Avoiding the R-word won't be as easy as boosting June quarter

Sorry to be blunt, but anyone who thinks avoiding a second quarter of decline in real gross domestic product means avoiding recession needs a lesson in economics.

It’s clear that Scott Morrison’s $17.6 billion stimulus package – what you might call Kevin Rudd with Liberal characteristics – was aimed primarily at boosting economic activity in the June quarter. Fully $11 billion of the $17.6 billion will be spent or rebated from the budget during the quarter.

Half of that will come from the cash-flow rebates to employers, and most of the rest from the $750-a-throw cash splash to social welfare recipients (including parents receiving family payments).

Not all the cash will have been spent, of course, but our and other countries’ experience suggests a lot more will be than you may expect. Former prime minister Rudd’s two cash splashes in 2008 and 2009 are immediately apparent in the retail sales figures of the time.

In any case, to the possible $11 billion you have to add well over $4 billion worth of spending on cars, vans and equipment by small and medium-size businesses, induced by the temporary investment incentive, which will be spent before June 30 but won’t hit the budget until next financial year.

This helps explain why Treasury estimates that the stimulus package will add 1.5 percentage points to whatever other growth or contraction in real GDP we get in the June quarter. Since growth in a normal quarter would be about 0.5 per cent – and, for comparison, Treasury and the Reserve Bank have estimated that the coronavirus will subtract 0.5 percentage points from growth in the present March quarter – this suggests the package stands a good chance of stopping next quarter being a second successive quarter of "negative growth" – contraction.

So, recession avoided? No, all that would have been avoided is having the financial markets and the media running around like headless chooks, shouting the R-word – and so frightening the pants off the rest of the populace – just as it was avoided in the March quarter of 2009, after Rudd’s carefully timed second cash splash.

Let’s be clear. Just as it was exactly right for Rudd and his advisers to do everything they could to avoid a second successive quarter of contraction, so it’s exactly right for Morrison and his advisers to do the same. That’s not because the two-quarters rule makes any sense, it’s because so many silly people think it makes sense.

When you’re trying to head off – or at least minimise – a recession, what people think and feel (their animal spirits) matter as much as what they actually do, for the simple reason that what people think and feel – their "confidence" – ends up having so much influence over what they do.

(What a pity the epidemiologists don’t have the same tried-and-true template for responding to a virus outbreak that economists have for responding to the risk of recession.)

But what anyone who wants to be smarter than the average bear needs to know is that the two-quarters rule makes little sense. It’s no more than an arbitrary rule of thumb with no science behind it. It appeals to the simple souls in the financial markets and the media because it’s simple, objective and (the killer argument) involves minimum waiting.

Only trouble is, for a rule of thumb it doesn’t work well. As the independent economist Saul Eslake demonstrated some years ago, it throws out too many false negatives. That is, it can tell you we don’t have a recession when we do. For instance, two negative quarters separated by even a zero quarter tells you we’re home free. Really? How long will the punters swallow that?

But another problem is that it focuses on the wrong variable – production – when what we really care about is employment and unemployment. Dr David Gruen, now boss of the Australian Bureau of Statistics, once proposed the most watertight definition of recession: "A sustained period of either weak growth or falling real GDP, accompanied by a significant rise in the unemployment rate."

And Eslake has road-tested a different rule, showing it has produced no false signals. It defines recession as "any period during which the rate of unemployment rises by more than 1.5 percentage points in 12 months or less".

Guess what? In the nine months between September 2008 and June 2009, the rate of unemployment rose by 1.6 percentage points to a peak of 5.9 per cent, but then fell back to 5.1 per cent over the following year. So we did have a recession, but it was so short and mild the punters didn’t notice it.

And taming recession so successfully brought Labor no thanks at the ballot box.

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Morrison's trickle-down stimulus may not be enough

I hope I’m wrong, but I doubt if Scott Morrison’s $17.6 billion stimulus package is big enough to stop the temporary shock of the coronavirus outbreak becoming a longer-lasting blow to the economy.

We live in an economy that produces goods and services worth $2 trillion a year. To have a significant impact on the economy we needed measures worth at least 1 per cent of that – about $20 billion in their first year.

To be fair, the package is much bigger than earlier envisaged, but “a touch less than 1 per cent” isn’t as comforting as well over 1 per cent. It’s clear the measures in the package have been carefully designed – Treasury’s fingerprints are everywhere – and Morrison keeps saying it’s “scalable”: it can be added to. Maybe he’s already intending to top it up.

Treasury’s famous advice to former prime minister Kevin Rudd during the global financial crisis in 2008 was “go hard, go early, go households”. That advice is as good today as it was then. Morrison and his Coalition colleagues have spent the past decade finding fault with Rudd’s stimulus but, as the prominent economist Chris Richardson has said, “it worked”.

Apart from not going hard enough, Morrison’s package is – for reasons easy to guess at - half-hearted about “going households” – that is, sending cash direct to households in the hope of making them less worried about their debts and getting them to spend in the shops.

Morrison’s allegedly nothing-like-Labor’s cash splash is $750 a throw, but limited to welfare recipients. Since retailers were doing it tough even before the virus, it should have gone to all low and middle income-earners.

A special feature of the virus “challenge” (as the spin-doctors prefer to put it) will be the need for workers to stay home – and the temptation for the quarter of them not covered by sick leave to keep working and earning when they shouldn’t.

Morrison’s solution is to waive the delay period once casual workers have jumped through all Centrelink’s hoops and applied for the little-used “sickness allowance”. Much easier and more effective to have included them in the cash splash.

Rather than the direct approach of a bigger cash splash, Morrison has favoured the trickle-down approach: he gives cash rebates to small and medium businesses, intended to discourage them from laying off workers if the virus disruption means they don’t have much work to do.

(Big businesses have been incentivised with an appeal to their patriotism. How this works if they are foreign-owned – like the Big Singaporean, BHP - I’m not sure.)

A praise-worthy effort to protect the jobs of the nation’s 120,000 apprentices and services-sector trainees has been included.

The temporary expansion of the instant asset write-off for smaller businesses should have some success in encouraging them to spend on new cars, trucks and equipment before June 30, despite the less-than-booming demand for their products. Of course, this will mainly draw forward spending that now won’t occur over the next year or two.

But the real money - $6.7 billion - will be spent on a temporary scheme to improve the cash flow by between $2000 and $25,000 of small to medium businesses that keep their staff on this year.

Trouble is, much of that money will go to businesses that had no intention of letting their skilled (and thus well-paid) workers go, whereas many small businesses whose workers are unskilled and badly paid (and thus more likely to be let go) won’t be entitled to anything more than the minimum $2000 rebate.

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Back in Black one minute, loose talk of recession the next

For most of last year, people kept asking me if our slowing economy was headed for recession. I always replied that we weren’t, but that our chronic weakness left us exposed to any adverse shock.

Turns out we’ve been hit by two. According to Treasury’s estimates, the bushfires will subtract 0.2 percentage points from whatever growth we get from other sources in the present March quarter, and the response to the coronavirus outbreak will subtract a further “at least 0.5 percentage points”.

With just three weeks of March quarter left to run, it’s clear the coronavirus response will also subtract from growth in the June quarter. By how much? Showing better judgment and greater experience than his political masters, Treasury secretary Dr Steven Kennedy told Senate Estimates on Thursday that it would be “unhelpful” to speculate. True.

Had he been paying attention – or just been willing to meet the former fire chiefs – Scott Morrison had plenty of reason to expect a bad, economy-damaging bushfire season, but he asks us to put up our hand if we expected the coronavirus. A neat rhetorical trick but, from the leader of a party claiming to be good at managing the economy, not good enough.

The risk of the economy being hit by shocks (good or bad) is always present. We could have had a terrible cyclone up north – or more than one. The US-China trade war could have escalated. And this isn’t the first virus to spread around the world.

Consider this. If you were to contract the coronavirus, in what physical state would you prefer to be at the time – in good health or poor health? It’s the same with economies. The stronger the economy is when the adverse shock hits, the easier it is to contain the disruption and get back on track.

Point is, good economic managers don’t allow the economy to get so weak that, should it be hit by a serious shock, recovery from that shock would be much harder and the risk of it turning into an actual recession much greater.

This helps explain why Reserve Bank governor Dr Philip Lowe has been urging Morrison to use the budget to strengthen the economy for several years, backed up by the International Monetary Fund, the Organisation for Economic Co-operation and Development and many of the nation’s macro-economists.

But no, our headstrong Prime Minister knew better. If he wasn’t prepared to take advice from fire chiefs and climate scientists, why would he listen to economists on a subject which, being a Liberal, he already knew all he needed to know: despite its weakness, the economy can take its chances while we get the budget Back in Black. That will leave us better-placed to respond to a recession once it’s upon us.

Turns out it took the medicos to bring him to his senses. Impose travel bans that decimate most of our services export industries? Yes, doctor, certainly, doctor. So now we’re doing what we said only spendthrift, Keynes-crazed Labor governments do: spending money and, more particularly, cutting tax receipts, to offset the damage the travel bans are doing.

Since the return to surplus is no more, we could use the opportunity to give the economy a much wider stimulus – put money directly into the hands of consumers, for instance – but no. It seems Morrison is still hoping a quick recovery from the virus shock will have the budget back to surplus in time for the next election.

Really? This is where his amateurism is still showing. In principle, the virus is, as Kennedy says, no more than a “short-term shock” from which the economy soon bounces backs. And that’s the right objective for fiscal (budget) policy.

But if that’s your objective, you don’t brief political journalists in ways that encourage them to inform their audience that two successive quarters of contraction in real GDP are likely, which – as God ordained, and every fool knows – equals a recession. Even the usual weasel-word “technical” is missing from these confident assertions.

What’s missing from the government’s – but, if you read them carefully, not its econocrats’ – thinking is an understanding that managing the confidence and expectations of consumers and businesses is half the battle. Animal spirits, as some unmentionable economist once put it.

If you’re trying to ensure that a short-term shock doesn’t become a lasting recession, you don’t encourage the media to make free with the R-word, even though it does help you cover your embarrassment at having claimed we were Back in Black when we weren’t, and now aren’t likely to be for ages.

When is a temporary economic shock a recession? When you listen to your political spin doctors, but not your econocrats.

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Don’t bank on budget surpluses this year or in future

This week’s mid-year budget update has changed the fiscal outlook markedly. It’s now a lot clearer that neither in this financial year nor those following is a budget surplus assured.

Whether he knows it or not, by staking so much of his political and economic credibility on getting back to surpluses, Scott Morrison has taken an enormous gamble. When the reality of this “courageous decision, minister” finally gets through to him, I won’t be surprised to see him perform a backflip to go down in history.

Since the election of the Coalition in 2013, there’s been a great debate about the causes of our economy’s continuing sub-par performance. While some economists have argued its roots lie mainly in changes to the structure of the economy (and thus lasting), the econocrats have insisted the causes are cyclical and thus temporary.

So Treasury and the Reserve Bank have gone on, budget update after budget after budget update, predicting that, although the latest indicators show the economy remaining sub-par, it will soon return to the trend growth we were used to before the global financial crisis.

Until now. The mid-year update represents the first stage in the econocrats’ quiet shift from cyclical to structural as the predominant cause of the economy’s weakness. And the first hint it was on its way came in late November, when Reserve Bank deputy governor Dr Guy Debelle pronounced that annual wage rises of between 2 and 3 per cent were “the new normal”.

By far the most significant revisions to the budget forecasts were made to annual growth in the wage price index. With the actual for last financial year coming in at 2.3 per cent rather than 2.5 per cent, the prediction for this year was cut by 0.25 percentage points to 2.5 per cent. The following three years were cut by 0.75 points to 2.5 per cent, by 0.75 points to 2.75, and by 0.5 points to 3 per cent.

This would be the main factor explaining why, after consumer spending grew by just 1.2 per cent over the year to September, the forecasts for consumer spending were cut by 1 percentage point to 1.75 per cent for this financial year, and by 0.5 points to 2.5 per cent for next year.

Despite offsetting changes to other components of gross domestic product, these major downward revisions to wages and consumer spending do most to explain why the forecast for real GDP growth for this financial year was cut by 0.5 percentage points to 2.25 per cent – but nothing to explain why growth the following year was kept unchanged at 2.75 per cent (but see below).

The major cuts to wages and consumer spending forecasts do most to explain why, after just eight months, the government’s been obliged to slash the budget’s estimate of tax collections and other revenue over the budget year and the three “forward estimates” years by a total of – amazingly — $33 billion.

Partly offsetting this, however, are its net cuts in estimated government spending over the four years of $11.5 billion. How is this possible when, in the time since the budget, the government has announced additional spending of $8.2 billion over the period on drought support, aged care and accelerated spending on infrastructure?

It’s possible because the lower predicted growth in wages and inflation will save the budget money on indexed welfare payments and, more particularly, because the fall in long-term interest rates will save it big money on interest payments on the net public debt. An expected gross saving on the spending side of $19.7 billion.

See what a difference less optimistic forecasts for the economy make to the budget?

Slashing revenue estimates by $33 billion, less the net saving on spending of $11.5 billion, means the expected budget surpluses over the four years have been slashed by $21.5 billion, from $45 billion to $23.5 billion. The expected budget surpluses have almost halved in the space of eight months.

This means the expected surplus for this financial year has been cut to $5 billion, or just 0.3 per cent of annual nominal GDP. Do you see how, in a budget worth $500 billion, such a small sum could disappear with just the smallest overestimate of revenue or underestimate of spending?

It’s the same for the revised predictions for surpluses in the following years: $6 billion (0.3 per cent of GDP), $8 billion (0.4 per cent) and $4 billion (0.2 per cent).

As former top econocrat Dr Mike Keating has argued, with no fall in unemployment expected until a modest improvement in 2021-22, the revised forecasts offer no convincing reason why annual wage growth will recover from its present rate of 2.2 per cent to a projected 2.75 per cent in 2021-22 and 3 per cent the year after.

Amazingly, the budget update papers imply this will happen because the budget’s projection methodology requires it to. Same with the return to (pre-crisis) trend GDP growth of 2.75 per cent next financial year. (This is a sign the econocrats have some way to go in fully accepting that structural changes will stop us ever returning to the “old normal”.)

But just as hard to believe as the out-year growth projections is the budget’s assumption that, having so far succeeded in limiting average real growth in government spending to 1.8 per cent a year, the government will now limit it to 1.3 per cent a year over the next four years.

As Keating has noted (and peak welfare group ACOSS’s Dr Peter Davidson before him), this implies real government spending per person will actually be falling.

Unsurprisingly, the Parliamentary Budget Office has warned it’s hard to believe such a degree of restraint could be maintained over such a long time.

Even Morrison’s secret weapon, aka hollow log – the budget’s highly conservative assumption on future world iron ore prices – rests on a gamble that iron ore prices will remain abnormally high. It would be so much less risky just to have some fiscal stimulus.

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Letting things get worse so we're well placed to fix them later

If you've been feeling the pinch of a massive mortgage and minuscule pay rises and resolving to keep your spending tight this Christmas, Scott Morrison has good news. You will be relieved to hear the federal budget is still on track to reach a surplus this financial year and stay in surplus as far as the accountants' eyes can see.

Although many economists have been panicking over the economy's weak state – and the panickers were joined this week by the International Monetary Fund – Morrison is sticking to his resolve to keep his foot on the budget brake rather than move it to the accelerator.

This, his Treasurer Josh Frydenberg assured us in the mid-year budget review, will bring great
economic benefits, providing "the stability and certainty that households and businesses need to
plan for the future, giving them confidence to spend and invest knowing that the government can
keep taxes low and guarantee funding for essential services".

Hasn't worked so far, but it's bound to kick in soon.

Admittedly the economy's growth is weaker than he predicted it would be before the election in
May, so Frydenberg has had to cut the expected surplus this financial year by $2 billion to $5 billion (not all that much in a $500 billion budget) and by $5 billion next year.

This is mainly because the government has been obliged to abandon the confident prediction it has been making throughout its time in office that wage growth would soon return to something much healthier.

The bad news from the update is that Frydenberg is not expecting pay rises to average as much as 3 per cent a year until the second half of 2022 at the earliest.

But if that makes you fear the budget may not stay in surplus for long, Morrison has more good news. Much of the budget's recent strength despite a slowing economy is explained by the huge taxes our mining companies will be paying because a mining disaster in Brazil has pushed the world price of iron ore way up.

The trick is they've built themselves a hollow log. The budget's figuring is based on the assumption that the iron ore price collapses to $US55 a tonne. Should that not happen, Morrison can use the difference to prop up his budget if the panickers are right and the economy stays weak rather than speeding up, as he's sure it will.

On a separate matter, remember the Future Fund, set up in the early years of the resources boom when the Howard government was running budget surpluses so big they were embarrassing? According to Frydenberg's latest figuring, the income from all the shares the fund's money was invested in will account for most of the budget surpluses the government is expecting to run.

Now that's the "responsible fiscal management" we have come to expect of the Coalition. And it must surely comfort you to know that, should the worst come to the worst, the government will be well placed to launch a few life boats. On a user-pays basis, of course.

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Your antidote to Frydenberg’s budget-update talking points

At a time when the Prime Minister is refusing to accept that our weak economy needs a boost rather than a drag from the budget, stand by for loads of look-over-there spin from his unfortunate Treasurer Josh Frydenberg when he unveils the mid-year budget update today.

That was Frydenberg’s way of bluffing his way round the news earlier this month that the economy had grown by a disappointing 1.7 per cent over the year to September. So it wouldn’t be surprising to see some of those talking points get another run today.

He started with the line that, despite a result that laughed at his forecasts made only eight months earlier, the economy remains “remarkably resilient in the face of significant global and domestic economic headwinds”.

That’s a spin doctor’s way of saying “it could have been even worse”. Arithmetically true, but cold comfort. Since Frydenberg is boasting about our strong growth in exports, it’s hard to see much evidence of the global headwinds he claims are holding us back. And the domestic headwinds we’re suffering are home-grown and all too evidently a sign of poor economic management.

But Josh has more: “While other major developed economies like Germany, the United Kingdom, South Korea and Singapore have experienced negative economic growth, the Australian economy is in its 29th consecutive year of economic growth.”

Yes, but at present almost all our growth is coming from high immigration-fed population growth, not rising prosperity. As AMP Capital’s Dr Shane Oliver has noted, our annual growth in gross domestic product per person is just 0.2 per cent, compared with America’s 1.4 per cent, Japan’s 1.6 per cent and even the Eurozone’s 1 per cent.

In the first of his look-over-there arguments, Frydenberg boasts that we’ve maintained our AAA credit rating from three leading US rating agencies. Since these agencies’ lapse in ethical standards contributed significantly to the global financial crisis, this isn’t a recommendation I’d be skiting about. Any government that lets those disreputable characters dictate its budget policy lacks the courage of its convictions.

Next, we’ve seen our current account on the balance of payments “return to surplus for the first time in more than 40 years”. Not sure whether this boast is a sign of our Treasurer’s economic illiteracy, or his assessment of ours. Only the same people who think now’s a good time for the budget to take more out of the economy than it puts back – that is, return to surplus – would be foolish enough to think a current account surplus was a sign of economic strength.

It’s actually a sign that business investment is so unusually weak that our households, companies and governments are saving more than is needed to fund our national investment in new productive assets. Our usual current account deficit would be a much better sign of strong investment in future expansion.

Then we’re told that “welfare dependency is at its lowest level in 30 years”. With the unemployment rate at 5.3 per cent and the under-employment rate at 8.5 per cent, that’s not because they’ve all got jobs, it’s because of the government’s greater use of excuses to cut people off the dole and make them reliant on charity for their survival. Talk about reversion to the mean.

In a breathtaking case of Orwell’s Newspeak, Frydenberg claimed “growth has been broad-based with household consumption, public final demand and net exports all contributing to GDP growth”.

This is the very opposite of the truth. Since growth in consumer spending was a negligible 0.1 per cent during the quarter, the vast private sector of the economy actually went backwards, with what little growth we got coming from the much smaller (and despised) public sector and from net exports.

Growth in the September quarter was weaker than expected because Frydenberg’s repeated assurances that his middle-income tax offset would boost consumer spending failed to happen. Talk about chutzpah. He changed his line to “whether spent or saved, the tax cuts are putting households in a stronger economic position, making them more financially secure with more money in their pockets” without a blush.

Finally, it’s the drought’s fault – and you surely can’t blame the government for that. “Farm GDP is 5.9 per cent lower through the year to the September quarter and falling in four of the past five quarters. Rural exports fell by 2.8 per cent in the quarter,” Frydenberg said.

Arithmetically correct, but calculated to mislead. What he hopes you won’t remember is that, these days, agriculture accounts for only about 2 per cent of GDP, meaning the drought shaved only 0.1 percentage points off growth in the quarter, and 0.2 points over the year.

All this is the balderdash we get when pollies give politics priority over policy.

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Lowe should rescue a PM lost in the Canberra bubble

Dr Philip Lowe, governor of the Reserve Bank, is one of the smartest economists in the land. You don’t get a PhD from the Massachusetts Institute of Technology unless you’re super-sharp. But the question now is whether he has the courage to stand up to a wilful Prime Minister whose confidence far exceeds his comprehension.

Scott Morrison, as we know, is refusing to do what Lowe – with the support of the international agencies and most of our economists – has been begging him to do: use his budget to come to the rescue of monetary policy and its ever-feebler efforts to stop the economy slowing almost to stalling-speed.

Morrison is desperate to deliver a budget surplus. So desperate he’s convinced himself that failing to do so would cost him more political support than would allowing the economy to continue failing to lift voters’ living standards, and be so weak that a shock from abroad could push us into recession.

How any politician could come to such a self-harming conclusion is hard to fathom. Perhaps it’s that the 28 years since our last severe recession have robbed the latest generation of Liberal pollies of their economic nous.

Morrison’s so green he hasn’t learnt the first rule of politics: if you stuff up the economy, they throw you out. If that’s news to you, remember the 1961 credit squeeze, which brought Bob Menzies within a whisker of having his career cut short.

Remember how the 1975 recession dispatched with Gough Whitlam, the recession of the early 1980s finished Malcolm Fraser and the 1990 recession caught up with Paul Keating despite a one-term reprieve granted by Liberal fumbling of the 1993 election.

The question for Lowe is how he responds to the Prime Minister’s misreading of his own best interests (not to mention ours). Does Lowe stand back and watch an overconfident leader dice with political death by pretending that monetary policy hasn’t reached the end of its useful life and that blood can still be squeezed from the stone? Or does he announce he’s done all he sensibly can and turn the economy’s problem back to the one (elected) person who could fix it if he came to his senses?

Conventional monetary policy (interest-rate manipulation) has lost most of its power because household debt is at record levels, because the official interest rate is almost at zero, and because rates are already so low that another few cuts won’t make much difference.

Further, as Lowe explained in his speech last week, there’s little to be gained from deciding to progress to QE – "quantitative easing". It’s not capable of lowering rates much further and, in any case, comes at a cost.

As Lowe himself has acknowledged, it creates a moral hazard. For as long as Lowe pretends monetary policy is still effective, he’s running cover for the person who could do something effective, but chooses not to.

And it’s not just the absence of a positive, it’s also the continuation of a negative. Everything that causes the budget to take more out of the economy than it puts back in government spending causes private demand to be weaker.

Consider the way continuing bracket creep (only partly countered by the new middle income-earners’ tax offset) takes a bigger bite out of households’ wage income before they can spend it. Fiscal policy is actually counteracting monetary policy.

In his speech outlining the "limitations of monetary policy" and his lack of enthusiasm for unconventional measures, Lowe noted that their modest benefits needed to be balanced against their possible adverse side-effects.

Such as? First, they may change incentives in an unhelpful way. Providing the banks with ready liquidity during emergencies may encourage them not to bother holding their own adequate buffers, thus making further crises more likely.

Similarly, "the willingness of a central bank to use its full range of policy instruments might create an inaction bias by other policymakers [and] this could lead to an over-reliance on monetary policy," he said. But which policymakers could he possibly have in mind?

A second possible side effect is reducing the efficiency with which resources are allocated throughout the economy. Low interest rates and flattening the yield curve (pushing long-term interest rates down to the level of short-term rates) can damage banks’ profitability, leaving them with less capacity to lend.

There are also risks to the stability of the financial system when low interest rates cause the prices of property or shares (and borrowing) to boom at a time when the economy’s actually weak.

Finally, a third side-effect is a blurring of the lines between monetary policy and fiscal policy. "If the central bank is buying large amounts of government debt at zero interest rates, this could be seen as money-financed government spending," and so damage a country’s credibility internationally.

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QE: not certain, not soon, no great help, no let-out for govt

The big economic development this week was Reserve Bank governor Dr Philip Lowe giving the financial markets’ expectations about QE – “quantitative easing” - and other unconventional monetary policy an almighty hosing down.

In his speech on Tuesday he disabused the financial markets of the notion that, as soon as the Reserve had cut the official interest rate to zero, it would be on with QE and business as unusual.

Equally, he disabused our surplus-fixated government of any notion that his resort to unconventional monetary policy (manipulation of interest rates) would relieve it of the need to use conventional fiscal policy (budget measures) to get the economy moving again.

Lowe’s first act was to pooh-pooh most of the unconventional policies the letters QE conjure up in the minds of excitable market players. He identified four possible tools and rejected two and a half of them.

Let’s start with “forward guidance” – the notion of the central bank seeking to improve the confidence of consumers and firms by making its intentions on interest rates unmistakably clear. Great idea, he said, which is why he’d be doing it for ages and would keep doing it. Interest rates, he said, “will remain low for an extended period”.

Second is “extended liquidity operations”. During the global financial crisis in 2008, many central banks made significant changes to their usual ways of dealing with banks.

This was when financial markets were so disrupted that banks were too worried about their own finances to want to keep lending to ordinary businesses, threatening to crunch the economy.

Central banks dramatically increased their lending to banks, lent against the security of assets other than government bonds, lent for longer periods and lent at discounted rates of interest.

That is, they did what anyone with any sense would do to calm a crisis. Most of these extraordinary arrangements were soon unwound after calm had been restored. The Reserve itself had done some of them.

Would it do the same again should another crisis occur? Of course. At present, however, everything was working normally and our banks were able borrow as much as they needed – here or from abroad - at reasonable interest rates. So forget that one.

The third unconventional measure Lowe listed was “negative interest rates”. We used to assume that interest rates couldn’t go below zero, but things have become so desperate in Japan and then Europe – but nowhere else – that central banks have started paying banks negative interest rates. Governments have issued bonds at negative yields. That is, the borrower doesn’t pay the lender, the lender pays the borrower.

“Unconventional” doesn’t do justice to such a topsy-turvy world. It was long assumed that if banks started charging people to deposit their money, most of them would keep their money in cash under the bed. Lowe says there’s been a bit of that, but not much.

Why not? Partly because the negative rates are tiny – minus 0.5 per cent in the euro area, minus 0.1 per cent in Japan. But mainly because the negative rates have been restricted to charging banks and bond holders. No one’s been mad enough to try it on ordinary businesses or households.

So what are the chances we’d see negative rates here? It’s “extraordinary unlikely”, according to Lowe.

Which brings us finally to “asset purchases”. This is the only one of the four unconventional tools that can be called QE – quantitative easing. The central bank buys financial assets – securities – from the banks, paying for them merely by crediting the banks’ deposit accounts with the central bank.

This adds to the central bank’s liabilities, and to its holdings of financial assets, thus expanding its balance sheet and increasing the supply of money. Many central banks have purchased huge amounts of securities since the financial crisis, the vast majority of them being government bonds.

So, what’s Lowe’s attitude to QE? Well, for openers, he has “no appetite” for buying private sector securities (that’s the half I mentioned). But “if – and it is important to emphasise the word if – the Reserve Bank were to undertake a program of quantitative easing, we would purchase government bonds, and we would do so in the secondary [second-hand] market”. That is, it wouldn’t buy bonds newly issued by the government.

It would do QE because government bonds are assumed to be risk-free, and adding to the demand for bonds would lower the risk-free interest rate – not just for bonds but for all borrowing, from short-term to long-term. This should encourage borrowing and spending, as well as making our industries more price-competitive internationally by further lowering our dollar.

Whoopee-do. The financial markets ride again and monetary policy rolls on, allowing the government to continue putting the state of the budget ahead of the state of the economy.

Not so fast. Lowe said he wouldn’t even start to wonder about QE until we reached the point where the official interest rate had been lowered to 0.25 per cent (which would be as low as it’s possible to go).

And get this: “the threshold for undertaking QE in Australia has not been reached, and I don’t expect it to be reached in the near future.”

But his “threshold” isn’t the official rate down to 0.25 per cent. It’s trickier. “There is not a smooth continuum running from interest rate reductions to quantitative easing. It is a bigger step to engage in money-financed asset purchases by the central bank than it is to cut interest rates.

“In considering the case for QE, we would need to balance [the] positive effects with possible [adverse] side-effects.” Oh, didn’t think of those. He implied that he wouldn’t move to QE unless he was convinced we’d begun moving away from the inflation target and full employment.

Finally, having said the official interest rate couldn’t be cut below 0.25 per cent, he then estimated the scope for using QE to lower interest rates was no more than 0.2 percentage points. Sound like a magic wand to you?

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Weak wages the symptom of our stagnant economy, but why?

If you don’t like the term "secular stagnation" you can follow former Bank of England governor Mervyn King and say that, since the Great Recession of 2008-09, we’ve entered the Great Stagnation and are "stuck in a low-growth trap".

On Friday we saw the latest instalment of our politicians’ and econocrats’ reluctant admission that we’re in the same boat as the other becalmed advanced economies, with publication of the Reserve Bank’s latest downward revisions of its forecasts for economic growth.

This time last year, the Reserve was expecting real growth in gross domestic product of a ripping 3.25 per cent over the present financial year. Now it’s expecting 2.25 per cent. Even that may prove on the high side.

What their eternal optimism implies is our authorities’ belief that the economy’s weakness is largely "cyclical" – temporary. What the past eight years of downward revisions imply, however, is that the problem is mainly "structural" or, as they used to say a century ago, "secular" – long-lasting.

If the weakness is structural, waiting a bit longer won’t see the problem go away. The world’s economists will need to do a lot more researching and thinking to determine the main causes of the change in the structure of the economy and the way it works, and what we should be doing about it.

Apart from dividing problems between cyclical and structural, economists analyse them by viewing them from the perspective of demand and then the perspective of supply.

Obviously, what you’d like is demand and supply pretty much in balance, meaning low inflation and unemployment, with economies growing at a good pace and lifting our material standard of living. In practice, however, it’s not that simple and demand and supply don’t always align the way we’d like.

For about the first 30 years after World War II, the dominant view among economists was that the big problem was keeping demand strong enough to take up the economy’s ever-growing potential supply – its capacity to produce goods and services – and keep workers and factories in "full employment". Keynesian economics was developed to use the budget ("fiscal policy") to ensure demand was always up to the mark.

From about the mid-1970s, however, the advanced economies developed a big problem with inflation. After years of uncertainty and debate, the dominant view emerged that the main problem wasn’t "deficient" demand, it was excessive demand, always threatening to run ahead of the economy’s capacity to produce and thus cause inflation.

The answer was to get supply – potential production – growing faster. Most economists abandoned Keynesian economics and reverted to the former, "neo-classical" macro-economics, in which the central contention was that, over the medium-term, the rate at which an economy grew was determined on the supply side, by the three key determinants of production capacity, "the three Ps" – population, participation (by people in the labour force), and productivity – the rate at which investment in more and better machines and structures allowed workers to produce more per hour than they did before.

If so, the managers of the macro economy could do nothing to change the rate at which the economy grew over the medium term. Their role was simply to ensure that, in the short term, demand neither grew faster than the growth in the economy’s production potential (thus casing inflation) nor slower than potential (thus causing unemployment).

And the best instrument to use to achieve this balancing act was, as Treasury secretary Dr Steven Kennedy explained recently, monetary policy (moving interest rates up and down).

Everyone agrees that the problem with the advanced economies at present – including ours – is weak demand. The question is whether that weakness is mainly cyclical or mainly structural. If it's cyclical, all we have to do is be patient, and the old conventional wisdom - that, fundamentally, growth is supply-determined - doesn’t need changing.

But the conclusion that fits our circumstances better is that the demand problem has structural causes. Consider this: we’ve had plenty of episodes of weak demand in the past, but never has demand been so weak that inflation is negligible. Nominal interest rates are way down in consequence, but even real global interest rates have been falling since even before the financial crisis.

That’s why monetary policy has almost done its dash. It doesn’t do well at a time of negligible inflation, and fiscal policy is back to being the more effective instrument. But if the demand problem is mainly structural, then a burst of stimulus from the budget may help a bit, but won’t get to the heart of the problem.

As former top econocrat Dr Mike Keating has argued consistently, weak growth in real wages seems the main cause of weak growth in consumer spending and, hence, business investment, productivity improvement and overall growth – both in Australia and the other advanced economies.

Reserve Bank governor Dr Philip Lowe would agree. But he tends to see the wage problem as mainly cyclical: wait until we get more growth in employment, then the labour market will tighten, skill shortages will emerge and real wages will be pushed up.

Other economists stick to the supply-side, neo-classical approach: if real wages aren’t growing fast enough it can only be because the productivity of labour isn’t improving fast enough, so the answer is more micro-economic reform. Not a big help, guys.

The unions say the root cause is that deregulation has robbed organised labour of its bargaining power – and there may be something in that. But Keating’s argument has been that skill-biased technological change has hollowed out the semi-skilled middle of the workforce, with wage increases going disproportionately to the high-skilled, who save more of their income than lower-paid workers.

So Keating wants any budget stimulus to be directed towards the lower-paid, and a lot more spending on all levels of education and training, to help workers adopt and adapt to the digital workplace.

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Morrison hasn't noticed that economic times have changed

Apparently, if you think Scott Morrison's refusal to use the budget to boost the economy is motivated by an obsession with showing up Labor by delivering a huge budget surplus, you’re quite wrong.

No, he’s sticking to the highest principles of macro-economic management (which principles Reserve Bank governor Dr Philip Lowe doesn’t seem to understand).

We now know this thanks to the first speech of the new secretary to the Treasury, Dr Steven Kennedy, made last week. He explained to Senate Estimates the long-established orthodoxy among macro-economists in the advanced economies that "short-term economic weakness or unsustainably strong growth is best responded to by monetary policy" (interest rates) not fiscal policy (government spending and taxation).

Although the budget’s "automatic stabilisers" shouldn’t be prevented from assisting monetary policy in keeping growth stable, fiscal policy’s medium-term objective was to "deliver sustainable patterns of taxation and government spending".

Temporary fiscal actions should be taken only in "periods of crisis", which would be uncommon.

Now, I have to tell you Kennedy isn’t making these rules up. They did become orthodoxy in advanced-economy treasuries in the 1980s. They’re the reason John Kerin’s budget of 1991, delivered in the depths of "the recession we [didn’t] have to have" contained zero stimulus, meaning the stimulus, when it came in February 1992, came too late.

And it was the lesson he learnt from this stuff-up that prompted former Treasury secretary Dr Ken Henry to urge Kevin Rudd to "go early" after the global financial crisis in 2008.

These rules will have a familiar ring to those of us who each year study the fine print in budget statement 3 on the fiscal strategy. Particularly in the reference to the role of the budget’s automatic stabilisers, you see the fingerprints of Treasury’s leading macro-economist in recent decades, Dr Martin Parkinson.

Which is all very lovely. Just one small problem: the circumstances of the advanced economies – including ours – have changed radically since those rules were establish in the 1980s. They made sense then; they make no sense now.

For a start, how can you say, leave it all to monetary policy, when the official interest rate is almost as low as it can go? Has no one in the Canberra bubble noticed? Or do they imagine a switch from conventional to unconventional monetary policy tools would be seamless and involve no loss of efficacy or adverse consequences?

And since when did the orthodox assignment of roles between fiscal and monetary policies involve monetary policy resorting to unconventional measures?

The diminished effectiveness of monetary policy is a big part of the reason the world’s leading macro-economists have for some time been moving away from the old view that monetary policy was superior to fiscal policy as the main instrument for stabilising demand.

All those reasons are spelt out by Harvard’s Professor Jason Furman – a former chairman of President Obama’s Council of Economic Advisers – in a much-noted paper (summarised by me here). It was written as long ago as 2016, but doesn’t seem yet to have reached the banks of the Molonglo.

If there’s one thing macro economists know it’s that, these days, the economies of the developed world – including ours – don’t work the way they used to in the 1980s, or even before the financial crisis.

Interest rates are at record lows around the developed world not only because inflation is negligible but also because the world neutral real interest rate has been falling for decades and is now lower than it’s ever been.

This is linked to the fact – often referred to by Lowe, but not mentioned by Kennedy - that the supply of loanable funds provided by the world’s savers greatly exceeds the demand to borrow those funds for real investment.

Around the developed world – and in Australia – consumption is weak, business investment is weak, productivity improvement is low and real wage growth is low, while employment growth is stronger than you’d expect in the circumstances. Countries keep revising down their estimates of the "non-accelerating-inflation rate of unemployment" (that is, full employment), but no one really knows just how low it now is.

To give him his due, Kennedy’s speech reveals him to be just as puzzled as the rest of us about why the economy is behaving so differently.

But one thing seems clear: the private sector isn’t generating sufficient demand to get us out of "secular stagnation," so it’s up to the public sector to fill the void. And, sorry, but with monetary policy down for the count, that means using fiscal policy. They're the new, 21st century rules.

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Treasury explains why we shouldn't worry about the economy

There’s a lesson for Scott Morrison in new Treasury secretary Dr Steven Kennedy’s first public speech this week: put the right person at the top of Treasury and they’ll defend the government’s position far more eloquently and persuasively than any politician could. The econocrat’s greater credibility demands they be taken seriously.

I fear that time will show it's been a costly mistake by the government not to respond to Reserve Bank governor Dr Philip Lowe’s unceasing requests for budgetary stimulus to supplement the diminishing effectiveness of interest rate cuts. Costly in terms of lost jobs – perhaps even including the Prime Minister’s.

But that Kennedy’s opening statement at Treasury’s appearance before Senate Estimates is a robust defence of official policy should surprise no one (except politicians, who are prone to paranoia). In my experience, senior Treasury officers never gainsay the government of the day, in public or private. If it’s an independent view you’re after, try the Reserve.

However, since this is the most ably argued exposition of the government’s case for sitting tight, it deserves to be reported in detail.

Kennedy is clearly worried about the threat to us from events in the rest of the world, but is
"cautiously optimistic" that the domestic economy will pick up. According to the government’s long-established "frameworks" for the respective roles of the two policy arms used to manage the macro economy – monetary policy (interest rates) and fiscal policy (the budget) – the heavy lifting is done by monetary policy, with fiscal policy being used only during a crisis. As yet, there’s no crisis.

Over the past year, Kennedy says, global growth has slowed. As a result, the International Monetary Fund and the Organisation for Economic Co-operation and Development now expect world growth this calendar year to be the slowest since the global financial crisis in 2008. Even so, they expect growth next year to improve to about 3 to 3.4 per cent – "which is still reasonable".

Chief among the factors involved are the ongoing and still evolving "trade tensions" between the United States and China. "There is no doubt that trade tensions are having real effects on the global economy, which you see in trade data from the US and China," he says.

Combined with other problems – Brexit, Hong Kong, and concerns about the financial stability of some countries – trade tensions are leading to an increased level of uncertainty around the outlook for the world economy.

Many central banks have responded to slowing global growth by supporting their economies. And South Korea and Thailand have also provided more supportive fiscal policy.

Turning to the domestic economy, it slowed in the second half of last year, then grew more strongly in the first half of this year. This amounted to growth of just 1.4 per cent over the year to June.

Household consumption, the largest part of the economy, grew by 1.4 per cent, held down mainly by weak growth in wages. Linked to this is a fall in home building over the past three quarters, which is likely to continue in the present financial year.

Moving to business investment spending, mining investment fell by almost 12 per cent over the year to June, and non-mining investment was weaker than expected.

But, Kennedy argues, these problems are temporary and "there are reasons to be optimistic about the outlook". Recent figures have shown early signs of recovery in the market for established housing. Overall, capital city house prices have risen for the past three months. Auction clearance rates have picked up and more homes are changing hands.

Consumer spending will be supported by the government’s tax cuts and the Reserve’s three cuts in interest rates.

The substantial investment in mining capacity of past years is boosting exports, and mining investment spending is expected to grow this year rather than contract, as it had been since 2012.

Despite modest growth in the economy, employment has continued to be strong, increasing by more than 300,000 over the past year. The rate of unemployment has been "broadly flat" rather than falling because near-record rates of new people are joining the labour force and getting jobs.

The rate of improvement in the productivity of labour – output per hour worked – has averaged 1.5 per cent a year over the past 30 years, but slowed to just 0.7 per cent a year over the past five. This isn’t as bad as it looks because it’s exactly what arithmetic would lead you to expect when employment is growing faster than output. And even 0.7 per cent is higher than the G7 economies can manage.

Now to the question of whether the government should be applying fiscal stimulus to guard against a recession.

Kennedy says that, in an open economy such as ours, having a medium-term "framework" (set of rules) for the way fiscal policy should be conducted, in concert with a medium-term framework for the way monetary policy should be conducted, "has long been held to be the most effective way to manage the economy through cycles".

Under this view, fiscal policy’s medium-term objective is to deliver sustainable patterns of taxation and government spending [and thus a sustainable level of public debt].  A further objective is usually to minimise the need for taxation, as is the case in Australia.

This approach reflects an assessment that apparent short-term economic weakness or, alternatively, unsustainably strong growth, is best responded to by monetary policy, not fiscal policy.

Within this framework, however, the budget’s in-built "automatic stabilisers" will assist monetary policy in stabilising the economy. For instance, revenue will weaken, and payments will strengthen, when an economy experiences weakness.

The other exception to the rule that fiscal policy should be focused exclusively on achieving sustainable public debt is that there’s a case for "temporary [note that word] fiscal actions" in periods of crisis.

But "the circumstances or crisis that would warrant temporary fiscal responses are uncommon".

So, sorry, Phil. Application denied.

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Morrison’s hang-ups make him a bad economic manager

Scott Morrison’s problem is that he gets politics – and is good at it – but doesn’t get economics.

The Prime Minister doesn’t get that if he keeps playing politics while doing nothing to stop the economy sliding into recession, nothing will save him from the voters’ wrath.

Neither he nor Josh Frydenberg seem to get that if we endure another year of very weak growth before they pop up next September boasting about their fabulous budget surplus, no one will be cheering.

How could a second financial year of weak growth possibly leave the budget with a big surplus? Because of the miracle of continuing bracket creep and iron ore prices kept high by BHP’s dam disaster in Brazil.

If there was any doubt about the likelihood of continuing weakness in our economy – independent of any adverse shock from abroad – it was swept away last week. The International Monetary Fund forecast real growth in Australia's gross domestic product of just 1.7 per cent this calendar year, improving only to 2.3 per cent next year.

So the IMF isn’t buying even Reserve Bank governor Philip Lowe’s “gentle turning point”, much less the efforts of Treasury’s seemingly unsackable Italian forecaster, Dr Rosie Scenario.

Frydenberg’s response has been that giving top priority to achieving a budget surplus isn’t just “a vanity exercise” because “a strong budget position helps build the resilience of the economy for external shocks, whenever that may occur, and your ability to respond to those stocks with a fiscal response”.

Translation: we can’t afford to spend money staving off recession because we’ll need to spend that money once we are in recession. The absurdity of this argument that a stitch in time doesn’t save nine has been hidden by his unstated assumption that, since the domestic economy's going fine, it’s only some shock from abroad that could lay us low.

Remember all the hand-wringing about quarter after quarter of weak growth in real wages, made even weaker – as Lowe has reminded us – by exceptionally strong growth in income tax collections? It’s imaginary, apparently.

Weak consumer spending, weak growth in business investment spending, contracting home-building? More imagining.

Oh yes, employment’s still growing surprisingly strongly. “See, I told you everything’s fine.” These guys are in denial.

Frydenberg’s argument about the need to “reload the fiscal canon” ready for the next downturn makes perfect sense - provided you’re paying back public debt at a time when the economy’s growing strongly and, if anything, could use a bit of slowing to ensure inflation doesn’t get away.

That's not us, unfortunately.

The IMF says “monetary policy [changing interest rates] cannot be the only game in town. It should be coupled with fiscal [budgetary] support where fiscal space is available, and policy is not already too expansionary”.

Far from being too expansionary, our fiscal policy is contractionary (which is why the budget balance is improving even as the economy slows).

And throughout the time that both sides of politics have been so worried about “debt and deficit”, the IMF has kept telling us not to worry because we have loads of “fiscal space” – that is, our level of public debt is way below the point where we should become concerned.

My bet is Morrison and Frydenberg will eventually panic and take stimulatory measures (probably a lot of them), but they’ll come too late in the piece to stop confidence unravelling, with punters tightening their belts as businesses lay off staff.

But not yet. Frydenberg has let it be known the government will try to boost business investment by introducing a special investment allowance – but not until the budget next May.

Even so, Finance Minister Mathias Cormann has let it be known that they’re thinking about turning the December midyear budget update into a mini budget if it soon becomes apparent the present tax and interest-rate cuts haven’t made much difference.

But even when that bullet is bitten, Morrison’s effectiveness as an economic manager will still be inhibited by his various political hang-ups. For instance, neither he nor his Treasurer can bring themselves even to utter the offensive S-word – stimulus.

And his determination never to be seen helping the poor (whom those in the party’s base know to be utterly undeserving) stops him taking two stimulatory measures that are simple, quick-acting and highly effective, while yielding lasting benefits.

The first is simply increasing the Newstart allowance.

The other is a proposal worked up by Dr Peter Davidson for the Australian Council of Social Service for the feds to invest $7 billion over three years building 20,000 social housing dwellings. This would not only boost growth and jobs in the becalmed housing industry, but also reduce homelessness.

Sorry, makes too much sense.

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How strange could money get if the worst came to the worse?

With our official interest rate heading ever closer to zero, there’s much talk that the Reserve Bank may be forced to join other central banks in resorting to “unconventional monetary policy,” including QE – “quantitative easing”. But how likely is this? What might it involve? Are there alternatives? And would it be good or bad?

These questions were debated by Dr Stephen Kirchner, of the United States Studies Centre at Sydney University, Dr Stephen Grenville, a former deputy governor of the Reserve now at the Lowy Institute, and Lyn Cobley, boss of Westpac’s institutional bank, at a meeting of the Australian Business Economists in Sydney this week.

But let’s start with what the Reserve’s governor, Dr Philip Lowe, said on the subject to the House’s economics committee earlier this month.

He said it was possible the official interest rate would end up at zero. Here’s the key quote: “I think it’s unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it.”

The Reserve had been doing a lot of thinking about unconventional policies, so as to be ready if they proved necessary, not because it thought them likely to be needed.

“I hope we can avoid that,” he said. Which I take to mean that, should they prove needed, the economy’s prospects would be much worse than they are now. But also that the Reserve doesn’t fancy having to use unconventional methods.

Conventional monetary policy involves the central bank using its “open market operations” (selling or buying Commonwealth bonds from the banks) to push its official interest rate, and hence the banks’ short-term and variable interest rates, up or down so as to discourage or encourage borrowing and spending (“demand”) in the economy.

Lowe’s list of unconventional measures includes the “negative” interest rates applying in Switzerland, the euro area and Japan (where lenders pay the borrowers tiny interest rates; don’t hold your breath waiting for this one), the central bank lending funds to banks at below-market rates provided they lend them on to businesses, the central bank buying corporate bonds or mortgage-backed securities, or intervening in the foreign exchange market to push the value of its currency down.

But the measure Lowe seemed least uncomfortable with is the central bank buying long-term government securities to try to lower risk-free long-term interest rates. This is similar to conventional policy, just at the long end rather than the short end.

Lowe also said that, if it became necessary to start buying long-term securities, you wouldn’t need to have cut the official interest rate to zero before you started. He implied he might go no lower than 0.5 per cent.

Why stop there? Because by then the banks’ deposit rates would be too low to be cut any further, meaning they couldn’t pass the cut on to their home-loan and business borrowers.

However, he admitted, if things got so bad internationally that all the other central banks had cut their official rates to zero, we might be obliged to follow suit. Another possibility would be if our economic growth slowed even further – say, into the 1 per cent range – though in that case a response would be needed from fiscal policy (the budget) as well as monetary policy.

Turning to this week’s debate, Westpac’s Cobley made it clear the banks would have trouble coping with most of the unconventional measures. Even cutting the official rate any further would hit the banks’ profits (sounds of weeping and breast-beating by the bank customers present).

Kirchner, who is among the minority of economists who believe fiscal policy is ineffective in managing demand, saw no problem with using unconventional measures, which could easily have the same effect as cutting the official rate by a further 2.5 percentage points.

He said the consensus of academic studies was that unconventional measures in the US had been quite effective. Grenville agrees with him that, for the central bank to switch from buying short-term securities to buying long-term securities in no way constitutes “printing money” (even metaphorically).

Grenville disagreed with his claim that unconventional measures don’t promote inequality by helping the rich get richer, however. They lead to higher prices in the markets for shares and property, which help expand the economy through a “wealth effect” – working best for the wealthy.

Except where unconventional measures were used to rescue financial markets that had frozen at the height of the financial crisis, Grenville was unconvinced they achieved much. The academic studies made too little distinction between different episodes.

So he opposes taking interest rates lower and moving on to unconventional measures. Rather, the Reserve should tell the government monetary policy had gone as far as it reasonably could – was already “pedal to the metal” – so now it was over to fiscal policy.

Unconventional measures (I think “quantitative easing” is misleading) would probably achieve lower long-term interest rates, inflate asset prices (particularly shares), encourage financial risk-taking and lower the exchange rate, Grenville said.

None of those things seemed particularly desirable, he said. Lower long-term interest rates wouldn’t help much because, unlike in America, Australian households and businesses borrow at the short end. We’ve had plenty of asset-price inflation already.

A lower dollar helps our exporters, but it’s a “beggar-thy-neighbour” policy (inviting others to do the same to us) and, in any case, the dollar is already low enough to make any viable exporter profitable.

When unconventional measures are discussed, some people think of “helicopter money” – governments distributing cash to ordinary punters, from a metaphorical helicopter. But central bankers insist such a measure is not monetary policy and would have to come from the government as part of fiscal policy.

If the government covered the cost of the cash by borrowing from the public in the usual way, such a stimulus measure would be quite conventional – a la Kevin Rudd’s 2008 “cash splash” into people’s bank accounts.

If the government simply ordered the Reserve to credit people’s bank accounts, that would be “printing money” and highly unconventional. Again, don’t hold your breath.

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Star pupil Philip Lowe gives tips on why inflation is so low

Reserve Bank governor Philip Lowe started his study of economics at high school in Wagga Wagga and finished it with a PhD from the Massachusetts Institute of Technology. Much thanks to his teacher, Mrs King, whose teaching style convinced him economics was interesting as well as important.

The great attraction of high school economics is its emphasis on linking theory to current events.

According to a speech he gave last week, when Lowe did the HSC in 1979, the standard exam question was: why does Australia have both high inflation and high unemployment ("stagflation") and what’s the government doing about it?

In those days there was much interest in the "misery index", which adds the inflation rate to the unemployment rate. We got to peaks well above 20 per cent. Today, however, it’s below 7 per cent.

As the Australian Bureau of Statistics advised this week, the consumer price index rose by just 1.6 per cent over the year to June. Which means it’s been below the Reserve’s inflation target of "between 2 and 3 per cent, on average, over the medium term" for almost five years.

So Lowe’s guess is that, these days, exam questions are likely to ask: why is inflation so low at the same time as unemployment is also low – and what’s the government doing about it?

Just to be of help, he told us how he’d answer the question – which is one of interest and importance to all of us, not just youngsters preparing for their finals.

He started by noting that very low inflation has become the norm in most economies. At present, three-quarters of advanced economies have an inflation rate below 2 per cent.

There’s no single answer, he says, but there are three factors that, together, help explain what’s happened.

First, the credibility of the monetary "frameworks" that central banks eventually adopted when, in the second half of the 1970s, they realised inflation was way too high and needed to be got under control.

It wasn’t until the early '90s that our Reserve Bank adopted its present target for inflation which, as Lowe says, helped cement low inflation “norms” in the economy. In econospeak, it provided an anchor for business and unions’ expectations about how much prices were likely to rise over the next year or two.

"Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary,” Lowe says.

It would do so by raising interest rates and so discouraging borrowing and spending, of course. Economists call this the "monetary policy reaction function".

(It’s one of the reasons for the old view among economists that attempts to use the budget to stimulate demand by cutting taxes or increasing government spending wouldn’t achieve much. The central bank, fearing the stimulus would push up inflation, would react by raising interest rates and so stymie it. In the new world of continuing weak demand and too-low inflation, however, central banks are most unlikely to react to budgetary stimulus in such a way, meaning the new view is that budgetary stimulus is very effective.)

Has inflation targeting worked? Well, annual inflation has averaged 2.4 per cent since the target was adopted, so it certainly seems to have.

The second part of Lowe’s explanation for very low inflation is that spare capacity to produce goods and services (including spare workers who are unemployed or under-employed) in many advanced economies means there’s little upward pressure on prices.

That certainly seems the case in Australia. Our unemployment rate could go a lot lower than its present 5.2 per cent without causing wages to take off – especially with our under-employment rate of 8.3 per cent.

Our labour market seems to be more flexible – and less inflation-prone - than it used to be.

The third part of his explanation is that changes in the structure of the economy caused by technology and globalisation seem to be keeping prices low.

For one thing, digitisation and globalisation seem to be lowering the cost of producing many goods. The entry of China and other emerging economies into the global trading system has added hundreds of millions of factory workers to the global market.

The prices of manufactured goods in the advanced economies have barely increased over the past couple of decades.

For another thing, globalisation and advances in technology are making markets more contestable and increasing competition. This is extending beyond manufacturing to almost every corner of the economy, including the services sector.

Historically, most services couldn’t be traded across national borders. But globalisation – driven mainly by advances in information and communication technology – means many services can now be delivered by somebody in another country.

Examples include preparation of architectural drawings, document design and publishing, and customer service roles (a nice name for call centres). As well, many tasks such as accounting and payroll have been automated.

The internet and its digital “platforms” have revolutionised services such as retail, media and entertainment, and transformed how we communicate, and search for information and compare prices.

"These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them," Lowe says.

"And many workers are concerned that if the cost of employing them is too high, relative to their productivity [an important qualification], their employer might look overseas or consider automation."

More broadly, using the internet for better “price discovery” keeps the competitive pressure on firms.

The end result is a pervasive feeling of more competition. And more competition normally means lower prices.

What’s the government doing about low inflation and the deficient demand that is part of its cause?

Well, if you mean the elected government, the short answer is: not nearly enough. Especially when you remember how little scope the Reserve Bank has left to cut interest rates.

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Want the jobless to find jobs? Then increase the dole

It’s so familiar a part of political economy you could call it Galbraith’s Law, after John Kenneth Galbraith, the literary Canadian-American economist who put it into words. As the late senator John Button paraphrased it: the rich need more money as an incentive and the poor need less money as an incentive.

Consider the first actions of the re-elected Scott Morrison and his government. First, pushing through its three-stage tax plan, which in time will cut the income tax of those on the minimum wage by 1.5¢ in every dollar, those full-time workers on the median wage by 2.4¢ in every dollar, and those on $200,000 a year by 5.8¢ in the dollar.

Second, steadfastly resisting the ever-mounting calls for a rise in the single dole of $278 a week (less than 38 per cent of the minimum wage), which hasn’t been increased beyond inflation since 1997, making it now about $180 a week less than the pension.

It’s true that, until very recently, Labor was just as opposed to raising the dole as the Coalition has long been. Why? Because both sides know that doing so would displease many of their supporters.

As everyone knows, the dole is paid to lazy youngsters, who much prefer surfing to looking for a job – which, if only they’d get off their arses, they’d soon find. (Never mind that the number of unemployed vastly exceeds the number of job vacancies.)

Even so, the number of those calling for an increase is mounting rapidly. Apart from the welfare groups, it has long included the Business Council, which has now been joined by various economists – including those working for two of the big four accounting firms, plus someone called Dr Philip Lowe – and backbenchers from both sides, including Barnaby Joyce, who says the dole isn’t high enough for country people to afford the travel to job interviews.

Even John Howard, the man who initiated the freeze in real terms, now says it’s time for it to end.

Morrison, however, is unmoved. He argues the dole is better than it's been painted. It’s increased twice a year in line with inflation, and 99 per cent of recipients get other payments.

True. But what the 99 per cent get is the “energy supplement”, which is worth 63¢ a day and doesn’t change the claim that the dole amounts to about $40 a day.

About 40 per cent of singles on the dole get rent assistance – of up to $9.80 a day – provided they’re paying rent of more than $21.40 a day which, rest assured, they are. Much more.

There are 722,000 people on unemployment benefits. Half of them are over 45 – strange to think how sure people are that employers discriminate against older job applicants, but don’t ever imagine them being on the dole.

Similarly, more than a quarter of recipients have an illness or disability, but are on the dole because they’ve been denied the disability support pension. These people, along with more than 100,000 single parents, face challenges and discrimination in finding paid work.

Another argument ministers use is that the dole was only ever intended to be a temporary payment while people find another job and, indeed, two-thirds of people going on to it move off within 12 months.

But get your head around this: accepting that’s true, it’s also true that, at any point in time, two-thirds of people on the optimistically named Newstart allowance have been on it for a year or more. These are the long-term unemployed who, presumably, include many of those with particular challenges.

I agree with Morrison that “the best form of welfare is a job”. It’s true, too, that in recent years many additional, full-time jobs have been created. But it’s equally true that many of those jobs have gone to immigrants and other new entrants to the labour force, meaning the rate of unemployment hasn’t fallen below 5 per cent. That’s acceptable?

The truth is that, even in the city, the meanness of the dole makes it hard for people to afford the transport and other costs needed to search for jobs. The notion that poor people will seek work only under the lash of poverty is heartless nonsense.

Other facts are that the economy has slowed sharply since the middle of last year, employment is growing more slowly and unemployment is now rising.

This is why Reserve Bank governor Lowe has twice cut the official interest rate and is begging the government use its budget to do more to stimulate the economy. It partly explains his support for an increase in the dole – an extra $75 a week is the popular proposal – which, as a stimulus measure, has the great virtue of being likely to be spent fully and quickly by its impoverished recipients.

So why the refusal? For the reasons we’ve discussed but also because, having given up tax revenue of $300 billion over 10 years, Treasurer Josh Frydenberg now insists he can’t afford a dole increase costing a whopping $39 billion over 10 years. Too much threat to his promised return to budget surplus.

Strange logic. Should the economy’s slowdown not be reversed, unemployment – and the budgetary cost of the dole – will go a lot higher, and hopes of budget surpluses will evaporate, replaced by angry people accusing the government of economic incompetence.

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Despite the photo-op, RBA knows we need fiscal stimulus

Never fear, Reserve Bank governor Dr Philip Lowe may have stumbled on the optics of agreeing to a photo-op with Treasurer Josh Frydenberg the other week, but the Reserve’s independence remains intact and our weak economy remains in need of budgetary stimulus.

Politicians have damaged our trust so badly that they like having respected econocrats appearing beside them to bolster their credibility. But central bank governors who wish to preserve the authority of their office don’t oblige, just as Lowe’s predecessor, Glenn Stevens, declined to be used as a prop by Kevin Rudd.

That’s the trouble, of course. There’s nothing wrong with treasurers and governors having private meetings – the more the better – but once the media are invited in the pollies will always be playing their own game, and it’s always one that puts their political standing ahead of the economy’s interests.

I suspect the message Frydenberg wanted to convey to viewers was that the economy was going fine and he had no intention of allowing fiscal stimulus to jeopardise the budget’s predicted and glorious return to surplus, which would make his name as a treasurer.

He and his Treasury officers had spent two hours explaining this to Lowe, and Lowe had accepted their arguments.

I very much doubt that’s what really happened. Nor do I except the media interpretation that, pressured by Frydenberg, Lowe went on to repudiate all he’d been saying about the economy’s weakness and why he’d needed to cut the official interest rate two months in a row.

Why then did Lowe say “I agree 100 per cent with you [Frydenberg] that the Australian economy is growing and the fundamentals are strong”?

Well, for a start, no one denies that the economy is still growing. And “the fundamentals” is such a vague concept it could be taken to mean lots of things. Presumably, Lowe doesn’t include wages among the fundamentals, because annual growth of 2.3 per cent is not what I’d call strong.

I think all he was trying to say was that he was confident we aren’t heading into recession.

But there’s a deeper point to understand: central bankers see it as an important part of their job to exude calm and confidence. No matter how worried they are, they take pride in never showing it.

They’re like a duck: moving serenely above the water, paddling furiously underneath. Lowe has spoken several times recently about the need to preserve stability and confidence.

So never hold your breath waiting for a Reserve governor, Treasury secretary or, let’s hope, treasurer  to be the first to warn that recession is possible. They’ll be the last to admit it.

Like Paul Keating on the day he tried to conceal his failure by bulldusting about “the recession we had to have”, they don’t use the R word until the figures make it impossible to deny.

And that is just as it should be. Why? Because – particularly when it’s negative, and when sentiment is wavering – what they say has too much influence over what the rest of us think and do. Too much risk of their prophesies becoming self-fulfilling.

That’s why, as a mere media commentator, it’s my job to be brutally frank, and theirs to be circumspect.

And that’s why it’s wrong to claim Lowe has suddenly changed his tune about the economy’s prospects. Those who think otherwise are like the people in the famous psych experiment who were so busy counting points in a basketball match they didn’t notice a gorilla run across the court.

In his announcement of the second rate cut – as in almost all his recent public utterances – Lowe insisted that “the central scenario for the Australian economy remains reasonable, with growth around trend expected”.

The significant change has been the Reserve’s revised judgement that the “non-accelerating-inflation rate of unemployment” has fallen from about 5 per cent to 4.5 per cent or lower. Lowe has used this as his justification for cutting interest rates.

“Today’s decision to lower the cash rate will help make further inroads into the spare capacity in the economy” and “will assist with faster progress in reducing unemployment . . .”, he said in the announcement.

It’s a lovely thought, but I fear the immediate challenge is not to get unemployment lower, but to stop it continuing to rise. And the latter risk fits better with Lowe’s repeated calls for more help from the budget – for it to be pointing in the same direction as monetary policy (interest rates), not the opposite direction, as at present.

Frydenberg’s photo-op made it clear his answer is no. Perhaps at their next two-hour meeting Lowe should explain to him how the budget’s “automatic stabilisers” work, and may well wash away his promised budget surplus.

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Poor Josh Frydenberg: on the wrong tram, heading for trouble

It’s not my policy to feel sorry for any politician – they’re all hugely ambitious volunteers – but I do feel sympathy for Treasurer Josh Frydenberg. He’s not the first treasurer to be strong on party dogma but light on economic understanding, but he’s among the first to be heading into stormy weather light on expert advice from a confident and competent Treasury.

There he was, thinking his first budget would be his last, primping up a pre-election budget that claimed to have fixed the economy and delivered on deficit and debt when that was all in the future and built on nothing more than years of wildly optimistic forecasts, combined with a massive tax bribe whose cost will keep multiplying for seven years.

Do you think that while cooking up the happy forecasts needed to justify his claims of Mission Accomplished and make his tax cuts seem affordable, Treasury warned him of the risks he was running, making himself and his government hostages to fortune?

I doubt it. They wouldn’t have been game to. The Coalition’s politicisation of Treasury, intended to kill its corporate sense of mission and replace it with people who’d proved their right-thinking and party loyalty as ministerial staffers, sent the message that the government wanted people who spoke only when spoken to and kept any contrary opinions to themselves.

In the process, however, most of the people with a deep understanding of macro-economic management have drifted away. People who understood the mysteries of the business cycle, with experience of recessions - and how excruciatingly painful they are for the government of the day.

These are people who know how much worse you make it for yourself – and for the economy voters depend on – by refusing to face the mess you’ve got yourself into, and who know how to help you change trams with as little loss of face as possible.

People game to tell you to stop digging. People who know that the longer you take to accept that the game has changed, the harder it will be to get the economy back on track – and, incidentally, to avoid getting the blame for completely stuffing it up.

People who’ll tell you to blame your about-face on changes coming from the rest of the world, but not to believe your own bulldust. People who’ll tell you to forget about party political doctrine – and the crowing of your opponents - and be completely pragmatic in doing whatever needs to be done to get you and the economy out of the poo.

Here’s what Frydenberg’s experts should be telling him, but probably aren’t – unless he speaks to Reserve Bank governor Dr Philip Lowe a lot more regularly than I imagine he does.

First, worrying about deficit and debt is something national governments can afford to do only when they’ve got an economy that’s growing strongly. The three successive quarters of pathetically weak growth we’ve experienced – complete with rising unemployment and underemployment - may prove to be just a blip, as the budget’s forecasts assume they will, but it’s much easier to believe they show the economy is fast running out of puff.

Recession is neither imminent nor inevitable in the next year or three, but with the economy in such a weakened state it is vulnerable to any adverse shock that happens along – whether of domestic or international in origin.

In such circumstances, it would be economically damaging and fiscally counterproductive (not to mention politically disastrous) to press on with fiscal consolidation rather give top priority to boosting economic activity and getting the economy back into strong-growth mode.

The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.

Policy has to break this cycle. But, as Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can't be the reason business investment is a lot weaker than it should be.

That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough. “Structural reform” is always a nice idea, but fixing a problem of deficient demand from the supply side would take far too long to be of practical help.

Over to you, Josh. If you’ve got the greatness in you, this could be your finest hour.

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