How our penchant for magic numbers gets us into trouble

A lot of the problems we cause ourselves – whether as individuals or as a community – arise from the way we've evolved to economise on thinking time by taking mental shortcuts.

We are a thinking animal, but there are two problems. First, we have to make so many thousands of decisions in the course of a day – most of them trivial, such as whether to take another sip of coffee – that there simply isn't enough time to think about more than a few of them.

Second, using our brains to think requires energy, in the form of glucose. But glucose is not in infinite supply. So we've evolved to save energy by minimising the thinking we do.

As Daniel Kahneman​ – an Israeli-American psychologist who won the Nobel prize in economics for his work with the late Amos Tversky​ on decision-making – explains in his bestselling Thinking, Fast and Slow, our brains solve these two problems by making all but the biggest, non-urgent decisions unconsciously.

This is Thinking Fast. We don't think about taking another sip of coffee, we just notice ourselves reaching for the cup.

But even when we are Thinking Slow, carefully considering a big decision – such as which house to buy, or whether to marry the person we've been seeing – we still have a tendency to save glucose by relying on what Kahneman and Tversky dubbed "heuristics" – mental shortcuts.

They stressed that our use of such shortcuts is, in general, a good thing. We fall into the habit of jumping to certain conclusions because, most of the time, they give us the right answer while saving brain fuel.

But they don't give us the right answer in every circumstance, and it's the classes of cases where they lead us astray that are most interesting and worth knowing about.

Kahneman and Tversky kicked off a small industry of psychologists thinking up different potentially misleading mental shortcuts and giving them fancy names.

I have a couple of my own I'd like to add to the list.

I call the first one "box labelling" – saving thinking time by consigning things or people to boxes with particular labels.

For example: "I regularly vote Labor/Liberal, therefore I don't have to think about the rights and wrongs of all the policy issues the pollies argue over, but can get my opinion just by checking which side my party's on."

You can see how common this is if you look those media opinion polls that show you how many people support or oppose a particular policy – say, curbing negative gearing – then show you who those people would vote for in an election.

Much more often than not, people take their lead on an issue from the position their favoured party takes.

You also see it by watching what happens to the index of consumer confidence when there's a change of government. Almost all those who voted for the losing party switch from optimism to pessimism, while those who voted for the winner switch from pessimist to optimist.

My second mental shortcut is "magic numbers". Experts develop and carefully calculate some economic or financial indicator, based on various assumptions.

The indicator measures changes in something we know is important, so we get used to watching it closely for an indication of how things are going.

Trouble is, we end up putting too much reliance on the indicator, using it as a mental shortcut – a substitute for thinking hard about what's going on.

We turn it into a magic number – a single figure that tells us all we need to know. We use it to inform us about things it wasn't designed to measure.

But, above all, we forget about all the assumptions on which it's built, assumptions that can become inappropriate or misleading without us noticing. That's when our magic numbers hit us on the head.

The American economic historian Barry Eichengreen attributes part of the blame for the global financial crisis to Wall Street's excessive reliance on a financial indicator called "value at risk" or VaR.

As Wikipedia tells us, VaR "estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses."

Eichengreen tells of the banking boss who, late each afternoon, would call for the figure giving the investment bank's VaR. If it fell within a certain range, the banker would go home content. If it was outside the range, he'd stay until he'd done whatever was needed to get it back into range.

The problem was his neglect of the assumptions on which the calculation was based, in particular, "given normal market conditions". Conditions stopped being normal without him realising and – like all its competitors – his bank got into deep trouble.

But the most notorious magic number is gross domestic product, GDP. It was developed by economists after World War II to help them manage the macro economy, but has since been widely adopted as the single indicator of economic progress.

Economists know that GDP is good at what it measures, but was never designed to be a broader measure of wellbeing. This, however, doesn't stop them treating the ups and downs of GDP as the be-all and end-all of economics, as a substitute for thought.

Another word for this is "bottomlinism" – don't bother me with the details, just give me the bottom line.

But never inquiring beyond the bottom line will often end up misleading yourself or getting you into trouble. That's particularly true of people who hear the words "deficit" and "debt" and immediately assume the worst.

In business, however, the most dangerous magic numbers – the most egregious substitute for the effort of thought – are known as KPIs – key performance indicators.

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Many guesses why productivity may have stopped improving

Conventional economics is falling apart, no longer making the sense we thought it made. Economists are entering a period of puzzlement and uncertainty, while their high priests struggle to hold the show together.

You can tell all that if you read between the lines of the Productivity Commission's discussion paper launching its inquiry into Increasing Australia's future prosperity, published last month.

It’s meant to be the first five-yearly review of our productivity performance, the micro-economic equivalent of Treasury’s (misnamed and now politically hijacked) five-yearly macro-economic intergenerational reports.

So it has potential to be a big deal. If you missed hearing about the discussion paper it may be because it was overshadowed that week by something that happened to a Mr Trump.

The commission opens its discussion with the alarming observation that "there is a justified global anxiety that growth in productivity – and the growth in national income that is inextricably linked to it over the longer term – has slowed or stopped".

Productivity is a measure of an economy's (or a business's) ability to convert inputs of resources into outputs of goods and services.

We commonly (and least inaccurately) measure it as output per unit of labour input – per worker or per hour worked.

But the commission prefers to measure it as output per unit of both labour and capital inputs, which it calls "multi-factor productivity". This is intended to be a measure of the essence of productivity improvement: technological advance and increased human capital.

Trouble is, the commission says, "since 2004, multi-factor productivity has stalled, here and around the developed world. This is a long enough period to suggest something is seriously awry in the economic fundamentals and the consequent generation of national wealth and individual opportunity."

Actually, by the commission's own figuring, Australia's labour productivity in the "12-industry market economy" improved by 1.9 per cent in 2014-15, the most recent year available, and our multi-factor productivity improved by 0.8 per cent, which was also our average rate of multi-factor improvement over the previous 40 years.

It's true, however, that our multi-factor performance has looked pretty sick since the turn of the century.

But the first point to note is that the problem is global, not just some weakness of ours – a fact a lot of those who've used our weak numbers to push their own favoured "reforms" have often failed to mention.

Next point, which is also often not mentioned: economists can't measure multi-factor productivity with even remote accuracy. That's mainly because they can only guess at the contribution one unit of physical capital (whatever that is) makes to production.

So it's hard to be sure the weak multi-factor productivity figures most developed countries are producing are real.

Next, assuming they are real, economists can only guess at the factors causing them. There's a lot of guessing going on by some of the world's top economists, but as yet there are no policy changes we could make with any confidence that they'd fix the problem.

Our eponymous commission produces an annual update on our productivity figures but, though it's been wringing its hands for years, its analysis has never once been able to put its finger on a causal factor we could do something about.

The few explanations it's found are either temporary or nothing to worry about.

The discussion paper acknowledges, but then dismisses, the argument of those wondering if the whole "problem" is merely a product of monumental mismeasurement.

I don't dismiss it. Had the economists not assured us of the opposite, most of us would look at the wonders of the digital revolution and the many industries being hit by digital disruption and assume the productivity indicators must be going gangbusters.

How can we be sure they aren't? One of our most thoughtful economists – one who's always gloried in digital advances – is professor John Quiggin, of the University of Queensland.

Quiggin argues that the economists' conventional model for thinking about the economy and how it grows is based on an industrial economy, which made sense in the 19th and 20th centuries, but is becoming increasingly outmoded and misleading.

We focus hard on the production of goods – agriculture, mining and manufacturing – but are vaguer about the production of services, which is the main part of the economy that's growing.

Today, he says, the primary engine of economic development is information, but information has radically different characteristics to a physical good or a service such as a haircut.

Information is often free ("non-excludable", as economists say) and it can't be used up ("non-rivalrous").

This outdated, industrial-age way of thinking about growth and productivity is reflected in the way we define and measure the economy and productivity via gross domestic product.

For instance, we measure only economic activity in markets, meaning we exclude all the activity taking place in households, and can't measure the productivity of the 20 per cent of GDP created in the public sector, including such minor industries as health and education.

And we ignore one of the most valuable outcomes of the greater prosperity that is the Productivity Commission's god: hours of leisure.

None of this, however, will stop the commission using its ultimate report to advocate a bunch of "reforms" intended to improve our small corner of the world's alleged productivity problem.

As we speak, Canberra's second biggest industry – the lobbyists – are busy churning out their self-interested submissions to the inquiry, advocating such radical new ideas as cutting company tax and weekend penalty rates.

To be fair, the commission says it's "particularly interested in new and novel ideas because there is already a strong awareness of many reform options that parties would like to see implemented. More of the same is not likely to be helpful."

We'll see how far it gets with that fond hope.

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How many Aboriginals died after the colonialists arrived?

If we can't lift our minds from earnest discussion of the economy and its discontents between Christmas and New Year's Day, when can we? So let's take a summer squiz at the work of the rapidly diminishing band of economic historians.

One of the most interesting things they do is try to piece together economic statistics covering the years before much official effort was devoted to measuring the economy. The United States didn't start publishing figures for gross domestic product until 1947; we didn't start until 1960.

The global doyen of economic historians was the Netherlands-based Scot, Professor Angus Maddison, who devoted his career to "backcasting" GDP to 1820 for all the major economies and regions of the world.

Despite all the unavoidable and debatable assumptions involved, Maddison's estimates are still widely used. They're a reminder that, before Europe's Industrial Revolution, the two biggest economies were China and India.

Australia's most distinguished economic historians were Noel Butlin, of the Australian National University, and his older brother, Syd, of Sydney University (after whom its Butlin Avenue is named).

Noel backcast Australia's GDP to 1861, then began researching what the Australian economy must have been like before white settlement. He wrote up his findings in Economics and the Dreamtime: A Hypothetical History (which I wrote up in a column on April 5, 1995).

As part of this research Butlin devoted much effort to estimating the size of the Aboriginal population before 1788. The anthropologist Alfred Radcliffe-Brown wrote in the Commonwealth Yearbook of 1930 that it would have been more than 250,000, maybe even more than 300,000.

But Butlin's piecing together of the evidence told him this was way too low. He wrote in 1983 that it would have been 1 million or 1.5 million.

Then in 1988 some of Australia's leading archaeologists, led by John Mulvaney, argued that a more accurate estimate would be between 750,000 and 800,000. This has become accepted as "the Mulvaney consensus".

Now enter Dr Boyd Hunter, of the Centre for Aboriginal Economic Policy Research at ANU. With Professor John Carmody, a physiologist at Sydney University, he published this year in the Australian Economic History Review a long paper reviewing Butlin's population estimates.

The point, of course, is that the Aboriginal population declined dramatically in the early days of white settlement. We can be reasonably confident that, by 1850, the Indigenous population was only about 200,000.

Thus backcasting the figures to 1788 involves determining the main factors that led to the loss of Aboriginal lives and estimating how many lives they took, then adding them back. So the paper is a kind of whodunit.

One factor springing to the modern mind is that the unilateral appropriation of Aboriginal land led to much frontier violence, which started shortly after the arrival of the First Fleet and persisted well into the 20th century.

"Like any war, declared or otherwise, the conflict led to many deaths on both sides," the authors say. But even the controversial historian, Henry Reynolds, estimated the number of violent Aboriginal deaths at as many as 20,000, making this only a small part of the explanation.

Butlin allows for Aboriginal "resource loss", where tribes' loss of productive members and land used for sustenance led to people dying of "starvation or dietary-related diseases". Butlin's calculation implies this factor would have involved as many as 120,000 people.

That's still not the biggest part of the story. No, the big factor is the spread of introduced diseases. Such as? Tuberculosis, bronchitis and pneumonia, not to mention venereal disease.

But the big one is smallpox. Butlin and others have assumed that it spread rapidly around Australia along the extensive pre-existing Aboriginal trading routes after its first recorded outbreak in Port Jackson in April 1789.

In 2002, however, the former ANU historian Judy Campbell argued in her book, Invisible Invaders, that it was brought to Northern Australia by the Macassan coastal traders following its outbreak in Sumatra in 1780, then spread across the continent, reaching Port Jackson by early 1789.

This is where Hunter – no doubt relying heavily on the expertise of Carmody – brings to bear modern medical understanding of the infectiousness and mortality rates of various diseases. Although smallpox has a high rate of mortality – between 30 and 60 per cent of those who contract it – it's not highly infectious.

This means it happens most in densely populated areas and doesn't spread rapidly to distant areas. This casts doubt on Campbell's theory that smallpox spread rapidly from lightly populated Northern Australia to densely populated NSW.

But it also casts doubt on Butlin's theory that smallpox spread rapidly from Sydney to the rest of Australia via Aboriginal trading routes.

So what's Hunter and Carmody's theory? Are you sitting down? Gathering all the suspects in a room, detective Hunter deftly turns the finger of guilt from smallpox to the so-far unsuspected chickenpox.

The two are quite separate diseases, but this wasn't well-known in the 1780s. And since they both give rise to rashes or spots around parts of the body, many people may not have been able to tell the difference.

The point, however, is that chickenpox is about five times more infectious than smallpox, meaning it could spread a lot faster. It can recur in adults as shingles, which is also highly infectious. When adults contract chickenpox it can be fatal.

When the authors use chickenpox to do their backcast, assuming a low mortality rate of 30 per cent and also taking account of resource loss, they get a pre-contact Indigenous population (including up to 10,000 Torres Strait Islanders and up to 10,000 original Tasmanians) of about 800,000 – which by chance fits with the Mulvaney consensus.

If so, colonialists didn't outnumber the (much diminished) Aboriginal population until the mid-1840s. And by 1850 the total Australian population was still 25 per cent smaller than it was before colonisation.

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Material success is coming at a social price

While there's been much worry of late that the economy isn't growing fast enough to get unemployment down, it remains true that our economic performance since the global financial crisis has been the envy of most other rich countries.

But it's old news that, while economic growth matters for employment – especially with our immigration-fuelled population growth – gross domestic product is a quite inadequate measure of the nation's wellbeing.

No doubt it was such criticism that, in 2002, prompted the Bureau of Statistics to introduce a four-yearly "general social survey" of about 13,000 households to give us more information on how Australians are faring from a personal and social perspective.

The bureau has now released the results of its fourth survey, for 2014. So what is this more humanistic second guess telling us about whether we're making progress?

On the face of it, we're doing fine. Look deeper, however, and cracks are apparent.

The survey measured our "subjective wellbeing" by asking people to assess their overall satisfaction with life – not how they feel at the moment, or how they feel about particular aspects of their life – on a scale of nought to 10.

Our average answer was 7.6, which is significantly higher than the average of 6.6 for all the countries in the Organisation for Economic Co-operation and Development. It was also up on what we said four years ago.

But the most useful thing to note is the categories of people whose ratings were well below the nationwide average: people with a disability (7.2), one-parent families with children (7.0), the unemployed (6.8) and people with a mental health problem, 6.6. Governments wanting to raise the nation's wellbeing now know where to start.

And when the bureau delved deeper, areas of slippage became apparent. One important factor affecting us that's ignored in the calculation of GDP – and in the thinking of most economists, politicians and business people – has been dubbed "social capital".

Social capital is seen as a resource available to both individuals and communities, arising from such things as networks of mutual support, reciprocity and trust. You can break it down into more measurable components, such as community support, social participation, trust and trustworthiness, the size of people's networks and people's ability to have some control over issues important to them.

There's plenty of research showing these things are strongly linked to the wellbeing of individuals and communities. But the survey reveals all is not well with various aspects of our social capital.

One indicator of how much we support each other is the amount of voluntary work we do for organisations. This has declined for the first time since the bureau began measuring it in 1995.

By 2010, the proportion of people aged over 18 who were volunteering had reached 36 per cent. But by last year it had fallen back to 31 per cent. There's also been a decline in the proportion of people providing informal help to neighbours and the like.

Voluntary work not only helps the people who are helped, of course, it also helps increase the wellbeing of the helpers. Not a good sign.

On social participation, the survey shows people are now less likely to be involved in social groups such as sport or physical recreation, arts or heritage groups and religious groups.

Civic participation – involvement in a union, professional association, political party, environmental or animal welfare group, human or civil rights group, or even a body corporate or tenants' association – is also down.

Of course, as the bureau notes, the way people meet and interact is changing. Some people suggest that young people in particular prefer to engage in politics by means of online activism – joining online advocacy groups or using social media to collect and disseminate information.

Other ways people support each other have been stable. In 2014, the proportion of people caring for someone with a disability, illness or old age was 19 per cent, little changed from previous years.

The proportion of people providing support to relatives living outside the carer's home, 31 per cent, was also little changed. This is likely to reflect the ageing of the population.

Last year nearly everyone – 95 per cent – felt able to get support from outside their home in a time of crisis, unchanged from earlier years. Similarly, weekly electronic contact with family and friends by telephone, text message or video link remained high at 92 per cent.

By contrast, face-to-face contact fell from 79 per cent to 76 per cent.

And people were less likely than they were in 2010 to feel able to have a say within their community all or most of the time – 25 per cent compared with 29 per cent.

There's been no change in the proportion of people agreeing that most people can be trusted – 54 per cent – but, to me, that seems a lot lower than it should be.

On the question of work-life balance, Australians are feeling time-poor, with 45 per cent of women and 36 per cent of men saying they were always or often pressed for time. This is higher than for other rich countries.

We may be doing better in the GDP stakes than most other advanced countries are, but we seem to be paying a high social price for our greater material success.

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At present GDP is more misleading that usual

I could attempt to explain to you why the Bureau of Statistics is having such embarrassing trouble with its monthly estimate of employment, but I won't bother. It's horribly complicated and at a level of statistical intricacy no normal person needs to worry about.

What this week's labour force figures now tell us is that, though the rate of unemployment has been slowly drifting up since mid-2011 - when it was 5 per cent - it seems to have steadied this year and, using the smoothed figures, has stayed stuck at 6 per cent for the past three months.

This is reasonably consistent with what we know about other labour-market indicators, such as job advertisements and vacancies, claims for unemployment benefits and employers' answers to questions about hiring in the National Australia Bank's survey of business confidence.

It also fits roughly with what the national accounts have been telling us about the strength of growth in the economy. We know that when the economy is growing at its trend rate of about 3 per cent a year, this should be sufficient to hold the rate of unemployment steady.

The accounts told us real gross domestic product grew by 3.4 per cent over the year to March, and by 3.1 per cent over the year to June.

But now let me tell you something that, while a bit technical, is much more worth knowing than the gruesome details of the bureau's problem with the labour force survey.

One of our smartest business economists, Saul Eslake, of Bank of America Merrill Lynch, has reminded us that GDP is only one of various summary indicators of overall economic activity provided by the national accounts. And the economy's peculiar circumstances over the past decade and for some years to come mean GDP is not the least misleading of the various measures.

Eslake says real GDP measures the volume (quantity) of goods and services produced within a country's borders during a particular period. (Actually, it doesn't include the many goods and services produced within households, which never change hands in a market.)

To estimate real GDP the bureau takes the nominal, dollar value of the goods and services produced, then "deflates" this figure by the prices of those goods and services relative to what those prices were in the base period.

We commonly take the value of the goods and services we produce during a period to be equivalent to the nation's income during that period. This easy assumption works for most developed economies most of the time.

But Eslake reminds us that "for an economy like Australia's, the prices of whose exports are much more volatile than those of other 'advanced' economies, abstracting from swings in the prices of exports (and imports) obscures a significant source of fluctuations in real incomes".

We've experienced a series of sharp swings in our "terms of trade" - export prices relative to import prices - over the past decade of the resources boom, which was interrupted by the global financial crisis in 2008-09. For the past three years, of course, mining commodity prices have been falling.

Trouble is, real GDP doesn't capture the effects of these swings. So the values of our production and our income have parted company, as they do every time our terms of trade change significantly. An improvement in our terms of trade causes our income to grow faster than our production, whereas a deterioration has the opposite effect.

This matters because of the chicken-and-egg relationship between production and income: we use the income we earn from our part in the production process to buy things and thus induce more production.

So if our real income slows or falls, soon enough this dampens our production.

However, the national accounts include a measure of overall economic activity that does capture the effects of movements in our terms of trade: real gross domestic income, GDI. It grew a lot faster than real GDP for most of the time between 2002 and 2011, but since then has grown much more slowly than real GDP (a big reason for our slowly rising unemployment).

Next Eslake says that as the resources boom moves into its third and final phase - with mining investment winding down and exports ramping up - real GDP growth will be an even less useful guide to what's happening to domestic income and employment.

This is because maybe 80 per cent of the income generated by resources exports will be paid to the foreigners who own most of our mining companies and who financed most of the new investment.

It's also because the depreciation of Australia's greatly enlarged stock of capital equipment and structures as a result of all the mining investment spending will now absorb a greater share of our gross income.

(A separate issue Eslake doesn't mention is that the highly capital-intensive nature of mining means the increased production of mineral exports will create far fewer jobs than you'd normally expect.)

If you've ever wondered about the difference between gross national product and gross domestic product it's that the former excludes all the income earned on Australian production that's owed to the foreign suppliers of our debt and equity financial capital, making it a more appropriate measure for us given our huge foreign debt and foreign investment in our companies.

If you've ever wondered what the "gross" in GDP, GNP, GNI etc means, it's short for "before allowing for the depreciation of our stock of physical capital".

So gross national income (GNI) is a better measure than gross domestic income (GDI), and net national disposable income (NNDI) is a better measure than GNI.

Which, by the way, explains why real NNDI is used as the base for all the further non-national-accounts-based modifications included in Fairfax Media's attempt to calculate a broader measure of economic welfare, the Fairfax-Lateral Economics wellbeing index, released each quarter soon after the publication of GDP.

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How my views have changed over 40 years

They say if you still believe at 50 what you believed when you were 15, you haven't lived. Just this week I've now worked at Fairfax Media as an economics journalist for 40 years. Those ages don't quite fit, but my views today are certainly very different from what they were when I started.

When, disillusioned with life as a chartered accountant, I began at Fairfax, most of my effort went into relearning the economics I was supposed to have learnt at university. There it didn't make much sense to me and I had trouble remembering enough of it to pass exams. Once passed, it was promptly forgotten.

A lot of my re-education came at the hands of the nation's most high-powered econocrats, who are remarkably generous with the telephone tutorials they're willing to give journos who seem genuine.

So at first most of my effort went into mastering and then propagating economic orthodoxy. I still see it as an important part of my job to help readers understand what it is that leads economists to do and say the things they do.

Newspaper economics tends to be pretty basic. Doing the job year after year is like answering the eternal year 12 economics essay question: "From your knowledge of economic theory, comment on ..." Joe Hockey's budget preparations, cabinet's decision not to give SPC Ardmona a $25 million subsidy, the government's inquiry into the financial system.

But one ambition has been to introduce something a little more sophisticated, to lift the level of analysis from introductory to intermediate. To this end I've devoted a fair bit of my free time to reading the latest books about developments in economics and, increasingly, psychology.

Though Australian academic economists write books that seem intended to impress by being incomprehensible, leading American academics write (carefully footnoted) books that explain their findings to the average intelligent person. Sometimes they even make the best-seller lists.

I've been looking for stuff that would interest readers, but also trying to deepen - and broaden - my understanding of the topic. It's this broadening that's done most to change my views about economics and how I should do my job.

Economics is the study of "the daily business of life" - earning money and spending it, buying and selling assets such as homes and shares, borrowing to finance the purchase of assets and saving to repay debts. Macro-economics is the study of how whole economies work and how governments can "manage" them, seeking to limit inflation and unemployment and promote growth.

So, contrary to my conclusions at uni, economics has a lot of practical application. There's always plenty of interest in the topic and plenty of coverage in the media.

But as I've got older and read more widely I've realised that, if anything, we tend to take economics too seriously. It deals only with the material side of life - getting and spending - and in this more materialist age we run a great risk of focusing excessively on getting and spending at the expense of other, equally important aspects of our lives. I've concluded there's more to life than economics.

Our heightened materialism means we take economists far more seriously today than we did 40 years ago. Their message is that we're not trying hard enough: not doing enough to change ("reform") our economic arrangements to foster faster growth in the economy and hence a more rapidly increasing material standard of living.

But I've concluded economists suffer from the same failing as other specialists. In their enthusiasm for their topic they want to take over your life. The economists' union wants to make becoming more prosperous the nation's central objective. And these guys urge us on with little thought about what trying harder and doing more may imply for the other dimensions of our lives.

You and I know most of the satisfaction in our lives comes from our personal relationships. But relationships aren't part of the economists' model, so they urge particular "reforms" without any thought about the implications for our relationships. Politicians act on their advice without such thought, either.

So, to borrow a cliche, economists need to be kept on tap but not on top. These days I try to explain the rationale for economic policies - what they're trying to achieve and how they're supposed to work - but also play the role of a sort of economics theatre critic, adding a critique of economics, economic policies and economists.

I've learnt there's little correlation between being a successful business person and having a good understanding of economics. They seize on an argument that seems to support the line they're pushing. Whether it's logical they seem not to know or care.

Economists study and advocate efficiency in the way we combine economic resources - land, labour and capital - to produce goods and services. This is supposed to maximise material prosperity. The position I've come to is that we should strive for efficiency unless we've got a good enough reason to be inefficient.

For instance, it's inefficient to have government rules specifying minimum levels of local content on television. It would be much cheaper to buy not just most but all our TV programs from America. But I agree it's better to force our TV channels to produce a bit of Aussie drama. Culture matters.

Even so, knowing where to draw the line on inefficiency ain't easy. It's too short-sighted to expect that those industries, interest groups or regions that have managed to extract assistance from government in the past retain their privileges forever, or that industries adversely affected by overseas developments be given ever-growing government assistance so nothing needs to change and all pain is avoided.

Life's a bit tougher than that. Change is unrelenting. It's our continuously changing circumstances - and, I hope, our improving understanding of how to respond to challenges - that keeps me going.

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Economy yet to make transition to post-boom world

The economists' buzzword of the week - and probably the year - is "transition". If it's not in your lexicon add it immediately. You'll need it - because this week we learnt how tricky it's likely to be.

As the construction phase of the resources boom nears its peak, the economy needs to make a transition from mining-led growth to growth led by all the normal sources: consumer spending, home building and non-mining business investment.

This week the national accounts for the March quarter from the Bureau of Statistics showed growth in real gross domestic product of just 0.6 per cent for the quarter and 2.5 per cent for the year to March.

For once this seems a reasonably reliable reflection of how the economy's travelling. It's not disastrous, but nor is it satisfactory.

The economy needs to be growing at its medium-term trend rate of about 3 per cent a year. Growth of that order is needed just to hold unemployment constant. And since we've been falling short of it for about a year it's not surprising that, over the year to April, the unemployment rate has drifted from 5.1 per cent to 5.5 per cent.

(If you had it in your mind our trend growth rate was nearer 3.25 per cent, you're not wrong, just out of date. The econocrats have lowered it to 3 per cent to take account of the ageing of the baby boomers, which means a larger proportion of the population is now in an age range with lower participation in the labour force.)

The worrying thing about this week's figures is that they reveal the pressing need for a transition from mining-led to broader growth, but not much sign it's about to happen.

As best he can determine it, Kieran Davies, of Barclays bank, estimates mining investment spending fell about 7 per cent in quarter. Rather than rising, however, non-mining investment spending fell about 3 per cent.

At the same time, new home building (including alterations) was flat. Consumer spending strengthened to grow 0.6 per cent, but this was still below trend.

Public sector spending grew 1.1 per cent, but this followed a much bigger fall the previous quarter and with all the pressure on state and federal governments to balance their budgets, we shouldn't expect much help from the public sector.

According to the opposition, the Gillard government's been doing far too much to help.

It turned out a lot of the growth in the March quarter came from "net external demand". The volume (quantity) of our exports grew 1.1 per cent, whereas the volume of imports fell 3.5 per cent, meaning "net exports" (exports minus imports) made a positive contribution to growth of 1 percentage point.

Some silly people have been saying if it hadn't been for net exports the economy would be in a bad way - which is a bit like saying if we cut off one of our arms we'd be in a bad way. What they're missing is that the growth in export volumes will be lasting (they grew 8.1 per cent over the year to March) because it's coming from strong growth in exports of coal and iron ore, as new mines come into production and the third phase of the resources boom kicks in.

In other words, it's wrong to imagine the boom's about to leave us high and dry. Mining production and exports have a lot further to grow in coming years. Even the fall in imports (which constitutes a reduction in their negative contribution to growth) is linked to the boom: reduced investment in new mines means reduced imports of capital equipment.

As for the second, construction phase of the boom, spending from quarter to quarter is too variable to allow us to conclude this quarter's fall means the peak has been passed. Maybe, maybe not. Nor is it clear how precipitous the fall will be when it arrives. It may be fairly gentle since the miners' pipeline of committed projects still stands at a record high of $268 billion.

What reason is there to hope the non-mining sources of growth will strengthen? The main one is that the Reserve Bank has cut the official interest rate 1.5 percentage points in a little over a year, taking the "stance" of monetary policy to its most stimulatory in many a moon.

Everything we know tells us lower interest rates encourage borrowing and spending, particularly in interest-sensitive areas such as housing and the purchase of consumer durables. We also know it often takes a while to work. In my experience, it's just when people are running around saying it isn't working that it starts to.

Of course, a significant fall in the dollar would help a lot by improving the international price competitiveness of our export and import-competing industries, particularly manufacturing and tourism. It would help them produce more for export and replace imports in the domestic market. (So much for those who think it makes sense to assume away net exports.)

The dollar does seem to have fallen about US7? in the past few weeks. This may be some help, but it's far short of what would be justified by the deterioration in our terms of trade (the passing of the first phase of the boom) and what our traders need to restore their competitiveness.

The best hope for further falls in the exchange rate is not further cuts in our official interest rate (its role is widely overrated) but better prospects for the US economy leading to expectations of the cessation of "quantitative easing" (metaphorically, printing money), which has the side effect of putting downward pressure on the greenback. The Reserve has been cutting rates since November 2011, not to induce a fall in our dollar so much as to offset the contractionary effect of its failure to fall as export prices have fallen.

Should the dollar keep falling the Reserve won't cut rates any further. Should the dollar fail to keep falling, it probably will.

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Why tax revenue is falling short of budget

Try this quick quiz: which matters more, the growth in ''nominal'' gross domestic product or the growth in ''real'' GDP? Sorry, it was a trick question. The right answer is a favourite reply of economists: it depends.

If your interest is in how fast the economy's growing (or not growing), the answer is real GDP - GDP after allowing for the effect of inflation. But if your interest is in how fast the federal government's tax receipts are growing the answer is nominal GDP - GDP before allowing for inflation.

Why is nominal the right answer for tax receipts? Because, as Treasurer Wayne Swan keeps saying, ''we live in the nominal economy through the prices we pay and the incomes we earn''. As part of this, the income tax we pay is based on our nominal income and the indirect taxes we pay are based on our nominal spending.

Fine. If you didn't know the growth in nominal GDP is the best guide to the growth in tax revenue before, you do now. But why has Swan been making so much of this in recent days? Because it's the main reason why, despite all his savings measures (and creative accounting), the government won't be able to keep the promise it made in the 2010 election campaign to get the budget back to surplus this financial year.

That promise was based on a Treasury projection for 2012-13 included in the 2010-11 budget. But tax collections simply haven't grown as strongly as Treasury projected they would, and the main reason they haven't is that nominal GDP has been behaving strangely.

We're used to assuming that, if the economy's growing in real terms (which it has been), the government's tax revenue will be growing at least as fast and probably faster. (Why faster? Because almost half the feds' tax collections come from personal income tax, which grows extra strongly because, in the absence of the indexation of tax brackets, it's subject to ''bracket creep''.)

When economic events are proceeding normally, the distinction between nominal and real GDP doesn't matter much. Obviously, the difference between nominal and real GDP is the inflation rate, and if inflation is running within the Reserve Bank's 2 per cent to 3 per cent target range, the two totals should be moving pretty much in parallel.

To put it another way, nominal GDP should be growing at a reasonably steady 2.5 percentage points or so faster than real GDP. But we learnt from last week's national accounts for the December quarter that, for the first time on record, the past three consecutive quarters have seen nominal grow by less than real, not more. Since real GDP grew by 1.9 per cent, nominal GDP should have grown by about 4 per cent. Instead it grew by a pathetic 1.6 per cent.

Swan noted in a recent speech to business economists that nominal has grown by less than real for only four short periods in the 53 years since the Bureau of Statistics began producing quarterly national accounts.

The last time nominal was really weak was in the global financial crisis. Before that it was the Asian financial crisis of 1997-98 and, before that, the Menzies government's credit squeeze in 1961. In all but the credit squeeze episode, the explanation was the same: a sharp fall in global commodity prices led to a sharp deterioration in our ''terms of trade'' - the prices we receive for our exports relative to the prices we pay for our imports.

Ah. Whenever we talk of inflation, people think automatically of the main measure of inflation we use, the consumer price index. But in fact there are many measures of inflation, most of the others being derived from the national accounts.

The difference between nominal and real GDP is measured not by the CPI but by the ''implicit price deflator'' for GDP. When the economy's travelling normally, there shouldn't be much difference between the GDP deflator and the CPI and other measures of the change in the price of domestic spending.

But ''normal'' means when our terms of trade aren't changing much. When they're improving or deteriorating sharply, the GDP deflator and measures of domestic-spending inflation really part company.

Why? Because domestic spending includes the prices of imports but excludes the prices of exports, whereas GDP and its deflator exclude the prices of imports but include the prices of exports.

It works out that nominal GDP will grow very much faster than real GDP when our terms of trade are improving sharply, but nominal may even grow more slowly than real when our terms of trade are deteriorating sharply - as they were last year. But why wasn't Treasury expecting

the terms of trade to deteriorate and allowing for this in its projections of tax revenue? It was, and it has been - for most of the past decade, in fact. But it wasn't budgeting for the deterioration to be as fast as it's been, particularly in the September quarter.

That was the first problem with its revenue forecasts. The second, less obvious, one was this: on the basis of past behaviour, Treasury (and everyone else) was expecting any deterioration in the terms of trade to be accompanied by a similar fall in the exchange rate.

To everyone's surprise, the dollar has stayed up. This means the prices of imports haven't risen in the way you'd have expected, causing domestic inflation to be lower than expected. This, in turn, has meant nominal incomes haven't risen as fast as could have been expected.

So this factor, too, helps explain why tax collections haven't risen as fast as forecast. The latest estimate is that tax collections will fall about $10 billion short of what was forecast in the budget last May.

The last thing to say is that by no means all federal taxes are closely aligned with nominal GDP. The strongest relationship is with taxes on profits - company tax, income tax on unincorporated businesses and the two resource rent taxes. These account for about a third of total tax revenue.

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'Wealth creators' push materialism over social side

There is a contradiction at the heart of the way we organise our lives, the way governments regulate society and even the way the Bureau of Statistics decides what it needs to measure and what it doesn't. Ask people what's the most important thing in their lives and very few will answer making money and getting rich. Almost everyone will tell you it's their human relationships that matter most.

And yet much of the time that's not the way we behave. Too many of us spend too much time working and making money, and too little time enjoying the company of family and friends.

We live in an era of heightened materialism, where getting and spending crowds out the social and the spiritual. That's the way most of us order our lives and it's the way governments order our society. They worry about the economy above all else.

Indeed, the parties' chief area of competition is over their ability to manage the economy. The opposition's latest criticism is that under Labor we're losing our "enterprise culture". What's an enterprise culture? One where all the focus is on "creating wealth" - making money, to you and me - and none is on how that wealth should be distributed between households or what it should be spent on.

It's one where the demands of the "wealth creators" (read business people) should receive priority over the selfish concerns of the wealth recipients and dissipaters (read you and me). But above all, it's one where the chief responsibility of governments is to hasten the growth of gross domestic product.

On the face of it, Julia Gillard seems to fit the opposition's criticism. This week she's hoping to make progress in putting her long-cherished national disability insurance scheme into law. Last week she was in the western suburbs of Sydney celebrating international women's day and offering "a pledge to all women and girls" that "Australia is promoting a world where women and girls can thrive and where their safety is guaranteed".

And Gillard used the occasion of her visit to the west to demonstrate her practical concern about growing traffic congestion and to announce a "national plan to tackle gangs, organised crime and the illegal firearms market".

At one level, all this is true, none of it's made up. At another level, however, it's carefully crafted image building, intended to highlight the difference between Gillard and her opponent and emphasise those differences considered most likely to appeal to traditional Labor voters who show every intention of changing sides.

The deeper truth is that, like most politicians, Gillard is working both sides of the street. Ask her and she'll assure you her government is just as good at managing the economy - and "creating wealth" - as her opponents, if not better.

Unsurprisingly, this other, harsher side of Labor was revealed at the weekend by the Treasurer. Wayne Swan opened his weekly economic note thus: "Putting a budget together is always about priorities. For the Gillard government, our No. 1 priority will always be putting in place the right strategies to support jobs and growth to keep our economy one of the best performing in the developed world."

Ah, yes. Labor professes to be just as devoted to the great god GDP as its evil, uncaring opponents. As part of this, it's been struggling - unsuccessfully so far - to get its budget back to surplus. And as part of this struggle it has required all government agencies to economise in their use of resources.

The Bureau of Statistics has been required to find savings of between $1.1 million and $1.4 million a year - hardly a huge sum in a government budget of $387 billion. But the bureau has found a way to solve its problem for the coming financial year pretty much in one go. It's decided to cancel the "work, life and family survey" long scheduled for this year.

This is mainly a survey of how people use their time, requiring a random sample of households to keep diaries of the way their time was spent for a short period. GDP measures only the value of work that's been paid for in the marketplace. It ignores all the unpaid work performed in the home, including caring for kids, and the work of volunteers.

Time-use surveys fill that gap. How much time are women spending in paid and unpaid work? How is women's participation in the paid workforce changing over time as they become better educated? How much paid work is being done by people of retirement age? To what extent is paid work encroaching on our weekends? How is the burden of housework being shared between husbands and wives in two-income families?

It had been hoped that this year's survey would shed more light on changes in the time devoted to caring for invalids and the frail aged as governments try to save money by keeping people out of institutional care. And while we're at it, what has growing traffic congestion done to the time we spend commuting?

One of the most popular maxims of the wealth creators is: you can't manage what you don't measure. Directly or indirectly, most of the Bureau of Statistics' efforts are directed at measuring GDP. It's so important it's measured four times a year. Our time use hasn't been measured since 2006. The cancellation of this year's survey means it won't be measured again until 2019.

How do we keep on our present, hyper-materialist path? One of the ways is by failing to measure its consequences.

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Underneath, the economy is slowing

THE world is a complicated place - and the Bureau of Statistics' national accounts are more so. Sometimes they're better than they look, but the figures we got this week aren't as good as they look. On their face, they say real gross domestic product grew by 3.1 per cent over the year to December.

Since the economy's trend (medium-term average) rate of growth is about 3.25 per cent a year, that doesn't look too bad. The worry is, a lot more than half that growth occurred in the first half of the year, with growth in the last quarter of just 0.6 per cent - suggesting the economy is slowing.

The figures are unlikely to prompt the Reserve Bank to make much change to its forecasts last month of growth of just 2.5 per cent over the year to June, and probably not much better by the end of this year.

Looking into the detail, although consumer spending has generally held up better in recent years than many people suppose, it grew by a weak 0.2 per cent in the December quarter, and no better the quarter before.

Just why consumption has been so weak of late is a puzzle. The problem hasn't been weak growth in household incomes, nor a rise in the rate of household saving, which has been roughly steady at 10 per cent of household disposable income. It's the "disposable" bit that has been the problem: an unexplained increase in tax payments.

There was strong growth in the quarter in purchases of food and motor vehicles (for the year, up a remarkable 23 per cent), but a fall in spending at hotels, cafes and restaurants.

Probably the best news is that home building activity increased 2.1 per cent in the quarter, its best growth since early 2011, following a pick-up in the September quarter.

This suggests housing is finally starting to grow again, stimulated by lower interest rates and slowly rising house prices. But no one's expecting the recovery to be strong.

On the face of it, business investment spending contracted in the quarter, whereas public sector spending grew surprisingly strongly. But both results were distorted by the sale of an existing asset from the private sector to a state public corporation. Kieran Davies, of Barclays Bank, believes this is the Victorian government's purchase of a desalination plant for up to $4 billion.

As best he can untangle the figures, business investment rose 1 per cent during the quarter, while public sector spending was pretty flat. The latter's not surprising since governments at all levels are struggling to get their budgets back to surplus.

Within the overall growth in business investment, spending by the mining industries continued very strong, whereas spending by all other industries was weak.

According to the latest estimate by the Bureau of Resources and Energy Economics, the pipeline of committed resource projects is a record $268 billion. This suggests the peak in mining investment remains some quarters off and that, even when it arrives, it may be more of a plateau than the start of a dive.

While we're on the resources boom, the next notable feature of the accounts was that the volume (quantity) of exports grew 3.3 per cent during the quarter, whereas import volumes grew just 0.7 per cent. This means "net exports" (exports minus imports) made a contribution to overall GDP growth of 0.6 percentage points. By far the strongest growth came from coal and iron ore exports.

But a slowing in the rate of inventory accumulation made a negative contribution of 0.4 percentage points and, as Dr Chris Caton of BT Financial Group has calculated, almost all of this came from a sharp decline in mining inventories. It thus makes sense to say mining exports made a net contribution to growth of 0.2 or 0.3 percentage points.

So it's a mistake to say, as some have, that mining accounted for all the growth in the quarter. Small contributions came from consumer spending and housing. And it's good to see signs of the third phase of the resources boom getting started: there's a lot more growth in the volume of our mineral exports to come.

This is the time to be clear on the distinction between export volumes and export prices. Even as export volumes are growing, export prices are falling. Indeed, prices are falling mainly because volumes are growing. That is, prices are falling as supply catches up with demand.

The fall in export prices relative to import prices caused our "terms of trade" to deteriorate by 2.7 per cent during the quarter (and by 12.9 per cent during the year). This explains why, though real gross domestic production grew 3.1 per cent over the year, real gross domestic income rose by just 0.2 per cent.

This weaker growth in national income feeds through to business profits and household incomes, thus acting as a dampener on spending. And this, plus the coming peak in mining investment (and despite the income we'll get from growing mining export volumes) explains why what we need to see now is a transition from mining-led growth to growth in the rest of the economy: consumption, housing and non-mining business investment spending.

That's what's disappointing about this week's seemingly OK national accounts: as yet, not much evidence the transition is occurring. It's being spurred on by the fall in interest rates over the past year or more, but held back by the continuing high dollar.

Even so, Wayne Swan is right to remind us that, whatever our troubles, they pale into insignificance compared with the troubles of most of the rest of the developed economies.

Our growth of 3.1 per cent is faster than almost all the other countries in the Organisation for Economic Co-operation and Development and more than four times the average. Of the 27 advanced economies, 15 actually contracted in the December quarter.

Our real GDP has grown by 13 per cent in the five years since December 2007. Among the seven biggest advanced economies, only Germany, the US and Canada can claim to have grown in that time. And the best of them - Canada - has grown much less than half as much as we have.

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Adding the environment to the national accounts

Over the eight years to 2010-11, gross domestic product increased by 28 per cent, whereas Australia's net energy use increased by 18 per cent. So our "energy intensity" - energy used per $1 of GDP - is falling at the rate of 1 per cent a year.


In 2010-11 we produced 89 per cent of our total energy supply domestically, with the remaining 11 per cent being mainly imported oil. This took our total annual supply of energy to almost 19,000 petajoules. Of this we exported 71 per cent - mainly coal, uranium and natural gas.

Turning from energy to water, the price charged to households rose by 17 per cent in 2010-11, while the amount of water consumed by households fell by 8 per cent. On average, households were paying $2.44 a kilolitre. Of total water consumption of more than 13,000 gigalitres, 54 per cent went to agriculture and 33 per cent to the rest of industry, leaving just 13 per cent going to households.

Turning from water to land, Victoria's 23 million hectares of rateable land are valued at more than $1 trillion. Residential land accounts for 83 per cent of this total value, even though it accounts for only 5 per cent of the state's total area.

How do I know all this? Because I've been reading the "energy account", the "water account" and the "land account (Victoria, experimental estimates)", each published by the Bureau of Statistics in the past few weeks.

You may think from the examples I've given that the sort of information contained in these "accounts" is mildly interesting. But this exercise is really important and, to those of us who worry about the ecological sustainability of economic activity, even exciting.

You've seen me bang on before about the need for us to stop thinking of the economy being in one box and the environment in a completely separate box. The economy can't sensibly be separated from the environment because it exists within the natural environment - the ecosystem, if you prefer.

The economy depends on the ecosystem for its continued existence. It draws renewable and non-renewable natural resources and "ecosystem services" (such as photosynthesis and other natural processes) from the natural environment, then pumps all manner of pollution and waste back into the ecosystem.

It's clear that if our neglect of the ecosystem as we run the economy causes damage or depletion to the ecosystem, a point could be reached where the malfunctioning of the ecosystem inflicts damage and loss back on the economy. We could get into an adverse feedback loop between the economy and the environment.

This, of course, is exactly what's worrying us about climate change. The extensive burning of fossil fuels is causing emissions of carbon dioxide and other gasses which, partly because the clearing of land has reduced the role of forests as carbon sinks, are building up in the atmosphere, trapping in heat and interfering with the world's climate.

I fear climate change is just the first and most pressing instance of adverse feedback between the economy and the environment. If so, we need to become a lot more conscious of the interaction between the two.

But how did we get into the habit of thinking of the economy in isolation from the environment? The rest of us fell into the habit because that's the way the economists have always thought of it.

In the second half of the 19th century, when economists were setting in concrete their way of conceptualising the economy and analysing its workings, it made sense for them to conclude the environment could be excluded from the model without any great loss of relevance.

At the time, global economic activity was quite small relative to the vastness of the natural world. They couldn't know how hugely economic activity would grow, with a rapidly multiplying global population and an ever-rising worldwide average material standard of living.

Nor could they know how damming rivers, irrigating crops and sinking bores would interfere with the water cycle, how clearing land, running farm animals and growing crops would interfere with soil quality, or how ever-improving fishing technology would almost denude our oceans of fish.

Another problem was that their model was built on the role of market prices in co-ordinating economic activity. Many aspects of the natural environment, vital though they were to the functioning of the economy, weren't privately owned and didn't have a market price, so were "external" to the model.

Yet another part of the reason we've fallen into the habit of ignoring the environment when we think about the economy is that this is the way we've constructed our economic indicators - our gauges of how it's travelling. The chief gauge is the "national accounts" with their bottom line, gross domestic product.

We've taken to sharing the macro-economists' obsession with GDP, a measure of market production of goods and services during a period and the income generated by that production. It's a good indicator of employment prospects, but it takes no account of the using up of natural resources, nor of the cost of the damage economic activity is doing to the ecosystem.

But though economists may be stuck in their ways, the world's national statisticians aren't so hidebound. The concepts, classifications and accounting rules needed to calculate the national accounts in member countries have long been set down by the United Nations Statistical Commission. Earlier this year the commission decided to introduce a system of integrated environmental and economic accounting. This will involve developing environmental accounts on a comparable basis to the existing economic accounts, so they can be combined to give a more comprehensive picture of how the economy is affecting the environment and the environment is affecting the economy.

This "system of environmental-economic accounting" - SEEA - is a huge project, involving the measurement of various environmental dimensions not presently measured and the conversion of physical measures - such as petajoules and gigalitres - into dollar values.

Our Bureau of Statistics is at the forefront of this international development. Its recently published energy, water and land accounts are stepping stones in this great advance.

Publishing integrated economic and environmental accounts won't magically solve all our environmental problems, but it will make it much harder to forget these two aspects of our existence are inextricably joined.

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Economics and wellbeing: beyond GDP

Economic Society, Sydney, Tuesday, December 11, 2012

We had been hoping to have a speaker willing to argue that GDP was good enough to guide our policy decisions without need for modification or supplementation, but he’s unable to attend - which is a pity because I would have been interested to hear his arguments. In the absence of someone in the audience willing to argue that position, I think there’s a lot we can agree on. Where we’re likely to differ is in our degree of enthusiasm for the beyond-GDP project and how exactly we should go about developing a supplementary measure or range of measures.

Starting with the ‘agreed facts’, as the lawyers say, I doubt there are many if any economists who need to be lectured by greenies or lefties on the various reasons why GDP is an inappropriate measure of wellbeing or social progress. We all know about defensive expenditures and so forth. Further, we all know GDP was never intended or designed to be such a measure.

And I think all of us here tonight can agree that GDP is a reasonable measure of what it was designed to measure - production and income - and that the continued calculation of GDP is vitally important as an aid to the management of the macro economy. So no one here wants to abolish GDP.

It’s worth noting, however, that the 2009 report of President Sarkozy’s Commission on Economic Performance and Social Progress - the Stiglitz, Sen, Fitoussi report - did offer some significant criticisms of GDP just from a quite conventional, narrow, material wellbeing perspective. It noted that GDP had given Americans in particular an exaggerated impression of how well they were doing in the years leading up to the GFC, with company profits overstated because they were based on asset values inflated by a bubble and with a lot of the growth built on consumers and governments spending money they’d borrowed rather than earnt. It argued that in measuring material wellbeing, the focus should be shifted from production (GDP) to real household income and consumption, since household income can grow at a different rate to GDP. It further argued that income and consumption should be judged in conjunction with households’ net wealth, and that focusing on median income rather than average income is a better, easy way to take at least some account of the distribution of income.

A lot of the report’s criticisms can be met merely by switching from GDP to another aggregate published each quarter in the national accounts (but given almost no attention): real net national disposable income - ‘rinndi’. This measure switches from production to disposable income, takes account of the depreciation of manmade capital, the effect of movements in our terms of trade and the truth that, particularly for an economy with a huge net income deficit like ours, national product is a more appropriate measure than domestic product.

As you may know, I’ve been banging on about the limitations of GDP, and the need for it to be supplemented by a better, broader measure of wellbeing for some time. I was greatly reinforced in this view by the report of such luminaries as Stiglitz and Sen. For more than a year now, Fairfax Media has commissioned Nicholas Gruen to prepare such a broader measure, the Herald-Age Lateral Economics wellbeing index, for publication a few days after the quarterly national accounts.

The HALE index starts by turning GDP into real net national disposable income - rinndi - but then it adds adjustments for as many wider aspects of wellbeing as Nicholas could find decent measures of: the value of the net depletion of natural resources (after allowing for new discoveries), the estimated cost of future climate change, the gain in human capital from all levels of education and training, changes in income inequality, the gain or loss from various measures of the nation’s health and the state of employment-related satisfaction.

If you’re interested in getting your teeth into what a beyond-GDP measure of wellbeing might look like, we’re happy to explain and defend the HALE index. I asked Nicholas to come up from Melbourne tonight for that purpose. We don’t make any claim the index is a complete measure of every dimension of wellbeing, we don’t claim there’s nothing about its methodology that’s open to debate, but we do claim it’s an honest attempt to measure broader wellbeing - welfare, if you like - not some lefty attempt to think of as many negatives as possible to subtract from GDP.

The most obviously debatable part of the methodology is the decision to produce a single, modified-GDP figure for wellbeing. We know Stiglitz and Sen opted for the ‘dashboard’ approach - produce a range of relevant indicators of the various dimensions of wellbeing - rather than a single magic number. And we know the Bureau of Statistics, with all the effort it has put into its MAP project - Measures of Australia’s Progress - is also very much in the dashboard, they-can’t-be-added-up camp. So what are the reasons to prefer a single measure and, once you’ve decided to go down that track, how on earth do you add them together?

These are questions Nicholas, as the designer of the index, is far better qualified to respond to than I am. But I do want to say something from a more psychological, behavioural economics, political economy perspective. Why is it so many people have fallen into the habit of treating GDP as though it was a measure of social progress, even though it isn’t? The first part of my explanation is that economists, by their behaviour rather than their conceptual understanding, have led the uninitiated - politicians, business people, the media - into assuming GDP is the only indicator that matters because they get so excited about it so often, and don’t get so excited about anything else.

They say that what gets measured gets managed, and what doesn’t get measured doesn’t get managed, so if you accept there’s more to our wellbeing that just GDP (or even rinndi) that’s the first reason for wanting to publish something to sit beside GDP. In terms of human psychology, part of the reason for the great attention GDP gets is that new figures are published so frequently and that they’re always changing to an interesting extent.

Finally, we know from the findings of neuroscience that, contrary to our assumption of rationality, humans have surprisingly limited mental processing power and can’t weight up more than one or two dimensions of a problem at the same time, which - among many other implications - means humans are irresistibly attracted to bottom lines - to ‘net net’, as they say in the markets. People want a bottom line, will probably pick one by default, and GDP looks likes it is one. Dashboards may be more methodologically pure, but in a world of human frailty and limited attention, they just don’t cut it.

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Economy slowing, not dying

To hear many people talk, the economy is in really terrible shape. Trouble is, we've been waiting ages for this to show up in the official figures, but it hasn't. This week's national accounts for the September quarter are no exception.

You could be forgiven for not realising this, however, because some parts of the media weren't able resist the temptation to represent the figures as much gloomier than they were.

One prominent economist was quoted (misquoted, I trust) as inventing his own bizarre definition of recession so as to conclude the economy was in recession for the first nine months of this year.

Really? Even though figures we got the next day showed employment grew by 1.1 per cent over the year to November, leaving the unemployment rate unchanged at 5.2 per cent? Some recession.

What the national accounts did show - particularly when you put them together with other indicators - is that the economy is in the process of slowing, from about its medium-term trend growth rate of 3.25 per cent a year to something a bit below trend.

That's not particularly good news - it suggests unemployment is likely to rise somewhat - but it hardly counts as an economy in really terrible shape.

The accounts show real gross domestic product growing by 0.5 per cent in the September quarter and by 3.1 per cent over the year to September - which latter is "about trend".

This quarterly growth of 0.5 per cent follows growth of 0.6 per cent in the previous quarter and 1.3 per cent the quarter before that. So that looks like the economy's slowing - although the figures bounce around so much from quarter to quarter it's not wise to take them too literally.

But the accounts contain a warning things may slow further. We always focus on the growth in real gross domestic product, which is the quantity of goods and services produced during the period (and is the biggest influence over employment and unemployment).

But if you adjust GDP to take account of the change in Australia's terms of trade with the rest of the world, to give a better measure of our real income, you find "real gross domestic income" fell by 0.4 per cent in the quarter to show virtually no growth over the year.

Leaving other factors aside, this suggests our spending won't be growing as fast next year, leading to slower growth in the production of goods and services (real GDP) and thus slowly rising unemployment.

Our terms of trade are falling back from their record favourable level because of the fall in coal and iron ore export prices as the first stage of the three-stage resources boom ends. (The second stage is the mining investment boom and the third is the rapid growth in the quantity of our mineral exports.)

For some time the econocrats and other worthies have been reminding us that, when ever-rising export prices are no longer boosting our incomes, we'll be back to relying on improved productivity - output per unit in input - to lift our real incomes each year.

This makes it surprising we've heard so little about the figures showing that GDP per hour worked rose by 0.7 per cent in the quarter and by a remarkable 3.3 per cent over the year. Again, it's dangerous to take short-term productivity figures too literally, but at least they're pointing in the right direction.

They also put a big question mark over all the agonising we've heard about our terrible productivity performance.

This week's figures confirm what we know: some parts of the economy are doing much worse than others. Business investment in plant and construction rose by 2.6 per cent in the quarter and 11.4 per cent over the year - though most of this came from mining, with investment by the rest of business pretty weak.

One area that isn't as weak as advertised is consumer spending, up by 0.3 per cent in the quarter and 3.3 per cent over the year - about its trend rate. The household saving rate seems to have reached a plateau at about 10 per cent of disposable income, meaning spending is growing in line with income.

Investment in home building grew 3.7 per cent in the quarter, suggesting its chronic weakness may be ending, thanks to the big fall in interest rates. Adding in home alterations, total dwelling investment was up 0.7 per cent in the quarter, though still down 6.3 per cent over the year.

The volume (quantity) of exports rose 0.8 per cent in the quarter and 4.7 per cent over the year, whereas the volume of imports rose 0.1 per cent and 3.5 per cent, meaning "net exports" (exports minus imports) are at last making a positive contribution to growth. This suggests we're starting to gain from the third stage of the resources boom, growth in the volume of mineral exports. The greatest area of weakness was spending by governments. Government consumption spending was down 0.4 per cent in the quarter (but still up 3.5 per cent over the year). Government investment spending fell 8.2 per cent in the quarter and 7 per cent over the year even though, within this, investment spending by government-owned businesses was strong.

All told, the public sector made a negative contribution to GDP growth of 0.5 percentage points in the quarter, and a positive contribution of just 0.3 per cent over the year - obviously the consequence of budgetary tightening at both federal and state levels.

This degree of contraction isn't likely to continue. But a strong reason for accepting the economy is slowing somewhat is the news from the labour market.

Don't be fooled by the monthly farce in which unemployment is said to jump one month and fall the next. If you're sensible and use the smoothed "trend estimates" you see unemployment steady at 5.3 per cent since August.

Even so, the economy hasn't been growing fast enough to employ all the extra people wanting work, causing the working-age population's rate of participation in the labour force to fall by 0.4 percentage points to 65.1 per cent.

And we know from the labour market's forward-looking or "leading" indicators - surveys of job vacancies - that employment growth is likely to be weaker in coming months.

That's hardly good, but it ain't the disaster some people are painting.

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Wellbeing index gives better picture of mining boom

DON'T believe the doomsayers.This week's national accounts indicate the economy is slowing to something a bit below trend but the critics of the great god gross domestic product are right: it is a quite inadequate and often misleading measure of the nation's progress.

This is why, for more than a year, the Herald has commissioned Dr Nicholas Gruen, principal of Lateral Economics, to calculate a broader index of wellbeing, which we have published within a few days of the release of the Bureau of Statistics' quarterly national accounts, with GDP as their centrepiece.

Our purpose has been to supplement rather than supplant the official figures, which have valid - if narrower - uses and were never intended to be treated as the nation's all-encompassing bottom line.

The Herald-Lateral Economics wellbeing index uses the national accounts to produce a modified version of GDP called "net national disposable income". This adjustment takes account of the annual depreciation (using up) of man-made capital and of the income earned within Australia which isn't owned by Australians.

It also shifts the focus from the value of the nation's production to how much disposable income the nation's households have available to spend on consumption or save, in the process allowing for the change in the prices of our exports relative to the prices of imports.

To this figure the index adds adjustments for the value of the net depletion of natural resources (after allowing for new discoveries), the estimated cost of future climate change, all levels of education and training, changes in income inequality, various measures of the nation's health and employment-related satisfaction.

All this means the index is well placed to help answer a question on many people's minds: what will we have to show for the resources boom?

Unlike GDP, the wellbeing index takes account of the loss of the minerals dug up and sent overseas, not just the export income earned from doing so. It also takes account of the loss of real income we have suffered from the end of the first stage of the boom: the marked decline in the world prices of coal and iron ore during the three months to the end of September.

This was the main factor that converted the growth of 0.5 per cent in GDP during the quarter - a measure of the quantity of goods and services produced in the economy - to a fall of 0.7 per cent in our net national disposable income.

But the accounts confirm that Australian households are continuing to save the high proportion of their disposable incomes. So that is proof we have been saving rather than spending some of our windfall gain from the boom.

But the broader index shows we have also increased our investment in the education and training of our workforce. So much so that, despite the fall in export prices, the index rose by 0.2 per cent during the quarter.

We should be using our good fortune to raise the value of workers' labour and improve their lives in the years ahead - and the wellbeing index shows we are.

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The two speeds not as far apart as claimed

Some people spent much of this year worrying about how the two-speed economy was affecting the south-eastern states. There was concern Victoria was on the brink of recession and South Australia and Tasmania were already in one.

So when, a week or two back, the Bureau of Statistics finally published the figures for the real growth in the various states' gross state product last financial year, 2011-12, there would have been great interest from the media, right?

Wrong. The only definitive figures we've had for economic growth by state for the past 12 months went virtually unreported.

Why? Because they were a bit dated? No. More likely because they showed no sign of recession. They also showed the gap between the fast and slow states to be narrower than we'd been led to believe.

Turns out we did a lot of worrying for nothing, misled by figures we should have known are always misleading.

The unreported figures show Victoria's gross state product grew by 2.3 per cent for 2011-12 as a whole, just a fraction less than NSW's 2.4 per cent. South Australia grew by 2.1 per cent and even Tasmania pushed ahead by 0.5 per cent.

By contrast, Queensland grew by 4 per cent and Western Australia by 6.7 per cent. Overall, gross domestic product (the national measure) grew by a respectable 3.4 per cent.

A point to remember, however, is that the populations of the states are growing at quite different rates and this accounts for part of the difference in the rates at which their economies are growing. Only to the extent a state's gross state product per person is increasing is it better off materially.

Nationally, economic growth of 3.4 per cent in 2011-12 drops to 1.8 per cent per person. Queensland's growth drops from 4 per cent to 2.2 per cent, while WA's drops from 6.7 per cent to 3.7 per cent.

Not quite so much cause for envy.

If you recollect reading during the year figures a lot more dramatic than these, you're right, you did. As I say, definitive figures for gross state product are published only once a year, on an annual basis. The figures the bureau publishes each quarter as part of the national accounts are for something quite different: state final demand.

These figures are always widely reported by the media, with journalists happily assuming SFD and GSP must surely be pretty much the same thing. Trouble is, they're not. And the media's insistence on reporting these largely meaningless figures means the public is regularly misled about the extent of differences between the state economies.

State final demand and gross state product would be pretty much the same thing if the states' shares of Australia's exports and imports never changed and, more to the point, if there was no trade between the states.

It shouldn't surprise you there's a lot of trade between the states. Nor should it surprise you the mining states import a lot more from the other states than they export to them. The other side of the coin is the other states - particularly NSW and Victoria - export more to the mining states than they import.

This trade between the states spreads the benefits of the resources boom around the continent. In consequence, the much-quoted state final demand figures tend to overstate how well the mining states are doing and understate how well the other states are doing.

That's how the recession furphy got started.

Consider this. According to the latest figures for 2011-12, WA state final demand of 13.5 per cent turned into gross state product of 6.7 per cent, while Queensland's final demand of 8.6 per cent was more than halved to 4 per cent.

By contrast, Victoria's final demand of 2.2 per cent was increased a fraction to gross product of 2.3 per cent, while NSW's final demand of 2 per cent was increased to 2.4 per cent.

SA's final demand and gross product were the same at 2.1 per cent (meaning it neither wins nor loses from the inclusion of international and interstate exports and imports), while Tasmania's final demand growth of zero was increased to gross product growth of 0.5 per cent.

You see how misleading those quarterly state final demand figures are. They exaggerate the true extent of the differences between the states.

So why do the media make so much of them? Because, at a time when the resources boom is doing so much to change the industry structure of our economy, there's much interest in what this is doing to the respective sizes of the state economies.

The quarterly state final demand figures don't give reliable answers to this question, but they're the best that regularly come our way.

But also because the ever-intensifying competition between the news media has prompted them to select their news on the basis of all care but no responsibility. If some information is interesting or controversial it will be published, even if the journalists know or suspect it's dodgy. After all, if I don't do it, my competitors will.

The relative sizes of the six state economies have been changing since federation, partly - but not solely - because of their differing rates of population growth. But, though it's possible to exaggerate the extent to which the resources boom is causing the mining and non-mining states to grow at different rates, the states' relative sizes have been changing particularly rapidly in recent years.

Those recent figures no one bothered to report, known as the State Accounts, showed how the states' shares of overall gross domestic product have changed over the eight years to 2011-12.

In that time, NSW's share has dropped 3.8 percentage points to 30.9 per cent. Victoria's share has dropped 2.6 points to 22.3 per cent.

By contrast, Queensland's share has increased 1.7 points to 19.3 per cent, while WA - which long ago overtook SA in the pecking order - had its share increase a remarkable 5.4 points to 16.2 per cent of overall GDP.

That leaves SA's share falling 0.8 points to 6.2 per cent and Tassie's falling 0.3 points to 1.6 per cent. Its share is now less than the ACT's (2.2 per cent) and only a fraction greater than the Northern Territory's (1.3 per cent).

Whether we like it or not, the shape of our economy is changing.

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MAIN STREET & WALL STREET: the interrelationship between the real and financial economies

Comview conference, Melbourne, November 2012

Last year Glenn Stevens remarked that it was ‘very sensible of Australian households to be strengthening their balance sheets’. What on earth did he mean? In recent years we hear a lot of jargon in the economic debate that we usen’t to hear and that certainly wasn’t mentioned when we were at university. People keep on about ‘balance sheets’ - household balance sheets, business balance sheets, government balance sheets - and how they need to be ‘strengthened’ or ‘repaired’. Sometimes they talk about ‘gearing’, other times they talk about ‘leverage’ - households or businesses are ‘deleveraging’ we’re often told these days. We hear a lot more about ‘asset prices’, and credit-fuelled ‘asset-price inflation’ leading to ‘asset bubbles’.

We also hear a lot these days about the ‘wealth effect’ and about the household saving ratio - it was falling for about 30 years but then it rose rapidly, making life hell for the retailers. And economists take a lot more interest in the sharemarket than they used to. Say you’re worried about household debt being 150 per cent of household disposable income and someone will counter that household liabilities are just 21 per cent of household assets.

Then there’s the balance of payments. Express some interest in the trade deficit or the current account deficit and economists are just as likely to respond by talking about the capital account surplus and the balance between national saving and national investment. Say you’re worried about foreign debt and someone will say you should be focusing on our net foreign liabilities. Then they’ll say the nation’s foreign liabilities account for just 20 per cent of its assets.

The real economy versus the financial economy

So what’s going on? What’s going on is that historically, Keynesian macroeconomics focuses almost exclusively on the real economy, to the exclusion of the financial economy. There is, of course, only one economy, but it has two dimensions, real and financial. The real economy is the physical, touchable world of getting and spending, of the production and consumption of goods and services. Inflation and unemployment are part of the problems of the real economy, and we focus on these. Saving and investment are part of the real economy, but pretty much only to the extent they constitute leakages and injections to the circular flow of income.

The financial economy is the intangible world of borrowing and lending, assets and liabilities, of people with savings connecting with people needing funds to finance their investment, usually via an intermediary such as a bank, but also via direct borrowing in the financial markets. It’s the world where financial assets such as shares, bonds and foreign currencies are traded on financial markets.

The real economy couldn’t exist without the financial economy. You can’t produce goods and services without physical capital such as machines and factories, and you can’t sell them without shopping centres and offices. The acquisition of most of those assets has been financed by borrowing and equity capital. The financial markets exist to supply that funding. Just about every business has a significant amount of debt, with interest payments forming a significant expense.

Similarly, consumers come from households that need assets such as housing and consumer durables, the purchase of which is usually financed by borrowing. Households also own much of our big businesses via their superannuation saving or direct shareholdings.

Why talk about the financial economy is now so prominent

But conventional macro has taken little interest in the financial side of the economy. It has focused almost exclusively on the three dimensions of GDP: income, expenditure and production. As you probably know, the national accounts measure GDP these three different ways. In theory they’re equal; in practice measurement problems mean they never are so, in practice, the bureau of stats takes an average of the three and calls it GDP(A). And in practice, of course, macro economists focus mainly on the expenditure side of the real economy: GDP = C + I + G + X - M.

What’s changed is that, though Australia’s macro managers have had considerable success in controlling both inflation and unemployment over the past decade or two, a lot of different problems have emanated from the financial economy. That’s painfully evident right now in the rest of the developed world, but you can see it here if you go back a bit.

The severe recession of the early 1990s, which was quite protracted and saw the unemployment rate rise to almost 11 per cent, was caused by problems in the financial economy. Our banks and businesses overreacted to the deregulation of the financial sector, and we ended up with borrowing-fuelled booms in the housing and commercial property markets. The bust in the commercial market left many of our businesses far too highly geared and our banks with a lot of bad debts, to the extent that Westpac went close to falling over. What made the recession so protracted and severe was the way businesses sought to repair their balance sheets - to deleverage; or in plain English, to reduce their liabilities relative to their assets - by avoiding new expansion and cutting costs so as to repay debt. In particular, they cut costs by laying off workers. The banks repaired their balance sheets by widening their interest margin (not passing on all the cuts in the cash rate) and limiting their lending for new business projects. Note that problems in the financial economy soon become problems in the real economy. Economists separate them conceptually, but they can’t be kept apart in real life.

As its name implies, the Asian financial crisis of 1997-98, which led to a sharp recession in most of East Asia, had its origin in the financial side of those economies. Most had property booms fuelled by foreign capital inflow; when the foreign capital started rapidly flowing back out, countries had to devalue their fixed exchange rates. Many businesses that had borrowed in foreign currencies now found their loans and interest payments far higher than their assets. Their economies entered a sharp recession. In new phenomenon called ‘contagion’, foreigners who lose confidence in the prospects for one country tend to spread their doubts to neighbouring countries.

This brings us to the global financial crisis and the world recession it led to - which, for the countries of Europe, hasn’t ended. Again as the name implies, the causes of this recession were financial. The huge extent to which China and some other Asian countries’ saving exceeded their investment led to them running up large reserves of foreign exchange, which were then lent cheaply to the developed countries, particularly the US. This excessive supply of cheap funding led to excessive consumption, home building and borrowing by US households, which became quite highly leveraged - that is, their debts grew relative to the value of their assets. At the same time, deregulation, weak supervision and ever-increasing use of derivatives caused banks in the US and Europe to become far too highly leveraged. As well, most governments continued their longstanding practice of running budget deficits in good times as well as bad.

(‘Gearing’ and ‘leverage’ are the same: the use of borrowed capital to buy assets, thus magnifying the return to equity capital while asset prices continue rising, but magnifying the loss when asset prices start falling. Gearing is the British and Australian term; leverage is the American term.)

When, inevitably, the US house-price bubble burst, the whole financial house of cards collapsed. The sharp fall in house prices caused some households to experience ‘negative equity’ (their liabilities now exceeded the value of their assets) and others to pull their horns in and seek to ‘deleverage’. As always, this touched off a multiplier effect where fear of unemployment causes households to cut their spending and get their finances in order but this, in turn, causes the very increase in unemployment they were afraid off, touching off a further round of contraction.

While this was happening in the household sector, the banks were getting into trouble. Their excessive gearing meant it took only small levels of bad debt to wipe out their capital and bring them close to bankruptcy. Individual banks realised the other banks were in trouble, so the banks as a whole refused to lend to each other, forcing central banks to fill the gap, providing huge short-term credit to all banks. Some global financial markets actually ceased to operate for a time. The banks also became reluctant to make new loans to business. Though the problem began in the US, it quickly spread to the European banks, eventually exposing the structural weaknesses in Europe’s monetary union.

After the collapse of the investment bank Lehman Brothers in September 2008, the US Government had to bail out many banks, buying some of their now-toxic financial assets and injecting equity capital. Governments in Britain and Europe had to do something similar. Delay in approval of the US rescue package added to the rout on US and global sharemarkets, which had begun falling when the problem started to emerge about a year earlier.

Every media-publicised announcement that a bank had failed or almost failed in the US or Europe prompted another loss of business and consumer confidence around the world. In the US and, more particularly, Europe, government borrowing to bail out banks and reflate economies, when added to decades of deficit budgeting, caused government debt levels to soar, thus prompting a ‘sovereign debt crisis’ - the fear governments are so heavily indebted they may default on their debts (an event which, as Reinhart and Rogoff demonstrate in their modern classic, This Time Is Different, has happened far more times than we remember).

How and why the world has changed

In the post-war period we got used to recessions that arose from problems in the real economy. Typically, inflation problems would arise as demand grew faster than supply (production capacity) and shortages of skilled labour led to excessive wage rises. The authorities would respond with tighter monetary policy, hoping to achieve a ‘soft landing’ but overdo things and causing a recession.

Clearly, our last recession in the early 90s, the Asian financial crisis and the latest, global financial crisis were all very different from that, coming out of the financial side of the economy. Essentially, they were products of the bursting of credit-fuelled asset-price bubbles.

Why are financial crises and financial-side recessions now more common? Because the deregulation of financial markets makes credit far more accessible and often cheaper to households and firms, thus making it easier for credit-fuelled asset-price booms to emerge. Because, at least in some countries, and at least until now, the era of financial deregulation has seen banks and their innovations inadequately supervised by the authorities. Because financial globalisation has increased short-term capital flows between countries, thus increasing the likelihood of problems in one country spreading to others. And because the globalisation of the media means news of disturbing developments in one country now spreads almost instantaneously around the world, adversely affecting business and consumer confidence.

Another part of the story is that, whereas central banks have finally mastered the art of controlling goods-and-services inflation via independence and inflation targeting, thereby greatly improving demand management, their efforts seem to contribute to booms in asset prices - problems the central bankers admit can’t be countered with conventional monetary policy.

But how has the world changed? What are the consequences of recessions that arise from the financial side? They tend to be more severe and to last a lot longer. This is because ‘deleveraging’ or ‘balance sheet repair’ is an essentially deflationary process which, in economies that are already weak, take months or years to bring about. Similarly, efforts by governments to deleverage take a long time. Should governments attempt to speed up the process by cutting their spending or increasing taxes at a time when the economy is already weak, their efforts are likely to prove counterproductive - as we’ve seen in Europe recently.

A second reason financial-side recessions are more severe and protracted is that they often involve a version of a liquidity trap, in that interest rates are already very low when the recession starts. Since interest rates can’t fall below zero, there’s little room for conventional monetary stimulus. In any case, banks are often too preoccupied with repairing their own balance sheets to want to increase their lending, notwithstanding the low interest rates obtaining. All this greatly limits the effectiveness of monetary policy, pushing more of the initiative onto fiscal policy. But, where governments have themselves over borrowed in the good years leading up to the financial recession, their ability or willingness to apply fiscal stimulus is also limited, as we’re witnessing at present in the US and Europe. The next step is reluctant resort to ‘quantitative easing’ (another new bit of jargon).

I’m sure you know that ‘QE’ is a euphemism for what we used to call ‘printing money’. Of course, just like most money created by the central bank, this is not physical cash but numbers in bank accounts. What you may not know is that it involves central banks expanding both sides of their balance sheet. They buy government bonds (sometimes newly created bonds direct from the government, sometimes second-hand bonds from the ‘secondary market’) or other assets (such as mortgage-backed securities) and pay for them with extra money they have created. The money issued by the central bank is a liability of the central bank, whereas the securities it buys are an asset. Thus both sides of their balance sheet are increased.

The ‘wealth effect’ economists worry about more than they used to represents a form of feedback from the financial economy to the real economy. It occurs when households’ feelings about what’s happen to their wealth (their assets and liabilities ie their household balance sheets) affect their decisions about how much of their income they should save and, therefore, how much is left for consumer spending. When asset prices (particularly house prices, but also superannuation balances and direct shareholdings) are rising strongly, households are likely to feel wealthier, and thus see less need to save rather than consume. When assets prices aren’t rising, or maybe superannuation balances are falling, households are likely to feel less wealthy and thus save more and consume less. You’d get the same effect when the economic outlook became more threatening and households became concerned about the extent of their debts. It’s possible the ageing of the population - that is, the higher proportion of households in or nearing retirement - will make the wealth effect a more powerful influence on the real economy.

As for the increasing tendency of economists to explain the current account deficit in terms of national saving and investment, it’s a financial-side way of examining the balance of payments.

The accounting side of the story

Another reason we hear a lot more about balance sheets these days is that there are a lot more of them about. Some years ago, the UN Statistical Commission decided to switch both the system of national accounts and government finance statistics from a cash to an accrual basis. This means the (annual) national accounts now include a national, whole-economy balance sheet and a balance sheet for the household sector. We also have balance sheets for the federal and state governments.

To get a clear understanding of the distinction been the real and financial economies you have to remember there are two kinds economic variable: flow variables and stock variables. Flow variables show the size of the flow of some item (such as income or expenditure) over a period of time (usually a month, a quarter or a year); stock variables show the amount of some item (such as assets or liabilities) at a point in time(usually the last day of the period eg June 30).

In a business, the flow variables are collected together in the profit and loss statement, where the flows of expenses incurred during the period are subtracted from the flows of income earnt during the period to give the profit or loss for the period. The stock variables are collected together in the balance sheet, where total liabilities at the end of the period are subtracted from total assets at the end of the period to give the business’s ‘net worth’ at the end of the period.

For an economy, the conventional national accounts are equivalent to the profit and loss statement, while the new balance sheet is equivalent to a business balance sheet. That is, the conventional national accounts show the flows of income, expenditure and production in the economy during a period, while the national balance sheet shows the stocks of manmade, natural and foreign assets, less the stock of foreign liabilities, to give the national economy’s net worth at the end of the period. (Note that, within the nation, debts to other Australians are matched by the financial assets of other Australians, and so cancel out.)

The point to note is that it’s the flows during a period that bring about the change in stocks between the start and end of the period. If, for example, the net public debt increased from 100 to 120 between the end of period 1 and the end of period 2, this tells us government expenses exceeded government revenue during the period by 20 - that is, the government ran a deficit in year 2 of 20.

This is relevant when we say that Keynesian macro management focuses on the real economy largely to the exclusion of the financial economy. It focuses on the flows in the national accounts - or the budget - but ignores the stocks building up in the balance sheet. So Keynesians care whether household consumption is growing faster or slower than household income, but don’t take much interest in whether household net worth is rising or falling. They care whether government spending exceeds or underruns government revenue - that is, whether the government is running a deficit or a surplus - but they don’t much care what’s happening to the net public debt.

This neglect helps explain how most of the governments of the North Atlantic economies managed to go for decades building up huge stocks of government debt, which left them very badly placed to cope with the fallout from the GFC. It also helps explain why so few economists saw the GFC coming. They didn’t notice, for instance, that in the US, much of the growth in consumption and the economy in the years leading up to the GFC was, in a sense, phoney - it was financed not by rising household incomes but by rising household debt.

The trouble with the excessive focus on the real economy is that while what happens to the levels of stocks may be ignored in the short to medium term, if they are ignored for too long and allowed to build up to unsustainable levels they will eventually precipitate a financial crisis.

Conclusion

In a financially deregulated and globalised world, macro economists can no longer get away with limiting their interest to the real economy - to flow variables - and taking little interest in balance-sheet, stock variables. When financial imbalances build up, the ultimate blow to the real economy - and the lives of real human beings - can be extensive.

Technical note: much of what accountants call the ‘ratio analysis’ used commonly by economists was developed in the days before the preparation of collective balance sheets. In those days, the only stock variables produced in the national accounting process were levels of debt - public debt, household debt, foreign debt. When economists wanted to study those debt levels they compared them with the only other variables available, flow variables. Hence the practice of comparing household debt with household disposable income, or the net foreign debt with nominal GDP.

But accountants know that comparing stock variables with flow variables involves comparing apples with oranges. Ideally, stock variables should be compared with other stock variables, and flow variables with other flow variables. Before the advent of balance sheets this wasn’t possible, but now they exist economists need to change their practices to take advantage of the more relevant data available to them.

For instance, novices are greatly disturbed to hear that household debt is equivalent to 150 per cent of household disposable income. But such a comparison is largely meaningless. It implies that a day may come when someone is required to repay their mortgage, but prohibited from selling their house to satisfy most if not all of the debt. When would anyone ever be suddenly asked to repay their mortgage purely from their income? What matters is how the household’s assets compare with its liabilities (a stock-stock comparison) and, within this, how the present market value of the house compares with the size of the loan attached to it; and how the household’s cost of servicing the mortgage compares with its disposable income (a flow-to-flow comparison).

Similarly, it makes more sense to compare the nation’s foreign debt (or net foreign liabilities) with its assets (stock-to-stock), then compare the cost of servicing our net foreign liabilities (which is the net income deficit in the current account) with the nation’s income (nominal GDP) or with export earnings (both flow-to-flow).

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