GDP hot air gives Hockey hiccups

See how long it takes you to figure this one out: if something falls by 50 per cent, then rises by 100 per cent, where is it? Answer: just back where it started.

If you had to think about it you need to be careful what conclusions you draw from this week's national accounts showing the economy - real gross domestic product - contracted by 1.2 per cent in the March quarter.

Thanks to economists' obsession with growth, we focus almost exclusively on the percentage change in GDP and its components from one quarter to the next, but if you don't have a good feel for how percentage changes work you risk bamboozling yourself.

(Speaking of which, remember that, though the percentage increase needed to get you back to par is always bigger than the original fall, the smaller that fall the less spectacular the subsequent rebound.)

Now try this reaction to the national accounts from Joe Hockey: ''If the mining boom has a cough the Australian economy can suffer pneumonia. The economy is increasingly reliant on the mining boom.''

It's a snappy soundbite for the telly, but it's nonsense. Indeed, it's roughly the opposite of what the national accounts are telling us.

For a start, the problem during the March quarter wasn't the mining boom, it was the weather. Is our economy heavily reliant on the weather? Our farmers are, but the rest of the economy isn't (well, not until we're finally screwed by climate change).

For another thing, what happened last quarter wasn't a cough that shows we've got pneumonia, it was a hiccup that isn't worth worrying about. Remember, 98.8 per cent of the economy was still there in the March quarter.

All that happened was that flooding and cyclones temporarily disrupted our production of coal, iron ore, agriculture and tourism. The disruption to mining in particular led to a decline of 27 per cent in the volume of coal exports during the quarter, causing the volume of all exports to fall by 8.7 per cent.

But today, two months after the end of the March quarter, we know the bad weather has stopped, most mines are working again, farmers have replanted and the rebuilding of houses, roads and other infrastructure has begun. Export volumes recovered in the month of March and further in April.

The natural disasters are estimated to have subtracted 1.7 percentage points from real GDP growth during the quarter. But Wayne Swan is expecting a rebound of about 1 percentage point in the present quarter and a further rebound in the September quarter. This is why Hockey's pneumonia is no more than a hiccup.

The rebound will come for three reasons: production will return to normal; some firms will work overtime to catch up on lost production and there will be much rebuilding and purchasing of new equipment.

Note that, thanks to our obsession with rates of quarterly change, part of the rebound is simply arithmetic. The government estimates the various natural disasters subtracted $6.2 billion from the real value of production in the March quarter, but will subtract only $3.1 billion in the June quarter. If so, this reduction in a negative represents a positive contribution to the growth in real GDP in the June quarter.

The point is, when the economy contracts in a quarter, you have to investigate the causes before you decide the economy has pneumonia and needs to be hospitalised. In this case, the causes are transitory - and self-correcting - rather than lasting.

Another clue is that the economy suffered a weather-caused shock to its supply side (production of goods and services) rather than weakness in its demand side (spending on goods and services).

A weakness in demand is more likely to be deeper-seated and longer-lasting, requiring the economy's demand managers - the government and the Reserve Bank - to adjust the settings of the instruments they use to influence the strength of demand: respectively, fiscal policy (the budget) and monetary policy (interest rates).

What makes Hockey's talk of pneumonia so opposite to the truth is, when you look past the temporary supply problem you see demand growth is quite healthy. Consumer spending grew by 0.6 per cent in the March quarter (and by 3.4 per cent over the year to March), with government spending on consumption items growing by 1.4 per cent (4.6 per cent for the year).

Turning to investment spending, spending on new or altered housing grew by 4.6 per cent (annual, 6.6 per cent) and business investment in new equipment and structures grew by 2.9 per cent (annual, 4.5 per cent).

That leaves public sector investment spending, which fell by 0.7 per cent (annual, minus 6 per cent) as the fiscal stimulus continued to be withdrawn. (Overall, the withdrawal of stimulus trimmed 0.4 percentage points from GDP growth during the quarter.)

Adding this up, ''domestic final demand'' grew by a whopping 1.3 per cent during the quarter and by 3.3 per cent over the year. Allowing for a fall in the level of business inventories (much of it probably caused by the natural disasters), ''gross national expenditure'' - which is domestic demand proper - grew by a healthy 0.8 per cent during the quarter and by 3.1 per cent over the year.

This healthy growth ain't surprising since total employment grew by almost 50,000 during the quarter.

As the secretary to the Treasury, Martin Parkinson, pointed out this week, though the mining sector gets most of the headlines, it accounts for only about 8 per cent of GDP (and an even smaller proportion of total employment). So that leaves 92 per cent of the economy that's not mining but is doing fine.

It's true that, of late, much of the growth in the economy has been coming, directly and indirectly, from mining. But it's rare for all parts of the economy to be growing at the same rate, so it's common for one sector - often it's been housing - to account for much of the growth in a particular period. That doesn't mean we'd catch pneumonia were that sector to falter.

Consider this: if the sky-high prices we're getting for coal and iron ore were to suddenly collapse, that would be a blow, but it would also bring about changes that encouraged other sectors to grow faster: the high exchange rate would fall, the Reserve Bank would cut interest rates and the budget wouldn't be as contractionary, taking longer to return to surplus.

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East moves west - more than a miner miracle

You'd need to be living under a rock not to have heard that the world's centre of economic gravity is moving from west to east - towards us. But most of us are yet to appreciate the full ramifications of this change in the globe's economic geography.

The shift is occurring because of the re-emergence of China and India as major economic powers. Why re-emergence? Because in the 18th century - before the West's industrial revolution - the two accounted for almost half of gross world product.

By 1990, China and India's share of world gross domestic product was down to less than a 10th. Today it's about a fifth and expected to be more than a quarter by the end of this decade. By 2030 it may be as much as a third.

Everyone knows the rapid industrialisation and urbanisation of these two countries is the cause of our present resources boom. But as Treasury points out in its annual sermon (otherwise known as budget statement No. 4), there's more to it.

''As China and India continue to develop, the growing cities now driving demand for Australia's mineral resources will be populated by an increasingly wealthy and upwardly mobile middle class, with incomes and tastes to match,'' Treasury says.

''Increasing consumer purchasing power and changing spending patterns will open up new, often unforeseen, opportunities for Australia - well beyond those flowing from the current mining boom.''

One study has estimated that the number of middle-class consumers in Asia could increase by more than 1.2 billion people by 2020. If so, these projections would mean that by the end of this decade Asia would have more middle-class consumers than the rest of the world combined, with China surpassing the United States as the world's single largest middle-class market in terms of dollars.

By 2030, with India following China's lead, the world could have gone from mostly poor to mostly middle class, with two-thirds of the world's middle-class consumers living in our region.

(Like all projections by economists, this one confidently assumes the natural resources and ecosystem services needed to make this possible will be readily obtained - presumably, from another planet. But let's not allow ecological realities to spoil our happy economic analysis.)

In poor countries, spending on basic goods typically accounts for quite a high share of GDP, with household incomes barely covering the necessities of life. Then, in the early stages of economic development, a surge in investment spending causes consumption's share of GDP to fall quite sharply.

In time, however, continued growth allows a larger middle class to devote more money to purchasing luxury goods and services, both in absolute terms and as a share of household spending. As a result, consumer spending's share of GDP recovers as economies reach middle-income status.

China's consumption-to-GDP ratio has declined markedly in recent decades, reaching a low of only 35 per cent in 2009. (Our proportion is about 55 per cent, which is lower than it used to be because of our much higher investment in new mining capacity.)

But China is fast approaching income levels where consumption often turns, and the Chinese government is focused on reforms to foster higher growth in household incomes and to rebalance the economy towards domestic demand. So Treasury says there's considerable scope for a strong rise in the consumption ratio in the medium term.

We know from the earlier experience of countries such as Japan and South Korea in travelling down this road that as the amount of consumer spending grows its composition changes. As they become more affluent, people devote a higher proportion of their spending to services and consumer durables.

The early stages of such a shift are already evident in China. Since the early 1990s, its urban households have devoted a declining proportion of their spending to food and increasing proportions to medical services, transport and communication, and education, recreation and culture.

If you divide urban households into four groups according to their incomes, you find that, as incomes rise, households devote smaller and smaller proportions to food, and bigger and bigger proportions to services.

Urban households constitute a large and growing proportion of China's 400 million households (Australia has 8.5 million). Just over the past 10 years, the proportion of urban households owning a car has gone from virtually none to 12 per cent. The proportion owning microwave ovens has gone from 16 per cent to 58 per cent.

And get this: the number of computers owned per 100 households has gone from eight to 70, while the number of mobile phones has gone from 16 to 188. So ''new technology'' goods are spreading faster than household appliances.

On the ladder of goods and services to which people with growing incomes aspire, after consumer durables come culture, tourism and advanced education.

On overseas tourism, China and India's sheer population size mean they're starting to overtake those countries formerly dominant in providing tourists, the US, Britain and Japan. In 1995, about 4.5 million people from mainland China and 3 million from India travelled abroad for business and leisure.

By 2009, China's travellers had increased tenfold to 48 million, meaning it was close to catching up with the US and Britain. India had experienced a three- to four-fold increase to 11 million travellers a year.

And all this before the rise of the middle class has really got going.

Australia, of course, is already getting its cut. China and India's share of our education exports has risen sharply. China's share of our wine exports is now five times larger than it was five years ago. Tourist arrivals from China have more than trebled in the past decade - overtaking Japan in 2008-09 - and are catching up with those from the US.

Of course, not all the opportunities created by Asia's rising middle class will fall within areas of our comparative advantage. And to maximise even those opportunities that do fit our bill we'll need to continue to change and innovate. Competition with other countries will be fierce. As their own education systems improve, a smaller proportion of Chinese and Indians may seek education abroad.

And Treasury says it's not possible to forecast the exact mix of goods and services that will be demanded, let alone the shape of the global economy that will best service these demands. You can say that again.

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When the price is right you're on the right track

if economists wore T-shirts what they'd say is PRICES MAKE THE WORLD GO ROUND. Conventional economists are obsessed by prices. It took me ages to realise that economics isn't actually about the economy. It's about markets. So economists tend to ignore those parts of the economy that don't involve markets, such as the production and consumption of goods and services that go on inside households.

Economic sociologists also study markets and what they see is the way unwritten rules of social relationships influence the behaviour of producers and consumers, sellers and buyers.

Economists, however, don't see any of that. What they see is the way prices adjust until supply and demand are in balance ("equilibrium"). They see the price mechanism as the fulcrum on which the market economy rests.

Sometimes economists say economics is the study of incentives. That's just a fancy way of saying they study prices. Lower prices are an incentive to consumers to buy more, but an incentive to producers to produce less. Higher prices create the opposite incentives. Higher wages (which are a price) are an incentive to work more, and so forth.

But what fascinate economists are relative prices - the price of this item compared with the prices of other items. They think changes in relative prices have an almost magical ability to change people's behaviour.

Inflation involves rises in the level of prices generally. Economists disapprove of inflation mainly because when the prices of everything are rising this makes it harder for people to see and react to changes in the thing economists really care about: relative prices.

Last week an assistant governor of the Reserve Bank, Dr Philip Lowe, gave a speech in which he predicted the resources boom would cause a significant change in the structure of Australia's industries. What would bring this change about? Changes in relative prices, of course.

The most basic relative price in this story is our terms of trade - the prices we get for our exports relative to the prices we pay for our imports. The super-high prices we're getting for our coal and iron ore make our terms of trade possibly the most favourable they have ever been and about 90 per cent better than their average for the 1990s.

The change in this relative price is the main reason for the change in another key relative price: our exchange rate - the price of our dollar relative to the price of the US dollar, the yen or the euro.

But Lowe points to some relative price changes that are much less remarked. One is the price of manufactured goods (such as clothing, footwear, furniture and floor coverings, vehicles, audio, visual and computing equipment) relative to the price of other goods and services.

The prices of manufactures have been falling relative to the prices of services around the world for many years. This is because productivity in manufacturing has improved faster than productivity in services and because more of the world's manufacturing is being done in developing countries where labour is cheap.

But in recent years that process has been accelerated in Australia by the appreciation of the dollar. So much so that the Australian retail prices of manufactured goods (many of which are imported) have not only been falling relative to the prices of other goods and services, but also falling in absolute terms.

Looking at the consumer price index over 2010, the prices of other goods and services rose by about 7 percentage points more than the prices of manufactured goods.

The next important change in relative prices is the price of "investment goods" (machinery and equipment) relative to the price of "output" (all goods and services produced in Australia). When the price of new machines is low relative to the price of the goods and services produced using those investment goods, investment in new machines tends to be high - which is just what we've seen over the past decade.

The relative price of investment goods tends to be cyclical, but there is also a clear downward trend over time. This secular decline is driven largely by technological improvements lowering the price of computing power. But, again, the decline over the past decade has been particularly large because of the high dollar (much machinery is imported).

The final key change in relative prices is the price of labour. For workers, what matters is their wage relative to the price of the goods and services they buy with that wage. Economists call this the "real consumption wage".

For firms, what matters is the wages they pay relative to the prices they get for the goods and services they produce and sell. This is the "real producer wage". Usually, these two relative wages should be pretty similar because the goods and services people buy are much the same as the goods firms produce.

In recent years, however, this correspondence has broken down because of the improvement in the terms of trade. By definition, Australian firms produce exports but not imports, but Australian consumers buy imports but not exports.

Since 2000, the economy-wide ("aggregate") real consumption wage has risen by about 25 per cent (great news for workers), whereas the aggregate real producer wage has risen by only about 10 per cent (good news for firms).

But these aggregate figures conceal big differences between industries.

In industries where productivity is improving quickly - such as manufacturing - the real producer wage tends to rise because competition passes the benefits of the higher productivity through to customers in the form of lower prices.

By contrast, in many service industries real producer wages have been pretty flat. And in mining the real producer wage has fallen significantly: although miners' wages have grown very strongly, the prices the mining companies have been getting for their coal and iron ore have risen infinitely faster.

See where this is leading? All the relative price changes we've discussed will be working to change the allocation of resources within the economy in the same direction: away from manufacturing (and other export or import-competing industries, such as tourism) and towards mining and those parts of the manufacturing and services sectors that hang off it.

Mining's share of total annual private and public sector investment spending has reached almost 20 per cent - roughly double its usual share - and may rise as high as

25 per cent before long.

However, the great bulk of the economy - the services sector, accounting for more than three-quarters of total employment - will be little affected.

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No more ignorant talk of a two-speed economy

The more economists examine it, the more they explode the seemingly self-evident truth that we're living in a two-speed economy.

Why do people keep saying this? I think they're saying that whoever's benefiting from all the talk of a boom, it ain't my state or my industry. In short: I see no evidence of any boom around me and I'm certainly not getting any benefit from it.

If there is a boom, they seem to be saying, it's limited to the mining industry while the rest of the economy is struggling. Similarly, Western Australia and Queensland may be doing OK, but the other states and territories aren't.

There's just one small problem with all this: the facts don't back it up. Consider, for openers, the figures we got last week for "state final demand" (an imperfect interim substitute for gross state product).

Growth in this measure over the year to December averaged 2.7 per cent across Australia, but varied from 4.3 per cent to 1.5 per cent. The three fastest growing areas were the Northern Territory, the ACT and Tasmania.

Western Australia came fourth on 3.1 per cent and Queensland came eighth and last on 1.5 per cent.

As Saul Eslake of the Grattan Institute has reminded us, it's not arithmetically possible for all the states to be above average like the kids in Garrison Keillor's Lake Wobegon. There'll always be some above the average and some below it. There'll always be a multitude of reasons why, at any moment, some states are doing relatively well and others relatively badly.

Eslake has had a good look at the figures and found that, in the past two decades, there's never been a gap of less than 2 percentage points between the annual rates of growth in gross state product of the fastest and slowest growing states and territories.

But that gap is narrower in recent years than it used to be. Over the past five years it's averaged 3.7 percentage points, which is 1.5 percentage points narrower than it averaged over the previous 15 years.

Eslake adds that there's much less divergence in the performance of our states and territories than there is in comparable federations. Over the past four years our divergence has been half what it is for the American states and about a third of what it is for Canada's provinces.

But now Kieran Davies and Felicity Emmett, of the Royal Bank of Scotland, have examined the two-speed economy proposition using labour market figures for almost 70 regions around the nation.

In particular, they test the contention that the resources boom and the high dollar that goes with it are making the economy too dependent on mining and hollowing out the rest of the economy, thus making us more vulnerable to external shocks.

They find that at the height of the first stage of the resources boom in 2008, when national unemployment fell just below 4 per cent, unemployment was low across the country. There was a gap of only about 6 percentage points between the lowest regional unemployment rate of 2 per cent and the highest of 8 per cent.

Then, at the time when the mild recession caused by the global financial crisis led to national unemployment peaking at close to 6 per cent, the gap between the lowest regional unemployment rate of 1 per cent and the highest regional rate of 20 per cent was a massive 19 percentage points.

But now, as unemployment has continued to fall back from that peak, the gap has narrowed sharply. At the start of this year it stood at 14 percentage points, with the lowest regional unemployment rate still at 1 per cent and the highest falling to 15 per cent.

And get this: many of the regions with the lowest unemployment rates are in the non-resource-rich states. The regions with rates between 1 per cent and 2 per cent are in NSW (the Hunter Valley excluding Newcastle, and some parts of Sydney) and the Northern Territory. WA doesn't feature in the top 10, though rural WA comes in at No. 13.

In 2008, before the onset of the crisis, more than 90 per cent of the regions had unemployment of 6 per cent or less. Now, with the economy yet to return to that height, 70 per cent of regions are at 6 per cent or less. If that doesn't prove the benefits of the resources boom are being spread right around the economy, nothing will.

It's true the retailers are doing it tough at present (mainly for reasons that have little to do with the resources boom), but it's just sloppy thinking to see this as more evidence of the two-speed economy.

Why is it not a two-speed economy? Because about three-quarters of us work in industries that are neither great direct beneficiaries of the resources boom, nor great victims of the high exchange rate it has brought about.

And also because we live in one national economy, not eight isolated economies. There is a high degree of trade between the states and territories. They are subject to the same exchange rate, interest rate and federal budgetary policy.

A fair bit of the cream from the resources boom goes to the federal government. And all the mining royalties gained by the WA and Queensland governments are shared with the other state and territory governments via the formula by which the proceeds from the goods and services tax are divided between them.

The rise in the dollar is actually one mechanism by which part of the earnings of the miners is redistributed to all other industries and all consumers, in the form of cheaper imports.

If you think you've got nothing to show for the resources boom, all you're showing is your economic ignorance.

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Glimmering lights help dispel the gloom and doom

Peering through the statistical mist, the national accounts we saw this week tell us that, contrary to some messages we have been getting, the economy is on track and growing quite strongly. For the foreseeable future, growth will be coming more from business investment spending than from consumption.

Bureau of Statistics figures show real gross domestic product grew by 0.7 per cent in the December quarter. But Treasury estimates that the early days of the Queensland floods cut production, mainly coal production, by about 0.4 percentage points during the quarter.

So the ''underlying'' growth in GDP was probably nearer 1.1 per cent. If we take the actual growth over the year to December of 2.7 per cent and add back the 0.4 percentage points, we get underlying growth for the year of 3.1 per cent.

(Why is it OK to keep adding back the effect of the floods? Because the loss of production is expected to be temporary. After the full effect of the disruption is felt in the present quarter - maybe reducing GDP by a further 1 percentage point - growth will be higher than otherwise as the miners catch up and much money is spent repairing and replacing damaged homes, businesses and public infrastructure. The authorities expect the floods' effect on GDP to have largely been offset by the end of this year.)

The figures for growth in the December quarter continue the recent pattern of very strong growth in one quarter followed by a quarter of very weak growth and then back to strong growth again.

So let's abstract from the volatility by focusing on the figures for the year to December. They show consumer spending growing by 2.8 per cent - below the trend rate of growth, but not by a lot.

If that's stronger than you were expecting, the reason is that, yet again, the monthly figures for retail sales have proved an unreliable guide to the quarterly figures for total household consumption (which is more comprehensive). In real terms, retail sales grew by only 1.1 per cent over the year to December.

The sub-par growth in consumer spending is not the product of any weakness in the growth of household disposable income. It rose by 6.4 per cent in nominal terms.

No, consumer spending is moderate because households are saving more of their incomes, to pay down debt rather than add to it. The household saving rate averaged more than 9 per cent over the year to December, much higher than it's been for ages.

Spending on new homes and renovations grew by a weak 2.2 per cent over the year, which means we are not building enough homes to accommodate the growth in the population. Taken by itself, this puts pressure on house prices and rents.

Turning to business investment, spending on new machinery and equipment fell by 8.2 per cent over the year. That's probably because a lot of businesses brought forward purchases they would have made this year to take advantage of a tax break that was part of Kevin Rudd's stimulus package.

But spending on new equipment actually grew by 4.7 per cent in the December quarter, which suggest the hiatus may now be over.

The other major component of business investment is ''non-dwelling construction'' - the building of office blocks, shopping centres and mines. It has not been doing too well lately, with the exception of ''engineering construction'', which is mainly the mines.

New engineering construction grew by a massive 12.4 per cent over the year to December. And we know from what businesses have told the Bureau of Statistics about their intentions that there's a lot more spending to come this year and next.

Over the year to December, the volume (quantity) of our exports increased by 5.1 per cent, but the volume of imports increased by 8.4 per cent, with the effect that ''net exports'' (exports minus imports) subtracted 0.7 percentage points from the overall growth in GDP.

Turning from export and import volumes to export and import prices, our terms of trade - export prices relative to import prices - improved a little further in the December quarter, to be 22 per cent better over the whole year.

An improvement in our terms of trade makes us richer. This explains why our real gross domestic income rose by 7.7 per cent over the year, compared with the rise in real gross domestic product of 2.7 per cent. As this extra income is spent in coming months, GDP will accelerate.

Because they're so volatile, it's always good to cross-check the quarterly national accounts by comparing them with what we know is happening in the labour market. Over the year to January, total employment grew by a rapid 3 per cent, with 80 per cent of the 330,000 jobs created being full-time. Unemployment fell by 0.3 percentage points to 5 per cent.

This is a healthy economy notwithstanding the caution consumers are showing and the temporary effects of floods and cyclones. The strength is coming from investment in the expansion of our mining industry, and there's a lot more of it to come.

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The economy is a lion disguised as a lamb

The big divide in economists' views on the outlook for the economy - and hence, for interest rates - is whether they regard the present weakness in consumer spending as worrying or welcome. And that turns on how forward-looking they are.

I suspect it's also affected by what psychologists call "salience" - the tendency for our judgments to be most affected by those events that are highly visible and memorable, those that make the biggest impression on us. Looking at the economy now, what stands out is the weakness of consumer spending, including quite anaemic growth in retail sales. Tourism - whether inbound or domestic - is another area of weakness, badly affected by the high dollar.

So weak is consumer spending that it's putting downward pressure on a lot of retail prices. As Dr Philip Lowe, of the Reserve Bank, pointed out last week, over the past year the Bureau of Statistics' price index for clothing has fallen by 6 per cent (assisted by a fall in import duty on footwear, clothing and textiles at the beginning of last year).

The various indexes have fallen by 4 per cent for major household appliances, 1.5 per cent for furniture and furnishings and by 18 per cent for audio, visual and computing equipment. Indeed, apart from processed food, the prices of very few manufactured goods rose during the past year.

Lowe suspects the weak consumer spending has led to a faster than usual pass-through to retail prices of the substantial appreciation of the dollar, which has lowered the cost of imported goods and services (and also put downward pressure on the prices of locally made goods and services that compete against imports in the domestic market). His suspicions are confirmed by the research of Kieran Davies, of Royal Bank of Scotland, who found the weakness of retail prices was more likely to be the result of pass-through of the higher exchange rate than the compression of retailers' margins.

Davies notes that, unless the dollar appreciates further (not something I'd wish for), the exchange rate's dampening effect on inflation will soon start to wane.

All this spells tough times for the retailers, and their lamentations have had much publicity. So it's easy to see the economy as going through quite a weak patch. This impression will be compounded when we see the way the Queensland floods and cyclone Yasi have taken a bite out of the growth in gross domestic product in the December and, more particularly, March quarters.

Little wonder the financial markets aren't expecting any further increases in the official interest rate until quite late this year, and the governor of the Reserve Bank, Glenn Stevens, thinks rates are "about right for the medium-term outlook". But I think there's a lot more strength behind the economy than all the surface noise would suggest. If I'm right, the rate rises will resume earlier than the markets presently expect.

For a start, the blow from the extreme weather events largely represents the displacement of activity from the March quarter to the June and later quarters. The Reserve is expecting the level of GDP to be no lower by the end of this year than was expected before the floods happened.

For another thing, the weakness in consumer spending is occurring because of a reversion to our earlier saving habits and a (presumably temporary) bout of caution. In other words, consumers aren't short of a bob, they're choosing not to spend.

It's not the sort of thing the media shout about, but household disposable income grew by 6.4 per cent over the year to September in nominal terms. It's being boosted by two major sources of present and future growth: our most favourable terms of trade in 140 years and strong growth in employment. The Reserve's index of commodity prices has risen by almost half over the past year. This doesn't add to GDP directly, but it does add to the nation's real income which, when spent, becomes more visible.

Another less salient factor is the strength of the labour market. Over the year to January, total employment grew by 3 per cent. Within that, full-time employment grew by 3.4 per cent. The unemployment rate is down to 5 per cent, while the rate of participation in the labour force is at a near record high of 65.9 per cent.

This is not the hallmark of a weak economy - quite the reverse. It also gives the lie to the silly talk of a two-speed economy. You may object that the labour market's yet to register the effect of the weak retail sector but, in fact, the various forward indicators suggest employment will continue growing strongly.

And to top off all that there's the least salient factor of all: the looming wall of mining construction spending. Consider this quote from the latest statement on monetary policy: "For some time, the [Reserve] has been expecting very strong growth in resources sector investment.

"The information received over recent months has provided greater confidence in this forecast, with announced plans to date at least as strong as had been expected."

All this is what you see when you lift your eyes from hard-pressed retailers and look at what's in the pipeline. When you do you see that, from a wider perspective, the fact we're not yet adding a consumption boom to a business investment boom is more welcome than worrying.

The economy's potential rate of economic growth is only about 3.25 per cent a year and, with unemployment already down to 5 per cent, we have little spare production capacity.

Even so, the Reserve is forecasting growth of about 4.25 per cent over this year, with growth of 3.75 to 4 per cent in the following years.

Sounds like a recipe for higher interest rates to me.

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Floods' economic pain greatly exaggerated

Most of us are back at work, but the silly season won't be over until we get the Queensland floods into perspective. They are a great human tragedy, but they're not such a big deal for the economy.

It's not surprising the public has been so excited about such amazing scenes and so much loss of life and property. Nor is it surprising the media devoted so much coverage to the floods when, with most of us at the beach, there's been so little other news.

It's not even surprising the Gillard government has been beating up the story, making it out to be the biggest thing since the global financial crisis. At one level this is just the pollies doing their instinctive I-feel-your-pain routine. They could seem heartless if they tried telling people things weren't as bad as they seemed.

At another level it's easy to see Julia Gillard trying to gain the same boost to her popularity as Anna Bligh. She'd be well aware of all the seats Labor lost in Queensland at the election in August. It's an almost inevitable assumption by the punters and the media that if an event is huge in human and media terms it must be just as big in its effect on the economy. When the punters tire of seeing footage of people on roofs, you "take the story forward" by finding some expert who'll agree it also spells disaster for the economy.

The wise and much-loved econocrat Austin Holmes used to say that one of the most important skills an economist needed was "a sense of the relative magnitudes" - the ability to see whether something was big enough to be worth worrying about.

That sense has been absent from the comments of those business and academic economists on duty over the silly season, happily supplying the media's demand for comments confirming the immensity of the floods' economic and budgetary implications.

With the revelation last week of the econocrats' estimates of the likely magnitudes, it's clear the figures supplied by business economists were way too high. And the economists' furious debate over how the budgetary cost of the rebuilding effort should be financed is now revealed as utterly out of proportion to the modest sums involved.

Of course, you still wouldn't have twigged to this had you focused on the government's rhetoric rather than its figures. In Gillard's speech on the budgetary costs and Wayne Swan's speech on the economic impact both were busily exaggerating the size of the crisis, even while revealing how small it really was.

Gillard said it was "the most expensive disaster in Australia's history" and that the "cost to the economy is enormous". The government's task, she kept repeating, was to "rebuild Queensland".

Swan repeated that "this is likely to end up being the most costly disaster in Australian history", which was "going to cost Australia dearly" and involves a "massive reconstruction effort". The closest he got to the truth was his observation that "the economic questions pale into insignificance next to the human cost of what we've seen".

If this is the most expensive natural disaster in Australian history, all it proves is the cost of earlier disasters was negligible. If you can "rebuild Queensland" for just $5.6 billion, it must be a pretty tin-pot place.

If $5.6 billion seems a lot, consider some "relative magnitudes": the economy's annual production of goods and services (gross domestic product) totals $1400 billion, and the budget's annual revenue collections total $314 billion.

Note that, though no one's thought it worthy of mention, the $5.6 billion in spending will be spread over at least three financial years, making it that much easier to fund.

We know that more than a third of the $5.6 billion will be paid out in the present financial year with, presumably, most of the rest paid in 2011-12. So just how the flood reconstruction spending could threaten the budget's promised return to surplus in 2012-13 is something no one has explained.

And if $5.6 billion isn't all that significant in the scheme of things, how much less significant is the $1.8 billion to be raised from the tax levy? The fuss economists have been making about it tells us more about their hang-ups over taxation than their powers of economic analysis.

And how they can keep a straight face while claiming it could have a significant effect on consumer spending (well over $700 billion a year) is beyond me.

Turning from the budget to the economy, Treasury's estimate is that the floods will reduce gross domestic product by about 0.5 percentage points, with the effect concentrated in the March quarter.

Thereafter, however, the rebuilding effort - private as well as public - will add to GDP and probably largely offset the initial dip. So the floods will do more to change the profile of growth over the next year or two than to reduce the level it reaches.

Most of the temporary loss of production will be incurred by the Bowen Basin coal miners. But, though it won't show up directly in GDP, their revenue losses will be offset to some extent by the higher prices they'll be getting as a consequence of the global market's reaction to the disruption to supply.

And despite all the fuss the media have been making over higher fruit and vegetable prices, Treasury's best guess is that this will cause a spike of just 0.25 percentage points in the consumer price index for the March quarter, with prices falling back in subsequent quarters.

So the floods do precious little to change the previous reality that, with unemployment down to 5 per cent and a mining investment boom on the way, the economy is close to its capacity constraint and will soon need to be restrained by higher interest rates.

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A reality check at last on what we take for granted

A recurring theme in my writing this year has been to point out the limitations of gross domestic product as a measure of wellbeing, particularly as related to the environment. But today I have good news: something is being done about it. Economists and statisticians long ago developed a "system of national accounts" to measure developments in the economy, based on Keynesian theory about how economies work.

Although these accounts give much detail about income, production, spending and saving during a period and, these days, a balance sheet outlining the values of the nation's assets and liabilities to the rest of the world on the last day of the period, we tend to focus on a single bottom line: the change in the real value of goods and services produced during the period, otherwise known as GDP.

A United Nations commission sets down an international standard for all countries to follow in preparing their national accounts, using the same theory, concepts and definitions so each country's figures are comparable and can be added together to give gross world product. But as we've become more aware of the problems economic activity is creating for the natural environment - degradation of rivers and soil, depletion of non-renewable resources, use of renewable resources faster than their ability to renew themselves, destruction of species and generation of waste and pollution, including greenhouse gases - we've realised that little of this cost is taken into account in measuring the change in our income.

It's as though we've been thinking of and measuring "the economy" - the production and consumption of goods and services - in total isolation from the natural environment in which the economic activity occurs.

The environment provides the economy with many "ecosystem services", which a leading ecological economist, Professor Robert Constanza, of Portland State University, defines as "the benefits provided to humans through the transformations of resources (or environmental assets, including land, water, vegetation and atmosphere) into a flow of essential goods and services,

for example clean air, water and food".

These ecosystem services are treated as though they're "free goods" - goods in such abundant supply they have no value or cost - while, as we've seen, most of the damage economic activity does to the ecosystem is also ignored.

The main reason for these limitations is that, with some exceptions, the national accounts and GDP don't actually measure "the economy" but rather market transactions within the economy. So, for instance, it ignores all the production and consumption that occurs within households without money changing hands. It measures professional sport, but not amateur sport.

It's clear we can't go on effectively ignoring the relationship between the economy and the environment. The damage economic activity does to the environment diminishes our wellbeing, as well as rebounding on the economy and damaging it. We can go on ignoring the damage excessive irrigation is doing to the Murray-Darling so as to avoid disrupting the livelihoods of the irrigators, but if we eventually turn the river into a drain, irrigation will be no more.

We need to recognise and measure the interrelationship between the economy and the environment because we don't want to give ourselves a false impression of the progress we're making, even in a narrow, material sense. Measurement is important because "what we measure affects what we do; and if our measurements are flawed, decisions may be distorted".

To this end the UN commission and its member national statistical agencies have agreed on a "system of integrated environmental and economic accounting", which will become an international standard in 2012. This brings environmental and economic information together within a common framework, meaning information from each side is on a comparable basis and can thus be combined.

Well that's great. But our longstanding focus on purely economic measurement means we don't yet collect all the data we would need to produce environmental accounts that could be integrated with the economic accounts to give us a more balanced picture of the progress we're making (although, of course, this says nothing about other dimensions of progress, such as the quality of our health, extent of our education, inequality in the distribution of income and treatment of minorities).

It turns out the efforts of our Bureau of Statistics have been concentrated heavily on collecting the reams of statistical information needed to produce the quarterly national accounts.

So that's the first stumbling block. The second is that, with the environment, you have to start with physical measures (millilitres, petajoules, hectares or tonnes) then see if you can convert them to dollar values - as they must be if they're to be combined with the economic accounts. (That's the problem with non-market activities, of course. When something is bought or sold, you know its dollar value.)

The bureau of stats has issued a paper describing its progress in moving Towards an Integrated Environmental-Economic Account for Australia. It needs to produce six accounts that will add up to the environmental side.

A water account (released a few weeks ago and now to be produced annually) includes the physical flows of water supplied to, and used by, the economy, and water returns to the environment. It includes monetary supply and use tables and indicators of the water productivity of industries.

An energy account (to be produced annually from mid next year) includes physical and monetary supply and use tables for various energy products, by industry. A land account (to be produced annually from early next year) includes physical and monetary land use by industry, land cover by industry and changes in land cover over time.

An "environmental protection expenditure" account (to be produced annually from late 2012) gathers together protective spending already included in GDP for things such as waste water treatment. A waste account (to be produced three-yearly from late 2012) covers physical generation and disposal of waste by industry, type of waste and destination.

It would be nice if, having done all this measurement, we could produce from the integrated environmental-economic accounts a single, bottom-line figure for "green GDP", that we could watch as closely as we watch the present brown GDP. As yet, however, the world's statistical agencies haven't agreed on a definition of green GDP, nor agreed on how to convert all physical quantities into dollar values. But there will be enough information to allow outfits or academics to calculate their own versions of green GDP using their own assumptions. And it should be possible to produce a figure for GDP after adjustment for environmental depletion and degradation.

That will be a big step forward.

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Only part of our fortune is down to minerals

If it exercises my doctor's mind I imagine it occurs to a lot of people: are we a stuffed nation living off our mineral wealth? The thought that we're making a lot of our income merely by digging stuff out of the ground and shipping it overseas seems to worry a lot of people. Is that the best we can do?

Considering the fuss politicians, economists and the media are making about the resources boom, you could be forgiven for thinking mining had taken over the economy, but it isn't true. A lot of people think a nation makes its living by selling stuff to the rest of the world. That isn't true, either. Roughly 80 per cent of all the goods and services Australians produce (gross domestic product) is sold to Australians, not foreigners. Similarly, roughly 80 per cent of the goods and services Australians buy is bought from Australians.

In other words, our economy is roughly 80 per cent self-sufficient. At a pinch, we could make it completely self-sufficient, though this would involve a significant decline in our standard of living. Why? Because we'd be denying ourselves access to all those goods and services that other countries produce better or more cheaply than we could.

Here you see the only reason we need to sell things to the rest of the world: so we can afford to import things from the rest of the world. All of us enjoy those imports, but the notion that 80 per cent of us survive by living off the 20 per cent who produce exports is quite mistaken.

Economies work by a process of specialisation and exchange. We each specialise in producing something we're good at, sell what we produce for money (usually wages), then use the money to buy the things we need from other producers. Most of this trade occurs within Australia, but extending our trade to people in other countries makes both them and us better off, because we've got stuff they want and they've got stuff we want.

Thanks to the industrialisation of China and India - accounting for almost 40 per cent of the world's population - the rest of the world is prepared to pay record prices for our coal and iron ore. Those prices won't stay at record levels but, because the process of industrialisation takes quite a few decades, they're likely to stay a lot higher than they were for a long time.

Though minerals and energy now account for about 42 per cent of our export earnings, this still leaves 58 per cent coming from other parts of the economy: 18 per cent from agriculture, 17 per cent from manufacturing and 23 per cent from services (particularly tourism and education).

When you get down to it, mining accounts for only 7 per cent of the value of all the goods and services Australians produce. That leaves agriculture accounting for 3 per cent, manufacturing for 12 per cent and the services sector for 78 per cent.

We have a lingering tendency to denigrate the services sector because it doesn't produce anything you can see and touch. But this is silly. As our standard of living has risen over the years, services account for an ever-increasing proportion of the things we buy (there is, after all, a limit to how much we can eat and how many cars and TV sets we need). And, as we've seen, it's not even true that we can't export services.

It turns out that 84 per cent of working Australians are employed in the services sector - similar to other advanced economies. And although some service jobs are menial - chambermaids, cleaners, waiters and shop assistants - most of the clean, safe, highly skilled, well-paid and intellectually satisfying jobs are in the services sector: doctors, lawyers, bankers, architects, engineers, managers, consultants, clergy, accountants, journalists, actors, media personalities, academics, teachers and many more.

Take away mining and we wouldn't be quite as rich as we are, but most of the economy would look much the same as it does. Most of us would still have good, secure, well-paid jobs.

In other words, our economy has a lot more going for it than just the good fortune of sitting on a lot of valuable minerals.

In Australia, as in every country, public discussion focuses on the bits that aren't working as well as we'd like them to. The bits that are working well get taken for granted. It would be a pity if all this left people with the impression things in Australia are substandard. They're not.

The level of educational attainment in Australia is high and ever-rising. Tests show our 15-year-olds' literacy, numeracy and science are well above average for the developed countries. Seven of our universities are ranked in the top 200 in the world.

With the notable exception of Aborigines, Australians' health is good by international standards. Our longevity is among the highest in the world. So despite all our complaints, we have a good health system, delivering better results than the Americans' at a much lower cost.

Our material standard of living is around average for the rich countries, but likely to go higher. Our gap between rich and poor is also about average, but not as bad as the other English-speaking countries.

For the past 20 years we've had a particularly well-managed economy, with low inflation, falling unemployment and a rising standard of living. Our banks have been well-supervised and kept out of trouble. Most other advanced economies have huge levels of public debt, but ours is minor.

It's true our mineral riches won't last forever, so we do have to make sure we invest the proceeds wisely, particularly in education. But even without mining we still have a healthy, prosperous economy.

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Gillard indulges the mendicants at her peril

It's just as well Julia Gillard and her purse-string ministers are so committed to "a strong economy" because that's just what they're about to get. And let me tell you: an economy as strong as we're getting requires a strong government - something this lot hasn't been noted for.

Contrary to last week's silliness over the national accounts, we have everything going for us. Our terms of trade - export prices relative to import prices - are the most favourable they've been in a century and are pumping an extra 12 to 15 per cent of gross domestic product into the economy.

Then there are the tens of billions the mining companies are planning to spend building mines and gas facilities. This mining construction boom could run for a decade.

The labour market is particularly strong and unemployment hasn't far to fall to reach the 4.75 per cent rate economists regard as full employment.

So the problem won't be keeping the growth going but holding it down because the demand for labour and capital will soon be outstripping the supply.

This is a problem mainly for the Reserve Bank. And it knows exactly what to do: raise interest rates whenever it fears inflation is headed up out of its 2 to 3 per cent target range.

But Gillard and her ministers have to do as little as possible to add to demand and as much as lies within their power to subtract from it.

How? By running the tightest budget they can manage. They need to let the boom push up their revenue and avoid cutting taxes. They need to control the growth in their spending as tightly as possible, getting the budget back to surplus as soon as possible.

They are, of course, committed to do just this by their deficit exit strategy and also by Gillard's promise (not just forecast) of achieving a surplus in 2012-13. The strategy requires them to stay in this fiscal chastity belt until the surplus is back to 1 per cent of GDP.

But the point Glenn Stevens of the Reserve made last week is that the government will need to maintain the budgetary discipline long after the budget's back to surplus and even after it's eliminated the net public debt.

If it follows the logic of Costelloism and starts cutting taxes and spending freely once the surplus is back to 1 per cent of GDP, fiscal policy becomes "pro-cyclical" - it adds to demand rather than restraining it - as it was in the sainted Howard government's last years.

In other words, for as long as the economy's booming you have to let the surplus get bigger and bigger every year. And to help make that easier politically, you probably need to put the surplus into some sort of stabilisation fund or sovereign wealth fund.

The hardest part, however, is resisting the temptation to splash taxpayers' money on every group with a hard-luck story. Take all the sympathetic noises the government's been making about the high cost of living.

Last week's national accounts told us the household saving rate is now at 10 per cent of disposable income. It's probably not really that high but it is clear people's incomes have been growing a lot faster than their consumer spending. Don't sound hard-up to me.

Another bad sign is the way the government's started echoing complaints about "the two-speed economy". Last week Gillard alluded to this as the "patchwork economy".

And the Treasurer, Wayne Swan, said: "We don't want to in any way inhibit the speed of the mining sector, but we also have to do everything we can to help all of those that are in the slower lane."

Sorry, but that's quite wrong headed. Anything "we do" to help those people via the budget will add to demand and, hence, put further upward pressure on interest rates and the exchange rate.

What's more, this talk conveys an exaggerated impression of the extent to which the rest of us will suffer as a consequence of the expansion of the mining sector in Western Australia and Queensland. The government should be trying to educate and correct this misperception, not pander to it.

The notion that there is, or will be, a wide and enduring gulf between the mining states and the rest is wrong. It's wrong because, in industry terms, it's not a two-speed economy it's a three-speed.

Top speed is mining and associated industries. Low speed is the non-mining tradeables sector - agriculture, manufacturing, education and tourism. But in between is the non-tradeables sector.

And get this: the non-tradeables sector accounts for about three-quarters of the economy. So the great majority of us work in neither the fast lane nor the slow lane. What's more, the non-tradeables sector benefits from the high dollar because that makes imported parts and equipment cheaper.

Note, too, that the non-tradeables sector accounts for the great majority of production and employment in all states. And though Queensland has a lot of mining, it also has a lot of tourism. This is why, when you look at the figures, you don't see the wide disparity the two-speed contention leads you to expect.

For 2009-10, WA's gross state product grew by 4.3 per cent, but Queensland's grew by 1.6 per cent - less than Victoria's 2 per cent and NSW's 1.7 per cent.

But a lot of that growth came from increased population. Look at GSP per person (to get a measure of changed material living standards) and WA's growth drops to 1.6 per cent, while Queensland's was minus 0.8 per cent. That was worse than all the other states.

A strong economy requires a government with the strength to stare down all the whingers trying to touch it for a handout.

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Keep your shirt on, life could be worse

Oh! No! The economy was roaring along in June quarter, growing by 1.1 per cent, but now it has almost come to a halt, up just 0.2 per cent in the September quarter. What's more, take out a leap in rural production and we actually went backwards.

It made a great story this week - thrills and spills in econoland - but I wouldn't believe it. Why not? Because in real life economies don't soar and dive in the space of six months without there being a very big and obvious reason - the introduction of the goods and services tax, for instance, or the collapse of Lehman Brothers and its aftermath scaring the pants off businesses and consumers.

You need to know that both the financial markets and the media have a vested interest in statistical volatility.

It gives them something to bet on or write stories about and makes their lives more interesting. So it suits them to take economic statistics literally, ignoring their well-known limitations.

Sensible people, however, always take them with a grain of salt, knowing the economy is far more stable than the stats - especially quarter-to-quarter changes - show it to be.

The making of the ''national accounts'' - the bottom line of which is gross domestic product - is like the making of sausages: you're better off not knowing what goes into them. They're pulled together using bits and pieces from thousands of different sources.

Often, inferior sources are used because the more reliable information isn't yet available. Sometimes no information is available, so the statisticians take a guess. When the better information does come along, the figures are changed. Since the better data come along at different times, the figures for a particular quarter are constantly being changed, for at least the next two years.

The original figure for growth in the December quarter of 2008 - the quarter when Lehman Brothers collapsed - was minus 0.5 per cent. It was then revised down each quarter until it reached minus 0.9 per cent. Then it was revised up each quarter, reaching minus 0.7 per cent three months ago.

This week it was revised down to minus 1 per cent. So we're now being told the contraction was twice the size we were originally told. And there were people at the time imagining that figure had been written by God on tablets of stone.

Or, let's try another one. Three months ago we were told real GDP grew by 3.3 per cent over the year to June. Now we're told it grew by 2.7 per cent over the year to September.

Why the sudden slowdown? Well, not primarily because of the alleged virtual cessation of growth in the September quarter, but because revisions shifted 0.4 percentage points of growth out of the December quarter of 2009 and into the September quarter of 2009 (which dropped out of the annual calculation).

The Bureau of Statistics acknowledges the ropiness of its figures, which is why it tries to direct users to its ''trend estimates'', which simply average out the quarterly ups and downs. But for good reasons and bad, economists, the markets and the media invariably ignore the trend figures and focus on the more volatile unsmoothed ones.

The point is that much of the quarter-to-quarter volatility in the growth figures isn't real but just ''statistical noise''. You have to ignore the noise to hear the true ''signal'' underneath it.

Remember, too, it's easy to be bamboozled by quarterly changes. If some big transaction is accidentally put into the wrong quarter, this distorts the quarterly change for three successive quarters.

Because a big thing such as a national economy - or an ocean liner - is actually quite hard to speed up or slow down, when the figures show it rapidly speeding up in one quarter, the greatest likelihood is that the figures for the following quarter will show it rapidly slowing down.

And that's just what the past two quarters' figures show. Logical deduction: the economy didn't really grow that fast in the June quarter and didn't really slow that much in the September quarter.

There's an old trick Treasury used to reduce the statistical noise and get a clearer signal: add the last two quarters together and take an average. That says the economy has probably been growing at a quarterly rate of about 0.65 per cent over the past six months ([1.1 + 0.2] ÷ 2).

That makes more sense, but even it seems too low. How can I say that? Because we have an independent (and less volatile) set of stats to measure the national accounts against: the employment figures.

These show employment growing fairly steadily over the past year, growing particularly strongly in the September quarter and increasing by 3.2 per cent for the year. That's not an economy that's suddenly run out of juice.

So when we peer through the statistical haze, what do we see in the national accounts? First, we see that the pick-up in business investment spending - particularly in the mining sector - is occurring, in line with what the companies have long been telling us about their plans for huge spending over the coming year and longer.

Second, despite strong growth in household disposable income (fed by strong growth in employment and rising real wages), consumer spending isn't growing nearly as strongly, meaning households are saving a lot more. (The figures say the household saving rate was 10 per cent of disposable income - which is too high to believe, but undoubtedly saving is high.)

This is bad news for retailers but good news for the economy generally because it postpones the time when, with the economy nearing full employment, the economic managers are struggling to cope with a massive mining investment boom and a consumption boom.

The way they'll cope with a double boom is simple: they'll jack up interest rates (which will also add upward pressure to the exchange rate) to discourage consumer spending. So the longer households keep thinking now's a good time to get on top of their debts, the better off we'll be. The bad news in the accounts, however, is the continuing weakness in the building of new homes and also in commercial (as opposed to industrial) construction.

This suggests inadequate supply will soon be pushing up rents and thus increasing inflation pressure.

So a literal reading of this week's accounts sends us just the opposite message to the true position.

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Do not let the environment go to waste

I sympathise with the calls from ecologists and others for an end to economic growth. But that doesn't mean I'd like to see no further increase in gross domestic product.

Huh? Let me explain. There's a lot of confusion between scientists and economists on exactly what is meant by "economic growth". Each side uses the words to mean something different.

As Professor Herman Daly, of the University of Maryland, a founder of ecological (as opposed to environmental) economics, has explained, what many ecologists want an end to is growth in the use of natural resources.

Actually, he says an end to the "throughput" of natural resources. This is a reference to the first law of thermodynamics, which says matter and energy can't be destroyed, just have their form changed.

So when we use natural resources as an input to the economic machine, so to speak, what comes out the other end (apart from the goods and services we sought to create) is various forms of waste - sewage, landfill, polluted air and waterways, not to mention greenhouse gases.

Thus from a scientific perspective, what economic activity does is convert natural resources into waste. Daly's point is that we have to worry about both ends of the process: not just the exhaustion of non-renewable resources and the over-exploitation of renewable resources, but also the unending stream of waste we're pumping into the environment.

The scientists are saying that, since the global economy (human activity of an economic nature, which is most of it) exists within the global ecosystem and the ecosystem is of a fixed size, it's simply not physically possible for the economy to grow at an "exponential" (a reasonably steady percentage) rate forever.

They're also saying we must be close to the ecological limits to growth in our throughput of natural resources, as is clearly the case with greenhouse gas emissions. Hence the calls for an end to "growth".

Most economists - particularly older economists who've known nothing but the promotion of endless growth throughout their careers - find this a pretty shocking notion. But it's not as bad as they fear.

Why not? Because the "growth" the scientists have in mind is not the same as the growth the economists have in mind. The economists' idea of growth is growth in (real) GDP - that is, growth in the economy's output of goods and services.

And the growth in the output from the economic machine comes from two different sources: from increased inputs of all resources (labour, man-made capital and "land", which includes natural resources), but also from the increased efficiency with which those resources are combined - otherwise known as improved "productivity" (output per unit of input).

So improved productivity means achieving more output of goods and services from an unchanged quantity of inputs. This increased production is achieved mainly by technological advance: the invention of better machines, the discovery of better ways to manage the production process (increased "know-how") and the exploitation of economies of scale, though increases in human capital (the skill of the workforce) also help.

It turns out that, over the decades, improved productivity is actually the main source of growth in GDP. Economists are mainly concerned with organising the economy in a way that creates the incentives for people to achieve greater efficiency in the use of all types of resources and thus improved productivity.

And though they usually don't realise it, the scientists aren't saying they have any objection to the pursuit of efficiency and improved productivity. Indeed, implicit in what they're saying is that they'd love to see us become more efficient in the use of natural resources if this allowed us to use fewer of them.

So the expertise economists contribute to society - their understanding of how to promote efficiency in the allocation of resources - wouldn't be under threat from moving to a "steady-state economy" in which the goal was no further growth in the throughput of natural resources.

Indeed, our move to such an economy couldn't be achieved without the expertise of economists. They understand how economies work and scientists don't.

Economists see what they do as helping people to "optimise under constraints", the main constraint being the scarcity of all resources. What the ecologists are calling for is simply the imposition on the economy of one specific constraint: no further increase in the throughput of natural resources. How would that be achieved? By using an "economic instrument" invented by economic rationalists, the cap-and-trade system. Just as an emissions trading scheme caps the amount of greenhouse gases allowed to be emitted, so you'd impose a cap on the use of natural resources.

Proceeds from auctioning permits to use natural resources would constitute "a great big new tax on everything", so you'd use those proceeds to finance cuts in other taxes, particularly those on income and consumption. You'd rejig the tax system so more revenue came from taxing environmental "bads" and less from taxing economic "goods".

You'd be significantly changing relative prices in the economy, so goods and services with a high natural-resources component became a lot dearer, whereas those with a low natural-resources component became a lot cheaper.

Market forces would adapt to the change in relative prices, achieving the cap in the use of natural resources with least disruption to the economy. The point of the cap is to stop market forces doing what they otherwise would: flowing the benefit of increased efficiency in the use of natural resources on to customers in the form of lower prices, which would then defeat the object of the exercise by encouraging greater demand for natural-resource-intensive goods and services.

Under the present constraints, market forces focus on economising in the use of the most expensive resource, labour (which is made more so by the high taxes on labour - income and consumption taxes). Often, this involves waste in the use of cheaper, natural resources because it's not economic to do more recycling and to repair rather than replace appliances.

The point is, even if you achieved an end to "growth" in the throughput of natural resources, you'd still be getting "growth" in real GDP arising from increased productivity in the use of all resources. The main difference is that the market's effort would go into raising the productivity of natural resources rather than the productivity of labour. Daly's way of trying to end the terminological confusion is to say that in a steady-state economy there'd be no "quantitative growth" but there'd still be "qualitative development".

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CURING AFFLUENZA: WHY ECONOMIC GROWTH SHOULD BE STOPPED

Talk to Festival of Dangerous Ideas, Sydney Opera House
October 3, 2010

Our economy, and pretty much every economy, has been growing for at least the past 200 years. Almost every year the quantity of goods and services being produced has increased. Production has grown faster than the population has grown, meaning that, on average, people’s annual consumption has increased. Our material standard of living has risen by a percent or two every year; we’ve become more affluent.

Almost every economist, business person and politician believes this is the way things should be and must continue to be forever. All those groups are convinced this is what the public wants: ever-increasing affluence. They think any politician who failed to promise economic growth would be pilloried; any government that failed to deliver it would be thrown out. Even the Greens avoid publicly expressing any doubt about the desirability of continuous growth. It’s just too hot. So deep-seated is this belief that it constitutes a bedrock assumption underlying the whole economic debate. Most of my participation in that debate - most of what I write in the Herald - implicitly accepts this conventional wisdom.

But the longer I’ve continued as an economics writer, the more I’ve read and thought about it, the more I’ve come to doubt the conventional wisdom. My rejection of the case for economic growth is spelt out in my new book, The Happy Economist. I have three reasons for breaking with this almost-compulsory belief.

The first is that, contrary to everything economists, business people and politicians assume, our increasing material standard of living over time hasn’t made us any happier. In many countries, annual surveys of the public’s satisfaction with life have stayed essentially unchanged over the decades despite ever-increasing real incomes. It’s true that, at any point in time, people with higher incomes tend to be happier - a little happier - than people with lower incomes. But as everyone’s income rises over time, average happiness is unchanged. Psychologists offer two main explanations for this paradox. One is that we quickly get used to pay rises and promotions and the extra stuff they allow us to buy; we soon take them for granted as our expectations adjust. The other is that what we like is an increase in our relative income, because the income and the flashy stuff it buys give us greater social status. It allows us to engage in conspicuous consumption, demonstrating to the world that we’re not only keeping up with the Joneses but getting ahead of them. That cynical and sexist old American journalist H. L. Menken said that to be wealthy is to have an income that’s at least a hundred dollars a year more than the income of your wife's sister's husband. But no amount of economic growth can make all of us feel socially superior to everyone else. It’s a status race that some people can win only at the expense of those who lose. So it’s socially wasteful.

My second reason for breaking with the belief that the pursuit of unending economic growth is desirable is that the things we do to encourage growth by increasing the economy’s efficiency often generate social costs, many of which go unnoticed. They go unnoticed partly because they’re subjective and hard to measure, but also because, being things that fall outside the economic model - the economic way of looking at things, which has a deep influence on the habitual lines of thought of politicians and business people - we’ve never put much effort into measuring them.

One of the clear lessons of the ‘science of happiness’ confirms something we all know: how much of the satisfaction we derive from life comes from our relationships. Relationships with our spouse and our children, our parents and siblings, our wider relatives, workmates, neighbours and friends. But despite their central importance to our wellbeing, our relationships simply don’t figure in the economists’ model. Which means economists frequently urge on our politicians ‘reforms’ they are sure will add to our affluence, without a moment’s thought about what effect these may have on our relationships and the social dimension of our lives.

A prime example is the effort in recent years to lift the nation’s productivity by deregulating shopping hours and getting rid of penalty payments, which has hastened the demise of the weekend, when most adults and school children weren’t working and so were able to enjoy each other’s company. Only when the economics-types went to the extreme of Work Choices did many people see clearly the social costs that would accompany the economic benefits - the greater affluence - it might have brought about.

My third reason for rejecting the belief that the pursuit of unending economic growth is desirable - or even possible - is the one that would have sprung first to the mind of many of you: the sheer impossibility of exponential growth in the economy - growth at a reasonably steady percentage rate - continuing indefinitely within a finite natural environment. The basic economic model, which hasn’t changed much since the second half of the 19th century, is a model of market transactions: the factors of production - land, labour and capital - change hands for a price and are used to produce goods and services which also change hands for a price. So it’s the model of a market and the only things in the model are things that have a price. Anything that isn’t bought and sold at a price - including clean air, clean water, photosynthesis, native species, natural sinks for carbon dioxide - is external to the model and thus tends to be ignored. So the ‘ecosystem services’ that are utterly essential to the functioning of the economy - indeed, to the survival of humanity - have historically been treated by economists as ‘free goods’ - goods in such abundant supply they don’t carry a price and so can safely be ignored. The natural environment is outside the market, so we can forget it.

Now, it’s important to note that, 100 or 150 years ago, this was a reasonable approximation of the truth. Human activity - most of which is economic activity - obviously caused damage to the local environment, but so limited was that activity relative to the vastness of the natural world that it was reasonable to assume it was having no significant effect on the overall ecosystem. If so, it was reasonable to ignore the natural environment.

Two things have happened since then. One is advances in the natural sciences, which have allowed us to understand the harmful effects of economic activity on the ecosystem that often aren’t visible to the naked eye. The other is the massive growth in economic activity, as a result of the success of capitalism and the technological advance it fosters and exploits. In the past 200 years, the world’s population has increased by a factor of more than six, thanks to advances in public health and medical science. In the same period, the average material standard of living of all the people in the world has also increased by a factor of six, thanks to capitalism and technological advance. Multiply the two together and you see the amount of economic activity - as measured by GDP - has increased 45-fold in the past 200 years since the start of the Industrial Revolution.

And all this in a natural environment that’s grown no bigger. So whereas it was possible say economic activity was too small to have much impact on the global ecosystem, it’s not credible to say it today. We get back to the earlier question of whether economic activity can continue growing exponentially in an ecosystem of fixed size. Clearly it can’t. And this raises a vital question: are we reaching the limits to growth? When ecologists first suggested this in the 1970s, economists laughed at them. But in the time since then the evidence has been stacking up on the scientists’ side. It’s now apparent, for instance, that we’re rapidly approaching the limits to growth in one dimension: greenhouse gas emissions arising from the burning of fossil fuels and the destruction of forests. There could be no clearer example of how economic activity is starting to do great damage to the ecosystem, some of which may soon be irreversible. But there are other areas where the damage we’re doing to the environment is mounting up: all the problems we’re having with water, rivers, farming methods and soil quality; the irreversible decline in fish stocks and the difficulties associated with fish farming; the declining reserves of certain non-renewable resources, and the destruction of species.

My fear that we’re approaching the limits to growth more generally than just in the case of greenhouse gas emissions is greatly increased by the rapid economic development of the two most populous countries in the world, China and India, which between them account for almost 40 per cent of the world’s population. We’re well aware of how hugely resource-intensive is the lifestyle of the 15 or 20 per cent of the world’s population in the developed countries. But now these two big countries have been growing at rapid rates for the past two or three decades. China’s GDP has been doubling every seven years; India’s every eight or nine years. Should this growth continue for another 20 or 30 years, the material standard of living of another 40 per cent of the globe’s population would be approaching that of ours. Question is: do we have enough natural resources available to make this possible? And could the global ecosystem survive such an immense call on its services?

Problem is: we’re in no position to urge the Asians to abandon their efforts to become as materially affluent as we have long been. It wouldn’t be moral for us to try and it wouldn’t have any effect if we did. There are two dimensions to the problem: the continuing growth in the world’s population and the continuing growth in the world’s average material living standards. I believe the only way to try to reconcile the poor countries’ material aspirations with the ecological limits to growth is for the developing countries to focus particularly on limiting their population growth and for developed countries such as Australia to focus on limiting our economic growth. (The rich countries don’t need to worry about population growth because our fertility rates are already below the replacement level of 2.1 babies per female.)

We rich countries need to move to a ‘steady-state’ economy, where there is no growth in our use (‘throughput’) of natural resources, even though there is no restriction on efforts to use all resources (natural, labour and man-made capital resources) with greater economy - that is, on productivity improvement. With a fertility rate below the replacement rate and limited net immigration, this should not involve a significant decline in our present material standard of living.

How would this absence of growth in the use of natural resources be achieved? By the much wider application of cap-and-trade schemes such as the emissions trading scheme proposed for greenhouse gas emissions. This would have the effect of raising the prices of natural resources and everything made from them, but provided the permits for firms to put natural resources into the production chain were auctioned rather than given away, the rise in prices would be equalled by an increase in government revenue. That is, the scheme would be equivalent to, in Tony Abbott’s immortal phrase, ‘a great big new tax on everything’. But the proceeds from the natural resource tax could be used to make equivalent cuts in other taxes, particularly income and consumption taxes. In other words, the tax system would be realigned, so that we increased the tax on environmental ‘bads’ while reducing the tax on environmental ‘goods’, without much change in the level of taxation overall. In the process, we’d be changing relative prices in the economy, discouraging activities that involved heavy use of natural resources while encouraging activities involving little use of natural resources.

At present, developed economies are oriented towards economising on the use of the most expensive (and most heavily taxed) resource, labour, but in the new regime labour would be a lot cheaper and the most expensive resources would be natural resources. So all of capitalism’s economising, productivity-seeking efforts would be redirected towards reducing the use of natural resources. The recycling of natural resources would become more economic, as would the repair rather than replacement of durable consumer goods. We’d still have a market-based, efficiency-oriented economy, but we’d impose a different set of constraints on it. It would be an economy that strove for improved quality, not increased quantity.

My guess is that a lot of people like the sound of an economy that does less damage to the environment, and aren’t particularly perturbed by the thought that their level of consumption wouldn’t keep increasing year after year, but wonder whether a capitalist economy that stopped growing would implode. If we stopped consuming more each year wouldn’t that lead to mass unemployment? They seem to think of the economy as being like riding a bike: if you stop going forward you fall off. Certainly, there are plenty of economists and business people who’d be happy to leave you with that impression.

The strongest argument in favour of economic growth is that we need a bigger economy to generate the extra jobs needed to gainfully employ an ever-growing workforce. But if ever there was a time when we were freed from that imperative it’s now. Like the other developed economies - and China - we’re entering a period where the ageing of the population means, if anything, the demand for labour will exceed its supply. What’s happening in Australia right now is that more than half the growth in our population and labour force is coming from immigration. In other words, our problem at present is the reverse of the one people worry about: to maintain our rate of economic growth we’re having to import workers from other countries. So if we give up our desire for growth in our use of natural resources, we can cut our rate of net migration and have little trouble finding jobs for everyone who wants to work. Should unemployment persist, however, the answer would be to take the gains from increases in workers’ productivity not as real wage rises (to permit higher consumption) but as a shorter working week.

The conventional view among economists, business people and politicians is that economic growth must continue. I believe, on the contrary, that growth in our use of natural resources must stop; that this could be achieved without great technical difficulty, that it wouldn’t involve any loss of human happiness and could lead to improvements in social relationships. The only question is how much further damage to the global ecosystem must occur before we come to accept the need for change. When we do come to accept it, however, it’s to the economists that we’ll turn to work out how it can be done.

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How to limit looming interest rate rises

It's a pretty safe bet we'll get another rise in the official interest rate this year and several more next year.

A rise next Tuesday is possible, though the Reserve Bank board has a predilection for changing rates on Melbourne Cup day, after it has seen the quarterly consumer price index figures.

After the minutes of last month's board meeting and the speech the governor, Glenn Stevens, gave last week, there's not much doubt rates will be rising soon enough.

Why? Because the economy is already growing at trend (3.3 per cent over the year to June) with little spare capacity (the unemployment rate is down to 5.1 per cent), but the strength of job advertisements suggests further growth in employment is coming and the Reserve is expecting an acceleration to above-trend growth.

What's worrying the Reserve is that, whereas business investment spending has been flat (though at a remarkably high level relative to gross domestic product), the survey of firms' capital expenditure plans suggests it could grow by as much as 24 per cent in nominal terms next financial year, with mining accounting for most of that.

Although sky-high commodity prices will be feeding incomes and flowing into consumption, it's such huge rates of increase in physical investment that will make the resources boom so big and so potentially inflationary - ''the largest minerals and energy boom since the late 19th century'', according to Stevens.

Our history tells us it's investment booms and improvements in the terms of trade, rather than recessions, that pose the greatest challenges for macro-economic policy - mainly because mismanaged booms invariably lead to recessions.

Because booms are such pleasant things, in the past governments have tended to ignore the building inflation pressure until it can be ignored no longer. Then they panic, jam on the brakes, keep raising interest rates because they don't seem to be working and eventually the economy runs off the road and crashes, hurting passengers and bystanders alike.

Rest assured the Reserve won't be letting that happen this time. Having already returned the stance of monetary policy - the level of interest rates - to normal (or ''neutral'') levels, it will tighten further to keep the economy growing pretty much in line with the trend rate to prevent inflation pressures building up.

What's more, the Reserve will act pre-emptively, basing its moves on its forecast for inflation rather than waiting to see hard statistical proof a problem is building. (Actual inflation figures are important mainly because they're used to revise the forecasts.)

With the economy already so close to full capacity, we can be sure any forecast for growth much above trend, or for inflation heading up out of the target range, implies the need for higher rates, and higher rates will be forthcoming. One thing the economic managers have going for them in this boom rather than those of the past is the floating exchange rate. By floating up, it helps to limit the build-up of inflation pressure by redirecting some part of demand into the now-cheaper imports.

And by limiting demand for the products of non-mining export and import-competing industries - particularly manufacturing, education and tourism - it frees up labour and other resources to meet the ever-expanding needs of the minerals sector. This helps limit wage inflation.

Even so, if anything like the expected increase in investment spending occurs, rates have a fair way to go yet.

One thing that could limit the need for further rate rises is subdued consumer spending as households seek to get on top of their debts. Consumers take a breather, thus leaving more room for investment spending.

The ratio of household debt to disposable income has been steady for the past few years and it would be nice to see it falling over coming years. But how long it will take for the boom to overwhelm households' present restraint is anyone's guess. Mine is: not long.

Remember that, though it may not be long before commodity prices fall back from their present heights - while remaining high relative to their long-term trend - the investment phase of the boom could run and run, perhaps for a decade.

So, barring some global or China-centred catastrophe, it's reasonable to expect the exchange rate and interest rates to be uncomfortably high for many years to come. But is there anything the government could do to take some of the pressure off rates?

Without wishing to give comfort to the dishonest nonsense talked by the opposition - which implies that all interest rate rises (even those needed merely to return the official rate from the emergency lows achieved during the financial crisis) are the simple and direct consequence of the government's failure to slash its spending - there is something that could be done.

While the government will have its work cut out turning last financial year's $54.8 billion budget deficit into the now-promised surplus by 2012-13 - and this turnaround will exert a useful restraint on demand - the real challenge will come thereafter.

By all the ignorant logic of Costelloism, governments can ease up once the budget is back to surplus, granting tax cuts and allowing strong growth in spending - just as John Howard and Peter Costello did in the resources boom Part 1.

But just as this behaviour left the Reserve needing to raise interest rates somewhat more than would otherwise have been necessary, so Julia Gillard and Wayne Swan will face a similar choice. This, of course, is because tax cuts and increased spending add to private demand.

The answer is for Labor to continue its present strictures on tax cuts and spending, allowing the budget surplus to grow ever-bigger each year, something that could be readily justified to the mesmerised punters as needed to pay back our supposedly stupendous public debt.

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Getting richer as we mess up our world

I guess you've heard the good news: the devastation of the Christchurch earthquake will be a godsend to New Zealand's gross domestic product, giving it an almighty and much-needed boost.

So maybe it's a pity earthquakes don't happen more often. Perhaps we could do the Kiwis a favour and send our air force bombers over there to use a few cities for target practice.

If you think this sounds stupid, you're right. To anyone in their right mind, an earthquake that destroys many buildings, roads, bridges and vehicles - and disrupts many people's lives - can't possibly be a good thing.

But it will boost gross domestic product. GDP measures market production (and the income that production generates). So as the South Islanders spend a couple of billion repairing and rebuilding their main city, much extra production will occur and many additional jobs will be created.

But what about the loss of all the valuable assets destroyed by the quake - doesn't that count? Short answer: no. GDP is a sum that's all pluses and no minuses. It counts the benefits, but ignores the costs.

It doesn't count the destruction caused by natural disasters, nor the depletion of renewable and non-renewable resources. Production involves the emission of many forms of pollution, but this cost too is ignored.

If the clearing of land to build a town involves destroying the habitat of animals, perhaps leading to their extinction, the cost of the clearing and the building counts as a plus, but the loss of habitat or species doesn't count as a minus.

So, does that make GDP a giant con job? Yes and no. Economists will tell you GDP is an accurate measure of what it's intended to measure: market production and national income; it's not, and was never intended to be, a measure of the nation's well-being.

But this is disingenuous. Economists don't understand it's possible to know things without that knowledge being reflected in our behaviour. And though all economists know GDP is not a measure of well-being, they still treat it as though it is, obsessing over it, ignoring other indicators and encouraging us to do the same.

If GDP is so defective as a measure of well-being or social progress, why doesn't someone try to fix it? Well, many people have tried, but they've had little success. Trouble is, many of the factors affecting our well-being can't be measured in dollars, so they can't be included in the sum that is GDP.

This is the conclusion our own Bureau of Statistics soon came to when it set out to answer the question: is life in Australia getting better? To answer that you need to look at a diverse range of indicators and it's not possible to convert those indicators to a common basis so they can be added up to give a single, summary indicator.

Instead, each year the bureau produces Measures of Australia's Progress. It collects 17 indicators, gathered under three headings - economy, society and environment - trying to judge whether we've progressed or regressed on each indicator over the past 10 years.

Its latest issue was released this week to coincide with its NatStats conference on the topic, "Measuring What Counts: economic development, well-being and progress in 21st century Australia".

It shouldn't surprise you we've made progress on most of the economic indicators. Real net national disposable income (about the most meaningful derivative of GDP) increased from $35,000 a year per person in 1999 to $45,300 in 2009. It grew at an average rate of 2.6 per cent a year, well up on 1.5 per cent annual growth for the previous decade.

The nation's real net worth (assets minus liabilities) grew at the average rate of 0.9 per cent a year over the decade to reach $314,000 per person.

But not all the key economic indicators are good. The affordability of rent by low-income households - that is, housing costs as a proportion of gross income for low-income renters - has stayed constant at 27 per cent over the decade.

And the level of "multifactor productivity" - a measure of the efficiency with which the economy transforms inputs into outputs - has been relatively flat throughout most of the decade. So our economic growth came more from using additional inputs than from using inputs more efficiently.

With that mixed picture on the economy, let's move on to the key social indicators. Over the past decade, life expectancy at birth has increased by 2.2 years for girls and 3.3 years for boys. Over the same period, the proportion of people aged 25 to 64 who have a vocational or higher education qualification has risen from 49 per cent to 63 per cent. And the annual average rate of unemployment fell from 6.9 per cent to 5.6 per cent.

On crime, 6.3 per cent of all Australians aged 15 and over say they were victims of at least one assault in 2008-09. On family, community and social cohesion, there's no summary measure that captures the story. But the proportion of children living without an employed parent has fallen from 18 per cent to 13 per cent; the proportion of adults doing voluntary work during a year has risen by half to 34 per cent, and suicide rates have fallen for both sexes.

Turning to the environment, the past decade has seen the number of threatened fauna species increase from 312 to 427. In that time our net greenhouse gas emissions per year have increased by 16 per cent.

We have no summary indicator on our use of land, but the amount of annual land-clearing has fallen by a third, whereas the area of native forest remaining has fallen by 10 per cent. There's no summary indicator of our use and abuse of inland waters, oceans and estuaries. The volume of waste generated in Australia has nearly doubled.

We're entitled to draw two conclusions. First, when you drill down you find the general impression of ever-increasing well-being given to us by politicians, business people and economists is misleading. GDP might be growing rapidly, and the available social indicators may be all right, but we're going backwards on most environmental indicators.

Second, it's clear that, historically, much of the bureau's effort has gone into measuring the components of GDP, with too little effort being devoted to measuring the other, social and environmental dimensions of our well-being. Until that imbalance is corrected, the bureau's output will continue to mislead us.

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