Showing posts with label microeconomics. Show all posts
Showing posts with label microeconomics. Show all posts

Monday, April 1, 2024

When funding healthcare, don't forget the caring bit

 It’s Easter, and we’ve got the day off. So let’s think about something different. As a community, we spend a fortune each year on health, mainly through governments. What has economics got to tell us about healthcare? And, since it’s Easter, what light has Christianity got to shed on how we fund healthcare?

One man who’s thought deeply on these questions is Dr Stephen Duckett, Australia’s leading health economist, whose career has included academia, running government health departments, and the Grattan Institute think tank. He’s now back in academia, at the University of Melbourne.

Duckett has long been a lay reader in the Anglican Church. He’s recently completed a doctorate in theology, awarded by the Archbishop of Canterbury. He’s turned his thesis into a book, Healthcare Funding and Christian Ethics, published by Cambridge University Press.

One way to run a hospital is to let the doctors and nurses do as they see fit until the money runs out but, for several decades, health economists’ advice has reshaped the health system, helping to ensure that the money available is spent in ways that do the most good to patients.

One definition of economics is that it’s the study of scarcity. We have infinite wants, but limited resources of land, labour and physical capital to achieve those wants. So we must carefully weigh the costs and benefits of the many things we’d like, so we end up choosing the particular combination of things that yields us the greatest “utility” (benefit) available.

Since there’s never enough money to spend on healthcare, hard decisions have to be made about what can be done and what can’t, what drugs should be subsidised and what can’t, who should be helped and who turned away.

Health economists analyse the cost-effectiveness of the various options to help governments and hospitals make their choices, working out the number of “quality-adjusted life years” each option would add.

The Scotsman called the father of modern economics, Adam Smith, saw it as a moral science but, as economists have striven to be more “rigorous” (which mainly means more mathematical) this touchy-feely stuff has fallen away.

Most economists see economics as amoral, that is, neither moral nor immoral; having nothing to say about moral issues. When it comes to means and ends, economists see themselves as sticking to means.

They’re saying: tell me what you want to do, and I’ll tell you the best way to achieve it. That’s what they say; it’s not always what they do.

Economics is based on utilitarianism: seeking the greatest good for the greatest number. But this ignores the question of “equity”: how fairly the benefits are shared. Are some getting a lot while others miss out?

Duckett says: “Economics’ assumption that humans are simply individual units, de-emphasising community, and [economics’] ubiquitous use in policymaking, comes at a cost, as Homo economicus [the self-interested, rational calculator that economists assume us to be] crowds out other manifestations of what it is to be human.”

Economists often say they have no expertise on equity and the community, so they leave that to others – such as the politicians. Economists often claim that economics is “objective” and “value-free”.

But Duckett says it’s not simple. By ignoring issues you’re implying that they don’t matter. And you’re making implicit assumptions that are value-laden.

For instance, if a cost-effectiveness study does not explicitly highlight the distribution of costs and benefits [how unequally they are shared between people], it is implicitly conveying the message that the distribution is not a relevant issue.

If nursing home funding allows money ostensibly allocated for care to be leached out as extra returns to the owners, then quality is assumed to be not a concern of those doing the funding.

If a system design places a higher monetary reward on cosmetic surgery intended solely to improve appearance compared to the monetary reward for caring for older patients and people with mental illness, this sends a signal about the value placed on care for the marginalised.

Duckett says that, because decisions about public policy inherently involve value choices, health economics becomes a “moral science” whether economists like it or not. What’s true, however, is that economics is not well-equipped to determine issues such as what should be society’s priorities, what value should be place on unfettered choice, and the value to place on ensuring no one is left behind.

This is where Christian ethics has a contribution to make, a contribution that, except on matters of sexual morality, doesn’t differ much from the views of the aggressively secular philosopher Professor Peter Singer and, no doubt, many other Western ethicists.

Duckett offers a “theology of healthcare funding” based on Christ’s parable of the Good Samaritan. As I hope you remember, a man was travelling to Jericho when he was set upon by robbers, who left him naked and bleeding by the road.

Two separate religious figures passed by him on the road without stopping to help. But a Samaritan saw him and “was moved with pity”. He bandaged his wounds, put him on his donkey and took him to an inn, where he paid the innkeeper in advance to look after him, promising to come back and pay for any extra expense.

From this parable Duckett derives three principles that should guide health economists in the advice they give on healthcare funding.

The three are: compassion (shown by the behaviour of the Samaritan), social justice (everyone included and treated equally; shown by the identity of the Samaritan, a race despised by the Jews) and stewardship (shown by the innkeeper, who was trusted to care for the traveller and to spend the Samaritan’s money wisely).

Compassion must involve feeling leading to doing. It must involve helping people other than yourself. So health economics must be less impersonal, remembering the flesh and blood behind the statistics and calculations. Any funding arrangement must allow time for workers to care for patients in a compassionate way.

The Christian ethic is that social justice is not simply about fairness for atomised individuals, but also the person as part of a community, something economists tend to forget. Archbishop Desmond Tutu has said “a person is a person through other people . . . I am human because I belong. I participate, I share.”

“Christian contributions to the public square need to challenge policy ‘solutions’ that rely on individuals pulling themselves up by their own bootstraps, victim-blaming approaches, and a narrow definition of [who is my] ‘neighbour’,” Duckett says.

As for stewardship, it’s the easy bit. It’s the Christian word for what economists already know about: making sure that other people’s money is spent carefully, and their property is looked after. It’s being efficient.

But the Christian contribution to what health economists do is to make sure stewardship is kept in tension with the other two principles. “Austerity does not mean that compassion and social justice can be ignored, or distributional consequences [for the rich and the poor] can be erased from consideration.


Monday, February 6, 2023

Want a better economy? Design better policies, don't just pick sides

A wise person has said that our brains love to make either-or choices. Which is why it’s wise not to waste much energy on the concocted furore over Treasurer Jim Chalmers’ 6000-word essay musing on future economic policy.

The world is a complicated place, and so are the choices we make about what we need to do get an economy that improves the lives of the humans who constitute it, including those at the bottom, not just the top.

But our brains look for ways to simplify the many choices we face. The simplest choice is binary: between A and B, black or white, good or bad. This fits with our tribal instincts. My tribe versus the rest, us and them, the good guys versus the bad guys.

Our two-party political system has been built to keep things simple. And thus, to minimise the need for hard thinking. Many people don’t have time to decide what they think about this policy or that, so they pick a political party and outsource their thinking to it.

“Am I for it or against it? Tell me what my party’s saying, and I’ll know what I think.” There’s plenty of survey evidence that people who voted for the government – any government – are more inclined to think the economy’s going well, whereas those who voted for the other side think it’s going badly.

Too much of the outrage over Chalmers and his essay has come from media outlets whose business plan is to pander to the prejudices of a particular “market segment”.

Economists like to think of themselves as rational and objective, but economics and economy policy are highly susceptible to binary choices, and fads and fashions.

All I’ve seen over the years has made me a believer in the pendulum theory of history: we tend to swing from one extreme to the other. After World War II, people – particularly in Britain and Europe - were very aware of the failings of the private sector, so they decided to nationalise many industries.

By the time Maggie Thatcher and Ronald Reagan arrived, people had become very aware of the failings of government-owned businesses. So they decided to privatise many industries.

The big binary issue in economic policy is broader than privatisation, it’s government intervention in markets. Should governments intervene as little as possible, or as much as is necessary? To put it in the comic book terms beloved by Chalmers’ partisan critics: we face a choice between the free market or socialism.

Except that we don’t. My point is that the truth – and the ideal place to be – is unlikely to be found at one extreme or the other. It’s much more likely be somewhere in the middle.

To me, this is what economics teaches. It’s why economists say we should make decisions “at the margin” and are obsessed by finding the best “trade-off” between our conflicting objectives.

We want to be free to do as we choose, but we also want to be protected from instability (high inflation and high unemployment) and unfair treatment in its many forms.

The period of deregulation and privatisation instigated by the Hawke-Keating government in the mid-1980s, known locally as “micro-economic reform” motivated by “economic rationalism”, eventually degenerated into a belief in public bad/private good under subsequent governments, and was dubbed “neoliberalism” by leftie academics.

While the inclination to favour business and sell off government businesses remained under the former Coalition federal government, it had no commitment to minimising government intervention. Its willingness to impose its wishes on electricity and gas producers, for instance, was often on display.

And while the big reforms undertaken in the name of economic rationalism – floating the dollar, deregulating the banks, ending import protection, and introducing national competition policy – have served us well, many of the privatisations and efforts to outsource provision of government services have not.

In 2023, we’re left somewhere between the two extremes, with an economy that’s not working nearly as well as we need it to. Chalmers and Labor’s other ministers will have to intervene – but do so in ways they’re reasonably sure will make matters better rather than worse.

That’s the hard part, and their econocrat advisers aren’t nearly as well-equipped as they should be to tell them “what works and what doesn’t”.

Why not? Because we’ve done far too little hard thinking about the problems, preferring to take refuge in the happy delusion that the answer lies at one extreme or the other.


Friday, November 11, 2022

Treasury thinks the unthinkable: yes, intervene in the gas market

If you think economists say crazy things, you’re not alone. Speaking about our soaring cost of living this week, Treasury Secretary Dr Steven Kennedy told a Senate committee that “the solution to high prices is high prices”. But then he said this didn’t apply to the prices of coal and gas.

How could anyone smart enough to get a PhD say such nonsense? He even said – in a speech actually read out by one of his deputies – that this piece of crazy-speak was something economists were “fond of saying”.

It’s true, they are. If they were children, we’d call it attention-seeking behaviour. But when you unpick their little riddle, you learn a lot about why economists are in love with markets and “market forces”, why they’re always banging on about supply and demand, and why (as I’ve said once or twice before) if economists wore T-shirts, what they’d say is “Prices make the world go round”.

At the heart of conventional economics – aka the “neo-classical model” – lies the “price mechanism”. Understand this, and you understand why the thinking of early economists such as Adam Smith and Alfred Marshall is still influential a century or two after their death, and why, of all the people seeking the ears of our politicians, economists get more notice taken of their advice than other professions do.

The secret sauce economists sell is their understanding of how a lot of seemingly big problems go away if you just give the price mechanism time to solve them.

A market is a place or a shop or cyberspace where people come to sell things to other people. The sellers are supplying the item; the buyers are demanding it. The seller sets the price; the buyer accepts it – or sometimes they haggle or hold an auction.

If the price of some item rises, this draws a response from the price mechanism, which is driven by market forces – the interaction of supply on one side and demand on the other.

The price rise sends a signal to buyers and a signal to sellers. The message buyers get is: this stuff’s more expensive, so make sure you’re not wasting any of it.

And see if you can find a substitute for it that’s almost as good but doesn’t cost as much. If you’ve been buying the deluxe, big-brand version, try the house brand.

On the other side, the message to sellers is: since people are paying more for this stuff, produce more of it. “I’m not in this business, but maybe now the price is higher, I should be.” If the price has risen because the firm’s costs have risen, maybe we could find a way to cut those costs, not put our price up and so pinch customers from our competitors.

See where this is going? If customers react to the higher price by buying less, while sellers react by producing more, what’s likely to happen to the price?

If demand for the item falls, and the supply of the item increases, the higher price should come back down.

Saying the solution to high prices is high prices is a tricky way of saying market forces will react to the price rise in a way that, after a while, brings it back down again.

When demand and supply get out of balance, market forces adjust the price up or down until demand and supply are back in balance. The price mechanism has fixed the problem, returning the market to “equilibrium”.

This is the origin of the old economists’ motto: laissez-faire. Leave things alone. Don’t interfere. Interfering with the mechanism will stop it working properly and probably make things worse rather than better.

There’s a huge degree of truth to this simple analysis. At this moment there are thousands of firms and millions of consumers reacting to price changes in the way I’ve just described.

Kennedy admits that “there are many conditions that underpin” this do-nothing policy, but “in most circumstances Treasury would support such an approach”.

There certainly are many simplifying assumptions behind that oversimplified theory. It assumes all buyers and sellers are so small they have no power by themselves to influence the price.

It assumes all buyers and all sellers know all they need to know about the characteristics of the product and the prices at which it’s available. It assumes competition in the market is fierce. And that’s just for openers.

However, Kennedy said, the circumstances of the price shocks caused by the Ukraine war are “different and outside the frame” of Treasury’s usual approach. Such shocks bring government intervention in the coal and gas markets “into scope”. That is, just do it.

“The current gas and thermal coal price increases are leading to unusually high prices and profits for some companies,” he said. “Prices and profits well beyond the usual bounds of investment and profit cycles.

“The same price increases are leading to a reduction in the real incomes of many people, with the most severely affected being lower-income working households.

“The energy price increases are also significantly reducing the profits of many [energy-using] businesses and raising questions about their viability.”

In summary, Kennedy said, the effects of the Ukraine war are leading to a redistribution of income and wealth, and disrupting markets. “The national-interest case for this redistribution is weak, and it is not likely to lead to a more efficient allocation of resources in the longer term,” he said.

(The efficient allocation of resources – land, labour and capital – is the main reason economists usually oppose government intervention in the price mechanism. Markets usually allocate resources most efficiently.)

The government’s policy response to the problem could take many forms, Kennedy said, but with inflation already so high, policymakers “need to be mindful of not contributing further to inflation”.

This suggests that intervening to directly reduce coal and gas prices is more likely to be the best way to go, he concluded.


Friday, August 24, 2012

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.

Tuesday, June 5, 2012


Talk to UBS Economics Lecture Day, Sydney, Tuesday, June 5, 2012

When you’re a manager of the Australian economy - when you’re the governor of the Reserve Bank in charge of monetary policy, or the federal Treasurer, in charge of fiscal policy - there’s always some problem you’re having to cope with. When the economy’s in recession, or growing only weakly, you probably don’t have a problem with inflation, but you are very worried about high unemployment and how you can get it down. When the economy’s growing strongly, you probably don’t have a problem with high unemployment, but you are worried about a build up in inflation pressure and what you have to do to keep inflation under control.

Economic report card

So what’s the big problem for the economic managers at present? Well, as you’ve been hearing, if you look overseas at the world economy, you find plenty. But I’m going to focus on our economy, and if you’d just arrived here from Mars and took a quick look, you might think it all looks pretty good. In last month’s budget, Wayne Swan forecast growth in real GDP in the coming financial year, 2012-13, of 3.25 per cent - which is right on the economy’s ‘trend’ rate of growth (its longer-term average rate, which is also its ideal cruising speed, so to speak). The latest figures say underlying inflation is running at 2.2 pc - almost down to the bottom of the RBA’s 2 to 3 pc inflation target. The latest figures say unemployment is running at about 5 pc - which economists say is down very close to our NAIRU - the non-accelerating-inflation rate of unemployment, which is the lowest point to which unemployment can fall before labour shortages start causing wage and price inflation. That is, unemployment is very close to its lowest sustainable rate. Even if you look at the latest figures for the current account deficit, you find it’s down at 2.3 pc of GDP, compared with its trend rate of about 4.5 pc.

The resources boom and its high dollar

So our Martian concludes everything in the Australian economy is going surprisingly well, and the economic managers don’t have any kind of problem at present. But they - and you and I - know better. The economic managers have, in fact, got plenty to worry about. Why? Because our economy is being hit by two major, but conflicting economic shocks: the expansionary effect of our exceptionally favourable terms of trade and the mining construction boom, and the contractionary effect of the accompanying high exchange rate.

The problem facing the economic managers at present is to ensure the net effect of those two conflicting forces continues to leave the economy growing at trend, with inflation within the target zone and unemployment neither much lower nor much higher than is now. For most of last year, the RBA’s biggest worry was that the economy would grow too strongly and inflation pressure would start to build. But that didn’t happen - partly because worries about what’s happening in the rest of the world dampened the confidence of consumers and businesses - and the economy didn’t grow as fast as forecast. Inflation is actually lower than expected, so now the RBA is focused on ensuring growth is fast enough to prevent much rise in unemployment.

The three-speed economy

Another way of saying the economy is not as problem-free as a Martian might think is to say, as so many people do, we have a two-speed economy: the part linked with mining is growing very strongly, while the part hit by the high dollar is growing only slowly. Similarly, the main mining states, Queensland and Western Australia, are in the fast lane, but the other states are in the slow lane. Actually, economic theory tells us it’s more accurate to think of the resources boom and the high dollar causing a three-speed economy. The third and middle lane is for the ‘non-tradeables sector’ - those mainly service industries that don’t export their product or compete against imports, so aren’t directly affected by the high dollar, but do benefit from their (and their customers’) access to cheaper imports. Industries and states in this middle lane won’t be growing as fast as the mining-related industries, but nor will they be as hard-hit as manufacturing and tourism.

The big problem: structural change

But perhaps the best way to think of it is that the problem facing the economy at present isn’t the usual cyclical problem - is the economy growing too fast or too slow? - but is more structural in nature. Economists argue that the exceptionally high prices we’re getting for our coal and iron ore exports and the huge investment we’re seeing in building new mines and liquid-gas facilities represents a long-lasting change in the rest of the world’s demand for our mineral (and rural) commodity exports. This necessitates change in the structure of our industries, with relatively more resources of labour and capital going to mining, and relatively fewer resources going to all other industries, but particularly manufacturing and service exports. Economists further argue that the high exchange rate is the market’s painful way of helping to bring about this structural change. They say that using government subsidies or other forms of protection to help our industries resist change reduces the efficiency with which the nation’s resources are allocated.

Retailing is another industry facing structural change as consumers shift their preferences from goods to services, and as the internet gives consumers access to overseas markets where retail prices are lower. This change is not related to the resources boom, but is related to the end of a long period when consumption grew faster than household income.

So the economic managers are having to manage the economy at a time when it is being hit by a lot of painful structural change. Let’s look at what they’re doing with the main economic instruments - or arms of policy - they use, starting with monetary policy, then moving to fiscal policy.

Monetary policy

Monetary policy is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Aware the unemployment rate was only a little above the NAIRU and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as the RBA had forecast. Instead, the outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by a further 0.5 point to 3.75 pc, more than offsetting the banks’ efforts to preserve their profit margins and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.

Macro bottom line

Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.

Microeconomic policy

The objective of microeconomic policy is to achieve faster economic growth and make the economy more flexible in its response to economic shocks. Whereas macroeconomic policy seeks to stabilise demand over the short term, microeconomic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. It does this mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 90s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.