Saturday, May 5, 2012

Pre-budget primer: how pollies fudge the figures

When governments discover their self-imposed budget targets are harder to achieve than they expected, they face an almost irresistible temptation to cover the gap with a little creative accounting.

As we wait to see on Tuesday night the herculean efforts the Gillard government has made to keep its promise to achieve a budget surplus in 2012-13, let's review some of the tricks governments get up to when they find themselves in a tight fiscal corner.

We'll do so with help from an International Monetary Fund staff discussion note, Accounting Devices and Fiscal Illusions, written by Timothy Irwin.

"If history is a guide," Irwin says, "some of the efforts that should be dedicated to cutting spending or raising taxes may be diverted to the devices, that is, stratagems that reduce this year's reported deficit only by increasing subsequent deficits. As a result, fiscal adjustment may be partly an illusion."

That history is long. Irwin notes the term "fiscal illusion" was first used in 1897. He defines an "accounting device" as a manoeuvre that improves the headline fiscal indicator without actually improving public finances, or without improving it to the extent suggested by the headline indicator.

Irwin says fiscal illusions are a lot easier to produce when the budget balance is calculated on a "cash" basis rather than an "accrual" basis, though even the accrual basis isn't tamper-proof.

Under cash accounting, budget transactions are recorded at the time when cash is transferred; under accrual accounting, transactions are recorded at the time when economic value is transferred. Changing the timing of cash payments is relatively easy.

The private sector has used accrual accounting for eons but our governments switched from cash to accrual only in the late 1990s, at the behest of a new international convention for government financial statistics issued by the IMF.

State governments moved their budgets to an accrual basis, as required, and left it at that. The federal government moved to accrual in 1999, then had second thoughts and, while continuing to produce the bulk of its figures on an accrual basis, reverted to using the "underlying cash" budget balance as its headline fiscal indicator.

Treasury insists the cash balance is more meaningful as a measurement of the budget's effect on the macro economy but that's debatable. It wouldn't be lost on Treasury that cash accounting affords its political masters a lot more wriggle room.

Irwin says an accounting device aimed at the deficit reduces this year's deficit but increases future deficits by an amount that largely offsets the initial improvement.

"To do this, it must either increase reported revenue or decrease reported spending in the year (or years) of interest. And, in return, it either decreases reported revenue or increases reported spending in future years," he says.

This means accounting devices can be divided into four broad categories, the first of which is "hidden borrowing". This involves increasing reported revenue now but increasing reported spending later.

In Europe, governments have reduced their headline deficits by taking over the pension schemes of public enterprises. They receive a compensating payment for taking over the scheme, which they count as revenue, but the offsetting obligation to make future pension payments doesn't count as a liability.

In effect, they've borrowed money from the outfit selling the pension scheme but the debt doesn't appear in their books.

Another way of achieving the same effect is to sell government buildings, then lease them back. Ring a bell? The Howard government did this extensively in the late '90s. And it drove bad bargains with the lucky landlords on the other side of the sale-and-leaseback.

The second accounting device, "disinvestment", increases reported revenue now but reduces reported revenue in the future. The proceeds of privatisations are counted to reduce the deficit but, though these proceeds may reduce the government's debt and so reduce its interest bill, no account is taken of the future dividends the government will no longer receive.

In principle, the Howard government's introduction of the concept of the "underlying" cash balance brought an end to this disreputable accounting practice, much used by the Hawke-Keating government.

In practice, however, this applied only to the sale of financial assets (such as a whole enterprise), not to the sale of non-financial assets such as real estate (and hence, not to sale-and-leaseback deals).

The third accounting device, "deferred spending", reduces reported spending now but increases it later. In the US, the government once reduced its deficit by postponing a military pay day by a single day (shifting it from one year to the next) and, another time, by deferring Medicare payments that would have been made in the last week of the year.

"Less directly, governments sometimes defer maintenance of roads and other assets even though maintaining assets is ultimately cheaper than letting them deteriorate to the point at which they must be rebuilt," Irwin says.

Shifting payments between a bit before and a bit after June 30 is a favourite device of our federal governments, producing double the effect when people compare the new year's balance with the previous year's. Not quite so trickily, the Gillard government has been doing much "reprofiling" of its spending - bringing it forward or pushing it into the future in preparation for the promised return to surplus next financial year. But where spending is pushed back beyond the three years of the "forward estimates," it drops off the radar completely.

There are potentially legitimate reasons for governments to use "public-private partnerships" for the construction of things such as toll roads. "Yet often it is their illusory fiscal benefits that make them appealing," Irwin says. The construction costs and the consequent debt don't appear on the government's books, even though the government has assumed "debt-like obligations" for the future.

The fourth accounting device, "forgone investment", reduces reported spending now but reduces reported revenue later. You avoid building the infrastructure you should but this means you don't get the revenue you would have got from charging for the use of that infrastructure.

More seriously, inadequate public infrastructure may act as a drag on the economy's growth, thus causing general tax collections to grow more slowly than they would have.

This effect may be the dark side of Australia's apparent fiscal rectitude during Peter Costello's reign.

Yet another device is to have spending undertaken by a public entity that isn't counted as part of the budget for reporting purposes. Do the initials NBN mean anything to you?

Wednesday, May 2, 2012

Truth is almost always in the middle

I like Americans. I have American friends, and I remember a trivial incident that endeared me to Americans forever. We were in a funicular going up one of the hills surrounding Lake Como in Italy, at close quarters with a group of Yanks. They were joking and teasing each other in a way that struck my contact-deprived mind as very Australian.

But thanks to a great American institution, the Pew Research Centre, I now realise I think more like a European than an American on one of the central issues of economics and politics.

The centre's study of "American exceptionalism" asked samples of people in the US, Britain, Germany, France and Spain which was more important - being free to pursue your life's goals without interference from the state, or for the state to play an active role in society so as to guarantee that nobody was in need.

In the US, 58 per cent of respondents favoured individual freedom and 35 per cent favoured ensuring nobody was in need. In Europe, it was the other way round, with just 38 per cent of Brits favouring individual freedom and the proportion declining to 30 per cent by the time you got to the Spaniards.

A related question asked people if they agreed that "success in life is pretty much determined by forces outside our control". Only 36 per cent of Americans believed they had little control over their fate, compared with 50 per cent in Spain, 57 per cent in France and 72 per cent in Germany. Britain was the only European country surveyed where fewer than half (41 per cent) shared that view.

The joke of this is, despite the Americans' confident belief anyone can go from log cabin to White House if they try hard enough (the most recent proof positive being Barack Obama), studies show the US to have the lowest degree of social mobility - people actually making it from a poor start to a prosperous finish (or vice versa).

Individualism is very much a Western value (and, by the way, deeply embedded in the economists' conventional model of how economies work). I confess I've got a lot of the individualist in me. I like being free to do things my own way; I don't feel a compelling desire to be the same as other people.

At another level, however, I accept the need for the community to pull together towards common objectives, for us to be led by our elected leaders and for the better-off to be required to assist the less-well-off. I don't resent having the taxman redistribute a fair bit of my income to those less fortunate.

So I can see merit in both sides of the story. And one of the firmest conclusions I've come to about life and the economy is that the truth - and the right place to settle - is almost always to be found not at either extreme, but somewhere in the middle.

Just where in the middle is the hard part. We spend our lives searching it out - the more so because changes in the rest of the world probably cause it to shift over time.

The great temptation is to seek the simplicity and false certainty of either extreme - on this question of the ideal role of the state, libertarianism at one end and socialism at the other.

It's actually all the time I've spent hanging out with economists that's led me to the centre. Economics teaches that life's about optimising not maximising. We almost always face a range of desirable but conflicting, objectives. So all of one and nothing of the others is never the most desirable combination.

Economics is about trade-offs - about finding the particular combination of rival objectives that yields the most satisfaction. So life's about balance - "equilibrium" as economists say. Perhaps the modern term "the sweet spot" puts it better. We're searching for the place that gives us the best of all worlds - at least, the best available.

And yet our history shows us more inclined to swing from one extreme to the other. After World War II, people were dissatisfied with the way the economy was working. Particularly in Europe, they decided the answer was to nationalise all the key industries.

Flash forward to the 1980s of Maggie Thatcher and Ronald Reagan. People are dissatisfied with the way the economy is working so they decide the answer is to privatise all the key industries and deregulate the rest.

In the aftermath of the global financial crisis, the pendulum may be swinging back in favour of regulation.

The sweet spot in the middle is so hard to find. We keep falling for the simplicity and false certainty of extreme solutions.

The truth is the capitalist system does need to be protected from its own excesses, which could bring it - and us - crashing down. We were reminded of this truth in the recent crisis, from which the Europeans and Americans have yet to escape.

But, by the same token, we mustn't go to the opposite extreme of having the state attempt to solve all our problems and leave us imagining any remaining difficulties in our life must be the government's fault.

The truth is the government can't solve all our problems, and the more we abandon primary responsibility for fixing them ourselves, the more dysfunctional society becomes.

More than 70 per cent of Germans believe they have little control over their fate? It's all the fault of The System? They're just as misguided as all those Yanks believing hard work will get them to the top. As ever, the truth is a bit of both.

Monday, April 9, 2012

What Jesus said about capitalism

Most churchgoers see no great conflict between their beliefs and life in a market economy such as ours. But proponents of the little-known "sabbath economics" argue Christ's teachings have been reinterpreted over the centuries to make them fit with modern capitalism.

All I know about sabbath economics comes from the little book, The Biblical Vision of Sabbath Economics, by the Californian theologian and teacher Ched Myers. I'll give you my summary of the book provided you don't presume I'm an advocate. It's an interesting topic for an Easter Monday.

The name sabbath (the seventh day) is a reference to the biblical injunction - mainly honoured in the breach - that the Jews practice "jubilee". Every 50th year (the year following the passing of seven times seven years), slaves were to be freed, people were to be released from their debts and land returned to its original owners.

So sabbath economics involves an "ethic of regular and systematic wealth and power redistribution". You can see why this is an uncomfortable topic (for me as much as anyone else).

Many Christians would argue this Old Testament stuff was superseded by the New Testament, but Myers counters that the New Testament reveals Jesus as preoccupied with jubilee ideas.

"There is no theme more common to Jesus's storytelling than sabbath economics," he says. "He promises poor sharecroppers abundance, but threatens absentee landowners and rich householders with judgment."

It's certainly true that Jesus was always blessing the poor, challenging the rich, mixing with despised tax-gatherers and speaking of a time when the social order is overturned and "the last shall be first".

It's also true, as Myers reminds us, that many of Jesus's parables deal with clearly economic concerns: farming, shepherding, being in debt, doing hard labour, being excluded from banquets and the houses of the rich.

Myers alleges that many churches handle the parables "timidly, and often not at all". "Perhaps we intuit that there is something so wild and subversive about these tales that they are better kept safely at the margins of our consciousness," he says.

"Most churches that do attend to gospel parables spiritualise them tirelessly, typically preaching them as 'earthly stories with heavenly meanings'. Stories about landless peasants and rich landowners, or lords and slaves, or lepers and lawyers are thus lifted out of their social and historical context and reshaped into theological or moralistic fables bereft of any political or economic edge - or consequence."

Myers devotes a chapter to the incident of Jesus meeting the rich man, who asks "what must I do to inherit eternal life?" Jesus neither welcomes him into the club nor outlines the things he must believe to gain admission.

Rather, he tells the man to go and sell everything he has, give the money to the poor and then come back and follow him. But the man, unwilling to give up his wealth, rejects discipleship and goes away.

Jesus responds, "how difficult it is for the wealthy to enter the kingdom of God ... It is easier for a camel to go through a needle's eye than for a rich man to enter the kingdom of God."

"The clarity of this text has somehow escaped the church through the ages, which instead has concocted a hundred ingenuous reasons why it cannot mean what it says," Myers says.

His interpretation? Jesus is simply saying the kingdom of God is a social condition in which there are no rich and poor. So, by definition, the rich cannot enter - not with their wealth intact.

Myers says that in first century Palestine, the basis of wealth wasn't possession of consumer durables, but land. And the primary means of acquiring land was through debt-default. Small agricultural landholders groaned under the burden of rent, tithes, taxes, tariffs and operating expenses.

"If they fell behind in payments, they were forced to take out loans secured by their land. When unable to service these loans, the land was lost to the lenders. These lenders were in most cases the large landowners," he says.

This is how socio-economic inequality had become so widespread in the time of Jesus. It's almost certainly how the rich man ended up with "many properties", according to Myers. And these are just the circumstances the jubilee is intended to correct.

"Jesus is not inviting this man to change his attitude towards his wealth, nor to treat his servants better, nor to reform his personal life," he says. "He is asserting the precondition for discipleship: economic justice."

Myers offers his explanation of a much-quoted saying from which today's prosperous Christians derive comfort: Jesus's observation that "the poor will always be with you".

This doesn't mean Christ accepted poverty as an inevitable characteristic of the economy, or part of the divine plan. Rather, he says, the divine vision is that poverty be abolished, but as long as it persists, God and God's people must always take the side of the poor - and be among them.

"Privately controlled wealth is the backbone of capitalism," Myers says, "and it is predicated upon the exploitation of natural resources and human labour. Profit maximisation renders socio-economic stratification, objectification and alienation inevitable.

"According to the gospel, however, those who are privileged within this system cannot enter the kingdom. This is not good news for first-world Christians - because we are the 'inheritors' of the rich man's legacy.

"So the unequivocal gospel invitation to repentance is addressed to us. To deconstruct our 'inheritance' and redistribute the wealth as reparation to the poor - that is what it means for us to follow Jesus."

Saturday, April 7, 2012

How to improve investment advice to retirees

They say that at every stage of life the baby boomers reach, the world changes to accommodate their needs. So now the boomers are starting to reach retirement, it's the investment advisers' turn to lift their game.

To date, the superannuation industry's greatest attention has been paid to the accumulation phase: how much people need to save to ensure an adequate income in retirement. But the boomers' interest is switching to the retirement phase: how their savings should be managed to best effect.

And there are signs financial planners are working to improve the advice they give retirees. This seems clear from a recent speech by Dominic Stevens, of the annuities provider Challenger. Stevens made extensive use of an article by Joseph Tomlinson, "A Utility-based Approach to Evaluating Investment Strategies", published in the US Journal of Financial Planning. I'll be drawing on both sources.

To date, most advice to retirees has focused on "asset allocation" - how their investments should be divided between shares and fixed-interest securities - and on setting a safe rate at which money can be withdrawn and spent without it running out before the retiree dies.

Tomlinson's objective is to provide advice that is less one-size-fits-all, encompasses more eventualities and incorporates the insights of behavioural economics. These days, computers make it easier to provide more accurate advice and deliver it in user-friendly programs.

Remember, no one knows what the future holds. Who knows what will happen to the sharemarket - or any other financial market? So advice is based on reasonable assumptions and on averages, and advisers seek to estimate expected returns.

But more can be done to allow for the personal preferences of the particular retiree and to take account of the range of likely outcomes around the average.

The first issue is the "risk-return trade-off". The higher returns some investments offer - shares versus fixed interest, for instance - usually reflect a higher degree of risk: risk you won't get your money back, and risk that returns will vary a lot from year to year. It's generally accepted that old people who need to live off their savings can't afford to run the same degree of risk as young people with many years to recover from sharemarket setbacks.

These days more attention is being paid to "sequencing risk". Say you need to live off your savings for 15 years and it's reasonable to expect there'll be two bad years for the sharemarket in that time. Just when those two years occur makes a big difference.

If they come late, it won't be so bad; if they come early you could be almost wiped out and never recover. This suggests retirees need to hold more of their savings in fixed interest than many do.

In any case, most people are "risk averse". Consider this choice: which would you prefer, the certainly of earning $100, or a 50 per cent chance of earning nothing and a 50 per cent chance of earning $200?

If you were "rational" you wouldn't care either way because both options have the same "expected value" (for the second: 50 per cent of $0 plus 50 per cent of $200 equals $100).

If you much preferred the certain $100, that makes you risk averse (and normal). If you fancied the chance of walking away with $200, that makes you a "risk seeker". Risk aversion is pretty much the only departure from "rational" behaviour that economists regularly allow for.

A vital question in working out how much of your savings you should withdraw each year (a common rule of thumb is 4 per cent) is how long you'll live. You can't know, of course.

The advisers' standard approach is to look up in the government's actuarial life tables the average life expectancy for someone of your sex and age.

If the answer was 20 years, this would be used for your planning. But a lot of people will fall a bit below or a bit above the average, and Tomlinson's more sophisticated calculations take account of this wider range of probabilities. At present, the main objective in setting your withdrawal rate is to ensure you don't suffer "plan failure" - run out of money before you die.

The alternative to running out is to die with money left - the "bequest amount".

Conventional economics assumes that, dollar for dollar, your pain at having your money run out before you're ready to die would be equal to your pleasure at knowing you'll be leaving a bequest to your relos.

But this seems highly unlikely. As Stevens argues, if a retiree was living on $30,000 a year and that dropped to $20,000, it would have a more profound negative effect that the positive effect of income increasing to $40,000.

The two psychologists who pioneered behavioural economics, Daniel Kahneman and Amos Tversky, call this "loss aversion" (as opposed to risk aversion). They found that most people hate losing $100 about twice as much as they like gaining $100. Since running out of money before you die is a much bigger deal than losing small sums while you're working, it's likely retirees' loss aversion is a lot greater than the usual rate of 2:1. Some preliminary surveys suggest it might be as high as 10:1.

If so, this means retirees' desire to avoid running out of money (and having to fall back on the age pension) is a lot stronger than investment advisers' conventional calculations assume. And this, in turn, suggests retirees' choice of investments ought to be a lot more cautious than it often is.

Tomlinson argues that particular retirees' degree of loss aversion ought to be taken directly into account when determining the best investment strategy to meet their needs. When you do so, the bottom line of the calculation is not the average expected return on their savings but the average expected utility from those savings.

His refinement takes account of the possible size of plan failure - whether your savings are gone one year before you die or 10 years - not just whether or not failure is likely.

It also acknowledges the size of bequests is likely to suffer from diminishing marginal utility. Each extra dollar gives you less satisfaction than the one before.

Shifting the focus from expected returns to expected utility could make investment advisers' advice a lot more realistic and thus a lot more helpful.

Wednesday, April 4, 2012

How business is white-anting the weekend

Whether or not they realise what they're doing, Australia's business people, economists and politicians are in the process of dismantling the weekend and phasing out public holidays. And they're doing it in the name of making us better off.

Historically, the two arrangements that have protected the weekend and public holidays from encroachment by employers are state government restrictions on trading hours and the requirement in industrial awards that employees required to work at "unsociable hours" be paid an additional penalty rate.

Charging employers a penalty was intended to discourage them from making unreasonable demands on their employees unless absolutely necessary.

The first assault on community-wide days off came in the second half of the 1980s with the deregulation of trading hours as part of micro-economic reform.

Not much later, the move to bargaining over pay rises, and then bargaining at the enterprise level, allowed employers to push for penalty rates to be abandoned in return for higher "annualised" wages.

Employers inculcated the view penalty rates were an anachronism standing in the way of progress and modernity. Many still think that way. One of the goals of John Howard's Work Choices was to make it easier - and less expensive - for employers to get rid of penalty payments.

(Another of its provisions was to make it easier for workers to "cash out" part of their annual leave - to exchange days off for money. How this squared with the original rationale for forcing employers to give their workers paid holidays was never explained.)

Julia Gillard's Fair Work changes to Work Choices represented the first setback in the push towards the 24-hour, seven-day-a-week economy. They made it harder for employers to buy out penalty payments. And the "modern award" process - which replaced the various state awards with single national awards - inevitably involved increasing some penalty rates in some states.

But now the push has resumed. Last week, the NSW government moved to join Victoria in allowing all shops - not just those in the CBD - to open on Boxing Day. Now, say the retailers, all we need is for restrictions to be lifted on Easter Sunday.

And this week, the major banks revealed their intention to push for the definition of ordinary hours in the national banking award to be extended to include Saturday afternoons and all of Sundays. The banks say they'd still pay penalty rates, but the union doubts this promise would last. It says the banks' goal is to be able to roster employees to work any five days of the week without recognising traditional work patterns.

What's the banks' justification for seeking such a change? To promote "flexible and efficient modern work practices in a way that has proper regard to the considerations of productivity and employment costs".

Ah yes. It would make the economy more flexible and efficient, and thus raise productivity. Well, in that case, say no more. Silly me.

It's not hard to see why there's been so little public questioning of this push towards a 24/7 economy. It's highly convenient to be able to shop whenever we have the time. The more two-income families we have, the more we value the ability to shop throughout the weekend.

It also fits with the trend towards leisure being commercialised - becoming something we buy (a meal out, a show) rather than something we do (kick a football in the park with our kids).

But this belief that life would be better if shops, restaurants and places of entertainment were open all hours rests on the assumption you and I won't be among those required to work unsociable hours to make it happen. An even less obvious assumption is that the push for a 24/7 economy will stop when it has captured shopping and entertainment; it won't continue and reach those of us who work in factories and offices.

As usual, the "flexibility" being sought is one-sided. Employers gain the ability to require people to work - or not work - at times that suit their firm's efforts to maximise its profits.

If those times don't fit with your family responsibilities - or just with your desire to enjoy your life (you selfish person, you) - or if the boss's requirements keep changing in unpredictable ways, that's just too bad.

It's the price to be paid for getting more prosperous (with the boss's standard of living rising quite a bit faster than yours).

But this is the part of modern life that makes no sense to me.

Accepting the economists' argument that keeping the economy running for more hours in the week is more efficient and so will raise our material standard of living, how exactly will this leave us better off?

Why does being able to buy more stuff make up for husbands and wives being able to see less of each other, having less time with the kids, having a lot more trouble getting together with your friends, and having your day off when everyone else is at school or working?

Why is this an attractive future? Why should our elected representatives reorganise our economy in ways that suit business and promote consumption, but do so at the expense of employees' private lives?

This is a classic case of business people, economists and politicians urging on us a mentality that prioritises the economic - the material - over the other dimensions of our lives. Yet again, no one pauses to ask what these "reforms" will do to our relationships.

Why is it the politicians who bang on most about the sanctity of The Family are also those most inclined to make family life more difficult?

Monday, April 2, 2012

Let's slow down the mining boom

Innovative thinking is not only in short supply in Australia's businesses - as our weak productivity performance attests - it's also hard to find in the economic debate.

You could count on one hand the economists who do some lateral thinking and throw into the debate some new way of viewing a problem and overcoming the familiar difficulties.

But one economist who does come up with new ideas to think about is Dr Richard Denniss, director of the Australia Institute. He observes that while everyone's been debating whether the mining boom's a good thing or a bad thing, no one's focused on the obvious question: what rate of growth of the mining industry is consistent with the national interest?

And in a paper to be published today, written with Matt Grudnoff, he puts his conclusion: The Macro-Economic Case for Slowing Down the Mining Boom.

Why has this idea not occurred to anyone before? Partly because of the unthinking belief of almost all business people, politicians and economists that all economic growth is good and the faster the better.

When the new Queensland Premier announced his intention to speed up the approval process for new mines, most of the aforementioned would have nodded in approval. But why is faster than the economy can cope with better?

Partly, Denniss argues, because

of the way economists divide economic issues into micro and macro. As a micro issue the focus is on allowing private interests to make profitable investments as they see fit, with no more government intervention than is necessary to limit damage to the local environment.

As a macro issue the focus is on taking whatever strength of demand the private sector serves up and "managing" it to ensure it leads to neither excessive inflation nor excessive unemployment. If demand's too strong you raise interest rates to chop it back; if it's too weak you cut rates to beef it up.

But Denniss argues the boom's too big to fit this neat division. According to the Bureau of Agricultural and Resource Economics, there are 94 mining projects worth $173 billion at an advanced stage of development (plus a lot more at earlier stages).

For the miners to attempt such a huge amount of activity in such a short space of time inevitably creates what Denniss calls "macro-economic externalities" - adverse spillover effects on the rest of the economy, in the form of skilled labour shortages, wages pressure and probably a higher-than-otherwise dollar.

No one understands this better than the Reserve Bank, of course. But the higher-than-otherwise interest rates it has and will use to limit the inflation fallout from the boom aren't intended to (and couldn't be expected to) limit the boom.

Rather, they're intended to crimp the rest of us - in particular, consumer, housing and non-mining business investment spending - to "make room" for the boom-crazed miners. This will succeed in controlling inflation, no doubt, but what reason is there to believe it will lead to the most efficient allocation of the nation's resources?

Denniss suggests this thought experiment: if all of Australia's mineral resources were controlled by a profit-maximising monopolist, would it respond to the present exceptionally high world prices by building as many new mines as possible as quickly as possible?

Would a monopolist bid against itself for scarce labour and infrastructure capacity (to get the minerals to port and onto ships)? Or would it invest in training and infrastructure before it began expanding production?

His point is not to advocate monopoly, obviously, but to make clear the potential for conflict between the interests of the miners and the interests of the nation.

We are a monopolist in the sense that all the natural resources belong to us. Which means it's up to us to ensure they're exploited in the way that benefits us most. In this we need to remember the miners are largely foreign-owned (meaning we retain little of the after-tax profits) and the resources are non-renewable.

How much do we lose if they stay in the ground a little longer? Are we really expecting that within a decade or so the world won't be willing to pay much for them?

We're a monopolist also in the sense that it's our economy and we bear all the cost of the inflation and excessive exchange rate generated by the foreign miners' mad dash to expand production. We aren't a monopolist in the sense that we control the world supply of coal and iron ore, but we are big enough in the world market for our actions to have a significant effect on world prices.

A monopolist would be more inclined to sit back and enjoy the high world prices and less inclined to madly expand production and thereby undermine the high price (to coin a phrase). And to the extent a monopolist did expand, it would start with the most profitable opportunities and progress towards the least profitable.

Denniss's point is: why should we allow the miners to turn the decision about which mines get built first into a race rather than a ranking? And why should we bear the macro-economic costs generated by the miners' race to be first out the door with our resources?

He proposes that new mining projects be required to bid at auction for a set number of development permits. This would ensure the most profitable projects proceeded first.

And if you don't like the sound of that, he says the same effect could be achieved by removing the mining industry's present subsidies on fuel and alleged research and development spending.

Saturday, March 31, 2012

We risk letting lawyers stifle innovation

If our business people, economists and politicians are genuine in their desire to lift our productivity, rather than just moan about the Fair Work Act, they'll put reform of the regulation of intellectual property high on their to-do list.

Unfortunately, the minor changes to intellectual property regulation put through Parliament last week, to the accompaniment of great self-congratulation by the Gillard government, suggest the professed true believers in productivity improvement just don't get it.

If we're really concerned to encourage invention, innovation and creativity, nothing could be more central than the way we regulate intellectual property. But I get the feeling a lot of people have lost sight of what we're doing and why we're doing it.

So let's start with the basics. When governments grant patent or copyright protection they are intervening in the market to give particular individuals or businesses a monopoly over the commercial exploitation of that idea for up to 20 years.

When you've got a monopoly you're able to charge higher prices than if you had competitors selling access to the same idea. So why on earth would a government grant such favours?

Well, the rationale is to increase the monetary incentive for people to come up with inventions, innovations and creations that benefit the community. If I dreamt up some new thing, but other people were immediately able to copy it and compete with me, I wouldn't get much reward for my effort and ingenuity.

In which case, people like me won't be trying very hard to come up with new ideas. So the government grants inventors and creators a temporary monopoly over their idea to encourage more good ideas.

The point to grasp is that this approach involves a trade-off. The government imposes a cost on the community by effectively allowing rights-holders to overcharge for their products, but it does so in return for the greater benefits this brings to the community.

This suggests, first, that governments should never grant rights or enhanced rights to individuals and firms unless it's clear the granting of those rights leaves the community better off. Second, governments should always be checking to ensure the benefits to the public from the protection of intellectual property exceed the costs to the public of that protection.

Were the public costs ever to exceed the public benefits, the entire economic justification for the artificial creation of property rights would evaporate. It would be a classic instance not of "market failure" but "government failure".

The reason reform of intellectual property should be high on the productivity promoters' to-do list is that we seem to be drifting ever closer to the point where its costs exceed its benefits. That seems particularly true in the United States - and we look to be going the same way.

The US plays a pivotal role in the globe's intellectual property. It's at the frontier of technological change and creativity, and is a net exporter of intellectual property to every country in the world. Increasingly, intellectual property, designs for new machines, pharmaceuticals, electronic gadgets, films, TV shows, books, recordings and much else, is the main thing the US sells the world.

These days, making the world a safer, more profitable place for American intellectual property is the main objective of US trade policy - as we found when we negotiated the misnamed free-trade agreement with the US in 2004. We were pressured to make our laws fit with the Americans', and we'll get more pressure to become more like them in all future trade negotiations.

So what's the problem? Much of it is that the whole area has been taken over by lawyers. It's become hellishly legalistic, complicated, loophole-ridden and expensive. In the process, the lawyers have lost sight of the economic object of the exercise. It's become an area of endless battles between businesses arguing over their rights.

The other part of it is that powerful industry groups have taken to lobbying politicians to change the law in ways that advance their interests without benefit to the public. And US businesses increasingly engage in game-playing in the hope of ripping each other off.

American pollies are often persuaded to extend the life of intellectual property protection retrospectively, which obviously does nothing to encourage innovation in the past.

The patent system has been extended to cover software (which was already copyright) and even business methods. It's too easy to get a patent - you can get them for very obvious ideas - and patents can be too broad, covering yet-unthought-of uses.

You can get a patent for something that's very similar to someone else's patent. But because they're handed out so easily, you often don't know whether a patent is valid - whether his patent beats your patent - unless you spend between $5 million and $7 million battling it out in court. The high cost of litigation means big businesses regularly intimidate small businesses.

This problem of "fuzzy boundaries" to patents is so bad some businesses make a living as 'patent trolls' buying up dodgy patents, then threatening to sue legitimate patent-holders. The victim pays what amounts to protection money to avoid the higher cost of a court battle.

You've no doubt heard of the huge patent battle between Apple and Samsung being fought in courts around the world. Which side has the legitimate patents for tablet technology?

Pharmaceutical companies use a trick called "evergreening" to stop their patents expiring, which would have allowed competition from generic drug producers to slash the prices they can get for their drugs.

The owners of intellectual property rights often attempt to use them to protect themselves from losing business to firms developing more innovative ways of doing things.

Just as undesirable, researchers trying to develop better products can be held back by the prohibitions or high costs imposed by existing patent holders (some of which may not be legit).

It's got so bad in the US that, according to the calculations of a leading academic campaigner for patent reform, James Bessen, of Boston University school of law, for all US patents bar those for chemicals and pharmaceuticals, earnings from their patents are more than exceeded by the cost of litigation to protect those patents. He calls this a "patent tax".

If he's right, the intellectual property system has degenerated to the point where it's actually inhibiting innovation. We're being forced to pay higher prices, but getting nothing in return.

Wednesday, March 28, 2012

Why most of us live in big cities

We live in the age of the city. A year or two ago we passed the point where half the world's population was now living in urban areas. This is because the rapid economic development of many large but poor countries is as much about urbanisation as industrialisation. Now experts are predicting the proportion of us living in cities will rise to 70 per cent within the next 40 years.

This isn't happening by accident. People migrate from the country to the city in the confident belief - invariably more right than wrong - this will raise their standard of living.

Putting it another way, there are huge economic advantages if most of us live in big cities, packed together like sardines. Economists call these the "economies of agglomeration".

When businesses are located close to their customers, suppliers and potential employees, they can produce their goods and services at less cost. When a number of businesses in the same industry are located in the same city there are further savings.

That's the economists' conventional explanation of why we pile into cities.

More recently, Professor Edward Glaeser, of Harvard, has argued that cities - and the face-to-face contact they make possible - are the ideal bed for germinating and propagating the ideas that drive the information economy.

So, much of the rich world's affluence is owed to our penchant for crowding together. And when politicians and economists turn their mind to cities their concern is usually to ensure the economic benefits keep rolling in.

But what about the social, psychological side? Do we pay a high social or mental price for so much unnatural crowding? As a general proposition, I'm not sure we do. Most city slickers enjoy living in cities, surrounded by so many people and so much choice.

Even so, we're engaged in a tricky balancing act, enjoying the benefits of having so many around us while retaining some personal space and privacy. In the country everyone looks after each other - or so we like to think - but in the city we tend to mind our own business.

When we get this balance wrong, city living becomes more impersonal and less satisfying than it should be. In the extreme case, there can be so much keeping-yourself-to-yourself that individuals feel lonely and isolated in the midst of the crowd.

Do economists ever worry about this sort of thing? No, not their department. Do politicians? Since they're so preoccupied with matters economic, probably not as much as they should.

These issues are explored in a new report from the Grattan Institute, Social Cities, by Jane-Frances Kelly and others. Let me summarise its findings.

It finds that social connection - our relationships with others - is critical to our wellbeing. Humans are social animals. We evolved in an environment where group membership was essential to survival, so now it's built into our brains.

We form connections at three levels: intimate personal and family relationships, links with a broader network of friends, relatives and colleagues, and collective connection - our feeling of belonging in our communities.

Social connection is important to our health as well as our happiness. Loneliness can be as bad for our health as high blood pressure, lack of exercise, obesity or smoking. Australian research shows that older people with stronger networks of friends live longer.

"The importance of social connection to health and wellbeing means that, for many people, improved relationships are a much more realistic path to a better life than increased income," the report says.

The few internationally comparable statistics relating to social connection suggest Australia is doing well. On the proportion of people who have relatives or friends they can count on in a time of need, we rank sixth out of 41 mainly developed countries. On the proportion of people who feel most other people can be trusted, we rank fifth.

Even so, our degree of social connection is declining. Our average number of friends has fallen in the past 20 years, as has the number of local people we can ask for small favours. And social connection is unevenly distributed. People on lower incomes and people with disabilities have lower trust in others.

One-person households account for a quarter of all households and are the fastest-growing type. You're not lonely just because you live alone, but the risk of it is a lot higher. Being a single parent is a risk factor, as is having limited English.

The report stresses it doesn't believe in physical determinism - that design is destiny. Even so, "the shape of our cities can make it easier, or harder, for people to interact'.

"Where we live, work and meet, and how we travel between these places, has a big impact on how much time we have to connect, and who we can meet face-to-face," it says.

Social connection is becoming more widely recognised as an important goal in the design of streets and the architecture of buildings. But when major decisions about transport infrastructure and land use are made, social connection is rarely given the same priority as the movement of people and goods for employment and commerce.

Inefficient urban transport networks see much of our day swallowed up by commuting, leaving us less time for friends and family. It's simpler for people to get together to play sport if training grounds are available nearby, and it's easier to organise a picnic if you can walk to a local park.

"If our cities are to absorb larger populations and improve quality of life for all, they will need to meet our social as well as our material needs," the report concludes.

Monday, March 26, 2012

Subsidies no way to fix high dollar problem

Emeritus Professor Max Corden, of Johns Hopkins University, formerly of Oxford University and now back at the University of Melbourne, is probably Australia's most distinguished living economist. So when he writes on what we could do about "Dutch disease" we ought to take note.

What follows is my account of his paper for the Melbourne Institute, The Dutch Disease in Australia: Policy Options for a Three-Speed Economy. As is often my custom, it will consist largely of direct quotes, indirect quotes and paraphrases of his paper. This practice is known as "reporting". If I misreport his views, feel free to criticise; but don't be silly and accuse me of stealing them.

Corden is an expert on Dutch disease - the economists' term for a situation where a boom in one export industry leads to an appreciation in the exchange rate, which reduces the profitability and the output of other export and import-competing industries.

He starts by dividing the economy into not two, but three sectors according to how they're affected by the boom. First is the "booming sector" (mining and related industries, in our case), then there's the "lagging sector", consisting of the other trade-exposed industries hard hit by the high dollar (part of manufacturing, agriculture and tradeable services such as tourism and some education).

But then there's the "non-tradeable sector" consisting mainly of those service industries whose prices are determined only by domestic supply and demand. This third sector is important because it's the largest part of the economy and "there are almost certainly net gains" from the boom.

The gains arise because the boom causes increased domestic spending on non-tradeables and because of the reduced prices of imported items.

Corden argues there are three broad options for the government to choose from in responding to the difficulties Dutch disease causes for the lagging sector.

Option 1 is "do nothing". "The real exchange rate appreciation is an inevitable consequence of the terms of trade boom and the capital inflow, both of which have benefits," Corden says.

"Some industries rise and some decline, and some declines, in any case, may be temporary. The government can help in the adjustment process, but should not try and stop or slow up adjustment," he says.

"This is one point of view, though it may not be politically attractive," he says. But "doing nothing" doesn't prevent the government from fostering the flexibility of the economy, improving the skills of the labour force, removing obstacles to people moving, temporarily assisting losers, providing information or improving infrastructure.

Option 2 is "piecemeal protectionism". "Of the various groups of industries adversely affected by Dutch disease it is manufacturing - or perhaps particular manufacturing industries, or even firms - that are usually selected for deserving special assistance, whether in the form of subsidies or import tariffs," Corden says.

But this option is "highly undesirable" and "based on questionable economic thinking". (Note that when Corden uses the term "protection" he's including subsidies as well as import tariffs.)

What's wrong with piecemeal protection? Apart from all the usual arguments against protection, there's one that applies particularly to Dutch disease, but is usually overlooked. Corden calls it the "general equilibrium effect".

"Suppose extra protection is provided for the motor car industry," he says (writing well before last week's announcement of extra assistance to General Motors). This reduces imports of cars, as is the intention of the policy, but will lead to extra appreciation of the exchange rate.

If all manufacturing industries were significantly protected there would be a substantial appreciation, which would actually worsen the Dutch disease effects on other industries in the lagging sector - agriculture, tourism and education exports.

Similarly, protection for selected manufacturing industries would have adverse effects on other industries in the lagging sector, including those parts of manufacturing that didn't receive the extra assistance.

"These losers would thus suffer not only from the effects of the mining boom but also from the political success of their industry colleagues in extracting protectionist measures from the government," he says.

It's been suggested that the miners should be required to source various supplies domestically rather than import them. A similar requirement could be imposed on government spending and on private suppliers to the government.

Such requirements would also lead to greater exchange-rate appreciation than otherwise. They would thus benefit some industries and workers but, through their aggravation of the Dutch disease effect, would damage other industries and workers.

The third option the government could choose in responding to Dutch disease is "fiscal surplus combined with lower interest rate". The government cuts spending or increases taxes to achieve or increase a budget surplus.

This would have a contractionary effect on demand in the economy, but its reduction of inflation pressure would allow the Reserve Bank to ease its monetary policy and lower the official interest rate. This, in turn, would lead to some depreciation of the exchange rate because our lower interest rates relative to those in other countries would reduce the net inflow of capital to Australia.

So the Dutch disease effect would be moderated, but at the cost of politically difficult changes in taxation and spending.

The advantage of this option is that it benefits all lagging-sector industries evenly. But, Corden argues, it's just one way of providing "exchange-rate protection". So it, too, creates winners and losers.

All tradeable industries benefit from the lower exchange rate (including the miners), but the much larger, non-tradeable sector loses from it by having to pay more for imports. The lower dollar also reduces the incentive to invest in Australian development.

I conclude from Corden's analysis there's no easy, costless way to ameliorate the downside that comes with the blessing of the mining boom. There are just options that carry more disadvantages than others.

Saturday, March 24, 2012

Is Australia living beyond its means?

It has become fashionable to say the US is ''living beyond its means''. But can the same accusation be levelled at Australia? It was a claim we used to hear often when people worried about the big deficits we were running on the current account of the balance of payments.

During the 1960s, the current account deficit averaged the equivalent of 2 per cent of gross domestic product. By the '80s, however, it was averaging 4 per cent, rising to 4.25 per cent during the '90s and noughties.

But though few people have noticed, in recent years the deficit has been falling. And for 2011 it was just 2.25 per cent.

Why the decline? And what does this tell us about whether we are or aren't living beyond our means?

It gets down to what's happening to the nation's levels of saving and investment. And James Bishop and Natasha Cassidy provide a detailed account of trends in national saving and investment in the latest Reserve Bank bulletin. Most of the facts and figures I'm using are from their article.

The nation's annual investment spending occurs in three categories: households investing in the construction of new homes, companies investing in new equipment, buildings and other structures, and governments investing in infrastructure.

The money to pay for all that investment spending has to come from somewhere and, for the most part, it's provided by the nation's savers.

Households save when they spend less than all their income on the consumption of goods and services. Companies save when they retain part of their after-tax profits rather than paying them all out to shareholders in dividends. Governments save when their raise more in revenue than they need to pay for their recurrent spending.

If Australians saved more than we wanted to invest in a period, we'd lend our excess saving to foreigners. If we want to invest more than we've saved in a period, we call on the savings of foreigners to make up the difference. We either borrow their money or we sell them Australian assets.

In fact, we almost always want to invest more than we save, and the amount we need to acquire from foreigners is called the current account deficit.

The level of our national investment spending has stayed reasonably steady over the years, somewhere below the equivalent of 30 per cent of GDP. Business investment accounts for more than half of this.

You might expect business investment to be particularly high at present because of the huge spending on new mines and natural gas facilities. But while mining investment has been exceptionally strong, other business investment spending has fallen sharply in recent years. This may be due to the effect of the high dollar on the profits of trade-exposed industries.

Public investment spending - covering such things as transport, hospitals, educational facilities and state-owned utilities - declined significantly as a share of GDP during the '90s. This partly reflected efforts to balance budgets and reduce government debt but also the trend to having the private sector, rather than the public sector, provide infrastructure such as expressways.

But this decline was reversed during the noughties, public investment reaching 6 per cent of GDP in 2010. Initially this recovery was underpinned by infrastructure spending by state governments, though in later years it was driven by the federal government's stimulus spending on school buildings and public housing. The latter has fallen off very recently, of course.

Households' investment spending on new housing usually fluctuates between 4 and 6 per cent of GDP. But it was particularly strong in the noughties and has fallen back in very recent years.

Putting these disparate trends together, national investment has actually fallen as a share of GDP in the past year or two, dropping to 27 per cent in 2011.

Australia's level of investment has almost always been significantly higher than the average for the developed economies, our 27 per cent at present comparing with their 19 per cent.

On the face of it, our desire to invest heavily in the further development of our economy hardly qualifies as a case of living beyond our means.

As the authors remind us, investment is a key driver of the productivity of labour. And when we spend on expanding the nation's capacity to produce goods and services, we're ensuring a higher material standard of living in future. The income we generate should easily cover the cost of servicing our foreign borrowings.

But it ain't quite that simple. Well-directed investment is a virtue, no doubt. But if we're having to borrow from foreigners because we're not doing enough saving of our own, that could be a problem.

Are we saving as much as we should be? Don't forget, saving equals income minus consumption. So if we're consuming too much, we won't be saving enough. But how much is enough?

As a nation we are saving - at present, a bit under 25 per cent of national income (GDP) - so we can't be accused of borrowing to finance consumption, which is surely the most obvious case of living beyond your means.

But, equally obviously, we could be saving more than we do, so are we saving enough?

Looking at the components of national saving, saving by companies has been slowly trending up over the decades and at present is at a record level of about 14 per cent of GDP.

Government saving was very weak in the '70s and '80s but, following the deep recession of the early '90s, strengthened to about 5 per cent of GDP during most of the noughties.

It's now back to zero, however, in consequence of the 2008-09 recession the pollies keep saying we didn't have.

The rate of household saving fell steadily through the '70s, '80s and '90s but began increasing sharply in the mid-noughties and is now back up to about 10 per cent of GDP, its highest since the '80s. Pulling the components together, national saving is now back up to almost 25 per cent of GDP, also its highest since the '80s. And this is about 6 percentage points higher than the average for the developed countries.

Why has our current account deficit almost halved to 2.25 per cent of GDP in the past year or two? Because national investment is down a bit on the one hand, while national saving is up a bit on the other.

The charge that we're living beyond our means has never been less applicable.

Thursday, March 22, 2012


Talk to TEAR Breakfast, Sydney, Thursday, March 22, 2012

I’m delighted to accept John McKinnon’s invitation to speak on TEAR’s theme for the year, Enough. What is enough for us? When will the poor have enough? The standard answer in a capitalist economy, of course, is that you can never have enough. Bigger is always better. And conventional economics gives the same answer. Indeed, the very goal of economics is to help communities deal with their craving for more.

The way economists put it is that their goal is to help the community deal with ‘the problem of scarcity’ - the fact that the physical resources available to us are finite, whereas our wants are infinite. There’s any amount of goods and services we’d like to consume, but the wherewithal to produce those goods and services is strictly limited. So micro economists see their role as to advise the community on ways to stretch those limited resources further, to help us get more bang for our buck.

But it can be argued that the developed market economies’ attack on the problem of scarcity over the time since the industrial revolution has been so remarkably successful we’ve actually defeated the problem of scarcity and replaced it with a different problem, the problem of abundance.

It’s hard to deny that the citizens of the rich world live lives of great abundance - of more than enough. Our material standard of living has doubled or trebled since 1950 and has multiplied many times over since the start of the industrial revolution in the mid-1700s. No one in the developed world is fighting for subsistence; even the relatively poor among us are doing well compared with the poor of Asia or Africa; we satisfied our basic needs for food, clothing and shelter a mighty long time ago; our real incomes grow by a percent or two almost every year, and each year we move a little higher on the hog. Our greater affluence can be seen in our ability to limit the size of our families, in the growth in the size and opulence of our homes, the fancy foreign cars we drive, our clothes, the private schools we send our children to, the restaurants we eat in and the plasma TVs, DVDs, video recorders, personal computers, mobile phones, stereo systems, movie cameras, play stations and myriad other gadgets our homes teem with.

How has this unprecedented and widespread affluence come about? It’s the product of the success of the market system and even of the sound advice of the economists in identifying ways to fine-tune that system. But above all it’s the product of all the technological advance - the invention and innovation - the capitalist system is so good at encouraging.

It’s therefore reasonable to say that, when we look around us, what we see is not scarcity but abundance. On the face of it, this is something to be celebrated. But, as with everything in life, no blessing is unalloyed.

The first and most obvious problem with abundance is the damage the huge expansion in human activity - most of it economic activity - is doing to the natural environment. For millennia, the environment was so vast and economic activity so limited it was easy to see the environment and the economy as completely divorced. Air and water and fish in the sea were in such abundance that economic analysis could class them as ‘free goods’ and promptly ignore them. By now, however, the huge expansion in economic activity has started to overwhelm the environment. We see that everywhere around us: air pollution in cities, widespread over-fishing and the destruction of species, waste discharges leading to the degradation of waterways and beaches, the damage caused by European farming methods, the near drying up of some of our river systems, the opening of the hole in the ozone layer and, of course, global warming. All these environmental concerns are the product of the abundance of human and economic activity, a concern that didn’t exist when our major concern was scarcity - our then-limited success in overcoming nature’s impediments to the satisfaction of wants.

The second but less obvious problem with abundance is that it exacerbates humankind’s difficulty achieving self-control. Problems of self-control are ubiquitous to daily life. The one we’re most conscious of these days is the temptation to eat too much. But there are many more: to get too little exercise, to smoke, to drink too much, to watch too much television, to gamble too much, to shop too much, to save too little and put too much on your credit card, to work too much at the expense of your family and other relationships. I could add: to give too little to the poor.

The more stuff we have - the fewer among us whose main problem remains satisfying our basic needs - the more problems of self-control emerge as our dominant concern. But there’s a deeper point: humans have never been good at self-control, but as long as we were poor and resources were scarce, our self-control problem was naturally held in check. It’s when things become abundant, when we can afford to indulge so many more of our whims, when we have a huge range of things or activities to choose from, that self-control problems become more prevalent and we have trouble making ourselves choose those options that are best for us in the longer term, not just immediately gratifying.

The third aspect to the problem of abundance - the problem of enough - is the increased resources devoted to the socially pointless pursuit of social status through consumption. When we have long passed the point where our basic needs for food, clothing and shelter are being satisfied, but our real incomes continue to grow by a couple of percent a year, we have to find something to do with the extra money. A fair bit of that extra income is spent on ‘positional goods’ - goods whose purchase is designed to demonstrate to the world our superior position in the pecking order. Everyone needs a car, but that need can be met quite adequately by a 10-year-old Toyota. When we feel we must buy a new car every few years, or when we buy an expensive imported European car, the extra we pay is commonly motivated by a conscious or unconscious desire to impress people and so constitutes a positional good. The fields in which we can use our spending to demonstrate our high social status are legion: the size, opulence and desirable location of our homes is probably the most significant instance, but there’s also the clothes we wear, the clothes we put on our children, the restaurants we visit, the cars we drive, the schools we send our kids to and much else. The point here is that, from the viewpoint of the community rather than the individual, the pursuit of status is a zero-sum game: the gains of those individuals who manage to advance themselves in the pecking order are offset by the loss of status suffered by those they pass. Thus a perpetual status arms-race is socially pointless. From the perspective of society, a lot of resources are simply wasted.

All this is the case for believing people in the rich world do have Enough already: that we waste so much trying to prove our superior social position, that we have so much trouble stopping ourselves doing things that feel good but are contrary to our long-term interests, and that the 15 per cent of the world’s population who make up the rich world have done so much damage to the natural environment in our efforts to raise our material living standards to where they are.

This is the case for saying we already have enough, that we don’t need more - that we should seek all further progress in the non-material dimensions of our lives - and that we should rejig our market economy in ways that allow it to function satisfactorily without growth.

But what about the world’s poor - do they have enough? Obviously not. Do they need to become as rich as we are before they can be said to have enough? In theory, and since it’s clear we have more than enough, it’s probably true to say they don’t need to have as much as us to have enough. But I doubt if they’d take our word for it and, more to the point, I don’t think we have a moral right to tell others they should settle for a level of affluence less than our own.

All this would be no more than a philosophical debate were it not for the fact that the two most populous poor countries in the world - China and India - are well-established on the path of rapid economic development. Their material living standards are rising quickly, and a lot of other large poor countries - including Brazil and Indonesia - are coming up behind them.

Is it physically, environmentally possible for all these extra billions to become anything like as materially prosperous as we already are? Looking at the environmental damage our efforts have already done, I doubt it. If so - if there probably aren’t enough natural resources and waste-absorbing capacity left for the poor to make themselves as rich as us - that says we should, at the very least, call a halt to our efforts to get richer. We already have more than enough.

Wednesday, March 21, 2012


Debate at The Sydney Globalist launch, Sydney University, Wednesday, March 21, 2012

I'm happy to be speaking in favour of govt intervention in the energy market and against a 'free' market. I’ll be giving an orthodox, economic response to the question and my colleague John Mikler will give a more radical, political response. He’s meant to be channelling Bob Carr - who cancelled his appearance here tonight when he got a better offer from someone called Julie/Julia - but I’m not sure John’s voice is deep enough.

The question we’re debating - a marketplace or a government’s place - is a clever play on words, but really, it makes no sense. It presents a false dichotomy. In the real world - as opposed to the world of economics textbooks - there are no markets that exist without government intervention and, since the fall of communism, no economies that governments attempt to regulate with no role for market forces. Even the most extreme libertarian - and we’ll be hearing from some extreme ones tonight - wants the government to intervene in the market to protect property rights and enforce contracts etc. Markets as we understand them are, in fact, the creation of governments. So the choice we face is not between the extremes of no government or no market, but what degree of intervention we judge to be appropriate - ie we're searching for - and arguing over - the right combination of intervention and market forces.

I prefer to make these judgments fairly pragmatically rather than based on ideology, and so make them case-by-case, or market-by-market. Only a fool denies the powerfulness of market forces, or their general efficiency in allocating resources. But, equally, only a fool imagines markets are perfect - infallible.

The overwhelming weight of scientific opinion tells us the burning of fossil fuels over the past 200 years or so has led to an excessive build up of greenhouse gases in the atmosphere, which has probably already begun to alter the world’s climate in damaging ways. Should this build-up continue, we’re told, there’ll be significant disruption to the climate, leading to significant disruption to the economy and a significant decline in our material standard of living.

If the scientists are right and we do have a problem, it would be idle to expect that market forces would, without assistance, act to correct the problem. That is, this is a clear case of ‘market failure’. The actions of the private producers and consumers of fossil fuels impose costs on the community, but those costs are not reflected in the market prices at which fossil fuels are exchanged. If we could find a way to get those costs incorporated into market prices - if we could, in economists’ jargon, ‘internalise the externality’ - then we could expect the operation of market forces to help discourage the use of fossil fuels, encourage people to turn to alternative forms of energy and create a monetary incentive for people to search for technological solutions to the problem.

If all this sounds like terribly standard economics, it is. The argument I’ve just given you is accepted by the great majority of economists. I need to remind you that the emissions trading scheme - and its close cousin, the carbon tax - are ‘economic instruments’ that were invented by economic rationalists as the best way of dealing with the threat of climate change with minimum loss to our material standard of living. Many economists would leave it there, but many others would add that there could well be a role for supplementing the price on carbon with more direct interventions such the imposition of emissions standards for new motor vehicles or building codes requiring better insulation. I’m a belt-and-braces man myself.

Under the urging of economists, many governments have used trading schemes or pollution taxes to solve more localised environmental problems, such as over-fishing. In contrast, climate change presents a far more daunting challenge - in Professor Ross Garnaut’s words, a diabolical challenge - because greenhouse gas emissions are a global issue than can be dealt with only with concerted action by all the major countries. This feature of the problem presents considerable scope for free-riding (why doesn’t my country bludge on the efforts of other countries) and Mexican standoffs (I’ll do something only after you’ve done something).

So far it’s proved hard to get agreement between the major countries on binding commitments to reduce emissions, which is not to say most of them are making no effort. There are problems with organising watertight schemes for the trading of emissions permits between countries, and real but hugely exaggerated problems with the potential for ‘carbon leakage’ (the risk of losing industries to those countries with lower emissions standards than ours).

I’m sure we’ll be hearing about these problems at length - mainly from people who, with their superior scientific expertise, deny we’ve got a problem with climate change in the first place. My response to these difficulties is simple: Australia has enough at stake for us to want to be part of the effort to break the Mexican standoff by putting our contribution on the table and getting on will implementing it. Assuming nothing can be done is the best way to ensure nothing is done, with all the economic destruction that would bring.

Endless growth and a healthy planet don't compute

Do you ever wonder how the environment - the global ecosystem - will cope with the continuing growth in the world population plus the rapid economic development of China, India and various other "emerging economies"? I do. And it's not a comforting thought.

But now that reputable and highly orthodox outfit the Organisation for Economic Co-operation and Development has attempted to think it through systematically. In its report Environmental Outlook to 2050, it projects existing socio-economic trends for 40 years, assuming no new policies to counter environmental problems.

It's not possible to know what the future holds, of course, and such modelling - economic or scientific - is a highly imperfect way of making predictions. Even so, some idea is better than no idea. It's possible the organisation's projections are unduly pessimistic, but it's just as likely they understate the problem because they don't adequately capture the way various problems could interact and compound.

Then there's the problem of "tipping points". We know natural systems have tipping points, beyond which damaging change becomes irreversible. There are likely to be tipping points in climate change, species loss, groundwater depletion and land degradation.

"However, these thresholds are in many cases not yet fully understood, nor are the environmental, social and economic consequences of crossing them," the report admits. In which case, they're not allowed for in the projections.

Over the past four decades, human endeavour has unleashed unprecedented economic growth in the pursuit of higher living standards. While the world's population has increased by more than 3 billion people since 1970, the size of the world economy has more than tripled.

Although this growth has pulled millions out of poverty, it has been unevenly distributed and has incurred significant cost to the environment. Natural assets continue to be depleted, with the services those assets deliver already compromised by environmental pollution.

The United Nations is projecting further population growth of 2 billion by 2050. Cities are likely to absorb this growth. By 2050, nearly 70 per cent of the world population is projected to be living in urban areas.

"This will magnify challenges such as air pollution, transport congestion, and the management of waste and water in slums, with serious consequences for human health," it says.

The report asks whether the planet's resource base could support ever-increasing demands for energy, food, water and other natural resources, and at the same time absorb our waste streams. Or will the growth process undermine itself?

With all the understatement of a government report we're told that providing for all these extra people and improving the living standards of all will "challenge our ability to manage and restore those natural assets on which all life depends".

"Failure to do so will have serious consequences, especially for the poor, and ultimately undermine the growth and human development of future generations." Oh. That all?

Without policy action, the world economy in 2050 is projected to be four times bigger than it is today, using about 80 per cent more energy. At the global level the energy mix would be little different from what it is today, with fossil fuels accounting for about 85 per cent, renewables 10 per cent and nuclear 5 per cent.

The emerging economies of Brazil, Russia, India, Indonesia, China and South Africa (the BRIICS) would become major users of fossil fuels. To feed a growing population with changing dietary preferences, agricultural land is projected to expand, leading to a substantial increase in competition for land.

Global emissions of greenhouse gases are projected to increase by half, with most of that coming from energy use. The atmospheric concentration of greenhouse gases could reach almost 685 parts per million, with the global average temperature increasing by 3 to 6 degrees by the end of the century.

"A temperature increase of more than 2 degrees would alter precipitation patterns, increase glacier and permafrost melt, drive sea-level rise, worsen the intensity and frequency of extreme weather events such as heat waves, floods and hurricanes, and become the greatest driver of biodiversity loss," the report says.

Loss of biodiversity would continue, especially in Asia, Europe and southern Africa. Native forests would shrink in area by 13 per cent. Commercial forestry would reduce diversity, as would the growing of crops for fuel.

More than 40 per cent of the world's population would be living in water-stressed areas. Environmental flows would be contested, putting ecosystems at risk, and groundwater depletion may become the greatest threat to agriculture and urban water supplies. About 1.4 billion people are projected to still be without basic sanitation.

Urban air pollution would become the top environmental cause of premature death. With growing transport and industrial air emissions, the number of premature deaths linked to airborne particulate matter would more than double to 3.6 million a year, mainly in China and India.

With no policy change, continued degradation and erosion of natural environmental capital could be expected, "with the risk of irreversible changes that could endanger two centuries of rising living standards". For openers, the cost of inaction on climate change could lead to a permanent loss of more than 14 per cent in average world consumption per person.

The purpose of reports like this is to motivate rather than depress, of course. The report's implicit assumption is there are policies we could pursue that made population growth and rising material living standards compatible with environmental sustainability.

I hae me doots about that. We're not yet at the point where the sources of official orthodoxy are ready to concede there are limits to economic growth. But this report comes mighty close.

Monday, March 19, 2012

How both sides stuffed the federal tax base

Two weeks ago the secretary to the Treasury, Dr Martin Parkinson, dropped a fiscal bombshell that's drawn remarkably little comment, even though - or perhaps because - it blows the budgetary calculations of both sides of politics out of the water.

Parkinson said that since the global financial crisis, federal tax revenue had fallen by the equivalent of 4 percentage points of gross domestic product [about $60 billion a year] and was ''not expected to recover to its pre-crisis level for many years to come''.

This had made the task of maintaining medium-term budgetary sustainability harder for both the Commonwealth and the states. ''For both levels of government, surpluses are likely to remain razor-thin without deliberate efforts to significantly increase revenue or reduce expenditure,'' he warned.

The most obvious (and least consequential) implication of this news is its threat to Julia Gillard's resolve to return the budget to surplus next financial year without fail.

But Gillard's problems pale in comparison to Tony Abbott's, with his oddly ideological and populist commitment to rescind both Labor's carbon tax and its mining tax without rescinding all the tax cuts and spending increases the taxes will pay for.

There seems little doubt Abbott's term in office would either be marked by an orgy of broken promises or be consumed by agonising over what spending to cut, with eternal lobbying both before and after the fact. Probably a fair bit of both.

Parkinson is telling us there's now a disconnect in the established relationship between the rate of growth in the economy and the rate of growth in tax collections. The economy can be growing at a reasonable rate without that meaning tax collections are growing strongly.

It will be a lot harder in future for politicians of either side to keep the budget in surplus. What was a doddle in the noughties will now require unremitting discipline and political courage.

And this says all the demonising of budget deficits and government debt we've heard unceasingly from the Liberals for the past three years - all of it seconded by weak-kneed Labor - will prove extraordinarily hard to live up to over the rest of this decade.

Keeping the budget in ''razor-thin surplus'' will be hard enough; eliminating net debt will be very much harder - especially since the potential-privatisations cupboard is now almost bare.

It would be the easiest thing in the world for our pollies on both sides to catch a dose of the North Atlantic disease and let deficits and debts roll on.

Should this happen, it will be because they possess neither the bloody-mindedness to live up to their professed smaller government ideal nor the courage to make and defend explicit tax increases. As in the North Atlantic economies, it will be the path of least resistance.

The fascinating question is why this economy/tax revenue disconnect has occurred. Parko says it ''reflects a combination of cyclical and structural factors''. Just so.

One part of the explanation is that the 2008-09 recession - which it suits both sides to claim we didn't have - knocked an enormous hole in tax collections.

The cumulative write-down in revenue against the forward estimates between 2007-08 and 2011-12 has been about $130 billion.

The global financial crisis put an end to asset price booms in the housing and sharemarkets - with implications for tax collections from capital gains - and in the post-crisis world it's hard to see when those markets will boom again.

The problem for state budgets is structural. Their chief revenue source is the goods and services tax. During the many decades in which households were reducing their rate of saving, their consumption spending (and hence, GST collections) grew faster than their incomes.

Now their rate of saving has stabilised, consumption and GST revenue will grow no faster than household income.

And household income will be constrained by the stable-to-declining terms of trade and weak productivity improvement.

The first phase of the resources boom was more lucrative for the taxman because the main thing that happened was hugely higher coal and iron ore prices going straight to the mining companies' (taxable) bottom line. In the second phase, the now stable-to-falling prices are accompanied by much higher accelerated depreciation deductions arising from the construction of new mines and gas facilities.

But all these things are just elements of a more fundamental explanation for the budget's new growth/tax disconnect: the Howard government's decision to cut the rates of income tax for eight years in a row.

This has robbed the income-tax scale of its propensity to bracket creep. It also represented a significant shift in the federal tax mix, greatly reducing reliance on personal income tax and greatly increasing reliance on capital gains tax and, particularly, company tax.

Get the point? This switch was made at a time when, for all the reasons we've discussed, the level of non-income tax revenue was artificially high. Now those temporary factors have evaporated, leaving us with a badly wounded tax base.

Of course, Peter Costello shouldn't get all the blame for this monumental act of fiscal vandalism. When he sprang the last three of those eight annual tax cuts on Labor in the 2007 election campaign, it unhesitatingly matched him. And it insisted on delivering them, even after their structural folly must have become apparent.

This means neither side of politics wants to acknowledge the huge hole they've driven into the budget. When the pollies won't admit it, the econocrats can't either. And all the rest of us sheep take our lead from whatever nonsense the pollies do want to talk about.

Saturday, March 17, 2012

Why the economy isn't splitting in two

The news from last week's national accounts seemed very clear and very worrying: the economy was splitting in two, with the mining-boom states of Queensland and Western Australia roaring off into the future, leaving the rest of Australia going nowhere fast.

Over the year to December, state final demand grew by more than 11 per cent in WA and by 10 per cent in Queensland, but by about 1.5 per cent in the rest of Australia.

Fortunately, the true position isn't nearly as bad as that, as Kathryn Davis, Kevin Lane and David Orsmond explain in an article in the March quarter Reserve Bank Bulletin, issued this week.

The trick was that label "state final demand". When we talk about "growth" in the context of the national accounts we're talking about growth in (real) gross domestic product - the value of all the goods and services produced by the market during a period.

We focus on production because it's production that creates jobs and generates income. The equivalent of GDP at state level is gross state product.

So if you want to compare how the states are travelling you compare the growth in their GSP.

Trouble is, the Bureau of Statistics doesn't publish GSP quarterly, only annually. What it does publish quarterly is state final demand, the national equivalent of which is "domestic final demand".

Because these are the only figures available, the media (and some economists who should know better) have fallen into the habit of assuming state final demand and GSP are much the same thing.

Wrong. State final demand differs from GSP in one minor respect and one major respect: it takes no account of exports and imports. And that's not just overseas exports and imports, it's also exports and imports between the states.

In other words, when you make state final demand a substitute for GSP you're implicitly assuming each state has no trade with either the rest of the world or even the other states. Or that its trade is always in balance.

Guess what? Make such unrealistic assumptions and you get misleading results.

The authors point out that growth in spending on home building and non-mining investment over the year to December didn't vary much between the states. There were two main differences. One was that whereas consumer spending grew by about 3.5 per cent in NSW, Victoria and Queensland, it grew by 6 per cent in WA.

The other difference was the huge growth in mining investment spending in WA and Queensland. This was what did most to explain why their growth in final demand was in double figures whereas NSW and Victoria's demand growth was so modest.

But here's the point: the Reserve estimates that roughly half the spending on mining investment goes on imported equipment. Take this into account and the gap between the mining and non-mining states gets a lot smaller.

Another factor narrowing the gap is that part of the miners' spending on investment (and their ordinary operations) goes on goods and services, such as accounting and consulting services, produced in other states. And some of the workers who fly-in/fly-out take their income home to other states.

To give you an idea of how the shift from state final demand to GSP narrows the gap between the states, let's look at the most recent figures, for 2010-11 as a whole. The final demand figures show spending growth ranging from 1.4 per cent in SA to 6.5 per cent in WA - a spread of 5.1 percentage points.

But the GSP figures show production growth ranging from 0.2 per cent in Queensland (get that) to 3.5 per cent in WA - a spread of 3.3 percentage points. After WA came Victoria on 2.5 per cent, SA on 2.4 per cent, NSW on 2.2 per cent and Tasmania on 0.8 per cent.

In other words, state final demand provided a quite misleading guide to the states' ranking. Queensland does so well on spending but so badly on production because, though it gains from having a fair bit of mining, it loses from being so dependent on tourism (hard-hit by the high dollar).

In the absence of more up-to-date figures for GSP, the trick is to examine independently estimated direct and indirect measures of state activity. If the mining states really were growing five or six times faster than the other states, you'd expect that to mean they had much lower rates of unemployment and much higher rates of inflation than the others.

It's true WA's trend unemployment rate was a very low 4.1 per cent in February, but the other mainland states were all tightly bunched around the national average rate of 5.2 per cent. As for inflation, over the year to December the mining states had the lowest rates rather than the highest.

If the gap between the mining states and the rest turns out to be narrower than you expected it's because you've been misled by all the talk of a two-speed economy: mining in the fast lane, manufacturing in the slow.

In truth, and as the distinguished economist Max Corden, of the University of Melbourne, reminded us this week, it's actually a three-speed economy, with mining in the fast lane and manufacturing (plus other export and import-competing industries) in the slow lane, but with almost all other industries - the non-tradable sector - in the middle lane.

This matters because the non-tradable sector benefits from the mining boom and the high dollar in two ways: from the increase in national income brought about by the high commodity prices, and from the lower prices of imports brought about by the high dollar.

Guess what? This non-tradable sector accounts for the great majority of production and employment in all states bar WA (where mining accounts for an amazing 33 per cent of GSP).

The people of Victoria see their state as weak on mining (true) and heavily dependent on manufacturing. Not true: manufacturing accounts for 8 or 9 per cent of GSP in all states bar WA (5 per cent). Where Victoria and NSW stick out is in their dependence on the business services sector (particularly financial and insurance services), which accounts for 28 per cent and 30 per cent of GSP, respectively, compared with about 17 per cent in the other states.

It's because business services are mainly in the not-hard-hit non-tradable sector that Victoria and NSW aren't travelling too badly compared with the mining states.

Wednesday, March 14, 2012

Why we should pay more tax

In the early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

Thirty years later, government is no smaller but the attraction of the idea is undiminished.

Its latest champion is Tony Abbott, who promises to eliminate government waste and cut taxes - and return the budget to surplus. Julia Gillard isn't far behind. She'd never admit to being against smaller government, and is insistent on getting the budget back to surplus next financial year and not a day later.

Smaller government is an idea that appeals at every level. It's attractive to libertarians, economists and business people, who remain suspicious of government. And it appeals to every voter who doesn't like paying more tax.

But Ian McAuley, a lecturer in public finance at the University of Canberra, questions our uncritical support for the smaller government ideal in an extended essay published today by the Australian Collaboration, The Australian Economy: Will our prosperity be short-lived?

Contrary to some perceptions, he writes, Australia already has a small public sector and a low level of public debt. "Successive governments have kept taxes and deficits down by keeping expenditures down. As a result Australia has one of the smallest public sectors of all developed countries."

Over the seven years to 2008, taxes paid in Australia to all levels of government averaged 29 per cent of gross domestic product, compared with a developed-country average of 35 per cent. Only Japan and the United States pay less than us - 27 per cent - and that's because they run perpetual budget deficits.

If you judge it by total government spending, rather than total taxation, our spending averages 34 per cent of GDP, compared with the developed-country average of 40 per cent. (In our case, the gap between taxation and spending is covered by non-tax revenue.)

Our aversion to supposed big government includes an obsession with government debt even though, with government net debt no higher than 13 per cent of GDP, Australia's public debt is "way below the level of almost every other developed country".

Economists' and business people's support for smaller government stems from their entrenched belief that big government causes economies to malfunction. One small problem: after decades of searching they can't find evidence to support such a link.

There's no correlation between size of government and rate of economic growth. Some countries with big public sectors do well; some countries with small public sectors do badly.

Many business people - who wrongly imagine countries compete the same way firms do - worry a great deal about their country's "competitiveness". So let's examine the (highly subjective and ever-changing) World Economic Forum's global competitiveness index.

Top of the ranking in 2011 is Switzerland, with the same rate of tax to GDP as us, 29 per cent. We come 20th. The United States, with a tax rate of 27 per cent, comes fifth. But it's pipped by Finland, on fourth, with a tax rate of 44 per cent and Sweden, on third, with a rate of 48 per cent.

Denmark, the country with the highest tax rate - 49 per cent - comes eighth. Germany, with a tax rate of 36 per cent, comes sixth, while the Netherlands, with a tax rate of 38 per cent, comes seventh.

As McAuley concludes, what counts rather than size of government are the uses to which public revenues are put and whether government services are provided efficiently.

Nor is there any necessary connection between the size of a country's government and its discipline in keeping the two sides of its budget within cooee of each other and thus limiting budget deficits and avoiding excessive government debt.

When we observe the bother the Americans and various European countries have got themselves into after decades of deficits, we see the upside of our debt-and-deficit phobia.

But, as McAuley reminds us, that phobia has a downside. What is important economically, he says, is not so much the level of debt as the use to which that debt is put. If governments borrow to fund present consumption, that's unsustainable over any extended period.

"There is no reason, however, to avoid using debt to finance productive infrastructure. Well-chosen infrastructure can provide good returns," he says.

You can divide public spending into spending on public goods (including physical assets such as roads, as well as services such as health care) and "transfer payments" (such as pensions, family allowances and industry subsidies).

McAuley argues we've yielded to pressure for ever-increasing spending on transfer payments, with the share of total federal spending on social security rising from 21 per cent in 1972 to 33 per cent today. This doesn't count the ever-growing amount of revenue forgone in the form of tax concessions for superannuation, private health insurance, capital gains and much else. Many of these benefits go to people who are reasonably well-off.

Combine this with our pre-occupation with limiting overall government spending and taxation and you find we've been crowding out spending on public services. We've gone for years squeezing our spending on education - particularly tertiary education - which is really an investment in the human capital of our future workforce.

We've also neglected investment in physical infrastructure and environmental protection. But these are important investments if we're to have a prosperous economy in a world where success rests on wise use of human and natural resources.

Bottom line: the only path that's both politically feasible and economically responsible - one that sustains transfer payments while spending more on needed public services - is for us to pay higher taxes.