product than I and my suppliers can keep up with, I could leave the price I’m charging unchanged, in which case it won’t be long before my shelves are empty, and I have nothing to sell.

That’s not the way it works in practice, however, nor the way it works in economic theory. I take advantage of strong demand to raise the price at which I’m selling the item. Why do I do this? Because, like all business people, I’m trying to maximise my profit.

The higher price means I won’t be selling my stock as fast as I was – so it will take longer for my shelves to empty – but I’ll still be better off.

Economists say that when demand exceeds supply, the stuff still available has to be rationed, one way or another. One way to ration supply is simply to keep selling at an unchanged price until everything is sold. After that, everyone who comes later misses out.

But when the seller raises their price, economists call this “rationing by [higher] price”. They believe this is always the better solution to the rationing problem because it does so in a way that uses the “market mechanism” to fix the problem.

The higher price encourages would-be buyers to reduce their demand – by wasting less of the product, or finding a cheaper substitute – while encouraging suppliers to produce more of the now-more-profitable product.

So because the higher price reduces demand while increasing the supply, the price mechanism causes the price of the item to fall back towards what it first was. Brilliant. Another win for market forces.

But this means a (possibly temporary) rise in prices is an essential part of the price mechanism. So a consequent rise in profits is also an inevitable part of the mechanism.

It’s gone out of fashion but, long ago, economists would say there were two causes of inflation: “cost-push” and “demand-pull”.

Sometimes firms raise their prices because they’re passing on the higher costs they’re paying for their inputs. At other times they’re raising their prices simply because the high demand for their product allows them to.

We now know from the work of behavioural economists that ordinary consumers accept it’s OK for businesses to raise their prices because of their higher costs. But they regard raising your prices just because shortages in supply let you get away with it as exploitative. (The classic example is charging more for umbrellas on rainy days.)

This dual, supply caused and demand-caused, explanation for inflation fits well with the Reserve’s analysis of the origins of the great surge in prices – in all the developed economies – in late 2021 and 2022.

Part of it was from disruptions to supply caused mainly by the COVID-19 pandemic, but also the Ukraine war, which pushed up the cost of building materials, various manufactured goods, shipping and oil and gas. But part of it was caused by the excessive stimulus applied to the economy by governments and central banks during the pandemic and its lockdowns, which had caused the demand for goods and services to run ahead of the economy’s ability to produce them.

Increasing interest rates can do nothing to increase supply, and the end of the lockdowns would see supply gradually return to normal, the Reserve reasoned. But higher rates could dampen the excess demand caused by all the extra government spending and rock-bottom interest rates that was applied to ensure the lockdowns didn’t lead to a lasting recession.

See how this analysis is undermined by claims there’s no sign of firms earning higher profits in the post-pandemic period? It implies that there’s no sign of excess demand, suggesting the surge in prices must have come only from supply disruptions and other cost increases.

In which case, the justification for maintaining high interest rates is greatly weakened. It implies that demand hasn’t been growing excessively and, rather than waiting for the supply problems to resolve themselves, we’re going to batter down demand to fit.

If so, that would be a very painful solution to a temporary problem. And, unlike the inflation problem we suffered in the 1970s, there’s no way this inflation surge can be blamed on excessive growth in wage costs.

Real wage growth had been weak long before the pandemic arrived. And in 2020, many workers were persuaded to skip an annual wage rise in the belief that we’d entered a lasting recession. As we subsequently discovered, government handouts to business meant many businesses sailed through the pandemic with few scratches.

Why so many economists want us to believe that, despite decades of increased market concentration – more industries dominated by just a few huge firms – and despite excessive monetary and budgetary stimulus, profits never increase, I’m blowed if I know.

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Albo’s quiet quest: stop wasting so much taxpayers’ money

If you’ve gained the impression that Anthony Albanese’s government is one that knows what it should be doing to fix our various problems, but lacks the courage to do anything that might be controversial – even just including questions in the census about people’s sexual orientation – I can’t tell you you’ve got the wrong idea.

What people outside Canberra often don’t realise is how obsessed governments, of either colour, become with how their opponents will react to anything they do or say. Albo seems to have a bad case of this.

It’s something economists understand from their study of the behaviour of duopolies. Albanese has forgotten the golden rule of competition laid down by the social psychologist Hugh Mackay: to compete successfully, focus on your customers, not your competitors.

But while Albo’s lack of courage keeps hitting the headlines, it’s not the whole story of this government. Behind the scenes, it’s gearing up to do a better job of ensuring that the many billions of taxpayers’ money it spends each year are more effective in improving our lives.

Governments don’t deliberately waste our money. Almost all of it is spent with the intention of making us safer, improving our health, adding to our education, ensuring we don’t starve because we can’t find a job or are too old to work, or just to help us travel from A to B more easily.

But while almost all government spending is done with good intentions, a surprising amount of it does little to achieve its stated objectives. Why? Because we’re spending on things we’ve always spent on, doing things the way we’ve always done them. Because we’re spending on new things just in the fond hope this will make things better. And because our spending choices are guided by ideology, anecdotes or – and this one’s a favourite – because it’s spending you know will give voters the impression things are improving.

After decades of pursuing the quest of making government smaller – by privatising government-owned businesses and paying private businesses to deliver government-funded services – Albanese and Treasurer Jim Chalmers are on a quest to make government better.

They’ve set up within the Treasury the Australian Centre for Evaluation, which will co-operate with other departments in assessing government spending programs to see how well they are achieving their objectives. The goal is to build a body of evidence of what spending works and what doesn’t. Spending programs should be based on such evidence, not on hunches and hopes.

Last week, Treasury secretary Dr Steven Kennedy gave a long speech outlining his department’s commitment to “evidence-informed policymaking”.

For many years, the medical profession has been committed to using “randomised controlled trials” to evaluate the effectiveness of medicines and medical procedures. These involve experiments where subjects are divided into two groups selected at random. One group is given the pill or the procedure, then compared with the “control” group to see what difference it made.

Now the econocrats want to use this technique to evaluate government spending. And on Tuesday Dr Andrew Leigh, the assistant minister for competition, charities and treasury, gave a speech on evidence-based policing.

Controlled experiments have been used to study the effectiveness of police behaviour in America for many years. For instance, it’s widely believed that the use of body cameras will improve the way police treat members of the public.

But a study involving more than 2000 police officers in Washington DC found that wearing cameras had an insignificant effect on police use of force and on civilian complaints. Their benefit was in providing better evidence in court.

In Australia, the Queensland community engagement trial tested the effect of training in “procedural justice” on citizens’ views of the police. Traffic police were taught to use a script when speaking to drivers stopped for random breath testing.

The study found it improved drivers’ views of the police, though they were no more likely to obey officers’ directions. (But I doubt if many people disobey the coppers, no matter how impolite they are.)

Many randomised trials involving the police are being conducted in Victoria. One seeks to reduce the number of people who fail to appear in court after being summonsed.

It tests the effect of providing simpler information, replacing a 2200-word, seven-page document with a 60-word statement and links to support services from Victoria Legal Aid and the Victorian Aboriginal Legal Service.

The initial results show that the shorter document leads to better court attendance, and thus fewer arrests and incarcerations of people who don’t turn up. The results of many more experiments are on the way.

Meanwhile, the Brits have set up a What Works Centre for Crime Reduction, and Leigh hints that we may do something similar in Australia.

Policing is just one example, of course. It all seems pretty laborious, but if it leads to less ineffective spending and better government it’s a worthwhile endeavour. And not before time.

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We should stop using a blunt instrument to manage the economy

In the economy, as in life, it helps a lot if you learn from your mistakes. Or, if you’re in public life, from the mistakes of your predecessors.

Accordingly, the caning that former Reserve Bank governor Dr Philip Lowe got for his assurance that interest rates wouldn’t rise before 2024 does much to explain why his successor, Michele Bullock, has been so persistently cagey about the future of rates.

Even as she’s announced a decision that the official cash rate was to be left unchanged, she’s warned that it may need to rise in future. And indeed, that the case for raising it had been seriously considered.

But last week, with the herd sniffing in the wind the smell of rate cuts, she took her life in her hands and got a lot more specific – though not before muttering the incantation that she was not providing “forward guidance” (that was the crime Lowe was convicted of).

In a carefully rehearsed line, she said that a “near-term reduction in the cash rate does not align with the board’s current thinking”. Oh yes, and what does “near term” mean? The next six months, she said.

“Current” thinking. Get it? In other words, that thinking could change over, say, the next six months. Especially because, as she repeated, the board’s decisions would depend on what the economic indicators were telling it. And, as she keeps saying, “the outlook remains highly uncertain”.

It’s clear many people aren’t convinced the board’s thinking against cutting rates will stay unchanged for the next six months. Because the financial markets are so heavily into betting, their predictions are almost always based on what they expect the Reserve will do.

But there are plenty of other, simpler souls, whose emphasis is on what they believe the Reserve should do to ensure it avoids the recession it says it wants to avoid.

The other point about learning from your mistakes and adventures is the familiar problem that those who were around at the time of lesson-learning pass on, handing over to people who weren’t around to have learnt.

This is what worries me as the Reserve ploughs on, determined to ensure the inflation rate returns to the centre of its target range within a time that the Reserve itself judges to be the maximum time acceptable. This determination seems to be regardless of the source of the forces that are slowing the return to mid-target and making it “bumpy”.

When the Reserve was granted operational independence by the elected government in the mid-1990s, its bosses at the time understood a truth I’m not sure their successors still understand. When you’re not free of the politicians, you can leave the politics to them. But when you are free of them, you have to do your own politics.

Now, I’ve been a great supporter of central bank independence. It’s been one experiment that time has shown to be a big improvement on leaving interest rates to the pollies. But we, and the central bankers, must understand that central bank independence is an uneasy fit with democracy.

We now have a situation where the central bank has the most control over whether the economy is plunged into severe recession, but the only people the voters can punish for this are not the central bankers, but the government of the day.

So, to get specific, if the Reserve Bank decides inflation can’t be fixed without a recession or, more likely, miscalculates and leaves interest rates too high for too long, it won’t be Michele Bullock that voters punish, it will be Anthony Albanese and his government.

Guess what? Should that happen, Labor is likely to be angry and vengeful. And, as Bullock’s predecessors understood, should government pass to the Liberals, their strongest emotion is likely not to be gratitude, but a determination that the Reserve won’t be allowed to trip them up the way it tripped up Labor.

With independent central banks being the long-established convention throughout the developed world, would any government of ours be game to strip the Reserve of its independence? Probably not.

But politicians have other, less noticeable ways of bringing independent institutions to heel. The usual way – practised by the previous federal government with the Administrative Appeals Tribunal and the Fair Work Commission, and by Donald Trump with the US Supreme Court – is to stack appointments to the board with people who share the government’s predispositions.

So there will be a way for the politicians to pass the voters’ punishment on to the Reserve should it stuff up. This is why it does have to do its own politics.

And there’s another, far more positive way that could be used to clip the Reserve’s wings. This episode of tightening, much more than any previous episode since the day-to-day management of the macroeconomy was handed over to the Reserve in the 1980s, has revealed just how unfair and ineffective it is to make the manipulation of interest rates the dominant instrument for managing the strength of demand.

As research by Associate Professor Ben Phillips of the Australian National University has confirmed, the much-lamented cost-of-living crisis has been imposed on households with big mortgages far more than on any other households.

When you take account of the way rents actually fell during the lockdowns, renters haven’t been hard hit, while those who own their homes outright have been laughing. People on pensions or the dole have been protected by indexation.

So the reliance on interest rates to reduce demand is hugely unfair. But it’s also lacking in effectiveness. All of us have contributed to the excessive demand for goods and services, but only the minority of us with big mortgages have been pressed directly to pull back our spending.

This is why our management of the macroeconomy needs reform. We need another, much broader-based instrument that could be used as well as, or in place of, interest rates. Temporary changes in the rate of the goods and services tax are one possibility, but I’m attracted to the idea of temporary changes to the rate of compulsory superannuation contributions.

The two instruments – one interest rates, and the other budgetary – could be controlled by a new independent authority.

Despite all the Reserve’s apologies for having just a single, blunt tool and all the hardship it causes home buyers, we’ll wait a long time before it suggests sharing its power with a rival independent authority.

As well, the banks have ways of ensuring they benefit from rising interest rates, while financial markets want to keep betting at Reserve Bank race days.

So I’m tempted by the thought that only if the Reserve stuffs up and causes a severe recession are we likely to see the reform to macroeconomic management we so badly need.

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The RBA has squeezed us like a lemon, but it's still not happy

Let me be the last to tell you the economy has almost ground to a halt and is teetering on the edge of recession. This has happened by design, not accident. But it doesn’t seem to be working properly. So, what happens now? Until we think of something better, more of the same.

Since May 2022, the Reserve Bank has been hard at work “squeezing inflation out of the system”. By increasing the official interest rate 4.25 percentage points in just 18 months, it has produced the sharpest tightening of the interest-rate screws on households with mortgages in at least 30 years.

To be fair, the Reserve’s had a lot of help with the squeezing. The nation’s landlords have used the shortage of rental accommodation to whack up rents.

And the federal government’s played its part. An unannounced decision by the Morrison government not to continue the low- and middle-income tax offset had the effect of increasing many people’s income tax by up to $1500 a year in about July last year. Bracket creep, as well, has been taking a bigger bite out of people’s pay rises.

With this week’s release of the latest “national accounts”, we learnt just how effective the squeeze on households’ budgets has been. The growth in the economy – real gross domestic product – slowed to a microscopic 0.1 per cent in the three months to the end of March, and just 1.1 per cent over the year to March. That compares with growth in a normal year of 2.4 per cent.

This weak growth has occurred at a time when the population has been growing strongly, by 0.5 per cent during the quarter and 2.5 per cent over the year. So, real GDP per person actually fell by 0.4 per cent during the quarter and by 1.3 per cent during the year.

As the Commonwealth Bank’s Gareth Aird puts it, the nation’s economic pie is still expanding modestly, but the average size of the slice of pie that each Australian has received over the past five quarters has progressively shrunk.

But if we return to looking at the whole pie – real GDP – the quarterly changes over the past five quarters show a clear picture of an economy slowing almost to a stop: 0.6 per cent, 0.4 per cent, 0.2 per cent, 0.3 per cent and now 0.1 per cent.

It’s not hard to determine what part of GDP has done the most to cause that slowdown. One component accounts for more than half of total GDP – household consumption spending. Here’s how it’s grown over the past six quarters: 0.8 per cent, 0.2 per cent, 0.5 per cent, 0.0 per cent, 0.3 per cent and 0.4 per cent.

A further sign of how tough households are doing: the part of their disposable income they’ve been able to save each quarter has fallen from 10.8 per cent to 0.9 per cent over the past two years.

So, if the object of the squeeze has been to leave households with a lot less disposable income to spend on other things, it’s been a great success.

The point is, when our demand for goods and services grows faster than the economy’s ability to supply them, businesses take the opportunity to increase their prices – something we hate.

But if we want the authorities to stop prices rising so quickly, they have only one crude way to do so: by raising mortgage interest rates and income tax to limit our ability to keep spending so strongly.

When the demand for their products is much weaker, businesses won’t be game to raise their prices much.

So, is it working? Yes, it is. Over the year to December 2022, consumer prices rose by 7.8 per cent. Since then, however, the rate of inflation has fallen to 3.6 per cent over the year to March.

Now, you may think that 3.6 per cent isn’t all that far above the Reserve’s inflation target of 2 per cent to 3 per cent, so we surely must be close to the point where, with households flat on the floor with their arms twisted up their back, the Reserve is preparing to ease the pain.

But apparently not. It seems to be worried inflation’s got stuck at 3.6 per cent and may not fall much further. In her appearance before a Senate committee this week, Reserve governor Michele Bullock said nothing to encourage the idea that a cut in interest rates was imminent. She even said she’d be willing to raise rates if needed to keep inflation slowing.

It’s suggested the Reserve is worried that we have what economists call a “positive output gap”. That is, the economy’s still supplying more goods and services than it’s capable of continuing to supply, creating a risk that inflation will stay above the target range or even start going back up.

With demand so weak, and so many people writhing in pain, I find this hard to believe. I think it’s just a fancy way of saying the Reserve is worried that employment is still growing and unemployment has risen only a little. Maybe it needs to see more blood on the street before it will believe we’re getting inflation back under control.

If so, we’re running a bigger risk of recession than the Reserve cares to admit. And if interest rates stay high for much longer, I doubt next month’s tax cuts will be sufficient to save us.

Another possibility is that what’s stopping inflation’s return to the target is not continuing strong demand, but problems on the supply side of the economy – problems we’ve neglected to identify, and problems that high interest rates can do nothing to correct.

Problems such as higher world petrol prices and higher insurance premiums caused by increased extreme weather events.

I’d like to see Bullock put up a big sign in the Reserve’s office: “If it’s not coming from demand, interest rates won’t fix it.”

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No one's sure what's happening in the economy

Treasury secretary Dr Steven Kennedy let something slip when he addressed a meeting of business economists last week. He said it was too early to say if the economy was back in a more normal period, “perhaps because no one is quite sure what normal is any more”.

This was especially because “unusual economic outcomes are persisting,” he added.

Actually, anyone in his audience could have said the same thing – but they didn’t, perhaps because they lacked the authority of the “secretary to the Treasury”.

No, standard practice among business economists and others in the money market is to make all predictions with an air of great certainty. Forgive my cynicism, but this may be because their certain opinion changes so often.

Often, it changes because something unexpected has happened in the US economy. Many people working in our money market save themselves research and thinking time by assuming our economy is just a delayed echo of whatever’s happening in America.

If Wall Street has decided that America’s return to a low rate of inflation has been delayed by prices becoming “sticky”, rest assured it won’t be long before our prices are judged to have become sticky as well.

But predicting the next move in either economy has become harder than we’re used to. Kennedy noted in his speech that, in recent years, the global economy, including us, had been buffeted by shared shocks, such as a global pandemic, disruptions to the supply of various goods, and war.

One factor I’d add to that list is the increasing incidence of prices being disrupted by the effects of climate change, particularly extreme weather events, but also our belated realisation that building so many houses on the flood plain of rivers wasn’t such a smart idea.

All these many “shocks” to the economy have knocked it from pillar to post, and stopped it behaving as predictably as it used to. But, as we’ll see, not all the shocks have been adverse.

Right now, the change everyone’s trying to predict is the Reserve Bank’s next move in its official interest rate, which most people hope will be downward.

Normally, that would happen just as soon as the Reserve became confident the inflation rate was on its way down into the 2 to 3 per cent target range. And normally, we could be confident the first downward move would be followed by many more.

But since, like Kennedy, the Reserve is not quite sure what normal is, and Reserve governor Michele Bullock says she expects the return to target to be “bumpy”, it may delay cutting rates until inflation is actually in the target zone.

If so, and remembering that monetary policy, that is, interest rates, affects the economy with a “long and variable lag”, the Reserve will be running the risk that it ends up hitting the economy too hard, and causing a “hard landing” aka a recession, in which the rate of unemployment jumps by a lot more than 1 percentage point.

Kennedy was at pains to point out that the rise in the official interest rate of 4.25 percentage points over 18 months is the “sharpest tightening” of the interest-rate screws since inflation targeting was introduced in the early 1990s.

He also reminded us how much help the Reserve’s had from the Albanese government’s fiscal policy, which has been “tightened at a record pace”. Measured as a proportion of gross domestic product, the budget balance has improved by about 7 percentage points since the pandemic trough. Add the states’ budgets and that becomes 7.5 percentage points.

That’s a part of the story those in the money market are inclined to underrate, if not forget entirely. Kennedy reminded them that, since 2021, our combined federal and state budget balance has improved by more than 5 percentage points of GDP. This compares with the advanced economies’ improvement of only about 1.5 percentage points.

So, has our double, fiscal as well as monetary, tightening had much effect in slowing the growth of demand for goods and services and so reducing inflationary pressure?

Well, Kennedy noted that, over the year to December, households’ consumption spending was essentially flat. And consumer spending per person actually fell by more than 2 per cent.

When you remember that consumer spending accounts for more than half total economic activity, this tells us we’ve had huge success in killing off inflationary pressure. And this week, when we see the national accounts for the March quarter, they’re likely to confirm another quarter of very weak demand.

So, everything’s going as we need it to? Well, no, not quite.

Last week we learnt that, according to the new monthly measure of consumer prices, the annual inflation rate has risen a fraction from 3.4 to 3.6 per cent over the four months to April.

“Oh no. What did I tell you? The inflation rate’s stopped falling because prices are “sticky”. It’s not working. Maybe we need to raise interest rates further. Certainly, we must keep them high for months and months yet, just to be certain sure inflation pressure’s abating.”

Well, maybe, but I doubt it. My guess is that a big reason money market-types are so twitchy about the likely success of our efforts to get inflation back under control is the lack of blood on the streets that we’re used to seeing at times like this.

Why isn’t employment falling? Why isn’t unemployment shooting up? Why are we only just now starting to see news of workers being laid off at this place and that?

It’s true. The rate of unemployment got down to 3.5 per cent and, so far, has risen only to 4.1 per cent. Where’s all the blood? Surely, it means we haven’t tightened hard enough and must keep the pain on for much longer?

But get this. What I suspect is secretly worrying the money market-types, is something Kennedy is pleased and proud about.

“One of the achievements of recent years has been sustained low rates of unemployment,” he said last week. “The unemployment rate has averaged 3.7 per cent over the past two years, compared with 5.5 per cent over the five years prior to the pandemic.”

Our employment growth has been stronger than any major advanced economy over the past two years, he said. Employment has grown, even after accounting for population growth.

And we’ve seen significant improvements for those who typically find it harder to find a job. Youth unemployment is 2.6 percentage points lower than it was immediately before the pandemic.

So, what I suspect the money market’s tough guys see as a sign that we haven’t yet experienced enough pain, the boss of Treasury sees as a respect in which all the shocks that have buffeted us in recent times have left us with an economy that now works better than it used to.

And Kennedy has a message for the Reserve Bank and all its urgers in the money market.

“It is important to lock in as many of the labour market gains as we can from recent years. This involves macroeconomic policy aiming to keep employment near its maximum sustainable level consistent with low and stable inflation,” he said.

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How the budget was hijacked by a $300 cherry on the top

Talk about small things amusing small minds. It looked like a textbook-perfect exercise in budget media management by Anthony Albanese’s spin doctors. Until it blew up in the boss’s face. Trouble is, it wasn’t just the tabloid minds that got side-tracked. So did the supposed financial experts.

Budget nights are highly stage-managed affairs, as the spinners ensure all the mainstream media are focused on the bit the boss has decided will get the budget a favourable initial reception.

You pre-announce – or “drop” to a compliant journo – almost all the budget’s measures, big or small, nice or nasty. This time they even revealed the exact size of the old year’s surplus. But you hold back one juicy morsel, knowing the media’s obsession with what’s “old” and what’s “new” will guarantee it leads every home page.

I call it the cherry on the top. And this time it was the $300 energy rebate going to all households. A prize for everyone (except the pensioners, who last year got $500) and proof positive that Jim Chalmers feels their cost-of-living pain. (It would have been much better to announce the rejig of the stage 3 tax cuts, of course, but Albo had to play that card early, to help with a dicey byelection.)

How were the spinners to know the punters would be incensed when they realised it would even be going to Gina Rinehart? And get this: if a billionaire owned, say, 10 investment properties, they’d be getting 11 lots of $300. Outrageous.

The way some tabloids tell it, the punters were so offended they were rioting in the streets, demanding Chalmers stick their $300 up his jumper. It was the Beatles returning their MBEs.

Why wasn’t the rebate means tested? Perfectly good reason: because that would have been more trouble and expense than it was worth. Don’t bother mentioning: because, apart from being a popular giveaway, the rebate’s other purpose was to help reduce the consumer price index by 0.5 of a percentage point, and means testing it would have reduced the reduction.

How so many shock jocks and journos could get so steamed up about such a small thing is hard to explain. But what’s much harder to explain is why so many otherwise sensible economists got so steamed up about the wickedness and counterproductive wrongheadedness of it.

I think it’s a perfectly sensible device to hasten progress in getting inflation down to the target zone, and by no means the first time governments have used it. The temporary energy rebate will cost $3.5 billion over two years and the continuing increase in the Commonwealth rent allowance for people on social security will cost $880 million over its first two years.

So while it’s true that increased government spending adds to inflationary pressure, to argue furiously about $4.4 billion in an economy worth $2.7 trillion a year shows the lack of something the late great econocrat Aussie Holmes said every economist needed: “a sense of the relative magnitudes”. It’s chicken feed.

But the financial experts’ righteous indignation about what they see as an inflationary attempt to fudge the inflation figures seemed to utterly distort their evaluation of the budget and its effect on the macroeconomy.

The budget was a “short-term shameless vote-buying exercise” in which Labor abandoned all pretence of fiscal responsibility and went on a massive spending spree. The budget’s return to surplus had been abandoned, leaving us with deficits as far as the eye could see. We now had a permanent “structural deficit”. The hyperbole flowed like wine.

It’s true that the policy decisions announced in the budget are expected to add $24 billion to budget deficits over the next four years. But if, as the financial experts assert, getting inflation down ASAP is the only thing we should be worrying about, then it’s really what’s added in the coming year that matters most. Which reduces the size of Chalmers’ crimes to less than $10 billion.

It’s true, too, that the expected change in the budget balance from a $9 billion surplus in the financial year just ending, to a deficit of $28 billion in the coming year, is a turnaround of more than $37 billion. Clearly, and despite Chalmers’ denials, this changes the “stance” of fiscal policy from restrictive to expansionary.

But the financial experts seem to have concluded this development can be explained only by a massive blowout in government spending. Wrong. It’s mainly explained by the $23-billion-a-year cost of the stage 3 tax cuts.

Perhaps they were misled by the budget’s Table of Truth (budget statement 3, page 87) which, like everything in economics, has its limitations. The tax cuts don’t rate a mention. Why not? Because they’ve been government policy since 2018, and so have been hidden deep in the budget’s “forward estimates” for six years.

But whatever its main cause, surely this shift to expansionary fiscal policy puts the kybosh on getting inflation back down to the target range? Well, it would if shifts in the stance of the macroeconomic policy instruments were capable of turning the economy on a sixpence.

Unfortunately, the first rule of using interest rates to slow down or speed up the economy is that this “monetary policy” works with a “long and variable lag”.

The financial experts seem to have forgotten that managing the strength of demand – and fixing inflation without crashing the economy – is all about getting your timing right.

So is predicting the consequences of a policy change. Two years of highly restrictive monetary and fiscal policies won’t be instantly reversed by a switch to expansionary fiscal policy. As the new boss of the Grattan Institute, Aruna Sathanapally, has wisely noted, at the heart of the budget is the sad truth that the economy is weak, which is one reason inflation will fall.

The inflation rate peaked at just under 8 per cent at the end of 2022. By March this year it had fallen to 3.6 per cent. To me, that’s not a million miles from the Reserve Bank’s target range of 2 per cent to 3 per cent.

But the financial experts seem to have convinced themselves there’s a lot of heavy lifting to go. They even quote one brave soul saying the Reserve will need two more rate rises. I think it’s more likely we’ll get down to the target in the coming financial year, and that the move to expansionary fiscal policy will prove well-timed to help reverse engines and ensure the Reserve achieves its promised soft landing.

Chalmers’ decision to use the $300 rebate to reduce the consumer price index directly by 0.5 of a percentage point adds to my confidence. It’s particularly sensible if, as the financial experts have convinced themselves, the inflation rate’s fall is now “sticky”.

Those dismissing this decline as merely “technical” display their ignorance of how wages and prices are set outside the pages of a textbook. To everyone but economists, the CPI is the inflation rate. It’s built into many commercial contracts and budget measures.

It’s a safe bet this device will cause the Fair Work Commission’s annual increase in minimum award wage rates – affecting the bottom quarter of the workforce – to be about 0.5 of a percentage point lower than otherwise. And do you really think employers won’t take the opportunity to reduce wage rises accordingly? I doubt they’re that generous.

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Budget's message: maybe we'll pull off the softest of soft landings

When normal people think about the economy, most think about the trouble they’re having with the cost of living. But when economists think about it, what surprises them is how well the economy’s travelling.

It’s been going through huge ups and downs since COVID arrived in early 2020. By 2022, it was booming and the rate of unemployment had fallen to 3.5 per cent, its lowest in almost 50 years. Meaning we’d returned to full employment for the first time in five decades.

Trouble was, like the other rich economies, prices had begun shooting up. The annual rate of inflation reached a peak of almost 8 per cent by the end of 2022.

The managers of the economy know what to do when the economy’s growing too fast and inflation’s too high. The central bank increases interest rates to squeeze households’ cash flows and discourage them from spending so much.

The Reserve Bank started raising the official “cash” interest rate in May 2022, just before the federal election. It kept on raising rates and, by November last year, had increased the cash rate 13 times, taking it from 0.1 per cent to 4.35 per cent.

While this was happening, Treasurer Jim Chalmers was using his budget – known to economists as “fiscal policy” – to help the Reserve’s “monetary policy” to increase the squeeze on households’ own budgets, reducing their demand for goods and services.

Why? Because, when businesses’ sales are booming, they take the chance to whack up their prices. When their sales aren’t all that brisk, they’re much less keen to try it on.

The government’s tax collections have been growing strongly because many more people had jobs, or moved from part-time to full-time, and because higher inflation meant workers were getting bigger pay rises.

As well, iron ore prices stayed high, meaning our mining companies paid more tax than expected.

Chalmers tried hard to “bank” – avoid spending – all the extra revenue. So, whereas his budget ran a deficit of $32 billion in the year to June 2022, in the following year it switched to a surplus of $22 billion, and in the year that ends next month, 2023-24, he’s expecting another surplus, this time of $9 billion.

So, for the last two years, Chalmers’ budget has been taking more money out of the economy in taxes than it’s been putting back in government spending, thus making it harder for households to keep spending.

Guess what? It’s working. Total spending by consumers hardly increased over the year to December 2023. And the rate of inflation has fallen to 3.6 per cent in the year to March. That’s getting a lot closer to the Reserve’s target of 2 to 3 per cent.

The Reserve’s rate rises have been the biggest and fastest we’ve seen. Wages haven’t risen as fast as prices have and, largely by coincidence, a shortage of rental accommodation has allowed big increases in rents.

And on top of all that you’ve got the budget’s switch from deficits to surpluses. Much of this has been caused by bracket creep – wage rises causing workers to pay a higher average rate of income tax, often because they’ve been pushed into a higher tax bracket.

Bracket creep is usually portrayed as a bad thing, but economists call it “fiscal drag” and think of it as good. It acts as one of the budget’s main “automatic stabilisers”, helping to slow the economy down when it’s growing too quickly and causing higher inflation.

The Reserve keeps saying it wants to get inflation back under control without causing a recession. But put together all these factors squeezing household budgets, and you see why people like me have worried that we might end up with a hard landing.

Which brings us to this week’s budget. The big news is that in the coming financial year the budget is expected swing from this year’s surplus of $9 billion to a deficit of $28 billion.

This is a turnaround of more than $37 billion, equivalent to a big 1.3 per cent of annual gross domestic product. So, whereas for the past two financial years the “stance” of fiscal policy has been “contractionary” (acting to slow the economy), it will now be quite strongly “expansionary” (acting to speed it up).

Some people who should know better have taken this turnaround to have been caused by a massive increase in government spending. They’ve forgotten that by far the biggest cause is the stage 3 tax cuts, which will reduce tax collections by $23 billion a year.

The same people worry that this switch in policy will cause the economy to grow strongly, stop the inflation rate continuing to fall and maybe start it rising again. But I think they’ve forgotten how weak the economy is, how much downward pressure is still in the system, and how long it takes for a change in the stance of policy to turn the economy around.

Treasury’s forecasts say the economy (real GDP) will have grown by only 1.75 per cent in the financial year just ending, will speed up only a little in the coming year and not get back to average growth of about 2.5 per cent until 2026-27.

So, the rate of inflation will continue falling and should be back into the target range by this December. All this would mean that, from its low of 3.5 per cent – which had risen to 4.1 per cent by last month – the rate of unemployment is predicted to go no higher than 4.5 per cent.

That would be lower than the 5.2 per cent it was before the pandemic, and a world away from the peak of about 11 per cent in our last big recession, in the early 1990s.

So maybe, just maybe, we’ll have fixed inflation and achieved the softest of soft landings. Treasury’s forecasting record is far from perfect, to put it politely, but it is looking possible – provided we don’t do something stupid.

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Chalmers finds a better way to get inflation down: fix the budget

There’s an important point to learn from this week’s mid-(financial)-year’s budget update: in the economy, as in life, there’s more than one way to skin a cat.

The big news is that, after turning last year’s previously expected budget deficit into a surplus of $22 billion – our first surplus in 15 years – Treasurer Jim Chalmers is now expecting this financial year’s budget deficit to be $1.1 billion, not the $13.9 billion he was expecting at budget time seven months’ ago.

Now, though $1.1 billion is an unimaginably huge sum to you and me, in an economy of our size it’s a drop in the ocean. Compared with gross domestic product – the nominal value of all the goods and services we expect to produce in 2023-24 – it rounds to 0.0 per cent.

So, for practical purposes, it would be a balanced budget. And as Chalmers says, it’s “within striking distance” of another budget surplus.

This means that, compared with the prospects for the budget we were told about before the federal election in May last year, Chalmers and Finance Minister Katy Gallagher have made huge strides in reducing the government’s “debt and deficit”. Yay!

But here’s the point. We live in the age of “central bankism”, where we’ve convinced ourselves that pretty much the only way to steer the economy between the Scylla of high inflation and the Charybdis of high unemployment is to whack interest rates up or down, AKA monetary policy.

It ain’t true. Which means Chalmers may be right to avoid including in the budget update any further measures to relieve cost-of-living pressures and, rather, give top priority to improving the budget balance, thereby increasing the downward pressure on inflation.

The fact is, we’ve always had two tools or instruments the managers of the economy can use to smooth its path through the ups and downs of the business cycle, avoiding both high unemployment and high inflation. One is monetary policy – the manipulation of interest rates – but the other is fiscal policy, the manipulation of government spending and taxation via the budget.

This year we’ve been reminded how unsatisfactory interest rates are as a way of trying to slow inflation. Monetary policy puts people with big mortgages through the wringer, but lets the rest of us off lightly. This is both unfair and inefficient.

Which is why we should make much more use of the budget to fight inflation. That’s what Chalmers is doing. The more we use the budget, the less the Reserve Bank needs to raise interest rates. This spreads the pain more evenly – to the two-thirds of households that don’t have mortgages – which should be both fairer and more effective.

Starting at the beginning, in a market economy prices are set by the interaction of supply and demand: how much producers and distributors want to be paid to sell you their goods and services, versus how much consumers are willing and able to pay for them.

The rapid rise in consumer prices we saw last year came partly from disruptions to supply caused by the pandemic and the Ukraine war. There’s nothing higher interest rates can do to fix supply problems and, in any case, they’re gradually going away.

But another cause of the jump in prices was strong demand for goods and services, arising from all the stimulus the federal and state governments applied during the pandemic, not to mention the Reserve’s near-zero interest rates.

Since few people were out of job for long, this excessive stimulus left many workers and small business people with lots to spend. And when demand exceeded supply, businesses did what came naturally and raised their prices.

How do you counter demand-driven inflation? By making it much harder for people to keep spending so strongly. Greatly increasing how much people have to pay on their mortgages each month leaves them with much less to spend on other things.

Then, as demand for their products falls back, businesses stop increasing their prices and may even start offering discounts.

But governments can achieve the same squeeze on households by stopping their budgets putting more money into the economy than they’re taking out in taxes. When they run budget surpluses by taking more tax out of the economy than they put back in government spending, they squeeze households even tighter.

So that’s the logic Chalmers is following in eliminating the budget deficit and aiming for surpluses to keep downward pressure on prices. This has the secondary benefit of getting the government’s finances back in shape.

But how has the budget balance improved so much while Chalmers has been in charge? Not so much by anything he’s done as by what he hasn’t.

The government’s tax collections have grown much more strongly than anyone expected. Chalmers and his boss, Anthony Albanese, have resisted the temptation to spend much of this extra moolah.

The prices of our commodity exports have stayed high, causing mining companies to pay more tax. And the economy has grown more strongly than expected, allowing other businesses to raise their prices, increase their profits and pay more tax.

More people have got jobs and paid tax on their wages, while higher consumer prices have meant bigger wage rises for existing workers, pushing them into higher tax brackets.

This is the budget’s “automatic stabilisers” responding to strong growth in the economy by increasing tax collections and improving the budget balance, which acts as a brake on strong demand for goods and services.

There’s just one problem. Chalmers has joined the anti-inflation drive very late in the piece. The Reserve has already raised interest rates a long way, with much of the dampening effect still to flow through and weaken demand to the point where inflation pressure falls back to the 2 per cent to 3 per cent target.

We just have to hope that, between Reserve governor Michele Bullock’s monetary tightening and Chalmers’ fiscal tightening, they haven’t hit the economy much harder than they needed to.

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Why it's doubtful we need another interest rate rise

There’s nothing the media likes more than an interest rate rise on Melbourne Cup day. It’s surprising how often it’s happened, and many in the financial markets have convinced themselves that’s what we’ll get next Tuesday. And the good news is that, despite the radical reform of moving to a mere eight board meetings a year, the Reserve Bank has ensured that meetings on cup day will continue.

What I’m not sure of is whether, if we do get a rate rise next week, it will be happening by accident or design. In central banking, getting your timing right is just as important as it is in a comedy routine.

It was no surprise last week when new Reserve Bank governor Michele Bullock used her first big speech to make sure everyone noticed her bulging anti-inflation muscles. “There are risks that could see inflation return to target more slowly than currently forecast,” she warned.

“The board will not hesitate to raise the cash rate further if there is a material upward revision to the outlook for inflation,” she said. She added some qualifications but, predictably, neither the markets nor the media took much notice of them.

Any new governor would have said the same in their first speech. Trouble is, her tough statement about not being willing to return to the 2 to 3 per cent inflation target “more slowly than currently forecast” came just the day before publication of the consumer price index for the September quarter.

And while it showed the annual rate of inflation continuing to fall from its peak of 7.8 per cent at the end of last year to 5.4 per cent nine months later, it also showed the quarterly inflation figure rising from 0.8 per cent to 1.2 per cent.

This was 0.2 percentage points or so higher than the markets – and, they calculate, the Reserve – were expecting. Bingo! Rate rise a dead cert. All the big four banks are laying their bets accordingly.

But the main reason for the slightly higher number was a rise in petrol prices, which contributed 0.25 percentage points of the 1.2 per cent. This rise comes from insufficient supply: the higher world price of oil, forced up the OPEC oil cartel and others trying to increase the price by restricting their supply.

It does not come from excessive Australian demand – which is the one factor the Reserve can moderate by increasing interest rates. Similarly, the next-biggest price increases, for newly-built homes (imported building materials), rents (surge in immigration) and electricity (Ukraine war) aren’t caused by anything a rate rise can fix.

So I think the case for yet another rate rise is weak. As Bullock clearly demonstrated elsewhere in her speech, the Reserve’s single, crude instrument, raising interest rates, delivers most of its punishment to the quarter or so of households with big mortgages.

Too many of these people are really hurting, and the full hurt from rate rises already made has yet to be felt. The economy is slowing, consumer spending is hardly growing, real income per person is falling.

And, as Treasury secretary Dr Steven Kennedy noted in a speech last week, last financial year’s budget surplus of $22 billion shows the budget’s “automatic stabilisers” are working hard to help the Reserve restrain demand – a truth that’s been completely missing from the Reserve’s commentary. That’s gratitude for you.

But if, having thought hard about such a small change to the “outlook for inflation”, Bullock decides a further rate rise isn’t warranted, what are the money market punters (and I do mean people making bets) going to think, considering all her chest-beating? That she speaks big but carries a soft stick?

There are a few things she – and her urgers in the financial markets (most of whom have never in their lives had reason to worry about the cost of living) – need to remember.

First, at this late stage in the game, we really are into fine-tuning. And acting because a revised forecast means we’ll return to target later than we had expected suggests you’ve forgotten what every governor needs always to remember: as with all economists, the Reserve’s forecasts are more likely to be wrong than right.

They can be wrong by a lot or wrong by a little. Worst, they can prove too optimistic or too pessimistic. If your previous forecast was wrong, what makes you so sure your next one will be right? When it comes to forecasts, the person making the actual decisions needs to be the biggest sceptic.

Second, the Reserve’s previous forecast was for inflation to be back to the top of the target range by the first half of 2025. If its latest forecast pushes that out to the second half, what’s so terrible about that? How much extra pain for young people with huge mortgages does that justify?

Ah, says the Reserve, the reason we can’t wait too long to get inflation back to target is that, the longer we leave it, the greater the risk that business’ and workers’ expected rate of inflation rises above the target range.

If that happened, we’d need much higher interest rates and much more pain to get expectations back down to the only range we’ve decided is acceptable.

This is true in principle but, in practice, it’s mere speculation. The fact is, the world’s central bankers have no hard evidence on how long it takes for inflation expectations to adjust – a few years or a few decades.

I’m old enough to remember that when inflation returned, in the late-1960s and early-’70s, it took a decade or two for expectations to adjust. The smarties used to advise youngsters to borrow as much as anyone would lend them. Why? Because real interest rates were negative.

But when a decade or two of tough inflation fighting eventually got expectations down to what became the target range, after the recession of the early ’90s, they’ve shown zero sign of moving for 30 years. Not even during the present inflation surge.

So when nervous-nelly governors decide to err on the safe side, they’re deciding to beat young home buyers even further into the ground. Either sell your house or starve your kids.

Finally, in her answers to questions last week, Bullock implied that the risk of rising inflation expectations was now so great that the Reserve could no longer afford the nicety of distinguishing between supply-side shocks and price rises driven by excessive demand.

Whatever the cause, continuing delay in getting inflation back to target presented such a threat to expectations that rates would have to keep rising regardless.

This means that if our return to target is delayed by supply-side problems – mismatches in the transition to renewable energy, leaps in meat and veg prices caused by extreme weather, or higher oil prices caused by worsening conflict in the Middle East – the home buyers cop it.

In this era of continuing supply shocks, failure to distinguish between the causes of price rises would be a recipe for deep recession. The Reserve’s professed “dual mandate” – full employment – would be out the window.

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How Philip Lowe was caught on the cusp of history

Outgoing Reserve Bank boss Dr Philip Lowe was our most academically outstanding governor, with the highest ethical standards. And he was a nice person. But if you judge him by his record in keeping inflation within the Reserve’s 2 to 3 per cent target – as some do, but I don’t – he achieved it in just nine of the 84 months he was in charge.

Even so, my guess is that history will be kinder to him than his present critics. I’ve been around long enough to know that, every so often – say, every 30 or 40 years – the economy changes in ways that undermine the economics profession’s conventional wisdom about how the economy works and how it should be managed.

This is what happened in the second half of the 1970s – right at the time I became a journalist – when the advent of “stagflation” caused macroeconomists to switch from a Keynesian preoccupation with full employment and fiscal policy (the budget) to a monetarist preoccupation with inflation and monetary policy (at first, the supply of money; then interest rates).

My point here is that it took economists about a decade of furious debate to complete the shift from the old, failing wisdom to the new, more promising wisdom. I think the ground has shifted again under the economists’ feet, that the macroeconomic fashion is going to swing from monetary policy back to fiscal policy but, as yet, only a few economists have noticed the writing on the wall.

As is his role, Lowe has spent the past 15 months defending the established way of responding to an inflation surge against the criticism of upstarts (including me) refusing to accept the conventional view that TINA prevails – “there is no alternative” way to control inflation than to cut real wages and jack up interest rates.

If I’m right, and economists are in the very early stages of accepting that changes in the structure of the economy have rendered the almost exclusive use of monetary policy for inflation control no longer fit for purpose, then history will look back more sympathetically on Lowe as a man caught by the changing tide, a victim of the economics profession’s then failure to see what everyone these days accepts as obvious.

Final speeches are often occasions when departing leaders feel able to speak more frankly now that they’re free of the responsibilities of office. And Lowe’s “Some Closing Remarks” speech on Thursday made it clear he’d been giving much thought to monetary policy’s continuing fitness for purpose.

His way of putting it in the speech was to say that one of the “fixed points” in his thinking that he had always returned to was that “we are likely to get better outcomes if monetary policy and fiscal policy are well aligned”. Let me give you his elaboration in full.

“My view has long been that if we were designing optimal policy arrangements from scratch, monetary and fiscal policy would both have a role in managing the economic cycle and inflation, and that there would be close coordination,” Lowe said.

“The current global consensus is that monetary policy is the main cyclical policy instrument and should be assigned the job of managing inflation. This is partly because monetary policy is more nimble [it can be changed more quickly and easily than fiscal policy] and is not influenced by political considerations.”

“Raising interest rates and tightening policy can make you very unpopular, as I know all too well. This means that it is easier for an independent central bank to do this than it is for politicians,” he said.

“This assignment of responsibility makes sense and has worked reasonably well. But it doesn’t mean we shouldn’t aspire to something better. Monetary policy is a powerful instrument, but it has its limitations and its effects are felt unevenly across the community.”

“In principle, fiscal policy could provide a stronger helping hand, although this would require some rethinking of the existing policy structure. In particular, it would require making some fiscal instruments more nimble, strengthening the (semi) automatic stabilisers and giving an independent body limited control over some fiscal instruments.”

“Moving in this direction is not straightforward, but some innovative thinking could help us get to a better place,” Lowe said.

“During my term, there have been times where monetary and fiscal policy worked very closely together and, at other times, it would be an exaggeration to say this was the case.”

“The coordination was most effective during the pandemic. During that period, fiscal policy was nimble and the political constraints on its use for stabilisation purposes faded away. And we saw just how powerful it can be when the government and the Reserve Bank work very closely together.”

“There are some broader lessons here and I was disappointed that the recent Reserve Bank Review did not explore them in more depth,” Lowe said.

So was I, especially when two of Australia’s most eminent economists – professors Ross Garnaut and David Vines – made a detailed proposal to the review along the lines Lowe now envisages. (If Vines’ name is unfamiliar, it’s because most of his career was spent at Oxbridge, as the Poms say.)

But no, that would have been far too radical. Much safer to stick to pointing out all the respects in which the Reserve’s way of doing things differed from the practice in other countries – and was therefore wrong.

In question time, Lowe noted that one of the world’s leading macroeconomists, Olivier Blanchard, a former chief economist at the International Monetary Fund (and former teacher of Lowe’s at the Massachusetts Institute of Technology), had proposed that management of the economy be improved by creating new fiscal instruments which would be adjusted semi-automatically, or by a new independent body, within a certain range.

Lowe also acknowledged the way the marked decline over several decades in world real long-term interest rates – the causes of which economists are still debating – had made monetary policy less useful by bringing world nominal interest rates down close to the “zero lower bound”.

How do you cut interest rates to stimulate growth when they’re already close to zero? Short answer: you switch to fiscal policy.

But what other central banks – and, during the pandemic, even our Reserve Bank – have done was resort to unconventional measures, such as reducing longer-term official interest rates by buying up billions of dollars’ worth of second-hand government bonds.

Lowe said he didn’t think this resort to “quantitative easing” was particularly effective, and he’s right. I doubt if history will be kind to QE.

However, there’s one likely respect in which the ground has shifted under the economists’ feet that Lowe – and various academic defenders of the conventional wisdom – has yet to accept: the changed drivers of inflation. It’s not excessive wages any more, it’s excessive profits.

More about all this another day.

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Fixing inflation doesn't have to hurt this much

They say that the most important speeches politicians make are their first and their last. Certainly, I’ve learnt a lot from the last thoughts of departing Reserve Bank governors. And, although Dr Philip Lowe still has one big speech to go, he’s already moved to a more reflective mode.

Whenever smarty-pants like me have drawn attention to the many drawbacks of using higher interest rates to bash inflation out of the economy, Lowe’s stock response has been: “Sorry, interest rates are the only lever I’ve got.”

But, in his last appearance before a parliamentary committee on Friday, he was more expansive. He readily acknowledged that interest rates – “monetary policy” – are a blunt instrument. They hurt, they’re not well-targeted and do much collateral damage.

“Monetary policy is effective, but it also has quite significant distributional effects,” he said. “Some people in the community are finding things really difficult from higher interest rates, and other people are benefiting from it.”

Higher interest rates don’t have much effect on the behaviour of businesses – except, perhaps, landlords who’ve borrowed heavily to buy investment properties – but they do have a big effect on people with mortgages, increasing their monthly payments and so leaving them with less to spend on everything else.

That’s the object of the exercise, of course. Prices – the cost of living – rise when households’ spending on goods and services exceeds the economy’s ability to produce those goods and services. So economists’ standard solution is to use higher interest rates to squeeze people’s ability to keep spending. Weaker demand makes it harder for businesses to keep raising their prices.

Trouble is, only about a third of households have mortgages, with another third renting and the last third having paid off their mortgage. This is what makes using interest rates to slow inflation so unfair. Some people get really squeezed, others don’t. (Rents have been rising rapidly, but this is partly because the vacancy rate is so low.) What’s more, some long-standing home buyers don’t owe all that much, so haven’t felt as much pain as younger people who’ve bought recently and have a huge debt.

Who are the people Lowe says are actually benefiting from higher interest rates? Mainly oldies who’ve paid off their mortgages and have a lot of money in savings accounts.

In theory, the higher rates banks can charge their borrowers are passed through to the savers from whom the banks must borrow. Some of it has indeed been passed on to depositors, but the limited competition between the big four banks has allowed them to drag their feet.

So the “significant distributional effects” Lowe refers to are partly that the young tend to be squeezed hard, while the old get let off lightly and may even be ahead on the deal. And the banks always do better when rates are rising.

All this makes the use of interest rates to control inflation unfair in the way it affects different households. And note this: how is it fair to screw around with the income of the retired and other savers? They do well at times like this but pay for it when the Reserve is cutting interest rates to get the economy back up off the floor.

But as well as being unfair, relying on interest rates to slow the economy is a less effective way to discourage spending. Because raising interest rates directly affects such a small proportion of all households – the ones with big mortgages – the Reserve has to squeeze those households all the harder to bring about the desired slowdown in total spending by all households.

In other words, if the squeeze was spread more evenly between households, we wouldn’t need to put such extreme pressure on people with big mortgages.

Lowe has been right in saying, “Sorry, interest rates are the only lever I’ve got.” What he hasn’t acknowledged until now is that the central bank isn’t the only game in town. The government’s budget contains several potential levers that could be used to slow the economy.

We could set up an arrangement where a temporary rise in the rate of the goods and services tax reduced the spending ability of all households. Then, when we needed to achieve more spending by households, we could make a temporary cut in the GST.

If we didn’t like that, we could arrange for temporary increases or decreases in the Medicare levy on taxable income.

Either way of making it harder for people to keep spending would still involve pain, but would spread the pain more fairly – and, by affecting all or most households, be more effective in achieving the required slowdown in spending.

The least painful way would be to impose a temporary increase or decrease in employees’ compulsory superannuation contributions. That way, no one would lose any of their money, just be temporarily prevented from spending it at times when too much spending was worsening the cost of living.

Our politicians and their economic advisers need to find a better way to skin the cat.

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Another rise in interest rates is enough already

Whatever decision the Reserve Bank board makes about interest rates at its meeting tomorrow morning – departing governor Dr Philip Lowe’s second-last – the stronger case is for no increase. Indeed, I agree with those business economists saying we’ve probably had too many increases already.

If so – and I hope I’m wrong – we’ll miss the “narrow path” to the sought-after “soft landing” and hit the ground with a bang. We’ll have the recession we didn’t have to have. (That’s where recession is measured not the lazy, mindless way – two successive quarters of “negative growth” – but the sensible way: a big rise in unemployment over just a year or so.)

For those too young to know why recessions are dreaded, it’s not what happens to gross domestic product that matters (it’s just a sign of the looming disaster) but what happens to people: lots of them lose their jobs, those leaving education can’t find decent jobs, and some businesses collapse.

Market economists usually focus on guessing what the Reserve will do, not saying what it should do. (That’s because they’re paid to advise their bank’s money-market traders, who are paid to lay bets on what the Reserve will do.)

That’s why it’s so notable to see people such as Deloitte Access Economics’ Stephen Smith and AMP’s Dr Shane Oliver saying the Reserve has already increased interest rates too far.

Last week’s consumer price index for the June quarter gave us strong evidence that the rate of inflation is well on the way down. After peaking at 7.8 per cent over the year to December, it’s down to 6 per cent over the year to June.

As we’ve been told repeatedly, this was “less than expected”. Yes, but by whom? Usually, the answer is: by economists in the money markets. Here’s a tip: what money-market economists were forecasting is of little interest to anyone but them.

That almost always proves what we already know: economists are hopeless at forecasting the economy. Even after the fact, and just a week before we all know the truth. No, the only expectation that matters is what the Reserve was expecting. Why? Because it’s the economist with its hand on the interest-rate lever.

So, it does matter that the Reserve was expecting annual inflation of 6.3 per cent. That is, inflation’s coming down faster than it thought. Back to the drawing board.

The Reserve takes much notice of its preferred measure of “underlying” inflation. It’s down to 5.9 per cent. But when the economy’s speeding up or slowing down, the latest annual change contains a lot of historical baggage.

This is why the Americans focus not on the annual rate of change, but the “annualised” (made annual) rate, which you get by compounding the quarterly change (or, if you can’t remember the compounding formula, by multiplying the number by four).

Have you heard all the people saying, “oh, but 6 per cent is still way above the target of 2 to 3 per cent”? Well, if you annualise the most recent information we have, that prices rose by 0.8 per cent in the June quarter, you get 3.3 per cent. Clearly, we’re making big progress.

But the next time someone tells you we’re still way above the target, ask them if they’ve ever heard of “lags”. Central Banking 101 says that monetary policy (fiddling with interest rates) takes a year or more to have its full effect, first on economic activity (growth in gross domestic product and, particularly, consumer spending), then on the rate at which prices are rising. What’s more, the length of the lag (delay) can vary.

This is why central bankers are supposed to remember that, if you keep raising rates until you’re certain you’ve done enough to get inflation down where you want it, you can be certain you’ve done too much. Expect a hard landing, not a soft one.

Since the road to lower inflation runs via slower growth in economic activity, remember this: the national accounts show real GDP slowing to growth of 0.2 per cent in the March quarter, with growth in consumer spending also slowing to 0.2 per cent.

How much slower would you like it to get?

The next weak argument for a further rate rise is: “the labour market’s still tight”. The figures for the month of June showed the rate of unemployment still stuck at a 50-year low of 3.5 per cent, with employment growing by 32,600.

But the nation’s top expert on the jobs figures is Melbourne University’s Professor Jeff Borland. He notes that, in the nine months to August last year, employment grew by an average of 55,000 a month – about double the rate pre-pandemic.

Since August, however, it’s grown by an average of 35,600 a month. Sounds like a less-tight labour market to me.

And Borland makes a further point. Whereas the employment figures measure filled jobs, the actual number of jobs can be thought of as filled jobs plus vacant jobs – which tells us how much work employers want done.

This is a better indicator of how “tight” the labour market is. And, because vacancies are falling, the growth in total jobs has slowed much faster. Since the middle of last year, part of the growth in employment has come from reducing the stock of vacancies.

Another thing the Reserve (and its money-market urgers) need to remember is that, when it comes to slowing economic activity to slow the rise in prices, interest rates (aka monetary policy) aren’t the only game in town.

Professor Ross Garnaut, also of Melbourne University, wants to remind us that “fiscal policy” (alias the budget) is doing more to help than we thought. The now-expected budget surplus of at least $20 billion means that, over the year to June 30, the federal budget pulled $20 billion more out of the economy than it put back in.

Garnaut says he likes the $20 billion surplus because, among other reasons, “we can run lower interest rates”.

One last thing the Reserve board needs to remember. Usually, when it’s jamming on the interest-rate brakes to get inflation down, the problem’s been caused by excessive growth in wages. Not this time.

Since prices took off late in 2021, wages have fallen well behind those prices. Indeed, wages haven’t got much ahead of prices for about the past decade. And while consumer prices rose by 7 per cent over the year to March, the wage price index rose by only 3.7 per cent.

This has really put the squeeze on household incomes and households’ ability to keep increasing their spending. And that’s before you get to what rising interest rates are doing.

Dear Reserve Bank board members, please remember all this tomorrow morning.

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Beating inflation shouldn't just be left to higher interest rates

Everyone’s heard the surprising news that last financial year’s budget is now expected to run a surplus of about $20 billion, but few have realised the wider implications. They strengthen the case for relying less on interest rates to fight inflation.

But first, the news is a reminder of just how bad economists are at forecasting what will happen to the economy – even in not much more than a year’s time. Which shows that economists don’t know nearly as much about how the economy works as they like to imagine – and like us to believe.

Then-treasurer Josh Frydenberg’s budget in March last year forecast a budget deficit in 2022-23 of $78 billion. By Jim Chalmers’ second go at the budget last October, that became a deficit of about $37 billion.

By the following budget, in May, the best guess had turned into a surplus of $4 billion. And just two months later – and that financial year actually over – the best guess is now a surplus of about $20 billion.

That’s a forecasting turnaround, over the course of only about 15 months, of almost $100 billion, or 4 per cent of gross domestic product.

What did Treasury get so wrong? It grossly underestimated the growth in tax collections. This was partly because it assumed a fall in the prices of our key commodity exports that didn’t happen, thus causing the company tax paid by our miners to be higher than expected.

But mainly because collections of income tax were much higher than expected. The economy grew at close to full capacity, so more people found jobs and many part-time workers got more hours or became full-time.

A huge number of new jobs have been created, almost all of them full-time. Do you realise that a higher proportion of people aged over 15 have paid employment than ever before? The rate of unemployment fell to its lowest in 50 years and many people who’d been unable to find a job for many months finally succeeded.

Obviously, when people find work, they start paying income tax, and stop needing to be paid unemployment benefits. So full employment is excellent news for the budget.

But the rapid rise in the cost of living during the year caused workers to demand and receive higher pay rises, even though those rises generally fell well short of the rise in prices.

So all the people who already had jobs paid more tax, too. But not only that. Our “progressive” income tax scale – where successive slices of your income are taxed at progressively higher rates – means that pay rises are taxed at a higher rate than you paid on your existing income.

Ordinary mortals call this “bracket creep”. Economists call it “fiscal drag”. Either way, the higher rate of tax workers paid on their pay rises also made a bigger-than-expected contribution to income tax collections and the budget balance.

Note that this unexpected move from deficit to surplus in the financial year just past, this underestimation of the strength of tax collections, has implications not only for the size of the government’s debt at June 2023, it has implications for the size of tax collections in the next few years, as well as for the amount of interest we’ll have to pay on that debt this year and every year until it’s repaid (which it won’t be).

In Frydenberg’s budget in March last year, the projected cumulative deficit for the five financial years to June 2026 was just over $300 billion. By the budget in May, this had dropped to $115 billion.

And now that we know last year’s surplus will be about $20 billion, the revised total projected underlying addition to government debt should be well under $100 billion.

Get it? Compared with what we thought less than 16 months ago, the feds’ debt prospects aren’t nearly as bad as we feared. And the size of our “structural” deficit – the size of the deficit that remains after you’ve allowed for the ups and downs of the business cycle – isn’t nearly as big, either.

Which suggests it’s time we had another think about our decision in the late 1970s – along with all the other rich economies – to shift the primary responsibility for managing the macroeconomy from the budget (“fiscal policy”) to the central bank and its interest rates (“monetary policy”).

One of the arguments used by the advocates of this shift was that fiscal policy was no longer effective in stimulating the economy. But our remarkably strong growth since the end of the pandemic lockdowns shows how amazingly effective fiscal policy is.

It’s now clear that fiscal “multipliers” – the extent to which an extra $1 of deficit spending adds to the growth in real GDP – are much higher than we believed them to be.

We know that a big part of the recent leap in prices was caused by shocks to the supply (production) side of the economy arising from the pandemic and the Russia-Ukraine war. But central banks have argued that a second cause was excessive demand (spending), which happened because the stimulus applied to cushion the effect of lockdowns proved far more than needed.

If so, most of that stimulus came from fiscal policy. Our official interest rate was already down to 0.75 per cent before the pandemic began. So, further proof of how powerful fiscal stimulus still is.

But another implication of the $20 billion surplus is that the stimulus wasn’t as great – and its ultimate cost to the budget wasn’t as great – as we initially believed it would be.

In the budget of October 2020, the expected deficit of $214 billion in 2020-21 was overestimated by $80 billion. In the budget of May 2021, the expected deficit of $107 billion in 2021-22 was overestimated by $75 billion. And, as we’ve seen, the deficit for 2022-23 was initially overestimated almost $100 billion.

This says two things: the fiscal stimulus caused the economy to grow much faster than the forecasters expected, even though the ultimate degree of stimulus – and its cost to the budget – was much less than forecasters expect.

Economists know that the budget contains “automatic stabilisers” that limit the private sector’s fall when the economy turns down, but act as a drag on the private sector when the economy’s booming.

We’ve just been reminded that the budget’s stabilisers are working well and have been working to claw back much of the fiscal stimulus, thereby helping to restrain demand and reduce inflation pressure.

Whenever departing Reserve Bank governor Dr Philip Lowe has been reminded of the many drawbacks of using interest rates to manage the economy, his reply has always been: sorry, it’s the only instrument I’ve got.

True. But it’s not the only instrument the government has got. It should break the central bank’s monopoly on macro management and make more use of fiscal policy.

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Enjoy the wonderful land of full employment - while you can

I hope that while you’re complaining about the cost of living, you’re also wallowing in the joys of living in an economy that’s reached the sacred land of “full employment” – being able to provide a job for almost everyone who wants one. This is the first time we’ve seen it in 50 years.

You have to say we’ve achieved it not by design, but as an unexpected consequence of our bumbling attempts to cope with the vicissitudes of the pandemic.

We used interest rates and, more particularly, the budget, to stimulate demand (encourage business and consumer spending) and ended up doing a lot more than we needed to. To the economy managers’ surprise, the rate of unemployment fell rapidly to 3.5 per cent – a level most of them had never seen before and never expected to see.

The sad truth is that, during the half century that the high priests of economics were wandering in the wilderness of joblessness, they lost their faith, and started worshiping the false god Nairu, who whispered in their ears alluring lies about the location they were seeking.

But now the wanderers have stumbled upon the promised land of Full Employment, a land flowing with milk and honey.

So now’s the time for us all to sing hymns of praise to one true god of mammon, Full Employment, in all its beneficence and beauty. And here to be our worship leader is Michele Bullock, deputy governor of the Reserve Bank, who published some new soul music this week.

Bullock says it’s “hard to overstate the importance of achieving full employment. When someone cannot find work, or the hours of work they want, they suffer financially. However, the costs of unemployment and underemployment extend well beyond financial impacts.

“Work provides people with a sense of dignity and purpose. Unemployment – particularly long-term unemployment – can be detrimental to a person’s mental and physical health,” she says.

“The costs of not achieving full employment tend to be borne disproportionately by some groups in the community – the young, those who are less educated, and people on lower incomes and with less wealth.

“In fact, for these groups, improved employment outcomes and opportunities to work more hours are much more important for their living standards than wage increases.”

Early in the pandemic and the imposition of lockdowns, we thought we were in for a regular recession. And “the sobering experience from previous recessions had taught us that these episodes leave long-lasting marks on individuals [called “scarring” by economists], communities and the economy.

“For example, if people stay unemployed for too long, their skills may deteriorate or become obsolete and their prospects for re-engaging in meaningful work may decline. This can result in more people in long-term unemployment or, alternatively, people withdrawing from the workforce,” Bullock says.

But, thanks to all the up-front stimulus, there was no recession and, hence, no scarring. Instead, outcomes in the labour market over the past three years “have consistently exceeded the expectations of the Reserve Bank and other forecasters”.

In fact, the share of the Australian population in employment has never been higher – higher even than in the decades between the end of World War II and the mid-1970s, when full employment became the norm.

Today, the number of Australians in a job has increased by more than 1.1 million since late 2021, and the level of employment is now almost 8 per cent above its pre-pandemic level. Get that.

Almost all the gains in employment since the start of the pandemic have been full-time jobs. Strong demand for labour has enabled many previously part-time employees to move into full-time work. This has pushed the underemployment rate – the proportion of people with jobs, but seeking more hours – down to its lowest since 2008.

Bullock says the people who’ve benefited most from all this are those on lower incomes and with less education. Unemployment has tended to decline more in local areas that had weaker employment to begin with.

Young people – those aged 15 to 24 years – who usually suffer most when recessions occur, have seen their rate of unemployment decline by more than twice the decline in the overall unemployment rate.

Long-term unemployment is defined as being without work for more than a year. Last year, a record number of the long-term unemployed found a job, and fewer gave up looking for one.

What’s more, the risk of not being able to find a job within a year declined significantly. So the rate of long-term unemployment is close to its lowest in decades.

Wow. Now, Bullock’s not exaggerating when she says it’s hard to overstate the many benefits – economic and social – of achieving full employment.

But she’s harder to believe when she assures us that, just because the Reserve has hardly spoken about anything other than the need to reduce inflation for the past year and more: “it does not mean that the other part of our mandate – maintaining full employment – has become any less important.

“Full employment is, and has always been, one of our two objectives.”

Well, I’d love to believe that was true, but both the Reserve’s present rhetoric and behaviour, and its record, make it hard to believe.

The Reserve has had independent control over the day-to-day management of the economy for more than 35 years. For almost all of that time we’ve had low inflation, but only now have we achieved full employment – and only by happy accident.

For most of that time it, like most macroeconomists the world over, has been listening to the siren call of the false god Nairu – aka the “non-accelerating-inflation rate of unemployment” – telling it that “full employment” really means an unemployment rate of 5 per cent or 6 per cent.

If you dispute that, answer me this: how many times in the past 35 years has a Reserve Bank boss been able to make a similar speech to the one Bullock gave this week?

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Gilding the budget lily: Labor brings in the creative accountants

This month’s budget is not as profligate as its critics claim, but nor is it the deficit-disappearing, penny-pinching budget it was tricked up to be.

When ministerial staffers use words to gild the fiscal lily, it’s called spin doctoring. When the government’s bureaucrats show the treasurer and, more particularly, the finance minister how to do it with numbers, it’s called creative accounting.

So, never fear, Jim Chalmers and Katy Gallagher didn’t need to pay PwC a motza to explain how to make the budget seem better than it was.

No, not the way the former NSW Coalition government paid KPMG to show it how to make its budget balance look better by moving the state’s trains off-budget. Nor has the same firm been paid by another part of the state government to write a report on why it was a bad idea.

There was something a bit odd about the media’s treatment of Chalmers’ second budget. Because the budget’s purpose is to reveal the government’s plans for taxing and spending in the coming financial year, the media give all their attention to the budget balance for the coming year.

Which, this time, is expected to be a deficit of $14 billion, rising to $35 billion the following year, with the budget projected to stay in deficit through to at least 2033-34.

Usually, the media ignore the estimated budget balance in the present financial year, which will end on June 30. It’s “old”. But not this year. This time, a surplus of $4 billion is expected.

Once the media got wind of a surplus, they lost interest in anything else. A surplus! First surplus in 15 years! What an achievement. And after being in power for only a year. How could you get more convincing proof of Labor’s skill as a manager of government finances?

Now, let’s be clear. The expected surplus is perfectly believable, and not the product of creative accounting. But it is the media displaying their economic ignorance.

For a start, in a budget of $630 billion a year, in an economy of $2600 billion a year, a surplus of a mere $4 billion is nothing to get excited about. It’s really a balanced budget, just as much as a deficit of $4 billion would be near enough to a balanced budget.

More significantly, the notion that any treasurer, no matter how wonderful, could turn an expected deficit of $78 billion into a surplus of $4 billion in the space of a year is fanciful. If any pollie should get the credit for it, it would have to be Chalmers’ Liberal predecessor, Josh Frydenberg.

Only he had enough time to do the things capable of helping produce such a result. With the benefit of hindsight, what Frydenberg did was greatly overstimulate the economy, adding to a surge in inflation as well as causing the unemployment rate to fall to 3.5 per cent so workers and businesses paid a lot more income tax.

Another way to look at it is that, had Treasury been better at forecasting, Frydenberg could have forecast a return to budget balance in his last budget.

But this didn’t stop Chalmers and his spin doctors from claiming the credit for himself. Consider this from the budget papers: “The improved fiscal outlook since October largely reflects government decisions to return tax upgrades to budget.”

Talk about twisting the truth. Chalmers wants to take all the credit because, confronted with an unexpected surge in tax collections of $88 billion, he only spent a bit of it.

But, surely, it was the silly media that made all the fuss about the surplus, not that nice young Mr Chalmers. Well, that’s certainly what his spin doctors want you to think – all the adulation came from the crowd.

But they were subtly pushing an easily distracted media in a favourable direction. Consider this. The usual practice in the construction of budget tables is to highlight the coming “budget year”. Not this time. This time it was the old year that got highlighted. So, the $4 billion surplus was shown in bold type, not the $14 billion deficit.

(By the way, as The Australian Financial Review has reported, had Frydenberg’s $690 million [yes, million] deficit in 2018-19 – the one that presaged all the Libs’ happy election talk about “back in black” – been calculated using the same accounting rules under which Chalmers’ surplus was calculated, it would have been a surplus of $7 billion. But no, this isn’t a fiddle, either. The decision to change the rules was made, in prospect, many years earlier by some finance minister named Penny Wong.)

Now we get to the creative accounting, which the Centre for Independent Studies’ Robert Carling, a former NSW Treasury officer, has pointed out. The budget papers make much of the claim that “the government’s spending restraint has limited real [note the real] payments growth to an average 0.6 per cent over five years from 2022-23 to 2026-27”.

Wow. Now that’s what I call restraint. What an achievement. Elsewhere in the papers we’re told that this compares with real average spending growth of about 4 per cent in the eight years before the global financial crisis, and 2.2 per cent over the eight years before the pandemic.

Wow. What restraint the Albanese government is showing. Except that pollies usually quote budget figures over the four years of the budget year plus three years of “forward estimates”. So, why is the 0.6 per cent an average over five years?

Because the extra year includes in the sum the pre-budget year ending in a month. And, purely by chance, real government spending in 2022-23 is expected to fall by 4.3 per cent.

By contrast, real spending in the coming year will grow by 3.7 per cent. Then comes projected annual real growth of 0.6 per cent, 1.9 per cent and 1 per cent.

Why the huge fall this year? Partly, I suspect, because of the effect of temporary pandemic spending programs coming to an end. But also because the indexation of various spending programs was lagging the huge rise in the consumer price index, which is the inflation measure used to calculate the “real” change.

What’s worth remembering from this little fiddle is: never trust calculations of average spending growth into the future. The first year will be close to the truth, but the projections for subsequent years will always be way too low because they’re based on the assumption of unchanged policies, whereas it’s certain that spending plans will have grown by the time we get there.

The first treasurer to con me with this averaging trick was Chalmers’ former boss, Wayne Swan. But Swan got his comeuppance by making himself a laughing-stock when he treated Treasury’s forecasts of future budget surpluses as in the bag. Turned out they weren’t.

The assumptions that policies won’t change and that targets will always be achieved are the reason the budget papers’ “medium-term” projections of deficits and debt 10 years into an unknowable future shouldn’t be taken seriously.

In both sense of the word, they are calculated to mislead.

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What they don't tell you about how the budget works

Now we have some space, there are things I should tell you that there’s never time for on budget night. If you don’t know these things, the media can unwittingly mislead you, and the government spin doctors can knowingly mislead you.

A budget’s just a plan for how much income you’re expecting in the coming period, and what you want to spend it on. Governments have budgets and so do businesses and families.

You may think you know a lot about budgeting and that all you need is common sense, but the federal government’s budget ain’t like any other budget you’ve known.

Where people go wrong is assuming the government’s budget is the same as their own household budget, only much bigger. Families budget so they don’t end up spending more than they earn.

But governments often spend more than they raise in taxes – run at a “deficit” – and only occasionally spend less than they raise – run a “surplus”. When they run deficits, they borrow to cover it; when occasionally they run a surplus, they can pay back a bit of it.

Governments can borrow, and keep borrowing, in a way families can’t. Why? Because they can’t go broke. When they run short of money, they can do what no family can do: order all the other families to give them money. It’s called taxation.

And national governments can go one step further and print their own money. Money is just a piece of plasticky stuff that’s worth, say, $50. Why is it worth $50? For no reason other than that the government says it is, and everyone believes it.

Actually, these days the government doesn’t print money so much as create it out of thin air, by crediting bank accounts. This is done not by the government itself, but by a bank the government owns: the Reserve Bank. It created hundreds of billions during the pandemic (although now the Reserve is making the government gradually pay it back, by actually borrowing the money).

Everyone knows that whatever you borrow has to be paid back. What’s more, you have to keep paying interest on the debt until it is paid back. Parents know they have to get any home loan paid back before they retire.

The trouble with a family is that eventually it dies. The kids grow up and start families of their own, then mum and dad pop off. But governments don’t die. The nation’s government acts on behalf of all the families in the country. There are always some families dying, but always others taking their place.

This is why families have to pay back their debts, but governments don’t – and often choose not to. Because governments go on and on, the main way they get on top of their debts is by waiting for the economy to outgrow them, so the size of their debt declines relative to the size of the economy.

Remember, unless you add to it, a debt is a fixed dollar amount, whereas the size of the economy – gross domestic product – grows with inflation and “real” economic growth.

The final thing making government budgets different from family budgets is that a particular family’s budget is too small to have any noticeable effect on the economy, whereas the federal budget is so big – about a quarter the size of the economy – that changes the government makes in its spending and taxing plans can have a big effect on an individual family’s budget and indeed, many families’ budgets.

But it also works the other way: what happens to one family won’t have a noticeable effect on the budget, but what happens to many families – say, everyone’s getting bigger pay rises, or many families are cutting back because they’re having trouble coping with the cost of living – certainly will affect the budget.

What common sense doesn’t tell you is that there’s a two-way relationship between the budget and the economy. The budget can affect the economy, but the economy can affect the budget.

Whenever a treasurer announces on budget night that he (one day we’ll get a she) is expecting the budget deficit to turn into a surplus, the media usually assume this must be because of something he’s done.

Possibly, but it’s more likely to be because of something the economy did. In this month’s budget, it’s because the economy’s been growing strongly, leading families and companies to earn more income and pay more tax on it.

Because many in the media imagine the government’s budget is the same as a family’s budget, they assume that budget deficits are always a bad thing and surpluses a good thing.

Not necessarily. If the budget was in surplus during a recession, that would be a bad thing because it would mean that, by raising more in taxes than it was spending, the budget would be making life even harder for families.

Only when the economy’s growing too fast and adding to inflation pressure is it good to have the budget in surplus and so helping to slow things down. And deficits are a good thing when the economy’s in recession because this means that, by spending more than it’s raising in taxes, the budget’s helping to prop up the economy.

But not to worry. When the economy goes into recession, the budget tends to go into deficit – or an existing deficit gets bigger – automatically. Why? Because people pay less tax and the government has to pay unemployment benefits to more people. Economists call this the budget’s “automatic stabilisers”.

Hidden away in the budget papers you find Treasurer Jim Chalmers quietly admitting he has no intention of trying to pay off the big public debt he inherited. His “overarching goal” is to “reduce gross debt as a share of the economy over time”.

Finally, for a family, a $4 billion surplus is an unimaginably huge sum of money. But for a federal government, it’s petty cash.

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