Why fiscal policy may be making a comeback

For four decades, fiscal policy has been the poor relation among the tools available for countries to use to stabilise demand as their economies move through the ups and downs of the business cycle. Monetary policy has been the preferred instrument. But this may be about to change.

Monetary policy refers to the central bank's manipulation of interest rates, whereas fiscal policy refers to the government's manipulation of taxation and government spending in the budget.

Of course, in those four decades fiscal policy hasn't been completely friendless. In times of recession, politicians have almost always resorted to budgetary stimulus, sometimes against the advice of their econocrats.

In the policy response to the global financial crisis in late 2008, aimed at preventing it turning into a worldwide depression to rival the depression of the 1930s, there was an instinctive resort to budget spending in addition to the sharp easing of monetary policy.

The fiscal response was partly because the North Atlantic economies needed to lend money to their banks, but also because demand needed bolstering at a time when households and businesses, conscious of their high levels of debt and the diminished value of their assets, were in no mood to spend no matter how low interest rates were.

Urged on by the International Monetary Fund, all the major economies engaged in huge fiscal stimulus at the same time. This succeeded in averting depression and getting their economies on a path to recovery.

But by then the North Atlantic economies had high levels of public debt, and the ideological opponents of fiscal activism fought back, persuading Britain and the rest of Europe to abandon fiscal stimulus and instead cut government spending and raise taxes, even while their economies were still very weak.

Unsurprisingly, the result was to prolong their recessions and force them to resort to ever more unorthodox ways of trying to stimulate their economies with monetary policy.

In this column last Saturday we saw Dr Philip Lowe, deputy governor of the Reserve Bank, accepting that monetary policy had become a lot less effective around the developed world, but arguing this would cease to be so after the major advanced economies had finally shaken off the Great Recession in about a decade's time.

But a leading American economist, Professor Lawrence Summers, of Harvard, a former US Treasury secretary, argues that monetary policy's reduced effectiveness could last for the next quarter of a century.

This is because he sees world interest rates staying very low for at least that period. In all the recessions since World War II, the US Federal Reserve has had to cut its official interest rate by an average of 4 percentage points to get the economy moving again.

If interest rates stay low, the Fed (and other central banks) won't have room to cut the official rate to the necessary extent before hitting the "zero lower bound". This will make economic managers more dependent on fiscal policy to provide stimulus.

Why does he expect interest rates to stay low for so long? Because, at base, interest rates are the price that brings the supply of saving into balance with the demand for funds for investment.

And, in the developed economies, Summers sees less investment occurring because of weak or falling population growth, because capital equipment gets ever cheaper and possibly because of slower technological advance.

On the other hand, he sees higher rates of saving because more of the growth in income will be captured by high-income earners, with their higher propensity to save.

So if the supply of saving increases while the demand for funds decreases, real interest rates will be very low, even after all the quantitative easing (money creation) is unwound. Continuing low inflation will keep nominal interest rates low.

Summers argues that, over the decades, the popularity of fiscal policy has fluctuated with economists' changing views about the size of the fiscal "multiplier" – the size of the increase in national income brought about by a discretionary increase in government spending.

The latest view, coming from the IMF, is that the fiscal multipliers are much higher than previously believed (particularly for spending on infrastructure, less so for tax cuts). This is mainly because the reduced effectiveness of monetary policy has caused a change in central banks' "policy reaction function".

Whereas in earlier times the central bank would have increased interest rates if it feared fiscal stimulus threatened to worsen inflation (thereby reducing the fiscal multiplier), these days the central bank would be less worried about inflation and pleased to see fiscal policy helping it get the economy growing at an acceptable pace.

But Summers has another point. Lasting low real interest rates not only make monetary policy less effective and fiscal policy more effective, they also mean that lower debt servicing costs allow governments to carry more public debt.

His oversimplified calculation is that if the interest rate on public borrowing halves from 2 per cent to 1 per cent, a government can now carry twice as much debt for the same interest bill.

Let's put this interesting discussion into an immediate, Australian context. We know from the latest national accounts that, at a time when the economy's growth is too weak to stop unemployment continuing to creep up, public sector spending is acting as a drag.

This isn't because of federal government cuts in recurrent spending, but because the states have allowed their annual capital works programs to fall back at a time when private construction activity is falling through the floor and yields (interest rates) on government bonds are the lowest in living memory.

If the Feds had any sense they'd be borrowing big for well-chosen infrastructure projects, thereby reducing the pressure on the Reserve Bank to keep cutting interest rates and risking a house price bubble. The Reserve would love a bit of help from fiscal policy.

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Why monetary policy stimulus is less effective

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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More infrastructure spending would boost economy

It's good to see Joe Hockey finally making the transition to government and joining the economic optimists' party. This week he greeted the national accounts by saying the economy had grown by "a solid 0.5 per cent in the December quarter to be 2.5 per cent higher over the past year".

"Our income as a nation picked up in the quarter, with nominal gross domestic product rising by a solid 0.6 per cent," he continued. "Real gross national income also rose in the quarter."

A treasurer should never talk the economy down, just as the official forecasters should never be the first to predict imminent recession. Such negativity tends to be self-fulfilling.

So I'm sorry to rain on Hockey's parade by telling you that "solid" growth is the econocrats' euphemism for "not so hot".

Just so. Annual growth of 2.5 per cent is well below our trend (average) rate of 3 per cent, especially disappointing when you remember we've been well below trend for quite a few years.

But though the figures from the Bureau of Statistics were unsatisfactory, they don't support the earlier fears of some that the economy fell apart in the previous quarter. A sensible reading is that the economy continues to plug along at the rate of about 2.5 per cent a year.

This, of course, is insufficient to stop unemployment rising. But for some years the rate of worsening has been steady at about 0.1 percentage points a quarter – which fits with reasonably steady growth in real GDP of about 2.5 per cent a year.

One encouraging sign in the accounts is that consumer spending grew by 0.9 per cent in the quarter and 2.8 per cent over the year. This isn't too bad when you consider that, with weak growth in employment and wages, real household income is growing at an annual rate of only about 1 per cent, according to calculations by Kieran Davies of Barclays bank.

Clearly, households must be reducing their rate of saving. Over the past year it's edged down by about 1 percentage point to a still-high 9 per cent of household disposable income. From now on consumer spending should be boosted by the fall in petrol prices.

Another bright spot is home building, which grew by 2.5 per cent in the quarter and by more than 8 per cent over the year. This is one area where the Reserve Bank's exceptionally low interest rates are really working, with building approvals reaching an all-time high in January.

It's likely all the real estate activity is helping to boost consumer spending on durables. There's nothing like changing houses to make you think you need a new lounge suite.

The weakest part of the accounts was business investment spending, which fell by almost 1 per cent in the quarter. Within this, and according to Davies' figuring, mining investment fell by 5 per cent while non-mining investment grew by only 2 per cent.

This is where we need the economy to be making the transition from the mining investment boom to non-mining-led growth. It's happening, but not fast enough to get the economy heading back towards trend growth.

That's why the Reserve has reverted to cutting interest rates. Not so much because the economy was slowing as because it wasn't picking up the way it had expected. And it's early days yet: mining investment fell by about 13 per cent last year, it's expected to fall by about that much again this year and by a lesser amount in 2016.

Arithmetically, the big saviour was the rising volume of exports, up 1 per cent in the quarter and more than 7 per cent over the year. This was driven by mineral exports, of course.

Combine that with a 2.5 per cent fall in the volume of imports in the quarter and "net exports" (exports minus imports) contributed 0.7 percentage points to GDP growth in the quarter and 2 percentage points to growth over the year.

Why are imports falling? Mainly because less mining investment means fewer imports of heavy mining equipment, but also because the fall in the dollar seems to have discouraged imports of business services and Aussies from "importing" overseas holidays.

But I can't get too excited about the surge in mineral exports. Mining is so capital-intensive that far fewer jobs are created by higher mineral exports than you'd expect from a jump in other exports. If that's the best we've got going for us, it's not good enough.

One more point of interest: spending by the public sector rose by a mere 0.1 per cent in the quarter and actually fell by 1.1 per cent over year. So, no help from government spending in getting the economy moving.

But before you start muttering about "austerity" and blaming poor old Joe, note this: public consumption spending rose by 0.4 per cent in the quarter and by 2 per cent over the year, whereas public investment spending fell by 0.9 per cent in the quarter and by (an amazing) 11.9 per cent over the year.

The great bulk of spending on capital works – "infrastructure" if you prefer – is done by the state governments. So it seems that, between them, the state governments – unduly worried about retaining their high credit ratings – have been allowing their works programs to run down.

This at a time when so many mining construction projects are winding up and construction workers and other resources are becoming available. Sensible governments adjust their construction programs to fit with downturns in private sector activity and take advantage of lower construction costs, thereby doing themselves and the economy a favour.

With monetary policy (interest rates) now less effective in stimulating the economy, it would be better if fiscal policy (budgets) was doing more to help, not less.

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How cutting interest rates affects demand and inflation

Although many people have their doubts, the Reserve Bank cut interest rates last week believing it would help the economy grow faster and reduce unemployment. But how exactly is this meant to work?

Monetary economists believe interest rates affect the strength of demand (spending) in the economy via several "channels" or mechanisms. Eventually the effect on demand affects the degree of pressure for higher prices.

As we work through these channels we'll see why some people didn't want interest rates to be cut further, why some believe monetary policy (the manipulation of interest rates) is at a point where it's less effective and why others (such as me) believe the further cut risks fuelling a house-price bubble.

The first channel goes by the fancy name of the "inter-temporal substitution" effect. Inter-temporal means "between time periods" and it's making the point that the rate of interest is the opportunity cost of choosing to spend now rather than later.

If you want to buy a car but don't have the money to pay for it, the cost of buying it now rather than waiting until you've saved the money is the interest you pay on the loan. But even if you already have the money in the bank to buy the car, the opportunity cost of buying it now rather than later is the bank interest you forgo by taking your money out.

So when the Reserve brings about a fall in interest rates it's hoping the lower cost of borrowing (or the lower opportunity cost of reducing the money in your bank account) will encourage households and businesses to bring forward their spending on consumer durables and assets from a future period to the present period. This is inter-temporal substitution.

The next channel is the cash flow effect. In principle, cutting interest rates reduces monthly mortgage payments, leaving people with more cash to spend on other things. Equally, the lower repayments make it easier for would-be home buyers to go ahead.

Remember, however, that although almost all businesses have debts, only about a third of households have mortgages. Roughly a third have paid off their homes, leaving about a third renting.

This suggests that about two-thirds of households are "net lenders" (they have more money in bank accounts and the like than they owe on credit cards and personal loans), leaving only a third of households as "net borrowers".

But as any retiree will unhappily remind you, a fall in interest rates might be good news for borrowers, but it's bad news for lenders. So about two-thirds of households (including oldies and young people saving for a house deposit) will be left with less cash to spend on goods and services.

It's true, however, that the remaining third of households gain more overall than the two-thirds lose, because the amount they owe exceeds the amount the two-thirds have in bank accounts and securities.

This is why you'd expect the cash flow channel to be a further mechanism that, in net terms, was encouraging spending and growth. Trouble is, a high proportion of people with home loans leave their monthly mortgage payments unchanged despite the fall in rates. That is, they don't spend their saving in interest, they save it.

A third channel by which a cut in interest rates should hasten economic growth is the exchange rate effect. When our interest rates fall relative to other countries' rates - thus reducing our "interest rate differential" - this should make bringing foreign funds into Australia less attractive and so reduce the demand for Aussie dollars, causing it to fall relative to other currencies.

A lower dollar makes Australian businesses more price competitive by making our exports cheaper to foreigners and imports dearer to Australians. This should encourage greater Australian production of goods and services, increasing employment.

It's a nice, neat chain of logic but, as the Reserve notes in its description of the monetary channels on its website, they are "far from mechanical in their operation". Lots of other factors affect our exchange rate beside the interest differential.

There's a strong, but far from automatic, correlation between our dollar and the prices we get for our commodity exports. Our exchange rate is also affected by the things our trading partners do in their economies, such as manipulating their exchange rate by engaging in "quantitative easing".

Don't forget, our dollar was falling during the 18 months that our interest rates were unchanged.

Even so, my guess is that trying to keep the Aussie's recent downward momentum going was a big part of the Reserve's reason for cutting rates last week. It knows forex markets are affected by speculation and bandwagon effects that don't get much coverage in textbooks.

Another part of the channels story is that cutting the return on safe financial investments such as bank accounts has the effect of encouraging individuals and businesses to seek higher returns by buying riskier assets. Retirees move from bank term deposits to shares, while some households respond to lower interest rates by buying negatively geared investment properties.

Lower rates lead to more borrowing to buy houses, which pushes up house prices. Rising house prices encourage more people to buy, particularly investors seeking capital gain. If you're not careful this becomes a house price bubble that inevitably ends in tears.

Left out of the standard story about the channels through which lower interest rates cause faster growth is that the era of greater reliance on monetary policy has also been the era of credit-fuelled asset price booms and busts. As witness, the global financial crisis.

Why did the Reserve wait 18 months before cutting interest rates to a new low? Because it knows it's running a high risk of sparking a housing boom and bust. But with the economy now so weak, it felt it had no choice.

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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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Treasury boss's parting advice is daunting

One of Tony Abbott's first acts on becoming Prime Minister was to sack the secretary to the Treasury, Dr Martin Parkinson. Parkinson's crime was to believe - as did the government he had been serving - that we need to take effective action against climate change.

Abbott also sacked Parkinson's obvious successor at Treasury, Blair Comley, for the same crime. It was a disgraceful, vindictive way to treat loyal and proficient public servants.

But Parko's departure from Treasury was delayed, first so he could help the new government prepare its first budget and then because his experience was sorely needed to help Abbott and Joe Hockey prepare to chair the G20 meeting this month.

But the time for his departure has finally arrived and this week he gave one of the last of many speeches during his distinguished career. It was a tour of the short-term and longer-term challenges and opportunities that lie ahead. He professed to be very optimistic about our prospects, but I found his remarks pretty daunting.

Starting with the rest of the world, Parkinson observed that, even this far on, the big, developed economies' recovery from the global financial crisis was slow and uneven. Forecasts for global growth next year had been downgraded again, to 3.75 per cent, following a pattern that had become familiar over the past few years, he said.

"We now have a situation where 200 million people around the world are looking for work. As the International Monetary Fund's Christine Lagarde noted, if the unemployed formed their own country, it would be the fifth-largest in the world."

The financial crisis led to rapid accumulation of public debt, and governments in many countries had neither the political support nor market tolerance to use deficit spending to stimulate their economies, he said.

In normal times, countries might use monetary policy to offset fiscal tightening, supporting demand by cutting interest rates and boosting economic activity by having their exchange rates fall. But many countries already had their interest rates at zero.

So their efforts to cut spending and raise taxes while their economies are still so weak - known as a policy of austerity - ran the risk of weakening demand further and making the budget deficit bigger.

Many countries had resorted to "quantitative easing" - metaphorically, printing money - to offset the budgetary tightening. Trouble was, we are yet to see the massive increase in funding this has generated translate into growth-inducing investment, he said. It was leading to too much financial risk-taking (buying high-priced shares and bonds) but not much economic risk-taking (increasing production capacity).

This was why our move to get each of the G20 members to agree to take measures that would cause their growth over the next five years to end up 2 per cent higher than otherwise, particularly by increased investment in infrastructure, made so much sense.

In the short-term construction phase, it adds to aggregate demand. If it's done well, it adds to the economy's supply capacity and boosts productivity for the long term. And if you price access to the infrastructure properly, it might even help the budget in the medium term.

Turning to our economy, the short-term outlook was dominated by our transition from resources investment-led growth and risks associated with continued weakness in the global economy and the potential for renewed financial instability, he said.

But our transition to broader sources of growth was occurring more slowly than we might have expected. In particular, the dollar hadn't fallen as much as expected, considering how far commodity prices had fallen, so the boost to the non-mining economy hadn't been as great as hoped.

The limited fall in the dollar was explained by the big countries' quantitative easing, which was pushing their currencies down relative to ours.

Our consumers were also cautious in their spending and businesses seemed unwilling to invest until they saw consumer spending picking up. It was looking likely the economy would have grown below trend for seven of the eight years to 2015-16.

The long-delayed return to healthy growth created a risk that cyclical (temporary) unemployment turns into structural (lasting) unemployment. However, working the other way was our moderate growth in wages, which was a sign that the labour market was adjusting flexibly, even though it was also likely to be limiting consumer spending.

Turning to our longer-term challenges and opportunities, our big opportunity arose from the shift in the centre of global economic growth to Asia. By 2050, four of the five largest economies in the world would be in our region: China, India, Japan and Indonesia.

In this decade, the number of Asian middle-class consumers would equal the number in Europe and North America. These people would increase their demand for a wide range of goods and services that we could help supply.

But if we were to grasp these opportunities, we would need to work for them, and work hard, Parkinson said. There were no grounds for complacency.

We must use the opportunity provided by all the present reviews - of the tax system, the workplace relations system, the financial markets, competition policy and the functioning of our federation - to make decisions that improve our productivity growth and position ourselves to reap the most from our prospects.

Our other big problem was achieving a more sustainable fiscal position - getting the budget back to surplus. Australia had a "structural" budget problem - that is, one that wouldn't disappear once the economy had returned to normal growth - requiring a sustained and measured response, involving people giving up benefits.

It was important we start the process of repairing the budget now, he said. We had recorded 23 years of consecutive growth and the budget projections were based on an assumption that this would continue for another decade.

Such an outcome - 33 years of uninterrupted growth - would be without precedent. Get it? We're unlikely to be that lucky.

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No 'reform' could increase jobs in the short term

What do we need to do to get the economy growing properly again? Wait ... for at least a year.

The most recent figures from the Bureau of Statistics confirm the economy has grown at an average annual rate of only 2.5 per cent over the past two financial years. Since it needs to grow at its medium-term trend rate of about 3 per cent just to hold unemployment steady, the jobless rate has been rising slowly over that time.

With the authorities holding out little hope of much improvement before 2016, it is not surprising people are wondering what more we could be doing to get things moving. Some have noted the impending loss of jobs in car making and elsewhere, and are wondering where the new jobs will come from.

At such times there is never a shortage of people peddling solutions. A perennial favourite is "industry policy" - which usually starts as a plan to kick-start some wonderful new industry, but too often ends up using subsidies to prop up industries from which the market has moved away.

Business lobbies perpetually tell us tax reform that lightens the burden on business and high-income earners would do wonders for the economy. But though it is true the tax system could be made more efficient, it is unlikely such reform could make more than a small addition to growth, spread over many years.

While it is true the economy's growth is weak because it is taking us a few years to get things back to normal following the major change in the structure of our economy that left us with a much-expanded mining sector, our growth problem is cyclical - that is, temporary - rather than structural.

Abstracting from the ups and downs of the business cycle, there is nothing fundamentally wrong with the functioning of our economy. While, as always, there are plenty of bits whose efficiency could be improved, there is no reform that could make a big difference in a short time.

Some people imagine the economy grows only to the extent the government is doing things to push it along. It ain't true. What propels the economy, keeping the number of jobs increasing virtually every year, is the material aspirations of business people and households.

All the macro managers do is hold the economy back a bit when it's going too fast, or give it a bit of a shove when it is going too slow. In normal times, the main instrument they use to slow things down or speed 'em up is interest rates.

That is just what is being done now, as an assistant governor of the Reserve Bank, Dr Chris Kent, explained in a speech this week reviewing the state of the economy and its prospects.

He warned that "GDP growth is expected to be below trend for a time before gradually picking up to an above-trend rate by 2016", meaning "the unemployment rate is likely to remain elevated for some time".

Many people devote a lot of time to following the chequered fortunes of the big economies - the United States, Europe, Japan, China - and probably conclude their slow growth will weigh heavily on our own.

If that's you, Kent has news: if you take our major trading partners' growth and weight it according to their share of our exports, it turns out our customers' economies have been growing since 2010 at the relatively stable rate of about 4 per cent a year, close to the long-term average.

The Reserve expects them to continue growing at that rate over this year and next. How is this possible? Simple: over the 13 years to last year, the advanced economies' share of our exports has fallen from 40 per cent to 25 per cent, with the much faster-growing developing Asian economies taking their place.

So the main adverse effects on us from the rest of the world are our still-too-high exchange rate, which is harming the price competitiveness of our export and import-competing industries, and continuing falls in the prices we get for our commodity exports, which reduce our real income.

The other big factor we will have working to keep our growth inadequate is mining investment spending, which "is set to decline more rapidly in the coming year or so than it has since it peaked in mid-2012".

Most of the factors pushing the other way arise from the stimulus provided by our exceptionally low interest rates. These have already led to growth in home building and some uptick in related spending on consumer durables, particularly in NSW and Victoria.

Growth in consumer spending is being constrained by weak growth in household income because growth in employment is so slow and wages are rising so modestly.

Even so, the Reserve is expecting consumer spending to be boosted by a continuation of the modest fall in the rate of household saving we've already seen. If so, this would represent households seeking to smooth the growth in their consumption despite weak income growth, as well as the effect of the rise in share and, particularly, house prices making them feel wealthier.

A separate source of stimulus Kent expects to see is a further fall in our exchange rate. With the American economy's recovery now entrenched, US authorities have ended their "quantitative easing" (creating money) and are expected to start raising their official interest rate in the middle of next year.

Once financial markets are convinced that tightening is on the way, the greenback should appreciate and our dollar depreciate. This would reduce the pressure on our tradeables industries and eventually help produce the long-awaited lift in investment spending by the non-mining sector.

As far as the Reserve is concerned, it has already done what needs to be done to get the economy back to normal. It's sitting tight, waiting for its sweet medicine to work, and thinks we should, too.

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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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Interest rates to stay low, but lending curbs loom

With the Reserve Bank worried by fast-rising house prices, but the dollar coming down and the unemployment rate now said to be steady, can a rise in the official interest rate be far off? Yes it can.

On the face of it, last week's revised jobs figures have clarified the picture of how the economy is travelling. The national accounts for the March and June quarters show the economy growing at about its trend rate of 3 per cent over the previous year, which says unemployment should be steady.

And now the jobs figures are telling us the unemployment rate has been much steadier than we were previously told, at about 6 per cent.

If economic growth is back up at trend, we need only a little more acceleration to get unemployment falling. The Reserve is clearly uncomfortable about keeping interest rates at 50-year lows while rapidly rising house prices tempt an already heavily indebted household sector to add to its debt.

So, surely it's itching to remind us that rates can go up as well as down and, in the process, let some air out of any possible house-price bubble.

Well, in its dreams, perhaps, but not in life. Even if hindsight confirms the latest reading that the economy grew at about trend in 2013-14, the Reserve knows it can't last. Its central forecast of growth averaging just 2.5 per cent in the present financial year is looking safer, maybe even a little high.

The sad fact is that a host of factors are pointing to slower rather than faster growth in 2014-15, implying a resumption of slowly rising unemployment and no scope for even just one upward click in interest rates.

The biggest likely downer is the long-feared sharp fall in mining investment spending. To this you can add weak growth consumer spending, held back by weak growth in employment and unusually low wage rises.

Now add the point made by Saul Eslake, of Bank of America Merrill Lynch, that real income is growing a lot more slowly than production, thanks to mining commodity prices that have been falling since 2011.

Weak growth in income eventually leads to weaker growth in production, which, in turn, is the chief driver of employment. With the Chinese and European economies' prospects looking so poor, it's easy to see our export prices falling even faster than the authorities are forecasting.

Real gross domestic income actually fell in the June quarter, and Eslake sees it falling again in the September quarter.

Apart from the recovery in home building, pretty much the only plus factor going for the economy is the recent fall in the dollar, bringing relief to manufacturers, tourist operators and others.

But measured on the trade-weighted index, the Aussie is back down only to where it was in February, and since then export prices have fallen further, implying the exchange rate is still higher - and thus more contractionary - than it should be.

In other words, the usually strong correlation between the dollar and our terms of trade has yet to be restored. Why hasn't it been in evidence? Because our exchange rate is a relative price, affected not just by what's happening in Oz but also by what's happening in the economy of the country whose currency we're comparing ours with.

The Aussie has stayed too high relative to the greenback not because our interest rates have been too high relative to US rates, as some imagine, but because one of the chief effects of all the Americans' "quantitative easing" has been to push their exchange rate down.

As the US economy strengthens and the end of quantitative easing draws near - and, after that, rises in their official interest rate loom - the greenback has begun going back up. The prospects of it going up a lot further in coming months are good.

That's something to look forward to. But our exchange rate would have to fall a long way before it caused the Reserve to reconsider its judgment that "the most prudent course is likely to be a period of stability in interest rates".

But that still leaves the real risk of low rates fostering further rises in house prices, particularly in Sydney and Melbourne.

What to do? Resort to a tightening of "macro-prudential" direct controls over lending for housing. The restrictions may be announced soon, be aimed at lending for investment and even limited to borrowers in the two cities.

But though they'd come at the urging of the Reserve, they'd be imposed by the outfit that now has that power, the Australian Prudential Regulation Authority.

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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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We've handled the resources boom surprisingly well

Are we in for big trouble in the aftermath of a misspent resources boom, or has the boom been over-hyped, leaving us in good shape to face the future?

This is a matter of debate among some of Australia's most prominent economists. Professor Ross Garnaut, of the University of Melbourne, advanced the former argument last year in his book Dog Days: Australia After the Boom, and Dr John Edwards, a fellow of the Lowy Institute and member of the Reserve Bank board, makes the counter-argument in his new book, Beyond the Boom.

This week Dr David Gruen, of Treasury, weighed into the argument in a speech written with help from Rhett Wilcox. Gruen took a middle position, agreeing with each man on some points and disagreeing on others. Appropriately, he was speaking at the annual conference of economists in Hobart. They enjoy that kind of thing.

Gruen strongly disagrees with Edwards' claim that the resources boom "hasn't been as important for Australian prosperity as widely believed", saying the boom was "one of the largest changes in the structure of our economy in modern times" which "generated the largest sustained rise of Australia's terms of trade ever seen".

"The result was that resources investment increased from less than 2 per cent of gross domestic product pre-boom to around 7.5 per cent in 2012-13, an increase, in dollar terms, from around $14 billion to more than $100 billion a year," he says. "This has seen an additional 180,000 workers employed in the resources sector since the boom began and will see the capital stock in the resources sector almost quadruple by 2015-16."

But Gruen disagrees with Garnaut's implication that the economy was not well managed during the boom. He notes that all previous commodity booms - including the rural commodity boom of the early 1970s - led to blowouts in wages and inflation, followed by recessions after the boom busted.

This time, however, wages have been well controlled and the rise in prices has rarely strayed far from the Reserve Bank's 2 per cent to 3 per cent target range. The boom in the resources sector has not led to excessive growth in the economy overall. Real GDP growth averaged 3 per cent a year over the decade to 2012.

Edwards supported his claim that the resources boom has not been as important for our prosperity as commonly believed by comparing this 3 per cent growth rate unfavourably with the 3.8 per cent annual rate achieved over the decade to 2002.

But Gruen counters by noting the earlier decade "saw above-trend growth as the economy recovered from the deep early-1990s recession, with unemployment falling from above 10.5 per cent to below 6 per cent over the course of that decade".

So why has the upside of the resources boom been handled so much better than in earlier commodity booms? Gruen gives much of the credit to three micro-economic reforms: the floating of the dollar in 1983, the move to letting the Reserve Bank set monetary policy (interest rates) independent of the elected government, formalised by Peter Costello in 1996, and the decentralisation of wage-fixing, largely completed by the Keating government before 1996.

(This to me is a point worth noting: the greatest continuing benefit from the era of micro reform - but also from the move to set formal "frameworks" for conducting the two arms of macro-economic policy - is a much more flexible economy, one that is less inflation-prone and less unemployment-prone. By the way, Garnaut and Edwards can take their share of credit for these reforms.)

Next Gruen rebuts Garnaut's argument that the income the nation earned from the boom was misspent.

Garnaut might have in mind the Howard government's decision to respond to the temporary increase in collections from company tax and capital gains by cutting income tax for eight years in a row, a move that does much to explain the trouble we are having getting the budget back into surplus.

But there is more to the economy than what the feds do with their budget. And Gruen points out that, over the decade to March 2014, national consumption spending (by households and governments) actually declined from about 76 per cent of GDP to 73 per cent. If so, the nation's saving must have increased by 3 percentage points of its income (remember: income equals consumption plus saving).

Against that, over the same period bar the last few quarters, national investment has been high and rising, relative to income. "Rather than the income gains from the boom having been consumed, it would be more accurate to conclude that they were invested," Gruen says - a point Edwards also made.

(Had the nation been "living beyond its means", that would show up as a widening in the current account deficit. Instead, the deficit has been narrower in recent years.)

But what about the downside of the boom? Will the bust result in a period of contraction for the economy as a whole? Gruen's answer is "so far, so good", but he concedes that, over the next three or four years, investment spending by the miners is expected to fall from about 7 per cent of GDP to about 2 per cent or 3 per cent, a subtraction from growth of about 2 per cent to 2.5 percentage points (remembering that about half of mining investment is in imported equipment).

Remember, too, that mining production and export volumes will be growing strongly. Even so, avoiding recession will require a further significant fall in the dollar.

Gruen agrees with Garnaut that for the economy to benefit from such a "nominal" depreciation in the currency, it will need to be translated into a "real" depreciation by only moderate wage growth. But this could be achieved provided real wages grow by less than the growth in labour productivity.

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