As you were: getting back to budget surplus no longer urgent

Sometimes, changes in fashion are shocking. In economics, the fashion leaders are top American economists. Their latest fashion call is highly relevant to Australia’s circumstances, but will shock a lot of people: stop worrying so much about debt and deficit.

Among the various big-name economists advocating this change of view, the one who made the biggest splash was Professor Olivier Blanchard, of the Massachusetts Institute of Technology, in his presidential lecture for the American Economic Association early this year.

Blanchard was formerly chief economist at the International Monetary Fund, and had a big influence on the advanced economies’ response to the global financial crisis. He offered a simpler version of his lecture in a paper for the Peterson Institute for International Economics in Washington.

When governments spend more than they raise in taxes, they cover their deficit by borrowing via the sale of government bonds. If you run deficits for many years, you rack up much debt.

So the conventional wisdom – which we heard from both sides in the election campaign – has long been that, as soon as the economy has recovered from its downturn, governments should raise more in taxes than they spend, so as to run an annual budget surplus. They use the surplus to buy back some of the bonds the government has issued, and thus reduce its debt.

Why do most people – and many economists still - think this is the right thing to do? Because when you borrow money you have to pay interest. The more you borrow, the more interest. And the only way to stop having to pay interest is to repay the debt.

Blanchard calls this the “fiscal [or budgetary] cost”. In the end, interest payments and repayments of principal have to be covered by the higher taxes extracted from people, which may discourage them from working or distort their behaviour in other ways.

But Blanchard realised there may be no fiscal cost because interest rates are so low – especially for governments, whose debt is regarded as risk-free (or “safe” as he calls it). Governments are almost always able to repay their debts because, unlike the rest of us, they can get the money they need by increasing taxes. Or they could simply print more money.

Safe interest rates in the rich economies – including Australia – are so low that, after you allow for inflation, the “real” interest rate may be close to zero, or even negative. If they’re zero they’re costing the government nothing.

If they’re negative, the lender is actually paying the government to borrow from them (once you remember that, because of inflation, the lender will be repaid in dollars with less purchasing power that the dollars originally borrowed).

But that’s not all. A government’s revenue-raising capacity tends to grow in line with the size of the economy – nominal gross domestic product. And nominal GDP almost always grows faster than the nominal safe interest rate.

If so, the government can go on, year after year, paying the interest on its debt and continuing to run a budget deficit - provided it isn’t too big – without its debt growing relative to the size of the economy.

Now, you may object that interest rates are so low at present only because it’s taking so long for the world economy to recover from the global financial crisis and the Great Recession.

But if interest rates are higher in the future, that will be because there’s stronger demand to borrow relative to the supply of funds available, and this, in turn, should mean the economy is also growing at a faster rate.

In any case, Blanchard and others have shown that nominal GDP growth has been higher than the safe interest rate for decades.

So, unless budget deficits are very high, the value of the debt should decline over time as a percentage of GDP. This, in fact, is the way all countries got on top of the massive debts they incurred during World War II.

The second conventional reason for worrying about government debt is the cost to the economy, which Blanchard calls the “welfare cost”. When governments borrow to fund their deficit spending, they compete with private sector borrowers, driving up the interest rates firms have to pay and so “crowding out” some business borrowers.

This causes firms’ investment in renewing or expanding their businesses to be lower than otherwise which, in turn, leads to less economic growth and job creation than otherwise.

(That’s the standard argument, used since Milton Friedman’s day. It’s still relevant to an economy as huge as America but, in an economy as small as ours, it stopped applying after we floated the dollar and our financial markets became integrated with the global market. In Australia, if crowding out happens, it does so via the inflow of borrowed foreign capital causing our exchange rate to be higher than otherwise and thus making our export and import-competing industries less price competitive.)

But Blanchard argues that, in fact, the welfare cost of high government debt is probably small. If the average rate of return on business investment projects is higher than the rate of growth in nominal GDP, this implies there is a cost to the welfare of people in the economy.

On the other hand, if the safe interest rate is lower than the rate of growth in nominal GDP, this implies a welfare benefit from the government debt. Putting the two together implies that the welfare cost, if any, wouldn’t be great.

Blanchard is quick to warn, however, that these arguments don’t “add up to a licence to issue infinite amounts of [government] debt”. Debt and deficit make sense when government spending is countering the weakness in private sector spending. When this fiscal stimulus succeeds in restoring strong growth in private sector spending, governments should pull back to avoid excessive inflation pressure.

And, to be on the safe side, government borrowing should be used mainly to support investment in needed infrastructure, education and healthcare, so it’s adding to the economy’s productive capacity, not just to consumption.

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Interest rate cuts are coming, which isn't good news

The Reserve Bank may have decided not to cut interest rates right now, but it’s likely to be only a few months before it does start cutting, and it’s unlikely to stop at one. So, is it just waiting until after the election? I doubt that’s the reason.

The Reserve has moved interest rates twice during election campaigns – raising them in 2007 (much to the surprise of Peter Costello, whose mind was on politics at the time) and cutting them in 2013 – so, had Reserve governor Dr Philip Lowe considered an immediate cut was needed, I doubt he would have hesitated to make it.

The Reserve acts independently of the elected government, so it is – and must be seen to be - apolitical. Lowe’s predecessor, Glenn Stevens – who instigated both those previous moves – decided that the only way to be genuinely apolitical was for him to act as soon as he believed the best interests of the economy required him to, regardless of what the politicians were up to at the time.

I doubt his former deputy and understudy, Lowe, would see it any differently.

So, is Lowe’s judgement that a rate cut isn’t needed urgently bad news or good for Scott Morrison – or, conversely, for Bill Shorten?

First point: stupid question. What matters most is whether it’s good or bad news for you and me, and the economy we live in, not the fortunes of the people we hire to run the country for us. The rest is mere political speculation.

The media invariably judge a fall in interest rates to be good news and a rise bad news. But this is far too narrow a perspective. For a start, it assumes all their customers have mortgages and none are saving for a home deposit or for retirement. The retired are absolutely hating the present protracted period of record low interest rates.

For another thing, it assumes that our loans or our deposits are the only things that matter to our economic wellbeing. That the central bank’s movement of interest rates has no implications for, say, our prospects of getting a decent pay rise, or of hanging onto our job.

The fact is that central banks use the manipulation of interest rates to influence the rate at which the economy’s growing. They raise rates when everything’s going swimmingly and, in fact, needs slowing down a bit to keep inflation in check.

They cut interest rates when things aren’t going all that well – when, for instance, low wage increases are causing anaemic growth in consumer spending and this is giving businesses little incentive to expand their operations, or when a rise in unemployment is threatening.

Penny dropped? A cut in interest rates is a portent of tougher times ahead, whereas a rise in rates says the good times are rolling and will keep doing so for a while yet.

So it’s not at all clear that, had he cut rates, Lowe would have been doing Morrison a favour politically and doing Shorten a disservice.

In Treasurer Josh Frydenberg’s budget speech a month ago – it seems an eternity – he used the phrase “strong growth” 14 times. Turned out Morrison was basing his case for re-election on the claim that the Coalition had returned the economy to strong growth – after the mess those terrible unwashed union people had made, as they always do.

That claim is now not looking so believable. It was in trouble even before the budget, when we learnt in March that the economy had suffered a second successive quarter of weak growth, slashing the rise in real gross domestic product during 2018 to just 2.3 per cent – rather than the 3 per cent the Reserve had been talking about.

This was the first sign that, having left its official interest rate steady at 1.5 per cent for more than two and a half years, the Reserve needed to think about using a cut in rates to help push the economy along.

The next sign came just a fortnight ago, when the release of the consumer price index showed that, while some prices fell and others rose during the March quarter, on balance there was no change in the cost of the typical basket of goods and services bought by households.

This caused the annual rate of price increase to fall from 1.8 per cent to 1.3 per cent – at a time when the Reserve had gone for more than three years assuring us it would soon be back in the Reserve’s target range of between 2 and 3 per cent.

So, quite a blow to the Reserve’s assurances that the economy was getting stronger, and a sign it should be thinking seriously about cutting rates to kick things along. (Prices tend to rise faster the faster the economy is growing so, paradoxically, very low inflation is a worrying sign.)

In which case, why has Lowe hesitated? Because, I suspect, he’s waiting for the third shoe to fall. Employment has been growing faster than you’d expect in a weak economy, so he may be waiting for signs it’s slowing, too.

And he’d want to be confident a cut in interest rates didn’t restart the housing boom in Sydney and Melbourne, which has left too many people with far too much debt.

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The economy isn’t in trouble, but let’s cut interest rates anyway

Rather than merely acknowledging that the next move in interest rates is as likely to be down as up, I think the Reserve Bank should get on with cutting them. But not for the reason you may imagine.

There are plenty of people – many of them in the media – silly enough to believe a fall in interest rates is always good, and a rise always bad. They have a mortgage-centred view of the universe.

They forget that lower rates are bad news for people living off their savings – or saving for a home deposit.

More particularly, they forget that central banks use interest rates to keep the economy on an even keel. Judged the conventional way, central banks cut interest rates when they judge the economy to be weak or weakening.

So, even for those with mortgages, a cut in rates is no reason to celebrate. They’ll be paying less interest, sure, but only because, in the econocrats’ judgement, there’s now a greater risk they’ll lose their job, be put on a short working week, or go for year or two without a pay rise.

Is that what you’re hoping for? I’m not. Nor do I think it’s our certain fate. The biggest risk we face is talking ourselves into a downturn – for no better reason than it would be something new to talk about.

Telling ourselves that a fall in house prices – something we’ve experienced many times before and lived to tell the tale – is the start of an avalanche.

Or, when Reserve Bank governor Dr Philip Lowe moves from saying the next move in rates is up, to saying the chances are evenly balanced between up and down, leaping to the conclusion he’s really saying a cut is imminent.

It isn’t. It isn’t because, as he made plain in a speech on Wednesday – and reiterated in the statement on monetary policy on Friday – he remains confident the economy has slowed a bit, but no worse. His revised forecast is for the economy to grow by an above-trend 3 per cent this year.

And a rate cut isn’t imminent because he said it wasn’t. “[The board] does not see a strong case for a near-term change in the cash rate. We are in the position of being able to maintain the current policy setting while we assess the shifts in the global economy and the strength of household spending.”

He also said that “what we are seeing looks to be a manageable adjustment in the housing market”.

So a rate cut isn’t imminent. According to Lowe, a cut would require “a sustained increase in the unemployment rate”. Which, judged by conventional standards, is good news. It means he believes the economy will continue plugging on.

But my point is different. Lowe is pursuing a conventional, business-as-usual approach to managing the economy because he assumes nothing fundamental has changed.

His conventional thinking is that it’s weak wage growth that’s driving the economy’s relative stagnation. It hasn’t occurred to him it’s the other way round: the economy’s stagnation is the cause of weak wage growth.

I think it’s clear the phenomenon of “secular (that is, long-lasting) stagnation” – exceptionally low inflation, low wage growth, low real interest rates, low business investment, low productivity improvement and low economic growth – applies to our economy as well as to the United States and the other advanced economies.

Every symptom on that list applies to us (bar the long-past mining investment boom). And stagnation isn’t a bad way to describe our position, where growth over the 10 financial years since the global financial crisis has averaged less than 2.6 per cent a year and only one year (2011-12) has been above trend.

One thing that’s become clear in America and other advanced economies is that secular stagnation – the causes of which economists are still debating – has caused conventional estimates of the NAIRU (“non-accelerating-inflation rate of unemployment” – the lowest rate to which unemployment can fall before wage and price inflation begin to worsen) to be far too high.

In those countries, unemployment has fallen well below where the NAIRU (sounds a bit like the island) was thought to be, without any sign of price inflation or excessive wage growth.

The same can be said of us. The Reserve estimates our NAIRU to be “about 5 per cent”. Our actual unemployment rate has been at 5 per cent or so for some months, while the latest reading for underlying inflation is 1.75 per cent and for the wage price index is 2.2 per cent.

So, we’re at the supposed NAIRU without the slightest sign of inflation pressure. Indeed, underlying inflation has been below the 2 to 3 per cent target range since the end of 2015, and Lowe is forecasting it won’t get up into the target range until the end of next year.

This suggests that, in our newly stagnant world, the true NAIRU is a lot lower: 4.5 per cent, maybe 4 per cent. And since, as Lowe reminds us, the RBA’s objectives include “delivering on full employment”, he should be trying harder to get unemployment down to the true NAIRU.

How? By using the one instrument available to him: cutting interest rates to loosen a monetary policy that’s tighter than it needs to be.

Until recently, Lowe’s best reason for not lowering rates was a desire to avoid adding fuel to the boom in house prices (“asset-price inflation”). But now that constraint has lifted, there’s no reason to hesitate.

You could argue that, with households already so loaded with debt, a rate cut may not do much to boost consumer spending. But it probably would lower the dollar, which would improve our industries’ price competitiveness internationally, encouraging them to hire more workers. We’ve got little to lose.

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How we killed off Australia's inflation problem

Before we let 2018 go, do you realise it’s the 25th anniversary of the introduction of the Reserve Bank’s target to achieve an inflation rate of between 2 and 3 per cent? It’s a milestone worth celebrating.

Why? Because it’s worked so well. For the past quarter century, we’ve had inflation that has fallen within the target range “on average, over time” and hence been low and stable.

This week the Reserve Bank issued a volume of papers from its conference to discuss inflation targeting, and whether it needed to change. (Conclusion: it didn’t.)

In that 25 years we haven’t had a serious worry about inflation – which certainly can’t be said of the 20 years before the target was unveiled in 1993.

In those earlier years we were continually worried about high inflation. It reached a peak of 17 per cent in the mid-1970s, averaged about 10 per cent for that decade and 8 per cent during the 1980s.

All the other advanced economies had high inflation rates at the time, but ours was higher and took longer to fix.

Our problem was usually linked with excessive growth in wages, and the “wage explosions” of the mid-1970s and early 1980s prompted the authorities to jam on the brakes, leading inevitably to severe recessions.

Even though inflation remained high, a third and more severe recession in the early 1990s was more the consequence of the authorities’ overdone attempt to end a boom in commercial property prices.

It’s not by chance that this year we reached 27 years of continuous growth since that recession. Before it, we had recessions about every seven years, all of them caused by the authorities jamming on the brakes – and then, when we crashed into recession, stepping on the accelerator, a “stop/go policy”.

The first reason we haven’t needed to worry much about inflation since then is that, as part of the adoption of the inflation target, responsibility for setting interest rates was moved from the politicians to the econocrats running an independent central bank.

They’ve been a much steadier hand on the interest-rate lever, moving rates up or down according to the needs of the business cycle, not the political cycle.

Another reason we’ve stopped worrying about inflation is that this year is also the 35th anniversary of the floating of our dollar in 1983. A floating exchange rate – which, remarkably, has almost always floated in the direction needed to keep the economy on an even keel – has made it a lot easier for the Reserve to keep inflation low and stable.

A third reason is the extensive program of “micro-economic reform” begun by the Hawke-Keating government in the 1980s – including the deregulation of many industries and the decentralisation of wage-fixing – which has made our economy much less inflation-prone than it used to be.

Yet another factor was the realisation at the time the inflation target was adopted – informally by the Reserve in 1993, and then formally by the incoming Howard government in 1996 – that the key to lower inflation was to get “inflation expectations” down to a reasonable level.

Why? Because there’s a strong tendency for the expected inflation rate in the minds of shopkeepers and union officials to become a self-fulfilling prophecy. If they expect prices to keep rising rapidly, they get in first with their own big price or wage rises.

We’ve spent the past 25 years demonstrating that if you can get everybody expecting inflation to stay low, you have a lot less trouble ensuring it actually does.

The hard part was how to get from the high expectations of the late-1980s to the low expectations we’ve had for most of the past 25 years.

Bernie Fraser, Treasury secretary turned Reserve Bank governor, the man who introduced the target, knew what to do: define what was an acceptably low inflation rate – between 2 and 3 per cent, on average - and keep the economy comatose until you actually achieved the target, then keep it low until everyone had been convinced that “about 2.5 per cent” was what today we’d call “the new normal”.

How did Fraser achieve this? He did the opposite of what his predecessors did whenever they realised they’d hit the economy harder than they’d intended to. Despite knowing we were in for a bad recession, he let the interest-rate brakes off only slowly, and didn’t hit the accelerator.

In other words, he made the recession of the early ‘90s longer and harder than it could have been. I think he decided that, since we were in for a terrible belting anyway, he’d make sure we at least emerged from the carnage with something of value: a cure for our inflation problem that wasn’t just temporary, but lasting.

And that’s what he delivered. With low inflation expectations embedded, he was able to stimulate the economy to grow faster and get unemployment down. It went from 11 per cent after the recession to 5 per cent today.

At the time the inflation target was adopted, some people worried it meant the Reserve didn’t care about unemployment. As events have demonstrated, that was wrong. To Fraser, low inflation was just a means to the ultimate end of low unemployment.

I rate him the best top econocrat we’ve had in 50 years. He was wise and caring, with the best feel for how the economy worked. Peter Costello gets the credit for formally adopting Fraser’s inflation target, pursued by an independent Reserve Bank.

But another person also deserves credit – Dr John Hewson. It was Hewson who, as Coalition shadow treasurer, made the most noise about the need for an independent central bank with an inflation target.

Fraser decided he’d better get on with specifying his own target before “some dickhead minister” tried to impose a crazy one on him.

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ACCC wins watchdog of the year, as others lick their wounds

It’s been an infamous year for Australia’s economic regulators. Most ended it with their lack of vigilance exposed, their reputations battered and their ears stinging from judicial rebuke.

The biggest loser is the Australian Securities and Investments Commission, followed by the Australian Prudential Regulation Authority. But the mismanagement of the national electricity market became more apparent. And neither the Reserve Bank nor Treasury emerged unscathed.

Just one regulator had a good year, the Australian Competition and Consumer Commission. It worked hard, discharging its duties with vigour and initiative, taking on powerful business interests, seeking and being granted hugely increased maximum penalties, and fighting to make up for the negligence of its fellow regulators.

As the others have been found wanting, its role has been expanded. And as next year we see the government’s response to this year’s seemingly endless revelations of regulatory failure, it’s role may well be further widened. That’s what tends to happen when rival regulators’ failures become apparent.

It’s been a watershed year. From now on, life will never be the same for regulators found wanting under the microscope of public scrutiny.

Much of that scrutiny came from the banking royal commission, of course. Its interim report in September criticised ASIC for "rarely" going to court "to seek public denunciation of and punishment for misconduct," and being too accommodative when negotiating penalties with the companies it polices.

APRA faced criticism for a "lack of action" in response to widespread misbehaviour in superannuation, including cases where thousands of members were kept in higher fee accounts, rather than being moved into no-frills MySuper products.

But the royal commission wasn’t the only critic of economic regulators this year. I’ve said plenty elsewhere about the failure of the national electricity market’s three (and now four) official operators and regulators to prevent the massive blowout in retail power prices.

One of the many things the Turnbull government did in its vain attempt to fend off pressure for a royal commission was to get the Productivity Commission to report on competition in the financial sector.

The commission confirmed competition in banking was weak and made one eye-opening revelation: part of the problem was that, in their concern to ensure the stability of the banking system, APRA and the Reserve Bank weren’t too worried about ensuring this did as little as possible to inhibit price competition between the big banks.

The commission noted that when APRA had imposed limits on new interest-only lending, it and the Reserve had looked the other way while all four big banks used this as an excuse to jack up interest rates on new and existing interest-only loans.

It recommended that a “consumer champion” be appointed to join APRA, ASIC, Treasury and the Reserve on the co-ordinating Council of Financial Regulators. No prize for guessing the ACCC was the champion the commission had in mind. Nor for reading between the lines that the commission suspected the Reserve and Treasury had been “captured” by the bankers they were supposed to be regulating.

The ACCC has done what little it could over the years to oppose the misregulation and oligopolisation of the national electricity market, and its reports this year revealed what went wrong.

Last week it acted on three fronts. Its preliminary report on digital platforms took on Google and Facebook, greatly expanding our understanding of the questionable ways they operate and working on ways they could be regulated.

ACCC boss Rod Sims has long worried publicly about the state governments privatising their electricity businesses and ports in ways that maximised their sale price by inhibiting price competition. The banker-led Baird-Berejiklian government in NSW is the worst offender.

Last week Sims announced the ACCC was taking the Botany port operator to court, alleging its agreement with the NSW government is anti-competitive and illegal.

And last week the ACCC released its final report on factors influencing residential mortgage prices, commissioned at a time when the banks were threatening to pass the new “major bank levy” straight on to their customers.

The report covered similar territory to the earlier Productivity Commission report, noting again the way the banks had used APRA’s move on interest-only loans as an opportunity for “synchronised pricing”.

But the ACCC’s analysis of pricing dynamics in an oligopolistic market like banking revealed far more realism (and advanced economics) than the Productivity Commission’s trademark introductory textbook neo-classicism. The more I see, the more I like.

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What's making homes hard to afford and what we could do

There aren't many material aspirations Australians hold dearer than owning their own home - but dear is the word. There are few greater areas of policy failure.

The rate of home ownership, of which we were once so proud, has been falling slowly for decades. And as the last high home-owning generations start popping off, it will fall much faster.

We've been debating this issue for years, while it's just got worse. Yet we have a better handle on the causes of the problem, and what needs to be done, than ever.

Let me see if I can pull a lot of the elements together and give you the big picture.

Don't let anyone tell you the younger generation would be happy to stay renting forever. Nuh.

And while the hurdle of owning a home and a mortgage seems almost insurmountable to the young, jumping it is just the start of our property ambition. Most people want to keep moving up to a bigger and better home. Every promotion we get makes us wonder whether we can afford a better place.

This preoccupation with the quality of our housing is the first part of the reason house prices have risen so high: ever growing demand.

Don't forget that our newly built houses are much grander than they were even 10 years ago. And most older houses have been renovated and extended to make them better.

When two-income families became common people thought "great, now we can afford a bigger mortgage on a better place".

When we got on top of inflation in the early 1990s and interest rates fell so far, people could have paid off their mortgage faster, or bought a boat, but more people said "great, now we can afford a bigger mortgage on a better place".

Trouble is, you can't satisfy increased demand for better houses – particularly better-located houses - by building more places on the outskirts of the city. And when a lot of people decide to move to a better place at the same time, the main thing they do is bid up the prices of existing houses.

One change in recent decades is the growth of the services sector and the knowledge economy (more workers knowing how to do things; fewer workers making things), which means many of the jobs have gravitated to the CBD and nearby suburbs.

So the meaning of "position" has changed from good views to "proximity" to the centre. In theory, the amount of land within 10 kilometres of the GPO is fixed. In practice, factories and warehouses can be moved further out, while detached houses can be replaced by townhouses and low-rise or high-rise units.

Even so, in every city, property prices have risen more the closer homes are to the centre.

Another source of increased demand for housing is our high population growth, caused by our policy of high immigration.

Then there's foreigners' investment in our housing, though this isn't as big a cause of higher prices as many imagine because – in principle but not always practice - foreigners are only supposed to buy newly built or "off-the-plan" homes. That is, create their own supply.

Another source of greater demand is Paul Keating's introduction of capital gains tax in 1985 and John Howard's introduction of a 50 per cent discount on the tax in 1999. This has made owner-occupied homes (which are exempt from the tax) and, thanks to negative gearing, rented-out homes, more attractive as a form of investment, relative to shares.

So house prices are higher partly because we've acquired a second motive for home-ownership: not just the security and freedom of owning the home you live in, but also the prospect of homes becoming much more valuable over time.

Of course, increased demand leads to higher prices only if supply fails to keep up. And that's where our governments – state and federal – have failed us.

It's better now, but for ages state governments failed to do enough to permit the building of more homes on the edge of cities. We got more immigrant families, but not more homes to put them in.

Worse, state governments have allowed people in inner and middle-ring suburbs and their councils to resist the pressure for more medium-density housing – more units – from people wanting to live closer to where the jobs and facilities are.

Just last week the Reserve Bank published estimates that this resistance to higher density had added more than $300,000 to the average Melbourne house price and almost $500,000 to the Sydney price, over the past two decades.

So, who pushed housing prices so high? We did. Who failed to do what was needed to counter the increase? Our governments.

The feds failed to limit the growth in demand (by limiting immigration and fixing the tax system), while the states did too little to increase supply (by discouraging the building of new homes on the outskirts and by permitting a first-in-best-dressed mentality by people in inner and middle-ring suburbs).

Why are they allowing the proportion of home owners to decline? Because most things they could do to genuinely help first home buyers would come at the expense of existing home owners, who have more votes than the youngsters.

If young people and their parents don't like that, the answer's more pressure at the ballot box. Wheels that squeak more.

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Times get tougher for the oldies

Glenn Stevens, governor of the Reserve Bank, is used to getting letters from angry citizens. Aside from the ones demanding to know why the Reserve can't solve all our problems by just printing more money, in days past most would have come from small-business people complaining about the latest increase in the official interest rate, which had taken their overdraft rate to ruinous levels.

These days, most come from angry retirees complaining about yet another cut in rates. Doesn't he realise people are trying to live on the interest on their savings?

That's the trouble with interest rates, of course, they cut both ways – a cost of borrowers, but income to savers. The media assume we're all borrowers, so they boo rate rises and cheer rate cuts, adding insult to the oldies' injury.

Like all central banks, the Reserve raises interest rates when it wants to slow the economy by discouraging borrowing and spending, and cuts rates when it wants to speed things up – as now. It jumps that way because households' and businesses' debts total a lot more than their savings.

When I was a young economic journalist in the 1970s, the retired were always complaining about high inflation. Their cost of living was rising rapidly, but they had to live on "fixed incomes" that didn't keep pace.

We eventually solved that problem. Interest rates caught up with higher inflation and, as well, we moved to adjusting pensions regularly in line with prices and then with wages. By the early 1990s we finally had inflation back under control.

How times change. These days, most people retire with superannuation or other savings, which they use to supplement – or occasionally replace – their pension. And since they need to live on the earnings from their savings, they need those earnings to be steady, not go up and down like the share market.

Thus the retired like to put most of their savings in interest-bearing bank accounts, term deposits or pension funds that have most of their money in bonds. So these days a lot of retired are back to living on "fixed incomes", meaning they hate to see interest rates falling.

Our official interest rate is down to 2 per cent, a record low, having been cut 10 times since late 2011. The rates paid to savers are only a little higher. Even so, our rates are relatively high compared with most advanced countries. They're near zero in most developed economies, and in parts of Europe you actually have to pay the bank a tiny percentage to persuade it to hold your money.

I'll let you into an open secret: Stevens will be retiring as governor next September, though since he'll only be 58 – just a boy, really – I doubt he'll be putting his feet up.

He said a few things last week that make you think he's turning his mind to retirement. And he doesn't like what he sees.

"My guess is that global interest rates are still going to be very low for a good part of the decade ahead," he told the Australian Business Economists.

It's likely the US Federal Reserve will raise its official interest rate a fraction this month. But Stevens doesn't see US rates rising far. The European Central Bank and the Bank of Japan were "a long way from even thinking about higher interest rates". And the Europeans are openly contemplating further cuts.

So the average official interest rate in the major money centres may be very low for quite a while, he said.

Trouble is, "in a low interest-rate world, the problems of providing retirement incomes will become ever more prominent".

The very low level of yields (returns) on government bonds and other fixed-interest securities means the prices of such securities are very high (it was actually rising bond prices that caused yields to go so low).

So these days it costs you or your pension fund a lot just to buy securities that pay such low amounts of interest. Which is another way of saying you now need to retire with a lot more savings than you did to maintain a given standard of living.

Added to that, we're living longer and so need our savings to last longer.

Stevens said the retiree can, of course, respond to the reduced attractiveness of fixed-interest securities by holding more of her savings in dividend-paying shares. This involves accepting more risk of volatility, of course.

Certain well-known Aussie companies pay big, steady dividends, which usually come with refundable income tax rebates (known as franking credits) attached. Most people would also be hoping to see these dividends grow over time, as inflation continues.

"It certainly seems that many Australian listed corporates feel the pressure from shareholders to deliver that, even some whose earnings are inherently volatile," Stevens said.

Can the corporate sector realistically promise growing dividends over a long period? Not without being prepared to take on greater risk by investing in new projects.

"How much of that risk an older shareholder base will allow boards and managements of listed entities to take is an important question," he said.

"Overall, in a world where a bigger proportion of the population wants to be retired and living (even if only in part) off the return on their savings, those returns are likely, all other things equal, to be lower."

A good argument for delaying retirement.

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Banks ponder their next game with interest

Actual mortgage interest rates have fallen from 7.1 per cent to 4.7 per cent over the past five years, but let one bank – Westpac – increase its rate by 0.2 percentage points and the righteous indignation knows no bounds.

It may not be the end of the world, but it's certainly the end of the housing boom as we know it. Well, maybe.

But outrage is a poor substitute for understanding. Why did Westpac move? Why now? Will the other three big banks match it? And will the Reserve Bank cut the official interest rate to counteract the banks' "unofficial" increase?

Standard economic theory offers little guidance to the classic oligopolistic behaviour we get from our banks. "Game theory" is supposed to be the way economists analyse the strategic decisions of oligopolists, but I doubt it offers much help, either.

Westpac made its rate move at the same time as it joined the other big boys in announcing plans to raise more share capital. The big four are acting in expectation that the government will accept a recommendation of the Murray report that it make Australia's banking system "unquestionably strong" (that is, safe) but requiring it to hold a lot more equity (shareholders') capital.

Part of this is the intention to increase the big four's capital requirement by more than the smaller banks' increase so as put the two groups on a more equal regulatory footing. Westpac gave the cost of this requirement that it hold more capital as its justification for increasing mortgage interest rates.

It's true the requirement does increase the big banks' "cost of intermediation" – that is, the cost of borrowing from some people and lending to others, which is represented by the size of the gap between the interest rate paid to depositors and the rate charged to borrowers.

In principle, this extra cost could be passed back to depositors in the form of lower deposit rates, passed forward to borrowers in the form of higher borrowing rates, or left with the banks' shareholders in the form of lower profits. Or some combination of the three.

Obviously, bank customers would prefer that the banks and their shareholders bear the cost. And there's no reason it shouldn't happen. Our big banks have long been extraordinarily profitable – making a return on equity of 15 per cent a year – in a business that's virtually government-guaranteed.

They could easily take the hit. There's nothing sacred about 15 per cent. And in an intensely competitive banking market that's probably what would happen. In our world, however, "greedy" (read profit-maximising) banks will protect their profitability to the extent that market conditions allow.

And right now they do. It's clear Westpac's intention is to pass the higher cost on to its borrowers. Its three big competitors now must decide whether to follow suit or leave it hanging out to dry as they try to win market share from it.

Going on past behaviour, they'll follow suit. After all, a few months ago when ANZ bank raised its interest rate on investor mortgage loans by about 0.25 percentage points, the other three lost little time in doing the same. The justification was the same: the cost of the tighter capital-adequacy requirement.

But this doesn't guarantee that, this time, the others will follow Westpac immediately or by as much as 0.2 per cent – which, by the way, also applies to investor loans.

One question all this raises is whether the banks are raising rates by more than required to recoup their higher costs. The Murray report said a 0.1 or 0.15 percentage-points rise would cover it.

So, why so much, and why now? Because, at the present exceptionally low rates, the demand for home loans exceeds supply, with the banks under pressure from the authorities and sharemarket analysts to avoid lending too much – to ordinary home-buyers, not just investors.

If you have to cut back your rate of lending, why not do it by raising your prices? This suggests the housing boom may indeed be reaching its closing stages.

One reason the other banks may delay following Westpac is the talk that the Reserve will respond by cutting the official interest rate on Melbourne Cup day. They'd love to be able to hide a rate rise behind a less-than-full pass-through of a rate cut.

The Reserve may oblige, but I won't be holding my breath. Nothing in its rhetoric to date suggests it's keen to cut rather than wait. And I doubt if it would want to be seen as trying to prolong the house-price boom.

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Debt-and-deficit brigade may bring us down

If the economy runs out of steam in the next year or two – and maybe even falls backwards – with unemployment climbing rapidly, there'll be plenty to share the blame: federal and state governments, federal and state Treasuries, and the utterly discredited credit-rating agencies.

The one outfit that will deserve little blame – but will get plenty – is the Reserve Bank. It shouldn't be criticised because it's had its monetary accelerator close to the floor for ages.

The official interest rate has been at or below 2.5 per cent for almost two years, but growth in real gross domestic product has remained stubbornly below trend.

If the economy does run out of puff it will be for a reason macro-economists have known was a significant risk for several years: the mining construction boom – which at its height accounted for about 8 per cent of GDP – is now rapidly coming to an end, with little likelihood that non-mining business investment (or anything else) will be strong enough to fill the vacuum it's leaving.

It's possible the Abbott government's surprisingly poor management of the economy is damaging business confidence, but the more powerful reason business isn't investing is simply that it has plenty of spare production capacity and doesn't see that expanding its capacity would be profitable.

So what can we do to reduce the risk of the economy losing momentum? It ought to be obvious. The Reserve has been dropping hints for months and earlier this month governor Glenn Stevens came right out and said it.

Fiscal policy – broadly defined to include state as well as federal budgets – needs to be pushing in the same direction as monetary policy (interest rates), not pulling against it. As Stevens pointedly noted, "public investment spending fell by 8 per cent over the past year".

Breaking down that contraction, it was caused by the states, not the Feds, with NSW by far the greatest offender. I suspect its poles-and-wires businesses have slashed their investment spending (no bad thing), with general government failing to take up the slack for fear of losing its precious AAA credit rating. So much for all last week's boasting about record infrastructure spending.

All this may have escaped the notice of Joe Hockey and his state counterparts – not to mention their federal and state Treasuries – but last week's statement by the International Monetary Fund's review team gave it top billing.

"The planned pace of [budgetary] consolidation nationally (Commonwealth and states combined) ... is somewhat more frontloaded than desirable, given the weakness of the economy, the size and uncertainty around the resource boom transition and the possible limits to monetary policy," the statement says.

"Increasing public investment (financed by more borrowing rather than offsetting measures) would support aggregate demand [GDP] and ensure against downside risks." Hint, hint.

"It would also employ [construction] resources released by the mining sector, catalyse private investment, boost productivity, take advantage of record-low borrowing rates, and maintain the government's net worth." Oh, that's all.

"Indeed, IMF research suggests that economies like Australia – with an output gap [spare production capacity], accommodative monetary policy and fiscal space – benefit most from debt-financed infrastructure investment, with the growth boost largely containing the impact on the (low) debt-to-GDP ratio."

The statement says the Feds should broaden the scope of investments they support – which may be, and certainly ought to be, a hint that they should be supporting urban public transport projects, not just yet more expressways.

And as well as direct funding, the statement says, the Feds could consider guaranteeing states' borrowing for additional investment, which "would keep accountability with the states but reduce their concerns about credit ratings".

That's one way to overcome the state governments' obsession with the credit ratings set by outfits that contributed greatly to the global financial crisis by granting AAA ratings to securities ultimately written off as "toxic debt".

State governments are letting these operators decide what's responsible and what's not? It's time state Treasuries stopped paying these characters to set arbitrary limits on borrowing for infrastructure spending, and state governments stopped putting retention or restoration of their AAA-rating status symbol ahead of their duty to provide their states with adequate infrastructure.

As for the Feds, Treasury should make it easier for its political masters to walk away from all their debt-and-deficit nonsense by abandoning its age-old objection to distinguishing between capital and recurrent spending.

These two artificial Treasury disciplinary devices – bulldust credit ratings and pretending all federal spending is recurrent – threaten to cause us to slip into an eminently avoidable recession. If that happens, we'll know who to blame.

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Why monetary policy still packs a punch

Perhaps the biggest question in macro-economic management today is whether monetary policy has lost most of its power to get the economy moving. To many of us the answer seems obvious. But this week a Reserve Bank heavy popped up to challenge the newly emerging consensus.

Whether you look at the way the major developed countries' resort to massive "quantitative easing" (creating money) hasn't exactly got their economies booming, or at the way our big cuts in the official interest rate haven't seen us return even to average ("trend") growth, it makes you doubt if "monetary policy" - the manipulation of monetary conditions - still packs a punch.

Consider our story. The Reserve Bank began cutting the official interest rate as long ago as November 2011. By August 2013 it had reduced it by 2.25 percentage points to a historic low of 2.5 pc. This year it's made more cuts to 2 per cent.

And yet the economy continues growing below trend and isn't expected to return to healthy growth before 2016-17.

Enter Dr Christopher Kent, an assistant governor of the Reserve. In his speech this week he didn't deny the facts: interest rates have been very low for a long time without there being any noticeable pick-up in growth.

But he did dispute the conclusion that this meant monetary policy had lost its power to stimulate economic growth. His point is that when we look at the position in the way I've just done, we're implicitly assuming "ceteris paribus" - that all else remained equal while the only thing that changed was the level of the official interest rate.

Obviously, a lot of other things changed over the period. To take just the most obvious examples, the big fall in coal and iron ore prices, the movement in the dollar and the impact of "fiscal policy" - the effects of the federal and state budgets.

To try to take account of all the things that change, not just interest rates, you need to use a sophisticated econometric model of the economy. And when Kent's people at the Reserve do this, their estimates "tentatively suggest that the overall effect of monetary policy has not changed significantly in recent years".

Such models have two kinds of variables "exogenous" and "endogenous". Exogenous variables are set by the modeller, whereas endogenous variables are determined by the model and its assumptions about how the economy works.

Kent says that in modelling work using a "dynamic stochastic general equilibrium" model (don't ask), estimates of the endogenous relationships based on the figures up to 2008 (the time of the global financial crisis) are about the same as estimates based on figures since then.

"This suggests that the period of below-trend growth in gross domestic product over the past few years may not reflect a change in the monetary policy transmission mechanism," he says.

"Rather, the model attributes below-trend growth to sizeable exogenous forces or shocks. The sharp fall in commodity prices has played an important role of late. Also, weakness in private investment - beyond that which can be explained by subdued domestic demand and falling commodity prices - has made a sizeable contribution to below-trend growth."

I think here he's alluding to the adverse effect on business investment of the still-too-high dollar.

"The model also suggests that consumption growth has been a bit weaker than in the past," he says.

Measuring the effects of monetary policy in isolation from other changes that may be happening at the time, this modelling tells us that a cut in the official interest rate of 1 percentage point will lead the level of real GDP to be between about 0.5 per cent and 0.75 per cent higher than it otherwise would be in two years' time.

It will also lead the level of prices to rise by a bit less than 0.25 percentage points a year more than otherwise over the next two to three years.

Of course, one part of the economy that has strengthened in response to low interest rates is housing construction. It's up by about 9 per cent over the past year.

Kent says housing is typically the most interest-rate sensitive sector and its response to date is "broadly consistent with historical experience".

Consumer spending, however, has so far been "a bit weaker over recent years than suggested by historical experience".

But much of that history captures the unusual period, from the early 1990s to the mid-2000s, of adjustment to the easier access to housing credit permitted by the deregulation of the banks and to the economy's return to low inflation.

In that period, household debt increased substantially and household saving fell to rates much below earlier norms. This allow households' consumption spending to grow faster than their incomes.

Since then, however, households' behaviour has reverted to its earlier norms, with a higher rate of saving and greater emphasis on repaying mortgages as early as possible.

If you ignore the growth in borrowing for investment property, but take account of the rising balances in mortgage offset accounts, the rest of household debt has fallen by 4 percentage points of annual household disposable income since early 2000.

Kent thinks many households are using the lower rates to repay their mortgages more quickly (rather than to borrow and spend more) and that some retired households are responding to their lower interest income by limiting their consumption.

As for non-mining business investment, businesses will start expanding their activities when they're closer to running out of spare production capacity. Business investment doesn't usually lead, it follows.

Kent concludes that monetary policy is working pretty much the way it always has, but is pushing against "some strong headwinds", including the huge fall-off in mining investment, tightening budgets at state and federal level and an exchange rate that's still higher than you'd expect it to be considering how far export prices have fallen.

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Very low rates are more worrying than you think

Never thought I'd see the day when Treasury willingly surrendered the leadership of the nation's economists to the Reserve Bank, but it happened this week.

The new Treasury secretary, John Fraser, has broken a tradition lasting more than two decades to speak about the budget at a luncheon of the Australian Business Economists on the following Tuesday.

This follows the absence of Budget Statement No. 4 from last week's budget papers. It's the statement I call Treasury's sermon, but a disappointed Saul Eslake, of Bank of America Merrill Lynch, calls Treasury's "thought leadership essay".

But Dr Philip Lowe, deputy governor of the Reserve Bank, personfully stepped into the breach with a ground-breaking speech about "what seems to be a transition to a world in which global interest rates are lower, at least for an extended period, than we had previously become used to".

Does that sound like a good problem to have? Don't be so sure. Interest rates are two-edged: a cost to borrowers, but income to lenders. No one enjoys suffering a drop in their income, as many oldies have been reminding us lately.

The central banks of the US, the euro zone and Japan have for some years had their official (overnight) interest rates set at or near zero. At the other extreme, the yields (interest rates) on 10-year government bonds in these countries are at "extraordinary low levels".

These very low nominal rates mean savers investing in risk-free assets (government bonds) are earning negative real rates of return – because nominal rates are lower than the rate of inflation. "They also mean the time value of money is negative," Lowe says.

Huh? Say you win $10,000 in a lottery, but are offered the choice of receiving the money now or in three years time. Which would you pick?

Most people would want the money now. If you've got it now you can either use it to buy something and enjoy what you've bought for three years, or you can lend the money to someone else for three years and be rewarded by the interest you charge them.

When you think about all that, you realise the truth of the economists' saying that "a dollar today is worth more than a dollar tomorrow". That's the time value of money. The actual amount of that value is determined by the interest rate you could earn if you had the dollar today, or the rate you'd avoid having to pay to be able to spend today a dollar you didn't have.

This analysis isn't about the effects of inflation, but about the value of the use of money over time. So the time value of money is the real interest rate (the nominal interest rate minus the expected inflation rate).

Time value means that if I had to pay you $10,000 in three years time, the amount I'd have to set aside today would be less than that because the money I set aside could be earning interest between now and then.

If I knew the interest rate was, say, 4.5 per cent, I could work out how much I had to set aside today to have $10,000 in three years time. The process of working this out is called "discounting". It's compound interest in reverse.

The initial amount you'd need turns out to be $8763, which is called the "present value" of $10,000 in three years.

All this is standard stuff for economists and business people evaluating investment projects or managing invested funds. It's deeply ingrained in the way they've been taught to think.

That's why it's quite shocking for Lowe to say the time value of money is now negative. He's saying that, for goodness knows how long, a dollar today is worth less than a dollar tomorrow.

Another implication is that there's now no compensation for postponing consumption to tomorrow – which, of course, is what savers are doing.

How do we find ourselves in this remarkable situation? The "proximate" (most obvious) cause is the actions of the big central banks and their "quantitative easing" (creation of money). But, Lowe says, central banks don't act in a vacuum, they respond to the world they find themselves in.

That world is one where more people want to save, but fewer people want to invest in new physical assets. In such a world, the interest rate, which is what "equilibrates" saving and investment, falls.

If this situation is long-lasting, Lowe says, it poses "new questions and challenges". It changes a lot of our unconscious rules about how the world works.

For a start, for people seeking to fund future liabilities – such as employers with defined-benefit pension schemes, or even just people saving to amass an adequate lump sum to retire on – it just got a lot harder. The present value of future liabilities is now higher, meaning you have to put more in to reach your target.

Second, lower rates mean the present (that is, discounted) value of a stream of future income from an asset is now higher. This, in turn, means the asset is worth more and so will now have a higher price.

This is brought about by savers, dissatisfied with the low returns on risk-free assets (government bonds), seeking the higher returns from riskier assets (say, shares of companies with high dividend rates) and thereby pushing up their prices.

Third, if the cost of (financial) capital has fallen but firms don't lower their "hurdle rates" – the expected rate of return required before potential physical investment projects get the go-ahead – then we don't get the growth in business investment spending needed to get the economy moving (and don't have increased demand for the use of savings working to get interest rates back up).

We just have to hope businesses eventually learn how the rules have changed and adjust accordingly.

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Why monetary policy stimulus is less effective

The advent of "stagflation" in the 1970s - the previously unknown combination of high inflation with high unemployment - led to a loss of confidence in Keynesian policies, with primary responsibility for management of the macro economy being shifted to monetary policy and with fiscal policy taking a lesser role.

Four decades later, the wheel may be turning again. The two hot stories in the world of macro management are the decline in effectiveness of monetary policy and a consequent resurgence of interest in active fiscal policy.

Last week Dr Philip Lowe, deputy governor of the Reserve Bank, gave a speech explaining the monetary policy story, so let's look at that today and leave the fiscal story for another day. (Monetary policy refers to the central bank's manipulation of interest rates - and, these days, its creation of money - and fiscal policy refers to the government's manipulation of taxation and government spending in the budget.)

In the aftermath of the global financial crisis of 2008, the big developed countries' central banks cut their official interest rates virtually to zero in their efforts to stimulate demand, avert a depression and get their economies moving again.

When this didn't seem to be having much effect, but being unable to cut their official rates below what economists pompously call "the zero lower bound", first the US and Britain, then Japan, then the euro zone resorted to an unorthodox practice known as "quantitative easing": central banks buying bonds from the commercial banks and paying for them by creating money out of thin air.

The main way this stimulated their economies was by pushing down their exchange rates relative to the currencies of those countries that didn't resort to QE - us, for example.

The Europeans got so desperate to get their economies moving their next step was to do something formerly believed impossible: they cut their official interest rate below zero - meaning the central bank charges its commercial banks a tiny percentage for allowing them to deposit money in their central-bank accounts. In a few cases, the commercial banks have passed on this "negative interest rate" to their business depositors.

As Lowe says, the present global monetary environment is "quite extraordinary". There's been unprecedented money creation by major central banks, official interest rates are negative across much of Europe, long-term government bond yields (interest rates) in most advance countries are the lowest in history and lending rates for many private-sector borrowers are the lowest ever.

Had anything like this much stimulus been applied in earlier decades, economies would be booming and inflation would have taken off. Instead, though the US and British economies are now growing moderately, Japan and the rest of Europe remain mired, with considerable idle capacity. Inflation rates are low almost everywhere and inflation expectations have generally declined, not increased.

But why have things changed so much? Lowe says it's partly because the GFC was the biggest financial shock since the Great Depression and so has required a much bigger dose of monetary stimulus than usual, which is taking longer than usual to work.

But it's also partly because monetary policy is less effective. "Economic activity does not appear to have responded to the stimulatory monetary conditions in the way that occurred in the past and inflation rates have been very low," he says.

The single most important factor causing the change, he says, is the very high levels of debt now existing in many advanced economies.

One of the "channels" through which stimulatory monetary policy works is by the lower interest rates encouraging people to borrow so as to bring forward future spending. This has worked well in the past, but the high stock of debt acquired from past episodes has left many households, businesses and banks (and even in some cases, perversely, governments) unwilling to add to their debt.

Rather, they're using the low interest rates to help "repair their balance sheets" by paying down their debts.

One aspect of easy monetary policy that is still working normally, however, is the rapid rise in the prices of assets such as property and shares.

Another thing that's different is the flow-on from demand to prices. Both workers and firms seem to perceive their pricing power to have been reduced. More worried about keeping their jobs, workers are accepting much lower wage rises. More worried about losing customers, firms are more cautious about putting up their prices.

So how is all this affecting us in Australia? Lowe says one big effect is to leave us with an exchange rate that's higher than it should be; that hasn't fallen as much as the fall in our mineral export prices implies it should have.

This has required the Reserve Bank to cut our official interest rate by more than it thinks ideal. It's done this partly to reduce our interest rates relative to other advanced countries' rates and so put some downward pressure on our dollar, but mainly to make up for the inadequate stimulus coming from the still-too-high exchange rate.

The big drawback to our very low interest rates is the boom in asset prices: for shares and, more worryingly, houses.

Second, Lowe says, the same factors affecting global monetary policy are evident in Oz, although to a lesser extent. Our banks, businesses and governments don't have excessive levels of debt, but our households do. So, many are using the fall in mortgage interest rates to step up their repayments of principal rather than increase their consumer spending.

Retirees living on interest earnings seem to have cut their consumption rather than eat into their capital.

Our wage growth is surprisingly low, contributing to low inflation.

Lowe's conclusion, however, is that our monetary policy is still working. And once the major advanced economies have fully recovered from the Great Recession - which could take as long as another decade - global monetary policy will return to normal.

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ECONOMICS FAQ

Talk to VCTA Teachers Day, Melbourne, Friday, August 23, 2013

Often when I talk to economics teachers I focus on helping them keep up to date with the latest thinking on some topic, believing they need to know a lot more background information than their students do and leaving it for them to decide how much of what I’ve said they need to pass on to their kids. But this time I’m going straight to the classroom to give you answers to what I imagine are frequently asked questions by your students - and maybe even by you. The full version of my speech is a lot longer than I’ll have time to talk to today, so make sure you get a copy. Even so, I’m sure there are many more FAQs than I’ve had time to write about - or even think of. So if you’ve got questions I didn’t answer, I’d be grateful if you’d write them down and give them to me - or send me, if you think of them later - and I’ll use them for another talk or bear them in mind for my Saturday column, which has high school economics students as primary target audience.

Can we trust the official unemployment figures?

Short answer: yes and no. Yes we can trust the figures in the sense that, contrary to a widely believed urban myth, there was no time in the past when some government - Labor or Liberal - doctored the figures to make them look better. The figures are calculated by the Bureau of Statistics, which is not a government department but, like the ABC, has a high degree of independence of the elected government and doesn’t let politicians tell it how to measure things. The bureau, which is regarded as one of the best statistical agencies in the world, sticks closely to the statistical conventions laid down by the UN Statistical Commission, the IMF and, in the case of the labour force survey, the ILO. The definitions it uses to decide who is employed, unemployed or ‘not in the labour force’ haven’t changed significantly for many decades.

Remember that the labour force figures come from a sample survey conducted every month by the bureau, using a sample of 26,000 households - up to 20 times those used in media opinion polls. Even so, this does mean it is subject to sampling error, and the results jump around from month to month, meaning it’s best to look at the ‘trend’ (smoothed seasonally adjusted) figures.

Many people assume that the number of people said to be unemployed by the bureau is the same as the number on the dole. This isn’t true. You can be on the dole but not counted as unemployed in the survey (say, because you picked up a few hours of casual work during the week) or you can be counted as unemployed by the survey but not on the dole (say, because your spouse’s job gives you too much income to be eligible). Some old people have ideas in their heads that are a hangover from the time before 1978, when the Fraser government paid to have the labour force survey moved from quarterly to monthly, so that it replaced the old method of measuring unemployment as the number of people registered with the Commonwealth Employment Service.

I suspect some people’s false memories of the government fiddling with the figures stem from their memory of controversies over governments changing rules about how much work you can do and still be eligible for disability benefits or the dole. It’s sometimes claimed that a government has tried to hide some of the unemployed by putting them on training schemes. But people have been making such claims for years and the claim implies the training schemes are phoney, that they’d be of little value to the job seeker and are motivated only by a desire to fudge the figures. Whether a person is classed as unemployed depends not on how they’re classified by a government department, but on what answers they give to the bureau’s interviewers.

So, yes, we can trust the official figures in the sense that they haven’t been fiddled. But, no, we can’t trust them in the sense that they don’t give an accurate picture of the extent of unemployment. It is true - and has been for decades - that, under the international convention, someone who’s done as little as an hour’s work in the previous week is classed as employed, not unemployed. This means the official definition of unemployment is too narrow, making it too hard to qualify as unemployed and thus understating the full extent of joblessness. Note that very few people actually work only a few hours a week. It’s also true that the majority of people working part time (ie less than 35 hours a week) are happy with the number of hours they’re working. Many full-time students, young mothers and semi-retired people don’t want to work full-time.

Even so, a significant number of part-timers do wish they could get more hours, so we have a significant problem with under-employment. I suspect this measurement problem has arisen because the decision to call someone employed if they worked for only a few hours was made long ago when part-time and casual employment was quite rare. As it has become increasingly more common, the original definition of unemployment has become increasingly misleading.

The bureau has tacitly acknowledged this by calculating the rate of underemployment and adding this to the official unemployment rate to get the rate of ‘labour force underutilisation’. This broader measure of unemployment is calculated every quarter and published with the monthly labour force survey. From July 2014 the bureau plans to calculate and publish the broader measure monthly. Let’s hope this will prompt economists and the media to give it more attention.

In May 2013 the trend unemployment rate was 5.5 pc, while the underemployment rate was 7.3 pc, giving an underutilisation rate of 12.8 pc. Note that the measure counts as underemployed not just people working part-time who’d prefer to be full-time, but also those part-timers who’d like only a few more hours. So to that extent its definition of unemployment is probably a little too broad.

For many years I’ve used the rough rule of thumb that the easy way to correct the official unemployment rate is to double it. If you’re making comparisons with the past, however, you have to remember to double both the starting point and the end point. And remember that even if the level of the official rate is too low, it should still give a reasonably reliable indication of whether unemployment is rising, falling or staying the same.

Does the RBA still control interest rates when the banks can do as they please?

Short answer: yes it does. The RBA uses market operations to keep the overnight cash rate under very tight control. The cash rate has acted - and still acts - as the anchor for all other short-term and variable interest rates. Of course, all the other interest rates - from bank bill rates to mortgage interest rates - are a margin (or ‘spread’) above the cash rate because they involve riskier lending, but for several years before the global financial crisis world financial markets were very steady and those margins changed little. This gave people the impression mortgage interest rates always move in lock-step with the cash rate. After the turmoil of the crisis, however, many of the margins widened. The banks passed this increase in their cost of funds on to their borrowing customers. In the case of people with home loans, the banks did this by increasing their mortgage interest rates by more than any increase in the cash rate, or by failing to pass on the whole of any cuts in the case rate. Note that the banks increased the rates they charge their business borrowers by a lot more than they increased the politically sensitive mortgage rates.

For a brief period during the GFC the overseas financial markets in which our banks borrowed a high proportion of the money they lent to their customers ceased to operate. When trading resumed their margins were a lot higher. Realising the extent of our banks’ over-dependence on overseas ‘wholesale’ markets, the share market, the credit rating agencies and the official regulators put pressure on our banks to borrow more of the funds they needed from domestic depositors, whose deposits tended to be ‘sticky’ (slow to move away in search of higher returns) and thus more dependable. The resulting sudden surge in all the banks’ demand for deposits forced up the interest rates they paid on deposits, particularly term deposits, raising them from below the cash rate to above it. This, of course, was a great benefit to Australian savers, but the banks passed this higher cost on to their borrowers.

Could the banks have absorbed these higher borrowing costs? They could have - their profitability (not just the absolute size of their profits, but the rate of their profits relative to the value of their total assets or their shareholders’ capital) is very high by world standards or by the standards of other Australian industries - but they chose not to. And the limited degree of competition between the members of the big-four banking oligopoly gave them the pricing power to pass their higher costs on to borrowers and preserve their rate of profitability.

But don’t confuse the rights and wrongs of the banks’ actions with the quite separate question of whether their behaviour has robbed monetary policy of its effectiveness. It hasn’t. Why not? Because although the RBA uses the cash rate as its instrument, what does the real work of monetary policy are the market interest rates actually paid by businesses and households, so the RBA focuses on getting market rates where it wants them to be. If the independent actions of the banks cause market rates to be higher than where the RBA wants them, it simply cuts the cash rate by more to achieve its desired result. In other words, the fact that the banks’ margin above the cash rate is now wider than it was before the GFC simply means the RBA has had to cut the cash rate by more than it otherwise would have to get markets rates to where it wants them.

Does monetary policy still work?

Short answer: yes. When the share and property markets were booming in the late 1980s, the RBA spent several years raising interest rates to get the boom under control. The rise in rates didn’t seem to be working, and it became fashionable to say that monetary policy had become ineffective. I was still wondering whether this could be true when the economy started the slide that became the recession of the early 90s, the worst recession since the Depression, in which unemployment got close to 11 pc. Then all the smarties started saying interest rates had been held ‘too high for too long’.

There could be no better experience to cure me of ever doubting that monetary policy was effective. And yet we hear such claims whenever people observe a delay between the RBA starting to move the cash rate and making clear its desire to speed up or slow down demand but nothing seems to be happening. When the RBA cuts the rate but there’s a delay before demand picks up, people use an old Keynesian phrase that using interest rates to try to stimulate demand is like ‘pushing on a string’. But that analogy is appropriate only when the economy is in a liquidity trap - which the North Atlantic economies may be in at present, but we certainly aren’t.

In 40 years of watching the management of the Australian economy I can’t recall any time when monetary policy has failed to move demand in the desired direction. The problem is just that, as you well know, monetary policy operates with a lag that’s ‘long and variable’. Another thing that makes the process slow and adds to people’s impatience is that the RBA almost invariably moves in baby steps of 0.25 percentage points. Clearly, a single 25 basis point change isn’t likely to have a big effect on decisions about borrowing and spending. It’s probably true, too, that the response to a monetary tightening or loosening episode isn’t proportional or linear. That is, you may adjust rates several times without getting much effect, but then anther click finally has a big impact. The RBA uses the rule of thumb that most of the effect of a monetary policy on demand occurs within two years, with maybe two-thirds of the full effect occurring in the first year. The effect on inflation - which, of course, runs via the effect on demand - is longer again.

Would a big cut in the cash rate produce a fall in the dollar?

Short answer: no. This question has been asked a lot in recent times as trade-exposed industries such as manufacturing have be hard hit by the high dollar associated with the resources boom.

The first point to understand is that, in practice, economists don’t have a good handle on what factors determine movements in the exchange rate over short periods of less than a year of so. There are rival theories, but no particular theory always gives a convincing explanation of why the exchange rate has moved - or not moved - as it has in recent weeks. Instead, one theory tends explain recent events better than another does at a particular time, so economic practitioners tend to switch between the rival theories depending on which one seems to be working better at the time. I think the reason no theory seems to work well at all times is that the global foreign exchange market isn’t nearly as rational as the perfect market hypothesis assumes.

In the old days, a common theory was that the currency of a country with an excessive current account deficit would tend to depreciate, so as to help bring it back to equilibrium and, similarly, the currency of a country with an excessive current account surplus would tend to appreciate. These days, you rarely hear this theory relied on because there’s little if any empirical support for it. I think it was a hangover from the days of fixed exchange rates, when it was clear the authorities’ decisions on whether to devalue or revalue the currency were determined by pressures on their current accounts. In these days of floating currencies and the removal for foreign exchange controls, it’s clear the ‘driver’ of floating exchange rates has switched from the current account to the capital account - that is, from trade flows to capital flows.

These days, and particularly from an Australian perspective, there are three main, rival theories to explain exchange rate movements. The first is that the biggest influence over our exchange rate is our terms of trade, and particularly world primary commodity prices. There is much empirical support for this view if you look at a graph of the two over the years, though you can see the correlation breaking down over some shorter periods. The second theory is that the biggest influence over our exchange rate is our ‘interest-rate differential’ - the size of the difference between our official interest rate (or short-term commercial rates) and those of the major developed economies, particularly the United States. The higher our rates are relative to the others, the more our exchange rate is likely to be high and rising, and vice versa. Note that this is very much a capital-flows driven theory. The third theory is a kind of combination of the first two: countries with strong economic prospects relative to the major developed countries should have strong currency, whereas countries with weak prospects relative to the majors should have a weak currency. This theory makes a lot of sense and often seems to be pretty true, but there are times when it’s far from true.

Australia’s very strong exchange rate over most of the past decade is commonly explained by the resources boom and our exceptionally favourable terms of trade as a result of record high prices for coal and iron ore. Its rise can not be explained by any increase in our interest rates relative to the major economies, even though their rates have been at rock bottom since the global financial crisis. But this has not discouraged people adversely affected by the high dollar from convincing themselves the high rate is the product of currency market speculation or our relatively high rates since the GFC, and then arguing the RBA should make a big cut in our cash rate with the express purpose of engineering a big fall in the dollar.

Our terms of trade began falling in about September 2011, but the dollar didn’t start to fall until April 2013. This delay probably encouraged people to switch to a different theory. They may have thought the RBA was being too cautious in the speed at which it was bringing rates down.

Although no one can be too dogmatic about these things, the RBA does not believe the interest rate differential has very much effect our exchange rate. And this is despite the signs we see that expectations about whether the RBA will or won’t move rates haves an immediate effect on the bill rate. These effects are very temporary. During the period in which the RBA was lowering rates and openly expressing its hope that the dollar would fall to a more appropriate level, many people concluded it was cutting rates in the hope this would lower the exchange rate. It wasn’t. Rather, it was loosening monetary policy because the exchange rate wasn’t coming down. That is, it was trying to ease pressure on the tradeables sector as a substitute for a lower dollar.

Although the Aussie stayed high for about 18 months after commodity prices had fallen sharply, it has fallen by about 10 per cent since April 2013. Some people may attribute this to steady easing in policy over most of that time, but the BRA doesn’t agree with them. A much more likely explanation is that the Aussie finally began falling when Wall Street began worrying that the long-awaited pickup in the US economy would prompt the Fed to start ‘tapering’ the size of its quantitative easing. QE - the central bank’s purchase of bonds and other securities which are paid for merely with bank credits - puts downward pressure on a country’s exchange rate.

The point to note is that the exchange rate is a relative price - the value of my currency relative to the value of yours. So it shouldn’t be so surprising that changes in the level of our exchange rate need to be explained in terms of changed conditions in the US as well as changes in Australia.

Why are our interest rates always higher than other people’s?

Short answer: because we’re riskier. It’s true our interest rates are almost invariably higher than those in the major economies. This has been true for many years. It wasn’t hard to understand before the mid-1990s - when our inflation rate was still well above everyone else’s - but it remains true even when you compare real interest rates.

The explanation seems to be that, as a nation of perpetual net borrowers from the rest of the world (we run a persistent current account deficit), we are required to pay our foreign lenders a significant risk premium on top of the going international rate to compensate them for the extra risks they run in lending to a country that already has a very large net foreign debt and that, being a relatively small economy, is perceived to be more volatile (even though that’s not always true).

Another way of putting it is that Australia always has higher interest rates because we’re a country with an abundance of potentially profitable investment projects relative to the major economies. Our projects have to be relatively profitable or we wouldn’t be able to continue borrowing despite the high risk premium foreign lenders require us to pay.

Does a budget deficit mean fiscal policy is expansionary and a surplus mean it’s contractionary?

Short answer: no they don’t. Life would be very simple for students of macroeconomics if they did, but unfortunately they don’t. Why not? Because what macro economists focus on is not the level of economic activity, but the change in the level - that is, whether the economy has been/will be expanding or contracting. That means they’re interested in determining whether the budget - fiscal policy - is making a positive or negative contribution to economic growth. So it’s the change in the budget balance - and the direction of the change - that matters when assessing whether a particular budget is expansionary or contractionary.

These days the RBA and most market economists assess the stance of policy adopted in a particular budget simply by looking and the direction - and size - of the expected change in the budget balance between the previous year and the budget year. An expected reduction in a deficit or increase in a surplus is regarded as contractionary; any expected increase in a deficit or decrease in a surplus is regarded is expansionary. As a guide, the change needs to be equivalent to at least 0.5 pc of GDP to be significant. A change of 1 pc or more is extremely significant.

Strict Keynesians, however, define the stance of fiscal policy differently, distinguishing between changes in the cyclical component of the budget balance (caused by operation of the budget’s automatic stabilisers as the economy moves through the business cycle) and changes in the structural component (caused by governments’ explicit changes to taxes and spending programs). So they define the stance of policy adopted in a budget according to the direction of the expected change in the structural component arising from the net effect of the spending and taxing changes announced in the budget. They ignore the change in the budget balance caused by the economy’s effect on the budget, focusing on the change caused by the budget’s effect on the economy.

Note, changes in the stance of fiscal policy will be only one of the factors contributing to whether the economy is expanding or contracting. Other factors include: the stance of monetary policy, movements in the exchange rate, changes in the world economy and in confidence.

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FISCAL POLICY AND THE 2012 BUDGET

Economics Seminar Day, Pymble Ladies’ College, Thursday, May 24, 2012

I want to start by giving you the basic facts of the budget Wayne Swan brought down on May 8, look at the forecasts for the economy included in the budget, then assess the ‘stance’ of fiscal policy adopted in the budget and finally comment on where this leaves us with the ‘policy mix’ - the government’s economic objectives and the way these objectives are divided between the arms or instruments of macroeconomic policy.

Key budget facts

Mr Swan is expecting budget receipts to grow by 12 pc in the coming financial year, 2012-13, while budget payments fall by 2 pc. This would cause the expected underlying cash deficit of $44.4 billion in the old financial year, 2011-12, to become a surplus of $1.5 billion in the new financial year. As a proportion of GDP, the budget balance would swing from minus 3 pc to plus 0.1 pc. Mr Swan is expecting the budget to remain in tiny surpluses for the following three years.

He is expecting the federal government’s net debt to peak at 9.6 pc of GDP - or about $143 billion - in June this year, then have fallen to 7.3 pc of GDP ($132 billion) by June 2016.

The main measures to take effect from the beginning of the new financial year are the minerals resource rent tax - expected to raise about $3 billion a year - and the carbon pricing mechanism, expected to raise about $7 billion a year when it’s fully under way. Neither tax is expected to contribute to returning the budget to surplus, however, because both are part of tax packages that are roughly revenue-neutral. Proceeds from the minerals tax will be used to pay for various tax concessions for small business, for various increases in benefit payments, and for the cost to the budget in forgone income-tax revenue of slowly increasing the rate of compulsory superannuation contributions from 9 pc to 12 pc of employees’ wages. Proceeds from the carbon tax will be used to pay for compensation to households (a small income-tax cut and an increase in pensions and the family tax benefit), assistance to emissions-intensive, trade-exposed industries and subsidies to encourage renewable energy projects.

These two packages were announced in earlier budgets. The new measures announced in this budget involve savings of $33 billion over five years (but $4.7 billion in the budget year), offset by new spending of $22 billion over five years (but $1.7 billion in the budget year). The main savings come from reneging on promises to cut the rate of company tax by 1 percentage point and to introduce various new tax concessions, from various reductions in ‘middle-class welfare’ and from deferring spending on defence and overseas aid.

The main new spending measures are replacing the education tax refund with a schoolkids bonus (the first payment of which will be made just before the start of the carbon tax), an increase in the family tax benefit and a tiny increase in the dole; the first stage of the national disability insurance scheme and increased spending on dental health.

Budget forecasts

The economy is forecast to return to growing at about its medium-term trend rate, expanding at an average rate of 3 pc in the old financial year and by 3.25 pc in the coming financial year. The growth in 2012-13 would be brought about by another very big increase in mining investment spending and trend growth in consumer spending, but no growth in new home building and a small contraction in public sector spending as federal and state governments seek to return to operating surplus. Domestic demand is expected to grow faster than trend, but net external demand (exports minus imports) will subtract from growth as the volume of imports increases faster than the volume of exports.

This fall in ‘net exports’, combined with a further modest decline in the terms of trade, is expected to see the current account deficit worsen from a very low 3 pc of GDP in the old year to 4.75 pc in the budget year.

The headline inflation rate is expected to worsen to 3.25 pc in the budget before returning to 2.5 pc the following year.

Employment is expected to grow by a weak 1.25 pc, with the unemployment rate creeping up to 5.5 pc and the participation rate little changed.

The forecasts for our economy are based on a forecast that world GDP will grow by a slightly below-trend 3.5 pc in calendar 2012, with strong growth in developing Asia offsetting weak growth in the developed economies. There is a significant risk this forecast won’t be achieved if the eurozone economies get into greater difficulties, or if China’s economy slows more than intended.

The stance of fiscal policy

The strict Keynesian way to assess the stance of fiscal policy adopted in the budget is to ignore the expected change in the budget balance brought about by the operation of the budget’s automatic stabilisers (known as the ‘cyclical component’ of the balance) and focus on the net effect of the explicit (discretionary) policy changes announced in the budget (the ‘structural component’).

These days, however, it’s more common for economists to take the short cut of simply looking at the direction and size of expected change in the overall budget balance from the old year to the new year. Taken a face value, the expected improvement in the budget balance of almost $46 billion - equivalent to 3.1 pc of GDP - says the stance of fiscal policy is extraordinarily contractionary.

But there are various reasons for doubting the contractionary effect is as big as it seems. The most important is that the budget includes decisions that push almost $9 billion worth of spending measures back into the last few weeks of the old financial year. Whether government spending occurs a bit before or a bit after June 30 makes little difference to the real economy, but it exaggerates the true size of the turnaround in the budget balance by almost $18 billion (ie it makes the old year $9 billion worse and the new year $9 billion better).

Another factor is that the new year’s budget is expected to benefit from increased revenue from resource rent taxes of $5.7 billion (that’s from the existing petroleum rent tax as well as the new minerals rent tax). These taxes are explicitly designed to be taxes on ‘economic rent’, so they have no effect on the incentive to exploit petroleum or mineral deposits and thus have no effect on economic activity.

A further factor is that, thanks to a quirk of public accounting, Swan’s underlying cash surplus of $1.5 billion takes no account of the government’s spending on the continuing rollout of the national broadband network. The relevant budget item is expected to involve increased spending of about $6 billion in 2012-13. Not all of that would relate to the broadband network, but to the extent it involves the government funding increased economic activity, it has the effect of reducing the budget’s adverse effect on activity.

To these arguments the Secretary to the Treasury, Martin Parkinson, has added one of his own: to some extent the budget redistributes income from higher income-earners (who would have a lower marginal propensity to consume ie be likely to save a higher proportion of their income) to lower income earners (with a higher propensity to consume), thereby tending to increase net consumer spending somewhat. Taking all these factors into consideration, Dr Parkinson has suggested the contractionary effect of the budget is probably less than 1 pc of GDP. Even so, that’s still a contractionary stance of fiscal policy.

The changing policy mix

The textbooks list two longstanding objectives of macro-economic management: ‘internal balance’ and ‘external balance or stability’. Internal balance means ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy is travelling at close to full capacity.

The point to remember is that it’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a steady rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’.

The objective of external stability meant achieving an acceptable CAD and a manageable foreign debt. Under the Hawke-Keating government, fiscal policy was allocated the role of achieving external stability. Because the CAD represents the amount by which national investment exceeds national saving, the goal was to contribute to higher national saving by achieving the biggest budget surplus possible. Soon after the election of the Howard government, however, it quietly abandoned external stability as a policy objective. Since then governments haven’t worried too much about the size of the CAD or the foreign debt.

It was under the Hawke-Keating government that the policy makers acquired a third objective: faster economic growth, combined with a more flexible economy, one capable adapting to economic shocks (shifts in the aggregate demand or the aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

Dr Parkinson made it clear in a speech after this year’s budget that the government has acquired an additional economic objective: fiscal sustainability. This is the desire to ensure we don’t run a long string of budget deficits and thus build up an excessive level of public debt (as we see has helped create the present European debt crisis).

We’re left with three macro-economic objectives: internal balance, faster economic growth and fiscal stability. To deal with these three objectives the policy makers have available for their use three economic instruments: fiscal policy, monetary policy and micro-economic policy. The policy makers’ decisions about which instrument to assign to which objective determines the ‘policy mix’.

Internal balance: the budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In the days when the exchange rate was fixed, macro economists used to think of the exchange rate as an additional instrument of policy. It could be ‘revalued’ (raised) to counter the inflation caused by a commodities boom, for instance, or ‘devalued’ (lowered) to cope with a balance-of-payments crisis. After the dollar was floated in 1983 - that is, after the market was allowed to determine the dollar’s external value - the exchange rate ceased to be an arm of macro policy. But in his recent speech, Dr Parkinson identified the macro role of the floating exchange rate, linking it with monetary policy. ‘Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments.’

Fiscal stability: Fiscal policy played a major role in the government’s efforts in 2008-09 to ensure the global financial crisis and the Great Recession it precipitated didn’t lead to a severe recession in Australia. The Rudd government announced at least three major fiscal stimulus packages. All of this spending was carefully designed to be temporary, rather than ongoing. But in his speech Dr Parkinson made it clear that this use of discretionary fiscal policy to assist monetary policy in maintaining internal balance was the exception to the rule.

‘A key objective of fiscal policy is to maintain fiscal sustainability from a medium-term perspective,’ he said. ‘Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policies should work together effectively to support activity, such as during the GFC.’

There are a few points to note about this. First, Dr Parkinson draws a clear distinction between the effects of the budget’s automatic stabilisers (cyclical component of the budget balance) and discretionary decisions to increase or decrease taxation and government spending (structural component). Second, the stabilisers should always be unimpeded in their role of helping to stabilise aggregate demand by reacting in a counter-cyclical way, thereby assisting monetary policy to achieve internal balance. Third, in normal circumstances, the role of discretionary fiscal policy is to pursue fiscal sustainability over the medium term. So, while the automatic stabilisers and monetary policy work together, in normal circumstances discretionary fiscal policy and monetary policy don’t work together because they have different objectives. Fourth, the budget’s expected return to surplus represents the return to normal circumstances.

The objective of fiscal sustainability is encapsulated in medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. Stick to this strategy and, over time, the accumulated deficits will be offset by the subsequent accumulated surpluses, leaving the government’s net debt little changed over the medium term. Note that the medium-term focus of the strategy allows for a) the unrestrained role of the automatic stabilisers and b) the application of discretionary fiscal stimulus during a major downturn in demand provided the stimulus is withdrawn promptly as the economy recovers.

At the time the government engaged in fiscal stimulus spending in 2008-09, it committed itself to a ‘deficit exit strategy’ to ensure the medium-term strategy was complied with. It set itself two targets: first, to allow the level of tax receipts to recover naturally as the economy improves (without breaching the government’s commitment to keep taxation as a share of GDP below its level in 2007-08 - 23.7 pc) - that is, to avoid unfunded tax cuts. And, second, to hold real growth in government spending to 2 pc a year, on average, until budget surpluses are at least 1 pc of GDP and while the economy is growing at or above trend.

Faster growth: the objective of faster and more flexible growth is pursued by the instrument of micro-economic (or structural) policy. Whereas macro-economic policy seeks to stabilise demand over the short term, micro-economic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. Over the medium to longer term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing. Micro policy works mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 1990s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.

Bottom line on the policy mix: Remember that, whatever job the policy makers decide they want fiscal policy to do, that doesn’t stop changes in the budget balance having an effect on demand. And, as we’ve seen, the stance of fiscal policy is contractionary. Even so, the present stance of monetary policy is mildly expansionary (market interest rates are a little below average). With inflation well controlled, however, the RBA has plenty of scope to ease monetary policy further should, for any reason, demand prove weaker than expected.

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