Saturday, December 3, 2011

How budget update affects stance of fiscal policy

The most remarkable thing about this week's mini mini-budget is how many words the media could spill without clarifying a rather important question: how will it affect the economy?

One of the ways politicians (and journalists) make such announcements sound big is by giving us the cost of measures ''over four years''. But the economy is lived through, and managed, one year at a time. So it's the year-by-year figures that matter most.

We know the avowed purpose of the spending and tax measures announced along with the midyear budget update was to get the budget back on track to return to surplus in 2012-13, as Julia Gillard promised in the election campaign.
The return to surplus had been put in doubt by the effect of the turbulence in Europe on the confidence of our consumers and business people, which is stopping the economy growing as quickly as had been expected at budget time.

In consequence, tax collections are now expected to grow by about $5 billion in 2011-12 and $6 billion in 2012-13 less than earlier thought. With other revisions, this would have turned the expected surplus in 2012-13 of $3.5 billion into a deficit of $1.4 billion.

So what did Wayne Swan and Penny Wong do about it? Ostensibly, they found savings sufficient to get back to an expected surplus of $1.5 billion. But, as we'll see, it's not that simple.

We've been told repeatedly the announcement involved savings measures worth $11.5 billion over four years. We've been told less often it also involved new measures with a cost to the budget of $4.7 billion over four years.

So the measures' net effect is to improve the budget balance by a much more modest $6.8 billion over four years. Of this, just $2.9 billion relates to next financial year, the year the government's concerns are focused on.

Is $2.9 billion a lot or a little? To you or me it's a king's ransom, more than we'd ever see in 400 lifetimes. But that's not the relevant comparison. Since we're interested in the budget's effect on the economy, it's the size of the economy that's the appropriate comparison.

The nation's annual income (from its production of goods and services, gross domestic product) is about $1.4 trillion ($1400 billion). So $2.9 billion represents a mere 0.2 per cent of our annual income.

You'd thus be justified in concluding that, from a macroeconomic point of view, the measures included with the revised budget estimates on Tuesday weren't worth worrying about. But there are ways of viewing this week's new information that make it seem a much bigger deal.

Consider this. The Reserve Bank's rough-and-ready way of judging the budget's effect on the economy is to look at the direction and size of the change in the budget's underlying cash balance from one financial year to the next.

At the time of the budget in May, the government was expecting a deficit in 2010-11 of $49.4 billion (equivalent to minus 3.6 per cent of gross domestic product) falling to a deficit of $22.6 billion (minus 1.5 per cent) in the present year, 2011-12, and then becoming a surplus of $3.5 billion (plus 0.2 per cent) in the target year, 2012-13.

So, measured against GDP, it was expecting an improvement in the budget balance of 2.1 percentage points this financial year, followed by an improvement of 1.7 percentage points next year.

Now, those proportions of GDP clearly were a big deal. They represented a very rapid reduction of the budget's net support to the economy. So I judged the ''stance'' (setting) of fiscal (budgetary) policy envisaged in the budget to be ''highly contractionary''.

This turnaround in the budget balance was to be brought about by three factors. First, the withdrawal of the earlier fiscal stimulus as its temporary spending came to an end. Second, the effect of the government's ''deficit exit strategy'' of holding the real growth in its spending to no more than 2 per cent a year and granting no further cuts in income tax.

But the third factor was central: the economy's expected strong recovery from the mild recession of 2008-09 would cause faster growth in tax collections and a fall in spending on dole payments. In other words, much of the improvement would come from the operation of the budget's in-built ''automatic stabilisers''.

Right. So how has that picture been changed by the revised forecasts for the economy and the new spending and tax measures announced on Tuesday? The government recorded an actual budget deficit of $47.7 billion (minus 3.4 per cent of GDP) last financial year. It's now expecting a deficit of $37.1 billion (minus 2.5 per cent) this year and a surplus of $1.5 billion (plus 0.1 per cent).

Looking at that the way the Reserve does, the government is now expecting an improvement of 0.9 percentage points (rather than the earlier 2.1 points) this year and 2.6 percentage points (rather than 1.7 points) next year.

Taking those figures at face value, you'd say the stance of fiscal policy was now planned to be much less contractionary this year, but a fair bit more contractionary next.

Some economists have observed that this would involve ''the sharpest improvement in the budget balance for four decades'' and would mean the budget acting as a ''substantial drag on economic growth'' in 2012-13.

Just one small problem. Much of the alleged blowout in this year's deficit and seeming rapid improvement in the budget balance next year arises not from the revised economic forecasts or the substantive spending measures, but from what the government euphemistically refers to as ''reprofiling'' - shifting intended spending and tax measures around between years.

In particular, the government took net spending of roughly $4.8 billion that should have occurred in the target year, 2012-13, and moved it forward to the last two months of this year, 2011-12, thus artificially worsening the comparison of the two years by double that amount, roughly $9.6 billion.

It also improved the target year's budget balance by about $850 million by delaying for a year the start of various tax concessions associated with the mining tax package.)

So, measured the Reserve Bank way, the ''underlying'' stance of fiscal policy remains pretty contractionary in both years - and, after you look through the reprofiling, not greatly changed.

This stance seems appropriate, remembering the economy is close to full employment and monetary policy can be eased (interest rates cut) should that prove necessary.

Wednesday, November 30, 2011

Farmers fall silent while food brings home the bacon

Sometimes, as when Sherlock Holmes solved a mystery by noting the dog that didn't bark, the story is not what happened but what didn't happen. If so, don't hold your breath waiting for the media to tell you such a story. Omission is much harder to notice than commission.

But let me ask you - in this year of endless complaint about the supposed two-speed economy - what's been missing? The retailers have been doing it tough and they've let everyone know. The high dollar is great news for consumers - overseas holidays are booming - but bad news for those of our industries that sell on export markets or compete against imports in the local market.

We keep hearing about the difficulties our manufacturers have encountered and, to a lesser extent, the problems facing our tourism industry (see above). Now we're hearing of staff cutbacks in universities because foreign student numbers are down.
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But who haven't we heard from?

A clue - which dog usually barks the house down every time the dollar goes up? Another - which industry contributed to our economy's boom and bust in the mid-1970s by virtually forbidding the McMahon government to revalue our currency in response to a world commodity boom?

That's right, the farmers. So, have they been suffering in silence for once in their lives? Have they, unlike other industries, stoically resisted the temptation to blame all their problems on a Labor government?

No, nothing so worthy. We've heard nothing from the farmers because they've been doing quite well for themselves. And we never hear from farmers when times are good. City slickers never get invited to the harvest festival for fear of undermining the media's stereotype that ''the man on the land'' is ALWAYS doing it tough. In any case, who's interested in GOOD news about the economy?

You can find the story in the official statistics and forecasts, of course, but public officials know always to understate good news about the farm sector for fear of bringing the farmers' ire down on their heads. The few parts of farming that are the exceptions to the rule will declare all you say is lies.

Our farmers export about three-quarters of what they produce. With the exception of wool, the stuff they sell abroad is priced in US dollars. So when the Aussie dollar goes up, the money they earn in US dollars isn't worth as much to them back home.

That's just as true of our miners. They, too, have suffered from the rise in the Aussie. But they're not complaining because the prices they're getting in US dollars have risen by far more than the Aussie has gone up.

It's a similar story for the farmers, though on a much smaller scale. Since the start of the resources boom in early 2003, the prices being received by our miners have risen by 380 per cent in US-dollar terms. Thanks to the Aussie dollar's rise against the greenback, they've risen by a smaller 175 per cent in Australian-dollar terms - which is what the miners care about.

Over the same period, the prices being received by our farmers have risen 90 per cent in US-dollar terms and almost 10 per cent in Australian-dollar terms. (The rise in the Aussie isn't just a matter of bad luck for our miners and farmers. Since our dollar's been floating it has always risen, or fallen, roughly in line with world commodity prices. What these comparisons show is that rising rural commodity prices contributed to the higher dollar, along with rising minerals and energy prices.)

If that was all there was to the story we probably WOULD have heard whingeing from the farmers. But what matters to our farmers even more than what's happening to prices is what the weather's doing to the size of their harvests and other kinds of production. Whatever the price, the world will always take however many tonnes our farmers are able to produce.

And the truth is that, despite exceptions (West Australian wheat for one; the effects of flooding and cyclones), the weather's been a lot kinder to our farmers over the past year or two. It's rained when rain has been needed, there's been more water for irrigation and the moisture content of the soil has improved, allowing more dryland plantings.

This year's winter wheat crop is expected to be a near-record high of about 40 million tonnes and this follows a good harvest last year.

This financial year, our agricultural export earnings are expected to be the second-highest since 2002-03, even after allowing for inflation. Last year's earnings were pretty good, too.

Rises in export earnings are expected for wheat, wool, rice, canola, cotton and lamb, though wine exports continue to languish.

After a bad year in 2009-10, real farm income more than doubled last financial year. This year it's expected to be down only a bit from that.

Why are world agricultural prices so strong? Various reasons, but mainly because of the development of Asia and the steady rise in incomes of its many hundreds of millions of people. As low incomes rise, food consumption tends to increase. And the increase is concentrated in the more expensive types of food.

So food prices are rising for much the same reason minerals and energy prices are rising. And that says they've got a long way further to rise over coming years. Whichever way you look, Australia is sitting pretty in the Asian century. The only shadow over the future of farming comes from climate change and our long mismanagement of water.

Monday, November 28, 2011

Econocrats get smarter on dodgy forecasts

You've heard the joke that economic forecasters are there to make weather forecasters look good. What you haven't heard is that the nation's top economic forecaster, Glenn Stevens, the governor of the Reserve Bank, thinks the joke "has something going for it".

There's an even older joke: everybody complains about the weather, but no one does anything about it. Actually, nothing we could do would change the weather. But, as Stevens remarked in a speech to the Australian Business Economists last week, some decisions based on economic forecasts can alter what happens (thus making forecasting the economy even harder than forecasting the weather).

That's true of the decisions made by central banks and governments, but it's also true of decisions made by businesses and households - even when their "forecast" is no more sophisticated than a bad feeling or a good feeling about how the economy's travelling and what lies ahead.

Actually, you can't not make a forecast. Even if you refuse to think about the future, you're implicitly making a forecast that things will stay as they are.

The Reserve Bank has no choice but to make the best forecasts it can because it can take two or three years for a change in the official interest rate to have its full effect on the economy. So the Reserve has to act before things get off the rails. Were it to wait until problems actually happened, it would always be acting too late.

But something I've always admired about the Reserve, and Stevens in particular, is their humility and realism on the subject of forecasting.

"It is only natural to desire certainty," he says. "Everyone wants to know what will happen. We all want to believe that someone, somewhere, does know and can tell us what to expect. But the truth is that the best we can do when talking about the future is to speak about likelihoods and possible alternative outcomes."

Like almost everyone else, the Reserve has expressed its forecasts as a "point estimate" - one number. But this gives forecasts an air of precision they don't possess. They're actually a "central forecast" within a range of possibilities.

People (and journalists) who don't understand this can attach too much significance to small changes in forecasts, or to small differences between the Reserve's forecasts and Treasury's. (Tip: they're never going to be very different because they're produced in the same factory, the Joint Economic Forecasting Group.)

Stevens says that "when consideration is given to the real margin for error around central forecasts, such differences are often, for practical purposes, insignificant". "When comparing forecasts, if we are not talking about differences of at least 0.5 percentage points, the argument is not worth having."

Consider this. In the case of a year-ended forecast for the growth of real gross domestic product four quarters ahead, the record over the past couple of decades says the probability of a point forecast being accurate to within 0.5 percentage points is about 20 per cent.

Experience since the start of inflation targeting in 1993 says the probability of underlying inflation over the next year or the next two years being within 0.5 percentage points of the central forecast is about 67 per cent. That is, if the forecast was 2.5 per cent, the chances of the outcome being between 2 and 3 per cent would be about 67 per cent.

"So any point forecast will very likely not be right," Stevens says.

According to Stevens, it would be vastly preferable for discussions of forecasts to be couched in more "probabilistic" language than tends to be the case, and for there to be more explicit recognition that the particular numbers quoted are conditional on various assumptions. To this end, the revised forecasts the Reserve published earlier this month, particularly those for the year to December 2013 (that is, more than two years away), were expressed as a 0.5 percentage point or even 1 percentage point range. Now you know why.

And, Stevens adds, the forecasts include "more extensive discussion these days of the ways in which things could turn out differently from the central forecast". "This goes at least some way to recognising the inherent uncertainties in the forecasting process, and is also important in relating the forecast to the policy decision."

But if forecasts are so dodgy, why bother? Why not merely assume things don't change, since that at least would be quicker and cheaper? Stevens insists economists can shed useful light on the future.

"We know something about average rates of growth through time," he says. That is, forecasts that the economy will return to its trend rate of growth are likely to be closer to the truth than forecasts that it will stay at the rate it is now.

Stevens says economists also know something about the long-run forces that produce economic growth: productivity and population growth. "We know that there have been, and will be again, periods of recession and recovery, though our ability to forecast the timing of those episodes is limited," he says.

"We know from experience some things about the nature of inflation, including its characteristic persistence, and the things that can push it up or down." But above all, Stevens says, we know some of the "big forces" working on the global and local economies at any time. The two big (and conflicting) forces at present are the resources boom and the troubles of the euro.

A lot of the work of forecasting boils down to weighing up the net effect of the conflicting big forces at the time. We'd be better off debating and understanding the effects of those forces than arguing about point estimates.

Saturday, November 26, 2011

Why economists are obsessed by the resources boom

The world is throwing two big things at our economy. One is new, exciting, even frightening, and is getting all the headlines. The other is old news and getting boring. But get this: the boring one is by far the more important.

The new and exciting story is the increasingly worrying developments in the euro area. The old story is the resources boom. Both come to us from the rest of the world. In terms of their effect on our economic growth, the resources boom is a huge stimulus, whereas Europe's problems are a drag on our growth. That drag is small so far but, if the worst comes to the worst, could be a big negative.

Another reason the commodity boom is less exciting is that we've had plenty of them before over our history. But one reason we shouldn't underestimate the boom is that, paradoxically, previous booms have really stuffed up our economy. And these booms can be great for some parts of the economy while making life really tough for other parts.

This week Treasury's Dr David Gruen gave a speech to the Australian Business Economists in which he compared this commodity boom with the one we had in the early 1970s. It helps you see why the econocrats who manage our economy are positively obsessed by the need to make sure we don't stuff this one up.

In contrast to this one, the commodities boom of the early '70s involved big rises in the prices we were getting for our agricultural exports. It got going under the McMahon Coalition government and continued under the Whitlam Labor government.

Comparing the two booms, after the first three years our terms of trade - the prices we receive for our exports compared with the prices we pay for our imports - had improved by about the same extent. In the '70s, they then fell back. This time, however, they continued improving to now be almost 50 per cent better than their best then.

So this boom is a mighty lot bigger - Gruen calls it a ''once-in-a-lifetime boom'' - and a lot longer. This one's been building for eight years (with a brief interruption by the global financial crisis), whereas the earlier one lasted only about three years. The reason this boom is much bigger and longer is that it arises from a historic shift in the structure of the world economy - the industrialisation of Asia - whereas the '70s boom arose merely from an upswing in the rich countries' business cycle.

The greater size and length of this commodity boom has two important implications. First, it's given our miners both the incentive and the time to invest in hugely increasing their capacity to export coal, iron ore and now natural gas. That didn't happen with farmers in the '70s. This present investment boom has added an extra dimension to this boom, thus causing its effect on the economy to be bigger.

Second, the '70s boom was too small and short to have much effect on the industry structure of our economy. But this boom will leave us with a much bigger mining and mining-related sector, thus reducing the relative size of other sectors and putting a lot of pressure to adjust on some industries, particularly manufacturing, tourism and education. It's actually changing our economy's ''comparative advantage'' (what we're good at relative to other countries).

Naturally enough, both commodity booms caused the economy to grow faster. But in the '70s growth was a lot more variable. Real gross domestic product grew almost 9 per cent over the year to March 1973, but by 1975 the economy was contracting. It recovered, then contracted again in 1977. Unemployment, which had been very low for many years, shot up and stayed up. This time, growth has been strong but steady and unemployment has fallen and then stayed pretty low.

In the '70s, the inflation rate took off, reaching a peak of 17 per cent in the mid-1970s and staying pretty high until the mid-1990s. Obviously, the '70s commodities boom can't take all the blame for this long period of economic malfunctioning. But it should get a fair bit, and it certainly got the rot off to a good start.

There's one other big difference between the two booms that does a lot to explain why this boom hasn't caused nearly as much volatility, inflation and unemployment as the first one did: the exchange rate.

The present boom quickly brought about a rise in the value of our dollar. Since June 2002 it has risen by about 45 per cent against the trade-weighted index. In the '70s, the rise didn't happen nearly as quickly or smoothly.

Why not? Because then we had a fixed exchange rate. It could be changed only by a government decision. For political reasons, the two governments waited too long and didn't do enough to get the dollar up.

The point is that our floating currency acts as a shock-absorber when the economy is hit by some shock - favourable or unfavourable - from abroad. In this boom, the higher dollar has caused the Australian-dollar income of the miners to rise by less than it would have, and has effectively handed that reduction in their income to all the other industries and individuals who buy imports. How's it done that? By making imports cheaper.

By transferring income from the miners to the non-miners, the high dollar has helped ensure the rest of Australia gets its cut from the boom, but it's also reduced the size of the commodity boom's effect on the growth in gross domestic product by directing a fair bit of the increased demand into imports. This has caused the boom to generate less inflation pressure, as well as directly reducing the prices of imported goods and services.

So it's clear the present boom has had far more benign effects on the economy than the '70s one did. Our economic managers get a lot of the credit for that, but much credit is due simply to our floating exchange rate.

Gruen concludes, ''if a sizeable boom is being generated in one part of the economy, significant restraint needs to be imposed on other parts to ensure that the economy overall does not overheat''. See what he's saying? Yes, you're right, there is a multi-speed economy and manufacturers and service exporters are doing it tough. But that's not happening by unhappy accident, it's happening by design. Live with it.

Thursday, November 24, 2011

Outlook for politics and government in 2012

Talk to Australian Business Economists Annual Forecasting Conference
Sydney, November 24, 2011

Taken as a whole, the first full year of the Gillard government has been terrible. Julia Gillard has hardly taken a trick all year and her present standing in the polls is worse - much worse, consistently worse - than it was at last year’s election, when she failed to attract enough votes to form government in her own right. Her present primary vote in the low 30s would give her zero hope of winning an election. Only if she could get it up to at least 40 per cent would she be in the hunt. This time last year - three years out from the next election, assuming the government runs full term - I fearlessly predicted Labor would lose it, because ‘this generation of Labor is terminally incompetent’.
Having made that call, I’m sticking to it. I’m doing so even though I know full well how easily the political outlook can change over a period as long as a year, let alone two years. After all, who would have predicted in October 2009 that the election would be months early and fought not between Kevin Rudd and Malcolm Turnbull, but between Gillard and Tony Abbott, that Abbott would come within a whisker of winning and that Labor would be forced into an alliance with the Greens and rag-tag independents?

But I have to add that, at the end of her first year, Gillard and her government are looking in better shape than they did half way through it. The first point to acknowledge is that she’s held her minority government and its alliances together for a year - longer than many people expected - and it’s never seriously looked in trouble. The second is that it’s been a year of great achievement. The opposition has frequently criticised Labor for being unable to actually do anything but, as was always Gillard’s intention, this has been a year of ticking off items on the to-do list - in particular, the various items inherited from Rudd. Of the three big problems he left her, the carbon tax has been put to bed, the mining tax is well on the way and only the asylum-seeker issue remains chronically unresolved. Along with Gillard’s opportunity to be seen looking like a leader on the international stage with other leaders, these runs on the board do much to explain her recent slow improvement in the polls, in the two-party preferred and, particularly, as preferred prime minister.

While the polls continue moving in the right direction - however slowly and with however far to go - Rudd is unlikely to mount a challenge. There’s no reason to doubt his desire to return, and should the poll recovery falter, we’re likely to hear from him. Would the caucus ever turn back to him? There is so much continuing dislike of him they’d have to be terribly desperate, but it’s not impossible. Would it help? No. His grass-is-greener popularity in the polls would soon evaporate as voters were repulsed by this ultimate proof of Labor’s disloyalty, ruthlessness and lack of principle.

Next year should be a year of consolidation and less frenetic policy making, with the government needing to be sure the introduction of the carbon price arrangements goes smoothly. Should the world economy stay on track, the government will press on with its priority of returning the budget to surplus - as, in all the circumstances, it should. Should things go really bad in Europe, the primary response will be from the Reserve Bank, but the government will at least have to reverse its rhetoric and allow the budget’s automatic stabilisers to widen the budget deficit, and may need to consider a new round of fiscal stimulus. For Abbott and the opposition it will need to be a year where, finally, they make their contribution more constructive, outlining their own plans for improvement - even if, as ever, they leave the revelation of their detailed policies until much closer to the election. The longer Abbott continues with his relentless negativity, the more he risks trying the patience of voters.

Can we be sure the minority government arrangement will hold together for another year? No. But the grubby deal to install the former-Liberal Peter Slipper as speaker means it now would take two by-election losses to bring Labor undone. It also reduces Labor’s dependence on any particular independent. And by now it ought to be clear to all that the independents on whose votes Gillard relies have much to gain by continuing to prop her up and much to lose by deserting her. It should also be clear that achieving continued co-operation from the people whose votes she needs is one of the things Gillard is good at.

Why Labor is so bad at it

I have no problem putting the boot into politicians who are flying high, but I don’t enjoy kicking people when they’re down. If for no other reason than that I prefer to be ahead of the conventional wisdom. But I can’t take a look at the political scene and not address the obvious challenge for political analysts: why exactly is this version of Labor so bad at governing?

A host of explanations has been offered, many of which have only some degree of truth and some of which are more in the nature of excuses. One we can dispense with is that it’s all down to the personal failings of Rudd. He had many failings and he left Gillard with a terrible inheritance of a far too long agenda of half-finished policy projects, but we’ve seen enough to know things didn’t immediately look up after his departure.

A favourite excuse of Labor and its supporters is that it’s been turned on by the Murdoch press. It’s true The Australian has turned from being a newspaper to a product aimed at gratifying the prejudices of a particular segment of the audience, but it is - by commercial design - preaching to the already converted. Its influence is limited to those silly people in Canberra who continue to take it seriously, imagining it still to be a newspaper. As for the depredations of Sydney’s Daily Telegraph, it was ever thus. That organ has been a vehicle for foisting the bosses’ views on workers since it was owned by Frank Packer. It’s true the radio shock jocks often take their line from those two outlets, but were they not available the jocks would just have to work harder to find their sources of daily indignation. So, sorry, but I think the Murdoch excuse is greatly overdone. It falls into a class of argument politicians trot out to sustain the faith of the party faithful, not because they believe it or expect the uncommitted to believe it.

I think part of the problem attaches to Gillard herself. The brutal circumstances in which she came to power count against her in the mind of many voters. I don’t doubt there’s an element of misogyny in the electorate’s failure to warm to her and that many people find her voice grates. But her deeper problem is her inability to come over on television as a warm and likable person. Some pollies have that ability, others don’t. Other politicians manage to substitute an air of paternal authority - don’t worry, father is in charge - for likeability (eg Malcolm Fraser, Maggie Thatcher), but Gillard can’t manage that, either.

Lack of an air of authority - leaders who look like leaders and hence command respect and compliance; leaders who seem legitimate - has plagued the Rudd-Gillard government. I’ve come to the conclusion that - at the federal level, at least - the Liberals really are the natural party of government. That’s what the electorate thinks, what business thinks, what the media think, what the Libs themselves think and what, deep down, even Labor thinks. On the central polling question of which party is best to handle the economy, the Libs always win. The Hawke-Keating government managed to out-poll the Libs for a while, but Rudd and Gillard never have. This is not a question of track record, but of long-held and deeply held stereotypes. The party of the bosses will always be better at managing the economy than the party of the workers.

This is what allows Abbott to turn opposition to outright obstruction without attracting criticism. It’s what allows Abbott to take the support of business for granted, while Labor knows it must always be seeking business’s approval. It’s what has allowed business to conclude Labor is anti-business even while Labor modifies its policies - including Fair Work - to avoid offending business. It’s what, in the battle over the mining tax before Rudd’s overthrow, allowed the public to believe the foreign mining giants’ ads claiming the tax would destroy the economy over their own government’s ads assuring them the tax wouldn’t be a problem.

It’s what explains the Libs’ ability to wind up the electorate over Labor’s mountainous deficits and debt and why few economists intervened to dispel the nonsense. It explains why the opposition has had an excessive influence over the government’s fiscal policy and why Labor is obsessed by returning the budget to surplus in 2012-13. It also explains why only at this point have economists entered the debate to attack the government’s deficit mania.

Labor’s universally assumed inferiority - combined with journalism’s highly selective approach to quoting evidence - explains the success of The Australian in convincing almost everyone - punters, gallery journalists and even Labor politicians - that most of the money spent on Building the Education Revolution was wasted.

Associated with Labor’s lack of apparent authority is the phenomenon of the slippery slope. When you’re in power and on top you get a lot of co-operation, compliance and tacit support from interest groups and the public generally - all of which help you stay on top. These benefits of incumbency give you the strength to stand up to particular vested interests and tide you through the ups and downs of the polls. But when your weakness in the polls becomes sustained, you hit the slippery-slope part of the curve where it becomes a lot easier to fall further than to claw your way back up. Where things start to unravel as people who formerly accepted the reality of your continuing authority begin to wonder how long you’ll survive, whether they should give you a push on your way and whether they should start cosying up to your likely vanquisher.

Though she seems to have made a little progress back up the greasy pole in recent days, Gillard has spent most of her time as PM sliding down the slippery slope. It’s a situation that emboldens your critics and opponents while making your supporters more cautious. So things have been unravelling. The denizens of the House with the Flag on Top - pollies on both sides, staffers and journalists - revere success, fear the successful and despise failure. Lindsay Tanner says the press gallery is either at your feet or at your throat. It shifts when it sees you languishing in the polls, emboldened to be a lot more probing and critical and take a lot less on trust. The denizens take the polls so seriously that everyone starts expecting anything you do will fail, and their expectations tend to be self-fulfilling.

One interest group that’s particularly susceptible to this behaviour is business. Business will live with a housetrained Labor government with a steady grip on power. But it does so against its natural preferences. Big business people expect Labor to court them, while quietly accepting it when the Libs choose to ignore or pressure them. Business is very unhappy with Labor and I have no doubt its disenchantment and its increasing willingness to make its unhappiness known is magnified by its perception the Gillard government is not long for this world. It’s willingness to accept the carbon tax has been diminished by Abbott’s success in turning public opinion against the tax. Its complaints against Fair Work - which don’t seem to have great substance - are directed mainly at persuading the next government to shift the balance back in favour of employers. If this does collateral damage to Labor between now and the election, so much the better.

Both the Rudd and Gillard governments seem remarkably inexperienced. This shouldn’t be an excuse because it’s unusual for incoming federal cabinets to have many members with previous ministerial experience. Labor doesn’t seem to realise that maintaining good relations with business isn’t just a matter of senior ministers trying to fit in as many boardroom lunches as possible, or even keeping in touch with the business lobby groups. It means having big business chiefs feel they can ring the PM about a problem and their being on the receiving end of calls from the PM to inquire about their views on relevant matters. The main union leaders would have such a relationship with the PM, but I doubt the business chiefs do. They’d know this and would feel alienated from Labor, especially because Howard was such a great private phoner of power-holders.

Similarly, Labor’s failure to make sure the big miners knew what to expect well before the unveiling of the resource super profits tax is a sign of inexperience. The name of that tax - chosen by Labor’s spin doctors - did much to convince the rest of the business community Labor was anti-profit and anti-business, without doing much to arouse the punters’ resentment of foreign mining giants. Labor’s PR people have been far too young, lacking much journalistic experience, let alone political experience. It should have recruited some old hands. Rudd treated his staff so badly he burnt through a generation of good advisers.

But Labor’s chronic inability to sell its policies to the electorate can’t be explained simply in terms of the inexperience of its spin doctors. It isn’t primarily about spin doctors. I think the root of this generation of Labor politicians’ problem - the key reason they’re so bad at governing - is their background. Unlike earlier generations, almost all of them are apparatchiks; they come from Labor’s professional political class: people who start working for ministers or unions straight from university and climb the Labor career path, never making a success of a career in the outside world or even spending a lot of time as an on-the-ground union official dealing with ordinary workers and disparate employers.

The trouble with this system is that it seems to be breeding a generation of politicians who don’t have a good feel for human nature and, above all, don’t give up their profession and enter parliament with a burning desire to make the world a better place. Their burning desire is to make cabinet minister. Their entry to parliament is a promotion and a pay rise, not any sacrifice. These guys don’t have deeply held values and convictions they’re prepared to fight for and run risks for. Their lack of conviction robs them of the ability to explain policies that arise from their framework of belief. They can’t fashion a compelling narrative of what drives them and where the government wants to take us. They lack the missionary zeal of someone like Paul Keating; they have no desire to convert. They think ‘selling’ policies is a matter for spin doctors and advertising agencies, not of working tirelessly to help people understand the vision and see why it’s so important. When you’re not passionate about explaining your policies, when you’re just a political player, you do what Labor has done from the moment it took office: focus on attacking your opponents, thus conferring them and their criticisms a status they wouldn’t otherwise have. When you’re not a passionate explainer, you avoid answering questions and merely repeat prepared lines.

The problem with all this isn’t just that you fail win public support for your policies, it’s also that the public can sense your lack of commitment and conviction, your preference for self-preservation over leadership, your interests over theirs. You lose authority and respect in the eyes of voters. Courage comes from convictions; public confidence in governments comes from people’s perceptions of your courage and conviction. As John Howard demonstrated with the GST, voters are perfectly capable of giving you grudging respect for pursuing a policy they don’t like the sound of.

Minority government may be the making of Gillard

But having said all that, I now have to highlight a qualification. At the end of its fourth year, Labor has now amassed an impressive list of achievements. Leaving aside its remarkably effective response to the global financial crisis, we have: paid parental leave, equal pay for community workers, plain packaging for cigarettes, the foundations for a national disability insurance scheme, a price on carbon, the likely passage of the minerals resource rent tax, and the continuing pursuit of compulsory pre-commitment on poker machines. (Admittedly, the mining tax was butchered and Labor’s health and hospital changes fell far short of their billing.)

Some of the items on that list may not greatly appeal to you, but they would to the Labor heartland. And it’s noteworthy that some of the items wouldn’t have been there had it not been for the insistence of those whose votes Labor has depended on to stay in government. On the carbon price, in particularly, Gillard had no choice but to press on with its early introduction. See what’s happened? The circumstances of minority government and the ferocious opposition of Abbott have left Gillard with no option but to take principled positions and stick to them through thick and thin. If her improvement in the polls proves lasting, it will be because her failure to win a majority has forced her to exhibit all the impressive qualities she seemed not to possess. Her steadfastness and ultimate achievement may be winning her the grudging respect of the electorate.

Provided she can hold the numbers in the House for another two years, Gillard should benefit from the effluxion of time. It will give people more time to get used to her idiosyncrasies and more time to tire of Abbott’s. And there’d be something very wrong if more than a year of living under the carbon tax didn’t cause people to lose their fear of it.

It’s interesting to observe the way conservatives have transferred the mantle of bogyman from the ALP to the Greens. Labor’s greatest crime is not being typically wrongheaded Labor, but falling under the spell of the demonic Greens. Exhibit A would have to be the carbon scheme. But, apart from its higher levels of compensation to industry, it was little different from Rudd’s carbon pollution reduction scheme, which the Greens rejected out of hand. It’s not politic to say so but, in the end, it was the Greens who changed their tune, much more than Labor did.

The prospect of Abbott

Abbott has been far more effective as opposition leader than I and other smarties expected. He quickly learnt to keep disciplined and avoid putting his foot in his mouth, and quickly displayed his greatest, most enviable strength as a politician: an ability to ‘cut through’ - to have the things he says noticed and broadcast by the media.

His policy of blanket opposition to all the government’s policies has served him well. Many expected the electorate to tire of his relentless negativity, but it hasn’t happened yet. Even so, some strains are beginning to show. His autocratic style has put noses out of joint within the party and, should his standing in the polls ever slip, we will hear from his detractors. There is much discontent within the party and in business over his refusal to criticise Fair Work and propose any changes that could reawaken the spectre of Work Choices.

Despite the opposition’s remarkably strong standing in the polls, Abbott is not personally popular. He has a 55 per cent disapproval rating for his job as opposition leader. And the authoritative Australian Election Study, in which ANU political scientists surveyed voters soon after the last election, found that Abbott’s unpopularity was the main reason he failed to win enough seats. Though Gillard’s popularity rating was low, Abbott’s was a lot lower - lower even than Keating’s in the 1996 election.

Abbott has little interest in economics and no commitment to economic rationalism. His policy positions reek of populism, protection and direct controls. His solemn promises to roll back the carbon and mining taxes, but not reverse the goodies they will be paying for, leave him with a funding gap of many tens of billions he has, as yet, made no attempt to fill. How such a man could bring himself to outline the sweeping spending cuts needed to make good his promise to return the budget to surplus without delay is hard to imagine. He has, however, taken the precaution of refusing to use the services of the new Parliamentary Budget Office to cost his promises. There is no precedent for parties promising to abolish major new taxes already in operation, nor for governments actually doing it. I find it very hard to believe it would happen.

Should Abbott be elected, we face either a monumental breaking of promises or a government totally consumed by the effort needed to turn back the clock. Why the part of the electorate that cares most about good macro management and micro reform has had so little to say about Abbott’s incredible performance I don’t know. Perhaps they’ll have more to say as the reality of an Abbott-led government draws closer.

Observations on monetary policy

I normally begin this section by observing that the market and the business economists have had another bad year in their efforts the second-guess the Reserve Bank’s moves in the cash rate, but this year I have to declare the second-guessers to be ahead on points. The notion that the Reserve might cut rates entered the futures market’s head a lot earlier than it entered the Reserve’s head, so the market has to get credit for that. I’m not sure the market was particularly prescient on size and timing - suggesting it might have been right for the wrong reason. I suspect the market was dominated by foreign players who merely projected North Atlantic conditions onto the Antipodes, making insufficient allowance for local conditions. But, as all of us in the prediction business know full well, a win’s a win. I wouldn’t make those criticisms of the other great hero of this episode, Bill Evans. He stuck his neck out ahead of all of us, we marvelled at his folly, but he turned out to be right and he deserves all the accolades he got.

From where I sit it’s clear to me that to make a legendary call like Bill’s you have to get well ahead of the game, well ahead of the data - and you have to be right. When I saw Bill make his call I thought, that’s not in the Reserve’s plan, so he’ll only be right if he foresees developments the Reserve doesn’t foresee and those developments are big enough to change the plan. He did and they were.

The Reserve begins each year with a view of how the year’s going to pan out and a rough idea of the policy adjustments the outworking of that view will necessitate. It must have such a view because it has an on-the-record forecast, and that forecast is its view. The trick for you guys is to work out what its forecast tells you about the policy adjustments needed to bring the inflation forecast about, given the growth forecast.

This year the Reserve was expecting growth to accelerate as the effects of the resources boom spread through the economy, adding to inflation pressures at a time when we were already close to full employment. It was therefore expecting to have to tighten a few times as the year progressed. But here’s the point: it’s continuously testing its forecasts and its expectations against the data as they roll in. And it makes its judgments about whether policy needs to be adjusted one board meeting at a time. As events unfolded, the economy didn’t accelerate in the way it had been expecting, and so the Reserve never reached a point where it saw the need to act on its ‘bias to tighten’. At first there was the temporary setback of the Queensland floods - which proved less temporary than first thought - and then there was the backwash from the growing sovereign debt problems in Europe, mainly on business and consumer confidence. By November it was clear the economy wasn’t taking off the way the Reserve had expected - mainly because of the confidence backwash from Europe - so the Reserve wasn’t going to have the trouble keeping inflation within the target range it had expected to have, thus allowing it to make what it expects to be a once-off reduction in the cash rate to get it back to neutral. It’s worth noting that part of the scope for this move came not from the effects of Europe but from the past and future revisions to the underlying inflation figures arising from the Bureau’s reweighting of the index.

I don’t think the Reserve has very firm ideas about where the stance of policy goes from here. The economy is pretty much in equilibrium, policy is set at neutral, so the rate will stay where it is until developments occur that knock the economy off its equilibrium path - and off the Reserve’s forecast - in one direction or the other and require a policy response. Clearly, the balance of risks is very much to the downside.

But Bill has made another call and, as I understand it, is predicting another three cuts -presumably 25-basis-point cuts - next year. Here again you see him getting well ahead of the game; well ahead of the Reserve’s thinking, as expressed in its forecast. He can see something coming down the pike the econocrats can’t, and he may again prove himself to be more prescient than them. What would fit Bill’s call of three further cuts over the course of 2012 would be for the economy to slow down rather than speed up as forecast - for it to run out of gas, presumably because of growing caution and uncertainty on the part of business and consumers in response to continued turmoil in Europe. This would be manifest in a continuing rise in unemployment and an inflation outlook that was even more benign, thus allowing the rate to be lowered another click. Of course, were Europe to turn into the full catastrophe, we all know from the events of late 2008 how the Reserve would react. In that case I wouldn’t be surprised to see three cuts next year, but they’d probably come thick and fast, and each be nearer 100 points than 25.

I remarked in my column last Saturday that when the news is full of stories about some economic issue and the authorities pop with a policy change, all the instincts of the media and the punters are to assume that A caused B. In this case, we hear all this bad stuff from Europe, which makes us think the European economy is stuffed, therefore we must be stuffed and that must be what caused the Reserve to slash its forecast and cut the rate. I think all humans have a tendency to string together chains of cause and effect in this way and for our thinking to be unduly influenced by those events that have ‘salience’ (prominence in our consciousness) because they are so dramatic, so highly publicised or so recent.

My point is that this defective reasoning may be very human, but economists need to do better. Because the markets and business economists spend so much time studying developments overseas - usually the US, but these days, Europe - and they do that because national financial markets are so highly integrated - these developments have great salience in their minds, which can tempt business economists to over-weight them when forming views about likely developments in our economy - our real economy.

We need to remember that overseas events may be very exciting and very important, but they’re only relevant to us, our forecasts and our policy stance to the extent that, by some clearly identified channel, they have an effect on our real economy. They may be big in Europe, but are they still big by the time they reach us? Our real economy isn’t nearly as well integrated with the world as our financial markets are. Our domestic demand (GNE) accounts for almost all of our aggregate demand, sometimes more than all. As I keep reminding my readers, roughly 80 per cent of what Australians produce they sell to other Australians and roughly 80 per cent of what they purchase they buy from other Australians. Of course, the sharemarket is a more important channel than it used to be, and so - thanks to an ever-more globally integrated media - are confidence effects. I say all this simply because I keep hearing business economists making predictions about what the Reserve will do, and explaining why it’s done what it’s done, much more in terms of overseas development than I see in all the Reserve’s detailed exposition of why it did what it did. You’ve got to get your direction of causation right. The Reserve is managing our economy, it’s responsible for our inflation rate. Its highest consideration will be what’s happening in our economy and its interest in what’s happening in other people’s economies is limited to assessing the extent to which those events impinge on our economy. That’s obvious, but people who know a lot about what’s happening in other economies seem to keep forgetting it. Sometimes I think the traditional order in which the econocrats set out their analysis - start with the world, then move on to the domestic - may confuse people as to which is the more important.

Last year I advanced my theory that the timing of rate changes is influenced by ‘bureaucratic neatness’. At the time I said:

"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."

That was a year ago. What’s happened since then? We’ve had just one rate move and it happened on . . . Melbourne Cup Day, making it the sixth cup day move in a row. Still think it’s mere coincidence? Last year when I advanced my crazy, utterly economics-free theory, my mate Rory Robertson was the first to express his scepticism. So I asked some relevant econocrats what they thought of it. They thought it had some validity. Provided the Reserve hasn’t got behind the curve, and thus needs to catch up ASAP, it will be more inclined to move in those months that fit its carefully constructed reporting cycle.

Wednesday, November 23, 2011

Facts count, because what's mined is yours

By far the biggest development in the economy in recent years is the mining boom, and it's likely to roll on for at least the rest of this decade. But Australians are having a lot of trouble getting their minds around the boom's implications. The area abounds with worries and misperceptions.

Economists keep banging on about the mining boom because it's the biggest factor driving the economy's growth. We've had a surge in export income because the world is paying such high prices for our coal and iron ore. And we're also getting huge spending on the construction of new mines and natural gas facilities.

The other reason economists get so excited about the topic is that this is hardly the first commodities boom Australia has experienced (the first was the gold rush) and most of our previous booms have ended in tears. We've quickly spent all the extra money coming our way, but that's led to rapidly rising prices. The authorities' efforts to stamp out inflation have ended up causing a recession and rising unemployment.

The present managers of the economy are determined to ensure that doesn't happen this time by keeping spending and inflation under control. This explains why, until recently, the Reserve Bank was always thinking about putting up interest rates, and why the Gillard government has been so keen to get its budget back into surplus.

But all the fuss people like me have been making about the boom has left many Australians with a quite exaggerated impression of the size of our mining sector. According to a poll conducted by the Australia Institute, on average people imagine mining accounts for 35 per cent of the goods and services the nation produces (gross domestic product).

But while mining's share of national production has increased significantly in recent years, it's still up to only 10 per cent.

Many of us see the main pay-off from an expanding industry as all the jobs it generates. So what proportion of the workforce is employed in mining? According to the Australia Institute's polling, our average answer is 16 per cent.

The truth? Even after all that expansion, less than 2 per cent. How could an industry responsible for 10 per cent of our production account for just 2 per cent of employment? By being intensely ''capital-intensive'' - by using a lot of machines and not many workers.

So, does that mean mining isn't really worth all the fuss? A lot of its industrial rivals will tell you so, but it ain't true. The true test of the worth of an industry is not how many people it employs but how much income it generates. And, particularly at present, mining is generating huge income. Do you realise it accounts for more than half the nation's export income?

The reason income trumps employment is that as income is spent it generates jobs. When you spend a dollar it percolates through the economy, supporting and creating jobs as it goes. So if mining creates 10 per cent of national income but only 2 per cent of national employment directly, that just means it supports another 8 per cent of national employment indirectly, in other (labour-intensive) industries.

Which other industries? For the most part, service industries. How can I be sure? Because after you allow for the 2 per cent of Australians employed in mining, the 3 per cent in agriculture and the 9 per cent in manufacturing, the remaining 86 per cent are employed in the many service industries: wholesaling and retailing (15 per cent), healthcare (11 per cent), construction (9 per cent), education and training (8 per cent), the professions (8 per cent), hospitality (7 per cent), public administration (6 per cent), financial and business services (6 per cent), transport (5 per cent) and many more.

Another reason I can be sure most of the jobs created indirectly by mining are in the services sector is that, for at least the past 40 years, all the net increase in national employment has come from the services sector.
Am I touching a nerve here? A lot of people are uncomfortable about the mining boom because they see it as temporary and they see digging stuff out of the ground as a pretty unsophisticated way to make a living. What do we do when it's over and what else do we do to make a buck?

It's true the sky-high prices we're getting at present won't last, but nor will they crash back to what we used to get. And we'll have a much bigger mining industry selling a lot more of the stuff than we used to. They may be non-renewable resources, but we've got a mighty lot of 'em.

What else can we do? What most of us have always done: sell services to one another and to foreigners. In these days of the information and communication revolution, most of the highly skilled, highly paid jobs are in the services sector. Those who find this intangibility discomforting are hankering after a bygone century.

It is true, however, that we must ensure we end up with something to show for this boom and that too much of the huge profit being made doesn't just end up in the hands of the mining industry's owners (about 80 per cent of whom are foreign). After all, the minerals they're mining are owned by all Australians, not the miners.

That's why it's good to see Julia Gillard's profit-based mining tax finally being passed by the House of Representatives, even though Tony Abbott's mindless opposition to it allowed the three big foreign mining companies to butcher the tax.


Monday, November 21, 2011

Internet commerce will foster price competition

The critics of economists often accuse them of trying to change the world to make it more like their textbooks. But now the mountain is coming to Muhammad. The internet, and the electronic commerce it promotes, is making real-life markets work more the way economists assume they do.

As the retailers - particularly the department stores - have sought to explain the weak growth in their sales, their gaze has fallen on the internet. The high dollar has made it more attractive for people to buy stuff on the net from overseas sites. And people who buy from foreign sites don't have to pay goods and services tax on purchases of less than $1000.

As an explanation for their weak sales, it's not persuasive. The share of consumer spending accounted for by internet purchases is still quite small. The more likely explanation is simply a shift in consumer preferences from goods to services.

But internet purchases will become a significant competitive challenge to retailers as people get more experienced at and relaxed about internet shopping. (And as Australia Post gets better at delivering parcels to households without a stay-at-home spouse.)

It's a mistake, however, to imagine it's primarily the high dollar that will drive this trend (or that the presence or absence of a 10 per cent GST makes much difference). No, the primary source of internet bargains is the existence of what economists call ''price discrimination'': the longstanding practice of international suppliers charging higher prices in some markets than others.

Global firms selling books, music, DVDs, software, sneakers and much else know the punters' ''willingness to pay'' varies greatly between countries. Why? Because, for instance, Aussies are simply used to paying higher prices than Americans are.

Such price discrimination is a great way to maximise profits - provided you can keep the various markets separate and stop people in high-price markets switching their purchases to low-price markets.

Various global industries have long used legislated restrictions on ''parallel imports'' to protect their price discrimination arrangements - against which economic rationalists have long fought mainly losing battles. But all that legal protection is being swept away as the internet provides us with direct and easy access to cheaper American goods. This will put a lot of pressure on Australian retailers (and their foreign suppliers and landlords) to lower their prices.

Cyberspace breaks down the natural protection provided by oceans and geographic distance (although, of course, this becomes less true as the bulkiness of the goods in question increases, making transportation over long distances uneconomic).

So it breaks down barriers between certain geographic markets and also breaks down barriers to firms entering a particular market. If you're a big, established player in a physical market, it's very hard for me to start up in competition with you and get myself noticed. In cyberspace, however, a web browser that finds your huge site will list my bedroom operation beside it. It takes the punter only a few clicks to check me out after he's checked you out. Since I don't have the brand recognition you have, my price may well be 5 or 10 per cent lower. I can't charge a premium for my established reputation for quality and reliability.

In its basic form, the economists' model assumes there's no cost in money or time to gather all the information you need to be a fully informed buyer or seller in a market. In reality, there's often a lot of cost involved.

So much so that the possession of information is often ''asymmetric'' - the seller knows a lot more about what's what than the buyer does. This asymmetry tends to favour (professional) business over (amateur) punters (except in the labour market, where a worker knows far more about their personal strengths and weaknesses than a potential employer does).

Clearly, the internet greatly reduces the cost of gathering information so as to make better-informed decisions. This should reduce the asymmetry of information, thus shifting reality closer to the model.

The economists' model focuses on price - the price of the item in question relative to other prices - as the key to how markets work. It assumes relative prices (''incentives'') are the only motivator and that all competition is price competition.

In reality, oligopolies much prefer non-price competition via advertising, marketing (such as the nature of the packaging) and merchandising (where and how you display items in your store).

On the internet, many of these non-price devices are a lot less ''salient'' (prominent), thus making prices more salient. And the internet is a lot better at gathering and comparing price information than information about qualitative considerations.

According to a psychology experiment, when people face a choice between an interesting job paying $80,000 a year and a boring job paying $90,000, most choose the boring one. That's not because they're money-hungry, but because of the limits to our neural processing power: we focus on the numerical comparison because it's a lot easier than the qualitative comparison.

Information technology makes it a lot easier and less costly for firms to adjust their prices (while allowing them to collect better information about the right direction and size of those adjustments).

So it's likely the more commerce we do on the net, the more importance will be attached to price - just as the economists have always assumed.

Saturday, November 19, 2011

The dots linking us to Europe's woes don't join

Humans are story-telling animals. We seek to understand developments in the world around us by turning them into ''narratives''.

When several things happen in the same field, people - including journalists - have a tendency to turn them into a coherent story by stringing them together.

For instance, the biggest economic news story for months has been the trouble the Europeans are having with their currency and high levels of sovereign debt, which are causing huge financial instability.
So, when, in the midst of this, our Reserve Bank cut the official interest rate and revised down its forecasts for the economy's growth, journalists and others joined the dots: clearly, and as might have been expected, the problems in Europe have caused a marked slowing in our economy.

There's just one problem: when you examine the facts, they don't fit the sense-making narrative people have woven them into.

The first point is that, despite the downward revisions to the Reserve's forecasts - which are unlikely to be very different from Treasury's revised forecasts when we see them in the next week or two - the economy isn't expected to slow down.

The truth is we've already had our slowdown when real gross domestic product contracted by 0.9 per cent in the March quarter of this year, mainly because of the effect of the Queensland floods. The economy has been recovering since that setback - but more slowly than expected because it is taking the Queensland coalminers so long to fix their flooded pits.

Over the year to last December, GDP grew by 2.7 per cent. Over the year to March, the growth rate dropped to 1 per cent and, over the year to June, it recovered to 1.4 per cent. The Reserve's latest forecast is for growth of 2.75 per cent over the year to December. Sound like a slowdown to you?

It's forecasting growth of 3 per cent to 3.5 per cent in 2012 and 2013. Is that weak growth? No, it's about ''trend'' - the economy's actual medium-term average rate of growth in the past and also the maximum rate at which it can grow over the coming medium term without worsening inflation, given the economy is already close to full capacity.

But, if the economy isn't slowing at present and isn't expected to slow, why has the Reserve had to revise down its forecasts? Because the economy isn't taking off the way the Reserve had earlier expected it would.

Admittedly, the main reason the economy now seems unlikely to really speed up is the dampening effect of Europe. The continuing saga has hit the sharemarket and made a lot of people feel poorer, as well as sapping the confidence of consumers and, more particularly, business people.

The Reserve cut the official interest rate a click - by 0.25 percentage points to 4.5 per cent - not because it feared disaster was on its way from Europe but because it now realised it wouldn't have as much trouble as it earlier expected keeping inflation within the 2 per cent to 3 per cent range over the next year or two.

A year earlier, it had tightened the ''stance'' of monetary (interest-rate) policy to ''slightly restrictive'' - one click above ''neutral'' (normal) - because it expected the economy to take off and push inflation above the top of the range. But now that was unlikely to happen.

As well, the Bureau of Statistics' move to a new series for the consumer price index had effectively revised history, showing underlying inflation in the June quarter wasn't quite as high as first thought and, for technical reasons, wouldn't rise as much in future.

There's plenty of evidence the economy isn't slowing and isn't likely to slow. For one thing, it's clear all the talk of ''the cautious consumer'' has been overdone. The weakness in retail sales (which in any case have been growing more strongly in recent months) isn't reflected in overall consumer spending, which is growing at about trend.

It turns out consumers have been changing their pattern of consumption rather than slowing the growth in it, buying less from department stores but more from service providers, including the providers of overseas holidays.

The acid test of whether consumers have become cautious is whether their spending is growing at a slower rate than their disposable income, thus causing their rate of saving to rise. The household saving rate seems to have stabilised at 10 per cent of disposable income.

The Reserve's revised forecasts imply it will rise a fraction in the short term, but be stable at 10 per cent over the next two years. If so, the laws of arithmetic say consumer spending will rise in lock-step with disposable income.

As for the index of consumer sentiment, although it fell heavily earlier this year, it's risen for three months in a row.

The economy is still receiving - and is expected to continue receiving - huge stimulus from the rest of the world, in the form of the resources boom. It's coming from the high prices we're getting for our mineral exports, from the growing volume of those exports and from hugely increasing investment spending on the development of new mines and natural gas facilities.

Although the Reserve believes our terms of trade - export prices relative to import prices - probably reached their peak in the September quarter and will now fall back, they're likely to stay better than we're used to. Iron ore prices fell heavily, but more recently are recovering.

It's true the labour market isn't as strong as it was last year. The unemployment rate has edged up from 4.9 per cent to 5.2 per cent. It may rise a little further, but then fall back. Overall, it seems about enough jobs are being created to cover the growth in the labour force.

And remember, with economists believing the lowest unemployment can go without causing inflation is about 4.75 per cent, we aren't travelling too badly.

The new forecasts are built on the assumption that sovereign debt problems in Europe don't cause a marked further deterioration in financial and economic conditions there. ''Fears of a major [global] downturn have not been borne out so far,'' the Reserve says.

There's a fair chance it could still happen, of course. But it's in no one's interests to jump to the conclusion it will.


Wednesday, November 16, 2011

Change is workers' only certainty

The shape of our economy is always changing, but lately the pace of change seems to have got a lot faster. Some industries are expanding, while others contract. Particular industries are having to change the way they operate - or the range of products they produce - in response to many pressures.

These changes almost always leave us better off materially. ''Structural change'', as economists call it, has been central to the process by which people in the developed world have become ever more affluent over the past 200 years.

The greatest force driving structural change is technological advance: the invention of better ways of doing things, new things to do and countless labour-saving machines. Globalisation has been driven partly by government policy, but mainly by the information and communications technology revolution, which has hugely increased the speed and reduced the cost at which information, money and people move around the world.
This has given us the global financial markets, but also the rise of the developing economies, particularly in Asia. Those countries' growing demand for our minerals and energy is bringing us great wealth but is also bringing intense pressure for change in the shape of our economy. Mining and the services sector are expanding, whereas manufacturing, the tourism industry and education exporters are being forced to adjust.

Then there are all the industries under pressure from the internet and the emergence of ''new media'': newspapers, free-to-air television, book publishing and book selling, and retailers whose customers have discovered how much more cheaply they can buy some things on the net.

The trouble with structural change, of course, is that the benefits go to the customers - new products, wider choice, lower prices - while all the problems go to the people working in the disrupted industries.

Managers have to find a new plan for their firm's survival. Meanwhile, workers go through considerable uncertainty and anxiety. At best, they have to shift to doing something completely different. They may be required to do a lot more for the same money. Perks may be cut. Or their prospects of advancement curtailed.

They may lose their status as permanents. At worst they get shown the door and take a long time to find another job. That job may well involve doing the same work for less money and poorer conditions - perhaps for the business to which their work was outsourced.

Managers have no choice but to face up to the business's changed conditions and cut their cloth accordingly. When they resist change or pretend it isn't happening they just make things worse. Non-unionised employees have to cop whatever solutions managers impose on them. But well-unionised employees have more power to resist, or at least have their viewpoint taken into account.

No firm fits this frame better than Qantas. It has lost its protected status as the nation's flag-carrier and must find a strategy for competing with myriad competitors, many of them low-cost. It can no longer afford the high salaries and cushy conditions its pilots, engineers and other employees have become accustomed to.

The problem at Qantas was not that workers wanted too much in pay rises - that's the standard stuff of such bargaining - but that they wanted to use their industrial muscle to force management to agree never to change the business in ways that disadvantaged their employees.

Sorry, but that's not possible. Here you see the grounds for business's latest complaint against Julia Gillard's Fair Work changes to industrial relations. Gillard has removed the list of ''prohibited content'' restricting the matters over which management and unions may bargain. This has permitted the unions to range far beyond claims about wages and conditions to issues that concern ''managerial prerogative'' and thus challenge ''management's right to manage''.

It's important to remember we're still engaged in the difficult transition from almost a century of compulsory arbitration - where, as soon as a strike began the umpire would step in to impose a settlement on both sides - to a new world of collective bargaining.

A central goal in making this transition - one expressed many times by the now-bellicose Peter Reith - is to encourage the two sides to bargain without external intervention. The goal was a new era of reduced industrial disruption as the parties recognised the great extent of their common interests and put less emphasis on their (undoubted) conflicting interests.

Right on. So I don't think banning debate about management decisions is the smart way to go. That would mean the law advantaging one side, giving managers permission to ride roughshod over the interests and even the opinions of their employees.

Half the trouble at Qantas is the employees' failure to recognise how the game has changed for their company, robbing them of their former bargaining power. The other half is the arrogance of management in their resort to ''managerial prerogative'', in their failure to explain and debate the new realities with their staff.

It's painfully clear management-employee relations within Qantas are utterly poisonous. The blame for that should be shared equally. The fate of Qantas is important in its own right, but it's more important as a case study in how big, unionised companies cope with structural change.

The industrial parties need to reach an accommodation, not rush to the ref. But I agree with Professor Paul Gollan, of Macquarie University, that Fair Work needs to provide a better mechanism to help the parties argue through their differences in cases where belligerence on either side threatens to impose unnecessary hardship on the parties and the public.


Monday, November 14, 2011

Shouting slogans will not further Fair Work debate

It's a compelling narrative: in the 1980s we deregulated the financial markets, slashed import protection and deregulated many markets for particular products. But then it dawned on us that deregulated, highly competitive product markets could hardly co-exist with a centralised, highly regulated labour market.

So Paul Keating started to deregulate the labour market, ending centralised wage-fixing and moving to collective bargaining at the enterprise level. The Liberals' Peter Reith introduced a formal system of individual contracts, Australian workplace agreements, then John Howard completed the process of deregulation by introducing Work Choices.

But then Labor used Julia Gillard's Fair Work Act to re-regulate the labour market. So we've reverted to our original problem of having a regulated labour market that simply doesn't fit with deregulated, trade-exposed product markets.

Just one problem with this neat analysis: it adds up only if you don't actually know much about how the labour market is regulated. The notion that Work Choices deregulated the market and Fair Work re-regulated it is simple, but makes no sense.

Consider this: the Work Choices legislation was much longer, more complex and more intrusive than the law it replaced. Does that sound like deregulation? The Fair Work legislation is considerably shorter and more straightforward. Does that sound like re-regulation?

One of the main complaints against Fair Work is that it has removed the list of ''prohibited content'' about which employers were prevented from agreeing with their unions. Inserting prohibitions in the law is deregulation? Removing prohibitions is re-regulation?

One thing Work Choices did was greatly bureaucratise the right to take industrial action, with the intention of discouraging it. Unions have to hold a postal ballot of their members and achieve a certain proportion of votes to commence a bargaining period after the expiry of their last enterprise agreement.

Then they have to hold another postal ballot before they can undertake protected industrial action during the bargaining period. Then they have to give 72 hours' notice of any action they actually intend to take.

By contrast, employers don't have to jump through any hoops or give any notice when they decide to retaliate by locking out their staff during a bargaining period.

These provisions of Work Choices were carried over largely unchanged in Fair Work. Do they sound terribly pro-union? Do they sound like deregulation? Does continuing them in Fair Work constitute re-regulation?

Confused yet? The simple truth is that ''deregulation'' isn't a sensible description of what Work Choices did and, in consequence, ''re-regulation'' isn't a sensible description of what Fair Work does.

Here's the point: the labour market has always been highly regulated. It remained highly regulated under Work Choices and it's still highly regulated under Fair Work. It's always likely to stay highly regulated for a simple reason: unlike all other markets, the labour market deals with human beings rather than the exchange of inanimate objects.

As a matter of politics, common humanity and common sense, the treatment of people in the labour market will always be carefully regulated. We are, after all, running the economy for the benefit of people.

What changes from time to time is not so much the degree of regulation as the objectives of that regulation. There's a fundamental imbalance of bargaining power between an individual worker and even the smallest employer.

So the main issue the regulation deals with is what should be done about that imbalance. The usual answer - the world over - is to permit workers to bargain collectively.

What Work Choices did - in its original form, at least, before Howard realised he'd gone further than the public would cop - was make individual bargaining far more attractive to employers by removing the ''no-disadvantage test'' which had limited the extent to which workers' wages and conditions could be reduced. A lot of the regulation it added to the system was to constrain the freedom of those employers who chose to continue bargaining collectively with their employees. And it further tightened restrictions on what unions could do.

Howard shifted the balance heavily in favour of employers and tried to delegitimise the (already declining) union movement. It's hardly surprising Labor used its first opportunity to shift the balance back the other way. What is surprising is how many of Work Choices' anti-union provisions it left intact.

All systems of collective bargaining permit unions to take ''protected'' industrial action, subject to certain tight conditions. Why do they need protection? What are they protected from? From being sued by employers in the civil courts because of the economic damage that action has done to the employers' businesses.

See what this means? It means that even if we really did attempt to deregulate the labour market by abolishing the industrial relations act, it would still be regulated by ordinary commercial law and common law. In that imaginary world, it would not be illegal to strike or take other industrial action, but any damage unions inflicted on employers - which, after all, is the very object of industrial action - would leave the unions open to being sued.

So, for all practical purposes, collective bargaining would be impossible - would be prevented by (ordinary civil law) regulation - unless governments regulated to specify the circumstances in which it would be permitted by being protected from actions for civil damages.

Still think it makes sense to talk about deregulating or re-regulating the labour market? There's always legitimate ground for us to debate whether the balance our industrial relations regulation strikes - between protecting workers on the one hand and achieving an efficient-functioning economy on the other - should be shifted in one direction or the other.

But shouting slogans at each other - it's deregulation if I like the latest changes; it's re-regulation if I don't - won't advance the debate one jot.

Saturday, November 12, 2011

Storm clouds over Europe, but sun is shining elsewhere

If you're confused about what's happening in the European economies, why it's happening and what it means for the world economy, don't feel you're alone.

The media's great strength is the speed with which they can bring us myriad details about the latest happening in Greece, Italy or anywhere else. Unfortunately, their great weakness is their inability to digest all that information and summarise what it means. The closest they go is in relaying the opinions of 101 supposed experts from Greece, Britain, America or anywhere else. Listen to more than one or two and you're soon none the wiser.

But this week our own secretary to the Treasury, Dr Martin Parkinson, gave us his tight summary of what and why and what next.

He began by warning that ''the global economy is heading down a winding road, with twists and turns ahead that we can't predict''. Following the global financial crisis, it was expected that the global economy would recover at a modest pace as the financial excesses were worked out of national, business and household balance sheets.

Instead, we've seen events occur that threaten to derail this recovery. ''The unfolding saga of the European sovereign debt crisis sees events change on a daily (if not hourly) basis,'' Parkinson says.

''It's not just events in Europe either, with the unprecedented downgrade by Standard and Poor's of their US sovereign credit rating in August providing yet another twist.''

He says there are four ''proximate'' (immediate) causes of the present situation in Europe. The first is the unsustainable sovereign (government) debts of some economies in the euro area, which reflect a period of weak economic growth and big budget deficits. This suggests a need for microeconomic reforms to enhance the country's international price competitiveness (because membership of the euro prevents the country from gaining competitiveness by devaluing its currency) and for more competitive taxation and social welfare policies.

The second cause of Europe's problem is policy responses from governments that are inadequate considering the size of government debt. This raises the fear of ''contagion'' (spreading disease) throughout the European banking system.

Third, the markets' continuing fear that political institutions are incapable of implementing concrete and credible responses to the problem.

And finally, a growing recognition by markets that the economic recoveries in both the US and Europe will be weaker than previously expected, making it even harder to work down their already excessive levels of government debt.

Financial markets around the world have been gripped by uncertainty and aversion to risk because of the prospect of weak global growth and the European sovereign debt crisis. Volatility has become the new norm.

The euro-area leaders' summit late last month finally made some much-needed announcements, but though markets initially reacted positively to these measures - despite the absence of detail - this was very short-lived.

Political developments in Greece and Italy in the past fortnight have further undermined confidence in the commitment of governments to deal with the underlying problems. Europe will remain a source of market volatility until governments' commitments are seen as clear and credible.

Market participants have become very reluctant to hold the bonds of certain governments, which is reflected in the market yields (effective interest rates) participants require to hold the bonds of particular governments.

The yield required on Spanish and Italian bonds, for instance, is about 5 percentage points higher than that for German government bonds. For Irish bonds this ''spread'' got as high as 12 percentage points, but has since fallen to about 7 points. For Portuguese bonds it's 10 percentage points and for Greek bonds it's about 30 percentage points.

Across the Atlantic, growth in the US weakened significantly in the first half of this year. Though it's strengthened a bit since then, the recovery remains vulnerable to external shocks such as a re-intensification of the European debt crisis.

''In the longer term we can have confidence that the US economic system will drive the innovation and investment needed to spur competitiveness and growth,'' Parkinson says. ''The question is whether the US political system can mobilise itself to address its medium-term fiscal challenges.''

But while both Europe and the US face budgetary challenges, there are some crucial differences, he says. Critically, the US has its own currency and monetary policy and a fiscal (budgetary) union between its 50 states.

And with the yield on 10-year US Treasury bonds at about a 60-year low, there's zero pressure from the market to force political action - and a political compromise - on a substantial medium-term reduction in the US budget deficit.

But until such a plan is agreed and legislated, the US will remain at risk of a sudden shift in market sentiment, as Italy has discovered in recent months.

Parkinson remarks that, with economic commentary focused on the short term and the North Atlantic, it's easy to overlook the bigger picture. We are in the midst of a once-in-a-century global economic transformation as the world's centre of economic gravity shifts from the advanced economies to the emerging market economies.

We focus on the rapid growth of China and, to a lesser extent, India. But we shouldn't overlook the strong growth of Indonesia and Vietnam. With a population of almost 240 million, Indonesia is the world's fourth most populous country. If we measure it using purchasing-power parity (as we should), Indonesia's economy overtook Australia in size in 2005.

Parkinson also points out that the rise of the developing countries isn't limited to Asia. ''We see a similar story developing in other emerging economies,'' he says.

''For example, a young population and improvements in human capital will likely contribute to an expected doubling in South Africa's gross domestic product in the next 20 years and Nigeria is expected to increase three-fold to displace South Africa as the continent's largest economy by the late 2020s.

''Latin America also continues to surge forward, with Brazil and Chile leading the way - with both expected to double in size by 2030.''

Returning to Asia, despite rapid growth in living standards, China and India remain at the early stages of their economic development. Assuming broad trends continue, China and India's cities will be populated by an increasing wealthy and mobile middle class in the decades ahead. ''On some projections, there will be 1.7 billion middle-class consumers in the Asia-Pacific region by 2020 - more than the rest of the world combined.''

Remember, however, all these projections rest on the economists' de rigueur assumption that there's no way shortages of natural resources or environmental pressures could prevent the global economy from continuing to grow forever.

Wednesday, November 9, 2011

We may be two-speed, but we are all sharing dividends

Forgive my absence at such an anxious time but I've been away on holiday in Western Australia, walking bits of the Bibbulmun Track, which runs from Perth to Albany. The wildflowers were unbelievable. And so was the affluence in Perth, where the mining companies' skyscrapers are so tall they can be seen from Rottnest Island, 19 kilometres away.

How'd you like to be living in Perth, in the winners' circle where everything is on the up, not doing it tough in Sydney or Melbourne, on the wrong side of the two-speed economy?

Actually, things in Perth aren't as wonderful as it suits envious easterners to imagine. Know what they complain about in the West? The two-speed economy. Most of them think they're missing out. Some people may be raking it in, but not me. I'm not on some fabulous salary, just paying the exorbitant house prices the well-to-do have brought about.

Now where have I heard that before? What is it about Australians at present - on both sides of the continent - that makes them so convinced they're missing out and battling to get by?

According to polling by Labor, 68 per cent of respondents believe average Australians aren't benefiting from the mining boom. Is that how you feel? If so, you haven't thought about it. As someone said, there are more things in heaven and earth than are dreamt of in your philosophy.

After such a long plane trip, I was half expecting WA to be like another country. And it's true they have things we don't: magnificent tall trees - jarrah, karri and marri - and strange animals such as quokkas. But step into the bush and it's very much part of Australia: gum trees everywhere, kangaroos and kookaburras.

It's the same story economically. They may have huge reserves of natural gas and iron ore that we don't, but their economy is really just a corner of the greater Australian economy. As the locals are the first to tell you, a lot of the money they make soon finds its way into the pockets of people Over East.

For a start, there are no customs barriers between the states, so there's a lot of trade between them. Step into a WA supermarket and you see they're selling just the same stuff ours do. Which means most of what they're selling was manufactured on the east coast.

Their big mining companies have been making huge profits for the best part of a decade. Nothing to do with you? Every east-coaster with superannuation has a fair bit of their savings invested in the shares of those big companies. So you've been getting your cut.

Your super's been looking a bit sick in recent years? That's mainly because of problems in the rest of the world. Whatever you've got, it'd be looking a lot sicker without the resources boom.

Those mining companies are subject to the federal government's 30 per cent tax on company profits. And the feds' company tax collections have been massive since the resources boom started in the early noughties.

Do you realise that under Howard and Rudd we had cuts in income tax eight years in a row? Where do you think the money came from to finance those cuts?

In the economy, everything's connected to everything else. So if you're conscious of only the direct connections you're missing a lot of the story. And no connection is more indirect - or mysterious - than the way the governments of NSW and Victoria have been benefiting from the good fortune of the WA and Queensland governments.

This arises from our longstanding commitment to the principle of ''horizontal fiscal equalisation'' - which holds that all Australians, no matter where they live, are entitled to the same quality of government services.

That ain't easy, particularly because most government services - education, hospitals, law and order, roads - are delivered by the states. The cost per person of delivering services varies with how big and decentralised the states are. But another factor is the states' varying capacities to raise revenue. These days, states gaining royalty payments from their big mining industry have considerable ''taxable capacity''.

To bring horizontal fiscal equalisation about, the Commonwealth Grants Commission does many intricate calculations which determine how the $48 billion-a-year proceeds from the feds' goods and services tax are divided among the states. The commission works out the average amount of GST paid per person throughout Australia, then decides whether each state requires more or less than that, per person, to be able to deliver services of equal standard.

This equalisation process was introduced in the early 1930s to mollify the restive West Australians. Until just a few years ago, it meant Victoria and NSW got a lot less than the national average, while South Australia and Tasmania got a lot more than average and Queensland and WA got a bit more.

In 2004-05, NSW got just 83 per cent of the national average GST paid per person, while Victoria got 84 per cent. WA got 104 per cent and Queensland got 107 per cent (with SA getting 123 per cent and Tasmania 171 per cent).

But the huge increase in the resource states' taxable capacity thanks to booming mining royalties has changed all that. This financial year NSW's cut has risen to 96 per cent and Victoria's to 90 per cent, whereas Queensland's cut has fallen to 93 per cent and WA's to - get this - 72 per cent.

It works out that, in effect, Queensland's benefit from its mining royalties this year will be reduced by $1.2 billion and WA's by $2.5 billion. Of their combined loss of $3.7 billion, NSW gains $1.3 billion and Victoria $1.8 billion.

Still think you're getting nothing from the boom?