Economic garden gets back to normal - very slowly

With the year rapidly drawing to a close, the chief manager of the economy has given us a good summary of where it looks like going next year. The word is: we're getting back to normal, but it's taking a lot longer than expected.

The chief manager of the economy is, of course, Reserve Bank governor Dr Philip Lowe, and he gave a speech this week.

For years Lowe and others have been tell us the economy is making a difficult "transition" from the resources boom to growth driven by all the other industries. But now, he says, it's time to move to a new narrative.

"The wind-down of mining investment is now all but complete, with work soon to be finished on some of the large liquefied natural gas projects," he says.

Mining investment spending rose to a peak of about 9 per cent of gross domestic product in 2013, but is now back to a more normal 2 per cent or so.

This precipitous fall has been a big drag on the economy's overall growth, meaning its cessation will leave the economy growing faster than it has been.

As Lowe puts it, "this transition to lower levels of mining investment was masking an underlying improvement in the Australian economy". The decline in mining investment also generated substantial "negative spillovers" to other industries, particularly in Queensland and Western Australia.

This is a good point: weakness in the mining states has made the figures for the national economy look below par, even though NSW and Victoria have been growing quite strongly.

The good news, however, is that these negative spillovers are now fading. In Queensland, the jobs market began to improve in 2015, and in WA conditions in the jobs market have improved noticeably since late last year.

This is one reason Lowe expects the economy's growth to strengthen next year. Another is the higher volume of resource exports as a result of all the mining investment.

"We expect GDP growth to pick up to average a bit above 3 per cent over 2018 and 2019." This may not sound much, but "if these forecasts are realised, it would represent a better outcome than has been achieved for some years now.

"This more positive outlook is being supported by an improving world economy, low interest rates, strong population growth and increased public spending on infrastructure," he says.

And the outlook for business investment spending has brightened. "For a number of years, we were repeatedly disappointed that non-mining business investment was not picking up . . .

"Now, though, a gentle upswing in business investment does seem to be taking place and the forward indicators [indicators of what's to come] suggest that this will continue.

"It's too early to say that animal spirits have returned with gusto. But more firms are reporting that economic conditions have improved and more are now prepared to take a risk and invest in new assets."

The improvement in the business environment is also reflected in strong employment growth. Business is feeling better than it has for some time and is lifting its capital spending as well as creating more jobs.

Over the past year, the number of people with jobs has increased by about 3 per cent, the fastest rate of increase since the global financial crisis.

The pick-up is evident across the country and has been strongest in the household services (which include healthcare, aged care and education and training) and construction industries.

It's also leading to a pick-up in participation in the labour force, especially by women.

So, everything in the economic garden is back to being lovely?

No, not quite. Consumer spending – by far the biggest component of GDP – "remains fairly soft". It's been weaker than its annual forecast since 2011 and hasn't exceeded 3 per cent for quite a few years.

Why? Because of weak growth in real household income and our very high level of household debt. The weak growth in household income is explained mainly by the weak growth in wages for the past four years, which have barely kept pace with (unusually low) inflation.

Lowe says "an important issue shaping the future is how these cross-cutting themes are resolved: businesses feel better than they have for some time but consumers feel weighed down by weak income growth and high debt levels".

Let me be franker than the governor. The economy won't get back to anything like normal until we get back to the modest rate of real (above inflation) growth in wages we've long been used to.

Just what's causing the weakness in prices as well as wages – which is a problem occurring in most other developed economies – and whether the problem is temporary or lasting, is a question that's hotly debated, with Lowe adding a few pointers of his own.

He thinks it's partly temporary, meaning wage growth will soon pick up from its present (nominal) 2 per cent a year, and partly longer-lasting, meaning it may be a long time before it returns to its usual 3½ to 4 per cent.

"We expect inflation to pick up, but to do so only gradually. By the end of our two-year forecast period, inflation is expected to reach about 2 per cent in underlying terms . . . Underpinning this expected lift in inflation is a gradual increase in wage growth in response to the tighter labour market."

Here's his summing up:

"Our central scenario is that the increased willingness of business to invest and employ people will lead to a gradual increase in growth of consumer spending. As employment increases, so too will household income. Some increase in wage growth will also support household income.

"Given these factors, the central forecast is for consumption growth to pick up to around the 3 per cent mark" – which would still be below what was normal before the GFC.

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Tax cuts would have cons and pros

Yippee! It's almost Christmas and Malcolm Turnbull has dropped a big hint that tax cuts are coming. Good old rich Uncle Mal has been to see his bank manager, got the overdraft extended, and is determined we'll all have a great Chrissie, no matter what.

Actually, it's all a bit vague at this stage. We don't yet know whether the cuts will even be announced before Christmas, let alone when they'll be delivered. Nor do we have any idea whether they'll be large, small or indifferent.

Wouldn't surprise me if they were on the small side, nor if we got them only as a reward for voting Turnbull back into office at the next election, to be held late next year or in the middle of 2019.

All we actually know is what Turnbull dropped into a speech to the Business Council after affirming his intention to press on with the hugely expensive company tax cuts for big business.

"In the personal income tax space, I am actively working with the Treasurer and my cabinet colleagues to ease the burden on middle-income Australians, while also meeting our commitment to return the budget to surplus," he said.

It wouldn't surprise me if even Turnbull doesn't yet have a clear idea about the size and timing of the cuts. That will depend partly on Treasury's grudging willingness to make it seem they can be afforded "while also meeting our commitment to return the budget to surplus", but just as much on the calculations of his spin doctors.

Will they decide to announce the cuts soon, using them as an attempt to break the circuit of negative media discussion of some problem the government's having, or keep them under wraps until much closer to the time when voters are asked to show their gratitude at the polls?

That Turnbull has dropped the big hint this early in the piece is a sign they're more likely to be chewed up in a desperate but futile attempt to give the government some "clear air", than carefully preserved as part of a grand re-election strategy.

But though uncertainty abounds, there are three iron laws of tax cuts.

The first is that a government's motive in making them is always mainly political. It either fears that if it doesn't cut it will lose votes – because voters are starting to resent how much tax they're paying on any pay rises or overtime – or it hopes if it does cut this will win votes in thanks for its magnanimity.

The second law is that, despite their political motivation, tax cuts always come colourfully wrapped in wonderful economic justifications. By taking this political gift, we're assured, we'll be creating jobs, reducing unemployment and making the economy grow.

It's almost our economic duty to accept the offer of the bloke selling tax cuts for votes.

The third law, however, is that voters' gratitude for being given a little of their own money back is faint to non-existent. A tax cut announced is soon forgotten; a tax cut delivered before an election has next to no influence on the outcome.

But can the budget afford tax cuts? Not if you accept the government's preferred way of measuring the deficit. It says we're still a long way from returning the budget to balance.

The government's prediction we'll be back to budget surplus by 2021 rests heavily on its forecast that wages will soon start growing strongly, much faster than inflation. Maybe.

If Treasury finds a way to maintain that trajectory while paying for tax cuts, it will be by stepping up its over-optimistic forecasts of wage growth. With circular logic, the "bracket creep" such forecasts imply would then be used to justify the tax cuts themselves.

For years we've been told a government that needs to borrow each month to keep itself afloat can't possibly afford to give aid to poor people overseas. But borrowing to cover tax cuts to big business isn't a problem nor, apparently, is borrowing to give voters a tax cut.

The sad truth is that this Abbott-Turnbull government has got neither the conviction nor the honesty to stick to a consistent line on debt and deficits.

In opposition they told us the debt was a frightening crisis, but easily fixed by them. In government they had one go at fixing it at the expense of everyone but their own supporters, but lost public support from that moment, and since then have abandoned any serious attempt at budget repair, merely waiting like Mr Micawber for something (bracket creep) to turn up.

Now it's decided it can't wait even for that, but must give some of it back on the assumption it will turn up – eventually.

But whatever their political motivation, tax cuts do have effects on the economy, so what would they be?

At a time like this, tax cuts would have a similar effect to a decent pay rise, making it a little easier for households to keep spending, giving consumer spending a modest boost and, indeed, creating a few more jobs.

And if you defy federal Treasury and measure the budget balance more sensibly, stripping out investment in infrastructure, you find the recurrent deficit has already been largely eliminated. A small tax cut wouldn't set it too far off course.

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Labor plans further blow to Treasury power

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Unis should never be allowed to set their own fees

The Productivity Commission has changed its ideological tune, shifting away from the slavish adherence to an idealised version of the "neoclassical" model of the economy for which it and its predecessors became notorious.

It's moved to a more nuanced approach, recognising the many respects in which real-world markets differ from those described in elementary textbooks.

This shift has been underway since the present chairman of the commission, Peter Harris, succeeded Gary Banks in 2012.

You could see it in the commission's 2015 report on the Workplace Relations Framework, which acknowledged, readily and in detail, the factors that made the simple neoclassical, demand-and-supply model unsuitable for analysing the labour market.

But it's even more apparent in the commission's blueprint for a very different approach to economic reform, Shifting the Dial. Consider this.

Remember the plan in the Abbott government's first budget, of 2014, to deregulate the fees universities are allowed to charge students doing undergraduate degrees?

It was a logical next step following the Gillard government's decision some years earlier to deregulate the number of undergraduate places each university was permitted to offer.

The unis had responded by hugely increasing the number of government-funded places, at greatly increased cost to the federal budget, after successive governments had spent decades trying to quietly privatise the unis and get them off the budget.

The economic rationale was that "market forces" – competition between the unis – would prevent them for using their new fee-setting power to overcharge students.

It was a reform that all right-thinking people should support, and those terrible popularity-seekers in the Senate should never have blocked.

Get this: as part of its plan to improve the teaching of uni students, and in the course of explaining how some students are being charged higher fees than they should be, the commission also shows why deregulating fees would have been a crazy idea.

At the same time as it allowed unis to set their own fees, the government's intention had been to cut its funding of places by 20 per cent. It wasn't hard to see that, as unis continued to raise their fees each year, the government would keep cutting its own funding contribution until it was no more.

The commission argues (on page 109) that government "regulation" of the maximum fees unis may charge for particular undergrad courses "is necessary because price competition [between universities] is difficult to establish in the domestic university market.

"This is primarily because the vast majority of domestic students have access to income-contingent HELP loans and consequently have a low price sensitivity, which was a necessary by-product of enabling university access on merit, rather than family income."

Get it? The elementary model's promise that "market forces" – competition between sellers, plus the self-interest of buyers – will stop firms overcharging rests on an assumption that customers have to pay the price upfront.

In the case of uni fees, however, the upfront price is paid by the government, and students incur a debt to the government, which they don't have to start repaying until their income reaches a certain level at some uncertain time in the future.

How long they'll be given to repay the debt is also uncertain, though it's certain their repayments will be geared to their ability to pay, and the only interest they'll pay is the rate of inflation. Cushiest loan you'll ever get.

With the cost of university tuition to a student so far into the future and so uncertain, it's unrealistic to assume students will shop around to find the lowest-charging uni. (Actually, they all charge the maximum allowed.)

Remember, too, that the fee is less than the full cost of the tuition, meaning the unis are "selling" a product whose retail price has been heavily subsidised by the government.

The commission notes that price competition is further limited by the geographic immobility of students. Because more than 80 per cent of commencing students live at home, and moving out would add greatly to their costs, you might get competition between the unis in a particular capital city, but that's all.

But even that's unlikely. The elementary model assumes "perfect knowledge" – both buyers and sellers know all they need to know about the prices and qualities of the products on offer.

In reality, knowledge is far from complete, and is often "asymmetric" – sellers know far more than buyers, usually because the sellers are professionals, whereas the buyers are amateurs.

The commission explains why all unis – big-name or bad-name, city or country – charge the maximum fees allowed.

"In the absence of good information, lower prices may undermine the prestige of a university and its capacity to attract good students," the commission says.

This is an admission of a weakness in the elementary model that affects far more than uni fees. The assumption of perfect knowledge leads to the further assumption that the prices market forces allow a firm to charge fully reflect the quality of its products relative to the quality of rival products.

As behavioural economists have pointed out, however, quality is something that's often very hard for buyers to know in advance. Only after they've bought it and tried it will they know. Think bottles of wine.

So whereas economists assume buyers' foreknowledge of differences in quality is what determines differences in the prices of similar products, buyers who don't know the differences in quality assume they can use prices as a quality indicator. Higher price equals higher quality.

So why don't lesser unis seek to attract more students by charging lower fees than the big boys? Because it would be taken as an admission of their inferior quality, and could lose as many customers as it attracted, maybe more.

The assumption that market forces would prevent unis from abusing their freedom to set fees as they chose was extraordinarily naive, as the commission is now happy to explain.

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What we can do to cure affluenza

If our grandparents could see us now, what would they think? They'd be amazed by our affluence, but shocked by our wastefulness.

You'd never know it to hear us grousing about the cost of living, but most of us are living more prosperous, comfortable, even opulent lives than Australians have ever lived.

We live in a consumer society, surrounded by our possessions. We're always buying more stuff, more gadgets, an extra car, more TVs for other rooms, more laptops, iPads and smartphones.

We update to the latest model, even though the old one's working fine, and make sure our car is never more than a few years old.

We buy new clothes all the time – a lot on impulse – filling our wardrobes with stuff we wear rarely, if ever.

We buy more food than we can eat, chucking it out when it's no longer fresh so we can buy another lot.

Why do we keep buying and buying? Short answer: because we can afford to. Long answer: because, for a host of reasons, we've become addicted to consumption, whether or not it provides lasting satisfaction. We suffer from "affluenza".

Many of us engage in "conspicuous consumption" so as to impress other people with our wealth – with how well we're doing in the materialist race. Can't have the neighbours thinking we can't afford the latest model.

Other people use their hairstyles or the clothes they wear to express their individuality or, paradoxically, to signal their membership of a particular tribe.

I heard about a partner in a law firm remarking with disapproval that whenever any young person was made a partner they immediately went out and bought a black Volvo. But, someone asked, don't you have a black Volvo yourself? Oh, no, he said, mine's blue.

In his new book Curing Affluenza, Richard Denniss, chief economist of The Australia Institute, observes that, these days, much consumption is done for symbolic, signalling reasons, not because we actually need the stuff.

And then there's retail therapy – stuff we buy purely for the fleeting thrill we get from buying some new thing.

If something's telling you all this needless consumption can't be a good thing, you're not wrong. What's less obvious is why: because of the damage it does to the natural environment.

Not only the extra emissions of greenhouse gasses, but also excessive use of natural resources – both non-renewable and renewable, when usage exceeds the rate at which they can be renewed (think fish in the sea).

The richest 15 per cent of the globe's 7.6 billion population can continue living the high life only for as long as we have the wealth to commandeer more and more of the other 85 per cent's share of the world's natural resources.

But as the world's poor, led by India and China, succeed in raising their material living standards towards ours, this will get ever harder. It is not physically possible for all the world's population to live the wasteful lives we do. Nothing like all the world's population.

How can we stop using more than our fair share of the globe's natural resources? Denniss says we can start by distinguishing between consumerism, which is bad, and materialism, which isn't. Huh?

He defines consumerism as the love of buying things, whereas materialism is just the love of things. Meaning the latter is a cure for the former. The more we love and care for the stuff we've already got, repairing it when it breaks, the less we're tempted to buy things we don't need.

It's true the capitalist system invests heavily in marketing and advertising to con us into believing we need to buy more and more stuff.

But we're free to resist the system's blandishments. Indeed, I often think the people most successful in the system are those who most resist.

Unusually for an economist, Denniss argues that much of what we do – and buy – we do for cultural reasons. Because it's the normal, accepted thing to do.

But, just as our grandparents weren't as spendthrift as we are, culture can change. And you need less than a majority of people changing their behaviour to reach the critical mass that prompts most other people to join them and, by doing so, cause an improvement in the culture.

If we all stopped buying stuff we don't need, however, wouldn't that cause economic growth to falter and unemployment to shoot up?

Yes it would – if that's all we did. The trick is that every dollar we spend helps to create jobs. So we need to keep spending, but we don't need to keep spending wastefully.

There are a host of things we could spend on – better health, better education, better public infrastructure, better lives for the disabled and the elderly, less congestion, less pollution – that would yield us more satisfaction while doing less damage to the environment.

I have a feeling, however, that the cure to affluenza will require more than just changed behaviour by enough individuals. We replace rather than repair many things because the cost of repairers' labour greatly exceeds the cost of the material parts we throw away.

We need to rejig the tax system so we reduce the tax on "goods" – labour income – and increase the tax on "bads" – use of natural resources.

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Econocrats are giving up on smaller government

You may not have noticed, but the Productivity Commission's search for "a new policy model" for reform, in reaction to the breakdown of the politicians' "neoliberal consensus", offers better prospects for finally getting the budget under control.

That's because, although the commission doesn't say so, its reformed approach to reform represents a retreat from a central tenet of neoliberal doctrine for the past 30 years: the goal of Smaller Government.

The retreat makes sense for three reasons. First, because attempts to reduce government's role in the economy – think privatisation, deregulation and cuts in government spending – are central to the populist revolt against neoliberalism.

Second, because the smaller-government push has had little success and, particularly in recent times, some spectacular failures – think the attempt to reform TAFE by making vocational education and training "contestable" by for-profit providers, which the commission now admits was a "disastrous intervention".

Third, because, paradoxically, abandoning the goal of smaller government offers a better prospect of budget repair and a return to "fiscal sustainability" (low public debt) via greater control of government spending over the medium term and a lifting of the fatwa against explicit tax increases.

That's partly because, as we've learnt since the ill-fated 2014 budget, the electoral opposition to significant cuts in spending on social security (read the age pension), healthcare and education actually exceeds the resistance to hypothecated tax increases (those linked to worthy spending programs).

But it's also because, as we've known for decades, but chosen to ignore, there's little empirical evidence of a correlation between the size of a country's public sector and its rate of economic growth or macro-economic stability.

Nor has there ever been much empirical evidence that the willingness of high income-earners to work hard - as opposed to "secondary earners" (mainly married women choosing between part-time and full-time work) – is greatly diminished by high rates of income tax.

If there's little evidence favouring smaller government, why's it been central to the neoliberal project? Because a presumption against government intervention is built into the assumptions of the economists' neoclassical model, and because limiting the size of government minimises the taxes and maximises the freedom of the rich and powerful.

The Productivity Commission's new reform agenda unconsciously reveals how much the old agenda of the past 30 years was influenced – and constrained – by the goal of smaller government.

If you're trying to improve productivity, there are two broad approaches. One is to reduce the role of government by privatising government-owned businesses (including natural monopolies), outsourcing the provision of government services, reducing government regulation and reforming taxation in ways believed to improve incentives to work, save and invest.

The alternative approach is to focus on ensuring the nation's education and training system delivers the best skill formation possible – including those skills most useful in the digital economy – and on ensuring spending on public infrastructure is both sufficient and sufficiently well directed to maximise the private sector's productivity, particularly in the big cities.

Get it? The commission's new reform agenda approaches productivity improvement more directly, accepting that the old agenda is well into diminishing returns. In the process it's shifted the goal from smaller government to better government.

The great side benefit of the commission's new policy model is that, as well as seeking to give micro-economic reform a new direction, it improves governments' chances of regaining control over their spending.

As successive federal and state intergenerational reports have shown, by far the greatest source of future growth in combined federal and state spending will be healthcare. The second biggest area of combined spending is on education and training.

The standard, Treasury and Finance-promoted approach to restraining these two spending areas adopted in the Abbott government's first budget was simply to shift a big chunk of spending off the federal budget and on to the budgets of households (the co-payment for GP visits) and the states (slashed federal grants for public hospitals and schools).

The vehemence of the public's opposition to these cuts not only rendered them impossible, it warned off governments of either stripe from trying such an approach again. Malcolm Turnbull's surprise embrace of needs-based school funding covered his retreat from cuts in grants for schools.

The alternative approach to controlling the rate of growth in spending on health and education over the medium term is to get deep into the nitty-gritty of what the respective systems do and how well they're doing it.

It's not hard to believe that improving the quality of service they deliver to patients and students could also reduce waste and inefficiency, thus slowing the rate at which their costs are growing.

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