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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Our economy has turned into a tortoise. The RBA will be pleased

By Millie Muroi, Economics Writer

Most of us know the age-old saying: slow and steady wins the race. Numbers released into the wild on Wednesday show the Australian economy is definitely a tortoise – but it should make the Reserve Bank pretty happy.

The national accounts – data gathered and shared every three months by the Australian Bureau of Statistics – gives us one of the most detailed pictures of how our economy has been tracking. The numbers always run slightly behind where we are because all the information has to be collected, crunched and spat out into a digestible clump. This week’s data drop was for the three months to June.

So, how did we go? There’s not much that should come as a surprise. Economists have long known the economy has been slowing. And most of the household data points to trends you’ve probably seen and lived yourself less spending, less disposable income and less of our income being put away for a rainy day.

Economic growth – or gross domestic product (GDP) – was weak, expanding 0.2 per cent in the June quarter for the third quarter in a row. But economic growth per person, which matters more when assessing our living standards, has tumbled … again. It fell 0.4 per cent – the sixth back-to-back quarter of shrinkage.

Will this worry our decision makers? Probably not. The focus is almost always on the total, not what’s happening on an individual level. It’s also much simpler to talk about GDP than GDP per capita – and much easier to fit in a headline!

The Reserve Bank, for one, won’t be worried by Wednesday’s figures. In fact, it’s probably quite happy. Why? Because its decisions are made at an aggregate level: it looks at the big picture, not the finer details.

There’s always a risk the bank will push the economy too far down the drain.

The bank’s forecasts for certain sections of the national accounts might have fallen on the wrong side of the fence: disposable income (how much people have to spend or save after taxes) for example, came in 0.3 per cent lower over the year, compared with the bank’s expectations for a 1.1 per cent increase.

But the Reserve Bank has one thing at the front of its mind: pushing inflation back into the 2 per cent to 3 per cent target range. In June, annual inflation was still sailing in at 3.8 per cent.

Sure, the bank also wants to keep Australians employed. But with the number of jobs still growing, and the unemployment rate (at least the headline measure) staying low by historical standards, it’s inflation that the bank is worried about.

As you know, inflation is determined by the balance – or imbalance – between demand and supply. There’s not much the Reserve Bank can do about supply (except shout from the sidelines about the importance of boosting productivity), so its focus is on demand.

From the bank’s perspective, it doesn’t matter where that demand comes from, or who exactly is doing the demanding. Its mission is to dampen demand when inflation is high, and give it a boost when inflation is low and the economy is slow.

There’s always a risk the bank will push the economy too far down the drain. We know GDP is only just managing to keep pace and the Reserve Bank has one tool – interest rates – which it’s not afraid of holding high until there’s a clearer sign it has inflation under its thumb.

After all, it doesn’t want inflation running high and finishing first, unless finishing means an end to high inflation.

For this to happen, the bank needs demand to slow down. That means less spending – at least until we figure out a way to pump out more goods and services with the limited people, machinery and materials we have.

It’s clear households are feeling more pressure. The proportion of households’ income that they were able to save dropped to 0.6 per cent in the June quarter, compared with 1.7 per cent at the same time last year. That’s despite households also cutting their spending.

Household consumption, at more than half of GDP, is the single biggest driver of economic growth. But with household spending down, it was government spending (which contributed 0.3 percentage points to growth) that helped keep the economy expanding. Investment spending on new homes, business equipment and building had no impact this time around, while net trade (the difference between exports and imports) contributed 0.2 percentage points, largely thanks to international students and all the spending they did in our economy.

Overall, there’s little in the national accounts to spook the Reserve Bank. Treasurer Jim Chalmers copped some heat this week for a tweak in his language when he said interest rates were “smashing” the economy. But Chalmers and the bank know that without a miracle or a slowing economy, it’s hard to see inflation being reined in anytime soon.

If anything, the national accounts show the economy is moving the way the bank wants. That means both an interest rate cut and rise are unlikely for the time being. The Reserve Bank doesn’t want the economy to stall, but it needs any increase in demand to run behind growth in supply, for inflation to come down.

Right now, our country is still running too hard down the shopping aisle for suppliers to keep up, meaning we’re putting upwards pressure on prices. That’s where the government needs to strike a fine balance. Spend too little and, as our figures showed, we could slip into recession. But spend too much and inflation could stick around for longer.

Anyone who runs knows it’s impossible to sprint all the time. Going slow is not always fun, but until we build up the stamina, muscle and skill, we have to make sure not to push ourselves too hard for too long in case we sustain an injury.

It’s a similar story for the economy. The demands we put on it have to grow alongside our ability to cater for them. The Reserve Bank is like a coach making tough calls because it thinks we’re pushing too hard.

Our economy is slowing, and it’s a fine balance to strike when jobs are on the line. But as long as we’re not running backwards, and with the jobs market so strong, the bank will be happy to stay the course with our tortoise economy.

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How GPT (not that one) could help fix our inflation problem

By Millie Muroi, Economics Writer

ChatGPT is not the answer to Australia’s productivity problem. At least, not yet.

But I asked ChatGPT what its chances were of productivity improving in Australia – if it was a betting man. The answer? 70 to 80 per cent.

Productivity growth excites economics nerds, like those at the Reserve Bank ... and just about no one else. But it matters for everything from your mortgage to the prices you pay at shops and the quality of your life.

Why? Because productivity growth means being able to make more with what we have, which is the best solution to the biggest economic issue of our time: inflation.

After all, there are two sides to this inflation problem: too much demand and too little supply. Instead of the Reserve Bank beating down our appetite for goods and services through ramping up interest rates, wouldn’t it be nice if businesses could simply produce more with the workers and equipment they already had, therefore keeping prices in check?

We could work longer hours and maybe even put our machines under more strain, but we can only do that for so long: it would be like trying to run a marathon at sprinting speed.

That doesn’t mean we should abandon all hope.

Instead, to curb price rises, and to lift our living standards over time, we need to improve productivity. Like a marathon runner improving their running technique, we need a way to get faster or better at what we do. A crucial way of doing this is through discovering and using new technology that helps us pump out more, or better quality, goods and services, in a way that can be maintained.

The most influential of these tools (those that have transformed the way we live) are called General-Purpose Technologies – or GPTs for short. The steam engine, cars, electricity and the internet all count as GPTs, because they were widely adopted and became crucial pieces of technology which dramatically yanked up our productivity.

We may not consciously think about it. But imagine what our lives would look like today without electricity, internet and cars. We would be slower, have much less information at our fingertips and would find it harder to work once the sun sets.

As Andrew Leigh points out in his book The Shortest History of Economics, the journey to create the electric bulb itself shows how our productivity has improved. In prehistoric times, producing as much light as a regular household lightbulb using wood fire would have taken our ancestors about 58 hours of foraging for wood. Today, it takes less than a second of work to earn enough to flick a household light bulb on for an hour.

ChatGPT is an example of a tool that could become a general-purpose technology. But the “GPT” in its name actually stands for “generative pre-trained transformer”: a fancy way of saying a piece of software trained using huge amounts of data to offer up human-like answers to questions like mine.

During the pandemic, there was a short-lived surge in the take-up of cloud computing (IT services that businesses can use without owning or running the physical servers, hard drives and networks required themselves). But generally, Australian businesses are behind the curve when it comes to adopting new technologies – and we don’t develop much of it ourselves.

That doesn’t mean we should abandon all hope. Instead, we need to think about the drivers of, and barriers to, adopting technologies such as cloud computing and artificial intelligence: two GPTs in the making.

Kim Nguyen and Jonathan Hambur at the Reserve Bank say these technologies could alter the way we do business. But knowing how to use and make the most of them also requires highly skilled and educated workers.

A website called ChatGPT is raising questions about the role of artificial intelligence in our education, work and relationships.

Nguyen and Hambur’s research involved trawling through the annual reports, job ads and earnings calls of Australian businesses to figure out how much workers’ and managers’ skills matter when it comes to successful adoption of GPTs.

Here’s what they found. Firms which had snagged a board member with experience in the IT industry were 30 percentage points more likely to adopt a GPT. While there were certainly businesses which took up GPT without a technologically skilled board member on their team, these firms generally failed to see much improvement in their profitability after putting a GPT in place.

Basically, having board members with relevant technological experience has been linked to more profitable use of GPT. Of course, the authors point out this could be because firms that appoint technology-savvy board members tend to be more focused on IT in the first place, and therefore more likely to be able to adopt GPT in a way that increases profitability.

But firms with technologically skilled board members were also more likely to look for workers with GPT skills, indicating those workers might also play an important role in profitable GPT adoption. Whatever the exact link, uptake of GPT is linked to higher demand for skilled workers, meaning education and training will be key to nailing the use of these technologies.

While the Reserve Bank’s toolkit is limited to setting interest rates (and, informally, jawboning) the less painful solution to getting inflation under control is to improve our productivity, and therefore the amount of goods and services to go around.

Productivity growth is difficult to measure, and quarter-to-quarter movements can be rocked by things that have little to do with anything. But it has flattened out in recent months, and without productivity growth to match, wages, which have begun to pick up in recent times, will worry the Reserve Bank and may build the case for the Reserve Bank to keep interest rates higher for longer.

ChatGPT has hit the headlines over the past year: from students using it in a bid to boost their marks and to some media companies relying on it to churn out AI-generated content. While it’s yet to join the ranks of coveted general-purpose technologies, ChatGPT is an example of innovation which could turn out to be a game-changer.

Right now, it’s an imperfect tool being put to use by an inexperienced user (me). But I asked ChatGPT if it could write a better opinion piece, and faster than I could. The answer? “I’d love to give it a try!” 

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RBA worries too much about expectations of further high inflation

Other central banks have started cutting interest rates, yet our Reserve Bank is declining to join them because, as governor Michele Bullock explained on Friday, it doesn’t expect our rate of inflation to fall back to the mid-point of its target range “in a reasonable timeframe”.

Its latest forecasts don’t see the “underlying” (that is, smoothed) annual inflation rate returning to 3 per cent until the end of next year, and reaching the mid-point of 2.5 per cent until late in 2026.

Clearly, the Reserve doesn’t see such a timeframe as reasonable, so it’s keeping interest rates high for longer, until it can see inflation returning to target much earlier. And, Bullock warns, should the inflation outlook get worse, she won’t hesitate to raise rates further.

Obviously, the longer interest rates stay high, the greater the risk of forcing the economy into recession, with much higher unemployment and business failures, something Bullock swears she wants to avoid.

But what’s the hurry? Why is taking another two years to get inflation down an unreasonable timeframe? (Another question is, what’s so magical about 2.5 per cent? Why would 3 per cent or 3.5 per cent also be unreasonable? But I’ll leave that for another day.)

The hurry comes from central bankers’ longstanding fear that, should the inflation rate stay high for too long, the people who set prices and wages will come to expect that inflation will stay high rather than return to where it used to be.

Why do their expectations matter? Because, many economists believe, when enough people expect inflation to stay high, they act on their expectations and so make them a reality. Workers and their unions demand higher wages, and businesses pass their higher costs on to customers in higher prices.

This is the much-remarked “wage-price spiral”. It’s important to remember, however, that inflation expectations and wage-price spirals aren’t a longstanding tenet of either neoclassical or Keynesian economics.

They’re just a bit of pop psychology some economists came up with to explain why, in the mid-1970s, the developed economies found themselves beset by “stagflation” – both high inflation and high unemployment.

So how much we should worry about inflation expectations is an empirical question: is the idea borne out by the facts and figures?

In 2022, Dr John Bluedorn and colleagues at the International Monetary Fund conducted a study of the historical evidence for wage-price spirals in the developed economies, concluding that a jump in wage growth shouldn’t necessarily be seen as a sign that a wage-price spiral is taking hold.

Bluedorn elaborated on these finding at the Reserve Bank’s annual research conference last September. The discussant for his paper was Iain Ross, former president of the Fair Work Commission and now a member of the Reserve’s board.

Ross (and leading labour market economists, such as Melbourne University’s Professor Jeff Borland) readily agree that Australia experienced a wage-price spiral in the 1970s. But both men conclude that our circumstances 50 years later are “very different”, which means it should be possible to sustain steady wage growth without initiating a wage-price spiral.

In mid-2022, Borland listed three respects in which our present circumstances are different. First, upward pressure on wages is being limited on the supply side by employers’ ability to give extra hours of work to part-time workers who’d prefer more hours, and by drawing more participants into the jobs market.

Second, changes in the “institutional environment” since the 1970s have reduced the scope for people to get wage rises based on the principle of “comparative wage justice” – “Those workers have had a pay rise, so it’s only fair that we get the same.”

And third, a decline in the proportion of workers who are members of a union, and a range of other factors, have reduced workers’ bargaining power, thus limiting the size of wage increases likely to be obtained.

There could hardly be anyone in the country better qualified than Ross to explain how the institutional arrangements governing the way wages are set have changed over the decades. He told the conference that “these changes have been profound and substantially reduce the likelihood of a wage-price spiral”.

The central difference was that, in the 1970s and 1980s, the institutional arrangements facilitated the transmission of wage increases bargained at the enterprise level – usually by unions in the metal trades – to the relevant industry sector and then ultimately to the broader workforce.

There were four important respects in which the present rules are very different. First, the new “modern awards” operate as a minimum safety net and the circumstances in which minimum wages may be adjusted are limited. In effect, there is no scope to adjust minimum award rates to reflect the outcome of collective bargaining at the enterprise level.

Second, the Fair Work Act limits the general adjustment of all modern-award minimum wage rates to one annual wage review conducted by the Fair Work Commission.

Third, enterprise agreements need to be approved by the commission before they acquire legal force. The length of agreements averages three years, during which time employees covered by that agreement can’t lawfully engage in industrial action in pursuit of further wage rises.

Fourth, the sanctions against engaging in such industrial action are, Ross said, “readily accessible and effective”.

Ross noted that the proportion of all workers who are members of a union has fallen dramatically since the 1970s. From a little above 50 per cent, it has fallen to 12.5 per cent. And in the private sector it’s down to 8.2 per cent.

The manufacturing sector and its unions were central to the wage-price spiral of the 1970s. But manufacturing’s share of total employment has fallen from 22 per cent to 6 per cent, while the proportion of union members in manufacturing has fallen from 57 per cent to 10 per cent.

Whereas the annual number of working days lost to industrial disputes was about 800 per 1000 employees during the 1970s, these days it’s next to nothing.

Ross said the present enterprise bargaining arrangements operate as a shock absorber by constraining the bargaining capacity of employees subject to an agreement. “To date there is no evidence of the emergence of a wage-price spiral in the present circumstances and recent data suggests such an outcome is unlikely,” he concluded.

My point is, there’s no reason for the Reserve to live in fear of an imminent worsening in inflation expectations if workers and their unions’ ability to turn their expectations into higher wages is greatly constrained. That being so, we shouldn’t allow impatience to get the inflation rate back to target to worsen the risk we’ll end up in a recession, the depth and length of which could greatly impair our return to full employment.

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Why the Reserve Bank thinks it's too soon to cut interest rates

By Millie Muroi, Economics Writer 

When the Reserve Bank’s second-in-command – recently appointed deputy governor Andrew Hauser – took shots at his closest observers this week, he ruffled plenty of feathers.

“It’s a world of winners and losers, gurus and charlatans, geniuses and buffoons,” he proclaimed. Then he wagged a finger at those confidently commentating from the sidelines on the direction of the economy. “It’s a dangerous game,” he warned.

We know economists – including those at the Reserve Bank – are notoriously bad at knowing exactly what we (and therefore the economy) will do. So, why was Hauser so mad at those confidently making their own calls?

Brash statements made by the media, government and economists have real-world consequences. People often rely on that information to make decisions, from taking out mortgages to negotiating wages.

“What about Phil Lowe?” you may ask. Didn’t the former RBA governor promise in 2021 that interest rates would not go up until 2024? Well, sort of. It was actually couched in caveats which many people glossed over.

The Reserve Bank generally treads carefully because the words of its bosses can shift behaviour: a hidden weapon beyond its interest rate-setting superpower.

RBA governor Michele Bullock often declares she is “not providing forward guidance” when fielding questions from journalists trying to get a steer on interest rates. But last week, she gave the closest thing to guidance in a while: people’s expectation for rate cuts in the next six months doesn’t align with the RBA board’s feeling, she said. At least, “not at the moment.”

In doing so, Bullock flexed the bank’s hidden bicep. She signalled for all of us to rein in our expectations of a rate cut and, she would have hoped, our inflation expectations.

This is important because what people believe can become reality. If we expect inflation to stay high, this belief can feed into the wages we ask for, and the prices businesses charge.

That’s not to say the Reserve Bank doesn’t believe its own thinking. The only medicine it can explicitly prescribe is the level of interest rates, but the central bank busies itself with a lot of data gathering, discussions and number crunching to diagnose the state of the economy.

Core to the Reserve’s thinking is its observation that, collectively, we are consuming more than we can produce for an extended period of time. Sure, young people and mortgage holders have been tightening their belts as housing costs surge. But that’s been more than offset by older, affluent Australians splurging on things such as travel, by population growth and by government spending.

Now, the government has bones to pick with any suggestion that its spending is contributing to inflation. And Government Services Minister Bill Shorten this week trashed RBA chief economist Sarah Hunter’s assessment that the economy is “running a little bit too hot”.

However, it is important to note Hunter’s view isn’t necessarily that Australians are doing too well, or that the economy is bubbling along. It’s more a reflection of the limited spare capacity we have to cater for the spending – however little or much of it we may be doing.

We’re spending “too much” mostly by comparison to the limited resources we have to keep up with it: the people making our coffee in the morning and machines they use to brew it for us, for example.

Unless we become more productive, making more with the things we already have, the more we strain people and machines to meet our demands, and the pricier things will be to produce.

Productivity is especially difficult to improve for sectors such as hospitality, which rely heavily on people rather than machines (there’s only so many ways your barista can brew a coffee faster and better). And it’s why services inflation is proving so much more stubborn than goods inflation.

How does the Reserve Bank know how much spare capacity we have (and therefore how much pressure we might expect on prices)? It looks at something called the output gap: the difference between how much we’re producing and how much we could produce without putting too much pressure on prices.

Heaven for the Reserve Bank would be an output gap of zero. Any lower means we’re not using our resources as intensively as we could – including people who want to work, but can’t find jobs, or machines sitting idle.

Any higher, and we’re using our resources too intensively. This can be OK for a short period, but as workers demand higher wages, machines are run into the ground and businesses compete for a shrinking pool of resources, prices rise. For the past few years, this is the state the Reserve Bank thinks our economy has been in.

Measuring the output gap is tricky. We can’t really see it, and our capacity can change over time as our population changes, or we find better ways to do things. So, how does the RBA measure it?

How much the economy is producing is measured through statistics such as Gross Domestic Product. The trickier task is pinning down how much the economy could produce without adding to inflation. To do this, the Reserve Bank uses economic models which spit out results based on things such as what’s happened in the past and the data plugged into them: relatively straightforward numbers such as population, as well as educated assumptions about other factors influencing the economy.

The bank also asks businesses about their capacity usage through surveys and by chatting with them through its liaison program. Then, there’s also the inflation figure itself.

While the output gap is just one gauge, it is given considerable weight in the Reserve Bank’s decisions. So far, the gap is narrowing, the bank says, but it’s likely we’re still pushing our resources past the ideal level to pull inflation back into line.

There’s not much the central bank can do to increase potential output, or capacity, in the economy, which is why it is instead focusing on weakening our demand, or spending.

While a rate cut now would be like an iron infusion for an anaemic economy, help preserve jobs, and bring mortgage holders relief, the bank is clearly on the warpath against its public enemy number one: inflation.

Keep in mind, though, no one is perfect. The Reserve Bank is careful to stress that the output gap, like most of its other measures, is “subject to considerable uncertainty.”

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One reason for our inflation problem: weak merger law

Nothing excites the business section of this august organ more than news of another merger between two public companies. “Merger” is the polite word for it; usually the more accurate word is “takeover”.

So, is the dominant firm offering a good price for the firm being acquired? And should the shareholders in the dominant firm be pleased or worried about the deal? Will it benefit them, or just the company executives who organised it? A bigger company equals higher salaries and bonuses, no?

The financial press tends to regard takeovers as all good fun. Part of the thrills and spills or living and investing in a capitalist economy. But such mergers change the shape of the economy that provides us with our living. Do they make the economy better or worse?

According to the Albanese government’s Assistant Minister for Competition Dr Andrew Leigh, a former economics professor, some mergers improve the economy, whereas some worsen it.

As he explained in a speech this week, mergers are part of the market mechanism that allows financial capital to go where it’s most needed and will do most good to the consumers, workers and savers who make up an economy.

Most mergers are a healthy way for firms to achieve economies of scale and scope, and to access new resources, technology and expertise, Leigh says.

But mergers can do serious economic harm when firms are motivated by a desire to squeeze competitors out of the market and so capture a larger share of the particular market.

So “the small number of proposed mergers that raise competition concerns warrant close scrutiny” to see whether they should be allowed to proceed, he says.

The point is that, according to economic theory, the main thing ensuring ordinary people benefit from living and working in a capitalist economy is strong competition between the profit-making businesses providing our goods and services, which limits their ability to charge excessive prices and make excessive profits.

Competition obliges businesses to pass on to customers much of the savings they make from using improved technology to increase their economies of scale, while preserving the quality of service provided to their customers.

Similarly, competition between a reasonable number of alternative employers is needed to ensure their workers are fairly paid.

This is why laws controlling mergers are one of the main pillars of policy to keep competition between firms effective, along with prohibitions on the forming of cartels and other collusion between supposedly rival firms, and the misuse of “market power” – the power to keep prices above the competitive level.

Leigh says merger law is unique among those pillars because it’s the preventative medicine of competition law. While the other pillars deal with anticompetitive practices that are already being used, it deals with the likely effect of future anticompetitive actions the merger could make possible.

Fine. Trouble is, reformers have been batting for about 50 years to get effective restrictions on the ability of Australian companies to proceed with mergers designed to limit competition and enjoy excessive pricing power.

Leigh notes that a less-competitive market can add to the cost of doing business, and reduce the incentives and opportunities to invest, grow and innovate. For consumers, a less competitive market leads to higher prices, less choice, and lower growth in wages.

Big companies have resisted previous reforms – sometimes as represented by the (big) Business Council – sometimes, when Labor’s been in power, by big unions in bed with their big employers.

But now the Albanese government is making another attempt to get decent control over mergers that are expected to worsen competition.

And not before time. The challenge in Australia is to name more than a handful of industries not dominated by a few big firms.

Academic research Leigh has been associated with has shown that monopoly power worsens inequality by transferring resources from consumers to shareholders. He found evidence that market concentration – a few firms with a big share of the market – had worsened.

As well, profit margins had worsened and “monopsony hiring power” – few employers in an industry – was a problem in many industries.

After the Albanese government’s election in 2022, Treasurer Jim Chalmers and Leigh set up a Competition Taskforce within the Treasury focused on advising the government on actionable reforms to create a more dynamic and productive economy.

The taskforce’s top priority was to reform our merger laws. Consultations with industries said our piecemeal merger process was unfit for a modern economy and lagged best practice in other countries.

We were one of only three developed countries with a system of notifying proposed mergers that was merely voluntary. The Australian Competition and Consumer Commission (ACCC) complained about inadequate notification of proposed mergers, insufficient public information about the mergers, “a reactive, adversarial approach from some businesses” and limited opportunity to present evidence of likely economic harm arising from a particular merger.

In April this year, Chalmers and Leigh announced what they said were “the most significant reforms to merger rules in almost 50 years”. They would reduce three ways of reviewing merger proposals to a single, mandatory but streamlined path to approval, run by the ACCC.

For merger proposals above a monetary threshold or market-concentration threshold, this means those which would create, strengthen or entrench substantial market power will be identified and stopped. But those consistent with our national economic interest will be fast-tracked.

Challenges to the commission’s decisions will be the responsibility of an Australian Competition Tribunal, made up of a Federal Court judge, an economist and a business leader.

This should make it easier for the majority of mergers to be approved quickly, so the commission can focus on the minority that are a worry on competition grounds.

It’s the great number of our industries dominated by just a few firms that makes us especially susceptible to the inflation surge we’re still struggling to get back under control.

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Cost-of-living crisis? Why only some of us are feeling the pinch

If you believe the opinion polls, we’re all groaning under the weight of the cost-of-living crisis. And Treasurer Jim Chalmers confirms we’ve all been “under the pump”. But it’s not that simple. Some of us are doing it a lot tougher than others. And some of us are actually ahead on the deal.

In any case, where did the living-cost crisis come from? That bit’s simple. The economy’s been on a rollercoaster for the past four and a half years. COVID and the lockdowns may seem a distant memory, but almost everything that’s happened in the economy since the end of 2019 has been the direct or indirect consequence of the pandemic.

The surge in consumer prices that began in early 2022 stemmed from a combination of temporary disruptions to supply caused by the pandemic, and excess demand for goods and services as people spent the money they’d earned but couldn’t spend during the lockdowns.

The tax cuts that began this month had been planned for six years, but Chalmers changed their intended shape radically to help people most affected by the cost of living. They mean that, by the end of this year, overall living standards should be just a little up on where they were five years ago.

Just as the media focus on bad news more than good news, so you and I focus more on what’s been happening to the cost of living than what’s been happening to our after-tax income. But it’s the difference between the two – our standard of living – that matters most.

Two economists at the Australian National University’s Centre for Social Policy Research, Associate Professor Ben Phillips and Professor Matthew Gray, have been crunching the numbers, and their results may surprise you.

They’ve examined the change in our standard of living since the end of 2019, and included a forecast up to the end of this year, to take account of the latest tax cuts and changes in the May budget.

Lumping all households together, they find that we did quite well in 2020 and 2021 as the Reserve Bank cut interest rates and governments spent billions on such things as the JobKeeper scheme and temporary doubling of JobSeeker unemployment benefits. But then living standards fell sharply in 2022 as consumer prices took off and housing costs rose. Living standards fell a little further last year, taking them to 0.6 per cent lower than they were before COVID arrived.

The authors estimate that, this year, the tax cuts and continuing pay rises will lift living standards to a princely 1.6 per cent above what they were in December 2019.

But those national averages conceal much variation. When the authors ranked all households by their disposable income, then divided them into five “quintiles”, the poorest 20 per cent are expected to end the five years with their living standard 3.5 per cent higher.

Huh? They did well partly because their pensions and benefits are indexed to inflation.

At the same time, the top 20 per cent of households are expected to be 2.7 per cent ahead. Why? Partly because they did well on their investments.

So it’s the middle 60 per cent of households that have been hit the hardest by the cost of living. The second lowest 20 per cent barely broke even, while the middle and upper-middle quintiles suffered a fall in their living standards.

But now we get to the pointy bit. Why did the middle do so much worse than the rest? Because that’s where you find most of the people with mortgages. Turns out all those households with mortgages are expected to see their living standards fall by 5.6 per cent over the five years to December 2024.

What about renters? Their living standards should rise by 2.9 per cent over the period. Huh? How could that be? It’s true that shortages of rental accommodation have caused rents to rise hugely this year and last. But much of that can be seen as catch-up for the lockdown-caused falls in rents in 2020 and 2021, and the small increases in 2022.

If you’re sitting down, I’ll tell you that the living standards of people who own their homes outright are expected to rise by … 8.5 per cent.

But here’s an even bigger shock: if you divide all the households by their main source of income, those in the “other” category – that is, not reliant on either wages or pensions – should see their standard of living rise by what the authors call “an astounding 15.8 per cent”.

Penny dropped yet? Yes, we’re talking about the group that always has its hand out for a handout to thank it for being too well-off to get the age pension: the self-described, so-called self-funded retirees.

But while you’re feeling sorry for all those poor souls (whose company I’ll be joining one day), spare a kick for the economists who, several decades ago, had the bright idea of using only interest rates to control inflation. They must have had a fairness bypass.

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OECD’s message to our inflation warriors: calm down, she’ll be right

Last week a bunch of international public servants in Paris launched a rocket that landed in Sydney’s Martin Place, near the Reserve Bank’s head office and the centre of our financial markets. It carried a message we should already know. Australia has a big problem with real wages: they’re too low. In which case, why are you guys so anxious about continuing high inflation?

The Organisation for Economic Co-operation and Development’s annual Employment Outlook says Australia’s real wages in May this year are still 4.8 per cent lower than they were in December 2019, just before the pandemic.

This is one of the largest drops among OECD countries. It compares with real falls of 2 per cent in Germany and Japan, and 0.8 per cent in the United States. Real wages have risen by 2.4 per cent in Canada and 3.1 per cent in Britain.

The organisation observes that, “as real wages are [now] recovering some of the lost ground, profits are beginning to buffer some of the increase in labour costs. In many countries, there is room for profits to absorb further wage increases, especially as there are no signs of a price-wage spiral”.

Just so. But this isn’t something you’re allowed to say out loud in Martin Place. When the Australia Institute copied various overseas authorities in calculating the contribution that rising profits had made to our rising prices, it was dismissed by the Reserve Bank and the financial press.

Apparently, it’s OK for the Reserve to say it must increase interest rates because demand is growing faster than supply and adding to inflation, but it’s not OK to say that businesses have used the opportunity to raise their prices and this has increased their profits.

No, in the Reserve’s eyes, the problem with prices soaring way above its inflation target has never been greedy bosses, but always the risk of greedy workers using their industrial muscle to prevent their real wages from falling and thus causing a price-wage spiral that perpetuates high inflation.

It was a worry that anyone who knew anything about the changed power balance between employers and workers and their unions – anyone who wasn’t still living in the 1970s – could never have entertained.

For many years, the Reserve Bank benefited greatly from having a senior union official appointed to its board along with the many business people. But John Howard soon put a stop to that.

Since then, the Reserve has had to fall back on the primitive understanding of how labour markets work that you gain from a degree in neoclassical economics. Fortunately, since last year the board has included Iain Ross, former president of the Fair Work Commission.

The Reserve’s great sense of urgency in getting the inflation rate back down since it began raising interest rates in May 2022 has been driven by two worries about wages. First, when excessive monetary and budgetary stimulus caused the post-lockdown economy to boom while our borders were closed to imported labour, it worried that shortages of skilled and even unskilled labour would cause wages to leap as employers sought to bid workers away from other firms.

Although job vacancies more than doubled, reaching a peak in May 2022, annual wage growth had risen no higher than 4.2 per cent in December last year, even though consumer price inflation had peaked at 7.8 per cent a year earlier.

So, though no one’s bothered to mention it, our first period of acute labour shortages in decades hardly caused a ripple. It’s probably fair to say, however, that had the shortages not occurred, wages would have fallen even further behind prices than they did.

The Reserve’s second reason for feeling a sense of urgency in getting inflation back down to the target range is its fear that, should we leave it too long, inflation expectations may rise, causing actual inflation to move to a permanently higher level.

Indeed, the signs that our return to target will be slow have been used by the Reserve’s urgers in the financial markets to call for another rate rise or two. Apparently, every week’s delay in getting inflation down could see inflation expectations jump.

But this is mere pop psychology. Even if the nation’s workers and unions were to expect that inflation will stay high, they lack the industrial muscle to raise wage rates accordingly. If you didn’t already know that, our outsized fall in real wages should be all the proof you need.

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Interest rate speculators should get back in their box

There’s nothing the financial markets and the media enjoy more than speculating about the future of interest rates. And with last week’s news that consumer prices rose by 4 per cent over the year to May, they’re having a field day.

Trouble is, the two sides of the peanut gallery tend to egg each other on. They have similar ulterior motives: the money market players lay bets on what will happen, while the media can’t resist a good scare story – even one that turns out to have scared their customers unnecessarily, thus eroding their credibility.

But the more the two sides work themselves up, the greater the risk they create such strong expectations of a rate rise that the Reserve Bank fears it will lose credibility as an inflation fighter unless it acts on those expectations.

Fortunately, the Reserve’s newly imported deputy governor, Andrew Hauser, has put the speculators back in their box with his statement that “it would be a bad mistake to set policy on the basis of one number, and we don’t intend to do that”.

He added that there was “a lot to reflect on” before the Reserve board next meets to decide interest rates early next month. Just so. So, let’s move from idle speculation to reflection.

For a start, we should reflect on the wisdom of the relatively recent decision to supplement the quarterly figures for the consumer price index with monthly figures.

This has proved an expensive disaster, having added at least as much “noise” as “signal” to the public debate about what’s happening to inflation. Why? Because many of the prices the index includes aren’t actually measured monthly.

Many are measured quarterly, and some only annually. In consequence, the monthly results can be quite misleading. Do you realise that, at a time when we’re supposedly so worried that prices are rising so strongly, every so often the monthly figures tell us prices overall have fallen during the month?

In an ideal world, the people managing the macroeconomy need as much statistical information as possible, as frequently as possible. But in the hugely imperfect world we live in, paying good taxpayers’ money to produce such dodgy numbers just encourages the speculators to run around fearing the sky is falling.

The Reserve has made it clear it’s only the less-unreliable quarterly figures it takes seriously but, as last week reminded us, that hasn’t stopped the people who make their living from speculation.

The next thing we need to reflect on is that our one great benefit from the pandemic – our accidental return to full employment after 50 years wandering in the wilderness – has changed the way our economy works.

I think what’s worrying a lot of the people urging further increases in interest rates is that, as yet, they’re not seeing the amount of blood on the street they’re used to seeing. Why is total employment still increasing? Why isn’t unemployment shooting up?

One part of the answer is that net overseas migration is still being affected by the post-pandemic reopening of our borders – especially as it affects overseas students – which means our population has been growing a lot faster than has been usual after more than a year of economic slowdown.

But the other reason the labour market remains relatively strong is our return to full employment and, in particular, the now-passed period of “over-full employment” – with job vacancies far exceeding the number of unemployed workers.

With the shortage of skilled workers still so fresh in their mind, it should be no surprise that employers aren’t rushing to lay off workers the way they did in earlier downturns. As we saw during the global financial crisis of 2008-09, they prefer to reduce hours rather than bodies.

It’s the changing shares of full-time and part-time workers – and thus the rising rate of underemployment – that become the better indicators of labour market slack in a fully employed economy.

The other thing to remember is the Albanese government’s resolve not to let the ups and downs of the business cycle stop us from staying close to the full employment all economists profess to accept as the goal macroeconomic management.

This resolve is reflected in the Reserve Bank review committee’s recommendation that the goal of full employment be given equal status with price stability, which the Reserve professes to have accepted.

This doesn’t mean the business cycle has been abolished, nor that the rate of unemployment must never be allowed to rise during a period in which we’re seeking to regain control over inflation.

What it does mean is that we can’t return to the many decades where the commitment to full employment was merely nominal, and central banks and their urgers found it easier to meet their inflation targets by running the economy with permanently high unemployment.

The financial markets may persist in their view that high inflation matters and high unemployment doesn’t, but that shouldn’t leave them surprised and dissatisfied with a central bank that’s not whacking up interest rates with the gay abandon they’ve seen in previous episodes.

But there’s one further issue to reflect on. It’s former Reserve Bank governor Dr Philip Lowe’s prediction in late 2022 that we’d be seeing “developments that are likely to create more variability in inflation than we have become used to”. As someone put it: shock after shock after stock.

The point is, it’s all very well for people to say we should keep raising interest rates until the inflation rate is down to 2 per cent or so, but what if price rises are being caused by problems on the supply (production) side of the economy, not by excessive demand?

High interest rates have already demonstrated their ability to end excessive demand, as quarter after quarter of weak consumer spending, and a collapse in the rate of household saving, bear witness. But if high prices are coming from factors other than excess demand, there’s nothing an increase in interest rates can do to fix the problem.

What surprises me is how little attention market economists have been paying to what’s causing the seeming end to the inflation rate’s fall to the target range.

Look at the big price increases that have contributed most to the 4 per cent rise over the year to May – in rents, newly built homes, petrol, insurance, alcohol and tobacco – and what you don’t see is booming demand.

Right now, all we can do to push inflation down is attempt to hide the effect of supply-side problems on the price index by putting the economy into such a deep recession that other prices are actually falling.

This was never a sensible idea, and it’s now ruled out by the government and the Reserve’s commitment never to stray too far from full employment.

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It's slowing the spin doctors' spin that keeps me busy

Do you remember former prime minister John Howard’s ringing declaration that “we will decide who comes to this country and the circumstances in which they come”? It played a big part in helping him win the 2001 federal election. But it’s only true in part.

The job of economic commentators like me is supposed to be telling people about what’s happening in the economy and adding to readers’ understanding of how the economy works.

But the more our politicians rely on spin doctors to manipulate the media and give voters a version of the truth designed always to portray the boss in the most favourable light, the more time I have to spend making sure our readers aren’t being misled by some pollie’s silken words.

These days, I even have to make sure our readers aren’t being led astray by the economics profession. For the first time in many years, I’ve found myself explaining to critical academic economists that I’m a member of the journos’ union, not the economists’ union.

Like many professions, economists are hugely defensive. And they like to imagine my job is to help defend the profession against its many critics. Sorry, I’m one of the critics.

My job is to advise this masthead’s readers on how much of what economists say they should believe, and how much they should question.

It’s not that economists are deliberately misleading, more that they like to skirt around the parts of their belief system that ordinary people find hard to swallow.

And then there’s the increasing tendency for news outlets to pick sides between the two big parties, and adjust their reporting accordingly. My job is to live up this masthead’s motto: Independent. Always.

So, back to Howard’s heroic pronouncement. It’s certainly true that “we” – the federal government – decide the circumstances in which people may come to Australia. If you turn up without a visa, you’ll be turned away no matter how desperate your circumstances. If you come by boat, your chances of being let in are low.

But if you come by plane, with a visa that says you’ll be studying something at some dodgy private college when, in truth, you’re just after a job in a rich country, in you come. If we’ve known about this dodge, it’s only in the past few weeks that we’ve decided to stop it.

No, the problem is, if you take Howard’s defiant statement to mean that we control how many people come to this country, then that’s not true. We decide the kinds of people we’ll accept, but not how many.

There are no caps because, for many years, both parties have believed in taking as many suitable immigrants as possible. It’s just because the post-COVID surge in immigration – particularly overseas students – has coincided with the coming federal election that the pollies are suddenly talking about limiting student visas.

But remember, the politicians have form. Knowing many voters have reservations about immigration, they talk tough on immigration during election campaigns, but go soft once our attention has moved on, and it’s all got too hard.

It’s a similar thing with Anthony Albanese’s Future Made in Australia plan. Polling shows it’s been hugely popular with voters. But that’s because they’ve been misled by a clever slogan. It was designed to imply a return to the days when we tried to make for ourselves all the manufactured goods we needed.

But, as I’ve written, deep in last month’s budget papers was the news that we’d be doing a bit of that, but not much. It’s just a great slogan.

On another matter, have you noticed Treasurer Jim Chalmers’ dissembling on how he feels our pain from the cost-of-living crisis, which is why he’s trying so hard to get inflation down?

What he doesn’t want us thinking about is that, at this stage, most of the pain people are feeling is coming not from higher prices, but from the Reserve Bank’s 4.25 percentage-point increase in interest rates.

Get it? The pain’s coming from the cure, not the disease. The rise in interest rates has been brought about by the independent central bank, not the elected government, of course. But when Chalmers boasts about achieving two successive years of budget surplus, he’s hoping you won’t realise that those surpluses are adding to the pain households are suffering, particularly from the increase in bracket creep.

And, while I’m at it, many people object to businesses raising their prices simply because they can, not because their costs have increased. This they refer to disapprovingly as “gouging”.

But few economists would use that word. Why not? Because they believe it’s right and proper for businesses to charge as much as they can get away with.

Why? Because they think it’s part of the way that market forces automatically correct a situation where the demand for some item exceeds its supply. In textbooks, it’s called “rationing by price”.

Rather than the seller allowing themselves to run out of an item, they sell what’s left to the highest bidders. What could be better than that?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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INFLATION, TAX & THE COST OF LIVING

May 2024

The economy has been going through huge ups and downs since COVID arrived in early 2020. Since most of you weren’t taking a great deal of notice of the economy that long ago, let me give you a quick summary. To slow the spread of the virus while a vaccine was being developed, governments locked the economy down, getting as many people as possible to work from home, closing schools and many shops, and telling people to stay in their homes as much as possible. Australia’s borders were closed to people coming and going, though many overseas students were encouraged to return to their home countries. The Australian states closed their borders to interstate travel.

This hugely reduced economic activity, causing an immediate recession and sending unemployment shooting up. But to ensure this didn’t cause lasting damage to the economy, the Reserve Bank cut the official interest rate to almost zero and the federal government spent a fortune on JobKeeper payments and many other things. As well, the state governments spent up big.

This worked like a charm. As soon as the lockdowns ended, the economy rebounded. Once people were allowed out of their homes, they really caught up with their spending. The economy boomed, with employment growing and unemployment falling like a stone. The boom, coming before our borders had been reopened to immigrants, caused the rate of unemployment to fall to 3.5 per cent, its lowest in almost 50 years. With job vacancies far exceeding unemployment, the economy had returned to full employment for the first time in five decades. Everything seemed wonderful, until we – like the other advanced economies – noticed prices shooting up.

The return of inflation

Until then, and like all the advanced economies, Australia had enjoyed years of low inflation, with the rate of price increases staying in the RBA’s target range of 2 to 3 pc on average since the mid-1990s. In the years before the pandemic, the RBA even had trouble getting inflation up to the bottom of the target range. But from early in 2022, prices started rising rapidly and, by the end of 2022, inflation reached a peak of 7.8 per cent. Similar things were happening in the other advanced economies. What caused this sudden surge in inflation, the worse we had seen for 30 years?

Two quite separate developments. The first factor was us being hit by global supply-side price shocks arising from disruptions caused by the pandemic. When people were locked up in their homes, they couldn’t get out and buy services such as restaurant meals, go to shows and sporting matches, or travel. But they could use the internet to buy things to improve their homes, new appliances or even new cars. So, while spending on services collapsed, spending on goods took off.  This sudden surge in the purchase of goods led to shortages – including a shortage of computer chips - and higher prices. Because, these days, all the rich countries import many manufactures from places such as China, this surge in demand for goods led to shortages of ships and shipping containers. So the pandemic led to temporary supply shortages, which pushed up prices.  As well, Russia’s attack on Ukraine caused a big increase in oil and gas prices.

But the second factor, adding to these problems on the supply – or production – side of the economy, was a strong surge in the demand for goods and services. Where did this come from? From all the economic stimulus the managers of the macro economy had applied during the lockdowns to hold the economy together. The official cash rate was already down to 0.75 per cent, but the RBA cut it almost to zero, 0.1 per cent. It also used unconventional measures – “quantitative easing”, or the buying of second-hand government bonds – to lower medium-term interest rates. As well, from a virtually balanced budget in the financial year to June 2019, the government’s hugely increased spending caused annual deficits of $85 billion (4.3 pc of GDP), $134 billion (6.4 pc of GDP) and, in 2021-22, $32 billion (1.4 pc). The state governments greatly increased their spending also.

With the wisdom of hindsight, it’s clear the economic managers provided a lot more monetary and fiscal stimulus than turned out to be needed. As a result, this excess demand for goods and services outstripped our businesses’ ability to increase their production of goods and services, thus causing prices to rise. So the surge in prices in 2022 had two quite different causes. The supply-side problems were beyond our control, but would sort themselves out in time. The excessive demand, however, was caused by our own miscalculations and so required the economic managers to move the two instruments for managing the strength of demand – monetary policy and fiscal policy – from a stimulatory setting to a restrictive setting.

The policy response to high inflation

The RBA responded to the worsening inflation in May 2022, just before the federal election in which the Morrison Coalition government was replaced by the Albanese Labor government. The RBA began increasing the official cash rate and, by November 2023, had raise it 13 times, from 0.1 pc to 4.35 pc. Note that, although 4.35 pc is not high by the standards of earlier decades, this was the biggest and fastest increase in rates ever, meaning it had a particularly sharp effect on those households with big home loans. There’s no doubt the present “stance” of monetary policy is very restrictive.

The surge in tax collections

And while all this was happening to monetary policy, the budget’s “automatic stabilisers” were tightening fiscal policy. Since the change of government in May 2022, the boom in the economy and the return to full employment caused income tax collections to grow strongly. (As well, the world prices of iron ore and other export commodities have stayed much higher than Treasury was expecting, causing mining companies to pay more company tax than expected.)

When more people get jobs, they go from being on JobSeeker to paying income tax. When strong demand for labour allows those who want to to move from part-time to full-time work, they pay more income tax. And when higher inflation causes people to get bigger pay rises, this increases their average rate of income tax, often by pushing them into a higher tax bracket. What people call “bracket creep”, economists call “fiscal drag”. It’s one of the budget’s main built-in, “automatic stabilisers” which, without any explicit decision by the government, act automatically to take a bigger tax bite out of people’s pay rises, so leaving them less to spend and helping to slow demand.

The incoming Labor Treasurer Jim Chalmers’ main part in this has been to spend as little of this revenue windfall as possible, allowing almost all of it to flow through to the budget’s bottom line. So, from a deficit of $32 billion in the year to June 2022, the budget flipped to a surplus of $22 billion in the year to June 2023. That’s a turnaround of $54 billion, equivalent to 2.3 pc of GDP. The “stance” of fiscal policy switched from expansionary to contractionary, adding to the downward pressure on demand coming from monetary policy. And we know from the new budget that fiscal policy stayed contractionary in the financial year just ending, 2023-24, with another surplus of $9 billion expected.

The price mechanism and “gouging”

Before I move on to the question of the cost of living, I must tell you about a big difference between the thinking of economists and the thinking of normal people. Economists believe that the best way to allocate resources in an economy is via the use of markets. They believe that the forces of supply and demand in a particular market interact to set the price of the particular good or service. And they believe that, when something happens to disrupt the market, the “price mechanism” works to bring demand and supply back together, and re-establish “equilibrium”. If something happens that causes the demand for a product to exceed its supply, sellers are able to increase the price they are charging. This price increase sends different messages to the buyers than to the sellers. The message to buyers is: don’t use any more of this product than you have to, and see if you can find cheaper substitutes for it. The message to sellers is: producing this product has become more profitable, so make more of it. So, putting the two sides together, the “price mechanism” works to reduce demand and increase supply, thus causing the price to fall back to pretty where it was before the disruption.

I hope you know all that. The point is that when businesses respond to excess demand for their product by using the opportunity to raise their prices, economists regard this as the completely normal way markets work to restore equilibrium. It’s thus a good thing. But consumers see it very differently. They often object to businesses raising their prices even though their costs haven’t increased. They criticise it as “gouging” the customers. (My opinion? I think markets don’t always work as well as economic theory assumes they do.)

The cost of living

Whereas economists focus on inflation and ensuring prices don’t rise too rapidly, and worry about wages rises in response to the higher prices helping to keep inflation high, ordinary people worry about the rising “cost of living”. They focus on how fast prices are rising – particularly the prices they see in the supermarket - but tend not to notice that what matters most to them is whether their wage or other income is keeping up with prices. And many may not notice that they suffer when their wage rises cause their average rate of income tax to rise, leaving them less money to spend.

Voters have had a lot to complain about in the past two years or so. Consumer prices have rising at a much faster rate than usual. As well, until recent months their wages haven’t kept up with the rise in prices. And the government has been taking a bigger tax bite out of their wages.

But what makes it worse is that the standard way central banks and governments stop the cost of living rising so fast is to make it worse to make it better. When prices are rising because households’ demand for goods and services is rising faster than the economy’s ability to supply them, the standard response by the economic managers is to squeeze households’ budgets so they can’t spend as much. When this causes demand for their products to slow, businesses aren’t able to raise their prices as much. The main way the RBA squeezes households is by raising the interest rates they pay, particularly on their mortgages. And this time, for different reasons, rents have been rising rapidly.

All this presents a problem for our politicians. The voters are crying out for them to do something to fix the cost-of-living crisis. But the only way the authorities can achieve a lasting improvement in the rate at which prices are rising is to keep the pain on for a while yet. This is why Mr Chalmers is doing fairly minor things like giving every household a $300 electricity rebate. What will do much more to ease some of the pain is the rejig of the long-planned stage 3 tax cuts. Those tax cuts are the main reason the budget is now expected to swing from a surplus of $9 billion in the year just ending, to a deficit of $28 billion in the new financial year. The budget’s forecasts say this move to expansionary fiscal policy will not stop inflation returning to the target range in the coming year and will ensure we avoid recession and achieve a “soft landing”, with the unemployment rate rising no higher than 4.5 pc. Let’s hope this is what happens.

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Treasury tells all: how the housing market is so stuffed up

Would you believe that our ever-rising house prices are a sign there’s something badly wrong with our housing market? Would you believe our housing arrangements are worse than in the other rich countries?

Well, I would when that’s what Treasury is admitting in the annual sermon it tacks onto the budget papers. This year it’s about meeting our housing “challenge”.

In a well-functioning economy, its industries can respond to the increase in demand for their good or service by increasing their supply without much delay. Of course, it takes a lot longer to build a new house or apartment than it does to churn out more ice-creams or haircuts.

But, even so, our housing industry has been too slow to respond to the increased demand for housing. This comes from our rising population which, thanks to continuing high levels of immigration, has grown faster than most of the other rich countries.

Figures from the Organisation for Economic Co-operation and Development, a group of mainly advanced economies, show that our number of dwellings per 1000 people increased only from 403 to 420 between 2011 and 2022. This compared poorly with most other countries.

In 2011, our level of housing supply was just 92 per cent of the OECD average. And by 2022 it had fallen to 90 per cent. This was behind countries such as Canada, the United States and England.

Our completions of new private dwellings reached a peak of more than 200,000 a year in 2018-19 but have since fallen to about 160,000 a year. This has left us with an acute shortage of properties available to buy or rent.

Nationwide, the number of homes being offered for sale has fallen since 2015, while the number offered for rent has been falling since early 2020.

Speaking of renting, Treasury says the rental market is considered to be in balance – meaning renters have little trouble finding a place and landlords have little trouble finding a tenant – when the vacancy rate is about 3 per cent. In cities such as Sydney and Melbourne it’s now down to about 0.5 per cent. Ouch.

Not surprisingly, when demand grows faster than supply can keep up with, prices rise. The rise in the cost of newly built homes, and the cost of renting, have contributed significantly to the general cost-of-living crisis.

So, why has our housing industry become so slow to respond to increased demand? Treasury says the causes are “multifaceted, complex and affect all stages of the housing construction process, including all levels of government and industry”.

One way to improve the market’s response to greater demand is to accelerate the construction process. But Treasury says that completion times for apartments, townhouses and detached houses actually worsened by 39 per cent, 34 per cent and 42 per cent respectively over the 10 years to June 2023.

Calculations (or, if you want to sound more scientific, “modelling”) by a federal government agency says that, over the next six years, the nation’s existing unmet demand will never be satisfied unless completion times are speeded up. In six years’ time, we’ll still have a backlog of about 39,000 dwellings.

Treasury says the expectation that churning out homes faster will help to lower house prices is supported by empirical research. One study found that those OECD countries that built more housing over the 15 years to 2015 experienced lower real growth in house prices.

Another study showed that adding an extra 50,000 homes a year for a decade could reduce house prices by up to 20 per cent.

So, what can be done to increase the housing industry’s annual output? Treasury says planning and zoning restrictions can limit the speed at which land is made available.

Delays in approving development applications by local councils can be excessive. I think councils and government departments are monopolists and, like all monopolists, they take advantage of the lack of competition.

Private sector monopolists whack up their prices and don’t worry about the quality of the service they provide. Public monopolists make you jump through hoops that aren’t strictly necessary, and they fix your problem in their own good time.

I wonder whether, over all these years, those outfits have ever had much pressure on them to lift their game. If that changed, I’m sure we could get more homes built per year.

Treasury says average times for the approval of development applications vary by state, with Victoria and NSW experiencing the longest waiting times early this month of 144 and 114 days, respectively.

It shouldn’t surprise you that Treasury wants housing to be delivered in well-located areas where the demand is greatest.

Dense development in the “missing middle” of major cities, where households can reside closer to jobs in areas with higher quality amenities and infrastructure, has been limited by planning and zoning restrictions and slow release of infill land, Treasury says.

Global supply constraints and price shocks on imported building materials associated with the pandemic have added to the cost of construction, driving up the price of newly built homes. Although prices aren’t rising as fast as they were, they haven’t fallen back.

Shortages of building labour have also increased the prices of newly built homes and slowed the pace of construction. The growth in non-dwelling construction activity has drawn labour away from home building. The productivity of labour in construction has not improved since the early 2000s.

The industry blames these shortages on the drop-off in rates of skilled migration during the pandemic. But I wonder if the deeper problem is that the former ready availability of imported labour tempted the industry to save money by failing to train as many apprentices as they should have.

So, what’s the Albanese government doing about this mess? It’s finally grasped the nettle and is spending big – $32 billion, including $6 billion in this month’s budget – to “address historical underinvest in the housing system” and build 1.2 million new, well-located homes. We’ll see how they go.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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