Treasury secretary cracks the whip over super funds

When Peter Costello announced his mindbogglingly generous changes to the taxation of superannuation in 2006, the air was thick with economists prophesying such profligacy would soon prove unsustainable.

Even in business circles, the good news was widely judged too good to last. Super payouts would be tax-free for those 60 and over (thus making people's age as well as the extent of their income a criterion for how much tax they paid) and the salary-sacrifice lurk for the better off was opened wide.

At the time, Treasury, whose advice seemed to have been followed by the Howard government, wasn't having a bar of the conventional criticism, and I volunteered to make sure the government's side of the story got an airing.

Since the arrival of the Rudd-Gillard government, however, the approach to super seems to have changed, suggesting the policy advice may also have changed. Despite (or maybe because it is) planning to phase up the compulsory employer contribution rate from 9 per cent of salary to 12 per cent, Labor has been chipping away at the cost - and the unfairness - of the super tax concession. It has largely eliminated the salary-sacrifice lurk, corrected the situation where those on low incomes gained no concession on their contributions and, in effect, restored the Howard government's 15 per cent super surcharge for those earning more than $300,000 a year.

Last week, the present secretary to the Treasury, Dr Martin Parkinson, removed any doubt that Treasury's attitudes have changed in a tough speech to the super funds association. He warned that, looking ahead, there were challenges for the present super arrangements. An obvious one, he said, was the ageing of the population. Although Australia was much better placed than many of the developed economies to cope with the budgetary costs of ageing, "the question remains, however, whether the current framework for our superannuation system will be sustainable into the future. While changes to the superannuation guarantee have been important for improving adequacy, they will clearly come at the cost of forgone revenue. Also, governments over time have introduced a range of concessions that encourage increased voluntary saving in superannuation. Again, these concessions come at a cost, indeed a very significant cost.

"With the Commonwealth budget coming under increasing pressure over the next few decades, the fiscal sustainability of all policies, including superannuation, will demand greater public scrutiny. This scrutiny will be even more important to the extent that existing concessions are seen to favour some at the expense of the majority."

When you remember all the promises both sides are taking into next year's election, and the difficulty whoever wins will have keeping the budget on track, it is not hard to guess where Treasury will be suggesting they look for savings.

Apart from the motor industry, there are not many sectors greedier in their rent-seeking than the super sector. Dr Parkinson took the opportunity to remind the funds in person he is no soft touch. How is this for frankness: "The government ensures the superannuation sector is provided with a steady, guaranteed and concessionally taxed supply of money. No other industry has this guarantee. None."

That sounds to me like a heavy hint the government is entitled to, first, keep the industry pretty tightly supervised and, second, expect a high standard of performance. He who pays the piper ...

"I would suggest that the superannuation industry has a responsibility to its stakeholders, including members and the government, to invest money prudently so the returns are in the best interests of members and to develop new products to meet the demands of our ageing population," he said.

"To date, the superannuation sector has focused primarily on the accumulation phase. But as the system matures, as more people move into the withdrawal phase, and as people in general live longer, there will be increased demand on the industry to assist individuals to manage the various phases of retirement and key risks like longevity ...

"Members reasonably ask: What has super delivered for me? And, more importantly, what will super deliver for me into the future? That means asking tough questions about the industry's readiness and capability to meet future challenges."

Now cop this: "I am not necessarily advocating any particular investment pattern, although I do have reservations about excessive reliance on equities."

It is a safe bet that, not long after the contribution rate reaches 12 per cent of salary, the industry will resume agitating for it to be raised to 15 per cent.

Dr Parkinson left the super funds in no doubt where he stands on the question of super's adequacy, quoting the example of a 30-year-old entering the workforce today, earning median wages and working for 37 years. They are projected to retire with an income equivalent to 90 per cent of their standard of living while working.

He said the level of super funds' management fees had been "a concern for Treasury". To tackle this concern, the government commissioned the Cooper review, from which had emerged its "stronger super" reforms, including SuperStream and MySuper.

SuperStream will see greater automation, common date standards and a network to centralise information and transactions. MySuper will provide a low-cost default super product that removes unnecessary and costly features.

The reforms could increase the retirement payout of a typical young worker by $40,000. I get the feeling that, should industry resistance prevent the reforms from delivering as expected, the issue will stay on Treasury's to-do list.

Read more >>

The two speeds not as far apart as claimed

Some people spent much of this year worrying about how the two-speed economy was affecting the south-eastern states. There was concern Victoria was on the brink of recession and South Australia and Tasmania were already in one.

So when, a week or two back, the Bureau of Statistics finally published the figures for the real growth in the various states' gross state product last financial year, 2011-12, there would have been great interest from the media, right?

Wrong. The only definitive figures we've had for economic growth by state for the past 12 months went virtually unreported.

Why? Because they were a bit dated? No. More likely because they showed no sign of recession. They also showed the gap between the fast and slow states to be narrower than we'd been led to believe.

Turns out we did a lot of worrying for nothing, misled by figures we should have known are always misleading.

The unreported figures show Victoria's gross state product grew by 2.3 per cent for 2011-12 as a whole, just a fraction less than NSW's 2.4 per cent. South Australia grew by 2.1 per cent and even Tasmania pushed ahead by 0.5 per cent.

By contrast, Queensland grew by 4 per cent and Western Australia by 6.7 per cent. Overall, gross domestic product (the national measure) grew by a respectable 3.4 per cent.

A point to remember, however, is that the populations of the states are growing at quite different rates and this accounts for part of the difference in the rates at which their economies are growing. Only to the extent a state's gross state product per person is increasing is it better off materially.

Nationally, economic growth of 3.4 per cent in 2011-12 drops to 1.8 per cent per person. Queensland's growth drops from 4 per cent to 2.2 per cent, while WA's drops from 6.7 per cent to 3.7 per cent.

Not quite so much cause for envy.

If you recollect reading during the year figures a lot more dramatic than these, you're right, you did. As I say, definitive figures for gross state product are published only once a year, on an annual basis. The figures the bureau publishes each quarter as part of the national accounts are for something quite different: state final demand.

These figures are always widely reported by the media, with journalists happily assuming SFD and GSP must surely be pretty much the same thing. Trouble is, they're not. And the media's insistence on reporting these largely meaningless figures means the public is regularly misled about the extent of differences between the state economies.

State final demand and gross state product would be pretty much the same thing if the states' shares of Australia's exports and imports never changed and, more to the point, if there was no trade between the states.

It shouldn't surprise you there's a lot of trade between the states. Nor should it surprise you the mining states import a lot more from the other states than they export to them. The other side of the coin is the other states - particularly NSW and Victoria - export more to the mining states than they import.

This trade between the states spreads the benefits of the resources boom around the continent. In consequence, the much-quoted state final demand figures tend to overstate how well the mining states are doing and understate how well the other states are doing.

That's how the recession furphy got started.

Consider this. According to the latest figures for 2011-12, WA state final demand of 13.5 per cent turned into gross state product of 6.7 per cent, while Queensland's final demand of 8.6 per cent was more than halved to 4 per cent.

By contrast, Victoria's final demand of 2.2 per cent was increased a fraction to gross product of 2.3 per cent, while NSW's final demand of 2 per cent was increased to 2.4 per cent.

SA's final demand and gross product were the same at 2.1 per cent (meaning it neither wins nor loses from the inclusion of international and interstate exports and imports), while Tasmania's final demand growth of zero was increased to gross product growth of 0.5 per cent.

You see how misleading those quarterly state final demand figures are. They exaggerate the true extent of the differences between the states.

So why do the media make so much of them? Because, at a time when the resources boom is doing so much to change the industry structure of our economy, there's much interest in what this is doing to the respective sizes of the state economies.

The quarterly state final demand figures don't give reliable answers to this question, but they're the best that regularly come our way.

But also because the ever-intensifying competition between the news media has prompted them to select their news on the basis of all care but no responsibility. If some information is interesting or controversial it will be published, even if the journalists know or suspect it's dodgy. After all, if I don't do it, my competitors will.

The relative sizes of the six state economies have been changing since federation, partly - but not solely - because of their differing rates of population growth. But, though it's possible to exaggerate the extent to which the resources boom is causing the mining and non-mining states to grow at different rates, the states' relative sizes have been changing particularly rapidly in recent years.

Those recent figures no one bothered to report, known as the State Accounts, showed how the states' shares of overall gross domestic product have changed over the eight years to 2011-12.

In that time, NSW's share has dropped 3.8 percentage points to 30.9 per cent. Victoria's share has dropped 2.6 points to 22.3 per cent.

By contrast, Queensland's share has increased 1.7 points to 19.3 per cent, while WA - which long ago overtook SA in the pecking order - had its share increase a remarkable 5.4 points to 16.2 per cent of overall GDP.

That leaves SA's share falling 0.8 points to 6.2 per cent and Tassie's falling 0.3 points to 1.6 per cent. Its share is now less than the ACT's (2.2 per cent) and only a fraction greater than the Northern Territory's (1.3 per cent).

Whether we like it or not, the shape of our economy is changing.

Read more >>

A new economic history of Australia

It drew little comment, but the centrepiece of Julia Gillard's white paper on the Asian century was her target of raising Australia's standard of living - income per person - from the 13th highest in the world into the top 10 by 2025. Considering the three richest economies on the list are the tiddlers of Qatar, Luxembourg and Singapore, it's clear we're already very rich.

Perhaps the reason this grand objective excited so little interest is that, for us Australians, there's nothing new about being in the materialist winners' circle. As Ian McLean, an economic historian at the University of Adelaide, reminds us in a new book, Why Australia Prospered, we joined that company from about 1820, and between 1860 and 1890 we were the richest country of all.

Few countries have been so successful for so long, he says. Some have achieved comparable levels of income only since World War II (think Japan or Italy). Many Asian countries are making good progress in catching up to these levels, though they still have some distance to travel (even South Korea).

McLean reminds us one country has experienced long-term relative decline after having achieved membership of the rich nations' club in the early 20th century: Argentina. And even New Zealand, which tagged along near us for most of the journey, has been falling further behind since the 1970s.

So, in the first major economic history of Australia for 40 years, McLean sets out to explain why we became rich so soon and how we've managed to stay that way for the most part of 200 years.

The story we have in the back of our minds explains it in a phrase: we're the Lucky Country. The Europeans who settled in this vast land had the good fortune to arrive at a place well suited to farming and teaming with valuable minerals. For more than 200 years we've been living off that great luck.

There's no doubt Australia's longstanding prosperity owes a lot to the exploitation of its bountiful "natural endowment". We became a major world producer and exporter of wool as early as the 1820s, and it stayed our principal export earner until the 1950s, save for the 1850s and 1860s when it was supplanted by gold.

McLean says the gold rush was "no flash in the pan". Gold continued to be important to our prosperity for several decades. And we remain a significant world producer to this day.

At the start of the wool boom in 1820, Australia's European population was just 30,000. By the time gold was discovered in 1851, it was up to 430,000. Thanks to the gold rush, in just 10 years it had reached 1.2 million. Most of those people stayed, and by the start of the serious depression of the 1890s it was 3.2 million.

The story of our lucky natural endowment continued with the discovery of many mineral deposits in the 1960s, right up to the Asia-driven resources boom of the past decade. Still today, primary products account for two-thirds of our export income.

But McLean disputes the notion our unending prosperity can be explained simply in terms of our lucky strikes. For one thing, their study of many countries has led modern economists to the conclusion that possession of some valuable resource deposit is almost always a curse rather than a blessing.

It tends to lead to squabbling over who gets the proceeds, corruption, complacency, underdevelopment and stagnation. By contrast, resource-bereft countries such as Singapore or Taiwan seem to have succeeded precisely because they knew they had nothing going for them beside their own efforts.

Clearly, Australia is an exception to the "resource curse" rule. But then we have our erstwhile southern hemisphere twin, Argentina, as a reminder you do have to play your cards right.

Our long prosperity defies another conventional wisdom: colonies get exploited by their colonising power. McLean finds no evidence of significant exploitation by the British. On the contrary.

Unlike some Asian colonies, our economy had to be built from scratch. Who built the foundations and paid for them? The British taxpayer. We benefited from our convict origins. The Brits were expecting it to cost them, and the 160,000 convicts they sent us were selected for their suitability for hard work.

A big part of the reason we got rich so quickly was that such a high proportion of the population was in the workforce. Then there was the advantage of being part of the British Empire trading bloc and the privileged access it gave us to Britain's market.

Self-government came early and bloodlessly in the 1850s.

But McLean gives much of the credit to the quality of our economic and political "institutions" - legal system, property rights, control of corruption, political arrangements and social norms - most of them inherited from the Brits.

The test of our institutions is their flexibility, their ability to adapt in response to changing circumstances and needs. As evidence of flexibility McLean cites the ending of transportation of convicts, a solution to the monopolisation of grazing land by squatters and the pull-back from using indentured islander labour on sugar plantations.

Much more recently you can point to all the economic reforms we undertook in the 1980s and '90s to open our economy to a globalising world. And to our skilful response to the global financial crisis - just the latest of many economic shocks the world has thrown at us.

Australians don't have tickets on themselves as great managers of our economic fortunes, but a look at the record - and at the performance of comparable countries - says we've had a lot more going for us than just luck.

Read more >>

What business needs to learn about politics

The way big business sees it, economic reform has ground to a halt because the politicians on both sides have lost the political will to make the tough decisions. But I think big business must share the blame for the stalemate we've reached.


Business leaders have lost confidence in the Gillard government and, having concluded its days are numbered, are uncharacteristically willing to attack it in public. In private, though, most would doubt an Abbott government would be any more willing to grasp the nettle.

Consider the GST. Despite all the good sense Nick Greiner was talking last week about the need to fix it, both sides refuse even to discuss the topic. It was specifically excluded in the terms of reference for Ken Henry's "root and branch" review of the tax system (which didn't stop him proposing a similar tax with a different name).

It's not hard to see what the problem is. Each side is afraid that, if it showed the slightest interest in considering the topic, the other side will use this as a pretext to launch a scare campaign.

Or, consider the mining tax. Although it's not true the tax raised no revenue in its first quarter, it is true it raised less than expected, mainly because of the fall in commodity prices.

But prices have recovered from their lows in the first two months of the quarter. As well, the nature of the quarterly instalment process means collections are likely to pick up in later quarters.

Even so, it is true that the compromise tax Julia Gillard negotiated with the big three mining companies was both badly designed and too generous to the miners.

Why did she give in to them? Because the opposition had sided with the miners in opposing the original tax and, in their efforts to destroy the Rudd government, the big miners would have given the opposition huge funding in the 2010 election campaign.

One reason the miners were so opposed to the original tax was that the government caught them off guard with a strange tax they didn't understand. This would not have happened had Labor released the Henry report for discussion well before it made up its mind about which recommendations to accept, reject or modify.

So, why didn't it? Because it was so afraid the opposition would run a scare campaign claiming that Labor intended to implement all of Henry's most controversial proposals.

Next, consider company tax. For reasons I can't fathom, big business has its heart set on a cut in the company tax rate. Labor promised a cut of 2 percentage points, but the deal with the miners obliged it to reduce the cut to 1 point.

Then the combined opposition to this from the opposition and the Greens allowed Labor to renege completely. Although all previous cuts to the rate have been funded by the removal of concessions, big business can't agree on which concessions it's prepared to give up.

This has allowed Labor to shelve the idea. And I wouldn't hold my breath waiting for an Abbott government to find the revenue needed to fund a cut.

Finally, consider all the reform the Hawke-Keating government undertook during the 1980s and early '90s: deregulating the financial system, floating the dollar, phasing out import protection, deregulating more industries than you can remember and decentralising wage-fixing.

What do these reforms have in common? They went virtually unchallenged by the Liberal opposition of the day, under the dominant influence of John Howard and John Hewson.

Are you starting to see a pattern? All the reforms that aren't getting up (or, in the case of the mining tax, got badly botched) have become party-political footballs. And almost all the reforms we did get were bipartisan policy - with the GST and the carbon tax as the notable exceptions (although in both these cases the lack of bipartisanship led to inferior policy).

The point is, it's not so much unhappy voters governments fear, it's their political opponents seeking to take advantage of the voters' unhappiness.

What many business people don't understand about politics is the power of oppositions to influence what governments do and don't do. It's rare for governments to make controversial reforms when they know their opponents are waiting to pounce.

The bipartisan support for micro-economic reform lasted throughout the Hawke-Keating government's 13 years, but broke down after Paul Keating's defeat in 1996. Since then, both sides have gone for short-term political advantage at the expense of the nation's longer-term interests.

So, the first lesson big business needs to learn is that it's not enough to pressure the government of the day to show "political will". You must also pressure the opposition to resist the temptation to score cheap political points.

That's particularly the case when it's the opportunism of a Liberal opposition that is discouraging a Labor government from doing what it knows it should.

The second lesson is that big business won't get far until it abandons its code of honour among thieves. That is, when one industry goes into battle with the government to resist a new impost or get itself a special concession, all the other industries keep mum, even though they know the first industry is merely on the make.

Big business looked the other way as the three big miners connived with the opposition to destroy the Rudd government. Its reward was to have its precious cut in company tax snatched away.

Read more >>

States are correcting earlier mismanagement

In most states around Australia, recent years have seen long-standing Labor governments tossed out and replaced by Coalition governments. In all cases, the new governments have immediately embarked on campaigns to cut government spending. Why?

Is it American-style anti-government ideology? Is it uniform Labor mismanagement across the nation? Could it be some changed feature of the national economy, or just the state governments' irrational pre-occupation with preserving or restoring their triple-A credit ratings?

Turns out to be a bit of most of those.

The Commonwealth Grants Commission, which is responsible for deciding how the proceeds of the goods and services tax are divided between the states, has published an information paper on the changes in state budgets over the 10 years to 2010-11 (which you can find on its website).

It found that, taking all the states and territories together, they ran small overall budget deficits (known as the "net borrowing position") in the first two years of the noughties. Then, for the next five years, from 2002-03 to 2006-07, they ran quite large overall budget surpluses ("net lending position"), meaning they could run down their level of government debt.

Great. But then, for the final four years, they switched back into ever-growing overall budget deficits, rising from $4.3 billion in 2007-08 to a mammoth and unsustainable $15.3 billion in 2010-11.

Can you think of some momentous event about that time that might help explain such a marked deterioration in the states' finances? How about the global financial crisis, which began in August 2007 and reached its climax in September 2008 with the collapse of Lehman Brothers investment bank?

But there was another factor, which got going a bit earlier: the states' rapidly increased spending on capital works. How much does this explain?

Before we go any further, note that these figures relate only to the states' "general government" sector. That is, they don't include the activities or the borrowing of government-owned businesses, such as water boards or electricity authorities.

Also, note that state budgets are heavily influenced by the receipt and spending of grants from the federal government. These receipts are the proceeds of the GST, plus "special purpose payments" - which include federal grants for spending on capital works. Much of the Rudd government's fiscal stimulus went on capital works spending by the states.

Total grants from the federal government account for about half the total revenue received by the states. Until 2007-08, the GST accounted for about 60 per cent of all federal money received; since then its share has fallen to half, a sign it's no longer the "growth tax" it was.

So far, however, this decline in the relative importance of GST money has been offset by increased special purpose payments - though whether this will remain true is different matter.

So next the Grants Commission's information paper strips out all federal payments (and the spending of them) so we can see what's been happening to the states' "own-account" revenue-raising and spending.

It turns out the states' own-account "expenses" - that is, their spending for recurrent purposes - have grown quite strongly relative to the growth in their economies, from 7.3 per cent of gross state product in 2005-06 to 8.1 per cent in 2010-11.

At the same time, however, the states' own-account revenue - composed of mainly of state taxes and receipts from public transport fares and public housing rents - has fallen relative to gross state product, from a peak of 7.8 per cent in 2006-07 to 7.4 per cent in 2010-11.

This explains the marked deterioration in the states' own-account "operating balance" from a surplus of $4 billion in 2006-07 to a deficit peaking at $12.1 billion in 2009-10, before falling to $9.7 billion in 2010-11.

All this suggests there was a degree of mismanagement by the mainly Labor governments in power at the time. While their own-account revenue raising was failing to keep pace with their economies, they were allowing their own-account expenses to grow very much faster than their economies.

I don't have a problem with a growing public sector, but I do have a problem with politicians allowing their day-to-day spending to grow rapidly without being willing to increase taxes to cover it. Particularly at the state level, that's not being "progressive", it's being irresponsible.

To be fair, much of the weakness on the revenue side of their budgets wouldn't have been the state premiers' fault. In particular, conveyancing duty - which accounts for 12 per cent of the states' own-account revenue - made a negative contribution to revenue growth after 2005-06.

This was due to the global financial crisis's effect on the housing market. At the same time the state governments were allowing their own-account operating budgets to deteriorate, they were also stepping up their own-account spending on capital works. This increased from a mere $32 million in 2004-05 to $5.6 billion in 2010-11. (If these figures seem low, it just shows how much of state capital works spending is financed by the feds - in the final year, about two-thirds.)

But if you look at it from the last overall budget surplus of $1.2 billion in 2006-07 to the overall deficit of $15.3 billion in 2010-11, the increase in own-account capital spending accounts for just $2.8 billion of the $16.5 billion deterioration.

So the popular impression that the states are in bother with the credit rating agencies simply because of their need to overcome the widely assumed (but rarely demonstrated) infrastructure backlog seems far from true.

The main problem is borrowing to finance recurrent operations - which, unless states are in the depths of recession, can't be defended.

I don't have much time for Standard & Poor's, Moody's and the other rating agencies. Their dereliction of duty contributed greatly to the global financial crisis, for which they've got away with far too little public censure.

Sometimes I suspect they run an especially hard line on government borrowers to distract attention from the way they disgraced themselves with their paying-customer private sector borrowers in the years before the crisis. They're walking proof that an independent opinion on your financial affairs is not something you can buy.

But in this case they're in the clear.

The main reason for all the belt-tightening by state governments is old-fashioned mismanagement.

Read more >>

Climatic adjustment limits our farmers' Asia boom

The first thing to realise about the rise of Asia is that our farmers are about to join our miners in the winners' circle. The second is that climate change and other environmental problems may greatly limit our farmers' ability to exploit this opportunity. The third is that what we see as a looming bonanza, the rest of the world sees as a global disaster.

According to the government's white paper on the Asian century (which, be warned, shares economists' heroic assumption that there are no physical limits to consumption of the world's natural resources), continuing population growth and rising living standards in Asia will cause global food production to grow 35 per cent by 2025, and 70 per cent by 2050.

Rising affluence is expected to change the nature of Asia's food consumption, with greater demand for higher quality produce and protein-rich foods such as meat and dairy products. This will also increase the requirement for animal feed, such as grains. There'll also be demand for a wider range of processed foods and convenience foods, and for beverages, including wine.

But environmental and other problems will prevent the Asians from producing much of the extra food they'll be demanding. Unlike in the past, Asia is likely to become a major importer of food. And, of course, any delay in increasing food production to meet the increasing demand will raise the prices being charged.

You little beauty. "Australia's diverse climate systems and quality of agricultural practices position us well to service strong demand for high-quality food in Asia," the white paper says. After all, Australia is one of the world's top four exporters of wheat, beef, dairy products, sheep, meat and wool.

"As a result, agriculture's share of the Australian economy is expected to rise over the decade to 2025," we're told, something that hasn't happened for many, many decades.

So, a new age of growth and prosperity for Aussie farmers? Don't be too sure. The environmental constraints the white paper expects to bedevil Asian farmers will also limit our farmers' ability to cash in on Asia's growing affluence.

Also published last week was a determinedly positive but franker assessment of our agricultural prospects, Farming Smarter, Not Harder, from the Centre for Policy Development.

It says "winners of the food boom will be countries with less fossil fuel-intensive agriculture, more reliable production and access to healthy land and soils". That's not a good description of us.

The first question is climate change - the problem so many Australians have been persuaded isn't one. Although other countries - including China - are doing more to combat climate change than the punters have been led to believe, we don't yet know how successful global efforts to limit its extent will be.

What we do know is we're already seeing the adverse effects - hurricane Sandy, for instance - and can expect to see a lot more, even if global co-operation is ultimately successful in drawing a line. At present we're focused on efforts to prevent further change; before long we'll need to focus on how we adapt to the change that's unavoidable.

This non-government report says climate change is projected to hit agricultural production harder in the developing world than the developed world - "with the exception of Australia".

"Rainfall is forecast to increase in the tropics and higher latitudes, and decrease in the semi-arid to arid mid-latitudes, as well as the interior of large continents," the report says. "Droughts and floods are expected to become more severe and frequent. More intense rainfall is expected with longer dry periods between extremely wet seasons. The intensity of tropical cyclones is expected to increase."

So, without action to reduce or manage climate risks, Australia's rural production could decline by 13 per cent to 19 per cent by 2050, it says.

And it's not just climate change. "One of the biggest challenges for Australian agriculture is that our soils are low in nutrients and are particularly vulnerable to degradation ... every year we continue to lose soil faster than it can be replaced."

The productivity of broadacre farming used to grow by 2.2 per cent a year; since the early 1990s it's averaged just 0.4 per cent. Australian farmers use a lot of fertilisers and fuel, the cost of which is also likely to rise strongly. And that's not to mention problems with water.

Meanwhile, those who worry about how the world's poor will feed themselves - or about the political instability we know sharp rises in food prices can cause - don't share our hand-rubbing glee at the prospect of Asia's greatly increased demand for food.

Almost as bad as high food prices are highly volatile prices. The three world price spikes in the past five years each coincided with droughts and floods in major food supply regions. Extreme weather events are likely to become even more frequent. (The growing diversion of grain to produce biofuels is another contributor to higher food prices.)

After the food price spike in 2008, 80 million people were pushed into hunger. But the growing concern with "food security" is often a euphemism for resort to beggar-thy-neighbour policies: countries that could export their food surplus to other, more needy countries decide to hang on to it, just in case.

The Asians' attempts to continue their (perfectly understandable) pursuit of Western standards of living are likely to be a lot more problem-strewn than the authors of the white paper are willing to acknowledge.

Read more >>

Asia white paper assumes away environment

The most glaring weakness in the Prime Minister' s white paper on the Asian century is its failure to factor in the high likelihood that mounting environmental problems will stop Asia continuing to grow so rapidly as well as limit our ability to take advantage of what growth there is.

To be fair, most of the environmental problems that could trip up Asia s economies and ours do rate a mention in the bowels of the 300-page document.

But it doesn t join the dots. Asia s environmental problems are dismissed merely as among the various challenges to be overcome bumps along the road. As for our own environmental problems, the government s existing policies have them well in hand.

And it would be unfair to single out the Gillard government as unwilling to face up to the seriousness of our problems with the natural environment and start integrating them into its forecasts and projections.

That s just as true of almost all economists and business people. While most economists (and some business people) are prepared to acknowledge particular environmental problems climate change, water, soil, fish stocks, biodiversity they re not prepared to see them as symptoms of a much bigger problem: we may be reaching the physical limits to continued growth in natural resource use.

So, just like the white paper, they continue to put worries about environmental problems in a box marked environment , which they keep separate from the box marked economy , where they do their forecasts and longer-term projections of economic growth.

It s an uncontroversial statement that the global economy the production, consumption and other economic activities of humans exists within, and depends on, the natural environment, the global ecosystem.

And it s obvious to anyone with eyes that certain economic activities are doing damage to the ecosystem, which is already rebounding on the economy in the form of costs and disruption (hurricane Sandy, for instance). It s not hard to believe these costs and disruptions are likely to multiply unless we start organising the economy very differently.

It thus makes all the sense in the world for economists to integrate the environment and the economy when thinking about what the future holds. So why don t they? Because they never have, and find the idea pretty frightening.

Economists standard way of thinking about the economy effectively assumes away the environment. That s because their conventional model which has changed little in the past 100 years is built around the prices charged in markets, whereas most environmental assets clean air, clean water, good soil, reasonably reliable weather can t be bought and sold in markets.

Thus most of the costs and benefits generated by the ecosystem are external to the model and so liable to be overlooked. Schemes such as the carbon tax are attempts to put a price on greenhouse gas emissions and so get them into the price mechanism (and the model).

So you can bolt bits of the environment onto the model, but you have to do it case-by-case, which is hardly satisfactory. As Professor Herman Daly has said, if the survival of your society is external to your model, you probably need a new model .

The funny thing is, if you re still not sure why so many scientists doubt it will be physically possible for Asia to grow as big as economists project, the clues are all there in the white paper. To put things in context, at present the developed world accounts for just 15 per cent of the world s population, but 51 per cent of gross world product.

The 19 per cent of the world s population living in China has a standard of living equivalent to 20 per cent of America s. The white paper expects that to reach 40 per cent in just 13 years.

For India and Indonesia, accounting for a further 21 per cent of the world s population, their standard of living could also double, from 10 per cent to almost 20 per cent. And, of course, living standards in other parts of Asia are also supposed to be rising rapidly, meaning more than half the world s population is applying to join the profligate rich club.

Have you any idea what that would mean in additional use of the world s energy and other natural resources?

The white paper advises that, in the 19 years to 2009, Asia s energy consumption more than doubled and its share of world energy consumption jumped from 25 per cent to 38 per cent. China is now the world s biggest energy consumer.

Having gone from consuming less than half as much energy as the US in 2000, China now consumes slightly more. It accounts for almost half the world s coal consumption. It s the world s largest consumer of steel, aluminium and copper, accounting for about 40 per cent of global consumption for each. It s predicted to be 90 per cent dependent on imported oil by 2050.

In 2009, fossil fuels accounted for about 82 per cent of Asia s energy mix. Asia accounts for about 40 per cent of global greenhouse gas emissions up from 31 per cent in 2001. China recently overtook the US as the world s largest emitter.

The white paper happily assumes effective global action to limit climate change will be forthcoming, so makes no allowance for it in its projections.

It s not the done thing for economists to imagine we could ever run out of natural resources. Prices may rise a bit, but this will merely call forth the solution to the problem, whereupon prices will fall back. And every textbook leaves you thinking this process happens seamlessly.

So, no need to worry. Our faith in unending growth remains unshaken.

Read more >>

How Asia is catching up with the rich West

Asia's transformation into the world's most dynamic economic region has been a defining development of our time. The pace and scale of its rise have been nothing short of staggering.

That's the story according to Julia Gillard's white paper on the Asian century, and it's right.

"Over the past 20 years, one third of the world's population has re-engaged with the global economy and more are set to do so," the paper says. "Living standards for billions of people in Asia have improved at a rate not previously experienced in human history."

Just between 2000 and 2006, about a million people were lifted out of poverty every week in East Asia alone, we're told.

Japan, South Korea, Singapore and, more recently, China and India doubled their income per person within a decade. Some went on to repeat this achievement two or three times.

By contrast, it took Britain more than 50 years to double its income per person during the Industrial Revolution of the late 18th and early 19th centuries.

Why so long? Because the Industrial Revolution was driven by the invention of new technology and it took a while for new inventions to come along and for their use to spread through the economy.

These days, the economy sitting at this "technological frontier" is the US. In principle, the fastest pace at which America's income per person - its material standard of living - can grow is determined by the pace of what today we call "innovation". And that's not fast - say, 2 per cent a year.

So with the rise of Asia we're seeing a phenomenon economists call "catch-up and convergence". Because all the improved machines and better ways of doing things have already been invented and are sitting on the shelf, so to speak, it's not hard for all the countries well back from the technological frontier to catch up with the leader by employing the new productivity-boosting technology. As they do, their standard of living converges on the leading economy's.

This is what happened in the West in the first 30 years or so after World War II. The economies of Europe (and Japan) grew very strongly and closed most of the gap between their living standards and America's.

Now that process of catch-up - and the global spread of the latest technology - has shifted from the developed countries to the developing countries. Japan was the first, followed by South Korea, Hong Kong, Singapore and Taiwan, with China getting going in the 1980s and India in the 1990s. More will follow.

Of course, transforming your economy from developing to developed can't be as simple as taking new technology off the shelf, otherwise all the poor countries of the world would be growing as fast as Asia is.

So how have the Asians done it? What have they got right that the others haven't?

The various countries' success hasn't followed a simple recipe, the paper says, but some common patterns have emerged in recent decades.

Many economists explain Asia's rise mainly in terms of its switch from the post-war policy of "import replacement" (seeking to grow by protecting your industries from competition with imports) to export-led growth.

If, as part of this, you allow foreign multinational corporations to set up factories in your country, they bring in the capital need to pay for building those factories, as well as access to the latest foreign technology and the knowledge of how to use it, which ends up being transferred to local technicians and managers and spreading to local firms.

But that's not how the white paper tells it. "Nearly all the high-performing Asian economies deliberately set out to support prosperity by investing in people, building capital and undertaking institutional change, including expanding the role of markets," it says.

Asia's young people enjoyed marked improvements in their access to education and its quality as governments invested in their youthful populations and dramatically transformed their education and training systems.

"With the benefits of a good education and employment-creating reforms, large numbers of young people have become productively employed as they reached prime working age."

Open global trading systems (created by the successive rounds of multilateral reductions in protection under the predecessor to the World Trade Organisation, to whose trade-promoting rules China signed up in 2001) and the construction of vital infrastructure to reduce transport costs have been drivers of integration between Asia and the rich economies, but also between the Asian economies themselves.

Intricate regional production networks have emerged, along with increased flows of "intermediate goods" (components) between countries in the region. Specialisation within the region, and the consequent economies of scale, have given the region a powerful advantage, particularly in manufactures.

Here's a point that ought to be obvious to older Australians - since they've been able to observe it over their lifetimes - but too few people understand: Asia's most successful economies have continually evolved.

"As incomes have risen in population-dense economies such as Hong Kong, Japan, South Korea and Taiwan, and as their labour-intensive activities have become less competitive, Asia's high performers have refocused their production on new areas of consumer demand - developing domestic markets and specialising in high-skill activities."

What oldies should have noticed is the way, over the years, the production of simple, labour-intensive goods - such as clothing, footwear and toys - has migrated from one country to another.

Why? Because, contrary to the propaganda of the unions and the Left, Asian workers get their cut from being exploited by wicked "transnational corporations".

As countries' economies grow, workers' real wages rise.

As well, a fair bit of the prosperity is ploughed back into raising the education level of the workforce.

Eventually, the workers' labour gets too expensive to continue using them to produce simple labour-intensive goods, so production of such goods shifts to the next, undeveloped Asian country.

In the first country, production shifts to using the more-skilled workforce to make more sophisticated manufactures. As well, more of the country's production shifts from export to being bought by the now-more-prosperous locals.

The white paper predicts, as this evolutionary process continues, within 13 years - 2025 - China will be the world's biggest economy, India will be third, Japan forth and Indonesia 10th. China will account for a quarter of gross world product and Asia for almost half.

Read more >>

GETTING PEOPLE TO DO THEIR JOB WELL

Talk to Jobs Australia National Conference, Manly, Thursday, November 1, 2012

The last time I spoke to your national conference, many moons ago, I offered some confident predictions about the outlook for the labour market. It seemed to go down quite well, but turned out to be hopelessly wrong. So this time I propose to do something quite different, something more philosophical, something I haven’t done before, even something a bit naughty. For many months I’ve been reading and ruminating on a question of motivation: how do we get people to do their job well? The trouble is, though I’ve come to some tentative conclusions, I haven’t yet finished my search and haven’t yet decided what the answer is. Despite that, I’m going to give you a progress report on my ruminations to date.

The question of how you get people to do their job well is one facing every manager, but it’s also a key question for public policy. Governments and their bureaucrats seem increasingly concerned to ensure people are doing their jobs in the way the pollies and their advisors think they should. For instance, they’re concerned to ensure the organisations contracted by them to deliver job services to the unemployed do so efficiently, effectively and accountably. So I hope you can see why I thought my topic to be of more than passing interest to all of you.

But governments’ concern with the topic goes a lot further than the management of contractors. It’s clear, for example, the Gillard government - like many governments - is quite dissatisfied with the performance of schools and teachers, and is using a wide range of strategies in the hope of achieving improvement: the regular, national assessments of literacy and numeracy, the publication of those Naplan results and much other data on the MySchool website, the offering of incentive payments to schools and teachers etc. Another case: the state governments respond to the public’s belief that the sentencing of criminals is too lenient by reducing judges’ discretion. A different case is occupational health and safety. We don’t want workers’ health to be endangered in the workplace, but what’s the best way to get employers to exercise the necessary care?

So what do I think about all this? Well, as I say, I’m still making up my mind. But let me give you my conclusions so far. They boil down to six.

First, I accept we need accountability and transparency from organisations and their employees.

That’s particularly true for government agencies, which operate with authority (and funding) derived from the public, and also for outfits delivering services on behalf of the government. If you’re handling taxpayers’ money you have to account for it, in a way that people working in the private sector need to be supervised but not be held publicly accountable to the same extent. Of course, it’s not just the money you handle, it’s also what you do to discharge the duties you were charged with.

Second, I agree with the modern trend to greater measurement of performance.

One of the slogans that accompanies the new mania for measurement says: you can’t manage what you don’t measure. I’m not sure that’s true, but it does contain an element of truth. Actually, the hard part of being a manager is managing the unmeasurable.

Putting these first two propositions together, I don’t accept the argument of the teachers’ unions that, because measures of schools’ performance are capable of being misunderstood by parents (or misused by the media), they should not be made public. Most of these measures have been calculated by education departments for many years and used for their own management purposes, but kept strictly confidential to all but the insiders. The fact is that all statistics - every one of the thousands produced each day by the Bureau of Statistics, from the national accounts to the CPI - are capable of being misunderstood and misused. That’s a reason for educating people in their correct interpretation, not a reason for the performance of elected governments and their agencies to escape public scrutiny. It’s not an argument for keeping the public in the Mushroom Club. Having said that, however, I must add a qualification:

Third, I have grave doubts about the modern management fad of using KPIs (key performance indicators) in the attempt to ensure people do their jobs well.

It is true that measures of performance (‘metrics’ in the fashionable business jargon) are capable of being misinterpreted, even by managers, let alone by outsider amateurs and a sensation-seeking media. Most managers know little about the rules and the pitfalls of statistical interpretation. It may be that when workers are employed to perform simple, repetitive tasks - workers on a factory production line, for instance, or those employed in data entry - you can get away with using numerical targets to ensure a satisfactory rate of output, provided you combine it with some form of quality control.

But, these days, the satisfactory performance of most skilled jobs simply can’t be measured with a few key numerical indicators. Nor is the quality of people’s performance easily checked. This is because satisfactory performance of the projects people work on has too many dimensions. It would be impractical to attempt to measure every dimension, and some dimensions may not be capable of measurement. In such circumstances, supervising the quality of people’s performance will also be difficult. Even where a person’s job is to process a number of cases each day or each week, it may be easy to count the number of cases they get through, but much harder to allow for the differing difficulty of those cases, as well as monitor how well they were dealt with. That’s true even of lowly workers in a call centre. While most of the problems they deal with may be routine, we all know from experience how easy it is to ask a question that’s beyond the operator’s pay grade or to be offered confident assurances we know, or soon discover, to be wrong. We all know how unhappy we can be with the experience, even when we eventually got what we wanted.

Numerical indicators of performance are particularly unsatisfactory when the task involves dealing with individuals - because people and their problems come in so many shapes and sizes. At least three-quarters of Australia’s workforce works in the services sector, and most of those jobs involve delivering services to individuals. Am I starting to ring any bells with your own circumstances?

But the fact that performance so often can’t be satisfactorily assessed using PKIs is just the start of the problem. The deeper problem is that PKIs are so easily manipulated - so easily ‘gamed’. If the satisfactory performance of my job has, say, five dimensions, and you slap a KPI on as many as three of them, rest assured I’ll meet my targets. But I’ll do it by cannibalising the two dimensions you haven’t measured. This kind of behaviour is rife and it’s the reason I regard the use of KPIs as a fad that management will soon see to be a snare and a delusion.

Early in the days of Paul Keating’s national competition policy, someone came up with the idea of encouraging better performance by the state governments by means of what I think was called ‘benchmark competition’. The idea was to publish each year, for each of the states, a host of key indicators of their performance in all their areas of responsibility (courts, prisons, hospitals, schools etc). The public would be able to see which states were doing better and which were doing badly, and this would encourage the states to try harder. At first the relevant state bureaucracies complained the figures weren’t on a comparable basis, so much effort was put into making sure they were. But someone who’d been close to the process told me the figures - which are still produced each year - are utterly unreliable because of each state’s efforts to manipulate their indicators.

This is why I have much sympathy with the teachers’ argument that a quality education has a lot more dimensions than just the literacy and numeracy so regularly measured by Naplan. Put too much emphasis on Naplan scores and you will get schools ‘teaching to the test’ and, in the process, neglecting those dimensions of a quality education not being measured. Whether this yields a net benefit to students is a question no one bothers to measure - assuming they could.

From the developed world’s unhappy experience with monetarism and money supply targeting in the 1970s emerged something economists call Goodhart’s Law, which holds that ‘any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’. That’s what’s wrong with KPIs.

It follows that attaching monetary incentives to KPIs is equally foolish. But I would go further and say:

Fourth, I have grave doubts about the equally fashionable practice of using performance pay to try to ensure people do their jobs well.

This is not just because good performance is hard to measure, but also because money is a bad motivator. Thanks to the limitations of their model, economists unconsciously assume money is the only motivator. And, perhaps because of their own materialism, business people easily assume monetary incentives are likely to be most effective. But the obvious truth is that people are also motivated by a host of non-monetary motivations, ranging from the pursuit of power and social status to the satisfaction of working hard and doing a job well. Many people have a deep commitment to doing their job to a high standard - for the benefit of customers, but primarily for their own satisfaction.

There are two problems with performance pay. One is that the more I’m motivated just by money, the more I’m likely to cut corners, sacrificing quality. The other is that studies by psychologists show monetary incentives drive out non-monetary motives. Once you’ve trained people to do things just for the money, any subsequent decision to abandon performance pay will lead to a deterioration in performance.

Fifth, I also doubt the effectiveness of the main alternative to monetary incentives, the imposition highly prescriptive rules and regulations.

This is the approach beloved of governments and bureaucrats. David Thompson tells me the rules the department imposes on providers of job services run to 3000 pages. So I imagine this is the main way the government tries to get you guys to do your jobs well. It also applies to governments’ attempts to oblige judges to impose harsher sentences.

You probably don’t need me to tell you why this approach doesn’t work well, either. As well as burdening people with a lot of red tape and compliance costs, it limits their freedom to exercise their discretion in responding to the peculiar circumstances of each of the cases they deal with. It stifles, and therefore wastes, people’s use of their experience and expertise in discharging their responsibilities to the best of their ability. It assumes the people making rules that fit the general case know better than practitioners on the ground dealing with specific cases that may or may not fit well with the general case. It also assumes practitioners aren’t to be trusted. And rules, too, can be gamed by people who’ve been discouraged from doing their best.

Consider the industrial relations tactic of ‘work-to-rule’. Work-to-rule demonstrates that it’s actually very hard to design rules on paper than work smoothly in practice, partly because circumstances may differ so much from case to case. It shows that well-functioning organisations are organisations that honour the spirit of rules rather than the letter, that turn a blind eye to rules that don’t work well.

But if PKIs, monetary incentives and prescriptive rules don’t work in getting people to do their jobs well, what does?

This I’m still working on. But I do have some clues.

Sixth, rather than trying to control people with rules or performance targets, or bribing them to do a good job, we should be aiming to produce well-trained and well-motivated workers, free to exercise their discretion in meeting the needs of the widely varying cases that come before them.

Psychologists tell us intrinsic motivation is superior to extrinsic motivation. That is, it’s better to encourage people to do things for their own sake, rather than for the external rewards they bring. When people take a pride in doing their job well, you get better performance than using rules or whips or bribes.

Sociologists tell us people’s behaviour is heavily influenced by something most economists and business people are oblivious to: social norms of acceptable behaviour. Studies show making people attend courses on ethics does little to make their behaviour more ethical. There will be exceptions but, in practice, people tend take their ethical standards from the behaviour of those around them. If most people around me cheat, I’m likely to cheat. If most people around me work hard, I’m likely to work hard. And if my group habitually works hard, it’s likely to come down hard on any individual within the group who slacks off. The thing about ‘norms of acceptable behaviour’ is that they usually involve the imposition of informal sanctions on individuals whose behaviour the group regards as unacceptable. You don’t get fined, you get gossiped about, chipped and, in the extreme case, sent to Coventry. Humans are such social, ‘groupish’ animals - we are so pre-programmed to want to ‘fit in’ - that such informal sanctions are usually highly effective in achieving adherence to group norms.

There’s an old debate in monetary economics over ‘rules versus discretion’. The best position is probably a half-way house - discretion within a set of fairly loose rules - but I believe leaving people with discretion to use their expertise to make the best decisions to fit the particular case is likely to maximise the chance they will be motivated to do their best work. Tight rules are de-motivating.

What we need to bolster this, however, is a group norm - a ‘culture’ - that we all work hard, we all do our best to meet our clients’ needs, and if we cut corners we do it to fit a client’s needs, not for our own convenience. How do you introduce such a culture where it doesn’t exist? How do you strengthen such a culture if it isn’t strong enough?

That’s what I’m still working on. One thing I do know is that it has to start at the top. Not surprisingly, bosses are hugely influential in affecting the attitudes and behaviour of the people working for them. But they’re influential not so much in the programs they introduce and the pep talks they deliver but in how they behave. As business people say, you have to walk the talk.

Another clue lies in the original meaning of the word ‘professional’. What does it mean to be professional? These days, it may mean you play sport for money, not just the love of the game. More commonly, it means well-trained, highly proficient. But its original meaning is instructive: it used to mean putting the client’s interests ahead of your own. In other words, the complete antithesis of doing a job just for the money. To say, I’m a member of a profession, is to say I put clients first.

I suspect the culture we need to introduce into organisations to lift their performance is old-fashioned professionalism. And though I’m still working on ways to do that, I do know this: if you can get the work culture right - get the norm of acceptable behaviour right - it will tend to be self-reinforcing, without need for KPIs, performance pay or highly prescriptive rules.

Read more >>

MAIN STREET & WALL STREET: the interrelationship between the real and financial economies

Comview conference, Melbourne, November 2012

Last year Glenn Stevens remarked that it was ‘very sensible of Australian households to be strengthening their balance sheets’. What on earth did he mean? In recent years we hear a lot of jargon in the economic debate that we usen’t to hear and that certainly wasn’t mentioned when we were at university. People keep on about ‘balance sheets’ - household balance sheets, business balance sheets, government balance sheets - and how they need to be ‘strengthened’ or ‘repaired’. Sometimes they talk about ‘gearing’, other times they talk about ‘leverage’ - households or businesses are ‘deleveraging’ we’re often told these days. We hear a lot more about ‘asset prices’, and credit-fuelled ‘asset-price inflation’ leading to ‘asset bubbles’.

We also hear a lot these days about the ‘wealth effect’ and about the household saving ratio - it was falling for about 30 years but then it rose rapidly, making life hell for the retailers. And economists take a lot more interest in the sharemarket than they used to. Say you’re worried about household debt being 150 per cent of household disposable income and someone will counter that household liabilities are just 21 per cent of household assets.

Then there’s the balance of payments. Express some interest in the trade deficit or the current account deficit and economists are just as likely to respond by talking about the capital account surplus and the balance between national saving and national investment. Say you’re worried about foreign debt and someone will say you should be focusing on our net foreign liabilities. Then they’ll say the nation’s foreign liabilities account for just 20 per cent of its assets.

The real economy versus the financial economy

So what’s going on? What’s going on is that historically, Keynesian macroeconomics focuses almost exclusively on the real economy, to the exclusion of the financial economy. There is, of course, only one economy, but it has two dimensions, real and financial. The real economy is the physical, touchable world of getting and spending, of the production and consumption of goods and services. Inflation and unemployment are part of the problems of the real economy, and we focus on these. Saving and investment are part of the real economy, but pretty much only to the extent they constitute leakages and injections to the circular flow of income.

The financial economy is the intangible world of borrowing and lending, assets and liabilities, of people with savings connecting with people needing funds to finance their investment, usually via an intermediary such as a bank, but also via direct borrowing in the financial markets. It’s the world where financial assets such as shares, bonds and foreign currencies are traded on financial markets.

The real economy couldn’t exist without the financial economy. You can’t produce goods and services without physical capital such as machines and factories, and you can’t sell them without shopping centres and offices. The acquisition of most of those assets has been financed by borrowing and equity capital. The financial markets exist to supply that funding. Just about every business has a significant amount of debt, with interest payments forming a significant expense.

Similarly, consumers come from households that need assets such as housing and consumer durables, the purchase of which is usually financed by borrowing. Households also own much of our big businesses via their superannuation saving or direct shareholdings.

Why talk about the financial economy is now so prominent

But conventional macro has taken little interest in the financial side of the economy. It has focused almost exclusively on the three dimensions of GDP: income, expenditure and production. As you probably know, the national accounts measure GDP these three different ways. In theory they’re equal; in practice measurement problems mean they never are so, in practice, the bureau of stats takes an average of the three and calls it GDP(A). And in practice, of course, macro economists focus mainly on the expenditure side of the real economy: GDP = C + I + G + X - M.

What’s changed is that, though Australia’s macro managers have had considerable success in controlling both inflation and unemployment over the past decade or two, a lot of different problems have emanated from the financial economy. That’s painfully evident right now in the rest of the developed world, but you can see it here if you go back a bit.

The severe recession of the early 1990s, which was quite protracted and saw the unemployment rate rise to almost 11 per cent, was caused by problems in the financial economy. Our banks and businesses overreacted to the deregulation of the financial sector, and we ended up with borrowing-fuelled booms in the housing and commercial property markets. The bust in the commercial market left many of our businesses far too highly geared and our banks with a lot of bad debts, to the extent that Westpac went close to falling over. What made the recession so protracted and severe was the way businesses sought to repair their balance sheets - to deleverage; or in plain English, to reduce their liabilities relative to their assets - by avoiding new expansion and cutting costs so as to repay debt. In particular, they cut costs by laying off workers. The banks repaired their balance sheets by widening their interest margin (not passing on all the cuts in the cash rate) and limiting their lending for new business projects. Note that problems in the financial economy soon become problems in the real economy. Economists separate them conceptually, but they can’t be kept apart in real life.

As its name implies, the Asian financial crisis of 1997-98, which led to a sharp recession in most of East Asia, had its origin in the financial side of those economies. Most had property booms fuelled by foreign capital inflow; when the foreign capital started rapidly flowing back out, countries had to devalue their fixed exchange rates. Many businesses that had borrowed in foreign currencies now found their loans and interest payments far higher than their assets. Their economies entered a sharp recession. In new phenomenon called ‘contagion’, foreigners who lose confidence in the prospects for one country tend to spread their doubts to neighbouring countries.

This brings us to the global financial crisis and the world recession it led to - which, for the countries of Europe, hasn’t ended. Again as the name implies, the causes of this recession were financial. The huge extent to which China and some other Asian countries’ saving exceeded their investment led to them running up large reserves of foreign exchange, which were then lent cheaply to the developed countries, particularly the US. This excessive supply of cheap funding led to excessive consumption, home building and borrowing by US households, which became quite highly leveraged - that is, their debts grew relative to the value of their assets. At the same time, deregulation, weak supervision and ever-increasing use of derivatives caused banks in the US and Europe to become far too highly leveraged. As well, most governments continued their longstanding practice of running budget deficits in good times as well as bad.

(‘Gearing’ and ‘leverage’ are the same: the use of borrowed capital to buy assets, thus magnifying the return to equity capital while asset prices continue rising, but magnifying the loss when asset prices start falling. Gearing is the British and Australian term; leverage is the American term.)

When, inevitably, the US house-price bubble burst, the whole financial house of cards collapsed. The sharp fall in house prices caused some households to experience ‘negative equity’ (their liabilities now exceeded the value of their assets) and others to pull their horns in and seek to ‘deleverage’. As always, this touched off a multiplier effect where fear of unemployment causes households to cut their spending and get their finances in order but this, in turn, causes the very increase in unemployment they were afraid off, touching off a further round of contraction.

While this was happening in the household sector, the banks were getting into trouble. Their excessive gearing meant it took only small levels of bad debt to wipe out their capital and bring them close to bankruptcy. Individual banks realised the other banks were in trouble, so the banks as a whole refused to lend to each other, forcing central banks to fill the gap, providing huge short-term credit to all banks. Some global financial markets actually ceased to operate for a time. The banks also became reluctant to make new loans to business. Though the problem began in the US, it quickly spread to the European banks, eventually exposing the structural weaknesses in Europe’s monetary union.

After the collapse of the investment bank Lehman Brothers in September 2008, the US Government had to bail out many banks, buying some of their now-toxic financial assets and injecting equity capital. Governments in Britain and Europe had to do something similar. Delay in approval of the US rescue package added to the rout on US and global sharemarkets, which had begun falling when the problem started to emerge about a year earlier.

Every media-publicised announcement that a bank had failed or almost failed in the US or Europe prompted another loss of business and consumer confidence around the world. In the US and, more particularly, Europe, government borrowing to bail out banks and reflate economies, when added to decades of deficit budgeting, caused government debt levels to soar, thus prompting a ‘sovereign debt crisis’ - the fear governments are so heavily indebted they may default on their debts (an event which, as Reinhart and Rogoff demonstrate in their modern classic, This Time Is Different, has happened far more times than we remember).

How and why the world has changed

In the post-war period we got used to recessions that arose from problems in the real economy. Typically, inflation problems would arise as demand grew faster than supply (production capacity) and shortages of skilled labour led to excessive wage rises. The authorities would respond with tighter monetary policy, hoping to achieve a ‘soft landing’ but overdo things and causing a recession.

Clearly, our last recession in the early 90s, the Asian financial crisis and the latest, global financial crisis were all very different from that, coming out of the financial side of the economy. Essentially, they were products of the bursting of credit-fuelled asset-price bubbles.

Why are financial crises and financial-side recessions now more common? Because the deregulation of financial markets makes credit far more accessible and often cheaper to households and firms, thus making it easier for credit-fuelled asset-price booms to emerge. Because, at least in some countries, and at least until now, the era of financial deregulation has seen banks and their innovations inadequately supervised by the authorities. Because financial globalisation has increased short-term capital flows between countries, thus increasing the likelihood of problems in one country spreading to others. And because the globalisation of the media means news of disturbing developments in one country now spreads almost instantaneously around the world, adversely affecting business and consumer confidence.

Another part of the story is that, whereas central banks have finally mastered the art of controlling goods-and-services inflation via independence and inflation targeting, thereby greatly improving demand management, their efforts seem to contribute to booms in asset prices - problems the central bankers admit can’t be countered with conventional monetary policy.

But how has the world changed? What are the consequences of recessions that arise from the financial side? They tend to be more severe and to last a lot longer. This is because ‘deleveraging’ or ‘balance sheet repair’ is an essentially deflationary process which, in economies that are already weak, take months or years to bring about. Similarly, efforts by governments to deleverage take a long time. Should governments attempt to speed up the process by cutting their spending or increasing taxes at a time when the economy is already weak, their efforts are likely to prove counterproductive - as we’ve seen in Europe recently.

A second reason financial-side recessions are more severe and protracted is that they often involve a version of a liquidity trap, in that interest rates are already very low when the recession starts. Since interest rates can’t fall below zero, there’s little room for conventional monetary stimulus. In any case, banks are often too preoccupied with repairing their own balance sheets to want to increase their lending, notwithstanding the low interest rates obtaining. All this greatly limits the effectiveness of monetary policy, pushing more of the initiative onto fiscal policy. But, where governments have themselves over borrowed in the good years leading up to the financial recession, their ability or willingness to apply fiscal stimulus is also limited, as we’re witnessing at present in the US and Europe. The next step is reluctant resort to ‘quantitative easing’ (another new bit of jargon).

I’m sure you know that ‘QE’ is a euphemism for what we used to call ‘printing money’. Of course, just like most money created by the central bank, this is not physical cash but numbers in bank accounts. What you may not know is that it involves central banks expanding both sides of their balance sheet. They buy government bonds (sometimes newly created bonds direct from the government, sometimes second-hand bonds from the ‘secondary market’) or other assets (such as mortgage-backed securities) and pay for them with extra money they have created. The money issued by the central bank is a liability of the central bank, whereas the securities it buys are an asset. Thus both sides of their balance sheet are increased.

The ‘wealth effect’ economists worry about more than they used to represents a form of feedback from the financial economy to the real economy. It occurs when households’ feelings about what’s happen to their wealth (their assets and liabilities ie their household balance sheets) affect their decisions about how much of their income they should save and, therefore, how much is left for consumer spending. When asset prices (particularly house prices, but also superannuation balances and direct shareholdings) are rising strongly, households are likely to feel wealthier, and thus see less need to save rather than consume. When assets prices aren’t rising, or maybe superannuation balances are falling, households are likely to feel less wealthy and thus save more and consume less. You’d get the same effect when the economic outlook became more threatening and households became concerned about the extent of their debts. It’s possible the ageing of the population - that is, the higher proportion of households in or nearing retirement - will make the wealth effect a more powerful influence on the real economy.

As for the increasing tendency of economists to explain the current account deficit in terms of national saving and investment, it’s a financial-side way of examining the balance of payments.

The accounting side of the story

Another reason we hear a lot more about balance sheets these days is that there are a lot more of them about. Some years ago, the UN Statistical Commission decided to switch both the system of national accounts and government finance statistics from a cash to an accrual basis. This means the (annual) national accounts now include a national, whole-economy balance sheet and a balance sheet for the household sector. We also have balance sheets for the federal and state governments.

To get a clear understanding of the distinction been the real and financial economies you have to remember there are two kinds economic variable: flow variables and stock variables. Flow variables show the size of the flow of some item (such as income or expenditure) over a period of time (usually a month, a quarter or a year); stock variables show the amount of some item (such as assets or liabilities) at a point in time(usually the last day of the period eg June 30).

In a business, the flow variables are collected together in the profit and loss statement, where the flows of expenses incurred during the period are subtracted from the flows of income earnt during the period to give the profit or loss for the period. The stock variables are collected together in the balance sheet, where total liabilities at the end of the period are subtracted from total assets at the end of the period to give the business’s ‘net worth’ at the end of the period.

For an economy, the conventional national accounts are equivalent to the profit and loss statement, while the new balance sheet is equivalent to a business balance sheet. That is, the conventional national accounts show the flows of income, expenditure and production in the economy during a period, while the national balance sheet shows the stocks of manmade, natural and foreign assets, less the stock of foreign liabilities, to give the national economy’s net worth at the end of the period. (Note that, within the nation, debts to other Australians are matched by the financial assets of other Australians, and so cancel out.)

The point to note is that it’s the flows during a period that bring about the change in stocks between the start and end of the period. If, for example, the net public debt increased from 100 to 120 between the end of period 1 and the end of period 2, this tells us government expenses exceeded government revenue during the period by 20 - that is, the government ran a deficit in year 2 of 20.

This is relevant when we say that Keynesian macro management focuses on the real economy largely to the exclusion of the financial economy. It focuses on the flows in the national accounts - or the budget - but ignores the stocks building up in the balance sheet. So Keynesians care whether household consumption is growing faster or slower than household income, but don’t take much interest in whether household net worth is rising or falling. They care whether government spending exceeds or underruns government revenue - that is, whether the government is running a deficit or a surplus - but they don’t much care what’s happening to the net public debt.

This neglect helps explain how most of the governments of the North Atlantic economies managed to go for decades building up huge stocks of government debt, which left them very badly placed to cope with the fallout from the GFC. It also helps explain why so few economists saw the GFC coming. They didn’t notice, for instance, that in the US, much of the growth in consumption and the economy in the years leading up to the GFC was, in a sense, phoney - it was financed not by rising household incomes but by rising household debt.

The trouble with the excessive focus on the real economy is that while what happens to the levels of stocks may be ignored in the short to medium term, if they are ignored for too long and allowed to build up to unsustainable levels they will eventually precipitate a financial crisis.

Conclusion

In a financially deregulated and globalised world, macro economists can no longer get away with limiting their interest to the real economy - to flow variables - and taking little interest in balance-sheet, stock variables. When financial imbalances build up, the ultimate blow to the real economy - and the lives of real human beings - can be extensive.

Technical note: much of what accountants call the ‘ratio analysis’ used commonly by economists was developed in the days before the preparation of collective balance sheets. In those days, the only stock variables produced in the national accounting process were levels of debt - public debt, household debt, foreign debt. When economists wanted to study those debt levels they compared them with the only other variables available, flow variables. Hence the practice of comparing household debt with household disposable income, or the net foreign debt with nominal GDP.

But accountants know that comparing stock variables with flow variables involves comparing apples with oranges. Ideally, stock variables should be compared with other stock variables, and flow variables with other flow variables. Before the advent of balance sheets this wasn’t possible, but now they exist economists need to change their practices to take advantage of the more relevant data available to them.

For instance, novices are greatly disturbed to hear that household debt is equivalent to 150 per cent of household disposable income. But such a comparison is largely meaningless. It implies that a day may come when someone is required to repay their mortgage, but prohibited from selling their house to satisfy most if not all of the debt. When would anyone ever be suddenly asked to repay their mortgage purely from their income? What matters is how the household’s assets compare with its liabilities (a stock-stock comparison) and, within this, how the present market value of the house compares with the size of the loan attached to it; and how the household’s cost of servicing the mortgage compares with its disposable income (a flow-to-flow comparison).

Similarly, it makes more sense to compare the nation’s foreign debt (or net foreign liabilities) with its assets (stock-to-stock), then compare the cost of servicing our net foreign liabilities (which is the net income deficit in the current account) with the nation’s income (nominal GDP) or with export earnings (both flow-to-flow).

Read more >>