Labor plans further blow to Treasury power

It's a process that's gone on for so long few people have noticed it: the waning influence of the once-mighty federal Treasury.

There was a time, 40 years ago, when Treasury sought to monopolise the economic advice going to the federal government. But those days are long gone.

The peak of Treasury's influence came with the sweeping micro-economic reforms and opening up of the economy in the 1980s and 1990s. It first convinced its minister, John Howard, of the need for widespread reform, but he made little progress under Malcolm Fraser.

Under a much more sympathetic Bob Hawke, Howard's successor as treasurer, Paul Keating, delivered on Treasury's reform agenda beyond its wildest dreams.

Since 2000, after Howard as prime minister won Treasury's 25-year battle to introduce a broad-based consumption tax, it's been largely downhill all the way on micro reform, with its loss of momentum, direction and purity of motive.

This is what's so significant about the Productivity Commission recently seizing the initiative to Shift the Dial and revive and redirect the reform agenda. Its "new policy model" could never have come from a tired and hidebound Treasury.

When Fraser sought to punish Treasury in 1976 by dividing it in two, Treasury and Finance, the initial judgment was that he'd succeeded only in doubling its vote in favour of budget rectitude at the cabinet table.

Forty years on, I now doubt that. Its bifurcation has diminished Treasury's effectiveness in the endlessly recurring task of "fiscal consolidation" (getting the budget deficit down) by robbing it of both the expertise and the motivation to find innovative, politically sustainable ways to limit the growth in government spending.

This trickier side of the budget has largely been left in the hands of the Finance accountants, whose vision rarely extends beyond this year's budget task, and who know more about creative accounting than the wider economic consequences of their crude spending cuts.

On the revenue side, Treasury shares the Business Council's unending obsession with tax reform. Why? To a surprising extent, for the simple, institutional reason that tax policy still lies within its own ministerial responsibility.

Treasury's become more inward looking and less concerned to oversee ("co-ordinate") the activities of other departments.

With one glaring exception. Treasury's greatest loss of influence came with the recognition of Reserve Bank independence in the mid-1990s.

From that time, the day-to-day management of the macro economy moved to the Reserve, with Treasury merely retaining a seat on the bank board and the ear of the treasurer.

Yet there's been great reluctance on Treasury's part to acknowledge this loss of power. It pretends nothing's changed, devoting far too many of its shrinking human resources to second-guessing the Reserve.

The Reserve devotes many resources to "liaison" (gathering businesses' views on the state of the economy), so Treasury must do it too.

The Reserve has an extensive forecasting round each quarter, so Treasury must do its own – but half-yearly, because its only actual forecasting need is for a set of macro-economic "parameters" to plug into its budget estimates of spending and revenue.

The Reserve regularly investigates the latest macro puzzle – say, why non-mining business investment is so slow to recover – so Treasury must do its own. Its new Treasury Research Institute focuses on macro management issues.

What gets neglected is Treasury's oversight of the big micro reform issues. Think health, education, infrastructure. Without an institutional understanding of the detail of these areas, Treasury simply isn't up to speed on either micro reform or budget sustainability.

So its recent establishment of a "structural reform" division seems a step in the right direction – until you learn that the group's first big project was to inquire into non-mining business investment's slowness to recover.

Another part of Treasury's decline is its politicisation, particularly Tony Abbott's decision to sack the Treasury secretary, Dr Martin Parkinson, and replace him with someone whose views he felt more comfortable with, John Fraser.

Recent Coalition governments have preferred Treasury and other departments to be less the fearless policy advisers and more the handmaidens to the minister and their office.

This politicisation makes it ever-harder to believe Treasury's persistently over-optimistic economic and budget forecasts are the product of forecaster fallibility rather than political interference.

Trouble is, the more your influence and authority decline, the more people want to take a crack at you.

Should Labor win the next election, it says it will shift responsibility for budget forecasting and the five-yearly intergenerational report (whose credibility Joe Hockey destroyed by turning it into a political tract) from Treasury to the more independent Parliamentary Budget Office.

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How to judge the 'stance' of monetary policy

Do you realise the Reserve Bank board hasn't changed Australia's official interest rate from 1.5 per cent for almost a year? But that hasn't stopped people in the financial markets from speculating furiously about whether rates are about to go down – or go up.

In the days leading to the board's meetings on the first Tuesday of the month, the market players start arguing and laying their bets.

It's clear the Reserve will have to start raising its official interest rate – also known as the short-term money market's overnight "cash rate" – to dampen the house price boom in Sydney and Melbourne, some people argue.

What's more, don't forget that rates around the world have started going back up. We'll have to follow suit.

Don't be silly, others say, the economy's growth is below par, unemployment is higher than it should be, wage growth is weaker than it's been in decades, and the inflation rate is actually below the bottom of the Reserve's 2 to 3 per cent target range.

In such circumstances, why on earth would the Reserve want to increase its official rate – also called its "policy" rate – which would push up the interest rates actually charged (or paid) by the banks, thus tending to discourage businesses and, more particularly, households from borrowing and spending and thus increasing economic activity?

But then, early last week, the Reserve issued the minutes of its previous board meeting, which revealed it had been discussing our economy's "neutral" interest rate, which the staff estimate had fallen by 1.5 percentage points to about 3.5 per cent, since the start of the global financial crisis in 2007.

Wow, said the rate-rise brigade, what bigger hint do you want? It's obvious the Reserve is softening us up for a return to a series of rate rises – maybe 2 percentage points' worth before it's finished.

Wrong. Next day the Reserve had to explain that the neutral interest rate was far more theoretical than that, and would have very little influence on its decisions about the policy rate in the foreseeable future.

And later that week the Reserve's deputy governor, Dr Guy Debelle, gave a long speech in which he explained what the neutral interest rate is, how it's determined and what notice the Reserve takes of it.

The Reserve uses its "monetary policy" – its ability to control the overnight cash rate, and thus influence the levels of all other short-term and variable interest rates in the financial system – to try to manage the strength of the economy's demand for the production of goods and services.

If it wants demand to grow faster, it lowers interest rates to encourage borrowing and spending. If it wants demand to slow down – usually because everything's roaring along and inflation pressure's building – it raises interest rates.

But how do we know whether, say, the present policy rate of 1.5 per cent, is really low and thus "expansionary", or not low enough to be very expansionary or, for that matter, whether it's so high relative the economy's weak state that it's actually "contractionary" (causing the economy to slow further)?

We know by comparing the actual policy rate with our best estimate of the "neutral" interest rate, which is neither expansionary nor contractionary. It thus provides a benchmark for assessing the "stance" of policy. If the actual official rate is below the neutral rate, the stance of policy is expansionary; if it's above, policy is contractionary.

Just how expansionary or contractionary you can determine with a little arithmetic. Right now, If the neutral rate is 3.5 per cent but the actual rate is 1.5 per cent, that sounds highly expansionary to me.

(Which ain't to say the stimulus is working; clearly, it's not having a huge effect – probably because households already have big debts, and don't want to borrow a lot more.)

Debelle explains that the neutral rate aligns the amount of the nation's saving with the amount of its investment, but does so at a level consistent with full employment and stable inflation.

That is, the neutral rate is where the Reserve's policy rate would be in the medium term if it was achieving the goals of monetary policy – that is, a rate of unemployment of about 5 per cent and an inflation rate within the 2 to 3 per cent target range.

So the level of a country's neutral interest rate will change with changes in the factors that influence saving and investment. Developments that increase saving will tend to lower the neutral rate, whereas those that increase investment will tend to raise it.

Debelle says you can group these factors into three main categories. First, the economy's "potential" growth rate – the fastest it can grow over the medium term without worsening inflation.

The faster a country's population and productivity are growing, the higher its neutral rate is likely to be because there should be strong demand for investment and less inclination to save.

Our potential growth rate is about 2.75 per cent a year, which is lower than it used to be, but higher than for other developed economies.

Second, the degree of "risk aversion" felt by a country's households and businesses. That is, how confident people are that the future is bright. This is what's taken a battering since the financial crisis. Greater aversion to risk makes people wary of investing and more inclined to save.

Finally, international factors. In our open economy, where financial capital can move freely across borders, global interest rates will also influence domestic interest rates.

If you think that means we've lost some of our freedom in the era of globalisation, note Debelle's reassurance: "We don't have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate."

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How and Why we've escaped recession for so long

When Glenn Stevens took over from Ian Macfarlane as governor of the Reserve Bank in September 2006, both men knew the new boy was being handed a poison chalice.

By the time of the deep recession of the early 1990s, Australians – like the citizens of most developed economies – had got used to enduring a recession roughly every seven years.

But Macfarlane had been governor for 10 years, and had been extraordinary lucky to get through all that time without a severe downturn.

It was obvious to both men that Stevens wouldn't be as lucky. We were overdue for a recession and it was bound to occur sometime during Stevens' term, probably early on.

Except that it didn't. When, after his own 10-year stint, Stevens handed over to his government-chosen successor as governor, Dr Philip Lowe, in September last year, he was leaving the job with his record unsullied.

This time there were no forebodings about a doomed inheritance, even though it's only natural to fear that each successive quarter of this world record run must surely increase the likelihood of it coming to a sticky end.

Certainly, there would be few economists so foolhardy as to predict that their profession had finally conquered the booms and busts of the business cycle. Most remember that such bouts of hubris had afflicted – and in the end, mightily embarrassed – the dismal scientists before.

No one wants ultimately to be caught having made that stupid mistake a second time. So, a commercial message sponsored by your local friendly economist: rest assured, we'll have another bad recession sooner or later.

Human nature being what it is, keeping in the forefront of their minds the very real risk of another recession is the best way the managers of our economy can avoid the negligent overconfidence that could bring our record run to an ignominious end.

Of course, the politician with the strength of character to avoid complacency and self-congratulation for a remarkably good performance has probably yet to be born.

That's why this story began, and will continue, as a story about the people who have most say over the day-to-day management of the economy: not the politicians, but the bureaucrats in our central bank.

It's important to remember that Australia's run without a severe recession became a personal best, so to speak, many years ago, and for many years has exceeded the records achieved in all other developed countries – bar the Netherlands, with its freakish record of 103 quarters, almost 26 years, of continuous growth. Until now, as the world record passes to us.

An obvious question to ask is how Australia managed to avoid serious damage from the global financial crisis of 2008, when almost every other advanced economy was laid so low by the Great Recession.

The short answer is first that, thanks partly to the bureaucratic bum-kicking Peter Costello did after the collapse of the HIH insurance group in 2001, our bank regulators kept our banks under a tight rein, preventing them from doing all the risky things the American and European banks were allowed to.

Second, the Reserve Bank positively slashed interest rates the moment it realised the severity of the crisis, while the Rudd government ignored the dodgy advice it was getting from then-opposition leader Malcolm Turnbull and sections of the media, and splashed around a lot of cash.

Both the rate cuts and the cash splash had the intended effect of steadying the badly shaken confidence of businesses and consumers, thus quickly arresting the self-reinforcing downward spiral of fear and belt-tightening that causes all deep recessions.

Third, whereas many employers had previously responded to a downturn in demand for their product by laying off staff, this time many of them, hoping the downturn would be temporary, limited themselves to putting all their staff on a period of short-time working.

This restraint on the part of business proved a much less damaging approach for everyone.

But remember this: most advanced economies have suffered not one, but two or three deep recessions since the world recession of the early 1990s.

So there has to be more to our 26-year record than just our deft response to the GFC.

The deeper reasons for our success start with the factor already alluded to: our politicians' decision in the first half of the 1990s to hand control of interest rates to the central bank, acting independently of the elected government.

Turns out moving interests rates up and down in response to the business cycle, as opposed to the proximity of elections, is a big improvement in keeping the economy chugging steadily along.

The other beneficial change was all the "micro-economic reform" undertaken mainly during the term of the Hawke-Keating government, often with bipartisan support from the opposition, led by John Howard and Dr John Hewson.

Deregulating the financial system, floating the dollar, rolling back protection against imports, decentralising wage fixing and the deregulation of many particular industries had the combined effect of making the economy more flexible, less inflation-prone and better able to reduce unemployment.

The era of micro reform didn't achieve the hoped for continuing improvement in productivity, and had various adverse side-effects, but it did make it much easier for the central bankers to keep the economy on an even keel.

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How our budget repair problem has been exaggerated

Before the budget Scott Morrison promised us "good debt" and "bad debt". What we actually got was less radical but more sensible.

The government has come under increasing pressure from the Reserve Bank to draw a clear distinction between its borrowing to cover "recurrent" spending (on day-to-day operations) and borrowing to cover investment in capital works ("infrastructure").

It was wrong to lump them together and claim the combined deficit constituted the government "living beyond its means", as the Coalition often has.

Government borrowing to pay for infrastructure that will deliver a flow of services to the community for many decades to come is not in any way irresponsible.

The Reserve's reason for pressing the government was its desire for "fiscal policy" (the budget) to give its "monetary policy" (low interest rates) more help trying to stimulate faster economic growth.

Make the recurrent/capital distinction and the government can move to repair its budget and avoid unjustified borrowing, while still investing in new infrastructure projects that both add to demand in the short term, and later – provided the projects are well chosen – add to the economy's potential to supply more goods and services by improving our productivity.

In this budget Malcolm Turnbull finally capitulated to this pressure, overturning decades of Treasury dogma.

Sort of. Treasury's fought a rear-guard action, retaining the old world while seeming to move to the new.

In the process it's been obliged to make clear all the budgetary cupboards in which it hides the government's spending on capital works.

In so doing it has revealed that the line between budget accounting and creative accounting is thin.

Let's start with what in accounting passes as theory. There are two main ways you can measure the financial performance of an "entity" such as a business or a government: the rough-and-ready "cash" basis, or the more careful "accrual" basis.

The private sector has been using accrual accounting for more than a century, whereas Australia's public sector moved from cash to accrual only in 1999, after the United Nations Statistical Commission shifted the national accounts framework to an accrual basis in 1993 and the Australian Bureau of Statistics complied.

The cash basis measures the government's financial performance merely by comparing the cash it received during a period – usually a financial year – with the cash it paid out during the period.

By contrast, the accrual basis puts much effort into ensuring the incomings and outgoing are properly "matched", so they are allocated to the accounting period to which they rightly apply.

If, say, on the last day of the year you paid for an insurance policy to cover you for the following year, an adjustment would be made to shift that cost to the following year's accounts.

When the feds moved their accounts and budget onto an accrual basis at the turn of this century, however, Treasury declined to play ball.

It stuck with cash, making the debatable argument that recognising government transactions according to when the cash changed hands gives a better indication of those transactions' effect on the macro economy.

(It couldn't admit the real reason. The cash basis leaves much more scope for creative accounting: quietly moving receipts and payments between periods so as to make the books look better or hide something the government finds embarrassing.)

So, to this day, the budget papers are written in two different financial languages. The bit prepared by Treasury is written in cash, whereas the much bigger bit prepared by the Finance department is written in accrual – as it's supposed to be.

Get this: our bilingual budget means the budget papers offer us four different measures of the budget bottom line to pick from.

There's the "underlying cash" balance (the one Treasury wants us to focus on), the "headline cash" balance (please don't ask questions about this one), the "fiscal" balance (the close accrual equivalent of underlying cash) and, buried up the back, the accrual-based "net operating balance".

The news is that Treasury is sticking with underlying cash as "the primary fiscal aggregate" – the one it will make sure we focus on – but will ditch the fiscal balance (always just a face-saver cooked up by Treasury) and replace it with – give "increased prominence to" – the net operating balance, henceforth known as the NOB.

Bringing the NOB from the back up to the front will "assist in distinguishing between recurrent and capital spending" because, in accountingspeak​, "operating" and "recurrent" mean the same.

Point is, the biggest practical difference between cash and accrual is their treatment of spending on capital works. In cash, it's lumped in with recurrent spending, whereas in accrual it's not. Instead, accrual includes as a recurrent or operating expense an estimate of a year's worth of "depreciation" (wear and tear) of the feds' stock of physical capital – as it should if you believe in "matching" (which Treasury doesn't).

With this unprecedented casting of a spotlight on its accounting practices, Treasury has had to admit that the NOB actually overstates the recurrent balance because it includes as an expense the feds' capital grants to the states to help cover their spending on infrastructure.

Correcting for this reduces the coming financial year's NOB from a deficit of almost $20 billion to one of just over $7 billion (just 0.4 per cent of GDP). So we're already close to a balanced recurrent budget and should be there in 2018-19, after which (if Treasury's economic forecasts prove reliable) we'll be up to a recurrent surplus of $25 billion by 2020-21.

Turns out that, from the time the budget dropped into deficit in 2008-09 until the year just ending, focusing on the underlying cash deficit rather than the corrected NOB has exaggerated the extent of our budget repair problem by a cumulative $150 billion.

So how much have the feds been spending on infrastructure? Long story. Watch this space.

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Budget gives mild fiscal stimulus to economy

Will Scott Morrison's big-spending, big-taxing, big-borrowing budget impart a big fiscal stimulus to the economy in the coming financial year? Not so much.

Why not? Short answer: because the higher spending is offset by higher taxes – so we get a bigger public sector, but not a big net budgetary stimulus – while most of the increased borrowing for infrastructure is years away.

The longer answer requires a little arithmetic gymnastics, partly because different economists have different ways of measuring the size of the impetus – whether expansionary or contractionary – a new budget imparts to the rest of the economy.

The Reserve Bank has its own shortcut way of assessing the impact of the budget ("fiscal policy") on the economy – which it does as part of its assessment of what it must do with its own "monetary policy" (manipulation of interest rates) to ensure the combined effect of these two "instruments" – which the economic managers use to smooth the strength of demand as the economy moves through the ups and downs of the business cycle – is as it should be.

The Reserve does this because it, not the elected government, accepts ultimate responsibility for stabilising demand. It thus uses its monetary policy as the "swing instrument".

If, for example, the Reserve found that a government was using its budget to stimulate demand at a time when demand was already growing strongly (and thus threatening to increase inflation pressure beyond its 2 to 3 per cent inflation target) it would seek to counter that stimulus by "tightening the stance" of monetary policy (that is, by increasing interest rates).

This is just what was happening under treasurer Peter Costello in the early years of the resources boom before the global financial crisis.

The government's coffers were overflowing with money and it was spending it and giving it back in eight tax cuts in a row – presumably because it believed the boom would last forever – when it should have been saving the excess for lean years to come, and thereby stopping the economy from "overheating".

Meanwhile, the Reserve was trying to counter this "pro-cyclical" fiscal policy – that is, policy that amplifies the business cycle rather than smoothing it – by jacking up interest rates.

It had the official cash rate up at 7 per cent by the time the crisis occurred in September 2008, but then lost little time in slashing the rate to 3 per cent.

This was an extreme reminder that fiscal and monetary policies aren't the only sources of stimulus or contraction bearing on the economy. The other main source is the rest of the world, the "external sector".

For example, a rise in the dollar ("an appreciation of the exchange rate") has a contractionary effect on demand – because it worsens the international price competitiveness of our export and import-competing industries – whereas a fall (depreciation) in the dollar has an expansionary (stimulatory) effect.

Point is, it's usually best for the two "arms" of macro-economic management to be reinforcing each other, by having them adopt similar stances.

This is why, now, while the Reserve has been cutting the official interest rate as low as 1.5 per cent in its effort to stimulate demand, successive governors have appealed to the government to use the budget to give them more help.

This could be done by distinguishing between the budget's deficit on "recurrent" (day-to-day) spending – which the government could continue reducing – while increasing its spending on capital works, thus adding to demand.

The year's budget is a belated response to that appeal.

But back to the Reserve's shorthand way of assessing the stance of fiscal policy. It's to look at the direction and the size of the expected change in the budget balance between the old year and the coming year.

ScoMo is expecting the underlying cash deficit to fall from $37.6 billion in 2016-17 to $29.4 billion in 2017-18, a drop of $8.2 billion.

A decline in the deficit (or, in other circumstances, an increase in a surplus) says the stance of policy is contractionary.

But $8.2 billion is less than 0.5 per cent of the size of the economy – nominal gross domestic product – which is expected to be $1.82 trillion ($1822 billion) in 2017-18, meaning it's barely visible on the economic radar.

The Reserve's shorthand measure doesn't distinguish between the two reasons for a change in the budget balance: cyclical factors (what the economy does to the budget as it moves through the business cycle) and structural factors (what the government's policy decisions do to the budget, and thus to the economy).

The strict Keynesian way of judging the stance of fiscal policy is to ignore the cyclical change and focus on the structural (or "discretionary") change.

(BTW, the budget papers estimate that the structural component of the budget deficit will be equivalent to about 2 per cent of GDP in 2017-18, compared with an overall underlying deficit of 1.6 per cent, implying the cyclical component is now back in surplus.)

If we look at the effect of the discretionary policy changes announced in the budget, but take account of the reversal of the "zombie" measures that had been included in the budget even though they never happened, decisions were made to increase spending in 2017-18 by $1.9 billion, but offset this with increased revenue of $1.7 billion, leaving a net addition to the structural deficit of about $200 million.

To this, however, we need to add the government's additional capital spending – on the national broadband network, the second Sydney airport and Melbourne to Brisbane inland freight railway – totalling about $12.8 billion, which for strange reasons Treasury excludes from the underlying cash deficit.

This takes discretionary policy spending up to about 0.7 per cent of GDP which, by Keynesian lights, makes the budget stimulatory, but only mildly so.

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Global leaders change direction while we play games

It's strange the way Malcolm Turnbull and Scott Morrison keep shooting off overseas to compare notes with world economic heavies, but come back none the wiser.

Fortunately, the wonders of the internet allow us to read for ourselves what they're being told by the trumps at the Organisation for Economic Co-operation and Development and the International Monetary Fund.

It's clear those at the leading edge are getting increasingly worried about the outlook for the world economy and are urging a marked change of policy direction.

But while the trumps see a need for policy to swing back to the centre, our unruly Coalition is intent on drifting off to the far right.

Our preoccupation is with protecting the aspirations of the richest superannuants, changing the Racial Discrimination Act, delaying same-sex marriage, protecting negative gearing and blaming the budget deficit on greedy welfare recipients.

Back where they still care about the economy, the OECD is worried that "the world economy remains in a low-growth trap, with poor growth expectations depressing trade, investment, productivity and wages.

"This, in turn, leads to a further downward revision in growth expectations and subdued demand. Poor growth outcomes, combined with high inequality and stagnant incomes, are further complicating the political environment, making it more difficult to pursue policies that would support growth and promote inclusiveness," last week's OECD interim economic outlook said.

Here's where you're supposed to think of Donald Trump, Brexit and the resurrection of One Nation. That's really gonna help.

What's turning the prolonged period of weak global demand into a trap – a Catch 22 – is the adverse effect on the growth in supply from weak business investment spending, weak productivity improvement and the atrophying skills of the long-term jobless.

The OECD estimates that, for its 35 member countries as a whole, their "potential" growth rate per person – the average rate of growth in their capacity to produce goods and services – has halved to 1 per cent a year, relative to their average growth in potential during the two decades before the financial crisis.

The organisation is worried that growth in global trade is "exceptionally weak" and that "exceptionally low and negative interest rates" are distorting financial markets – including overblown share and housing prices – and creating risks of future crises.

So what should we do to escape the low-growth trap? Change the mix of policies.

We've relied too heavily on loose monetary policy, which won't be sufficient to get us out of trouble. Worse, it's "leading to growing financial distortions and risks".

Rather, we should move to "a stronger collective fiscal [budgetary] and structural [micro reform] policy response". Note the word "collective" – fiscal stimulus always works better when every country acts at much the same time.

The goal with fiscal and structural measures is to boost demand and raise the economy's productive capacity.

"All countries have room to restructure their spending and tax policies towards a more growth-friendly mix by increasing hard and soft infrastructure spending and using fiscal measures to support structural reforms," the organisation says.

The OECD and the IMF have argued that Australia has plenty of "fiscal space" to increase borrowing for productivity-enhancing infrastructure; space that's been increased by the very low interest rates payable on our existing and any further debt.

The latest OECD economic outlook continues: "Concrete instruments include greater spending on well-targeted active labour market programs and basic research, which should benefit both short-term demand, longer-term supply, and help to make growth more inclusive."

And, in the present environment of weak demand, supportive macro-economic policies would create a more favourable environment for the short-term effects of structural reforms, we're told.

Now get this: easing the fiscal stance through well-targeted growth-friendly measures is likely to reduce the debt-to-GDP ratio in the short term, we're told. How? By adding more to nominal GDP than it adds to public debt.

"Furthermore, provided that fiscal measures raise potential output, a temporary debt-financed expansion need not increase debt ratios in the longer term," the organisation concludes.

To be fair, both our retiring and our new Reserve Bank governor (who also go to all the international meetings) have told the government monetary policy has done its dash and we need to rely more on spending on infrastructure.

The question is how long it will take our politicians to realise that their survival in government is more likely if they improve our economic performance and improve their electoral appeal by returning to policies of the "sensible centre" and ensuring growth is more "inclusive" – as they say in Paris and Washington, but not Canberra.

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The rules on how we conduct monetary policy

Something happened this week that occurs only about once a decade, an event that deserves much of the credit for our avoidance of a severe recession for 25 years and counting.

It was the announcement of a new agreement between the elected government, represented by the Treasurer, Scott Morrison, and the newly appointed governor of the Reserve Bank, Dr Philip Lowe, recorded in a "statement on the conduct of monetary policy".

The statement re-affirmed the government's willingness to allow the Reserve, our central bank, to set "monetary policy" - to manipulate the level of short-term and variable interest rates paid and charged in the economy, so as to influence the strength of demand - without reference to the wishes of the politicians.

The length of the period of continuous growth in the economy is measured from the end of June 1991, the last quarter of contraction during the severe recession of the early 1990s.

It's no coincidence that the era of central bank independence began just a few years later in 1993, first informally under the Keating government and then formally under the Howard government in 1996, at the time of the appointment of Ian Macfarlane as governor.

Handing control of interest rates from the pollies to the econocrats has been a huge success, though it's important to remember that, in the time since then, the economy contracted - got smaller - in the December quarter of 2000 and again in the December quarter of 2008, with unemployment rising significantly on both occasions.

That's why I always say it's been 25 years since our last severe recession. We've had two small recessions since then, though they were too short and shallow for anyone but economists to remember them.

But their very mildness is testimony to the success of the move to central-bank independence. The econocrats move interest rates up or down according to their best judgement on what's needed to keep the demand for goods and services as stable as possible.

The pollies were too inclined to let the approach of the next election influence whether rates should be going up or down.

Of course, another factor has contributed to the vastly improved management of our economy: all the "micro-economic reform" of the 1980s and '90s.

The floating of the dollar, the removal of import protection, the move to enterprise wage bargaining and myriad small acts of deregulation in particular industries have greatly increased the degree of competition within our economy, making it more flexible in its ability to cope with economic shocks and less inflation-prone.

So the managers of the macro economy have found it easier to keep the economy on an even keel, avoiding extremes in inflation or unemployment.

When we joined the rich-world fashion of making central banks independent, we adopted another new idea of making a target for the rate of inflation the main guide for decisions about changing interest rates.

While other countries set hard and fast inflation targets of zero to 2 per cent, we set a target that not only was higher - 2 to 3 per cent - but was also less hard and fast.

We were required to hit our target only "on average, over the cycle". So when you take the average of the inflation rate over a reasonable period, the result always has to be 2-point-something.

We were criticised for our target's fuzziness, but we've since won that argument. The others weren't able to achieve their "hard-edged" targets and had to modify them, whereas we've always achieved ours, even though we've been outside the range for 46 per cent of the time.

This week, in his regular testimony before a parliamentary committee - one of the conditions of accountability and transparency required in return for the Reserve's independence - Lowe argued that the target's flexibility meant there was no need to change it, even though it seems likely the world has entered a period of lower inflation.

This third version of the statement on the conduct of policy contained two minor changes.  "On average, over the cycle" became "on average, over time".

The two words mean much the same thing. How long is "over time"?  As the statement says, it means "the medium term". How long's that? We're not told, but I'd put it somewhere between five and 15 years.

The second change made clearer the link between monetary policy and the stability of the financial system.

In setting interest rates, the Reserve will take account of the need to ensure people can always borrow, lend and make payments, and ensure the failure of a particular financial institution doesn't cause any doubt about the stability of the others.

When the inflation target was first adopted, some people feared it meant the Reserve wouldn't worry about unemployment or growth. More than 20 years later, we know those fears were unwarranted.

The Reserve sees low and stable inflation as a precondition for achieving strong growth in employment and income.

And so it's proved. The Reserve has shown that the best way to keep unemployment low is to keep recessions as shallow and far apart as possible.

The flexibility built into the formulation of the inflation target is designed to keep inflation in perspective, absolving the Reserve of the obligation to crunch the economy whenever inflation pops its head above 3 per cent, or madly rev up the economy whenever inflation drops below 2 per cent.

Monetary policy is the primary "arm of policy" used to achieve "internal balance" - price stability and full employment or, more simply, low inflation and low unemployment.

It does need backup, however, from the other arm, "fiscal policy" - the manipulation of government spending and taxation in the budget - whose primary goal is "fiscal sustainability" - making sure public debt doesn't get too high.

There's much more to the story, but that's enough for now.

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Why Treasury is wrong on deficits and debt

The last speech of the retiring Reserve Bank governor, Glenn the Baptist, was a touch biblical. Whatever your point of view, you could find a verse here or there that seemed to back you up.

If, for instance, you accept the conventional view that the budget deficit is way too high, that the government should be more daring in seeking to cut the deficit, and its opponents should be less opportunist and more responsible in agreeing to spending cuts, Glenn Stevens offered a verse for you to quote.

He observed that "when specific ideas are proposed that will actually make a difference [to the budget deficit] the conversation quickly shifts to rather narrow notions of 'fairness', people look to their own positions, the interest groups all come out and the specific proposals often run into the sand.

"If we think this rather other-worldly discussion will not have to give way to a more hard-nosed conversation, we are kidding ourselves.

"That will occur should there be a moment of crisis, but it would be better if it occurred before then," he said.

A treasury secretary couldn't have said it better. But look at the totality of Stevens' remarks and he's actually challenging the conventional wisdom.

"As would be clear from my utterances over the past couple of years, I have serious reservations about the extent of reliance on monetary policy around the world."

The problem is that what central banks do could never be enough to fully restore demand after a period of recession associated with a very substantial debt build-up.

"In the end, the most powerful domestic expansionary impetus that comes from low interest rates surely comes when someone has both the balance sheet capacity and the willingness to take on more debt and spend," he said.

"The problem now is that there is a limit to how much we can expect to achieve by relying on already indebted entities taking on more debt.

"In some countries there may be no safe way of [increasing] borrowing and spending because debt, both public and private, is just too high.

"In Australia, gross public debt, for all levels of government, adds up to about 40 per cent of gross domestic product. We are rightly concerned about the future trajectory of this ratio.

"But gross household debt is three time larger – about 125 per cent of GDP. That is not unmanageable – but nor is it a low number."

Get it? He's saying that monetary policy is out of puff. Lowering interest rates is no longer very effective in encouraging households to take on even more debt. (He noted later that he'd never believed cutting rates had much effect on businesses' decisions to increase investment spending.)

So which sector has the most capacity to increase its deficit spending "in the event that we were to need a big demand stimulus"?

The public sector. Sorry, but that's not what a treasury secretary would say.

Stevens was quick to add: "I am not advocating an increase in deficit financing of day-to-day government spending. The case for governments being prepared to borrow for the right investment assets – long-lived assets that yield an economic return – does not extend to borrowing to pay pensions, welfare and routine government expenses, other than under the most exceptional circumstances.

"It remains the case that, over time, the gap in the recurrent [my emphasis] budget has to be closed, because rising public debt that is not held against assets [my emphasis] will start to be a material problem."

Now that's something no secretary to the treasury would say. Unlike all its state counterparts, federal Treasury has long opposed the drawing of a distinction between government recurrent spending and government investment in "long-lived assets that yield an economic return" and add to national productivity.

Treasury wants little old ladies to feel as guilty about borrowing to improve the Pacific Highway as they do about borrowing for "routine government expenses".

So, let's worry about getting the recurrent budget back to surplus (as most state governments did long ago), but not about borrowing for infrastructure. Agreed?

Except that when you read the budget papers carefully enough to find the info Treasury has hidden on page 6-17, you discover that the expected underlying cash deficit for this financial year of $37 billion includes capital spending of $36 billion.

Get it? We're already back to a balanced recurrent budget. So why so much hand-wringing? And why aren't we getting on with planning the infrastructure pipeline we could expedite "in the event that we were to need a big demand stimulus"?

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Why cut interest rates again? It's the exchange rate, stupid

The trouble with the Reserve Bank's continuing cuts in the official interest rate – this week to another record low, of 1.5 per cent – is that it could leave people thinking the economy's in bad shape.

It isn't. As Reserve governor Glenn Stevens was at pains to point out, recent figures suggest that "overall [economic] growth is continuing at a moderate pace" notwithstanding a very large decline in investment in new mines and natural gas facilities.

In consequence, employment is increasing and unemployment is, as they say in the financial markets, “flat to down”.

It's not brilliant, but it's not bad. Our economy is growing faster than most other developed economies. Nor is it expected to slow.

In which case, why is the Reserve cutting interest rates? Good question. Actually, it says more about the trouble other rich countries are having getting their economies moving than it does about ours.

The advanced economies – even the Americans – have still not recovered properly from the Great Recession precipitated by the global financial crisis of 2008.

The long boom that preceded the crisis involved a lot of borrowing by banks, businesses and households, partly to bolster living standards, but also to buy housing, commercial property and other assets.

When, inevitably, the credit-fuelled boom busted and asset prices fell back to earth, a lot of households and businesses were left with assets whose value no longer exceeded their liabilities.

Recessions that arise from such "balance sheet" problems always take a long time to recover from, as households and businesses cut their spending and investing in order to pay off their debts.

That was bad enough. But the difficulties were compounded by governments on both sides of the North Atlantic convincing themselves the problem wasn't excessive private sector borrowing, but government borrowing.


They not merely concluded they should do no further deficit spending, they embarked on the deeply misguided policy of "austerity", in which they tried to cut government spending and raise taxes at a time when the economy was already weak. Unsurprisingly, they made little progress in reducing deficits and debt.

This foolish fashion of forswearing the use of fiscal policy (the budget) to increase public sector demand at a time when private demand was weak threw all the task of restoring the economy's growth onto monetary policy.

From a position in most North Atlantic economies where official interest rates were already quite low, central banks cut their rates almost to zero.

When this did little to boost demand they resorted to the unconventional policy of "quantitative easing" – they bought bonds from banks with money they created with the stroke of a pen.

This was intended to lower long-term bond rates, which it did. But it did more to push up the prices of financial assets than to encourage increased spending in the real economy.

With QE doing little to help, some European central banks have even moved to negative interest rates – actually charging lenders a tiny percentage for borrowing their money.

If this sounds increasingly crazy, it is. But it's the world we and our central bank have to live in.

Historically, monetary policy was designed to keep inflation low. But it's a long time since many countries had to worry about high inflation. These days more of them worry about the opposite problem of "deflation" – continuously falling prices.

We, too, have very low inflation: an underlying rate of 1.5 per cent, compared with the Reserve's target range of 2 to 3 per cent.

This situation has led some to conclude the Reserve's reason for cutting the official rate this week was to help get the economy growing a lot faster, so inflation pressures would build and get the inflation rate back into the target zone.

That would make sense in normal times, but times aren't normal. Nor do I imagine the Reserve thinks a cut of another 0.25 percentage points (and less for people with mortgages) will make much difference to the strength of borrowing and spending.

So why did the Reserve feel it needed to cut by another notch? My guess is it had more to do with trying to reduce upward pressure on the dollar – our exchange rate.

The biggest effect of QE – creating more of a country's currency – has been to put downward pressure on that country's exchange rate. Meaning, of course, upward pressure on other countries' exchange rates – including ours.

Our dollar soared during the resources boom when the world was paying extraordinary prices for our coal and iron ore. It dropped back when commodity prices fell, but its return to more comfortable levels for our export and import-competing industries was impeded particularly by the Americans' resort to QE.

It eventually got down to the low US70¢s and the Reserve regards a lower dollar as a key element, along with low interest rates, in stimulating faster growth in our production of goods and services.

Of late, however, the dollar has drifted back up to about US76¢, which the Reserve regards as a retrograde step.

Get this: contrary to the easy assumption of some people, there's no simple, mechanical relationship between the level of our interest rates (or, strictly, the difference between our rates and those offered by big players such as the Americans) and the level of our exchange rate.

Even so, with no inflation problem in sight – and, indeed, with any fall in expected inflation leading to a rise in our real interest rate – the Reserve decided to err on the safe side by trying to reduce upward pressure on the dollar.

So why did the Reserve cut rates? It's the exchange rate, stupid.

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Banks ponder their next game with interest

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Security scare intended to hide economic failure

Am I the only person who isn't cringing in fear, looking for a rock to hide under and hoping Tony Abbott and Peter Dutton will save us from the tide of terrorism surging towards our shores?

As is their wont, the media are enthusiastically indulging our desire to dwell on all the gruesome details of a spate of terrorist acts in faraway countries of which we know little.

But this seemingly innocent nosiness is leaving us with a quite exaggerated impression of the chances of our ever coming into contact with such an event.

Apparently, all you have to do to be in mortal danger is attend the making of an ABC current affairs program. It's a field day for any attention-seeking nut of Middle Eastern background.

Would you say our Prime Minister is seeking to calm our overblown fears or is playing them for all he's worth?

Precisely. And I'll tell you why. Because he's discovered he's not much chop at leadership - at inspiring us with a vision of a better future, at explaining and justifying necessary but unpopular measures - but he is good at running scare campaigns, to which the Aussie punter seems particularly susceptible.

But, above all, because he wants to divert our attention from the hash he's making of managing the economy.

In opposition, and facing a Labor government that lacked all confidence in its own ability as an economic manager, Abbott assured us the Liberals had good management in their DNA. I thought he had a point, but what we didn't discover until too late was that he and his chosen Treasurer just didn't have that gene in their bodies.

They started by telling us that, apart from the immense damage being done by Labor's carbon and mining taxes, the economy's big problem was the budget, something they, being Libs, could fix in a jiffy.

They had one go at fixing the budget, got themselves into terrible trouble in the polls, then gave up. Pretty much the sole purpose of this year's budget was to reverse their poor political standing by ditching or modifying many of their unpopular policies.

From that day to this, we've heard little more of the evils of debt and deficit. Almost all of what little improvement in the budget deficit is expected will come from bracket creep.

Fortunately, the budget deficit and the still-small level of public debt to which it has given rise was never the central, pressing problem for the economy the oppositional Abbott & Co made it out to be.

We will have to deal with the deficit eventually, but it's not pressing. And fortunately, thanks to the good offices of Peter Costello, primary responsibility for the day-to-day management of the economy was long ago shifted from the politicians to the econocrats of the Reserve Bank.

Trouble is, no matter how many more times the Reserve cuts interest rates, it's having little success in getting the economy moving at a satisfactory clip. And with more mining construction projects being completed as each day passes, the economy is in danger of drifting into recession.

It may not happen, but the possibility that it will is too high for comfort. The Reserve has been calling out for help from Canberra, but Abbott and Hockey have been turning a deaf ear, far too busy coping with the confected national security crisis.

Now we've received a very could-do-better annual report card from the International Monetary Fund. Far from urging Abbott and Hockey to redouble their efforts to reduce deficit and debt, it's telling them they have plenty of "fiscal space" relative to other advanced economies - room to increase debt - and should be doing more to encourage spending on infrastructure by the state governments.

The problem is that while the Reserve has been using too-low interest rates to get the "non-mining" private sector moving, the public sector has been doing nothing to help. Indeed, despite the incessant talk - federal and state - about the greater efforts being made to ensure the adequacy of our infrastructure, nationwide public capital expenditure actually fell by 8 per cent over the year to March.

The decline came from the state governments, not Canberra. But since it's the national government that's primarily responsible for the health of the national economy, this provides Abbott and Hockey with no excuse.

That covers the Abbott government's poor performance in the immediate management of the economy. But it's just as ineffectual in dealing with the less pressing, more structural need for us to lift our economic game if our continued material prosperity is to be assured.

Despite the ever-growing pile of reports it has commissioned on the financial system, competition, industrial relations, taxation and federalism, it's becoming increasingly clear that, having wounded itself so badly in last year's budget and still being behind a weak-led opposition in the polls, the government has no stomach for taking reform proposals to next year's election.

Economists, business people and even the government's own intergenerational report are warning that our productivity isn't likely to grow fast enough in coming years without further reform, but to no avail.

If the Liberals do have good economic management in their DNA you'd think by now they'd be turning to others among their number with greater leadership skills. But not, apparently, while they can hide behind the charade of concern about threats to national security.

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Debt-and-deficit brigade may bring us down

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Why monetary policy still packs a punch

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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A far from wonderful set of growth numbers

The economy may have grown faster last quarter than business economists were expecting, but that tells you more about their forecasting ability than the economy's strength. Despite what Joe Hockey says, the numbers weren't all that wonderful.

According to the national accounts released by Bureau of Statistics this week, real gross domestic product grew by 0.9 per cent in the March quarter and by 2.3 per cent over the year to March.

This, of course, is well below the economy's "trend" (long-term average) rate of growth of 3 per cent a year, the rate needed just to hold unemployment steady in an economy with a growing number of people wanting to work.

But that's just the first reason the figures aren't as good as they initially appear. Another - one economists perpetually forget to remind us about - is that we have a population growing at the rapid rate of about 1.5 per cent a year, thanks to high immigration.

So we need quite a bit of growth just to stop average income per person falling. Turns out real GDP per person grew by just 0.8 per cent over the year to March.

Another thing to remember is that the growth in real GDP - the quantity of goods and services produced in Australia - is just one way, the most common way, of measuring economic activity.

It's usually assumed that the growth in the nation's production is the same as the growth in its income. But, first, the assumption breaks down if there's a significant change in Australia's terms of trade - in the prices we're getting for our exports relative to those we're paying for our imports.

That's because changes in our terms of trade affect the international purchasing power of the nation's income. When our terms of trade improve, the goods and services we produce are worth more when we buy goods and services overseas; when our terms of trade deteriorate, the stuff we produce is worth less when we're paying for imports.

With the prices we received for our mineral and energy exports rising greatly in the years before their peak in 2011, our "real gross domestic income" grew a lot faster than our production, real GDP.

Now, however, with coal and iron ore prices falling sharply, our real gross domestic income is growing much more slowly than our production, even falling. In the March quarter, real GDP grew by 0.9 per cent, while real GDI grew by only 0.2 per cent.

Over the year to March, real GDP grew by 2.3 per cent, but real GDI fell by 0.2 per cent. This matters because the real value of our income has an indirect effect on future real GDP, which is what drives growth in employment.

But a second assumption implicit in our almost exclusive focus on real GDP is that all the goods and services produced in Oz belong to Australians. They don't. In particular, maybe as much as 80 per cent of the value of the minerals and energy we produce and export is essentially the property of the foreign owners of our mining companies.

The Bureau of Stats highlights gross domestic product in conformity with international convention. But the fact is we'd be better off using gross national product, which measures how much of GDP actually stays with us rather than going to foreigners in interest and dividend payments.

And, because the deterioration in our terms of trade arises mainly because of the fall in prices of mineral exports, real GDI overstates the fall in our income. Real gross national income grew by 0.4 per cent in the quarter, and by 0.6 per cent over the year to March.

But, turning back to real GDP and its components, another reason the figures aren't as good as they appear is their heavy reliance on growth in exports. The volume (quantity) of our exports grew by 5 per cent in the quarter and by 8.1 per cent over the year to March.

This means exports contributed 1.7 percentage points to our overall growth of 2.3 per cent for the year. That's almost three-quarters of it.

Normally, this wouldn't be a worry. But when you remember that most of the export growth came from mining, and that mining is highly capital-intensive, you see there is a worry. It means that real GDP growth of 2.3 per cent isn't contributing as much to employment growth as we usually assume.

The figures show that the Reserve Bank's efforts to stimulate growth in the "non-mining" economy are having mixed success. They're working well with investment in new housing, which grew by 4.7 per cent in the quarter and 9.2 per cent over the year.

But they're getting nowhere with encouraging non-mining business investment to offset the sharp fall in mining investment. Overall, business investment fell by 2.7 per cent in the quarter and by 5.4 per cent over the year.

And get this: fiscal policy (including the budgets of the state governments) is hindering, not helping. Public investment in infrastructure fell by 2.4 per cent, its fifth successive quarterly decline, to be down by 9.1 per cent over the year, which subtracted 0.4 percentage points from overall growth over the year.

Consumer spending grew by an improved, but still below-trend, 2.6 per cent over the year, despite weak growth in wages and employment, and a rising tax bite from household disposable income.

What's keeping consumption reasonably strong is a falling rate of household saving. It fell from 8.8 per cent of household disposable income to 8.3 per cent in the quarter, down from 9.6 per cent a year ago.

It's normal and rational for households to adjust their saving to smooth their consumption spending as the economy moves through the ups and downs of the business cycle.

Even so, it's yet another respect in which the numbers weren't all that wonderful.

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Very low rates are more worrying than you think

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Budget has reverse weaknesses, strengths to last year's

This is the budget of a badly rattled government that has put self-preservation ahead of economic responsibility. It will do much to restore Tony Abbott's political fortunes, but next to nothing to return the budget to surplus or hasten the economy's return to strong growth.

What it's not is "dull". Turns out, when Abbott promised a dull budget what he meant was one that was the opposite of last year's.

This budget will be incessantly compared with Joe Hockey's first attempt because that is its almost sole objective: to have the reverse effect of last year's.

Last year, the budget's overriding goal was to chart a path back to eventual budget surplus. By delaying the cuts in the deficit until after the economy was expected to have recovered, it won high marks for its management of the economy.

It was a budget designed to please the (big) Business Council.

Its big problem was that most of the measures taken to effect that objective were judged by voters to be blatantly unfair, hitting low and middle income-earners but not the well-off. And it broke a host of election promises.

This was why so much of it failed to get through the Senate.

Another problem was the crudeness of its measures. They did little to make government spending more efficient, but simply shifted a lot of the cost off onto pensioners, the unemployed, patients, university students and state governments.

Last year's budget had no giveaways. Its only "winners" were people who weren't hit. This budget will leave many low and middle-income families better off - although most of its key measures won't take effect until 2017.

Its big measures are reworkings of cuts proposed last year. The planned GP co-payment has been replaced by savings to be imposed on drug companies and chemists, with reform of overgenerous fees to doctors to follow.

The planned move to less-generous indexing of the age pension has been replaced by a tighter assets test, which will leave some pensioners better off, but prevent others from receiving a part-pension.

The promised more generous paid parental leave scheme has been abandoned, with the savings used to pay part of the cost of a reform of childcare subsidies, which leaves low and middle-income families better off. Some high-income parents will get less.

Despite some serious flaws in the parental leave and childcare arrangements, the various reworked measures are not only fairer, but of much higher quality and careful design. This is a big improvement on last year.

But the reworked measures will do a lot less to reduce the budget deficit over time. Overall, the budget's measures actually slow the return to surplus by more than $9 billion over four years..

More seriously, this budget does far too little to bolster spending on infrastructure while tightening up on recurrent spending.

Last year's timid "asset recycling initiative" has not been supplemented adequately at a time when the Reserve Bank's ever-more ineffective efforts to use cuts in interest rates to resuscitate the economy need all the help they can get.

The increased money for infrastructure in Western Australia and Northern Australia and other bits and pieces won't make a big enough difference.

The announced crackdown on profit-shifting by foreign multinational companies sounds impressive, but how much tax it actually raises remains to be seen.

If last year's budget was intended to please big business, this one purports to do wonders for small business. But its various new concessions are likely to do more to please small businesses than to transform their investment spending.

Don't be misled by all the happy talk of an improving economy and all the jobs to be created. We can always hope, but there is little reason to believe the budget will do much to improve business confidence.

From the perspective of economic management, this budget represents dereliction of duty.

And there's one respect in which nothing has changed: the tax perks of the well-off - superannuation concessions, negative gearing, discounted tax on capital gains, family trusts - remain untouched.

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How Hockey can do the impossible in the budget

I wouldn't like to be in Joe Hockey shoes as he prepares to deliver the budget on Tuesday night. Which is not to say I or any other commentator will be going easy on him. It's too important a job for that and, after all, he volunteered for it.

To be bringing down our eighth budget in a row with a substantial deficit when, according to popular opinion, we didn't even have a recession, is pretty hard to explain.

Our problem is that a monumental resources bonanza is harder to handle than simple recession. In the early stages we were spending and cutting taxes as though the budget would never be a problem again.

Now, on the other side of that boom the transition to normal growth is proving excruciating. With commodity prices still falling and weak growth in wages and employment, tax collections just aren't recovering in the way we could have expected.

Hockey inherits the adverse budgetary consequences not just of Labor's reluctance to find ways to pay for its big spending plans, but also all the profligacy of his sainted Liberal predecessors.

John Howard used the cover of the temporary boom to spend big on middle class welfare for the supposedly self-funded retirees, while Peter Costello initiated an irresponsible eight tax cuts in a row (the last three of which were delivered by Labor) and an unsustainable superannuation tax regime, linked with liberalisation of the pension assets test that Scott Morrison is now reversing.

Hockey also inherits all the crazy things said by someone called J. Hockey while in opposition. Almost every sensible thing he says today can be countered by a clip of him saying the opposite a year or two ago.

Leaving aside whether a cut in interest rates should be seen as good news or bad — it's both — there's all his scaremongering about the rapidly growing mountain of deficits and debt, all his exploitation of the punters' incomprehension that the rules for countries aren't the same as those for households, and all his claims about how simply, quickly and painlessly the budget could be returned to surplus by the Coalition, with good government in its DNA.

And, of course, Hockey also "inherits" all the government's loss of voter goodwill and now-blocked-off options from last year's ill-judged and ill-prepared budget. How any, even a Coalition government imagined it could get away with a delivering a budget designed to gratify the Business Council is beyond comprehension. I thought you guys were professional politicians?

So now Hockey finds himself delivering a budget that's "dull" and "fair" but still has the deficit and its successors heading slowly down rather than up. With all the headwinds Hockey's facing, even that short order will be hard enough.

But even if he pulls it off without resort to creative accounting — and I'll be watching — it won't be enough.

The strangeness of our circumstances is that for Tuesday's budget to win a high mark it has to initiate plans for major improvements in the budget deficit, building up in the "out years" and introduce budgetary stimulus ASAP to rescue the flailing and failing efforts of monetary policy (bargain-basement interest rates) to get the economy moving again.

The need for that second leg became painfully apparent on Friday, with the Reserve Bank revising down its growth forecasts for the second quarter in a row, notwithstanding its two rate cuts so far this year.

In February it cut its "year-average" forecast for the financial year just ending from 2.5 per cent to 2.25 per cent. On Friday it cut its forecast for the coming financial year from 3 per cent to 2.5 per cent.

But isn't a stimulatory, deficit-cutting budget a contradiction, an impossible combination? Only if you haven't​ thought much about how fiscal policy (budgets) works.

There's a simple, age-old distinction that makes the impossible possible: capital versus recurrent. We need faster progress in reducing the recurrent budget deficit, which can be achieved at the same time as you stimulate the economy by spending on needed, productivity-enhancing infrastructure projects.

The irony is that Hockey has already attempted to implement such strategy — last year. The structure of last year's budget was first rate — even before the economy's continuing weakness became so evident.

The problem last year was the unfairness and poor quality of the measures proposed to achieve the strategy. Then, Hockey didn't manage even to explain the concept.

This time, I fear, he may not try to meet the economy's needs while busy trying to repair the government's political standing.

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Let's be more hard-nosed towards foreign miners

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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