Let's be more hard-nosed towards foreign miners

Joe Hockey and Competition and Consumer Commission boss Rod Sims must surely deserve a medal for their selfless devotion to the interests of foreigners, after their shocked reaction to Twiggy Forrest's suggestion that the world's big producers stop the plunge in iron ore prices by limiting their output.

And here was me thinking economics was about rational self-interest.

Hockey sniffed that the idea smacked of forming a cartel. Which was good of him when you remember the way the plunging price of iron ore is robbing his budget of company tax revenue and causing his deficits to be bigger than those Labor left.

We can't afford to give much money to the foreign poor, but if foreign-owned mining companies want to keep forcing down ore prices by expanding production at a time when world demand is weak, that's fine by Joe.

Sims proclaims that cartels are illegal and is investigating whether Twiggy should be prosecuted. It surely can't have escaped his notice that very little of Australia's iron ore production is used locally, meaning no Australian consumers or businesses would suffer from such an arrangement.

But that, apparently, is not the point. Cartels are morally wrong, even if they advance Australia's national interest. If big foreign-owned producers such as Rio Tinto and BHP Billiton want to use their lower costs per unit to keep expanding production, forcing down the world price and attempting to wipe out higher-cost Australian-owned producers such as Forrest's Fortescue Metals, good luck to them.

Fine by us. That's the way the global resources game has always been played – wild swings from excess demand and inadequate supply causing booms, to weak demand and excess supply causing busts – and so that's the way it must continue to be played.

No effort can or should be made to moderate this crazy game. That there is a lot of fallout on bystanding industries, workers and consumers in the countries where big mining chooses to play this contact sport, is just an unfortunate fact of economic life which it is our government's sacred duty to make us grin and bear.

But while we're being so noble and self-sacrificing, it's worth remembering it wasn't always thus. Consider the many decades in which our governments sought to stabilise the world price of wool, which ended badly only after misguided economic rationalists handed control of the scheme to the woolgrowers themselves.

And don't forget the old Australian Wheat Board's "single desk". We weren't big enough to control world wheat prices, but we did make sure our growers weren't bidding against each other.

While the punters talk xenophobic nonsense about Chinese state-owned corporations taking over NSW's electricity poles and wires, Australia's economists have a deeply ingrained ethic that it's a form of racism ever to acknowledge that a company is foreign-owned.

Now we're in the final throes of the decade-long mining resources boom, it's a good time to reflect on how much we got out of it (not all that much, remembering it's all our minerals) and how well we handled it.

We played it by letting the foreign mining companies do pretty much whatever they wanted, which was to build as many new mines and gas facilities as possible in minimum time. This insane rush came at the expense of all our other industries, but no one questioned its wisdom.

It was left to the Reserve Bank to ensure the miners' greedy stampede didn't cause a wages breakout and inflation surge, which it did by repressing the rest of the economy. To "make room" for the money-crazed miners, it held interest rates higher than they otherwise would have been, which may have caused the exchange rate to be even higher than otherwise.

Was any effort made to assess whether attempting to build 180 resource projects in three years was in the national interest? Yes, but the economists left it to the lawyers. Each of those projects would have been accompanied by an environmental assessment assuring some court that the project would create thousands of jobs and do wonders for the economy.

Evaluating each project separately, the lawyers bought it. You needed to be a macro-economist to see that, added together, those claims made no sense. There wasn't that much skilled labour available and, with the economy near full employment, it just isn't possible to create many extra jobs. All you'd do is move jobs around, bidding up wages and creating shortages in the process.

But the macro-economists were away at the time, probably busy explaining to politicians why it was our economic duty to allow foreign mining companies to use our economy as a doormat.

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Worried officials opt for risky strategy

My guess is the Reserve Bank is a lot more worried about the weak state of the economy than it's prepared to admit in its soothing words and the small downgrade to its growth forecast.

That's the only explanation I can think of for its decision to cut the official cash rate by 0.25 percentage points last week, despite governor Glenn Stevens' most recent "forward guidance" that "the most prudent course is likely to be a period of stability in interest rates".

The Reserve  could have preserved the credibility of its formal signalling regime by delaying such a tiny rate cut by just four weeks and using last week's statement to change its guidance, but such was its impatience that it reverted to its formerly forsworn practice of briefing selected journalists.

The financial markets got the message - thus giving the Reserve the self-generated justification that it had to act because the market was expecting it to - but most business economists didn't. In their naivety, most economists regard the word of the governor as more reliable than media speculation.

Despite the rate cut - and the assumption of at least one further cut - on Friday the Reserve shaved its forecast for real growth this year by 0.25 percentage points to 2.75 per cent, but left its forecast for next year unchanged at a midpoint of 3.5 per cent.

So what was so worrying that the Reserve, having sat on its hands for 18 months, couldn't wait another four weeks so as to protect its reputation?

The old story. This year has long been expected to be when mining investment spending falls hardest, leaving a huge hole in activity, to be filled by the resurgence of the non-mining economy, particularly ordinary business investment.

The Reserve worries that business investment isn't recovering fast enough. So, despite having already cut the official interest rate from its peak of 4.75 per cent in late 2011, it decided to take off another click or two.

It might make all the difference, but I doubt the high cost of borrowing is what's holding businesses back from expanding. More likely, they don't see any great scope for making a bigger buck, and they're not in any mood to try their luck.

As central banks in other developed economies have discovered, when "animal spirits" aren't helping, you can get to a point where even exceptionally low rates do little to encourage borrowing and spending, when cutting rates to encourage growth is like "pushing on a string".

There's one exception, however: borrowing for homes. The main reason the Reserve has waited so long to cut rates further is its fear this would do more to encourage musical chairs in the housing market - the buying and selling of existing homes - including yet more negative gearing.

This doesn't do much to increase economic activity, but does bid up house prices and so add to the risk of a price bubble developing, particularly in Sydney and Melbourne.

It also leads to faster growth in household debt. Saul Eslake, of Bank of America Merrill Lynch, notes that after stabilising for some years, the ratio of household debt to annual household income has been rising to more than 150 per cent and will now go higher.

With their official interest rates down virtually to zero, the Americans, Europeans and Japanese have already got close to the limits of monetary policy. They've had to resort to "quantitative easing" (creating money out of thin air), but this has done a lot more to distort exchange rates and inflate prices in asset markets than it has to encourage real economic activity.

At 2.25 per cent, our official rate is still well above zero but, even so, we're close to the point where the costs and risks of a rate cut threaten to exceed the benefits.

The upshot of the great battle between Keynesians and monetarists in the 1970s was agreement that monetary policy was the most effective way to fight the opposing evils of inflation and unemployment.

By the 1990s, some concluded that manipulation of interest rates by independent central banks had conquered the problem of keeping economies on an even keel. Yeah, sure.

We discovered a fatal weakness in the new macro management: monetary policy was great at controlling ordinary inflation, but when used to stimulate weak demand it was prone to encouraging excessive borrowing and asset-price bubbles which, when inevitably they burst, caused deep and protracted "balance-sheet" recessions.

From our perspective, the answer to our present problem isn't more risky rate cuts, it's greatly increased federal spending on infrastructure to fill the hole created by the fall in mining investment.

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Why we're doing so much better on recessions

With the economy growing below par and spirits so flat that people have started making up new and silly terms like "technical income recession" just to spook us, it's time we put our present discontents into context.

And who better to provide it than the unfairly sacked secretary to the Treasury, Dr Martin Parkinson, who on Friday gave the last of his final speeches in a farewell tour equal to Johnny Farnham's (though well short of Nelly Melba).

On his last day in the job, Parko reflected on all the economic reforms he'd seen since he joined Treasury in 1981 and the economy's greatly improved performance since then. We are, after all, in our 24th year of growth since the severe recession of 1990-91.

Parkinson observed that about half the people of working age today weren't old enough to work at the time of that recession. They thus have little conception of how terrible recessions are. Or why oldies like me object to the R-word being invoked with such flimsy justification.

In that recession, the official unemployment rate rose from 5.8 per cent in December 1989 to 11.1 per cent in October 1992, an increase of more than 5 percentage points.

But, as Parkinson reminds us, up to that point we were used to having recessions about every seven years. In the Whitlam government's recession of the mid-1970s, which continued for some years into the Fraser government's term, the unemployment rate rose by about 4 percentage points.

Then came the Fraser government's own recession, in which unemployment rose from 5.4 per cent in June 1981 to 10.3 per cent in May 1983.

It was the era of "stop-start growth". In banging on about 23 years of uninterrupted growth, however, it's important to remember there were several periods of slower growth in that time, as Parkinson acknowledges.

Indeed, Reserve Bank governor Glenn Stevens observed recently that "but for the vagaries of quarterly national accounting we might well have called the end of 2000 a recession; we would have called the end of 2008 one, in fact I would call it that ... I think we had a recession then, but it was a brief one.

"It wasn't terribly deep and we got out of it fairly quickly. The question isn't how you can go another 23 years without a recession, it is how you have small ones and get out of them quickly."

Just so. Parkinson notes that, in 2000-01, the unemployment rate increased by about a percentage point, and during the global financial crisis of 2008-09, it went up by about 2 percentage points.

But this acknowledgment that we've had a few mini-recessions in the past 23-plus years only enhances Parkinson's point: compared with the previous 20 years, we've got vastly better at macro-economic management, at smoothing the business cycle.

"Those recessions of the 1970s, '80s and '90s were devastating to the economy," Parkinson said. "There was the direct loss to economic output of having around 5 per cent of our workforce thrown out of jobs.

"And there were the social and personal costs of increased unemployment that are more difficult to measure, but likely just as large, or larger, and more persistent, than the direct loss to economic output.

"Large numbers of people experienced long periods of unemployment following these recessions. In many cases, those long-term unemployed never worked again."

In the past 23 years we weren't knocked off course by the Asian financial crisis of 1987-88 or by the bursting of the technology bubble and subsequent recession in the United States in the early 2000s.

You can't put such a record down to good luck. So what changed to make our economic performance so much better than it had been? Parko identified three main factors.

First, all the micro-economic reforms of "product markets" (for oil, air travel, telecommunications, manufacturing, agriculture, rail, waterfront, water and electricity, bread and eggs) and "factor markets" (the exchange rate, banks and financial markets; labour market decentralisation).

These reforms not only improved the allocation of resources and so added to national income, they also made the economy more flexible in its response to economic shocks: less inflation-prone and unemployment-prone.

This, in turn, made the economy's growth more stable and the macro managers' job easier.

Second, there were reforms in the way macro-economic management was conducted, with the introduction of "frameworks" (rules and targets) and greater transparency. Monetary policy (control of interest rates) is now conducted independently by the Reserve Bank, guided by an inflation target.

Fiscal policy (the budget) is now conducted according to the Charter of Budget Honesty with a "medium-term fiscal strategy" and regular reviews.

Third, the building of economic institutions with operational independence in regulating the economy (Australian Prudential Regulation Authority, Australian Securities and Investments Commission, Australian Competition and Consumer Commission and Australian Taxation Office) and in advising the government (Productivity Commission).

Parkinson stressed that these reforms were "an important pre-condition for stronger and more stable growth" but the growth itself was produced mainly by Australia's businesses and households.

"Australia is not immune from economic cycles," he concludes. "But the economic reforms of the 1980s, 1990s and 2000s mean recessions will happen less frequently and be less severe, on average, than if we still had the economic policies and structures of the 1970s."

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Econocrats touch base with reality

As every small-business person knows, the econocrats who think they manage the economy sit in their offices without ever meeting real people. Instead, they pore over figures the Bureau of Statistics bods dream up without ever leaving their desks.

That last bit has always been wrong. Small business is run by people who think their sales this week equal the state of the national economy. If the official figures don't line up with their experience, some bureaucrat must be lying.

The first bit - that the macro managers look at stats without ever talking to business people - used to be true, but hasn't been since some time after the severe recession of the early 1990s.

That was when Treasury (and yours truly) was supremely confident the economy would have a "soft landing". For once, people who knew no economics but had heard the squeals coming from business were right and the supposed experts were wrong.

The econocrats' disdain for "anecdotal evidence" had led them badly astray. They learnt the obvious lesson: as well as studying the stats, they needed to keep their ears to the ground.

But what even many well-versed observers probably don't realise is just how much effort the Reserve Bank puts into its consultations with business and how seriously it takes the results. The workings of its "business liaison program" are described in an article in the Reserve's latest quarterly Bulletin.

The program was put on a highly systematic basis in 2001, so as to lift it above the level of anecdote. Specialised officers talk to up to 100 businesses a month. You try to speak to a range of businesses (or, failing that, industry associations) in each of the economy's industries. You speak to the same people each time, asking the same questions and seeking quantification where possible.

You stay conscious of the gaps in your industry coverage. Ensuring you speak to businesses across the nation means "liaison" is the main role of the Reserve's state branches. Ideally, this should alert you to differences between the state economies.

Some industries are dominated by few big companies, making them easier to cover. But others - particularly the service industries - are composed mainly of small businesses. This is much harder and it's where you may need to fall back on industry associations.

Firms are asked about the usual key variables: sales, investment spending, employment, wages, prices and margins.

The Reserve uses its liaison more to determine where the economy is now - and where particular industries are in their business cycle - than where it's headed.

Most of the intelligence it produces ends up fitting reasonably well with the official statistics, but in some cases it comes in earlier than the stats.

It's a reasonable fit also with the NAB survey of business conditions and confidence, which the Reserve always studies carefully.

The Reserve's well-established links with key businesses allow it to "hit the phones" at times of great uncertainty, such as the global financial crisis. Its liaison made it among the first to realise business was responding differently to the downturn in demand, preferring wage freezes and cuts in hours to mass layoffs.

Its contact with miners made it among the first to realise the biggest hangover from the Queensland cyclone in 2011 wouldn't be farming but the surprising delay in getting the water out of flooded coalmines.

Right now its resource contacts will help improve its guesses about the precise timing of the probably sharp fall-off in mining investment spending.

By now other central banks, including the Bank of Canada and the Bank of England, also conduct big business liaison programs, but our lot were early adopters.

Now you're better informed about the Reserve's use of liaison you're likely to be more conscious of the many references to its findings in the bank's pronouncements.

The Reserve regularly reviews the accuracy of its forecasts and publishes the sobering results. So does Treasury, for that matter. Neither institution pretends its forecasts are much more than educated guesses.

The central bankers haven't been able to detect that their liaison has done anything to improve the accuracy of their forecasts.

But it would a brave - or foolhardy - person who concluded from this that it was wasting its time. Managing the economy without major mishap is a bit trickier than getting forecasts spot on.

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Re-writing the re-write of the GFC fiscal stimulus

Economists may be bad at forecasting - even at foreseeing something as momentous as the global financial crisis - but that doesn't stop them arguing about events long after the rest of us have moved on.

That's good. Economists need to be sure they understand why disasters occurred so we can avoid repeating mistakes. They need to check the usefulness of their various models and whether they need modifying.

One thing that causes these debates to go for so long is that economics - particularly academic economics - is based more on theories than evidence. Some theories clash, so empirical evidence ought to be used to determine which hold water.

But economists aren't true scientists. They pick the rival theories they like best and become more attached to them as they get older. They will try to talk their way around evidence that seems to contradict the predictions of their model.

This leaves plenty of room for ideology, for individuals to pick those theories that fit more easily with their political philosophy.

There's been much mythologising of our experience with the GFC. Many punters' memory is that we thought there'd be a bad recession, the Rudd government spent a lot of money, but no recession materialised so the money was obviously wasted.

This isn't logical. You have to consider what economists call "the counterfactual": what would have happened had Kevin Rudd not spent all that money? Maybe it was the spending that averted the recession.

One Australian newspaper has worked assiduously to inculcate the memory that pretty much all Rudd's "fiscal stimulus" spending was wasteful. It went for months reporting every complaint against the school-building program, while ignoring the great majority of schools saying they didn't have a problem, then misrepresented the inquiry findings that the degree of waste was small.

What got the economy growing again so soon after the big contraction in gross domestic product in the December quarter of 2008, we were told, was the return of the resources boom as China's demand for our commodities ballooned. (This ignores that China's economy was hit for six by the GFC, but bounced back after it applied massive fiscal stimulus.)

To bolster the line it was pushing, the paper did much to publicise the views of Professor Tony Makin, of Griffith University. Makin adheres to a minority school of thought among macro-economists that fiscal stimulus never works. He repeated his long-held views when assessing Rudd's efforts.

Early last month, the Minerals Council published a monograph it had commissioned from Makin on Australia's declining competitiveness. Guess what? All the subsequent events have confirmed the wisdom of his earlier forebodings.

Makin used "the classic textbook macro-economic model" to argue that, even during recessions, fiscal policy is ineffective in adding to economic growth in an open economy with a floating exchange rate because it "crowds out" net exports (exports minus imports).

Borrowing to cover the extra government spending tends to push up domestic interest rates, which attracts foreign capital inflow. This, in turn, pushes up the exchange rate. Then the higher dollar reduces the price competitiveness of our export and import-competing industries, thus increasing imports and reducing exports. Any increase in domestic demand is thus offset by reduced net external demand.

Next Makin examined the national accounts showing a strong rebound in growth in the March quarter of 2009 (thus silencing the two-quarters-of-negative-growth brigade) and found the turnaround was explained not by increased domestic spending but by an improvement in net exports.

There you go: proof positive that his long-held views were spot on. He attacked the claim that the fiscal stimulus saved 200,000 jobs, saying "this assertion is based on spurious Treasury modelling of the long-run relationship between GDP and employment". He criticised Treasury's estimates using dubious Keynesian "multipliers" of the addition to GDP caused by the fiscal stimulus.

Treasury quickly released a response to Makin's criticism. His theoretical argument was based on the Mundell-Fleming model (from as long ago as the early 1960s), which assumes unilateral fiscal action, a high degree of openness to trade and perfect mobility of financial capital between countries. (It could have added the assumption that the central bank controls the supply of money rather than the level of short-term interest rates, as ours has long done.)

In reality, all the major economies applied fiscal stimulus in concert, trade accounts for much less of our GDP than it does for most developed countries, and the turmoil of the GFC meant capital mobility was far from perfect at the time (I'd say all the time).

As for his empirical checking, Makin's use of the national accounts failed to consider the counterfactual. It's likely imports fell in that March quarter not so much because the dollar fell heavily (and didn't shoot back up for about a year, once commodity prices had reversed and were on their way to new heights) as because the fear unleashed by the GFC prompted people to postpone planned purchases of imported items. If so, their spending would also have fallen, offsetting to boost from net exports.

Makin's claim that Treasury used multiplier estimates that were long-term rather than short-term is wrong. The whole idea of the stimulus was to boost spending (and confidence) quickly to counter the collapse in confidence. Since the spending measures were always intended to be temporary (and were, despite the mythology) it was always known that the effect on GDP growth would be negative before long.

The short-term multipliers Treasury used were based on the conservative end of the range of estimates calculated for our economy by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

Makin is entitled to his opinions, but he's in a small minority among economists, even the academics. The two international agencies were full of praise for our fiscal stimulus and in no doubt about its effectiveness.

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Why we're still not free of the GFC

Almost six years since the global financial crisis reached its height, it's easy to forget just how close to the brink the world economy came. To someone like Reserve Bank governor Glenn Stevens, however, those events are burnt on his brain.

Which explains why he thought them worth recalling in a speech this week. And also why, so many years later, the major developed economies of the North Atlantic are still so weak and showing little sign of returning to normal growth any time soon.

When those key decision-makers who lived through 2008 and 2009 say that there was the potential for an outcome every bit as disastrous as the Great Depression of the 1930s, "I don't think that is an exaggeration", he says.

"Any account of the events of September and October 2008 reminds one of what an extraordinary couple of months they were. Virtually every day would bring news of major financial institutions in distress, markets gyrating wildly or closing altogether, rapid international spillovers and public interventions on an unprecedented scale in an attempt to stabilise the situation.

"It was a global panic. The accounts of some of the key decision-makers that have been published give even more sense of how desperately close to the edge they thought the system came and how difficult the task was of stopping it going over."

But, despite the inevitable "mistakes and misjudgments", the authorities did stop it going over. Stevens attributes this to their having learnt the lessons of the monumental mistakes and misjudgments that that turned the Great (sharemarket) Crash of 1929 into the Great Depression.

Economic historians (including one Ben Bernanke) spent decades studying the Depression and, in Stevens' summation, they came up with five key lessons: be prepared to add liquidity – if necessary, a lot of it – to financial systems that are under stress; don't let bank failures and a massive credit crunch reinforce a contraction in economic activity that is already occurring – try to break that feedback loop; be prepared to use macro-economic policy aggressively.

So far as possible, maintain dialogue and co-operation between countries and keep markets open, meaning don't resort to trade protectionism or "beggar-thy-neighbour" exchange rate policies. And act in ways that promote confidence – have a plan.

There was a lot of action and a lot of international co-operation, and it worked. As a result, we talk about the Great Recession, not the Great Depression Mark II.

"We may not like the politics or the optics of it all – all the 'bailouts', the sense that some people who behaved irresponsibly got away with it, the recriminations, the second-guessing after the event and so on," he says. "But the alternative was worse."

With collapse averted, the next step was to fix the broken banks. Their bad debts had to be written off and their share capital replenished, either by them raising capital from the markets or accepting it from the government.

Fixing the banks' balance sheets was necessary for recovery, but not sufficient. A sound financial system isn't the initiating force for growth, so stimulatory macro-economic policies were needed to get things moving.

On top of all the government spending to recapitalise the banks came a huge amount fiscal (budgetary) stimulus spending. Stevens says a financial crisis and a deep recession can easily add 20 or 30 percentage points to the ratio of public debt to gross domestic product.

Then you've got the weak economic growth leading to far weaker than normal levels of tax collections. Add to all that the various North Atlantic economies that had been running annual budget deficits for years before the crisis happened.

"So fiscal policy has not had as much scope to continue supporting recovery as might have been hoped," Stevens says. "Policymakers in some instances have felt they had little choice but to move into consolidation mode [spending cuts and tax increases] early in the recovery."

He doesn't say, but I will: this crazy, counterproductive policy of "austerity" has helped to prolong the agony.

With fiscal policy judged to have used up its scope for stimulus, that leaves monetary policy. Central banks cut short-term interest rates hard, but were prevented from doing more because they soon hit the "zero lower bound" (you can't go lower than 0 per cent).

But long-term interest rates were still well above zero and, in the US and the euro area, long-term rates play a more central role in the economy than they do in Oz. Hence the resort to "quantitative easing".

Under QE, the central bank buys long-term government bonds or even private bonds and pays for them merely by crediting the accounts of the banks it bought from. Adding to the demand for bonds forces their price up and yield (interest rate) down. And reducing long-term rates is intended to stimulate borrowing and spending.

Has it worked? It's intended to encourage risk-taking, but are these risks taken by genuine entrepreneurs producing in the real economy, or are they financial risk-taking through such devices as increased leverage?

Stevens' judgment is that it always takes time for an economy to heal after a financial crisis [because it takes so long for banks, businesses and households to get their balance sheets back in order - they've borrowed heavily to buy assets now worth much less than they paid] so it's too soon to draw strong conclusions.

For Stevens, the lesson is that there are limits to how much monetary policy can do to get economies back to healthy growth after financial crises. "If people simply don't wish to take on new business risks, monetary policy can't make them," he says.

Perhaps the answer is simply subdued "animal spirits" – low levels of confidence, he thinks. But, at some stage, sharemarket analysts and the investor community will ask fewer questions about risk reduction and more about the company's growth strategy.

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Budget's effect on economy: not as bad as it looks

The consumerist question about this week's budget is: how did it affect my pocket? The egalitarian question is: was its treatment of people at the bottom, middle and top reasonably fair? But the macro-economic question is: how will the budget affect the economy?

We know the economy has been, and is expected to continue, growing at below its medium-term trend rate of about 3 per cent a year, the rate that keeps unemployment steady. So will the budget help to speed things up or slow them down? In the economists' jargon, will its effect be "expansionary" or "contractionary"?

It may seem a simple question, but economists have various ways of attempting to answer it. One outfit asking itself this question is the Reserve Bank. The Reserve will take account of the budget's effect - along with various other factors' effects - on the strength of demand in the economy in making its monthly decisions about whether to raise, lower or leave unchanged the instrument it uses to affect the strength of demand, the official interest rate.

In making that assessment the Reserve takes a very simple approach: in what direction is the budget balance expected to change between the present financial year and the coming financial year that starts in July? And having determined the direction of the change, how big is it? Obviously, the bigger it is, the more notice we should take of it.

Taken at face value, the answers to those questions aren't ones most people would be pleased to hear. Joe Hockey is expecting a budget deficit of $49.9 billion in the financial year just ending and a deficit of $29.8 billion in the coming year.

That's an expected improvement of $20.1 billion - which may please those people who think getting the government's deficits and debt down as quickly as possible is the only thing that matters, but would worry most business people and economists.

Why? When governments spend more in the economy than they take out of it in tax collections - that is, run a deficit - they're contributing to the net demand for the production of goods and services that keeps the economy growing and increasing employment opportunities. Which, when private demand is weak, is a good thing.

(It would be a different matter if private demand were strong and the additional demand from the public sector was adding to inflation pressure.)

So the expected reduction of $20.1 billion in the budget's net addition to demand will have a contractionary effect which, taken by itself, will tend to make the economy grow even more slowly. And since the budget papers imply nominal gross domestic product will be $1632 billion in 2014-15, a $20.1 billion change represents 1.2 per cent of GDP - making it highly significant.

Oh dear. Doesn't sound good. But, as I say, this is taking the budget figures at face value - always unwise in economics. What's more, simply focusing on the direction and size of the expected change in the budget balance is a bit simplistic.

For a start, Hockey inflated the old year's deficit by choosing to make a payment of $8.8 billion to the Reserve Bank. This is just the government moving money between its pockets; it has no effect on demand.

If you ignore the one-off payment to the Reserve, the expected improvement in the budget deficit falls to $11.3 billion, which is equivalent to 0.7 per cent of GDP - but that's still a quite significant degree of contraction.

But here's where we start getting tricky. When you imagine that reducing the budget deficit by $1 will therefore reduce nominal GDP by $1, you're implicitly assuming that whatever the government does to bring that $1 reduction about won't have any effect on the behaviour of people who've had their benefits cut or their tax increased.

In the economists' jargon, you're assuming a "multiplier" of 1. In 2009, however, the Organisation for Economic Co-operation and Development published estimates of the multiplier effects of changes in various classes of government spending and taxation by the Australian government.

It found, for instance, that increased government spending on building new infrastructure would have a multiplier of 0.9 in the first year (and 1.3 in the second year, as the increased spending by the government prompted the eventual recipients of that money to increase their own spending).

By contrast, it found that, on average, an increase in government spending on "transfers to households" (such as a cash splash) had a multiplier of just 0.4 in the first year, rising to 0.8 in the second year.

Why? Because a lot of people would hang on to the money (save it, or use it to reduce their debts) rather than spend it, particularly at first.

This explains why the OECD's multiplier for a cut in income tax is only 0.4 - people would save most of it. Similarly, an increase in income tax would reduce consumer spending by only 60 per cent of the increase because some people would cut their rate of saving to "smooth" their consumption.

The OECD's various multipliers for Australia range from 0.3 to 1.3. If we use a narrower range closer to the middle of that range - 0.6 to 0.9 - and apply these multipliers to the 0.7 per cent of GDP we calculated earlier, we get an estimated negative impact on GDP of between 0.4 and 0.6.
This suggests the budget's negative effect on demand won't be too terrible.

And note this: most of the expected improvement in the deficit in 2014-15 comes from an expected improvement in the economy (more people paying more tax; fewer people needing assistance) rather than from all the tough changes Hockey announced on Tuesday night.

The lion's share of the budget savings don't come until 2017-18. Why? Partly for political reasons but also because, as he's long been saying, Hockey didn't want to hit the economy while it was down.
 

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Clear signs the economy is picking up

At last some good news on the economy. This week's national accounts for the December quarter show the economy speeding up and, in the process, starting its fabled "transition" away from being driven largely by mining investment.

The economy's medium-term "trend" rate of growth in real gross domestic product - the rate that holds unemployment constant - is thought to be 3 per cent a year. For much of last year the economy was seen to be travelling at only about 2.5 per cent, thus leading to a slow but steady rise in unemployment.

But this week's accounts from the Bureau of Statistics show real GDP growing by 0.8 per cent in the December quarter and by 2.8 per cent over last year. Applying a bit of judgment, we can say the economy is probably now growing at an annualised rate of about 2.8 per cent.

This isn't enough to stop unemployment rising - and we really need a period of growth well above 3 per cent to get the jobless rate heading back down to its own trend level of about 5 per cent - but it beats 2.5 per cent.

And, as I say, the accounts show reasonably convincing evidence the "rebalancing" of the economy - away from mining investment and towards the other sectors of the economy and sources of growth - is finally under way.

After quite a few quarters of weakness, consumer spending grew by 0.8 per cent in the quarter and by 2.6 per cent over the year. This strengthening is a bit of a surprise when you remember household disposable income is only crawling ahead, with no growth in employment and very low rises in wages.

Arithmetically, the explanation is a fall in the household saving rate from 10.6 per cent of disposable income to 9.7 per cent. But this ratio is volatile, so I wouldn't take it too literally. It's possible households have shaved their rate of saving - say, from the high 10s to the low 10s - but I doubt it signals a return to the low saving rates we saw in the couple of decades before the global financial crisis.

The second sign of rebalancing was long-awaited real growth of 1 per cent in spending on home building, including renovations. This is not unexpected considering the rises in established house prices and in the issue of local government building permits.

More recent "partial indicators" for the month of January confirm that consumption and home building have picked up. Nominal retail sales grew by a strong 1.2 in the month to be up 6.2 per cent on a year earlier. And residential building approvals rose strongly in the month to be up 34 per cent on a year earlier.

Public sector spending rose by 1.1 per cent in the quarter, contributing 0.3 percentage points to the overall growth of 0.8 per cent in real GDP. Most of this came from public infrastructure spending.

But now we get to the bad news. Most of the growth I've outlined so far was offset by a sharp fall in business investment spending, which dropped by 3.6 per cent.

Most of this decline is explained by a drop in mining investment as the investment phase of the resources boom comes to an end. It's now clear mining investment peaked about a year ago.

It was our knowledge that mining investment was about to fall back from the dizzying heights it reached that caused us to see the need for "transition" or "rebalancing" in the economy (plus a few other buzzwords I've forgotten).

But this brings us to the weak part in the transition so far. Although most of the fall in total business investment is explained by mining, it's clear investment spending in the non-mining sector also fell - which is not what the doctor ordered. Rough estimates by Kieran Davies, of Barclays bank, suggest it fell by 1.2 per cent in the quarter and by 7 per cent over the year.

So if most of the growth in domestic demand in the quarter was cancelled out by the fall in business investment, where did the overall growth in aggregate demand of 0.8 per cent come from? From the one place left: net external demand, otherwise known as "net exports" - exports minus imports.

The volume (quantity) of exports grew by 2.4 per cent in the quarter and by 6.5 per cent in the year, whereas the volume of imports fell by 0.6 per cent in the quarter and by 4.6 per cent in the year.
Put the two together and net exports made a positive contribution to overall growth of 0.6 percentage points in the quarter and 2.4 points over the year.

Why are exports growing so strongly? Mainly because of rapid growth in our exports of minerals and energy as new mines come on stream. Why are imports so weak? Partly because domestic demand has been weak, but particularly because of the fall off in mining investment, which involves a lot of imported equipment.

So the investment phase of the resources boom is coming to an end and leaving a hole in the economy, but the production and export phase of the boom is helping to fill the hole - helping to tide us over while the non-mining economy is getting back on its feet (to mix a few metaphors).

The resources boom's now favourable effect on net exports translates into a much lower current account deficit on our balance of payments. Whereas it used to get as high as 6 per cent of GDP in the old days, and averaged about 4.5 per cent, for the December quarter it was just 2.6 per cent.

Maybe the economy has a future after all.

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Our three top treasurers in 40 years

In the 40 years I've now been an economic journalist for Fairfax Media I've given 12 federal treasurers the benefit of my free advice. I doubt it has made much difference, but I do know this: despite all you read in the paper, our economy is now far better managed than it used to be.

For this I give most of the political credit to just three of them: Paul Keating, by a country mile, Peter Costello and one you won't believe: Wayne Swan.

That the economy is now far better managed is easily proved. We went from boom to recession in my first year, 1974, back into a severe recession in 1982 under treasurer John Howard, and then again in 1990 with Keating's "recession we had to have".

Each was worse than the one before and each was correctly labelled "the worst recession since the Great Depression". I formed the view that recessions happened about every eight years.

But as Paul Bloxham, of the HSBC bank, has reminded us, Australia is now in its 23rd year of continuous economic growth. Must be doing something right.

To have achieved such an unprecedented gap since the last severe recession we had to escape the Asian financial crisis of 1997-98, the US "tech-wreck" recession of the early 2000s and the Great Recession that followed the global financial crisis in 2008 - and still isn't really over.

Reckon that was all down to good luck?

We owe it at least as much to good management. I know because I remember the roller-coaster ride the economy was on before the econocrats got it back under control.

Wages rising 25 per cent in a year and inflation hitting more than 17 per cent under the Whitlam government; inflation back up to 12 per cent under treasurer Howard and unemployment peaking above 10 per cent after his recession; mortgage interest rates hitting 17 per cent and unemployment peaking at 11 per cent in Keating's recession.

Turns out the present growth period accounts for just over half my 40 years. And of my 12 treasurers, Keating, Costello and Swan were in office for well over half.

Keating is our best treasurer by far because he instigated the sweeping reforms that transformed the economy and laid the groundwork for better day-to-day management of it. He made the economy less inflation-prone and more flexible, thus able to reduce unemployment faster.

Costello's greatest achievement was to free the Reserve Bank to change interest rates as it saw necessary, meaning the economy is now managed more by econocrats than politicians. He also ensured our banks were tightly supervised while the Americans were letting theirs create so much havoc.

Swan deserves a spot on the treasurers' honour board purely for his surprisingly deft handling of stimulus spending and human confidence after the GFC, ensuring we suffered only the mildest of recessions.

Aided by some in the media, his political opponents have had great success in rewriting that recent history. But later historians won't be deceived.

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A short history of the economy

To me it doesn't seem all that long ago, but looking back I have to admit the economy has changed hugely since my first day as an over-age cadet journalist on February 7, 1974. Some things are worse, but a lot are better.

What strikes me most, however, is the roller-coaster ride we have been on to get from then to now.

In those days, just eight years after we moved from pounds, shillings and pence, TV was still black and white and my new employer had a five-digit phone number. Gough Whitlam was prime minister and Billy Snedden was opposition leader.

An ambitious young suburban solicitor named Howard was preparing to take a seat in Parliament at the election to be held three months later. (Outlasted you, John.)

As a cadet I earned about $100 a week, a big comedown from my former pay as a chartered accountant, but a lot better than the $45.50 a week paid to married pensioners. It would take me some years to get up to the top tax rate of 66.7 per cent, which cut in at $40,000 a year.

Child endowment was 50c a week for the first kid and $1 for the second.

The standard interest rate paid on passbook savings accounts of 3.75 per cent doesn't look too bad today, and the mortgage interest rate of 8.4 per cent probably isn't as low as you expected. But remember that the inflation rate was 14 per cent.

A few years after I joined Fairfax we bought a not-so "ideal first home" in the inner city for $27,000. Its value would have increased at least 20-fold since then. Incomes have also increased a lot, of course, there are a lot more two-income families, and even established houses get ever bigger and better. But, even allowing for all that, we have bid up the prices of houses and units relative to other things.

The rate of unemployment was 2.4 per cent in 1974, which was up from 1.8 per cent the previous year and so considered high. It would hit 4.6 per cent by the time the Whitlam government was dismissed in November 1975.

Almost two-thirds of the labour force was male and only one worker in eight was part-time. Today women account for a bit less than half the labour force and almost one worker in three is part-time. The number of people in jobs has almost doubled to 11.6 million.

These days, a higher proportion of students stay on to year 12 and a high proportion go on to uni. Biggest difference: females have a higher rate of "educational attainment" than males.

Then, almost one in four workers worked in manufacturing (which in those days included John Fairfax Limited, manufacturer of newspapers) whereas today it's about one in 12.

The big jobs growth has been in health, education and all manner of "business services". The fastest-growing occupations have been managers, professionals and associate professionals. Beats blue-collar work.

The value of the Australian dollar was fixed at $US1.49 but, in those days before the advent of the jumbo jet, overseas travel was much more expensive, relative to other things, than it is today.

Forty years ago imports accounted for 13 per cent of the value of all we bought. Today it's more than 21 per cent. But then we exported less than 13 per cent of all we produced, whereas today it's almost 21 per cent.

Thanks particularly to the efforts of Paul Keating and Bob Hawke, our economy is these days a lot more open to the rest of the world. Less of our trade is with America and Europe and a lot more is with Asia - China, Japan, South Korea and India.

When I started my economy-watching, the value of all the goods and services Australia produced in a year was $54 billion. Today it's more than $1.5 trillion. But don't forget consumer prices have increased by 700 per cent since then and the population has gone from less than 14 million to more than 23 million.

Even so, Australia's real income per person has almost doubled, so there's no doubting we are far better off materially.

What price we have paid for this in strained relationships, stress and mental ill-health, greater inequality and damage to the environment is another matter - one we prefer not to think about and put too little effort into measuring.

From the viewpoint of economic news, the timing of my arrival at Fairfax was perfect. In 1974 the postwar Golden Age of low inflation and full employment throughout the developed world came to an abrupt end.
It was ushered out by the first OPEC oil price shock, which hit in late 1973, and the advent of an ugly word to describe a new and ugly state of affairs - stagflation, the combination of high inflation with high unemployment.

It was a turning point in the history of the world economy and the Whitlam government had no idea what hit it. It was undeterred in its efforts to correct 23 years of perceived Liberal backwardness within a three-year term.

But it wasn't just the politicians who didn't get it. It took the world's economists at least a decade to work out why things had gone wrong and how economies should be managed so as to keep both inflation and unemployment low.

It took the rich world's governments even longer to get their economies back in working order and it took longest in Australia, mainly because of the Whitlam government's excesses, which took longer to work off.

When I arrived at Fairfax the economy was booming, with wages set to rise by 25 per cent in a year and prices headed for an inflation rate of 17.7 per cent.

But before the year was out the economy was contracting thanks to a Treasury-inspired "short, sharp shock". Despite Dr Jim Cairns' frantic efforts to revive it, the Whitlam recession had begun.

Malcolm Fraser happily echoed all the "smaller government" rhetoric coming from Maggie Thatcher and Ronald Reagan, but didn't really believe it. He thought it was just a case of not doing the things Whitlam had done and everything would get back to the way it had been before the arrival of the interlopers.

It didn't. He dismantled Medibank because it annoyed the doctors so much, but couldn't bring himself to cut government spending hard. Unlike his treasurer, Howard, he was no economic rationalist.

The economy did pick up a bit. The inflation rate fell, but by September 1982 it was back up to 12 per cent. There was talk of a mining boom, but instead we got the severe recession of the early 1980s, with unemployment reaching a peak of 10.3 per cent just a month or two after the election of the Hawke government.

Hawke's timing was perfect. The drought broke and the recession ended within months of his ascension. He used his Accord with the union movement to cut real wages and the result was very strong growth in employment.

The election of March 1983 gave voters no indication that Labor's treasurer, Keating, was about to completely remodel the economy - though, as Keating reminded the ABC's Kerry O'Brien recently, he did spell out his intentions in an interview with me within a few weeks of taking the job.

Labor floated the dollar, deregulated the banks, reformed the tax system, largely removed protection against imports, privatised most federal government-owned businesses, ended centralised wage-fixing and moved to enterprise bargaining.

It was most un-Labor-like behaviour and many supporters hated it. But with their new-found freedom the banks went crazy with their lending to business, the economy boomed and unemployment got to a brief low of 5.9 per cent in late 1989, which was when the government's frantic efforts to slow the economy took mortgage interest rates to 17 per cent.

The result was the severe recession of the early 1990s, in which unemployment peaked at 11 per cent in the first half of 1992. Because so many businesses had borrowed so much to buy assets now worth a lot less than they had paid, the recession was particularly protracted and the recovery painfully slow.

After Dr John Hewson muffed things, Howard was perfectly placed in 1996 to benefit from all Keating's economic reforms as well as the "recession we [didn't] have to have". Inflation got back under control late in Keating's term, but Howard didn't get unemployment back under 6 per cent until late 2003.

He made few further reforms apart from granting policy independence to the Reserve Bank, introducing the Goods and Services Tax and over-reaching on industrial relations.

Peter Costello steered the ship steadily until the revenue flooding in from the resources boom led him to go crazy with tax cuts and unsustainable superannuation concessions, thus laying the foundations for the present chronic budget problems now being blamed solely on Kevin Rudd and Julia Gillard.

Their failings are too recent to need repeating, but already we've forgotten Labor's greatest macro-economic achievement: limiting the fallout from the global financial crisis to a mild downturn. Anyone could have done it? Don't believe it.

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How my views have changed over 40 years

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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How what's hurting most is also what saved us

While many business people see the economy as badly performing and badly managed, our econocrats see it as having performed quite well and better than could have been expected. Why such radically different perspectives on the same economy?

Partly because business people - particularly those from small businesses - view the economy from their own circumstances out: If I'm doing it tough, the economy must be stuffed. By contrast, macro-economists are trained to ignore anecdotes and view the economy from a helicopter, so to speak, using economy-wide statistical indicators.

A bigger difference, however, is that business people are comparing what we've got with what we had, whereas the economic managers are comparing what we've got with what we might have got, which was a lot worse.

Business people know everything was going swimmingly in the years leading up to the global financial crisis of 2008-09, but in the years since many industries - manufacturing, tourism, overseas education, retailing, wholesaling - have been travelling through very rough waters.

The econocrats, however, have a quite different perspective: whereas the rest of us love a good boom, those responsible for managing the economy view them with trepidation. Why? Because they know they almost always end in tears and recriminations.

Particularly commodity booms. As a major exporter of rural and mineral commodities, we've had plenty of these in the past. They've invariably led to worsening inflation, a blowout in the trade deficit and ever-rising interest rates, followed by a recession and climbing unemployment. The latest resources boom was the biggest yet, involving the best terms of trade in 200 years, leading to a once-a-century mining investment boom. It could have - even should have - led to a disaster, but it didn't.

The macro managers' primary responsibility is to maintain "internal balance" - low inflation and low unemployment - which involves achieving a reasonably stable rate of economic growth. No wonder commodity booms make them nervous.

So how have they gone? As Dr Philip Lowe, deputy governor of the Reserve Bank, said in a speech this week, over the three years to March, economic output (real gross domestic product) has increased by 9 per cent, the number of people with jobs has risen by more than half a million and the unemployment rate today is 5.4 per cent, the same as it was three years ago.

Underlying inflation has averaged 2.5 per cent over the period, the midpoint of the medium-term inflation target. "So over these three years we have seen growth close to trend, a stable and relatively low unemployment rate and inflation at target," he says.

And that's not all. The investment boom hasn't led to a large increase in the current account deficit. There hasn't been an explosion in credit. Increases in asset prices have generally been contained. And the average level of interest rates has been below the long-term average, despite the huge additional demand generated by the record levels of investment and high commodity prices.

So "we have managed to maintain a fair degree of internal balance during a period in which there has been considerable structural change, a very large shift in world relative prices, a major boom in investment and a financial crisis in many of the North Atlantic economies", Lowe says.

So how was this surprisingly OK performance achieved? Well, that's the funny thing. The two factors that have done so much to make life a misery for so many businesses - the high dollar and increased household saving - are the very same factors that have been critical to our good macro-economic performance.

The high dollar brought about by the resources boom has reduced the ability of our export industries to compete in the international market and reduced the competitiveness of our import-competing industries in our domestic market, making life very tough for many of them.

For a while, many hoped the dollar's rise would be temporary, but now "there is a greater recognition that the high exchange rate is likely to be quite persistent and firms, including in the manufacturing sector, are adjusting to this", Lowe says.

"Many are looking to improve their internal processes and address inefficiencies. They are focusing on products where value-added is highest and where the quality of the workforce is a strategic advantage. We hear from businesses right across the country that they are looking for improvements and that many are finding them."

But here's the other side of the story. Had we not experienced the sizeable appreciation, he says, it's highly likely the economy would have overheated and we would have had substantially higher inflation and substantially higher interest rates.

"This would not have been in the interests of the community at large or ... in the interests of the sector currently being adversely affected by the high exchange rate." And it's unlikely we would have avoided a substantial real exchange-rate appreciation, with it coming through the more costly route of higher inflation. (The real exchange rate is the nominal exchange rate adjusted for our inflation rate relative to those of our trading partners.)

Next, the rise in the net household saving rate from about zero to 10 per cent of household disposable income since the mid-noughties represents about an extra $90 billion a year being saved rather than consumed by households.

This reversal of the long-running trend for consumption to grow faster than household income explains much of the pain retailers and wholesalers have been suffering. We've had more retail selling capacity than we've needed, forcing shops to fight for their share of business.

But had households spent that extra $90 billion a year on consumption, it's likely there would have been significant overheating. The exchange rate would have been pushed up, the trade balance would be worse and there would have been more borrowing from the rest of the world.

"And both inflation and interest rates would have been higher. I suggest that these are not developments that would have been warmly welcomed by most in the community," Lowe concludes.

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Productivity improves, but no one notices

You could call it the mystery of the disappearing productivity crisis. Last week's national accounts for the December quarter confirmed that, if we ever really had an underlying problem with weak productivity improvement, we don't have one now. By now, that's not such a mystery. No, the puzzle is why the people who made so much noise about the supposed productivity crisis show little sign of having noticed its evaporation.

For months we had big business arguing the seemingly weak rate of improvement in the productivity of labour during the noughties needed to be corrected by restoring the Howard government's WorkChoices biasing of industrial relations law in favour of employers. Some even went so far as to claim it was Labor's Fair Work changes that caused the weak productivity improvement.

Another line we kept hearing was that a big cut in the rate of company tax was needed to get productivity up. No one prosecuted this campaign more enthusiastically than the national dailies; they were always fretting about productivity. Yet in their extensive reporting of the national accounts, neither found space to note what those accounts told us about such a crucial issue. Even the media's exaggerated preference for bad news over good isn't sufficient to explain that omission.

Call me cynical, but it makes me suspect all the tears shed over productivity were little more than cover for an exercise in big-business rent-seeking. Shift the rules in my favour and it'll do wonders for the economy.

In case you're wondering, the national accounts showed that, on the simplest measure - gross domestic product per hour worked - the productivity of labour improved by a roaring 3.5 per cent over the year to December.

But I think the best way to see what's been happening is this: using the trend (smoothed seasonally adjusted) figures for labour productivity in the market sector, it's been improving at the rate of 0.5 per cent or better for seven quarters in a row.

Obviously, 0.5 per cent a quarter represents an annualised rate of 2 per cent, which compares with the average rate of 1.8 per cent a year achieved over the past 40 years (and the 1.6 per cent Treasury is projecting for the next 40).

To be sure, the Bureau of Statistics warns against taking short-term movements in productivity too literally, preferring to do its measurement in completed "productivity cycles" that run for four or five years.

But the improvement we've seen over the past year or two isn't hard to credit. After all, the volume of production (real GDP) grew by 3.1 per cent over the year to December, whereas total employment grew by only 1.1 per cent and average monthly hours worked grew by just 0.2 per cent.

Nor is it hard to see how the few industries whose special circumstances did so much to make the economy-wide productivity figures look so bad are moving on from those circumstances. The mining investment boom shot the mining industry's productivity figures to pieces by adding inputs without yet adding much to outputs.

But the strong growth in the volume of coal and iron ore exports in the December quarter tells us the expanded production capacity is at last starting to come online. And we know the water utilities haven't undertaken a second round of building, then mothballing, desalination plants.

Big business is wedded to the happy notion that productivity improves when governments do things to make business's life easier. If these guys were a bit better versed in economics [as opposed to rent-seeking] they'd know the truth is roughly the opposite: productivity improves when governments either do things, or allow things to happen, that make life tougher for business.

What the Gillard government did was do nothing to lower the high dollar - not that there was anything sensible or effective it could have done - and limit the budgetary handouts to only part of manufacturing industry.

The result was a lot of pressure on export-and import-competing industries to raise their efficiency (or, at the very least, cut costs) or go under. As well, a lot of other industries, including retailers and much of the media, have been subject to pressure on sales and profits coming from the digital revolution and structural change.

These are just the tough times you'd expect would oblige firms to lift their game. As Reserve Bank governor Glenn Stevens said recently: "In several sectors of the economy a combination of factors is putting pressure on business models, and firms have been responding with an emphasis on lifting productivity and paring back costs. This process, while unavoidable, feeds into measures of sentiment ..."

As we go through a period of transition from mining-led growth to stronger growth in the rest of the economy, he said, "the pressures to adapt business models, contain costs, increase productivity and innovate will remain. But such adjustments are actually positive for longer-run economic performance."

Moral: Don't get your economics from overpaid chief executives - or crusading newspapers.

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Hockey would be no soft touch as treasurer

If the Liberals take over the management of the economy in September - as seems likely - one advantage should be that big business becomes more realistic about the extent to which it imagines the government can solve its problems. And just to make sure, Joe Hockey, the opposition's treasury spokesman, gave business his first pep talk along those lines last week.

Hockey is much underestimated. If you've been watching you've seen him progressively donning the onerous responsibilities of the treasurership, the greatest of which is making it all add up.

He has used his - now less considerable - weight to avoid raising unrealistic expectations and to tone down overly generous promises. You can see him thinking: "I'm the guy who'll have to find a way to pay for all these commitments. We've made a huge fuss about the need to get the budget back to surplus and it'll be down to me to ensure it happens."

In opposition the temptation is to espouse populist solutions that sound good but don't work. As a former cabinet minister, Hockey knows it's hard for governments to get away with such wishful thinking. If you've been listening carefully you'll have noticed Hockey quietly taking an economic rationalist approach while others demonstrated their lack of economic nous.

Those who doubt the strength of Tony Abbott's economics team should note that Hockey would be backed by Senator Arthur Sinodinos, a former senior Treasury officer. I believe Sinodinos played a key part in formulating the "medium-term fiscal strategy" - "to maintain budget balance, on average, over the course of the economic cycle" - which the Libs developed when last in opposition.

If so, Sinodinos deserves induction to the fiscal hall of fame. There have been few more important or wiser contributions to good macro-management of our economy.

One of the greatest failings of the Rudd-Gillard government was the way, in an attempt to keep in with big business, it yielded to the temptation to modify its policies in response to lobbying from particular industries. The consequence was to annoy other industries and incite them to get in for their cut. But the more concessions business extracted from Labor, the more business lost respect for its judgment and self-discipline.

This generation of Labor doesn't seem to have learnt from its Hawke-Keating predecessor which, with some lapses, stuck to the line that the days of industry rent-seeking were over and that, in a well-functioning market economy, the main responsibility for solving an industry's problems rests with the industry.

Judging by his speech to a business audience last week, I suspect Hockey has learnt the lesson. He outlined the many ways in which he believed the Coalition's policies would be better for business than Labor's, but stopped well short of promising business everything its heart desired.

For instance, he discussed the case of "a significant manufacturer with similar operations in Australia and the United States", who complained that labour costs were much higher in Australia.

"Australian labour is expensive," Hockey said. "Is that a bad thing? No, not at all. We can compete with higher wages provided our output per worker is globally competitive.

"Higher household income means that our people have higher spending power. That provides a high standard of living and facilitates strong household consumption. And it benefits businesses because it provides a strong and expanding domestic market."

Australia's standard of living must not go backwards, he said. There was no national benefit in cutting wages. "What we do need to do is to ensure that our workers have the skills and knowledge that our industry needs. Education, training and retraining is a key step to unlock labour productivity gains. And we need to ensure that employment conditions can meet the varied and changing requirements of Australian workers and Australian businesses."

This was why, within the framework of the Fair Work Act, a Coalition government would look at "cautious, careful and responsible improvements to labour market regulation".

Hockey noted that part of the reason Australian wages seemed high relative to US wages was our high dollar, which "is impeding the competitiveness of Australian exporters and making life difficult for Australian producers.

"But on the other side of the coin," he said, "the high Australian dollar brings benefits for businesses which rely on imported goods, and for consumers who purchase cheaper imported products. So what could or should be done?"

He made two points in reply. First, there's no "correct" value for the dollar. Second, all movements in the currency create losers as well as winners. "Those who argue for a lower dollar are effectively arguing in favour of higher prices for consumers," he said.

A Coalition government "would need to be extremely cautious in tinkering with such a successful policy measure" as the freely floating dollar. "We would encourage businesses to view the high dollar as an opportunity. A high dollar means imports are cheap. Business should be utilising this period to import cutting-edge equipment and world-class technology."

Hockey is already sounding like a more forthright treasurer than the incumbent.

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Outlook for economy not bright

As far as the economy's concerned, 2013 will be the year when many people's dreams come true. For at least the past two years, many of us - business people and consumers alike - have been convinced the economy is slowing and generally in bad shape.

Trouble is, until recently the hard statistics on the state of the economy have persistently refused to confirm this pessimism.

But now there's good news for the fearful. The nation's economists are as agreed as they ever get that this year the economy will slow, with the rate of unemployment likely to rise towards 6 per cent. Gloomy news will abound. Yippee.

The problem is that the great surge of investment in the construction of new mines and natural gas facilities seems close to its peak. It is unlikely to fall away dramatically, but it should at least reach a plateau and may fall back a little.

All these years of expanding our production capacity is now producing growth in the quantity of our exports of mineral and energy but, at present, this won't be sufficient to replace the impetus we have been getting from the growth in spending on new mines.

And the rest of the economy is not likely to be growing fast enough to fill the vacuum. Business confidence has been poor for some time and, apart from mining, business investment in expansion has been weak and is expected to stay weak.

Normally, a fair bit of the economy's growth comes from the building of new homes, in line with the growth in the population. But in recent years the housing sector has been surprisingly weak. We haven't had as much building of new homes as usual, nor renovation of existing homes, nor buying and selling of existing homes.

Just why housing has been weak for so long is hard to know. It hasn't been a lack of population growth. But the absence of steadily rising house prices is both a consequence and a cause of the weakness.

Housing activity is at last starting to pick up, but it is unlikely to be particularly strong this year.

Next in this tour of the dark side is what many business people regard as the clincher: lack of consumer confidence. Consumers are going through a period of great caution, we have been told repeatedly, and so aren't spending much.

One small problem: so far this hasn't been true. It is true consumer confidence has been surprisingly weak, but it is not true this has led to weak growth in consumer spending. It is also true households are saving a much higher proportion of their incomes than they did for many years.

But the rate of household saving has been steady for several years, meaning consumer spending has been growing at the same rate as household disposable incomes. And since household income has grown reasonably strongly, so has consumer spending.

So how do we account for the tales of woe from retailers? It is simple. Contrary to popular impression, only about a third of all the money consumers spend is spent in the shops of retailers. The retailers have been doing it tough because the share of the consumer dollar going to them has been declining.

With the dollar so high, imports have been cheaper and we have been spending a lot more on overseas holidays and imported cars. To a small but growing extent, our retailers have suffered as we are using the internet to access the cheaper prices charged abroad. And with fewer new homes being built and fewer people moving homes, fewer of us have been buying new furniture and furnishings.

What interests me, however, is why the gloom of so many business people and consumers has so far greatly exceeded the reality. Why people's perceptions of the state of the economy have been so much worse than what the hard facts tell us.

It may be that people have attached too much local significance to all the gloomy news we have been hearing from abroad about troubles with the euro and the Americans' fiscal cliff, but I believe a big part of the explanation is political.

Many business people seem to be sitting on their hands until the political atmospherics improve. They say the period of minority government has damaged confidence, but this is code for their impatience to see the back of Julia Gillard.

At least with business people their measured lack of confidence accords with their reluctance to invest in expanding their businesses. With consumers, the standard measure of their confidence compiled by Westpac and the Melbourne Institute has proved an unreliable guide to their actual behaviour.

If you delve into that index you discover that people intending to vote Liberal are far more pessimistic about the economy than those intending to vote Labor. I suspect it will prove a better indicator of who will win this year's election than of the prospects for consumer spending.

Another part of the explanation for the discrepancy between perception and reality is surely that the tribulations of certain industries - notably manufacturing and retail - have mistakenly been taken as symptomatic of the whole economy.

But not to worry. The economists assure us 2013 will be the year when reality finally aligns with our negative perceptions. Not being a pessimist myself, however, I see two grounds for hope.

One is that if all the economists are sure the economy will slow, there must be a good chance they are wrong yet again.

And remember the light at the end of the tunnel: come the election, God will be back in his Liberal heaven and all will be right with the world.

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THE EVER-EVOLVING POLICY MIX: Keeping up with changing fashions in macro management

Talk to VCTA Teachers Day, Melbourne, Friday, August 24, 2012

One of my self-appointed roles is to help economics teachers keep up to date with changing economic policy and economic thinking. Today I want to give you an update on the policy mix, but I’m going to put it in historical context and so it will also involve a bit of a refresher course. The macro managers change the policy mix in response to the economy’s ever-changing circumstances, but there’s also a fair bit of economic fashion involved.

What we call the policy mix the academic literature calls the ‘assignment of instruments’. On the one hand, the macro managers have various economic policy objectives. On the other, they have various instruments, or tools, available to use to meet those objectives. They have to decide which instruments are best-suited to use to achieve which objectives. This assignment is fairly settled, but does change over time in line with changing circumstances and changing views. The other thing that changes with the economy’s circumstances - and particularly its present position in the business cycle - is the ‘stance’ or setting of the key policy instruments.

I’m going to discuss four objectives: internal balance, external balance, fiscal sustainability and faster growth with greater flexibility. Then I’ll discuss the five instruments we’ve used on and off over the years to achieve those four objectives: monetary policy, fiscal policy, exchange rate policy, incomes policy and micro-economic policy.

Internal balance

Achieving internal balance is the single most important objective of the macro managers. It means achieving ‘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 at present is travelling at close to full capacity. (Remember that, although we think of full employment as referring primarily to the employment of labour, it also refers to the full employment of all factors of production.)

The other way to think of internal balance is that it involves achieving a fairly stable rate of growth. 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 reasonably steady or stable 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’ and ‘stabilisation policy’. The greatest swearword in demand management is to call some policy decision ‘pro-cyclical’ - something that will increase the amplitude of the business cycle rather than narrowing it.

External balance

The objective of external balance (or external stability) has had a chequered history. In the years before the dollar was floated in 1983, it would have meant keeping the exchange rate fixed at the rate established under the post-war Bretton Woods system of fixed exchange rates. To be forced to devalue or revalue the exchange rate was regarded as a sign of serious economic mismanagement. To avoid having to devalue, it was necessary to ensure the economy didn’t grow too quickly and suck in too many imports, thus incurring a deficit on the current account greater than the net capital inflow on the capital account and thus running down the stock of foreign exchange reserves. This could lead to a period of uncertainty, speculation by people paying for imports and receiving money for exports, and a run on the currency while the government agonised over a devaluation. When the economy was growing too quickly and pulling in too many imports it was said the economy had hit the ‘balance-of-payments constraint’, to which the answer was always to use tight fiscal and monetary policies to crunch demand, including demand for imports.

After the exchange rate was allowed to float in 1983 - following another exchange-rate crisis earlier in the year - the RBA withdrew from the forex market and allowed the dollar’s value to be continuously determined by the relative strength of the demand for and supply of Aussie dollars. This meant the deficit on the current account was always exactly offset by the surplus on the capital account. It also meant the disappearance of the balance-of-payments constraint, though it took economists quite a few years to realise how much the rules had changed.

After the float the current account deficit became a lot bigger, with a lot more of it financed by foreign borrowing rather than foreign equity investment, thus causing the foreign debt to rise rapidly. As part of our slowness to understand the full implications of leaving the world of fixed exchange rates, the Hawke-Keating government became very concerned about the high CADs and growing foreign debt. During this period the meaning of ‘external stability’ became achieving a manageable CAD and an acceptable level of foreign debt.

Sometime after the election of the Howard government, however, academic economists led by the ANU’s John Pitchford finally succeeded in convincing Treasury (having much earlier convinced the RBA) that seeking to influence the CAD was not an appropriate objective of macro management. This case was strengthened once the federal budget returned to surplus and the government adopted its ‘medium-term fiscal strategy’ of achieving a balanced budget on average over the cycle, meaning the budget balance (net public sector saving or dissaving) would make no net contribution to the CAD over the cycle. In the early 2000s, the Howard government quietly abandoned external stability as a policy objective. This has not changed under the Rudd-Gillard government.

Fiscal sustainability

In the 2012 budget papers, the Gillard government formally articulated a new macro policy objective: ‘fiscal sustainability’. This means avoiding the build-up of an excessive stock of government debt as a consequence of many years of running budget deficits. The perils of excessive debt are now painfully apparent in Europe, where the financial markets’ unwillingness to continue funding some governments is forcing them to adopt policies of ‘austerity’ that are actually counterproductive (pro-cyclical). You can argue the Europeans’ problem was caused by the GFC, with all the borrowing needed to bail out their banks and reinflate their economies. You can also argue their problems have been greatly compounded by the unstable foundations on which their euro currency union was built. But the fact remains that, had they not run up such high levels of public debt before the GFC, they would have been far better placed to cope with its demands. By contrast, Australia’s longstanding implicit objective of fiscal sustainability left us very well placed to cope with the GFC. We were able to spend and borrow heavily to stimulate the economy, and had it been necessary to borrow to rescue our banks we would have been starting with a clean slate. In all these circumstances, it’s not surprising the government has raised fiscal sustainability to the status of a formal objective. Getting back to our earlier position of no net public debt will take a long time.

Faster growth, with greater flexibility

It was under the Hawke-Keating government (1983 to 1996) that the policy makers acquired another explicit objective: faster economic growth, combined with a more flexible economy - one capable adapting to economic shocks (shifts in the aggregate demand or 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.

That brings us to the end of the policy objectives, so now let’s look at the five policy instruments used over the years.

Monetary policy

Monetary policy has been assigned the objective of achieving internal balance. The 2012 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 developed economies, the modern approach to monetary policy involves the adoption of a ‘framework’ to govern the way it’s conducted, including an inflation target and a central bank that’s independent of the elected government ie able to change interest rates without the government’s permission. In Australia, the formal acceptance of the RBA’s independence, and its inflation target, was made by the Howard government in 1996.

Although the mechanics of monetary policy involve manipulation of the overnight cash rate via open market operations (often abbreviated to just market operations), one of the main ways it works is by achieving and maintaining low inflation expectations. Expectations matter because they tend to influence the behaviour of price setters and wage bargainers. The lower expectations are, the easier is for the RBA to keep actual inflation low without having to keep monetary policy tight and growth slow. Part of the inflation target’s role is to ‘anchor’ inflation expectations at between 2 and 3 per cent. But the target’s effectiveness in anchoring expectations rests on the RBA’s credibility - the public’s confidence that it will keep inflation within the target it has set itself. Its credibility came only after it had achieved several years of keeping actual inflation within the target range. The greater its credibility, the faster it can allow the economy to grow. And the more well-anchored inflation expectations are, the less inflation-prone the economy will be.

Implicit in all I’ve just said is that, though the expression of monetary policy’s target deals solely with inflation, it’s quite mistaken to assume the RBA cares solely about inflation and doesn’t care about growth and unemployment. What it actually indicates is the belief that a foundation of low inflation provides the only basis for sustainable growth and low unemployment. Other ways to express the goal of monetary policy is ‘non-inflationary growth’ or, as per the 2012 budget papers, keeping ‘the economy growing at close to capacity, consistent with achieving the medium-term inflation target’.

It’s important to be clear that the target is not an inflation rate of 2 to 3 pc. It’s a rate of 2 to 3 pc ‘on average, over the cycle’. This qualification is very important because it makes it clear the target is to be achieved on average, not at every point in time. It’s what makes the target a ‘medium-term’ target. It means the target doesn’t require the RBA to crunch the economy the moment inflation pops above 3 pc. What it means is that, if inflation rises above the target, the RBA must be able to demonstrate it is taking effective steps to get the rate back down into the target range within a reasonable time, without disrupting growth. Note, too, that the target is symmetrical: having the rate fall below the target range is as much a cause for concern - and for remedial action - as having it rise above the target range.

Because changes in interest rates take up to two or three years to have their full effect on economic activity, the RBA conducts monetary policy on a ‘forward-looking’ or ‘pre-emptive’ basis. It adjusts the stance of policy on the basis of its forecast for inflation over the coming 18 months to two years. It uses the latest actual figures for inflation simply to check its forecast is on track.

The ‘stance’ or setting of monetary policy being adopted by the RBA at a particular time is assessed by first determining what level of the cash rate would be ‘neutral’ in its effect on economic activity - that is neither expansionary (‘loose’) nor contractionary (‘tight’). Obviously, when the rate is above neutral it’s contractionary and when it’s below it’s expansionary. As a first approximation, the RBA judges the neutral level of rates to be their longer-term average. However, what ultimately matters to the RBA is the level of the market rates actually paid by households and businesses. So when the size of the margin between the cash rate and market rates changes, this shifts the level of the cash rate that can be regarded as neutral. The increase in our banks’ funding costs since the GFC has caused their margin above the cash rate to increase. In response, the RBA has lowered its assessment of the level of the cash rate that’s now seen as neutral. It used to be regarded as about 5 pc, now it’s regarded as about 4 pc. This means a cash rate of 3.5 pc would be regarded as ‘mildly stimulatory’.

Fiscal policy

The objective to which fiscal policy is assigned has changed many times over the years. During the High Keynesian period up to the mid-1970s, it was used as the primary instrument to achieve internal balance, with money policy playing a subordinate role. After the mid-70s, following the world-wide disillusionment with Keynesian fine-tuning and the flirtation with monetarism, the primary responsibility for achieving internal balance was shifted to monetary policy - a lasting consequence of the monetarist attack on the theoretical foundations of Keynesianism.

After the dollar was floated and CADs became a lot higher, the Hawke-Keating government assigned fiscal policy to the objective of achieving external balance and, in particular, to lowering the ‘structural’ (long-term average) CAD. This was based on the identity: CAD = capital account surplus = national investment minus national saving. Since the federal budget balance (strictly, revenue minus recurrent spending) is one of the components of national saving, improving the budget balance by reducing a deficit or increasing a surplus will cause the CAD to be less than it otherwise would be. So that became the goal of fiscal policy: to improve the CAD by improving the budget balance.

After the Howard government became confident the budget was securely back in surplus, it quietly abandoned the objective of external balance. Thereafter, fiscal policy’s de facto role was to support monetary policy in the pursuit of internal balance. During the mid-noughties, however, when the early stage of the resources boom was causing the government’s coffers to overflow and it was pursuing a policy of using spending increases and annual income-tax cuts to hold the surplus down to 1 pc of GDP, fiscal policy became pro-cyclical - it added to the amplitude of the business cycle rather than dampening it. This was because it was effectively preventing the budget’s automatic stabilisers from doing their job of slowing the surge in demand.

In 2008-09, the Rudd government’s prompt response to the GFC and the threat that the global recession would spread to Australia unleashed a huge burst of stimulus spending which propelled fiscal policy to the forefront of efforts to maintain internal balance (although monetary policy was also playing a prominent role, with the cash rate being cut by 3.75 percentage points in four months).

But here’s the point: with the stimulus spending having ceased and the budget expected to return to surplus in 2012-13, the 2012 budget papers nominate a new and different role for fiscal policy: ‘the primary objective of fiscal policy is to maintain the budget in a sustainable position from a medium-term perspective’. That is, the primary objective of fiscal policy is now maintaining ‘fiscal sustainability’.

However, it has also been made clear the budget retains an important role in assisting monetary policy achieve internal balance. How? By allowing the budget’s automatic stabilisers to be unimpeded in doing their job of helping to stabilise demand as the economy moves through the business cycle. The stabilisers bolster aggregate demand when private demand is weak and restrain aggregate demand when private demand is strong. The latter process is known as ‘fiscal drag’ - which is, of course, a helpful thing when you’re trying to keep the growth rate stable.

What does it mean to say fiscal policy’s primary objective is to achieve fiscal sustainability but the automatic stabilisers must be free to assist monetary policy in attaining internal balance? It means the policy makers are drawing a very Keynesian distinction between the effect of the automatic stabilisers (producing the ‘cyclical component’ of the budget balance) and the operation of discretionary fiscal policy (producing the ‘structural component’ of the budget balance). It’s discretionary fiscal policy that’s used to achieve fiscal stability over the medium term.

Everything I’ve just said about the modern roles of fiscal policy is consistent with the ‘medium-term fiscal strategy’. This was established by the Howard government in 1996 as ‘to maintain budget balance, on average, over the course of the economic cycle’. In 2007 the Rudd government changed the wording to maintaining a budget surplus on average - which, when you think about it, is little different. This strategy has been carefully worded to, first, permit the free operation of the automatic stabilisers and, second, permit the use of discretionary fiscal policy to stimulate the economy during a recession - provided this stimulus is withdrawn (wound back in) as the economy begins to recover. That is, the strategy has been designed to accommodate what you could call ‘symmetrical Keynesianism’. Note, the one thing the strategy doesn’t accommodate is long-term borrowing for infrastructure. That is, it doesn’t distinguish between spending for recurrent purposes and spending for capital purposes. This a weakness.

These days, best-practice macro management involves laying down ‘frameworks’ to govern the conduct of policy instruments, particularly fiscal and monetary policies. The frameworks often involve the establishment of medium-term strategies and targets. The framework for fiscal policy is established by the Charter of Budget Honesty Act, passed by the Howard government in 1998. The charter requires governments to set out their medium-term strategy in each budget, along with their shorter-term fiscal objectives and targets. It also requires full reports on the fiscal outlook and the economic outlook to be made public at the time of the budget, in the middle of each financial year and immediately after an election is called. It sets out arrangements for the costing by Treasury and the Department of Finance of the election promises made by both government and opposition - although the costing of policies for the non-government parties is now carried out by the Parliamentary Budget Office. When the Rudd government unveiled its second fiscal stimulus package in February 2009, the charter required it to set out its ‘deficit exit strategy’ at the same time. In this strategy the Rudd government imposed various restrictions and targets on itself to ensure it didn’t end up breaching its medium-term fiscal strategy.

How do you judge the ‘stance’ of fiscal policy - whether it’s expansionary, neutral or contractionary? The old Keynesian way involved working out the cyclical and structural components of the budget balance, then determining the likely net effect of all the discretionary policy decisions announced in the budget on the structural component. A worsening in the structural balance represented an expansionary stance of policy; an improvement represented a contractionary stance.

These days, however, many macro economists use a simpler approach favoured by the RBA, which ignores the cyclical/structural distinction - and hence the distinction between the effect of the stabilisers and the effect of discretionary decisions - and focuses on the expected change in the overall budget balance - the direction of the change and the size of the change. So, for example, a large expected reduction in a budget deficit would be classed as a ‘quite contractionary’ stance of policy. In my judgement, a change needs to be bigger than 0.5 percentage points of GDP to be significant. One exceeding 1 percentage point is a big deal. Note, it’s a bit odd to have the RBA choosing to ignore the distinction between the roles of the stabilisers and discretion in assessing the stance of policy, at a time when the government is using the distinction to explain how fiscal policy can have two objectives: to assist monetary policy in achieving internal balance in the short term, and to achieve fiscal sustainability in the medium term.

As covered in the Year 11 syllabus, the budget has three effects on the economy: on the strength of demand, on the allocation of resources, and on the distribution of income. In all our focus on its effect on demand in Year 12, I think it’s important not to forget to examine the effects of this year’s budget on allocation and redistribution. It’s often the case that a government’s micro-economic reform measures have major implications for the budget. And many budget measures have implications for the distribution of income, whether or not that was their purpose. Sometimes budget measures are directly aimed at influencing demand; sometimes they have a quite different motivation - even one that’s purely political. Remember that all budget measures affect demand, whether or not that was the reason for them being taken.

Exchange-rate policy

In the days after the breakdown of the Bretton Woods system of fixed exchange rates anchored to the US dollar in the early 1970s, when many developed countries’ currencies were floating while ours remained fixed, it could be thought that the government’s ability to make discretionary changes to the value of our dollar constituted an instrument of policy. When a world commodity boom caused a surge in export income, for instance, the dollar could be revalued to help fight the inevitable inflation pressure (and also redistribute some of the proceeds from the export industry to the rest of the economy). In the years immediately before the dollar was floated in 1983, it was known that Treasury favoured a slightly overvalued dollar as an aid to fighting inflation.

It’s clear the decision to float the dollar involved abandoning the possibility of using the exchange rate as an instrument of policy. In practice, however, we’ve seen that the strong (but far from perfect) correlation between the dollar and our terms of trade means the floating dollar does a much better job of helping to limit the inflationary effects of commodity booms than did discretionary adjustments to the fixed exchange rate. This may explain why, in a speech after the 2012 budget, the Secretary to the Treasury, observed that ‘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’.

Incomes policy

During the decades of the arbitration system of industrial relations and centralised wage-fixing until the abandonment of the national wage case in 1994, the government had a wages policy in the sense that it sought to influence the growth of wages directly by seeking to persuade the Industrial Relations Commission to limit the wage rises it granted to all award workers. This became known as an incomes and prices policy after the election of the Hawke government in 1993 and the implementation of its ‘incomes and prices accord’ with the union movement. In practice, however, it remained a wages policy, because the Accord period involved no attempt by the Labor government to influence non-wage incomes such as profits, dividends, interest and rent, nor to control the prices of goods and services (leaving aside the investigative role of the Prices Surveillance Authority). But the Accord arrangement lapsed with the election of the Howard government in 1996, meaning the government lost any instrument for trying to influence wages directly. Now wage rates are influenced indirectly via monetary policy.

Micro-economic policy

Micro-economic policy (also known as structural policy) was recognised as a policy instrument when the Hawke-Keating government began pursuing what it called micro-economic reform. At the time, Mr Keating portrayed the role of micro reform as to reduce the CAD by making Australia firms more competitive on international markets. But academic economists soon demolished this argument of political convenience, pointing out that only policies which caused an increase in national saving relative to national investment could reduce the CAD. The true objective of micro reform is faster growth, with greater flexibility.

Note that, despite its name, micro-economic policy is an instrument of macro management. What distinguishes it from the other instruments is that rather than working on the demand (spending) side of the economy, it works on the supply (production) side. As well, demand management has a short-term focus, whereas micro-economic policy works over the medium to longer term. Over the medium 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.

The sources of growth in the economy’s productive capacity - and thus the ‘potential’ rate at which it can grow - are: growth in the population of working age combined with the rate of participation in labour force, growth in education and skills (ie human capital), growth in investment in housing, business equipment and structures, and public infrastructure, and (multi-factor) productivity. Thus the supply side grows each year, as does demand. While ever the economy retains spare production capacity, aggregate demand can grow faster than aggregate supply. Once the idle capacity has been used, however, the rate at which the supply side is growing sets the upper limit on the rate at which demand and production can grow without causing inflation pressure. It follows that achieving faster growth involves increasing the economy’s potential growth rate.

Micro policy works mainly by reducing government intervention in markets to increase competitive pressure, which leads to increased efficiency and productivity. 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 - is assumed by most economists to have led to a surge in the rate of productivity improvement in the second half of the 90s. But the return to more normal rates since then suggests micro reform has failed to achieve the hoped-for lasting increase in the rate at which the economy can grow.

Micro reform seems to have been more successful at making the economy more flexible and resilient in the face of economic shocks. Greater competition within many product markets, the floating of the dollar and the move from centralised wage-fixing to bargaining at the enterprise level, in particular, have greatly reduced the problem of cost-push inflation pressure and made the economy significantly less inflation-prone. It may also be argued the greater flexibility accorded to employers by industrial relations reform has made the economy less unemployment-prone, as shown by their changed response to staff retention (their preference for shorter hours rather than lay-offs) in the mild recession of 2008-09. The more flexible the economy becomes, the easier it is for the macro managers to achieve internal balance and a stable rate of economic growth.

While micro reform focused initially on reducing government intervention in markets to encourage greater efficiency, under the Rudd-Gillard government the focus has shifted to trying to achieve higher productivity by reforming and increasing the investment in human capital (education and training) and public infrastructure. The carbon pricing arrangement to which it has devoted so much attention is intended not so much to increase productivity as to help avoid the loss of productivity that climate change would cause.

Macro lags and the assignment of instruments

A long time ago the macro managers identified three lags (delays) that make their task of managing demand quite difficult. The ‘recognition lag’ is the delay in them recognising that some aspect of the macro economy is not working well and requires a policy response. This lag is caused partly by delay in the publication of economic indicators for a particular period.

The ‘implementation lag’ is the delay between realising a policy response is required, deciding what the response should be and actually putting it into implementation.

The ‘response lag’ is the delay between the time the policy measure takes effect and the time the economy has fully responded to it. Policy measures almost invariably take longer to change people’s behaviour than we expect them to.

These practical considerations have influenced the macro managers’ choices on whether to rely on fiscal policy or monetary policy for internal balance. The length of the recognition lag would be the same for both policies, but monetary policy has a clear advantage in the case of the implementation lag. The RBA board meets every month and, if necessary, it can consult more frequently by phone. Once a decision to change the cash rate has been made, the market operations needed to bring it about can be done quite simply the same day. In contrast, the changes to government spending or taxation needed to alter the stance of fiscal policy involve many meetings of the Cabinet, in which all the possibilities and ramifications are debated. In practice, the stance of fiscal policy can be changed only once a year in the budget or, at best, twice a year if a mini-budget is brought down.

Fiscal policy probably performs better on the response lag than monetary policy does. It takes a long time - two to three years - for a change in interest rates to have its full effect on demand and inflation. As we’ve seen, however, the RBA seeks to reduce this problem by taking a forward-looking approach, basing decisions about changes in the official interest rate on its forecast for inflation.

A further practical consideration is that fiscal policy is harder to tighten politically. Politically, it's easy to loosen fiscal policy. The public never objects to increased government spending or to cuts in taxes. But when the time comes to tighten fiscal policy, there is always much objection to cuts in particular spending programs or to increases in particular taxes. Though an increase in interest rates is never popular, it’s easier to achieve politically than spending cuts or tax increases.

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