How our economic prospects turn on wage growth

You know the world's behaving strangely when you hear a heavy from the central bank saying it's expecting more "progress" on the "turnaround in inflation", then realise they're hoping inflation will go higher.

That's just what Dr Luci Ellis, the Reserve Bank's third heaviest heavy, told a bunch of economists at a conference this week.

Why would anyone hope for prices to be rising faster than they are? Not so much because higher prices are a good thing in themselves, as because rising inflation is usually a sign of an economy that's growing strongly and keeping unemployment low.

By contrast, very low inflation – say, below 2 per cent – is usually a sign of an economy that's not growing strongly, with unemployment either rising or higher than it should be.

Ellis' remarks are a reminder that the economy's biggest problem at present is weak growth in wages. She knows that if prices started rising faster, the most likely explanation would be higher growth in wages, which employers were passing on to their customers by raising their prices.

What could oblige employers to increase the wages they pay? Their need to retain or attract more workers – particularly skilled workers – at a time when the demand for labour was rising, caused typically by increased demand for the goods and services businesses were employing people to produce.

The point to note here is that the Reserve's mental model of inflation is of what economists used to call "demand-pull" inflation. It's simple: the prices of goods and services rise when the demand for them is outpacing their supply.

Note, too, that this involves an inverse relationship between inflation and unemployment: when one goes up, the other goes down, and vice versa. Economists call this the "Phillips curve", named after its discoverer, Bill Phillips, a Kiwi economist.

Ellis confirmed that, although the economy (real gross domestic product) grew at a trend rate of just 2.4 per cent over the year to September, the Reserve's forecast that growth will pick up to about 3¼ per cent over this year and next remains unchanged.

This will involve a pick-up in wage growth and inflation, she said.

The Reserve is more confident of these forecasts than it was when it first made them in early November. Even so, Ellis admitted to some particular "uncertainties": how much production capacity in the economy is going spare at present, and how much, and how quickly, wage growth and inflation will pick up as spare capacity declines.

How much unused production capacity remains in the economy matters because, until it's used up, the economy can grow much faster than it can once the economy's at full capacity – full employment of labour and capital – without this causing inflation pressure to build.

Once the economy is at full employment, how fast rising demand can cause the economy to grow without also causing higher inflation is determined by the economy's "potential" growth rate – that is, by the rate at which rising participation in the labour force, increasing investment in capital equipment and improving productivity are adding to the economy's ability to produce more goods and services.

That is, how fast potential supply is growing. So the economy's potential growth rate sets the medium-term speed limit on how fast demand can grow before causing a build-up in inflation.

The Reserve's most recent estimate is that our potential growth rate has slowed to 2.75 per cent a year (mainly because of the retirement of the bulge of baby boomers).

But how do we measure how much spare production capacity we have at any time? We measure the spare capacity of our mines, factories and offices mainly by looking at answers to questions in the regular surveys of business confidence.

That's physical capital. In the labour market, idle production capacity is measured by the rate of unemployment.

But it's wrong to think full employment is reached when the unemployment rate falls to zero. That's partly because, at any point in time, there will always be some workers moving between jobs (called "frictional" unemployment).

Also because of a much higher rate of "structural" unemployment. The structure of the economy is always changing, with some industries expanding and some contracting. This increases the number of workers who don't have the particular skills employers are seeking, or who do have them but live far away from where the job vacancies are.

In the old days, there were a lot of low-skilled jobs that could be filled by people who had left school early and hadn't learnt much. These days, there a far fewer of those jobs, so people with inadequate skills are often out of a job.

Economists measure full employment by estimating the rate to which unemployment can fall before shortages of skilled labour cause employers to bid up wages and thus cause price inflation to accelerate.

They call this the NAIRU – the non-accelerating-inflation rate of unemployment – and the Reserve's latest estimate is that it's "around 5 per cent". It says "around" because every economist's estimate is different, so it's wrong to be too dogmatic.

This week's trend figures from the Australian Bureau of Statistics for the labour force in January show the unemployment rate has been steady at 5.5 per cent since July. That's well above the NAIRU.

Over the same six months, however, employment has grown by almost 180,000, or 1.5 per cent, causing the rate at which people are participating in the labour force to rise by 0.4 points to 65.6 per cent – its highest for seven years and a record high for participation by women.

If the laws of supply and demand still hold – a safe bet – this unusually strong growth in the demand for labour should lead to higher wages and then higher prices sooner or later. But Ellis warns it's likely to be "quite gradual".

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Private health insurance is a con job

You won't believe it, but my birthday was on Tuesday and I got a present from the federal government. I also got a card from my state member, sending his "very best wishes" for reaching such an "important milestone" in my life.

I almost wrote back asking him to alert the Queen to be standing by in 30 years' time. Instead, my ever-sceptical mind told me the pollies have awarded themselves privileged access to the private information we're obliged to give the electoral commission.

So, what was my fabulous federal birthday present? Apparently, I'm now so ancient and infirm I get a bigger private health insurance tax rebate.

I never tire of pointing out that, contrary to what people say, our cost of living, overall, has not been rising strongly, unless you regard 2 per cent a year as "soaring".

It is true, however, that a few, easily noticed prices have risen a lot – including the government-regulated price of private health insurance.

My "important milestone" reminds me that people have been complaining about – and I've been writing about – the high cost of private health insurance for as long as I've been an economic journalist.

And the opposition leader of the day – Bill Shorten, as it happens – hasn't resisted the temptation to exploit people's disaffection by putting it firmly on the agenda for this maybe-there'll-be-an-election year.

The popular view is that everyone needs private insurance – if only they could afford it. Which about half of us can't.

Opinion polling by Essential has found that, although a clear majority of people believe "health insurance isn't worth the money you pay for it", 83 per cent of people believe that "the government should do more to keep private health insurance affordable".

The former opinion is right; the latter is delusional. Governments have been trying to keep health insurance affordable on and off for decades, while its cost just keeps climbing.

Why? Because it's a self-defeating process. The more you do to make insurance affordable, the easier you make it for the people running the health funds, the owners of private hospitals and the surgeons and other procedural specialists who work in hospitals, to raise their prices and fatten their profits.

Which the pollies fully understand.

In the old days, health funds were owned by their members, except for the government-owned Medibank Private. These days, three of the biggest funds – Medibank Private, Bupa and NIB – are for-profit providers, thus increasing the pressure on the government to allow big price rises and reducing the chance of getting value for money.

As Ian McAuley, of Canberra University, has written, from a policy perspective health insurance is a high-cost and inequitable way to fund healthcare.

Only 85 cents of every dollar passing through private insurance makes its way to paying for healthcare. And only if you can afford it do you share in the government subsidies taxpayers provide.

From the customers' perspective, it's a con job. Most people under 60 get back only a fraction of what they pay. Often when you do claim you don't get what you expected, because you don't get choice of doctor or a private room, you're caught by ever-changing exclusions from your policy, or because no one warned you about a huge gap payment.

Many buy insurance to avoid waiting times for elective surgery. But if private insurance didn't exist, surgeons would have to earn more of their income from public hospitals and waiting times would be shorter. It creates the problem it purports to solve.

Health insurance is such bad value that, when John Howard sought to prop up the private system, he had to make it subject to a tax rebate. When that didn't work he imposed a Medicare levy surcharge on better-off people who don't have insurance, and imposed escalating prices for people who aren't in a fund by the time they're 31 (which is a con trick on the innumerate).

When the Hawke government reintroduced Medicare, it intended that the universal, taxpayer-funded provision of high quality hospital and medical care would make private insurance unnecessary. Those who preferred the snob status of private care could pay for it from their own pocket.

This is why Labor long opposed public support for private insurance. Shorten, however, has taken a populist line, carrying on about the big increases in premiums and promising to cap them at 2 per cent a year for two years.

Another con. The profit-driven funds would respond either by excluding more procedures from coverage, or by demanding catch-up increases once the cap was lifted (as happened last time).

Private insurance is so counter-productive and so unfair that the best thing would be to end the subsidies and use the saving to improve the performance of the public system. (Howard's claim that his tax rebate would reduce the pressure on public hospitals was always just a fig-leaf to hide his attempt to prop up the two-class system.)

A less politically controversial alternative was first proposed in an Abbott government federalism discussion paper: use the saving to introduce a commonwealth hospital benefit, where the same amount would be paid to the hospital someone chose to go to, whether public or private.

Private hospital beds would stay in the system – at a price fixed by the government – but the parasitic private funds would be out on their own.

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Economists do little to promote bank competition

The royal commission into banking, whose public hearings start on Monday, won't get a lot of help from the Productivity Commission's report on competition within the sector. It's very limp-wristed.

The report's inability to deny the obvious - that competition in banking is weak, that the big four banks have considerable pricing power, abuse the trust of their customers and are excessively profitable – won it an enthusiastic reception from the media.

Trouble is, its distorted explanation of why competitive pressure is so weak and its unconvincing suggestions for fixing the problem. It offered one good (but oversold) proposal, one fatuous proposal (to abolish the four pillars policy because other laws make it "redundant") and a lot of fiddling round the edges.

It placed most of the blame for weak competition on the Australian Prudential Regulation Authority, egged on by the Reserve Bank, for its ham-fisted implementation of international rules requiring banks to hold more capital, and for its use of "macro-prudential" measures to slow the housing boom by capping the banks' ability to issue interest-only loans on investment properties.

The banks had passed the costs of both measures straight on to their customers. It amounted to an overemphasis on financial stability (ensuring we avoid a financial crisis like the Americans and Europeans suffered) at the expense of reduced competitive pressure on the banks.

This argument is exaggerated. Even so, it's quite likely that, in their zeal to minimise the risk of a crisis, APRA and the Reserve don't worry as much as they should about keeping banking as competitive as possible.

The report's proposal that an outfit such as the Australian Competition and Consumer Commission be made the bureaucratic champion of banking competition, to act as a countervailing force on the committee that makes decisions about prudential supervision, is a good one.

The report's second most important explanation for weak competition is inadequacies in the information banks are required to provide to their customers. Really? That simple, eh?

See what's weird about this? It's blaming the banks' bad behaviour on the regulators, not the banks. If only the bureaucrats hadn't overregulated the banks, competition would be much stronger.

Why would the bureaucrats in the Productivity Commission be blaming other bureaucrats for the banks' misdeeds? Because this is the prejudiced, pseudo-economic ideology that has blighted the thinking of Canberra's "economic rationalist" econocrats for decades.

Whatever the problem in whatever market, it can never be blamed on business, because businesses merely respond rationally (that is, greedily) to whatever incentives they face. If those incentives produce bad outcomes, this can only be because market incentives have been distorted by faulty government intervention.

Market behaviour is always above criticism; government intervention in markets is always sus.

When the report asserted that the big banks had used the cap on interest-only loans as an excuse for raising interest rates, and would pass the new bank tax straight on to customers, there was no hint of criticism of them for doing so. They were merely doing what you'd expect.

In shifting the blame for these failures onto politicians and bureaucrats, the report fails to admit that the distortion that makes interest-only loans a worry in the first place is Australia's unusual tolerance of negative gearing and our excessive capital gains tax discount.

In criticising the bank tax, the report brushes aside the case for taxpayers' recouping from the banks the benefit the banks gain from their implicit government guarantee, and the case for taxing the big banks' super-normal profits (economic rent), doing so in a way that stops the impost being shunted from shareholders to customers.

Here we see a hint that the rationalists' private-good/public-bad prejudgement​ is only a step away from Treasury being "captured" by the bankers it's supposed to be regulating in the public's interest, in just the way it (rightly) accuses other departments of being captured.

The report's criticism of existing interventions would be music to the bankers' ears. Its fiddling-round-the-edges proposals for increasing competitive pressure have one thing in common: minimum annoyance to the bankers.

The Productivity Commission's rationalists can't admit that the fundamental reason for weak competition in banking comes from the market itself: as with many industries, the presence of huge economies of scale naturally (and sensibly) leads to markets dominated by a few big firms.

Market power and a studied ability to avoid price competition come with the territory of oligopoly. Have the rationalists spent much time thinking about sophisticated interventions to encourage price competition in oligopolies? Nope.

Have they learnt anything from 30 years of behavioural economics? Nope. When you've learnt the 101 textbook off by heart, what more do you need?

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Indigenous middle class arises despite slow closing of the gap

It's easy for prime ministers to make big promises at some emotion-charge moment of national attention, but a lot harder to keep those promises when the media spotlight (and that prime minister) are long gone.

I could be alluding to the promise Kevin Rudd made that the federal government would never forget the needs of the victims of Victoria's Black Saturday bushfires in 2009, but I'm referring to the promise he made a year earlier, at the time of his apology to the stolen generations, to Close the Gap between Indigenous and non-Indigenous Australians.

The gap needing to be closed – and the commitments Rudd made – referred particularly to health, education and employment.

But all of those gaps contribute to another one: the gap between Indigenous and non-Indigenous incomes. What's been happening there?

I'm glad you asked because Dr Nicholas Biddle and Francis Markham, of the Centre for Aboriginal Economic Policy Research at the Australian National University, have just written a paper on the subject.

And, on the face of it anyway, the news is reasonably good.

First, however, some background. You won't be surprised that there is a gap between the two group's incomes. But it's worth remembering that gap has existed since the early days of European settlement of the Wide Brown Land.

To be euphemistic, it's a product of our colonial history. To be franker, Indigenous people were systematically and violently deprived of access to economic resources, especially land, a process that continued until well into the second half of the 20th century.

And though Aboriginal and Torres Strait Islander people engaged with the settler-colonial economy in many ways, underpayment or theft of wages was systematic in many parts of the country until the 1950s and '60s.

This colonial legacy endures into the present, Markham and Biddle say.

They quote another academic saying that "Aboriginal people, families, households and communities do not just happen to be poor. Just like socioeconomic advantage, socioeconomic deprivation accrues and accumulates across and into the life and related health chances of individuals, families and communities" (my emphasis).

The authors use the censuses of 2006, 2011 and 2016 to study what's been happening to the level and distribution of incomes within the Indigenous population, and between it and the non-Indigenous population.

The good news is that the median (the one dead in the middle) disposable equivalised​ household income for the Indigenous population rose from 62 per cent of non-Indigenous income in 2011 to 66 per cent in 2016. ("Equivalised" just means adjusted to take account of differences in the size and composition of households.)

That's the highest the percentage has been since reliable data started in 1981. And, in fact, it's been trending up since then.

There's progress, too, on the Indigenous "cash poverty rate", which measures the proportion of Indigenous incomes falling below 50 per cent of the median disposable equivalised household income of the nation's entire population.

So, as is usual in rich countries, it's a measure of relative poverty (how some incomes compare with others) rather than absolute poverty (whether people's incomes are high enough to stop them being destitute).

It's called "cash poverty" in recognition of the truth that there's more to poverty than how much money you have. As well, it acknowledges that no account is taken of "non-cash income", such as the value of food gained by hunting and gathering in remote areas.

Remember, however, that there are also costs involved in hunting. And the prices of basic necessities are much higher in remote areas.

Measured this way, the Indigenous poverty rate has declined slowly over past decades. More recently, it's gone from 33.9 per cent in 2006 to 32.7 per cent in 2011 and 31.4 per cent in 2016.

Sorry, that's where the good news runs out.

For a start, the rate of improvement is far too slow. Markham and Biddle calculate that if the gap kept narrowing at the rate it did over the five years to 2016, the medians for Indigenous and non-Indigenous incomes would be equal by 2060. That fast, eh?

Now get this: while the gap between the two groups has been narrowing, the gap within the Indigenous group has been widening.

If you take the weekly disposable personal incomes of all Indigenous people aged 15 or older, adjust them for inflation, rank them from lowest to highest, then divide them all into 10 groups of 10 per cent each, you discover some disturbing things.

Between 2011 and 2016, the average income of those in the top decile rose by $75 a week, compared with $32 a week for those in the middle decile. Individuals in the bottom decile had no income (possibly because they were students or home minding kids), while those in the second and third lowest deciles saw their incomes fall.

But what explains this growing gap between the top and the bottom within the Indigenous population?

Turns out it's explained by where an Indigenous person lives. Household disposable incomes are highest – and have grown fastest - in the major cities, with a median of $647 a week, but then it's downhill all the way through inner regional areas, outer regional, and remote, until you get to "very remote", where the median income is $389 a week.

Over the five years to 2016, the real median income in remote areas hardly changed, and in very remote areas it actually fell by $12 a week.

Got your head around all that? Now try this: despite the weakness in median incomes in remote (but not very remote) areas, the incomes of the top 20 per cent are higher and have been growing relatively strongly.

Get it? However poorly we're doing on Closing the Gap, we are getting an Indigenous middle class.

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If we had more sense, we'd push early childhood education

Did I tell you that my grandson, fast approaching his second birthday and not many months away from losing his status as our one and only grandchild, is a budding genius?

His educational development is supervised by his father, who, being a doctor, started with identifying parts of the body. My grandson's always being quizzed, and loves showing off how much he knows.

Already he can count – provided you don't test him too closely above two or three – and, courtesy of Play School, can sing the alphabet song, whether or not he's invited to. He misses no more than a few of the letters, and is always careful to sing zed rather than zee.

Do I worry about how he'll manage to scratch out a living in the looming, frightening world of robots and artificial intelligence? No I don't. Not with the parents he's got.

For centuries the great advantage has been seen as inherited wealth. But, as The Economist magazine pointed out a few years ago, in the knowledge economy it's probably just as advantageous, maybe more, to inherit your intelligence from two highly educated, well-paid, education-conscious and bookish parents.

Of course, not every Aussie kid is as fortunate as any grandchild of mine. Which is why I worry a lot about the continuing high high-school dropout rate. Join the workforce without even a good grasp of the basics and the rest of your working life is likely to be "problematic", as mealy mouthed academics say.

It's also why I get so annoyed with politicians – and Treasury and Finance econocrats – who regard early education as just another of the outstretched hands that must be given something, but never enough to fully exploit its potential to improve our wellbeing, social as well as economic.

The good news is that Simon Birmingham, federal Minister for Education and Training, announced over the weekend the government's decision to spend $440 million extending for a year the "national partnership agreement" on universal access by four-year-olds to early childhood education, while federal and state ministers continue "negotiating" (haggling over) a new long-term agreement.

The bad news is that, when it comes to making sure all children attend preschool, we started much later than most of the other rich countries, and aren't catching up nearly as fast as we would be if we had more sense.

Our politicians on both sides think their interests are best served by using the limited funds available to placate as many interest groups as possible, rather than spending money where it's likely to yield the most lasting benefit.

Our econocrats ought to be encouraging their masters to spend more wisely, but if they are it's news to me. They seem to think it their job to disapprove of all extra spending equally. Not working well so far, guys.

There are no magic bullets in government spending, but putting money into early education – whether by lifting the quality of childcare, or beefing up preschool – comes a lot closer than most of the other things governments spend on.

We've known it for decades, but the evidence keeps growing. According to the Ontario early learning study, "the early years from conception to age six have the most important influence of any time in the life cycle on brain development and subsequent learning, behaviour and health".

Early experiences and stimulating, positive interactions with adults and other children are far more important for brain development than previously realised, it says.

According to a paper on early childhood education, issued last year by Dr Stacey Fox and others, of the Mitchell Institute at Victoria University, "investing in early learning is a widely accepted approach, backed by extensive evidence, for governments and families to foster children's development, lay the foundations for future learning and wellbeing, and reduce downstream expenditure on health, welfare and justice".

While all children benefit from high-quality early learning, research also shows that children experiencing higher levels of disadvantage benefit the most, and can even catch up to their more advantaged peers, the paper says.

In an earlier Mitchell report, Fox says that nearly a quarter of Australian children arrive at school with significant vulnerabilities – in their knowledge and communication, their social skills and emotional wellbeing, or in their physical health.

Here's a surprise: a child's risk of being developmentally vulnerable is closely, but inversely, correlated with their socio-economic status.

After five or six years, we've got close to achieving universal access by four-year-olds to a potential 15 hours a week of preschool. The only state dragging the chain is NSW (yeah, but look how much bigger its budget surplus is).

But kids from disadvantaged homes are less likely to be getting the full 15 hours. And there's strong evidence that two years of preschool – that is, starting at three – yields more than twice the benefit.

British research shows 16 year olds who attended at least two years of preschool were three times more likely to take a higher academic pathway after leaving school.

It's easier to get kids up to speed in preschool than at any later level of education. Clearly, the smart way to improve the performance of the whole system is to start at the bottom. Make sure we get preschool right, and the benefits will flow on to schools, TAFE and uni.

Nah, too much trouble. Let's just give ourselves a tax cut. My grandkids will do fine.

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