Saturday, June 30, 2012

Poor getting wealthier faster than the rich

There’s not much justice in the world, but there is a bit: according to a researcher at the Reserve Bank, the poor have been getting wealthy faster than the wealthy have been in recent years.

If you find that hard to believe, I don’t blame you. It’s not a conclusion you come to from looking at the Bureau of Statistics’ survey of the distribution of wealth. Rather, it comes from Richard Finlay’s decomposition of the wealth figures included in HILDA - the survey of household, income and labour dynamics in Australia.

But let’s start at the beginning. In Australia, as in all countries, the distribution of disposable income (wages and other earnings, plus welfare benefits, less income tax) between households is quite unequal. And here, as well as in other countries, the distribution of wealth (household assets less liabilities) is even more unequal.

According to the bureau’s figures for 2009-10, the best-off 20 per cent (‘quintile’) of households had 40 per cent of all the income, but 62 per cent of all the wealth. By contrast, the worst-off quintile had 7 per cent of the income, but just 1 per cent of the wealth.

Why the disparity between income and wealth? Partly because some forms of wealth (such as owning your own home) don’t generate explicit flows of income. But also because governments focus most of their efforts on redistributing income rather than wealth between rich and poor, using the tax and transfer (welfare benefits) system.

The poorest 20 per cent of households have some income because the government pays them a pension or the dole to make sure they don’t starve. They have no wealth primarily because they don’t own the home they live in.

So there’s no great mystery to wealth. The main way to acquire it is to buy a home and pay it off. The next most common way is to have a job and be compelled to put 9 per cent of your wage into superannuation saving. Then comes buying a weekender or an investment property.

Most people would have some money in the bank; some people have a lot. About a third of households own shares (directly, not just via super) and some own businesses. It’s mainly these latter that distinguish the really rich.

You’d expect the people with the highest incomes to have to most wealth, but it’s not that simple. People who own their home outright tend to be richer than people with a mortgage and people with a mortgage tend to be richer than people who rent.

As well, older people tend to be richer than younger people because they’ve had longer to save (and benefit from capital gain). Of course, once people retire they inevitably (and sensibly) run down their savings.

Naturally, the value of people’s assets has to be weighed against their liabilities. Few people acquire property without also acquiring debt, and property debt accounts for 80 per cent of all household liabilities. We worry about our credit card debt, but it pales compared with property debt, which divides 70/30 between the principal home and weekenders and investment properties.

It’s much more the rich than the poor who have debts. These days you borrow to make money and, in any case, banks are reluctant to lend to the poor. That’s particularly true of people borrowing for negatively geared property or share investments.

The top income quintile accounts for almost half the total household debt, while the top two quintiles account for more than 70 per cent.

When people see that household debt now accounts for about 150 per cent of annual household disposable income, they think of young couples getting in over their heads to buy their first home. There are some of them, of course, but for the most part the people with the most debt are those with the greatest ability to service it.

Finlay’s article in the Reserve Bank Bulletin says the real (inflation-adjusted) wealth per household was relatively flat from the late 1980s to about 1996. But then it started to increase, driven by the rising prices of property and shares. Over the following decade it grew at the real rate of 6 per cent a year.

But in 2008, ‘with the onset of the global financial crisis, household wealth fell substantially as the prices of dwellings and financial assets fell,’ he says. Wealth recovered somewhat in 2009 and 2010, but since then (and not covered in our figures, which are for 2010) house and share prices have been, as they say in the market, ‘flat to down’.

Over the four years to 2010, mean real wealth per household grew at the rate of just 1 per cent a year. But here’s a trick: whereas the mean (arithmetic average) wealth per household was almost $700,000, the median (middle) wealth was about $400,000.

It’s actually common for the mean to be a lot higher than the median in the case of income or wealth. That’s because a relatively small number of individuals or households are so much better off they push up the mean, thus making the median a better measure of the ‘typical’ household.

Another way to put it is that the distribution of wealth is ‘skewed’ in favour of people at the top. But Finlay finds the degree of skewness seems to have fallen over the past four years.

Using the median rather than the mean to characterise each quintile (which I suspect explains why his findings differ from the bureau’s), he finds that median real wealth in the lowest quintile grew by 5 per cent a year over the period, whereas the medians for the three middle quintiles grew by about 2 per cent a year and for the wealthiest quintile by less than 1 per cent a year.

Why? Partly because of a low-base effect: the less you’ve got to start with, the easier it is to have a larger percentage increase.

But also because richer households tend to hold a higher proportion of their wealth in riskier forms, such as shares. So they would have suffered bigger losses during the financial crisis and maybe smaller gains since then.

Richer households are more likely to have taken on negatively geared property and share investments. The crisis wouldn’t have been kind to them. As well, the very highest house prices tend to be more volatile than other home prices.

There’s just a bit of justice in the world.
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Wednesday, June 27, 2012

Carbon tax is nothing to object to

When psychologists study those sects that predict the end of the world on a certain day, they find the leaders rarely willing to admit they were wrong and their true believers rarely willing to admit they were duped.

Rather, the sect members find some dubious rationalisation. It was our prayers, brothers and sisters, that interceded for this wicked world and persuaded the Good Lord to stay his hand.

Since the day he won the leadership of the opposition on the strength of his willingness to switch from supporting to opposing putting a price on carbon, Tony Abbott has been predicting the carbon tax would wreak devastation on the economy, wrecking industries and destroying jobs.

To be fair, running scare campaigns against new taxes has always been accepted as a legitimate tactic by our ethically challenged political class.

Labor was happy to exploit the fears of the ill-informed in its opportunist opposition to John Howard's ''great big new tax on everything'', the goods and services tax.

The biggest difference is that Abbott's misrepresentations have been so much more successful.

But with the carbon tax taking effect from Sunday, the moment of truth approaches. Soon enough it will become clear that, for consumers and the vast bulk of businesses, the dreaded carbon tax will have an effect much smaller than the GST.

The retail prices of electricity and gas will rise about 9 per cent, but the increases in other prices will be very small.

Whereas the GST increased the consumer price index 2.5 per cent, the carbon tax is expected to raise it just 0.7 per cent.

Whereas the GST is expected to raise revenue of $48 billion in the new financial year, the carbon tax is expected to raise about $4 billion in its first year and about $7 billion in subsequent years.

Julia Gillard and her supporters have been hoping against hope that, as soon as this reality dawns on a fearful public, as soon as the magnitude of the Liberals' hoax is revealed, voters will switch back to Labor in droves.

I don't see it happening. It rests on an unrealistic view of the lack of self-delusion in human nature.

Political parties and their cheerleaders don't like admitting they've been dishonest - even to themselves. And you and I don't like admitting we've allowed ourselves to be conned by unscrupulous politicians and shock jocks.

So we look for rationalisations, no matter how tenuous. And in these the carbon tax abounds. With the GST, the object of the exercise was clear and simple: to raise more revenue. With the carbon tax the object is far from clear to anyone who hasn't done their homework.

For a start, it's clear the object is not to raise revenue, because much of the revenue raised is being returned to households as ''compensation'' in the form of a small cut in income tax for most people and small increases in pensions, allowances and family benefits.

But if the object is simply to discourage people from using emissions-intensive goods and services - which it is - why give back to most people the extra tax they'll be paying?

Because economists believe that to change people's behaviour it's necessary only to change the relative prices they face: to raise the prices of fossil fuels (particularly electricity and gas) relative to all other prices. It's not necessary to leave people out of pocket by keeping the proceeds from the tax you used to bring about the change in relative prices.

You may say you can't see how such a relatively modest rise in the price of electricity could make much difference to households' use of power. That's probably true, though it may encourage people to buy a more energy-efficient model next time they're replacing an appliance.

Actually, the price increase is aimed mainly at big industrial users of energy and, more particularly, the generators of electricity.

If the industrial users can be induced to eliminate wasteful use of power, this will make a difference. And if power companies can be induced to replace their present generators with less emissions-intensive models when the time comes, this will make a big difference. Raising the price of electricity produced by burning fossil fuels helps make the price of power produced from renewable sources more competitive.

But if those objections to the tax don't wash, there are plenty more. One is that the tax of $23 per tonne of carbon dioxide is way too high. I discuss this one in my little video on the website.

Yet another objection is that, since there's nothing an individual country can do to have a significant effect on global emissions of greenhouse gases, in the absence of a binding agreement to act by all the major countries there's no point in us doing anything.

Trouble with that argument is it increases the likelihood of failure. Only if enough countries demonstrate their good faith by getting on with it is effective global action likely to eventuate. We should line up with the good guys, not the bad guys - and we're far from the only good guy.

But if all else fails - if you can't find any other argument to confirm the wisdom of your original conclusion the carbon tax is a terrible thing - just tell yourself that, when the vast majority of scientists specialising in the area warn us continued emissions of greenhouse gases will lead to devastating climate change, they've got it all wrong.
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Monday, June 25, 2012

Punters turn away from share investment

The return of the prudent consumer is being accompanied by the return of the risk-averse consumer. Households aren't only saving more of their incomes, they're saving more through banks and less through shares.

In the days when the public was less economically literate, many people had no conception of saving other than putting money in the "savings accounts" offered by banks. After a season in which we thought that was for mugs, saving through bank accounts is back.

In truth, the main way Australians saved was to take on a huge home mortgage, then pay it off over the next 25 or 30 years. By the time most people retired, most of their savings were embodied in the unencumbered value of their home.

And their outright ownership of their home was a big part of the reason they were able to scrape by happily enough on little but the age pension. Although the value of the pension has been rising in line with real wages for decades, ours is the first generation convinced it couldn't possibly live on the pension alone.

So it's probably just as well that, starting in the mid-1980s, employees have been compelled to save via superannuation. Super is now the chief rival to paying off a home loan as the main way Aussies save over their working lives.

Remember when John Howard was encouraging us to become "a nation of shareholders"? That was at a time when government-owned businesses such as the Commonwealth Bank and Telstra were being privatised and non-profit outfits such as AMP and the NRMA were being "demutualised", so many households acquired tiny shareholdings of this and that.

And, having taken the plunge, many then acquired shares in the more usual way. Well, owning shares directly is no longer fashionable. Of course, working households' indirect ownership of shares via superannuation increases as each pay day passes.

But, as the Reserve Bank observes in an article in last week's quarterly Bulletin, households have shifted their "portfolios" away from riskier financial assets, such as shares, and towards less risky assets, such as deposits. I'll be drawing from that article.

I've no doubt much of households' saving has taken the form of reducing debts and getting ahead on their mortgage repayments. There was a time when Aussies' highest financial goal was to repay the mortgage as early as possible. That goal is coming back into its own with the return of the prudent consumer.

I guess the chief motivation was a desire to be unencumbered but, as a tax-effective investment strategy, repaying the mortgage has always scored highly - exceeded only by negatively geared property or share investments.

Which brings us back to risk - and risk aversion. Between 2003 and 2007, the proportion of household financial assets held in shares (both directly and via super) increased from 35 per cent to 45 per cent.

Much of this increase came from capital gain. Total return on shares averaged about 20 per cent a year over this period, compared with average deposit rates of about 5 per cent. But then came the fall in wealth caused by the global financial crisis and the mild recession of 2008-09.

Between 2008 and 2011, there were net outflows from households' direct holdings of shares of $67 billion, while holdings of deposits rose by $225 billion.

It's likely people were reacting, on the one hand, to the large capital losses in the sharemarket, but also to the market's volatility, which has doubled since 2007.

But, on the other hand, people would have been reacting to the advent of much higher interest rates offered on bank term deposits as, in the aftermath of the global crisis, the banks bid up those rates in their competition to replace now-riskier overseas funding with more stable, "stickier" funding from domestic deposits.

Over the past 30 years, the average annual real return on Australian shares (including capital growth and dividends) has exceeded the average annual real return on deposits by about 5.5 percentage points.

Since 2008, however, that's been reversed, with a return on shares of minus 5 per cent versus 2.5 per cent on deposits.

The share of households' financial assets held directly in equities has more than halved from 18 per cent before the crisis to 8 per cent at the end of last year. In contrast, the share of deposits has increased from 18 per cent to 27 per cent.

That this shift has been driven mainly by households' greater aversion to risk is confirmed by the changed answers people are giving to relevant questions in the survey of consumer sentiment and other reputable surveys.

In theory, households have shifted to a less risky risk/return trade-off and, by doing so, are willing to live with lower returns over the longer term. But whether the "equity premium" - the much higher rate of return on shares relative to fixed-interest securities - will stay as high as it's been in the past is open to doubt.

The equity premium has always looked much healthier over long periods than it has over many shorter periods, meaning people in or approaching retirement shouldn't be too mesmerised by it and should be favouring more stable returns.

So the shift from shares to deposits may well be explained partly by the baby boomers' rapidly approaching retirement.

The big super funds have also shifted their mix away from shares to some extent, though they've done so by less than the self-managed super funds, suggesting they're more wedded to "equity" than they ought to be.

Why might that be? Well, part of the problem is that the dividend imputation system means share returns are more favourably taxed than fixed-interest returns. Not good.
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Saturday, June 23, 2012

Summary of many tax and benefit changes on July 1

The government has taken to announcing changes in taxes and benefits long before they take effect. But that day has to come eventually and a host of changes - big and small, good and bad - are set to start tomorrow week, July 1, the first day of the new financial year.

Actually, all the bad changes start on July 1, but some of the good ones have arrived this month.

Even so, July 1 will be the most significant day for tax changes since July 1, 2000, the start date for the goods and services tax.

Two new taxes are starting, the carbon tax and the mining tax, though combined they raise far less than the GST.

Like the GST, both taxes come as part of packages, meaning much of the proceeds from them are used to cover the cost of cuts in other taxes and increases in pensions and benefits.

But here's a difference: the government is increasing the budget's redistribution of income from higher- to lower-income earners by imposing means tests and by other means.

A means test on the 30 per cent private health insurance rebate will take effect and the 20 per cent net medical expenses tax offset will also be means-tested.

Next are changes to the taxation of superannuation. Super contributions have been taxed at the flat rate of 15 per cent. Now, workers earning up to $37,000 a year will, in effect, pay no contributions tax, whereas those earning more than $300,000 a year will pay 30 per cent.

Older workers had been permitted to make concessional contributions to super, including by salary sacrifice, of up to $50,000 a year, but this will now drop to $25,000.

The minerals resource rent tax will raise only about $3 billion a year and has been designed to have no adverse effects on the economy or retail prices.

Proceeds from the tax will be used to provide two new tax concessions for small business and cover the cost of replacing the tax rebate on parents' spending on school children's education expenses with lump-sum bonuses for each schoolchild. The first bonuses have just been paid.

Mining tax revenue will also cover the cost of a tiny increase in unemployment benefits (from March) and an increase in the family tax benefit Part A, to take effect from July 1 next year.

The carbon tax will fall mainly on the production of electricity and gas. It will add 9 per cent to household electricity and gas bills, but quite small amounts to most other retail prices.

Treasury has estimated that, all told, the tax will add just 0.7 per cent to the consumer price index. Since Treasury was right in predicting the 10 per cent GST would add 2.5 per cent to the index, you can believe it.

However, the total rise in household electricity bills from July 1 will be twice that attributable to the carbon tax.

Whereas the GST will raise $48 billion next financial year, the carbon tax is expected to raise $4 billion in its first year and about $7 billion in later years.

Because it's designed simply to raise the prices of emissions-intensive goods and services relative to other prices, much of its proceeds are being used to compensate people for their higher cost of living.

But, again, the compensation is going only to low- and middle-income earners. Means-tested pensions, allowances and family benefits have already been raised.

And a limited tax cut will take effect from July 1. The tax-free threshold will be raised from $6000 to $18,200 (but with a largely offsetting reduction in the low-income tax offset). About 60 per cent of all taxpayers will get a tax cut worth about $5.80 a week, but no individual earning more than $80,000 a year will receive a cut.

All that higher-income earners get is a separate, backhanded saving: the end of the temporary flood levy.
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We're adding the environment to the national accounts

How do you get economists and business people to take the environment and its relationship with the economy seriously? Change its name to one that resonates with commercial values. What's a word that denotes great value, preciousness to a capitalist? I know - "capital".

You've heard of physical capital (machines, buildings and other structures), financial capital (securities such as shares and bonds), human capital (an educated and skilled workforce) and social capital (the shared values and norms of behaviour that enable mutually advantageous cooperation).

So why don't we rename the environment "natural capital"? It wasn't me who thought of it, however.

It doesn't sound like a lot of progress has been made at the Rio+20 summit on sustainable development. But one thing giving me hope is the "natural capital declaration" made by banks and big businesses, including our National Australia Bank, represented by its chief executive, Cameron Clyne.

"Natural capital," it says, "comprises Earth's natural assets (soil, air, water, flora and fauna) and the ecosystem services resulting from them, which make human life possible. Ecosystem goods and services from natural capital are worth trillions of US dollars per year and constitute food, fibre, water, health, energy, climate security and other essential services for everyone.

"Neither these services, nor the stock of natural capital that provides them, are adequately valued compared to social and financial capital. Despite being fundamental to our wellbeing, their daily use remains almost undetected within our economic system.

"Using natural capital this way is not sustainable. The private sector, governments, all of us, must increasingly understand and account for our use of natural capital and recognise the true cost of economic growth and sustaining human wellbeing today and into the future," the declaration says.

It goes on to say that "because natural capital is a part of the 'global commons' and is treated largely as a 'free good', governments must act to create a framework regulating and incentivising the private sector - including the financial sector - to operate responsibly regarding its sustainable use.

"We therefore call upon governments to develop clear, credible and long-term policy frameworks that support and incentivise organisations - including financial institutions - to value and report on their use of natural capital and thereby working towards internalising environmental costs."

Lovely. Great stuff. Most enlightened. But if you think we're just at the earliest stages of realising we need to measure our impact on the environment and incorporate it into our decision making, I have good news. At the level of national accounting, we're a lot further advanced than you realise.

You often see me banging on about the "national accounts", from which key economic indicators such as gross domestic product emerge. You've also seen me pointing to the limitations of GDP as a measure of wellbeing or progress, particularly its failure to take account of the costs economic activity is imposing on the environment and of the environment's present state of repair.

The "system of national accounts" we use is laid down by the United Nations Statistical Commission for use in all countries. It's an accounting framework that measures economic activity and organises a wide range of economic data into a structured set of accounts. It defines the concepts, classifications and accounting rules needed to do this.

So here's the news: earlier this year the UN Statistical Commission adopted as a new international statistical standard with equal status to the system of national accounts, the "system of environmental-economic accounting" - SEEA.

Our Bureau of Statistics has been at the forefront in the development of SEEA. Last month, it published a document, Completing the Picture: Environmental Accounting in Practice, explaining what SEEA is. I'm drawing on this document.

SEEA is another accounting framework that records as completely as possible the stocks and flows relevant to the analysis of environmental and economic issues. So SEEA is different from the various present independent sets of statistics because it demands coherence and consistency with a core set of definitions and treatments.

Get it? An accounting framework allows you to add a lot of different things together, making sure they fit together logically and there's no double-counting. SEEA puts information about changes in the environment on the same basis as the existing information about changes in the economy, so they can be combined and give us an integrated picture of how the environment and the economy are affecting each other.

Just a small problem, however. The existing national accounts measure economic activity in money terms. To achieve this, they stick almost wholly to measuring transactions in the market, since these reveal market valuations.

But the very reason economists and business people have been taking too little notice of the environment for the past centuries is that, for the most part, it's outside the market system - a "free good". There's not one price for clean air and another for dirty. Photosynthesis, pollination and precipitation are ecosystem services to the economy that aren't paid for, so it's hard to put a figure on what they're worth.

Despite this, SEEA extends the national accounts by recording environmental data that are usually available in physical or quantitative terms in coherence with the economic data in monetary terms. Maybe one day we'll discover a way to value natural capital so we can add it all together.

There are three main types of account in the SEEA framework that are added to the existing monetary flow (the change in something over a period) and stock (the position at a point in time) accounts of the national accounts.

First are physical flow accounts that record flows of natural inputs from the environment to the economy, flows of products within the economy and flows of "residuals" (various forms of waste) generated by the economy. These flows include water and energy used in production and waste flows to the environment, such as solid waste to landfill.

Second are functional accounts for environmental transactions between different economic sectors (such as industries, households, governments). Such transactions include investing in technologies designed to prevent or reduce pollution, restoring the environment after it has been polluted, recycling, conservation and resource management.

Finally, asset accounts in physical and money terms measure the stocks of natural resources available and changes in the amount available. There'd be accounts for minerals and energy, timber, fish, soil, water and land.

The bureau is beavering away to produce more of these accounts. It's making progress in turning SEEA into an Australian reality.
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Wednesday, June 20, 2012

The economy isn't a Sunday school - it often hurts

When I was a kid marbles were the rage. When you played at home with your brothers and sisters, mum made sure that, whoever won, everyone got their marbles back when the game was over. When you played at school, however, the big boys insisted on "playing for keeps", so kids like me went home with a lot fewer marbles.

I also went to Sunday school, which was run by kindly mothers. If you forgot to memorise your verse of scripture, there was no comeback. If you misbehaved there was no punishment, just a look of disappointment on the face of your teacher.

We've been hearing a lot lately about people losing their jobs. Firms in manufacturing, but also other industries, are announcing redundancies. There've been so many they could give you the impression employment is falling. Fortunately, it isn't; the people losing their jobs are being more than made up for by others gaining jobs (including people who lost their jobs earlier).

Sometimes people are laid off because the economy is in recession, but at present it's happening because powerful forces are changing the industrial structure of the economy. Older industries are shrinking while newer ones are expanding.

It must be a terrible thing to lose your job through no fault of your own, even if they do give you a fat cheque as they push you out. It's anxious waiting after an announcement to see if you'll be among those tapped on the shoulder. When "downsizing" was the fashion in the 1980s and '90s, it was said even those who kept their jobs suffered "survivor guilt".

When you're a victim of structural change - or just a feeling person looking on - it's tempting to look for someone to blame. Managers have been altogether too ruthless in protecting the business's bottom line; they took too long to recognise the problem and when they did respond they could have done it far better. The government should have stepped in to protect the industry.

Since managers are as subject to human frailty as ordinary employees (just extraordinarily more highly paid), there's often some truth to these criticisms - especially with the wisdom of hindsight.

If businesses weren't so quick on the trigger in laying off workers in the early stages of a downturn, fewer downturns would turn into full-blown recessions. If they were more imaginative and innovative they'd find less painful solutions to problems (they'd probably also anticipate a lot of problems that didn't materialise).

But when there are major changes in the forces bearing down on an industry, there's no point imagining change could have been resisted, nor any way that all human pain could have been avoided.

The economy isn't run like a Sunday school. In an economy like ours, everyone - bosses, workers, customers - pursues their self-interest. The economic game is played for keeps. So everyone runs a greater or lesser risk of losing their job. Even bosses get the bullet.

All of us act in self-regarding ways that, whether or not we realise it, contribute to someone's job insecurity. And that means a fair bit of uncertainty, anxiety, fear, disappointment, loss of status, self-doubt, frustration, family discord, despair, humiliation, depression, belt-tightening and worse are part of the deal.

Nor is the risk of pain fairly distributed. Some people never lose their job in a long career, some make the transition to a new job relatively easily, some move into retirement earlier than they'd bargained for, some have considerable difficulty finding another job, some never work again.

Perhaps the greatest force driving structural change is advances in technology - people inventing new products, new things to do or new ways of doing old things. The digital revolution is reshaping our economy - destroying jobs here, creating them there - in ways and to an extent we as yet see only dimly.

Does anyone suggest we should halt technological advance because of all the economic disruption it brings - and has brought since the days of the Luddites? Does anyone imagine such an attempt could work?

Another major force driving economic change is globalisation - the lowering of natural and government-made barriers between countries, caused by technological advance and, to a lesser extent, deregulation.

The historic re-emergence of the mighty economies of China and India - and the rapid economic development of the poor countries generally - is shifting jobs around the world.

Most rich countries are benefiting from cheaper imported manufactures (gains to consumers, but job losses in manufacturing), but Aussies are also benefiting from higher prices and quantities for our rural and mineral exports (increased income for the whole nation, but pressure for capital and labour to shift to mining).

Think the poor countries' pursuit of prosperity should be stopped because of the economic disruption it's causing? Think it could be?

For decades we tried to shut out change from the rest of the world by protecting particular industries. These days we use taxpayer subsidies. But jobs in particular industries can be protected only at the expense of jobs in the unprotected industries. Import restrictions and subsidies merely shift the job pressure (which never troubles the people demanding assistance).

When you're in the thick of it, it's easy to imagine structural change leads to ever-rising unemployment. But businesses have been installing new, "labour-saving" technology continuously for two centuries without it leading to mass unemployment.

Structural change doesn't reduce jobs overall, it destroys them in some industries and creates them in others.

Market economies deliver almost continuously rising material prosperity. But they do so by continually changing, and that change comes with a fair bit of pain for many people.
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Monday, June 18, 2012

Present gloom is more political than economic

The release of two downbeat indicators of business and consumer confidence last week serves only to deepen the puzzle over the gap between how we feel and what the objective indicators are saying about the state of the economy.

My theory is we have two-track minds. Many of us are thinking gloomier than we’re acting.

As you recall, the national accounts from the Bureau of Statistics show real gross domestic product growing by a remarkable 1.3 per cent in the March quarter and a rip-roaring 4.3 per cent over the year to March.

The bureau’s latest labour force figures, for May, show employment growing by an average of 25,000 a month over the first five months of this year, with much of the growth in the ‘non-mining’ states.

I never take the initial reading of frequently revised estimates too literally. The governor of the Reserve Bank, Glenn Stevens, has noted the annual growth figure is probably inflated by a catch-up effect following the disruption to economic activity caused by the Queensland floods early last year. He’s willing to say only that the economy’s travelling at about ‘trend’ (3.25 per cent a year).

Now Dr Chris Caton, of BT Financial Group, has advanced his own theory to explain the surprisingly strong 1.3 per cent growth in the March quarter. He notes the inclusion of a leap day in the quarter - so it contained 91 days rather than the usual 90 - may have thrown out the bureau’s seasonal adjustment process.

Some components of GDP would have been adjusted for this ‘trading-day effect’, but many may not have. Sounds far fetched? Caton looked back over the five previous leap years, finding the March quarter growth figure exceeded the average rate of growth for the three preceding and three subsequent quarters in four of those years, with the excess for the five years averaging 0.46 percentage points.

But even if you accept Stevens’s judgement the economy’s growing at about trend - which I do - you’re still left saying it’s doing a lot better than implied by the gloominess of business and consumer confidence as we conventionally measure them.

NAB’s business survey for May showed business conditions (the net balance of respondents regarding last month’s trading, profitability and employment performance as good) fell to their weakest level in three years.

To put this in context, the conditions index is now 5 points below its long-term average since 1989, but nothing like as bad as it got during the global financial crisis of 2008-09, let alone the recession of the early 1990s.

The index of business confidence (how the net balance of respondents expects conditions to change in the next month) is saying something roughly similar. NAB says the survey implies GDP growth will slow to an annualised 2 per cent in the June quarter.

The Westpac-Melbourne Institute index of consumer sentiment rose a fraction in June to 96, down almost 6 per cent on a year earlier. It’s pretty low, though at nothing like the depths to which it sank in 2008-09.

The overall index can be divided into two bits, the current conditions index and the expectations index. In June the conditions index rose by 6 per cent, whereas the expectations index fell by 4 per cent. And whereas the conditions index stands at 104, the expectations index is a 90.

I’m a great believer that the mood of consumers and business people does a lot more to drive the business cycle than it suits most economists to admit (because their theory tells them little about what drives confidence and, in any case, it’s not easy to be sure what you’re measuring).

So it pains me to admit that, at present - and not for the first time - the conventional confidence indicators seem to have been bad predictors of what HAS happened in the economy, and don’t look like reliable predictors of what WILL happen.

I think there’s a gap between how people are feeling and how they’re acting. How consumers and business people feel is a function of their direct experience and what their peers are saying and doing, but also of what the media is telling them about the wider world.

They probably give a lot more weight to the former than the latter. Direct experience tells them things aren’t too bad; interest rates have dropped a long way in the past six months and, despite all the media stories, they’ve seen little in the way of job losses close to them.

On the other hand, the media are bringing them a lot of worrying news about Europe and elsewhere. It seems pretty clear this is having a big effect on how they feel. It’s less clear how much it has affected their behaviour - so far, at least.

I suspect the present mood - as opposed to present behaviour - is also affected by political sentiment. A lot of people have decided - rightly or wrongly - the economy is being badly managed.

The NAB business survey showed 47 per cent of respondents believed the May budget would have a negative effect on their business. This seems a huge overreaction to the one piece of bad news for business in the budget: the cost of a cut in the company tax rate of a mere 1 percentage point was instead being paid into the pockets of business’s customers.

And consider this: when you divide the consumer sentiment index according to federal voting intention you find the index for Labor voters stands at 119, whereas the index for (the far greater number of) Coalition voters is down to 82.

Perhaps the main thing the confidence indicators are telling us is something we already know: the Gillard government is highly unpopular with consumers and business people.
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Saturday, June 16, 2012

How GST has sprung a leak

It's not a good time to be the taxman. The poor chap has fallen on hard times. But if you think that sounds like good news, you haven't thought it through. We don't pay taxes for fun and the government doesn't tear up our money when it receives it. Obviously, it's used to pay for all the services governments provide.

It's now clear how much trouble the Europeans have brought on themselves by ignoring the two sides of their budgets. It's equally clear a big part of the reason we don't share the Europeans' predicament is the acceptance by our governments - federal and state, Labor and Coalition - over many years that their spending and their tax collections must be kept in balance over time.

So if tax collections are falling short of spending, it follows that either spending must be cut or taxes increased. At present, governments are willing to contemplate only spending cuts, and are working on the theory there's enough inefficiency in the public sector to reduce costs without significantly reducing the services it delivers.

But you can push that relatively politically painless idea only so far. And the problems with tax collections are so deep-seated eventually they - and we - will have to face the terrifying prospect of higher taxes.

The federal government has structural problems with income tax, capital gains tax and company tax, but the tax with the biggest problems is the goods and services tax, as was well explained this week in the NSW government's budget papers, which I'll draw on.

When John Howard introduced the GST in July 2000, he neutralised opposition from the premiers by promising them all the proceeds from the tax in place of the feds' former general revenue grants. So GST is a federally controlled and collected tax that benefits only the states.

It's divided between them according to the principle of "horizontal fiscal equalisation", which aims to ensure each state and territory has the fiscal capacity to provide the national average standard of services and infrastructure.

This means the GST proceeds are divided in a way that ensures those states with greater capacity to raise revenue subsidise those with lesser revenue-raising capacity.

For decades this meant taxpayers in Victoria and NSW subsidised taxpayers in all other states. Since 2008-09, however, the resources boom has left the governments of Queensland and, particularly, Western Australia so flush with mining royalties they too have become subsidisers of the remaining states and territories. So, of late, NSW and Victoria haven't had to subsidise the others nearly as much.

When Howard first handed the proceeds of GST to the states, it seemed clear he'd given them the fabulous "growth tax" they'd long dreamt of. Up to 2007-08, collections grew at an average rate of more than 8 per cent a year - faster than the economy (nominal gross domestic product) was growing.

But every time the federal Treasury peers into the future it revises down its projections for growth in GST receipts. It's now expecting growth over the period from 2008-09 to 2015-16 to be just 4.5 per cent a year.

So what's the problem? Well, there are a couple. The first is that, during the 30 years in which Australian households were progressively lowering their rate of saving, their consumer spending on goods and services was (as a matter of simple arithmetic - the formula is: consumption plus saving equals income) growing faster than household disposable income.

But from about mid-2003 households began increasing their rate of saving, and after the global financial crisis in late 2008 they really got down to it. Obviously, while the rate of saving is increasing consumer spending will be growing more slowly than income.

So it's clear the GST captured only the final few years of the outsized growth in consumer spending. In its first year, 2000-01, consumer spending accounted for 59 per cent of nominal GDP. By 2007-08 it had fallen to 56 per cent and by 2010-11, 54 per cent.

But for the past 18 months the net household saving rate has been roughly steady at about 9.5 per cent of household disposable income, meaning consumer spending has been growing at much the same rate as household income. If the household saving rate has stabilised, consumer spending will continue falling as a proportion of GDP only if household disposable income grows at a slower rate than GDP, which doesn't seem likely.

But that's just the first reason the joy has come out of GST as a great little revenue raiser (of an expected $48 billion in the coming financial year, or 3.2 per cent of GDP).

Although we tend to think of GST as a tax on the purchase of all goods and services, in fact a significant slice of the value of our purchases (initially, about 36 per cent) is exempt from the tax. Our spending on rent, health and education were excluded because taxing them accurately was judged too hard. Then spending on food was excluded as part of the deal needed to get the tax passed by the Senate.

Fine. What's happened since then is, although the volume (quantity) of our purchases of these exempt items has grown pretty much in line with the volume of taxable items, the prices of the exempt items have consistently grown faster than prices of the taxable items.

So much so that over the tax's first 11 years, the value (price times volume) of taxable consumption relative to total private consumption has fallen about 4 percentage points.

Since health and education are "superior goods" (we spend an increasing proportion of our income on them as our incomes rise), and costs in both areas grow significantly faster than other consumer prices, we can expect this erosion of the GST tax base to keep rolling on.

At first blush, the feds can dismiss this as the premiers' problem. But the states are so dependent on GST revenue (in NSW's case, to the tune of a quarter of total revenue) and are so restricted by the constitution in what they may tax that, in the end, it's a problem for Canberra.

And since we know from successive intergenerational reports that most of the pressure on federal and state budgets over the next 40 years will come from health spending, the lasting solution is staring us in the face: the GST's tax base must be broadened at least to include private spending on education and health.
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Wednesday, June 13, 2012

Much change is structural, not cyclical

One of the first lessons economists teach us is that the economy moves in cycles of boom and bust. A second, trickier lesson is that although most of the changes going on in the economy at any moment are "cyclical" (temporary), there may also be changes driven by "structural" (longer-lasting) forces.

In a speech last week, Glenn Stevens, the governor of the Reserve Bank, implied that much of the "unrelentingly gloomy" public discussion about the economy may be caused by people mistaking structural problems for cyclical ones.

Despite the official statistics saying the economy's quite healthy, people think it's weak and want the economy's managers to get it moving by such standard remedies as a tax cut or a cut in interest rates.

But if the problem is structural - if it arises from deep-seated changes in the economic environment - such remedies will make little difference. Structural change is rarely painless - it often involves people losing their jobs and businesses failing - but it's almost always better to adapt to the way the world now works than try to resist it.

The boom in export prices and the construction of new mines arises from the historic re-emergence of the Chinese and Indian economies and is a classic example of structural change. The accompanying high dollar is helping to bring about a long-term shift of workers and capital into mining and away from manufacturing, tourism and overseas education.

But Stevens argues the resources boom is getting blamed for the problems of industries whose tough times are the product of a quite different source of structural adjustment: the markedly changed behaviour of Australian households. Consider his figuring.

In the mid-1970s, households began reducing the proportion of their disposable incomes they saved, meaning their spending was able to grow faster than their incomes. But this went into overdrive between 1995 and 2005.

Over that decade, households cut their rate of saving by a cumulative 5 percentage points. In consequence, their consumer spending grew at an average annual rate of 2.8 per cent per person, after allowing for inflation, even though their disposable incomes grew at a real annual rate of just 2.3 per cent per person.

Why did so many of us feel we no longer needed to save much of our income for use later on? Largely, it seems, because we saw ourselves getting wealthier as each year passed. The gross value of assets held by households - mainly the value of our homes - more than doubled between 1995 and 2007. That involved a real annual increase of more than 6 per cent per person.

Only a small part of this increase came from the building of additional homes. Most of it was just the rise in the prices of existing homes.

So why did housing prices rise so dramatically? Mainly because we went through a decade-long frenzy of competing with each other to move to better homes, which bid up prices.

In the process, of course, households took on a lot more debt, including for investment properties. Total household debt rose from 70 per cent of total annual household income in 1995 to about 150 per cent in 2007. This unprecedented "gearing up" by households was made possible by the deregulation of the banks and the return to low inflation and, hence, low mortgage interest rates.

All this borrowing couldn't have gone on forever, and households began to call a halt a year or two before the global financial crisis reached its peak in late 2008, after which they really began saving a lot more and trying to get on top of their debts.

While households were increasing their rate of saving, their consumer spending grew more slowly than their incomes. But their saving rate has been relatively stable - at a rate last seen in the 1980s - for about 18 months, meaning consumer spending has returned to growing at the same rate as incomes.

As part of our households' return to their former prudence, the rate at which homes change hands has fallen by a third from its average over the previous decade. And now the demand for housing has slackened, house prices have fallen back a bit. They won't keep falling forever, but nor are we ever likely to see them shooting up the way they used to.

The return of the prudent consumer is causing adjustment pains for various industries: the banks aren't doing as much business (I know your heart bleeds), nor are the real estate agents. State governments are getting a lot less revenue from conveyancing duty.

Last but not least are the retailers. The halcyon days of rapid growth in consumer spending are gone for good and they'll just have to get used to it. Those retailers selling the sorts of things people buy when they move into a new home are finding life a lot tougher.

But the end of the "platinum age" is just one source of structural change facing retailers. Another source is that retailers sell goods, but as each year passes, more of the consumer dollar goes on services and less on goods.

Yet another is the digital revolution. While shopping in one store, people are using their smartphones to check the prices being offered in rival stores, then demand they be matched. And the internet is giving people access to the cheaper prices charged by retailers in other countries.

None of these various structural changes are the fault of the government and there's little the managers of the economy can or should do to halt or even alleviate them. Business has little sensible choice but to adjust. In any case, most are for the better.
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Monday, June 11, 2012

THE ECONOMY AND THE POLICY MIX

June 2012

If you’re not quite sure what’s happening in the economy at present, don’t feel bad. Some people are saying the economy’s in bad shape; others are saying it’s doing pretty well. The reason for the confusion is that the economy’s being hit by three different factors, at present: one expansionary, one contractionary and one that sounds worse than it actually is - so far, at least. These conflicting factors are affecting different industries differently and different states differently. This is because they’re bringing about a change in the structure of our economy, and structural change is often painful. The three factors are: first, the resources boom; second, the high exchange rate the resources boom has brought about and, third, the problems in the developed economies of the North Atlantic, particularly the Europeans’ debt crisis and worries about the survival of the euro. Let’s start with the troubles in the North Atlantic, then move to the boom then on to the high exchange rate.

Problems in America and Europe

The mighty US economy is recovering only very slowly from the Great Recession of 2008-09. But the problems are much more severe in continental Europe, as well as Britain. Europe’s basic problem of excessive levels of public debt is greatly complicated by the now-exposed structural weaknesses in the euro currency union. Most governments have resorted to the policy of ‘austerity’ - attempting to reduce budget deficits by slashing government spending and raising taxes at a time when their economic recoveries were still very weak. Unsurprisingly, this policy has proved counter-productive and has pushed various economies back into recession.

The media have given great publicity to Europe’s troubles and its tribulations have caused weakness in global sharemarkets, including ours. But the real question is the extent to which Europe’s problems affect our economy. They could do so via three main channels. First, the financial channel: they could cause certain global lending markets to seize up for a time, or increase the risk premiums paid by Australian banks or businesses borrowing in those markets. Second, the confidence channel: media reports of problems in Europe could damage the confidence of Australian consumers and business people. Third, the trade channel: weak growth or contraction in Europe could reduce our exports.

So what damage have we suffered so far? Europe’s tribulations have added a little to our banks’ costs of borrowing overseas. They do seem to have added to the uncertainty of our business people, helping to explain the weakness of non-mining business investment spending. But it’s hard to be sure Europe has had much effect on consumers because the household saving rate has been steady for more than a year and consumer spending has been growing at its trend rate. Europe accounts for less than 10 pc of our exports, so its weakness has had little direct effect on our export income.

However, Europe is a significant customer of our biggest export customer, China. So any adverse effect from Europe’s weakness could come to us via China - unless China were to offset the fall in its export income from Europe by stimulating its domestic demand, as it seems willing and able to do.

Bottom line: Europe’s problems have had some negative effect on us, but so far, not much. This could change, however, if the euro arrangement collapsed. Were something really bad to happen in Europe, the RBA would react quickly with big cuts in the official interest rate.

Resources boom

The big expansionary shock to the economy is coming from the resources boom, the biggest we have experienced since the gold rush. The rapid industrialisation of China and India has pushed prices for our exports of coal and iron ore to extraordinary heights, with our terms of trade only now starting to fall from their best level in 200 years. The improvement in the terms of trade represents a significant increase in the nation’s real income which, when spent, adds to demand. The boom has also added to demand by sparking a huge surge of investment spending on the construction of new mines and liquid-gas facilities. The emerging economies’ demand for the main components of steel is likely to stay strong for a decade or two. So, though the price of our exports of coal and iron ore is likely to fall back to less extreme levels, the volume of our exports is likely to continue growing for many years.

High exchange rate

The big contractionary shock to the economy is coming from the still very high exchange rate caused by the resources boom. An improvement in our terms of trade almost always leads to a rise in our exchange rate. Our dollar is likely to stay unusually high for some years, even as commodity prices fall back, because of the significant net inflow of foreign capital needed to finance the expansion of our mining sector. The high exchange rate helps to prevent the resources boom from leading to inflation by, first, directly reducing the price of imports and, second, reducing the international price competitiveness of our export and import-competing industries, thus reducing their production and so working in the direction of diminishing demand.

Structural change

The public is used to thinking about the economy in cyclical terms: it’s either booming or turning down. At present, however, because these two big shocks to the economy - the resources boom and the high dollar - are working on opposite directions, the economy is neither booming nor busting. It’s easier to understand what’s going on in the economy if you think of it in structural terms: the interplay of the two conflicting forces bearing on the economy is causing some industries to expand while others contract. The mining industry and mining-related parts of the construction industry and the manufacturing industry - accounting in total for up to 20 per cent of GDP - is expanding rapidly, whereas most of the other trade-exposed industries (manufacturing and service export industries such as tourism and education) are likely to get relatively smaller. The other industry that’s suffering from structural change is retailing. The pressures it’s facing have little to do with the high dollar, however. It’s being affected by the digital revolution and the rise of e-commerce.

Outlook for the economy

Over the year to March, the economy grew by an exceptional 4.3 pc, lead by strong consumer spending and the boom in mining investment. But now the economic managers are expecting growth to return to its trend rate of 3.25 pc for the coming financial year, 2012-13, as a whole. But this is expected to involve quite disparate growth in the components of GDP: another very big increase in mining investment spending and trend growth in consumer spending, but no growth in new home building and a small contraction in public sector spending as federal and state governments seek to return to operating surplus.

And note that the other economic indicators are looking pretty good at present. The latest figures say underlying inflation is running at 2.2 pc - almost down to the bottom of the RBA’s 2 to 3 pc inflation target. The latest figures say unemployment is running at about 5 pc - which economists say is down very close to our NAIRU - the non-accelerating-inflation rate of unemployment, which is the lowest point to which unemployment can fall before labour shortages start causing wage and price inflation. That is, unemployment is very close to its lowest sustainable rate.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

Aware the unemployment rate was only a little above the NAIRU and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as the RBA had forecast. Instead, the outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by 0.5 points in June by a further 0.25 points, taking the cash rate down to 3.5 pc, more than offsetting the banks’ efforts to preserve their profit margins, and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.

The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.

In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.

Conclusion

Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.
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