Is it our future to be China's quarry? Decision 2010

Australia's traditional economic challenges will be turned on their head in this decade.

WHAT our economy needs in the 2010s is success in balancing supply and demand. Does that sound obvious and not very hard? It's neither.

A big part of the problem is neither you nor I nor the politicians are used to thinking of the economic problem in those terms. And even when we do, we define the problem in conventional terms, failing to take account of the ultimate provider of both supply and demand: the natural environment.

Speaking at the nationwide level, when demand exceeds supply we get inflation. When supply exceeds demand we get unemployment. So we need to keep them in alignment to minimise both problems.

But both demand and supply are moving targets. The economy keeps growing, so we need to keep both demand (spending on goods and services) and supply (capacity to produce them) growing at much the same rate.

If the severe difficulties facing European economies were to spread - including to China, India and the developing world - our problem would be one of deficient demand relative to supply, leading to slow growth and rising unemployment.

But the greater likelihood is that our overarching problem will not be deficient demand but deficient supply as we struggle to greatly expand our capacity to meet developing Asia's voracious appetite for our minerals and energy.

Supply is by far the better deficiency to have. It's the problem of the prosperous and successful, not the waning and struggling. But that doesn't stop it being a problem.

In early 2008, before the global financial crisis hit, we were in the midst of a resources boom. Relative to the prices we were paying for our imports, the prices for our exports were the highest in 50 years.

Our economy was operating at close to full capacity. Unemployment was down to 4 per cent, shortages of skilled labour were emerging, factories and other businesses were flat-chat and real wages were rising, although inflation pressure was building and the Reserve Bank had pushed its official interest rate to a 14-year high.

Mainly because Asia's demand for our exports scarcely missed a beat, but also because our domestic recession was so mild, the likelihood is that the resources boom will soon resume and we'll soon return to full capacity.

Everyone assumes it is hardest to manage Australia's economy in bad times. Recessions are painful and economic managers come in for criticism, but it's the good times that are hardest to manage.

Why? It is easy to stimulate demand - with increased government spending, tax cuts and much lower interest rates - but hard to conjure up increased supply. That requires more skilled workers, housing, machines, factories, mines and offices, as well as more public infrastructure: roads, bridges, public transport, power stations, coal loaders and ports.

In the past the solution was to minimise inflation by using high interest rates or tax increases to suppress demand. But we've usually done too much too late and ended up in recession.

However, past booms have been temporary, "cyclical" events caused by brief periods of strong growth in the developed world. This boom, which began in 2003, seems more lasting ("structural") because it arises from the two most populous countries entering decades of economic transformation from underdeveloped to developed.

We're likely to go through an extended period in which supply grows rapidly - we greatly increase the economy's productive capacity. But we're already close to full employment.

Assuming Asia's strong demand for commodities continues, an increase in our capacity to produce coal, iron ore and natural gas is already in train. Business spending on physical investment will soon take its highest share of gross domestic product in half a century.

But when our labour and capital are already pretty much fully employed, the only way we can put more resources into new mines, gas terminals and related infrastructure is by taking those resources from somewhere else.

Some industries (and states) have to give up resources so the mining industry (and the states it is in) can have more resources. This doesn't necessarily mean other industries and states have to contract in absolute terms, it may just mean the lion's share of future annual growth in employment and physical capital goes to mining and the mining states.

Governments can help by adding to the supply of skilled labour (through increased training and skilled migration), well-located land for home building and necessary public infrastructure. But even though the nation's supply constraint moves out each year, and can be made a little faster, it's still a constraint. It still limits how much more we can do. If we try to exceed that limit, all we get is inflation.

A big part of the political problem governments will face is that, after 30 years of high unemployment, the public is locked into a mentality that our key problem is deficient demand, with the implication that any proposed project claimed to create jobs is unquestionably worthy of government support.

The notion that if project X is to create 500 jobs, those workers will have to be taken from jobs elsewhere is foreign to our thinking. What's more, the higher wages it needs to attract workers could provoke a wages bidding war that adds to inflation.

Can you imagine any politician saying a new project requiring 500 workers didn't sound like such a good idea? Welcome to the future challenge.

The economy has a natural mechanism for helping the needed geographical and industrial change in its structure: the floating exchange rate. By going high during resource booms, it squeezes those export and import-competing industries whose demand isn't booming.

But this automatic mechanism will need reinforcement from overt government policy. Adding to supply often involves adding to demand in the first instance. Demand can be divided into spending on consumption and spending on physical investment.

If supply constrains the demand we can accommodate without inflation, but an increased share of demand needs to be devoted to investment - in business plant, housing and public infrastructure - that leaves less room for consumer spending.

A lasting resources boom needs to constrain growth in consumer spending if it's not to involve runaway inflation. Households need to spend less and save more.

The economic managers have ways of combating inflation pressure and discouraging excessive growth in consumption (particularly spending on consumer durables such as cars and major household items, which are usually bought on credit): raise interest rates.

So the bigger and longer the resources boom, the higher you can expect interest rates to be.

Don't like that solution? A better (but only partial) substitute would be for the federal government to run ever-increasing budget surpluses even after its debt is paid back, with the money invested anywhere but in Australia.

We look like we'll need some unfamiliar and controversial policies from the next and future federal governments if we're to exploit our geological and geographical luck without coming unstuck.

And that's just the conventional analysis, which conveniently ignores the natural environment. Responding to the way economic growth is damaging the ecosystem and starting to feed back adversely on the economy will require an extra dimension of unfamiliar and controversial policies.

Read more >>

HISTORY, MEMORY AND TRUTH

Talk to Independent Scholars Association, Sydney
July 24, 2010

I’m not a historian, philosopher or even an independent scholar, so I confess I find today’s topic rather daunting. So I’ll make a few general observations and then comment on the topic very much from a journalist’s perspective, which I imagine is the most useful contribution I can make.

I’m old enough to believe there is such a thing as objective truth, if only we could find it. But the truth is elusive. It’s known to God, but we mere mortals merely seek it, never knowing for certain how close we’ve come to it. Of course, in the search for truth some people try harder than others. Plenty of people are happy to give us ‘the truth as I see it’ without making any great attempt to offer a balanced account. It’s often a safe bet that such accounts are far from even-handed. And some of us are happy to repeat that version - sometimes unadorned, sometimes as part of a more conscientious attempt to discern the truth of the matter.

As for memory, it’s highly fallible. Last year I was invited to speak to the annual dinner of the old boys’ association of my school, Newcastle Boys’ High. I did a lot of thinking back to my time at school in the early 1960s, and mentioned to a friend that one of the things I planned to mention was my memory of being in the school playground when the news came through that President Kennedy had been shot. My friend said I’d better check it because he was sure the news came through on a Saturday. I checked and he was right. So what it is that I have such a clear memory of I now have no idea.

The illustrious psychologist Daniel Kahneman, who won the Nobel Prize in economics for discovering behavioural economics, has more recently turned his mind to the study of happiness, particularly the definition and measurement of it. His recent research - too recent to be included in my new book, The Happy Economist - draws a distinction between experienced happiness and remembered happiness. He found that when you ask people how happy they are during an event - a holiday, for instance - you get a different answer to the one you get if you ask them after the event how happy it was. People are generally happier about things in retrospect than they were at the time. Which of the two perspectives represents the truth?

Earlier, Kahneman did a famous experiment that asked people how they felt about their colonoscopy examination, which in those days seems to have been a lot more painful than it is today. What emerged from this was the psychologists’ ‘peak-end rule’. How people felt about their experience was determined by two factors: how it felt at its worst, and how it felt at the end. This meant that doctors could influence how painful people remembered the procedure as being simply by leaving the scope in for an extra minute or so without moving it and making it painful. I think this tells us something about the fallibility and susceptibility of memory.

It’s often said that newspapers provide ‘the first draft of history’. I guess that’s true, but since I imagine many of you refer to newspapers in your research, I want to stress what a rough and ready first draft it is. Newspapers - and the media more generally - offer only the roughest and potentially quite misleading first draft for many reasons. One is the haste with which the first draft is prepared. Media outlets are increasingly understaffed these days and, in any case, journalists are required to produce their reports in only a few hours. Economic and political journalists, for instance, have to summarise the purport of lengthy government reports or budget documents before they could possibly have had time to read them properly.

The more the media turn to ‘breaking news’ - as even the morning newspapers are now doing on their websites - the more they’ll be telling us things that are undigested, ill-considered, incomplete and probably wrong in some respects. That’s true almost by definition. With breaking news, the highest priority goes to getting the news out within minutes of it occurring. In the case of a set-piece event (such as the announcement of a change in interest rates) it has be on the site within seconds. It’s all about racing your competitors, and accuracy runs a very poor second. An editor once said to me that the only way you could produce breaking news was to use the principle: ‘Never wrong for long’. Trouble is, the media are reluctant to admit and correct their mistakes. More generally, they pass judgment too quickly and are reluctant to return to stories they regard as old hat. They’re weak on follow up, often not following stories to their conclusion.

People are always claiming to have been misquoted or misrepresented by the media. The media’s attitude is generally ‘they would say that, wouldn’t they’. And it is true that people say things then, when they see them in the paper for all the world to see (including their boss), have second thoughts and claim to have been misreported. But I’ve been interviewed and reported on by print journalists a few times in my life, and I’ve been quite unimpressed by the results. They’ve not understood what I was on about, they’ve misquoted me or taken me out of context, or they’ve filled in facts without asking me and not got them right.

There may have been a time when newspapers took a pride in being ‘journals of record’, but those days are long gone, even for the broadsheets. Much that transpires - even government decisions - is these days regarded as too boring to waste space on. Newspapers face a lot more competition from the electronic media - radio, television and now the internet - which means they’re often bring their readers news the readers have already heard. They compensate for this by search for new ‘angles’, reporting reaction and by ‘taking the story forward’ - which means they assume their readers already know the basic facts of the story and don’t bother repeating them, or allude to them only well down in the fine print of the story.

But the main thing I want to say to you is that the media simply aren’t in the truth business. You may be seeking the truth, but we aren’t. You’re entitled to expect us to be truthful - that is, to get our facts right and resist the temptation to distort - but not to imagine we’re seeking the truth. We’re not in the truth business, we’re in the news business. We’re literally in the business of selling news. That is, our primary motivation is commercial - to make a profit - not ideological or scholarly. What’s more, humans’ evolutionary drive to compete means that, despite its lack of commercial motivation, the ABC behaves much the same way as its profit-motivated rivals do.

Why aren’t we seeking the truth? Because much of the time the truth is dull. Media owners are dedicated to profit maximisation, and their minions seek to do this by selling a product called ‘news’. What is news? Whatever sells. What sells - what’s ‘newsworthy’ as journos say? Anything happening out there that our audience will find interesting or important, although the interesting will always trump the important. Paris Hilton is interesting but of no importance; the latest change in the superannuation rules is important but deadly dull - guess which one gets more media coverage?


Maybe 99 per cent of what happens in the world is of little interest: it’s the old, not the new; the good, not the bad; the usual, not the unusual. It’s dog bites man, not man bites dog. Much of the criticism of the media rests on the unspoken assumption that the media’s role is to give us an accurate picture of the world around us. We don’t have first-hand experience of much of what’s happening around us and we need the media to inform us.

Sorry, but that’s just not what we do - because we don’t think there’s much of a market for it. Let me tell you a story or two to demonstrate how we select news - how what we do bears no relation to the scientific method that guides so much of what scholars do. Once when I was answering a question at a Treasury seminar in Canberra it occurred to me to say this: when social scientists take a random sample they may examine the sample and discard any outliers that could distort their survey, throwing them on the floor. A journalist is someone who comes along, finds them on the floor and says, ‘these would make a great story’.

Final story: I happened to be in the Herald’s daily news conference in February 2009 on the day Kevin Rudd’s $42 billion stimulus package was announced, with all its (then) $950 cash handouts. We discussed searching for a farmer who’d get $950 because he was in exceptional circumstances, $950 because he paid tax last year, $950 because his wife also works, $4750 because he has five school-age kids, and maybe another $950 because one of the kids is doing a training course. And, of course, he’d have a big mortgage, meaning he’d also save $250 a month because of the 1 per cent cut in interest rates announced the same day. Had we found such a person and taken a good photo of him he’d have been all over our front page. The point is that we were search for the most unrepresentative person we could find. Why? Because our readers would have been fascinated to read about him. It’s reasonable to expect the media to be accurate in the facts they report but, even if they are, it’s idle to expect them to give us a representative picture of the world. They’re not in that business.

Read more >>

Economists waive any responsibility on climate

Julia Gillard's stop-gap substitutes for Labor's abandoned emissions trading scheme is unlikely to produce much reduction in emissions or be cost-effective. I reckon just about every economist would agree with that proposition, just as they'd agree with its corollary: the key to reducing emissions is to put a price on carbon.

Yet the nation's economists were neither unanimous nor active in supporting the Rudd government's carbon pollution reduction scheme.

Why weren't they? Why do so many economists behave in such an uninterested and even disinterested way on the subject?

Dr Martin Parkinson, the secretary of the Department of Climate Change, observed in a recent speech that, unlike with other, earlier economic reforms, ''there has not been a broad consensus within the economics profession on the merits of action to reduce Australia's greenhouse gas emissions, nor on the general approach to how it should be implemented''. With a few notable exceptions, he said, it had been surprising ''how little serious engagement we have seen from economists in the carbon pollution reduction scheme debate''.

Economists' preference for a carbon price signal was where agreement among economists ended. ''There is disagreement on the detail required for practical implementation, such as the timing, level and nature of the mechanisms that should be used to provide a carbon price signal, and in some cases disagreement on whether action should be taken at all,'' he said.

So why is there this lack of broad consensus and engagement by economists? Parko suggests four possible reasons.

First, some economists see climate change as an environmental problem rather than a multi-disciplinary problem. If it's an environmental issue, it's probably being dominated by environmentalists who are interventionist and anti-growth. In truth, the policy response to climate change is based on work coming from scientists, not greenies.

Note that Parkinson is a former deputy secretary of Treasury and has a quite a few ex-Treasury people around him. Emissions trading is an ''economic instrument'' and it was being designed and implemented by highly orthodox economists.

''When it comes to climate change science and projections, it is probably reasonable that economists without expertise in the relevant scientific disciplines should let scientists be the professional experts in this area,'' Parko said.

Even where some economists are genuinely sceptical of the scientific evidence, ''it has been surprising that some economists have resisted serious consideration of the professional application of the precautionary principle - that is, that taking action on climate change today is a form of insurance''.

Second, economists usually deal with marginal issues and have little experience with issues having potentially catastrophic outcomes. To a neo-classical economist trained in ''marginal analysis'', marginal doesn't mean of little importance, but quite the reverse. All the interesting things happen on the margin.

But climate change has the potential to involve a complete change in the state of the world, including the possibility of catastrophic outcomes. Economists have little experience in dealing with ''non-trivial'' (that is, worth taking seriously) probabilities of such outcomes occurring, or the related application of the precautionary principle and need for risk management.

This is the ''fat-tailed'' or ''black swan'' problem that's very difficult to assess using economists' conventional ''expected-value'' risk analysis: that is, a tiny probability of an unthinkable event.

The third reason economists have failed to provide strong support may be that, though they understand ''externalities'' in principle, in practice they have a strong preference for leaving things to the market.

The existence of market failure doesn't automatically justify government intervention in the market. You also have to be satisfied intervention will do more good than harm, otherwise all you end up with is ''government failure''.

This highlights the cost of inaction, which both Britain's Stern report and our own Garnaut report have shown is very high. This being so, the chances are high that, without guidance from economists, governments will pursue remedies involving high efficiency costs.

Parko's fourth possible explanation for economists' lack of support is that they prefer to be pure in their proposed solutions to problems and are suspicious of politically negotiated outcomes and transitional assistance.

Academic economists in particular love an ''elegant'' solution to a complex problem, but policy action is a messy, compromised business, that never starts with a clean slate and involves building coalitions around concrete policy proposals.

No sooner had the Rudd government fixed on an emissions trading scheme than economists came out of the woodwork arguing a carbon tax would be better. That trading schemes had long been the centre of international efforts to achieve a co-ordinated reduction in emissions troubled them not a bit.

''These proposals are generally put forward at a conceptual level, where they may be models of elegance and simplicity, untrammelled by questions of practical implementation or political reality,'' Parko said.

As for the objection to transitional assistance, ''no one ever suggested that tariff reform wasn't worth doing because it was implemented gradually and with generous transitional assistance packages - yet despite the careful attention paid to preserving the abatement incentives and ensuring that assistance is provided for a transitional period only, this is exactly what many are saying about the carbon pollution reduction scheme''.

Parkinson concludes that economists' lack of agreement on key implementation questions renders their preference for a carbon price signal largely meaningless in practice. In fact, it undermines public support for least-cost solutions. Well done.

Read more >>

Why economists didn't see the big crunch coming

Psychologists call it "framing". When rarely they think about it, economists call it "models". What it means is that our understanding of things and our reactions to them are heavily influenced by the way we choose to look at them.

Macro-economics - the idea that governments can manage the economy as it moves through the business cycle - has really only been going since World War II. But it involves a particular way of looking at national economies, a way heavily influenced by the priorities of John Maynard Keynes and his followers.

Economic variables come in two kinds: they're either "flows" or "stocks". When you watch something increasing or decreasing over a period of time you're watching a flow variable.

It might be your wage, which comes in every week over a year, or it might be your spending on groceries, which is added to every time you go to the supermarket over a period.

When you measure something at a point in time you're looking at a stock variable. It might be how much you've got in the bank on a particular day - June 30, for instance - or how much you owe the bank. Or you could get a real estate agent to value your house.

That value applies at the time it was assessed, but may not be accurate a few months later. So a stock value is like a photograph: it shows you what the world looked like at the moment the photo was taken.

If you know anything about company accounts, you know about flows and stocks. The profit and loss statement shows flows: the flow of sales over the period, the flow of expenses over the period and the profit or loss made over the period.

The balance sheet, on the other hand, shows stocks: the stock of assets owned by the business on the last day of the period, the stock of debts and other liabilities owed by the business on that day, with the difference between the two being the value of the business to its owners on that day.

Here's the point: from the start, macro-economists developed the habit of focusing on flows and taking little interest in stocks. They studied the economy-wide equivalent of the profit and loss statement - the components of gross domestic product - and ignored the balance sheet. (National balance sheets have been added to the national accounts only in recent years.)

Another way to put it is that economists tend to focus on the "real" economy of getting and spending, production and consumption, not on the "financial" economy of who owns and owes what - assets and liabilities.

Yet another kink in the way macro-economists look at the economy is that they focus on the demand side of the economy (what people are spending their money on, consumption or investment) rather than the supply side (the economy's capacity to produce goods and services for people to buy).

The rationale for this focus on the demand side is that governments can influence demand in the short run, but supply (the number of machines and factories, the size of the labour force and its degree of skill) can be influenced only in the longer run. Hence macro is called "demand management".

Why am I telling you all this? Because all these biases in the way economists tend to think about the economy help explain the global financial crisis - which the world's sharemarkets' recent reaction to developments in Europe shows isn't over - and why economists didn't see it coming.

The global financial crisis had its origins in the financial economy (which most macro-economists don't take a great interest in), but this inevitably damaged the real economy of spending and employment.

What's happening in Europe (and to a lesser extent the US) is that people are getting increasingly worried by governments' high and rapidly rising levels of debt. What happens if the financial markets lose confidence in governments' ability to repay their debts?

Debts are a stock, incurred as a consequence of deficits, which are a flow. You have to borrow to allow a deficit to be incurred during a period and that leaves you with a (higher) stock of debt at the end of the period.

Because deficits - budget deficits, trade deficits, current account deficits - are flows, they're part of the purview of macro-economists. But deficits matter only because they add to debt levels, and if it's not your practice to take much interest in debt (because it's a stock) you face a great temptation not to worry too much about deficits, not to be aware of how they're starting to mount up.

Economists didn't cause the public debt build-up. It was caused by politicians pandering to electorates that want more and more government spending, but don't want to pay higher taxes. But economists, with their focus on annual flows, failed to raise the alarm over mounting debt levels.

Then you have a global financial crisis that threatens to bring down the banking system and the real economy with it. You have no choice but to borrow heavily to prop up the banks and borrow again to try to get the economy moving.

One small problem: put all that borrowing on top of already high levels of public debt and suddenly everyone in the financial markets is worried about "sovereign risk" and whether you'll be able to repay your debts.

(That some of the people now carrying on about governments' huge debts were the same people whose reckless behaviour - and accumulation of huge levels of private debt - required the government to bail them out, allows you to call them rude names but not to ignore their ability to bring down those governments.)

Urged on by financial-side economists, governments in Europe are seeking to stave off a possible loss of financial market confidence in those governments' ability to repay their debts by slashing their spending and raising taxes, even while their economies are weak and the austerity programs will make them weaker.

But Keynesian macro-economists are appalled by this and locked in a furious debate with the financial economists. The financial guys are saying it's stocks (of public debt) that matter most and they must be cut at whatever cost; the macro guys are saying it's flows of spending and production that matter most, and to cut them now is madness.

Thankfully, our Liberal Party's obsession with budget deficits and debts has left us in the clear.

Read more >>

Show us your ticker, Gillard, before we vote

Excuse me, but what's the tearing hurry? We've had a new Prime Minister for five minutes, but we're being rushed off to an election before we can get her measure. Why? Is there a fear, if the election were delayed until October, the gloss would have worn off and we'd see Julia Gillard in a less hopeful and flattering light?

Is the new leader's fleeting honeymoon all that stands between Labor and electoral defeat? Is Labor's record in government that bad? Is Tony Abbott such a formidable opponent?

I'm not impressed by what we've seen of the Gillard government so far. We've seen the triumph of political expediency over good government. From her first day she's left little doubt three running political sores - the mining tax, resentment of boat people and the vacuum left by Labor's abandonment of its emissions trading scheme - needed to be staunched quick smart if the government's re-election were to be secured.

But what hasty, amateurish patch-up jobs we've seen. Wayne Swan has fudged up figures purporting to show the revenue cost of the deal done with the three biggest mining companies was minor, whereas sharemarket analysts are saying the extra tax to be paid by the companies will be minor. Then we had the fearful muddle over the Timor solution the Timorese hadn't agreed to, and now we're getting the climate change policy you have when you don't have a climate change policy.

The trouble with all this is it's terribly reminiscent of Kevin Rudd. Lacking in courage, not thought through and thrown together at the last moment. None of these stop-gap solutions will have been legislated before the election. So is that to be Gillard's agenda for Labor's second term: finishing off all the stuff not finished in the first term? Is that to be as inspiring as it gets? First re-elect my government and then I'll have time to think up my own agenda?

I'm sure the government has plenty of announcements up its sleeve to make between now and election day, but I'm not sure they'll add up to anything more than a grocery list. Bit of this, bit of that, tinker with this, fine-tune that. Nothing controversial, of course, and (given the budget deficit) nothing too expensive.

Before we vote on whether to retain Gillard we need to know a lot more about her and, more particularly, where she proposes to take us.

She tells us she believes in hard work, egalitarianism and the value of education, and she's proud of her mum and dad. I doubt if there are many who'd disagree, but if that's as big as her vision gets she's not ready to be our leader.

One of Rudd's biggest problems was he couldn't set priorities for himself. He took on too much, wanted the biggest and best in everything, and ended up not getting much achieved. He took on a couple of big economic reforms - the emissions trading scheme and the resource rent tax - but took them far too cheaply, underestimated the amount of explaining that needed to be done, then when the going got tough, turned turtle.

So what are Gillard's priorities? What does she plan to devote most of her attention to at the expense of all the other things she could focus on? Does she know but doesn't want to tell us, or hasn't she had time to think about it? Will she work it out as she goes along?

We know, despite her protestations, climate change won't be one of her second-term priorities. She says (correctly) we need to put a price on carbon, but then says she won't get ahead of public opinion and won't act on a carbon price until after 2012. Her next term will be spent doing the explaining that should have been done this term.

I fear most of what passes for economic debate in the election campaign will be of little consequence. Labor dumped its emissions trading scheme and emasculated its resource super profits tax for fear of being accused of introducing "a great big new tax", but that won't stop both sides accusing each other of planning to do just that.

Both sides will express their determination to get the budget into surplus as soon as possible and eliminate our (tiny) public debt post haste, while accusing the other of profligacy.

If there's one thing we don't need to worry about it's deficits and debt. Why not? Because we worry about it so much. The Libs make such a fuss about it it's a crime Labor wouldn't dare to commit.

The big economic issues facing us include how we'll make room for a greatly expanded mining sector in an economy already close to full employment, whether there's more tax reform in the Henry report we should be getting on with, and how we'll fix the ever-growing shortage of housing, including improving public transport to make homes in the outer suburbs more accessible.

Far from spending the next three years chatting about whether to get serious about combating climate change, we need to debate our unquestioned commitment to unlimited economic growth.

Does ever-rising affluence - much of it used to fuel an unending status competition - make us happier as both sides of politics assume? Are we paying a hidden price for it in damage to our family and social relationships? Is it really possible for the rich world to keep increasing its consumption of natural resources while the developing world - led by China and India - rapidly raises its standard of living towards Western levels without this irreparably damaging the ecosystem?

A bit too much for a prime minister from the left desperate to prove she's not left-wing? Far too threatening a subject for either of the political parties? I fear so. Much safer to have a furious argument about great big new taxes and the budget deficit.

Read more >>

Swan's sleight of hand hides mining concession

Tony Abbott is right. Julia Gillard and Wayne Swan have grossly misled the public on the cost of their abject surrender to the three big mining companies over the former resources super profits tax.

They claimed that almost halving the rate of the tax - from 40 per cent to an effective 22.5 per cent - and making various other concessions demanded by the companies would reduce tax collections by just $1.5 billion over its first two years, a mere 12.5 per cent of the originally budgeted $12 billion.

How was that unbelievably small cost achieved? Partly by shifting the goal posts. As we now know, the revenue to be raised by the new version of the tax was estimated using higher prices for coal and iron ore than were used in estimating the revenue to be raised by the original version. The new estimates also used different assumed production volumes.

To what extent do these "parameter" revisions cause the revenue cost of the policy changes to be understated? Gillard and Swan are still refusing to say. Apparently, this is none of the electorate's damn business. So we're forced to rely on estimates by people not in full command of the facts.

These suggest the government's figure of $1.5 billion over the first two years understates the value of the concessions to the big miners by

$1.6 billion (according to sharemarket analysts at Goldman Sachs JBWere), or $3 billion (according to mining tax consultants quoted by David Uren of The Australian, who deserves special mention for pursuing this issue).

Let's be clear: there's nothing wrong with the government using more up-to-date parameters when it redoes its budget figuring. No, the crime is to do so without acknowledgement, let alone without indicating the value of the parameter changes. Swan not only failed to acknowledge the change, he avoided answering a direct question on whether he had changed any of the assumptions that underpinned the revenue estimates. (These figures have not been made public - you won't find them on Swan's website - but merely "circulated" to gallery journalists, presumably because Swan had something to hide.)

Coming from a treasurer, this isn't tricky behaviour, it's dishonesty. If you can't trust the Treasurer to be honest about the cost of measures, who can you trust? I can't think of a previous treasurer who betrayed our trust so badly.

But the other part of the sleight of hand is to change the tax in ways that have implications over many years, then tell us only about the first two. Telling us more would involve making assumptions about commodity prices and exchange rates, but that's just as true of the four years of estimates produced for every budget and budget review.

It's a weak excuse that could be overcome if the government wanted to do so. So again we're forced to rely on figuring by outsiders lacking the Treasury's knowledge. The Goldman Sachs analysts estimate that, on a like-with-like basis and using quite pessimistic assumptions about commodity prices, the cost to revenue of the changes imposed by the big three will total about $35 billion by 2019-20.

With the original tax package (that is, including all the tax concessions on which the resources tax revenue was to be spent) we were given no idea of whether it was revenue neutral beyond the first two years. It may not have been because the loss of revenue arising from lifting the superannuation guarantee to 12 per cent by 2019-20 will be huge.

But whatever the position originally, it's a safe bet it will be worse now the chief payers of the minerals resources rent tax have been allowed to redesign it.

Even so, there are a few points to make. Few people have noted that, according to Swan's figures, revenue will be $1 billion higher in the first year, but $2.5 billion lower in the second. These differences partly reflect the secret parameter changes, but they also seem to reflect the choice companies were given between writing off their assets at book value at an accelerated rate over five years (36 per cent in the first year, 24 per cent in the second), or writing them off at market value over 25 years (4 per cent a year).

Since we can be sure the companies will pick the method that favours them, this choice will end up reducing the amount the tax collects. In the early years, however, those companies opting for market value will pay more tax rather than less.

But it doesn't follow that all the tax saved by the big companies equals the amount lost by the taxman. Why not? Because Gillard and Swan have allowed the big three to rejig the tax in ways that suit them at the cost of the smaller miners, particularly those in the early years of their projects and those mining ventures yet to be born.

The original tax's now-abandoned guarantee to pick up 40 per cent of losses was of little value to the big boys, but (despite their claims to the contrary) of great value to the new small boys (as was also the now-abandoned plan to give a refundable rebate rather than a simple deduction for exploration costs).

Whereas under the original tax 2500 firms would have been affected, now only about 320 will be. But this means about 2200 mining companies will now not be relieved of paying state royalties. And those remaining in the tax net will get only a deduction against profits (and a carry-forward in the event of losses), not an automatic refund.

This greatly reduces the economic efficiency gain from the new tax because so many miners will remain subject to royalties based on volume or price, not profits. Well done.

Read more >>

Why 600,000 out of work is a magic number

Who would have expected it? A year ago we thought we were headed for a severe recession and this week we learn the rate of unemployment is down to 5.1 per cent. Do you realise that's just a fraction above what economists - and the Gillard government - regard as full employment?

Huh? If 5 per cent of the labour force - 600,000 people - is still looking for work, how on earth can economists say we're at full employment? Good question. Unfortunately, economists don't have a good answer.

This year's budget papers - which seem to have been overtaken by events already - say the unemployment rate is expected to fall to 5 per cent by the middle of next year and to 4.75 per cent by mid-2012, "around levels consistent with full employment".

Last month a senior Treasury officer, Dr David Gruen, told a Senate committee it was "a longstanding practice" to regard full employment as 5 per cent, although there was "a reasonable band of uncertainty around that number".

"With the best will in the world, we cannot really tell whether it is 5 per cent or anywhere in the range, say, from about 4.75 per cent to 5.25 per cent," he told

the committee.

I guess the first thing to understand is that, to an economist, "full employment" does not mean what you and I think it does. It does not mean everyone who wants a job has found one.

Rather, it refers to the lowest sustainable rate of unemployment. That is, the lowest rate to which unemployment can fall before shortages of labour lead to excessive wage increases and start pushing up inflation.

In the jargon, this is the "non-accelerating-inflation rate of unemployment" (NAIRU). So in an economist's mind the NAIRU is synonymous with full employment.

As Gruen implied, no one knows for certain where the NAIRU is, though we do know it can shift over time.

So, though economists do make calculations to estimate where it lies, you really have to discover where it is by real-world experience.

When the unemployment rate got down to 4 per cent in early 2008, most economists would have regarded that as clearly below the NAIRU. The private-sector wage index rose by 4.3 per cent over the following year - hardly a wage explosion, but clearly on the high side, particularly when the productivity of labour has been improving so slowly.

And the underlying rate of inflation has now been above the target range of 2 per cent to 3 per cent for more than three years. So I guess that does confirm that the NAIRU is nearer 5 per cent than 4 per cent.

Economists actually regard 5 per cent as good because, not that long ago, they believed the NAIRU was up somewhere between 7 per cent and 8 per cent. The rest of us, on the other hand, are shocked by the idea that economists could be satisfied with unemployment no lower than 5 per cent.

And oldies can remember the 1950s, '60s and early '70s when full employment (and the NAIRU) was regarded as an unemployment rate no higher than 2 per cent.

The 2 per cent was easily justified as "frictional unemployment". At any time, roughly 2 per cent of the labour force are unemployed simply because they are moving between jobs, and thus of no concern. In those days people were unemployed so briefly many did not bother to register for the dole.

But how do economists explain why the lowest point at which inflation pressure can be quiescent has shifted from 2 per cent to 5 per cent over the past 35 years or so? Well, the reason you can get inflationary wage pressure while still having 600,000 people looking for jobs is "structural mismatch": the remaining unemployed either don't have the skills employers are seeking or don't live in the parts of the country where those workers are being sought.

But that does not explain why structural mismatch is a much greater problem today than it was 40 years ago. So the truth is, economists can't offer a thorough explanation for why the full-employment rate has risen, as many of them will admit.

It is worth noting, however, that since the postwar Golden Age ended with the arrival of stagflation in the mid-1970s, NAIRUs have risen significantly in most developed economies.

And just because economists can prove it, that doesn't stop them having theories - rival theories, naturally.

Economists of a neo-classical disposition incline to the view that the full-employment rate is higher these days because a combination of increased interventions in the economy - minimum wage rates that are too high, unemployment benefits that are too generous and unfair dismissal laws - have stopped the labour market functioning as efficiently as it used to.

Limits on employers' freedom to dismiss unsatisfactory workers have made them more reluctant to hire those workers at the bottom of the barrel, it's argued.

Or, unduly high minimum wages effectively price unattractive workers out of a job, while generous unemployment benefits reduce the incentive for people to find work.

There may be other reasons why people don't try as hard to find work these days: because the stigma of being unemployed has declined, because dual-income households reduce the pressure on one partner to find work, which may be particularly true of married women.

But these arguments aren't terribly convincing. Relative to average income, our dole payments are very low.

And while it's true our minimum wage is quite high relative to average income, our NAIRU isn't that much higher than America's, even though its minimum wage is terribly low.

So economists of a more Keynesian disposition try to explain the higher full-employment rate more in terms of how the structure of the economy has

changed (as opposed to how governments have made prices more inflexible). When you get down to an unemployment rate of 5 per cent, most of those who have been unemployed for any length of time are unskilled, with a chequered work history. It may be that the kind of jobs suitable for such people no longer exist to the same extent they once did.

And there's a suspicion that where the NAIRU lies is affected by how rapidly you approach it. If unemployment falls rapidly, you may hit the NAIRU at a

higher level than if growth is more sedate and it takes a lot longer to get unemployment down.

Sorry, but all this is about the best explanation economists can offer. There is a lot economists do not know.

Read more >>

Green jobs just muddy the climate-change waters

A cartoon by Jon Kudelka shows Julia Gillard ticking off items on her to-do list: first, appease billionaires; second, appease xenophobes; third, appease climate sceptics. Too true ... although, actually, when she has finished appeasing those who live in fear of boat people her last bit of pre-election deck-clearing will be to appease those who regret the government's decision to walk away from its emissions trading scheme by announcing a program of government subsidies to induce people to reduce their emissions directly.

Amazing though it may seem, the climate-change-denying opposition has a post-trading scheme policy to encourage "direct action", whereas the government - which still protests its acceptance of human-caused climate change - doesn't.

It's a fair bet that when we see Gillard's direct-action policy it will come complete with boasts about how many "green jobs" it will create.

Creating green jobs is all the rage. About a year ago Kevin Rudd promised to create 50,000 of them. Tony Abbott has plans for a standing army of 15,000 green workers who could be deployed across the country. And every environmental group or renewable energy lobby group wants to tell us how many "green-collar jobs" could be generated if only we'd do as they say.

It seems the notion of green jobs arose as a response to the claims of the opponents of climate policy that moving to a low-carbon economy would destroy lots of jobs. No it wouldn't, environmentalists cried, it would create lots of jobs. What's more, they would be green jobs.

But as the Australia Institute warns in a policy brief to be released today, there's a lot of woolly thinking about green jobs. It seems to be little more than a propaganda tool.

For a start, there has been little attempt to define what constitutes a green job. If, for instance, a job maintaining a wind turbine is a green job, what about a job in the business that makes the turbines?

And if it's green to manufacture steel turbines, what about the jobs of the people who mine the iron ore and coking coal needed to make the steel? But if it's not green to be a miner, would it be better for us to import all the turbines we need so the sin of being non-green was on someone else's head?

Should people who work in industries with a low environmental impact be regarded as having green jobs? If so, a significant proportion of all our existing jobs - particularly those in health, education and community services - are green.

But what about jobs in industries that have reduced their ecological footprint, even though it remains substantial? Are these jobs more green or less green than jobs in industries whose footprint has always been small?

As a general rule, industries that are capital-intensive are likely to have a bigger footprint than industries that are labour-intensive, such as service industries. Does this mean we could make the economy greener by abandoning our age-old quest to use machines to replace workers wherever possible?

Do workers whose job is to return a mine site to nature after it has been worked out qualify as green-collar workers? If so, what about workers who clean up after oil spills?

And what about jobs that make the natural environment more accessible to people? If, for instance, you employ some young people to improve the signs on a bush-walking track (for which I'm always grateful) are these green jobs? The advocates of such projects seem to think so.

Visiting the great outdoors may make people more environmentally conscious. But what if the greater accessibility attracts more people and thus adds to the degradation of the area? Would the green jobs then turn brown?

If I were to drive all around the state - or fly all around the world - educating people about the damage the use of fossil fuels does to the climate, would that make me a green-collar worker?

Give up? I reckon it's virtually impossible to come up with a watertight definition of green jobs. But I don't think that matters. As the Australia Institute's report argues, focusing on green jobs is at best a distraction and at worse a snare and a delusion. The object of the climate change exercise is to move to an economy where little of our energy needs are met by burning fossil fuels, thereby making us a "low-carbon economy" and greatly reducing our emissions of greenhouse gases.

Focus on that and the jobs will look after themselves. What seems to be missing from the preoccupation with green jobs is an understanding that all economic activity creates jobs. Moving to a low-carbon economy may well involve reducing jobs in industries that produce fossil fuels, but it will also create them in renewable-energy industries. And even should producing a quantity of energy from solar, wind or whatever involve fewer jobs than producing the same quantity from coal, that's not a problem either. This greater productivity of labour would leave income to be spent elsewhere in the economy - probably the services sector - where it would create jobs.

Our businesses have been using "labour-saving equipment" to replace workers for 200 years and it hasn't cause mass unemployment yet. (It's true, however, that the workers displaced from fossil-fuel industries may not be well placed to take the jobs created in the renewable industries or elsewhere, but that problem - which does need to be dealt with - is common to all the changes in the structure of the economy that continuous technological advance has caused over the centuries.)

It's OK for governments to spend money for the dominant purpose of creating jobs when they're fighting to urgently reduce the impact of recession. Apart from that, however, the money they spend should be aimed at achieving its nominal purpose. The number of jobs this spending creates should be incidental.

If we continue our muddled thinking about green jobs, we risk having politicians trying to curry our favour by wasting money on schemes that will do little to combat climate change.

Read more >>

Economists help cause gutless government

I hope I'm wrong, but I fear the all-in fight over the resource super profits tax will in time be seen to have brought the era of micro-economic reform to an end. If so, the economics profession will bear its share of the blame.

You could argue (as I did on Saturday) that, though the compromise deal Julia Gillard came up with is far from perfect, it still represents a net increase in economic efficiency relative to the present arrangements. But that ignores the psychological scars this dog fight will leave on the pollies.

You have to ask yourself what conclusions the politicians - of both sides; they're very similar animals - will draw, first from Kevin Rudd's palpable loss of credibility following his decision to dump the emissions trading scheme, and second from the government's near-death experience with the resource tax.

There is a host of useful lessons you'd hope the pollies would draw: don't over-promise and under-deliver, don't announce contentious reforms just before an election, don't take on too much, don't underestimate the attention and effort needed to sell unpopular reforms to a confused electorate, and more.

But the lesson the pollies are more likely to draw is much more damaging: don't let economists sell you complex reforms that are almost impossible to explain to mere mortals because the economists will fall to arguing among themselves and leave you in the lurch.

Think about it: what is reform? It's governments making changes that economic theory says will make us all better off, but in the process arousing intense resistance from those who fear their rents are threatened.

Governments then face the problem that the great number of modest winners stay mute while the small number of big losers scream blue murder. As we've just seen, the political problem is greatly compounded by the ease with which powerful vested interests can convince the public the interests' problem is actually the public's problem.

The antidote to this propaganda involves economic reasoning that's beyond most of the public's comprehension and which the pollies find almost impossible to explain without the help of economists capable of speaking plain English.

When people don't understand policy debates and don't know what to believe, they fall back on the opinions of presumed experts, such as prominent business people. But business people are either on the make or they're adhering to an honour-among-thieves ethic that you keep mum while fellow business people are trying it on (we've just seen the Business Council doing exactly this on the resource tax).

The other, better qualified authority source is the economics profession. But reforming pollies have learnt economists always let you down. You think you're fighting their good fight, but they're more inclined to attack you or muddy the water than support you. There are different kinds of economists, of course. The econocrats generally aren't free to speak publicly on policy.

Most market and private sector economists are prevented by their employers from joining the non-macro policy debate, prevented from offending clients or potential clients and sometimes required to spruik their firm's interests.

Then you have the self-employed economic consultants, whose arguments are for hire - sometimes by governments trying to side-step the econocrats, but usually by vested interests battling the government.

Apart from a handful of media economic commentators who are free to express their opinions (those working for Fairfax, anyway) that leaves only the academic economists free to take sides and speak out.

The great majority of academics don't say boo beyond the staff room. But the few who do are far more likely to argue the toss with government policies than support them.

(The 21 academic economists who issued a statement supporting the resource super profits tax are an honourable exception.) I have sympathy for the Treasury secretary's expression of the frustration ministers of both colours feel at the unsupportive contributions of academics.

Ken Henry acknowledged the value of the academic "contest of ideas", but said there were "occasions on which economists might, at least for a period, put down their weapons and join a consensus".

The reaction of the academics wasn't just defensive, it dripped with righteous indignation. Professor Warwick McKibbin, of the Australian National University, said Henry "can't believe you should have consensus because it is better to have bad policy that everyone agrees with than eventually get good policy that will work".

Note the assumptions in that remark: the policies governments advance are always bad and always in need of correction by that fount of wisdom, W. McKibbin. It tells you more about his personality than the state of public policy. I don't remember him ever doing anything but criticise. McKibbin was among the first economists to propose a detailed solution to climate change and is an expert of international rank. But no government has accepted his solution and now he tears down every proposal different from his own.

He's so negative the opponents of action see him as an ally.

Professor Joshua Gans, of Melbourne Business School, said "you have to believe Ken Henry really doesn't understand academics at all when he publicly says stuff like this". He had supported various government policies, but was never invited to help improve those policies ("something they could clearly use"). Failing that, he would "speak my mind from the sidelines".

It's a free country, and if academics are willing only to advocate (their personal version of) policy perfection and not support policies that inevitably and unavoidably are less than first-best, no one can make them.

But let's not hear any economists whose only contribution is a counsel of perfection complain governments lack the "political will" to implement economic reform policies even economists refuse to support.

Read more >>

Battle over tax leaves Labor with bloody nose

The deal Julia Gillard has done on the mining tax is bad for her government's reputation, bad for democracy and bad for the future of economic reform, but not too bad for the economy.

The immediate reaction of most parties will be relief. What was seen as a great threat has gone away.

The big miners will be quietly congratulating themselves on the extent of their victory, but leaving it to their friendly business commentators to do the crowing for them.

Concessions extracted from the government because the big mining companies were holding a gun to its head will be interpreted as proof that all the miners' dubious arguments against the resources super profits tax were valid.

But the initial emotional reaction to the deal is one thing, the longer-term consequences are another.

Although Gillard, being a new prime minister, will be given a lot of slack by the electorate, the Labor government's backdown on the mining tax, coming on top of its retreat on the emissions trading scheme, will entrench its reputation for weakness and lack of conviction, and further embolden vested interests to actively resist legislation they don't like.

Labor will be looking for people to blame, but it should consider its own part in this political disaster. Its decision to adopt such a controversial reform so close to an election was a basic political miscalculation.

Its belief that, simply by naming the tax a "super profits" tax, it could harness all the public's envious resentment of the rich mining companies, which would be sufficient to outweigh all the propaganda the miners would put up, was another bad call.

This government has shown an inability to set priorities for itself, tried to do too much, and grossly underestimated the degree of ground-preparing, consulting and explaining needed to ensure a controversial reform makes it from announcement to reality.

Professor Ross Garnaut said early in this war that it would be a test of whether difficult economic reform remained possible in Australia, or whether powerful interest groups now had too much sway over the political process.

By that test we haven't done well, even if a significant element of reform remains in the compromise forced on the government. It's now clear to all that governments daring to take on the mighty mining industry can expect to lose.

The big miners have won their fight against the emissions trading scheme, and now they'll be seen as achieving major concessions in the attempt to make them share with the owners of the resources a larger proportion of the windfall gains from the resources boom.

These guys are giant killers. They saved themselves $1.5 billion over the first two years - and probably a lot more in later years - for the price of an advertising campaign estimated to have cost just $7 million.

They prove that if you're big enough, rich enough and aggressive enough you can push around the elected government of Australia.

This Labor government has always been afraid of big business and now its drubbing at the hands of three big companies will deepen that fear. What do you reckon are the chances of a re-elected Labor government returning to the Henry report for further ideas on tax reform?

I fear this is the end for controversial micro-economic reform from Labor. And it's hard to see the cause being taken up by a future Liberal government. Don't forget the major part the Abbott opposition's unprincipled opportunism played in this affair and in the abandonment of the emissions trading scheme before it.

The deal involves changing the (dumb) name of the resources super profits tax to the minerals resource rent tax, turning it into a more generous version of the existing petroleum resource rent tax and extending the coverage of the petroleum tax.

That's not the end of the world. The miners had been expecting something similar to petroleum tax and, had that been what the government decided to introduce, it would have been greeted by economists as a big improvement in the efficiency of resource taxation.

In theory, the originally proposed tax was more economically efficient than the petroleum tax - that is, it would have done less to distort miners' choices about what projects to undertake. But some of the miners' criticisms of it - namely, that bankers would discount for purposes of collateral the value of the government's guarantee to cover 40 per cent of project losses - were genuine.

The main difference in changing the original tax to be more like the petroleum tax is to drop the guarantee to pick up 40 per cent of losses, in return for the cut-in point for the application of the rent tax being raised from the long-term bond rate to the long-term bond rate plus 7 percentage points.

This is just a change in the way the tax allows for "risk" in the universally accepted proposition that economic rent is what projects earn in excess of their risk-adjusted rate of return (the long-term bond rate being taken as the risk-free rate of return). Don't forget that those minerals that remain covered by the new tax - iron ore and coal - will still have the new tax effectively take the place of the states' volume- or price-based (but not profit-based) royalty charges. This feature does much to improve efficiency.

What's hard to understand about the deal is that so many changes could be made at such a small net loss of revenue from the new tax: $1.5 billion over the first two years. Three possible explanations come to mind. First, the original costings had a lot of leeway built into them in anticipation of some concessions having to be granted.

Second, the ultimate cost of the concessions won't be felt until after the first two years of the tax (the estimates for which we've never been shown).

Third, the exclusion of many other minerals from the tax may involve a net saving to revenue because those firms would have gained from not having to pay state royalties while paying little or no resource rent tax. If so, the small miners have only themselves to blame for throwing in their lot with the big boys and then being dudded.

And the same goes for all those businesses now facing a cut in company tax of only 1 percentage point rather than 2 points because they stood back while their big mining mates did over the government at their expense.

Read more >>

Tiny tax cut a blessing for battlers

Forgive me, but I'm tickled by the latest joke: the good thing about having a woman as prime minister is we don't have to pay her as much. Actually, the amount the prime minister gets paid is just one of the many things that won't be changed by Labor's leadership switch.

A new face, a new atmosphere, a new attitude towards the government for many people, but surprisingly little change in policy.

Take, for instance, the tax cut we get from tomorrow. Its arrival has been forgotten in all the excitement, but it's still coming. It's the third of the three annual tax cuts Kevin Rudd promised and, though our budgetary circumstances have changed markedly since then, there was never much doubt it would be delivered.

Even so, the government has waxed hot and cold on the promised cuts. This time last year it didn't want to draw attention to them, perhaps because it might have seemed profligate adding a tax cut to all the cash it had been splashing around.

This year it's happy to have us noticing the cut because people have begun complaining again about "cost of living pressures". So, we're told - conveniently - the cut is intended to help.

But that's not all.

It's remarkable the things politicians think our forgetfulness will allow them to get away with saying. Wayne Swan claimed recently, "the Rudd government designed these tax cuts to boost incentives for labour force participation..." blah, blah, blah.

In truth, the cuts were designed by Peter Costello. Rudd simply pinched them from John Howard during the election campaign. The cut we get from tomorrow, the first day of the new financial year, will be the eighth we've had in a row, surely a record.

And next year? Next year we'll get nothing. Indeed, unless a change of government brings a change of policy, we're unlikely to see another tax cut for four years, maybe longer. That's because Labor has vowed not to cut taxes again until the budget is back in surplus and the surplus is equivalent to at least 1 per cent of gross domestic product (by then, about $17 billion).

So it's good to take note of tomorrow's cut, even if for most people it isn't all that generous. People with part-time jobs, or full-timers close to the minimum wage, earning between $16,000 and $37,000 a year will save a princely $2.90 a week. Those earning between $37,000 and $67,000 will save $8.65 a week.

From there up to $80,000 a year, the saving drops to $5.80 a week. But from there on it starts rising, to reach a peak of $25 a week for those battlers on $180,000 a year or more.

The higher dollar savings going to people on very high incomes shouldn't surprise you and, since those people pay a much higher proportion of their income in tax, this doesn't prove the tax cuts are biased in favour of the well-off.

By the same token, however, the government's trick of showing us the percentage decline in the amount of tax paid at each level of income is another unreliable guide to who benefits most.

This will always show those on the lowest incomes - and thus paying the lowest amounts of tax - make the biggest proportional savings.

If, for instance, I was formerly paying just $1 a week in taxation and the tax cut relieved me of this, the government could claim it had given me a saving of 100 per cent. But that would hardly leave me much better off. No, the tax economists will tell you the right way to determine the fairness of a tax cut is to look at the change in the proportion of people's total income they lose in tax - that is, their "average tax rate".

Judged this way, it turns out the maximum saving of about 1¢ in every dollar of income goes to people earning between $37,000 and $50,000 a year - quite modest incomes, well below the average full-time earnings of about $67,000 a year.

The workers who do best from this tax cut are those earning up to $30,000 a year less than average earnings. But, surprisingly, those who do worst are those earning up to almost $30,000 a year more than average earnings.

People earning incomes a bit below or above $180,000 a year save only about 0.7¢ in every dollar of income. Someone on $300,000 a year saves just 0.4¢ in the dollar.

Tax cuts can be expensive from the taxman's point of view. Just how expensive they are turns not on how much you give the high-income-earners (there aren't enough of them to make a big difference) but on how much you give those on incomes around the middle.

That's because such a high proportion of incomes are clustered around the middle. But the middle (or median) income is actually lower than average (or mean) full-time earnings of $67,000 a year. And since there are a lot more people on incomes a bit below the mean than a bit above it, this seemingly modest tax cut is actually quite an expensive one, coming at a cost to revenue of $3.8 billion a year.

So, largely by chance, these tax cuts really will do a bit to help a lot of genuine battlers cope with the rising cost of living.

Will it satisfy them? I very much doubt it. Because wages - and age pensions - rise faster than the cost of living, complaints about the rising cost of living are actually a cover for worries about the success of our efforts to keep up with our peers' ever-rising standard of living.

Most of us are pounding away on this hedonic treadmill, as psychologists call it, and all our economists and politicians can think to do is help us run faster.

Read more >>

Gillard has little room for compromise on tax

Ending the fight over the resource super profits tax may be at the top of Julia Gillard's to-do list, but she has no scope to drop the tax and little scope to reduce it.

Surprisingly to some, the reason the new Prime Minister can't drop the tax is not because it would leave a hole in the budget. Arithmetically, the tax could be dropped without affecting the government's commitment (repeated by Gillard) to have the budget back in surplus in 2012-13.

Why? Because, as Wayne Swan repeated on Friday, the resource tax is part of a package of tax changes. That package is essentially revenue-neutral and thus detachable from the budget.

Virtually all the proceeds of the tax would be used to pay for the other alleged reforms in the package: the cut in the rate of company tax, the instant asset write-off for small business, the various superannuation concessions, the resource exploration rebate, the standard tax deduction, the discount on tax on interest income and contributions to the planned state infrastructure fund.

Since the resource tax isn't due to start until July 2012, all the measures it pays for will be phased in from that date, a further indication it's part of a package.

Thus dropping the tax wouldn't leave a hole in the budget, but it would mean dropping all the political goodies it would have paid for.

So that's the first reason Gillard can't just drop the resource tax. It would rob the government of all its election promises and much of its second-term agenda; its rationale for seeking re-election.

But there's a deeper reason. Kevin Rudd, and now Gillard, have repeatedly insisted the miners pay the owners of the resources they mine a "fairer share" of the proceeds. Simply walking away from the tax because it had proved unpopular with the miners would be seen as a repeat of Rudd's decision to walk away from the emissions trading scheme (something he now says Gillard and Swan urged him to do).

And just as even people who were relieved to see the back of the trading scheme still concluded Rudd lacked convictions and the courage of them, so people with doubts about the wisdom of the resource tax would nonetheless conclude Gillard was equally lacking in convictions - an impression that would be reinforced by the motivation behind her brutal installation as leader.

If anything's crystal clear from Rudd's remarkable decline in public esteem following his cowardly abandonment of the emissions trading scheme, it's that voters expect their leaders to stand for something. Show them your sole motive is clinging to office and you're dead meat.

Combine the voters' desire for strength of character with the budgetary arithmetic and you see why Gillard has little scope to reduce the revenue raised by the resource tax. Cut too much from expected collections and you look weak in the face of powerful vested interests and you have to cut back your promised tax goodies to fit.

Considering the way business people have either stood silent or actively sympathised with the miners' resistance to paying more tax, it would serve them right if the net cost of reducing the tax was covered by reducing the planned 2 percentage point cut in the company tax rate.

Gillard will need to distinguish between changing those features of the resource tax the miners find most objectionable and simply reducing the burden of the tax. The former is a lot easier to concede than the latter.

Resource rent taxes come in different models. Ken Henry's version is theoretically superior to the present petroleum resource rent tax, with the latter's less generous treatment of losses but its threshold for the tax set at the long-term government bond rate plus 5 percentage points.

But it seems the miners were expecting the extension of the petroleum tax. They've been hugely critical of the Henry tax's guaranteed 40 per cent rebate on losses in place of the extra 5 percentage points on the threshold.

Gillard could accommodate them on this, and probably also exclude various lower value resources from the tax regime, at no great net cost to revenue - particularly if the planned move to a rebate (rather than a deduction) for exploration expenses was also abandoned.

This would probably make a lot of the smaller miners less unhappy and it would also yield modest savings to the big miners. Would it be sufficient to satisfy the big boys? I doubt it.

Here's where the "negotiations" (why an elected government should negotiate with unelected vested interests I don't know) get hard. The big boys' demand that the tax not apply to existing projects is simply impossible to accede to.

Why? Because, leaving aside the weakness of the argument that they should be excluded, it's clear existing projects would account for all the revenue. Indeed, it's a safe bet the reason BHP Billiton, Rio Tinto and Xstrata are carrying on so much is they'll be paying the lion's share of the $9 billion a year in revenue.

That leaves the possibility of cutting the 40 per cent rate of the resource tax. But this would be hugely expensive. Independent modelling I have commissioned (using a pocket calculator and the back of an envelope) suggests cutting the rate just to 35 per cent would cost about $1.1 billion a year.

It's therefore possible no compromise Gillard could come up with would satisfy the big miners now they've had the taste of blood.

But whether they go quietly or keep fighting turns on Gillard's skills as a conciliator and whether she can use a combination of offered concessions and argument to convince most voters that the miners' objection to giving the community a greater share of their windfall gains is unreasonable.

Read more >>

Model way of conning us all

A new prime minister but the same old problem: the mining industry claims the resource super-profits tax would damage it and the economy, whereas the government claims it would be great for the industry and the economy.

And both sides have "independent modelling" to support their claims.

If that doesn't make you sceptical about the use of modelling in the political debate, it should. But if you need more, try this: the two seemingly diametrically opposed modelling exercises were undertaken by the same commercial firm, KPMG.

It's taking people - even those close to the political action - a long time to wake up to the truth that the use of modelling in political arguments is just a way of conning the electorate. The less you know about economic models and how they work, the more impressed you are by their seemingly authoritative results.

The economy is a highly complex mechanism, which economists don't understand all that well. When you construct a mathematical model of the economy, you end up with a hugely oversimplified version of the real thing.

Often you can't test what you'd like to test - and what the punters assume you tested - because the model isn't sophisticated enough or because the data series you'd need don't exist. You end up with a model full of "proxies" (the best substitutes you can find). You can't model shades of grey, so you make do with black and white.

In other words, you have to make lots of assumptions. Economists don't know how the economy works; they just have rival theories about how it works. So their models are based on one theory or another.

The results thrown up by models are based heavily on the assumptions used. Use this set of assumptions, get that result. Use a different set, get a different result. Tell them what results you'd like and competent modellers can find the assumptions that produce what you want.

Economists don't accept the results of someone else's modelling until they know what assumptions were used and decide whether they consider them realistic or consistent with their own prior beliefs. Ideally, they want to determine which particular assumptions are driving the results.

Honest use of modelling results highlights the key assumptions used. But that is never the way modelling results are used in the political debate. Rather, the people who paid for the modelling quote a version of the results as impressive as possible and quite unqualified. The assumptions on which the results are based are never mentioned. They're trying to con the uninitiated.

The government paid KPMG Econtech to model the long-run effects on the economy of the resource super-profits tax and the cut in the rate of company tax. The government says the results were a "reform dividend" of a 0.7 per cent increase in long-run gross domestic product and a long-run increase in real average after-tax wages of 1.1 per cent.

If the long run is 15 or 20 or 30 years (we're not told), that's a pretty modest dividend. And the key assumption? Apparently, that the changes would make the tax system more economically efficient (because economic theory says they would).

Get it? If you thought the modelling was testing whether the changes would be good for the economy, you were conned. All the modelling tells us is by how much the changes would benefit the economy if they're economically efficient as assumed ... given all the other assumptions.

The modelling KPMG prepared for the industry lobby group, the Minerals Council of Australia, was begun in September last year - so much for the claim the industry was "ambushed" by the government.

It found that the impact of a higher effective tax rate and funding costs above the long-term government bond rate would be to reduce the net present value of new mining projects under evaluation. "This is likely to result in mining companies deferring or cancelling Australian mining projects in the short to medium term."

But what were the key assumptions used to achieve this result? I can tell you thanks to an evaluation of the study by Professor Paul Frijters, of the University of Queensland, found on the clubtroppo.com.au blog site.

He says that, rather than looking at what the new tax would do to all possible future projects, the report looks at the "second quartile" of all projects. That is, not the 25 per cent of most profitable projects but the 25 per cent after those.

"This is, of course, because the first quartile will go ahead anyway and the third quartile will probably see increases in net present value due to the cost-sharing in the resource super-profits tax. It loads the dice towards the negative to focus on only 25 per cent of all considered future projects," Frijters says.

Even so, Frijters says the study relies on two tricks to get its low net present values. In four out of six cases it assumes new projects have to obtain their equity capital at a cost of 15 per cent a year. And it assumes all projects last 30 years, even those that soon fail.

The 15 per cent required return is based on actual returns to equity over the past 30 years (including capital gains) which are unlikely to be repeated in the coming 30 years (you can't go on growing by 15 per cent a year forever), rather than the cost of obtaining capital.

Frijters says huge mining companies should be able to use corporate bonds to borrow capital for about 8 per cent. Clearly, inflating the assumed cost of capital makes projects appear less profitable.

Given this inflated cost of capital, the assumption that even failed projects last 30 years hugely reduces the value of the new tax's guarantee of a 40 per cent rebate on all losses, because firms have to wait up to 30 years to receive their rebate, with the value of that rebate indexed by only the long-term government bond rate.

I noted, too, the assumption that the guaranteed 40 per cent rebate on losses doesn't affect the cost of equity capital, the cost of borrowed capital or the proportions of each that are used.

So a key attraction of the proposed tax is effectively ignored as, remarkably, these economists assume businesses don't respond to incentives.

Frijters concludes that, in his mind, the report carries a big sticker saying "some poor competent modeller was told to make up a set of assumptions that would help the cause of a rich client".

Read more >>

Our media roasts old chestnuts

If a genie appeared from a bottle and offered me one wish, I'd choose to be a columnist on a major newspaper. So I guess you could say I love my job. But there are times when I feel compelled to warn people to be careful about what they read, hear and see in the media.

Many people assume the media give them a representative picture of what's going on in the world beyond their own experience. But this is a misunderstanding of the role of the news media and the nature of "news".

The media select from all the things happening in the world only those things they consider "newsworthy" and thus worth drawing to our attention. What is newsworthy? Anything the media believe their audience will find interesting and nothing they fear the audience will find boring.

What's interesting? Anything unusual. But also anything threatening. It's perfectly clear that people find bad news more interesting than good news, which is why the media give prominence to things that are going wrong and say little about things that are going well.

Most of what's happening in the world is highly predictable and terribly ordinary. This means much news is selected because it's unrepresentative. So there's a high risk it will leave people with a mistaken impression of what's happening in the world.

Journalists like to believe everything they report is new. In truth, it's often just a new example of a familiar story, one the journos know the audience loves to hear again. Sometimes a new, offbeat angle is ignored so the story can be forced to fit a tried-and-true formula.

A lot of news is selected because it will appeal to the audience's prejudices or stir people's emotions in the way they like to be stirred. Consider some recent examples from my field of economic news.

There has been much indignation over the Keneally government's decision to change the tax on poker machines in hotels, with suggestions of undue influence by the Australian Hotels Association. About 60 per cent of hotels with pokies - those that don't make much out of them - will now pay less tax or even no tax.

You have to read the reports carefully to discover the changes are actually "revenue neutral", meaning the savings to the 60 per cent of hotels will be exactly offset by the higher tax paid by the remaining 40 per cent, leaving the government's total revenue unaffected.

Rather deflating of the righteous indignation, don't you think?

The media make no pretence of being bound by the scientific method. Economists are always being reminded not to draw general conclusions from anecdotal evidence rather than economy-wide statistics.

But the media are tellers of stories. They're the industrialised equivalent of cavemen sitting around the fire at night swapping yarns. The telling of stories about other people meets one of our most primitive human needs.

What it doesn't do, however, is give us an accurate picture of what's happening in the world. Take all the stories we're hearing about waste in the Rudd government's program to stimulate the economy by constructing a new building at every primary school.

News gathering is selective. People with complaints of waste - justified or otherwise - have had no trouble getting publicity. People without complaints don't bother approaching the media. And where reporters have encountered people saying everything was fine, these facts would have been ignored as "not news".

There have been enough anecdotes to convince me waste has been a significant problem. The real question is: how significant? What proportion of schools has experienced wastefulness? What proportion of the government's spending has been wasted?

No number of examples of alleged waste can answer these questions. What they can do is cause people who don't understand the biases involved in news gathering to gain the impression "the waste has been huge" or even "all that money has been wasted".

The one thorough report we've seen so far came from the federal Auditor-General. It was critical, but far from damning. One of his findings was that 95 per cent of school principals agreed they were confident the funds "will provide an improvement to my school, which will be of ongoing value to my school and school community".

Every year since 1997 the Reserve Bank has published an annual survey of the fees banks charge to their business and household customers. And every year the media turn the survey results into the same much-loved story: huge increase in the fees banks rip from you and me.

This year, however, the story tended to be relegated to the business section, though the same formula was used: huge increase in the fees banks charge businesses.

You had to read the reports carefully to get the real story: last financial year the fees the banks charged households grew by 3 per cent (the lowest increase since the survey began and far less than the 8 per cent increases in the two previous years), whereas fees charged to business leapt by 13 per cent (far more than in the two previous years).

Most of the growth in fees collected from households came from charges paid by the greater number of people choosing to break their fixed-rate mortgage contracts, but this was largely offset by a fall in banks' income from transaction and account-keeping fees. Much of this was explained by the banks' offers to waive fees to people who made regular deposits, part of their greatly increased competition to attract deposits.

By contrast, most of the huge growth in fees collected from business came from higher fees to existing customers now considered to be more risky and higher fees on undrawn overdrafts.

The story no one thinks worth writing is that since the global financial crisis, the banks have gone easier on their household customers but harder on their business customers.

Read more >>

God give us better armed forces, but not yet

Kevin Rudd's chronic tendency to over-promise and under-deliver means the Australian Strategic Policy Institute's annual review of the defence budget is always an object lesson in how his long-suffering purse-string ministers manage to square the budget circle each year.

The fact that the Howard government was prepared to neglect many areas of spending that the Rudd government isn't - education and infrastructure, for openers - doesn't leave it hard to believe Rudd will be economising in areas John Howard favoured, with spending on defence the prime example.

Not, of course, that Rudd hasn't promised to spend a lot more on defence. In his defence white paper delivered a week or two before last year's budget, he matched Howard's commitment to 3 per cent real growth a year in defence spending until 2017-18, and 2.2 per cent thereafter until 2030.

To be fair to him, he also announced a "strategic reform program" in which $20.6 billion worth of the real growth would be covered by savings.

These brave plans took their first blow just two weeks later, when last year's budget cut $8.8 billion in funding from the following six years and deferred it to undisclosed years beyond.

Clearly, the goal of returning the budget to surplus (which includes limiting the real growth in overall budget spending to 2 per cent a year) was given priority over plans to strengthen our defence capability.

The author of the institute's review, Dr Mark Thomson, says that, on the face of it, defence was let off lightly in this year's budget. There were no further spending deferrals (not within the period of the forward estimates, anyway).

And defence was given a $1.6 billion "supplementation" to cover the cost of overseas deployments over the next four years, although it was required to absorb almost all of the $1.1 billion cost of enhanced protection for our forces in Afghanistan.

Defence spending is budgeted to increase by 3.6 per cent in real terms in the coming financial year, reaching almost $27 billion. What's wrong with that?

Just that the job done on defence spending in last year's budget was so thorough it didn't need further adjustment this year. For the following two years, spending is planned to fall in real terms, before recovering in 2013-14 (which just happens to be the year after we're now projected to have the budget back in wafer-thin surplus).

Thomson points out that the now-expected budget surplus of $1 billion in 2012-13 would not have been possible had last year's budget not deferred $3.4 billion of defence funding in that year.

The government now has a lot of credibility riding on the achievement of a surplus that year. If this looked in doubt, how reluctant do you reckon the purse-string ministers would be to push a bit more defence spending off into the future?

But Thomson notes that defence is already holding a lot of IOUs. Real spending is projected to recover the following year, 2013-14. After that, the catch-up needed to deliver the promised average 3 per cent real growth in spending should see defence funding increase by 29 per cent over five years.

Perhaps by then the resuming resources boom will be so well entrenched that Treasury's coffers will again be overflowing, so accommodating such huge real growth in defence spending will be no probs. Failing that, however, I don't find it hard to imagine the government welching on some of those IOUs.

The record spending budgeted for in the coming financial year sounds more comfortable than it is. Thomson says money available to initiate new equipment projects will have fallen by 55 per cent on the forward estimates in last year's budget, with further falls of 42 per cent and 36 per cent in the following two years. Only some of that could be explained by a higher Aussie dollar.

When Lindsay Tanner was shadow finance minister before the 2007 election he invited various worthies (including yours truly) to offer suggestions on ways the budget papers could be made more transparent and generally more informative to people on the outside of government.

These suggestions were developed into the Operation Sunlight policy Labor took to the election and has, we're assured, been implemented now it's in government. But Thomson complains of a lot of newly darkened corners in the defence budget.

He says the government ceased disclosing funding deferrals in its first budget. And this year, "in a marked departure from previous years, the budget papers do not list the projects planned for approval in the coming 12 months. Instead we get an omnibus listing of projects under development which will be approved in the next two to three years."

I have my own beef about lack of sunlight. There are two budget languages, "accrual" and "cash". The budget papers are written in accrual (which I think of as French), but Treasury and the government have encouraged us to continue the macro policy debate in cash (English). Trouble is, the government doesn't provide a full English translation. We get the key totals, but not much else, which means that as soon as you start trying to hold the government to account on some specific issue, you run into the language barrier.

When people tried to use the budget papers to establish how much the government saved by abandoning its emissions trading scheme, they were told their figures were quite wrong because they were in French, not English. Then, when people asked for an English translation of budget figures in another part of the debate, the government refused to supply it.

I guess all governments engage in this sort of budgetary obfuscation, but I confess I had hoped for better from that nice Mr Rudd.

Read more >>

Population fall poses immense new challenges

Peter Costello used to say demography is destiny. Like many of the things he said, that's an exaggeration. But it is going to have a big effect on your future.

Demography is the study of human populations. In principle, it's quite separate from economics. But economists are likely to be saying a lot more about it - and boning up on it - because demographic change will have a big effect on the thing they care about most: the growth of the economy.

Actually, as you realise when you read the article by Jamie Hall and Andrew Stone in this quarter's Reserve Bank Bulletin, demographic change has always had a big effect on the growth in gross domestic product.

It's just that, because so far its effect on growth has been positive, we've been able to take it for granted. From about now, however, its effect is likely to be negative, so we'll be taking a lot more notice.

Leaving aside migration (as we will do in this article), the main factor that drives population growth is the fertility rate - the number of babies per woman. (The death rate also matters, obviously, but we'll also take rising longevity as read.)

The world's population has been growing rapidly for most of the past century, thanks to improvements in public health, medical science and economic development. But the global fertility rate has been falling sharply since the end of the postwar baby boom. From five babies per woman it's now down to about 2, thanks to the spread of effective contraception and rising living standards.

United Nations projections foresee the rate falling to two babies per woman by the middle of this century, which is lower than the replacement rate of 2.1 babies.

So the rate of growth in the world's population has been slowing for decades and, while population is expected to continue growing until the second half of this century, it will then start to decline.

Get that: some of our youngsters will live to see the world's population falling. But population decline will start earlier in some countries than others. Indeed, it's already started in Japan and Germany. And it won't be just the rich countries where population is falling.

The growth in a country's output of goods and services (GDP) can be viewed as coming from two sources: growth in the input of labour and improvement in the productivity of that labour. Three main factors determine the growth in the input of labour: growth in the population, growth in the proportion of the population that is of working age, and changes in the rate at which people of working age choose to participate in the labour force. (Again for simplicity we'll ignore changes in the participation rate.)

Over the 10 years to 2005 the United States' average growth in real GDP was 3.3 per cent a year. Turns out that 1.1 percentage points of that growth came from increased population (meaning it did nothing to raise America's standard of living) and 0.2 percentage points came from the rising proportion of the population that was of working age (here assumed to be those aged between 15 and 64).

But now Hall and Stone estimate that, over the 10 years to 2020, the average annual contribution to economic growth from population increase will be a smaller 0.9 percentage points, and the contribution from change in the working-age share will be minus 0.3 percentage points.

In other words, America's average rate of economic growth is expected to be 0.8 percentage points a year (or about a quarter) less, simply because of direct demographic change. The equivalent expected declines in the demographic contribution are 0.6 percentage points for Japan, 0.3 points for Germany and 0.2 points for Italy.

Why is America's loss likely to be greatest? Because demographic change is only now catching up with it. The others have already taken a fair bit of their medicine. It turns out that most of Japan's "lost decade" of weak economic growth is explained by its ageing and now declining population. Without that, its growth was much the same as Germany's.

So far we've tended to think of slow-growing or falling population as an issue purely for the developed countries. But Hall and Stone demonstrate that the coming decade will see demographic change making a reduced contribution to growth throughout Asia.

What's more, China's population will start to fall slowly in about 20 years' time and South Korea's population will peak in 10 year's time and then fall quite rapidly.

Looking again at the 10 years to 2005, China's economic growth averaged 8.8 per cent a year. Of this, 0.8 percentage points came from population increase and 0.6 percentage points from a higher working-age share.

Over the coming 10 years, however, Hall and Stone estimate that population's contribution to growth will slow to 0.6 points a year and the working-age share's contribution will be minus 0.3 per cent. So demography's contribution to growth will be 1.2 points a year lower than in the previous period.

Now take Korea. Demography contributed 0.7 percentage points to its average economic growth of 4.4 per cent a year in the first period, but will make a zero contribution over the coming decade.

The general story for east Asia (the five main ASEAN countries plus Korea, Taiwan and Hong Kong, but excluding China and Japan) is that demography's contribution of 1.8 percentage points (or almost half) during the 10 years to 2005 will fall to 1 percentage point in the coming decade.

But two Asian countries stand out from this general picture of demographic change making a significantly reduced contribution to economic growth over the next 10 years. Population growth in Indonesia and India will be slowing, but still relatively strong.

So the demographic contribution in Indonesia will slow only from 1.9 percentage points a year to 1.2 points a year. In India it will slow only from 2.2 points a year to 1.6 points.

Much of the demographic difference between China on one hand and India and Indonesia on the other would be explained by differences in population control policies, particularly China's one-child policy, which is about to really make its presence felt. (The main explanation for Korea, I suspect, is simply rising affluence prompting people to have fewer kids.)

But however it's explained, the likelihood is that, in about 2030, India will overtake China as the most populous country. So rest assured, economists will be saying a lot more about demography in coming years.

Read more >>