ECONOMICS FAQ

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

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

Can we trust the official unemployment figures?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Does monetary policy still work?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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How Reserve Bank retains control of interest rates

When the banks began moving their mortgage and other lending rates at variance with the Reserve Bank's changes in its official interest rate, many people took this as a sign the Reserve had lost its ability to control market interest rates, making its monetary policy ineffective.

Fortunately for all of us, this impression was wrong. That so many people came to this conclusion showed their grasp on the mechanics of monetary policy (the central bank's manipulation of interest rates to influence the strength of demand in the economy) was shaky.

But this week one of the Reserve's assistant governors, Dr Guy Debelle, gave us all a little tutorial in a speech to a business school breakfast.

On Tuesday (and on the first Tuesday of every month bar January), the board of the Reserve meets to determine the appropriate "stance" (setting) of monetary policy. The decision takes the form of a target for the official rate (known in the trade as the "cash" rate). Sometimes the target is moved down a little, sometimes up a little, but mainly it's left where it is.

How does the Reserve unfailingly achieve the target? Settle back. The cash rate is the interest rate the banks charge each other to borrow and lend funds overnight.

Every bank has an account with the Reserve called its "exchange settlement account". Just about every monetary transaction in the economy goes through these accounts. As Debelle explains, when you pay your electricity bill by direct debit, the funds are effectively transferred from your bank account, across the exchange settlement account of your bank to that of your electricity company's bank and into the electricity company's account.

All these transactions mean the balance in each bank's exchange settlement account goes up and down throughout the day. But the Reserve requires each bank to ensure its account always has a positive balance. Banks that leave funds in their account overnight are paid interest at a rate 0.25 percentage points below the cash rate, whereas banks that look like having a negative balance may borrow the difference from the Reserve overnight at a rate 0.25 percentage points above the cash rate.

Get it? These penalties are designed to encourage the banks to borrow and lend to each other overnight at the (more attractive) cash rate.

The Reserve's ability to control the cash rate arises because it has complete control over the supply of funds in this market. It ensures there is just sufficient supply to meet the demand for funds at the interest rate it is targeting.

Where an increase in demand threatens to push the interest rate up, it will use its "open market operations" to increase the supply of funds just sufficiently to keep the rate where it wants it. Where a fall in demand for funds threatens to push the rate down, the Reserve will reduce the supply to ensure the rate doesn't change.

Historically, the Reserve would increase the supply of cash by buying second-hand government bonds from the banks and paying for them with cash. (Note that in this context, "cash" doesn't mean notes and coins, it's a nickname for the funds in exchange settlement accounts.)

Conversely, it would reduce the supply of funds by selling bonds to the banks, which they had to pay for from their exchange settlement accounts. These days, however, the Reserve achieves the same effect using repurchase agreements ("repos").

The main reason for fluctuations in the overall daily demand for exchange settlement funds is transactions involving the Reserve's one big banking customer, the federal government. Demand will rise on days when the government's receipts from taxation exceed its payments of pensions and all the rest. Demand for cash will fall on days when the government's payments exceed its receipts.

All this ensures the Reserve has a vicelike grip on the cash rate. And this gives it the ability to influence all the other interest rates in the economy. Why? Because the cash rate is, in effect, the anchor point for all other rates.

Banks fund only a very small part of their operations in the cash market, Debelle explains, but all their funding could be done from that market if they wanted to. The rate at which they're prepared to borrow for periods longer than overnight is the averaged expected path of the cash rate over the life of the loan plus various margins for risk.

If this were not the case, a bank would be better off borrowing all the funds it needed in the overnight cash market and rolling them over every day.

The reason banks borrow and lend at rates higher or lower than the average expected cash rate over the life of the loan is the need to allow for the various risks involved (the risk of not being repaid, the risk in agreeing to lend your money for a longer time, and so forth) and, of course, profit margins along the way.

For several years leading up to the global financial crisis, these various margins (known as "spreads" or "premia") didn't change much, meaning a change in the cash rate brought about an identical change in mortgage and other bank lending rates.

Since the crisis, however, margins have been changing a lot, as a result of people realising they weren't charging enough to cover the risks they were running, and our banks realising they needed more domestic, retail and longer-term funding to protect them against future crises, leading to intense competition between them to attract term deposits.

The net effect has been that the banks' borrowing costs have risen more (or fallen less) than the cash rate has, causing changes in, say, the mortgage rate, to be less generous than changes in the cash rate and thus widening the margin between the cash rate and the mortgage rate.

The Reserve has allowed for this shift in margins, cutting the cash rate by more than it would have so as to ensure market interest rates - the rates people actually pay - are where it wants them to be.

Its influence over market rates thus remains undiminished. And that's because the cash rate remains by far the most powerful influence over other interest rates - though, as we've seen, not the only influence.

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What happens now on interest rates

Until last week, the financial markets and most business economists thought the Reserve Bank had several rate cuts up its sleeve and would start doling them out this month. The smarter ones don't think that any more.

When the Reserve failed to cut the official interest rate last week, some observers swung to the opposite view of expecting no further cuts for the foreseeable. And with all the fuss about the banks' small "unofficial" increases in mortgage rates, you can bet the punters are now convinced rates are heading back up.

Needless to say, the official rate is unlikely to rise. With luck, it won't need to be cut further. But if the outlook for the economy deteriorates, it will be.

Since the Reserve cares most about the rates households and businesses actually pay, and has no desire to tighten the interest-rate screws, the tiny unofficial increase will be one factor - but only one - favouring another cut in the official rate sooner rather than later.

Why didn't the Reserve cut last week? Because you may have convinced yourself the economy's in trouble, but the Reserve hasn't.

For the markets and business economists to have been so sure the Reserve would cut, it was necessary for them to be convinced of the truth of one or both of two propositions.

First, that the outlook for the world economy is now worse than it was late last year. It's true that, in recent times, the Reserve has judged the state of the rest of the world to be the greatest single threat to the continuing growth of our economy.

But almost all the news we've received from abroad so far this year has been reassuring. Things have calmed down a lot in the euro zone, with the actions of the European Central Bank making people a lot less worried about the European banks than they were, with sovereign bond yields falling back to more sensible levels, with banks able to raise funds with new bond issues, with Greece looking like it may reach a deal with its saviours, and with world sharemarkets looking up.

None of this implies the Europeans don't have a lot more to do, nor that there's little chance of something somewhere suddenly going badly wrong. The continuing risk that things could deteriorate in Europe remains the greatest single reason the Reserve could cut rates again this year.

But you do have to say the improvement in conditions in Europe so far this year makes it easier to believe the Europeans will muddle through.

As for the United States, its economy isn't roaring, but it is doing better than it was, growing fast enough to slowly reduce unemployment. For China, it's slowed a bit, but is still growing strongly.

The second proposition you'd need to believe to have been so confident the Reserve would cut last week is that the domestic economy is clearly slowing.

The tribulations of particular parts of the economy - notably manufacturing and retailing - have generated so many negative headlines I've no doubt many people are convinced the economy's in trouble.

Certainly, the belief the economy is slowing is widely held. But that's what happens when the news is mixed, with the bad bits trumpeted and the good bits played down. Just why the commercial media regard misinforming the public in this way as good for business I'm blowed if I know.

Do they imagine only the Labor government will suffer if they succeed in talking the economy down? Do they think it's like "a Martian ate my baby"? It's just entertainment and no one actually believes them?

The unrecognised truth is, the economy's speeding up a little, not slowing down. That's because we're recovering from the effects of the bad weather this time last year. Abstract from the weather effect and the economy's been travelling at about its medium-term trend annual rate of 3.25 per cent for the past two years or so, and is expected to grow at that rate this year.

With the unemployment rate steady at just 5.2 per cent and underlying inflation in the centre of the target range and expected to stay there for the next two years, you'd have to conclude the economy is right on normal.

In which case, the present level of interest rates - close to their own trend rate - must surely be pretty right. But it's clear from the Reserve's rhetoric that it retains a weak "bias to ease" (cut rates further): "the current [favourable] inflation outlook would, however, provide scope for easier monetary policy should demand conditions weaken materially".

How would such a weakening be manifest? Well, obviously by a deterioration in the world economy. Were Europe to implode, the flow-on to the rest of the world would be considerable - even for us. In this case we know how the Reserve would react: by slashing interest rates in a few big, bold steps.

But the requisite material weakening could also be brought about by a deterioration in essentially domestic factors.

The way the Reserve sees it, the economy is being hit by two powerful but opposing shocks: the expansionary effect of the once-in-a-century mining construction boom and, against that, the contractionary effect of the high exchange rate, which has reduced the international price competitiveness of our export and import-competing industries.

At present, the two conflicting forces are roughly offsetting each other, leaving the economy travelling at its trend rate. Should it become clear the high exchange rate is doing more restricting than the construction boom is doing expanding, which would show itself in slowly but steadily rising unemployment, the Reserve will cut rates further.

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Outlook for politics and government in 2012

Talk to Australian Business Economists Annual Forecasting Conference
Sydney, November 24, 2011

Taken as a whole, the first full year of the Gillard government has been terrible. Julia Gillard has hardly taken a trick all year and her present standing in the polls is worse - much worse, consistently worse - than it was at last year’s election, when she failed to attract enough votes to form government in her own right. Her present primary vote in the low 30s would give her zero hope of winning an election. Only if she could get it up to at least 40 per cent would she be in the hunt. This time last year - three years out from the next election, assuming the government runs full term - I fearlessly predicted Labor would lose it, because ‘this generation of Labor is terminally incompetent’.
Having made that call, I’m sticking to it. I’m doing so even though I know full well how easily the political outlook can change over a period as long as a year, let alone two years. After all, who would have predicted in October 2009 that the election would be months early and fought not between Kevin Rudd and Malcolm Turnbull, but between Gillard and Tony Abbott, that Abbott would come within a whisker of winning and that Labor would be forced into an alliance with the Greens and rag-tag independents?

But I have to add that, at the end of her first year, Gillard and her government are looking in better shape than they did half way through it. The first point to acknowledge is that she’s held her minority government and its alliances together for a year - longer than many people expected - and it’s never seriously looked in trouble. The second is that it’s been a year of great achievement. The opposition has frequently criticised Labor for being unable to actually do anything but, as was always Gillard’s intention, this has been a year of ticking off items on the to-do list - in particular, the various items inherited from Rudd. Of the three big problems he left her, the carbon tax has been put to bed, the mining tax is well on the way and only the asylum-seeker issue remains chronically unresolved. Along with Gillard’s opportunity to be seen looking like a leader on the international stage with other leaders, these runs on the board do much to explain her recent slow improvement in the polls, in the two-party preferred and, particularly, as preferred prime minister.

While the polls continue moving in the right direction - however slowly and with however far to go - Rudd is unlikely to mount a challenge. There’s no reason to doubt his desire to return, and should the poll recovery falter, we’re likely to hear from him. Would the caucus ever turn back to him? There is so much continuing dislike of him they’d have to be terribly desperate, but it’s not impossible. Would it help? No. His grass-is-greener popularity in the polls would soon evaporate as voters were repulsed by this ultimate proof of Labor’s disloyalty, ruthlessness and lack of principle.

Next year should be a year of consolidation and less frenetic policy making, with the government needing to be sure the introduction of the carbon price arrangements goes smoothly. Should the world economy stay on track, the government will press on with its priority of returning the budget to surplus - as, in all the circumstances, it should. Should things go really bad in Europe, the primary response will be from the Reserve Bank, but the government will at least have to reverse its rhetoric and allow the budget’s automatic stabilisers to widen the budget deficit, and may need to consider a new round of fiscal stimulus. For Abbott and the opposition it will need to be a year where, finally, they make their contribution more constructive, outlining their own plans for improvement - even if, as ever, they leave the revelation of their detailed policies until much closer to the election. The longer Abbott continues with his relentless negativity, the more he risks trying the patience of voters.

Can we be sure the minority government arrangement will hold together for another year? No. But the grubby deal to install the former-Liberal Peter Slipper as speaker means it now would take two by-election losses to bring Labor undone. It also reduces Labor’s dependence on any particular independent. And by now it ought to be clear to all that the independents on whose votes Gillard relies have much to gain by continuing to prop her up and much to lose by deserting her. It should also be clear that achieving continued co-operation from the people whose votes she needs is one of the things Gillard is good at.

Why Labor is so bad at it

I have no problem putting the boot into politicians who are flying high, but I don’t enjoy kicking people when they’re down. If for no other reason than that I prefer to be ahead of the conventional wisdom. But I can’t take a look at the political scene and not address the obvious challenge for political analysts: why exactly is this version of Labor so bad at governing?

A host of explanations has been offered, many of which have only some degree of truth and some of which are more in the nature of excuses. One we can dispense with is that it’s all down to the personal failings of Rudd. He had many failings and he left Gillard with a terrible inheritance of a far too long agenda of half-finished policy projects, but we’ve seen enough to know things didn’t immediately look up after his departure.

A favourite excuse of Labor and its supporters is that it’s been turned on by the Murdoch press. It’s true The Australian has turned from being a newspaper to a product aimed at gratifying the prejudices of a particular segment of the audience, but it is - by commercial design - preaching to the already converted. Its influence is limited to those silly people in Canberra who continue to take it seriously, imagining it still to be a newspaper. As for the depredations of Sydney’s Daily Telegraph, it was ever thus. That organ has been a vehicle for foisting the bosses’ views on workers since it was owned by Frank Packer. It’s true the radio shock jocks often take their line from those two outlets, but were they not available the jocks would just have to work harder to find their sources of daily indignation. So, sorry, but I think the Murdoch excuse is greatly overdone. It falls into a class of argument politicians trot out to sustain the faith of the party faithful, not because they believe it or expect the uncommitted to believe it.

I think part of the problem attaches to Gillard herself. The brutal circumstances in which she came to power count against her in the mind of many voters. I don’t doubt there’s an element of misogyny in the electorate’s failure to warm to her and that many people find her voice grates. But her deeper problem is her inability to come over on television as a warm and likable person. Some pollies have that ability, others don’t. Other politicians manage to substitute an air of paternal authority - don’t worry, father is in charge - for likeability (eg Malcolm Fraser, Maggie Thatcher), but Gillard can’t manage that, either.

Lack of an air of authority - leaders who look like leaders and hence command respect and compliance; leaders who seem legitimate - has plagued the Rudd-Gillard government. I’ve come to the conclusion that - at the federal level, at least - the Liberals really are the natural party of government. That’s what the electorate thinks, what business thinks, what the media think, what the Libs themselves think and what, deep down, even Labor thinks. On the central polling question of which party is best to handle the economy, the Libs always win. The Hawke-Keating government managed to out-poll the Libs for a while, but Rudd and Gillard never have. This is not a question of track record, but of long-held and deeply held stereotypes. The party of the bosses will always be better at managing the economy than the party of the workers.

This is what allows Abbott to turn opposition to outright obstruction without attracting criticism. It’s what allows Abbott to take the support of business for granted, while Labor knows it must always be seeking business’s approval. It’s what has allowed business to conclude Labor is anti-business even while Labor modifies its policies - including Fair Work - to avoid offending business. It’s what, in the battle over the mining tax before Rudd’s overthrow, allowed the public to believe the foreign mining giants’ ads claiming the tax would destroy the economy over their own government’s ads assuring them the tax wouldn’t be a problem.

It’s what explains the Libs’ ability to wind up the electorate over Labor’s mountainous deficits and debt and why few economists intervened to dispel the nonsense. It explains why the opposition has had an excessive influence over the government’s fiscal policy and why Labor is obsessed by returning the budget to surplus in 2012-13. It also explains why only at this point have economists entered the debate to attack the government’s deficit mania.

Labor’s universally assumed inferiority - combined with journalism’s highly selective approach to quoting evidence - explains the success of The Australian in convincing almost everyone - punters, gallery journalists and even Labor politicians - that most of the money spent on Building the Education Revolution was wasted.

Associated with Labor’s lack of apparent authority is the phenomenon of the slippery slope. When you’re in power and on top you get a lot of co-operation, compliance and tacit support from interest groups and the public generally - all of which help you stay on top. These benefits of incumbency give you the strength to stand up to particular vested interests and tide you through the ups and downs of the polls. But when your weakness in the polls becomes sustained, you hit the slippery-slope part of the curve where it becomes a lot easier to fall further than to claw your way back up. Where things start to unravel as people who formerly accepted the reality of your continuing authority begin to wonder how long you’ll survive, whether they should give you a push on your way and whether they should start cosying up to your likely vanquisher.

Though she seems to have made a little progress back up the greasy pole in recent days, Gillard has spent most of her time as PM sliding down the slippery slope. It’s a situation that emboldens your critics and opponents while making your supporters more cautious. So things have been unravelling. The denizens of the House with the Flag on Top - pollies on both sides, staffers and journalists - revere success, fear the successful and despise failure. Lindsay Tanner says the press gallery is either at your feet or at your throat. It shifts when it sees you languishing in the polls, emboldened to be a lot more probing and critical and take a lot less on trust. The denizens take the polls so seriously that everyone starts expecting anything you do will fail, and their expectations tend to be self-fulfilling.

One interest group that’s particularly susceptible to this behaviour is business. Business will live with a housetrained Labor government with a steady grip on power. But it does so against its natural preferences. Big business people expect Labor to court them, while quietly accepting it when the Libs choose to ignore or pressure them. Business is very unhappy with Labor and I have no doubt its disenchantment and its increasing willingness to make its unhappiness known is magnified by its perception the Gillard government is not long for this world. It’s willingness to accept the carbon tax has been diminished by Abbott’s success in turning public opinion against the tax. Its complaints against Fair Work - which don’t seem to have great substance - are directed mainly at persuading the next government to shift the balance back in favour of employers. If this does collateral damage to Labor between now and the election, so much the better.

Both the Rudd and Gillard governments seem remarkably inexperienced. This shouldn’t be an excuse because it’s unusual for incoming federal cabinets to have many members with previous ministerial experience. Labor doesn’t seem to realise that maintaining good relations with business isn’t just a matter of senior ministers trying to fit in as many boardroom lunches as possible, or even keeping in touch with the business lobby groups. It means having big business chiefs feel they can ring the PM about a problem and their being on the receiving end of calls from the PM to inquire about their views on relevant matters. The main union leaders would have such a relationship with the PM, but I doubt the business chiefs do. They’d know this and would feel alienated from Labor, especially because Howard was such a great private phoner of power-holders.

Similarly, Labor’s failure to make sure the big miners knew what to expect well before the unveiling of the resource super profits tax is a sign of inexperience. The name of that tax - chosen by Labor’s spin doctors - did much to convince the rest of the business community Labor was anti-profit and anti-business, without doing much to arouse the punters’ resentment of foreign mining giants. Labor’s PR people have been far too young, lacking much journalistic experience, let alone political experience. It should have recruited some old hands. Rudd treated his staff so badly he burnt through a generation of good advisers.

But Labor’s chronic inability to sell its policies to the electorate can’t be explained simply in terms of the inexperience of its spin doctors. It isn’t primarily about spin doctors. I think the root of this generation of Labor politicians’ problem - the key reason they’re so bad at governing - is their background. Unlike earlier generations, almost all of them are apparatchiks; they come from Labor’s professional political class: people who start working for ministers or unions straight from university and climb the Labor career path, never making a success of a career in the outside world or even spending a lot of time as an on-the-ground union official dealing with ordinary workers and disparate employers.

The trouble with this system is that it seems to be breeding a generation of politicians who don’t have a good feel for human nature and, above all, don’t give up their profession and enter parliament with a burning desire to make the world a better place. Their burning desire is to make cabinet minister. Their entry to parliament is a promotion and a pay rise, not any sacrifice. These guys don’t have deeply held values and convictions they’re prepared to fight for and run risks for. Their lack of conviction robs them of the ability to explain policies that arise from their framework of belief. They can’t fashion a compelling narrative of what drives them and where the government wants to take us. They lack the missionary zeal of someone like Paul Keating; they have no desire to convert. They think ‘selling’ policies is a matter for spin doctors and advertising agencies, not of working tirelessly to help people understand the vision and see why it’s so important. When you’re not passionate about explaining your policies, when you’re just a political player, you do what Labor has done from the moment it took office: focus on attacking your opponents, thus conferring them and their criticisms a status they wouldn’t otherwise have. When you’re not a passionate explainer, you avoid answering questions and merely repeat prepared lines.

The problem with all this isn’t just that you fail win public support for your policies, it’s also that the public can sense your lack of commitment and conviction, your preference for self-preservation over leadership, your interests over theirs. You lose authority and respect in the eyes of voters. Courage comes from convictions; public confidence in governments comes from people’s perceptions of your courage and conviction. As John Howard demonstrated with the GST, voters are perfectly capable of giving you grudging respect for pursuing a policy they don’t like the sound of.

Minority government may be the making of Gillard

But having said all that, I now have to highlight a qualification. At the end of its fourth year, Labor has now amassed an impressive list of achievements. Leaving aside its remarkably effective response to the global financial crisis, we have: paid parental leave, equal pay for community workers, plain packaging for cigarettes, the foundations for a national disability insurance scheme, a price on carbon, the likely passage of the minerals resource rent tax, and the continuing pursuit of compulsory pre-commitment on poker machines. (Admittedly, the mining tax was butchered and Labor’s health and hospital changes fell far short of their billing.)

Some of the items on that list may not greatly appeal to you, but they would to the Labor heartland. And it’s noteworthy that some of the items wouldn’t have been there had it not been for the insistence of those whose votes Labor has depended on to stay in government. On the carbon price, in particularly, Gillard had no choice but to press on with its early introduction. See what’s happened? The circumstances of minority government and the ferocious opposition of Abbott have left Gillard with no option but to take principled positions and stick to them through thick and thin. If her improvement in the polls proves lasting, it will be because her failure to win a majority has forced her to exhibit all the impressive qualities she seemed not to possess. Her steadfastness and ultimate achievement may be winning her the grudging respect of the electorate.

Provided she can hold the numbers in the House for another two years, Gillard should benefit from the effluxion of time. It will give people more time to get used to her idiosyncrasies and more time to tire of Abbott’s. And there’d be something very wrong if more than a year of living under the carbon tax didn’t cause people to lose their fear of it.

It’s interesting to observe the way conservatives have transferred the mantle of bogyman from the ALP to the Greens. Labor’s greatest crime is not being typically wrongheaded Labor, but falling under the spell of the demonic Greens. Exhibit A would have to be the carbon scheme. But, apart from its higher levels of compensation to industry, it was little different from Rudd’s carbon pollution reduction scheme, which the Greens rejected out of hand. It’s not politic to say so but, in the end, it was the Greens who changed their tune, much more than Labor did.

The prospect of Abbott

Abbott has been far more effective as opposition leader than I and other smarties expected. He quickly learnt to keep disciplined and avoid putting his foot in his mouth, and quickly displayed his greatest, most enviable strength as a politician: an ability to ‘cut through’ - to have the things he says noticed and broadcast by the media.

His policy of blanket opposition to all the government’s policies has served him well. Many expected the electorate to tire of his relentless negativity, but it hasn’t happened yet. Even so, some strains are beginning to show. His autocratic style has put noses out of joint within the party and, should his standing in the polls ever slip, we will hear from his detractors. There is much discontent within the party and in business over his refusal to criticise Fair Work and propose any changes that could reawaken the spectre of Work Choices.

Despite the opposition’s remarkably strong standing in the polls, Abbott is not personally popular. He has a 55 per cent disapproval rating for his job as opposition leader. And the authoritative Australian Election Study, in which ANU political scientists surveyed voters soon after the last election, found that Abbott’s unpopularity was the main reason he failed to win enough seats. Though Gillard’s popularity rating was low, Abbott’s was a lot lower - lower even than Keating’s in the 1996 election.

Abbott has little interest in economics and no commitment to economic rationalism. His policy positions reek of populism, protection and direct controls. His solemn promises to roll back the carbon and mining taxes, but not reverse the goodies they will be paying for, leave him with a funding gap of many tens of billions he has, as yet, made no attempt to fill. How such a man could bring himself to outline the sweeping spending cuts needed to make good his promise to return the budget to surplus without delay is hard to imagine. He has, however, taken the precaution of refusing to use the services of the new Parliamentary Budget Office to cost his promises. There is no precedent for parties promising to abolish major new taxes already in operation, nor for governments actually doing it. I find it very hard to believe it would happen.

Should Abbott be elected, we face either a monumental breaking of promises or a government totally consumed by the effort needed to turn back the clock. Why the part of the electorate that cares most about good macro management and micro reform has had so little to say about Abbott’s incredible performance I don’t know. Perhaps they’ll have more to say as the reality of an Abbott-led government draws closer.

Observations on monetary policy

I normally begin this section by observing that the market and the business economists have had another bad year in their efforts the second-guess the Reserve Bank’s moves in the cash rate, but this year I have to declare the second-guessers to be ahead on points. The notion that the Reserve might cut rates entered the futures market’s head a lot earlier than it entered the Reserve’s head, so the market has to get credit for that. I’m not sure the market was particularly prescient on size and timing - suggesting it might have been right for the wrong reason. I suspect the market was dominated by foreign players who merely projected North Atlantic conditions onto the Antipodes, making insufficient allowance for local conditions. But, as all of us in the prediction business know full well, a win’s a win. I wouldn’t make those criticisms of the other great hero of this episode, Bill Evans. He stuck his neck out ahead of all of us, we marvelled at his folly, but he turned out to be right and he deserves all the accolades he got.

From where I sit it’s clear to me that to make a legendary call like Bill’s you have to get well ahead of the game, well ahead of the data - and you have to be right. When I saw Bill make his call I thought, that’s not in the Reserve’s plan, so he’ll only be right if he foresees developments the Reserve doesn’t foresee and those developments are big enough to change the plan. He did and they were.

The Reserve begins each year with a view of how the year’s going to pan out and a rough idea of the policy adjustments the outworking of that view will necessitate. It must have such a view because it has an on-the-record forecast, and that forecast is its view. The trick for you guys is to work out what its forecast tells you about the policy adjustments needed to bring the inflation forecast about, given the growth forecast.

This year the Reserve was expecting growth to accelerate as the effects of the resources boom spread through the economy, adding to inflation pressures at a time when we were already close to full employment. It was therefore expecting to have to tighten a few times as the year progressed. But here’s the point: it’s continuously testing its forecasts and its expectations against the data as they roll in. And it makes its judgments about whether policy needs to be adjusted one board meeting at a time. As events unfolded, the economy didn’t accelerate in the way it had been expecting, and so the Reserve never reached a point where it saw the need to act on its ‘bias to tighten’. At first there was the temporary setback of the Queensland floods - which proved less temporary than first thought - and then there was the backwash from the growing sovereign debt problems in Europe, mainly on business and consumer confidence. By November it was clear the economy wasn’t taking off the way the Reserve had expected - mainly because of the confidence backwash from Europe - so the Reserve wasn’t going to have the trouble keeping inflation within the target range it had expected to have, thus allowing it to make what it expects to be a once-off reduction in the cash rate to get it back to neutral. It’s worth noting that part of the scope for this move came not from the effects of Europe but from the past and future revisions to the underlying inflation figures arising from the Bureau’s reweighting of the index.

I don’t think the Reserve has very firm ideas about where the stance of policy goes from here. The economy is pretty much in equilibrium, policy is set at neutral, so the rate will stay where it is until developments occur that knock the economy off its equilibrium path - and off the Reserve’s forecast - in one direction or the other and require a policy response. Clearly, the balance of risks is very much to the downside.

But Bill has made another call and, as I understand it, is predicting another three cuts -presumably 25-basis-point cuts - next year. Here again you see him getting well ahead of the game; well ahead of the Reserve’s thinking, as expressed in its forecast. He can see something coming down the pike the econocrats can’t, and he may again prove himself to be more prescient than them. What would fit Bill’s call of three further cuts over the course of 2012 would be for the economy to slow down rather than speed up as forecast - for it to run out of gas, presumably because of growing caution and uncertainty on the part of business and consumers in response to continued turmoil in Europe. This would be manifest in a continuing rise in unemployment and an inflation outlook that was even more benign, thus allowing the rate to be lowered another click. Of course, were Europe to turn into the full catastrophe, we all know from the events of late 2008 how the Reserve would react. In that case I wouldn’t be surprised to see three cuts next year, but they’d probably come thick and fast, and each be nearer 100 points than 25.

I remarked in my column last Saturday that when the news is full of stories about some economic issue and the authorities pop with a policy change, all the instincts of the media and the punters are to assume that A caused B. In this case, we hear all this bad stuff from Europe, which makes us think the European economy is stuffed, therefore we must be stuffed and that must be what caused the Reserve to slash its forecast and cut the rate. I think all humans have a tendency to string together chains of cause and effect in this way and for our thinking to be unduly influenced by those events that have ‘salience’ (prominence in our consciousness) because they are so dramatic, so highly publicised or so recent.

My point is that this defective reasoning may be very human, but economists need to do better. Because the markets and business economists spend so much time studying developments overseas - usually the US, but these days, Europe - and they do that because national financial markets are so highly integrated - these developments have great salience in their minds, which can tempt business economists to over-weight them when forming views about likely developments in our economy - our real economy.

We need to remember that overseas events may be very exciting and very important, but they’re only relevant to us, our forecasts and our policy stance to the extent that, by some clearly identified channel, they have an effect on our real economy. They may be big in Europe, but are they still big by the time they reach us? Our real economy isn’t nearly as well integrated with the world as our financial markets are. Our domestic demand (GNE) accounts for almost all of our aggregate demand, sometimes more than all. As I keep reminding my readers, roughly 80 per cent of what Australians produce they sell to other Australians and roughly 80 per cent of what they purchase they buy from other Australians. Of course, the sharemarket is a more important channel than it used to be, and so - thanks to an ever-more globally integrated media - are confidence effects. I say all this simply because I keep hearing business economists making predictions about what the Reserve will do, and explaining why it’s done what it’s done, much more in terms of overseas development than I see in all the Reserve’s detailed exposition of why it did what it did. You’ve got to get your direction of causation right. The Reserve is managing our economy, it’s responsible for our inflation rate. Its highest consideration will be what’s happening in our economy and its interest in what’s happening in other people’s economies is limited to assessing the extent to which those events impinge on our economy. That’s obvious, but people who know a lot about what’s happening in other economies seem to keep forgetting it. Sometimes I think the traditional order in which the econocrats set out their analysis - start with the world, then move on to the domestic - may confuse people as to which is the more important.

Last year I advanced my theory that the timing of rate changes is influenced by ‘bureaucratic neatness’. At the time I said:

"Over the past five years the Reserve has changed rates 20 times. Since there are 11 meetings a year, if decisions to change rates occurred at random, each month would have a 9 per cent chance of being chosen for a rate change. The four meetings a year that are preceded by the release of the CPI and followed immediately by the release of the statement on monetary policy, would account for just over 36 per cent of random chances. But, in fact, the SoMP months - February, May, August and November - accounted for 65 per cent of rate changes, with November alone accounting for 25 per cent. The point is that the Reserve has set up a pattern in which the SoMPs come soon after the meeting that comes soon after the CPI release, and two of the SoMPs come not long before the Reserve’s twice-yearly appearance before the parliamentary committee. Remember, too, that the release of the CPI is a key influence on the revision of the Reserve’s inflation forecasts, which are published in the SoMP and which heavily influence decisions about rate changes. The SoMP serves as the main vehicle the Reserve uses to explain and defend its rate decisions. Is it surprising that, having carefully set up the timing of its key publication and parliamentary appearances, the Reserve is more inclined to fit its decisions into that timetable? But why in the past five years has the November pre-SoMP meeting had more than twice the hits that the other three pre-SoMP meetings have had? Perhaps because of an unconscious desire to get the books straight before the end of the year and the knowledge that what you’ve done has to tide the economy over until February."

That was a year ago. What’s happened since then? We’ve had just one rate move and it happened on . . . Melbourne Cup Day, making it the sixth cup day move in a row. Still think it’s mere coincidence? Last year when I advanced my crazy, utterly economics-free theory, my mate Rory Robertson was the first to express his scepticism. So I asked some relevant econocrats what they thought of it. They thought it had some validity. Provided the Reserve hasn’t got behind the curve, and thus needs to catch up ASAP, it will be more inclined to move in those months that fit its carefully constructed reporting cycle.

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Doomsday rate cut scenarios off mark

If the Reserve Bank ends up cutting the official interest rate by 0.25 percentage points on Melbourne Cup Day, it won't be because the economy has weakened so much as because it's not looking as strong - and thus, inflationary - as the Reserve had earlier expected.

The air is full of uncertainty and fear about the fate of the European and American economies, with one excitable pundit even predicting a ''world recession''. But, short of a major meltdown, the North Atlantic countries' troubles won't be a big part of the Reserve's reasons for fine-tuning the stance of its monetary (interest rate) policy.

No one knows what the future holds, and there's a ''non-trivial probability'', as the economists say, that the US economy will start contracting again and, more significantly, the problems in Greece will be so badly handled that the European economies implode.

Were that to happen, be in no doubt: the Reserve wouldn't just be lowering rates by one or two clicks, it would be slashing rates in much the way it did in the global financial crisis of 2008-09. But that's far from the authorities' ''central forecast''. They expect the US to grow by a bit under 2 per cent next year, while the euro area achieves no growth.

What would plunge Europe and the world back into crisis - with Europe entering a period of severe contraction - would be for Greece to leave the euro. That's because of the panic this would cause to euro depositors in many other member-countries.

It's likely the Europeans well understand what they need to do to avoid a conflagration: first, restructure the Greek government's debt (which means bond holders accepting big write-downs); second, recapitalise those European banks hard-hit by the write-down; third, have the European Central Bank purchase large quantities of European governments' bonds so as to lower bond yields and, hence, commercial interest rates.

So the Europeans' problem isn't knowing what to do, it's achieving the agreement of 17 squabbling member-countries to do it. The likeliest outcome is that they do enough to avert catastrophe, but not enough to prevent recurring episodes of financial-market jitters.

Our authorities' forecasts for 2012 aren't far from those the International Monetary Fund published last month. These have the US growing by 1.8 per cent and the euro area by 1.1 per cent. If so, that leaves the world economy growing by, what - 1.5 per cent? No, by 4 per cent - which is about the trend rate of growth. Huh?

What's missing from the sum is China's growth, expected to slow to a mere 9 per cent, and India's, to a paltry 7.5 per cent. Even Latin America is expected to grow by 4 per cent and sub-Saharan Africa by 5.8 per cent.

So much for a world recession.

Weakness in the North Atlantic doesn't equal weakness in Australia by a process of magic. You have to trace linkages between them and us. An important one is psychological: the effect of a sliding sharemarket, worrying news from the North Atlantic and over-excited talk of world recessions on the confidence of Australian consumers and business people.

As for ''real'' (tangible) linkages, these days the US and Europe aren't big export customers of ours. So the key question is the extent to which weakness in the North Atlantic leads to weakness in China, India and the rest of developing Asia.

These days, China is a lot less dependent on exports to the North Atlantic than it used to be. And the Chinese authorities have both the political imperative and the economic instruments needed to keep domestic demand growing fast enough to prevent much of a slowdown in production and employment growth.

So, barring a European implosion, the North Atlantic troubles' effect on us is likely to be limited mainly to their effect on confidence. If so, what are the domestic factors that could lead the Reserve to lower interest rates a little?

In May the Reserve was forecasting growth in 2011 of 4.25 per cent. In August it cut that to 3.25 per cent. Today it would probably say 3 per cent.

But get this: the overwhelming reason for these revisions is the temporary effect of the Queensland floods, in particular the loss of output from coalmines that are taking far longer than expected to resume production.

There have been various highly publicised areas of weakness in the domestic economy - the troubles our manufacturers are having coping with a high exchange rate, very weak department store sales and weak housing starts - but overall (and excluding extreme weather events), there's little sign of weakness.

Despite the much-publicised fall in

consumer confidence, consumer spending grew by 3.2 per cent over the year to June, bang on trend. Business investment has been strong and is sure to get stronger. And earlier figures showed worsening inflation and worryingly strong growth in labour costs per unit of production.

Indicators released this week show strong growth in exports and strengthening retail sales, home building approvals and non-residential building approvals.

The strongest evidence of weakening is in the labour market, with employment growth clearly slowing from its earlier fast past, and the unemployment rate jumping 0.4 percentage points to 5.3 per cent in just two months.

But this is a puzzle because, though growth in employment is weak, growth in hours worked isn't. And though surveyed unemployment is supposed to have jumped, the number of people on the dole is steady.

So how does the Reserve come to be contemplating lowering the official interest rate a little? Because its job is to keep interest rates at a level sufficient to keep inflation travelling within its 2 to 3 per cent target range, and the outlook for inflation has become less threatening.

For a start, the Bureau of Statistics has revised the underlying inflation rate over the year to June from 2.75 per cent to 2.5 per cent. Second, the outlook for economic growth isn't quite as strong as it had been. And third, the atmospherics of the labour market have improved, with more consumers worried about losing their jobs and employers less worried about the emergence of excessive wage demands.

The present stance of monetary policy is ''mildly restrictive''. But if the risk of inflation rising above the target range is now much reduced, the stance of policy should be returned to neutral. That would require a fall in the official rate of just one click - two at most.

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Our future is mining, not making

The lessons from BlueScope Steel's decision to sack 1000 workers in Port Kembla and Western Port are that, in the economy, benefits always come with costs: we can't have everything and one country can't do everything well.

Leaving aside the continuing fallout from the global financial crisis, the most momentous, long-term development in the global economy is the rapid industrialisation and urbanisation of the developing countries, with Asia as the epicentre of this trend.

For the economic emergence of the developing countries to be occurring at a time when the major advanced economies of the North Atlantic have made such a hash of their affairs is a great blessing to all of us. Whereas we're used to America and Europe providing the motivating force to the world economy, now it's the strong growth in the developing countries that will keep the world growing.

Among the developed economies, Australia is almost uniquely placed to benefit from the emergence of the poor countries. That's because we're located so close to the epicentre, but also because the main thing we sell the world is raw materials, and raw materials are the main thing the developing countries need to import: energy, food and fibre and, above all, the chief ingredients of steel - iron ore and coking coal.

The world prices of all these things have shot up in recent years and all Australians - not just the miners and farmers - have benefited from them. Although these prices are sure to fall back soon enough, they're still likely to stay much higher than they were. That's because the process of economic development in Asia has so much further to run. As people in poor countries get richer and seek more protein, agricultural prices will probably go a lot higher.

But as well as higher prices, our resources boom has entered a second phase of massive investment in expanding our capacity to supply coal, iron ore and natural gas to the rest of the world. This hugely increased investment spending is set to run for years. It will underpin our economy, protecting us against recession.

That's the good news and, overwhelmingly, this is a good-news story - even though, remarkably, we seem to be in the process of convincing ourselves times are tough and that no one who's not a miner has benefited from the boom: we didn't really have eight income tax cuts in a row; the NSW and Victorian governments aren't really getting bigger shares of the revenue from the goods and services tax at the expense of Queensland and Western Australia; none of us has benefited from the high dollar; we're not taking more overseas trips; not buying cheaper electronic gear and not paying less than we would have for our petrol.

And now, just while we're feeling so uncertain and sorry for ourselves in our immense good fortune, we're reminded that with all the benefits of the resources boom also come costs. Who'd have thought it? Quick, double the gloom.

For decades we thought we were losers, being a country obliged by its history and natural endowment to earn most of its export income from raw materials. Now we discover we're winners. But world trade works by each country specialising in what it's good at. You can't specialise in everything and the truth is we've never been good at manufacturing.

Our domestic market has been too small to give us economies of scale and we've been too far away from

the developed countries that buy manufactures.

The flipside of our increasing specialisation in the export of raw materials is our Asian trading partners' increasing specialisation in what they're best at: using their abundant but mainly unskilled and thus cheap labour to produce manufactures, including steel.

Increasing their exports of manufactures is the way they pay for our raw material exports to them, including the chief ingredients of steel.

Our manufacturers are copping it two ways: increased competition with the growing supply of cheaper manufactures from the developing countries, and our high dollar, which makes our manufacturers' prices high relative to those of other countries' manufacturers.

There are limits to the resources of labour and capital available to us in Australia, so the expansion of mining will tend to pull resources away from other Australian industries, particularly those we're not relatively good at, such as manufacturing. Our high exchange rate - which always rises when commodity prices are high - is part of the market mechanism that helps shift workers and capital around the economy.

There are bound to be a lot more job losses in manufacturing. And a lot of those displaced workers are likely to end up in mining or mining construction. Some, of course, will take the places of other workers who've been attracted into high-paying mining and construction jobs. Others will fill vacancies that have no obvious links to the resources boom.

It will be tough for those workers obliged to make this transition and even tougher for those who don't make it. Fortunately, it's happening at a time when unemployment is low. Even so, governments

need to do all they can to help displaced manufacturing workers find jobs elsewhere.

What governments shouldn't do is increase protection and other assistance to manufacturing industry itself in an attempt to stave off change. It needs to adjust to the reality of a significantly changed world economy.

Efforts to help manufacturing resist change can come only at the expense of all other industries. There are no free lunches in industry assistance.

It would be a good way to fritter away the proceeds from what the governor of the Reserve Bank has called "potentially the biggest gift the global economy has handed Australia since the gold rush of the 1850s".

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Don't wish a fall in interest rates on us

So you like the sound of a cut in interest rates? Don't get your hopes up. It's possible, but not probable. And remember, rates go down only when times get tougher. Is that what you want?

Though the likelihood is that hysteria over the imminent devastation to be wrought by the carbon tax accounts for the greatest part of the present caution among consumers, vague anxiety over the incomprehensible goings on in Greece is probably also contributing.

I don't believe in troubling trouble until trouble troubles me - especially when there's nothing you can do about it. But it seems I'm in a minority. Scare yourself over some event that with any luck won't happen? Yeah, why not? Got to get some excitement in your life.

The surest way for us to get a cut in interest rates would be for some major disaster in Europe - say, a disorderly debt default by Greece that caused the flighty financial markets to spread contagion to other highly indebted members of the euro area - to bring about another global financial crisis.

Should it happen, it would be similar to what we experienced after the collapse of Lehman Brothers in September 2008, with one exception: the financial markets are less likely to freeze up the way they did then. This time, no bank, central bank or government could say they had no inkling it was coming - which is what reduces the likelihood of a disaster being allowed to happen.

What we would get is the same wave of fear and uncertainty among consumers and businesses sweeping instantaneously around the world to every country that has television news - even those with little direct connection to the debt problems, including China (as happened last time) and us (ditto). We wouldn't be human if we didn't act like sheep.

We now know what happens when consumers and businesses around the globe become uncertain about the future and so suspend any plans they may have had for new spending until the outlook becomes clearer: international trade plummets, industrial production dives and world commodity prices crash.

The first time that happened it didn't take the Reserve Bank long to figure out what it needed to do: slash interest rates. It cut the official interest rate by 4 percentage points in five months. It would take it even less time to come to a similar conclusion this time.

If you could enjoy some such huge cut in your mortgage rate while being completely sure you and yours would keep their jobs, what a wonderful world this would be for those schooled by politicians and the media to take an utterly self-centred view of the economy. Trouble is, with everyone around you panicking, you couldn't be at all sure of keeping your job.

But let's step back from the worst-case scenario to something more probable. The truth is that despite all the self-pitying, over-hyped gloom, the Reserve retains a ''bias to tighten'' - its expectation that sooner or later it will need to raise interest rates, not cut them.

Why? Because we're in the middle of the biggest commodity boom, and the early stages of the biggest mining construction boom, we've experienced in 140 years. And because it's delusional to imagine all the benefit from that boom is penned up in Western Australia.

To be more specific, it's because the Reserve's first responsibility is to keep inflation in check and inflation is showing signs of breaking out. In particular, wages are growing at the relatively fast rate of 4 per cent.

Were labour productivity improving at the 2 per cent or even 1.5 per cent rate we've enjoyed in the past, that would be nothing to worry about. But productivity improvement has been particularly limited for some years, meaning ''unit labour costs'' (the average cost of labour per unit of production) are rising at a rate that will add to employers' price pressure.

How do you slow down wages growth? By using an increase in interest rates to slow the growth in borrowing and spending - demand - and, hence, the derived demand for labour.

All this says the Reserve will be scrutinising the consumer price index figures we get on Wednesday with particular concern.

It's true, however, that significant parts of the economy are doing it tough at present. Some of this is the unavoidable and actually helpful consequence of the resources boom's effect on the dollar, but in the case of retailing it's a self-inflicted bout of caution.

So, despite its worries about inflation, the Reserve will be reluctant to raise interest rates while the weakness in retail sales and other parts of the economy raise a question about the ongoing strength of demand. If underlying inflation in the June quarter comes in at about 0.7 per cent, it will be happy to stay its hand and await a clearer picture. Were the underlying increase to be as high as 1 per cent, it would probably still avoid raising rates at its board meeting the following Tuesday, but would be most uncomfortable about it.

When will it raise rates? When it sees signs consumers are losing their caution, or if the unemployment rate were to keep falling.

But what would prompt it to cut rates in the absence of global catastrophe? A lower than expected rise in underlying inflation next week plus, over the next few months, continuing consumer caution leading to further weakness in economic activity and a significant rise in unemployment.

You may wish for a rise in joblessness to bring about a cut in your mortgage rate, but that would be selfish and quite possibly foolhardy.

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Gillard's budget critics run for cover

One reason governments aren't nearly as "tough" as economists and others urge them to be is their knowledge that when the going gets rough - when the losers from that toughness start vigorously objecting - the urgers will be missing in action.

The reaction to last week's budget offers a good example. On budget night every petshop galah was complaining it wasn't tough enough - a "missed opportunity", the last Julia Gillard will get before the next election.

What they were on about was the need to roll back all the middle-class welfare John Howard inserted into the budget.

But there was a fair bit of rolling back in the budget and, on day two, when battlers on more than $150,000 a year (egged on by the media) were screaming blue murder, claiming to be on middle incomes and insisting "$150,000 a year isn't rich", almost all the previous day's urgers were out to lunch. (The media are always accusing the pollies of spin, but the media often put their own spin on the pollies' words. Neither Labor nor any politician would be stupid enough to claim people on more than $150,000 a year were "rich" rather than just comfortable, but the media happily put that emotive word into the pollies' mouths.)

Our small army of taxpayer-subsidised commentators from the libertarian think tanks - the Institute of Public Affairs in Melbourne and the Centre for Independent Studies in Sydney - had surprisingly little to say (with the honourable exception of the centre's Jessica Brown). Presumably, they were too busy preparing another jihad against "churning". You get the feeling Labor cops more criticism for its slowness to roll back middle-class welfare than Howard got for putting it there (here the economist Saul Eslake is the honourable exception). Certainly, the smaller-government brigade is a lot tougher on the government for its timidity than it is on the opposition for its blatant populism and inconsistency.

And if some of the measures proposed in the budget fail to get through the Senate, just watch as economists and media commentators blame it all on the Greens, not the Libs.

But I'm fairly confident most of the measures will get through. I have a feeling they were selected to be acceptable to the Greens and lower-house independents.

Against that, however, the failure of the pure at heart to offer the government any support in its battle with rent-seeking punters, an increasingly partisan media and an unprincipled opposition is a good way to increase the likelihood that those with the balance of power will decide the issue has become too hot so they dare not risk supporting the reforms.

It's funny commentators who last year were claiming Gillard's minority government would be incapable of achieving any reform are now berating it for this "missed opportunity". What were they hoping for: a truckload of tough measures that didn't stand a chance of getting through?

What the two attitudes have in common is they both frame Gillard as a loser. We know about Aussies' love of cutting down tall poppies, but here we're seeing something darker: if someone's down, why not join all those who are kicking them.

It's surprising how those who profess to care so deeply about the good government of the country see so little need to help a weak government be stronger. With our reform advocates it's all care but no responsibility.

As for the notion that governments can only do unpopular things in their first budget after an election, I don't think it applies to minority governments.

In any case, a look at the budget figures makes it clear Gillard is sailing close to the wind in being sure of achieving a small budget surplus in 2012-13 and keeping that surplus in the following few years.

There's a high likelihood that, to increase her margin of safety (and meet her pledge to limit real spending growth to 2 per cent a year), Gillard will need to achieve further spending cuts in her next two budgets - whether she fancies the idea or not.


Last Monday I wrote that the Reserve Bank governor's pay (I should have called it his total remuneration package) of $1.05 million a year had jumped 85 per cent in the past five years. This calculation was based on information in the Reserve's annual reports.


Now the chairman of the Reserve's remuneration committee writes that the figures used in this calculation are not comparable because of the changed accounting treatment of non-cash benefits. He says the cumulative pay rise over the period was in fact 34 per cent.


I have been unable to confirm his calculation from publicly available information. I am puzzled by it because the figure used as the base for my calculation, $570,000, was described in the Reserve's 2005 annual report as the governor's "remuneration package", which included "cash salary, the Reserve's contribution to superannuation, housing assistance, motor vehicles, car parking and health insurance and the fringe benefits tax paid or payable on these benefits".


The letter the previous chairman of the remuneration committee wrote to the Treasurer in September 2009 (made public because of a freedom-of-information request) advised that the value of the governor's total remuneration package had risen by 33 per cent just between 2008 and 2009.


I note that the incorporation into the governor's base salary of "other allowances (including motor vehicle)" worth $44,600 a year - which also included an unused entitlement to spouse travel, valued at $25,800 a year - led to a commensurate increase in his employer's superannuation contribution, which is made at the rate of 21.3 per cent.

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Stevens sells his moral authority

Everyone who's seen The Godfather knows how the Mafia works: it's more than happy to do you a favour, but once it has it owns you forever. Our coterie of grossly overpaid chief executives and directors operates much the same way.

They're a mutual pay-raising society - you raise my pay and I'll raise yours - and more than a year ago they induced the governor of the Reserve Bank, Glenn Stevens (a most estimable fellow in every other respect), to join their club.

Stevens accepted the recommendation of the Reserve board's "remuneration committee" that his salary be raised to $1.05 million a year. This is at least double what the heads of federal departments get, and far more than almost all other central bank chiefs get.

It's about five times what the US Federal Reserve chairman, Ben Bernanke, gets. Stevens's pay has jumped 85 per cent in five years, equivalent to annual rises of 13 per cent.

This compares with a former governor's "line in the sand" many years ago setting 4.5 per cent a year as the maximum non-inflationary pay rise for ordinary mortals (a limit that these days would be too high because of our weaker productivity growth).

The price of Stevens's admission to the lowest rung of the indefensible-salaries club is the loss of his - and the Reserve's - moral authority on the question of excessive pay rises for punters. (He also forfeits the ability to be at all critical of the example set by his fellow club members.)

The chances of skilled-labour shortages turning into a general round of excessive wage increases in the next few years are high. If that happens, Stevens has lost the ability to fight it with "open-mouth operations" in the way his predecessor, Ian Macfarlane, sought to talk down the housing boom in 2003 - with some success. No, Stevens will be left with only one instrument: higher interest rates. And consciousness of his self-inflicted impotence in the moral suasion department may lead him to raise rates just that little bit higher than otherwise.

If so, he will have added injury to his insult to wage slaves. The more some workers seek a fraction of the percentage wage settlements Stevens has been accepting, the more others of them will be priced out of a job.

But how does it come about that Stevens is now paid so much more than other central bank bosses? The rest have boards composed largely of economists and public servants. Pretty much only in Australia is the board composed largely of business people.

So what more is natural than this group of chief executives and professional board members seeking to run chief-executive remuneration at the Reserve the way they run it on money-obsessed private-sector boards? And what is more natural than them cutting a nice guy like Stevens in on the easy dosh?

Studies by psychologists show that people engaged in ethically dubious practices are commonly anxious to convince others - and themselves - that "everyone's doing it". And now the governor's just as morally compromised as I am. Told you.

The Reserve's delay in making Stevens's pay rise public - or even privately informing the Treasurer - for almost a year suggests it knew full well it was out of line with "community expectations" and had done something to be ashamed of.

The arguments members of the Reserve's "remuneration committee" have offered in defence of their actions are characteristically weak. The Reserve has to compete with "lucrative offers in the financial sector" to retain staff, we're told.

At the level we're talking about, that's rubbish. These guys aren't real bankers, they're economist bureaucrats who know a lot about monetary policy, but not much else. They could never run a real bank; some could run a dealing room or be a chief economist.

If any of the Reserve's top people have had "lucrative offers" lately it would be nice hear about them. I'll bet they haven't. Even if they had, they wouldn't be tempted.

Anyone who hangs in at the Reserve long term, and thinks they have a shot at being governor, is motivated by something no private-sector job can offer: the knowledge you're playing a significant role in steering the Australian economy. As a bonus, you get to sign banknotes.

It's true salaries need to be reasonably competitive with the financial sector much lower down in the Reserve hierarchy. That's where good young people are often tempted away - especially since the intellectual firepower needed to progress up the Reserve's ranks is formidable.

But that's the joke. In line with the ethic of the indefensible-salaries club, lower salaries aren't increased commensurately. It's demigods only. Little trickles down.

Asked how the yawning gap between Stevens's and Bernanke's salaries could be justified, one genius on the "remuneration committee" argued it was all about how much you could earn after you ceased being governor. Bernanke would command $250,000 a speech. That's a market-forces argument?

In truth, retiring Reserve governors - who have excellent superannuation - can earn vastly higher incomes by accepting all the positions on boards they're offered. Their inside knowledge allows them to become professional directors overnight - and help jack up other top people's salaries. The only constraint is their personal ethics.

It seems clear the Remuneration Tribunal intends to raise the salaries of federal department heads to reduce the gap with Stevens's $1.05 million, on the grounds of comparable responsibilities.

So we start with a bulldust market-forces argument and progress to fairness arguments. When workers argued this way in the old days it was called "comparative wage justice" and every economist condemned it as economically irresponsible. The demigods live by different rules.


Letter From Donald McGauchie to the Treasurer - 18 September 2009


Letter From the Treasurer to Donald McGauchie - 15 September 2010


Letter From Jillian Broadbent to the Treasurer


Letter to the Editor, May 12:

I write as chairman of the Reserve Bank Board's Remuneration Committee to correct a misinterpretation in a recent article by Ross Gittins (BusinessDay, 9/5) that claims there had been an 85 per cent increase in the remuneration of governor of the Reserve Bank Glenn Stevens between 2005 and 2010.

The cumulative pay rise over that five-year period was, in fact, 34 per cent. The numbers used by Gittins are not comparable owing to the changed accounting treatment of non-cash benefits between 2005 and 2010.

Roger Corbett, chairman, Remuneration Committee, Reserve Bank Board


Last Monday I wrote that the Reserve Bank governor's pay (I should have called it his total remuneration package) of $1.05 million a year had jumped 85 per cent in the past five years. This calculation was based on information in the Reserve's annual reports.

Now the chairman of the Reserve's remuneration committee writes that the figures used in this calculation are not comparable because of the changed accounting treatment of non-cash benefits. He says the cumulative pay rise over the period was in fact 34 per cent.

I have been unable to confirm his calculation from publicly available information. I am puzzled by it because the figure used as the base for my calculation, $570,000, was described in the Reserve's 2005 annual report as the governor's "remuneration package", which included "cash salary, the Reserve's contribution to superannuation, housing assistance, motor vehicles, car parking and health insurance and the fringe benefits tax paid or payable on these benefits".

The letter the previous chairman of the remuneration committee wrote to the Treasurer in September 2009 (made public because of a freedom-of-information request) advised that the value of the governor's total remuneration package had risen by 33 per cent just between 2008 and 2009.

I note that the incorporation into the governor's base salary of "other allowances (including motor vehicle)" worth $44,600 a year - which also included an unused entitlement to spouse travel, valued at $25,800 a year - led to a commensurate increase in his employer's superannuation contribution, which is made at the rate of 21.3 per cent.

Monday May 18

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