Monday, January 31, 2011

Floods' economic pain greatly exaggerated

Most of us are back at work, but the silly season won't be over until we get the Queensland floods into perspective. They are a great human tragedy, but they're not such a big deal for the economy.

It's not surprising the public has been so excited about such amazing scenes and so much loss of life and property. Nor is it surprising the media devoted so much coverage to the floods when, with most of us at the beach, there's been so little other news.

It's not even surprising the Gillard government has been beating up the story, making it out to be the biggest thing since the global financial crisis. At one level this is just the pollies doing their instinctive I-feel-your-pain routine. They could seem heartless if they tried telling people things weren't as bad as they seemed.

At another level it's easy to see Julia Gillard trying to gain the same boost to her popularity as Anna Bligh. She'd be well aware of all the seats Labor lost in Queensland at the election in August. It's an almost inevitable assumption by the punters and the media that if an event is huge in human and media terms it must be just as big in its effect on the economy. When the punters tire of seeing footage of people on roofs, you "take the story forward" by finding some expert who'll agree it also spells disaster for the economy.

The wise and much-loved econocrat Austin Holmes used to say that one of the most important skills an economist needed was "a sense of the relative magnitudes" - the ability to see whether something was big enough to be worth worrying about.

That sense has been absent from the comments of those business and academic economists on duty over the silly season, happily supplying the media's demand for comments confirming the immensity of the floods' economic and budgetary implications.

With the revelation last week of the econocrats' estimates of the likely magnitudes, it's clear the figures supplied by business economists were way too high. And the economists' furious debate over how the budgetary cost of the rebuilding effort should be financed is now revealed as utterly out of proportion to the modest sums involved.

Of course, you still wouldn't have twigged to this had you focused on the government's rhetoric rather than its figures. In Gillard's speech on the budgetary costs and Wayne Swan's speech on the economic impact both were busily exaggerating the size of the crisis, even while revealing how small it really was.

Gillard said it was "the most expensive disaster in Australia's history" and that the "cost to the economy is enormous". The government's task, she kept repeating, was to "rebuild Queensland".

Swan repeated that "this is likely to end up being the most costly disaster in Australian history", which was "going to cost Australia dearly" and involves a "massive reconstruction effort". The closest he got to the truth was his observation that "the economic questions pale into insignificance next to the human cost of what we've seen".

If this is the most expensive natural disaster in Australian history, all it proves is the cost of earlier disasters was negligible. If you can "rebuild Queensland" for just $5.6 billion, it must be a pretty tin-pot place.

If $5.6 billion seems a lot, consider some "relative magnitudes": the economy's annual production of goods and services (gross domestic product) totals $1400 billion, and the budget's annual revenue collections total $314 billion.

Note that, though no one's thought it worthy of mention, the $5.6 billion in spending will be spread over at least three financial years, making it that much easier to fund.

We know that more than a third of the $5.6 billion will be paid out in the present financial year with, presumably, most of the rest paid in 2011-12. So just how the flood reconstruction spending could threaten the budget's promised return to surplus in 2012-13 is something no one has explained.

And if $5.6 billion isn't all that significant in the scheme of things, how much less significant is the $1.8 billion to be raised from the tax levy? The fuss economists have been making about it tells us more about their hang-ups over taxation than their powers of economic analysis.

And how they can keep a straight face while claiming it could have a significant effect on consumer spending (well over $700 billion a year) is beyond me.

Turning from the budget to the economy, Treasury's estimate is that the floods will reduce gross domestic product by about 0.5 percentage points, with the effect concentrated in the March quarter.

Thereafter, however, the rebuilding effort - private as well as public - will add to GDP and probably largely offset the initial dip. So the floods will do more to change the profile of growth over the next year or two than to reduce the level it reaches.

Most of the temporary loss of production will be incurred by the Bowen Basin coal miners. But, though it won't show up directly in GDP, their revenue losses will be offset to some extent by the higher prices they'll be getting as a consequence of the global market's reaction to the disruption to supply.

And despite all the fuss the media have been making over higher fruit and vegetable prices, Treasury's best guess is that this will cause a spike of just 0.25 percentage points in the consumer price index for the March quarter, with prices falling back in subsequent quarters.

So the floods do precious little to change the previous reality that, with unemployment down to 5 per cent and a mining investment boom on the way, the economy is close to its capacity constraint and will soon need to be restrained by higher interest rates.


Saturday, January 29, 2011

It's about China, and steel

You wanna make guesses about what will happen to the economy this year? Here's a tip: forget the floods and take more notice of China.

Australia's business economists have already got the message that China dominates the rest of the world's effects on us, whereas their mates in the money markets are slower on the uptake, retaining their obsession with all things American.

China matters, first, because, with a population of 1.35 billion, it's the most populous country in the world. That gives it 20 per cent of the world's population, making it 11 times larger than Japan.

The second reason China matters is because its economy has been growing so rapidly for so long: an average rate of 10 per cent a year for three decades, meaning it's been doubling every eight years.

This means that, since 1980, it's gone from being the 12th-largest economy in the world to the second-largest. This is measured using "purchasing power parity" - that is, taking account of the fact that one US dollar buys far more in China than it does in the US.

So China's economy has moved from being 9 per cent of the size of America's to about 60 per cent in 2009. The International Monetary Fund is expecting it to reach 90 per cent in 2015. If so, it won't be long before China's the biggest economy.

Of course, this still leaves the average Chinese a lot poorer than the average American. Income per person in China has reached only 18 per cent of American incomes - suggesting the Chinese have scope for a lot more growth yet (provided the world has enough idle resources to make it possible).

When you combine China's huge population with its rapid economic growth you find this growth accounted for a quarter of all the growth in the world economy during the noughties. Get that. America's share of world growth would have been very much smaller.

The third reason China matters so much to us: its economy is in our part of the world and is such a good fit with ours. China needs to buy what we've got to sell, and vice versa.

According to figures from the Department of Foreign Affairs and Trade, last financial year China became both our largest export market and our largest trading partner. Our two-way trade in goods and services grew by more than 18 per cent to $90 billion.

China has been our biggest market for exports of goods for some time but last year it overtook the United States to become our largest market for services as well.

Over the course of the noughties China's share of our two-way trade increased from 5 per cent to almost 18 per cent. Its ascension means Japan is now our second-largest export market. And get this: our third-largest is India.

Our top three imports in 2009-10 were travel ($19 billion), passenger vehicles ($15 billion) and petroleum ($15 billion). But to get back to the point, our top three exports were coal ($36 billion), iron ore ($35 billion) and education ($19 billion).

Why's that the point? Because coal and iron ore are the main things we sell China. Iron ore and coking coal are the main components of steel - and, as part of their economic development, the Chinese are producing huge quantities of steel.

So the well-versed economy watcher needs to know more than a bit about China's steel industry. Its story was summarised by James Holloway, Ivan Roberts and Anthony Rush in an article in the latest Reserve Bank Bulletin.

China is now the world's largest producer and consumer of steel. Ten years ago it accounted for 15 per cent of global steel production; today its share is 45 per cent.

Just how much of a country's gross domestic product is devoted to steel is determined by its stage of economic development. Undeveloped countries don't use much steel and advanced countries aren't very "steel-intensive" because much of their economic infrastructure has been built and most of their growth is coming from expanding services.

In between, however, countries are rapidly industrialising and urbanising. And that's where China is. Remembering its average rate of growth in GDP of 10 per cent a year for the past three decades, its steel production grew at average annual rates of 7 per cent in the 1980s, 10 per cent in the '90s and almost 20 per cent in the noughties.

The Chinese steel industry is highly decentralised, with plants scattered throughout the country and with a small number of large, advanced, state-owned steel makers and a large number of small and medium-sized private firms. The Chinese government's policy is to consolidate the industry, to improve economies of scale and reduce the use of high-polluting facilities.

The industry mainly produces steel directly from iron ore and coking coal using the blast furnace and basic oxygen converter method. This means that, on average, each tonne of steel produced requires about 1.7 tonnes of ore and 0.5 tonnes of coking coal.

China has its own extensive reserves of iron ore, but their ore content averages only about 33 per cent, compared with 62 per cent in Australia and about 65 per cent in Brazil and India, making local ore more expensive. So now more than half the ore used is imported.

Until recently China was self-sufficient in coking coal. But many of its deposits are relatively inaccessible and thus costly to mine. And many of its mines are unsafe. So since 2009 there's been a surge in demand for our coal.

More than half China's annual steel production is used for investment in buildings, structures and machinery. (Total public and private investment spending's share of GDP is a remarkably high 45 per cent - a sign China's in the industrialisation phase of development.)

At least a quarter of steel production is used for manufacturing cars, home appliances and much else. A lot of these would be consumed locally but most are probably exported.

The authors conclude that China's steel-intensive industrialisation phase - and hence its strong demand for our iron ore and coking coal - is likely to continue "over the next decade or so".

One conclusion from this is that the floods' biggest effect on our economy is likely to be the temporary disruption to the Queensland mines' production and export of coal.

Think of China, think of steel; think of Chinese steel, think of Australia making big bucks

Wednesday, January 26, 2011

Aged care dilemma: tap homes, or let taxpayers pay

There's a lot more to life than money. But it's money - how much things cost and who will pay for them - that causes many of the arguments in families and most of the arguments in politics. Nowhere is that truer than in aged care.

We all agree that old people must be adequately cared for in their declining years and that governments must ensure this happens. But where does private responsibility end and public responsibility begin? More to the point, how should the cost of care be shared between the individuals involved, their heirs and successors, and the taxpayer?

The scope for duck-shoving - the temptation to push costs off on to someone else, particularly the anonymous taxpayer - is enormous. Trouble is, governments represent the taxpayer. Elected politicians know that if the demands they make on taxpayers get too high or grow too rapidly, they're in trouble.

Unless we're careful, we end up with government paralysis: politicians who aren't game to push more of the costs back on to individuals and their families, but aren't prepared to impose a lot more cost on the taxpayer.

The result is an aged care system that isn't working properly. Where some old people who need care aren't getting it because the government has imposed arbitrary limits on how much it's prepared to spend; where some individuals are getting a much bigger public subsidy than is fair, while others are paying a lot more than is fair, and where institutions are underfunded and the people who work for them are underpaid.

As last week's draft report from the Productivity Commission reminds us, that's where our aged care system is now and where it will stay until we find federal leaders with the courage to stand up to both the duck-shovers and the reluctant taxpayers.

But, actually, the system won't stay as it is for long. The ageing of the population means a lot more people will be requiring aged care in coming years, particularly when the bulge of baby boomers reaches old age.

The commission says there's no way the cost of aged care to federal taxpayers will fail to grow significantly over the years. So, barring the unlikely event of offsetting cuts in other government spending, we will have to pay higher taxes.

We can, however, limit the growth in cost to the taxpayer - as well as alleviating other deficiencies in the present system - by making the system more efficient and requiring greater contributions to aged care costs from those individuals in a position to make them.

What would be fair? The commission starts by dividing the total costs faced by old people requiring care into four categories.

First is the cost of accommodation, which is equivalent to rent or mortgage payments and home maintenance. Next are everyday living expenses, such as for food, clothing, laundry, heating and social activities.

Third is the cost of healthcare, such as nursing, therapies and palliative care. And fourth is "personal care" - the additional costs of being looked after because of frailty or disability.

The commission argues that accommodation and everyday living expenses should be the responsibility of individuals, but with a safety net for people of limited means. (Remember, this is why people receive the age pension. Those ineligible for the pension - or for a full pension - have other, private means to call on.)

The commission argues that health services should attract a universal (that is, non-means-tested) subsidy, as is a key principle of Medicare.

On the cost of personal care, the commission says individuals should be required to contribute according to their capacity to pay, but shouldn't be exposed to catastrophic costs of care. It suggests maximum lifetime payments be capped at $60,000.

We tend to think of the elderly as among the poorest in the community, but that's because we focus on their usually modest incomes. But it's a different story when the focus is on their assets.

The distribution of wealth has been shifting towards older Australians since the mid-1980s, and this trend is likely to continue. It's estimated that, in 2000, the 12 per cent of the population aged 65 and over held about 22 per cent of the total net wealth of households. It's projected that by 2030, the aged's share of the population will rise by 7 percentage points, but their share of net wealth will more than double to 47 per cent.

Where's all this wealth coming from? From the rising value of the family home. The rate of home ownership among the elderly is very much higher than among the rest of us. Yet the value of people's homes is largely ignored when calculating their aged-care charges and subsidies - until the house is sold, when everything changes.

This is what the commission says must change to make the cost-sharing fairer to those oldies who've never owned their homes or have recently sold their home, not to mention working taxpayers who may be far less well placed in the housing market.

Taking account of the value of people's homes in assessing their ability to contribute to the cost of their care - which the commission says should vary between 5 per cent to 25 per cent - would increase the pressure on people to sell their home or at least borrow against it.

It proposes widening the use of accommodation bonds - where money is lent to the care institution interest-free - but with the proviso that the size of bonds reflects the actual cost of accommodation.

Many old people and their inheritance-conscious children will hate the sound of all this. But since even John Howard lacked the courage to impose these reforms, it's doubtful whether Julia Gillard will be game to touch them.

The only trouble is, our treatment of people receiving and providing aged care will continue to worsen until we as a nation are prepared to call a halt to the duck-shoving.


Monday, December 27, 2010

First of a line of green Treasury bosses

In the olden days you didn't get to be boss of a major company, government department - or this newspaper - until you were in your late 50s or early 60s. You stayed in the job until you reached what was then imagined to be the official retirement age of 65. So whether they performed well or badly, no one spent all that long in a top job.

(Going not that far further back, you didn't get to be governor of NSW, Anglican archbishop of Sydney or editor of the Herald unless you were an Englishman, recruited from the Old Country. Having done your bit in governing the colonies, you retired to the Home Counties.)

These days, top jobs go to much younger people, which means they get a longer go at it - assuming they work out - but have to give it up and let someone else have a turn well before they're old enough to retire.

Dr Ken Henry was 43 when he became secretary to the Treasury in 2001. His five-year term was renewed in 2006, so he's held the job for almost a decade and now it's time to move on. He's likely to take a long break before accepting another job.

Henry is what his present political masters aren't: a believer. Like all his predecessors - and his successor, Dr Martin Parkinson - he's an economic rationalist. He believes in the power of market forces and the need to ensure they're harnessed to advancing the wellbeing of the community. Sometimes they need to be let off the leash, sometimes they need to be channelled, sometimes they need to be introduced to an area where they haven't existed but can be used to improve its performance (though sometimes this is a bad idea).

At a time when our politicians seem bereft of bedrock beliefs and values, and most government departments seem to have lost their compass, it's good to have a central agency with a clear view of what constitutes good policy in the public interest and an unwavering willingness to argue for it.

Henry continued to inculcate the Treasury View among his troops - maintaining their esprit de corps - and within the government.

Parkinson is a macro-economist, but Treasury is no longer involved in the day-to-day management of the macro economy - except to the extent that its secretary is an ex officio member of the outfit that does manage the economy, the Reserve Bank board.

Henry is a micro-economist, and Treasury has more than enough to do urging governments to take a rational approach in all the many markets it has influence over. And nowhere is that need greater than in using "economic instruments" - such as a price on carbon and the trading of water rights - to reconcile the conflict between economic activity and preserving the natural environment.

Henry is an environmentalist (as well as an active defender of kangaroos and wombats). He played an important part in developing the Howard government's plans for an emissions trading scheme, as did Parkinson, and Treasury modelling informed the Rudd government's initial attempt to get a scheme up.

There was a joke that the people running Treasury were greener than those running the Environment Department.

Parko, originally Henry's deputy in Treasury, left to work on trading schemes, taking various senior people with him and eventually being appointed to head the new Department of Climate Change.

Now he'll be succeeded by another Treasury man, Blair Comley. So under Henry, Treasury managed to colonise the environmental departments.

Is Henry "one of the greatest of all Treasury secretaries" as Julia Gillard has said? No doubt. Is he the greatest? He's the greatest in my memory.

Treasury was at its most influential during the term of the Hawke government, but I give the credit for that to our greatest ever treasurer, Paul Keating, a man with a deep understanding of how to obtain and use political power, and who needed a purpose to fight for. Treasury supplied that purpose, affecting his conversion to economic rationalism.

Treasury's highest institutional objective has long been to dominate the economic advice going to the government, and no secretary has been more successful in this than Henry, thanks to the arrival of the deeply insecure Rudd government, which sought to hide behind the authority of the supposedly independent Treasury.

Henry obliged - after all, Treasury is not and never could be independent - and became a key adviser to the prime minister, as well as being appointed to every policy committee worth being on.

That was Treasury's institutional reward, the rent it received for the use of its authority. Henry's personal reward was being allowed to head his own comprehensive review of the federal and state tax system.

Those who condemn the government's cursory dismissal of the Henry report have missed the point. Henry's ambition was to lay out a blueprint for long-term tax reform, which would provide a guide to his Treasury successors and an antidote to political ad-hockery for decades to come.

Tax reform was Henry's first love and he played an important part in all the reforms of the past 25 years. He was the first Treasury secretary to acknowledge the validity and usefulness of behavioural economics.

His tax report would have been better had he made more use of behavioural precepts.

Despite its loss of day-to-day macro management, Treasury - and budgetary policy - comes into its own when recession threatens. Here the micro-economist excelled himself.

He played a central role in the Rudd government's response to the global financial crisis and, learning from the policy errors in the severe recession of the early 1990s, urged Rudd to "go hard, go early, go households".

Most punters will never know it, but many owe their continued employment to that wise advice.


Wednesday, December 22, 2010

Take a break and we'll all be happy

Psychologists have a form of treatment for unhappy people called PAT: pleasant activity training.

It's quite simple: you make a list of the things you like doing, then do them more often. It's not as silly as it sounds. We've learnt our brains have one system that controls wanting and one that controls liking. The wanting system tends to dominate the liking system, so we often end up doing less of what we like than we'd like to.

I suspect that's true of taking holidays. A survey conducted by Professor Barbara Pocock of the University of South Australia, as part of the Australian Work and Life Index, found 57 per cent of full-time employees would prefer an extra two weeks' paid annual leave to a pay rise of 4 per cent.

So it seems we like taking holidays (and it sounds like a good idea to me). And yet there's a wealth of evidence that many of us don't take the leave we've already got. A survey conducted regularly by Roy Morgan shows that only about 70 per cent of Australians aged 14 or older intend to take at least one holiday over the next 12 months.

Another survey conducted for Reuters by a global market research company, Ipsos, found that only 47 per cent of Australians expected to use all their annual leave. This was the lowest proportion for any country bar the Japanese, on 33 per cent. By contrast, 89 per cent of the French, 77 per cent of the Brits, 75 per cent of the Germans and even 57 per cent of the Americans expect to take all their annual leave.

Australia's governments have required employers to provide their workers with paid annual leave since 1941. In 1973 it was increased to four weeks. At the time many people thought this extravagant, but it's about average. The French get six weeks, while the Finns, Norwegians and Swedes get five.

Pocock's survey shows 60 per cent of Australian employees stockpile at least some of their annual leave. And according to calculations by Roy Morgan, the stockpile has reached 117 million days.

But if people like annual leave, why don't they take it all? According to Pocock's survey, 31 per cent of full-time employees say they're too busy at work and 13 per cent say they couldn't get time off that suited them. Nine per cent say they prefer to work.

And 41 per cent say they're saving their leave for a future holiday - though I'm not sure I believe it. If it were true - if people were merely delaying their holiday-taking - unused leave wouldn't have piled up the way it has.

It may be that some young people want to combine a few years' leave for an extended overseas trip, but I think "saving for later" is just something you say when you don't get around to taking it all.

I guess it's true that, consciously or unconsciously, some employers don't encourage their workers to take their leave, especially key employees.

But is all this a problem? Why turn unused leave into another crisis? Well, a lot of employers think it is a problem, including one quite close to me. If an employee takes all her leave during the year, the business suffers an expense of 52 weeks' wages on her behalf. But if she works all year without taking leave, the expense rises to 56 weeks' wages, with the extra four weeks of untaken leave owing to her adding to the firm's liabilities. (What's more, the firm doesn't get a tax deduction until the leave's actually taken.)

In theory, insisting that everyone take their leave during the year means the firm has to employ more people. In practice, it means we all have to work a bit harder when we're not on leave to cover for those of us who are. Whistle-blowing economists call this "work intensification" - but it comes from employer penny-pinching, not from the leave itself.

Another group that sees untaken leave as a great problem is Tourism Australia, the federal government's tourism marketing body. Last year the minister, Mar'n Fer'son, launched a campaign called No Leave No Life to encourage us to take our leave and spend it in Australia, complete with commercial TV show.

Tourism Australia can think of many reasons why it's good to take your leave (and for employers to offer a "leave-friendly workplace"). Achieving work-life balance, we're told, comes with improved physical and mental well-being.

Taking your leave helps you avoid the stress of exhaustion and burnout. You get greater job satisfaction when you approach your task in a refreshed state. Taking leave helps you "rediscover your friends, your family and most importantly yourself".

The figures show we're taking more, shorter breaks rather than blowing the lot in one go. Maybe this explains why we have trouble making sure we've taken it all. There's some evidence that taking more short breaks is more re-creational (though I like to make sure of it by taking short breaks through the year and a big break at the end of it). Tourism Australia says there are so many great experiences to be had we should "take the opportunity to visit some more of Australia and gain some lasting memories as well as some great stories to share with others".

It may be advertising copy, but it does have evidence behind it. Psychologists have shown that one reason we get more satisfaction from buying experiences rather than things is the memories and stories we're left with.

Recent research also shows that much of the pleasure we gain from holidays is in thinking about them before we take them. But please don't think that's what I've been doing in this column. And if you're working through, please don't think I'm trying to make you guilty or envious. But I'm off.


Monday, December 20, 2010

Beware gurus selling high migration

The economic case for rapid population growth though immigration is surprisingly weak, but a lot of economists are keen to give you the opposite impression. Fortunately, the Productivity Commission can't bring itself to join in the happy sales job.

I suspect that, since almost all economists are great believers in economic growth as the path to ever higher material living standards, they have a tendency to throw in population growth for good measure. There's no doubt a bigger population leads to a bigger economy; the question is whether it leads to higher real income per person, thereby raising average living standards.

Of course, business people can gain from selling to a bigger market, regardless of whether the punters are better off. So I'd be wary of advice coming from economists employed by business or providing consulting services to business.

In 2006 the Productivity Commission conducted a modelling exercise to assess the effect of a 50 per cent increase in our skilled immigrant intake. It found that, after 20 years, real gross domestic product was only about 4 per cent higher than otherwise.

And the increase in real income per person was minor. What's more, most of the gains accrued to the migrants themselves, with the existing population suffering a tiny net decline in income. Why this lack of benefit? You'd expect the extra skilled labour to raise the proportion of the population participating in the labour force, thus boosting production per person.

But most of the productiveness of workers are achieved by the physical capital they're given to work with. So unless your extra workers are given extra capital equipment - a process known as "capital widening" - their productivity is likely to decline, thus offsetting the gain from having more workers.

Note, too, that we have to increase the housing stock to accommodate the migrant workers and their families, as well as providing the extra public infrastructure for a bigger population. So the migrants are paid to supply their labour, but the rest of us have to provide the extra economic and social capital they need if standards aren't to fall.

Last week Tony Burke, the federal minister responsible for developing a "sustainable population strategy" next year, released an issues paper to encourage discussion. It was accompanied by the reports of three advisory panels, including one on the economic aspects, led by Heather Ridout of the Australian Industry Group.

Ridout's report sets out to talk up the economic case for high migration by dispelling "myths" and pointing to hard-to-quantify benefits "often ignored by low-growth advocates when they skim the literature" (that's what they call a professorial put-down).

The main hard-to-quantify benefits left out of the Productivity Commission's modelling are the economies of scale arising from a bigger market. But why after all these years have economists been unable to produce good empirical evidence of something as straightforward as scale economies?

And why wax lyrical about unmeasurable benefits without mentioning unmeasurable costs? In its recent booklet on population and immigration, the commission acknowledges that as well as economies of scale there could be diseconomies.

The Ridout report objects that the commission's modelling measured the benefit of increased immigration only over 20 years. Sorry, but if you have to wait more than 20 years for the payoff you're not talking about a powerful effect.

A relatively new argument in favour of high immigration is that it could foster economic growth by countering to some extent the decline in labour-force participation caused by the ageing of the population. But, since immigrants age too, all this can do is put off the evil hour (not a course of action usually promoted by economists). To continue postponing the crunch you have to keep upping the dose of immigration.

The Productivity Commission is blunt: "changes in migration flows are unlikely to have a significant and lasting effect on the ageing of Australia's population".

The Ridout report argues that a faster-growing, immigration-fuelled economy would require greater levels of investment by businesses and in public infrastructure. This greater capital spending would generally involve investment in more productive capital equipment, as recent technological improvements will be embedded in the newer stock. In this way, faster growth of the size of the economy would drive the productivity gains that are central to advances in material living standards, we're told.

Huh? The proposition is that by taking on a need for considerable investment in capital widening (to provide the extra workers with the equipment and infrastructure they need to be as productive as the existing workers) we're increasing the scope for capital deepening (giving each worker more and better capital equipment).

Am I missing something? This is a twist on a common economists' argument I've never managed to fathom: we need to grow more and do more damage to the natural environment because when we're richer we'll be able to afford to fix the damage we've done to the environment.

The Ridout report asserts that provided population growth is "balanced and managed well", living standards will rise. It needs to be "matched by greater commitments to education and skills development, more and better investments in infrastructure, greater attention to the development of our cities and regions and to our natural environment".

In other words, to give business the extra population it wants but prevent this from worsening all those things, governments at all levels will really need to lift their game as well as spend a lot more. Turn in a perfect performance and high immigration won't be a problem.

I prefer the commission's way of putting it: "population growth and immigration can magnify existing policy problems and amplify pressures on 'unpriced' entities, such as the environment, and urban and social amenity".


Saturday, December 18, 2010

A reality check at last on what we take for granted

A recurring theme in my writing this year has been to point out the limitations of gross domestic product as a measure of wellbeing, particularly as related to the environment. But today I have good news: something is being done about it. Economists and statisticians long ago developed a "system of national accounts" to measure developments in the economy, based on Keynesian theory about how economies work.

Although these accounts give much detail about income, production, spending and saving during a period and, these days, a balance sheet outlining the values of the nation's assets and liabilities to the rest of the world on the last day of the period, we tend to focus on a single bottom line: the change in the real value of goods and services produced during the period, otherwise known as GDP.

A United Nations commission sets down an international standard for all countries to follow in preparing their national accounts, using the same theory, concepts and definitions so each country's figures are comparable and can be added together to give gross world product. But as we've become more aware of the problems economic activity is creating for the natural environment - degradation of rivers and soil, depletion of non-renewable resources, use of renewable resources faster than their ability to renew themselves, destruction of species and generation of waste and pollution, including greenhouse gases - we've realised that little of this cost is taken into account in measuring the change in our income.

It's as though we've been thinking of and measuring "the economy" - the production and consumption of goods and services - in total isolation from the natural environment in which the economic activity occurs.

The environment provides the economy with many "ecosystem services", which a leading ecological economist, Professor Robert Constanza, of Portland State University, defines as "the benefits provided to humans through the transformations of resources (or environmental assets, including land, water, vegetation and atmosphere) into a flow of essential goods and services,

for example clean air, water and food".

These ecosystem services are treated as though they're "free goods" - goods in such abundant supply they have no value or cost - while, as we've seen, most of the damage economic activity does to the ecosystem is also ignored.

The main reason for these limitations is that, with some exceptions, the national accounts and GDP don't actually measure "the economy" but rather market transactions within the economy. So, for instance, it ignores all the production and consumption that occurs within households without money changing hands. It measures professional sport, but not amateur sport.

It's clear we can't go on effectively ignoring the relationship between the economy and the environment. The damage economic activity does to the environment diminishes our wellbeing, as well as rebounding on the economy and damaging it. We can go on ignoring the damage excessive irrigation is doing to the Murray-Darling so as to avoid disrupting the livelihoods of the irrigators, but if we eventually turn the river into a drain, irrigation will be no more.

We need to recognise and measure the interrelationship between the economy and the environment because we don't want to give ourselves a false impression of the progress we're making, even in a narrow, material sense. Measurement is important because "what we measure affects what we do; and if our measurements are flawed, decisions may be distorted".

To this end the UN commission and its member national statistical agencies have agreed on a "system of integrated environmental and economic accounting", which will become an international standard in 2012. This brings environmental and economic information together within a common framework, meaning information from each side is on a comparable basis and can thus be combined.

Well that's great. But our longstanding focus on purely economic measurement means we don't yet collect all the data we would need to produce environmental accounts that could be integrated with the economic accounts to give us a more balanced picture of the progress we're making (although, of course, this says nothing about other dimensions of progress, such as the quality of our health, extent of our education, inequality in the distribution of income and treatment of minorities).

It turns out the efforts of our Bureau of Statistics have been concentrated heavily on collecting the reams of statistical information needed to produce the quarterly national accounts.

So that's the first stumbling block. The second is that, with the environment, you have to start with physical measures (millilitres, petajoules, hectares or tonnes) then see if you can convert them to dollar values - as they must be if they're to be combined with the economic accounts. (That's the problem with non-market activities, of course. When something is bought or sold, you know its dollar value.)

The bureau of stats has issued a paper describing its progress in moving Towards an Integrated Environmental-Economic Account for Australia. It needs to produce six accounts that will add up to the environmental side.

A water account (released a few weeks ago and now to be produced annually) includes the physical flows of water supplied to, and used by, the economy, and water returns to the environment. It includes monetary supply and use tables and indicators of the water productivity of industries.

An energy account (to be produced annually from mid next year) includes physical and monetary supply and use tables for various energy products, by industry. A land account (to be produced annually from early next year) includes physical and monetary land use by industry, land cover by industry and changes in land cover over time.

An "environmental protection expenditure" account (to be produced annually from late 2012) gathers together protective spending already included in GDP for things such as waste water treatment. A waste account (to be produced three-yearly from late 2012) covers physical generation and disposal of waste by industry, type of waste and destination.

It would be nice if, having done all this measurement, we could produce from the integrated environmental-economic accounts a single, bottom-line figure for "green GDP", that we could watch as closely as we watch the present brown GDP. As yet, however, the world's statistical agencies haven't agreed on a definition of green GDP, nor agreed on how to convert all physical quantities into dollar values. But there will be enough information to allow outfits or academics to calculate their own versions of green GDP using their own assumptions. And it should be possible to produce a figure for GDP after adjustment for environmental depletion and degradation.

That will be a big step forward.


Wednesday, December 15, 2010

Only part of our fortune is down to minerals

If it exercises my doctor's mind I imagine it occurs to a lot of people: are we a stuffed nation living off our mineral wealth? The thought that we're making a lot of our income merely by digging stuff out of the ground and shipping it overseas seems to worry a lot of people. Is that the best we can do?

Considering the fuss politicians, economists and the media are making about the resources boom, you could be forgiven for thinking mining had taken over the economy, but it isn't true. A lot of people think a nation makes its living by selling stuff to the rest of the world. That isn't true, either. Roughly 80 per cent of all the goods and services Australians produce (gross domestic product) is sold to Australians, not foreigners. Similarly, roughly 80 per cent of the goods and services Australians buy is bought from Australians.

In other words, our economy is roughly 80 per cent self-sufficient. At a pinch, we could make it completely self-sufficient, though this would involve a significant decline in our standard of living. Why? Because we'd be denying ourselves access to all those goods and services that other countries produce better or more cheaply than we could.

Here you see the only reason we need to sell things to the rest of the world: so we can afford to import things from the rest of the world. All of us enjoy those imports, but the notion that 80 per cent of us survive by living off the 20 per cent who produce exports is quite mistaken.

Economies work by a process of specialisation and exchange. We each specialise in producing something we're good at, sell what we produce for money (usually wages), then use the money to buy the things we need from other producers. Most of this trade occurs within Australia, but extending our trade to people in other countries makes both them and us better off, because we've got stuff they want and they've got stuff we want.

Thanks to the industrialisation of China and India - accounting for almost 40 per cent of the world's population - the rest of the world is prepared to pay record prices for our coal and iron ore. Those prices won't stay at record levels but, because the process of industrialisation takes quite a few decades, they're likely to stay a lot higher than they were for a long time.

Though minerals and energy now account for about 42 per cent of our export earnings, this still leaves 58 per cent coming from other parts of the economy: 18 per cent from agriculture, 17 per cent from manufacturing and 23 per cent from services (particularly tourism and education).

When you get down to it, mining accounts for only 7 per cent of the value of all the goods and services Australians produce. That leaves agriculture accounting for 3 per cent, manufacturing for 12 per cent and the services sector for 78 per cent.

We have a lingering tendency to denigrate the services sector because it doesn't produce anything you can see and touch. But this is silly. As our standard of living has risen over the years, services account for an ever-increasing proportion of the things we buy (there is, after all, a limit to how much we can eat and how many cars and TV sets we need). And, as we've seen, it's not even true that we can't export services.

It turns out that 84 per cent of working Australians are employed in the services sector - similar to other advanced economies. And although some service jobs are menial - chambermaids, cleaners, waiters and shop assistants - most of the clean, safe, highly skilled, well-paid and intellectually satisfying jobs are in the services sector: doctors, lawyers, bankers, architects, engineers, managers, consultants, clergy, accountants, journalists, actors, media personalities, academics, teachers and many more.

Take away mining and we wouldn't be quite as rich as we are, but most of the economy would look much the same as it does. Most of us would still have good, secure, well-paid jobs.

In other words, our economy has a lot more going for it than just the good fortune of sitting on a lot of valuable minerals.

In Australia, as in every country, public discussion focuses on the bits that aren't working as well as we'd like them to. The bits that are working well get taken for granted. It would be a pity if all this left people with the impression things in Australia are substandard. They're not.

The level of educational attainment in Australia is high and ever-rising. Tests show our 15-year-olds' literacy, numeracy and science are well above average for the developed countries. Seven of our universities are ranked in the top 200 in the world.

With the notable exception of Aborigines, Australians' health is good by international standards. Our longevity is among the highest in the world. So despite all our complaints, we have a good health system, delivering better results than the Americans' at a much lower cost.

Our material standard of living is around average for the rich countries, but likely to go higher. Our gap between rich and poor is also about average, but not as bad as the other English-speaking countries.

For the past 20 years we've had a particularly well-managed economy, with low inflation, falling unemployment and a rising standard of living. Our banks have been well-supervised and kept out of trouble. Most other advanced economies have huge levels of public debt, but ours is minor.

It's true our mineral riches won't last forever, so we do have to make sure we invest the proceeds wisely, particularly in education. But even without mining we still have a healthy, prosperous economy.


Monday, December 13, 2010

Faithful few attend the economic church

If the nation's economists are right in assuming almost all of us share their belief that the pursuit of an eternally rising material standard of living must be a key goal of government, they're left with a puzzle: why then is there so little support for further micro-economic reform?

It's true virtually all our politicians and business people share the economists' assumption that almost every Australian sets a high store by an ever-rising standard of living.

At the Australian Business Economists' conference in Sydney last week, Saul Eslake of the Grattan Institute went so far as to say that only those who are "deep green" would doubt the primacy of ever-rising living standards.

In that case, Saul, you'd better start calling me Kermit the Frog. But I doubt I'm Robinson Crusoe.

The chief speaker at the conference was Gary Banks, chairman of the Productivity Commission and a high priest in the economists' Temple of Mammon. With Eslake as altar boy, he preached a fiery sermon about the need for more micro reform to lift Australia's faltering productivity performance.

Factually, he's right. If you're obsessed by economic growth then, as Paul Krugman has famously put it, "in the long run, productivity is nearly everything". Over the past four decades, growth in the productivity of labour accounted for about 80 per cent of the growth in Australians' real income per person.

The main way to increase the productivity (productiveness) of labour is to give workers more machines (physical capital) to work with. But 36 percentage points of the 80 came from "multi-factor" productivity improvement - that is, not from using either more labour or more capital, but from pure technological advance.

But though our productivity performance surged in the 1990s, in the early noughties it fell back to its long-term average. And since then it's worse than it was before the '90s. In 2009-10, there was only slight growth in multi-factor productivity - though the year before, buffeted by the global crisis, it actually fell by 2.4 per cent, something not seen in almost 30 years.

Like most economists, Banks attributes the surge in productivity during the '90s to the delayed effect of the many micro reforms begun by the Hawke-Keating government in the mid-1980s. He attributes the poor performance in the noughties to the dearth of further reform.

He notes that the surge in national income we're enjoying at present thanks to sky-high coal and iron ore prices is concealing our poor productivity performance and warns that, when those prices eventually come down, our weak economic performance will be exposed for all to see - and feel in their pockets.

But is the nation's presumed commitment to higher living standards that superficial? Are we so ignorant or lazy we're content to enjoy the easy affluence of the resources boom while it lasts, uncaring about the underlying deterioration in the endless-prosperity machine's performance?

If so, this hardly fits with another of the economists' assumptions: that we're all ruthlessly rational in our single-minded pursuit of more baubles and bangles.

The alternative possibility is that we're not nearly as committed to ever-rising living standards as the economists presume; that we have a range of objectives, of which acquiring more stuff is only one.

Economists have a concept they call "revealed preference", which boils down to a belief that people's true motivations are revealed by what they do, not by what they say.

(It was by means of this device that economists managed to convert their assumption that people seek to maximise their "utility" into a belief that utility could be measured by gross domestic product - the market's production and consumption of goods and services - thus making economics the handmaiden to materialism it is today.)

But if revealed preference is the test, there's a lot of economic apostasy and agnosticism about, starting with our politicians.

It's fashionable to berate the Rudd-Gillard government for its lack of commitment to economic reform, and it's true it hasn't shown all that much determination, particularly not compared with the performance of the Hawke-Keating government.

But, as Banks is at pains to remind us, that version of Labor was able to press on with its reforms secure in the knowledge it would draw little criticism from its Liberal opponents, particularly under John Howard and John Hewson.

By contrast, the present Labor mob has experienced from the Liberals nothing but criticism and active Senate resistance to its reform attempts. Their obstructionism has ranged from implacable opposition to putting a price on carbon to trouble-making on the Murray-Darling Basin to opposing the rolling back of Howard's middle-class welfare.

The Libs have never had a more destructive, anti-rational leader than Tony Abbott. Every timid Labor attempt at reform has been used as an opportunity to fan populist resistance for partisan gain.

To be fair, the bipartisan support for micro reform broke down just as soon as Labor lost government in 1996. Turning their face against the rationalism of Bob Hawke and Paul Keating, Kim Beazley and his colleagues did all they could to profit electorally from the unpopularity of the goods and services tax and much else.

Even so, if economists, business people, economic rationalists within the Liberal Party and economic commentators are dismayed or distressed by Abbott's resistance to what little reform Labor has attempted, they've got a funny way of showing it.

No, I think the truth is staring us in the face: the two parties' loss of enthusiasm for economic reform merely reflects the public's lack of single-minded commitment to the pursuit of ever-greater, ever-faster material acquisition.

And the punters are right. Human well-being is a bit broader and more complicated than it suits the economic priesthood to acknowledge.


Saturday, December 11, 2010

A few facts would be useful in the migration debate

If we are going to have great debate about whether we want a Big Australia, people will need a much stronger grasp on the factors driving population growth and immigration than they've shown so far.

This is the rationale for a useful booklet, Population and Immigration: Understanding the Numbers, issued by the Productivity Commission this week.

Over the past 50 years, Australia's population has averaged growth of 1.6 per cent a year, causing it to double to 22.3 million. This is faster than for most developed countries.

The growth in our population comes from two factors: natural increase (more births than deaths) and "net overseas migration" (more immigrants than emigrants).

Natural increase is relatively stable, averaging about 130,000 people a year, whereas net migration can vary a lot from year to year.

Our "total fertility rate" (the number of babies per woman) has risen a bit in recent years to 1.9, although it's only about half the peak it reached in the 1960s.

It's fallen over the decades because of more effective contraception, the higher education of girls, and married women wanting to return to the paid workforce.

It's recovered a bit in recent years because of a slight reversal of the trend for women to leave starting their families later and later. Women worry more about leaving it too late and, when they start a bit earlier, more couples are able to achieve the common desire to have two kids rather than one.

The commission doubts whether Peter Costello's baby bonus has had any significant effect on fertility.

Demographers put the population "replacement rate" at 2.1 children (the extra 0.1 is to allow for a few who die before being able to reproduce). Since our fertility rate has long been below that (as it is in most developed countries), without net migration our population eventually would start to fall.

However, natural increase has been kept positive by rising longevity (a falling death rate). Longevity has risen significantly over the past century because of improvements in public health measures, improved nutrition (from a rising material standard of living) and advances in medical science.

Since the 1980s, net migration has overtaken natural increase as the main contributor to population growth. In the 1970s it accounted for about 30 per cent of population growth but in the past 10 years it's grown strongly to now account for about 65 per cent of the growth.

Our long-term rate of population growth is 1.6 per cent but in recent years strong migration has caused growth to be higher than that, with a rise of 2 per cent in the year to June 2009. This included net migration for the year of 313,500.

This high level of migration - combined with Treasury's projection that our population could reach 36 million by 2050, Kevin Rudd's remark that he believed in a big Australia and public anxiety over boat people - has prompted the debate about Big Australia.

But there's a lot of confusion over the extent to which the government controls the level of immigration.

Immigrants can be divided into two streams: those coming permanently and those coming temporarily. Starting with the former, the government has a permanent migration program. Each year it decides on the maximum number of permanent immigrants it will take and this figure gets a lot of publicity.

The limits set for this financial year are unchanged from last year: a total of almost 169,000, being 114,000 places for skilled migration plus 55,000 places for families. The big increase in recent years has been in the skilled category.

Also in the permanent stream is the government's humanitarian program. Each year the government sets a limit of about 14,000 on the number of refugees it's prepared to let in. People who arrive by boat and are found to be genuine refugees are given permanent residence under this program.

But fewer than 3000 humanitarian places a year (less than 20 per cent) are given to people who apply after they get here. The rest apply overseas and the program doesn't increase to make room for onshore applicants.

So repeated TV footage of people arriving on overcrowded boats has left the public with a quite exaggerated impression of how many of them there are. Some people imagine it's boat people who explain the high levels of migration in recent years but that's quite wrong. Their numbers are trivial in the scheme of things and don't increase the modest total of refugees admitted each year.

Finally in the permanent stream come Kiwis. Just as you and I can move to New Zealand any time we choose, so Kiwis can come here without government permission.

But here's the trick: most of the growth in net migration in recent times has been in the short-term stream, accounting for about two-thirds of annual net migration. In June 2009, there was a stock of almost a million people in the country on temporary visas. The three main temporary categories are: overseas students (contributing 110,000 to net migration in 2007-08); long-stay "457" business visas (contributing about 35,000); and working-holiday visas (about 21,000).

Long-stay business visas can run for as long as four years. In principle, if there was no increase in the number of people in these three categories over time, they'd make no contribution to population growth. About the same number of people would be coming and going each year.

Similarly, if that was all there was to it, any increase in their numbers would make only a temporary contribution to population growth. Eventually the increase would stop and eventually they'd go back home.

But in recent years more than half the people with long-stay business visas have been granted permanent residency, as have about a third of the overseas students.

Now, it's important to realise the government imposes no limits on any of these categories. Overseas student numbers are driven by the efforts of Australian universities and private training colleges to attract paying customers. The long-stay business visa numbers are driven by employer demand for skilled workers not available locally.

But the government has recently more than halved its list of skilled occupations in short supply and tightened up on the overseas student category. Combine this with the high dollar and the troubles of Indian students in Melbourne and it seems likely the number of overseas students will now fall quite heavily.

It's a safe bet net migration won't grow nearly as fast in the next few years.


Wednesday, December 8, 2010


Talk to Australian Business Economists Annual Forecasting Conference Sydney, December 8, 2010

Just as Glenn Stevens starts each appearance before the House economics committee by reviewing the fate of the forecasts he made at his previous appearance, so I have to start by reviewing the fearless forecasts I made this time last year. Usually Stevens can say his forecasts turned out pretty well, but I can’t. Since I know you guys like people to make a clear ‘call’, I gave one. And as a well-trained journo I put it in the lead: ‘it now seems clear the next federal election will be a double dissolution held not much earlier than normal - late September - with climate change and Work Choices as its main issues. It also seems likely that Kevin Rudd will win in a landslide’. Later, I referred to Tony Abbott, elected to be opposition leader just the previous week, as ‘unelectable’.

Whoops. Every one of those judgments proved wrong. My key miscalculation was in assuming Rudd couldn’t and wouldn’t abandon his commitment to achieving his emissions trading scheme. The other errors I made flowed from that. Labor insiders tell me I was among the first outsiders to detect Rudd’s feet of clay, but as it turned out even I overrated him. Had Rudd not lost his nerve on the ETS he would have had to hold a double dissolution, but the one he considered and eventually decided against would have been held early in the year, not later as I predicted. His about-face on the ETS started his precipitous decline in the polls which, combined with his difficulties over the mining tax, prompted his overthrow. But his brutal replacement by Julia Gillard did little to revive Labor’s electoral standing. Clearly, I and other smarties greatly underestimated Abbott’s powers as a politician, including his ability to largely defuse Work Choices as an election issue.

I’ve known for many years how foolhardy it is to make long-term political predictions - that is, predictions of events more than a year away - because events and attitudes can change so easily between now and then. But, for the sake of a fearless call (and also because the earlier you make your forecast the more time there is for people to have forgotten it), let me break my rule: I predict the Gillard government will run full term but, though that ought to give it plenty of time to lift its game, will lose the next election. I’ve come to the conclusion this generation of Labor is terminally incompetent.

Federal Labor’s achievement this year has been nothing short of extraordinary. To quote Wayne Swan: ‘We came within a whisker of losing government despite the best performing advanced economy in the world, despite substantially increasing the pension, despite fairer workplace laws, despite record investments in human capital, and despite cutting income taxes three times.’

I’m going to devote a fait bit of this talk to trying to explain why Labor stuffed up so badly, before looking to the future for politics and government.

The Demise of Rudd

The man who emerged from relative obscurity to become Labor’s saviour in 2007 turned out to be deeply flawed. Matched against the ageing John Howard, he looked appealing - young, good looking, well spoken, well educated and articulate - and unthreatening. At the same time, he promised to end the unfairness of Work Choices and was judged the more credible of the two in his promise to take decisive action on climate change. But he didn’t look particularly ‘Labor’.

He didn’t look it because he wasn’t. He hadn’t had to fight his way up through the party or the union structure, even though he - like almost everyone at the top of modern Labor - had cut his teeth working for state Labor, in his case as a politically appointed senior bureaucrat working for the Goss government. Labor’s egalitarian ethos hadn’t rubbed off on him, he held the unions in disdain, he was in a faction but not of one, he had little personal support within the parliamentary party and no mates. The main things that got him into the opposition leader’s job were his sponsorship by the NSW Right and his deal with Gillard of the Left. He did deals with many party people, most of whom he stopped talking to after he’d attained the exalted heights of prime minister. He burnt up much goodwill by giving jobs for the boys to boys from the other side - something Howard would never have dreamt of doing. He failed my acid test for Labor ministers: his staff didn’t love him (as most do).

He turned out to be all ambition and little principle. His overriding goal was to maintain his own popularity. He had little courage and was part of a cabinet that almost universally lacked courage. Everything started falling apart when he, after a long period of indecision, took the fatal decision to abandon the ETS because it had become too hard. To be fair, he took a lot of persuading to give up the ETS, but eventually those urging him to stick with it - Lindsay Tanner, Penny Wong and John Faulkner - were overwhelmed by those urging him to drop it: initially, Sussex Street (Mark Arbib and Karl Bitar) and then Gillard and Swan - the two whose careers benefited most from that fatal miscalculation, which in one blow destroyed the credibility of both Rudd and his government.

Despite his reputation as a policy wonk, Rudd turned out to be a hopeless administrator. He couldn’t set priorities or delegate (meaning he had no intrinsic feel for opportunity cost). He moved from one enthusiasm to the next, wanting everything he touched to be the biggest and best ever (he was addicted to superlatives), but had great trouble making up his mind and would delay a decision by demanding more options and the answers to more and more questions. His personal staff and senior bureaucrats were treated very badly. People would work all night to have a response to his queries on his desk next morning, only to discover he hadn’t found time to read it. They’d be summoned to a meeting with him several days later, where he’d flick through their paper, asking questions to which the answer was often ‘on the next page, prime minister’. Papers piled up in his in-tray, everything ran late and often had to be thrown together at the last minute to meet some deadline. Bureaucrats who needed something ticked by the PM would save it till he was out of the country and then submit it to Gillard, who would turn it around in no time. Government decision-making became chaotic.

Rudd was also an autocrat. He didn’t consult - not the unions, business, the backbench, the outer ministry or even the cabinet. Key decisions were made by the kitchen cabinet or Gang of Four, the strategic priorities and budget committee - Rudd, Gillard, Swan and Tanner - and even then there’ve been suggestions the other three were consulted rather than allowed to decide. After Rudd was deposed because the government had ‘lost its way’, Gillard and others were often asked whether they’d done anything to warn or remonstrate with Rudd. The honest answer is: No, not really. People were afraid to speak frankly to Rudd for fear of incurring his (frequently displayed) displeasure and being cut out of the loop. Rudd lacked the courage to sack people, but would just stop talking to those - even those within his office - who’d lost his confidence. By the end, pretty much his only confidants were a couple of inexperienced 30-year-olds in his office. His fatal mistake was to stop talking to Mark Arbib.

Rudd returned from his failed attempt to broker an agreement at Copenhagen exhausted and dispirited. He seems to have gone into a funk of indecision. He baulked at calling a double dissolution, then sought to distract himself with health reform, visiting about 40 hospitals around the country to ‘consult’. Senior bureaucrats and ministers followed him around, hoping he’d make decisions and reach their agenda item.

Rudd’s obsession with always trying to dominate the daily news cycle proved a snare and a delusion. His insistence on having ministers and departments come up with an unending stream of minor ‘announceables’ wasted their time and annoyed them while distracting them from more important matters. Worse, it deluded the government into imagining it was communicating effectively with the electorate. Labor’s small army of young PR punks manhandled the press gallery more than it was used to, meaning the media were ready to turn on Rudd as soon as his dominance slipped. The notion that if you could dominate the news cycle every day for three years the election would be a pushover proved to be wrong. As soon as the decision to drop the ETS destroyed Rudd’s credibility - among people who didn’t fancy the idea, as much as those who did - all those days of media dominance counted for nought.

Rudd’s backdown on the ETS weakened him for the next big battle, over the resource super profits tax. It emboldened the big three miners to seek to destroy the government rather than bargain with it, while reducing the government’s creditability in defending the tax to the public and making the notion of reaching a significant compromise with the miners unthinkable. (What isn’t widely known is that the big three’s resistance was heightened because the tax would have cost them more than twice what Treasury had estimated it would.)

Rudd’s losing fight over the RSPT proved the last straw for the spurned Sussex Street, which patched up its relations with the parliamentary Right in other states, gathered the numbers in caucus and made a last-minute offer to Gillard she couldn’t resist. The former Hawke minister Neal Blewett has expressed surprise at how quickly the party panicked. All successful governments go through periods of being behind in the polls. The explanation is partly that modern Labor is more committed to power than principle, but also that, by then, the entire party was so fed up with the chaotic, authoritarian Rudd. The night the bureaucrats learnt Rudd was being replaced by Gillard there would have been dancing in the streets.

The unlosable election (just)

It’s remarkable that a first-term federal government - particularly one that had performed so well in managing the economy - failed to win the election and went so close to losing it. We’ll never know whether Labor would have done better at the election had Rudd been allowed to stay on. We do know the election would have been held in October rather than brought forward to August. It’s clear the brutality of Rudd’s overthrow would have cost Labor votes - more than the conspirators ever bothered to imagine it might. But it’s doubtful Rudd would have been able to reach a compromise with the big miners over the resource tax, so one imponderable is how well he would have withstood the continued onslaught, including a massive ad campaign and funding of the Liberals.

On the other hand, Rudd’s overthrow robbed Labor of the ability to boast about its various achievements (paid parental leave is one Swan didn’t mention in that earlier quote). How could you justify Rudd’s ousting as necessary because the government had ‘lost its way’ and then praise his performance? Thus did Labor forfeit much of the benefits of incumbency - another price I doubt the conspirators thought about before they acted. But most Labor insiders are saved from worrying about what might have been by their conviction that, one way or another, Rudd had to go.

I think it’s now clear Gillard’s strategy of reaching a quick fix on the government’s three most pressing problems - reaching a compromise on the mining tax, doing something about asylum seekers and filling the vacuum on climate change - then rushing to an early poll while Gillard was still enjoying her honeymoon with the electorate was a costly miscalculation. The honeymoon quickly evaporated, leaving a woman with blood on her hands rushing to the polls before the dust had settled and people had got a chance to get to know her. Unsurprisingly, they weren’t greatly impressed.

The campaign was surprisingly badly run, and was marred by several damaging leaks, which party insiders are convinced came from Rudd. Before the election we were told a uniform swing of just 1.7 per cent against Labor would be sufficient to tip it out, but it actually suffered a two-party preferred swing of 2.6 per cent and still ended level pegging with the coalition on the number of seats. Why? Because the swing was far from uniform, varying greatly between states: down 5.6 per cent in Queensland, 4.8 per cent in NSW and 3.2 per cent in Western Australia, but up 4.4 per cent in Tasmania, 1 per cent in Victoria and 0.8 per cent in South Australia. And because swings aren’t uniform even within states, they don’t translate evenly to seats. In net terms, Labor loss seven seats in Queensland and one each in NSW, WA, Tasmania and the Northern Territory, gaining a net one seat in Victoria, to lose 10 seats in total, eight to the coalition, one to the Greens and one to an independent in Tassie.

On first preference votes, Labor lost 5.4 percentage points, though only 1.5 percentage points of this went to the coalition, leaving almost 4 percentage points going to the Greens. The Greens’ two-party preferred vote in the Reps rose to 11.8 per cent (with 79 per cent of their preferences going to Labor). This was Labor’s fourth lowest primary vote since the beginning of the two-party system in 1910.

Breaking up Labor’s vote by region, its two-party preferred vote fell by 3.3 percentage points in inner metropolitan seats, by 3.1 points in rural seats, but by only 1.8 per cent in outer metropolitan and provincial seats.

On a depressing note, both sides judged it easier to scare people into rejecting the other side than to inspire people to support them. On an encouraging and remarkable note, because both sides were so anxious to claim they’d be better at eliminating budget deficits and debt, both felt they had no choice but to nominate offsetting savings to cover the cost of their election promises (although the Liberals’ costings were deceptive).

Gillard’s strengths and weaknesses

As Peter Hartcher has pointed out, Gillard has one thing in common with Abbott: both seized their party leadership as part of a reform panic. Abbott: the coalition’s panic over Malcolm Turnbull’s commitment to the ETS; Gillard: Labor’s panic over the opposition to the mining tax. Not an auspicious beginning for either of them. I don’t believe Gillard undermined or plotted against Rudd but, even if she didn’t, it looked bad and she has had no honeymoon with the electorate.

She isn’t able to appear warm and likable on television, which means she lacks charisma. She isn’t disliked, but she isn’t liked either. A substitute for likeability (eg Bob Hawke) is being respected - seen as a strong and capable leader (eg Howard, Malcolm Fraser), but she doesn’t have that either. Since the election she and Labor have been flat-lining in the polls, making no progress from their perilous position at that time. You can see this as a sign she’s failed to impress the electorate or that it’s suspending judgment - both, probably.

One of her strengths is she’s a highly capable administrator (notwithstanding the exaggerated problems with the schools halls building program). She’s smart, she works hard, turns the paper around and chairs a very disciplined meeting. Another great strength - much in evidence in the 17-day period between the election and Labor’s confirmation it had the number to continue in government - is her ability as a negotiator and deal-maker. She can give you little, but send you away happy. A third great strength is her willingness to listen, consult and include. All leaders learn from the mistakes of their predecessor, but she would have been inclusive anyway. Cabinet is back to functioning normally. Even if her polling doesn’t improve, it will be a long time before the caucus can be roused against her. And she has had the sense to abandon Rudd’s obsession with dominating the daily news cycle.

Her great weakness is her lack of belief. She’s hugely ambitious, but doesn’t seem to have a deep commitment to Labor’s traditional preoccupation with fairness and redistribution, equality of opportunity, social justice and compassion. She came to power via the Left faction, but shows no sign of having left-wing values. Indeed, I suspect she’s trying to live down her left-wing label by erring on the conservative side. She does keep saying what her values are: she believes in hard work, a fair go through education, and that we’re all equally worthy of respect. That’s fine, but it doesn’t get us far. And though she and her cabinet colleagues keep stressing their belief in ‘a strong economy’, that doesn’t mean she’s an economic rationalist - just a politician who’s concluded a growing economy is essential to staying in office.

Laurie Oakes says Howard made every mistake in the book in his first term, but he only made them once. My big question about Gillard is the steepness of her learning curve. If you learn from your stuff-ups, your chances of survival and success are greatly improved. I concluded Rudd didn’t have a learning curve, so wasn’t sorry to see Labor bundle him out. Gillard was at the fore in persuading Rudd to abandon the ETS, which proved a disastrous mistake, but her decision to fill the vacuum with a citizen’s assembly suggests she was very slow to see the error and start getting back into the carbon-price game.

One of Rudd’s failings was his hankering after the biggest and best in everything, regardless of whether all his grand projects were consistent with his (utterly genuine) commitment to returning the budget to surplus ASAP. This says Gillard should have seen the gold-plated national broadband network coming and taken quite steps to tone it down, but she didn’t.

Tony Abbott and the Libs

Abbott has proved a far more disciplined and successful politician than I ever imagined he could be. He got the job because of his willingness to switch to implacable opposition to a price on carbon (that is, to a policy on climate change that’s less rational that the Greens’), but also because the Libs, expecting a drubbing in the election, wanted him to minimise the loss of their base vote. He not only held the base, he gained almost enough of the middle ground to win. He just kept punching away during the election campaign, kept his foot out of his mouth, and did far better than anyone expected.

Abbott is a contradiction: intensely personable in the flesh, but capable of coming across as a crazed zealot in the media. But after a rocky start he kept all his zealotry well controlled. He can say stupid things (eg that this was the worst Labor government ever) but also things that are charming and disarming (eg that Gillard’s success with the independents showed her to be a talented negotiator).

The Libs are the natural home of economic rationalism, starting with Bert Kelly, The Modest Member, John Hyde and the Dries, and the pre-PM Howard, who once fairly dubbed himself the father of economic rationalism. But rationalism is out of fashion today; Abbott’s not interested in economics and is happy to argue that putting a price on carbon is crazy and pretend that ‘direct action’ will fix climate charge rather than just waste money. There are no rationalists left in the party bar Turnbull (and maybe Joe Hockey), though Hockey is regarded as lazy and has two people after his job (Andrew Robb and Turnbull). But Robb’s credibility has been damaged greatly by the disclosure after the election that his policy costings - which he refused to submit to Treasury and Finance - were flawed to the point of fraudulence.

It took Abbott too long to realise he’d lost the election and that the government was unlikely to fall any time soon. He should assume the election will be in three years’ time. If so, it doesn’t follow that just because he almost won this time he’s sure to win whenever the next election’s held. As I’ve been reminded to my cost, the political world can change dramatically within a year, let alone three. One thing that could change is that three years of Abbott’s unrelenting opposition to everything - punch, punch, punch - could wear very thin with an electorate that gets terribly tired of seeing politicians perpetually arguing with each other. You get the feeling Abbott would oppose the Second Coming if it was Labor policy. Smart oppositions avoid appearing excessively negative by being more selective in what they oppose and drawing attention to the things they support. Abbott has indicated he understands the Libs’ need to do more to articulate their own positive policies, but whether he can force himself to be more positive and less relentlessly negative remains to be seen.

Labor and the economy

The more loudly Labor proclaims its fealty to ‘a strong economy’ the more you realise there’s something amiss. These days, it’s virtually compulsory for governments to claim to be committed to economic reform, though they have considerable latitude in what they define as reform. With the retirement of Tanner, Labor’s down to just one avowed economic rationalist, Craig Emerson, who’s sidelined in Trade. It will take some time for Labor’s new economics professor, Andrew Leigh, to progress from the backbench to the front. I don’t regard Swan as a true believer, though I have hopes for Wong. She did, after all, spend Labor’s first three years trying to introduce market pricing to carbon emissions and water. No, these guys are just politicians, first and foremost, who realise the political importance of good economic performance, but don’t have a deep understanding of, respect for and belief in the power of market forces. They are dogged by an inferiority complex in the economic area, born of their knowledge that they’re only faking it as economic rationalists and of Peter Costello’s decade-long success in reinforcing the electorate’s instinctive belief that the party of the workers couldn’t be any good at managing the economy, whereas the part of the bosses obviously would be.

Rudd and Gillard happen to have done particularly well at macro management, as well as it’s reasonable to expect flesh-and-blood politicians to do. They’ve left the Reserve Bank alone and uncriticised as it’s done its job; they stimulated the economy vigorously at just the right moment, they managed business and consumer expectations brilliantly, and they’ve imposed budgetary strictures on themselves from the off (starting with the requirement that all stimulus spending be temporary and moving to the restrictions on tax cuts and real spending growth till the surplus is back to 1 per cent of GDP). I have no doubt they’ll do ‘whatever it takes’ to get the budget back to surplus in 2012-13. I don’t regard this performance as having been seriously marred by the problems with insulation and school building. It has suited the opposition and sections of the media to leave us with a greatly exaggerated impression of the extent of waste, and to deny the very real trade-off between macro-economic timeliness and value-for-money.
It’s on the micro side that Labor’s performance has been weak, with its wasteful spending on industry assistance, cash-for-clunkers and the like, its inadequate rollback of Howard’s extensive middle-class welfare, its excessive compensation to polluters under its ETS and then its abandonment of that scheme when the going got tough, and finally its mishandling and ultimate butchering of the minerals resource rent tax.

Throughout its life the government has exhibited three related deficiencies: a lack of values, a lack of courage and a lack of skill in managing its relations with the electorate. It’s mainly because of Labor’s lack of deep belief in rational policies that it lacks the courage to fight for them when an unprincipled opposition exaggerates their cost to the electorate. And it’s the same lack of genuine belief and understanding that leaves ministers unwilling or unable to explain and defend policies whose short-term costs will be outweighed by longer-term benefits.
Labor’s explanatory powers and its belief in its own ability to exercise those powers have atrophied through lack of use. It’s relied too long on spin doctors, whose stock in trade is to conceal, confuse and distract rather than explain. People who should be being paid to find effective ways to explain complex and unfamiliar concepts put their effort into trickery, such as announcing backdowns late on Friday afternoons, or bullying journalists. Ministers agree to the public’s self-pitying misconceptions rather than explain complex truths. We didn’t have a recession because we didn’t have two successive quarters of negative growth - what a way to denigrate your own success! Any change in mortgage interest rates not in lock step with changes in the cash rate is profiteering. If power prices have risen a lot the cost of living has gone through the roof and you’re right to feel impoverished.

Why do ministers perpetually attack the opposition rather than explain and defend their policies? Because they’re politicians doing what politicians do, not economic believers doing what believers do. You’ve got to build support for reform - even if only among opinion leaders - but you don’t do it by attacking your political opponents, you do it by unceasing explanation and persuasion.

Why Labor’s so bad at it

In watching the government’s performance over the past three years - but particularly over the past year - I’ve come to the startling conclusion that federal Labor has lost its race memory of how to govern. The Hawke/Keating government knew how to do it, but after 11 years in the wilderness Labor has lost the knack. These guys are amateurs. Many of the ministers and their advisers had experience in government at the state level, but it hasn’t successfully translated to the federal level.

One sign of amateurism is that Labor is still talking and acting like an opposition. Not being in power, oppositions do little other than criticise the other side, leaving it until close to the election to produce positive policies. Sensible governments ignore their opponents as much as possible, exploiting the advantage of incumbency to deny them air. Responding to opposition criticism gives that criticism legitimacy in the eyes of the media and the public. Labor spends all its time attacking its opponents. The electorate finds this far more alienating and confusing than convincing. Those who aren’t one-eyed for one side or the other don’t feel equipped to adjudicate the debate and so are likely to conclude ‘they’re all liars’. In other words, attacking the opposition isn’t persuasive. It’s a sign Labor is confusing scoring points inside parliament house with scoring in the electorate. But the other disadvantage of perpetually disagreeing with the opposition is that it crowds out what the government should be doing: explaining its policies and expounding on their many virtues.

Another sign of opposition thinking is the way Labor keeps expressing sympathy for punters’ complaints that it picks up from its focus groups eg the cost of living, the greedy banks, executive salaries. Oppositions can get away with this, but governments can’t because they’re expected to act on their expressed concern. Governments are unable to do much to fix most of these complaints, many of which are ill-founded. By sympathising with these whinges rather than making the counter points, governments foster the belief that they can and should solve all the problems of individuals, a recipe for voter disenchantment.

If there’s one thing you’d expect Labor politicians to understand it’s the need to ‘do the numbers’ - make sure you have enough support for a proposal before you make it public and risk losing face if you then have to seriously modify or even abandon it in the face of vigorous opposition. Partly this is about pre-marketing controversial ideas to find small modifications that could significantly reduce opposition, without any loss of face. Partly it’s about conditioning people’s expectations and also allowing the leaders of key interest groups to condition their supporters’ expectations. Everyone appreciates a heads-up; no on enjoys being caught by surprise. Consulting before announcement rewards and encourages loyalty among natural supporters eg the unions, and builds trust with non-supporters eg business.

The sad story of the resource super profits tax is a case study. The tax was intended to be no more burdensome than the miners would reluctantly accept, but in the event the big three objected so strongly they declined the opportunity for post-announcement consultation and set out to bring about the government’s electoral defeat. The miners had signalled their willingness to accept a profits-based tax, but seem to have been expecting an extension of existing petroleum resource rent tax (which is roughly what they ended up with). The only warning the miners had was being told of the government’s plan the day before it was announced. The proposed tax was in a highly sophisticated form unfamiliar to the miners (and their financiers), but the bigger problem was Treasury’s gross underestimate of the revenue the tax would raise. When, after weeks of public battling, the government finally realised the extent of this miscalculation, it soon agreed to change the tax in ways that reduced its revenue-raising potential to about what had been originally intended. This was seen by the public as a huge backdown in the face of opposition from a powerful foreign interest group. But worse, in the process the tax was butchered, greatly reducing its intended efficiency benefits. Had the government known the tax’s true revenue-raising power beforehand, it would merely have halved the rate at which it was imposed, from 40 per cent to 20 per cent. Had that happened, the miners’ opposition would have been greatly reduced and no one would have thought any the worse of the government. And the government would have been much better informed in advance of any announcement had it released the Henry report for public comment soon after receiving it, rather than releasing it simultaneously with the announcement of its response. The miners would have known what was being proposed, could have done their sums as to its effect on them and privately warned the government about their misgivings. Taking another example, I believe the controversy over the government’s reservations about the budgetary cost of equal pay is another case where pre-consultation could have saved the government a lot of skin.

This government lacks the confidence that should come from incumbency, that should embolden it to take calculated risks in support of good policy and should, in turn, foster the electorate’s confidence that the country is in safe and competent hands. This is a circular process: acting confident makes the electorate confident in you, which justifies and reinforces your own confidence. Instead we find a government with an economic inferiority complex, always trying to hide behind the authority of others: the allegedly ‘independent’ Treasury, the Henry report, the Murray-Darling Basin Authority, the NBN business case etc. Rudd would also have co-opted the Reserve Bank to his management team had the (genuinely independent) Reserve not politely declined.

Because of the human fallibility of the electorate, politics abounds in paradoxes. But Labor has no instinctive understanding of paradox. When you’re not conscious of paradox - when you don’t realise the public is perfectly capable of holding logically inconsistent attitudes - you’re easily misled by focus groups. One paradox is that though voters don’t welcome hip-pocket pain, they want to be led by someone with the strength and confidence to inflict pain when he or she believes it to be in the nation’s best interests. This explains why even those who feared the hip-pocket cost of the ETS reacted with disillusionment to Rudd’s decision to ditch it. From all he’d said, we really needed it, but he was willing to shirk his leadership responsibility to avoid unpleasantness. What’s particularly worrying is that none of those still at the helm of the post-Rudd Labor Party foresaw the price this expediency would extract. By contrast, Howard pressed on with his far more unpopular ‘great big new tax on everything’, the GST, and (narrowly) survived. What got him over the line was the public’s grudging confidence that he must be doing this unpleasant thing because the country really need it to be done.

Another paradox is that the more concessions you make to interest groups, the more you stimulate rather than satiate the demand for concessions. Show me you’re a soft touch, and I come back for more. Let me see rival interest groups getting in for their cut and I’ll hasten to join the queue. But let me see that nobody else is getting much and I won’t feel bad about getting little myself. The Hawke-Keating government had an objective of trying to stamp out the rent-seeking culture. It wasn’t always honoured, but it served the government - and good policy - better than what we have now.

Another paradox is that the public will overlook individual bad practices for a long time, but eventually the smell will reach a point that registers with the electorate and causes it to turn away in disgust. Individual controversies over conflicts of interest - failure to declare interests; politicians taking jobs with interest groups soon after leaving parliament - don’t excite much interest in the electorate, but if there’s sufficient controversy over time to convince people a government is merely feathering its own nest, it’s in trouble. Politicians devote much time to crafting arguments - often using statistics - designed to mislead without actually lying. People haven’t the knowledge, time or interest to get to the bottom of arguments of this type. They just conclude both sides are lying. It took a long time for politicians to break sufficient promises for the public to conclude that all politicians break almost all promises. I doubt it’s possible for governments to keep a high enough proportion of their promises for sufficient years as to turn that perception around.

One paradox most politicians do understand is that, in this big and complex world where no one has the time to pay the attention they should, voters’ perceptions about things are more important than the reality of those things. Indeed, as the pollies say, ‘the perception is the reality’. There’s much truth to this. But you can push it too far. Neglect the underlying reality of effective service delivery badly enough for long enough and no amount of effort to manipulate perceptions will hide the unacceptable reality. Once you reach that point, nothing you say will be listened to and nothing you do to remedy the situation will help you. This is the story of the long demise of the NSW Labor government.

A final paradox is that when you’re surrounded by risks whichever way you turn - when you’re a minority government, for instance - and are most inclined to proceed cautiously, that just when you need to be bold. Why? Because the public’s reaction to leaders is instinctive and unconscious. They’re impressed by confidence and courage and unimpressed by uncertainty and timidity. They can tell when you’re faking it.

Gillard says she must ‘govern from the centre’ if she’s to win sufficient votes to hold government. This attitude is based on the notion that each side has core support of about 40 per cent, leaving them battling to attract a majority of the remaining 20 per cent of uncommitted, swinging voters in the middle. Market research reveals the uncommitted middle to be social conservative, uninterested in politics and very hip-pocket in its attitude to economics.

But in this, too, Labor is showing signs of amateurism - and being a slow learner. It’s true you can’t get too far from the centre, but it’s not true you should be right in the centre. If you’re Labor you have to govern from left of centre just as, if you’re Liberal, you have to govern from right of centre (as Howard did). You can’t get too far from the Left (or, for the Libs, the Right) or you’ll lose too much of your base, your core support. If you’re right in the centre - neither Left nor Right - you lose your identity, your defining characteristics. Apart from your party name, you don’t look like anything in particular and who wants to vote for you? Not a lot of your base vote and not a lot of the swinging middle.

This, of course, is the story of Labor at this year’s election. It lost a lot of its base to the Greens, but at the same time failed to attract many in the middle, meaning its primary vote fell 5.4 percentage points to 38 per cent - as we’ve seen, federal Labor’s fourth lowest primary vote since the beginning of the two-party system in 1910. In Western Australia its primary vote got down to 31 per cent, in Queensland, 34 per cent. NSW was a fraction below the national average. Humans are meaning-seeking animals. They want to know what leaders and their parties stand for and be able to put them in one box or another. Particularly because of its inferiority complex on economic management, Labor tried to turn itself into a pale imitation of the Liberals and, unsurprisingly, not enough people wanted to vote for it. If that short of thing appeals, why not vote for the real thing?

Particularly because of its decision to abandon the ETS, Labor lost a lot of its primary vote to the Greens, and also Tanner’s seat of Melbourne. Does this matter if it all comes back in preferences? Yes. Not all of it comes back and, in the Senate, it doesn’t come back. In those state elections with optional preferential voting it may not come back. In a growing number of inner-city seats it doesn’t come back if the Greens come second, the Libs come last and the Libs preference the Greens. The Libs didn’t do that in the recent Victorian election, but this just puts Labor at the mercy of the Liberals’ goodwill. It’s clear that, had the Libs preferenced the Greens, Labor would have lost three seats in Victoria. It may well lose some at the coming NSW election.

Experienced politicians know that first you hold your base vote, then you attract enough of the middle. Howard was always rewarding the Liberal heartland with baubles: a tax rebate for private health insurance, a school grants formula biased in favour of elite private schools, concessions for self-funded retirees and so forth. As Costello has said of Labor, ‘a party that can’t hold its base is heading for long-term decline’. One of the great lessons of economics is that we rarely face either/or choices. Rather, the trick is to find the best trade-off between conflicting objectives. To say Labor has no choice but to govern from the centre is to pick one extreme over the other. Labor needs to look like Labor and do enough to satisfy its base while also finding policies that will attract sufficient of the swingers.

Howard has said, ‘you have to spend political capital on reforms’. Labor ministers often decline to adopt worthwhile but difficult policies, privately telling supporters ‘we can’t sell that’. My response is: Then when are you moving to a profession to which you might be more suited? Politicians who can’t sell good policy can’t do their job.

The year ahead

Right now, five out of nine parliaments in Australia are hung. Someone has calculated that 15 of the 16 minority (state) governments in Australia since 1989 ran their full term. The reason for that isn’t hard to discover: the independents who prop up those governments have no desire to risk bringing their positions of prominence and power to an early end. So I think it’s reasonable to assume there’ll be no federal election in 2011.

Gillard would no doubt like to be able to put her own stamp on the government’s agenda, but she’ll have quite a wait before she can because Rudd left her with a long list of unfinished business. She says 2011 will be ‘a year of delivery’ and ‘a year of decision’. Anything she wants to put through the Senate before July 1 will need the support of Fielding and Xenophon and the Greens if it’s opposed by the opposition; anything after then will just need the support of the Greens.

Gillard needs to resolve the ambiguity in her deal with the big three miners on the minerals resource rent tax concerning whether the feds will cover the miners for future increases in state royalties (which would be equivalent to writing the states an open cheque) and also decide on any modifications to accommodate the smaller miners excluded from the election-eve deal. Enacting the mining tax will allow the government to legislate for the rest of the tax package: the phasing up of compulsory super contributions to 12 per cent by 2019, cutting the company tax rate by 1 percentage point to 29 per cent, and so forth.

The tax summit will be held in the middle of the year, but I’ll be surprised if much comes of it. The Henry report was commissioned before the global financial crisis, when the government believed it would have a big budget surplus and plenty of spare revenue to compensate the losers from reforms to be announced before the 2010 election. The budget deficit has put paid to all that, with the government committed to bank all revenue growth and avoid tax cuts until the budget surplus is back to 1 per cent of the GDP. If the economy is booming at that time it will be under pressure to continue avoiding measures that could make fiscal policy pro-cyclical. This greatly reduces its scope for significant reforms.

The more health economists and others have studied Rudd’s reforms to health and hospital funding the less enthusiastic they are. The growing number of Liberal premiers is also unenthusiastic about giving up 30 per cent of their GST revenue, but Gillard will have to get on with legislating the deal that the feds take over 60 per cent of hospital funding, which is supposed to start in July.

The government will keep working on its decision about the plan for the Murray-Darling Basin. The early signs are that it won’t have the courage to adequately increase environmental flows. It will also keep working on the search for a regional solution to its asylum-seeker problem.
Ross Garnaut will release his updated report on climate change in May and the Productivity Commission will publish its advice on the measures being taken by our trading partners and on the impacts of a carbon price on our international competitiveness. Gillard announced recently that the government will decide by the end of the year on the way it will price carbon. This is likely to be a carbon tax - at least initially - rather than an ETS.

Looking further into the future, if the Gillard government runs full term she’s likely to find that, by 2013, the present coalition governments in Western Australia and Victoria will have been joined by coalition governments in NSW and Queensland. This may make COAG meetings more difficult, but it’s likely to improve federal Labor’s chances of re-election. Many voters like the idea of an each-way vote between federal and state, just as many like the idea of federal governments not having a majority in the Senate. Even so, Labor will need to become a lot cannier and a lot more courageous if it’s to win re-election. From her performance so far, I’m not confident Gillard will pull it off.

Observations on monetary policy

It’s been another bad year for business economists and markets in their attempts to second-guess the Reserve Bank’s rate adjustments. I said that last year but - though I haven’t counted up - this year has been a lot worse, with the ratio of misses to hits way up. It’s become a lot harder for you guys to predict now the nation’s economics editors have retired from the prediction game. But that’s the way the more loud-mouthed of your brethren seem to have wanted it.

I should say, however, that market economists’ predictions have been closer to the mark - or less far off the mark - than market pricing. Why? Because the markets are still too focused on what’s happening in the US, whereas the economists have twigged to how heavily the Reserve’s thinking is influenced by developments in the Chinese economy.

I’ve said many times that monetary policy is as much an art as a science and that it’s set in the governor’s gut. All I’d add this year is that this governor’s gut decides which way it’s jumping at the last possible moment. So if he has so much trouble making up his mind, it’s hardly surprising you guys have trouble second-guessing him.

You guys generally get the direction of changes right, and you seem to have figured out that, in all but exceptional circumstances, the size of moves is 25 basis points, but you have a lot of trouble picking at which meeting the change will be made. I guess because you rely on fundamentals rather than chartism, you don’t seem to have explored one potential guide to the timing of moves: bureaucratic neatness. This idea occurred to me when I realised we’d had a Melbourne Cup day rate change for five years in a row. Could this be purely by chance? I decided to do some arithmetic. Over the past five years the Reserve has changed rates 20 times. Since there are 11 meetings a year, if decisions to change rates occurred at random, each month would have a 9 per cent chance of being chosen for a rate change. The four meetings a year that are preceded by the release of the CPI and followed immediately by the release of the statement on monetary policy, would account for just over 36 per cent of random chances. But, in fact, the SoMP months - February, May, August and November - accounted for 65 per cent of rate changes, with November alone accounting for 25 per cent. The point is that the Reserve has set up a pattern in which the SoMPs come soon after the meeting that comes soon after the CPI release, and two of the SoMPs come not long before the Reserve’s twice-yearly appearance before the parliamentary committee. Remember, too, that the release of the CPI is a key influence on the revision of the Reserve’s inflation forecasts, which are published in the SoMP and which heavily influence decisions about rate changes. The SoMP serves as the main vehicle the Reserve uses to explain and defend its rate decisions. Is it surprising that, having carefully set up the timing of its key publication and parliamentary appearances, the Reserve is more inclined to fit its decisions into that timetable?

But why in the past five years has the November pre-SoMP meeting had more than twice the hits that the other three pre-SoMP meetings have had? Perhaps because of an unconscious desire to get the books straight before the end of the year and the knowledge that what you’ve done has to tide the economy over until February.

Glenn Stevens offered some cryptic clues to his thinking and behaviour in his recent parliamentary testimony. He noted that decisions at particular meetings are often finely balanced. When you’re moving in baby steps of 25 points, it’s hard to believe that going now or waiting a month for more data will make much difference to ultimate macro outcomes. If the decision isn’t finely balanced - if it’s quite clear what you need to do - it’s a sign you’ve got behind the curve.

Stevens tacitly admitted that monetary policy isn’t as forward-looking and pre-emptive as it should be. He couldn’t think of any time when it later became clear the Reserve had tightened too soon, but he could think of ‘several times’ when it should have tightened earlier. This is a reference to the first half of 2007, when the Reserve should have tightened further but didn’t because of two successive CPI results that were falsely reassuring, and ended up having to tighten before and during the election campaign. The proposition is that the more timely your tightening, the less you end up having to do. The lesson from this episode is that you have to trust to your judgement of the big picture - which embodies your core beliefs about how economies behave - and not be too swayed by bits of data than don’t fit.

I think Stevens’ remarks alluded to two different circumstances: when you know you’re behind the curve and when you know you’re not. When you’re not behind the game - which should be most of the time - increases are likely to be ‘only fairly gradual and not very close together’. (Say, before each quarterly SoMP?) When you believe you are behind the game, however: ‘I think it is better really to move in a reasonably timely fashion to a point where you might be able to rest for a while. That is a better position to be in.’ I think this explains Stevens’s behaviour between October last year and May this year. He kept saying he was going to move ‘gradually’ towards ‘normal’ (neutral), but in fact he moved at six meetings out of seven (with only two of them SoMP meetings). Why? Because he knew he was behind the game: he’d cut like mad fearing a severe recession but the recession was proving to the remarkably mild so he was anxious to get back to neutral without delay. He eventually decided the banks’ extra rate rises had shifted neutral down from 5.5 per cent to 4.5 per cent, and once he reached that point in May this year, he rested for six months before deciding it was time to start gradually tightening into the restrictive range.

Looking to the monetary policy outlook for 2011, at the parliamentary hearing Stevens gave a lot of hints about the timing of his next move. Quote: ‘What it means is that for the period we are going into in the near term I think this is about the right level. At the moment most commentators do not anticipate and market pricing does not anticipate any further near-term change by us for quite some time. I think that is probably a reasonable position for them to have based on the information we have now.’

But exactly how long is ‘in the near term . . . for quite some time’? I think it’s a guarantee that’s already expired: it applied only to the December meeting - and so, of course, will carry us through to the February meeting. But it leaves the February decision an open question. So if you rule out a February rise you’re doing so on the basis of your own judgment, not a clear indication from the boss.

My call for next year is that, assuming the economy continues to strengthen as forecast but there’s no rapid build-up of inflation pressure, we’ll see another two or three tightenings, well spaced over the course of the year.

Ross Gittins 2011 Outlook